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[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]

 
               FIRST IN SERIES ON TAX CODE SIMPLIFICATION

=======================================================================

                                HEARING

                               before the

                       SUBCOMMITTEE ON OVERSIGHT

                                  and

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION

                               __________

                             JULY 17, 2001

                               __________

                           Serial No. 107-40

                               __________

         Printed for the use of the Committee on Ways and Means

                    U.S. GOVERNMENT PRINTING OFFICE
75-055                      WASHINGTON : 2001
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov  Phone: toll free (866) 512-1800; (202) 512-1800  
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001

                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois            MARK FOLEY, Florida
E. CLAY SHAW, Jr., Florida           KEVIN BRADY, Texas
NANCY L. JOHNSON, Connecticut        PAUL RYAN, Wisconsin
AMO HOUGHTON, New York               CHARLES B. RANGEL, New York
WALLY HERGER, California             FORTNEY PETE STARK, California
JIM McCRERY, Louisiana               ROBERT T. MATSUI, California
DAVE CAMP, Michigan                  WILLIAM J. COYNE, Pennsylvania
JIM RAMSTAD, Minnesota               SANDER M. LEVIN, Michigan
JIM NUSSLE, Iowa                     BENJAMIN L. CARDIN, Maryland
SAM JOHNSON, Texas                   JIM McDERMOTT, Washington
JENNIFER DUNN, Washington            GERALD D. KLECZKA, Wisconsin
MAC COLLINS, Georgia                 JOHN LEWIS, Georgia
ROB PORTMAN, Ohio                    RICHARD E. NEAL, Massachusetts
PHIL ENGLISH, Pennsylvania           MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma                WILLIAM J. JEFFERSON, Louisiana
J. D. HAYWORTH, Arizona              JOHN S. TANNER, Tennessee
JERRY WELLER, Illinois               XAVIER BECERRA, California
KENNY C. HULSHOF, Missouri           KAREN L. THURMAN, Florida
SCOTT McINNIS, Colorado              LLOYD DOGGETT, Texas
RON LEWIS, Kentucky                  EARL POMEROY, North Dakota

                     Allison Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel

                                 ______

                       Subcommittee on Oversight

                    AMO HOUGHTON, New York, Chairman

ROB PORTMAN, Ohio                    JENNIFER DUNN, Washington
JERRY WELLER, Illinois               WILLIAM J. COYNE, Pennsylvania
KENNY C. HULSHOF, Missouri           MICHAEL R. McNULTY, New York
SCOTT McINNIS, Colorado              JOHN LEWIS, Georgia
MARK FOLEY, Florida                  KAREN L. THURMAN, Florida
SAM JOHNSON, Texas                   EARL POMEROY, North Dakota

                                 ______

                Subcommittee on Select Revenue Measures

                    JIM McCRERY, Louisiana, Chairman

J.D. HAYWORTH, Arizona               MICHAEL R. McNULTY, New York
JERRY WELLER, Illinois               RICHARD E. NEAL, Massachusetts
RON LEWIS, Kentucky                  WILLIAM J. JEFFERSON, Louisiana
MARK FOLEY, Florida                  JOHN S. TANNER, Tennessee
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.

                            C O N T E N T S

                               __________
                                                                   Page
Advisory of July 10, 2001, announcing the hearing................     2

                               WITNESSES

Gale, William G., Brookings Institution..........................    76
Joint Committee on Taxation, Lindy Paull.........................     8
National Taxpayers Union, David L. Keating.......................    49
Steuerle, C. Eugene, Urban Institute.............................    69
Tax Foundation, Scott Moody......................................    56

                                 ______

                       SUBMISSIONS FOR THE RECORD

American Bankers Association, statement..........................   109
Association of Financial Guaranty Insurors, Albany, NY, statement   112
Group Health Incorporated, New York, NY, statement...............   114
Investment Company Institute, statement..........................   116
Massachusetts Software & Internet Council, Boston, MA, Joyce L. 
  Plotkin, letter and attachment.................................   119
Mortgage Insurance Companies of America, statement and attachment   121
National Association of Professional Employer Organizations, 
  Alexandria, VA, statement......................................   123
National Council of Farmer Cooperatives, statement and 
  attachments....................................................   125
Rangel, Hon. Charles B., a Representative in Congress from the 
  State of New York, statement...................................   128

               FIRST IN SERIES ON TAX CODE SIMPLIFICATION

                              ----------                              

                         TUESDAY, JULY 17, 2001

              House of Representatives,    
               Committee on Ways and Means,
                         Subcommittee on Oversight,
                   Subcommittee on Select Revenue Measures,
                                                    Washington, DC.
    The Subcommittees met, pursuant to notice, at 2:00 p.m., in 
room 1100 Longworth House Office Building, Hon. Amo Houghton 
(Chairman of the Subcommittee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS

                       SUBCOMMITTEE ON OVERSIGHT

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                                CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
July 10, 2001
No. OV-5

Houghton and McCrery Announce First in a Series of Hearings on Tax Code 
                             Simplification

    Congressman Amo Houghton (R-NY), Chairman of the Subcommittee on 
Oversight, and Congressman Jim McCrery (R-LA), Chairman of the 
Subcommittee of Select Revenue Measures, Committee on Ways and Means, 
today announced that the Subcommittees will hold the first in a series 
of hearings on the need for simplification of the Internal Revenue Code 
(IRC). The hearing will take place on Tuesday, July 17, 2001, in the 
main Committee hearing room, 1100 Longworth House Office Building, 
beginning at 2:00 p.m.
      
    Oral testimony at this hearing will be from invited witnesses only. 
However, any individual or organization not scheduled for an oral 
appearance may submit a written statement for consideration by the 
Committee and for inclusion in the printed record of the hearing. 
Future hearings will review specific reform proposals.
      

BACKGROUND:

      
    Under Section 4022(a) of the Internal Revenue Service (IRS) 
Restructuring and Reform Act of 1998 (P.L. 105-206), the Joint 
Committee on Taxation (JCT) is required at least once every Congress to 
provide a comprehensive study on the state of the Federal Tax system. 
In April of this year, the JCT released a document entitled ``Study of 
the Overall State of the Federal Tax System and Recommendations for 
Simplification'' (JCS-3-01), outlining the complex nature of the IRC, 
andproviding recommendations for its simplification.
      
    Compiled and instituted into American society shortly before World 
War I, the IRC has gone through enormous revisions and additions, 
enough to make it the most complex income tax code in history. A number 
of economists and academics have documented the ways in which 
complexity increases the costs of our current tax system.
      
    ``The Oversight Subcommittee continues to hear from individuals, 
businesses, and tax professionals about complexity in our income tax 
system,'' said Chairman Houghton. ``Our first hearing will explore the 
costs of tax complexity and review the very comprehensive report of the 
Joint Committee on Taxation.''
      
    ``For most Americans, the term `tax simplification' is an oxymoron 
like `deafening silence' or `jumbo shrimp','' remarked Chairman 
McCrery. ``I am hopeful this hearing and our joint efforts will help 
rid the tax code of some of its complexity, reducing the frustration so 
closely associated with paying taxes.''
      

FOCUS OF THE HEARING:

      
    The hearing will focus on the nature and cost of complexity in the 
tax code and the options for tax simplification.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch 
diskette in WordPerfect or MS Word format, with their name, address, 
and hearing date noted on a label, by the close of business, Tuesday, 
July 31, 2001, to Allison Giles, Chief of Staff, Committee on Ways and 
Means, U.S. House of Representatives, 1102 Longworth House Office 
Building, Washington, D.C. 20515. If those filing written statements 
wish to have their statements distributed to the press and interested 
public at the hearing, they may deliver 200 additional copies for this 
purpose to the Subcommittee on Oversight office, room 1136 Longworth 
House Office Building, by close of business the day before the hearing.
      

FORMATTING REQUIREMENTS:

      
      Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect or 
MS Word format, typed in single space and may not exceed a total of 10 
pages including attachments. Witnesses are advised that the Committee 
will rely on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
      The above restrictions and limitations apply only to material 
being submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press, 
and the public during the course of a public hearing may be submitted 
in other forms.
      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at ``http://waysandmeans.house.gov''.

      The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.

                                

    Chairman Houghton. If I can have your attention, I think we 
will call the meeting to order. I am going to say a few things, 
and then I will turn over the mike to Mr. McCrery, who is the 
co-leader here, and then I will recognize Mr. Coyne and Mr. 
McNulty.
    What I would like to do is begin by noting that this is, as 
I mentioned earlier, a joint hearing of the Oversight and 
Select Revenue Measures Subcommittees, and I have the gavel 
because I outweigh and I out-age my colleague, Mr. McCrery, and 
I haven't been treated, frankly, with the proper respect over 
the years.
    The Oversight Subcommittee has a long history of activity 
on tax simplification, and I certainly welcome the 
participation of the Select Revenue Measures Members in the 
important need to simplify our Tax Code. What I have here in my 
hand is the number of pages used for our income taxes in 1913. 
Now, I was not alive in 1913, but that is what it was.
    Now, I was alive in 1937, and the four pages have now grown 
to eight. However, if you will look down here right in front of 
me, this is the requirement for the income tax reporting in 
2000. The current Tax Code is so complex that I couldn't begin 
to hold up those forms and the pages of instructions put out by 
the IRS, but they are right here in front of me.
    Our past hearings have given us a range of numbers on the 
cost and complexity of the Tax Code. The lowest estimates, in 
the range of $75 billion per year, commonly include only the 
cost of preparing Federal income tax forms. If you add up all 
the costs of the Federal tax system including education, 
recordkeeping, preparing returns, governmental administration, 
tax litigation and things like that, the total overall overhead 
cost of our Federal tax system is probably in the range of $200 
billion, and I really think that is a conservative estimate. So 
think what we could do if we had that available--that amount of 
money available for health care or other important activities.
    So today's hearing really is going to begin our quest to 
simplify the Tax Code. I don't know that we can do it, but we 
are going to have a mighty effort in that regard. We will hear 
from several witnesses who have studied the complexity of the 
system and its cost to society, and we will also review the 
excellent report produced by the Joint Committee on Taxation 
(JCT) for which we commend Mrs. Paull very much, and her staff.
    So future hearings--so this is not the only one. Future 
hearings will examine a host of other simplification 
recommendations. And I understand that the Treasury Department 
is reviewing the simplification study done by the Joint 
Committee on Taxation together with simplification proposals 
advanced by the IRS Restructuring Commission, National Taxpayer 
Advocate, a number of professional associations. And also, in 
addition, the Treasury Department will be developing proposals 
that were not addressed by these other reports.
    Now, a future hearing is going to require the Treasury 
Department to come back at us and give the opportunity to 
present specific proposals that would simplify the tax system 
and provide for enhanced economic growth. We look forward to 
hearing the Treasury Department's recommendations when the 
analysis is complete.
    And I am now pleased to yield to the Chairman of the 
Subcommittee for Select Revenue Measures, Mr. McCrery.
    [The opening statement of Chairman Houghton follows:]
    Opening Statement of the Hon. Amo Houghton, a Representative in 
  Congress from the State of New York, and Chairman, Subcommittee on 
                               Oversight
    Good Afternoon. Let me begin by noting that this is a joint hearing 
of the Oversight and Select Revenue Measures Subcommittee. I think I 
have the gavel either because I outweigh or out-age my colleague 
Chairman McCrery. The Oversight Subcommittee has a long history of 
activity on tax simplification and I welcome the participation of the 
Select Revenue Measures Members in the important need to simplify our 
tax code.
    What I have here in my hand is the total number of pages used for 
our income taxes in 1913--four simple pages. By 1937 the tax return had 
grown to four pages with another four pages of instructions. But the 
current tax code is so complex I couldn't begin to hold up all the 
forms and pages of instructions put out by the IRS--thousands of 
pages--and they are displayed here in front of me.
    Our past hearings have given us a range of numbers on the cost of 
complexity in the tax code. The lowest estimates, in the range of $75 
billion per year, commonly include only the cost of preparing federal 
tax forms. If you add up all the costs of the federal income tax 
system, including the cost of:
           education;
           record-keeping;
           preparing returns;
           paid preparers;
           governmental administration;
           tax litigation;
           and the substantial costs associated with tax 
        planning the total overhead cost of our federal tax system is 
        probably in the range of $200 billion per year. Think of what 
        we could do it we had that available for heath care or other 
        important activities.
    Today's hearing will begin our quest to simplify the tax code. We 
will hear from several witnesses who have studied the complexity in our 
tax system and its cost to society. We will also review the excellent 
report produced by the Joint Committee on Taxation, for which we 
commend Ms. Paull and her staff.
    Future hearings will examine a host of other simplification 
recommendations. I understand that the Treasury Department is reviewing 
the simplification study done by the Joint Committee on Taxation 
together with simplification proposals advanced by the IRS 
Restructuring Commission, the National Taxpayer Advocate, and a number 
of professional associations. In addition, the Treasury Department will 
be developing proposals that were not addressed by the other reports.
    A future hearing will provide the Treasury Department the 
opportunity to present specific proposals that would simplify the tax 
system and provide for enhanced economic growth. We look forward to 
hearing the Treasury Department's recommendations when the analysis is 
complete and will welcome the views of other groups on this important 
topic.
    I am pleased to yield to the Chairman of the Subcommittee on Select 
Revenue Measures, Mr. McCrery.

                                

    Chairman McCrery. Thank you. It is a pleasure to co-host 
this hearing with the Oversight Subcommittee. The Select 
Revenue Measures Subcommittee is certainly interested in the 
findings of the Oversight Committee with respect to tax 
simplification and potentially moving forward legislation at 
some point to make the Tax Code more simple.
    Chairman Houghton has said pretty much what I would say in 
my opening remarks, and, in the interest of time, I would 
submit for the formal record my written opening remarks and 
yield back to the Chairman.
    [The opening statement of Chairman McCrery follows:]
Opening Statement of the Hon. Jim McCrery, a Representative in Congress 
   from the State of Louisiana, and Chairman, Subcommittee on Select 
                            Revenue Measures
    Good afternoon. Today, I am pleased the Select Revenue Measures 
Subcommittee is joining Chairman Houghton and our colleagues on the 
Oversight Subcommittee in the first in a series of hearings on the 
ever-timely topic of tax code complexity.
    For most Americans, the term `tax simplification' is an oxymoron 
like `deafening silence,' or `jumbo shrimp'. As society has become more 
complex, so has the tax code. In raw terms, the number of words in the 
tax code grew from 235,000 in 1964 to almost 800,000 words in 1994--an 
increase of more than 300 percent!
    Our constituents are rightly frustrated by the billions of hours 
they spend trying to figure out how much tax they owe Uncle Sam.
    It may be impossible to quantify the frustration folks experience 
as they scour tax forms and the accompanying pages of instructions.
    But it is possible to measure the difficulty of the code itself. 
Consider the fact that a Treasury Department sampling of service at IRS 
walk-in clinics found taxpayers were given accurate answers less than 
one-third of the time.
    The implications are clear: even the IRS' own employees who are 
trained and paid to understand the tax code and work through individual 
problems have difficulty doing so.
    That strongly argues to me the importance of finding ways to 
simplify the code.
    Today's hearing will begin this inquiry for the 107th 
Congress. We will hear from several groups about the societal costs of 
complexity, which include the billions of hours and dollars spent by 
individuals and corporations trying to comply with our tax system.
    I also look forward to hearing from Lindy Paull, whose staff at the 
Joint Tax Committee produced a thorough examination of the causes and 
cures for tax code complexity. Their recommendations will be extremely 
helpful as we further pursue this matter.
    As I stated at the outset, this is the first in a series of 
hearings on this important issue and I look forward to working with my 
colleagues as we look for solutions.

                                

    Chairman Houghton. Thanks very much, Mr. McCrery, and also 
I am honored to be able to do this thing with you. What I would 
like to do is call my friend here, Mr. Coyne.
    Mr. Coyne. Thank you, Mr. Chairman. It is helpful that this 
hearing be held to discuss the need for tax simplification. I 
believe that the time for tax simplification is now. We must 
make the decision to simplify the Tax Code and make tax reform 
a high priority. The Oversight Subcommittee has held numerous 
tax simplification hearings. In 1998 we held hearings on the 
impact of the tax law complexity on individual taxpayers and 
businesses. At the beginning of each year since then, we have 
held a tax return filing season hearing which included 
discussion of tax complexity and the most common taxpayer and 
tax practitioner errors.
    As the Subcommittees proceed this year, I suggest that we 
consider simplification measures that address both simpler Tax 
Code rules and improved IRS notices, forms, and instructions. 
The Joint Committee on Taxation's April 2001 simplification 
report is an excellent document. This report was mandated by 
the 1998 IRS Reform Act to provide the Congress with a 
professional and objective analysis of why the tax laws are 
complex and how the tax laws can be simplified. The study 
outlines in quite specific terms what could be done to simplify 
the Code.
    I want to thank Chairman Houghton for keeping tax 
simplification at the top of the Oversight Subcommittee's 
agenda. I look forward to developing a tax simplification 
package and also to working with all members of both 
Subcommittees on tax simplification throughout the year. Thank 
you, Mr. Chairman.
    [The opening statement of Mr. Coyne follows:]
  Opening Statement of the Hon. William J. Coyne, a Representative in 
                Congress from the State of Pennsylvania
    I am pleased that today's joint Subcommittee hearing has been 
scheduled to discuss the need for tax simplification. Having introduced 
and sponsored tax simplification legislation in the past, with 
Congressman Neal and others, I can tell you there are simple solutions 
to some of the most complex tax Code provisions.
    As Ranking Member of the Oversight Subcommittee and a Member of the 
IRS Restructuring and Reform Commission, I believe that the time for 
tax simplification is now. We must make the decision to simplify the 
tax Code and make reforms a priority.
    Since I have been Ranking Member, the Oversight Subcommittee have 
held numerous tax simplification hearings. In 1998, we held hearings on 
the impact of tax law complexity on individual taxpayers and 
businesses. At the beginning of each year, we held a tax return filing 
season hearing which included discussion of tax complexity and the most 
common taxpayer and tax-practitioner errors.
    As the Subcommittees proceed this year, I suggest that we consider 
simplification measures that address both simpler tax Code rules and 
improved IRS notices, forms and instructions.
    Finally, the Joint Committee on Taxation's April 2001 
simplification report is excellent. This report was mandated by the 
1998 IRS Reform Act to provide the Congress with a professional and 
objective analysis of why the tax laws are complex and how the tax laws 
can be simplified. The study outlines in quite specific terms what 
needs to be done.
    In conclusion, I want to thank Chairman Houghton for keeping tax 
simplification in the top of the Oversight Subcommittee's agenda. I 
look forward to developing a tax simplification package for quick 
action this why the tax laws are complex and how the tax laws can be 
simplified. The study outlines in quite specific terms what needs to be 
done. I want to thank Lindy Paull, Chief of Staff of the Joint 
Committee on Taxation, for a job well done.
    In conclusion, I want to thank Chairman Houghton for keeping tax 
simplification in the top of the Oversight Subcommittee's agenda. I 
look forward to working with all members of both Subcommittees in tax 
simplification throughout the year.

                                

    Chairman Houghton. Thanks very much, Mr. Coyne. Mr. 
McNulty.
    Mr. McNulty. Thank you, Mr. Chairman. I ask unanimous 
consent that all members of the two Subcommittees have 5 
legislative days in which to submit statements for the record.
    Mr. Chairman, today our two Subcommittees are joined 
together to discuss one of the most frustrating issues facing 
taxpayers: the complexity of our tax laws. The witnesses' 
testimony will provide us with an excellent basis for analyzing 
the specific tax law provisions that deserve our priority 
attention for simplification. Tax simplification has strong and 
widespread bipartisan support. Given this, I would hope that 
the Committee will decide to take tax simplification seriously 
and do more than just holding hearings.
    We have been talking about tax simplification for years, 
but little has been done. Instead, the tax laws have, as you 
have pointed out, Mr. Chairman, become more and more 
complicated and taxpayers, justifiably, are becoming more 
frustrated. I believe that we could develop a tax 
simplification legislative package immediately. As a priority, 
we should focus on those tax provisions that impose significant 
unnecessary burdens on the greatest number of individual 
taxpayers. Simplification could begin with reforms to the 
earned income tax credit, alternative minimum tax, education 
credits, capital gains, and other areas affecting average 
working individuals and their families.
    There is no question that the tax laws are complicated and 
that simplification reforms are needed. The real question is 
when will the Committee act to simplify the Tax Code. And, much 
more important than simplification, it is critical that any 
reforms we enact are fair to average taxpayers. Mr. Chairman, I 
look forward to working with you and the Members of the 
Committee on this subject. Thank you.
    [The opening statement of Mr. McNulty follows:]
 Opening Statement of the Hon. Michael R. McNulty, a Representative in 
                  Congress from the State of New York
    Today the select revenue measures and oversight subcommittees are 
joining together to discuss one of the most frustrating issues facing 
taxpayers--the complexity of our tax laws. The witnesses' testimony 
will provide us with an excellent basis for analyzing the specific tax 
law provisions that deserve our priority attention for simplification.
    Tax simplification has strong and widespread bipartisan support. 
given this, I would hope that the committee will decide to take tax 
simplification seriously and do more than just holding hearings. We've 
been talking about tax simplification for years but little has been 
done. Instead, the tax laws have become more and more complicated and 
taxpayers justifiably are becoming more frustrated.
    I believe that we could develop a tax simplification legislative 
package immediately. As a priority, we should focus on those tax 
provisions that impose significant, unnecessary burdens on the greatest 
number of individual taxpayers. Simplification could begin with reforms 
to the earned income tax credit, alternative minimum tax, education 
credits, capital gains, and other areas affecting average, working 
individuals and their families.
    There is no question that the tax laws are complicated and that 
simplification reforms are needed. the real question is when will the 
committee act to simplify the tax code?
    And much more important than simplification--it is critical that 
any reforms we enact are fair to average taxpayers.
    I look forward to working with the members of the two 
subcommittee's on this important issue.
    Thank You.

                                

    Chairman Houghton. Thanks very much, Mr. McNulty.
    Unless other people have opening statements, Mrs. Paull, we 
are delighted to have you here, and please proceed.

 STATEMENT OF LINDY PAULL, CHIEF OF STAFF, JOINT COMMITTEE ON 
                            TAXATION

    Mrs. Paull. Thank you, Mr. Chairman, and Mr. Chairman, and 
Members of the Subcommittees. Let me start by thanking you for 
holding this series of hearings. I am especially appreciative 
of you inviting us to present to you the report that we did 
earlier this year on the overall state of the Federal tax 
system and our recommendations on ways to make it a little bit 
more simple.
    Simplification of the Tax Code is really an ongoing 
process. It requires a lot of diligence, and it requires a lot 
of focus on the ways that we write our tax laws. And I think 
this project was really quite an interesting one for our staff 
to engage in, to step back and take a big broad look at the Tax 
Code. So we thank you for inviting us to do that as well.
    Our report, of course, stems from the work of this 
Committee leading to the 1998 IRS Restructuring Act. And I also 
would like to thank everybody who contributed to the work of 
this study, because it was not only our staff which did a 
tremendous job on the report but also our colleagues at the 
U.S. General Accounting Office (GAO), the Congressional 
Research Service (CRS), and we elicited some outside advisors 
to help us as well, and it was quite a pleasure to work with 
all of them.
    I have submitted written testimony for the record, and I 
would just like to provide some highlights of that testimony so 
that there will be ample time for questions. I also thank you 
for accommodating my schedule. The Committee has a major markup 
tomorrow and we are getting ready for that as well; so, thank 
you for that.
    There is no doubt that the tax system is complex, 
illustrated by Chairman Houghton's very high stack of 
instructions and forms and publications that the IRS puts out 
on an annual basis to assist taxpayers in complying with the 
tax law.
    We have over 100 million individual income tax returns that 
are filed annually on behalf of about 90 percent of the U.S. 
population, and the individual income tax return itself 
consists of about 79 lines, 144 pages of instructions, 11 
schedules that have another 443 lines, 19 separate work sheets, 
the possibility of having to file numerous other forms and to 
have to look and to consult with all kinds of other schedules 
and instructions. So it is quite a complicated, daunting and 
intimidating task for taxpayers when they sit down to try to do 
their annual tax return.
    The Tax Code consists of approximately 1.4 million words. 
Almost 700 sections of the Tax Code are applicable to 
individual taxpayers, over 1,500 sections are applicable to 
businesses, and almost 500 sections to tax-exempt 
organizations, employee plans, and so forth. There are almost 
20,000 pages of regulations, encompassing about 8 million words 
that you have to try to sort through on various topics of the 
tax area, and there are a lot of missing regulations as well.
    Another interesting thing that we would note is that the 
number of paid tax return preparers has increased over the last 
decade, from about 48 percent of individual returns to 55 
percent, which is almost a 27-percent increase. And the use of 
computer software for the preparation of income tax returns has 
increased even more, from about 16 percent in 1990 to 46 
percent now. Some of the complexity of the Tax Code is actually 
hidden in the sense that you go to a tax preparer, you use 
computer software as opposed to having to try to sort through 
the returns and do it yourself.
    As a part of the study, we undertook a review of all the 
present-law tax provisions. We didn't focus only on one, but 
obviously we spent a lot more attention on the individual side 
and the complexity with respect to small businesses, because we 
thought that was one of the principal emphasis from the IRS 
Restructuring Act. And we determined that there was really no 
single cause of complexity. There are a multitude of causes. 
There are many, many factors, and you have to be diligent in 
all aspects of the tax law in order to try to make a change so 
that the complexity doesn't overcome and overwhelm the system. 
It is quite close to doing that right now.
    In the course our study we were able to identify numerous 
areas of the tax law that could be simplified. We did not think 
that our mission was to compare the current Tax Code to a 
theoretical or a perfect world Tax Code, but to look at the Tax 
Code and explore, considering the policies that have been 
enacted, are there simpler ways to go about implementing the 
policy that the Congress was desirous of achieving through 
those provisions of the tax law?
    So what we were identifying were areas where we thought you 
could go about achieving the same goal, but do it in a simpler 
way. In many instances, we found that there are multiple tax 
provisions that are trying to achieve the same thing. We 
explored whether they could be combined into one so that you 
would have one way of achieving that goal.
    In some instances we ultimately decided, especially with 
respect to the structure of the Tax Code, that there were so 
many policy issues involved in some of these structural issues 
that we could not make arecommendation. For example, the 
multiple filing statuses or whether or not you have one pass-through 
entity regime versus a different tax system for subchapter S 
corporations, partnerships, and other entities. While we didn't make a 
recommendation on it, we certainly left you a road map for us to come 
back and do some further work if after you have reviewed our report you 
wanted us to look further into it.
    In addressing the simplification, we have a few 
recommendations on how to tackle what seems to be an 
overwhelming effort to simplify the Tax Code. First, we would 
echo I think what has already been said, that particular 
attention ought to be paid to recommendations that have 
widespread applicability to individuals. For example, a 
simplification recommendation that we made with respect to the 
alternative minimum tax, and with respect to uniform definition 
of a child for various purposes of the Tax Code, ought to be 
given a very high priority by the Congress because so many 
people are affected by those provisions.
    There is another tier of recommendations that we made that 
basically involve the notion of uniform definitions that--
although we haven't estimated all our recommendations--we think 
that are probably pretty low cost and would give a coherence in 
the Tax Code and get rid of so-called dead wood, out-of-date 
provisions. We identified over a hundred of those provisions in 
the Tax Code. It would be a relatively simple proposition to go 
about doing that.
    The third thing we would urge--which we would participate 
in this when you are marking up a tax bill--is that when you 
are marking up a tax bill and you are adding new provisions to 
the Tax Code, some weight ought to be given to the benefit of 
the policy that you are trying to promote through the Tax Code 
versus the complexity and additional stacks of paper you are 
going to be adding to the instructions on the forms.
    And, finally, we would ask that you follow up on some of 
the structural issues that we identified. We identified over 20 
area that would be major projects and would involve a 
significant amount of policy decisions. So it would be up to 
the Congress to move forward those types of policy changes.
    Since my time is up and the report has been out since 
April, I will not highlight our specific recommendations as I 
had intended to. I would be happy to answer any questions you 
may have. Again, I appreciate you inviting me to appear before 
you today, and I think it is great that you are holding these 
hearings on tax code simplification.
    [The prepared statement of Mrs. Paull follows:]
 Statement of Lindy Paull, Chief of Staff, Joint Committee on Taxation
    My name is Lindy Paull. As Chief of Staff of the Joint Committee on 
Taxation, it is my pleasure to present the written testimony of the 
staff of the Joint Committee on Taxation (the ``Joint Committee 
staff'') at this hearing concerning the complexity of the Internal 
Revenue Code (the ``Code'').1
---------------------------------------------------------------------------
    \1\ This testimony may be cited as follows: Joint Committee on 
Taxation, Testimony of the Staff of the Joint Committee on Taxation at 
a Hearing of the Subcommittees on Oversight and Select Revenue Measures 
of the House Committee on Ways and Means Concerning Complexity of the 
Internal Revenue Code (JCX-60-01), July 17, 2001.
---------------------------------------------------------------------------
    The Joint Committee staff completed in April of 2001 a statutorily 
mandated study of the overall state of the Federal tax 
system.2 This study included a thorough review of the 
Federal tax system and made more than 100 recommendations for proposals 
to simplify the Federal tax system. Our testimony today will review 
some of the findings of our study, suggest an approach to addressing 
legislatively some of the complexity of the Federal tax system, and 
discuss specific recommendations that we believe would achieve the 
greatest simplification to the Federal tax system.
---------------------------------------------------------------------------
    \2\ Code sec. 8022(3)(B). This provision was added by section 
4002(a) of the Internal Revenue Service Restructuring and Reform Act of 
1998 (Pub. L. No. 105-206). Preparation of the Joint Committee study is 
subject to specific appropriations by the Congress. For fiscal year 
2000, the staff of the Joint Committee staff advised the House and 
Senate Committees on Appropriations that an appropriation of $200,000 
would be required for the Joint Committee staff to undertake the study 
and amounts were appropriated for this purpose. The three-volume report 
of the study was published in April 2001. Joint Committee on Taxation, 
Study of the Overall State of the Federal Tax System and 
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of 
the Internal Revenue Code of 1986 (JCS-3-01), April 2001. A copy of the 
executive summary for the Joint Committee study is attached to this 
testimony.
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A. Background Information on Tax Law Complexity and the Joint Committee 
                              Staff Study

    There is no doubt that the Federal tax system is complex and that 
this complexity affects almost all Americans. In the course of our 
study, we found extensive evidence of the complexity of the Federal tax 
system, including the following:
     Over 100 million individual income tax returns are filed 
annually on behalf of roughly 90 percent of the U.S. population.
     A taxpayer filing an individual tax return could be faced 
with a return consisting of 79 lines (Form 1040), 144 pages of 
instructions, 11 schedules totaling 443 lines, 19 separate worksheets, 
and the possibility of having to file numerous other forms. For 1999, 
IRS publications included 649 forms, schedules, and instructions, 159 
worksheets imbedded in instructions, and approximately 340 
publications.
     The Code consists of approximately 1,395,000 words. There 
are 693 sections of the Code that are applicable to individual 
taxpayers, 1,501 sections applicable to businesses, and 445 sections 
applicable to tax-exempt organizations, employee plans, and 
governments.
     As of June 2000, the Treasury Department had issued almost 
20,000 pages of regulations containing over 8 million words.
     The use of paid return preparers increased from 48 percent 
of returns filed in 1990 to 55 percent of returns filed in 1999 (a 27 
percent increase) and the use of computer software for return 
preparation increased from 16 percent of returns filed in 1990 to 46 
percent of returns filed in 1999 (a 188 percent increase).
    The complexities of the Federal tax system and the associated 
problems such complexities create have received considerable and 
increasing attention from the Congress, the Administration, taxpayer 
groups, and tax professionals.3 While complexity of the 
Federal tax system has been a concern almost since the inception of the 
income tax, concerns regarding complexity have intensified over the 
past decade. As part of growing concern over complexity, the Congress 
mandated that the Joint Committee staff study the Federal tax system 
and make recommendations for simplification.
---------------------------------------------------------------------------
    \3\ See, e.g., Deborah L. Paul, The Sources of Tax Complexity: How 
Much Simplicity Can Fundamental Tax Reform Achieve?, 79 N.C. L. Rev. 
151 (Nov. 1997); Most Serious Problem? Complexity!, J. Acct. (Feb. 
1999) (discussing the AICPA tax executive committee's list of the most 
serious problems encountered by taxpayers); Amy Hamilton, Tax Law 
Complexity Ranks 1st--and--2nd Among Taxpayer Problems, 90 Tax Notes 
140 (Jan. 8, 2001).
---------------------------------------------------------------------------
    As part of this study, we undertook a review of all provisions of 
present law. We determined that there is no single cause of complexity. 
The complexity of the Federal tax system has developed over many years 
and is the result of many different factors, including frequent changes 
in the law, the use of temporary provisions, administrative guidance, 
judicial interpretations, and the effects of the Congressional budget 
process. In addition, simplicity often is in conflict with other policy 
objectives, such as fairness and efficiency.
    The cost of complexity for taxpayers cannot be easily quantified. 
Complexity results in increased time required by taxpayers to prepare 
and complete tax returns, increased use of tax return preparers, and 
increased taxpayer requests for assistance by the IRS. The burdens of 
complexity fall particularly on individual taxpayers. For example, to 
receive many tax benefits, individuals must assess their eligibility, 
retain records, and prepare the proper forms or worksheets. Even though 
there is no reliable estimate of the cost of the complexity of the 
Federal tax system, it is clear that complexity results in an increase 
in the time and money required to comply with the Federal tax system. 
Complexity also undermines faith in the tax system and can undermine 
voluntary compliance with the tax laws.
    In the course of our study, we identified specific sources of 
complexity in the Federal tax system and made more than 100 
simplification recommendations involving virtually every area of the 
Federal tax system. We identified complexity associated with structural 
aspects of the Federal tax system, but we did not make specific 
recommendations in these areas because we did not believe that it was 
within the scope of our study to make recommendations that would alter 
the underlying policy decisions made by the Congress. However, we 
believe that these areas also should be considered as part of any 
simplification process.
    Given the breadth and depth of the complexity of present law, there 
is no quick fix to achieve simplification. We believe that 
simplification of the Federal tax system is a long-term and ongoing 
process that requires a systematic approach by the Congress.

