UNITED STATES OF AMERICA

\+ + + + +

PRESIDENT'S ADVISORY PANEL ON

FEDERAL TAX REFORM

\+ + + + +

ELEVENTH MEETING

\+ + + + +

TUESDAY,

OCTOBER 11, 2005

\+ + + + +

The Panel met in the Grand Ballroom of the Renaissance Hotel, 999 9th
Street, N.W., Washington, D.C., at 10:00 a.m., Connie Mack, Chairman,
presiding.

PRESENT:

THE HONORABLE CONNIE MACK, Chairman

THE HONORABLE JOHN BREAUX, Vice Chairman

THE HONORABLE WILLIAM E. FRENZEL, Panel Member

ELIZABETH GARRETT, Panel Member (via telephone)

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:

JEFFREY KUPFER, Executive Director

JON ACKERMAN, Senior Counsel

ROSANNE ALTSHULER, Senior Economist

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

(10:13 a.m.)

CHAIRMAN MACK: Well, welcome everyone. This is our eleventh meeting of
the President's Advisory Panel on Federal Tax Reform. We're nearing the
end of our work, as the deadline for our report is a little over three
weeks away. We will have another meeting a week from today on October
18th, and we plan to present our recommendations to the Secretary by
November 1st. Before discussing today's agenda, I want to make a
personal comment and for all of us on the Panel express our sympathies
to those who have been affected by Hurricanes Katrina and Rita, as well
as those who have been affected by the most recent earthquake in South
Asia. Hurricane Katrina was the reason for our delay, as the Government
and many private citizens focused on coping with the disaster. As many
of you know, we held one of our panel meetings in New Orleans, which is
one of our very special cities. My colleague, John Breaux, a former
Senator from Louisiana, has been affected by these events. And I think,
John, at this point, again, I just want to express to you, and you and I
have had the opportunity to chat a number of times during this last
month that you, your family, the people of New Orleans and the Gulf
Coast have certainly been in our thoughts and prayers. If there's
anything you want to say.

VICE CHAIRMAN BREAUX: Just real quick, Connie, thank you very much for
that expression. I've talked to many of the members of the Panel and, of
course, it is \-- it truly is a national disaster and I've been very
impressed with the support that I think the Gulf Coast area of Louisiana
and Mississippi and Alabama have received from throughout the country.
It's been really an outpouring of assistance, and help, and support, and
certainly changed the climate from the standpoint of the cost and the
burdens that are going to have to be borne in trying to find a way to
try and get an entire area back on its feet. I think I mentioned that in
Hurricane Andrew I think we had lost in Florida about 30,000 odd houses,
and the Gulf Coast is over 300,000 houses, about 350,000; so, the
magnitude of it is just absolutely incredible. But life goes on and
cities can be rebuilt and, you know, we will work very hard in that
regard to do that, so thanks very much for your encouragement.

CHAIRMAN MACK: Thank you. Today's meeting will build on our last meeting
which took place in July. At that time we conducted what we referred to
as a policy experiment. We had Treasury craft a comprehensive income
tax, as well as a comprehensive consumption tax modeled on the flat-tax.
For both of these tax systems, we started with a tax base free of almost
all \-- every deduction credit and exemption that litters our current
code. We saw what the rates and distribution would be with these clean
tax bases, and then we saw what the rates would be after adding back the
top tax rate. And just to \-- those numbers caught my attention; I just
\-- again, with using that clean base, the lowest tax rate falls from 10
to 6.6. The 25 bracket declines to 17; the top bracket drops from 35 to
23, and you get a sense of the significance of these various deductions
and exemptions. We also discovered \-- discussed a number of the issues
associated with a clean tax base, such as the lack of a work credit,
like the Earned Income Tax Credit, and the lack of savings incentives in
a comprehensive income tax. We also covered a number of issues on the
business side; however, there were a few issues that we did not discuss
at that meeting, and the Panel would like to cover them today.
Specifically, we're going to talk about three major tax expenditures in
our current code. They are housing, charity, and healthcare. Housing and
charity are specifically mentioned in our Executive Order, which
directed the Panel to recognize "the importance of home ownership and
charitable giving in American society". And provisions relating to
healthcare are the single largest set of tax preferences in the code
affecting almost all Americans. We're going to have different panel
members introduce each topic and then we will have an open discussion.
Tim Muris will start us off on healthcare; followed by Charles Rossotti
on charity; and Jim Poterba will finish with housing. And for reasons of
panel member availability, we will book-end the discussion of the tax
preferences with reports from a couple of working groups. We will begin
with Bill Frenzel. Bill is part of the working group that has been
studying a partial replacement value-added tax (VAT). On behalf of that
group, Bill will identify a number of important issues that arise with
proposals to adopt a VAT to replace a portion of the revenues from the
income tax. And after discussing the tax preferences, then we will turn
to Ed Lazear; Ed is part of the group that has been looking at a full
replacement national retail sales tax or value-added tax. And on behalf
of that group, he will present issues for the full Panel to discuss. So
I think we do have a full agenda this morning and I think it's going to
be an interesting discussion. And so with that, I think Bill we're going
to turn to you to get us started.

MR. FRENZEL: Thank you, Mr. Chairman. As you've noted, our agenda today
is an interesting one and is going to take as much time as we're willing
to give to it.

CHAIRMAN MACK: Can I interrupt you just a minute \--

MR. FRENZEL: Please do.

CHAIRMAN MACK: \-- and try to see if Beth \-- Beth, can you hear us now?

VICE CHAIRMAN BREAUX: Do it again.

CHAIRMAN MACK: I understand she can hear us but she can't respond.

VICE CHAIRMAN BREAUX: We can't hear her. Beth, can we hear you?

CHAIRMAN MACK: Okay. All right. Sorry with that, go ahead.

MR. FRENZEL: Thank you, Mr. Chairman. I was just going to note that
because of our heavy agenda that we're only going to want to take so
long on each section and I'll look to the Chairman for guidance as to
when we might think we'd be done, because we can discuss all of these
things forever if we want. Economists have long agreed that VAT, or
goods and services tax, is a highly efficient and administrable tax, and
over the last 50 years, 130 countries have adopted it, including all of
the developed world. And so it's natural that we should have taken a
look at it. We had our choice of some different ways of proceeding. One,
we could have used a replacement for the total corporate income tax, but
that would have been only half of our job. We could have used it as a
replacement, as some economists have suggested, for Social Security
taxes; that seemed to be a little bit beyond our scope when we began the
program. And so the kind of goods and services tax, or VAT, that we
looked at is one that would reduce the personal income tax, reduce the
corporate income tax, and install a VAT, a pretty strong VAT. It is
often called the 15/15/15 suggestion because the thought is that the
income tax could be lowered to a 15 percent maximum, that the corporate
tax could be a 15 percent maximum, and that the VAT would be a 15
percent collection. Now, we at this point do not know yet whether those
figures can be achieved, but just take them as sort of a general target,
or perhaps possibilities. Now, we determined early on that we should
have the broadest base possible for the VAT that we were going to work
on, that the VAT would have a single uniform rate, that it would be high
enough to make a significant replacement of the corporate and personal
income tax rates, and that it would be border adjustable. There are some
other qualifications for the tax that you may want to mention, or other
members may want to mention, but I'm not going to go into them now. That
is that there are a few exemptions and there a few so-called zero-rated
pieces, and there are some exceptions to our perfectly flawless and
broadly general VAT. Now, some of the things that we discussed that I
think this group would want to discuss and I'd like to begin the \--
this isn't a presentation, it's a discussion among all of us and just
let me list a few of the things I think we ought to talk about this
morning. And one is the frequent complaint about a VAT that it is a
great money machine that will \-- can be raised at will without taxpayer
complaint, and will in fact not only over-tax the economy but also
create an unwarranted enlargement of government. And another question
that I think is worthy of discussion this morning is the transparency,
although it's really not transparency as it is, I guess, the visibility
or the understanding by the taxpayer of what is happening to him and her
in the collection of this tax. Then I think we ought to discuss the
administration and compliance costs of the system, remembering that
there are some advantages and some disadvantages, because while we are
taking a system that seems more simple we are also laying the system
over one that already exists and so we're really talking about two
systems. Another point that needs to be discussed is the coordination of
state sales taxes with the VAT. And here we might remember what happened
in Canada when all of the providences decided they were not going to
adopt the federal model and so you have nine sales taxes up there and
one VAT. Now, another point that needs to be discussed, and it's a big
point, and that is the benefits of introducing a goods and services tax
to the U.S. system, the economic and efficiency gains, et cetera, and
going down in fact to the border adjustability. So, I would like to
begin with the question of, is the VAT a dangerous tax and would it
simply be too easy to increase, and provide too much money, and provide
for the unnecessary enlargement of government. And I wonder if anybody
either on that sub-panel or otherwise would like to discuss this matter.

CHAIRMAN MACK: Do I have any opening comments, well just in order to get
the discussion going. I mean the issue of transparency or you want to
focus on the money machine aspect \--

MR. FRENZEL: Well, I thought we'd talk about \-- I think the most
popularly perceived weakness of the system is that it would run away
with it. And I recall that in 1986 in the Congress that point being
raised very vigorously in connection with tax reform. It was a great
fear on the part of at least the members at that time.

CHAIRMAN MACK: Now, there have been, as I recall, there have been
several \-- maybe just two, two studies that had been done. One by the
International Monetary Fund (IMF), I think \--

MR. FRENZEL: That's correct.

CHAIRMAN MACK: \-- addressing this issue. I mean, I guess to put it in
my terms, basically, is you put a VAT in place it's just a matter of
time before the rate goes from whatever it would be introduced to, to
the next, to the next, the next. And people used to point to the
experiences of the European countries as an example, but the data that
I've seen indicates that that's not quite accurate.

MR. FRENZEL: That's, as we looked at the data, that's what we found,
that that isn't the way it works. But of course we're doing it
differently. The European countries are probably not a very good model
because they used it usually to replace some kind of a sales tax or a
similar consumption tax. And \-- but you're right, the record has shown
they have not been huge increases; there have been a country or two that
does, so at least in the European example, the IMF papers indicate that
there isn't a huge increase \--

CHAIRMAN MACK: Tim \--

MR. FRENZEL: \-- in that batch. Tim?

CHAIRMAN MACK: \-- I was wondering when I could get you into this
discussion.

MR. MURIS: Yes, well I have a different view of that evidence and it's
based on the work of Gary Becker who won the Nobel Prize several years
ago. The argument is the same argument many people make for a partial
VAT \-- system with a VAT, and those who oppose it. We heard testimony
that was we have a looming fiscal crisis because of the retirement of
the baby boom and that therefore because this is an efficient tax that
it should be part of the solution. But I am willing to accept the idea
that we obviously have to deal with the baby boom retirement issues.
Herb \-- the late Herb Stein once famously said that anything
unsustainable won't be sustained, but I think that a VAT, partial VAT,
would bias the resolution toward higher taxes than would occur
otherwise. The European evidence, I believe, if you look at Professor
Becker's article, which was the most elaborate version, was published in
the Journal on Economics in 2003; his argument is that more efficient
taxes, in the sense of imposing less of a burden will be raised more,
and by passing those efficient taxes you'll collect more taxes, all else
equal. If you collect more taxes you're going to spend more. So if you
look at the mix, I think the IMF evidence is too simple. If you look at
the mix, I think what he \-- what Professor Becker has shown is if you
have a tax system with a part of it that's a VAT that you will have
higher taxes overall. Some other evidence, I think, that supports that
argument, if you look at the one flat tax that we have at the federal
level in many ways is the payroll tax. And the payroll tax, as I recall,
has been increased a lot, but it hasn't been decreased. The income tax,
on the other hand, has gone up and down. And property taxes which are a
visible and inefficient tax, in many ways, are taxes that have seen
taxpayer revolts. All that evidence is consistent with the idea that the
VAT, that this idea of a partial VAT will lead to overall higher taxes
and therefore overall higher spending. John?

MR. FRENZEL: Any other \--

VICE CHAIRMAN BREAUX: Well, just two \-- well, just two comments. Number
one, with regard to more revenues, I mean, you know, it's important to
note that we'd be looking at a 300 to 400 billion dollar deficit and a
long term debt in the trillions. And with the explosion of the baby
boomers, obviously the demand on entitlement programs, particularly in
healthcare, are going to be overwhelming. Now, you know, how do we, how
do we account for all of that? And, you know, those that have looked at
a VAT combination hybrid with an income tax, you know, a lot of the
industrialized countries seem to be doing very well with that type of a
combination. But I go back to the purpose for which this Commission was
created \-- Panel, and it's for simplification. And can you address
maybe, Bill, or anybody else perhaps the additional complexity, if any,
if we do a hybrid income tax plus a value-added tax, plus trying to
integrate that with the state municipalities and locals is are we not
moving in an area that is not simplifying the system, but perhaps
complicating it even more. So I ask \-- it's almost two points I'm
trying to make. One is the need for additional revenues, you know, which
I don't know how we're going to meet these obligations if we don't try
to do that and only look at the cut-side of the equation; I think you
have to look at both. But then the second thing is of course the
simplification. Do we meet our charge in simplifying the code if created
a hybrid system with a VAT and continue the existing income tax.

MR. FRENZEL: It's a \--

CHAIRMAN MACK: Bill, before you respond to that, let me \-- Jim, did you
want to address the other question of the money machine thing \--

MR. POTERBA: Yes, let me jump \--

CHAIRMAN MACK: \-- and then we'll get back \--

MR. POTERBA: Yes, I mean I think on the money machine discussion I would
just offer two thoughts. One is to remind us, I think it was Michael
Graetz who was testifying at one point, who suggested that for precisely
these money machine concerns that one, if one thought about a VAT, it
would be dangerous to think about a small VAT, but to bring in a VAT at
a somewhat higher level where there might be more pressure to keep it at
whatever the level was would be a more attractive way to go. And I think
that this, this concern about raising the rate probably does apply with
greater force if one has a small VAT, than if one has a substantial VAT,
which is taking other taxes either off the table or offering a
substantial amount of revenue replacement. The second thing is, I think
that Tim's, you know, Tim's eloquent discussion of the, the sort of
political economy issues raised by efficient versus inefficient taxes
reminds us that nothing is simple in this business. I think we want to
be careful though not to go to the extreme of thinking our mission
should be to find inefficient taxes because they will constrain the size
of government. The flipside of an inefficient tax is that it's one which
will hinder economic growth. And what we'll hear is substantially as I
think we discuss various options over the next couple of weeks will be a
search for finding taxes that will, will in fact raise revenue in a more
efficient way to try and encourage growth and the expansion of the
economy. That's all, in some sense, conditioning on the size of the
government sector and I think what this discussion is very difficult
because it says you can't really think of the tax system as independent
of the size of the government you get.

