UNITED STATES OF AMERICA

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PRESIDENT\'S ADVISORY PANEL ON

FEDERAL TAX REFORM

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SIXTH MEETING

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THURSDAY

MARCH 31, 2005

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The Panel met in the Golden Gate Room, Building A, Fort Mason Center,
San Francisco, California, at 9:05 a.m., Connie Mack, Chairman,
presiding.

PRESENT

THE HONORABLE CONNIE MACK, Chairman

ELIZABETH GARRETT, Panel Member

EDWARD LAZEAR, , Panel Member

JIM POTERBA, Panel Member (by telephone)

CHARLES O. ROSSOTTI, Panel Member

LIZ ANN SONDERS, Panel Member

WITNESSES

GOVERNOR ARNOLD SCHWARZENEGGER, Governor of the state

of California (videotape)

WILLARD TAYLOR, Partner, Sullivan & Cromwell, LLP

MIHIR DESAI, Rock Center for Entrepreneurship

Associate Professor, Harvard Business School

JEFFREY OWENS, Director, OECD Center on Tax Policy

and Administration

LARRY LANGDON, Partner, Mayer, Brown, Rowe & Maw, LLP;

Former Commissioner, Internal Revenue Service,

Large & Mid-Size Business Division

PAUL OTELLINI, President and Chief Operating Officer,

Intel Corporation

WITNESSES (Cont.)

ROBERT GRADY, Managing Director, The Carlyle Group and

Member of the Board of Directors

of the National Venture Capital

Association

MILTON FRIEDMAN, Nobel Laureate in Economics, Senior

Fellow Hoover Institute

MICHAEL BOSKIN, Tully M. Friedman Professor of

Economics and Senior Fellow,

Stanford University and Hoover

Institute

ALAN AUERBACH, Robert D. Burch Professor of Economics

and Law, University of

California, Berkeley

I‑N‑D‑E‑X

Page

Welcome by the Panel Chairman 4

Panel: Overview of International Tax Systems

Testimony of Willard Taylor 9

Testimony of Mihir Desai 19

Testimony of Jeffrey Owens 36

Testimony of Larry Langdon 51

Panel: How Taxes Affect Business Decisions

Testimony of Paul Otellini 77

Testimony of Robert Grady 86

Remarks by Milton Friedman 111

Panel: Impact of Taxes on Savings,

Investment, and Economic Growth

Testimony of Michael Boskin 130

Testimony of Alan Auerbach 143

P‑R‑O‑C‑E‑E‑D‑I‑N‑G‑S

9:05 a.m.

CHAIRMAN MACK: First of all, I want to welcome everyone who has shown up
this morning on this gorgeous day where we\'re all inside and also say
to the panelists who are going to make presentations this morning how
appreciative I am of the effort that you all have made in the
preparation and the travel and to be with us and to give us your
insight.

A couple of other kind of housekeeping items. I just want to introduce
the folks who are on the panel with me this morning. To my left is
Elizabeth Garrett. She\'s the Professor of Public Interest Law, Legal
Ethics and Political Science, University of Southern California. Beth
also served as the Legislative Director for tax and budget to former
U.S. Senator David Boren.

To her left is Ed Lazear, Senior Fellow Hoover Institution and Professor
of Human Resources, Management and Economics, Stanford University
Graduate School of Business.

And to my right, Liz Ann Sonders, Chief Investment Strategist, Charles
Schwab. Ms. Sonders joined U.S. Trust, a division of Charles Schwab, in
1999.

I also want to say Ed Lazear has been really \-- there have been a
meeting or two he was not able to attend in person, but he was with us
every moment and sent by e-mail questions to the panelists and again \--
I really think that the President has chosen an excellent group of
individuals, great backgrounds, deep interest in what we\'re doing and
have provided I think significant input to what we\'ve been pursuing.

A couple of other things. Obviously we are extremely pleased that Milton
Friedman is going to be with us later in the day. I will save my
introductory remarks for him until he takes his seat with us. Also in
just a moment, we have a short welcoming video from the Governor of
California, and I will make a few remarks at this point just kind of
laying out where we are and the panelists that we will be hearing from
today.

We will explore how the tax code affects economic growth and our
country\'s international competitiveness. At our first five meetings, we
have heard much about the individual income tax, the overwhelming
complexity, the myriad of special provisions that treat certain
taxpayers or activities differently, and the distortions that get in the
way of an efficient and growing economy.

Today we are going to continue looking at the relationships between the
tax system and economic growth, and we\'re also going to turn to an area
that is as complex as any that we have covered so far, specifically the
international provisions of the tax code.

We\'re going to have three discussion panels at today\'s hearing. The
first panel will provide an overview of the international tax rules and
describe how those rules affect a variety of important decisions that
multinationals must make to stay competitive. Willard Taylor from the
law firm of Sullivan & Cromwell will provide an overview and describe
how the piecemeal evolution of the rules related to international tax
adds complexity and complicates planning for important business
decisions.

Harvard Professor Mihir Desai will summarize how the tax system affects
multinational activity as well as provide some thoughts on how the
current system hinders the competitiveness of American firms operating
abroad.

As we consider options for reform, it\'s important to understand how
other countries have structured their tax systems, and with us from
Paris, Jeffrey Owens from the OECD will provide us with an overview of
tax systems in developed countries around the world and the forces that
have led to a wide series of tax reform in these countries over the last
20 years.

And Larry Langdon who was in charge of the IRS Large and Mid Size
Business Division and prior to that was Hewlett Packard\'s lead in-house
tax expert will present his views of how our international tax systems
presents compliance challenges for both the IRS and U.S. businesses.

Our second panel will continue to focus on how the tax code affects
business decisions. Paul Otellini, the President of Intel and the person
slated to become CEO in a few months, will describe how the tax code
impacts his company, especially in the all important decision of where
to locate a chip factory.

Bob Grady, a Managing Director of the Carlyle Group, will share his
perspectives on the impact of the tax code on investment decisions. Bob
runs Carlyle\'s Global Venture Capital Group and serves on the board of
directors of the National Venture Capital Association.

And our last session will focus on economic growth, arguably the most
important topics of our hearings. Professor Michael Boskin of Stanford
will explain how our current tax system affects the savings decisions of
U.S. taxpayers. And Berkeley Professor Alan Auerbach will then share his
insights on how the tax system influences business investment. Both
Professors Boskin and Auerbach will describe how fundamental tax reform
could boost economic growth and make the U.S. economy stronger.

And as you can see, we do have a full set of panelists today and it\'s
going to be a challenge, but we will keep them I think on time and on
schedule.

So with that, if we could have the Governor\'s welcome and we will then
move to the first panel.

(Videotape played)

\"Leading Academics and Entrepreneurs: California has a huge stake in
your work because we have vital interests and a vibrant growing American
economy. California\'s farmers and workers and business compete in a
global marketplace, and to keep a competitive edge, we need the state
and federal taxes that are simple and fair.

\"Here in Sacramento, there\'s always so much pressure to spend more
money and to raise taxes, but that solves nothing. Responsible spending
is the best tax relief.

\"I want to thank you all for your hard work on tax reform that is fair
to all and helps our economy grow. You are making our nation a place of
great prosperity and promise. So I know that you will have a productive
meeting and a fantastic stay here in California. Thank you for all your
hard work.\"

(End videotape)

CHAIRMAN MACK: I think that\'s an appropriate beginning. And with that,
Willard Taylor, we\'ll turn to you.

MR. TAYLOR: Is this on?

CHAIRMAN MACK: It is.

MR. TAYLOR: But the slides aren\'t. There go.

Okay. Well, first of all, thank you very much. It\'s a pleasure and an
honor to be here to testify. I\'ve got a brief number of slides, 32, in
which I\'m going to try and give you the overview. It\'s accompanied by
a lot of appendices for those who want to read further.

Now, if you teach international tax in the U.S., you commonly
distinguish between outward investment and inward investment, that is
between investment outside of the United States and investment coming
into the United States. Provisions like the domestic production
deduction that was allowed in the last Act and DSC and FSC rules tend to
be sort of set aside.

Most of the debate and most of the complaints that you hear relate to
the treatment of outward investment and so I\'m going to start there.

Now, what\'s different here? I think a lot of witnesses in other
sessions of this panel have talked about complexity and other problems,
but how does this area differ?

I think there are essentially three reasons. First of all, there\'s a
huge factual change in the U.S. position in the international economy if
you measure it from 1962 when the rules took place to where we are
today.

A modest capital exporter in 1962, we\'re now a big capital importer as
well as a big capital exporter and the world\'s largest debtor nation.

Secondly, the rhetoric and the debate is framed differently. People
don\'t talk about fairness to U.S. individuals when they talk about the
taxation of outward investment. They talk about capital export and
capital import neutrality and sometimes what\'s called national
neutrality.

Capital export neutrality basically takes the view that no matter where
you invest as a U.S. person, you ought to be taxed at the ‑‑ on the same
basis. Capital import neutrality yields taxation to the country in which
you invest and basically provides either a foreign tax credit or an
exemption for the foreign income.

The third distinguishing factor of what goes on in this area I think is
the fact that you can\'t go it alone. You can\'t choose between these
systems and achieve their goals without reaching some sort of consensus
with major trading partners on the appropriate system and probably the
rates of tax.

Now, there are \-- in this capital export/capital import neutrality
debate, from time to time, people say well, why don\'t you just change
the system. We have a foreign tax credit system today and one proposal
is to provide for an exemption system in which you just didn\'t exempt
foreign income of U.S. \-- didn\'t tax foreign income of U.S. companies.
You just exempted it with no foreign tax credit system.

I myself don\'t think that that solves the complexity issue. I think it
probably contributes to the complexity issue, and I don\'t think it
changes the terms of the debate. And we\'ll talk about that little bit
further.

So where are we today? I quoted here a number of prominent academics and
lawyers and I could go on and on. Nobody thinks the system works. It is
as the last quote says a cumbersome creation of stupefying complexity.

Remarkably, notwithstanding that, there is very little consensus or no
consensus on whether it really interferes with the competitiveness of
U.S. business in the sense of making it less competitive than foreign
owned business. There\'s no doubt that complexity interferes with
competitiveness. We\'d be more competitive without that complexity, but
whether it puts us at a disadvantage as opposed to foreign owned
businesses is a debated point.

How did we get to where we are today, to this system that is so complex?
Well, we started in 1954 with a system that was really fairly simple. I
mean broadly speaking, income of non-U.S. subsidiaries, foreign \-- U.S.
owned foreign subsidiaries wasn\'t taxed until it came home. When it
came home, it was a foreign tax credit limited to the amount of U.S. tax
on that foreign income.

But what happened between 1962 and 2004 is ever more complicated
limitations on first of all the deferral of the tax and secondly the
foreign tax credit.

The \-- in 1962, there was a concern that this capital import neutrality
system if you will unfairly favored investment abroad by U.S. people
over the investments they would make domestically. So the 1962 Act
limited the deferral of U.S. tax and unrepatriated earnings of foreign
subsidiaries.

That was followed by further limitations in \'75, \'76, and \'86. At the
same time, Congress became concerned that the foreign tax credit didn\'t
work right because it allowed foreign taxes on one kind of income to be
used against U.S. tax on another kind of income. So the system of
establishing baskets began, baskets of income, and applying the foreign
tax credit basket by basket. And more baskets were added in \'75, \'76,
\'84, and \'86.

In addition, we had to develop very elaborate rules for the allocation
of expenses to determine the foreign tax credit.

And you can take these, as I have in this and the next slide, and just
develop a chronology in which we limited deferral by first taxing
foreign personal holding company income. So no deferral there. Then
foreign based company sales income and so on and so forth through the
years from \'62 to \'86 and without any real change in \'04.

The same thing happened with respect to the foreign tax credit baskets,
although that was somewhat simplified in \'04. Started with passive
interest income, then all passive income, then financial services income
and huge growth in complexity because in a basket system, you have to
identify foreign taxes on specific kinds of income. You have to
separately allocate expenses to that kind of income. You have to do that
for taxes paid and expenses incurred through multiple tiers of foreign
subsidiaries, and then you have to relate this whole thing to the income
that is and is not eligible for deferral under the deferral regime.

I must say it\'s hard to explain in 15 minutes how complex this is, but
it is and Larry and I were talking about this \--

CHAIRMAN MACK: Actually you\'ve accomplished that in about five minutes.

MR. TAYLOR: Okay. That probably means I\'ve lost you, but Larry said to
me is there anybody who really understands these rules. I think the
answer is no.

The best you can get are people who are knowledgeable and smart enough
to say I understand the issue; now let me go look it up. But nobody
understands them so they can answer every question just like this which
is what you\'d expect in a tax system.

Now I don\'t want to focus solely on the foreign tax credit and the
anti-deferral rules because while those were being tightened up,
Congress also enacted a whole bunch of other rules which I mentioned
here all of which are very, very complicated and have not in most cases
been revisited.

I think in evaluating complexity, you also need to understand that the
statutory changes don\'t get made and stay there. They get reversed and
reamended, that they are followed by pages and pages of explanatory
regulations, and that in addition, the Internal Revenue Service on its
own has adopted a lot of regulations which have made life more
complicated, including \-- and I\'ll jump over this \-- the so-called
check the box regulations which have the capacity to very much uncut
subpart F.

The \'04 Act did do some simplification, but it also did a lot of
complication. There were as many provisions that are as complicated as
are simple. It did not begin in my judgment the process of addressing
broad simplification and it arguably dropped the ball on a lot of
important points. So it was not \-- it may have been a mini step
forward, but it was also a step back in some respects.

Now that\'s outward investment. Inward investment is different. Again we
have a big change in the U.S. position since 1954 since we\'re now a
major capital importer.

The debate about what \-- how inward investment, investment by
foreigners, into the United States has not been in this capital
export/capital import neutrality framework. It \-- there hasn\'t been
any great philosophical debate with it notwithstanding its growing
importance.

And one of the great problems I think is that leaving aside issues like
earnings stripping, there isn\'t a political constituency for reform.
Foreign businesses come or they don\'t come, and you don\'t have people
carrying placards about ?Repeal the FIRPTA tax,? or this tax, many of
which don\'t make any sense. It\'s sort of off the radar screen.

The system basically for taxing foreign income consists of three pieces:
a flat withholding tax on U.S. source nonbusiness income like dividends
taxed at regular rates when the business is conducted directly like a
foreign bank with a U.S. branch and of tremendous importance of course
because this is what really prevents the system from being eroded, the
rules that require arm\'s length pricing because most foreign companies
do business in the U.S. through subsidiaries, and those rules are the
only way to stop the erosion of the tax base through mispriced
transactions.

So what are the problems with inward investment? Complexity, arguably
not to the same extent as with outward investment, but still very
complex. Rules that are in my judgment not administrable nor as a
practical matter in fact administered. I mean there are a whole bunch of
rules which as practitioners we never see raised by the Internal Revenue
Service because they don\'t devote the attention to it.

So it\'s on the books, but it\'s not really being administered. And a
lot of rules that are out of date because these rules in their origin go
back 20, 30, 40, 50 years.

So conclusions: What are the issues? I think there\'s general agreement
that the subpart F and the foreign tax credit rules that relate to
outward investment are stupefying in their complexity and not
administrable, and you can say the same about some of the inward
investment rules.

I don\'t think there\'s an easy solution to this. I don\'t think
changing the system is going to change the simplicity question or even
the terms of the debate. I also don\'t think it\'s really an answer to
go back \-- other than sort of a throw-your-hands-up answer to go back
to 1954 because a lot of what\'s happened, although it\'s complex, is
not bad necessarily.

And I then set out the reasons why I don\'t think an exemption system
really would be simpler and we can go over those if somebody to ask
questions about it. But the only way you\'re going to get simplification
in my judgment is to have a serious compromise between the proponents of
the different views as to how we should tax outward investment, capital
export or capital import neutrality, and more important possibly a
serious intent to simplify solely for the reasons of simplification.

So that the debate is not simply between the export/import neutrality
people. There\'s a third person there and he\'s the \-- or she\'s the
simplifier who says simplification is an independent value, and I\'ve
heard both sides of the argument, and we\'re not going to do it simply
because it\'s too complicated.

I think there\'s also a need in this area, whether you\'re talking about
inward or outward investment, to consider other countries, what they do,
tax treaties and international consensus.

CHAIRMAN MACK: Willard, thank you very much and, Mihir, we will hear
from you next.

MR. DESAI: Great. Thanks so much to the members of the panel for the
invitation to be here. It\'s a pleasure and honor to share some thoughts
with you.

I want to provide the perspective of an economist on the issues that
Willard raised. In the process, I want to share with you some research
about the effects of these rules on multinational firms and I want to
share with you some perspectives on \-- this will be available on the
Web site who want to go through this. Terrific.

I want to \-- as I was mentioning, I want to provide the perspective of
an economist on the effects of these rules as well on ways to think
about the efficient design of these rules. In the process, I want to
take you through really four things.

You know, first I want to anchor this discussion in the reality of what
multinational firms do and what we as economists think about what
multinational firms do rather than the caricature of what they do.
Second, I want to take you through some of their behavioral responses to
these tax rules and what we know about them, and then third, I want to
tell you about how economists think about efficiency in this setting and
what that tells us about where we are today and where we should be
potentially going. And finally I\'ll summarize with some costs and
benefits as an economist is wont to do of the current system.

First, this echoes Willard\'s point. This plot shows you the ratio of
outbound foreign direct investment relative to domestic investment. So
this is a way of saying that the magnitude of international activities
for U.S. firms has grown tremendously, particularly in the last 20
years.

To give you some more numbers on this, if you look at large U.S.
corporations, about 40 to 50 percent of their profits come from
overseas. Their overseas activities tend to be more profitable than
their domestic activities.

So it\'s clear that you cannot think about the corporate tax without
thinking about international provisions, and in part what has happened
over time is that there\'s \-- they\'ve been viewed an appendage rather
than central to the corporate tax. And these trends make it clear that
that is no longer a viable way to do this.

Aside from the rising share of multinational activity, I also just want
to take you through some thoughts about how what multinational firms do
is different now than it used to be. You know, so specifically when we
used to think about what multinational firms did, we used to think,
well, they want to serve customers around the world. So they want to
serve some Austrian customers or some Brazilian customers. So what do
they do. Well, they send some capital to Austria or Brazil or China and
then they produce there for the Chinese customers, Brazilian customers,
or Austrian customers.

That\'s the basic idea behind what most people think multinational firms
do, is they send capital around the world.

This, as you can tell, is highly inefficient. You know, why, because
you\'re sending capital and duplicating your activities around the
world. Why would you do that? Well, if there are a lot of tariffs or if
transport costs are really high, that\'s what you would do.

Well, what\'s happened over the last 20, 30 years. Basically these
tariffs and transport costs have come way down. So what multinational
firms do now is quite different. And I\'ve tried to depict it in this
simple way.

Now instead of kind of serving their Austrian customers by setting up an
Austrian sub, what\'s much more likely to happen is there will be some
intellectual property generated in the U.S., a patent, an idea, a
design. That will be shipped over the Austria and their Austrian
subsidiary where they will take that idea and maybe build some precision
machinery.

That precision machinery will then be shipped along with other parts to
Brazil where they will assemble all those things into some kind of a
final good. That\'s a very, very different notion of what multinational
firms do, and it has consequences for tax policy.

This system is one where efficiency is paramount. Tariffs and transport
costs don\'t matter any more and it\'s all about creating this very
integrated efficient production process. And then you serve your
customers all around the world through this process.

Well, what does that mean for taxes and tax policy. It has several
implications I think. You know, first transfer pricing issues loom much
larger. What do I mean by that. Well, now you\'re basically selling to
yourself all the time. You\'re selling patents. You\'re selling goods
and that means you can change those prices very easily. I\'ll come back
to that, but that\'s one big issue. The transfer pricing issues are much
larger.

We know, for example, most international trade for the U.S. is intrafirm
trade.

Second, these very frictionless markets create much greater pressure for
efficiency as a consequence. Tax costs which may have been second order
or third order are much more likely to be pivotal. Similarly tax
advantages are much more likely to be pivotal.

If your home country changes the way they tax you, that\'s much more
likely to be pivotal. So that again raises the importance of taxes.

You know, third, what a good regime should do is really make sure that
firms can create these integrated production processes as efficiently as
possible. That\'s what a good regime should do. And I\'ll come back to
return to that idea when I talk about efficiency later.

Finally, it undercuts the idea \-- and this is some research which
suggests \-- you know, typically we think of the Lou Dobbs version of
FDI where we\'re losing American jobs. Now new research suggests that
that\'s not right, which is basically when American firms go abroad and
expand abroad, they expand domestically. So that changes our notion of
what these firms are doing, and if that\'s the case, then it\'s really
important from a competitiveness position to get these rules right.