                  B. Addressing Simplification Issues

    Because of the magnitude of the task of simplifying the Federal tax 
system, we believe that the Congress should prioritize its 
simplification objectives. Therefore, we make the following suggestions 
with respect to a process by which the Congress could address the issue 
of simplifying the Federal tax system:
          (1) The Congress should first consider simplification 
        recommendations that affect the largest numbers of individual 
        taxpayers. Particular attention should be given to 
        simplification recommendations affecting low-income taxpayers 
        who lack the resources to cope with complex Federal tax laws. 
        Complexity for individual taxpayers contributes not only to 
        increased costs of compliance with Federal tax laws, but also 
        to reduced respect for the Federal tax system. We have made a 
        number of simplification recommendations, such as repeal of the 
        alternative minimum tax, that we believe fall into this 
        category. These recommendations are discussed below.
          (2) The Congress should consider other simplification 
        recommendations that have either a relatively small revenue 
        effect or achieve modest amounts of simplification without 
        great disruption for taxpayers. For example, we recommend the 
        elimination of over 100 obsolete or near obsolete provisions in 
        the Internal Revenue Code. While any one of these 
        recommendations will not affect large numbers of taxpayers, 
        collectively these recommendations would improve the clarity of 
        the Federal tax system. Other recommendations from our study 
        that fit into this category, such as the adoption of uniform 
        definitions of terms in the Code, are discussed below.
          (3) When changes are made or new provisions are added to the 
        Code, the Congress should give more consideration to the 
        overall effect on complexity of the Federal tax system. 
        Simplification of the Federal tax system is an ongoing process, 
        which is undermined by the enactment of new complex tax 
        provisions.
          (4) The Congress should consider whether there are structural 
        issues in the Federal tax system that should be addressed. In 
        our study, we identified areas of complexity in the Federal tax 
        system for which specific recommendations were not made. We 
        believe these issues were beyond the scope of our study because 
        they involve significant underlying policy decisions made by 
        the Congress. However, we believe that simplification cannot be 
        fully achieved without revisiting some of these structural 
        issues.
    We highlight below our simplification recommendations that we 
believe should be considered first by the Congress. A complete 
discussion of our specific recommendations concerning each particular 
issue can be found in our published report on the simplification study.

           C. Specific Joint Committee Staff Recommendations

1. Individual income tax
In general
    In our study, we focused significant time and effort on identifying 
areas of complexity for individual taxpayers. We believe that 
simplification recommendations affecting the largest number of 
individual taxpayers should be given the highest priority. 
Additionally, several complex individual provisions affect low-income 
taxpayers who generally are not assisted by sophisticated tax advisors 
and we believe these recommendations should also be given priority 
consideration.
    Although we believe that all of our individual income tax 
simplification recommendations should be considered by the Congress, we 
believe certain provisions warrant special attention.
Alternative minimum tax
    As a top priority, we recommend that the individual and corporate 
alternative minimum tax should be eliminated. The alternative minimum 
tax contributes complexity to the present-law Federal tax system by 
requiring taxpayers to calculate Federal income tax liability under two 
different systems. The alternative minimum tax causes complexity not 
only for taxpayers with minimum tax liability; although a taxpayer 
ultimately may not have a minimum tax liability, many taxpayers must 
make the computation to determine if they do.
    We believe that the individual alternative minimum tax no longer 
serves the purposes for which it was intended. The present-law 
structure of the individual alternative minimum tax expands the scope 
of the provision to taxpayers who were not intended to be alternative 
minimum tax taxpayers. It is expected that many taxpayers are, and will 
in the future become, individual alternative minimum taxpayers because 
they (1) have large families, (2) live in States with high income 
taxes, or (3) have significant capital gains. Other special situations, 
such as large medical expenses, could also result in minimum tax 
liability.
    We believe that the corporate alternative minimum tax no longer 
serves the purpose for which it was intended. The corporate alternative 
minimum tax adjustments do not necessarily produce a more accurate 
measurement of economic income than the regular tax, which was the 
original purpose of the corporate alternative minimum tax.
    For 2001, it is estimated that 1.4 million individual tax returns 
are affected by the alternative minimum tax. By 2010, this number is 
projected to grow to 35.5 million individual tax returns. The number of 
individual taxpayers required to comply with the complexity of the 
individual alternative minimum tax calculations will continue to grow 
due to the lack of indexing of the minimum tax exemption amounts and 
the effect of the individual alternative minimum tax on taxpayers 
claiming nonrefundable personal credits. The Economic Growth and Relief 
Reconciliation Act of 2001 provided some relief from the individual 
alternative minimum tax; for example, the Act increased the exemption 
amount for individuals for 2001 through 2004. The Act also provided 
other alternative minimum tax relief and provided that, after 2001, 
there is no reduction in the child credit or earned income credit 
because of the alternative minimum tax.4
---------------------------------------------------------------------------
    \4\ This provision is subject to the general sunset of the Act.
---------------------------------------------------------------------------
    However, other provisions of the Economic Growth and Tax Relief 
Reconciliation Act will cause additional complexity as a result of the 
alternative minimum tax rules. It is estimated that for the year 2010, 
18 million additional individual income tax returns that will benefit 
from the Act's rate reductions, increased standard deduction, and 
expanded 15-percent rate bracket will be affected by the alternative 
minimum tax. For these taxpayers, it could be expected that the 
interaction of the provisions with the alternative minimum tax rules 
would result in an increase in tax preparation costs and in the number 
of individuals using a tax preparation service.
Uniform definition of a qualifying child
    We recommend that a uniform definition of qualifying child should 
be adopted for purposes of determining eligibility for the dependency 
exemption, the earned income credit, the child credit, the dependent 
care tax credit, and head of household filing status. In order to 
determine whether a child qualifies a taxpayer for each of the 
provisions, the taxpayer must apply up to five different tests.
    The different rules regarding qualifying children have been 
identified as a source of complexity for taxpayers for over a decade. 
The rules relating to qualifying children are a source of errors for 
taxpayers both because the rules for each provision are different and 
because of the complexity of particular rules. The variety of rules 
causes taxpayers inadvertently to claim tax benefits for which they do 
not qualify as well as to fail to claim tax benefits for which they do 
qualify. Adopting a uniform definition of qualifying child would make 
it easier for taxpayers to determine whether they qualify for the 
various tax benefits for children and reduce inadvertent taxpayer 
errors arising from confusion due to different definitions of 
qualifying child.
    Often, the individual taxpayers who are affected by the varying 
definitions of a qualifying child are low-income taxpayers who do not 
have access to competent tax advisors. Therefore, we believe that 
simplification in this area will directly benefit millions of low- and 
moderate-income taxpayers.
    Our recommendation would provide simplification for substantial 
numbers of taxpayers. Under present law, it is estimated that, for 
2001, 44 million returns will claim a dependency exemption for a child, 
19 million returns will claim the earned income credit, 6 million 
returns will claim the dependent care credit, 26 million returns will 
claim the child credit, and 18 million returns will claim head of 
household filing status.
    The Economic Growth and Tax Relief Reconciliation Act of 2001 
adopted our recommendation on the definition of qualifying child for 
purposes of the earned income credit, but did not go the further step 
of applying the definition to the dependency exemption, the child 
credit, the dependent care credit, and head of household filing status. 
Thus, a uniform definition is still urgently needed for all of these 
provisions.
Phase-outs and phase-ins
    We recommend that various phase-outs and phase-ins applicable to 
individuals should be eliminated. We recommend that the following 
phase-outs should be eliminated: (1) overall limitation on itemized 
deductions (known as the ``PEASE'' limitation); (2) phase-out of 
personal exemptions (known as ``PEP''); (3) phase-out of child credit; 
(4) partial phase-out of the dependent care credit; (5) phase-outs 
relating to individual retirement arrangements; (6) phase-out of the 
HOPE and Lifetime Learning credits; (7) phase-out of the deduction for 
student loan interest; (8) phase-out of the exclusion for interest on 
education savings bonds; and (9) phase-out of the adoption credit and 
exclusion.
    These phase-outs require taxpayers to make complicated calculations 
and make it difficult for taxpayers to plan whether they will be able 
to utilize the tax benefits subject to the phase-outs. Taxpayers in the 
phase-out range must perform separate worksheet calculations to 
determine the amount of allowable tax benefit. In addition to the 
additional time required of a taxpayer to educate himself or herself on 
the applicability of the phase-out to their particular circumstances, 
the worksheets themselves can be quite complicated to complete. This 
increases both the time required to prepare a return and the 
probability of making an error.
    Eliminating the phase-outs would eliminate complicated calculations 
and make planning easier. These phase-outs primarily address 
progressivity, which could be more simply addressed through the rate 
structure. Elimination of the phase-outs would provide simplification 
for up to 30 million returns that are subject to one or more of the 
present-law phase-outs and phase-ins.
    The Economic Growth and Tax Relief Reconciliation Act of 2001 
provided some simplification of phase-out complexity. The phase-out of 
the personal exemption and the overall limitation on itemized 
deductions will be gradually repealed after 2006 and completely 
eliminated after 2009. However, the provisions repealing the phase-outs 
are subject to the general sunset of the Economic Growth and Tax Relief 
Reconciliation Act of 2001.
Provisions relating to education
    Our study includes several recommendations with respect to 
education provisions. These recommendations include the following: (1) 
a uniform definition of qualifying higher education expenses should be 
adopted; (2) the HOPE and Lifetime Learning credits should be combined 
into a single credit; and (3) the restrictions on interaction among 
various education tax incentives should be revised.
    Numerous present-law provisions allow taxpayers to reduce the cost 
of post-secondary education and also provide special rules governing 
the tax treatment of qualified scholarships and fellowships, the 
forgiveness of certain student loans, and withdrawals from IRAs for 
educational expenses. The numerous provisions relating to education 
create transactional complexity for taxpayers making it difficult to 
determine which tax benefit is best for them.
    The present-law education incentives are structured in several 
different ways. Understanding the tax benefits provided by the 
different provisions, the various eligibility requirements, the 
interaction between different incentives and provisions within each 
incentive, as well as the different recordkeeping and reporting 
requirements that may apply, can be time consuming and confusing for 
taxpayers and lead to inadvertent errors.
    Two of the recommendations included in our study were adopted in 
the Economic Growth and TaxRelief Reconciliation Act of 2001; the 60-
month limit on the student loan interest deduction was eliminated and 
the exclusion for employer-provided educational assistance was made 
permanent.5 Nevertheless, other sections of the Economic 
Growth and Tax Relief Reconciliation Act of 2001 added to the 
complexity of the tax law relating to education, increasing the need 
for simplification in this area.
---------------------------------------------------------------------------
    \5\ The provisions are subject to the general sunset of the Act.
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Other individual tax simplification recommendations
    Our study contains other recommendations with respect to individual 
income tax issues, including the following:
          (1) The dependent care credit and the exclusion for employer-
        provided dependent care assistance should be conformed. This 
        would eliminate the confusion caused by different rules for the 
        two present-law tax benefits for dependent care expenses and 
        could provide simplification for as many as 6 million returns.
          (2) Determination of head of household and surviving spouse 
        statuses should be simplified. Filing status errors are common 
        and can cause errors throughout a tax return.
          (3) Taxation of Social Security benefits should be simplified 
        by providing a fixed percentage of benefits that are includible 
        in income for all taxpayers. Computation of the taxable portion 
        of social security benefits is extremely complicated and 
        results in frequent errors. Our recommendation could provide 
        simplification for as many as 12 million returns that show 
        taxable Social Security benefits.
          (4) The current rate system for capital gains should be 
        replaced with a deduction equal to a fixed percentage of the 
        net capital gain available to all individuals. Our 
        recommendation would simplify the computation of a taxpayer's 
        tax on capital gains and streamline the capital gains tax forms 
        and schedules for individuals for as many as 27 million returns 
        estimated to have capital gains or losses in 2001.
          (5) The definition of ``small business'' for capital gain and 
        loss provisions should be conformed. The different definitions 
        of small business for the special gain and loss rules can 
        create taxpayer confusion and uncertainty as to whether an 
        investment qualifies for the special rule.
          (6) The two-percent floor applicable to miscellaneous 
        itemized deductions should be eliminated. The two-percent floor 
        applicable to miscellaneous itemized deductions has added to 
        complexity because it has (1) placed pressure on individuals to 
        claim that they are independent contractors, rather than 
        employees; (2) resulted in extensive litigation with respect to 
        the proper treatment of certain items, such as attorneys' fees; 
        (3) resulted in inconsistent treatment with respect to similar 
        items of expense; and (4) created pressure to enact deductions 
        that are not subject to the floor. Although the two-percent 
        floor was enacted, in part, to reduce complexity, it has 
        instead shifted complexity to these other issues relating to 
        miscellaneous itemized deductions.
          (7) The taxation of minor children should be simplified by 
        expanding the election to include a child's income on the 
        parents return and eliminating the interaction of the child's 
        return with other returns by applying trust rates to the 
        child's income. The rules relating to the taxation of minor 
        children are complicated and require the completion of multiple 
        worksheets to calculate a child's income and appropriate amount 
        of tax.
2. Recommendations that would be relatively simple to implement
    We believe that the Congress should include as a priority those 
recommendations that would be relatively simple to achieve or would 
have a relatively low revenue effect. While such changes may not have a 
widespread impact on the Federal tax system, implementing the 
recommendations would improve the readability of the Code and would be 
a logical step in the simplification process.
    We recommend that out of date and obsolete provisions in the Code 
should be eliminated. We identified (1) more than 100 provisions that 
could be eliminated as deadwood, and (2) several obsolete and near-
obsolete tax-exempt bond provisions.
    We have recommended a number of areas in the Federal tax system 
that can be simplified by the use of uniform definitions. Great 
complexity results from inconsistent definitions assigned to the same 
term. Uniform definitions would eliminate the need for taxpayers to 
understand multiple definitions and make multiple determinations, and 
would reduce inadvertent taxpayer errors resulting from confusion with 
respect to the different definitions. Uniform definitions would also 
reduce inconsistencies in the Code.
    Uniform definitions of terms is a core foundation of a simplified 
tax system. Assigning uniform definitions to terms should be a 
relatively simple process with minimal revenue cost. Our report 
includes many recommendations for uniform terms, including the 
following:
          (1) A uniform definition of compensation should be used for 
        all qualified retirement plan purposes;
          (2) Uniform definitions of highly compensated employee and 
        owner should be used for all qualified retirement plan and 
        employee benefit purposes;
          (3) A uniform definition of employees who may be excluded for 
        purposes of the application of the nondiscrimination 
        requirements relating to group-term life insurance, self-
        insured medical reimbursement plans, educational assistance 
        programs, dependent care assistance programs, miscellaneous 
        fringe benefits, and voluntary employees' beneficiary 
        associations should be adopted;
          (4) A uniform definition of a family should be used in 
        applying the attribution rules used to determine stock 
        ownership;
          (5) The references in the Code to ``general partners'' and 
        ``limited partners'' should be modernized consistent with the 
        purposes of the references; and
          (6) A single definition of highway vehicle should be enacted 
        to eliminate taxpayer uncertainty about the taxability of motor 
        fuels and retail sales.
3. Other recommendations
    Our study includes numerous other recommendations for 
simplification of the Federal tax system. We recommend changes to 
virtually every area of the Federal tax system. While we suggest that 
the individual income tax and modest recommendations should have the 
highest priority, we believe that other simplification recommendations 
should also be considered.

                             D. Conclusion

    Simplification of the Federal tax system is not an easy task. We 
recognize that important considerations, such as the need to balance 
the goal of simplification with specific policy objectives and 
potential revenue constraints, make the process of achieving 
simplification of the present-law Federal tax system difficult. We hope 
that our study will help you prioritize your simplification objectives.
    I thank the Subcommittees for the opportunity to present the Joint 
Committee staff recommendations on simplification of the Federal tax 
system and I welcome the opportunity to answer any questions you may 
have now or in the future.
                                 ______
                                 

 EXECUTIVE SUMMARY OF A STUDY OF THE OVERALL STATE OF THE FEDERAL TAX 
   SYSTEM AND RECOMMENDATION FOR SIMPLIFICATION, PURSUANT TO SECTION 
            8022(3)(B) OF THE INTERNAL REVENUE CODE OF 1986

        Prepared by the Staff of the Joint Committee on Taxation

                    A. Study Mandate and Methodology

    Under the Internal Revenue Code, the Joint Committee on Taxation 
(''Joint Committee'') is required to report, at least once each 
Congress, to the Senate Committee on Finance and the House Committee on 
Ways and Means on the overall state of the Federal tax 
system.6 This study is required to include recommendations 
with respect to possible simplification proposals and such other 
matters relating to the administration of the Federal tax system as the 
Joint Committee may deem advisable.
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    \6\ Internal Revenue Code (``Code'') sec. 8022(3)(B). This 
provision was added by section 4002(a) of the Internal Revenue Service 
Restructuring and Reform Act of 1998 (Pub. L. No. 105-206). The 
requirement for a study stemmed from recommendations of the National 
Commission on Restructuring the Internal Revenue Service in 1997. 
Report of the Commission on Restructuring the Internal Revenue Service: 
A Vision for a New IRS: Report of the National Commission on 
Restructuring the Internal Revenue Service, June 27, 1997. Preparation 
of the Joint Committee study is subject to specific appropriations by 
the Congress. For fiscal year 2000, the staff of the Joint Committee on 
Taxation (``Joint Committee staff'') advised the House and Senate 
Committees on Appropriations that an appropriation of $200,000 would be 
required for the Joint Committee staff to undertake the study and 
amounts were appropriated for this purpose.
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    In the course of this study, the Joint Committee staff:
          (1) Undertook an extensive review of prior simplification 
        proposals, including review of legal and economic literature 
        making simplification and other legislative recommendations 
        during the past 10 years; prior published and unpublished work 
        of the Joint Committee staff with respect to simplification; 
        various published Treasury studies; materials published by the 
        National Taxpayer Advocate and the Commissioner of Internal 
        Revenue, including the Tax Complexity Study issued by the 
        Commissioner on June 5, 2000; and published simplification 
        recommendations of various professional organizations, 
        including the American Bar Association, the American Institute 
        of Certified Public Accountants, and the Tax Executives 
        Institute;
          (2) Assembled two groups of advisors (approximately 40 
        academic advisors and approximately 25 individuals who 
        previously held senior-level tax policy positions in the 
        Federal government) to assist in the analysis of various 
        simplification proposals and to solicit simplification ideas 
        that may not have been previously advanced;
          (3) Conducted a full-day meeting with representatives of the 
        Internal Revenue Service (``IRS'') to solicit comments and 
        suggestions on specific issues under the Federal tax system and 
        a separate meeting with the IRS and the Director of the 
        American University Washington College of Law Tax Clinic on 
        issues relating to the present-law earned income credit;
          (4) Requested that the General Accounting Office provide 
        information that would assist in measuring the effects of 
        complexity on taxpayers, including the size of the Code, the 
        number of forms, instructions, and publications, and taxpayer 
        errors and requests for assistance to the IRS; and
          (5) Requested the Congressional Research Service to provide 
        information regarding legislative and regulatory activity 
        relating to the Federal tax system and information on the 
        efforts of foreign countries to simplify their tax laws.
    The Joint Committee staff (1) collected background information on 
the Federal tax system, (2) identified the sources and effects of 
complexity in the present-law tax system, (3) identified provisions 
adding complexity to the present-law tax system, and (4) developed 
simplification recommendations.

          B. Background Information on the Federal Tax System

    The Joint Committee staff collected background information on the 
sources of complexity in the Federal tax law and data concerning the 
filing of tax forms, taxpayer assistance, and information on error 
rates and tax controversies. Some of the information collected by the 
Joint Committee staff (with the assistance of the General Accounting 
Office) included the following:
          (6) Over 100 million individual income tax returns are filed 
        annually on behalf of roughly 90 percent of the U.S. 
        population;
          (7) The Internal Revenue Code consists of approximately 
        1,395,000 words;
          (8) There are 693 sections of the Internal Revenue Code that 
        are applicable to individual taxpayers, 1,501 sections 
        applicable to businesses, and 445 sections applicable to tax-
        exempt organizations, employee plans, and governments;
          (9) As of June 2000, the Treasury Department had issued 
        almost 20,000 pages of regulations containing over 8 million 
        words;
          (10) During 2000, the IRS published guidance for taxpayers in 
        the form of 58 revenue rulings, 49 revenue procedures, 64 
        notices, 100 announcements, at least 2,400 private letter 
        rulings and technical advice memoranda, 10 actions on decision, 
        and 240 field service advice;
          (11) For 1999, publications of the IRS included 649 forms, 
        schedules, and separate instructions totaling more than 16,000 
        lines, 159 worksheets contained in IRS instructions to forms, 
        and approximately 340 publications totaling more than 13,000 
        pages;
          (12) A taxpayer filing an individual income tax return could 
        be faced with a return (Form 1040) with 79 lines, 144 pages of 
        instructions, 11 schedules totaling 443 lines (including 
        instructions), 19 separate worksheets embedded in the 
        instructions, and the possibility of filing numerous other 
        forms (IRS Publication 17, Your Federal Income Tax (273 pages), 
        lists 18 commonly used forms other than Form 1040 and its 
        schedules);
          (13) In 1997, of the more than 122 million individual income 
        tax returns filed, nearly 69 million were filed on Form 1040, 
        as opposed to Form 1040A, Form 1040EZ, or Form 1040PC;
          (14) In 1999, taxpayers contacted the IRS for assistance 
        approximately 117 million times, up from 105 million contacts 
        in 1996; and
          (15) The use of paid return preparers increased from 48 
        percent of returns filed in 1990 to 55 percent of returns filed 
        in 1999 (a 27 percent increase) and the use of computer 
        software for return preparation increased from 16 percent of 
        returns filed in 1990 to 46 percent of returns filed in 1999 (a 
        188 percent increase).

     C. Sources of Complexity in the Present-Law Federal Tax System

    In the course of its study, the Joint Committee staff identified 
various sources of complexity in the present-law Federal tax system. No 
single source of complexity can be identified that is primarily 
responsible for the state of the present-law system. Rather, the Joint 
Committee staff found that, for any complex provision, a number of 
different sources of complexity might be identified.
    Among these sources of complexity the Joint Committee staff 
identified are: (1) a lack of clarity and readability of the law; (2) 
the use of the Federal tax system to advance social and economic 
policies; (3) increased complexity in the economy; and (4) the 
interaction of Federal tax laws with State laws, other Federal laws and 
standards (such as Federal securities laws, Federal labor laws and 
generally accepted accounting principles), the laws of foreign 
countries, and tax treaties. The lack of clarity and readability of the 
law results from (1) statutory language that is, in some cases, overly 
technical and, in other cases, overly vague; (2) too much or too little 
guidance with respect to certain issues; (3) the use of temporary 
provisions; (4) frequent changes in the law; (5) broad grants of 
regulatory authority; (6) judicial interpretation of statutory and 
regulatory language; and (7) the effects of the Congressional budget 
process.

           D. Effects of Complexity on the Federal Tax System

    There are a number of ways in which complexity can affect the 
Federal tax system. Among the more commonly recognized effects are (1) 
decreased levels of voluntary compliance; (2) increased costs for 
taxpayers; (3) reduced perceptions of fairness in the Federal tax 
system; and (4) increased difficulties in the administration of tax 
laws. Although there is general agreement among experts that complexity 
has these adverse effects, there is no consensus on the most 
appropriate method of measuring the effects of complexity. The Joint 
Committee staff explored certain information that may be helpful in 
assessing the possible effects of complexity in the present-law Federal 
tax system.
    It is widely reported that complexity leads to reduced levels of 
voluntary compliance. Complexity can create taxpayer confusion, which 
may affect the levels of voluntary compliance through inadvertent 
errors or intentional behavior by taxpayers. The Joint Committee staff 
found that it is not possible to measure the effects of complexity on 
voluntary compliance because (1) there has been no consistent 
measurement of the levels of voluntary compliance in more than a decade 
and (2) there is no generally agreed measure of changes in the level of 
complexity in the tax system over time.
    Commentators also state that complexity of the Federal tax systems 
results in increased costs of compliance to taxpayers. The Joint 
Committee staff explored some of the commonly used measures of the 
costs of compliance, such as the estimate of time required to prepare 
tax returns, but found that there is no reliable measure of the change 
in costs of compliance. The Joint Committee staff did find, however, 
that individual taxpayers have significantly increased their use of tax 
return preparers, computer software for tax return preparation, and IRS 
taxpayer assistance over the last 10 years.
    Complexity reduces taxpayers' perceptions of fairness of the 
Federal tax system by (1) creating disparate treatment of similarly 
situated taxpayers, (2) creating opportunities for manipulation of the 
tax laws by taxpayers who are willing and able to obtain professional 
advice, and (3) disillusioning taxpayers to Federal tax policy because 
of the uncertainty created by complex laws.
    Finally, complexity makes it more difficult for the IRS to 
administer present law. Complex tax laws make it more difficult for the 
IRS to explain the law to taxpayers in a concise and understandable 
manner in forms, instructions, publications, and other guidance. In 
addition, the IRS is more likely to make mistakes in the assistance 
provided to taxpayers and in the application of the law.

              E. Identifying Provisions Adding Complexity

    In conducting this study, the Joint Committee staff looked at a 
variety of factors that contribute to complexity. Although the Joint 
Committee staff's focus was on complexity as it affects taxpayers 
(either directly or through the application of the law by tax 
practitioners), the Joint Committee staff also took into account 
complexity encountered by the IRS in administering the tax laws.
    The Joint Committee staff generally did not take into account the 
level of sophistication of taxpayers or the complexity of transactions 
in identifying complex provisions; however, as discussed below, such 
factors were taken into account in making recommendations for 
simplification.
    Factors the Joint Committee staff analyzed in identifying 
provisions that add complexity include the following:
          (16) The existence of multiple provisions with similar 
        objectives;
          (17) The nature and extent of mathematical calculations 
        required by a provision;
          (18) Error rates associated with a provision;
          (19) Questions frequently asked the IRS by taxpayers;
          (20) The length of IRS worksheets, forms, instructions, and 
        publications needed to explain and apply a provision;
          (21) Recordkeeping requirements;
          (22) The extent to which a provision results in disputes 
        between the IRS and taxpayers;
          (23) The extent to which a provision makes it difficult for 
        taxpayers to plan and structure normal business transactions;
          (24) The extent to which a provision makes it difficult for 
        taxpayers to estimate and understand their tax liabilities;
          (25) Whether a provision accomplishes its purposes and 
        whether particular aspects of a provision are necessary to 
        accomplish the purposes of the provision;
          (26) Lack of consistency in definitions of similar terms;
          (27) The extent to which a provision creates uncertainty;
          (28) Whether a provision no longer serves any purpose or is 
        outdated;
          (29) Whether the statutory rules are easily readable and 
        understandable;
          (30) The extent to which major rules are provided in 
        regulations and other guidance rather than in the Code; and
          (31) The existence of appropriate administrative guidance.