CHAIRMAN MACK: Okay, again, I think Beth \--

VICE CHAIRMAN BREAUX: Sure, sure, sure.

CHAIRMAN MACK: \-- Beth, are you there?

MS. GARRETT: Yes, hi, can you hear me?

CHAIRMAN MACK: We can hear you; we all applaud.

MS. GARRETT: Yes, I just wanted to sort of echo some of Jim's remarks. I
think that when you look at the size of government and the growth of
government over the past few years the reasons for that are many, and
you certainly can't only look at a kind of tax that the European
countries have had as the causal factor in that growth of government.
Our government has also grown and we have not relied on a VAT. And I
also just wanted to underscore what he said with respect to the choice
between efficient and inefficient taxes. I think it's a peculiar
argument to make to privilege inefficient taxes because we distrust our
politicians, as opposed to relying on efficient and stable sources of
revenue to fund what government has to be doing. Remember that one of
our main principles is that the tax system ought to raise the revenue
that we need to fund government programs, and I think the evidence is
that a hybrid system that includes a VAT and an income tax would be a
more stable and effective system. Part of the political economy argument
is based on the invisibility of the taxes as well. We haven't gotten to
that, but it's not a necessary feature that the VAT be invisible. It can
be reflected on each of the sales receipts that a tax payer receives.

CHAIRMAN MACK: Very good. Tim, did you \--

MR. MURIS: Yes, just a couple of comments in response. I mean I agree
with what Jim says about the complexities of the world and that's one of
the reasons we need to be concerned about the interplay of the size of
government and the tax system. Second, in terms of distrust the
politicians, I think that's always the wiser course.

VICE CHAIRMAN BREAUX: No offense taken.

MR. MURIS: Well, I've been a fellow traveler so I'm including myself \--

VICE CHAIRMAN BREAUX: They're not as bad as bureaucrats.

MR. MURIS: Right, right. I've been a bureaucrat more than a politician
so. Third, in response to Senator Breaux's point, I'm one of those who
agrees we have to deal with the fiscal problems that the baby boom
retirement will cause, and in our political system it wouldn't surprise
me, I would obviously want to do as much as possible on the spending
side, but it wouldn't surprise me if the ultimate mix requires some
compromise that involves both, but my problem is biasing the resolution
of that problem, which I do agree we will have to deal with.

CHAIRMAN MACK: Ed?

PROFESSOR LAZEAR: In addition to the complexity issues that Senator
Breaux raised and Congressman Frenzel raised with respect to having two
systems, there's an additional problem of having two systems. And that
is the requirement that they be integrated. And what I mean by
integrated is that what we'd essentially be doing is relying on Congress
to take into account what they're doing with one hand and offset it with
the other hand. And my concern on that is that they haven't done that
effectively in the past. So, for example, if we look at payroll tax
revenues and we ask what happens when payroll tax revenues go up
unexpectedly because the economy happens to be good and we collect a lot
of payroll taxes as a result? You might say, well, you know, Congress
should simply offset that by lowering income taxes appropriately, and in
fact the evidence suggests just the opposite, that what seems to happen
is that Congress seems to take the payroll tax and spend every
additional dollar that it has collected. So I would have exactly the
same concern with respect to having a VAT tax run parallel to an income
tax system. The problem is not that conceptually it can't be done, but I
think as a practical matter it's very difficult to integrate the two
systems, in addition to adding the complexity.

VICE CHAIRMAN BREAUX: Is that what happened in Canada? That you're
referring to?

MR. FRENZEL: I do not know, John. That was a different problem, that of
integrating the states with the federal. And people who have talked
about this, you know, suggest they may or they may not. And I don't
think we know. At least we know in Canada they did not, which caused
them a little extra fuss and a little extra complication.

CHAIRMAN MACK: I might just make one comment and then I'll think maybe
we'll move on to the issue that John raised. But, we also had a
presentation, as I recall, when we were in San Francisco, a gentleman
from the OECD showing a graph, if you will, of all the countries that
have a VAT, or maybe all members I think including the United States.
The United States, as I recall, was the only country that did not have a
VAT. And the chart was showing the percentage, the growth in the
percentage of GDP consumed by government for these individual countries.
And the only country over this period of 20 years that did not have a
growth of government as a percentage of GDP was the United States. And
one could conclude, certainly arguably, that the reason for that is
because there was no VAT. But that stuck out to me when I heard that or
saw that. So you've raised the issue. If our \-- in essence if our task
is simplicity \--

VICE CHAIRMAN BREAUX: Yes, it's a problem.

CHAIRMAN MACK: \-- and we were to add a VAT to the system, not replacing
anything else, have we really \-- would we be doing the right thing? Any
\-- Charles?

MR. ROSSOTTI: Can I comment? I think that the answer is we wouldn't. I
think we would raise \-- we would not be simplifying. I mean it's just
common sense that if you've got two major taxes, the corporate income
tax and an individual tax, leaving aside the payroll tax, both of which
are, you know, the interaction between those is relatively complicated,
certainly the testimony that we've got through reports of this Panel is
that the federal income tax system has become immensely complicated. If
you were to then add a VAT system on it, granted it's viewed as a
relatively efficient tax, but we've got plenty of testimony about the
complexity of administering a VAT, including the fact that there's ample
room for fraud and non-compliance. The U.K., which probably does the
best job of anybody that I know of, you know, has somewhere around a 13
or 15 percent non-compliance rate. And they put a lot more resources
into administering taxes than we do. And what you can end up with if you
related that on top of what we've already got is three complicated taxes
instead of two complicated taxes, neither of which is effectively
administered, so that what ends up happening is that while we now have a
\$350 billion tax gap, which means that there's \$350 billion that
should be paid that are not being paid for one reason or another and
that's being made up by honest taxpayers, you would now maybe go up to
\$450 or \$500 billion because you now have, you know, \$100 billion in
VAT taxes that weren't, that weren't being paid. So I think that my view
is that the mission of this Panel is to simplify; we wouldn't be, at
least as a first step, taking a real good step in that direction by
adding a third complicated tax, that has to interact with two other
complicated tax. Instead, what would be much better, would be to do what
I think we're charged with, which is to take the system that we have and
at least make it more efficient, more transparent, simpler, and I
believe if we add to that the right kind of compliance measures, we
could actually collect more revenue without raising any taxes, but just
by the fact that we would have a more administrable system. I think
that's a far better step to take as a first, first foundation. If at
some point in the future, after that's all done, people say well it's
still, it still isn't raising enough revenue to meet the needs that may
come up in the future, you could then make a more rational choice as to
whether the better way to meet that is to add a third tax, i.e. a VAT,
or maybe just raise some of the rates on, you know, the taxes you have
if it's on a solid foundation. You know, having spent five years trying
to administer the system, I can only think in horror of taking the IRS's
existing 35 year old computer systems and trying to add VAT on top of
them, you know, in which you're supposed to send out refunds to anybody
that sends you a, you know, an invoice, you know, with a VAT on it. I
mean, people talk about the so-called refund fraud with Earned Income
Credit, you haven't seen nothing until you start to see refund fraud
with VATs.

CHAIRMAN MACK: Powerful statement, Liz Ann?

MS. SONDERS: Yes, Charles, I wanted to actually reiterate some of what
you said. I was going to bring up an issue of fairness, since that is
one of the other mandates that we have to consider. But I think it's
important since we're now expressing our views on this that I too think
we do not go anywhere near the direction that was proposed to us from a
simplicity standpoint by adding a VAT. And it is a system that unlike
the 14,000 changes to our income tax code that we have talked about over
this process since January, we are still dealing with the same base
system of monitoring this stuff. So the administration, although
arguably has become more complex, it is still off the same sort of
central function. And when you add in a VAT, you are talking about a
level of complexity that goes beyond anything that we have ever
experienced in this country, not having adopted that in the past in any
form. But let me bring up the issue of fairness because I think that the
way the United States views its tax system in terms of distribution
tables and progressivity is very different than a lot of the rest of the
world. And I think that the way we approach looking at issues of
fairness is probably a lot different than some of the European nations.
And I wanted to bring up the fact that certain structures of a VAT,
whether it's add-on or replacement tend to hit the middle class a little
bit more, and we've talked about the simplicity issue, but I wanted to
bring up the discussion of a fairness issue, in terms of where the
biggest hits come, relative to the way our structure of income taxes sit
right now from a progressivity perspective.

CHAIRMAN MACK: Does anybody want to \--

MR. FRENZEL: Thank you. I think that's a good start into the
distribution. And as you know, because of its nature, a consumption tax
is likely to be a more onerous for lower income folks than for higher
income folks. And, so to make the burden tables roughly equivalent with
the experience that we're having now with our tax system, you have to
impose some kind of a tax credit at the bottom end. That does okay for
the burden tables if you're looking at quintiles; it does something that
disturbs me, and it may not affect other members of the Committee, that
is it takes more people out of the tax system completely, particularly
the income tax system. And I think we've done an awful lot of that. I
believe that most Americans who earn income should at least pay a little
bit. I don't quarrel with the distribution quintiles, but I hate to
take, keep taking people off of the bottom unless they're in a position
where they obviously should not be paying any taxes. But the net of it
is, you can, through the application of some kind of a credit, even the
distribution tables, but the inevitable result is you're taking more
people out of the tax system, at least that's what the Committee found.
And I don't know how the other members of the \--

CHAIRMAN MACK: Yes, I think Beth has a comment she'd like to make with
respect to the distribution issue.

MS. GARRETT: Yes, if I could just address both Liz Ann and Bill's
comments. I think you have to be concerned about two taxpayers. Bill
address the lower income taxpayers, which I think you address if you
adapt a VAT through refunds and other transfer payments to those at the
lower quintile. But I think Liz Ann raises a really terrific question,
which is about middle-income Americans who are also hit very hard by a
VAT, and it's for that reason and although it's beyond the scope of this
particular Panel that as the country begins to talk about an add-on VAT,
my hope would be that they would talk about it in the context of payroll
taxes, another regressive form of taxation that hits the middle-class
very hard. So that as this discussion goes forward in the country, I
think one of the focuses, something we can't do in this Panel, would be
the trade-off between payroll and VAT taxes.

CHAIRMAN MACK: Thank you, Beth.

MR. FRENZEL: Thank you.

CHAIRMAN MACK: Are there other areas that we've \-- there's been some
discussion on the compliance cost, as Charles raised.

MR. FRENZEL: Yes, Charles and Ed and John have commented on those. I
wonder if the Panel members have some thoughts on the coordination of
the state sales taxes with the VAT. As you know, we have, I think, no
two states that do it the same way and we don't know if they would all
climb onboard and say we would accept the VAT model and collect it. I
suspect not because they tend to want to exempt big pieces of their own
system, healthcare, food, whatever, housing maybe. And so, my guess is
we'd be left with the state's sales taxes perhaps as they are. And
whether that's a good or bad, adding a new consumption tax in the form
of a VAT doesn't seem to cause any simplification there. Whether that's
more confusion or not, I don't know.

CHAIRMAN MACK: I think one other area I would like for us to address
would be the issue of the base. And we're going to talk about this too
when we get into the national retail sales tax. But the size of this
base has an enormous impact on rate, and there is a tendency to hear
about the rate but not talk about the base. I think you made some
reference to it earlier; I just wonder, does anybody have any thoughts
they want to \-- about what you \-- how different would the base be for
a VAT, versus the base that's used at the state level?

MR. FRENZEL: Mr. Chairman, we, at least in the Panel \-- subpanel looked
at this matter. We tried to keep the base at the maximum. We had three
exemptions. One for charitable and religious services, and these
provided they're not something that's paid for. Food produced and
consumed on farms and small businesses of under \$100,000 revenues. Then
we had some things that were zero rated, and these would be exports,
that is you'd border adjust the stuff on the way out, foreign travel,
state and local government services, and here you would have to
distinguish between commercial services and non-commercial services. And
this job, I think, is sort of what you were talking about. I see that as
a particularly thorny definitional problem for the future. And then the
Panel just sort of arbitrarily decided that primary and secondary
education, normally a governmental responsibility, and therefore that
would be zero rated. Secondary education, usually some kind of a charge
made on it, and that would be subject to the VAT. In regard to a couple
of other questions, we looked at residential housing and decided the VAT
would apply on the house when it was, the first sale. And after that, it
would no longer apply. And that meant, of course, that existing housing
is not picked up, other than as it is maintained or improved. And then
the last exception was financial services, which would be subjected to
what has been described to me as the uniform capital tax, which I don't
understand, but guys like Charles do, I guess. And those were the
exceptions. It makes a very broad base and it's subjected to a single
tax.

CHAIRMAN MACK: I see that your comments apparently have triggered some
responses.

MR. FRENZEL: Yes \--

CHAIRMAN MACK: So we're going to go with John, then Liz Ann and Ed and
back to Jim. I'd ask you to make your comments brief. I think I'm
getting a sense about where we're heading on this thing and a proposal
to toss out to you, so let's do that.