Second part of this is going to be about how multinationals respond to
these international tax rules, and the short version is they respond
extremely actively. To be a little bit more specific, there are three
dimensions on how they respond.

The first is kind of the caricature of how they respond which is
avoidance. You know, this kind of brings to mind this million dollar
paperclip that you sell from a high tax place to a low tax place to
change the location of profits. That\'s one way.

There are a variety of other ways: the way you finance yourself, the way
you do your dividends, the way you set up your capital structure. There
are also ways to do this with respect to intellectual property. You
change the way you price a patent. Who knows what a patent is worth. You
can change it and change it pretty freely.

The consequence of all this is that there\'s an enormous amount of
resources dedicated to basically recharacterizing, relocating, and
rearranging profits.

Just to give you some sense of the magnitudes, 10 percent tax rate
differences are associated with 2.3 percent differences in reported
profit rates. You know, given reported profit rates as a benchmark, you
can think of as being 10 percent, that\'s a large difference. People are
basically just changing reported profit rates in response to this.

Similarly repatriations back home respond significantly to the
repatriation tax. That\'s one avoidance.

Second, the way \-- who owns what and exactly in what form those assets
are owned is also influenced by taxation. So Willard walked you through
these basket rules.

These basket rules in 1986 significantly changed the way multinational
firms did joint ventures, which we think of being \-- some people think
of as being an important learning way to enter markets. They were much
more penalized in the process of setting up those joint ventures and
they consequently did less. That\'s one example.

The more dramatic example is firms \-- U.S. firms deciding they don\'t
want to be U.S. firms anymore. They just expatriate and they go to
Bermuda or somewhere else. Well, that\'s been highly publicized.
There\'s another phenomenon that related to that which is new firms just
start in other countries. They still get listed on the New York Stock
Exchange, but they start in Bermuda. Then they don\'t have to deal with
any of these rules.

And that again is a way of saying, you know, who owns what is actually
influenced by this. And finally, you know, mergers and acquisitions get
influenced by this.

So a German company and a U.S. company of relatively the same size
merge. Who should own who and should it become a German company or an
American company.

Well, if Germany or France has more favorable international tax rules
and they\'re doing business all around the world, it\'s going to be a
German company. And there\'s evidence on this on the magnitudes of joint
venture changes as well as firms changing nationality.

Finally and most importantly, there\'s just real effects of investment,
and by that I mean dollars going in different places than they would
have otherwise to build plants.

So where and how much firms invest is being shaped by tax incentives. So
just to give you a sense again of the magnitudes, 10 percent differences
in tax rates are going to be associated with 10 percent differences in
investment. And that is true across countries.

So, for example, when multinational firms go abroad and they look at all
these different tax rates or between home and abroad. So across all
these margins, avoidance, ownership, and investment, we see high degrees
of sensitivity.

Next set of things I want to talk to you about \-- and again this is a
fairly arcane field \-- I just want to give you a map of what
policymakers can do and what countries can do and where we are and what
efficiency tells us.

So this is a simple story, but I think it helps us wade through some of
the complexity. So if you are a policymaker and you want to tax \--
well, you have to decide how to tax multinational activity. You can sit
all the way on the right-hand side of that, and you can effectively do
double taxation.

What do I mean by that? The U.S. company has some profits in Brazil.
Brazil\'s going to tax them and then we\'re going to tax them as well.
That would be double taxation. That\'s full taxation, no relief.

No one does this for reasons you \-- by that I mean no countries do
this. And you can imagine why. That double taxation is highly
inefficient.

You can do something that\'s a little bit more \-- a little less severe
which is you can tax everything abroad, but you can give them full
credits for everything they pay in taxes abroad.

Now that would actually give you some relief from the double taxation.
The problem with that and the reason we don\'t do that and nobody does
that is because in effect you\'re subsidizing other countries\' tax
systems.

If you give them full foreign tax credits for all the taxes they pay
abroad, other countries can start raising their tax rates and we will be
giving them credits for that. So that obviously is not a good idea.

And then finally the most \-- on the far left is you only tax \-- that
income only gets taxed in Brazil. That\'s called exemption.

Several countries either explicitly do this or effectively do this. And
by that I mean they either say they have an exemption system or they
don\'t say that, but they don\'t police it, and so it\'s effectively
that.

So that\'s the spectrum of choices, you know, basically we\'re faced
with. Where are we?

CHAIRMAN MACK: I didn\'t hear. How many countries do the exemption of
foreign income?

MR. DESAI: So a lot of major countries, France, Germany, effectively do
exemption or the Netherlands. There will be many and then there are some
countries that are more like the foreign tax credit systems like the
U.K. and Japan.

It\'s important though that some countries that are calling themselves
foreign tax credit systems, because of the supervision of that system
being pretty weak, it\'s effectively exemption. While we in the U.S. are
actually \-- you know, we actually have a very complex code designed to
actually protect that.

So where are we. We\'re kind of stuck in the middle. We do full
taxation, but we give these partial credits to get around that weird
incentive for other countries, but \-- so that\'s, you know, not full
credits but partial credits, so that makes it a little bit heavier, but
we give deferral, so we don\'t tax them when they earn it. We only tax
them when they bring it home. So that makes it a little bit lighter.

But then on top of that, we have complex allocation rules. If you have
expenses in the U.S., like R&D, that are associated with international
activities, we punish you for that in some sense.

So we\'re \-- I think it\'s fair to say we\'re one of the more costly
and complex regimes in the world.

Where have we been going recently, and I think the short version is in
circles. So we kind of go a little bit towards the left, then we go a
little bit towards the right, and we kind of move around in circles. So
we kind of move towards exemption when we give these repatriation tax
holidays like we did last year, which is a one-time kind of bring it on
home and we\'ll call it quits.

Or \-- and sometimes we move away from exemption by basically
restricting deferral and making tougher allocation rules, in effect
going in circles.

What does efficiency tell us about this debate, and Willard made
reference to this, and I want to just say something about this. So on
the right where we have double taxation, that\'s highly distortionary.
Nobody thinks that\'s efficient for any reason.

What\'s more credible and what Willard referred to as capital export
neutrality is this middle story, and if you think FDI is about taking a
dollar of capital from the U.S. and putting it in Brazil \-- so that\'s
a dollar that\'s kind of lost from the U.S. and going to Brazil \-- then
the right thing to do is do this foreign tax credit system.

If instead \-- and by the way, the logic for that is tax rules are
basically leaving those flows undisturbed. Capital will go where it
would have gone anyway.

If instead you think FDI is not about that but is about making sure that
the highest productivity owner of something owns that, then in fact
exemption can make sense. And what do I mean by that.

If what you really believe is going on is that \-- for example, Wal-Mart
is very good at retailing. They have just great technologies for
retailing. So when they go to Brazil, they don\'t actually put a lot of
capital in Brazil. They borrow locally. They kind of raise money. They
actually just get capital in Brazil.

But what they bring is a really good way of retailing. And if that\'s
what really makes FDI important, higher productivity people doing what
they do best around the world, then exemption can make sense because it
leaves that allocation undisturbed. It makes sure that the highest
productivity person gets to do what they should and we\'re all made
better off as a result.

Almost finally, the cost and benefits of the current system \-- I\'m a
little bit more optimistic about the, you know, concordance of views of
what economists think and partly because I have a paper on this with Jim
Hines which estimates very large efficiency costs of the current system
relative to an exemption system.

And I want to just underscore why that\'s the case. Some people say
revenues are really small from this tax, so how could it be
distortionary? And the answer is that\'s exactly why it\'s so
distortionary.

People are extremely responsive, and when people are extremely
responsive to this, that creates large distortions and large efficiency
costs. So you have a system which has very or relatively speaking low
revenues but high, high efficiency costs, and that of course is a very
bad system.

Compliance costs are also enormous as Willard suggested and American
firms are competing with firms that don\'t face these costs and that
obviously is costly.

In terms of going to exemption, what are the costs of doing that? There
are two big ones that people raise. You know, first if you had more
lightly taxed foreign income, would that lead to outbound FDI, and
Rosanne Altshuler who\'s really a leader in this field has work that
suggests that actually there\'d be very little locational response to
that.

Even if it did, it\'s not clear that that\'s a bad thing, for the
reasons I mentioned earlier, which is if U.S. firms who are growing
abroad are growing more at home, it\'s not clear that that would
necessarily be a bad thing.

Could it lead to an erosion of corporate tax revenues? You know,
possibly, but as you\'ve heard already, that\'s already happening in
pretty significant ways.

Just returning to the President\'s criteria for reforms, on terms of
simplicity, it\'s clear. The current system is extremely complex.
Exemption could be much simpler, and again I\'m a little bit more
optimistic than Willard. It depends critically on how you do these
allocation rules.

You spend some R&D in the U.S., but it\'s got benefits to your
international income, how do you deal with that.

In terms of fairness \-- and this is the one I underscore \-- complex
systems with costly avoidance opportunities are always easier for larger
firms. Larger firms \-- and it\'s been shown \-- are much more
aggressive than smaller firms. Why? Because it costly to go about doing
this.

So it\'s unfair in some sense because you\'re tilting the playing field
towards larger firms, and of course you\'re tilting the playing field
for U.S. firms generally relative to global firms with less costly
regimes.

Finally in terms of growth, as I mentioned, this idea that FDI is a loss
to the U.S. economy is not right. Enhancing the competitiveness of U.S.
firms internationally actually is going to help at home and in addition
the current rules have large efficiency costs.

Just to wrap up. As arcane as they are, international tax rules are
central to the future of the corporate tax. Multinational firms are
extremely aggressive and sensitive in responding to them on the margins
of avoidance, ownership, and investment.

Viewing them as a threat to the domestic economy I think is exactly
wrong. You know, reform should reflect their competitive environment in
part because as they expand globally they tend to expand at home.

The efficient design of these rules, you know, rather than being stuck
in this debate about capital export and capital import neutrality should
probably \-- should actually emphasize the minimization of distortions
to ownership patterns. Again that Wal‑Mart example, making sure that the
highest productivity owner owns those assets. And that suggests lighter
taxation of foreign activities and exemption.

And obviously overall, the current system is extremely distortionary and
as a consequence very costly.

CHAIRMAN MACK: Mihir, thank you very much for that presentation. I\'m
sure we\'ll get back into some discussion about the different points of
view. And, Jeffrey, again thank you for your making the trip to be with
us. That\'s a long, long flight and we\'re looking forward to your
comments. Go ahead.

MR. OWENS: Thank you, Mr. Chairman. It\'s a pleasure in fact for the
OECD to be invited to present its experience to the panel this morning.
I must say I can\'t think of a more pleasant environment to talk about
taxation than in San Francisco. I\'m a sailor, so I\'m having a real
problem keeping my mind on taxes when I look out the window here.

The OECD, I mean we \-- our main function is to encourage countries to
share experiences, to develop best practices, and where appropriate to
develop international standards. And what I want to do this morning is
to draw on that experience in the tax area and really to show you
what\'s been happening throughout the OECD area \-- and you see the
countries on the slide \-- in the tax over the last two decades.

And much has happened in fact. There has been a wave of tax reform that
started basically in mid 1980s. Some people like to think it started
with Reagan. It actually started in the United Kingdom in 1984, yes, but
Reagan was very quick in picking it up.

Now, so what I\'ll do is just briefly describe those experiences and
then also present you with some statistical comparisons so that you can
see how the United States tax system relates to that in other developed
democracies.

The first slide really talks a little bit about what have been the
drivers for tax reform in the OECD countries. Governments want a fairer
tax system, and that\'s \-- clear. Governments also want a tax system
that is overall progressive.

Fairness, it\'s a complex issue. I mean how do you decide when taxpayers
are in similar circumstances. How do you take into account the different
noncompliance opportunities that arise at different income levels.

Nevertheless, I mean for me fairness is one of the key concepts in the
tax reform debate because unless taxpayers perceive the current system
as being fair, they will not comply. No? So I think fairness is a key
concept.

Another driver of reform has been the need to provide a competitive
fiscal environment and one encourages risk taking and one which
encourages entrepreneurship, one which encourages people to get out
there and work, yes.

And governments have recognized that in today\'s environment, a much
more competitive environment, an environment where capital and
highly‑skilled labor are much more sensitive to tax differentials and
\-- that they have to all the time be looking over their shoulder and
asking how does our tax system compare with that of our competitors.

Although I think it is important to keep in mind that tax is only one
factor and I would say perhaps not even the most important factor that
determines location decisions. Nobody goes into Ireland or Russia or
Slovakia just because there\'s a low tax rate. They go in for other
reasons, although tax can act as a barrier for those decisions.

Another driver I think of reform is the need to achieve simplicity. And
again nobody contests ‑‑ in fact we all want simpler tax systems. The
question is though how do you reconcile that need for simplicity for the
need for fairness, yes? And how do you actually have a simple tax system
that operates in a complex environment? That I think is a major
challenge and a challenge frankly that no OECD country has
satisfactorily addressed.

Within Europe, I think another driver of reform has been the need to see
whether we can have tax provisions that encourage a better environment.

So those are some of the main drivers of reform in our member countries.
How then have the 30 member countries gone about trying to achieve these
goals?

The first thing that they\'ve done is they\'ve lowered the tax rates.
Personal income tax rates in fact are substantially lower today than
they were even five years ago and in some cases, these rates have
actually been halved, yes. So a significant fall in rates right
throughout the OECD area.

At the same time as the rates have been coming down, there\'s been a
concerted effort in fact to broaden the tax base for both the personal
and the corporate income tax. How they\'ve done \-- how governments have
done this, they\'ve done it by eliminating loopholes, eliminating
special provisions, and eliminating targeted relief.

I think one reason why this has been such a dominant sort of theme in
the tax reform for the last decade is that people know \-- economists,
politicians, practitioners \-- they know that a low rate, broad-based
tax system, it\'s not only simpler. It\'s fairer and it produces less
tax induced distortions.

Second thing that they\'ve done is to move towards what I call flatter
personal income taxes, and this has been achieved by reducing the number
of tax brackets in the personal income tax scale and today we find that
there\'s very few OECD countries that have more than four brackets. And
there are some like Slovakia that actually has a single positive
bracket ‑‑ a single positive rate of tax, 9 percent.

Another interesting development has been the way that certain countries
particularly in the Nordic countries have moved toward what I call dual
income tax systems. Those are systems under which wages are taxed at one
rate, generally a progressive rate, and then nonwage income, like
dividends and royalties and interest, are taxed at a flat rate \-- a
single rate, yes.

I think a lot of people are looking at what is going to be the
experience of these countries with that particular approach.

Another trend I think has been the way the governments have tried to use
the income tax system to deliver social benefits particularly to the
lower income groups. And what we\'ve found over the last few years is
that many OECD countries have followed the lead of the United States and
put in earned income credits. And frankly that\'s been a success.

It\'s encouraged labor participation particularly by lower income
groups. It\'s also I think produced a fairer tax system.

However \-- and it is a big however \-- it has made the tax system more
complex, and that brings us back to the continual trade-off between your
fairness and efficiency, efficiency/simplicity. So that a problem.

As regards the taxation of dividends, I think the general tendency
within the OECD area has been to try to lighten the burden in fact of
taxation on dividends either by providing relief at the corporate level
or by providing relief at the level of the shareholder, and the next
slide \-- well, I\'ll come to it in a moment \-- will show you how
they\'ve done that.

I think an interesting \-- a structural development in our tax systems
has been this gradual move to place an increased reliance on consumption
taxes and less of a reliance on income taxes, but it is important, Mr.
Chairman, to recognize that no OECD country has decided that they\'re
going to replace the whole of the income tax with consumption taxes.

So in all of our 29 countries, including the United States, you\'ll find
a mix of income taxes and consumption taxes.

Complexity, it would be nice to have just a session on this. It\'s such
an important issue. The reality is is that in most of the reforms that
our member countries have put in place, reducing complexity has not been
a great success. It is very hard to have a simple tax system operate in
a complex environment, yes.

So that has not been a great success story.

The introduction of market based environmental instruments, as I said,
you know, the Green tax reform, it\'s very popular in Europe at the
moment. There are many countries that have put in different types of
measures, CO2 taxes, particular levies that apply to polluting products.

Again the reality is that these raise very, very little revenue, less
than \-- 5 percent GDP. So I think we\'re very much at the start \-- in
seeing Green tax reform take off.

On this slide, the only other point I would make is that what we\'ve
learned in the last 15 years is that tax reform is an ongoing process,
and this may disappoint you. It may actually depress you, but it\'s an
ongoing process. You can\'t reform the system and then walk away for 20
years. It doesn\'t work that way. You need to be continually adapting it
to a changing environment, yes.

That\'s good news for the tax law and probably bad news for governments.

Let\'s move to some of the \-- this is a slide that just shows you a
little bit on how countries tax dividends, but I\'ll skip that. Let\'s
move to some of the statistical comparisons.

And this slide is always in fact the one that politicians tend to like.
You know, what\'s the overall tax burden as measured by tax to GDP
ratios. It\'s not perfect, but it\'s probably the best that we have.

What you see here is that a country like Sweden is \-- has \-- takes
almost 50 percent of its gross domestic product in taxation. You see
also the United States, it has the second lowest tax burden in the OECD
at 25 percent, yes.

The other thing that you can see from this slide is, you know, where
does the money come from, what\'s the rate of reliance on different
taxes. My starting point is that 90 percent of tax revenues actually
come from three sources: income taxes, Social Security contributions,
and consumption taxes, yes. All countries get 90 percent of their
revenues from these three sources.

The U.S. stands out I think as a country that does tend to have a
relatively high reliance on income taxes and a relatively low reliance
on consumption taxes, and that\'s something that I\'ll come back to in a
moment.

MS. GARRETT: Can we interrupt you one minute? The U.S. figures is that
just federal taxes or \--

MR. OWENS: No.

MS. GARRETT: \-- federal and state?

MR. OWENS: All the comparisons I\'m presenting to you take into account
all levels of government unless I say the contrary. That is the only way
that you can have, you know, meaningfully international comparisons.

I think this is a \-- this is a fascinating chart for me. The question
is how did the United States manage to buck the trend in almost, you
know, every other advanced democracy, yes. How come the United States
and the U.K. in fact \-- you know, from \'75 to 2003, the overall tax
burden \-- I was going to say remained the same. It was the same \-- the
level did not change between \'75 and 2003.

I think that\'s an interesting sort of fact to reflect on. I suspect it
may be partly to do with maybe interstate competition. It may have
something to do with the lack of robust consumption tax. It may also \--
it certainly does probably reflect the way the choices that have been
made on how to finance social welfare, education, retirement, yes.

And I think it also reflects attitudes towards government, yes. But to
me this is quite an interesting \-- I mean if you have a Ph.D. student
that wants to do a thesis, this is a good one. How did the U.S. stay
where it is.

Let\'s move from sort of the macro to the micro level and look at some
of the structural features of our tax systems. What we see here are the
top scheduled \-- and I emphasize scheduled not effective rate \-- the
top scheduled rates of personal and corporate income taxes.

What we see is that on the personal income tax side, Denmark has the
highest rate at 60 percent and Slovakia, the lowest at 9 percent. The
U.S. at 40 percent is just below the OECD average. If you look at \--
corporate income tax rates, Japan has the highest rate, 45 percent, and
Ireland the lowest at 12.5. It\'s interesting to see that the United
States is the second highest in fact in the OECD area, although again I
think it\'s important to recognize that that high rate is offset by
quite generous corporate tax relief.

This \-- the next slide then looks at what we call the tax wedge, and I
think the best way to understand this is to actually focus on one
country because it is quite a complex chart to understand.

If you look at Belgium \-- it\'s right on the right-hand side of the
chart. What this chart says that if a company in Belgium decides to take
on a new employee, it will end up by paying 50 percent of its labor
costs to the government either in the form of personal income taxes or
in the form of Social Security contributions. That seems to me and I
suspect to many Belgiums to be a significant disincentive to take on new
labor.

The United States tax wedge is roughly half that of Belgium, and here
we\'re looking at a single individual at average earnings. There are
other charts in the appendix that provide different ‑‑ the same
comparisons for different households.

Turning now to VAT, you know, I think here ‑‑ it\'s very rare in the tax
world that you get a revolution, but VAT is a revolution. For a tax that
only was thought of just about 40 years ago, it has swept through the
world. 29 OECD countries of the 30 now have a VAT and I\'ll let you
guess which one doesn\'t, yes.