          F. Summary of Joint Committee Staff Recommendations

1. Overview
    The Joint Committee staff analyzed each possible simplification 
recommendation from a variety of perspectives, including:
          (32) The extent to which simplification could be achieved by 
        the recommendation;
          (33) Whether the recommendation improves the fairness or 
        efficiency of the Federal tax system;
          (34) Whether the recommendation improves the 
        understandability and predictability (i.e., transparency) of 
        the Federal tax system;
          (35) The complexity of the transactions that would be covered 
        by the recommendation and the sophistication of affected 
        taxpayers;
          (36) Administrative feasibility and enforceability of the 
        recommendation;
          (37) The burdens imposed on taxpayers, tax practitioners, and 
        tax administrators by changes in the tax law; and
          (38) Whether a provision of present law could be eliminated 
        because it is obsolete or duplicative.
    In developing possible simplification recommendations, the Joint 
Committee staff applied one overriding criterion: the Joint Committee 
staff would make a simplification recommendation only if the 
recommendation did not fundamentally alter the underlying policy 
articulated by the Congress in enacting the provision. As a result of 
applying this criterion, the Joint Committee staff did not make certain 
simplification recommendations reviewed in the course of this study. 
However, further simplification could be achieved by addressing certain 
of the policy decisions made in developing various provisions of 
present law.
    Among the types of issues with respect to which the Joint Committee 
staff did not make specific simplification recommendations because of 
policy considerations are the following: (1) reducing the number of 
individual income tax filing statuses; (2) determining marital status; 
(3) reducing the number of exclusions from income; (4) making 
structural modifications to above-the-line deductions and itemized 
deductions; (5) increasing the standard deduction; (6) making 
structural changes to the dependency exemption, the child credit, and 
the earned income credit; (7) modifying the treatment of home mortgage 
interest of individuals; (8) modifying the distinction between ordinary 
income (and losses) and capital gains (and losses); (9) integrating the 
corporate and individual income tax; (10) altering the basic rules 
relating to corporate mergers and acquisitions; (11) eliminating the 
personal holding company and accumulated earnings tax provisions; (12) 
reducing the number of separate tax rules for different types of pass-
through entities; (13) determining whether an expenditure is a capital 
expenditure that cannot be currently expensed; (14) modifying the rules 
relating to depreciation of capital assets; (15) providing uniform 
treatment of economically similar financial instruments; (16) modifying 
the rules relating to taxation of foreign investments; (17) 
modifications to the foreign tax credit; (18) altering the taxation of 
individual taxpayers with respect to cross border portfolio investments 
overseas; (19) changing the determination of an individual's status as 
an employee or independent contractor; (20) clarifying the treatment of 
limited partners for self-employment tax purposes; (21) providing 
alternative methods of return filing; and (22) eliminating overlapping 
jurisdiction of litigation relating to the Federal tax system.
    The Joint Committee staff did not conclude that a simplification 
recommendation was inconsistent with the underlying policy of a 
provision merely because the recommendation might alter the taxpayers 
affected.
    In some instances, the Joint Committee staff concluded that a 
provision did not accomplish the underlying policy articulated when the 
provision was enacted. In such instances, the Joint Committee staff 
concluded that recommending elimination or substantial modification of 
a provision was not inconsistent with the underlying policy.
2. Alternative minimum tax
    The Joint Committee staff recommends that the individual and 
corporate alternative minimum taxes should be eliminated. The 
individual and corporate alternative minimum taxes contribute 
complexity to the present-law tax system by requiring taxpayers to 
calculate Federal income tax liability under two different systems.
    The Joint Committee staff believes that the individual alternative 
minimum tax no longer serves the purposes for which it was intended. 
The present-law structure of the individual alternative minimum tax 
expands the scope of the provisions to taxpayers who were not intended 
to be alternative minimum tax taxpayers. The number of individual 
taxpayers required to comply with the complexity of the individual 
alternative minimum tax calculations will continue to grow due to the 
lack of indexing of the minimum tax exemption amounts and the effect of 
the individual alternative minimum tax on taxpayers claiming 
nonrefundable personal credits. By 2011, the Joint Committee staff 
projects that more than 11 percent of all individual taxpayers will be 
subject to the individual alternative minimum tax.
    Furthermore, legislative changes since the Tax Reform Act of 1986 
have had the effect of partially conforming the tax base for 
alternative minimum tax purposes to the tax base for regular tax 
purposes. Thus, the Joint Committee staff finds it appropriate to 
recommend that the alternative minimum tax be eliminated.
3. Individual income tax
Uniform definition of a qualifying child
    The Joint Committee staff recommends that a uniform definition of 
qualifying child should be adopted for purposes of determining 
eligibility for the dependency exemption, the earned income credit, the 
child credit, the dependent care tax credit, and head of household 
filing status. Under this uniform definition, in general, a child would 
be a qualifying child of a taxpayer if the child has the same principal 
place of abode as the taxpayer for more than one half the taxable year. 
Generally, a ``child'' would be defined as an individual who is (1) the 
son, daughter, stepson, stepdaughter, brother, sister, stepbrother, or 
stepsister of the taxpayer or a descendant of any of such individuals, 
and (2) under age 19 (or under age 24 in the case of a student). As 
under present law, the child would have to be under age 13 for purposes 
of the dependent care credit. No age limit would apply in the case of 
disabled children. Adopted children, children placed with the taxpayer 
for adoption by an authorized agency, and foster children placed by an 
authorized agency would be treated as the taxpayer's child. A tie-
breaking rule would apply if more than one taxpayer claims a child as a 
qualifying child. Under the tie-breaking rule, the child generally 
would be treated as a qualifying child of the child's parent.
    Adopting a uniform definition of qualifying child would make it 
easier for taxpayers to determine whether they qualify for the various 
tax benefits for children and reduce inadvertent taxpayer errors 
arising from confusion due to different definitions of qualifying 
child. A residency test is recommended as the basis for the uniform 
definition because it is easier to apply than a support test.
    This recommendation would provide simplification for substantial 
numbers of taxpayers. Under present law, it is estimated that, for 
2001, 44 million returns will claim a dependency exemption for a child, 
19 million returns will claim the earned income credit, 6 million 
returns will claim the dependent care credit, 26 million returns will 
claim the child credit, and 18 million returns will claim head of 
household filing status.
Dependent care benefits
    The Joint Committee staff recommends that the dependent care credit 
and the exclusion for employer-provided dependent care assistance 
should be conformed by: (1) providing that the amount of expenses taken 
into account for purposes of the dependent care credit is the same flat 
dollar amount that applies for purposes of the exclusion (i.e., $5,000 
regardless of the number of qualifying individuals); (2) eliminating 
the reduction in the credit for taxpayers with adjusted gross income 
above certain levels; and (3) providing that married taxpayers filing 
separate returns are eligible for one half the otherwise applicable 
maximum credit.
    The recommendation would eliminate the confusion caused by 
different rules for the two present-law tax benefits allowable for 
dependent care expenses. The recommendation also would simplify the 
dependent care credit by eliminating features of the credit that 
require additional calculations by taxpayers.
    This recommendation could provide simplification for as many as 6 
million returns, the number of returns estimated to claim the dependent 
care credit in 2001.
Earned income credit
    The Joint Committee staff recommends that the earned income credit 
should be modified as follows: (1) the uniform definition of qualifying 
child (including the tie-breaking rule) recommended by the Joint 
Committee staff should be adopted for purposes of the earned income 
credit; and (2) earned income should be defined to include wages, 
salaries, tips, and other employee compensation to the extent 
includible in gross income for the taxable year, and net earnings from 
self employment.
    Applying the uniform definition of child recommended by the Joint 
Committee staff to the earned income credit would make it easier for 
taxpayers to determine whether they qualify for the earned income 
credit and would reduce inadvertent errors caused by different 
definitions. The elimination of nontaxable compensation from the 
definition of earned income would alleviate confusion as to what 
constitutes earned income and enable taxpayers to determine earned 
income from information already included on the tax return.
    This recommendation could provide simplification for as many as 19 
million returns, the number of returns estimated to claim the credit in 
2001.
Head of household filing status
    The Joint Committee staff recommends that head of household filing 
status should be available with respect to a child only if the child 
qualifies as a dependent of the taxpayer under the Joint Committee 
staff's recommended uniform definition of qualifying child. Applying 
the uniform definition of child recommended by the Joint Committee 
staff would make it easier for taxpayers to determine if they are 
eligible for head of household status due to a child and reduce 
taxpayer errors due to differing definitions of qualifying child.
    This recommendation could provide simplification for up to 18 
million returns that are estimated to be filed in 2001 using head of 
household filing status.
Surviving spouse status
    The Joint Committee staff recommends that surviving spouse status 
should be available only for one year and that the requirement that the 
surviving spouse have a dependent should be eliminated. The 
recommendation would eliminate confusion about who qualifies for 
surviving spouse status.
Phase-outs and phase-ins
    The Joint Committee staff recommends that the following phase-outs 
should be eliminated: (1) overall limitation on itemized deductions 
(known as the ``PEASE'' limitation); (2) phase-out of personal 
exemptions (known as ``PEP''); (3) phase-out of child credit; (4) 
partial phase-out of the dependent care credit; (5) phase-outs relating 
to individual retirement arrangements; (6) phase-out of the HOPE and 
Lifetime Learning credits; (7) phase-out of the deduction for student 
loan interest; (8) phase-out of the exclusion for interest on education 
savings bonds; and (9) phase-out of the adoption credit and exclusion.
    These phase-outs require taxpayers to make complicated calculations 
and make it difficult for taxpayers to plan whether they will be able 
to utilize the tax benefits subject to the phase-outs. Eliminating the 
phase-outs would eliminate complicated calculations and make planning 
easier. These phase-outs primarily address progressivity, which can be 
more simply addressed through the rate structure.
    This recommendation would provide simplification for up to 30 
million returns that are subject to one or more of the present law 
phase-outs and phase-ins.
Taxation of Social Security benefits
    The Joint Committee staff recommends that the amount of Social 
Security benefits includible in gross income should be a fixed 
percentage of benefits for all taxpayers. The Joint Committee staff 
further recommends that the percentage of includible benefits should be 
defined such that the amount of benefits excludable from income 
approximates individuals' portion of Social Security taxes. The 
recommendation would eliminate the complex calculations and 18-line 
worksheet currently required in order to determine the correct amount 
of Social Security benefits includible in gross income. This 
recommendation could provide simplification for as many as 12 million 
returns that show taxable Social Security benefits; 5.7 million of such 
returns are in the income phase-out range.
Individual capital gains and losses
    The Joint Committee staff recommends that the current rate system 
for capital gains should be replaced with a deduction equal to a fixed 
percentage of the net capital gain. The deduction should be available 
to all individuals. The recommendation would simplify the computation 
of the taxpayer's tax on capital gains and streamline the capital gains 
tax forms and schedules for individuals for as many as 27 million 
returns estimated to have capital gains or losses in 2001.
    The Joint Committee staff recommends that, for purposes of ordinary 
loss treatment under sections 1242 and 1244, the definition of small 
business should be conformed to the definition of small business under 
section 1202, regardless of the date of issuance of the stock. The 
recommendation would reduce complexity by conforming the definition of 
small business that applies for purposes of preferential treatment of 
capital gain or loss.
Two-percent floor on miscellaneous itemized deductions
    The Joint Committee staff recommends that the two-percent floor 
applicable to miscellaneous itemized deductions should be eliminated. 
The Joint Committee staff finds that the two-percent floor applicable 
to miscellaneous itemized deductions has added to complexity because it 
has: (1) placed pressure on individuals to claim that they are 
independent contractors, rather than employees; (2) resulted in 
extensive litigation with respect to the proper treatment of certain 
items, such as attorneys' fees; (3) resulted in inconsistent treatment 
with respect to similar items of expense; and (4) created pressure to 
enact deductions that are not subject to the floor. Although the two-
percent floor was enacted, in part, to reduce complexity, it has 
instead shifted complexity to these other issues relating to 
miscellaneous itemized deductions.

Provisions relating to education

    Definition of qualifying higher education expenses

    The Joint Committee staff recommends that a uniform definition of 
qualifying higher education expenses should be adopted. A uniform 
definition would eliminate the need for taxpayers to understand 
multiple definitions if they use more than one education tax incentive 
and reduce inadvertent taxpayer errors resulting from confusion with 
respect to the different definitions.

    Combination of HOPE and Lifetime Learning credits

    The Joint Committee staff recommends that the HOPE and Lifetime 
Learning credits should be combined into a single credit. The single 
credit would: (1) utilize the present-law credit rate of the Lifetime 
Learning credit; (2) apply on a per-student basis; and (3) apply to 
eligible students as defined under the Lifetime Learning credit.
    Combining the two credits would reduce complexity and confusion by 
eliminating the need to determine which credit provides the greatest 
benefit with respect to one individual and to determine if a taxpayer 
can qualify for both credits with respect to different individuals.

    Interaction among education tax incentives

    The Joint Committee staff recommends that restrictions on the use 
of education tax incentives based on the use of other education tax 
incentives should be eliminated and replaced with a limitation that the 
same expenses could not qualify under more than one provision. The 
recommendation would eliminate the complicated planning required in 
order to obtain full benefit of the education tax incentives and reduce 
traps for the unwary. The recommendation would eliminate errors by 
taxpayers due to the provisions that trigger adverse consequences as a 
result of actions by persons other than the taxpayer.

    Student loan interest deduction

    The Joint Committee staff recommends that the 60-month limit on 
deductibility of student loan interest should be eliminated. The 
recommendation would make determining the amount of deductible interest 
easier because taxpayers would not need to determine the history of the 
loan's payment status.

    Exclusion for employer-provided educational assistance

    The Joint Committee staff recommends that the exclusion for 
employer-provided educational assistance should be made permanent. The 
recommendation would reduce administrative burdens on employers and 
employees caused by the present practice of allowing the exclusion to 
expire and then extending it. The recommendation would make it easier 
for employees to plan regarding education financing. The recommendation 
would eliminate the need to apply a facts and circumstances test to 
determine if education is deductible in the absence of the exclusion.
Taxation of minor children
    The Joint Committee staff recommends that the tax rate schedule 
applicable to trusts should be applied with respect to the net unearned 
income of a child taxable at the parents' rate under present law. In 
addition, the Joint Committee staff recommends that the parental 
election to include a child's income on the parents' return should be 
available irrespective of (1) the amount and type of the child's 
income, and (2) whether withholding occurred or estimated tax payments 
were made with respect to the child's income. Utilizing the trust rate 
schedule would eliminate the complexity arising from the linkage of the 
returns of parent, child, and siblings. Expanding the parental election 
would decrease the number of separate returns filed by children.
4. Individual retirement arrangements, qualified retirement plans, and 
        employee benefits
Individual retirement arrangements (``IRAs'')
    The Joint Committee staff recommends that the income limits on 
eligibility to make deductible IRA contributions, Roth IRA 
contributions, and conversions of traditional IRAs to Roth IRAs should 
be eliminated. Further, the Joint Committee staff recommends that the 
ability to make nondeductible contributions to traditional IRAs should 
be eliminated. The Joint Committee staff recommends that the age 
restrictions on eligibility to make IRA contributions should be the 
same for all IRAs.
    The IRA recommendations would reduce the number of IRA options and 
conform eligibility criteria for remaining IRAs, thus simplifying 
taxpayers' savings decisions.
Recommendations relating to qualified retirement plans

    Definition of compensation

    The Joint Committee staff recommends that: (1) a single definition 
of compensation should be used for all qualified retirement plan 
purposes, including determining plan benefits, and (2) compensation 
should be defined as the total amount that the employer is required to 
show on a written statement to the employee, plus elective deferrals 
and contributions for the calendar year. The recommendation would 
eliminate the need to determine different amounts of compensation for 
various purposes or periods.

    Nondiscrimination rules for qualified plans

    The Joint Committee staff recommends that: (1) the ratio percentage 
test under the minimum coverage rules should be modified to allow more 
plans to use the test, (2) excludable employees should be disregarded 
in applying the minimum coverage and general nondiscrimination rules, 
and (3) the extent to which cross-testing may be used should be 
specified in the Code. The first recommendation would simplify minimum 
coverage testing by eliminating the need for some plans to perform the 
complex calculations required under the average benefit percentage 
test. The second recommendation would simplify nondiscrimination 
testing by eliminating the need to analyze the effect of covering 
excludable employees under the plan. The third recommendation would 
provide certainty and stability in the design of qualified retirement 
plans that rely on cross-testing by eliminating questions as to whether 
and to what extent the cross-testing option is available.

    Vesting requirements

    The Joint Committee staff recommends that the vesting requirements 
for all qualified retirement plans should be made uniform by applying 
the top-heavy vesting schedules to all plans. A single set of vesting 
rules would provide consistency among plans and will reduce complexity 
in plan documents and in the determination of vested benefits.

    SIMPLE plans

    The Joint Committee staff recommends that the rules relating to 
SIMPLE IRAs and SIMPLE 401(k) plans should be conformed by (1) allowing 
State and local government employers to adopt SIMPLE 401(k) plans, (2) 
applying the same contribution rules to SIMPLE IRAs and SIMPLE 401(k) 
plans, and (3) applying the employee eligibility rules for SIMPLE IRAs 
to SIMPLE 401(k) plans. This recommendation would make choosing among 
qualified retirement plan designs easier for all small employers.

    Definitions of highly compensated employee and owner

    The Joint Committee staff recommends that uniform definitions of 
highly compensated employee and owner should be used for all qualified 
retirement plan and employee benefit purposes. Uniform definitions 
would eliminate multiple definitions of highly compensated employee and 
owner for various purposes, thereby allowing employers to make a single 
determination of highly compensated employees and owners.

    Contribution limits for tax-sheltered annuities

    The Joint Committee staff recommends that the contribution limits 
applicable to tax-sheltered annuities should be conformed to the 
contribution limits applicable to comparable qualified retirement 
plans. Conforming the limits would reduce the recordkeeping and 
computational burdens related to tax-sheltered annuities and eliminate 
confusing differences between tax-sheltered annuities and qualified 
retirement plans.

    Minimum distribution rules

    The Joint Committee staff recommends that the minimum distribution 
rules should be simplified by providing that: (1) no distributions are 
required during the life of a participant; (2) if distributions 
commence during the participant's lifetime under an annuity form of 
distribution, the terms of the annuity will govern distributions after 
the participant's death; and (3) if distributions either do not 
commence during the participant's lifetime or commence during the 
participant's lifetime under a nonannuity form of distribution, the 
undistributed accrued benefit must be distributed to the participant's 
beneficiary or beneficiaries within five years of the participant's 
death. The elimination of minimum required distributions during the 
life of the participant and the establishment of a uniform rule for 
post-death distributions would significantly simplify compliance by 
plan participants and their beneficiaries, as well as plan sponsors and 
administrators.

    Exceptions to the early withdrawal tax; half-year conventions

    The Joint Committee staff recommends that the exceptions to the 
early withdrawal tax should be uniform for all tax-favored retirement 
plans and that the applicable age requirements for the early withdrawal 
tax and permissible distributions from section 401(k) plans should be 
changed from age 59-1/2 to age 55. Uniform rules for distributions 
would make it easier for individuals to determine whether distributions 
are permitted and whether distributions will be subject to the early 
withdrawal tax.

    Allow all governmental employers to maintain section 401(k) plans

    The Joint Committee staff recommends that all State and local 
governments should be permitted to maintain section 401(k) plans. This 
will eliminate distinctions between the types of plans that may be 
offered by different types of employers and simplify planning 
decisions.

    Redraft provisions dealing with section 457 plans

    The Joint Committee staff recommends that the statutory provisions 
dealing with eligible deferred compensation plans should be redrafted 
so that separate provisions apply to plans maintained by State and 
local governments and to plans maintained by tax-exempt organizations. 
This will make it easier for employers to understand and comply with 
the requirements applicable to their plans.

    Attribution rules

    The Joint Committee staff recommends that the attribution rules 
used in determining controlled group status under section 1563 should 
be used in determining ownership for all qualified retirement plan 
purposes. Uniform attribution rules would enable the employer to 
perform a single ownership analysis for all relevant qualified 
retirement plan purposes.
Basis recovery rules for qualified retirement plans and IRAs
    The Joint Committee staff recommends that a uniform basis recovery 
rule should apply to distributions from qualified retirement plans, 
traditional IRAs, and Roth IRAs. Under this uniform rule, distributions 
would be treated as attributable to basis first, until the entire 
amount of basis has been recovered. The uniform basis recovery rule 
would eliminate the need for individuals to calculate the portion of 
distributions attributable to basis and would apply the same basis 
recovery rule to all types of tax-favored retirement plans.
Modifications to employee benefit plan provisions

    Cafeteria plan elections

    The Joint Committee staff recommends that the frequency with which 
employees may make, revoke, or change elections under cafeteria plans 
should be determined under rules similar to those applicable to 
elections under cash or deferred arrangements. Applying simpler 
election rules to cafeteria plans would reduce confusion and 
administrative burdens for employers and employees.