VICE CHAIRMAN BREAUX: Well, very briefly, Mr. Chairman, I think the
points that Bill Frenzel is making is \-- ought to be well-noted, in the
sense that if you have a country as broad as the United States with 50
separate states and 50 separate taxing entities, to try and coordinate a
national VAT with the 50 states and all their exemptions and all their
ways of collecting their sales taxes on the state level and coordinating
that on a federal level is indeed extremely challenging and extremely
complex. And my main concern is that if we have a mandate to simplify,
it seems that you're going to maintain a hybrid income tax, national
value-added tax. It seems to me that we're moving in a different
direction than simplification. It seems like we're moving in the
direction of complicating the already complicated tax code. I mean
that's just one aspect of it. Where the money could be used, I think,
there's a need for it, but I mean if we're charged with simplifying the
tax code it seems to me that this type of a hybrid proposal is more
complicated, more difficult to manage, more difficult than, of course,
what we have now.

CHAIRMAN MACK: Liz Ann?

MS. SONDERS: I get to be very brief because I could easily just say
ditto, but I think that's a very important point that Senator Breaux
made because the vast differences in how states structure their own
income tax, in terms of exemptions, and we've seen examples of a state
like Florida, notwithstanding our youthful Chairman here, there's a bias
there towards certain exemptions that are a function of an older
population down in Florida. So every state has a reason why their own
specific set of circumstances, and I think they're going to be very
hesitant to make broad nationalistic changes just by virtue of an add-on
VAT.

CHAIRMAN MACK: Ed?

PROFESSOR LAZEAR: Whatever our base starts out to be we can be quite
certain that it will be smaller over time, both logic and empirical
evidence tells us that. So, even taking your quite Spartan list of the
exemptions, given the testimony it's quite clear that over time we would
end up with a much narrower base and that's a big problem with any of
these kinds of tax ventures.

CHAIRMAN MACK: Jim?

MR. FRENZEL: I must say that I do agree to the point that Ed makes. What
we have done is give the amenders, who are inevitable and perpetual,
more of what my friend, Barbara Conoval used to call opportunities for
mischief. And I think that's simply inherent when you lay one over the
other.

CHAIRMAN MACK: Jim?

MR. POTERBA: Just to quickly remind us, as we've talked about fairness,
we've talked about simplicity, we haven't said much about efficiency
except this concern that it might, might sort of make it easier to raise
revenue. But one of the things that moving to a VAT-type structure would
do is it would enable us to reduce the tax burdens on capital income,
both through reducing the corporate tax rate and the individual income
tax rate. And I think one of the things, which I'm sure we'll talk more
about, but just want to lay out here is there is substantial, you know,
research based evidence that lowering tax burdens on capital will
ultimately lead to greater productivity gains, greater investment, and
that's part of the motivation for thinking about this as a move toward
consumption taxation. So I think that this does not take anything away
from the other points which we've raised, but I want to, you know, just
flag the fact that is, in some sense, the reason for thinking about this
in some positive way.

CHAIRMAN MACK: Yes. Bill, if you will allow me, I think maybe I'll wrap
this up.

MR. FRENZEL: Well, I \-- yes, if \-- may I conclude with a couple \--

CHAIRMAN MACK: Sure.

MR. FRENZEL: \-- sentences, Mr. Chairman? Jim has sort of gotten to the
fifth point that I thought we ought to be discussing, and that is the
benefits, the efficiency, the alleged fairness, the U.S.
competitiveness, using the international experience that's out there and
the economic advantages and the investment advantages. And I think Jim
made them probably better than I could. In short, however, our subpanel
could not come to consensus. And, after listening to this discussion,
I'm not sure the whole Panel will either, Mr. Chairman, so you can move
forward.

CHAIRMAN MACK: All right. Well, let me tell you what I would like to do
and see if you all are agreeable. There clearly are feelings and beliefs
on the Panel that the VAT is the money machine. There are those who,
however, fell that this is an efficient system, as Jim indicated a
minute ago, that could lower the rates on capital, could encourage
growth. I think it's going to be very difficult to get a consensus on a
plan like this, but what I would like to suggest at this point is that
we at least let staff put together a plan that we can look at a week
from now that puts all of this in context, a plan with rates and let's
take a look at it. The other choice would be to just conclude today with
we don't want to do that. Is everybody comfortable with allowing the
staff to operate for another week on this? Okay, all right, I think that
\-- but as I say, I think it's going to be very difficult to get a
consensus on this, but I think we ought to be able to give it a shot.
Okay, with that, I think Tim \-- I think you're up with healthcare.

MR. MURIS: In the last however long this has been, certainly longer than
we intended when we started, we've considered the entire code. We've
looked at provisions in terms of their simplicity, their fairness, and
their impact on economic growth. One of the most opaque and costly tax
benefits is the exclusion from income for premiums on employer provided
health insurance. This insurance is deductible for employers and
tax-free to employees. Moreover, other tax provisions allow some workers
to pay from pre-tax earnings, premiums, and medical expenses not covered
by their employers. The preferences for healthcare are the largest tax
expenditures and greatly influence how much we spend on healthcare.
These benefits cost about \$140 billion \-- they will in 2006. The
largest component, \$125 billion, is the employee exclusion for employer
provided health insurance and medical care. Even after adjusting for
inflation, this exclusion's cost has more than doubled in recent years.
The amount of healthcare related tax benefits is even higher when you
include the additional exclusions from payroll taxes and from state and
local taxes. These tax preferences also benefit higher income households
more than lower income ones, and that's for two reasons. First, the
deduction is worth more to a higher income taxpayer in a progressive tax
system like we have, and second the higher income are more likely to
have insurance. In 2004, families earning more than \$75,000 received 48
percent of the tax benefits for health. Families earning more than
\$100,000 received 27 percent of the benefits. Now, during our hearings
we've learned how the current health exclusion is inefficient. It
provides an incentive for people to take more health coverage than they
would otherwise because the tax preference subsidizes much of the cost.
The tax subsidizes \-- the tax subsidies for healthcare contribute to an
unable distribution of risk protection and medical care use. It also \--
the tax incentive also distorts healthcare decisions. The higher the tax
break, the more likely people will buy additional insurance. As a
result, the higher income buy more generous coverage with higher
administrative costs. This more generous coverage increases overall
healthcare spending. In addition, these tax subsidies for the higher
income may raise premiums for those with lower incomes and thereby
increase the uninsured. Ultimately, the tax treatment worsens
disparities and insurance coverage, use of care, and potentially health
outcomes. So what should we do? We could propose eliminating this tax
benefit. Our charge is not to reform the healthcare system, however, but
the tax code. We currently have a system based on employer- provided
health insurance. Fundamental changes are probably beyond our scope and
may be unwise in any event, but it would be consistent with our mission
to recommend limits on the amount of tax-free compensation an employee
could receive in the form of health insurance. The level of such a cap
on the exception could obviously be set at various amounts. One possible
amount, to throw out a possibility, is the level of government
contributions to the Federal Employee Health Benefit Program, which is
currently over \$11,000 for families. This is the amount a member of
Congress receives. It's still generous and imposing such a cap would
help us achieve our goals. Even with a cap, the tax code would still
encourage employers to provide health insurance plans by allowing
insurance to be purchased with pre-tax earnings. To level the playing
field between workers with access to employer provided insurance and
those without access, we could allow the latter group a new deduction
for health premiums to the same extent as workers whose employers
provide health insurance. There are lots of other issues that this
raises, Mr. Chairman, but I think that preliminary discussion will get
the ball rolling.

CHAIRMAN MACK: Well, you've put some interesting thoughts on the table.
John?

VICE CHAIRMAN BREAUX: Well, obviously this is a very difficult area.
When you recognize that you still have over 40 million Americans that
don't have any insurance at all, at any one time in a years period time,
and premiums increasing at a double digit rate of inflation in many
areas. More and more small employers are not providing any health
insurance whatsoever. So anytime we recommend changes in this area that
puts some type of a cap on the contribution that an individual gets in
order to be able to buy health insurance, which is something that I
think all Americans should have, you're walking on a very dangerous
area, because it's very sensitive and it's very, very difficult to make
these changes. But this, I would imagine, is a revenue raiser to the
government and we're looking at other areas where we're going to make
revenue losers, in policy changes that we're recommending. AMT is just
one of them. It's great to be able to say we're going to eliminate the
AMT at the cost of \$1.2 trillion a year \-- I mean over ten years, then
how do we pay for it? And how you pay for it always brings up some very,
very difficult choices. And this is one way to do it. The fact that
we're not eliminating by this proposal the contribution of an employer
to an employee needs to be clearly understood, but this suggestion is to
tap into the same average rate that we \-- that federal employees get,
which is about \$11,000 a year, on average. So, I mean one of the things
it's going to do I would think is to get people to be wiser in what
policies they pick, perhaps generate more competition among those who
sell it if they know it's going to have a cap on it. This is an
uncomfortable area for me to get into with this policy and I would
rather be \-- I would rather if I was still back in that other body
trying to find ways to help people with their premiums they're paying
now. This moves in an opposite direction. But I mean none of these
choices are going to very easy and this is one that I think needs to be
considered, but it's a tough one.

CHAIRMAN MACK: Lizann?

MS. SONDERS: I want to talk about the cost-benefit analysis, to your
point, Senator Breaux. And Tim touched on this very briefly, but you
have a system that has clearly benefited higher-income folks, and as a
result has pushed up the cost of healthcare, which he touched on. But I
think it's pushed up prohibitively, and as you suggested, a lot of the
lower income workers, to the extent they work, they tend to work for
smaller companies that have been priced out of the system by virtue of
inflation. And I think that if we do cap this, I think the trickle down
effect has the potential to work in a positive way, particularly if
there is this addition in where we attempt to sort of fund a deduction
for some of these lower income people for healthcare. And I think the
intended effect here of being very, very generous with the current
healthcare deductions in the tax system have proportionally benefited
upper income and disproportionately hurt the lower income folks. And I
think you have to think of it in a broader sense, versus just looking at
the numbers because I think it is this inflation that has caused the
biggest problem, in terms of access for not only lower income workers,
but also the employers of those workers potentially.

VICE CHAIRMAN BREAUX: Can I just ask a question for clarification? Is
the concept to cap the employee benefit and also to restrict the
employer's deduction?

MR. MURIS: Well, you can do it in various ways. I think that would make
the most sense. I mean this is not a zero/one proposition. The incentive
\-- the distortions of the incentive are on both sides. The distortions
of the incentive are on the employee and the employer side.

MR. ROSSOTTI: I think that the answer is it wouldn't make any difference
because if we take \-- if we don't have the exclusion on the employee
side, the employer, you know, if you want to pay more money you pay it
out in salary and it would be the same effect, so it would just a
compensation decision at that point, you know, whether \-- even if it
was \-- even if the payment of the health premium was deducted from the
employer, so would the salary that he paid for that person. So it would
not therefore make a distinction as between paying it to the person in
the form of health benefits as opposed to just paying them. And it
would, I think, therefore, eliminate the distortionary effects. The key,
I think to doing it, is to capping how much is excluded in the income of
the employee.

MR. MURIS: Sure, Charles, yes, no, Charles makes a very good point. And
the bottom line here, and I think Liz Ann was raising this is the
proposal has potential for benefits. It has potential, particularly the
idea of allowing people who can't get the \-- whose employer doesn't
provide insurance to be able to deduct the premiums. It has obviously
significant potential for benefits by lessening the subsidy impact and
the distortions that occur. It could even, although I think the effect
would not be great, because of the inefficiencies in the system that end
up causing more uninsured, I don't think this would have a negative
impact in that area and might even have a slight positive impact.

CHAIRMAN MACK: Ed, did you have comment?

PROFESSOR LAZEAR: Yes, following up on Charles's point, just a question
for you, Tim. Did you have in mind a cap that would be \-- a cap on
total amount of healthcare, whether it were through the employer or not.
So that consider someone who's not employed but has income, just income
resources say through capital income or something else, would you allow
that to be deductible as well against taxes, or would it only be through
the employer contribution. And if so, would that require a lower total
cap?

MR. MURIS: Well, I'm not sure what you're driving at. Right now \--
well, the proposal that I was talking about would allow this additional
deduction for buying insurance where your employer doesn't provide it
and whatever the source of your \--

PROFESSOR LAZEAR: That's what I had in mind.

MR. MURIS: Okay, that's what I thought.

CHAIRMAN MACK: Was there any discussion or thought given to if we cap?
Is there \-- is it indexed? If we were going to index it, what would we
use as the \--

MR. MURIS: Well, that's \-- I mean \--

CHAIRMAN MACK: Fifteen percent a year?

MR. MURIS: Obviously, I believe it should be indexed. I would hope this
would have a positive impact on lowering healthcare inflation. The
normal indexation that we use in the tax code for a variety of purposes
is the CPI. I think that could be used here as well. Obviously the, you
know, there are separate decisions here. Do we impose a cap? Do we
impose an index, and if so, what should the level of the index be?

CHAIRMAN MACK: Any other thoughts?

VICE CHAIRMAN BREAUX: I've got to go back to the question and maybe it's
just \-- it's probably just me not understanding it. But, Charlie, if
you cap the employees deduction at \$11,000, and the employer provides a
policy that is valued at \$14,000 in premiums, the employer would be
able to deduct the whole \$14,000, but the employee would have a tax
liability on the \$3,000?

MR. MURIS: That's right.

VICE CHAIRMAN BREAUX: How is that made up to the employee?

MR. MURIS: It isn't made up. I mean it's just \-- I mean you could do
the same thing by saying that you pay directly for the, you know, the
employee has a \$14,000 policy. He gets an exclusion for \$3,000 \-- or
the employer actually provides directly the \$11,000 premium and then
pays the person \$3,000 more salary. They could, you know, they could do
that under the existing code or any code. The only thing that really is
unique about the healthcare system, you know, now is the fact that the
employer can pay for an unlimited amount of health insurance and not
have it count as income to the employee. The fact that they can deduct
it as a business expense is not unique to the health deduction, any
different than it is to a salary deduction or bonus or anything else. So
you would be treating it \-- by this proposal you would be treating
health from the standpoint of the employer exactly the same as any other
business expense. What would you be doing is you would then be taking a
cap on that portion of the health which is unique, which is the
exclusion of income to the employee.

VICE CHAIRMAN BREAUX: I'm just concerned, and maybe I'm missing
something about \-- it seems to me that we're treating the employee not
in the same sense as the employer from the standpoint of fairness?