Around the world, there are 136 countries that have value added taxes.
What you see from this slide is just some very basic features of the
VAT, and you can see in fact that the \-- in terms of the standard VAT
rate, yes, the lowest rate is found in Japan at 5 percent and the
highest rate in Denmark at 25 percent.

If you then look at how much revenues are raised by VAT, you see within
the OECD area it\'s almost 19 percent of the total tax revenues now come
from VAT. Compare that with the 8 percent that come from sales taxes
here in the United States, yes. 19 percent versus 8 percent.

And I think in fact what we\'ve seen is that VAT has become a very
buoyant source of revenues for government, and it\'s interesting that
most of our member governments have managed to deal with the perceived
regressivity of the tax by various means \-- if I can explain that
later, Mr. Chair.

And to give you an idea of this buoyancy, it\'s interesting to compare
what\'s been happening in the United Kingdom. In 1975, the United
Kingdom had a sales tax. It raised 8 percent of total tax revenue.
That\'s roughly the same as you raise here. Today it has a VAT. It
raises almost 20 percent of total tax revenue. So VAT actually is a very
buoyant source of revenue.

There are many problems with it. It\'s not foolproof, but it does seem
to be able to raise large amount of revenues in a cost-effective way.

I always think \-- and I think it is important for the panel, Mr. Chair,
that as you progress on looking at tax reform you also look at the tax
administration aspects because at the end, one of the criteria \-- and
in some ways one of the key criteria are by which one would judge any
reform is, is it administrative feasible. Seems very appropriate to have
Charles Rossotti enter the room at this time, yes. Excellent timing,
Charles, yes. This wasn\'t arranged.

CHAIRMAN MACK: For those of you who don\'t know, but I suspect most of
you do, Charles is the former Commissioner of the IRS and is a member of
the panel. Welcome, Charles.

MR. ROSSOTTI: Thank you.

MR. OWENS: I\'ll just say, Charles, that I think administrative
feasibility is one of the key criteria that any reform proposal must be
judged by.

Life today is not easy for tax administrations. Tax shelters abound.
More and more taxpayers have easier access to tax havens. General
attitudes towards tax compliance is declining and I think also tax
administrations have difficulties in keeping pace with changing business
models, the type of changes that Professor Desai has described.

I mean I work on the basis that most tax administrations are at least
five years behind the curve, yes, and that\'s probably optimistic.

So I think there are many challenges that face tax administrations. How
are they responding to these challenges. In part by using new
technologies to provide a better service to taxpayers, in part by using
new technologies to enforce the tax system more effectively.

What I think is important is that you\'ve got to get the balance right
between service and enforcement. It\'s not one or the other. You need
both good service and good enforcement if you\'re going to get good
compliance.

And that in a sense has been I think the mantra for many commissioners
to get that balance right. But I think also commissioners are
recognizing it\'s not enough. They\'re \-- also I think they\'ve
accepted that they must get out and put tax \-- paying tax at the center
of a good corporate governance agenda so that boards of directors are
aware of both the financial and the reputational risks that are
associated with any tax strategy.

The last slide then is really bringing together the experience of OECD
countries in terms of the process of reforms. I\'m not talking about the
substance here. I\'m talking about the process. How do you get the
reform in place.

I think many of these factors will apply to the United States. Not all,
but I think many of them will.

And so I think \-- you know, you need to reflect on as you move forward
in your discussions on tax reform.

Three concluding comments, Mr. Chair. One, I think fundamental tax
reform, it will always require a trade-off, a trade-off between
efficiency, fairness, effectiveness, and administrative feasibility, and
that is the difficult issue. How \-- where do you put the balance. Where
do you put the emphasis.

I think economists can help by providing an analysis and good data. I
think looking at the experience of other countries can also help.

A second concluding comment is that I mean I\'ve \-- in ten minutes, I
clearly have not been able to present all the richness and the
experience that the OECD has in this area. The annex to my paper does
provide some more information.

But, Mr. Chair, we will be very happy in fact to provide additional
comparative information to the panel as you proceed in your discussions
and reflections on fundamental tax reform. Thank you very much.

CHAIRMAN MACK: Thank you. Thank you again for that wonderful
presentation, and I believe we\'ll be taking you up on that offer. And
lastly we will go to Larry.

MR. LANGDON: Thank you, Mr. Chairman. I think it\'s extremely important
that we deal with this topic and frankly we do it in a constructive way
that has been outlined by the panel.

What I\'m going to do is frankly build on my other three panelists\'
comments, but put an increased emphasis on the need for simplification
and also hopefully a better understanding with regard to how diverse the
taxpayer base is both in the United States and abroad.

First, it\'s clearly been articulated and it\'s clear that we\'re in an
increasingly complex global economy. It\'s both inward and outward
bound. International tax competition is an important factor, but it\'s
not the be all, end all.

We\'ve got to concede that different countries have different advantages
with regard to certain types of business practices and frankly tailor
our tax system to a degree to acknowledge that and not try to change
that.

Jeffrey did a very good job of articulating the need for a broad-based
tax system. We need to acknowledge and understand what\'s happening on a
global basis. Many of the issues that we face here have been faced
abroad and in an increasing global economy, it\'s very, very important
that we encourage both inward and outward bound investment.

Daimler-Chrysler \-- I used to work at Ford ‑‑ in certain respects needs
to be treated the same as Ford on a global basis, and that\'s important.

The thing that has not been emphasized enough in that regard is
intercompany pricing. Jeffrey did mention that. It is the gray area of
tax law, and I think that there is a series of improvements that we can
make in that area, both with regard to tax administration, efficiency,
and most importantly speeding up the resolution process.

And then we have to deal with old myths and new realities. I also manage
customs at Hewlett Packard which in \-- with the GATT arrangement has
gone ‑‑ by the board as being an important consideration, but as you
think about international trade, it\'s no longer the teacup. It\'s the
technology chip, the trademark, the way of doing business. And those new
realities are things that really put a great deal of stress on our
traditional tax notions.

The impact of tax rules on business has been clearly articulated by
other panelists. Income taxes are secondary, but they\'re there. I also
submit that the complexity of our tax system complicates decision making
by business managers and large enterprises, and then one key take-away
that I\'d like to leave with you is vertical and horizontal impact of
the tax system.

We tend to and we\'ve tended to put all of our remarks with regard to
large global enterprises. We totally ignore mid size and small
businesses with regard to the global tax system and I submit that maybe
it\'s a paradigm shift to begin to think of different rules for
different size businesses.

The issues of international tax reform, one, we\'ve got to concede what
isn\'t going to change and I think again the panelists did an excellent
job of pointing out we\'re going to have deferral in one way or another.
It is going to exist with either worldwide or territorial type system.

We need to simplify the rules for inclusion and then as I emphasized
earlier, the arm\'s length pricing issues for related entities are not
going away and I\'ll talk about some proposed solutions with regard to
that.

Simplification of the tax code is essential. What we don\'t take into
account when we add complexity is what do we do in that regard with
regard to tax administration and also what do we do with regard to
taxpayers who then just opt out of the system because it\'s too complex.

And I think that\'s an increasing phenomenon. Charles Rossotti, I\'d
like to cite your book with regard to, you know, the increased lack of
the ability of the IRS to enforce the rules both domestically and
internationally and that is \-- that\'s a scary phenomenon that I think
is in part driven by the complexity of the tax code.

We need to look at the entire taxpayer base and realize that it\'s
global, and there\'s a sense in which the globalization is both with
regard to corporations but also individuals. We have more nonresident
aliens in this country, but it\'s a worldwide phenomenon. The migration
of people worldwide is a challenge and it does impact businesses as
well.

We need to develop more in the way of safe harbors and standards for
compliance and we need to watch how we administer things with regard to
both broad and narrow definitions. And again Jeffrey\'s experience in
some of his criteria from an OECD standpoint I think are extremely
important.

If we increase simplification, I think we will improve the effectiveness
of the tax system on a global basis. Tax administrators and global
enterprises do face significant challenges. We\'ve got to acknowledge we
have limited resources. Even the large companies have difficulty in
compliance, and again we\'re ignoring mid size and small businesses.

Increasingly we\'re seeing the phenomenon with regard to accounting and
tax irregularities that, you know, runs the gambit with regard to
basically good accounting principles to outright fraud, and that not
just a U.S. phenomenon. It\'s a global phenomenon.

We need to take that into account in our tax simplification and tax
administration.

Frankly I\'m a fan of the OECD efforts. More cooperation and involvement
in the United States on a global basis I think is key. We also need to
work more effectively with our treaty partners to speed up resolution
processes. That was one of my goals having responsibility for competent
authority which we didn\'t accomplish which is speeding up the
resolution of tax disputes on a worldwide basis.

And we need to consider various tools and techniques to do that. We \--
in effect what happened in large and mid size business division is we
devoted a hundred percent audit resources to large companies. Medium
size companies basically got 10 percent audit coverage, and then small
companies went substantially lower than that.

In effect that audit profile and the lack of resources I think
substantially impacts tax compliance.

But there is hope with regard to e-filing of corporate returns,
developing audit techniques that work on a global basis and working with
treaty partners in exchange of information.

And then last and not least, I think we need to put a higher priority on
alternative tax dispute resolution techniques, mediation back stopped
with appropriate arbitration and perhaps even an international tax court
of some sort.

With that I\'ll conclude my remarks. Thank you for the opportunity.

CHAIRMAN MACK: Thank you, Larry. And we\'ve had \-- as you could
imagine, we\'ve had many panels over the \-- I guess this is our sixth
hearing and I just want to say you all have just been terrific. The
presentations were extremely helpful this morning and I appreciate that.

Ed, why don\'t we start with you. I know you\'ve got some questions from
Jim. Why don\'t you hold off on Jim till I can see what the timing
situation is.

MR. LAZEAR: Okay. All right. Good. Let me see if I can roll these two
questions into one.

Mihir, you mentioned earlier some of the effects of outward and inward
investment on growth and on jobs in particular. One of the facts that we
know if we look at the data for the U.S. is that probably the most
important determinant of earnings of workers, even in the short run, is
labor productivity. So when productivity is growing, wages are growing.

So with that in mind and to the extent that productivity is affected by
capital and investment in capital in the United States, the inward
component becomes extremely important. And one of the things that you
documented was the growth in that inward investment over time.

If I think about the distortions associated with the tax system \-- and
this is a more general question for the rest of you. If I think about
the distortions associated with the tax system, any tax system that has
the goal of raising revenue also has associated with it distortions.

But the issue I think for us is to think about ways to create a tax
structure that both raises the revenue necessary and minimizes the
number of distortions. So the question would be if you had to target one
particular or perhaps two particular aspects of the tax code
particularly with respect to international investment and flows of
capital, which ones would you say are the most distortionary in terms of
having adverse consequences for investment but at the same time
generating perhaps the least amount of revenue, so kind of a least bang
for the buck that we\'re getting out of those.

MR. DESAI: So \-- thanks, Ed. I would say, you know, two things. You\'re
absolutely right to bring this to wages in some sense, which is what of
course we care about, you know, the most as citizens. And it is the case
that the evidence suggests that these outbound FDI flows are leading to
both, you know, more increased domestic investment and more growth for
those firms, and the translation of that of course is higher
productivity activities in the U.S. and as a consequence, you know,
higher wages in the U.S.

And that \-- you know, it\'s a logic which I think people resist because
it\'s very easy to see activity going abroad and then just say well,
that\'s lost activity and consequently lost wages. And that logic I
think is exactly wrong.

Now on your second question, I\'ll begin to tackle it. You\'re
absolutely, you know, right to emphasize the ratio I think of these
distortions to revenues, and that\'s a big idea I think. We always as
economists tend to think about the ratio of revenues ‑‑ or sorry \-- the
ratio of distortions to revenues.

And the international tax regime generally, I would submit, is one where
that ratio is extremely high. Extremely high levels of distortions, very
little revenue, and as a consequence within the spectrum of the tax code
generally, I think it\'s fair to say that the international provisions
are among the worst on that margin.

With respect to the specifics of particular aspects of the international
tax code or the tax provisions on international income, I think probably
the most distortionary are some of these allocation rules. You know, and
we didn\'t talk about them, but they\'re really at the heart of this.

And that means, you know, you borrow money in the U.S., but some of that
capital is meant to go abroad. You do R&D in the U.S., but some of those
ideas end up getting used abroad. And so there are these really complex
systems which evolve to make sure that that\'s done correctly and in the
process, very kind of arbitrary rules of thumb are used or ratios are
used. There\'s a lot of gaming and it \-- I think that within the
international spectrum \-- sorry \-- with respect to the international
rules is probably one of the most, you know, distortionary.

MR. OWENS: Perhaps I could just add to that because I think you\'ve got
\-- one of the major barriers to both inward and outward investment is a
lack of certainty, and if you\'re multinational, you\'re going into a
country, what you want to know is am I going to pay 10 percent, am I
going to pay 15 percent, and sometimes, you know, you\'re more \-- less
concerned whether it\'s 10 and 15 than what the actual figure\'s going
to be.

And I think this comes back to the complexity issue. The more complex
the international tax arrangements are, the greater it is to achieve
that certainty.

The second related I think barrier and one which Larry raised is this
lack of effective dispute settlement procedures. I think a multinational
enterprise has the right to know that if there are disputes between two
tax authorities, there are mechanisms in place that will ensure that
those disputes are resolved.

That seems to be something that\'s a very useful thing for the
multinationals.

A general comment I think on this whole link between your level of
taxation, structure of taxation, and competitiveness, I think you have
to look at what are the taxes used for. You know, tax revenues just
don\'t disappear. They\'re used to do things, and I think sometimes
governments use the tax revenues in ways which actually increase the
productivity of their economies.

Think about the fact that in every survey I\'ve seen of competitiveness
always puts Finland as one of the most competitive countries in the
world, and yet Finland is also one of the highest taxed countries in the
world.

MR. TAYLOR: I don\'t know whether your question called for answers from
all of us, but it\'s wrong to look for one or two things exclusively to
fix in this. You know, that\'s possibly \-- and I don\'t mean this
disparagingly \-- an economist point of view.

I mean at some point you ought to take a lawyer\'s point of view of
this. You can go down through the Internal Revenue Code and if none of
us had clients here, we could reach an agreement I\'m sure on the
deletion of numerous provisions with very probably inconsequential
revenue effects, but huge simplicity.

And we have taxes FIRPTA taxes, for example, we impose this elaborate
tax on sales of real properties by foreigners which is a like a window
tax. I mean it\'s completely irrational in a rational tax system, and
you can make lists of this and just click them off and make a major,
major contribution to simplicity.

CHAIRMAN MACK: Liz Ann.

MS. GARRETT: My question is somewhat related to Ed\'s although I\'m torn
because I\'d also like to talk more with Mr. Owens about the move in the
VAT system and I hope that the additional \-- I know you have a paper in
here and I hope there\'s some discussion about how the OECD has been
changing some of their VAT systems and where that revenue\'s been going.
If not I\'d love to see more about that.

But let me follow up on Ed\'s question. As I understand from Professor
Desai\'s presentation and his work, the distortion you were mostly
concerned about as I read what you\'ve written here and what you said is
the distortion in ownership patterns more than some of the other
distortions you talked about which as I understand it leads you more to
an exemption regime than our current regime or our credit regime.

But you\'re still going to have some of the allocational difficulties
that you\'ve already discussed as among the most complex. So I just
wanted to make sure that I understood that as your recommendation and if
you might explain to us more about what\'s the major distortion that you
would focus on rather than others, and then I wondered if the other
panelists could give us a reaction to our moving more toward an
exemption system.

Mr. Owens from sort of the perspective of the OECD and Mr. Taylor and
about how you would perceive as those who are helping the companies with
their tax situations.

MR. DESAI: So I think you\'re right to characterize \-- the way you
characterize my views is exactly right and let me try to explain a
little bit about it.

This notion that FDI or multinational firms are taking dollars of
capital, that was quite current in the \'60s and \'50s, and anybody \--
and I\'m not one of them, but if you look at people who study
multinational firms deeply, they just don\'t think that is what is going
on.

They really think what is going on is exploiting intangible assets
abroad and it has very little to do with taking dollars from one place
and dollars to another. That\'s a very relevant thing about portfolio
flows. So, you know, Fidelity or Charles Schwab or whoever takes money
and you just kind of take it from one place to another place.

When IBM or General Electric does that, that\'s not what they do. They
take ideas and they exploit them abroad, and in particular they borrow
money abroad. They finance themselves abroad.

And so there isn\'t really that reallocation of capital. That\'s one
which is it just doesn\'t cohere with the facts of what FDI is.

Second, you know, one of the revolutions in economics in the last 30 or
40 years is really an emphasis on ownership and who owns what. You know,
it really depends \-- a lot of productivity depends on who owns what,
what they bring to the table, and as a consequence, efficient design of
tax regimes has to get that right above all else.

And to go back to that example, you know, it could be that Carrefour who
is a French retailer is a better retailer on some dimensions than
Wal-Mart. Could be or the Brazilian retailer who\'s domestic may be
better because they know, you know, Brazil very well.

But making sure that the right person gets to own that store is what
determines big economic differences in terms of outcomes, and so that\'s
why I think the debate has to shift towards emphasizing the distortions
in ownership.

And finally, you know, we see this evidence that taxation is distorting
who owns what. And so that\'s why I\'m particularly concerned about it.

It is the case that allocation rules under an exemption \-- or sorry.
The middle point I want to make is just that it is true that the logic
leads you towards exemption and leads you towards lighter taxation of
foreign earnings.

The question that actually comes up which is how do you deal with these
allocation issues, and that is thorny. I\'m not going to deny that, but
I think you\'d get a lot of simplification from using exemption as the
benchmark rather than using a foreign tax credit system as the
benchmark.

And then we will have to struggle with some of these very thorny details
about borrowings in the U.S. and interest deductions. Do they count for
the U.S. or abroad.

Now \-- but I have more confidence on that dimension than I do on
staying within the regime we\'re in and you\'re trying to muck around
with the same questions.

MR. OWENS: Yeah. And just to answer the question what\'s the experience
of other countries. Again I think it\'s wrong to see this in black and
white terms. You know, worldwide versus territorial, exemption versus
credit countries.

You know, the reality is that most countries are a mix and the real
policy choice is where do you put the balance. And in some countries
like France in fact, you\'ll actually switch from an exemption to a
credit system if you think there\'s tax at risk, yes.

So I think it\'s very important that you go down this debate \-- it\'s
either which is A or B. No, it\'s where do you put the balance.

I agree with Professor Desai that it\'s useful to start in fact from an
exemption system because exemption systems certainly are less complex,
yes. That\'s important.

The \-- I think the other comment I would make that if the panel thought
it were useful, we could put together a short paper for you on the
different international tax arrangements that would describe the
experiences. I mean I would need a long time to explain them at this
point in time, but we could do that for you in the next sort of month or
so.

MS. GARRETT: Thank you.

CHAIRMAN MACK: And we would appreciate that.

MR. TAYLOR: You know, I differ only with my colleague here on this
question of simplicity because I think first of all there is no
exemption system. I mean we can say \-- you know, what is an exemption
system. Is it simply that the U.S. does not tax foreign income and no
foreign tax credit is allowed.

Then I say to you, okay, well, that\'s great. I love your Brazilian
example, but I\'m going to give you another one. I borrow a billion
dollars. I put it in a Cayman Islands subsidiary which does nothing but
buy portfolio stocks and securities, and is that exempt, and you say to
me, oh, no, wait a second. I didn\'t mean that. That\'s not my idea of
an exemption system.

So we\'ll have to figure out how to make that not work. So we\'ll
distinguish between good countries and bad countries or countries that
impose taxes and countries that don\'t, and I\'ll have to allocate that
debt expense somehow.

And when you\'re through doing all of that, particularly in the context
of the way tax legislation is enacted in this country as opposed to
other countries, I think you\'re right back where you started from.

You might as well take that system and you have not gotten away from the
foreign tax credit system because if you tell me that I don\'t get an
exemption on my Cayman Islands earnings, then surely you\'re going to
allow me a foreign tax credit if the Cayman Islands imposes a tax on it.

So there I am. I\'m back again, and I really think that if you want to
move to an exemption system, in a way what you\'re saying is adopting
the theory that you tear the Internal Revenue Code up and anything you
get is bound to be simpler at least for a year \-- you know, which may
be right.

But \-- I mean you could get to the same place by going back to the \'54
code\'s foreign tax credit system. I think if you wanted to move to a
exemption system, you might very well take our foreign tax credit regime
and graft an exemption system on it, but I am not at all optimistic that
there\'s any intrinsic simplicity merit in the exemption system.