    Excludable employees

    The Joint Committee staff recommends that a uniform definition of 
employees who may be excluded for purposes of the application of the 
nondiscrimination requirements relating to group-term life insurance, 
self-insured medical reimbursement plans, educational assistance 
programs, dependent care assistance programs, miscellaneous fringe 
benefits, and voluntary employees' beneficiary associations should be 
adopted. A uniform definition of excludable employees would eliminate 
minor distinctions that exist under present law and make 
nondiscrimination testing easier.
5. Corporate income tax
Collapsible corporations
    The Joint Committee staff recommends that the collapsible 
corporation provisions should be eliminated. This recommendation would 
eliminate a complex provision that became unnecessary with the 
enactment of the corporate liquidation rules of the Tax Reform Act of 
1986.
Active business requirement of section 355
    The Joint Committee staff recommends that the active business 
requirement of section 355 should be applied on an affiliated group 
basis. Thus, the ``substantially all'' test should be eliminated. This 
recommendation would simplify business planning for corporate groups 
that use a holding company structure.
Uniform definition of a family
    The Joint Committee staff recommends that a uniform definition of a 
family should be used in applying the attribution rules used to 
determine stock ownership. For this purpose, a ``family'' should be 
defined as including brothers and sisters (other than step-brothers and 
step-sisters), a spouse (other than a spouse who is legally separated 
from the individual under a decree of divorce whether interlocutory or 
final, or a decree of separate maintenance), ancestors and lineal 
descendants. An exception would be provided with respect to limiting 
multiple tax benefits in the case of controlled corporations (section 
1561), in which case the present-law rules of section 1563(e) would be 
retained. A single definition of a family would eliminate many of the 
inconsistencies in the law that have developed over time and would 
reflect currently used agreements relating to divorce and separation.
Redemption through use of related corporations (section 304)
    The Joint Committee staff recommends that section 304 should apply 
only if its application results in a dividend (other than a dividend 
giving rise to a dividends received deduction). The recommendation 
would limit the application of a complex set of rules.
Corporate reorganizations
    The Joint Committee staff recommends that assets acquired in a tax-
free reorganization pursuant to section 368(a)(1)(D) or 368(a)(1)(F) 
should be allowed to be transferred to a controlled subsidiary without 
affecting the tax-free status of the reorganization. This 
recommendation would harmonize the rules regarding post-reorganization 
transfers to controlled subsidiaries and eliminate the present-law 
uncertainties with respect to such transfers.
    The Joint Committee staff recommends that the rules relating to the 
treatment of property received by a shareholder in reorganizations 
involving corporations under common control or a single corporation (or 
a section 355 transaction) should be conformed to the rules relating to 
the redemption of stock. This recommendation would simplify business 
planning by conforming the rules for determining dividend treatment if 
a continuing shareholder receives cash or other ``boot'' in exchange 
for a portion of the shareholder's stock.
Corporate redemptions
    The Joint Committee staff recommends that a stock redemption 
incident to a divorce should be treated as a taxable redemption of the 
stock of the transferor spouse, unless both parties agree in writing 
that the stock is to be treated as transferred to the other spouse 
prior to the redemption. If one spouse actually receives a distribution 
and purchases the other spouse's stock, the form of the transaction 
would be respected. The recommendation would eliminate uncertainty and 
litigation regarding the treatment of the parties when a corporate 
stock redemption occurs incident to a divorce.
6. Pass-through entities
Partnerships
    The Joint Committee staff recommends that references in the Code to 
``general partners'' and ``limited partners'' should be modernized 
consistent with the purpose of the reference. In most cases, the 
reference to limited partners could be updated by substituting a 
reference to a person whose participation in the management or business 
activity of the entity is limited under applicable State law (or, in 
the case of general partners, not limited). In a few cases, the 
reference to limited partners could be retained because the provisions 
also refer to a person (other than a limited partner) who does not 
actively participate in the management of the enterprise, which can 
encompass limited liability company owners with interests similar to 
limited partnership interests. In one case, the reference to a general 
partner can be updated by referring to a person with income from the 
partnership from his or her own personal services. The recommendation 
would provide simplification by modernizing these references to 
accommodate limited liability companies, whose owners generally are 
partners within the meaning of Federal tax law, but are not either 
general partners or limited partners under State law.
    The Joint Committee staff recommends that the special reporting and 
audit rules for electing large partnerships should be eliminated and 
that large partnerships should be subject to the general rules 
applicable to partnerships. The recommendation would simplify the 
reporting and audit rules by eliminating the least-used sets of rules.
    The Joint Committee staff recommends that the timing rules for 
guaranteed payments to partners and for transactions between 
partnerships and partners not acting in their capacity as such should 
be conformed. The timing rule for all such payments and transactions 
should be based on the time the partnership takes the payment into 
account. The recommendation would provide simplification by eliminating 
one of two conflicting timing rules applicable to similar types of 
situations.
S corporations
    The Joint Committee staff recommends that the special termination 
rule for certain S corporations with excess passive investment income 
should be eliminated. In addition, the corporate-level tax on excess 
passive investment income should be modified so that the tax would be 
imposed only on an S corporation with accumulated earnings and profits 
in any year in which more than 60 percent (as opposed to 25 percent) of 
its gross income is considered passive investment income. The 
recommendation would eliminate much of the uncertainty and complexity 
of present law for S corporations that are required to characterize 
their income as active or passive income, and at the same time would 
conform the tax with the personal holding company rules applicable to C 
corporations (that address a similar concern).
    The Joint Committee staff recommends that the special rules for the 
taxation of electing small business trusts should be eliminated and 
that the regular rates of Subchapter J should apply to these trusts and 
their beneficiaries. Under this recommendation, no election to be a 
qualified subchapter S trust could be made in the future. The 
recommendation would eliminate some of the complexity regarding the 
operating rules for electing small business trusts as well as the 
overlapping rules for electing small business trusts and qualified 
Subchapter S trusts.
7. General business issues
Like-kind exchanges
    The Joint Committee staff recommends that a taxpayer should be 
permitted to elect to rollover gain from the disposition of appreciated 
business or investment property described in section 1031 if like-kind 
property is acquired by the taxpayer within 180 days before or after 
the date of the disposition (but not later than the due date of the 
taxpayer's income tax return). The determination of whether properties 
are considered to be of a ``like-kind'' would be the same as under 
present law.
    The Joint Committee staff recommends that, for purposes of 
determining whether property satisfies the holding period requirement 
for a like-kind exchange, a taxpayer's holding period and use of 
property should include the holding period and use of property by the 
transferor in the case of property (1) contributed to a corporation or 
partnership in a transaction described in section 351 or 721, (2) 
acquired by a corporation in connection with a transaction qualifying 
as a reorganization under section 368, (3) distributed by a partnership 
to a partner, and (4) distributed by a corporation in a transaction to 
which section 332 applies. In addition, the Joint Committee staff 
recommends that property whose use changes should not qualify for like-
kind exchange treatment unless it is held for productive use in a trade 
or business or investment for a specified period of time.
    The recommendation would reduce complexity by allowing taxpayers to 
reinvest the proceeds from the sale of business or investment property 
into other like-kind property directly without engaging in complicated 
``exchanges'' designed to meet the statutory and regulatory rules 
regarding deferred exchanges. In addition, the recommendation would 
remove the confusion and uncertainty under section 1031 with respect to 
whether a taxpayer is considered to hold property for productive use in 
a trade or business or for investment when the property has been 
recently transferred.
Low-income housing tax credit
    The Joint Committee staff recommends that the payout period for the 
low-income housing tax credit should be conformed to the initial 
compliance period (15 years). This recommendation would eliminate the 
present-law credit recapture rules, which are a significant source of 
complexity for the credit.
Rehabilitation tax credit
    The Joint Committee staff recommends that the 10-percent credit for 
rehabilitation expenditures with respect to buildings first placed in 
service before 1936 should be eliminated. Thus, the rehabilitation 
credit would not be a two-tier credit, but instead would provide only a 
20-percent credit with respect to certified historic structures.
    The recommendation would achieve simplification in two respects. 
First, it would eliminate the overlapping categories of ``old'' and 
``historic'' buildings eligible for different levels of credit under 
present law. Second, it would eliminate the record-keeping burden 
currently imposed under the 10-percent credit.
Orphan drug tax credit
    The Joint Committee staff recommends that the definition of 
qualifying expenses for the orphan drug tax credit should be expanded 
to include expenses related to human clinical testing incurred after 
the date on which the taxpayer files an application with the Food and 
Drug Administration for designation of the drug under section 526 of 
the Federal Food, Drug, and Cosmetic Act as a potential treatment for a 
rare disease or disorder. As under present law, the credit could only 
be claimed for such expenses related to drugs designated as a potential 
treatment for a rare disease or disorder by the Food and Drug 
Administration in accordance with section 526 of such Act. The 
recommendation would reduce complexity by treating all human clinical 
trial expenses in the same manner for purposes of the credit and any 
allowable deduction.
Work opportunity tax credit and welfare-to-work tax credit
    The Joint Committee staff recommends that the work opportunity tax 
credit and welfare-to-work tax credit should be combined and subject to 
a single set of rules. The combined credit would be simpler for 
employers because they would use a single set of requirements when 
hiring individuals from all the targeted groups of potential employees.
Indian employment credit
    The Joint Committee staff recommends that the Indian employment 
credit should be calculated without reference to amounts paid by the 
employer in 1993. Eliminating the incremental aspect of the credit 
would reduce the record retention burden on taxpayers in the event the 
credit is extended permanently.
Reduced emissions vehicles
    The Joint Committee staff recommends that the tax benefit for 
reduced emissions vehicles should be adeduction of qualified expenses 
related to all such qualifying vehicles, provided that the Congress 
chooses to extend the tax benefits applicable to such vehicles. Fewer 
tax benefit options for a similar policy goal would simplify taxpayer 
decision making and promote a uniform incentive.
8. Accounting provisions
Cash method of accounting
    The Joint Committee staff recommends that a taxpayer with less than 
$5 million of average annual gross receipts should be permitted to use 
the cash method of accounting and should not be required to use an 
accrual method of accounting for purchases and sales of merchandise 
under section 471. A taxpayer that elects not to account for inventory 
under section 471 would be required to treat inventory as a material or 
supply that is deductible only in the amount that it is actually 
consumed and used in operations during the tax year. The recommendation 
would not apply to tax shelters and would not alter the rules for 
family farm corporations. The recommendation would enlarge the class of 
businesses that can use the cash method of accounting, which is a 
simpler method of accounting. Such businesses would have reduced 
recordkeeping requirements and would not need to understand the 
requirements associated with an accrual method of accounting.
Organizational costs
    The Joint Committee staff recommends that the rules and 
requirements to elect to amortize organizational costs should be 
codified in a single Code provision irrespective of the choice of 
entity chosen by the taxpayer. In addition, organizational costs 
incurred in the formation of entities that are, or are elected to be, 
disregarded for Federal income tax purposes would be eligible to 
recover organization costs over 60 months. The recommendation would 
consolidate the rules governing the treatment of organizational costs 
for all types of entities into one provision and would clarify the tax 
treatment of organizational costs incurred with respect to legal 
entities that are disregarded for Federal income tax purposes.
Mid-quarter convention for depreciation
    The Joint Committee staff recommends that the mid-quarter 
convention for depreciable property should be eliminated. This 
calculation, which requires an analysis of property placed in service 
during the last three months of any taxable year, can be complex and 
burdensome because taxpayers must wait until after the end of the 
taxable year to determine the proper placed-in-service convention for 
calculating depreciation for its assets during the taxable year. The 
recommendation would simplify the rules for calculating depreciation, 
because an analysis of property would no longer need to be performed 
with respect to property placed in service during the last three months 
of a taxable year to determine application of the mid-quarter 
convention.
9. Financial products and institutions
Straddle rules
    The Joint Committee staff recommends that the general loss deferral 
rule of the straddle rules should be modified to allow the 
identification of offsetting positions that are components of a 
straddle at the time the taxpayer enters into a transaction that 
creates a straddle, including an unbalanced straddle. Straddle period 
losses would be allocated to the identified offsetting positions in 
proportion to the offsetting straddle period gains and would be 
capitalized into the basis of the offsetting position.
    The Joint Committee staff recommends that the exception for stock 
in the definition of personal property should be eliminated. Thus, 
offsetting positions involving actively traded stock generally would 
constitute a straddle.
    Modifying the general loss deferral rule to permit identification 
of offsetting positions in a straddle would eliminate an additional 
level of complexity and uncertainty encountered by taxpayers in 
applying the loss deferral rules to straddles, particularly unbalanced 
straddles. Similarly, eliminating the stock exception would simplify 
the straddle rules by eliminating an exception that has become very 
complex in practice and only applies to a narrow class of transactions.
Interest computation
    The Joint Committee staff recommends that the eight different 
regimes for imposing interest on deferred taxes should be consolidated 
into three separate regimes: (1) an annual interest charge rule; (2) a 
look-back rule in which estimates are used; and (3) a look-back rule in 
which the tax is allocated to prior years based on the applicable 
Federal rate. The interest rate that would be applied in connection 
with the three separate regimes would be a uniform rate. Consolidating 
the interest charge rules would reduce complexity by providing a more 
uniform application of rules that fulfill the same policy of imposing 
interest on the deferral of tax. Computing the interest charges at a 
uniform rate would further reduce the complexity of interest charges.
Taxation of annuities
    The Joint Committee staff recommends that section 72, relating to 
taxation of annuities, should be redrafted to eliminate overly 
convoluted language and improve the readability of the statutory 
language. The Joint Committee staff provides a recommended redraft of a 
portion of section 72 for public review and comment.
    In addition, the Joint Committee staff recommends that the 
provisions of section 72 that apply to qualified retirement plans 
should be separated from the other provisions of section 72 and 
combined with the other rules governing the taxation of distributions 
from such plans. The recommendations would provide simplification by 
improving the readability of the provisions and by grouping related 
provisions together so they can be more easily found and understood.
Insurance companies
    The Joint Committee staff recommends that the special rules 
permitting a deduction for certain reserves for mortgage guaranty 
insurance, lease guaranty insurance, and insurance of State and local 
obligations should be eliminated. The recommendation would reduce 
complexity by eliminating tax rules that principally serve a financial 
accounting purpose.
    The Joint Committee staff recommends that the special rules 
provided to Blue Cross and Blue Shield organizations in existence on 
August 16, 1986, should be eliminated. Appropriate rules would be 
provided for taking into account items arising from the resulting 
change in accounting method for tax purposes. Complexity would be 
reduced by eliminating special rules that are based on historical facts 
and that are of declining relevance to the tax treatment of health 
insurers.
    The Joint Committee staff recommends that the two five-year rules 
relating to consolidated returns of affiliated groups including life 
insurance companies and nonlife insurance companies should be 
eliminated. Appropriate conforming rules should be provided. The 
complexity both to the acquired corporations and the existing members 
of the affiliated group in corporate acquisitions involving life 
insurance and nonlife insurance companies would be reduced, with 
respect to recordkeeping and with respect to calculation of tax 
liability.
10. International provisions
Foreign personal holding companies, personal holding companies, and 
        foreign investment companies
    The Joint Committee staff recommends that (1) the rules applicable 
to foreign personal holding companies and foreign investment companies 
should be eliminated, (2) foreign corporations should be excluded from 
the application of the personal holding company rules, and (3) subpart 
F foreign personal holding company income should include certain 
personal services contract income targeted under the present-law 
foreign personal holding company rules. The recommendation would 
provide relief from the complex multiple sets of overlapping anti-
deferral regimes that potentially apply to U.S. owners of stock in a 
foreign corporation.
Subpart F de minimis rule
    The Joint Committee staff recommends that the subpart F de minimis 
rule should be modified to be the lesser of five percent of gross 
income or $5 million (increased from the present-law dollar threshold 
of $1 million). For taxpayers with relatively modest amounts of subpart 
F income, the recommendation would provide relief from the complexity 
and compliance burdens involved in separately accounting for income 
under the subpart F anti-deferral rules.
Look-through rule for 10/50 companies
    The Joint Committee staff recommends that, for foreign tax credit 
limitation purposes, the look-through approach should be immediately 
applied to all dividends paid by a 10/50 company (regardless of the 
year in which the earnings and profits were accumulated). The 
recommendation would provide relief from recordkeeping burdens on U.S. 
corporations required to account for dividends paid by a 10/50 company 
under both the single basket limitation approach and the look-through 
approach.
Deemed-paid foreign tax credits
    The Joint Committee staff recommends that a domestic corporation 
should be entitled to claim deemed-paid foreign tax credits with 
respect to a foreign corporation that is held indirectly through a 
foreign or U.S. partnership, provided that the domestic corporation 
owns (indirectly through the partnership) 10 percent or more of the 
foreign corporation's voting stock. The recommendation would clarify 
uncertainty in the law that may exist with respect to the application 
of the indirect foreign tax credit rules when a partner indirectly owns 
an interest in a foreign corporation through a partnership.
Section 30A and section 936
    The Joint Committee staff recommends that, if the credits under 
section 30A and section 936 are extended (these provisions will expire 
after 2005), consideration should be given to conforming the 
application of the credit across all possessions and to combining the 
rules in one Code section. The recommendation would improve the 
readability of the rules for potential credit claimants with operations 
in Puerto Rico and other U.S. possessions by consolidating similar 
requirements for claiming such credits in one Code section.
Uniform capitalization rules
    The Joint Committee staff recommends that in lieu of the uniform 
capitalization rules, costs incurred in producing property or acquiring 
property for resale should be capitalized using U.S. generally accepted 
accounting principles for purposes of determining a foreign person's 
earnings and profits and subpart F income. The uniform capitalization 
rules would continue to apply to foreign persons for purposes of 
determining income effectively connected with a U.S. trade or business. 
The recommendation would relieve taxpayers and the IRS from the 
compliance and enforcement burdens associated with applying the uniform 
capitalization adjustments in the context of certain foreign 
activities.
Secondary withholding tax
    The Joint Committee staff recommends that the secondary withholding 
tax with respect to dividends paid by certain foreign corporations 
should be eliminated. The recommendation would spare taxpayers the 
burden of having to understand and comply with rules that have limited 
applicability, and relieve the IRS of the difficult task of trying to 
enforce the tax against a foreign corporation with little or no assets 
in the United States.
Tax on certain U.S.-source capital gains of nonresident individuals
    The Joint Committee staff recommends that the 30-percent tax on 
certain U.S.-source capital gains of nonresident individuals should be 
eliminated. The recommendation would spare nonresident individuals with 
U.S. investments the burden of having to understand and comply with a 
rule that has limited applicability.
Treaties
    The Joint Committee staff recommends that the Secretary of the 
Treasury should update and publish U.S. model tax treaties at least 
once each Congress. The recommendation would help inform potentially 
affected taxpayers of the Administration's current treaty policy goals, 
afford affected taxpayers the opportunity to offer more helpful 
commentary to treaty policy makers, and enable affected taxpayers to 
make more informed assessments regarding investments in countries in 
which treaty negotiations are being carried out.
    The Joint Committee staff recommends that the Treasury should 
report to the Congress on the status of older U.S. tax treaties at 
least once each Congress. The recommendation would establish a process 
for renewing older U.S. tax treaties that may not reflect current 
policy and that provide different tax outcomes than do more recent U.S. 
tax treaties. Timely updates of U.S. tax treaties would reduce 
complexity that may arise for taxpayers and tax administrators as any 
one taxpayer may be subject to multiple different tax regimes on 
otherwise similar transactions by reason of the transactions involving 
different taxing jurisdictions with different treaties.
11. Tax-exempt organizations
Grass-roots lobbying
    The Joint Committee staff recommends that the separate expenditure 
limitation on grass-roots lobbying by certain tax-exempt organizations 
should be eliminated. Eliminating this limitation would relieve 
charities making the section 501(h) election of the need to define and 
allocate expenses for grass-roots lobbying as a subset of total 
lobbying expenditures. This would simplify the Code and regulations by 
eliminating a largely unnecessary, but burdensome, process of 
definition and calculation.
Excise tax based on investment income
    The Joint Committee staff recommends that the excise tax based on 
the investment income of private foundations should be eliminated. The 
recommendation would relieve private foundations of having to calculate 
net investment income, to make estimated tax payments, and to consider 
whether annual charitable distributions should be increased or 
decreased because of the two-tiered nature of the tax. In addition, 
taxable foundations would not be required to calculate the unrelated 
business income tax they would have been required to pay if they were a 
taxable organization. Short of elimination, the tax could be revised to 
generate less revenue and at the same time become less complex, for 
example, by basing the tax on a percentage of the value of a private 
foundation's assets at the end of a taxable year.
12. Farming, distressed communities, and energy provisions
Conservation payments
    The Joint Committee staff recommends that the Code should be 
amended to reflect that the agricultural conservation program 
authorized by the Soil Conservation and Domestic Allotment Act has been 
replaced by the Environmental Quality Incentives Program. The 
recommendation would clarify that cost-sharing payments under the 
Environmental Quality Incentives Program are excludable from gross 
income.
Reforestation expenses
    The Joint Committee staff recommends that the separate seven-year 
amortization and tax credit for $10,000 of reforestation expenses 
should be replaced with expensing of a specified amount of 
reforestation expenses. Expensing could provide approximately the same 
tax benefit for qualified reforestation expenditures without requiring 
two distinct calculations and without requiring the additional 
recordkeeping to carry forward the taxpayer's unamortized basis in the 
expenditures through eight taxable years.
Sales of timber qualifying for capital gains treatment
    The Joint Committee staff recommends that (1) the sale of timber 
held more than one year by the owner of the land from which the timber 
is cut should be entitled to capital gain treatment and (2) the 
provision relating to a retained economic interest should be 
eliminated. The recommendation would eliminate the need to make 
subjective determinations of dealer status with respect to sales of 
timber and would eliminate a source of controversy and litigation.
District of Columbia (``D.C.'') Enterprise Zone
    The Joint Committee staff recommends that, if the D.C. Enterprise 
Zone is to be extended for a significant period of time, then the 
poverty rates and the gross income thresholds applicable to the zero-
percent capital gains rate should be conformed to the poverty rates and 
gross income thresholds that apply to the other tax incentives with 
respect to the D.C. Enterprise Zone. Thus, the Joint Committee staff 
recommends that a new business should qualify for the zero-percent 
capital gains rate if (1) more than 50 percent (rather than 80 percent) 
of its gross income is from the active conduct of a qualified business 
within the zone, and (2) the business is located in census tracts with 
at least a 20-percent (rather than 10 percent) poverty rate. The 
recommendations would eliminate much of the confusion, as well as traps 
for the unwary, for businesses that locate in the D.C. Enterprise Zone 
by providing a single gross income and single poverty test for 
determining whether a new business qualifies for the various tax 
incentives.
Tax incentives for business located in targeted geographic areas
    The Joint Committee staff recommends that a uniform package of tax 
incentives for businesses that locate in targeted geographic areas 
should be adopted. In addition, the targeted geographic areas that 
would be eligible for the tax incentives would be determined based on 
the application of a consistent set of economic measurements. The 
recommendation would eliminate many of the complexities that exist 
under present law for businesses in determining where to locate its 
business facilities, and for the Treasury, the IRS, and State and local 
agencies in selecting the distressed areas complying with the tax laws 
and monitoring the effectiveness of the tax incentives.
Geological and geophysical costs
    The Joint Committee staff recommends that taxpayers should be 
permitted immediate expensing of geological and geophysical costs. The 
recommendation would reduce complexity by eliminating the need to 
allocate such expenses to various properties and by eliminating the 
need to make factual determinations relating to the properties, such as 
what constitutes an area of interest and when a property is abandoned.
13. Excise taxes
Highway Trust Fund excise taxes
    The Joint Committee staff recommends that the number of taxes 
imposed to finance Highway Trust Fund programs should be reduced by 
eliminating or consolidating the non-fuels taxes. The rates at which 
the fuels taxes or the restructured non-fuels taxes are imposed could 
be adjusted to ensure that future funding for Trust Fund programs is 
not affected. Adoption of this recommendation would reduce the number 
of taxpayers having direct involvement with the highway excise taxes. 
Further, the non-fuels taxes are heavily dependent on factual 
determinations; their elimination would end numerous audit issues 
between taxpayers and the IRS.
    The Joint Committee staff recommends that the definition of highway 
vehicle should be clarified to eliminate taxpayer uncertainty about the 
taxability of motor fuels and retail sales (if the retail sales tax is 
retained). Enacting a single definition of highway vehicle would 
provide certainty to taxpayers.
    The Joint Committee staff recommends that the option to pay the 
heavy vehicle annual use tax in quarterly installments should be 
eliminated (if that tax is retained). Elimination of this payment 
option would increase compliance with the highway excise taxes while 
eliminating the need for tracking relatively small amounts of tax due 
from numerous taxpayers.
    The Joint Committee staff recommends that several technical 
modifications should be made to the present Code provisions governing 
motor fuels refund procedures and tax collection: (1) timing and 
threshold requirements for claiming quarterly refunds should be 
consolidated to allow a single claim to be filed on an aggregate basis 
for all fuels; (2) to the extent necessary to implement item (1), 
differing present-law exemptions should be conformed; (3) clarification 
of the party exclusively entitled to a refund should be provided in 
cases in which present law is unclear; (4) the regulatory definition of 
``position holder'' (the party liable for payment of the gasoline, 
diesel fuel, and kerosene taxes) should bemodified to recognize certain 
two-party terminal exchange agreements between registered parties; and 
(5) the condition of registration requiring terminals to offer for sale 
both undyed and dyed diesel fuel and kerosene should be eliminated. 
Consolidation and clarification of differing rules that affect similar 
transactions by taxpayers would provide certainty to taxpayers, as well 
as reducing needed IRS resources in administering these taxes.
Airport and Airway Trust Fund excise taxes
    The Joint Committee staff recommends that liability for the 
commercial air transportation taxes should be imposed exclusively on 
transportation providers.
    The Joint Committee staff recommends that the penalties for failure 
to disclose commercial air passenger tax on tickets and in advertising 
should be eliminated. Department of Transportation consumer protection 
disclosure requirements would remain in force for these as well as 
other currently regulated fees and charges.
    The Joint Committee staff recommends that a uniform, statutory 
definition of the tax base for the commercial air freight tax should be 
enacted with any exclusion for accessorial ground services being 
specifically defined. This recommendation would provide a level playing 
field for all air freight carriers, and also would eliminate numerous 
audit disputes that occur under present law.
    The Joint Committee staff recommends that the current definition of 
commercial air transportation, as applied to non-scheduled 
transportation, should be reviewed and, if appropriate, conformed to 
Federal Aviation Administration aircraft safety and pilot licensing 
regulations.
    The Joint Committee staff recommends that the present-law Code 
provisions governing aviation fuel refund and tax collection procedures 
should be coordinated with comparable rules for Highway Trust Fund 
excise taxes, if possible.
Harbor Maintenance Trust Fund excise tax and tax on passenger 
        transportation by water
    The Joint Committee staff recommends that the Harbor Maintenance 
Trust Fund excise tax and the General Fund tax on passenger 
transportation by water should be eliminated. This recommendation would 
conform the Code to court decisions and U.S. international trade 
obligations.
Aquatic Resources Trust Fund excise taxes
    The Joint Committee staff recommends that the sport fishing 
equipment excise tax should be eliminated. The current tax requires 
excessive factual determinations and disadvantages some industry 
participants relative to manufacturers of similar, untaxed articles 
that compete in the marketplace.
Federal Aid to Wildlife Fund and non-regular firearms excise taxes
    The Joint Committee staff recommends that Federal Aid to Wildlife 
Fund and non-regular firearms excises taxes should be eliminated. If 
the taxes are retained, consideration should be given to (1) 
consolidating certain of the taxes and (2) changing the tax rates to 
fixed-amount-per-unit rates in lieu of the present ad valorem rate 
structure to reduce factual and tax-base issues arising under the 
current structure. Tax law simplification would be furthered if the 
dedicated taxes were repealed and the Wildlife Fund program financed 
with general revenue appropriations.
Black Lung Trust Fund excise tax
    The Joint Committee staff recommends that the Code provisions on 
exported coal should be modified to eliminate the provisions imposing 
tax on coal mined for export in light of a recent court decision 
holding that portion of the tax to be unconstitutional.
Communications excise tax
    The Joint Committee staff recommends that the present-law Federal 
communications excise tax should be eliminated. If the tax is not 
eliminated, the Joint Committee staff recommends that: (1) liability 
for the tax should be shifted to telecommunications service providers 
so that unpaid tax would be collected as part of regular bad debt 
collections; (2) the present Code provisions should be updated to 
reflect current technology; and (3) broad grants of regulatory 
authority should be provided to the Treasury to allow it continually to 
update the tax base to reflect future technological changes. Under 
present law, the communications tax does not reflect the state of 
technology in the industry, thereby giving rise to disparate treatment 
of different providers of similar services and requiring highly factual 
determinations as to when services are taxed.
Ozone-depleting chemicals excise tax
    The Joint Committee staff recommends that the ozone-depleting 
chemicals excise tax should be eliminated as deadwood in light of 
provisions of the Montreal Protocol and the Clean Air Act that 
significantly restrict the use of the chemicals subject to tax.
Alcohol excise taxes
    The Joint Committee staff recommends that the three separate excise 
taxes currently imposed on alcoholic beverages should be consolidated 
into a single tax, with the rate being based on alcohol content of the 
beverage. The Code provisions governing operation of alcohol production 
and distribution facilities similarly should be consolidated to the 
extent consistent with overall operation of Federal alcohol regulation 
laws.
    The Joint Committee staff recommends that, if the current three-tax 
structure is retained, the reduced rates for production from certain 
small facilities and for distilled spirits beverages containing alcohol 
derived from fruit should be eliminated. This recommendation would 
result in identical beverages being subject to the same tax rate, 
thereby eliminating economic advantages that currently flow to some, 
but not all, producers of the same product as well as reducing 
recordkeeping requirements on taxpayers.
    The Joint Committee staff recommends that the alcohol occupational 
taxes should be eliminated. These taxes are in the nature of business 
license fees and serve no tax policy purpose.
    The Joint Committee staff recommends that the rules governing cover 
over of rum excise taxes to Puerto Rico and the U.S. Virgin Islands 
should be consolidated to reduce Federal administrative resources 
required for this revenue-sharing program.
Tobacco excise taxes
    The Joint Committee staff recommends that the present excise taxes 
on pipe tobacco, roll-your-own tobacco, and cigarette papers and tubes 
should be consolidated into a single tax on pipe and roll-your-own 
tobacco.
    The Joint Committee staff recommends that the tax rate imposed on 
cigars should be modified to eliminate the ad valorem component. 
Adoption of this recommendation would reduce audit issues as to the 
correct tax base in transactions where the products are sold between 
manufacturers and related parties in the distribution system.
    The Joint Committee staff recommends that the tobacco occupational 
tax should be eliminated. This tax is in the nature of a business 
license fee and serves no tax policy purpose.
14. Tax-exempt bonds
Unrelated and disproportionate use limit
    The Joint Committee staff recommends that the unrelated and 
disproportionate use limit under which no more than five percent of 
governmental bond proceeds may be used for a private purpose that is 
unrelated to the governmental activity also being financed should be 
eliminated. The general limits on private business use of governmental 
bond proceeds, combined with the requirement that certain larger issues 
receive an allocation of State private activity bond volume authority, 
adequately restrict issuance of tax-exempt governmental bonds to 
situations in which a private party does not receive excessive benefit.
Prohibition on use of private activity bond proceeds for certain 
        business
    The Joint Committee staff recommends that the prohibition on using 
private activity bond proceeds for certain business should be conformed 
for all such bonds and consolidated into one Code section. The multiple 
sets of rules for similar types of bonds create unnecessary complexity 
for taxpayers and the IRS.
Obsolete and near-obsolete provisions
    The Joint Committee staff recommends that the special qualified 
mortgage bond rules for residences located in Federal disaster areas, 
which have expired, should be eliminated as deadwood.
    The Joint Committee staff recommends that the temporary 
gubernatorial authority to allocate the private activity bond volume 
limits, which has expired, should be eliminated as deadwood.
    The current qualified mortgage bond and qualified veterans' 
mortgage bond programs substantially overlap. The Joint Committee staff 
recommends that only one mortgage interest subsidy--qualified mortgage 
bonds--should be provided through the issuance of tax-exempt private 
activity bonds. Consolidation of two similar provisions would reduce 
the need for duplicate administrative agencies and eliminate potential 
confusion among potentially qualifying beneficiaries and among 
potential lenders in those States that issue both qualified mortgage 
bonds and qualified veterans' mortgage bonds.
    The Joint Committee staff recommends that the $150 million limit 
for qualified section 501(c)(3) bonds should be eliminated as it 
relates to capital expenditures incurred before the date of enactment 
of the Taxpayer Relief Act of 1997. This limit was repealed in 1997 for 
capital expenditures incurred after enactment of the Taxpayer Relief 
Act.
    The Joint Committee staff recommends that the qualified small-
issuer exception for certain bank-qualified bonds should be eliminated 
in light of the development since 1986 (when the rule was enacted) of 
State bond banks and revolving pools that provide needed market access 
for smaller governmentalunits without the bank subsidy provided by the 
exception. In addition, provisions of the Community Reinvestment Act 
now require banks to invest in local projects without regard to 
subsidies such as that provided by this exception. The elimination of 
this exception would help streamline the arbitrage rebate rules without 
disadvantaging qualified small-issuers.
Public notice requirement
    The Joint Committee staff recommends that the ``public notice'' 
requirement for a qualified private activity bond should be allowed to 
be satisfied by other media if the objective of reasonable coverage of 
the population can be met. For example, notice via the Internet in 
addition to radio and television would satisfy an expanded public 
notice requirement. The Joint Committee staff recommends that, in lieu 
of a public hearing, the public comment requirement should be satisfied 
by written response and Internet correspondence. The recommendation 
would reduce the compliance burden by offering issuers less costly ways 
to obtain public scrutiny of proposed bond issues.
Arbitrage rebate
    The Joint Committee staff recommends that the present-law 
construction period spend down exception should be expanded to 36 
months with prescribed intermediate targets. Expanding the present-law 
construction period spend down exception to somewhat longer 
construction projects would expand the number of issuers who are not 
required to track temporary investments and compute arbitrage without 
creating excessive incentives to issue bonds in larger amounts or 
earlier than needed for governmental purposes in order to invest 
proceeds for profit.
    The Joint Committee staff recommends an increase to the basic 
amount of governmental bonds that small governmental units may issue 
without being subject to the arbitrage rebate requirement from $5 
million to $10 million. Specifically, these governmental units would be 
allowed to issue up to $15 million of governmental bonds in a calendar 
year provided that at least $5 million of the bonds are used to finance 
public schools. This recommendation reflects the increased dollar costs 
of activities financed by smaller governments since the provision was 
enacted in 1986 without expanding the benefit beyond those smaller 
governments that often lack in-house accounting staff to perform needed 
investment tracking and arbitrage calculations.
15. Estate and gift tax
    The Joint Committee staff recommends that the qualification and 
recapture rules contained in the special-use valuation and the 
qualified family owned business provisions be conformed to the extent 
practicable. Uniform rules to the extent practicable would make these 
related estate tax benefits easier to understand and administer.
16. Deadwood provisions
    The Joint Committee staff recommends that out of date and obsolete 
provisions in the Code should be eliminated. The Joint Committee staff 
has identified more than 100 provisions that could be eliminated as 
deadwood.

                                