MR. MURIS: No, I don't \--

VICE CHAIRMAN BREAUX: I mean, how does the, how does the \--

MR. MURIS: \-- think so.

VICE CHAIRMAN BREAUX: Well, the employee is going to bear the burden of
the cap; I mean the employee will, but the employer just will deduct it
no matter what it is.

MR. MURIS: But the employer can deduct any business expense. I mean if
you said that \--

VICE CHAIRMAN BREAUX: Well, we could change that.

MR. MURIS: \-- but no, but if you said, for example, that the employer
can't deduct more than the \$11,000 cap that's excluding for the
employee, it wouldn't, in practice, change anything, because if the
employer wanted to provide a more expensive policy to an employee and
deduct it, all they would do is just buy an \$11,000 policy and then
give \$3,000 worth of additional income and take tax on it and buy
\$3,000 more of insurance. In other words \--

VICE CHAIRMAN BREAUX: Yes, but what guarantee is there that an employer
is going to do that?

MR. MURIS: There isn't any. There isn't any, but the point is that the
only thing that the employer is being \-- the only thing that the
employer has now that is special about health over any other form of
compensation they give to employees is the fact that the employee
doesn't get the \-- doesn't have to pay tax on it. It's \-- for the
employer, it's no different than any other kind of deduction.

CHAIRMAN MACK: We have several people who want to hop in here; let me go
with Ed first, then Jim, and then Tim.

PROFESSOR LAZEAR: I just wanted to make one point and that is that I
know it's never popular to argue for lowering the amount of deduction
exemption on an item that's as important as healthcare, but we should
remember that the current numbers when we think about the average
expenditures on healthcare policies, those current numbers do build in
the fact that healthcare is currently deductible, which already distorts
the decision to buy healthcare. So if we were thinking about what would
happen in the economy where there weren't incentives to buy additional
healthcare, the amount that you would see would not be the current
amount, but something lower than the current amount. So when we say are
we giving enough healthcare, we should remember that the healthcare that
we are targeting right now is, in some sense, is a distorted and too
high a number. So I would think that, you know, you made the case Tim
that it was a generous number; I would argue that in fact it is quite
generous because it already builds into the fact that we do get
healthcare deduction on it.

CHAIRMAN MACK: Jim?

MR. POTERBA: Yes, and I think to come to Senator Breaux's question,
which really gets exactly at the mechanics of how this will all work out
and to emphasize what Ed just said, the, you know \-- mechanically you
could think of this working so that when you got your W-2 you would
basically have a new box which would say, employer provided health
insurance in excess of whatever the cap was, and that would now be part
of your taxable income as you did the calculation. The fact that today
people are able to purchase health insurance through their employer out
of pre-tax dollars, whereas with most other goods they purchase them
with after-tax dollars is precisely the source of the distortion and the
inefficiency here. The people are able to basically circumvent the tax
on other types of wage income by getting this employer provided health
insurance; and I think exactly as you were saying, what you would expect
if you started to do this with people would start to look at these W-2s
and say, whoa, wait a minute, you know, do I really want to have the
employer choosing to provide \$15,000 worth of health insurance for me
or maybe we ought to move that back down to some number which is closer
to wherever the cap level is. And, you know, we don't know where the new
level of insurance demand would play out in all this, but I think that
there's a presumption that because you're effectively raising the price
of health insurance above that cap amount and now that people see this
they would potentially demand less.

CHAIRMAN MACK: Tim?

MR. MURIS: Yes, I just wanted to elaborate on a point that Charles and
John were making. Charles is right that if we treat healthcare to
employers the same as any other deduction, then the issue is on the
employee side. We need to make sure we do that because there will be
people who want to change the, you know, the differential treatment from
the employer's side.

VICE CHAIRMAN BREAUX: Back to my point, I mean I don't want to belabor
it, but I guess I am, but if we're talking about a cap that has good
benefits from a health purchasing standpoint by making people more aware
of what they're buying, and we're telling the employee that after a
certain amount you're going to be taxed on it, but we're saying what
we're saying to the employer that doesn't apply to you. I mean if you
want to do a \$14,000 value policy, go ahead and we'll let you continue
to deduct 100 percent of it. How can we do it in one way and not the
other? I mean if I buy on to the concept of limiting the value of
healthcare premiums in this country, which to me is a big step, I don't
see how I can justify saying that I have one way of treating those
premium values to an employee and then an entirely different ways of
treating for the employer's ability to deduct it, no matter how much it
is. Suppose he has a \$20,000 a year policy. He can deduct the \$20,000,
but then the employee is going to be taxed on that difference?

CHAIRMAN MACK: Well, Jim, did you \--

MR. POTERBA: The employer, at the moment, can deduct essentially any
more of compensation that they're providing to the employee. If they're
providing turkeys for Thanksgiving, they can deduct the cost of the
turkeys, just as they can deduct the wage cost or the \--

VICE CHAIRMAN BREAUX: But we're changing that for the employee.

MR. POTERBA: But the employee will now, just as though this were wage
income, in an amount above whatever the cap is will be taxed just as on
all the other forms of compensation, you know, meals provided at work,
dependent care benefits above threshold things like that. The employee
is today is also taxed on all of them. The employer is trying to decide
where on this menu of different kinds of compensation that can be
provided, all of which are tax deductible, the menu should be set. And
the employee is now going to be facing, you know, a different set of tax
rules than they currently face on different choices within that menu.

CHAIRMAN MACK: Is it \-- Beth, I'm going to get to you in just one
second, but let me just \-- is it fair to say that the employee becomes
involved now in this decision if the employer says I want to provide you
\$20,000 in health benefits the employee may say well that's great, but
I don't really, you know, given the circumstances, I'd rather have the
other \$9,000, in this case, in the form of cash, and I'll make the
decisions about how I'm going to spend that money.

VICE CHAIRMAN BREAUX: Suppose the employer only offers one plan? Suppose
he doesn't give the employee a choice? Suppose he offers him the
\$20,000 plan; it's that or nothing?

MR. MURIS: Yes, just \-- I don't think that will happen, but anyway
that's \--

MR. ROSSOTTI: I think the chances are more the other way that what will
happen is employers will be more prone to, you know, pay for health
insurance only up to the cap because above that there's no advantage.
They might as well just, you know, pay them whatever they think the cash
is and if the employer wants to buy a more expensive policy they can do
it, because there's no advantage to having a more expensive policy being
issued by or paid for by the employer.

VICE CHAIRMAN BREAUX: Well, if you deduct 100 percent of it what's the
difference?

MR. ROSSOTTI: But he could deduct 100 percent of any form of
compensation he gave.

CHAIRMAN MACK: May I suggest that we're probably not going to \-- but
Beth, let me let you hop in here.

MS. GARRETT: Well, I was just going to underscore what Charles and Jim
have been saying. I think the way to look at it is to look at all of
this as compensation, and the business treatment of compensation is the
same. The only tax preference is with respect to the exclusion of income
on the employee side, and that's what we're really focusing on, the
breadth of that tax expenditure. The deduction is how you treat any kind
of compensation and I think the answer to some of John's concerns is
that employees now have an incentive to be more involved in the question
of the form of compensation than they do now.

CHAIRMAN MACK: Very good. Very good. Again, I don't think that we're
necessarily going to solve this part of the question here this morning.
I just \--

VICE CHAIRMAN BREAUX: You almost did, you've only got one person
objecting.

CHAIRMAN MACK: Well, what I meant was I thought you and I might talk and
see. But are there some other areas that we need to discuss with respect
to this proposal? Again, as I understand it, we're talking about a cap;
we're talking about the issue of index; we're talking about making \--

VICE CHAIRMAN BREAUX: CPI Index?

CHAIRMAN MACK: Yes. We're talking about employees of companies that
employers don't offer a plan would have a tax deductible treatment?

MR. MURIS: Yes, to level the playing field for those employees.

CHAIRMAN MACK: One of the comments that was made is that under the
present system the benefits, more of the benefits go to the higher
income than to the lower income. What does putting a cap on do to
address that?

MR. MURIS: Well, it obviously mean that the incentive, the subsidy, if
you will, to take an income \-- a policy above the cap will be removed
and therefore there will be a \-- people will be much more sensitive to
that, and, you know, when a subsidy is removed on a good, there's going
to be less of it consumed. And, as long as, and again, I think Senator
Breaux, there's an instinct about what Senator Breaux is saying. I mean
it would not surprise me at all if when a cap is imposed the next day
there would be ten proposals to make 125 percent deductible or something
on the employer's side. So as long as things were treated equally and
health insurance was deductible just like any other deduction, I don't
think we would have, you know a problem.

CHAIRMAN MACK: Okay, I'm going to attempt to \-- unless there's some
other \-- I do believe there is a consensus from taking some of your
earlier comments with the notion of a cap, addressing the issue of an
index, making it available to employees and companies that don't offer
plans, we'll just have to discuss further how we do a cap I think. And
if \-- are we in general agreement there? Okay, all right. All right.
Very good. We'll move on and I think next is Charles.

MR. ROSSOTTI: Well, this is one time that in the tax business that I
drew the lucky straw because I've been asked to talk about charitable
contributions because, without question, the easiest question in this
entire Panel. I can only assume that was because I paid my dues for five
years with the IRS that they gave me that one. Well why is that the
easiest? First of all, President Bush singled or recognized it as one of
only two incentives in the tax code where it would be important to
recognize that in the tax code. And second, you know, from my soundings
among my fellow panelists as we've been discussing this along the way, I
concluded that actually almost everybody on the Panel actually agrees
with the guidance the President gave us, which is very nice. So that
makes it a little bit easier. I think it's not really that hard to
understand why this has been given such acceptance by the President and
by, you know, most of the people we've talked about, and that is that
really charitable giving is one of the special aspects of American
society. We know that people give to a wide range of causes and in
amounts that, as far as I know, and I asked around about this and
checked a little bit, is really unmatched in any other major country in
the world. And you add in the volunteer time as well as the money
donations, these resources that are given to charitable organizations
support a huge infrastructure of churches, schools, arts organizations,
human services, and many, many other things throughout the country. So
it's really a big part of the way our country works. And the tax code
encourages this by giving or providing a deduction for charitable
contributions. According to the 2002 tax returns, there were 40 million
taxpayers who gave \$141 billion to charities, for which they claimed
deductions. Of course there were many more taxpayers that actually made
donations, but they didn't claim them on their tax returns because they
did not itemize. Only itemizers can claim deductions on the return
system. So what are the issues that this Panel needs to address
concerning charitable contributions. I think they really boil down to
two things. One is to \-- how to encourage all taxpayers to give while
making the process as simple as possible, because simplification is the
other part of our mission. But it's also important to make sure that the
amounts that are claimed to be given for charitable purposes actually
are given for charitable purposes because we need to recognize that the
opportunity in this area does exist, that either false or inflated
claims can be made, which then of course both burden the honest
taxpayers in the form of higher rates, or and in addition, they
discredit the idea of this charitable division in the tax code, which is
very important. If you look at it today, one of the key features of this
distribution \-- this provision is only 35 percent of taxpayers itemize
their deductions. So those are the only ones that can claim a charitable
contribution. As I mentioned, there are millions and millions of others
that do give but don't get any tax benefits in doing it. By simplifying
the code, we may be able to eliminate the distinction between itemizing
and non-itemizing as a concept. And if we then, in that context, retain
the charitable contribution, we would be making it available then as an
incentive for all taxpayers, encouraging everybody to give. That,
however, raises a bit of a problem in our overall objective of
simplification of practicality because we would not want to have all
taxpayers, you know, 175 million taxpayers, even those who gave very
small amounts feel that they had to keep records on this in order to
justify their giving, nor would it be practical for the IRS to verify
hundreds of millions of small contributions. So one way to solve that
problem is that if we make charitable giving incentives to all
taxpayers, we need to find to keep the filing in and compliance process
manageable, and one way to do that is to, in effect, build in or assume
a level \-- a certain level of charitable giving, build that in
automatically for all taxpayers, and then given a specific deduction for
those that give more than this minimum amount. That's one way to do it.
The other issue gets back to this issue of abuse and compliance, and
regrettably I think we know, and I certainly know from the business I
was in for awhile, that any provision in the tax code that allows people
to reduce their taxes will be abused by some people and there's no
exception in that regard for charitable contributions. As a matter of
fact, the most recent IRS study which just came out with some data on
this indicated that, I believe it was 2001 was the year they studies,
there were actually over \$16 billion, almost \$17 billion, of
charitable contributions that were claimed incorrectly. In other words,
they were claimed and they shouldn't have been claimed. That's a
significant amount of money. Some of those were undoubtedly inadvertent
errors, but many of them were just inflated deductions made in the hopes
that the error would not be caught, and I would say that tax
professionals and many taxpayers are aware that the only data the IRS
has about charitable contributions are what the taxpayer provides on the
return. The only way to check it, under current circumstances, is to do
an audit, which is very expensive. There is another problem which has to
do with the fact that \$33 billion of the claimed deductions out of the
\$140 were not made in cash, but were made in property. And that covers
a wide range of items, from clothing and household goods to one of the
more publicized items recently, which was easements of real estate. And
in looking into that, I learned that the claimed deductions in that area
for easements of property averaged a million dollars each, which is a
pretty substantial amount. The underlying problem with these non-cash
donations is that the taxpayer alone determines what the value of the
donations are. There are rules that require appraisals in some cases,
but in practice there is no meaningful check on these appraisals and
verifying the value of these non-cash donations is very expensive and
makes the odds really too good for those that would like to inflate
their claims. So I believe that we need to do something on the
compliance side if we're going to retain this and broaden this deduction
for everybody. I think that's important both for financial
responsibility and really to maintain continued support for the idea of
the charitable contribution, because as attractive as it is and you read
in the papers about people abusing it, it doesn't give you a good
feeling. I think there's a number of techniques that could be used; the
most proven one is that we could require more independent reporting to
the IRS, at least from recipients of substantial sized donations. With
respect to the non-cash donations is the more difficult area, but one
proposal would be to actually allow taxpayers who are donating
appreciated property to actually sell the appreciated property to
themselves, give the proceeds to the charity and within a limited period
of time without incurring a capital gain as they would now. So this
would make it more attractive to actually sell the property themselves
rather than having to give appreciated property and get into the issue
of how to value it and what the charity does with it. Another method
would be to set some standards for those cases where appraisals are
needed, which really don't exist today, as well as to potentially
require the charities, as well as the taxpayer to report the appraised
value to the IRS, at least for large gifts. And there are some other
methods for smaller gifts that could be used, such as having the IRS set
standards for valuing clothing and household goods. The last issue that
is \-- I wanted to just mention that we did discuss in some of our
subgroup is not directly part of the charter of our Panel, but I think
it's important if you talk about charitable giving, and that is the
issue of making sure the charities who receive the money actually use it
for charitable purposes. This has to do with the regulation of charities
by the IRS and is not directly part of the scope of this Panel, but we
did feel worth mentioning, or at least I felt it worth mentioning, that
if we're going to really make this tax deduction part of the simplified
system and imbed it for the long-term in our system and even make it
available to more people that it's important that the Treasury and the
Congress take the steps that they need to, to make sure that the abuses
that have been identified by charities and the lack of use of money for
the intended purposes be combated as much as possible. So those are some
of the issues that we came up with in the area of charitable
contributions.