CHAIRMAN MACK: And if I could, Larry, rather than to \-- because of
time, I want to move on to raise another question so \-- Liz Ann.

MS. SONDERS: Let me concur with Senator Mack. This is really a terrific
panel and I find myself with six or seven questions that I\'m trying to
condense down into one or two. But I want to stay on this issue of FDI
for a moment if I could.

You know, you\'ve talked about the impact of taxation on decisions
related to FDI and I know, Mr. Owens, I\'ve read some of your work.
There are obviously many other factors, size and maturity of the market
and labor and skills and education and infrastructure and all those
things too, but I\'m guessing that taxation is moving up as a \-- as to
a point of impact.

And I know in particular there have been some citings of manufacturing
becoming more mobile and as a result, they\'re more impacted.

Can you \-- staying on that, whether you answer specifically
manufacturing but more in general, other industries that based on the
current system have more biases for or against them that we need to
consider when we think about this, and I do want to throw in my
follow-up question because I believe it\'s a quick answer.

In the business that I am in in the stock market, we are just deluged
every day with corporate governance issues now. I mean the headlines are
getting a little bit alarming, but it\'s much more about financial
statements.

And I\'m wondering since you made the comment about corporate governance
specific to taxation, do you think enough is being done to monitor the
taxation piece of this from corporate governance perspective?

MR. OWENS: The short answer is no. I think lots of governments have
ignored the link between tax and good corporate governances.

To me there are two aspects to this. One, all countries should be
looking very carefully at their existing tax systems and asking are
there provisions that encourage bad governance, for example, provisions
that encourage the retention of profits. Maybe that leads to bad
governance practices.

Provisions that encourage companies to pay remuneration in the form of
stock options, yes. Maybe that\'s one thing.

The other thing that I think that we must be doing is actually getting
out to, you know, the CEOs and saying pay in tax, you know, you should
be paying attention to this should be on your agenda. And that is not
saying that a company should not adopt an aggressive tax strategy.
That\'s a choice they can make.

But that decision should be made by the CEO and the board and they
should be aware of what are the reputation or risks attached to that
strategy and what are the financial risks as well.

On the first question of the FDI, I think it is important to look at the
way in a sense, you know, FDI has changed. I mean today, you know, in
cross-border trade, it\'s services. That\'s where the big growth is and
that does pose problems with taxation because it\'s always far more
difficult to tax cross-border services than cross-border goods.

I think it\'s also interesting to look at the way in which a
multinational decides decisions on foreign direct investment. To me the
first thing that the multinational says which area do I want to go into.

And let\'s say they decide we want to go into Latin America, yes. For
that decision, tax is not that important, I think. It\'s markets. It\'s,
you know, the whole range of things.

Then once they\'ve decided the area, they\'ll decide the country. And at
that point, they\'ll look at political stability. Extremely important.
They\'ll look at factors that affect long‑term profitability. What\'s
the wage cost. Is there a skilled labor force. What\'s the
infrastructure, yes. What\'s the legal system like.

And then they\'ll look at taxation. Tax does become a factor in
determining which country.

Once you\'ve taken the decision of which country to go into, then the
tax people are the decision makers because in terms of how you structure
that decision. Do you go in by means of a branch or a subsidiary. Do you
finance it from your head office, from your local branch or a foreign
subsidiary so tax is a big driver there because that determines how you
can devise strategies to get your profits out in the most tax effective
way.

CHAIRMAN MACK: If I could, again I\'m going to cut people off because we
just are running short on time. Charles is here. Quick question you\'d
like to pose?

MR. ROSSOTTI: Well, actually just one additional area that I think \--
I\'m sorry I missed the first part of the panel and if you answered
this, then I won\'t \-- don\'t answer it again.

But did you talk at all about the influence of tax regimes in some of
the countries where the most investment is going into now, at least from
the U.S., such as China and India? I mean, you know, I think if you look
at what\'s happening in manufacturing and it\'s an overwhelming, you
know, trend towards having manufacturing \-- on services \-- certain
kinds of services anyway, software and business services. The same thing
is happening India.

I actually don\'t know much about the tax regimes in those countries,
but I just wondered if you had any thoughts about how any of these
issues that we\'re raising apply to those issues because that\'s where
at least right now and probably for the next five or ten years, the
biggest outflows are going to be.

MR. DESAI: I can speak briefly to that which is that both those
countries have been very successful in using tax incentives and tax free
zones either on the services side in India or on the manufacturing side
in China. And so they\'ve been very aggressive in making tax a nonfactor
by setting up areas which are tax free.

MR. ROSSOTTI: So you believe that they have actual transparent taxes \--
you actually know what the taxes are if you\'re going to be doing
business say in China?

MR. DESAI: Right. I think especially in China it\'s a negotiation.

MR. ROSSOTTI: Yeah.

MR. DESAI: I mean I think it\'s basically a negotiation with a person
about how much tax should be paid. I think that\'s effectively, you
know, what happens.

CHAIRMAN MACK: Jeffrey, did you have \--

MR. OWENS: I think in fact \-- I mean we do a lot of work with both
China and India and what we\'ve tried to do over the last five years is
to get them to see that it\'s in their interest to adopt internationally
consistent rules and they are.

I mean they\'ve put in place transfer pricing regulations that are
broadly consistent with the OECD rules, that treaties follow quite
closely the OECD model, yes. And I think that\'s because they recognize
it and this comes back to the \'70 issue, yes.

When you follow the international rules, you know, it provides a comfort
zone for multinationals. You know you go in there. You know what it\'s
going to be. You know if there\'s a dispute, you know how it\'s going to
be resolved, yes.

But I think the other comment I would make is the \-- I don\'t think
that tax is a major barrier to foreign direct investment in these two
countries. I mean large corporations, they just have to be India.
They\'ll go there.

The important thing for these countries is to make sure that you don\'t
have major tax obstacles. And I\'ll give one example of how tax can be
an obstacle.

Just think, okay. Up until about four years ago, Russia had less foreign
direct investment than Hungary. Why? Because for a multinational going
into Russia, you as the tax director could not say what your tax
liability was going to be.

So you have this sort of dichotomy. Tax can be a major barrier to inward
investment. It may not be the driver, you know, it may not be the major
determinant of whether you go in, but it can be a major determinant of
whether you don\'t go into a country.

CHAIRMAN MACK: Gentlemen, again I want to thank all of you for your
presentations and for your thoughtful responses. I\'m sure we could
continue on with question after question. You\'ve raised lots of
thoughts in our minds and again we thank you.

I would ask now if the second panel would come forward. This is a panel
on how taxes affect business decisions. We will have testimony from Paul
Otellini and from Mr. Robert Grady.

Mr. Otellini is the President and Chief Operating Officer of Intel
Corporation, and Mr. Grady is with the Carlyle Group, and again we
welcome both of you and look forward to your comments this morning. And,
Paul, I think we\'ll start with you first.

MR. OTELLINI: Thank you, Mr. Chairman, and good morning, Commissioners.
Let me begin by just giving you a quick snapshot of who Intel is. We
were founded in 1968. We\'re the world\'s largest semiconductor company
and have been so for about a decade. 75 percent of our revenue is
outside the United States. Revenue last year was about \$34 billion.

We have 80,000 employees. 60 percent are inside the U.S. 12 of our 16
semiconductor factories are inside the U.S. as well, and if you\'re not
familiar with semiconductor manufacturing, it is one ‑‑ it is a business
which is intensive relative to R&D and intensive relative to the
deployment and depreciation of capital.

Both of these things have tax implications. Relative to my comments
today \-- and I listened to the earlier panel. I firmly believe that tax
policy is not just about revenue generation, fairness, and simplicity. I
think it\'s also about providing the proper stimulus in terms of
investments and the economy.

And as I look at the U.S. competitiveness, I think there\'s two
fundamental things as we move towards a knowledge based economy that we
need to think about. One is the incentives we provide for continued
research and development inside this country and the other is the
incentives that we provide or don\'t provide in the case of the U.S.
relative to the location of production facilities for the deployment of
the research and development that you do.

These long term I think will drive our competitiveness.

The R&D slot of Intel is I think a good example of what drives our
industry. The two things to note there is that the industry went through
its sharpest decline in 2001 and 2002. Revenues dropped precipitously,
but R&D did not.

Our business, like many of our fellow semiconductor companies, is one
where you have to invest. You have to build new products. Your
generation of products obsoletes itself very quickly, and if you don\'t
have substantial amounts of R&D, you just can\'t go forward.

This year \-- in 2004 we spent \$4.8 billion in R&D. 83 percent of that
was in the U.S., so substantially inside the U.S. This year it will be
in excess of \$5 billion.

Pertinent to the R&D tax credit to the R&D investment is the tax credit.
In this country, the R&D tax credit has never been permanent. I would
point out this is something which is not just used by large companies.
16,000 firms last year took advantage of this deduction.

However, because of its nature of being on and off, it\'s very difficult
to have a long-term view associated with R&D tax credit. R&D investment
in our industry is one that you\'re looking out over five to ten years.
Today our semiconductor technologies are being developed for the
deployment in 2011 and 2013.

And so knowing the levels of credits and so forth that we have forward
is important to the decision making of where we\'ll do the research and
development.

I think making this permanent is \-- making the credit permanent is
probably long overdue. That would be my first recommendation today.

The second and probably the more important thing has to do with capital
expenditures, and as I said earlier, the semiconductor industry is very
capital intensive. Each new chip fabrication facility today costs in
excess of \$3 billion. These are factories that have a useful life of
maybe five to seven years. In their first phase, they\'ll be used for
two to three years and then they have to be retooled with new equipment
and so forth. You can still use the shells.

So when to build these factories and where to build them is the most
important decision a semiconductor CEO can make.

The initial cost of the factory is just the beginning. When we introduce
a new generation, we will change that tooling inside the factory as I
said every 18 months.

70 percent of our capital expenditures \-- and this year, it\'s about
\$4 billion. You can see the trend here in the last decade or so \-- has
been multibillions of dollars per year. Most of it\'s been inside the
United States for semiconductor manufacturing.

In Arizona, for example, where most of our factories are located right
now, we employ 9,600 people working in and around our fabs. The payroll
at Intel for that 9,600 people is \$1.2 billion. But if you look at the
people directly associated with feeding those factories, it\'s 24,000,
and a \$2.4 billion payroll per year.

So when we look at spending \$3 billion a factory, we don\'t just look
at the cost of it. We look at the annual payrolls, annual costs, the
associated tax benefits, so forth, in each geography.

The world around us is changing very rapidly, and I\'ll show you some
data about non-U.S. investments in semiconductor factories.

But the allure of a \$3 billion factory that generates multibillion
dollars\' worth of payroll per year and is a high-tech icon is one that
most emerging countries \-- most emerging nations desire very much, and
we like other members of the semiconductor business are being lobbied
relentlessly to locate factories in the various countries.

The problem we have and the industry has is that it costs today \$1
billion more to build and operate a chip factory in the United States
than outside the United States. And you may first think, well, that\'s
just wages and capital \-- construction costs and those kinds of things.
And in fact as I\'ll show you in a second it\'s not.

It is almost all directly attributed to tax benefits or the lack thereof
in the United States relative to what\'s being offered elsewhere.

This chart looks at a hypothetical but very real example of building a
\$3 billion factory, 300 millimeter, state of the art factory in the
United States versus offshore. And we look at these models not just on
the out-of-pocket costs up front but what it costs to operate over the
ten year expected life of these factories.

So we use a factor called NPC or net present cost. It\'s a net present
value calculation taken around the costs of running a factory. And what
you can see is it\'s a billion dollar gap. There\'s essentially no
change in labor or materials because these are fairly standard around
the world.

You\'re hiring very highly trained individuals to work inside these
factories. Typically they\'re bachelor\'s degrees or above on a
worldwide basis inside the factories.

The big difference is tax benefits and in some nations, which I\'ll show
you in a second, there\'s also capital grants, and that gives you the
difference in the green parts of the bar which are the capital
investments for these factories.

And when you\'re looking at a net present cost of between \$7- and \$8
billion or so here in the United States, a billion dollars is a big
difference and it\'s something that we can\'t afford not to look at
despite the fact that we have significant investments here.

There was a question in the last panel about effective and comparative
tax rates in some of the emerging markets and this is a chart that
we\'ve put together for that.

In the U.S., as you know, the corporate tax rate is 35 percent. There
are various but relatively small state level incentives available to us,
property tax things, purchase kinds of incentives, but relatively small.

Israel will grant us up to 20 percent capital grant and a ten-year tax
holiday 10 percent tax rate for the life of that factory with the first
two years having a hundred percent tax holiday. China, five-year tax
holiday is the current opening bid.

As was mentioned in the last panel, these are all the stated opening
rates for all of these countries. We believe that should we negotiate
seriously with any one of them we would get substantially lower rates
with the exception of the country on the top of the list.

In China, there is a tax holiday, and after that holiday, there is a
normal rate which again is well below the nominal rate that they give
you. In Malaysia, ten-year tax holidays. Ireland, we have two fabs there
now. We currently pay 10 percent tax \-- corporate tax rate there.
They\'re raising that to 12 and a half percent, but they provide other
incentives.

And I would also note that recently even Germany is talking about a 19
percent federal tax rate for corporations which is down substantially
from where they are today.

The investment in semiconductor manufacturing is following the money.

CHAIRMAN MACK: The only thing that I can think that is comparable to
that is that I asked Alan Greenspan a question at one of our earlier
meetings and as soon as I concluded, he was about to answer, the fire
alarm went off. And it was a true fire alarm and everybody evacuated.

We didn\'t get an answer, but we\'re going to allow you to continue.

MR. OTELLINI: Well, I don\'t think it\'s the end of daylight yet. But
most \-- if you look at this, this is a chart that looks at the
deployment right now, real time, of new semiconductor factories. This is
the largest kind of factory built today. 300 millimeter is the size of
the wafer, and this is the way the world is deploying them today. 20
percent in the U.S., 5 percent in China, 33 percent in Taiwan, and so
forth.

If you \-- China appears very low because it\'s 300 millimeter factories
which are to some extent state of the art and you don\'t see China yet
deploying those. If you were to look at all factories being developed
around the world right now, there are 74 fabs under construction. 77
percent of those are in Asia. 24 percent of the world is in China today.
9 percent in Europe and 14 percent in the United States.

So any way you cut it, whether it\'s the most advanced factories or
generation N minus 1 technology, the money is shifting outside the
United States in terms of this kind of investment.

And people like us are looking at that, you know, quite concerned
relative to the erosion of the manufacturing base in this country for
our kinds of product.

So what do we think we can do from a gap closing perspective? There\'s
really four things. There are three things that we\'re \-- we\'d like
you to look at. One is a rate reduction on the corporate taxes and I
understand that this has a revenue implication, but I also believe that
these kinds of factories can absolutely generate more net revenue as the
payroll and downstream implications get rolled out of them.

I think you could think about changing the depreciation schedule for tax
purposes and fully expense those factories in year one. That would allow
for a recovery \-- a better recovery of the present value of money. It
doesn\'t change the long-term cash, but it present values out a little
bit better.

You could reinstitute some kind of investment tax credit or some
combination of all the above.

I think that unless something in this area is done, it\'s very likely
you\'ll see a continued erosion of semiconductor manufacturing at least
moving outside of this country.

With that, I appreciate the opportunity to talk to you this morning and
open to any questions you have.

CHAIRMAN MACK: Paul, thank you very much. Bob, we\'ll turn to you.

MR. GRADY: Thank you, Mr. Chairman, and good morning. It\'s an honor to
be here to testify to this commission today and to you and the other
members of the panel, including my \-- Professor Lazear, former
colleague for many years of mine on the faculty of Stanford and Mr.
Rossotti and others.

I also want to welcome the panel to San Francisco here and to the heart
of Silicon Valley which of course is the heart of the entrepreneurial
economy in the United States and has been for many years in the world,
and the reason I\'m here today is I hope that the recommendations this
panel makes will allow that entrepreneurial economy to continue to
thrive and to succeed.

I\'m here wearing two hats today. One is that of the National Venture
Capital Association which is a group that represents over 460 venture
capital firms here in the United States which represents the
overwhelming majority of venture capital managed here in this country.

We also have an affiliate organization, the AEEG as you see here, which
represents the CEOs of over 14,000 growth companies that favor the type
of entrepreneurial environment I\'ll talk about.

It\'s also worth nothing that of all of the professionally managed
venture capital in the world, about three-quarters of it is run here in
the United States, and this has been a source, as I\'ll talk about, of
tremendous both innovation and job‑creating benefits to our economy.

The second hat I\'m wearing is that of my own firm, Carlyle Group, which
is a private equity firm, in fact the largest private equity firm in the
world by dollars under management with about 24 billion in 26 different
funds. I run the venture capital arm of Carlyle. We have venture capital
funds with about 1.8 billion under management.

We\'ve funded dozens even hundreds of high‑growth technology and
healthcare companies. In total, Carlyle has 377 investments it has made
into companies and this is a significant job-creating and important
contribution in our view because as you can see, those companies
together employ 150,000 people and generate over 31 billion in sales.
And of course the reason we\'re in business is we\'ve also generated
gains for our investors averaging 34 percent on the gross level over the
last 18 years.

I\'d like to talk about three topics today: the role of venture capital
in our economy, just a quick example of how venture capital investing
works, and then obviously some suggestions for this commission.

So first the role of venture capital in the U.S. economy. I mentioned
that I sit on the board of the National Venture Capital Association and
I chair its government affairs committee and in fact I will be chairman
of the organization in 2006.

We commissioned a study by the artist formerly known as Work
Econometrics and Decision Resources now called Global Insight, and we
found some staggering data with respect to the contribution of
venture-backed companies that have been financed in the last 30 years in
the United States.

Venture-backed companies funded since 1970 today employ directly over 10
million Americans. And to Mr. Otellini\'s point about the indirect
benefits, directly and indirectly these companies employ over 27 million
Americans.

In addition, they generated 1.8 trillion in sales, and just to put some
context around that, that\'s about 10 percent of U.S. GDP. It\'s also
about 10 percent of U.S. employment and that\'s on less than 2 percent
of the invested capital \-- the equity invested in that 30-year period.

So it has had an enormous leverage, this venture capital investment, in
terms of job creation in the United States, as well as in terms of
innovation.

And that leverage continues today. We initially conducted this study in
2000 and updated it in 2003, and one of the things that the data showed
was that in that interim period, which was a period of brief softness
for the U.S. economy, venture-backed job growth exceeded national job
growth about 2 \-- actually as you can see 6 and a half percent versus
2 percent job growth nationally \-- the percentage increased 2X I should
say.

And in addition, sales went up faster than the national average, about
11 percent for venture‑backed companies whereas only about 6 percent for
all.

And venture-backed wages of course do grow faster than the national
average.

I\'d like to, if I could, enter into the record as an appendix a copy of
that study as well as a separate one we did on one particular sector,
the life sciences sector, which also was amazing. It showed of course
that more than a hundred million Americans have benefited from
venture-backed innovations in the healthcare sector addressing the big
diseases, heart disease, diabetes, cancer, et cetera.

Another thing that is interesting about this segment, we\'ve talked \--
Mr. Otellini talked about research and development in the United States.

Increasingly large companies have come to recognize that these small
companies are in fact a good R&D lab for the big companies. And in fact
this data that you see in the second bullet on this slide comes from the
National Science Foundation and I believe it\'s staggering. It shows
that the proportion of U.S. R&D performed by firms with less than 500
employees grew from 5.9 percent 20 years ago to about 20 percent today.

So this is not only in the pharmaceutical industry. It increasingly is
across all industries including in technology, I think the
representative from Intel would agree.

And obviously that has contributed these startup companies to major
productivity gains which have contributed of course to U.S. economic
performance, and you mentioned Chairman Greenspan. He has certainly been
one who has cited the role of technology in creating the enormous
productivity growth we\'ve seen in this decade in the last five or ten
years relative to what was thought to be a steady state, you know, 1 or
2 percent productivity improvement.

And whole new industries of course have been created out of that from
biotechnology to buying things online to auto ID which is bar codes and
RFID tags to make the supply chain more efficient and to everything to
do with wireless which is now the rage and the way many of us choose to
communicate all the time.

The industry which supports that has become a large institutional asset
class as you can see from a cottage industry in the 1960s and \'70s.
There\'s now 900 firms that we track in the U.S. in venture capital
managing almost a quarter of a trillion dollars. So it is a significant
institutional asset class.

I just want to briefly touch on how venture capital investing actually
works because it will form my comments on the tax system. And just a
simple example, when we and other firms in the business invest in a
company, it\'s typically in a preferred stock, and it\'s usually the
first or second or third institutional round of financing. Almost always
it\'s before the company goes public of course and used to expand the
company.