    Chairman Houghton. Thanks very much, Mrs. Paull. I just 
have a quick question, and I will pass it over to Mr. McCrery 
and others. It has always amazed me that we don't get at this 
every year, I mean every year, and for us to start a series of 
tax simplification proceedings--and I know other people have 
gotten out of it and a lot of things have been written about 
it, but many times I will talk to the Treasury and they will 
say this is a really a government policy issue; or I will talk 
to the IRS and they will say, really it is not ours, it is the 
Treasury Department's.
    So we just keep going around in circles. And I think that 
you can help us not only in prioritizing, which you have, in 
terms of obsolete provisions and uniform definitions and things 
like that, but also help us to set us on a course where we can 
help those people who must help all the citizens out there, 
because this is really ridiculous. There is just so much wasted 
time, so much wasted effort, so many things burned up in the 
process.
    So the only thing I plead with you is, as we go along here 
and have these other hearings, help us think through, 
prioritize, but also find handles that we can get on with this.
    Mr. McCrery.
    Mrs. Paull. Mr. Houghton, if I could just respond very 
briefly. I think a red flag should come up with the Committee 
Members when the provision is of a very narrow scope and it 
doesn't have a broad application, because when you load up the 
Tax Code with these very, very narrow provisions, you start 
seeing difficulties in applying and understanding the tax law.
    Chairman Houghton. And also I think your point about the 
cost and benefit of some of these things, we very rarely talk 
about that. It is a side issue; it is not a core issue. Thank 
you very much.
    Mrs. Paull. You are welcome.
    Chairman Houghton. Mr. McCrery.
    Chairman McCrery. Just one topic I would like for you to 
touch on, and that is the AMT, alternative minimum tax. If I am 
not mistaken, in your report you recommend total repeal of 
alternative minimum tax for individuals and corporations; is 
that correct?
    Mrs. Paull. That is correct, Mr. McCrery.
    Chairman McCrery. I have often heard, and I will see if you 
agree, that the easiest thing we could do to simplify the Tax 
Code in one fell swoop would be to repeal the alternative 
minimum tax. Is that one of the--one of the main things you 
would recommend for simplification is repeal of the AMT?
    Mrs. Paull. Yes, it is. Our report starts with the repeal 
of the AMT. While we didn't necessarily order our 
recommendations, the fact that the report starts with the AMT 
indicates we thought it was a pressing issue. For those people 
who might be subjected to the alternative minimum tax or are in 
fact having to make those calculations, they are having to make 
a completely double set of calculations to figure their income 
taxes. It is not bad enough to have to do it once, but they get 
to do it twice. Many people must run through a check box of 
questions as to whether or not you should try to make those 
computations. Many people make them when they are actually not 
going to pay the tax. Unfortunately, in the future, many people 
are in fact going to be minimum taxpayers. They would have been 
under the previous law before the large bill that was just 
signed into law, and even more will be minimum taxpayers.
    The profile of the individuals that we are dealing with 
here tend to be large families or in a high income tax State, 
or they may have some other things like incentive stock options 
that will throw them in in 1 year. Sometimes you are in, 
sometimes you are not, but over time we are going to see a lot 
more people who are consistently in the AMT. It is a very 
complicated system, and it was not designed for those types of 
people.
    For businesses, some of them have to compute their taxes 
three ways. It is really kind of mind-boggling, the paperwork 
that they have to go through to comply with the alternative 
minimum tax. Again, they may go back and forth from year to 
year. Many of the reasons why there was an alternative minimum 
tax no longer are present. The regular tax has been changed, 
the alternative minimum tax was not, and so it is just picking 
up aberrational cases, and more than was ever intended.
    Chairman McCrery. Well, for purposes of today's hearing, it 
is not so much the actual alternative minimum tax that some 
taxpayers have to pay--and you say that number is going to 
grow--it is thecomplexity that it adds to the Code and to the 
calculation of one's taxes. And in fact, Mrs. Paull, isn't it correct 
that every taxpayer that itemizes his deductions has to go through the 
minimum tax calculation?
    Mrs. Paull. Yes they do to make sure that they are not 
going to be a minimum tax payer. If you knew something--if you 
were a lower income person and you knew something about the 
minimum tax, you might be able to do it shorthand, but most 
people have to go through various calculations to figure out 
whether or not they are AMT taxpayers.
    Chairman McCrery. Thank you.
    Chairman Houghton. Thanks very much, Mr. McCrery. Mr. 
Coyne.
    Mr. Coyne. Thank you, Mr. Chairman.
    Mrs. Paull, based on your analysis of the Tax Code and the 
study you did and the recommendations you made, who bears more 
of the responsibility for the complexity of the Code; the tax-
writing committees of Congress or the IRS?
    Mrs. Paull. Well, we did not try to identify it in that 
way. We have a long list of contributing factors.
    Mr. Coyne. You have done an exhaustive study of the Code, 
and I am just asking for your professional opinion. Who bears 
more of the responsibility?
    Mrs. Paull. I would say that obviously the Congress bears a 
significant responsibility because they write the tax laws.
    Mr. Coyne. Thank you. What policy considerations prevented 
you from making comprehensive recommendations in the areas of 
dependency exemption, child credit, earned income tax credit?
    Mrs. Paull. We made some recommendations in that area that 
we think are long overdue, having to do with the unified 
definition of a child for the five purposes of the Tax Code. It 
is possible to go further structurally to make additional 
simplifications of some of these provisions, but we believe the 
recommendations we made are significant. This was our first 
report, the first time we had done a comprehensive report like 
this, and we were not given very much guidance by the Congress 
on what kind of recommendations to make. So we made the 
recommendations that we felt were appropriate, which were not 
to second-guess policy decisions, but to try to go about 
implementing the policy of the Congress in a simpler way. You 
could give us some authority to look at specific areas to make 
recommendations, and we could give you some options with 
respect to the policy trade-offs that you could make. But we 
were really trying to focus on simplifying and implementing in 
a simpler way existing policy decisions in the Tax Code.
    Mr. Coyne. But aren't some of the areas that I cited, like 
dependency exemption, child credit, earned income tax credit--
aren't these exactly the ones that cause taxpayers most of the 
trouble?
    Mrs. Paull. One of the big reasons they have a lot of 
trouble is because they might have a child that qualifies them 
for one provision, and then they think they are qualified for 
all the other purposes and they are not. So, again, we made a 
recommendation for a unified definition of child so that when 
you qualify for one provision, you qualify for them all. In 
some instances, our recommendation would expand some of those 
provisions from present law if you were to move forward with 
that, but generally it would make it so much simpler for 
millions of people with children under the age 19 or 18.
    Mr. Coyne. But they do tend to be the areas that cause the 
most trouble for taxpayers; is that correct?
    Mrs. Paull. That is a significant area, yes.
    Mr. Coyne. Thank you.
    Chairman Houghton. Mr. McNulty.
    Mr. McNulty. Thank you, Mr. Chairman. I yield to Mr. Neal.
    Mr. Neal. Thank you Mr. Chairman. Thank you, Mr. McNulty.
    First of all, Mrs. Paull, let me thank you for last year 
for accepting many of my recommendations----
    Mrs. Paull. You are welcome.
    Mr. Neal. In H.R. 1420, and certainly you demonstrated wise 
judgment in that instance. What do we do to ensure that this 
tax simplification study really becomes real tax simplification 
for the American people as opposed to just another study?
    Mrs. Paull. Well, you know, we took our job seriously. We 
did not view this as a study that would be put on the shelf, 
that would be collecting dust. Simplification is an ongoing 
process. Our report is an outgrowth of a major initiated by 
this Committee on the IRS Restructuring Act, and we took it 
seriously. Now we hope the Congress will take our report 
seriously and act on some of the recommendations and develop 
additional ones.
    Mr. Neal. What is the disincentive for Congress not to take 
it up?
    Mrs. Paull. The disincentive? Well----
    Mr. Neal. I heard the former Chairman of this Committee for 
6 years talking about yanking the Tax Code out by its roots and 
throwing it to the side. We are no closer to that today than we 
were the day that he first said it. That was a big thing around 
here 6 years ago. We were going to tear the Tax Code apart and 
we are going to have a simplified Tax Code, and we are going to 
have a flat tax and we are going to have all these other 
things. President Bush put it on the front page of the New York 
Times yesterday; so we are all worked up about it again. It has 
been circulating in this arena for a long time, and we haven't 
done anything about it.
    Mrs. Paull. Mr. Neal, we didn't approach this, as our 
report deals with fundamental tax reform. Again, we approached 
it as is exploring if there is a simpler way to implement the 
policies of the present tax law, and we felt that was our 
mission. Obviously, the Committee can consider fundamental tax 
reform. My experience has been that there isn't a consensus on 
fundamental tax reform as to which way to go. That is a 
political issue and a policy issue for the Congress, and it 
appears to be stymied. Then you still have the Tax Code and 
there are still many, many well-intended ideas going into the 
Tax Code. This is an opportunity for you to step back and take 
a broad look and see if there isn't something you can do to 
make life simpler for a lot of people.
    Mr. Neal. Did you say well-intended or well-intentioned?
    Mrs. Paull. Both.
    Mr. Neal. Good follow-up. Bear with me for a second. I want 
to raise a point with you, and you really have tried hard to 
answer these questions in the past, but give me a few minutes 
here.
    You are certainly familiar with the incentive stock option 
alternative minimum tax problem. This, as you know, is a poster 
child for the unintended consequences of the complexity in the 
Code. On the one hand, we have a regular Tax Code telling 
people to keep their exercise incentive stock options for a 
year to get long-term capital gains; then we tax them 
immediately in AMT. And since thousands of people were unaware 
of this interaction, now people are paying all or part of their 
tax bill by cashing out of their pensions, taking second 
mortgages, and contemplating filing for bankruptcy. Now, let me 
just read you part of a letter that I received:
    ``Dear, Mr. Neal, my husband's company, quote, rewarded him 
with an incentive stock option for his hard work and dedication 
to the company. Since we exercised incentive stock options when 
the price was about triple the current value of the stock, we 
were forced to pay over $150,000 in AMT taxes, which is 
approximately the current value of the stock if we sold it 
today. If we sold the stock to pay the taxes, our real tax rate 
would be close to 100 percent, not the 25 percent the AMT is 
supposed to be. We are lucky enough to be able to take out a 
second mortgage on our home; however, several of our friends 
have not been so lucky. In this instance people conceivably 
could be losing their homes, vehicles, and child education 
funds because of the AMT and the timing of the tax at the 
exercise of International Organization for Standardizations 
(ISO).''
    Is this a result of the kind of complexity in the Tax Code 
that we should be worried about, Mrs. Paull?
    Mrs. Paull. Yes it is. I think the incentive stock option 
is not the only issue that people face. I certainly heard some 
very unfortunate situations dealing with actual capital gains 
that were realized, reinvested in the stock market, and the 
market fell and they had to pay their tax on their capital 
gains for last year. But that is not to say this is an 
unfortunate circumstance that should be addressed at the 
appropriate time.
    Mr. Neal. Well, let me ask you this. Have we ever backdated 
pro-taxpayer changes in the Tax Code because of policy reasons 
or because of an injustice?
    Mrs. Paull. Well, I think the fundamental policy question 
for this Committee is the AMT serving the purpose for which it 
was designed? You are giving an example of someone for whom the 
AMT was not designed to cause them to pay a hardship tax on 
them. I don't think the AMT was designed for large families to 
have to pay the AMT, or people living in high-tax States, or 
the kinds of profiles of people that you are seeing now having 
to pay the AMT. This is the crux of the fundamental policy of 
the question. We certainly considered whether or not the AMT 
ought to be fixed, so to speak, rather than recommend repeal. 
But we couldn't see an obvious big fix to it that was 
appropriate, and so we made a recommendation of repeal both on 
the individual and on the business side.
    Mr. Neal. What was the cost, do you recall?
    Mrs. Paull. The cost was at the time we made the 
recommendation, about 200 billion over 10 years on the 
individual side. I don't know what it was on the business side. 
But that cost has gone up significantly since the recent tax 
bill, and I don't have a precise figure for you today. I know 
you have an estimate request in for it and we are working on 
it.
    Mr. Neal. Thank you very much. Finally, Mrs. Paull, I 
pursued this issue with some diligence, as you know----
    Mrs. Paull. Sure.
    Mr. Neal. For a considerable period of time. It seems to me 
that the AMT issue not only highlights the complexities that we 
are talking about, but it really is something that we could 
have done before we took up tax issues. There was room to get 
this done, and the Chairman has acknowledged that we have to 
get it done. And just to point out to the members of the two 
respective Subcommittees that are here today, the longer the 
problem goes on, not only the more complicated it becomes but 
the worse it gets. So it is going to be more costly to fix next 
year than it was this year. You are free to comment on that if 
you would like that.
    Mrs. Paull. That is true.
    Mr. Neal. Thank you. Thank you, Mr. Chairman.
    Chairman Houghton. Thanks very much. Mr. Ryan.
    Mr. Ryan. Thanks, Mrs. Paull. This is my first time up 
here, actually, in this top tier. Nice to be here. I want to 
ask you one question about your capital gains recommendation 
and then two questions about policy decisions. I know you were 
restricted to the parameters of not making recommendations that 
would change underlying policy; but first could you describe to 
me your recommendation on your capital gains provision which 
would be a flat tax rate on a deduction from capital gains net 
calculation? Is that how you would do it?
    Mrs. Paull. Yes. Our recommendation on capital gains would 
be to go back to the way it was before the Tax Reform Act 
1986----
    Mr. Ryan. Pre-TRA.
    Mrs. Paull. Which would be to have a flat exclusion or 
deduction for whatever percentage the Congress chooses--it had 
been various percentages over the years before the change in 
the law. This new notion of putting a cap, or a maximum rate, 
on capital gains has added tremendous complexity, and now we 
have even more people who are investing in the stock market. We 
have over 27 million people who are filing an incredibly 
complicated Schedule D now. So that is another proposal, 
honestly, that would have widespread applicability that should 
be attended to soon.
    Mr. Ryan. And depending on where you set the level, I 
suppose, would you include an indexing component of that? 
Because if you set the level too low, it is going to be a big 
revenue raiser. I assume you would probably calculate that. 
Where would you estimate the revenue neutral to be set at; not 
the rate but the level?
    Mrs. Paull. We had estimated it in the past in the high 
30's percent; but after this new tax bill we have to reestimate 
it, and we have not done that yet.
    Mr. Ryan. In your model right now----
    Mrs. Paull. But indexing, I would just note, is a separate 
matter. One of the issues with indexing in the past has been 
the complexity it would add to the Tax Code.
    Mr. Ryan. And I think you and I have talked about this once 
before, but do you believe that the revenue-maximizing rate for 
capital gains right now is something like 22 percent? Is that 
what your model projects?
    Mrs. Paull. Because we have had such a substantial tax cut 
this year, we would have to go back review the rate and get 
back to you on that. I would be happy to do that. It will have 
a different effect under lower tax rates.
    Mr. Ryan. Right. Right. Going on to--I think in your 
testimony in the beginning you talk about being restricted to 
the parameters of things that would not make policy changes. 
You talk about changing depreciation, quote, determining 
whether an expenditure is a capital expenditure that cannot be 
currently expensed, and modifying the rules relating to the 
depreciation of capital assets. Obviously, that is a real 
source of an incredible amount of complexity in the Code.
    Could you expound on any ways that could make that simpler, 
including possible policy changes?
    Mrs. Paull. Well, we would be happy to work with you on 
that. I think the notion would be to try to determine a broader 
category of types of assets that could be currently expensed, 
and perhaps have a smaller number of categories of depreciable 
lives, so you could lump more equipment together. But when you 
do that, you are going to have winners and losers. Some 
averaging would go on, but you certainly could simplify the 
depreciation regimes, on a revenue-neutral basis or some other 
basis.
    Mr. Ryan. On a revenue-neutral basis, do you believe that 
neutral cost recovery--you know, the concept of bringing 
forward the time value of money with respect to depreciation--
can be done in a revenue-neutral way, which also makes 
depreciation more or less complex?
    Mrs. Paull. Well, again, I haven't looked at that proposal 
in years, but it had an indexing component to it. And when you 
have an indexing component to these kinds of proposals, you are 
going to end up with a much more complicated system than you 
start out with without the indexing. When you take into account 
the time value of money, you end up accelerating deductions. 
And so you end up having to overcome the revenue loss from 
that.
    Mr. Ryan. I think the last time your Committee scored that, 
though, that was--that was a revenue-neutral provision; 
correct?
    Mrs. Paull. I am not sure. It has been a long time since I 
have looked at that estimate.
    Mr. Ryan. Has anybody taken a look at that?
    Mrs. Paull. I think the last time we had looked at it was 
in early 1995, and the cost was significantly higher than the 
Committee wanted to get into at the time.
    Mr. Ryan. Did that have indexing at the time----
    Mrs. Paull. I don't know the number off the top of my head.
    Mr. Ryan. One more quick question. I know that this is not 
in the report either, but have you given thought to studying 
the multiple levels of taxation that occurs in any given dollar 
moving through the economy? Have you looked at analyzing the 
different layers of taxation that occurs moving from individual 
to business and back and forth through the economy, and 
calculated the cost of its complexity or tried to nail down 
exactly how that effect occurs through the Tax Code?
    Mrs. Paull. Mr. Ryan, we have not. We are much more focused 
on the individual provisions of the Tax Code at this point. We 
have never done a study like that.
    Mr. Ryan. Or not even on the individual side?
    Mrs. Paull. Not that I am aware of.
    Mr. Ryan. OK. I see my time is up. No further questions.
    Chairman Houghton. Fine. Thanks very much, Mrs. Paull. Mrs. 
Thurman.
    Mrs. Thurman. Thank you, Mr. Chairman.
    Mrs. Paull, first of all, let me compliment both you and 
your staff for trying to put this together. I can't even 
imagine what kind of an undertaking this had to have been to go 
through all of these issues. And I was particularly moved by 
page 109 in Volume I where you actually talk about the effects 
of complexity on perceived fairness of the Federal tax system. 
But, more importantly, at the end, where it says ``cynicism 
among taxpayers which ultimately can lead to intentional 
noncompliance'' is a pretty interesting statement, when 
particularly this Committee writes the bills and, in fact, 
either give or take from the taxpayer, and fairness obviously 
is a big issue for them.
    So in saying that, let me ask you this. In the last markup 
that we had in this Committee, there was quite a bit of debate 
on the charitable givings as to the complexity that might be 
incurred by the taxpayer for this particular piece of 
legislation. And I think it was pointed out once or twice that 
it really was about $3.56 when you got done with it all, for 
the complexity. I remember when the Committee talked about the 
simplification and the analysis particularly.
    In any of these volumes, is there any recommendation in 
here at all that, since we have already acknowledged that 
Congress is the tax-writing body, that we should in fact put 
the analysis and simplification before, as part of the analysis 
of the tax bills before us, as versus waiting to the end, when 
we get it at the end of the report, after we have had the 
markup and before we go to the floor, in the fact that, quite 
frankly, what I have seen around here, once we get to the 
floor, very little action is taken based on what the analysis 
was given us?
    So is there any kind of a recommendation in here that 
suggests that we should actually use the simplification 
analysis as a part of the taxwriting process?
    Mrs. Paull. We were trying to make recommendations with 
respect to the actual structure of the tax law in this report. 
We obviously are the ones who shepherd the complexity analysis. 
The way the process is working on tax legislation, there is not 
adequate time for full consideration to be given to this. The 
standard that we have been using in order to determine whether 
or not to prepare a complexity analysis is a standard that you 
have to have--and this is what the statute says, too--
widespread applicability. And we are using a standard of at 
least 10 percent of individual taxpayers or small businesses 
being affected. The non-itemizer deduction, of course, did meet 
that standard, but there is an awful lot of provisions that do 
not meet that standard, but add complexity to the Tax Code.
    We don't have the resources to keep on top of every single 
proposal, to be honest with you. So we are doing the best we 
can. It is a new role for us since the 1998 act, and I think 
that it does provide some useful information. It is mostly far 
along in the process; because, as you said, while I am prepared 
at the markup to discuss it, you don't get anything in writing 
until the report is filed. And at that time, we haveasked the 
Treasury Department and the IRS to scramble and give us something for 
the report so it is available for floor action.
    Mrs. Thurman. Why would----
    Mrs. Paull. And then the legislation moves over into the 
Senate, and the Senate is, of course, adding many more 
provisions, and the same thing is going on. So it doesn't lend 
itself, considering the way the tax laws are written right now, 
to be part of the mix very easily, because the laws are written 
in such a time compressed way.
    Mrs. Thurman. But the idea of the law specifically was to 
in fact make sure that Congress was aware of the complexities 
as we wrote----
    Mrs. Paull. Right.
    Mrs. Thurman. The laws. I mean, that was the idea.
    Mrs. Paull. Right.
    Mrs. Thurman. I mean, we talked about how the IRS should be 
involved in this because, quite frankly, that is as much of a 
problem as anything because when we send it out there into, you 
know, kind of the IRS divisions, each one of these divisions is 
interpreting the law a little bit differently; so therefore 
some of our taxpayers are feeling like they are not getting the 
fair representation of the Tax Code, and I would still go back 
to page 109.
    I think, and I would say to the Chairman, Mr. Chairman, I 
hope that as we go through this, that what we do up here should 
not be done in such a rush that we can't look at this 
complexity, because then all of the things that we are doing 
today mean nothing to us in the future. Thank you.
    Chairman Houghton. Is that it, Mrs. Thurman? OK. Good. Let 
me understand your time. You have got to get out of here pretty 
soon, don't you? Have you got enough time to continue the 
questions?
    Mrs. Paull. I can continue taking questions.
    Chairman Houghton. OK, fine. Ms. Dunn.
    Ms. Dunn. Thank you, Mr. Chairman. I think this is a 
fascinating report, and I appreciate our having it so that we 
can look through it. And I am wondering, Mrs. Paull--I will 
wait until you finish.
    Mrs. Paull. Sorry.
    Ms. Dunn. You talked about 55 percent of tax returns 
currently being done by professionals. I am not sure whether 
that increase that you stated is due to the complexity of the 
Code or the continuing lack of time in a normal person's life 
these days. But I wonder, just off the top--and briefly--if you 
think that the numbers of professionals who are preparing tax 
returns are going to increase until we have a complete reform 
of the Tax Code.
    Mrs. Paull. Well, there is an increase both in the paid 
professionals as well as in the use of computer software, where 
you can go out and buy a computer program to help you with your 
tax return. We are not sure why, but there is a growing use of 
both by non-itemizers. I think you can only assume that, even 
though they have a very simple tax return, they are very 
intimidated by the instructions and whether or not they can get 
it right. As a result, more non-itemizers have to use someone 
else or to buy software because they are not confident they can 
get it right.
    Ms. Dunn. They just don't want to face one more problem in 
their lives.
    Mrs. Paull. They don't want that letter from the IRS, I 
think.
    Ms. Dunn. And they want to do it right and they want to do 
it fairly and they want to stay out of trouble.
    Let me ask you a question. Something that has concerned me 
recently in some of the moves that we have done as we work 
toward making the Tax Code fairer and less of a burden on the 
backs of normal taxpayers, and that is the increasing gap 
between corporate capital gains and individual capital gains. 
It seems to me that at some point we have to figure we are 
really voting in favor of the individual and against the 
corporation in how we are collecting these taxes. And I am 
wondering if it is not going to lead to a reorganization in 
some businesses in order--as REITs, Real Estate Investment 
Trusts, for example, in order to avoid paying the high capital 
gains that corporations have to pay. What do you think would be 
the situation? Would we be better off if we had a lower capital 
gains rate that applied equally to corporations and 
individuals?
    Mrs. Paull. Well, we are getting into not so much 
simplification but a policy call that needs to be made by the 
Committee. The issue with respect to a lower capital gains rate 
has been focused on individual investors, because they tend to 
be very sensitive to the rate at which the capital gains are 
taxed.
    Therefore you find a lot of incentive being derived from a 
lower capital gains rate. With respect to corporations, the 
economic literature is not very supportive of a lower rate in 
the sense of providing an incentive because businesses are 
going to invest for solid business reasons and for the long 
haul. So the incentive part of it has been always a little bit 
cloudy, and that is why I think the law has developed the way 
it is.
    On the other hand, there are certain industries, and I 
think you know I am familiar with an industry that has a 
presence in the Northwest, that a lower corporate capital gains 
rate could make a big difference.
    Ms. Dunn. That of course is the timber industry. I 
appreciate your mentioning that.
    Let me ask you a question. You mentioned in your testimony 
a recommendation for simplifying the qualifying rules for 
children and I am wondering if you could describe how that 
works, why that is a problem right now, and also perhaps at the 
same time why is it difficult to account for the income of 
minor children?
    Mrs. Paull. Let me start with the definition of qualifying 
children. As we discussed in our report, in order to figure out 
whether or not a child qualifies you for the earned income 
credit, the dependent care credit, the dependency exemption, 
head of household status, and the $500 now increasing to $1,000 
child credit, you have to go through a maze. And it is 
literally a maze, 17 pages of instructions, all kinds of flow 
charts. We did an outline in our report comparing the different 
eligibility criteria, and it is 7 pages long and it is an 
outline. So it is very difficult to try to figure out if your 
child qualifies you for each of these things or which one you 
are eligible for.
    And as I said, it is extremely confusing. You make it 
through the maze for one provision and you think you are home 
free on all of them. So that particular recommendation is, I 
would hope, at the top of the list of things that Members would 
be interested in pursuing. With respect to children under the 
age of 14, right now we have a very complicated system, called 
the kiddie tax, to try and determine the tax on the unearned 
income of those children. This provision was well-intentioned 
but it is extremely complicated to try to figure out how much 
tax your child under the age of 14 should pay. So we have a 
recommendation in our report to make it much simpler.
    Ms. Dunn. Mr. Chairman, I do hope we can put those at the 
top of our list. I think it would save a lot of families a lot 
of time.
    Chairman Houghton. Well noted. Thanks very much. Mr. 
Pomeroy.
    Mr. Pomeroy. Hello, Mrs. Paull. You know I am new on this 
Committee and, honestly, it just drives me nuts that it seems 
like we can't hold two thoughts in our head at the same time. 
And so when this Committee was considering tax cuts, we talked 
about all manner of tax cuts but we didn't talk at all about 
tax cuts relative to simplification and Code complexity. That 
is like an entirely different thought that we hold at other 
periods of time.
    I would like to show you a chart. We have tried to diagram, 
and it is complex to do, but we have tried to chart the phase-
ins and the phase-outs of the various aspects of the recently 
enacted Tax Relief Act. And as you can see, some are calling it 
the hokey-pokey tax cut. You phase a tax cut in, you phase a 
tax cut out, you phase a tax cut in, you shake it all about. I 
just would ask you straight up, when the Tax Relief Act is 
completely implemented, assuming no change, will the Code be 
more complex than today or less complex?
[GRAPHIC] [TIFF OMITTED] T5055A.004

      
    Mrs. Paull. It will be more complex. We indicated that in 
our testimony.
    Mr. Pomeroy. One feature where you have made, I think, an 
important recommendation relates to elimination of the 
alternative minimum tax. Now check that. Before I get to the 
AMT, I don't really understand the constraints of the Joint Tax 
Committee. I mean, you answered questions for some hours before 
this Committee as we considered the tax cut, and during the 
pendency of the report that came out this April I never heard 
you discuss simplification. Were you precluded from doing it 
under the direction of the Committee or how come simplification 
never came up?
    Mrs. Paull. Mr. Pomeroy, I am here to explain to the 
Committee the provisions and answer questions. Now there were a 
lot of questions, if I remember right, about the alternative 
minimum tax, the implications of that tax, of the lowering of 
the regular income tax rates, throwing more people on the AMT. 
It is going to make the system more complicated for a lot of 
people. Many of the provisions that were before the Committee 
were not phased in and sunsetted the way the final bill ended 
up. So that discussion really didn't occur before the Committee 
because the provision wasn't before the Committee.
    But, last week when we were talking about the non-itemize 
or charitable deduction, I think we had a very good discussion 
about complexity. I am here to help you out in any way I can.
    Mr. Pomeroy. I wish this idea that you all advanced in your 
April report about elimination of the AMT had taken root with 
the Committee, and we really wrestled with it as we evaluated 
what to put into the package. I think we could have had a 
package that in the end wouldn't have looked like that; it 
wouldn't have required future work.
    Mrs. Paull. Unfortunately, I think you marked up the rates 
in March, our report came out in April after 18 months of work. 
We were working as hard as we could in between the Congress' 
legislative activity. I didn't let our staff have Easter break 
because of this report.
    Mr. Pomeroy. But 1 month later on Memorial Day we enacted a 
significantly more complicating component to the Tax Code. So 
it is unfortunate sometime during the month of May we did not 
quite catch from you what you were recommending and what you 
were recommending be something quite different than what we 
were doing. What is your relative belief to be able to achieve 
simplification in a relative neutral way without touching any 
of those tax cut phase-ins or finding other spending offsets or 
dipping into trust funds or using the contingency fund, if 
there is a contingency fund? Can you get the job done on a 
revenue neutral basis within the Code or does it have a revenue 
impact?
    Mrs. Paull. Well, some of these proposals you can probably 
do on a revenue neutral basis, but of course you are going to 
make some tradeoffs because somebody's tax provision may not be 
as generous as it is under present law. And in order to achieve 
a broader simplification----
    Mr. Pomeroy. Could one conclude that really in order to in 
a meaningful way advance simplification we will need to revisit 
some of the aspects of the recently enacted tax legislation?
    Mrs. Paull. I would imagine what seems to be the easy 
target around here is the high rates.
    Mr. Pomeroy. Thank you. Thank you, Mrs. Paull. I yield 
back, Mr. Chairman.
    Chairman Houghton. Thank you very much. Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman. And thank you, both 
you and Chairman McCrery, for conducting this hearing. I often 
hear the folks back home in the south suburbs of Chicago, they 
always complain their taxes are too high but if you listen a 
little longer they talk about how complicated and how unfair 
the Tax Code is and of course the need to simplify it. And 
there is strong interest and support for simplifying the Tax 
Code, and listening to some of my colleagues and the questions 
they have, I would note that in the tax cut that we recently 
passed and the President signed into law we did move toward 
simplifying some key provisions, particularly in the area of 
marriage tax penalty, which I always considered to be one of 
the more glaring results of our complicated Tax Code. We need 
to do more.
    Our friends in the Senate of course wanted to have a 
smaller tax cut. At the same time there were those who wanted 
to do more with a smaller tax cut, which forced us to phase in 
some provisions that we would liked to have started immediately 
rather than phasing them in over a period of time. You know, 
when it comes to the complications, and really the marriage tax 
penalty is an example there of--when we were first researching 
the marriage tax penalty we noted that that impacting joint 
filers was the biggest of them all. But in analyzing the Tax 
Code there were about 62 other marriage tax penalties. And 
they, like a lot of other complications in the Code, resulted 
from the income eligibility and income thresholds and the so-
called targeting of the tax, various tax provisions and certain 
groups that were selected by the President, and the Congress' 
legislation moved through. I was wondering, Mrs. Paull, just 
from a historical perspective when did the so-called targeting 
tax provisions and determining who would qualify, be eligible 
for certain--such as the child tax credit or the student loan 
interest deduction--when those income thresholds--was that 
something that started in the seventies, the eighties, the 
nineties? When did all that begin?
    Mrs. Paull. The $500 per child credit and the student loan 
deduction were both enacted in 1997.
    Mr. Weller. Was that a common practice in the Tax Code well 
before the time that I came onto this Committee to create 
income thresholds determining who was eligible; is that prior--
--
    Mrs. Paull. It is becoming a more common thing in the 
recent decade.
    Mr. Weller. What was the primary reason for that? Was it 
just for selecting who would qualify or was it for scoring 
reasons because of limited revenue? What was kind of the 
primary motivation from your experience?
    Mrs. Paull. Sometimes it would be to provide assistance but 
only to certain people, and therefore they would put some 
income limits on it. The other reason would be driven by the 
budget limitations.
    Mr. Weller. You know, my friend Mr. Ryan touched on one 
issue which I considered a need to modernize the Tax Code, and 
that is the whole issue of depreciation. I really believe that 
technology is driving the need to change how we depreciate 
assets. It doesn't make sense to carry the office computer on 
the books for 5 years when businesses on average replace their 
PCs about every 14 months. It should be expensed. And there is 
a lot of other taxed assets, wireless and communications 
medical technology, software, computer components and other 
assets, that we should expense. From your study, as we look at 
ways to simplify and modernize the Tax Code, what do you 
consider to be the chief roadblocks to expensing technology and 
other assets?
    Mrs. Paull. You have selected a group of equipment or 
property that you would like to revisit, but there are other 
groups of property that people would like to revisit. Trying to 
come up with a uniform way to apply a new set of depreciation 
rules is the challenge, because while I might have sympathy 
toward the kinds of property you are talking about, before long 
we are going to have a whole long other list. That is what has 
happened over the last few years with respect to depreciation. 
As a result, the Committee had asked the Treasury Department to 
prepare a comprehensive study on depreciation--this is a very 
technical area--but only gave the Treasury Department a limited 
time period to do the study. I believe the Subcommittees are 
going to be looking at that study.
    But I think what the challenge is, not just a couple of 
pieces of property, but to try to do the whole thing.
    Mr. Weller. Well, just to follow up on that, you know, I 
think we are all disappointed with that Treasury study. That 
report really said little other than we should study it some 
more. I think we are all very disappointed in what they 
produced. Obviously it is going to require a complicated 
effort. Could you also just see from an international 
competitiveness standpoint any thoughts that you have on the 
whole issue of depreciation as we work to modernize our Tax 
Code and make it more user friendly, as we look at how we can 
better compete in the global marketplace, how depreciation can 
play a role?
    Mrs. Paull. Mr. Weller, we are in the process of taking a 
look at this area ourselves. As I said, it is a difficult area. 
We have been soliciting comments. We are doing a study of how 
other countries treat depreciation and hope to be able to 
provide the Committee with some useful information on which to 
move forward on this. But I think again you have got to roll up 
your sleeves and do it in a comprehensive way.
    Mr. Weller. The information I have seen, particularly the 
Asians have a much more attractive treatment of assets, 
particularly in the area of technology, than we do. Would you 
agree with that?
    Mrs. Paull. I personally have not looked at it, so I would 
have to get back to you on it. We are, as I said, compiling 
this information for this Committee at the Chairman's request.
    Mr. Weller. Thank you, Mr. Chairman.
    Chairman Houghton. Mr. Brady, do you have a question? Mrs. 
Paull, thank you so much. We really appreciate your being with 
us.
    Next I would like to call the panel, Mr. David Keating, 
Senior Counselor, National Taxpayers Union; Mr. Scott Moody, 
Senior Economist, Tax Foundation; Mr. C. Eugene Steuerle, 
Senior Fellow of the Urban Institute; and Mr. William Gale, 
Senior Fellow of the Brookings Institution.
    While you are coming toward the desk, I was just reading 
over the income tax form for 1913. It makes me want to cry.
    All right. Now let's go right ahead. Mr. Keating, would you 
start?

   STATEMENT OF DAVID L. KEATING, SENIOR COUNSELOR, NATIONAL 
                        TAXPAYERS UNION

    Mr. Keating. Thank you, Mr. Chairman, and Members of the 
Committee, for holding this hearing on tax complexity and for 
inviting me to testify. It is kind of like old age, tax 
complexity; it has been creeping up on us for many years and 
you may not notice 1 year at a time, but when you look back at 
how things have changed over the decades it is shocking. Sixty-
five years ago the 1040 instructions, as you pointed out, were 
just two pages long and even when the income tax became a mass 
tax during World War II they were four pages long. Today 
taxpayers have 117 pages of instructions, triple the number in 
1975 and more than double the number in 1985. This was the year 
before taxes were simplified.
    I also note that today's news report that the IRS has 
apparently sent out a half a million erroneous notices about 
the size of the tax refund checks. So if the IRS can't get it 
right I am not sure we can expect the average taxpayer to 
either.
    Now, if you need help with something more complicated than 
the basic 1040 instructions, I think this stack right here that 
you had on exhibit is a perfect example. This is a total of 
about 13,000 pages of other forms and instructions that some 
taxpayers need to file or consult when preparing their return. 
Even the IRS itself is complaining about the burden. The new 
annual report of the Taxpayer Advocate cites complexity for 
individuals and businesses as the number one and two most 
serious problems encountered by taxpayers and the root cause of 
the top 20.
    It is no surprise, I think, that paid professionals now 
prepare most of the tax returns. In fact, the use of paid 
professionals has soared by 50 percent since 1980, and this is 
even more remarkable when you consider that the average home 
didn't have access to a computer in 1980. When you look at the 
tax returns prepared not only by paid professionals but by 
incredibly sophisticated tax return software, now 80 percent of 
the people are preparing returns either with computers or paid 
preparers.
    Despite the use of more powerful computers and faster 
printers, tax preparation fees are on the rise, even when you 
adjust for inflation. That is solely due to the rising 
complexity. One way of tracking this trend is to look at the 
average fee charged by H&R Block, which fortunately is a 
publicly traded company and has to report how much it makes. In 
fact, last month the company again raised its dividend and 
declared a two for one stock split.
    You can almost track the growth of the H&R Block stock to 
the increasing complexity. The average fee they charge is now 
up to $112 this year, which is a rise of about 50 percent after 
accounting for inflation. If you don't account for inflation, 
the increase tops 140 percent.
    Now, it has been pointed out by Lindy Paull earlier, that 
the recent tax law changes have made things more complicated 
and I suspect things will get worse before they get better. But 
here is one interesting thing that I found while researching 
this area for the Subcommittees. I was looking at the Paperwork 
Reduction Act 1995, which set annual goals for reduction of the 
paperwork. But this law by any measurement has been an abject 
failure, largely due to the increasing paperwork burdens 
generated at the IRS. Now in all fairness to the IRS, these 
burdens aren't the result of IRS bureaucrats mindlessly 
dreaming up new forms and regulations. Much of the burden 
increase has been due to the fact that the tax law's flood of 
complexity is continuing unabated.
    Another thing that we examined was the IRS' own 
measurements of how long it takes to prepare and file tax 
return. Now, as Bill Gale points out in his statement, these 
estimates are not perfect. But I do think it gives some 
indication of the trends. Look at the 1040 form with the fairly 
common schedules of A, B, and D where taxpayers report itemized 
deductions, interest, and dividend income as well as capital 
gains. In 1988, when the IRS started tracking this information, 
to this year's tax return, the average paperwork burden climbed 
from 17 hours and 7 minutes to 27 hours and 2 minutes, an 
increase of 58 percent. Even the short forms are becoming more 
complicated under these calculations. The so-called EZ form now 
requires 3 hours and 53 minutes, up from 1 hour and 31 minutes, 
a jump of 156 percent. I point out that these estimates are 
certainly incorrect, but they are the best that we have.
    For example, the IRS reports that taxpayers only have to 
spend 1 minute understanding the earned income credit. Well, 
this is a provision of the tax law that the IRS reports has an 
extremely high error rate.
    My statement details some of the suggestions as to how 
Congress can move toward simplification. I note that the '98 
IRS Reform and Restructuring Act required Congress to at least 
consider complexity before passing tax legislation. The report 
on complexity that accompanied this year's tax legislation was 
an afterthought and an embarrassment. I think the Joint 
Committee could have done a much better job.
    Clearly tax laws as they are being drafted are being driven 
by numbers--revenue loss estimates, revenue gain estimates, how 
the burden of the tax system is distributed, but there is 
nothing that requires, for example, complexity neutrality. So 
until you start getting driven by numbers on how complex things 
are, I suspect we will not see simplification.
    Thank you very much.
    [The prepared statement of Mr. Keating follows:]
  Statement of David L. Keating, Senior Counselor, National Taxpayers 
                                 Union
    Mr. Chairman, and members of the Committee, thank you for holding 
this hearing on tax simplification and for inviting me to testify. Like 
old age, tax complexity has been creeping up on us. We may not notice 
it one year at a time, but a review of older tax instructions reveals 
just how shockingly complicated taxes have become today.
    Sixty-five years ago the Form 1040 instructions were just two pages 
long. Even when the income tax became a mass tax during World War II, 
the instructions took just four pages. Today taxpayers must wade 
through 117 pages of instructions, triple the number in 1975 and more 
than double the number in 1985, the year before taxes were 
``simplified.''