CHAIRMAN MACK: John?

VICE CHAIRMAN BREAUX: Thank you, Charles. I think probably everybody
agrees in the importance of individual charitable deductions. I was just
wondering, on the Finance Committee we had looked at the concern of the
explosion of growth in 501(c)(3) corporations that many of which, you
know, own buildings, run businesses, have revenue streams of millions of
dollars, yet are organized as a 501(c)(3) and therefore tax-exempt. And
the growth of these and the popularity of these organizations have just
multiplied many times over. I was wondering whether there was any
opportunity to get into that area, if you're talking about charitable
deductions that deserve government support. I mean it seems like some of
them have gone outside, certainly outside the boundary of the individual
who's just donating to his church or to the Katrina Relief Fund in
Louisiana or anything like that.

MR. ROSSOTTI: Well, I mean that was really the last point I summarized.
I mean it's really beyond the scope of this because we're talking about
the income tax, individual and corporate income tax and what would be
included in the code in that way. There's a whole section of the code
which regulates 501(c)(3) and all the other charities and determines
what is an appropriate thing to actually qualify to be charitable, which
is I think really the point that you were getting at, and I do think
myself and I think at least the subgroup members that I worked on think
that even though it's not directly in our scope that we should say
something to emphasize the point you're making, which is that if we're
going to keep this charitable contribution, we have to have some serious
enforcement of the regulations and maybe some review of some of
regulations on what constitutes a charity and, you know, what they can
use the money for that still allows them to be \-- receive these
charitable contributions. We didn't get into specific roles and, you
know, our subgroup had to that, but we just decided the best we could do
is to make a strong statement that it should be looked at. It's really
something \-- that's something for the Treasury and Congress to look at.

CHAIRMAN MACK: Bill?

MR. FRENZEL: Charles, I think John makes a good point here and that
maybe if your subgroup could at least try to suggest improvement in
keeping a narrow (c)(3) definition and use the other ones, the other
designations, (4), (5), (6), (7), (8) and worry less about them. But I
also have a question about the, when you suggest a deduction or some
kind of a credit for preference for everybody, when you do it for a
non-itemizers of course there's no way for the IRS or the treasury to
audit that particular return. A number of years ago we did give
everybody what we called a \-- I can't remember what we called it, a
below the line deduction, and simply everybody took it. And we had no
idea whether they gave anything to anybody. And so that isn't what you
envisioned?

MR. ROSSOTTI: Well, I think \-- I said, I said that that's one of the
issues that is a tradeoff that you have to deal with. And I think
there's two \-- in what I'm thinking about, there's two ways that you
could deal with, two points that would help to deal with that. One way
would be to, in effect, assume some kind of a minimum that everybody
would give and therefore only require or only allow for itemized, you
know, deductions above that amount \--

MR. FRENZEL: Okay, so you put a floor \--

MR. ROSSOTTI: You put a floor say \-- we assume that everybody is going
to give some amount of their income, 1 percent or whatever you want and
that's already built into the numbers. And it's also a simplification
for people because if they're giving small amounts they don't have to
worry about it, but for somebody who's giving more than that floor or
whatever it could be, we could debate what that could be, then they
would itemize. So that would be one way; that would eliminate a lot of
small ones and so forth. It also make it easier for taxpayers. The other
side is that I do believe that the most proven method for any kind of
deduction or any kind of income is to have some kind of independent
financial \-- independent reporting to the IRS. Right now you don't have
that on charitable contributions and I don't think you'd want to for
every charitable contribution, but I think we could come up with a
proposal that for charitable, charities that receive more than a certain
amount for more than larger ones \--

MR. FRENZEL: This is like a 1099 filed by \--

MR. ROSSOTTI: Yes, it would be that kind of information reporting,
recognizing that it really tends to be the larger gifts and larger
amounts that cause most of the problems. So between those two proposals
I think you would have something that would be practical. And of course
we'd have to work out the details of that, but those would be the ways
that I would suggest we could solve that problem.

CHAIRMAN MACK: Liz Ann?

MS. SONDERS: Charles, can you talk about a tax treatment of charitable
contributions from retirement accounts because we know that's been one
of the issues with retirees who opt to fund their contributions through
retirement accounts and the inability at times to get the full tax
benefits.

MR. ROSSOTTI: Well, and I think that's another thing that we should fix.
I think we should make it so that people, you know, in the retired,
senior citizens can take that money out and make their retirement
contributions. That is a good point; I would agree with that.

CHAIRMAN MACK: Jim?

MR. POTERBA: Charles, I'm sure that some would say that many of the
non-profits are, at the moment, don't have the administrative
wherewithal to think about filing 1099s and issues like that. Have you
thought about that?

MR. ROSSOTTI: Well, I think the answer is, again, to be practical, not
to require it for everybody. Most of the small ones you wouldn't need to
do it, just set a threshold for those that \-- two thresholds I would
say, would be one, the total amount of money that the organization
receives, so if it was less than a certain amount you wouldn't even have
to bother with it, and second of all, only for, you know, contributions
over a certain size.

CHAIRMAN MACK: Any other thoughts? I conclude from what we've heard that
we are going to modify the existing provisions, that we want to have
incentives apply to all those who give donations. Itemizers shouldn't be
the only one who get a deduction; that we try to address the \-- make an
effort to limit the abuse and improve information reporting. Is that a
fair \--

MR. ROSSOTTI: That's fair.

CHAIRMAN MACK: All right.

MR. ROSSOTTI: And try to retain the simplification by having some sort
of a built in floor that assumes you gave that much and you only have to
itemize over and above that floor.

VICE CHAIRMAN BREAUX: And that would be a percentage of income maybe?

MR. ROSSOTTI: A percentage of income would probably be the most best way
to do that.

VICE CHAIRMAN BREAUX: All right.

CHAIRMAN MACK: Okay, very good. We will now turn to \--

MR. FRENZEL: Mr. Chairman, before you do that, this has become sort of
an endurance contest, do you suppose we could break for a few moments?

CHAIRMAN MACK: We can break here. Thank you for reminding me that there
may be some needs that people have that I just wasn't aware of at the
time. We'll take about a five minute break; get back as quick as we can.

(Whereupon, the above-entitled matter went off the record at 11:39 a.m.
and went back on the record at 11:48 a.m.)

CHAIRMAN MACK: Jim, I think that given our time, you probably ought to
go ahead and get started with your presentation.

MR. POTERBA: Okay, well if Charles drew the long straw for talking about
charity, I must've drawn the short one since the topic of taxes and
housing markets is the one that I want to address for a few minutes. And
I think the starting point for this is exactly what Senator Breaux said
a few minutes ago, which is that the only reason one thinks about this
is because there are large tax expenditures in this area and if one is
looking for revenues to cover the cost of AMT reform or other things
that we may be attempting to do, it is natural for us to look at all the
options that are on the table and to think about tax changes in those
areas. The President, of course, in establishing our Panel enjoined us
to preserve incentives for homeownership, and I think that it's easy to
understand why that is. There are a few issues that \-- as many people
worry about whenever one raises the subject of tax reform as how this
would affect the housing market and what this might do to construction
and the house prices. What I will do in sort of laying out the issues
for the Panel to think about just say a little bit about the current
system of what we do in terms of the taxation of owner-occupied housing.
I'll talk briefly about the economic effects that those provisions have,
and then I'll lay out several of the options we could think about in
terms of reforms as a Panel and then close by addressing some transition
issues and suggesting what one might do if we were moving from the
status quo to some alternative. I think most people are familiar with
the rules of present law. Homeowners are allowed a mortgage interest
deductions, limited to loans of up to a million dollars, \$100,000 of
home equity line interest can also be deducted, property taxes are an
itemized deduction, and there is a tax exemption for \$250,000 per
person of capital gain of a primary residence which can be claimed every
two years. That's a new provision that was introduced in 1997.
Fundamentally, the other part of the tax treatment of housing that is
important is the imputed rental income, the income in some sense that a
homeowner would earn if he or she was a rental landlord renting the
house to themselves is not taxed under the current system, and that's
the root of much of the current favorable tax treatment of
owner-occupied housing, relative to many other types of capital
investment. I might note that the mortgage interest deduction has been a
more valuable deduction in the past, both because marginal tax rates
have been higher and mortgage interest rates have been higher so that
today the mortgage interest is not by any means at its high water mark,
and I also note that the alternative minimum tax, which we've talked
about in earlier meetings has begun to claw back some of the pieces of
the home ownership subsidies in the tax system, in particular the
property tax deduction runs into the limitations from the AMT. The size
of the tax benefits to homeowners within the current code are
substantial. Looking back say to 2001 when there were 130 million tax
returns filed, 45 million of those were itemizers, of those itemizers 37
million claimed mortgage interest deductions, 44 million claimed the
state and local tax deduction, presumably most of those included a
property tax deduction. The total tax expenditure, the tax revenue that
is foregone as a result of the combination of these tax provisions that
bear on owner-occupied housing is on the order of \$100 million a year
at this point and it is a substantial flow going forward. So, whenever
we think about revenue raising options, this is one that emerges on the
table. Let me say just a bit about the distribution of these current
benefits. They, like the health insurance benefits, that Tim spoke about
earlier are very skewed toward the top end of the distribution, both
because lower-income households might not itemize and consequently may
not be able to claim any of the mortgage or property tax benefits
because the marginal tax rates are higher at high-income levels and
because on average those folks may have larger mortgages on which they
are claiming these. Now, the result of all this is that about 2.2
percent of returns, the top 2.2 percent of returns claim about 22
percent of the benefits of the current tax subsidies toward
owner-occupied housing. And that, of course, you know, reflects the
combination of these factors that I mentioned. There are some
homeowners, of course, who have no mortgages at all and don't claim any
mortgage deduction, about 40 percent of homeowners don't have a mortgage
at the present. Now, let me just say a little bit about the economic
effects of these provisions. I think it's important to think about the
role of housing, owner-occupied housing relative to other kinds of
investment assets, business assets, plant and equipment, because at the
moment owner-occupied housing is a very low tax burden asset within the
scheme of different capital assets. That has the effect of encouraging
investment in housing, in owner-occupied housing, it also presumably
discourages investment in the other kind of assets relative to
owner-occupied housing, tilts the allocation of capital toward the
housing sector. One should distinguish in this case two different
issues. One is the amount of housing that people choose to purchase; the
other is whether or not they choose to be homeowners versus renters,
okay. For many purposes, the homeowner versus renter decision will be
affected by the sort of the first dollar costs of moving into the
homeownership tenure, on the other hand some of the incentives we have
on the current code which provide mortgage interest deductions on very
large mortgages, for example, are unlikely to lead people to be
homeowners versus renters. They are, however, likely to change the
amount of housing people consume; so one might think about linking some
of the, you know, the expansion of the size of houses and the growth in
some kinds of residential investment to some of the incentives that are
built in through the tax system. So, I think if one were to summarize
what the research literature on housing and taxing suggests, there is
clear evidence that people do demand more housing when the after-tax
cost is lower and that leads one to suspect the current system leads to
larger houses and more housing consumption. The evidence on whether
homeownership is encouraged by the current tax rules I think is more
mixed, but that would focus primarily on some of the subsidies that are
available to the lower and modest income houses, households, one
suspects. There may also be some incentive for people to borrow, rather
than to finance their homes with their own equity when they make
purchases. Well, we know that housing is price sensitive and therefore
the changes in the tax treatment of housing might affect the quantity of
housing consumed, what about the level of homeownership? Here, we can
look perhaps to other countries. In other countries, there is experience
with non-deductible mortgages. Australia, Canada, the U.K., New Zealand,
all have non-deductible mortgage interest at the moment. Homeownership
rates in those countries are not substantially different from those in
the U.S. In the U.K., the rate is comparable to that in the U.S.
Australia's is somewhat lower; the U.S. is lower than the Australian
homeownership rate. It's a bit higher than Canada. The U.S. is about 68
percent; Canada is 66 percent in recent years. Well, let me \-- having
laid out the basic, you know, territory of where we are and what the
affects might be say a bit about the options that we might consider as a
Panel in thinking about, you know, changes here. One possibility would
be to tighten the limits on mortgage interest deductibility to simply
ratchet down the current million dollar cap. That would be a revenue
raiser and we could think about that as a strategy. A second possibility
would be to allow full deductibility of mortgage interest or partial
deductibility of mortgage interest, but to do that at a reduced rate of
tax, instead of at the individual's top current marginal rate, we could
do that at a rate which is somewhat lower. The third possibility would
be to replace the current deduction for mortgage interest and property
taxes with a tax credit for those items, and the credit rate could of
course be set at a rate we could choose; the revenue consequences would
be very dependent on that rate, but the credit option would enable one
to try to get some of the benefits to the non-itemizers who currently do
not share in the mortgage interest or property tax deductions. And
again, another possibility would be to think about the capital gain tax
rules and change possibly the deduction threshold, the exempt threshold
for the taxation gains on houses. What would the economic effects of any
of these changes be? I think there are two kinds of effects to focus on;
one is the near-term effect on house prices and construction; the other
is the long-term effect on the composition of the housing stock and the
nature of the household balance sheet. I think in the short-term there
is reason to be concerned that if one tightened up some of these
subsidies in the current structure that one might see some adverse
effects on house prices, exactly how large is difficult to judge; it's
also likely to be different depending on the types of houses or the
types of buyers associated with them. Some of the provisions, like a
credit for example, might actually support the demand for modest size
homes. The provisions that might change the top marginal tax rate
applicable to high end homeownership deductions might have some adverse
effects on the largest houses; the ones typically bought by top bracket
investors. The effects on construction activity again I think are
difficult to call because one might see some additional demand at lower
income levels offset by some reductions at the higher level. Over the
long haul I think what this would, you know, ultimately lead to
presumably is some reallocation of the capital stock in the U.S. If we
reined in some of these deductions, one would expect to see a larger
long-run size of the other components of the capital stock and somewhat
smaller housing capital stock in tandem with that. And I think as one
recognizes these effects and recognizes both the short run as well as
the longer term objective that one is moving toward, that raises the
last point that we should think about which is transition. It's
important to, you know, to put on the table I think the question of
whether we would like if we were doing de novo tax design to put in
place the provisions we currently have, but then to ask the question,
given we have them already, would we want to take them away at once or
would we gradually do something so that the existing investors and
houses were in some ways, you know, protected from some of the changes
that might take place. And I know these transition issues are very, very
important for us to consider. One thing we could consider as a
transition issue would be allowing the current mortgage holders to
deduct their current mortgage interest, either under current rules or
under some set of rules, which would, gradually over a period of time,
phase down to whatever additional limits we might want to put in place.
We know that some recent homebuyers, especially given the level of house
prices are probably stretched very thin and that that would create an
argument for trying to protect some of those recent homebuyers for the
near-term, and we also know that some middle-income houses have much of
their portfolio, much of their net worth, tied up in housing, and
therefore one would want to be concerned about trying to buffer them
from some of these house price changes. I think all of that suggests
that one wants to think about ways to either gradually phase in any
changes that one might think about or to consider some sort of
grandfathering or, you know, transition relief which would enable people
who had made decisions in the past, not just for the distributional
reasons, but also for the fairness reasons. Someone who bought a house
yesterday should not be treated dramatically differently than somebody
who buys one tomorrow; we'd want to think about those issues. So, I
think that, you know, more or less covers the territory in terms of
raising the issues that the group needs to think about. Unlike Tim, I
don't come with a particular proposal here, but I think we need to
discuss this as a Panel and consider some of the options that one might
imagine. Thank you.