But in almost every case, there are really only two \-- to proceeds.
It\'s either R&D or \--

CHAIRMAN MACK: Say that again. I missed that.

MR. GRADY: Oh, okay. Two uses of proceeds. In other words, one, it\'s to
develop new products, conduct R&D, build the products that the
company\'s looking into or to increase the sales force.

The typical company that we invest in I would say today probably
averages 20 employees at entry and if we succeed, a couple hundred at
exit. So it is a job-creating force, but what\'s interesting is the
finance departments of these companies are very small. When we enter,
it\'s usually one person and often it might be two or three over time.
Even the bigger ones that we still invest in might be ten people.

So complexity in the code is very difficult for these companies.

Secondly, there are really principally two ways that we exit these
transactions and that value is realized. One is it\'s sold to a larger
company or the second is, it comes public in the capital markets, most
often in the United States on the NASDAQ, although it can also be on the
New York Stock Exchange.

And it\'s important to note how these companies are valued in those
transactions when they are exited. The most common form of valuing in an
initial public offering is simply a price-earnings ratio. That is the
stock price relative to the net after tax income of that company.

And therefore every point, if you will, in the tax rate is directly
related to the ultimate valuation of that company which in turn is
directly related to the willingness of people to work there and
obviously the willingness people to invest in that company.

Ultimately higher tax rates then will result in less company creation
because they will result in less value at exit for the majority of the
companies.

Now some are valued on a multiple of revenue. That was increasingly
prevalent during the technology bubble that we had late in the 1990s,
although I think people learned the perhaps flaw in that.

And certainly an M&A transaction, people judge whether there\'s a
premium being controlled \-- being paid to the existing shareholders.
But net income is the key variable.

And I say that it also \-- it is related to people\'s willingness to
work there, et cetera. I just think it\'s important to know the
characteristics of these companies. Many of the employees out here are
willing to work and in fact for lower cash and increased ownership.

They \-- we did a survey of all venture capital companies represented by
our member firms. 70 percent of the companies in the venture sector in
the United States award stock options to a hundred percent of their
employees from the receptionist to the CEO.

And in the early rounds, prior to institutional financing, many are S
corps of the \-- the tax for the pure startups is often paid by the
individuals. So prior to this institutional financing, it\'s really a
matter of individual tax rates.

Just to give an example that this is sort of not totally in the
abstract, I just thought I would just highlight our firm. We started in
the venture business out here in 1997 and in that short period of time
in the funds we\'ve invested, we\'ve been fortunate as you can see to
exit through M&A and IPO some of these transactions, but in the 15
companies in which we still hold investments in the first fund and
another 30 or so in this fund, those 38 companies have created over
4,000 jobs and actually more than half of them are right here in the Bay
Area.

Let me turn then to what this means from a tax perspective. First of
all, the history of the venture capital business. I think that the
incentives for capital formation have been critical not only to the
growth of this industry but to U.S. economic outperformance in the last
30 years.

This industry really started to explode after the first sort of major
capital gains tax cut introduced by Congressman Bill Steiger of
Wisconsin, the late Congressman Steiger back in 1978.

It was also by the way around that time that the ERISA rules were
changed to the prudent \-- so-called prudent man rule was changed to say
that it would be prudent to invest in venture capital funds.

There are certainly other factors that have led to the growth of this
industry: protection of IP, our deep and transparent exit markets,
capital markets, the cultural acceptance of the risk of startups. But I
do believe that incentives for capital formation have been critical.

CHAIRMAN MACK: Bob, again because of time, could I get you kind of wrap
up.

MR. GRADY: I will. I have just two slides with recommendations to end.

One is \-- and I should just introduce this by saying that I and I think
most people involved in the entrepreneurial segment of economy am not an
expert on the tax code. Our companies are not experts on the tax code.
In fact it would be difficult to be so given how complex it is.

But so our goals I think are relatively simple. One, policies friendly
to capital formation. We do believe low capital gains tax rates have
been favorable. Certainly encourage the 15 percent rate to be permanent.

Two, a simple code. Most of the entrepreneurial companies I\'ve
mentioned have very modest finance departments. I\'d say the average in
our companies is four to five people.

Complex provisions in the code, I really think are for the most part
designed for much larger and in a lot of cases, what I would call legacy
industries that have a slower rate of job creation. So this is a
hands-on demonstration of when economists talk about distortions, et
cetera, you really see a lot of those provisions are designed to attract
capital to industries, whether it be some in, you know, agricultural or
oil and gas or whatever, that are slower job creators than the
entrepreneurial sector typically in technology and healthcare and some
other fields.

Thirdly, and this was touched on by the last panel, so perhaps we might
get into it \-- low corporate rates. I think one thing it\'s been
interesting as I\'ve read about the committee\'s meetings and some of
the deliberations that one reads about in the newspaper about this panel
is that most of the focus has been on individual rates; what to do about
individual income taxes, whether to move toward a flatter rate for
individuals, et cetera.

But I do think that corporate rates, while they have not been the
centerpiece of your debate, are important as you think about where
companies will locate, not only because small companies tend to be
valued on multiples of net income but also because we are in an
increasingly global economy.

The prior panel highlighted the trend, for example, in OECD in
particular in Europe, of countries lowering their corporate tax rates
frankly as a means of attracting knowledge industries. Ireland, the most
famous example, starting with their 10 percent rate for software
companies and now having a 12 and a half percent rate across the board,
but it\'s been true in the Netherlands, Portugal, et cetera, even
Germany I might say.

I do think that most of the decision making is really driven by the
availability of growth and not tax, but in a global world \-- and this
is the point I\'ll close on \-- it is really not that important where
the company is domiciled. They will seek the lowest tax rate regime as
well as educated people, access to university research, many other
factors, as the prior panel pointed out. It\'s not solely a tax driven
decision.

But the \-- we pioneered, for example, at my former firm, Roberts &
Stevens. We took the first company public on the NASDAQ, created labs
back in 1993 that was located in Singapore.

There is \-- there really is no sort of restraint even in the U.S.
capital markets which are ‑‑ which as I say are the deepest and for the
most part, most highly valued in the world on where a company might be
domiciled. So there is no constraint on a company domiciled in China
coming public on the NASDAQ, Ireland or anywhere else, and to the extent
they\'re operating in a zero tax rate regime, as folks in China today
are, or a low tax rate regime as people in Ireland or Israel are,
that\'s a competitive advantage, and if they continue to invest in
education, et cetera, they will continue to attract more of the
knowledge generating and job generating jobs that I highlighted at the
beginning at the beginning of my testimony.

Thank you, Mr. Chairman.

CHAIRMAN MACK: Thank you very much. Paul, I want to go back to your
comments and get a sense and the first page of your presentation
indicated that 12 of the 16 factories are here in the U.S. I\'d like to
get a sense though about the trend.

Is there a trend to be building of these outside the U.S. given the
other breakdown that you gave us of the differential costs between the
U.S. and international.

MR. OTELLINI: The four that aren\'t in the U.S. are two in Israel and
two in Ireland. And those decisions were made essentially more than a
decade ago and then we\'ve been re-upping those. And it was driven by
economics and by the availability of human capital and by \-- in the
case of Ireland around \-- at the time it looked like Europe was going
to put a significant import tax in on our kinds of products. So we
wanted to be inside the walls around that.

Today it\'s a little bit different. Today there\'s a significant
economic difference and it\'s principally in Asia. Most of the countries
offering the billion dollar differentials are in the Far East and they
also have the ability to give you the same human capital and they also
have a very large and growing market.

So the consideration that we\'ll make on the next factory is much more
\-- much different than ten years ago when we made the decision to go
offshore.

CHAIRMAN MACK: When was the last time you built a \--

MR. OTELLINI: Well, we just are completing a factory in Ireland that was
\-- begun construction two years ago and is just coming online now.

CHAIRMAN MACK: Yeah. And again the last U.S. factory.

MR. OTELLINI: The last \-- there\'s one being retooled now in Arizona.

CHAIRMAN MACK: Okay. And the other thing that struck me with respect to
the differential between U.S. and international with respect to the tax
side, it sounds like it\'s more negotiation about what that tax rate \--
or the tax costs will be as opposed to what the underlying rates \--

MR. OTELLINI: The starting gap is 20 points difference or so \-- and
then you have an opportunity to get a better deal from there. All right.
So even the ante to even draw you into discussions is significant and
then depending on the kind of employment base you can bring and so
forth, you can negotiate a better deal.

CHAIRMAN MACK: All right.

MR. GRADY: I might add, Mr. Chairman, that for startup companies today
in particular in China, the starting rate is usually zero. In other
words, there are whole business parks being created and encouraged and
facilitated with other forms of physical infrastructure by the Chinese
government which when companies locate there tend to have zero ‑‑
startups locate there tend to have zero tax rates.

MR. OTELLINI: We have five factories in China now. None of them are
semiconductor manufacturing. It\'s assembly test. They run a couple of
hundred million dollars each, but it\'s exactly for those reasons. The
land was free. The tax holidays were many, many years.

CHAIRMAN MACK: All right. Good. Charles.

MR. ROSSOTTI: I just wanted to ask Mr. Otellini, do you factor in at all
the fact that under the U.S. tax code and since you\'re a U.S. based
company that, you know, that you would eventually be taxed on that
corporate income if it was \-- when it was repatriated back into the
U.S. or are you just assuming that you\'ll be constantly reinvesting it
overseas so you\'ll never face that \--

MR. OTELLINI: Well, if we were one of the people who were encouraging
legislation for the Homeland Repatriation Act in terms of bringing some
cash back because as I said a significant amount of our investment is
here and we \-- you know, there\'s something north of \$6 billion that
we would be able to consider bringing back now under the temporary
window.

I don\'t see us changing our needs for investment in the United States
any time soon for any reason. It\'s still going to be significantly
large. The issue is on the margin. Where do you build the next factory
and then the one after that and then the one after that.

MR. ROSSOTTI: Thank you.

MS. SONDERS: Maybe I could get an answer to this question that\'s sort
of Intel specific and then maybe more broadly.

The impact of the current tax code right now on a couple of different
things: one, what you do with your earnings, the biases toward the
retention of earnings, dividends, stock buy-backs, and then also the
biases in place driven the tax code for equity or debt financing.

MR. OTELLINI: Well, let me go backwards. We do very little debt. So the
tax code even though it favors debt versus equity, it\'s \-- our
business risk profile doesn\'t necessarily encourage us to want to have
a lot of debt, given the cyclical nature of our business. So we\'ve
historically tended to avoid that.

In terms of the use of cash relative to earnings, we believe \-- two
strong things. One, in our business, that dividends are important. So
we\'ve continuously grown the dividend.

On the other hand, we will use \-- probably spend a lot more money on
buy-backs this year and certainly last year we did than we did on
dividends. And the buy-back tends to be in our view a very effective use
of cash when you have more than you need to run the business.

MR. GRADY: Right of all, in the venture capital sector, for the most
part, companies are not paying dividends or using the capital to
reinvest in the growth of the company, so that has tended not to be a
major priority item for the venture capital business, although obviously
we understand the sort of double taxation argument that\'s long been
made.

I think similarly most of the high growth companies tend to be financed
with equity because in the early stages, they\'re probably not
financeable with debt, although in the current market environment we\'ve
been in, whenever anyone can, I think the feeling is that terms, et
cetera, currently for debt are attractive enough that you\'ve seen a lot
more use of different facilities.

MS. GARRETT: My question is for Mr. Otellini, and it\'s directed at the
potential gap closer slide that you gave us. And there you identified
attention we have to struggle with which is reform that broadens the
base and lowers the rates or reform that might be more targeted in its
approach.

And so I wondered if you could talk a little bit about that with
particular \-- we have the trade-offs that are required in a proposal
that\'s going to be revenue neutral under current scoring conventions,
and so there are always trade-offs as you think about these things.

You\'ve got the trade-off too with respect to durability. It\'s at least
my \-- if somebody watches the political process, it\'s my observation
that these targeted provisions tend to be less durable as politicians
continue to tinker.

There may be problems with durability as well just to take account of
changes and how R&D is moving, how investment is moving, so you want to
keep changing it in that respect, yet we hear over and over that
stability is very important.

So there are all these kinds of trade-offs that we have to think about,
and I wondered if you could address that, Mr. Otellini, a little bit
more with respect to your gap closers, and I take it one of the things
that you want here too is permanence of R&D credits. It\'s not listed on
this page, but that\'s another more targeted kind of provision.

MR. OTELLINI: Yeah. Well, the permanence in the R&D credit is more just
the ability to be predictive. Obviously that\'s a little bit different
than the others.

I understand that you have a lot of things to weigh here and you also
have societal issues in terms of home mortgage deduction, things that
you want to be able to keep. That\'s why I said up front that I think
that there\'s another thread that I\'d like you to think about weaving
through your thoughts beyond fairness and revenue neutrality and so
forth and that is are we providing the proper incentives for what the
country needs in terms of an industrial base long term.

And if we are not focusing on beyond today\'s revenue generation and
thinking about tomorrow\'s capability to be competitive and generate
revenue, I think you\'ll make a terrible mistake.

And that may not be the best answer \-- the answer you\'d like to hear,
but I think that you\'re going to have to make some guns or butter
trade-off in this decision, and without appearing too biased, I would
say that those that are focused on knowledge based industries in general
in terms of where the world is going are probably more important than
ensuring that we are competitive against the Canadian french fries
import which was this week\'s debate about potato taxes and incentives
and stuff.

You know, french fries are fun, but chips in the long term and the kinds
of things that Carlyle\'s venture firms do are much more important to
our country.

MR. LAZEAR: Let me follow on that. I actually had the same question as
Beth did, but let me push you a little harder because your answer is at
variance with what most people think of as an efficient tax system and
that is one that\'s neutral.

So you made an argument for particular kinds of spillovers that come
from your industry that accrue to others in society, but of course other
industries would like to make the same arguments. I mean this is the
kind of stuff that\'s behind locating a ball park in a particular
neighborhood. It generates jobs, generates other kinds of revenue.

What is it that would distinguish one particular industry vis-a-vis
another? Are there basic principles \-- and Bob, you can answer this as
well \-- that we might think about in terms of saying, okay, these are
the kinds of industries that should receive special attention and these
are the ones that shouldn\'t.

MR. OTELLINI: Well, I think that is one ‑‑ that the \$64 million
question; right? You know, a hundred years ago, you could point at that
and say it\'s very clear the industry of the future is going to be
steel. It\'s going to be automobile manufacturing. It\'s going to
transportation on rails, et cetera, et cetera, and none of us would have
understood what happened with aeronautics and electronics.

Sitting here today, it sure seems like the bet isn\'t on those
industries. It\'s on the industries of the future.

And it\'s not just our view. It\'s also the view of our global
competitors relative to countries in terms of where they\'re placing
their bets. They\'re placing their bets in terms of developing
engineering talent, capital infrastructure, manufacturing infrastructure
to compete with the United States, not in steel, but in knowledge-based
businesses.

MR. GRADY: I would agree with everything Paul just said. I would just
\-- I would say though that I think the sort of small company sector,
the economy, the job-creating small company sector would come down
strongly in favor of a broader, simpler, lower rate tax structure. Very,
very strongly.

I don\'t think you can pick industries to which that should apply and
not apply. It should pick across \-- it should apply across the board.

I think there are policy decisions within that structure. You know, how
should certain types of capital investment be taxed at all. Maybe it
should be \-- everything should be expensed in the first year.

One thing we\'re noticing there\'s a tendency of state and local
jurisdictions to start taxing revenues which I do think is adverse to
certainly the startup companies which generally have revenues but not
yet have net income and I think it will \-- that will hurt job creation,
but they are very much in search of tax receipts.

But I would come down very, very, very strongly on the side of a broader
base, much simpler code. The \$225 billion in compliance costs a year is
largely dead weight loss and a much lower rate environment.

CHAIRMAN MACK: All right. We thank you very much for your presentation
\-- your responses to our questions. We\'ll take about a five-minute
break and then we\'ll move on to our next presenter.

(Recess)

CHAIRMAN MACK: Professor Friedman, if you would allow me to just make a
short introduction and then we\'ll turn to you.

I am \-- as I mentioned to Professor Friedman, I\'m especially delighted
that we were able to have you join us this morning.

You\'re widely considered one of the greatest economists of the 20th
century. Professor Friedman is known as the father of the Chicago School
of Economics. For this important work, he received the Nobel Memorial
Prize in Economics in 1976. He was also awarded the Presidential Medal
of Freedom and the National Medal of Science in 1988.

He is currently a Senior Fellow of the Hoover Institution and as you
will see, remains extremely engaged and active in the important economic
issues of the day.

And again it\'s a special privilege to have you here this morning and to
hear your thoughts and as I \--

(Applause)

CHAIRMAN MACK: And if you would give our regards to your wife Rose as
well who certainly has a distinguished career of her own in economics.

MR. FRIEDMAN: Thank you. I\'m glad to be here and contribute whatever
little I can.

Let me start out by first just saying, just in order to have it on the
record, what I think would be the ideal tax system for the United States
for the long run. We\'re not going to get it. But it\'s worth keeping
that ideal in mind so we know in what direction we\'re headed.

And I think most economists today would come close to agreeing that the
major tax ought to be a flat rate tax on consumption, whether that tax
is collected by a retail sales tax or whether it\'s collected by \-- the
way the income tax is by individual reporting \-- would be open to
circumstances.

But it has enormous virtues, that it is the simplest, the most efficient
from an economic point of view, and that it doesn\'t discourage savings,
that \-- and that it has a great virtue which is also the reason it will
never exist, that limits what Congress can do to mess things up from
year to year.

But as I say \-- and that\'s the reason why it won\'t occur. But yet we
have been moving to some extent in that direction with the allowances
for savings, with the tax exemptions for savings, and the various
allowances of that kind.

Now let me turn to some more practical considerations.

I was involved \-- heavily involved in World War II in the construction
of the tax system for the war, which has provided the basis for the
system we now have.

I was an economist at the tax research division of the Treasury
Department in 1941, \'2, and \'3 which were the years of the \--
preparing for the tax system for the war.

And I learned a number of lessons from that which I think are extremely
important. The first is that measures that are taken for short-run
purposes turn out to have a long life and to be very important in the
long run.

And my prime exhibit in that direction is the withholding tax. One of
the things I was involved in at the Treasury was helping to design the
withholding tax.

It comes as a shock to people today to realize there once was a time
when there was no withholding tax. Almost nobody alive today really
knows that.

But before 1943, there was no withholding tax. And the withholding tax
was essential in order to collect wartime tax rates. And we did it for
that purpose.

But in my opinion, it has been a mistake in the post-war period, and we
would have been better off in the post-war period if we did not have a
withholding.

The reason for that is the withholding tax makes it easy to collect
taxes. It\'s taken from your check before you know that you\'ve got it.

And so you could not today have a government of the size it is \-- you
could not have a government budget financed by taxes that amount to
something like \-- for federal, state, and local to something like 30
percent or more of national income. You could not have such a system if
you did not have the withholding tax as a way of raising the money.

So when you consider changes to meet a current need, you should keep in
mind and will keep in mind, I\'m sure, the consequences in the long run.

Another thing that impressed me very much about that episode was the
tyranny of the status quo. Today I do not believe \-- I think the
Internal Revenue Service would throw up its arms in despair if you
suggested doing away with the withholding tax.

But in 1942 and \'3, our difficult opponent in constructing the
withholding tax was the Internal Revenue Service. They believed it was
too complicated and you could never make it work.

And the extent to which whatever is, is. There\'s a tyranny of the
status quo, a strong inertia in things as they are.

That also came out in the same episode. In order \-- we knew that
Britain and Germany both had withholding taxes and we discussed how to
structure withholding tax with both Britain and \-- the British and
German experts whom we could get hold of. We had plenty of German
experts because of the refugees.

They were certain that the only way you could possibly do it was the way
they were doing it. The issue at that time was do you have a correction
possibility or is the withholding tax a final tax or can it be
corrected. And both of those insisted that there was no way to
administer a withholding tax in which \-- unless the amount taken
initially was the final amount taken and there was no correction later.

We did \-- as you know, we developed a system under which there is a
correction, under which you file a return in which if you owe \-- if
withholding has taken too much of your income, you get a refund or if
you haven\'t paid enough, you have to pay more.

And it turned out that could work. So again the major obstacle to change
is the tyranny of the status quo in that sense.

Now, another thing that has been \-- on a general level that has been
\-- that that same episode implies is the fact \-- is a conflict \--
often the conflict between political \-- between tax efficiency on the
one hand and political desirability on the other.