                    Form 1040--Form and Instructions
------------------------------------------------------------------------
                                                     Instruction Booklet
    Tax Year         Lines 1040     Form Pages 1040       Pages 1040
------------------------------------------------------------------------
       2000               70                 2                 117
       1995               66                 2                  84
       1985               68                 2                  52
       1975               67                 2                  39
       1965               54                 2                  17
       1955               28                 2                  16
       1945               24                 2                   4
       1935               34                 1                   2
------------------------------------------------------------------------

    If you need help with something more complicated, the IRS prints at 
least 943 forms and instructions. UncleFed.com added up the length of 
these publications at our request and found a total of 12,933 pages for 
this tax-filing year alone.
    Even the IRS is complaining about the burden. The new annual report 
of the IRS National Taxpayer Advocate identifies tax complexity for 
individuals and businesses as the number one and two most ``serious 
problems encountered by taxpayers,'' and the ``root cause'' of the top 
twenty.
Paid Professionals Now Prepare Most Tax Returns
    As the tax system's complexity has grown, more taxpayers are 
running to tax professionals to prepare their returns. Once again, it 
appears that more taxpayers will use a tax pro this year. Through May 
4, 56.7% of taxpayers used a pro, up from 55.8% at the same time last 
year. The more complex tax returns, which require professional 
assistance, are often filed within the statutory extension period, and 
final data on the use of paid professionals will become available in 
September.
    The number of taxpayers using paid professionals has soared by 50% 
since 1980 and by 19% during the past decade. While some of this 
increase can be attributed to rising incomes, the growing use of home 
computers and tax preparation software has likely curtailed the rush to 
paid professionals.
    The growth in the use of paid preparers can be accurately tracked 
because beginning in 1977 tax professionals have been required to sign 
returns they have been paid to prepare.

                  Tax Returns Signed by Paid Preparers
------------------------------------------------------------------------
              Tax Year                 Paid Preparer  Returns (percent)
------------------------------------------------------------------------
                   1980                                38.0%
                   1985                                45.9%
                   1990                                47.9%
                   1995                                49.9%
                   1999                                56.2%
                  2000*                                57.0%
------------------------------------------------------------------------
* NTU estimate

    Between 1966 and 1977, anyone who prepared a return was required to 
sign it in addition to the taxpayer, meaning many unpaid relatives or 
friends signed the returns. Therefore, the data for the first few years 
probably overstates paid-preparer participation, because undoubtedly 
many unpaid people who had signed returns for years kept doing so even 
after the law had changed.
    Tax preparation software has grown in sophistication as Windows has 
come to dominate the PC market, enabling more taxpayers to sit in front 
of a computer and answer a seemingly endless stream of questions while 
the computer figures out how to prepare the return.
    In 1980 no individual taxpayers used computers to prepare their 
taxes. Yet today, when accounting for paid preparers and computer 
returns combined, about 80% of all returns are prepared with such 
assistance.

                   Use of Paid Preparers and Computers
------------------------------------------------------------------------
                                         Paid Preparer plus Computer
              Tax Year                    Prepared Returns (percent)
------------------------------------------------------------------------
                   1980                                38.0%
                   1996                                66.4%
                   1997                                70.5%
                   1999                                76.3%
                  2000*                                78.3%
------------------------------------------------------------------------
* Through May 4

Tax Preparation Fees Are Rising Too
    Tax preparation fees have increased substantially, largely due to 
the increased complexity of the average tax return. One way of tracking 
the trend in fees is to examine the average fees charged by H&R Block, 
the nation's largest tax preparation firm.
    This rise in complexity has boosted profits at H&R Block, a 
publicly traded company. Last month, the company again raised its 
dividend and announced a two-for-one stock split. Its average $112 fee 
has increased 146% since 1985, or 48% after accounting for inflation. 
The sharp rise in fees is even more remarkable considering the huge 
increase in the capability of computers, tax return software, and 
printer speed. The efficiency gain of computers and printers has likely 
been overwhelmed by the increases in complexity.

                    Average Fee Charged by H&R Block
------------------------------------------------------------------------
     Calendar Year           Nominal Dollars      Adjusted for Inflation
------------------------------------------------------------------------
            1985                   $45.39                  $75.33
            1988                   $49.21                  $74.47
           1998*                   $84.39                  $91.44
           1999*                   $92.57                  $98.65
           2000*                  $101.29                 $105.07
           2001*                  $111.51                 $111.51
------------------------------------------------------------------------
* Through April 15

Tax Complexity Will Probably Get Worse
    Tax complexity probably will get worse before it gets better. 
Although the tax relief legislation enacted by Congress and the 
President this year would cut tax rates, it increases complexity. The 
long phase-in of the tax cut and long phase-out of the death tax will 
cause new tax planning headaches.
    Income taxpayers will consider timing their incomes to take 
advantage of later-year tax rate cuts, while those concerned about the 
death tax must revise their estate plan to account for the gradual 
phase-out of the tax and its possible temporary repeal.
    Because the tax cut would sharply reduce middle-class taxes, over 
18 million more taxpayers (and 35.5 million by 2010) would be forced to 
complete a second tax return for the Alternative Minimum Tax (AMT), a 
parallel and complex tax system once aimed at ensuring the rich paid a 
substantial tax bill. As if one tax return weren't difficult enough 
already.
    There are some positive steps that were taken to simplify the law. 
Notably the new law repeals the phase-out of the personal exemption and 
itemized deductions, though even the repeal of the phase-out is itself 
phased-in later this decade. The repeal was due in part to a fortunate 
coincidence of an excellent report by the Joint Committee on Taxation 
that contained recommendations for tax simplification with the need for 
a compromise on the highest tax rate bracket under the new law.
Federal Law Orders Cut in Paperwork, but Tax Paperwork Burden Rises
    In an attempt to bring the paperwork burden under control Congress 
passed the Paperwork Reduction Act of 1995, which set annual goals for 
federal agencies to meet. According to the Office of Management and 
Budget, the new law ``set an annual governmentwide goal for the 
reduction of the total information collection burden of 10% during each 
of Fiscal Years 1996 and 1997 and 5% during each of Fiscal Years 1998 
through 2001. The baseline is the total burden of information 
collections as of the end of FY 1995.''
    By that measurement, the law has been a failure, largely due to the 
increasing burdens at the IRS. Burden hours at all agencies are 
expected to increase from 6,901 million hours in 1995 to 7,435 million 
hours in 2000.
    Instead of declining by double-digit rates, tax paperwork burdens 
will have soared by about 15% during the five years ending in 2000.
    An earlier Paperwork Reduction Act passed in 1980 required federal 
agencies to track the paperwork burden imposed on citizens and business 
by their forms and recordkeeping requirements. In order to comply with 
the law, the IRS commissioned Arthur D. Little to undertake a 
comprehensive estimate of tax compliance costs for the tax year 1983, 
and this survey served as the basis for the methodology used to track 
tax paperwork burdens that the IRS finalized with the 1988 tax year.
    While the Little study is by far the most comprehensive available, 
James Payne estimated in his 1993 book Costly Returns that even it may 
understate the real burden ``perhaps by about 20-30 percent.''
    While no figures are separately published for the IRS, tax form 
paperwork burdens alone account for roughly 80% of the total paperwork 
burden hours of the United States Government. The IRS is part of the 
Department of the Treasury and very nearly accounts for the 
Department's entire paperwork burden.
    In Fiscal Year 2000, total paperwork burdens for all agencies were 
estimated at 7,447.20 million hours, and the Treasury Department 
accounts for 6,131.85 million of these hours, or 82%.

            Paperwork Burden Hours Department of the Treasury
------------------------------------------------------------------------
            Burden Hours       Paperwork       Cumulative
  Fiscal         (in       Reduction Act of     Increase     Compared to
   Year       millions)       1995 Target      Since 1995      Target
------------------------------------------------------------------------
    1995       5,331.30
    1996       5,352.85            4,798.17          0.4%        554.68
    1997       5,582.12            4,318.35          4.7%      1,263.77
    1998       5,702.24            4,102.44          7.0%      1,599.80
    1999       5,909.07            3,897.31         10.8%      2,011.76
    2000       6,131.85            3,702.45         15.0%      2,429.40
------------------------------------------------------------------------
From the Information Collection Budget, Office of Management and Budget.
Target hours assume Treasury Department reductions meet the law's
  overall average reductions for all federal paperwork.

    If the Treasury Department were to reduce its burden by the average 
amount mandated by the 1995 Paperwork Reduction Act, the burden would 
decline to 3,702 million hours in 2000. Instead, the Treasury has 
overshot that target by 2,429 million hours.
    Paperwork burdens aren't the result of IRS bureaucrats mindlessly 
dreaming up new forms and regulations. Much of the burden increase is 
due to a flood of new tax laws, including the Taxpayer Relief Act of 
1997. That law did reduce tax bills for middle-class taxpayers, but 
significantly increased their paperwork burdens. The 1997 Taxpayer 
Relief Act alone added an estimated 92 million hours to the paperwork 
burden.
    These figures apparently only account for the time spent in keeping 
the necessary records and learning about and complying with the law. 
Yet a significant additional but uncounted burden comes from trying to 
exploit the law's loopholes to the maximum extent. For example, 
millions of citizens subscribe to personal finance publications and 
much of the advice offered deals with taxes. Taxpayers are often 
advised to consider the tax consequences of any major financial 
transaction, and this form of tax planning undoubtedly adds many 
millions of hours to the time spent coping with the tax system.
It's Taking Longer to Prepare and File Tax Returns
    Despite the passage of the 1995 Paperwork Reduction Act, the time 
it takes to file commonly used individual income tax forms has 
increased.
    The 1040 form is often filed with Schedules A, B and D where 
taxpayers report itemized deductions, interest and dividend income, and 
capital gains, respectively. From 1988, when the IRS started tracking 
this information, to 2000, the average paperwork burden hours climbed 
from 17 hours and 7 minutes to 27 hours and 2 minutes, an increase of 
58%. The time burden has increased by 28% since 1995.

                      History of Estimated Preparation Time, 1040 Form and Common Schedules
----------------------------------------------------------------------------------------------------------------
                                                                Learning                  Copying,
                                                               about the  Preparing   assembling,  and
                     Year                       Recordkeeping    law or    the form  sending  the form    Total
                                                                the form                 to the IRS
----------------------------------------------------------------------------------------------------------------
Form 1040 and Schedules A, B, & D
2000                                                  7:52         7:16      10:05               1:49     27:02
1999                                                  7:57         5:43       9:59               1:50     25:29
1995                                                  7:04         4:36       7:11               2:21     21:12
1990                                                  7:04         4:04       5:26               1:50     18:24
1988                                                  6:56         3:39       5:02               1:30     17:07
Form 1040 only
2000                                                  2:45         3:25       6:16               0:35     13:01
1999                                                  3:15         2:39       6:22               0:35     12:51
1995                                                  3:08         2:54       4:43               0:53     11:38
1990                                                  3:08         2:33       3:17               0:35      9:33
1988                                                  3:07         2:28       3:07               0:35      9:17
----------------------------------------------------------------------------------------------------------------

    Even the short forms are becoming more complicated. The 1040EZ 
form, the simplest in the IRS inventory, now requires 3 hours and 53 
minutes, up from 1 hour and 31 minutes in 1988, a jump of 156%. The 
1040A and Schedule 1 (interest and dividend income) has seen a 
paperwork burden increase of 35% since 1995.

                               History of Estimated Preparation Time, 1040EZ Form
----------------------------------------------------------------------------------------------------------------
                                                          Learning                     Copying,
                                                          about the   Preparing    assembling,  and
                  Year                    Recordkeeping  law or the   the form   sending the form to     Total
                                                            form                       the IRS
----------------------------------------------------------------------------------------------------------------
2000                                             0:05         1:38        1:50                 0:20        3:53
1999                                             0:05         1:34        1:47                 0:20        3:46
1995                                             0:05         0:55        1:22                 0:20        2:42
1990                                             0:05         0:34        0:40                 0:40        1:59
1988                                             0:07         0:24        0:40                 0:20        1:31
----------------------------------------------------------------------------------------------------------------

                               History of Estimated Preparation Time, 1040A Forms
----------------------------------------------------------------------------------------------------------------
                                                                 Learning                 Copying,
                                                                about the  Preparing  assembling,  and
                      Year                       Recordkeeping    law or    the form  sending the form    Total
                                                                 the form                to the IRS
----------------------------------------------------------------------------------------------------------------
Form 1040A and Schedule EIC
2000                                                    1:10         3:05       5:11              0:54     10:20
1999                                                    1:11         2:44       4:45              0:55      9:35
1995                                                    1:04         2:25       3:02              0:40      7:11
1992                                                    1:42         2:24       3:20              1:22      8:48
Form 1040A and Schedule 1
2000                                                    1:29         3:08       5:11              0:54     10:42
1999                                                    1:31         2:46       4:45              0:55      9:57
1995                                                    1:24         2:27       3:08              0:55      7:54
1990                                                    1:42         2:35       3:26              0:55      8:38
1988                                                    1:53         2:16       3:12              1:10      8:31
Form 1040A only
2000                                                    1:10         3:04       4:58              0:34      9:46
1999                                                    1:11         2:42       4:31              0:35      8:59
1995                                                    1:04         2:23       2:58              0:35      7:00
1990                                                    1:22         2:31       3:16              0:35      7:44
1988                                                    1:20         2:11       2:52              0:35      6:58
----------------------------------------------------------------------------------------------------------------

    The Tax Code is so convoluted that no one inside or outside the IRS 
understands it. For many years Money magazine's annual test of tax 
preparers proved that paid professionals often make huge mistakes. In 
1998, the last year Money administered the test, all forty-six tested 
tax professionals got a different answer, and not one got it right. The 
pro who directed the test admitted ``that his computation is not the 
only possible correct answer'' since the tax law is so murky. The tax 
computed by these pros ``ranged from $34,240 to $68,912.'' The closest 
answer still erred in the government's favor by $610.
Steps Toward Simplification
    While the 1998 IRS Reform and Restructuring Act requires Congress 
to at least consider complexity before passing tax legislation, that 
has not provided enough incentive for Congress to avoid additional 
complexity or encourage simplification. The report on complexity that 
accompanied this year's tax legislation was an afterthought and an 
embarrassment.
    The tax-writing committees should be required to quantify the costs 
of proposals that add complexity or the savings from proposals that 
simplify the law.
    The report on simplification by the Joint Committee on Taxation 
this year proves the worth of giving Congress trusted recommendations 
on this important issue. Several of the report's recommendations were 
included in the new tax cut law. Congress should look for ways to 
encourage both the Joint Committee and the Treasury Department to offer 
more such recommendations.
    The National Commission on Restructuring the IRS suggested that 
Congress consider a quadrennial simplification process, and Congress 
and the President should implement such a process either through 
legislation or by executive order. The Commission found that many 
members of the private sector tax community were willing to volunteer 
substantial time to make suggestions for simplification.
    A quadrennial simplification commission would harness this 
volunteer activity and give a broad group of people much more incentive 
to work for the adoption of simplification rules. This quadrennial 
commission would also give the Joint Committee on Taxation and the 
Treasury Department more incentive to suggest simplification of the 
law.
Conclusion: A New Approach to Taxes Is Needed
    Fundamental overhaul of our tax system remains a critically 
important goal. As the Internal Revenue Code becomes increasingly 
incomprehensible, the intrusive measures provided to the IRS for 
enforcing it seem to become more draconian. Every detail of a 
taxpayer's private financial life is open for government inspection. 
IRS employees can make extraordinary demands on taxpayers, and can 
takeextraordinary actions against them. Mixing such broad powers with a 
vague and complex law is a recipe for a civil liberty catastrophe. The 
threat of abuse is always present.
    Until we change how we tax income, we will continue to have an 
intrusive agency with broad powers. It doesn't have to be that way. Our 
economy as well as our civil liberties would be better off with 
fundamental tax reform.

                                

    Chairman Houghton. Thank you. We have a vote. So why don't 
we go ahead with your statement, Mr. Moody, and then if people 
want to peel off, fine. If not, we will finish with that, go 
and have a vote and come back. So go right ahead, please.

   STATEMENT OF SCOTT MOODY, SENIOR ECONOMIST, TAX FOUNDATION

    Mr. Moody. Thank you, Mr. Chairman and Members of the 
Committee. My name is Scott Moody. I am the Senior Economist of 
the Tax Foundation. It is an honor for me to appear before your 
Committee today on behalf of the Tax Foundation to discuss the 
cost of tax complexity on taxpayers.
    The Tax Foundation's goal is to explain as precisely and as 
clearly as possible the current state of fiscal policy in light 
of established tax principles so that you, the policy makers, 
have the information to make informed decisions. Among these 
principles, a good tax system should be as simple and as stable 
as possible.
    The Tax Foundation has worked on estimating how much it 
costs both individuals and businesses to read the rules, fill 
out the forms and do all the other things necessary to comply 
with the Nation's tax laws in time for the April 15th deadline. 
Many studies of the Tax Code find that our system, particularly 
the income Tax Code, is excessively complex. In 2001, 
individuals and businesses will spend an estimated 4.6 billion 
hours complying with the Federal income tax with an estimated 
cost of compliance of over $140 billion. This amounts to 
imposing a 12-cent administrative burden for every dollar that 
the income tax system collects.
    To put this tax compliance burden into perspective, the 140 
billion tax surcharge is greater than the combined revenue of 
Sears, Walt Disney, Microsoft, Rite Aid, McDonald's, 3Com and 
Radio Shack. Put another way, 4.6 billion hours per year 
represents a work force the equivalent of over 2.2 million 
people. That is more people than would reside in four 
congressional districts.
    The Tax Foundation has also projected future compliance 
costs out to 2006 as shown in the chart here to my left. Over 
this time period compliance costs will grow by almost $30 
billion from 140 billion in 2001 to 170 billion in 2006.
    To illustrate the magnitude of these compliance costs the 
chart also compares the year-to-year cost with that of the 
recently enacted tax reduction. In every year between 2001 and 
2006 the total tax compliance cost is greater than the tax 
reduction. So from the taxpayers' perspective the recent tax 
cut represents only a partial refund of their total yearly tax 
compliance burden. In fact, the cumulative compliance burden 
over this time period will come to almost $930 billion while 
the cumulative tax relief over the same period will only cover 
a little more than half that cost, or roughly $550 billion.
    Because complying with the tax laws represents a fixed cost 
for many individuals, it seems likely that lower income 
individuals would bear a greater relative tax burden than 
higher income individuals. In previous research, the Tax 
Foundation has found this to be true of corporations. New 
research by the Tax Foundation finds that the same is also true 
for individuals. As you can see in the second chart, the 
compliance costs of individuals is quite regressive. As a 
percent of adjusted gross income, taxpayers with AGI of less 
than $20,000 are hit the hardest. They pay a compliance tax 
surcharge of over 4 percent of their income, because compliance 
costs are essentially a fixed cost.
    The compliance tax surcharge falls as income increases. For 
taxpayers with $40,000 to $75,000 in income their surcharge 
consumes a much lower 1 percent. The surcharge drops to two-
tenths of a percent for taxpayers with incomes over $200,000.
    As in chart 1, chart 2 compares the distribution of the 
individuals' compliance costs to the distribution of the recent 
tax reduction. Chart 2 illustrates that a very effective way to 
provide tax relief for lower income taxpayers is via tax 
simplification. In fact, nearly half of the tax surcharge 
savings resulting from tax simplification would go to taxpayers 
with less than $40,000 in income. For example, Form 1040, which 
accounts for almost half of the tax compliance burden on 
individuals, takes nearly 13 hours to complete. Every hour 
shaved off the 1040 would save taxpayers over $2 billion a 
year. A mere 3-hour savings would net a 10-year $60 billion 
windfall for taxpayers at zero cost to the U.S. treasury.
    In addition to the tax surcharge itself, the tax complexity 
due to the size and instability of the Tax Code creates two 
other economic costs. I don't measure these costs in my 
testimony, but they are significant enough to keep in mind. One 
is the overhead cost associated with the economically sterile 
exercise of tax planning, compliance and litigation. The second 
cost results from the economic opportunities that are foregone 
because of taxpayer uncertainty in the Tax Code.
    In conclusion, the benefits of reducing the tax complexity 
burden would dramatically benefit lower income taxpayers, since 
they bear a disproportionate amount of the burden. Overall, 
though, taxpayers in all income brackets would benefit from a 
tax reduction via tax simplification. This could be done under 
a comprehensive revision of the Tax Code guided by established 
tax principles such as those supported by the Tax Foundation.
    Thank you very much.
    [The prepared statement of Mr. Moody follows:]
       Statement of Scott Moody, Senior Economist, Tax Foundation
    Mr. Chairman and Members of the Committee, my name is Scott Moody 
and I am the senior economist at the Tax Foundation. It is an honor for 
me to appear before your committee today on behalf of the Tax 
Foundation to discuss the cost of tax complexity on taxpayers.
    The Tax Foundation is a non-profit, non-partisan research and 
public education organization that has monitored fiscal policy at all 
levels of government since 1937. The Tax Foundation is neither a trade 
association nor a lobbying organization. As such, we do not take 
positions on specific legislative proposals. The Tax Foundation does 
not receive any federal funds.
    Our goal is to explain as precisely and as clearly as possible the 
current state of fiscal policy in light of established tax principles, 
so that you, the policy makers, have the information to make informed 
decisions. Among to these principles, a good tax system should be as 
simple and stable as possible.
    As such, the Tax Foundation has worked on estimating how much it 
costs both individuals and businesses to read the rules, fill out the 
forms, and do all the other things necessary to comply with the 
nation's tax laws in time for the April 15th tax filing deadline. My 
testimony will provide the results of our work to date on the cost of 
tax compliance.
    It is important for the public to have an estimate of this cost 
because the performance of the economy is dramatically affected by the 
state of tax law. If lawmakers create an Internal Revenue Code that is 
terribly complex or that changes rapidly, taxpayers may not be able to 
obtain a reasonably certain conclusion about how taxation will affect a 
business plan or investment. When the tax consequences of various 
economic activities are unpredictable, then tax policy is handicapping 
the growth and dynamism of the U.S. economy.
    As if the complexities inherent in taxing income did not pose a 
sufficiently daunting challenge to the writers and administrators of 
the tax code, political and social demands have also been taken into 
account. In particular, two goals for the code that contribute to 
complexity are ``fairness'' and social utility. They come into play 
when determining how much individual taxpayers should owe--the 
``ability-to-pay'' principle, and when providing incentives for 
socially beneficial activities.
    Many studies of the tax code find that our system, particularly the 
income tax code, is excessively complex. This study concurs, 
quantifying the code's complexity in a way that makes clear how 
unnecessary much of it is. In 2001 individuals and businesses will 
spend an estimated 4.6 billion hours complying with the federal income 
tax, with an estimated cost of compliance of over $140 billion. This 
amounts to imposing a 12-cent administrative burden for every dollar 
the income tax system collects.
    If the high cost of complying with the federal income tax were a 
necessary price to pay for a fair and effective tax system, perhaps 
there would be little room for complaint, but in fact the complaints 
are justified.
The Complications of the Federal Income Tax
    Most Americans naturally think of their income tax burden simply as 
the amount at the bottom line of their 1040 form. Economists, on the 
other hand, may express Americans' tax burden as a percentage of GDP or 
even as a date on the calendar, such as Tax Freedom Day. But such 
measures fail to register another cost to taxpayers--the cost of 
complying with the tax system.
    Experts complained about the complexity of the federal income tax 
system as early as 1914, the year immediately following the adoption of 
the 16th Amendment to the Constitution which authorized the income tax. 
Since then, the quest for tax simplification has waxed and waned with 
generally little progress over the years and the tax code has grown in 
complexity. Veteran tax professionals commonly point to the Tax Reform 
Act of 1969 as the legislation that infused much needless complexity 
into the income tax code. But they say nothing in that Act came 
anywhere near the bewildering complexities that were introduced by the 
tax enactments of the 1980s.
    Within a three-year period in the first half of the 1980s, the 
income tax code was subjected to three massive pieces of legislation. 
First was what became known as ``the Reagan tax cut,'' the Economic 
Recovery Tax Act of 1981. This was followed immediately by the Tax 
Equity and Fiscal Responsibility Act of 1982, and soon thereafter came 
the Deficit Reduction Act of 1984. However, the tax drama had not yet 
reached its climax, which occurred in 1986 with the enactment of the 
Tax Reform Act of 1986 (TRA'86).
    TRA'86 was meant to make a clean break from the past complexity and 
instability in the tax code. The primary goal of its authors was tax 
simplification, and toward that end, the act reduced the number of 
rates and expanded the tax base (through the elimination of numerous 
tax preferences). While the goal was laudable, the nation did not end 
up with a simpler tax code--especially from the perspective of 
businesses. Previous research by the Tax Foundation has found that 
there is near unanimity among senior corporate tax officers that TRA'86 
brought tax complexity to an unprecedented level. They point to the 
alternative minimum tax, inventory capitalization rules, and foreign 
income rules as the main culprits.
The Complex Job of Taxing Income
    In 1927, the Joint Committee on Internal Revenue Taxation (Vol. 1, 
p. 5) reported that: ``It must be recognized that while a degree of 
simplification is possible, a simple income tax for complex business is 
not.'' This early recognition of how difficult it is to tax income 
bears repetition and elaboration.
The Problem of Defining Income
    Income tax complexity is almost wholly related to tax base 
questions--that is, questions or uncertainty about the timing or 
definition of taxable transactions. The inherent complexity of an 
income tax results from the difficulty of defining income and 
determining when and to whom to recognize income and expense for tax 
purposes. Over time, the political process of give-and-take has made 
these difficult tax base questions inordinately complex. The definition 
of taxable income has not only expanded dramatically, but it has 
undergone chronic change.
Non-Economic Demands on the Code
    In addition to the inherent complexities of taxing income, an 
important political goal of our tax system is to ensure that the income 
tax code is both fair and equitable. This goal comes into play in two 
important areas of the tax code that contribute to complexity: (1) 
determining how much individual taxpayers should owe--the ``ability-to-
pay'' principle, and (2) providing incentives for socially beneficial 
activities.
Ability to Pay
    From an economic perspective, the most efficient way to levy taxes 
is with a head tax. In other words, every person would pay an equal 
lump-sum tax. According to recent Tax Foundation research, if such a 
head tax were instituted today, every man, woman and child in the 
nation would have to pay $11,116 to fund the government at current 
levels. The federal government alone would account for almost 70 
percent ($7,754) of the tax bill with state and local governments 
accounting for the remainder ($3,362).
    Economists would call such a head tax efficient because it is 
economically neutral, avoiding all distortion of the free-market 
process. In other words, the burden of a head tax does not fall on any 
particular economic activity, so taxpayers' economic decisions would be 
completely unaffected by the tax system. Even the simplest income tax 
could never be 100 percent economically neutral precisely because the 
burden of the tax falls on income-producing activity, inevitably 
persuading some taxpayers in some circumstances to earn less income.
    Obviously, such a head tax would be administratively efficient as 
well, as neither taxpayers nor the government would need to document 
taxpayers' income. However, the head tax is politically troublesome, to 
put it mildly. Taxation anywhere near the current level would 
constitute an insuperable burden for low-income citizens. If television 
stars and day laborers must pool their resources to fund government 
operations that consume roughly one third of the nation's income, as 
they now do, then devising a tax system that takes ``ability to pay'' 
into account becomes inevitable, even if it does lead to a much more 
complex tax code.
    Today the tax code includes a multitude of provisions to adjust the 
tax burden according to this ``ability-to-pay'' principle. The most 
obvious application of this principle is the graduated rate structure 
which increases a taxpayer's liability as a percentage of income as 
income rises. Other provisions adjust for the number of children in the 
family, family status (single, married, head of household), etc.
Promoting Socially Useful Activities
    In addition to making allowances for the poor, today's income tax 
code includes numerous provisions to encourage activities that are 
deemed ``socially beneficial.'' In the personal code, taxpayers are 
allowed various credits and deductions such as home mortgage interest, 
health care expenditures and the child tax credit, to name a few. On 
the business side, there are various credits--such as the investment 
tax credit--and preferential depreciation rules. As a result, the 
income tax code today is a hodgepodge of deductions and credits that 
have nothing to do with raising the revenue needed to fund government 
operations. In fact, these tax code items not only reduce revenues but 
at the same time dramatically increase the complexity of the tax code.
    Unfortunately, once inserted into the code, these preferential tax 
provisions become entrenched over time as various groups lobby for 
their protection and expansion.
    To economists this is known as rent-seeking. Such lobbies have a 
strong interest in maintaining the tax preference because they have 
usually spent substantial resources obtaining it. Also, the general 
public usually mounts little opposition since the benefits are 
concentrated on a relatively small group of taxpayers while the costs 
are spread amongst everyone else.
    For example, let's look at the tax complexity caused by the ever-
popular deduction for charitable contributions. As for any itemized 
deduction, taxpayers must keep an accurate accounting of their 
charitable contributions. If the value is over $250, the taxpayer also 
needs a statement from the charitable organization. While such record-
keeping does not appear overly onerous, just look at some of the 
problems lurking in the background.
    For one, charitable contributions are a significant source of ``tax 
leakage,'' a term the Internal Revenue Service uses when it refers to 
the loss of tax revenue caused by under-reported income or over-
reported deductions. For instance, a phantom donation of $25 a week 
would lead to a deduction of $1,300 a year. Obviously, if a significant 
number of taxpayers did this, the revenue loss would be quite 
significant. Not all tax evaders are as blatant as the tax lawyer who 
was recently caught claiming to have given his church $500 every 
Sunday--when the IRS inquired, the pastor of the taxpayer's church was 
not obliged to keep his parishioner's sin a secret. Such over-reporting 
of deductions leads to higher compliance costs for all taxpayers as the 
IRS has to resort to increased auditing and/or the addition of more 
rules and regulations.
    Charitable organizations have to go through an approval process 
administered by the IRS before a contribution by an individual can be 
legally declared as a charitable deduction. The burden of this process 
is not a one-time cost because every approved charity has to be aware 
at all times that even the slightest change in its mission could 
nullify its charitable status according to the IRS. Of course, this 
process is costly, in time and money, for the charities and the IRS.
    The rules and regulations governing the deduction not only add to 
the complexity in the tax code, but naturally, the deduction also 
lowers government revenue, forcing everyone else to pay higher tax 
rates. However, while there are a multitude of organizations that stand 
ready to defend the deductibility of charitable contributions, there 
are no large groups of taxpayers that oppose its complexity.
    The complexity caused by this one popular deduction is like the 
proverbial tip of the iceberg. There are literally thousands of similar 
special preferences written into the tax law that promote various 
activities or benefit a group of taxpayers. These groups of taxpayers 
stand ready to defend their tax preferences with economic and emotional 
arguments that relate to the taxpayers' ability to pay or the social 
benefits of the activity in question. This organized resistance to 
simplification has been phenomenally successful over many years, 
causing many legislators to despair of piecemeal efforts at tax 
simplification.
Fundamental Tax Reform
    One way to get around the problems caused by rent-seeking, thereby 
reducing complexity and its attendant costs in the income tax code, is 
to reform the entire federal income tax system. Reform proposals are 
currently on the table that attempt to make simplification and the 
promotion of economic growth the principal strategies of tax policy. 
These include the national sales tax sponsored by Rep. Billy Tauzin and 
the flat income tax proposal sponsored by Rep. Dick Armey.
    The national sales tax takes the direct approach and moves away 
from the concept of taxing income completely--taxing consumption 
instead. The flat tax, on the other hand, moves to cash flow as the tax 
base, rather than accrued income. A cash flow tax, as it applies to 
business, totals business receipts and then subtracts purchases from 
other businesses. On the individual level, the approach resembles a 
universal IRA.
    Both proposals would boost economic performance by eliminating the 
double tax on savings, and both promise huge reductions in the 
complexity of the tax code. As of this writing, however, neither plan 
has garnered widespread support. Even if a plan to fundamentally 
simplify the tax system did gain momentum, the possibility exists that 
provisions would be added during the legislative process that would add 
new complexity, such as happened in 1986.
The Growth and Instability of the Income Tax Code
    Despite decades of concern over its undue complexity, the income 
tax was formally placed at the core of the federal tax system by the 
Internal Revenue Act of 1954. Overall, two important measures of tax 
complexity have climbed dramatically since then--the size and the 
instability of the tax code.
The Growth of the Code
    Table 1, Figure 1 and Figure 2 chart the dramatic growth over the 
past 40 years in the combined number of words that define the body of 
both the federal income tax laws and their attendant regulations. 
Since1954, the estimated number of words in the entire tax code devoted 
to the income tax has grown from 42 percent to 59 percent, more than a 
40 percent increase over the last four decades. The volume of income 
tax regulations has grown even more. In 1954, income tax regulations 
represented 55 percent of the body of tax code regulations. Today, that 
figure has grown to 81 percent, an increase of more than 47 percent 
over the past four decades.