CHAIRMAN MACK: Liz Ann?

MS. SONDERS: Well, Jim, as you well know I have hours worth of thoughts
on this that I'll try to condense into a minute or two worth of comments
here today in the interest of time. And I'll play the replay button a
little bit on my comments on healthcare, in terms of the trickle down
effects and the impact on inflation. I think it's particular important
in housing, and you touched on it, with the success that we have seen in
the housing market, having been biased toward the higher end and you
mentioned the move toward bigger pieces of property, bigger homes, it is
trickled down to a rate of inflation in housing that has not just hit
those higher end homes, but also the lower end homes, and it's lifted
the price across the board, which I think has brought on some of these
speculative lending practices that are now causing some concern. If you
look at foreclosure and delinquency rates, although in the aggregate,
the national level they're declining, they are not declining, they're
going up for the sub-prime area. So we are starting to see a lot of pain
come in for these marginal buyers that have had to take on these
speculative lending practices in order to just simply afford the price
of homes right now. And one way to think about this is looking at
housing affordability and thinking of it in terms of demand destruction.
We have seen the average median home price go up so significantly that
just in the last couple of months, this is a very near-term phenomenon,
the housing affordability index, which is an index that measures just
that based on median home price and median income, the ability for
Americans to afford homes has plunged to 14-year lows, just in the last
couple of months. And the last time we were at these levels was the 1991
recession. So we are starting to see some significant pain here. I would
rather see through transition rules not a change here that impacts the
housing market in a very, very quick and negative way, but if we were to
slowly see some of these pressures ease, it may take some of the
pressure off the regulators to have to come in and rein in some of these
speculative lending practices; that being the only way for some of these
lower-income people to afford homes. So, I view this possible change
here, although we don't have details on what the potential
recommendations would be, as longer-term and more net-positive than it
is a net-negative, assuming we deal with the transition issue
effectively to not cause some sort of calamitous events here with
housing.

CHAIRMAN MACK: Tim, I think I would come back to you and say \-- you
mentioned several things, the cap, what kind of cap should we be
thinking about? What suggestions do you have for us?

MR. POTERBA: Well, this is something where one can sort of turn the dial
and just raise more revenue as you bring the cap down, not surprisingly.
One thing one could imagine, I mean, in looking for, you know, guidance
sort of like the federal health benefits level as an anchor, one might
think, for example, about the level of the FHA mortgage allowance in
different communities, which is a number that varies place to place in
terms of the level of mortgage. I think that's designed to, you know, be
a sort of standard level of house, you know, not a starter but not
another specialty high end house. One could think about more or less
than that. I think that's, you know, what I think would be very helpful
for us is to have some anchors again which we could measure where we
were going in these ways.

CHAIRMAN MACK: Give \--

MR. POTERBA: I think that's \--

PROFESSOR LAZEAR: I was just going to jump in and suggest that's a good
idea for another reason and that is that, as Jim has pointed out, much
of the distortion, to the extent that there is over consumption of
housing, it tends to be not so much that people are buying too many
houses, but rather that the houses are too big. And what that means is
that if we were going to eliminate the distortion and say we want to
favor other kinds of investment rather than investment in housing at the
top end, what we'd want is a cap that probably wouldn't affect the
median homeowner too much, but would affect only the top buyers. And so
the cap that Jim has in mind would probably do \-- go most of the way to
doing that.

MR. POTERBA: I think that the key is something like that would still
preserve the incentive to be a homeowner, but it would change the
incentive for adding the extra bathroom or extra bedroom on the house.

VICE CHAIRMAN BREAUX: That's a very difficult thing to do when you're
trying to figure out what the cap is. I mean a \$500,000 home in San
Francisco is not that much, whereas in my hometown in Louisiana it's a
mansion.

CHAIRMAN MACK: That's right.

VICE CHAIRMAN BREAUX: So when you put an arbitrary dollar amount on the
cap \--

MR. ROSSOTTI: I think one of Jim's points is the FHA does vary \--

MR. POTERBA: That varies.

MR. ROSSOTTI: \-- based on the median size. It varies from
place-to-place, based on \--

VICE CHAIRMAN BREAUX: Each area would be different?

MR. ROSSOTTI: Yeah.

CHAIRMAN MACK: Again, let me just so that we will have a sense of the
scope, if we were to do the FHA that number falls how? What kind of
number are we looking at?

MR. POTERBA: I think it's in the high 200's, low 300's at this point.

CHAIRMAN MACK: Okay.

MS. SONDERS: And what would the range around that be based on the
region?

MR. POTERBA: I mean \-- it doesn't vary very nearly as much as John's
hypothetical house does. I think it varies maybe within a range of
\$100,000 or something.

CHAIRMAN MACK: Now, what about the notion of, in essence, changing the
marginal rate I guess of \-- tell me a little bit more about that and
what kind of range we might be looking at?

MR. POTERBA: Well, you know, there have been proposals made for a long
time to think about allowing people to deduct their mortgage interest
and their property taxes, say at the 15 percent or 25 percent rate; for
example, to essentially change the slope of the distribution of tax
benefits across the income distribution. That would have the effect of
preserving most of the benefits of the middle class. It would have the
effect of trimming the benefits at the highest end; it would also change
the incentives for investing more in housing for the highest income
households while more or less leaving an effect of that of the modest
income groups. The current structure of benefits, as I suggested, is
very skewed toward the top end, so this is something where one could
pick either I think, you know, the 15 or 25 percent rate, sort of the
middle rate, and then just cap the rate at which you can deduct the
mortgage interest.

CHAIRMAN MACK: Other questions? I might just throw out a couple of
other. What about the treatment \-- you mentioned the capital gains tax?

MR. POTERBA: Right.

CHAIRMAN MACK: Any thoughts there?

MR. POTERBA: Well, I think, you know \-- we've had some suggestions in
testimony and others that sort of unlocking housing capital gains in the
aftermath of the '97 Act which upped the threshold for excludable
capital gains has increased turnover; it's increased a lot of the \--
stimulated a lot of activity in the housing market. And, you know,
there's \-- it's tricky here because on the one hand you'd like to avoid
any sort of lock-in, people being locked in with their assets with a tax
which is due only on realization. On the other hand, you don't want to
have this differential playing field so that you're getting essentially
zero tax on housing gains, whereas other kinds of financial asset gains
and other things are being taxed. And if people are assuming that
they're going to get very large capital gains going forward, what
potentially you created is an incentive for people to be investing more
in housing to think about this capital gain relative to stock, bonds,
other assets that they might consider. So, I think \-- I don't have a
particular number to offer here. One could think about either, within an
income tax concept one would think about trying to rein back in the
level of that exclusion, another way to go with this and the Panel
should be considering this, is on the consumption tax alternative regime
what you're basically moving toward is saying well, there are two ways
of leveling this playing field, one is to level one down and the other
is to bring the other up. And if we move to something which provides,
you know, relatively low capital gains tax treatment for all gains, then
that would be a way of trying to regress the disparity as well.

CHAIRMAN MACK: I do remember one of the first briefings that I had with
respect to the issues we're talking about is that how different that
different types of investments are treated by the tax code and how it
distorts investment decisions. How much motivation is that for you
anyway looking at this issue?

MR. POTERBA: Well, I think that's a great question because it links back
to the earlier discussion about some of the efficiency aspects of even
the VAT and things like that because one way to calibrate this is that
when various groups have tried to evaluate the total tax burden that's
placed on a new investment in different kinds of capital in the United
States; you know, you could think about building a new owner-occupied
home, you could think about a new plant, you could think about new
equipment, the tax burden on the corporate sector today on new
investment there averages probably in the mid-20's. Housing is based \--
owner-occupied housing is basically a zero or very close to a zero. It
could even be a negative number at this point, so what that does is it
means that if you're thinking about the allocation of all the investable
resources in the economy that there's going to be a substantial tax on
those investments if they go down the corporate route, because there's
basically no tax on the housing side, and that's going to lead to this
misallocation of the capital stock. When economists have tried to model
these tax effects and tried to evaluate the efficiency costs, they often
discover that there really are substantial losses in total national
output from distorting the capital stock in one direction or another,
and that we'd have a larger total GDP if we could basically put a level
playing field so all these different assets would be taxed in the same
way. So, to me the differential across sectors is really a very
important consideration and it plays right into the mission that we have
to think about the efficiency improvement and economic growth mandate.

CHAIRMAN MACK: And let's make an assumption here from this. Suppose we
did put \-- supposed we lowered the present cap of a million to some
lower number, how would you suggest that we structure this in sense of
deduction or credit?

MR. POTERBA: Well, I think \--

CHAIRMAN MACK: How do you think about that?

MR. POTERBA: Well, I mean we could \-- I don't know. One could \-- if
the cap comes down, the cap could be brought down within the deduction
framework very easily. If one were going with the credit that does the
same sort of thing but in a different way. You could combine them. You
could have a lower cap and use a credit strategy instead of a deduction
strategy. So it isn't an either/or on these things. I think the critical
thing is really deciding how much, at the margin, how much subsidy you
want to allow for people making their housing purchase decisions. And if
you allowed a credit at the 15 percent rate on all of the current
mortgage deduction up to a million dollar mortgage, then you still
provide an incremental incentive for someone buying a very big house to
buy a bit more housing. If you cap the mortgage deduction at, say
\$300,000 or \$350,000, then for someone borrowing more than that,
effectively you've limited their incentive to go further in terms of the
size of their house and you effectively made the effective tax burden on
that investment much more comparable to what they face in, you know, a
sort of business investment or something else. So, I think the credit
strategy with an unlimited one would provide some continued incentive
for the big houses, capping the deduction and saying above this level
you get nothing would basically, you know, rein in more tightly the sort
of high end as Liz Ann was discussing.

CHAIRMAN MACK: I think the last point that I would raise and welcome
anybody who else wants to jump in here is the \-- if we were to do
something, the transition rules, as you indicated or someone, there are
lots of families that have, for various reasons, what's going on in the
market with respect to the price of homes, the types of mortgage
instruments that have been developed over the last few years, I think we
need to keep them in mind as we're walking through this area. What \--

MR. POTERBA: Just \-- certainly from all of my discussions with other
Panel members, I think everybody is acutely aware of the importance of
transition in this area in particular, and of the need to move slowly in
thinking about any move from the current system towards some alternative
structure of the tax treatment of owner-occupied housing. Ways we could
consider such transition relief could, for example, mean that you either
allow existing tax law treatment for all of the current commitments that
people have made, so that someone who has an existing mortgage would
continue to be taxed in the way that that mortgage would've been taxed
otherwise. We could alternatively, basically, if one were, for example,
moving toward a credit, one could move from the current system toward
that credit step-by-step over the next ten years that you could
basically say, you know, this \-- the next year 90 percent of your
mortgage would be taxed under the existing income tax deduction rules,
ten percent of the credit, and then move that up gradually moving
forward. And I think that these issues basically involve not just, you
know, trying to make sure that we don't cause radical dislocations
within this market, but also there's a basic fairness issue here of not
changing the rules of the game for people who've already put asset
investments in place, often large investments relative to the rest of
their financial portfolio in their household.

CHAIRMAN MACK: Okay, let me put a question to the Panel. What is your
reaction to, what is your thought about pursing the idea of a cap of
modifying the existing housing provisions in the code? Is this something
we should pursue?

MS. SONDERS: Yes.