Simply from the point of view of tax efficiency, the withholding \--
withholding is a desirable thing, but as I\'ve argued from the point of
view of political desirability, it\'s an undesirable thing.

The same thing goes for a value added tax. The value added tax is a very
efficient tax. That\'s its virtue. And it\'s also its vice because it
makes the tax appear invisible and thus it\'s always tempting to raise
it.

I once examined the situation for all the European countries that had
installed \-- instituted a value added tax and every single country that
had instituted a value added tax subsequently raised the rate, and every
one of the countries, government spending went up sharply after they
introduced a value added tax.

And so that\'s why I say that\'s its virtue and its vice.

Of course we all know that the basic function of taxes is supposed to be
raise funds to pay the government \-- to enable the government to
finance its activities. But we also know that that\'s not the real
function of taxes.

The other \-- the only function of taxes. The other function of taxes is
the political function. The function of taxes is as a way in which
legislatures \-- legislators can raise campaign funds and that\'s widely
recognized.

A seat on the Ways and Means Committee is a very valued seat because
it\'s a good way to raise funds. And it seems to me that the way \--
that the interpretation to be placed upon the 1986 tax reform is that as
of 1986, the number of \-- the tax system had gotten so complicated, you
had filled up the blackboard essentially so that Congressmen had nothing
more to sell, and they were therefore willing to wipe the slate clean
and start over again. And that\'s essentially \--

CHAIRMAN MACK: Notice I\'m not trying to defend myself here.

MR. FRIEDMAN: That\'s essentially what happened in 1986 and that\'s why
we\'re able to get that very good measure which eliminated many
loopholes and many complications. And maybe it\'s time again for another
wiping the slate clean and getting rid of \-- you know, our tax system
is \-- everybody agrees that our tax system is obscene.

It\'s incredibly complicated, incredibly lengthy, and it\'s not
equitable at all. People with the same income pay very different taxes.
We all know that, and we all know that the reason is because special
interests have been able to get special provisions or an absence of
provisions through lobbying.

And that \-- but one of the most difficult questions is to how to
construct a tax system which serves a political purpose at the same time
that it serves a fiscal purpose. And I have no magic answer to that
question.

But the \-- it\'s disgraceful that we should have a tax system that is
changed as frequently as it is. It\'s disgraceful that we should have a
tax system which is as complicated and as lengthy as it is, but the only
way I think you will ever get a real change in that would have to be
through constitutional amendment and not through legislation.

Now I really have \-- those are just sort of random comments that I
thought might be of some interest to you, but I\'ll be glad to talk
about anything you want me to.

CHAIRMAN MACK: Well, again thank you very much for your comments and for
your thoughts. I guess one of the things that I have attempted to do
during these first several months of hearings is not tip my hand about
where I might be heading or any of the members might be heading, but you
have made some comments that are \-- that almost draw us into that
discussion.

But I do have one question that I want to put to you because there has
been a lot of emphasis in ‑‑ all throughout our hearings on moving away
from income \-- an income tax based tax system to a consumption based
tax system.

And this is a broader economic question. Do we need to be concerned
about moving either too rapidly or taxing consumption too much that it
becomes an \-- it slows down demand and reduces economic growth?

MR. FRIEDMAN: I\'m sorry. I\'m kind of \-- I\'m a little hard of hearing
and I didn\'t really quite understand.

CHAIRMAN MACK: Well, the question is, is there a concern that we could
tax consumption too much?

MR. FRIEDMAN: Well, you\'re taxing consumption now. All taxes ultimately
\-- the consumer pays the taxes. Nobody else pays the taxes.
Corporations don\'t pay taxes. They collect them, but they don\'t pay
them.

The only people who pay taxes are people and people are all consumers.
So ultimately the taxes are paid by consumers and the question is if you
impose a tax on consumption, that means people will have less to spend
than they otherwise would. If you impose a tax on income, people will
have less to spend than they otherwise would, but there is no reason why
people on that account \-- of course they might spend less and save
more, but the saving is a good thing.

It\'s what produces the factories, the machinery, and the source of our
income.

CHAIRMAN MACK: Thank you. Ed, why don\'t we start with you.

MR. LAZEAR: Okay. Milton, you mentioned earlier that you had looked at
some of the data on the VAT tax, and one of the concerns was that VAT
taxes have started at relatively low rates but then have increased over
time and that\'s been a source of additional revenue for governments,
which obviously concerns you.

The same is true though if we look at income tax rates. So if \-- you
mentioned the 1986 tax reform started out with a marginal rate of 28
percent and then ended up creeping up to somewhere around the 40 percent
mark.

The question that I pose for you is do you think there\'s more stability
associated with one particular method of collection versus another
particular method of collection. So the political concern that you have
I guess plagues both systems. Do you have a feel for which one is worse?

MR. FRIEDMAN: Well, it seems to me that the \-- that a system of a flat
tax with a minimum of exemptions \-- indeed a \-- if you have a system
in which there were no exemptions, no special deductions, would be least
\-- most likely to stay the same from year to year and not have the
interventions.

But that system unfortunately doesn\'t provide a means for legislators
to raise campaign funds. And that\'s why it will not be adopted. It
should be adopted. I\'m in favor of adopting it, but it won\'t be.

MS. GARRETT: Let me follow up on Connie\'s question about a possibility
of a move to a consumption tax which is something we\'ve heard from you
and from others who have testified.

In an idea world, you get to put the consumption tax into place
immediately and you write on a blank slate. But in the real world, such
a move would come after years of an income tax, would require
transition, would have a period of time during which you were thinking
about the move and people could act strategically.

I wondered if you could maybe for us talk about some of the concerns
that we would have to be aware of in a transition from the current
income tax to a tax that\'s more like your ideal system. What are the
transition issues, what need we be careful about.

One of the issues that\'s been raised is what you do with old previously
taxed savings that would be taxed again, for example. I just wondered
your thoughts about those transition issues.

MR. FRIEDMAN: That\'s a very difficult question you\'ve raised, a very
important one. Suppose you were tomorrow to be able to enact a
constitutional amendment replacing the 16th Amendment and specifying
that a tax could be imposed at a flat rate on consumption with an
exemption \-- with a single exemption, minimum amount taxed and you were
\-- that was to be in effect two years from now.

That\'s \-- and your question is how do you go from here to there most
readily.

I don\'t really see any special problem, that the simplest way to do it
would be to impose it as a spending tax. That is to say people \-- every
individual would report a tax form just as he does now, but on that tax
form, in addition to his income, he would indicate what additions \--
what was the state of his balance sheet, additions or subtractions to
his balance sheet, and that would be \-- they would be subtracted from
his income and that would give you an estimate of his consumption.

I hate to say this, but that\'s a spending tax on which I wrote an
article 60 odd years ago. And at the time, I was at the Treasury and so
I was a little bit more skilled with the details.

But at that time, it seemed to me that that was \-- would not raise any
significant transition problems. Every individual would be filing the
same kind of a return as he does now. He would be using the same sources
to \-- for income. The income side of it would be exactly the same.

The only difference would be that you would add the section on additions
or subtractions from his balance sheet.

What kind of transition problem were you thinking of?

MS. GARRETT: Well, some that have been raised are \-- people who have
savings now that have already been taxed under the income tax and would
use that savings to consume would be then taxed again. So there\'s a
generational \-- and many of those people are older Americans that have
savings. So there are concerns ‑‑ and maybe this is a political concern
more than it is an economic concern. Indeed the economists argue that
that one time tax on old savings might be a particularly efficient tax,
but it\'s politically difficult.

There\'s also I think the transition problem that lots of businesses
have on their balance sheets, tax assets that they would no longer be
able to use perhaps. Do those just disappear the day we move to a
consumption tax?

Also under your \-- if you really have a two‑year phase-in, you know,
one would presume that people would act strategically in those two years
knowing that they were about to move to a consumption tax. Right. You
might do a lot of consuming in those two years. I certainly would buy
all my durable goods during those two years to avoid then the tax on
consumption.

So those are the kinds of transition issues that we\'ve heard raised or
we\'ve thought about.

MS. SONDERS: Professor, I\'m going to stay on this consumption tax here
and one of the other, in addition the transition issues which Beth just
talked about \-- one of the other \-- maybe criticisms isn\'t the right
word, but one of the issues you have to take into consideration is the
idea of progressivity and particularly the lower income taxpayers who
arguably would be hurt more under a consumption tax and how do you
address that, whether it\'s \-- you know, the criticism against credits
or rebates is that you put more people in a position to start getting
monthly checks back from the governments.

So how would you handle that piece from an income perspective, those
folks who really would get hurt by a consumption tax?

MR. FRIEDMAN: Well, if you had it \-- if you did it through the income
tax device, there would be the exemption as we do now \-- the present
exemption for low income people.

If you do through a \-- try to do it through a retail sales tax, that\'s
when you have to provide a rebate. You have to distribute essentially a
check to every family to cover the basic consumption ‑‑ tax on the basic
consumption.

But either way, it seems to me you do have to make allowance for low
income families.

MS. SONDERS: What about any allowances between sort of investments or
healthcare, all \-- that\'s been another criticism that you may be
strapping certain families if their consumption suddenly increases by
virtue of a sick child and how do you differentiate \-- are you setting
yourself up for the need to make so many exceptions to the rule that it
becomes just as complicated?

MR. FRIEDMAN: You know, I wish I were sitting closer to you so I could
hear you better. It\'s my defect. I have hearing aids, but they don\'t
work very well. So I really have \--

MS. SONDERS: I\'ll make the question much simpler.

MR. FRIEDMAN: Why don\'t I come there and you tell \--

MS. SONDERS: Oh, no, no. Sit. Sit. How about I just speak closer to the
microphone. Can you hear me now?

MR. FRIEDMAN: This may be much better. Okay. Now.

MS. SONDERS: I\'ll make the question much simpler. Healthcare as a
consumption item. Do you differentiate things like healthcare and some
people even suggest differentiating education because it\'s an
investment in the future, or is consumption consumption under your view?

MR. FRIEDMAN: I would say consumption is consumption.

MS. SONDERS: Okay.

MR. FRIEDMAN: And if you start making a differentiation here, you\'re
back in the position \--

MS. SONDERS: Complexity.

MR. FRIEDMAN: \-- of having a lot of \--

MS. SONDERS: Right.

MR. FRIEDMAN: And \-- in the case of healthcare, presumably we\'re
approaching the point where everybody will be insured for catastrophic
healthcare one way or another. That\'s the direction in which we\'re \--
it seems to me we\'re going. And I think that\'s a desirable direction.

So I don\'t think that there\'s any special reason for doing anything
about healthcare. Certainly with health savings accounts and a
catastrophic insurance policy, people are pretty well protected.

CHAIRMAN MACK: Charles.

MR. ROSSOTTI: Professor Friedman, just one question. Can you hear me
okay?

MR. FRIEDMAN: Oh, yeah, I can hear you.

MR. ROSSOTTI: Okay. Fine.

MR. FRIEDMAN: \-- was fine.

MR. ROSSOTTI: Does it make any \-- if you went to a pure consumption
tax, not through spending, but just let\'s say you got rid of all income
taxes and just had a VAT to raise all the government\'s revenues.

Does it make any difference in thinking about the tax system what the
source of income that lies behind the consumption is? For example \--
I\'ll give you an example to make it clear.

You have two individuals. One of them is working and earning \$50,000 a
year, supporting a family, and spends the whole \$50,000 a year, you
know, and pays the consumption tax and it\'s consumption.

The other person through whatever means has inherited wealth and has
\$50,000 worth of dividends or interest that they pay. So they don\'t
work at all. They still spend \$50,000 doing the same thing, but they
have a hundred percent of their time available to do whatever they want.

Is that equivalent in your view?

MR. FRIEDMAN: From the point of taxation, yes.

MR. ROSSOTTI: Okay.

MR. FRIEDMAN: It\'s not equivalent from the point of view of merit \--

MR. ROSSOTTI: Yeah.

MR. FRIEDMAN: \-- your value of it, but as a tax matter, remember
you\'re imposing tax to finance government spending.

MR. ROSSOTTI: Yeah.

MR. FRIEDMAN: And that affects those two people equally.

MR. ROSSOTTI: Okay.

CHAIRMAN MACK: Very good. Professor, thank you so much for spending some
time with us today.

MR. FRIEDMAN: Well, I\'m sorry. I wish I had come down here earlier.

CHAIRMAN MACK: I think you did pretty well.

CHAIRMAN MACK: Thank you very much.

MR. FRIEDMAN: You\'re welcome.

(Applause)

CHAIRMAN MACK: Well, I don\'t know how you fellows like following Dr.
Friedman, but give it your best shot; all right?

We\'re delighted to have both of you here with us \-- still this morning
I think. And I\'ve introduced you all before you came in in my opening
comments and I suspect, Michael, most of us read your Op Ed piece in the
Journal yesterday on social security, but we\'re here today to talk
about tax issues. So we\'re looking forward to your comments.

MR. BOSKIN: Thank you very much. Just following Milton, all economists
are students of Milton and Alan Auerbach was briefly a student of mine
and managed to survive and thrive, so I guess he\'s also Milton\'s
grand-student in some sense as well as direct student.

And it\'s a pleasure, Chairman Mack, to see you and see you so well and
to your distinguished colleagues. You\'re working on something very
important to the President of the country, so I\'m glad to be able to be
of whatever assistance I can.

I was asked to speak about the impact of taxes on saving, investment and
economic growth. I\'m going to do that. Some of these slides I will
barely mention to focus on about a half dozen of them.

First just to briefly summarize. Taxes affect saving, investment, and
growth in a variety of ways, but real incomes rise when productivity
rises which in turn reflects the growth rate of the capital stock, the
growth and improvement in technology, and improvement in the skills of
workers.

So taxes affect growth through those mechanisms, affecting the
incentives to engage in those activities and withdrawing resources from
the private sector which might have \-- some of those resources \--
conduct those activities and divert them to government purposes.

The effect of taxes on saving are central to this argument because
saving helps \-- as Professor Friedman said, helps provide the capital
\-- originating source of the capital to invest in increasing
productivity.

As the next few slides show \-- so because of all these different ways
taxes affect capital formation and economic growth, at the very least it
would be desirable to strive for neutrality in the tax code toward
saving investment.

Some economists believe there is extra benefits to investment that are
not appropriable by the firms and people doing the investment, that
investment generates additional technology, and that might mean it would
even be sensible to subsidize investment. I would not go that far. If
there\'s any germ of truth in that, I believe it would be abused in the
political system, so I\'d be very leery of that argument.

But we ought to aim for neutrality between saving and investment.

The U.S. is a low saving nation. As these charts show, both the personal
saving rate and the national saving rate, the sum of what governments,
state and local and federal, businesses, and households are low and have
been declining.

The usual national income of product account measures in my view
understate the saving rate and overstates the decline for reasons I
mention in the next slide, but I won\'t dwell on here. I think they\'re
well documented.

But let it say that my conclusion is the U.S. is still a low saving
country. It would be good things \-- if other things being equal, if we
move to a tax system that was less biased against saving.

To set concepts, taxes affect saving and investment in a variety of
ways, but firms invest up to the point where the returns to that saving,
the marginal product of capital if you recall your Economics I, equals
the cost of their funds.

We then tax \-- we then impose business taxes. Net of the business
taxes, we return those directly or eventually to owners of the capital
\-- to suppliers of the capital, and then they pay personal taxes.

So there\'s a wedge equal to the marginal real effective tax rate of the
corporate and personal taxes between the private and presumably social
return to investment and what is on balance at the end received by
taxpayers.

The source of these issues is that this tax wedge can be large and can
be quite consequential. The harm done by tax \-- high tax rates
distorting decisions in the economy, especially in this case the saving
and investment decisions, goes up with the square of the tax rate.

So if we double tax rates, we quadruple the harm done.

It\'s also important to note \-- this may be a little too complex here
but \-- that if we have \-- if we\'re earning 10 percent before tax on
an investment in the economy and the capital taxes, corporate and
personal, are 40 percent, so savers only wind up with 6 percent \--
these are just numbers of arithmetic, not necessarily reflective of
what\'s going on in the economy today \-- it might seem whether we have
a dollar ten a year from now or a dollar sixty a year from now if we
save and invest wouldn\'t affect decisions very much. We get 96 percent
\-- plus percent back regardless.

But many saving decisions span long periods of time when families start
to save for their children\'s education or when people start to save for
retirement. Those are decisions that span 20, 30 or more years, and the
compounding and accumulation of deleterious effects of capital tax can
be quite severe.

As this example shows, this distortion grows ever more \-- ever larger
as we compare the distortion between spending or saving today and
spending in the distant future rather than the near future.

It\'s also immensely difficult to measure capital income. Measuring
depreciation, capital gains and losses, inflationary gains, the timing
of events means it\'s in my view close to hopeless to get that right in
an income tax and to avoid a lot of engineering that goes on in the
private sector, and therefore attempts to get a pure income tax I think
are basically doomed to failure.

You all know that we have the well-known double taxation of saving and a
pure income tax where saving is taxed first when you earn it and then
when you earn the return on it, interest or dividends.

We also know that for IRAs and 401Ks, there\'s tax deferral. Not tax
free but tax deferred so that moves from double taxation to single
taxation. Roth IRAs do that the other way around, back‑loading.

Then they seem to be \-- that our income tax is a hybrid then between an
income and a consumption tax, but actually it is more complex than that
because our tax system subsidizes some saving and investment and
quadruple or quintuple tax others.

It\'s a pure income tax, double taxation of saving. Pure consumption tax
neutral.

We have the corporate tax. It\'s a third tax. Professional Auerbach will
explain in more detail how the combination of interest deductions and
depreciation allowances tells us whether we\'re taxing or subsidizing,
how heavily we\'re taxing that investment.

A consumption tax which allowed us to write off investment immediately
would be neutral with respect not only to the types of investment we do,
but to the choice between consuming or saving and investing.

So think of a football field. A pure income tax that got things exactly
right according to the textbook would be level sideline to sideline, but
you\'d be running uphill when you tried to save. It would be taxing \--
doubly taxing saving, taxing future consumption heavily, penalizing
people who are patient in trying to add to capital.

A pure consumption tax \-- again pure, hypothetical. We probably
wouldn\'t get either pure income or pure consumption tax in the real
world \-- is neutral with respect not only sideline to sideline but goal
post to goal post, which economists believe is the far more important
thing to get right.

Debt raises the possibility of subsidizing investment. I made an
argument before there might be a case for doing so, but we ought to be
careful about that because with interest deductions, you can actually
take interest, deduct it, and then say invest in a tax free saving
account, you are actually subsidizing it.

The tax treatment of housing again complicates matters. So the estate
tax can be a third or fourth or we add state and local income taxes, a
fifth or sixth tax on saving.

Taxes also affect human investment, but as I pointed out three decades
ago, only to the extent that they are progressive rates will that really
be a serious issue because most human investment is financed by the
foregone earnings of people and that isn\'t taxed. It\'s similar to
earning the income and then being allowed to deduct it immediately.

So it\'s an issue, but it\'s much less of an issue than might appear at
first hype.

I think I will skip the explanation of that in detail.

How much do income taxes affect saving? By taxing, doubly taxing, and
taxing the return to interest, dividends, and capital gains received by
savers, it makes it more expensive to save for future consumption, for
example, during retirement.

The amount of savings theoretically could increase or decrease. I won\'t
bore you with the technical economics of that.

Usually we think households reduce the amount purchased of any good as
price goes up, but to oversimplify \-- if we had target savers who
wanted to have a fixed amount when they retired let\'s say, if the rate
of return went down, they would save more to hit that target.

Now I think target savings not a good approximation for how households
behave, although in the short run for some defined benefits programs, it
might \-- pension funds, it might be.

The effects of taxes on saving is an empirical question. There\'s a
range of estimates. All the studies have issues. There\'s never been
anything close to a perfect study, but I think if you take the time
series estimates, they would suggest for every 10 percent increase in
the rate of return to saving, perhaps caused by a reduction in the
double taxation, say going from 5 percent to 5 and a half percent, you
get between a 1 percent and a 5 percent increase in saving.

Similar even perhaps stronger effects comes from most, not all, of the
studies of tax deferred saving vehicles, their introduction and
expansion which are sort of like natural experiments because we\'re now
shifting or allowing people to save more tax free. That\'s a higher
after tax rate of return.