                                Table 1

              Growth of the Number of Words in the Internal Revenue Code Selected Years, 1955-2000
----------------------------------------------------------------------------------------------------------------
                                                   1955       1965       1975       1985       1995       2000
----------------------------------------------------------------------------------------------------------------
Internal Revenue Code
Income Taxes Only                                    172        243        395        645        881        982
Entire Tax Code                                      409        548        758      1,107      1,488      1,670
Period-to-Period Percent Growth
Income Taxes Only                                      *      41.4%      62.8%      63.2%      36.6%      11.5%
Entire Tax Code                                        *      33.8%      38.3%      46.0%      34.5%      12.2%
Internal Revenue Code Regulations
Income Taxes Only                                    572      1,715      2,571      3,762      4,880      5,947
Entire Tax Code                                    1,033      3,098      3,295      4,613      6,135      7,307
Period-to-Period Percent Growth
Income Taxes Only                                      *     199.6%      49.9%      46.3%      29.7%      21.8%
Entire Tax Code                                        *     199.9%       6.4%      40.0%      33.0%      19.1%
Internal Revenue Code and Regulations
Income Taxes Only                                    744      1,957      2,966      4,406      5,761      6,929
Entire Tax Code                                    1,442      3,646      4,053      5,720      7,623      8,976
Period-to-Period Percent Growth
Income Taxes Only                                      *     163.1%      51.5%      48.6%      30.8%      20.3%
Entire Tax Code                                        *     152.8%      11.2%      41.1%      33.3%      17.7%
----------------------------------------------------------------------------------------------------------------
Source: Tax Foundation calculations based on the annual publications of ``Internal Revenue Code'' and ``Federal
  Tax Regulations'' from West Publishing Company.

      
    [GRAPHIC] [TIFF OMITTED] T5055A.001
    
      
    [GRAPHIC] [TIFF OMITTED] T5055A.002
    
      
    The Tax Foundation has determined that over the past 45 years the 
number of words detailing the income tax laws has grown from 172,000 
words in 1955 to 982,000 today--an increase of 472 percent. Income tax 
regulations, which provide taxpayers with the ``guidance'' they need to 
calculate their taxable income, have grown at an even faster pace from 
572,000 words in 1955 to 5,947,000 words today--an increase of 939 
percent. Combined, the federal income tax code and regulations grew 
from 744,000 words in 1955 to 6,929,000 today--an increase of 831 
percent.
Growth of the Code by Subject Area
    Perhaps a more revealing measure of tax code complexity is the 
multiplication of the subchapters and subsections that comprise the 
Internal Revenue Code. In 1954, federal income tax law was comprised of 
103 code sections. Today, there are 725 income tax code sections, a 604 
percent increase. (See Table 2.)

                                Table 2

                  Comparison of 1954 Code and 2000 Code
------------------------------------------------------------------------
                                     Number of Sections in
                                          Subchapter           Percent
                                  --------------------------    Growth
                                       1954         2000
------------------------------------------------------------------------
Subchapter of Income Tax Code
Determination of Tax Liability...            4           50        1150%
Computation of Taxable Income....            9          152        1589%
Corporate Distributions and                 14           35         150%
 Adjustments.....................
Deferred Compensation............            2           31        1450%
Accounting Periods and Methods...            6           33         450%
Tax-Exempt Organizations.........            4           19         375%
Corporation Used to Avoid Income             4           27         575%
 Tax on Shareholders.............
Banking Institutions.............            3            8         167%
Natural Resources................            3           10         233%
Estates, Trusts, Beneficiaries,              7           32         357%
 Etc.............................
Partners and Partnerships........            7           36         414%
Insurance Companies..............            5           30         500%
Regulated Investment Companies,              1           22        2100%
 Etc.............................
Tax Based on Income from Within              9           79         778%
 or Without the United States....
Gain/Loss on Disposition of                  7           40         471%
 Property........................
Capital Gains and Losses.........            4           56        1300%
Readjustment of Tax Between Years            6            7           17
 and Special Limitations.........
Tax Treatment of S Corporations..            0           14           NA
Other (a)........................            8           44         450%
TOTAL............................          103          725         604%
------------------------------------------------------------------------
(a) Includes all subchapters not explicitly listed as well as Chapters 2-
  6 of Subtitle A of the Internal Revenue Code.
Source: Tax Foundation computations from Internal Revenue Code

    Almost all of the growth relates to tax base questions. For 
example, since 1954, the number of sections dealing with the 
``Determination of Tax Liability'' has grown 1,150 percent; the number 
of sections dealing with ``Capital Gains and Losses'' has grown 1,300 
percent; the number of sections dealing with ``Deferred Compensation'' 
(e.g., pension plans) has grown 1,450 percent; and the number of 
sections dealing with the ``Computation of Taxable Income'' has grown 
by more than 1,589 percent.
    The growth in the volume of the income tax laws and regulations is 
a direct result of the 32 significant federal tax enactments that have 
taken place since 1954--or approximately one every 1.4 years. Previous 
Tax Foundation research (based on a sample of one-fifth of the core 
sections of the income tax code) found that these enactments have not 
only increased the volume of the tax code, but resulted, on average, in 
the amendment of each section once ever four years (as of 1994). This 
instability has been much more pronounced in the past 20 years than it 
was during the 20 years immediately following the 1954 Act.
Quantifying the Cost of Tax Compliance
    The complexity generated by the growth and constant change of the 
tax code creates two general types of economic cost: overhead and 
opportunity cost. Overhead can be divided into three principal 
activities: the economically sterile exercises of tax planning, 
compliance, and litigation, all of which act like tax surcharges on 
taxpayers.
           The first type of overhead is tax planning, which in 
        this context refers to all the economic decisions that 
        individuals and firms make because of the tax code.
           The second type of overhead, tax compliance, refers 
        here to the basic actions required to comply with the federal 
        income tax, including record keeping, education, form 
        preparation and packaging/sending.
           The third type of overhead is litigation, referring 
        to the cost of the IRS and the Tax Court, as well as all the 
        legal costs that taxpayers incur while dealing with these two 
        government institutions.
    Of these three costs, the second--tax compliance--is the only one 
estimated in this report. It is for this reason that the data presented 
here should be viewed as extremely cautious estimates of the federal 
income tax compliance burden on taxpayers.
    For example, a company plans to build a manufacturing facility. 
However, after tax planning, thedecision is reached to build a slightly 
different facility in a different location. The company later files a 
tax return on the activities of the facility, but the IRS objects to 
some aspect of the tax return, and after some legal wrangling, the 
return is finalized. In this case, only the firm's costs of actually 
calculating and filing its tax return are part of the Tax Foundation's 
estimate of the ``cost of compliance.''
    As for the second general type of economic cost caused by the tax 
system--opportunity costs--they are also excluded from Tax Foundation 
estimates of the compliance burden. Arriving at an estimate of 
opportunity costs is a much more difficult and speculative task.
    For instance, imagine a software developer who has to spend time 
complying with the tax code. Data are available to compute an estimated 
value of the tax work he accomplishes, and this report does that. But 
it is not possible to estimate with any precision the value of the work 
that the taxpayer might have accomplished had tax compliance not 
replaced entrepreneurial effort. This time may have been spent working 
on a new idea that one day blossomed into the next Microsoft--creating 
tens of billions of dollars in wealth. And even if phenomenal wealth 
would not have been created in that time, it is still true that every 
hour or dollar spent complying with the tax code represents resources 
that could have been spent tending to business problems, adding value 
to the economy while doing the work that the taxpayer is good at.
    As shown in Tables 3 and 4, the Tax Foundation estimates that in 
2001 individuals and businesses spent over 4.6 billion hours complying 
with the federal income tax. Using an hourly cost of $25.21 for 
individuals and $36.20 for businesses, the estimated cost of compliance 
in 2001 is $140 billion. (See Methodology section for details about how 
the hours and wages were determined.) Therefore, the overall compliance 
cost surcharge alone amounts to nearly 12 cents for every $1 collected 
by the federal income tax.

                                Table 3

                                          Estimated Cost to Individuals for the Federal Income Tax System, 2001
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                        Number of     Record  Education      Form     Packaging/
                            Individuals                                  Returns     keeping    Stage    Preparation    Sending    TOTAL    Total Hours
--------------------------------------------------------------------------------------------------------------------------------------------------------
Forms
1040(a)............................................................      77,914,480      2.8       3.4         6.3         0.6      12.0     936,272,335
1040A (b)..........................................................      14,702,000      2.3       3.5         6.5         2.0      14.3     209,993,567
1040EZ (c).........................................................      16,660,000      0.1       1.6         1.8         0.3       3.9      64,696,333
1040ES.............................................................      43,251,000      1.3       0.3         0.8         0.2       2.6     111,731,750
1040X..............................................................       3,274,000      1.3       0.5         1.2         0.6       3.6      11,622,700
4868...............................................................       8,333,000      0.4       0.2         0.3         0.2       1.1       9,027,417
(Extension of Time) (d)
2688...............................................................       3,066,000      0.0       0.2         0.3         0.3       0.8       2,350,600
(Extension of Time) (e)
1041 (Estates and Trusts)..........................................       3,670,000     46.6      18.5        35.0         4.3     104.4     383,025,667
1041ES.............................................................       2,017,000      0.3       0.3         1.5         1.0       3.1       6,252,700
1040 Schedules
Sch A..............................................................      52,017,347      3.1       0.7         1.6         0.3       5.6     292,164,098
Sch B..............................................................      53,939,047      0.6       0.1         0.4         0.3       1.4      77,312,634
Sch D..............................................................      35,277,366      1.5       3.1         1.8         0.6       7.0     245,765,650
Sch E..............................................................      21,135,796      3.1       1.0         1.4         0.6       6.1     127,871,564
Sch EIC............................................................      23,026,802      0.0       0.0         0.2         0.3       0.6      13,048,521
Sch H..............................................................         436,280      1.6       0.5         0.9         0.6       3.6       1,563,337
Sch R..............................................................         592,602      0.3       0.3         0.5         0.6       1.6         967,917
Estate and Gift
706 and 706NA (Estate).............................................         121,000     12.4       7.6        14.6        10.6      45.3       5,477,267
709(Gift)..........................................................         300,000      0.7       1.1         1.9         1.1       4.7       1,410,000
Individual Totals..................................................     359,733,721       NA        NA          NA          NA        NA   2,500,554,057
--------------------------------------------------------------------------------------------------------------------------------------------------------
(Forms + Schedules)
(a) Includes 1040PC and electronically filed 1040 forms.
(b) Schedules 1-3 are included in the average time.
(c) Includes Telefiled 1040EZ forms.
(d) Application for automatic extension of time in which to file the individual income tax return.
(e) Application for additional extension of time in which to file the individual income tax return.
Source: Tax Foundation, using Internal Revenue Service data and estimation methods.

      

                                Table 4

                       Estimated Cost to Business for the Federal Income Tax System, 2001
----------------------------------------------------------------------------------------------------------------
                                 Number of    Record  Education      Form     Packaging/
          Businesses              Returns    keeping    Stage    Preparation    Sending    TOTAL    Total Hours
----------------------------------------------------------------------------------------------------------------
Sole Proprietorships
Form 1040....................    19,775,520      2.8       3.4        6.3          0.6      13.0     257,411,352
Sch C........................    15,488,696      6.0       1.4        2.3          0.7      10.4     160,824,293
Sch C-EZ.....................     2,535,193      0.8       0.1        0.6          0.3       1.7       4,352,081
Sch F........................     1,751,631      3.5       0.5        1.4          0.3       5.8      10,203,253
Sch SE.......................    19,245,221      0.3       0.3        0.4          0.3       1.3      24,216,903
Partnership
Form 1065....................     2,132,000     39.9      22.2       37.8          4.0     104.0     221,656,933
Part. Schedules
Sch D........................     2,132,000      6.9       2.2        2.4          0.0      11.5      24,518,000
Sch K-1......................     2,132,000     27.0      10.1       11.0          0.0      48.2     102,762,400
Sch L........................     2,132,000     15.5       0.1        0.4          0.0      16.0      34,112,000
Sch M-1......................     2,132,000      3.4       0.2        0.3          0.0       3.8       8,137,133
Sch M-2......................     2,132,000      2.9       0.1        0.2          0.0       3.1       6,644,733
Corporations
Forms
1120.........................     2,270,000     71.5      42.0       73.0          8.0     194.5     441,590,667
1120A........................       259,000     44.2      23.6       41.1          4.6     113.5      29,387,867
1120S........................     2,856,000     63.4      21.4       39.2          4.6     128.4     366,805,600
1120X........................        14,000     12.4       1.4        3.6          0.5      18.0         251,533
1120F........................        23,000    107.6      40.5       70.1          7.5     225.8       5,192,250
1120FSC......................         6,000     94.0      18.5       36.4          0.0     148.9         893,300
1120POL......................         5,000     17.0       5.1       12.1          1.9      36.0         179,750
1120RIC......................        11,000     56.9      18.5       34.2          4.0     113.7       1,250,700
7004 (Extension of Time) (a).     2,900,000      5.7       1.4        2.5          0.3       9.8      28,468,333
4626 (AMT)...................       363,200     18.2      12.2       13.1          0.0      43.4      15,774,987
4562 (Depreciation)..........     2,529,000     37.3       5.2        6.0          0.0      48.5     122,572,200
1120 Schedules
Sch D........................     2,270,000      7.2       4.1        6.3          0.5      18.1      41,011,333
Sch H........................       227,000      6.0       0.6        0.7          0.0       7.3       1,649,533
Sch PH.......................       113,500     15.3       6.2        8.6          0.5      30.6       3,474,992
1120S Schedules
Sch D........................     2,856,000     10.5       4.6        9.7          1.3      26.1      74,636,800
Sch K-1......................     2,856,000     15.5      10.4        2.1          1.1      29.1      83,062,000
Business Total...............    91,146,961       NA        NA         NA           NA        NA   2,071,040,927
(Forms + Schedules)
GRAND TOTAL..................   450,880,682       NA        NA         NA           NA        NA   4,571,594,984
----------------------------------------------------------------------------------------------------------------
(a) Application for automatic extension of time in which to file the corporate income tax return.
Source: Tax Foundation, using Internal Revenue Service data and estimation methods.

[GRAPHIC] [TIFF OMITTED] T5055A.003

    To put the tax compliance burden into perspective, the $140 billion 
tax surcharge is greater than the combined revenue of Sears ($40.9 
billion), Walt Disney ($25.4 billion), Microsoft ($22.9 billion), Rite 
Aid ($14.7 billion), McDonalds ($14.2 billion), 3 Com ($5.4 billion) 
and Radio Shack ($4.8 billion). Put another way, 4.6 billion hours per 
year represents a work force of over 2,235,000 people, larger than the 
populations of Dallas (1,076,000) and Detroit (965,000) combined, and 
more people than work in the auto industry, the computer manufacturing 
industry, the airline manufacturing industry, and the steel industry 
combined. This is also more people than would reside in four 
Congressional districts.
    In addition, the Tax Foundation has projected future compliance 
costs out to 2006. These projections are based on estimates published 
by the Internal Revenue Service (see Methodology section). As Shown in 
Figure 2, compliance costs will grow by almost $30 billion from $140 
billion in 2001 to $170 billion in 2006.
    To illustrate the magnitude of these compliance costs, Figure 2 
also compares the year-to-yearcompliance cost with that of the recently 
enacted tax reduction. In every year between 2001 and 2006, the total 
tax compliance cost is greater than the tax reduction. So from the 
taxpayer's perspective, the recent tax cut represents only a partial 
refund of their total tax compliance burden. The cumulative compliance 
cost over the 2001-2006 period will come to almost $930 billion while 
the cumulative tax reduction over the same period will only cover a 
little more than half the compliance costs at $550 billion.
Who Bears the Burden of Tax Compliance
    Because complying with tax laws represents a fixed cost for many 
individuals, it seems likely that lower income individuals would bear a 
greater relative compliance burden than higher income individuals. In 
previous research, the Tax Foundation has found this to be true in 
corporate compliance costs. In fact, in 1996, small corporations--those 
with less than $1 million in assets--spent at least 27 times more on 
compliance costs as a percentage of assets than the largest U.S. 
corporations. New research by the Tax Foundation finds the same is true 
for individuals.
    As shown in Figure 3, the compliance cost on individuals is quite 
regressive (see Methodology section). In other words, the compliance 
cost hits lower income individuals harder than higher income 
individuals. In fact, taxpayers with less than $50,000 of adjusted 
gross income (AGI) pay almost 60 percent of the total compliance cost 
for individuals--$37 billion of the total $65 billion compliance cost 
imposed on individuals.
    As a percentage of AGI, taxpayers with AGI of less than $20,000 are 
hit the hardest. They pay a compliance tax surcharge of over 4 percent 
of their AGI. Because compliance costs are essentially a fixed cost, 
the compliance tax surcharge falls as AGI increases. For taxpayers with 
$40,000-$75,000 in AGI, their surcharge consumes a much lower 1 percent 
of their AGI. The surcharge drops to 0.2 percent for taxpayers with an 
AGI of over $200,000.
    This result occurs for two reasons. First, 75 percent of all 
returns are filed by taxpayers with less than $50,000 in AGI. Secondly, 
taxpayers with less than $50,000 in AGI only account for 33 percent of 
total AGI. Therefore, the fixed cost nature of tax compliance has a 
larger negative impact on lower income individuals.
    Again, for illustrative purposes, the distribution of the 
individual compliance costs is compared to the distribution of the 
recent tax reduction. This comparison is made for year 2001 which is an 
appropriate comparative year because the majority of the tax cuts were 
aimed at individuals--particularly lower income taxpayers with the 
retroactive implementation of the lower 10 percent bracket.
    Figure 3 reveals that a more effective way to provide tax relief to 
lower income taxpayers is via tax simplification. In fact, nearly half 
of all the tax surcharge savings resulting from tax simplification 
would go to taxpayers with less than $40,000 in AGI. For example, Form 
1040--which accounts for almost half of the tax compliance burden on 
individuals--takes nearly 13 hours to complete. Every hour shaved off 
the 1040 would save taxpayers over $2 billion. A mere 3 hour savings 
would net a ten-year $60 billion windfall for taxpayers--at zero cost 
to the U.S. Treasury. Every hour shaved would also save taxpayers some 
80 million hours a year--time better spent with family or tending to 
business.
Measures to Reduce the Cost of Compliance
    What can be done to reverse the current situation? To reduce tax 
compliance costs, lawmakers and regulators must focus on the causes of 
tax complexity. One set of causes is economic and the other set is 
political.
    As explained earlier, the economic causes of complexity are 
inherent in an income tax itself. The tax base questions, ``What is 
income?'' ``When is it income?'' are difficult to answer--especially on 
the corporate side. The inherent difficulty of these questions explains 
why, for example, the rules of depreciation and the rules of transfer 
pricing associated with foreign-source income create such mind-boggling 
tax code complexity.
    However, the political process, particularly the politics the 
deficit/surplus debate, has made an inherently complex tax system 
worse. To a vast degree, the complexity of the current tax code is a 
by-product of the era of chronic federal budget deficits. The drive to 
balance the budget placed a policy emphasis on increasing on increasing 
government revenue, rather than on refining and promulgating consistent 
definitional answers about income. In this sense, tax policy has become 
tactical rather than strategic. Tax policy has no unifying theme. 
Instead, the budgetary aspects of dealing with the tax system are 
generally controlling the policy process.
    This past budgetary dynamic has combined with the issue of tax 
fairness and the normal course of lobbying to accelerate the trend of 
``created complexity'' and the artificial expertise that necessarily 
accompanies it. And this artificial expertise creates its own problems 
with regard to tax code complexity.
    The interplay of these forces works something like this: Under 
budgetary rules, nothing can be done unless it is paid for. To date, 
however, cutting spending has rarely been a realistic political option, 
so inventive ways are found to raise revenue. Often, such revenue-
raising exercises amount to broadening the tax base in some ad hoc or 
indirect way--like the AMT--since raising rates or removing tax 
preferences in a straight-forward manner would face clear and powerful 
opposition.
    Naturally, when the individuals or businesses that will be affected 
by the tax changes get wind of the proposals, they lobby to change the 
proposal, or shift the tax burden altogether. These activities may 
further contort the tax proposals.
    When the final provisions are passed into law, the regulating 
agencies must devise ways to administer them. When the regulations are 
drawn up so as to be comprehensive--that is, when they attempt to cover 
every contingency while attempting to assure a zero possibility that a 
taxpayer can avoid taxation--the result is complex regulation 
superimposed on complex (or vague) legislation.
    The net result of this process over time, is that few, if any, of 
the tax writers--the ``artificial'' experts--understand the mechanics 
of the entire tax code. The tax writing specialists become comfortable 
in dealing only with their own narrow specialty. Tax specialists begin 
writing detailed rules with other tax specialists in mind. This narrow 
focus explains why, on occasion, there are complete inconsistencies in 
the Internal Revenue Code. No one person is capable of grasping the 
entire body of law. In this way,complexity seems to beget further 
complexity.
    Short of overhauling the entire federal tax system, Congress can 
work to reduce the complexity of the current tax system (and, 
therefore, its high compliance costs) through two courses of action. 
First, Congress should strive to achieve a much larger measure of tax 
stability. Although not measured in this testimony, the taxpayer 
uncertainty that results from frequent tax law changes is a key source 
of complexity. Second, legislators and regulators should place a larger 
emphasis on tax simplicity. There exists an inherent trade-off between 
completeness and simplicity. In their steady pursuit of tax revenue and 
tax ``fairness,'' legislators and regulators have emphasized 
completeness by trying to shut off all avenues of tax avoidance without 
regard to the incremental costs or unintended consequences of such an 
approach to governance.
Conclusion
    Current forecasts of compliance costs on taxpayers reveal a large 
and growing tax compliance surcharge over the next few years--from $140 
billion in 2001 to $170 billion in 2006. In 2001 alone, this surcharge 
amounted to nearly 12 percent of all income tax revenue collected.
    In addition to the tax surcharge, the tax complexity due to the 
size and instability of the tax code creates two other types of 
economic costs--costs not measured in this testimony, but significant 
enough to keep in mind. One is the overhead cost associated with the 
economically sterile exercise of tax planning, compliance and 
litigation. The second cost results from the economic opportunities 
that are foregone because of taxpayer uncertainty.
    In conclusion, the benefits of reducing the tax complexity burden 
would dramatically benefit lower income taxpayers since they bear a 
disproportionate amount of the burden. In essence, taxpayers could 
enjoy a tax reduction via tax simplification--at zero cost to the U.S. 
Treasury. This could be done under a comprehensive revision of the tax 
code guided by established tax principles, such as those supported by 
the Tax Foundation. In addition, such tax reform would diminish the 
need for corrective tax legislation in the future and thereby increase 
the stability in the tax code and regulations.
Methodology
    The federal income tax compliance cost estimate is based on data 
from the Internal Revenue Service. Table 3 compiles a list of the core 
individual income tax forms along with both the estimated paperwork-
burden calculation (in hours of compliance time) generated by the 
Internal Revenue Service. It also reports IRS projections for 2001 of 
the number of tax returns by type. Table 4 compiles a similar list for 
the business sector. These lists are far from exhaustive. Not only are 
many obscure forms and schedules left out, but the lists are also 
incomplete to the degree that adequate tax return information could not 
be obtained or estimated for the many schedules and forms that are 
common auxiliary components of the core forms.
    One trend in tax filing has been the growth in alternative methods 
of filing--the tele-file and the e-file. These filing methods primarily 
affect the delivery of the tax filings rather than the filings 
themselves. In the case of the tele-file, the 1040EZ must be used in 
order to file over the phone. As such, all tele-filed forms were 
counted under the 1040EZ form. In the case of the e-file, both the 1040 
and 1040A forms can be filed electronically. Unfortunately, no data is 
available to break down the types of e-filings. In order to keep the 
time estimates on the conservative side, all e-files were counted as 
1040 filings (as the 1040 requires less time to file than the 1040A).
    Once the total number of hours spent on compliance has been 
determined, an hourly rate is then applied in order to determine the 
cost of compliance. This hourly rate was determined in one of two ways.
    First, for individuals who filed themselves, the report uses their 
hourly compensation rate (wages and salary plus benefits) as a proxy 
for their ``tax surcharge.'' Some may argue that individuals would 
value their time more highly than their hourly salary rate since it is 
their leisure time (time not spent in formal work) that is given up to 
file taxes. However, to avoid speculation, we believe that the hourly 
compensation rate represents the best estimate of a minimum compliance 
cost level for individuals.
    Utilizing data from the National Compensation Survey and Employment 
Cost Index published by the Bureau of Labor Statistics, the Tax 
Foundation estimates a national hourly wage and salary rate of $16.22. 
In addition, utilizing data from the National Income and Product 
Accounts published by the Bureau of Economic Analysis, the Tax 
Foundation estimates that benefits increase total compensation by 18.4 
percent, for a total hourly compensation rate of $19.20.
    Second, for filings made by tax professionals, the report uses the 
average compensation rate for tax accountants. Unfortunately, the 
National Compensation Survey does not list ``tax accountants'' as a 
separate occupation. Therefore, the Tax Foundation estimates their rate 
by averaging ``accountants and auditors'' and ``lawyers'' together--
since tax accountants must be adept not only in accounting procedures, 
but also in interpreting tax law and court rulings. This yields an 
hourly wage and salary rate of $29.27. After adjusting this wage to 
include benefits, a final hourly compensation rate of $34.66 is 
reached.
    To derive the final average compensation cost for individual 
filings, the report also takes into account the number of forms 
prepared by individuals and those prepared by tax professionals. The 
latest IRS data shows that 56 percent of all forms are prepared by tax 
professionals. Using a weighted average, the final compensation cost is 
$24.14. For businesses, the average compensation cost is the rate 
derived for the average tax accountant--$34.66.
    The compensation cost was initially derived for 1999. In order to 
project the compensation cost out to 2006, the cost was conservatively 
scaled up by the estimated rate of inflation as published by the 
Congressional Budget Office. The projections for the number of forms 
filed by type were taken from the Internal Revenue Service's own 
estimates. The hourly estimates for the projections were taken from the 
2000 forms and held static throughout the projected time-span--as such, 
recent policy changes are not incorporated into the hourly form 
estimate.
    The income distribution of income tax compliance costs is the 
result of an allocation model developed by the Tax Foundation utilizing 
data published by the Internal Revenue Service--Individual Income Tax 
Returns, 1998. Utilizing this data, the model allocates every IRS form 
examined in the compliance study by income cohort.

                                

    Chairman Houghton. Thank you very much, Mr. Moody. Mr. 
Steuerle and Mr. Gale, we just have to suspend for a moment. We 
will be back as soon as this vote is over. Thank you.
    [Recess.]
    Chairman Houghton. OK. Gentlemen, thank you very much for 
your patience. We would like to continue the hearing. Mr. 
Steuerle, if you would like to give your testimony, we would 
appreciate it.