MR. FRENZEL: I think we should think about it.

CHAIRMAN MACK: John?

VICE CHAIRMAN BREAUX: I agree.

CHAIRMAN MACK: Okay. Well then let see \-- go ahead?

MR. FRENZEL: May I ask a quick \-- you're not suggesting any change in
the capital gains tax? In fact, as I recall, you suggested that it had
some kind of salubrious effect?

MR. POTERBA: Well, I think \-- I mean we could \-- I think that any
specific change in the capital gains rules here would have to be very
dependent upon what we were doing on a broader structure. So that if we
were moving toward a lower tax burden on all capital income, for
example, that would move in the direction of sort of putting everything
else kind of on a footing, which is closer to where owner-occupied
housing has gotten. I think if we are moving in a direction which
tightens, you know, toward a comprehensive income tax notion, then in
fact one might review the question of whether the whole \$500,000 for a
couple exemption is on the table.

MR. FRENZEL: Thank you.

CHAIRMAN MACK: Well, as I understand it, where we're heading is we
should modify the existing housing provisions; we should try to ensure
the provisions promote homeownership. There's evidence which was
suggested that the benefits of the current tax incentives are not shared
equally and we ought to address that issue. And also I'm hearing that
the notion of some transition rules, some grandfathering, ought to be
part of any proposal that would be put together in this area. Is that a
fair recap? Okay, if there aren't any other \--

VICE CHAIRMAN BREAUX: Well, is there a specific recommendation on
lowering the cap? Are we saying we're going to consider that? We don't
have a lot more time to consider it.

MR. POTERBA: Well, I think something like this FHA level would be one
that we could consider quite explicitly.

CHAIRMAN MACK: Okay.

MR. ROSSOTTI: I would go further and say I agree with that, but I also
think there's great merit to the credit approach. I think it's simpler.
It really gets to the heart of the issue, which is to encourage
homeownership, as opposed to bigger houses. Now, I'm not sure if
everybody agrees with that, but I think the combination of an FHA cap
with a percentage credit, whatever that percentage might be of that
amount, very simple and it makes it, you know, something that is
targeted very much at the objective of homeownership rather than bigger
and more expensive.

CHAIRMAN MACK: All right. We'll work our way through that one then. Any
other comments? If not, I think we will go to our last topic for today,
which is the national retail sales tax. And Ed, we're going to look to
you for the introduction on that discussion.

PROFESSOR LAZEAR: What I'd like to do is start by laying out a few
thoughts on some of the principles that may help us guide us on the
virtues and drawbacks of the national retail sales tax. And in
particular, what I'd like to do is start by talking about consumption
taxes in general. I'll do this very briefly since Bill has already
walked us through a number of these issues so I'll just kind of jump
through them. But I want to point this out because again I think that
many of the taxes that we're going to be thinking about over the next
two weeks may come back to this consumption tax issue and so we want to
think through whether we want to go that direction or not. Why would we
even think about going in the direction of a consumption tax? Well, the
first one is that a consumption tax taxes consumption only once and as
such does not discourage saving. That is particularly important giving
the low savings rate that we see in the United States. The current
savings rate is down below 1 percent; so that's a concern both in the
short run and in the long run. Consumption tax also does not tax return
to investment and as such keeps investment and incentives for investment
high. That's also key because productivity growth depends directly on
investment and wage growth depends on productivity growth. So if we're
thinking about improving the standard of living for American workers
over the long run, what we need to do is we need to make sure we adopt a
tax system that keeps the incentives to invest high. The other thing
that a consumption tax does is that it doesn't favor one form of
business investment \-- business organization over another, so you can
select your form of governance based on a business principles rather
than on saving taxes, and that's another thing that I think we ought to
be thinking about. And finally, it doesn't favor one form of financing
over another; so, for example, you wouldn't go debt over equity as a
result of tax considerations. That having been said, the national retail
sales tax is perhaps the simplest form of consumption tax. And because
it is very simple, it has relatively few gimmicks; it has the advantage
that all Americans share in the burden of supporting government, the
point that Bill raised earlier, and as such I think the national retail
sales tax has much to recommend it. Whether a national retail sales tax
is valid or is viable or not depends primarily on implementation issues.
So we need to think a little bit more specifically about how we would
actually implement this. The key, of course, is the base and what we use
to think of our base for the National retail sales tax. Broad bases are
better because they imply lower rates and spread the burden more evenly.
But the problem of course with broad bases is there are some items that
obviously seem to be inappropriate for taxation. And when I say
obviously seem to be, what I'm talking about is by historical precedent,
if we look at other countries, we look at state systems, we see that
certain things tend to be excluded from the base. Those usually include
things like education and medical expenditures. The National retail
sales tax would also impose a very different tax burden on the economy,
and that would mean that we would either have to live with a new tax
burden or we have to try to address that by some other method of
transfer payments. Once we start talking about transfer payments that
means that we have to have a system that raises more revenue, which
consequentially implies higher rates and again more economic
inefficiency. So in order to think about these items that are conceptual
I think what we need to do is be a bit more specific and think \-- look
at some numbers. So in the next two minutes or so, let me give you some
numbers that may put some meat on these bones. Let's think first about
the breadth of the base. Using Treasury's broadest definition of the
base, which includes most items with the exception of education and a
couple of other items, the rate that would be required would be
something between 22 and 20 percent, and that's on a tax-exclusive
basis. In other words, that would be if you paid a dollar at the cash
register, you would then see 22 cents added on to that. So that's the
rate we're talking about, 22 cents to 27 cents depending on your
assumptions about evasion. Low evasion would be 22 percent; high evasion
would be something like 27 percent. But the problem with that is that
\--

CHAIRMAN MACK: Let me just clarify that.

PROFESSOR LAZEAR: Yeah, please.

CHAIRMAN MACK: When you talked about the evasion there, you didn't give
\--

PROFESSOR LAZEAR: What that means?

CHAIRMAN MACK: \-- what the evasion rate would be.

PROFESSOR LAZEAR: Yeah, sorry. I \--

CHAIRMAN MACK: You were giving a rate of what the tax rate would be, not
the evasion rate.

PROFESSOR LAZEAR: The tax rate would be 22 percent based on assumptions
of low evasion of taxes. Now, what do we mean by low evasion? What we
mean by low evasion is something on the order of the tax evasion that we
see now, something like 15 percent tax evasion. The high evasion numbers
assume something like 30 percent tax evasion. So when I say that the
rate would go from 22 percent to 27 percent what we're assuming is that
evasion rates go from 15 percent to 30 percent. Sorry to be \--

CHAIRMAN MACK: That's okay.\
PROFESSOR LAZEAR: \-- adding all these percentages to you without kind
of putting them up on a screen for you to see, but the number you want
to basically think about is somewhere in the 25 percent range without
doing anything else.

CHAIRMAN MACK: Okay.

PROFESSOR LAZEAR: That would be the tax rate. Okay, now as I mentioned
though, the problem with that is that it's difficult to maintain a broad
base because there are always arguments that one can make for narrowing
the base, and as I mentioned earlier when Bill was talking about the
add-on VAT, if we look historically we do see that other countries have
gone to narrower bases. And so one thing we could do is we could look to
see how our states have behaved with respect to retail sales taxes. And
if we look at the typical state base, which usually exclude things like
medical, food, sometimes clothing, financial, government provided
services, Treasury calculates that the rate that we would need to raise
sufficient revenue to be revenue neutral would be somewhere between 64
and 87 percent. So that would mean that if you were checking out and you
paid a dollar, you'd end up paying about a \$1.75 or something after
that. Go ahead, Charles?

MR. ROSSOTTI: Just a clarification.

PROFESSOR LAZEAR: Please.

MR. ROSSOTTI: When you're talking about revenue neutral, just to replace
the corporate and individual income tax.

PROFESSOR LAZEAR: That's right.

MR. ROSSOTTI: It doesn't replace the payroll tax?

PROFESSOR LAZEAR: Absolutely right.

MR. ROSSOTTI: Okay.

PROFESSOR LAZEAR: So that's on the assumption of revenue neutrality,
just based on the corporate, on I'm sorry the corporate and personal
income tax to start

MR. ROSSOTTI: Okay.

VICE CHAIRMAN BREAUX: So I mean that rate is with the current deductions
or sort of a \-- what's it based on in terms of deductions, or certain
items are not covered?

PROFESSOR LAZEAR: So this is a full replacement system, so what you'd be
doing is just replacing the entire income tax structure with a retail
sales tax that would be somewhere on the order set.

CHAIRMAN MACK: I think John is asking what would be excluded under the
retail sales tax base, like education, health.

PROFESSOR LAZEAR: Yeah, okay, I'm sorry I thought I \-- maybe I didn't
mention that. Let me do it again. It exempts prescription drugs, food,
clothing, financial services, medical/government services, utilities and
transportation. That's the typical base that the states use right now.
So that exempting, obviously that's exempting a large amount of
consumption expenditure. The reason the Treasury gave us those numbers
is simply as a benchmark to use that as a comparison against the one
that they started initially with, which would be extremely broad based
where virtually everything is taxed.

MS. SONDERS: And what defines the lower end of that range versus the
higher? We're not talking about evasion?

PROFESSOR LAZEAR: Evasion, yes.

MS. SONDERS: Oh, still evasion?

PROFESSOR LAZEAR: Yes, it's still evasion. So when you say 64 percent,
what we're talking about is the assumption of 15 percent evasion. When
you're talking about 84, you're assuming 30 percent evasion. Now, I
should point out, I was actually going to get to that, but that's a
great point, Liz Ann, because I should point out that the assumptions
about evasion may be realistic when we're talking about rates down in
the 20 percent range. So you might say well we'll get 15 to 30 percent
evasion. Once you start talking about a Retail Sales Tax that's
somewhere in the neighborhood of 70-75 percent, the incentives to evade
go way, way up. And so what we're thinking of is high evasion at 30
percent may not be high evasion at all so we'd have to address that
point. But again, these are the numbers that we started with as a
benchmark just to get a feel for it. I mean obviously when you're
talking about rates of 64 to 87 percent, even without worrying about
additional evasion, those rates are pretty staggering, so.

MR. FRENZEL: Do you include a small business exemption there?

PROFESSOR LAZEAR: There's no \-- no, no small business exemption in
these calculations. So, this is just again the full consumption base.
All right, well as you get a sense from this discussion, the rates are
extremely high if we went to the narrow base, but they would be
reasonable if we had the much lower base \-- much broader base, sorry.
But there is another issue and the other issue is the distribution of
the tax burden across income groups. So let me go back to the base case,
just to keep things simple. Let's think about the broadest base the
Treasury considered where we would be talking about 22 percent tax rate,
and so this is the low-evasion, broad-based case, kind of the best-case
scenario. And let's ask, under the best case scenario, what would the
distribution of tax burdens be? And the answer in a nutshell is that it
would raise the tax burden dramatically on the bottom part of the income
distribution and lower the tax burden on the top part of the
distribution. Just to give you a number, it would raise the tax burden
on the lowest quintile by about a factor of three. So the lowest 20
percent would be paying about three times as much as they are paying
right now. Well, I think most people who look at this recognize that
that's probably not realistic and it's probably not something that we
would favor, and so they have built into the plan different kinds of
rebate structures. One plan that we looked at, presented by the Fair Tax
Group, has what they call a "prebate" structure, and the prebate
structure distributes \$2,500 back for every single, \$5,000 for every
married couple, plus about \$850 per dependent, and every American would
receive the rebate. Now that's an important consideration; again, coming
back to some of the things that we talked about in the context of the
VAT. The reason that it's important that every American receive it is we
don't have to make that transfer income dependent, and as such it's
unnecessary to run a parallel income tracking system. So when we talked
about two systems before, one of the things that we were concerned
about, Bill, when were talking about the VAT was the fact that you would
have to run a VAT structure and you'd also have to run an income tax.
You'd have the IRS system running in parallel. The notion of going to a
standalone retail sales tax with a prebate system eliminates the need
for that, but the problem is that even that plan, even with the prebate
system, doesn't necessarily remedy the tax burden in the way that many
of us would like to see. In particular, the tax burden for the middle
and upper class, defined as those between the 40th and 80th percentile
would see their burden go up by about 16 percent, and the top would see
their burden go down. So, kind of the heart of the middle-class, in some
sense, would see a significant tax increase associated with this plan.

MR. FRENZEL: Does that take people out of the tax system, the large
prebate?

PROFESSOR LAZEAR: Well, you know, in some sense \--

MR. FRENZEL: Anymore than today?

PROFESSOR LAZEAR: In some sense, no one is taken out of the tax system
because everybody pays taxes on their consumption, but with a prebate
everybody also gets the money and so I think \-- that's one of the nice
features of this in that the logic is that everybody on the margin does
pay tax. When you go to the store, you feel the burden of the tax system
and you know that you're supporting government through that tax system.
So I think the proponents of the retail sales tax view that as an
advantage, and I guess I would view that as an advantage as well. The
prebate structure also, as I said, has the advantage that you don't have
to keep track of income. The disadvantage is that a prebate structure is
not very targeted in the way it gives refunds and transfers to
individuals within our society, and as such, what it tends to do is it
tends to load up the burden disproportionately on the middle class.
That's simply a fact as a result of that structure. So, what one could
do is one could envision having a rebate structure that's more income
dependent; and in fact, what we could do is essentially undo some of the
consequences, some of the distributional consequences by simply making
these tax transfers income dependent. The problem with doing that is
that then we come back to the situation that we were concerned about
before, where we were running parallel systems. If you're going to do
that, you've got to run a retail sales tax administration and you also
have to run an income tax \-- not an income tax administration, but an
income administration that keeps tax of individual incomes and then runs
transfers back. Additionally, the program would cost about \$600 billion
a year, which is about a fourth of total federal expenditures. So we
would be running a transfer program that's larger than Social Security,
larger than Medicare, larger than virtually anything we see right now.

MR. ROSSOTTI: With a prebate?