And so even modest effects of taxes on saving, however, have very
profound effects. I pointed this out several decades ago. Much more
sophisticated research by macro-economists since then summarized here in
my quoting Bob Lucas, Nobel Laureate Economist, University of Chicago,
in his presidential address to the American Economics Association,
indicated that removing the tax distortions to saving and investment are
by far the most important avenue for improving economic well being of
any potential public policy reform that is being considered.

Now that is a strong statement. Not every economist would agree with it,
but we all agree I think that there will be substantial benefits from
improving this and getting it right.

Briefly on tax reform, we\'re focusing on improving the economy. You and
the people you report to are going to know better than me issues that
Professor Friedman raised.

There are a lot of political economy issues. Some taxes will make it
easier to increase government. Some tax reforms remove more people from
the tax rolls and have less people paying a price for expansion of
government, for example.

There are federalism issues. The obvious one that VATs and retail sales
taxes aren\'t popular with governors and mayors, but also if you\'re
thinking of replacing the federal income tax with some other tax device,
remember that those of us in California aren\'t going to have a much
simpler tax system unless California also abolishes its income tax.

So you\'re making a big change. A big federal change will put incentives
for the states to change, but you\'re operating in a federal system and
it\'s important to remember that.

You have four basic decisions to make. What\'s the appropriate tax base
or bases, tax rate and rates, the unit and time period of account. These
are all issues and they\'re interrelated. It\'s hard to take one at a
time, although we focused on the consumption versus income tax debate
which is basically a tax \-- a debate about the base.

The most important thing in my opinion is to keep rates as low as
possible. The next most important is to make sure we limit the double
taxation of saving.

And by the way, the best way to keep rates as low as possible is to keep
spending to only what\'s necessary for the government to do.

Two types of reform are income tax. Move it closer to or to a pure
consumed income tax, hopefully integrated with a corporate tax, or
something comprehensive either in addition to a reduced income tax or as
a replacement for the income taxes.

You\'ve all heard from other people I\'m sure. There are alternative
ways to tax income and consumption. There are many arguments that have
been put forward in favor of consumption taxes. I would mention one that
dates to Professor Friedman\'s \-- work on this which is a third
sub-bullet under equity.

Consumption may be a better measure of permanent income \-- income over
a long span of time \-- than is current income because people smooth
their consumption. When their income fluctuates, they don\'t let their
consumption fluctuate as much.

And therefore they\'re doing some income averaging for you. We abolished
income averaging in 1986, but in some sense, there \-- it may be fairer
in some sense to tax consumption and income. There are other dimensions
of fairness, but that\'s something that doesn\'t get emphasized enough
in my opinion.

There are obviously lots of arguments against. I\'ve listed the main
ones here.

I think overwhelmingly we wind up thinking that a pure consumed income
tax or consumption tax would be far better economically than a pure
income tax, but we have our current tax system which is neither and
it\'s not even exactly a hybrid as I pointed out, and the consumed
income tax we\'re likely to get has to be compared to the actual income
tax, not comparing two theoretical ideals.

Transition issues were raised before. I\'d be happy to take questions
about them.

I would conclude that the U.S. saving rate is low and declining,
although not nearly as much as the need for measure. The current tax
system on balance is biased against saving.

Even if we had a higher saving rate, for other reasons, we ought to get
rid of that bias as best we can, but it\'s especially severe given our
low saving rate.

Redressing this imbalance is very important and should be a major
component of tax reform. It\'s especially so for other reasons \--
related reasons.

You have two routes to reform. One that I think is quite plausible would
be to move closer to a pure consumed income flat tax with lower rates,
maybe two or three of them, with the top rate equal to the corporate
rate and cleaning up the corporate and personal income tax, getting rid
of most exemptions and deductions.

I know you were charged not to deal with housing or charity which are
probably the two strongest claimants for continuation.

I\'m concerned \-- I think there are many theoretical advantages to VATs
and retail sales taxes and many dimensions, but I think there are many
issues about federalism and the growth of government that are raised by
them.

So I\'d be happy to take questions after Professor Auerbach has a chance
to make his remarks.

CHAIRMAN MACK: Thanks, Michael. Alan.

MR. AUERBACH: Mr. Chairman and other members of the panel, I\'m very
happy to be here.

I\'m going to give you an overview of my comments, and I\'ll try to be
brief. I want to talk about four things, each briefly. First how the tax
system can influence growth in our national competitiveness, the theme
of this panel meeting; second, issues in the design of effective tax
incentives; third, how the tax system cannot influence growth and
international competitiveness, and here I have one particular thing in
mind which has to do with the importance of border adjustments which I
know often comes up in these discussions; and finally just some
concluding comments on implications of my previous comments for the
design of fundamental tax reform.

Now the hardest task here is to define competitiveness. There are many
definitions. I think perhaps intuitively we think of the cost of goods
produced here relative to foreign goods with which we compete, but
obviously that has problems. It depends on the exchange rate which can
vary a lot and also it really comes up against the fundamental economic
principle of comparative advantage which dates to Ricardo, which is that
you can\'t best at everything.

You can be best at everything, but it doesn\'t mean you\'ll be
relatively better at everything and so you\'ll end importing things even
if you are better at producing them because there are some things that
you\'re even better at.

So you can\'t really define competitiveness that way. I think the most
sensible way of doing it is to think about productivity, how productive
your technology is which depends on human capital, physical capital, and
tangible capital, and for the purposes of our discussion today, how
these are affected by tax policy.

To consider these in turn, human capital, you know, which we think of as
primarily education and training already is very heavily tax favored
relative to other investments because the main cost of investing in
human capital is the foregone earnings that we experience when we go to
school or when we work in a low paying job in which there\'s a lot of
training.

Because we avoid the income taxes on those investments that we make, we
already have immediate expensing for those investments, and therefore we
already have close to consumption tax treatment for human capital
investment.

The major negative \-- and in that sense, it\'s rather neutral already.
The major negative impact is through the progressive rate structure. If
you like the success tax, it\'s only if you do really well, then you pay
a higher marginal tax rate.

But one thing to keep in mind when thinking about lowering the rates is
progressive rates do something else which is that they provide
insurance.

If you\'re undertaking a risky human capital investment, you\'re trying
to decide whether to go into a career that \-- and you\'re not sure what
the returns to the investment are going to be, progressive rates provide
a form of insurance.

If you do very well, you\'ll be in a better position to pay more of your
income in tax then if you don\'t do so well.

Moving to intangible capital which was the subject of the comments of
some of the earlier speakers and indeed in addressing the issue of
whether there should be special attention paid to intangible capital,
there is evidence that the technological progress that results from R&D
investment involves positive spillovers from individual advances which
means that the social returns are higher than the private returns and
that does justify some sort of more favorable treatment.

The question is how much more favorable because R&D expenses like human
capital investment are already favored relative to physical capital
investment because research and experimentation expenditures \-- those
that qualify for the R&E credit also get immediate write-off. Now
there\'s an adjustment for the credit, but it\'s still quite favorable.

And so the question is how much not whether.

It\'s \-- I think it\'s also worth keeping in mind here that R&D is not
the only vehicle to spur technological progress. If one compares the
U.S. to other countries, it\'s certainly true that regulation,
flexibility of the employment relationships which are often emphasized
in the U.S. relative to Europe, for example, are very important, are not
related to the R&E credit or tax incentives like that.

So I\'ve just summarized my comments.

Now to move on to tangible capital, and I\'ll spend the most time on
this. Of course it\'s affected by \-- investment is affected by myriad
provisions that influence the overall rate of capital income taxation
and one needs to take all these into account in thinking about what the
effects are.

I think it\'s useful to distinguish four dimensions: first, broad versus
targeted provisions; second, temporary versus permanent provisions;
third, saving versus investment; and finally, all the new capital which
is an issue that came up earlier.

Broad versus targeted: Well, we start from a general principle I think
that\'s already been enunciated today which is that we should seek a
broad‑based and low tax rate because in general that\'s what provides
the greatest economic efficiency and it also provides the greatest
simplicity and ease of administration.

So why deviate from this norm? For example, why have an investment tax
credit. Positive spillovers here too. I think there\'s really no
convincing evidence with respect to physical capital investment compared
to research and development.

To offset other tax benefits so are there some investments that should
get an investment tax credit or some other benefit because some other
kinds of investments get higher benefits through more capital gains or
other types of provisions.

In principle, you can start down this road, but it\'s very difficult to
get it right, that is to offset other distortions that are already
present. I think you\'re much better off trying to clean the whole thing
rather than add yet another layer of complexity trying to offset an
existing problem.

Finally there are concerns. For example, with an investment tax credit,
if the effects are perceived to be temporary, it doesn\'t just affect
the level of investment, but it also affects the mix. You\'re going to
try to invest more in very durable investment if you think the ITC is
temporary and that can lead to effects that you really didn\'t
anticipate or desire.

And to say more about temporary versus permanent, we\'ve had a lot of
temporary investment incentives. Sometimes intentionally temporary,
announced to be temporary, sometimes not but ending up being temporary
in any event. The investment credit was officially permanent when it was
eliminated in 1986. The bonus depreciation we had recently was intended
to be temporary, although it became a little bit less temporary in 2003
than it had originally been in 2002.

It\'s often done in periods when investment has suffered. That was
certainly in 2002. We had a very sharp decline in equipment investment.

A thing to keep in mind when one is thinking about temporary investment
incentives is there\'s no evidence that these things actually stabilize
investment or GDP.

I put one paper in the references here of mine and a coauthor which
actually found the opposite, that having \-- actually trying to time
investment incentives is \-- at least historically has gone the wrong
way.

Now turning to the third distinction, saving versus investment, of
course with international capital flows, these things are different. We
can save abroad and that\'s investment somewhere else but not here.

Foreigners can invest in the U.S. We may have a very low saving rate as
we do now, but we may still have a reasonable level of investment
because it\'s being financed by foreigners.

So what should we be thinking about. Should we be thinking about saving
or should we be thinking about investment.

Well, each of these has something to argue for it. Saving after all is
what generates national wealth. It\'s \-- put another way, it\'s what
increases GNP, the product that we \-- that accrues \-- the factors that
exist in the U.S. capital and \-- ownership of capital, ownership of
labor.

And so it\'s the most direct way to wealth creation. On the other hand,
if we somehow think that production that occurs here matters, not just
for, you know, nationalistic reasons, but because we think, for example,
that technology is embodied in new investment so that we need to get not
just more saving, but the stuff in place here in order to get that new
technology applied, then we may want to think about investment
incentives as opposed to saving incentives.

I don\'t think one should necessarily worry too much about this
distinction though because empirically the evidence is that saving and
investment move together. So whether you\'re encouraging saving or
encouraging investment, the other is going to move up at the same time.

Now, to the distinction between new and old capital which is a very
important consideration when one is thinking about moving to a
consumption tax because implicitly there is a tax on old capital and
moving to a new consumption \-- to a consumption tax without transition
relief. Reducing the burden on existing capital as opposed to on new
capital actually discourages saving and investment.

Now, not if you do it all together, but if you just designed \-- not
that you would \-- but if you designed a tax provision that just reduced
the income accruing to old capital, that\'s just going to make people
wealthier. That\'s going to encourage consumption. It doesn\'t do
anything to the incentive to save on a going-forward basis, and so it\'s
just a windfall that people will consume.

Now of course one doesn\'t set out to design a provision like that, but
existing provisions do vary a lot in the extent to which they favor new
capital versus old capital, and you can \-- I have \-- it\'s sort of
really pretty close to a continuum. You can go all the way from
provisions like a capital gains tax cut which favors old capital quite a
bit because all the income that\'s been accruing on assets that have
been placed for a long time and the incomes already accrued will get a
tax benefit all the way to something like an incremental investment tax
credit or an R&D credit which says you don\'t \-- not only is this
focused on new activity, but only some new activity.

So in terms of focusing on new capital, things like incremental credits
are the most efficient ways of doing it. The problem is they\'re also
more complicated.

So the R&D credit, there is a board of discussion of incremental
investment credits in the early \'90s. We have an R&E credit. There is
the problem of a moving base and the disincentives that that caused.

We now have a fixed base, but the question is how to define it. Once you
start trying to cut it too finely and focus too much on new investment,
things get very complicated.

But I think you can make it better and more efficient and still have a
relatively simple system by considering things like phase-ins. So, for
example, if you\'re going to cut the corporate tax rate, consider
cutting the corporate tax rate over time rather than cutting it all at
once.

It\'ll still give you the benefits of an immediate incentive to invest,
but it\'s going to focus more of the benefit on investment that occurs
in the future not investment that\'s already occurred in the past.

And I should just say on \-- while talking about all the new capital,
there\'s an important language issue here that sometimes when we talk
about saving incentives, we think we\'re talking about new saving, but,
for example, if we increase incentives to save in certain kinds of tax
sheltered form and you can qualify for that by transferring assets from
a taxable account into a tax free account, that\'s not new saving. It\'s
a transfer of saving.

So it may be referred to as consumption tax treatment, but that is not
what would happen under a consumption tax.

Just one further point on this issue of old and new capital. We can
sometimes confuse ourselves particularly if we\'re working with short
budget horizons like a five- or a ten-year budget window in terms of
which is the most focused on new investment, or put another way, what
gives you the most bang for the buck.

So I said before that investment credits give you more bang for the buck
that, for example, a reduction in the corporate tax rate. It wouldn\'t
necessarily show up that way if you did a five- or a ten-year
calculation because all of the revenue loss from investment credits for
investment come right away.

You put capital in place, the loss is right away. Whereas if there\'s a
rate reduction, it affects the income from that capital over time.

The same difference applies when you\'re thinking about traditional
Individual Retirement Accounts and Roth IRAs.

Anytime you have a finite and a very short horizon budget window like
five or ten years, the comparison between these two types of things,
back‑loaded and front-loaded provisions, is not going to give you the
right answer when you\'re thinking about the efficiency of a tax
incentive.

Now, here\'s a point which I think is important to make, although can\'t
necessarily be \-- I can\'t necessarily give it justice in the time that
I probably don\'t have any more.

CHAIRMAN MACK: You\'re all right. Go ahead.

MR. AUERBACH: The \-- this is just about border adjustments because
these always come up in discussions of various kinds of consumption
taxes. The current account balance \-- you know, imbalance that we have
now, largely a trade imbalance, if we add that together with the capital
imbalance which we also have, they have to sum to zero. That\'s just
an ‑‑ part of the national income identity. There\'s nothing about
policy that can change that.

And the capital account imbalance in turn equals the difference between
the investment put in place here and national saving. So we have a \--
we have capital inflows because our investment exceeds national saving
and that exactly balances our current account deficit right now.

That\'s always going to be true. The numbers \-- each number will be \--
differ over time, but the sum of the two is always going to be zero.

So we can\'t change the current account imbalance unless we increase
national saving or reduce domestic investment. That\'s a fact.

Now border adjustments as under a destination based value added tax, for
example, don\'t encourage saving and they don\'t discourage investment.
So if we have an exchange rate adjustment, there\'s going to be little
impact on capital flows of the trade balance.

Now the reason why this conflicts with the logic that one might have is
it\'s different \-- it would be different if we were talking about
specific incentives. So if we had an export subsidiary \-- if we \--
value added tax not for everything, but just for some goods, then that
certainly would shift the balance of trades.

Those goods would be encouraged in terms of exports, discouraged in
terms of imports, relative to other goods. The logic breaks down when
we\'re talking about the entire current account imbalance not when
we\'re talking about certain components of it.

So what are the implications for tax reform. Well, with few exceptions I
think \-- and I mentioned R&D and human capital. You can certainly shape
things away from a neutral tax system, but I think with few exceptions,
one should start from the position of avoiding targeted tax incentives
and then look for a serious justification before doing so.

Second \-- and this relates to the distinction between new and old
capital \-- transition provisions matter a lot. And again based on some
research that I\'ve done which is cited in the references, a consumption
tax transition that fully protects existing capital allows continuation
of depreciation allowances, allows other kinds of tax benefits that
wouldn\'t necessarily exist under a cold turkey switch to consumption
tax \-- can turn a winner into a loser.

That is you can \-- if you simulate the economic gains from moving to a
consumption tax straight out and find \-- you might find that can lead
to significant increases in welfare and GDP and those increases may
largely go away or even disappear if you give sufficiently generous
transition relief.

So it\'s very important what happens in the transition.

And here again, to echo a comment I made earlier, phase-ins may help. If
you\'re thinking about moving to a tax system \-- a different tax system
over time, trying to structure it in a way that gives you the
incentives, for example, by announcing that capital income tax rates are
going to decline over time might be a way to focus the benefit on new
capital but without giving you the kinds of short-run transition
problems that you might otherwise have.

And finally piecemeal approaches may go the wrong way. It\'s often said
that we have a hybrid system which is some \-- now which is somewhere in
between an income tax and a consumption tax because we have a lot of tax
sheltered saving.

So that one might lead some people to believe that we\'re sort of
halfway there or some part of the way there. I think that\'s wrong. I
think you actually can argue that we have worse incentives to save under
a hybrid system than we would under either a pure income tax or under a
pure consumption tax because under current systems, for example,
companies that can get bonus depreciation and borrow to invest in tax
favored assets will actually get a negative tax rate.

The same thing holds for people who borrow or run down savings to put
money in tax sheltered form at the individual level. There\'s no \--
there\'s not a zero tax rate there on saving. There may be a negative
tax rate and there may not be a real incentive to engage in new saving
either.

That wouldn\'t be true under a pure income tax in which liabilities were
treated symmetrically in terms of income and expenses and it certainly
wouldn\'t happen under a pure consumption tax either.

So thinking \-- feeling comfortable about having a hybrid system and
thinking about sort of shifting, you know, where we are in a hybrid
system is not necessarily the way to go and certainly not one that I
would encourage. Thanks very much.

CHAIRMAN MACK: Well, again thank you both for your presentations, and,
Liz Ann, we\'ll turn to you first.

MS. SONDERS: Thank you both very much. I have one question that I\'m
hoping both of you can answer.

You know, Michael, you touched on one of the limitations we have in that
we have to maintain the biases toward home ownership and charitable
giving, but another one is that at least one of our proposals has to
maintain the current federal income tax, and both of you made strong
arguments, which I absolutely agree with, for the need to incentivize
savings more.

So what would be your best recommendation to us? Under the idea of
maintaining the current federal income tax, what can be done on top of
that to best incentivize savings.

MR. BOSKIN: To best \-- I think something that\'s quite doable \-- and
here I think Alan and I might have a slightly different perspective \--
would be to take the current personal and corporate income taxes, move
further in integrating them with dividend relief for getting rid \--
completely rid of the double taxation of dividends, lower the rates to
say 10, 20, 30, or something like that, lower the top corporate rate to
30 percent. That would be good. Eliminate most exemptions and
deductions, combine a variety of definitions, exemptions and deductions,
et cetera, while maintaining housing and charity which you\'re required
to do, but then you have to be very careful how you limit deductions.

I think both Professor Auerbach and I agree that that is the basic issue
in avoiding a negative tax rate \--

CHAIRMAN MACK: Would you \-- on that again? I\'m not sure I got the \--

MR. BOSKIN: What we\'re getting at is if we just allow people to have a
super IRA and put all their saving in it, you might start out by
thinking, well, we\'re taxing income. We\'re really not. We\'re not
measuring it, but we\'ve got income and \-- we\'re subtracting all
saving.

So that leaves us with the \-- part of your income that is consumed,
what Professor Friedman in 1943 called a spending tax. I mean you could
have all the features like exemptions and et cetera that cushion
people\'s first \$30,000 of income or whatever it happens to be or
consumption from taxation.

But now if we allow unlimited deduction of interest, people can borrow,
put the money in a tax‑deferred saving account. Instead of going \--
expanding single taxation of saving, you\'ve actually reduced it to \--
and being neutral with respect to when people consume, today or in the
future, you\'re actually subsidizing the saving and making \-- and
subsidizing future consumption at the expense of consumption today.

So you have to have some sorts of limits on interest deductions. That\'s
not an easy thing to do for many reasons, but we do that to some extent
now with limits on home equity loans and things of that sort.

So that\'s where some care and thought has to be given to moving in this
direction in my opinion. I think that abolishing the income taxes which
might be hard to do and certainly not consistent with this particular
part of your charter and replacing it with something that\'s close to a
practically pure VAT or retail sales tax could accomplish some of these
things, but it engenders a lot of other issues.

As Professor Friedman says, it may be real easy to grow the government.
You don\'t get rid of the complexity for people in states that already
have income taxes and won\'t remove them after you do this. You \--
federalism is important. You know, we have the 10th Amendment.

Governors and mayors say you\'re going to crimp on their abilities. So
each of these has various aspects to them beyond just the pure textbook
saving incentives that are important to consider.

But I would strongly commend that for the part of your charter that is a
reformed income tax, to move in that direction.

MR. AUERBACH: Yeah. I would just say that I think this was implicit when
Michael was just saying \-- that you don\'t really lose much flexibility
working within the existing income tax. You can have a personal cash
flow tax which would be equivalent to a consumption tax within the
framework of the existing income tax as Professor Friedman already said.

One thing to point out and many advocates of simple tax reforms will do
this is that it\'s a lot easier to get rid of things you\'d like to get
rid of moving to a new tax system. You don\'t have to worry about
existing depreciation deductions, about interest deductions if you were
to adopt a retail sales tax.

I\'m not advocating retail sales tax, but I think this is a point that
many would make that under indirect taxes, be it a value added tax,
retail sales tax, these types of transition issues disappear, probably
very much to the disappointment of the taxpayers, but they disappear
because there\'s no way you can really take a depreciation deduction
under a retail sales tax.

And so working under the individual income tax, then you\'ll still have
all the problems we have now. And so the real question is, you know,
what to do. I suppose 1986 was a lesson. I don\'t think it got
everything right. There were some problems on the capital income side,
for example.

But moving in that direction of looking for deductions and other kinds
of exclusions to eliminate to bring marginal tax rates down is certainly
not simply for capital formation but for a host of reasons, so the
direction in which to move.

MR. BOSKIN: I would add one comment which is I think the worst of all
worlds would be to keep the existing income taxes and add a VAT or a
retail sales tax to them.

CHAIRMAN MACK: Well, that certainly got the \-- Charles.

MR. ROSSOTTI: I just wanted to make sure I was clear on one thing. If
let\'s say you\'re operating within the structure of the income tax for
the moment.

If you did eliminate the ability to deduct interest or \-- in some way,
would you then believe that the structure of savings accounts, whatever
form that might be like Roth IRAs and that sort of thing, would move
appropriately and correctly towards taxing consumption and not taxing
savings if you were somehow able to deal with the restrictions on
borrowing.

MR. BOSKIN: Yes, if you also dealt with the corporate tax side.

MR. ROSSOTTI: Yeah.

MR. BOSKIN: You can\'t just deal with the personal tax side.

MR. ROSSOTTI: Right. But just on the individual tax side. The issue that
you\'re raising has to do with the ability of people to manipulate by
borrowing and \--

MR. BOSKIN: Yes. I think it\'s easy to overstate it from a hypothetical.
Clearly some of this goes on now.

MR. ROSSOTTI: Yeah. Yeah.

MR. BOSKIN: And clearly more would go on if there was a big expansion.

MR. ROSSOTTI: Sure.

MR. BOSKIN: I think the notion that every taxpayer would max out and \--

MR. ROSSOTTI: Sure.

MR. BOSKIN: \-- that would be the end is exaggerated, but some attention
has to be paid to this.

MR. ROSSOTTI: Okay. That answer \-- thank you.

MR. AUERBACH: If I could just jump in on this. If you really went to a
personal consumption tax with no transition provisions, it would be
equivalent to telling people that all the assets they\'ve accumulated
are already in an IRA or a 401k or a lifetime savings account. They get
no further deduction for putting them in even if they never did put them
in.

But if they take them out, they have to pay a tax. Because that\'s the
way a consumption tax would work. That\'s the hard fact for old capital.

So it\'s really not \-- except in the long run, it\'s not the same as a
consumption tax to allow putting all existing assets into tax favored
accounts. That may be an appropriate transition to a consumption tax,
but it has both fairness benefits for people with existing assets, but
it also reduces economic efficiency of the transition.

MR. BOSKIN: Yeah. I think you\'re going to have to maintain this
distinction between new and old capital. You have to analyze both.

CHAIRMAN MACK: Beth.

MS. GARRETT: I want to stay on the topic of savings but combine this
day\'s hearings with our hearings last week in New Orleans which was on
\-- which was a hearing on fairness issues.

And I wondered if you could talk a little bit about how we might be able
to through the tax system incentivize those in the lower incomes to save
who may not have disposable income to save now.

There\'s been some discussion about refundable credits for such savings,
and I wondered what your reaction was to that.

I suppose one reaction I have is that assuming it\'s not financed by
deficit spending, which I suppose is not a safe assumption, but assuming
it\'s not financed by deficit spending, it would actually be new savings
since it wouldn\'t be a shift from current savings into tax favored
vehicles and it might also help deal with sort of ability to pay issues
as lower income Americans face difficult health and other kinds of
issues.

But I wondered if you could just talk about that generally whether it\'s
refundable credits or otherwise to incentivize lower income Americans to
save.

MR. BOSKIN: I think the fact that half the population owns virtually no
assets is a startling fact in a society as rich as ours and it\'s the
major reason I strongly support an individual account component to
Social Security which is equivalent to cutting people\'s taxes and
requiring them to save that amount.

Now for this bottom half that\'s saving nothing, that will be new
saving. For Alan Auerbach and Michael Boskin and Milton Friedman,
perhaps we\'ll adjust our other savings so it\'ll only be some \-- only
some partial increase in saving.

I think that\'s probably a more promising route to take.

My own opinion is we\'ve gone too far with the proliferation of
refundable credit vehicles. I was a very ardent supporter of an idea
originally proposed by Milton Friedman and Jim Tobin of a negative
income tax with the idea being used to tax transfer system efficiently
to transfer income to people, improve work incentives relative to
bureaucratic categorical welfare.

Instead of removing all of those other things, we\'ve sort of added the
earned income tax credit, refundable child \-- all these things on top
of them and they have \-- they\'ve done a variety of things, one of
which I think was unintended by most people, but they\'ve removed so
many people from the income tax rolls that when we expand general
government services \-- not Social Security and Medicare which are
financed by payroll taxes.

When we have to make social decisions about expanding the role of
government, close to half the population won\'t pay anything, and I
think you can\'t make those rational discussion if they don\'t \--
decisions if they don\'t pay anything because it\'s easy for them to
vote for more spending if they\'re not going to pay anything.

So I think \-- now maybe if you got rid of most of the rest and had one
\-- that moves back to the original negative income tax model and got
rid of all this other stuff and integrated them, that would greatly
simplify things and probably could deal with some of these issues.

But if you ask me, I think we should be cleaning this stuff up and
integrating it and making it consistent \-- consistent with definitions.
We have five definitions of a child for these different programs, et
cetera, and not just adding new devices on top of the proliferation of
credits and deductions that has eroded the base and caused rates to be
higher than they otherwise would have to be.

MR. AUERBACH: I think the \-- there\'s also a problem with the details
of provisions like this, for example, with the saver\'s credit we have
now which I guess you might want to make refundable.

I think it\'s an easier call if you\'re talking about retirement saving,
but if you\'re thinking about saving more generally, what \-- you\'re
talking about people who typically are of limited means, may have very,
very severe needs for the cash in the future. You\'re going to limit the
extent to which they can take money out in a few years for problems that
they may encounter.

You\'re going to recapture the credit when they have a health emergency
and have to take the money out. I sympathize with the objective of
trying to get more people involved in saving, but my sense is that I
think I agree with Michael that doing it through a retirement saving
reform is probably the place to do it first. That\'s the most important
reason to save and trying to do it more generally through the tax system
might lead to some significant complications.

MS. GARRETT: Thank you.

CHAIRMAN MACK: Ed.

MR. LAZEAR: I have a couple of questions. One is a question from Jim
Poterba who\'s on the panel but isn\'t here today and this one\'s for
Alan, and then I\'ll ask you a question myself, Mike.

So, Alan, the question that Jim poses is the following:

Transition rules that avoid windfalls to old capital are likely to be
criticized as adding complexity to the tax code. Are the efficiency
gains from avoiding these windfalls large enough to warrant the
associated administrative and complexity costs?

You touched on this a bit in your presentation, but maybe you could
amplify on that.

MR. AUERBACH: I think the premise is not necessarily \-- I don\'t
necessarily agree with the premise. It depends on the tax system.

It could very well be simpler to avoid relief for old capital than more
complicated. It\'s a lot \-- as some experience has shown when people
have tried to put together, for example, the USA tax system that was
designed in the \'90s, which tried to effect various forms of transition
relief and ended up being extremely complicated, it\'s easier not \--
it\'s easier to just say no. No depreciation allowances, no interest
deductions.

I\'m not saying that\'s necessarily the way you want to go, but it\'s
actually quite easy if you\'re going to a consumption tax to just say
sorry, that was yesterday\'s tax system. You don\'t \-- you know, we
have a different tax system today.

And trying to keep track of bases, trying to carry existing assets
forward as \-- and keep track of them under a new system, but give them
treatment they would have received under an old system is actually more
complicated.

I think the problem of treatment of old capital is a political \-- one
of \-- political considerations, one of fairness, but I don\'t think
it\'s \-- I don\'t think it makes the system more complicated. I think
it makes the system less complicated.

MR. LAZEAR: Thanks. Mike, I\'d like to go back to the distinction
between saving and investment. Alan touched on that a bit in his
presentation.

There are good reasons to neutralize the impact on current consumption
versus future consumption simply on the consumption side.

Even if it had no effect on investment or saving, you don\'t want to
create distortions and induce people to consume in weird ways simply to
avoid taxes.

But you\'re one of the pioneers in doing work on the effect of
responsiveness of individual saving to rates. What I\'d like to know is
given that we do live in this global capital market and if you looked at
the past three years, investment has increased dramatically at period
when personal savings actually declined, what do you think would be the
empirical effect of changing the effect of taxation on saving on the
investment side \-- domestic investment?

MR. BOSKIN: Well, let me just make two comments. First as I briefly
touched on, the low and declining saving I think are greatly understated
by the national \-- the level\'s understated and the decline is
overstated in my opinion by the NPC. About half of it because of the
wealth effect and other things with respect to capital gains, another
quarter with respect to the way it mechanically deals with pensions and
other flows in and out.

So I think that \-- it is true I think the saving rate has declined a
little bit. The expansion of investment has been financed by importing
foreign capital.

And also in the last few years of course, government dissaving has
increased.

So that\'s point one.

Point two, in the short run to the extent that a tax reform raise
personal saving, its likely short-run impact would be on the flow of
foreign capital \-- the net flow of foreign capital into the United
States.

That is it would \-- to oversimplify, it would displace some of that. It
would decrease the crowding in of foreign capital we\'re doing now.

I want to be careful in saying this because some people have this
connotation that it\'s really bad we have this foreign capital. Quite
the contrary, it\'s very good that we have it because the alternative of
not having it would be much worse.

And so it\'s important to understand that. But I believe over time, it
would increase investment in the United States. I think that would take
time. I think it would not happen immediately because we are a large net
importer of capital right now.

So I think in a general proposition you\'d see little impact on
investment and interest rates in the short run. It would mostly show up
on the net flows of capital internationally.

MR. LAZEAR: Thanks.

CHAIRMAN MACK: I\'m going to follow up on that because this has been one
of the questions that I can\'t quite get my hands around. I mean I kind
of intuitively know that it would be better if we increase savings.

But I do remember back from our discussions in economics years and years
ago, you talk about either a closed system or an open system. Obviously
in a closed system your need to save is much more important than in an
open system I believe.

And so I guess my question really is \-- and I heard you say over time
it would increase investment, but I really wonder is that\'s the case. I
mean if \-- we seem to be able to attract all the capital that we need
for investment.

So as I said \-- I started out I intuitively believe that it\'s better
for us to increase our savings rate, but I\'m not quite sure I
understand why.

MR. BOSKIN: Let me give you an answer to your question and let me start
with another statement.

Even if what you said were true, that it wouldn\'t affect investment,
the fact that we would have \-- Americans would be saving more. They\'d
be wealthier. They\'d have more available at retirement. It may be
located somewhere else, but they would have the returns to that. It
would ease the \-- it would improve their retirement standard of living.
It would ease the pressures on the public purse for future Social
Security and Medicare things.

So the wealth creation aspect of it is important to understand as well
as where the investment may be located.

Now it\'s my own \-- I think economists have argued \-- to give a
synopsis of a couple of centuries of intellectual history, have argued
whether trade flows drive capital flows or capital flows drive trade
flows. My own view is they\'re simultaneously determined. They affect
each other.

There must be an upper limit to the fraction of their wealth if
foreigners are willing to invest in dollar denominated assets for
diversification reasons. Otherwise they\'ll have too much at risk in a
bad exchange movement if they\'re a hundred percent in dollar assets, if
you\'re French or Japanese or Singaporean.

So economists have argued how close to that we\'ve gotten. Many
economists have said ten years ago that we had imported all we could.
This is going to end and it keeps on flowing.

Once we get to that upper limit, if we haven\'t already gotten there,
and I think we probably are getting close, that doesn\'t mean that we
won\'t get ‑‑ attract any more foreign capital. It just \-- it will only
attract that pro rata share of foreign wealth.

A lot of this has happened in the last two decades in a climate in which
Europeans and the Japanese deregulated their financial markets so their
insurance companies and pension funds which were not allowed to own
foreign assets started being able to diversify into foreign securities.

We are the largest, safest in most dimensions, most secure, most liquid,
most transparent capital market in the world. We are a quarter \--
little less than a quarter of world GDP. We\'re probably a third of the
world capital market or more.

So it is \-- or of the transparent liquid capital market, we\'re even
larger.

So it\'s not surprising that there\'s been this big flow. But at some
point, the pace of that will slow down.

We also know that over the very long run, the flows in, there\'s going
to be a return \-- a growing return of interest and dividends paid to
foreigners. So ceteris paribus, it would be a good thing if Americans
save more and were a little less dependent on foreign capital.

But I want to say that in the context that it\'s a good thing that
foreigners are investing here, better than not having that investment,
number one, and number two, I think our \-- it\'s heavily not completely
a reflection of the strength of our economy relative to theirs.

CHAIRMAN MACK: If it\'s all right with the rest of the panel, I have a
couple of other questions.

Alan, I think that it would be good to go back to this cross border
adjustment issue because what we do hear from those who support the VAT
or the retail sales, it would make us more competitive internationally.
We would be able to sell more abroad.

And almost every economist that I\'ve heard basically has made the same
statement that you have had.

It might be worthwhile to expand a little bit though on kind of why and
how that happens. That is that \-- the data seems to indicate that there
really isn\'t an advantage to a country that a value added tax, but why
don\'t you take a moment to \--

MR. AUERBACH: Okay. Well, let me first talk about the advantages of the
value added tax.

A value added tax could well improve the trade balance, improve the
current account balance, and make it a nation more competitive.

But the channel through which it would do that would not be border
adjustments, but the taxation of consumption. Because if you encourage
saving, you\'re going to increase national saving and remember that was
what I said you had to do in order to improve the current account
balance. That or reduce domestic investment.

All value added taxes in practice are destination based value added
taxes. So when you look at the effects of value added taxes on promoting
an increase in the current account or a reduction in the current account
deficit, the question is what to attribute it to.

I think it\'s perfectly plausible that moving to a consumption based tax
is going to encourage national saving and improve competitiveness. I
don\'t think it would be due to the border adjustment.

We haven\'t had an experiment in that. We\'ve had proposals to do that.
For example, the flat tax that\'s been proposed by Hall and Rabushka,
introduced in Congress by Armey and others, would have been an origin
based tax.

That is it would have been like a value added tax, some administrative
differences, but like a value added tax except without border
adjustments.

And if you adopted a tax like that, I\'m arguing that you\'d get
whatever benefits you\'d get in terms of competitiveness from a
consumption tax without the border adjustments.

Now in terms of the logic and where the logic breaks down I think, again
I think intuition develops from thinking of specific circumstances, and
we know that if we have specific export subsidies that\'s going to
encourage exports and there\'s no disagreement about that and economists
will agree with that.

Same thing if we put a tariff on imports of certain commodities. We know
that\'s going to discourage imports. Because whatever exchange rate
adjustments occur, there will still be a difference in the relative
incentive to export the favored and the unfavored goods or the relative
incentive to import.

When we do it across the board as we would under a system of border
adjustments with \-- under value added tax, assuming it was a very broad
based value added tax, not something like our state retail sales taxes,
then you\'re saying to everybody, you know, we\'re giving you all an
incentive, but in a sense giving them all an incentive gives none of
them an incentive because then if the exchange rate adjusts ‑‑ so
there\'s two pieces to the logic.

First of all, if the exchange rate adjusts, then it will wash out all
the advantages.

Now the \-- then the key question is, well, why might the exchange rate
adjust, and here my argument is that if the exchange rate adjusts,
you\'re back where you started.

There\'s been no change in the incentive to import or export, so things
will be as they are and because there\'s been no change in the
incentives to save or invest or to send capital abroad, nothing\'s going
to happen on that side either.

And so \-- so you can end up in the original place you were and there\'s
nothing further to disturb you away from this so-called economic
equilibrium.

There\'s further logic one can discuss. I\'m not sure it\'s \-- it\'s
not really a different argument, but it amounts to the same argument as
to why there\'s no additional incentive for capital flows, which is that
you can think of the border adjustments going out and coming in because
in the long run if we, you know, establish trade deficits, we have to
pay it off with future trade surpluses.

You can think of \-- over time of these border adjustments as offsetting
each other. So if we have a system where we have export border
adjustments and add taxes to imports and we\'re currently exporting
capital \-- we have the current account surplus and that means we\'re
exporting capital, then it\'s as if we\'re getting a deduction when
we\'re investing abroad and then when we import in the future and we\'re
\-- and capital\'s coming back in in the form of earnings \--
repatriated earnings, we\'re paying a tax on the imports, it\'s as if we
have \-- it\'s like the treatment under an Individual Retirement
Account.

Tax deduction on the way out, a tax added on the way back, and if you
don\'t do any \-- either of those border adjustments, then it\'s like a
Roth IRA.

And we\'ve \-- economists have made the argument before and I\'m sure
you\'ve heard it that Roth IRAs and traditional IRAs are basically the
same in their incentive to invest as long as the tax rates don\'t change
over time.

So that\'s the argument as far as it can be made. I understand that it
doesn\'t correspond to the intuition that people have when they\'re
thinking about individual circumstances because of course they haven\'t
seen the exchange rate change. Exchange rates move all around and it\'s
sometimes hard to discern \-- it would certainly be hard empirically to
discern small changes in the exchange rate due to border adjustments
from all the other exchange rate changes that occur.

MR. BOSKIN: To oversimplify a bit in \-- because I remember trying to
explain this to the Ways and Means Committee and several members who
were aware of the rebates they had gotten when they\'d come back from
their purchases in Europe.

So if you get a 20 percent rebate, you might think that\'s making them
20 percent more competitive.

It\'s reducing the cost to us of buying their goods by 20 percent of
their VAT. And I won\'t go into the boring details of it, but economists
think that there will be a 20 percent adjustment in the dollar versus
the Euro that will exactly offset it.

So the net \-- on net there\'s no change.

CHAIRMAN MACK: And I \-- again at the risk of ‑‑ I just wanted to ask
you, Michael, with respect to your comments about the value added tax
earlier. Is it from an economic perspective that you made that statement
or from a political perspective that you made the statement?

I mean in the sense of \-- again I think we heard Professor Friedman
this morning said that value added tax, since it\'s so easy to collect,
it just encourages growth in government. Maybe he didn\'t say it that
way, but that\'s the way I kind of took what he had to say.

MR. BOSKIN: Well, I think a bit both. There are all these political
economy issues. You might grow the government \-- in Europe \-- Europe
has their so-called advance welfare states which I think we are wise to
have called a halt to approaching because I think that would have
basically destroyed our economies as it has basically undermined
theirs ‑‑ are about 50 percent larger in round numbers than ours.

The size of government \-- taxes and spending are roughly half again as
large as they are here, and the main way that\'s been financed has been
the addition of value added taxes to other things \-- to other tax
devices.

So people who say well, they rely more on consumption taxes, that\'s
true, but in a much larger system. So there\'s that and the federalism
issues.

But there are economic issues as well. If we replace the federal income
tax with a value added ‑‑ with a good value added tax, there would be
substantial administrative savings if we also eliminated all the state
income taxes.

But Professor Friedman, Professor Auerbach, and Professor Boskin and
Professor Lazear are going to have \-- their income taxes would be
simplified two or three percent by eliminating the federal income tax
because they still have to pay the California income tax.

They have to do almost everything they do now to do that. So there\'s
\-- in terms of the costs and administrative costs and compliance costs
on taxpayers, the advantages of replacing the federal income tax depend
heavily on also replacing state income taxes.

CHAIRMAN MACK: Well, again thank you very much for being here with us
today and for your thoughts and your presentation.

And to the panel members, thank you also for your involvement. And to
you all, thank you for coming.

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