PROFESSOR LAZEAR: With a prebate, \$600 billion dollars, or with a
targeted rebate. They cost about the same, as it turns out, even with a
targeted rebate it would be about somewhere in the neighborhood of \$600
to \$700 billion dollars. So we're talking about big money going through
government hands. All right, so let me conclude then with three thoughts
and then turn it open to discussion, although you guys \--

MR. ROSSOTTI: What would the rate be up? What would it do for the rate?

PROFESSOR LAZEAR: The rate \-- sorry, very good point. The rate would go
up to anywhere between 34 and 49 percent, again, depending on your
assumptions about evasion. So figure, you know, sort of in the middle of
that range, about 40 percent.

MR. ROSSOTTI: That's still the broad base?

CHAIRMAN MACK: That's with the broad base again?

PROFESSOR LAZEAR: That would be with the broad base, but with the
prebate or targeted rebate. Either one, they're about the same, targeted
rebate structure or prebate. Okay?

CHAIRMAN MACK: So that initial range of 22 to 27 with a prebate, large
base, low-evasion ends up being a rate \--

PROFESSOR LAZEAR: 34, it goes to 34. So if you start with the broad base
but you build in a prebate or targeted rebate, you go up to 34 percent.

MR. ROSSOTTI: And that would be in addition to whatever the states taxes
are?

PROFESSOR LAZEAR: That's right.

MR. ROSSOTTI: So if it was 34 and they had a 6 percent tax, you'd be at
40?

PROFESSOR LAZEAR: That's right. Okay. All right. So let me conclude then
with three thoughts. First of all, I think there's much to recommend a
National retail sales tax, at least at the conceptual level. In some
sense it's the best form of tax; it's a straight consumption tax.
Consumption taxes have many beneficial features. The National retail
sales tax is simple, straight forward, and in its purest form results in
limited economic distortion. So that's the good side. Second, it \-- I
think it is probably unrealistic to think we can maintain the broadest
base. What we'll probably end up with over time is likely to be a
narrower base than we start with and increasingly so, which means that
rates will have to be high and perhaps very high. As rates become high,
we invite additional evasion. Third, plans that have been proposed and
considered result in different distributions of tax burdens in those
that we have now. In particular that means that the middle class is
likely to see tax increases of between 15 and 20 percent. In order to
remedy this we would have to run some kind of income base transfer
program, and although feasible what that would imply is running about
\$600 billion through a transfer program administered by the federal
government every year. So let me stop there and open it up for
discussion.

CHAIRMAN MACK: Good. That was an excellent presentation.

PROFESSOR LAZEAR: Thank you.

CHAIRMAN MACK: Who wants to \--

MS. SONDERS: I have one question. Explain why it would be equivalent
with a universal prebate program and a targeted \--

PROFESSOR LAZEAR: Rebate?

MS. SONDERS: \-- because the targeted rebate would just give more to the
lower income people so the numbers net out the same?

PROFESSOR LAZEAR: It's actually the reverse. What's happening is in the
prebate system you're giving too much to the bottom and too much to the
top. The way to think about it is the top doesn't need it \--

MS. SONDERS: Right.

PROFESSOR LAZEAR: \-- but the bottom, because it's a fixed amount that's
supposed to cover everybody \--

MS. SONDERS: They're getting a much better \--

PROFESSOR LAZEAR: \-- you give them, you know, too much in the sense
that if you were trying to get them right back to where they are right
now that prebate system gives them more than where they are right now.
Where does it take it from? It takes it from the middle class. So if you
just kind of spread that back over the income distribution, it tends to
cost about the same thing. It just works out that the numbers are about
the same.

MS. SONDERS: Okay, thanks.

PROFESSOR LAZEAR: Yeah.

CHAIRMAN MACK: Jim?

MR. POTERBA: Ed, one of the common concerns with taxes, the rates that
you alluded to at various points, is just that compliance issues would
become very difficult? As best I can tell from looking, we don't have
much direct evidence on that just because there's not much experience in
the world with taxes, you know, retail sales taxes or even value-added
taxes that the kind of rates that we're discussing are there. I mean is
that roughly an accurate description of what we know or do we have any
on-point evidence that tells us about the compliance risk with these
things?

PROFESSOR LAZEAR: Yeah, I mean unfortunately \-- we've heard testimony
on it. I don't know if you recall; I think it was in \-- I'm trying to
remember which hearing \-- my memory fails.

MR. POTERBA: Was it the San Francisco meeting?

PROFESSOR LAZEAR: I think it was the San Francisco hearing where we
heard testimony from a couple of European administrators who suggested
that anything above 20 to 25 percent would result in massive evasion.
Now, I don't know on what they based that evidence, but that was the
claim that we heard. I mean there are logical reasons why that would be
the case if you kind of do a back in the envelope calculation on what
are the incentives to engage in that kind of evasion, it's pretty
significant. But I don't think they really presented us with any
empirical evidence, those \--

MR. POTERBA: Yeah, you know, I think that one \-- we can certainly
discuss this as a replacement for the whole personal and corporate
income tax option, but I think that realistically as it might well play
out, given the rates that one gets into with the full replacement that
it may, in fact, turn out to be a partial replacement so that it becomes
much more similar to what we discussed at the beginning of the morning
with the VAT as a part of all this, just because if it does become
difficult to raise additional revenue with the retail sales tax at the
rate where it's stuck, then we may well turn to the individual income
tax or the corporate income tax as a way to try to fill the gap.

PROFESSOR LAZEAR: That's a very good point.

MR. ROSSOTTI: I don't know \-- remember the numbers, but it seems to me
that there was possibly a little bit of data in Canada where they tried
in one of the providences that posed an extremely \-- it wasn't on the
whole base but on certain products like cigarettes they had very, very
high taxes, sales taxes, and I think they eventually backed-off because
the evasion was so great.

PROFESSOR LAZEAR: Everybody was going to the United States to buy their
cigarettes.

MR. ROSSOTTI: Well, that was one of the evasions. I think one of the \--
when we talk about evasion it's a general word, but I think one of the
things that we need to remember is what some of the kinds of simple
evasion you could have with retail sales taxes because \-- and remember,
they're not supposed to be \-- they're supposed to be imposed only on
consumers, not on businesses, because a business is using it for its
internal business and it's not a final product. So that just means
basically there's 35 million people right now who are self-employed to
some degree, so if they could go into a store, you know, whether it be
Wal-Mart or Home Depot and say that they're buying such and such a
product for their business and they might even have a number that says
they have a business, you know, instead of paying 35 percent \-- you
know, instead of paying, if they bought something for \$100, instead of
paying \$135 they pay \$100, then all they have to do is use their
number to go into the store, who's going to challenge them to say that
they're using this particular home product for their home business. And
then if you want to extend it further, you say well this is 35 percent
of the people now who are reporting under taxes that they're
self-employed; if they have that kind of benefit from being
self-employed, you know, maybe you'd have 100 million people that would
be self-employed to some degree because they \-- all they have to do is
show they're doing something; they can get a number to show they have a
business, they go in and buy products without having it be subject to a
40 percent tax. I think that the evasion issues, you know, are not so
theoretical when you get into these kind of numbers and especially with
broad based taxes. They can be pretty substantial.

CHAIRMAN MACK: Ed, do you remember \-- can you give us some thought as
to the difference between the "Fair Tax", as the group refers to the
National retail sales tax. If I remember correctly that they have
indicated that they believe that a 22 or 23 cent or percent tax would be
sufficient to replace the income, personal and in essence almost all
federal taxes, and yet we had heard this morning that you're looking at
22 percent that just does the corporate and the personal income tax. And
I'm just wondering are there some \-- what are the reasons for the
difference?

PROFESSOR LAZEAR: Yeah.

CHAIRMAN MACK: Because, I mean, you know \--

PROFESSOR LAZEAR: There are two. The small one is differences and
assumptions about evasion. The major one has to do with government
expenditures. What the Fair Tax people do is they assume that everybody
would pay taxes, so government services are taxed for the purposes of
calculating revenue, but they don't build in to the cost of running the
government, the additional tax. So the problem is you get it on the one
side; you get the revenue, but then you don't have to pay for that. So,
in other words, if we were going to make our plan revenue neutral in
some sense, what we should really do is we should build into our revenue
neutrality an assumption to the fact that the government is now going to
have to pay tax on all of those services as well. So, their failure to
take account of that results in lower numbers. When Treasury did the
calculations for us, I think they did it appropriately. They took into
account the tax on both sides of the equation and got the correct
number.

MR. POTERBA: I think there's also an issue about just an arithmetic
issue about the measurement of the tax rate on a tax-inclusive or
tax-exclusive rate.

PROFESSOR LAZEAR: Good point.

MR. POTERBA: Just think about a simple example of you go to the store
and you buy a candy bar for a dollar and the tax rate is 50 percent; you
pay 50 cents in tax. The way Ed has just been describing that tax it
would be a 50 percent tax on what you purchased. You could alternatively
say what fraction of the tax-inclusive price, the \$1.50 that you had to
pay to actually get that \$1.00 candy bar including the sales tax, what
was the tax rate on the tax-inclusive price. And then it would be 50
cents over \$1.50, so it's only a third. And this difference is small
when the tax rates are little, but when the tax rates get to the range
of 30, 40, 50 percent, this difference gets large. It's not obvious how
one ought to portray these tax rates. The way we currently run those
retail sales taxes in the states, they are run on a tax-exclusive basis,
which means you buy something for a \$1.00 and then they add on the
extra 8 cents or whatever. On the other hand, the income tax at the
moment, you know, if you think about it, you earn \$1.00, you get to
keep 65 cents of it, the tax there, in some sense is run on a
tax-inclusive basis because we're describing the tax rate of 35 percent
on the dollar that you earned, not on the 65 cents that you got to keep.
And that difference of how to present the numbers turns out to be an
important part of some of this.

CHAIRMAN MACK: I think I have only one last point to raise, and I think
you touched on it in your comments. There is a potential problem in
this; maybe integration is not the right word to use, but the impact on
states. If you were to replace the income tax at the federal level with
the National retail sales tax, you've got what, 45 states that have \--

PROFESSOR LAZEAR: It's somewhere close to that.

CHAIRMAN MACK: \-- 45 states that have an income tax. Fundamentally, I
think they use the federal income tax as a base. So, you've got that.
You've got the issue about well, would you have a different base for the
National retail sales tax versus what an individual state base would be.
Would they conform there's to the federal? One could make an argument
that they would. They, in most respects have done that with the income
tax, but I think that is another issue. I suspect and I will again look
to you all, we could go on and on and on with the discussion about this,
but I get the sense and I've picked this up since the first meetings
that we held, or the hearing, or meetings we held that this is not an
area in which the Panel wants to pursue. John?

VICE CHAIRMAN BREAUX: Yeah, I mean I think the points that have been
made are to be well noted. I mean evasion is a huge problem and the
complexity of it I think is far more complex than anything else that
we've considered and looked at. I mean you made the points about all the
states that have a state sales tax, how about all the municipalities? I
mean in that 47 you're adding literally thousands that rely on that as
the main way of, you know, raising their revenues for city governments.
So I just think when you add up the evasion potential and the complexity
potential I think that you got something that is not something that I
would favor moving towards.

CHAIRMAN MACK: Is that \--

MR. FRENZEL: Ed, could I ask you, when you make the change to the
national sales tax, you have an enormous effect on general price levels,
don't you?

PROFESSOR LAZEAR: Well, you know, this is a tough issue. This is sort of
the macroeconomic effect. Remember that at the same time you remove the
tax on income. So just take the simplest case and I'll sort of doing an
economics one thing here. I'll try to do it very quickly, but take the
simplest case. Suppose that what you did was you raised taxes on goods
purchases by 25 percent, but at the same time you give people back take
home income that's 25 percent higher because you're not removing the
income tax. If everything \-- if everybody had the same amount of
dollars and tax burdens were distributed evenly, then it would be
neutral. The problem of course is that everybody doesn't have the same
tax burdens, everybody doesn't have the same amount of dollars, and so
there could be secondary and very important macroeconomic consequences
of this.

MR. FRENZEL: Yeah, and if your current income is not protected against
inflation or that increase, you're in trouble.

PROFESSOR LAZEAR: You're hurt. That's right.

MR. FRENZEL: If you're on fixed income \--

PROFESSOR LAZEAR: Exactly, I was going to say \--

MR. FRENZEL: \-- you get beat over the head.

PROFESSOR LAZEAR: Particular \--

MR. FRENZEL: Another question, most of our professionals now operate
under LLC's or S Corps or whatever. They of course have been used to
paying no taxes at the, what we would consider to be the corporate
level, the institutional level, now suddenly those businesses are paying
those taxes, the national sales tax. So, there suddenly immensely
disadvantaged compared to where they were when we started.

PROFESSOR LAZEAR: Yeah, there could be very significant transition
effects associated with that problem. It's actually akin to the question
that you asked before. If you think about retirees, individuals who say,
feel they already paid their taxes in on particular kinds of plans and
then now they're getting taxed again because it's built into the
consumption, similarly business that went in investing, taking into
account that they weren't going to be taxed on that investment, now they
get taxed on it. So you would have some transition issues that could be
quite substantial and quite significant. You may actually have a
substantial number of bankruptcies as a result.

CHAIRMAN MACK: Any other thoughts, questions? Then, I would summarize
then this area is that basically we have come to the conclusion we will
not be recommending this as an alternative. That decision is pretty
clear. Besides the concerns about rates and evasion, the issue about the
distribution and the size of government transfer programs weigh heavily
in that decision. Is that fair?

VICE CHAIRMAN BREAUX: Complexity too.

CHAIRMAN MACK: Complexity too. All right, well with that I think that
that concludes our meeting for today and thank you all for coming.

VICE CHAIRMAN BREAUX: Next meeting when?

CHAIRMAN MACK: A week for today, October 18. I might just mention that
before that Beth had to get off the phone a few minutes ago. She
indicated she was not in favor of recommending the National retail sales
tax and Tim Muris indicated that he was in that same position.

MR. FRENZEL: Can you tell us what time we commence on the 18th?

CHAIRMAN MACK: 9:00.

(Whereupon, the above-entitled matter was concluded at 12:47 p.m.)