STATEMENT OF C. EUGENE STEUERLE, SENIOR FELLOW, URBAN INSTITUTE

    Mr. Steuerle. Thank you, Mr. Chairman. It is an honor for 
me to be here today, in part because earlier in my career I 
worked extensively with this Subcommittee on tax simplification 
in the late '70s. So the issue is not a new one. But I am 
always honored to work with the Subcommittee. Its work is 
always well respected, although often little recognized as 
well.
    Ever the bridesmaid, simplification seems never to get the 
attention it deserves no matter which political party is in 
power. It would be a mistake, however, to fault elected 
officials for pursuing broader agendas. Government does not 
exist to simplify itself. It is entirely appropriate for policy 
to be the handmaiden to broader budget and economic policy. 
Nonetheless, almost everyone would agree that simplicity has 
been given far too little weight in the legislative process, 
leading to substantial waste and taxpayer cynicism.
    In my oral remarks I will focus only on certain parts of my 
written testimony: the importance of reforming processes if 
simplification is to be attained, and how simplification may 
offer an ideal way to give direction to what otherwise could be 
a rather chaotic tax process over the coming months and years.
    While some complexity in the tax law is inevitable at its 
heart, excessive complexity is a failure of process. This 
process failure could be mitigated by the adoption of certain 
executive branch and congressional procedures that would grant 
simplicity a higher priority. I give several examples in my 
testimony: Upgrading the biennial report for the study of the 
overall state of the Federal tax system and publishing it 
annually much as the Congressional Budget Office used to 
publish potential expenditure cuts and tax increases to deal 
with the deficit problem; improving the requirement under the 
government Performance and Results Act 1993 for Treasury to 
apply a performance plan to the many programs listed in the tax 
expenditure budget; encouraging IRS to make much greater effort 
to analyze the programs under its control and take greater 
responsibility for reporting on their success or failure; 
giving simplification greater weight in the legislative process 
by continually providing some witnesses who focus solely on 
simplification; requiring IRS to produce mock tax forms before 
passage of final legislation; and give higher status to the 
Joint Committee's tax complexity analysis.
    Despite the trend toward increased complexity, significant 
tax simplification has a good chance of being passed some time 
in the near future. I remain an optimist. The first Secretary 
of the Treasury, Alexander Hamilton, had it right. ``The truth 
is,'' he asserted, ``in human affairs there is no good, pure 
and unmixed; every advantage has two sides.'' So, let me argue, 
does every disadvantage. The seed that could sprout into major 
simplification is in one of the worst failures of the recent 
legislation: the extraordinary growth scheduled in the number 
of taxpayers subject to the AMT. But follow the scenario out a 
little bit. As millions of taxpayers get added to the AMT rolls 
every year, public ire will be aroused over perceived unfair 
treatment. Americans do not take kindly to the notion that 
their dependents or forced payments are taxes to State and 
local governments or tax shelters. Accordingly, something will 
be done to fix the AMT despite all the difficulty.
    At issue, though, is what type of bill will contain it. A 
large AMT fix by itself would mainly lower taxes for those with 
incomes still well above the average. Previous Presidents and 
Congress have shied away from any bill that could cater only to 
higher income groups. Any politically feasible AMT fix 
therefore probably also has to do something for taxpayers in 
other income classes. But AMT reform isn't a natural fit, say, 
with offering deductions for the middle class. The most logical 
way to help those less well off at the same time would be 
through across-the-board simplification.
    Moreover, there is another issue at stake: gaining control 
of the agenda. There are going to be a lot of tax proposals 
that this Subcommittee and the fuller Committee are going to 
have to deal with in the nearfuture. Simplification offers some 
chance of channeling this momentum, limiting the amount of special 
interest legislation, and keeping the focus on the attainment of a more 
efficient tax system. If Hamilton could see a national blessing in a 
national debt, then surely some modern President, Secretary of the 
Treasury or congressional leader will recognize that rising tax 
complexity itself presents an opportunity to advance tax simplification 
legislation before taxpayers rebel.
    In sum, process reforms can accord simplicity more weight 
in the legislative process, in Treasury analysis and in IRS 
research. And the mandate for AMT relief could catalyze a much 
broader attack on the complexity of the tax system for all 
taxpayers, from poor to rich. As a practical matter 
simplification offers the President and congressional leaders a 
focus that could channel what could otherwise become a more 
chaotic tax policy process into an effort producing significant 
efficiency gains for the American economy. Thank you.
    [The prepared statement of Mr. Steuerle follows:]
    Statement of C. Eugene Steuerle*, Senior Fellow, Urban Institute
    Mr. Chairman and Members of the Subcommittee:
---------------------------------------------------------------------------
    * Senior Fellow, The Urban Institute, columnist for The Financial 
Times and Tax Notes Magazine, and First Vice-President, National Tax 
Association. Portions of this testimony were first discussed in Tax 
Notes and the Financial Times. Any opinions expressed herein are solely 
the author's and should not be attributed to any of the organizations 
with which he is associated.
---------------------------------------------------------------------------
    The 2001 tax act was only one in a long series of tax laws 
complicating an already byzantine tax system. Ever the bridesmaid, 
simplification seems never to get the attention it deserves, no matter 
which political party is in power--mainly because broader agendas are 
always being pursued.
    It would be a mistake, I believe, to fault elected officials for 
pursuing those broader agendas. That is their job. Government doesn't 
exist to simplify itself. It is entirely appropriate for tax policy to 
be the handmaiden to broader budgetary and economic policy, whether the 
issue is rate reduction in 2001 or deficit reduction in 1993. Moreover, 
simplification is merely one principle among several, sometimes 
conflicting, principles. For example, taxing all income on an equal 
basis generally makes the tax more efficient and fair. But carried to 
an extreme, it can add to complexity.
    Still, in pursuing broader objectives and balancing principles, 
almost everyone would agree that simplicity has been given far too 
little weight in the legislative process. Many items in the tax law add 
significant complexity with little gain in achieving any other 
legislative goal. Almost no one would introduce many of the provisions 
now in current law, if designing a code from scratch. But once there, 
these complexities are hard to remove.
    Complexity creates waste, not merely cost. Here one must 
distinguish between costs that might provide benefits and those that do 
not. A transfer of $1 from me to you may cost me $1, but there is an 
offset in the $1 that you pick up. Waste--including extra time and 
effort--involves resources that are simply lost to everyone. Professor 
Joel Slemrod of the University of Michigan and the National Tax 
Association has concluded that for each $100 of tax collected, we spend 
about $10 in time, effort, and administrative costs. Another cost, 
although more subtle, is taxpayers' resentment from filling out an 
unreasonable number of forms. Needless tax complexity increases their 
cynicism toward government and frustrates a healthy relationship 
between a citizenry and its government.
    My testimony will concentrate on four items. First, I will give two 
examples from recent legislation of how complexity arises. Second, I 
will suggest ways that I believe that the process can be reformed to 
give greater weight to simplification. Third, I will argue that 
simplification could unify and give direction to tax policy efforts in 
the near future. Furthermore, I will show how the inevitable need to 
deal with the Alternative Minimum Tax (AMT) could trigger 
simplification reform. And, finally, I will list some of the items that 
should be addressed when reform comes. The last list is not 
comprehensive, and many of the issues are covered elsewhere, including 
the recent Joint Committee report on simplification.
Two Examples of How Complexity Arises in the Tax Process
    Example 1: Excessive Complexity in the Refundable Child Credit. 
During the legislative process leading to the 2001 tax cut, a number of 
members of Congress and private groups sought relief for those with 
incomes too low to pay income tax. The result was a provision that 
allowed the new child credit to be partially refundable, along with the 
retention of an alternative method of calculating a refundable child 
credit for taxpayers with more than two children. But combining this 
new credit with the refundable earned income tax credit (EITC), while 
retaining an alternative child credit, adds whole layers of complexity 
to a tax system for low- and moderate-income Americans that is already 
among the most complex possible.
    If Congress wants to channel refundable dollars to this portion of 
the population, three options could achieve roughly the same 
distributional and revenue effects:
           Simplest of all, adjust the EITC--in particular, by 
        slowing down the rate at which the credit phases out, which for 
        many taxpayers effectively adds a 21 percent tax rate on 
        additional earnings;
           Next most simple, add on the new refundable child 
        credit but remove the older, scarcely used and exceedingly 
        complex, form of the refundable child credit that applies to 
        households with more than two children; and
           Not so simple, add a new refundable child credit, 
        but give taxpayers the option of the alternative child credit 
        if they have more than two children, and add these two child 
        credit calculations to the EITC calculation already required.
    Almost all analysts and students of tax policy, conservative or 
liberal, Republican or Democrat, agree that the first option would work 
best and the second would be the next most preferable. Congress, 
nonetheless, chose the third, most complex, option. Bad intentions 
weren't at play, but simplicity didn't receive its due in the 
bargaining process. Here were the logical steps that led to the final 
result:
           First, the President and leaders of Congress wanted 
        to prevent the tax bill from being overwhelmed with additional 
        provisions. They sought to limit amendments only to the main 
        items put forward by the President (e.g., rate relief, the 
        child credit, marriage penalty relief). They interpreted this 
        process rule to mean that major amendments to the EITC, other 
        than marriage penalty relief, were not allowed.
           Second, substantial dollars were being offered in 
        the form of a child credit. Many thought it would be easier to 
        explain that low-income households got some portion of the new 
        child credit rather than that taxable households got the child 
        credit but that others got a slower phase out of the EITC. In 
        fact, the EITC is close to a child credit in design, although 
        its phase-in and phase-out schedules would have to be adjusted 
        to achieve roughly the same net result.
           Third, the spirit of the tax bill was one of 
        ``creating no losers.'' Every tax break was to be a reduction 
        in rates or an additional credit or deduction patched onto the 
        existing system--no one would face additional tax. Hence, 
        Congress decided also to keep an old child credit for those 
        with more than two dependents to cover the few cases where that 
        calculation might yield a higher credit than the new refundable 
        child credit.
    Note that each of the first two goals--to circumscribe what would 
be considered in the bill and to grant some share of new credits to 
lower-income individuals--is perfectly reasonable when considered by 
itself. The problem is that simplicity was not given much weight in the 
process; no one had strong authority to come forward with easier ways 
to pursue the goals. The third objective--creating no losers anywhere--
almost guarantees that systems will grow more complex since new options 
are not allowed to supersede older ones.
    Example 2: The Alternative Minimum Tax. The alternative minimum tax 
(AMT) problem keeps growing in size, not because anyone really likes 
it, but rather, because no one wants to bear the cost of addressing it. 
If you will allow me to generalize, Republicans would be glad to get 
rid of the AMT or have a skeletal representation. But, historically, 
given a choice between lower statutory rates and fixing the AMT, they 
will choose lower statutory rates. Democrats, of course, would be glad 
to have some AMT fix also. They simply don't want to give away any more 
money to those in the upper-income brackets or to pay for it by giving 
up other tax breaks that they favor too. Given a choice between a bill 
with an AMT fix and a less progressive distribution of taxes and one 
without an AMT fix and more progressivity, so far they have chosen the 
latter.
    In a sense, both political parties get what they want: the 
Republicans get some of the statutory rate cuts they want and the 
Democrats maintain some of the progressivity they seek. The AMT 
provides the funding to do both. This is how it's been for a long time 
now; the recent tax bill is only the latest act in the drama. The 
current tax bill gave tax cuts with one hand (mainly statutory rate 
reduction) and then took some of them back with the other (the AMT). 
But this wasn't the first time, and everyone plays the game.
    What's going to end the game? With or without a broader agenda on 
which to hang the AMT reform, it's going to require movement beyond 
current positions. For some, it will mean accepting a somewhat less 
progressive system. For others, it will require accepting higher 
statutory rates. Once again, progressivity and lower rates are both 
legitimate goals or principles. Simplification is simply going to have 
to be given more weight when choices among competing principles are 
made.
Process Reforms
    Out of the thousands that could be cited, the two examples just 
presented imply that while some complexity in tax law is inevitable, at 
its heart, excessive complexity is a failure of process. This process 
failure could be mitigated by the adoption of certain Executive Branch 
and Congressional procedures that would grant simplicity a higher 
priority in the policy process. More fiduciary-like responsibility 
needs to be assessed and formalized in specific ways. Below, I list two 
types of process reforms: (1) those that would involve periodic 
reporting on existing law; and (2) those that would apply to new 
legislation. Of course, in the end, what makes any process work is the 
good will of the parties involved to see that its spirit is maintained.
Periodic Reports
     My first suggestion is that the biennial requirement for a 
study of the overall state of the federal tax system (if funded by the 
Appropriations Committee) should be upgraded in status. It should be 
published every year much as the Congressional Budget Office used to 
publish potential expenditure cuts and tax increases to deal with the 
deficit problem. The list should receive continual updates, and options 
over time should be spelled out in greater detail and variety. By 
raising the status of such a list, tax simplification is liable to get 
the greater attention it deserves, year after year.
     The Government Performance and Results Act of 1993 
requires a performance plan review that has been extended on an 
embryonic basis to Treasury's tax expenditure budget. Treasury has made 
some very tentative steps here, though officials complain about the 
lack of data. While it would be foolish to think that Treasury could 
study each of these programs adequately each year--Congress continually 
mandates studies without providing the resources to back up the 
mandate--a cycle could be established so that each would be reviewed 
periodically.
          At the same time, I believe there is a fundamental failure in 
        the IRS administrative structure that leads to Treasury's 
        complaints about inadequate information and, indirectly, to 
        some of IRS' internal management problems. That defect is IRS' 
        failure to partially organize itself by program. Currently, IRS 
        organizes itself by tax return category or type of taxpayer, 
        not by the programs under its administration. It prepares few 
        analyses of these programs and takes no responsibility for 
        their success or failure because of its excessive focus upon 
        itself only as a tax collector. Only indirectly do we find out 
        about these programs, as when IRS measures error rates by line 
        item on returns. It is not surprising, then, that IRS almost 
        always ends up behind the 8-ball when Congress suddenly decides 
        to examine the effectiveness of, say, the Earned Income Tax 
        Credit, the tax exclusion for employer-provided health 
        insurance, or the compliance costs imposed upon charities.
          IRS sometimes excuses itself by saying that it is in charge 
        of administration, whereas Treasury and the White House set 
        policy. I have some sympathy with this argument, but it is 
        weak. No one can properly administer a program without 
        understanding how target efficient it is and analyzing the 
        costs of administration for both the government and its 
        customers. IRS does not have to make any judgment on the policy 
        itself--just on who gets the benefits, the costs of 
        administration, and error rates (both underclaims and 
        overclaims). In effect, it has responsibility for better 
        development and dissemination of the information it acquires in 
        administering the programs.
          IRS is also scared to put out reports on administrative 
        effectiveness. In reporting on the EITC during the 1990s, for 
        instance, it knows that both former President Bush and 
        President Clinton favored an increase in the grants made under 
        this program. It's not going to make the political mistake of 
        rushing out a report on problems associated with the 2001 tax 
        rebate. And so on. Unless a regular reporting schedule is 
        mandated, IRS will fear that the timing of any report release 
        will appear to be politically motivated by one side or the 
        other.
Reporting on New Legislation
    Here, in turn, are some methods for giving simplicity greater 
weight in the legislative process:
           Testimony on proposed bills should always include at 
        least some witnesses who focus solely on the simplification and 
        administration issues. Although affected persons should be 
        invited, some witnesses should be more impartial and not 
        represent stakeholders.
           When the markup of a bill occurs, one individual at 
        the witness table should have the sole assignment of providing 
        information on the administrative aspects of the bill. This 
        individual might be from the IRS, the Treasury's Office of Tax 
        Policy, or the Joint Committee on Taxation.
           Before going to conference, the IRS should produce 
        mock tax forms showing exactly what has been wrought from bills 
        produced in both houses. Changes in number of users of forms 
        and line items should also be provided, when possible.
           In conference committee, one person at the witness 
        table should be held responsible for providing information only 
        on the simplification aspects of the bills from both chambers 
        of Congress.
           The Joint Committee is required to provide a ``Tax 
        Law Complexity Analysis'' after reports on bills are filed. 
        This assessment somehow needs to be given higher status in the 
        legislative process itself. One option might be to devote one 
        day of hearings to this type of analysis near to completion of 
        a tax bill.
    In sum, if simplification is important, then processes must be set 
up to insure that it is given attention and that needed resources are 
devoted to tracing potential and actual failures. I am hopeful that 
this subcommittee will devote some attention to these process efforts 
and not merely concentrate on items worthy of reform.
    Of course, no process reform guarantees that simplification will 
occur. Nor, as I noted in my opening remarks, should simplification be 
the only factor under consideration. Nonetheless, a combination of 
some, if not all, of these procedures could help deter new sources of 
unnecessary complexity and spur the types of simplifications this 
subcommittee seeks.
Momentum for a Simplification Bill
    Despite the trend toward increased complexity, significant tax 
simplification has a good chance of being passed sometime in the near 
future. The first Secretary of the Treasury, Alexander Hamilton, had it 
right. ``The truth is,'' he asserted, ``in human affairs there is no 
good, pure and unmixed; every advantage has two sides.'' So, let me 
argue, does every disadvantage. The seed that could sprout into major 
simplification is in one of the worst failures of the recent 
legislation: the extraordinary growth scheduled in the number of 
taxpayers subject to the Alternative Minimum Tax (AMT).
    Under the AMT, a taxpayer calculates a separate tax on a different 
and narrower tax base than the regular income tax. He or she then pays 
the higher of the two. The AMT grows much faster than the regular tax 
because its exemption levels grow more slowly. Meanwhile, the new tax 
cut will make it more likely still that the AMT will be higher than 
regular tax. Thus, millions of taxpayers will get a far smaller tax cut 
than they anticipate. The AMT basically cancels out many of the 
benefits of the new lower rates in the regular income tax.
    According to the Joint Committee on Taxation, the number of 
taxpayers subject to the AMT will grow from 1.4 million today to 5.3 
million in 2004 to 19.6 million in 2006 to 35.5 million in 2010. 
Moreover, the revenues to be paid under that tax are also scheduled to 
grow into tens of billions of dollars. What puts more and more 
taxpayers under the AMT are not the ``tax shelters'' it was designed to 
expose but such simple items as dependent exemptions and state and 
local tax deductions, which the AMT doesn't allow.
    For the immediate future, rude surprises are inevitable for 
taxpayers expecting palpable relief. And help is not on the way. With 
the decline in revenues as the 2001 tax legislation is phased in, and 
the increase in spending on national defense, drug benefits for the 
elderly, and new and expanded educational programs, not a lot is left 
over to pay for simplification.
    But lets play this scenario out a bit. As millions of taxpayers get 
added to the AMT roles every year, the level of protest is going to 
rise quite rapidly. Nothing arouses public ire more than perceived 
unfair treatment, and Americans don't take kindly to the notion that 
their dependents and forced payments of taxes to state and local 
governments are tax shelters. Take my word for it: something will be 
done to fix the AMT despite all the difficulty.
    At issue, though, is what type of tax bill will contain it. A large 
AMT fix by itself would mainly lower taxes for those with incomes above 
$70,000, still well above the average income. Previous Presidents, 
including Bill Clinton and the senior George Bush, as well as both 
Democratic and Republican Congresses, have shied away from any bill 
that would cater only to higher income groups. Even the 2001 
legislation was pitched as applying to taxpayers in all income classes.
    Any politically feasible AMT fix probably also has to do something 
for taxpayers in middle and lower income classes. But AMT reform isn't 
a natural fit with, say, expanding welfare benefits or offering special 
deductions for the middle class. The most logical--perhaps the only 
logical-- way to help the less well off too would be across-the-board 
simplification.
    Congress and the President are going to have to simplify taxes one 
way or the other. Moreover, there's another issue at stake: gaining 
control over the agenda. There are going to be a lot of tax proposals 
put forward in the near future. Simplification offers the President, as 
well as Congressional leaders, some chance of channeling this momentum, 
limiting the amount of special interest tax legislation, and keeping 
the focus on the attainment of a more efficient tax system.
    Smart politicians will see personal opportunity in taking a lead 
and setting the agenda. If Hamilton could see a ``national blessing'' 
in a national debt, then surely some modern President, Secretary of the 
Treasury, or Congressional leader will recognize that rising tax 
complexity itself presents an opportunity to advance tax-simplification 
legislation before taxpayers rebel.
IV. A Few Candidates for Reform
    In addition to the alternative minimum tax noted above, among the 
many sources of needless complexity today are the following:
           Phase-out after phase-out of such allowances as 
        earned income tax credits, eligibility for IRAs, eligibility 
        for other saving incentives, eligibility for educational tax 
        breaks, as well as the itemized deductions and personal 
        exemptions temporarily dealt with in the 2001 legislation. Each 
        of these phases-outs operates like an additional mini-tax 
        system all to itself.
           Pension and saving incentives that add 
        administrative costs and possibly even reduce net saving by 
        providing different rules for withdrawals, penalties, Social 
        Security tax treatment, allowableamounts of exclusion or 
deduction, and so on.
           A tax treatment of dependent children that 
        needlessly makes millions of Americans file unnecessary tax 
        returns;
           A capital gains tax law calibrated by 7 different 
        tax rates and requiring taxpayers to fill out pages of forms 
        even when they have only a few dollars of gains;
           A multiple choice system of taxation of mutual fund 
        gains, as opposed to a single system whereby mutual funds could 
        accurately report total gains from all transactions (not just 
        gross sales) to their account holders and to IRS;
           Multiple educational tax breaks that are poorly 
        coordinated with each other and with direct educational 
        expenditures, thus requiring duplicate administration and 
        complexity for students, parents, educators, and the IRS;
           Complicated rules for charitable deductions and 
        charities, including multiple limits on giving as a percentage 
        of income and a perverse excise tax on foundations that 
        actually discourages charitable giving;
           Child credits and dependent exemptions that could 
        easily be folded into one, and, even more appropriately, folded 
        into the earned income tax credit (EITC), and
           Unnecessarily strict estimated tax rules that pick 
        up very little extra revenue for all the complexity they 
        introduce.
Conclusion
    Simplification is achievable if given enough attention and effort. 
Process reforms can accord simplicity more weight in the legislative 
process, in Treasury analysis, and in IRS research. The good news in 
all this bad news is that the tax system has now become so complicated 
that almost any new legislation can make taxes simpler on balance. And 
the mandate for AMT relief could catalyze a much broader attack on the 
complexity of the tax system for all taxpayers, from poor to rich. As a 
practical matter, simplification offers the President and Congressional 
leaders a focus that could channel what could otherwise become a more 
chaotic tax policy process into an effort producing significant 
efficiency gains for the American economy.

                                

    Chairman Houghton. Thank you very much. Mr. Gale.

    STATEMENT OF WILLIAM G. GALE, JOSEPH A. PECHMAN FELLOW, 
                     BROOKINGS INSTITUTION

    Mr. Gale. Thank you very much, Mr. Chairman. I appreciate 
the opportunity to be here this afternoon, and I want to 
emphasize that I think the attention given to tax 
simplification is a welcome development.
    I would like to structure my comments around what I view as 
the fundamental paradox of tax simplification, and that is, on 
the one hand, probably the only single thing about tax policy 
that everyone agrees on is that the tax system is too 
complicated. On the other hand, every year the tax system gets 
more complicated rather than less complicated. I think this 
paradox needs to be kept in mind in all tax simplification 
discussions, and I think it motivates several questions and 
answers regarding why taxes are complex and how we might make 
taxes simpler.
    So let's start with the first question. If everyone thinks 
taxes should be simpler, why are taxes so complicated? Gene has 
pointed to process reasons. I want to point to policy reasons, 
and that is taxes are complicated because policy makers run 
into tradeoffs between simplifying taxes and other policy 
goals.
    For example, the simplest tax would be an equal lump sum 
tax on each person, a single dollar amount per year. We don't 
have a tax like that and no other country has a tax like that. 
When England had a tax like that it created riots and it was 
repealed. Rather, all countries tailor tax burdens to the 
characteristics of individual taxpayers. Why? Because it is 
thought to be fairer. Well, it may in fact make taxes more 
fair, but it also makes them more complicated. It requires 
tracing consumption or income from the business sector to the 
individual, it requires reporting and documenting individual 
characteristics such as marital status, number of dependents, 
age, the composition of expenditures, the composition of 
income, et cetera. But if we want to impose taxes on an 
individual basis, we are stuck with some additional complexity 
compared to imposing an equal lump sum tax per person. So in 
essence policy outcomes balance one goal again the other and 
simplicity often comes up short in those outcomes.
    This leads me to two implications for thinking about tax 
complexity. The first is that the fundamental question is not 
how complicated the tax system is. Rather the question is are 
we getting good value for the complications that are out there. 
That is, some complications are probably worth the cost and 
some complications aren't. In that regard you might think of 
tax complexity as like air pollution. It is an unfortunate, 
undesirable consequence of other things that we happen to like 
as a society. Just as we couldn't get rid of all pollution 
because that would mean we couldn't produce many of the things 
we would actually like, it is also not realistic to think that 
we can get rid of all tax complications. Nevertheless, just as 
we look for the most efficient ways to make the world cleaner, 
we should also look for the most efficient or fair way to 
simplify taxes.
    The other issue to think about is that the factors that 
generate complicated tax systems, which are these policy 
tradeoffs and politics and taxpayers' desire to cut their own 
taxes, are not features of specific tax policies per se. If we 
went to a flat tax or sales tax or any other system, those 
features would be part of the landscape and therefore the scope 
for simplification I think in a realistic sense is limited by 
these policy tradeoffs. I would caution you to be very 
skeptical of claims that some other tax system which has never 
existed, never been tried anywhere in the world, would actually 
turn out to be very simple. Unless you can repeal politics at 
the same time you repeal the Tax Code, you are likely to end up 
with a very complicated tax system in one way or another.
    My testimony outlines the various ways that the recent tax 
bill makes taxes more complicated. I won't harp on that here 
except to mention that the new tax law also made it more 
difficult to simplify taxes in the coming years precisely 
because it uses so much of the revenue from the projected 
budget surpluses for other purposes. So I view the recent Tax 
Act as not just a missed opportunity to simplify the tax system 
but a tax law that actually made the system worse and made the 
prospects for simplifying even more difficult.
    As you think about simplifying the tax system I would 
suggest two principles: One is to make fewer distinctions 
across economic activities and personal characteristics. This 
would suggest that taxes be imposed on a broad base at 
relatively low rates that don't vary by income source or 
expenditure type or person type. It should be embodied in the 
rate structure and the tax base, not in the design of specific 
provisions. The other principle I think, especially in light of 
the recent Tax Act, is that revenue neutral tax simplification 
not only can but should now be undertaken, and I would add that 
simplification that is revenue neutral and distributionally 
neutral would likely be the most compelling.
    In terms of specific reforms, my proposal outlines a 
variety of them. They are not that different from the JCT 
proposals. I do want to emphasize the possibility that filing 
and recordkeeping could be enhanced by consideration of return 
free tax systems and/or by significantly raising the standard 
deduction. The last thing I would like to toss out on a more 
speculative note is that, for a lot of these simplification 
ideas, we just don't know if they work or not. If Congress 
would take, say, one-half of 1 percent of all tax cuts and 
devote those revenues to tax simplification experiments to find 
out which proposals work, which proposals don't, how to design 
a provision to make it simpler, I think that could actually 
reap very large policy dividends.
    Thank you very much.
    [The prepared statement of Mr. Gale follows:]
    Statement of William G. Gale, Ph.D., Joseph A. Pechman Fellow, 
                         Brookings Institution
    My analysis of tax simplification has been influenced by 
discussions and collaborative research with Len Burman, Janet 
Holtzblatt and Joel Slemrod. The views expressed are the author's and 
should not be ascribed to other researchers, or to the trustees, 
officers, or staff of the Brookings Institution.
    Mr. Chairman and Members of the Committee:
    Thank you for providing me with the opportunity to present my views 
on issues and options related to simplification of the tax code. My 
testimony is divided into two sections. The first provides a summary of 
my principal conclusions; the second provides the economic analysis 
that supports these views.
Summary
Basic issues
           Although everyone thinks that the tax system should 
        be simpler, almost every year taxes becomes more complex. This 
        suggests that pleas for simplification need to be buttressed by 
        an understanding of the causes of complexity and the likely 
        outcome of simplification efforts.
           Simpler taxes have numerous benefits. They would 
        reduce taxpayers' of complying with the tax system in terms of 
        time, money, and mental anguish. They would likely raise the 
        use of tax subsidies--say, for education--and reduce tax 
        evasion. And they would likely let people see the tax system as 
        fairer.
         But the fundamental question is not the overall level 
        of complexity; rather it is whether particular tax provisions, 
        tax systems (or alternative means of providing government 
        services, such as spending or regulations) provide good value 
        for the complexity they create. This depends on the magnitude 
        and incidence of the costs and benefits of complexity, where 
        the benefits include the extent to which complexity aids in 
        achieving other policy goals.
           The factors that generate complex tax systems--
        policy trade-offs, politics, and taxpayers' desire to reduce 
        their own tax burdens--are not features of tax policies per se. 
        They will likely remain in force even if the tax system were 
        reformed or replaced. As a result, an analysis of the extent to 
        which policy changes can affect tax complexity should 
        incorporate these factors.
Simplification and EGTRRA
           The new tax law provided a few simplifying measures 
        (with respect to the EITC, the repeal of limitations on 
        itemized deductions and personal exemptions, and the reduction 
        in marginal tax rates).
           On net, however, the new law made taxes much more 
        complex and made tax planning much more difficult. This is a 
        result of the ``sunset'' provisions, the long and variable 
        phase-ins and abrupt phase-outs of numerous provisions, the 
        failure to address the long-term AMT problem, complicated 
        provisions regarding the estate tax, and an increase in 
        targeted subsidies in education and retirement saving.
           The new law also reduced future prospects for 
        simplification because it allocated such a large share of 
        projected budget surpluses toward other uses.
Simplifying the existing system
           The key to tax simplification is to make fewer 
        distinctions across economic activities and personal 
        characteristics. Taxes should be imposed on a broad base at 
        relatively low rates that do not vary by income source or 
        expenditure type. Progressivity should be embodied in the rate 
        structure and the tax base, not in the design of specific 
        provisions. Universal exemptions, deductions, or credits are 
        much simpler than targeted ones.
           The following types of reforms could make taxes 
        simpler as well as fairer and more conducive to economic 
        growth: addressing the uncertainty created by sunset and phase-
        out provisions of EGTRRA; reforming the individual AMT; 
        eliminating (or at least coordinating) phase-outs of tax 
        credits; coordinating and consolidating provisions with similar 
        purposes (including retirement saving and education); reducing 
        the top tax rates in conjunction taxing capital gains as 
        ordinary income.
           Filing and recordkeeping could be enhanced by 
        consideration of ``return-free'' tax systems, and by 
        significantly raising the standard deduction.
Complexity in the current system
           Reliable estimates of the costs of compliance, 
        administration, and enforcement of the income tax vary widely, 
        due in part to inadequate data. The best estimate is that, in 
        1995, those costs ranged between $75 billion and $130 billion, 
        or between 10 and 17 percent of revenues. These costs are 
        distributed mainly to taxpayers in higher income groups.
           There is wide disagreement on the compliance costs 
        of the estate tax, but the most reliable estimates place those 
        costs at about 10 percent of revenues.
Complexity and fundamental tax reform
           Some have turned to new tax systems--such as a flat 
        tax or a national retail sales tax--as an alternative way to 
        simplify taxes. These taxes are extremely on paper. But a 
        crucial caveat is that no country has successfully enacted or 
        administered a high-rate national retail sales tax or a flat 
        tax. Tax systems that exist in the real world have been forged 
        through a combination of revenue requirements, political 
        pressures, responses to taxpayer avoidance and evasion, 
        lobbying, and other processes that any operating tax system 
        would eventually have to face. Notably, all of these factors 
        tend to raise complexity. In contrast, tax systems that exist 
        only on paper--such as the NRST and the flat tax--appear to 
        simpler in significant part because they have not had to face 
        real world tests yet.
Conclusion
           Tax simplification is a long-standing issue that 
        garners widespread support, at least in principle, and is 
        technically feasible. But the fact that most existing taxes 
        turn out to be far more complex than most proposed alternatives 
        should serve as a caveat to the view that achieving tax 
        simplification, in the existing or a new tax system, will prove 
        easy or durable.
I. Tax Complexity: Some basics (1)
A. Measuring complexity
    Tax complexity has many dimensions and could plausibly be defined 
in different ways.
---------------------------------------------------------------------------
    \1\ Slemrod and Yitzhaki (2000) provide an excellent summary and 
analysis of issues relating to tax avoidance, evasion, and 
administration.
---------------------------------------------------------------------------
    Following Slemrod (1984), we define the complexity of a tax system 
as the sum of compliance costs--which are incurred directly by 
individuals and businesses--and administrative costs--which are 
incurred by government. Compliance costs include the time taxpayers 
spend preparing and filing tax forms, learning about the law, and 
maintaining recordkeeping for tax purposes.(2)
---------------------------------------------------------------------------
    \2\ These items constitute the costs measured by the Paperwork 
Reduction Act of 1980 and printed in the instructions for federal tax 
forms.
---------------------------------------------------------------------------
    The costs also include expenditures of time and money by taxpayers 
to avoid or evade taxes, to have their taxes prepared by others, and to 
respond to audits, as well as any costs imposed on any third-parties, 
such as employers. Administrative costs, although incurred by 
government, are ultimately borne by individuals. These costs include 
the budget of the tax collection agency, and the tax-related budgets of 
other agencies that help administer tax programs.(3)
---------------------------------------------------------------------------
    \3\ For example, the Department of Labor certifies employers as 
eligible for the Work Opportunity Tax Credit and the Welfare-to-Work 
Tax Credit.
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    Defining complexity as the total resource cost provides a 
quantitative measure by which different tax systems can be compared, 
and by which the administrative aspects of a particular tax system can 
be evaluated relative to its impacts on equity, efficiency, and 
revenue. But the definition is not ideal. Slemrod (1989a) points out 
that a particular subsidy could be so complicated that few taxpayers 
use it. If it were simplified, and enough additional people used the 
subsidy, total resource costs would rise, even though the subsidy 
itself had become less complicated.
    A number of issues arise in efforts to measure tax complexity: 
First, permanent and transitory costs may differ. A new tax provision 
may raise compliance costs temporarily, as people learn about the 
change, even if it reduces costs in the long-term. Likewise, for 
administrative costs, the capital cost of upgrading IRS computers might 
appear as a current-year budget expenditure rather than being amortized 
over time. Second, only the incremental costs due to taxes should be 
included. Even with no taxes, firms would need to keep track of income 
and expenses to calculate profits, and individuals would engage in 
financial planning. This activity should be omitted from compliance 
cost measures. Third, an analysis of tax complexity alone may generate 
misleading conclusions. Governments can impose policies via taxes, 
spending, regulations, or mandates. Any tax provision can be made 
simpler by eliminating it, but if it then is recreated as a spending 
program, the overall complexity of government may rise.
B. Benefits of simpler taxes
    Simpler taxes would be beneficial in a number of ways. First, 
simpler taxes would reduce taxpayers' of complying with the tax system 
in terms of time, money, and mental anguish. By reducing these costs, 
simplification would reduce the overall burden of taxation.
    Second, tax provisions that are simpler are more likely to be used. 
Provisions aimed at encouraging certain activities--such as saving for 
college--will be less likely to be used and hence less effective if 
people cannot understand how they work.
    Third, making taxes simpler would probably raise compliance rates 
(i.e., reduce illegal tax evasion). To some (uncertain) extent, people 
do not pay taxes because they do not understand the tax law. Clarifying 
and simplifying tax rules can only help to make people understand the 
law better, and would likely make it easier to enforce tax law as well. 
Evidence also suggests that people are more likely to evade taxes that 
they consider unfair. People who can not understand tax rules may also 
question the fairness of the tax system and feel that others are 
reaping more benefits than they are, and thus prove more likely to 
evade taxes.
    Finally, simpler taxes would generate more public support and thus 
should be an essential part of any effort to improve the delivery of 
government services. The biggest complaint about the tax system for 
many people is not the amount of taxes they pay but rather the sheer, 
and seemingly needless, complexity of what appear to be everyday tax 
situations (Graetz 1997).
C. Which features of the tax code generate complexity?
    The level of complexity can be influenced by structural elements--
such as the tax base, the tax rate structure, and the allowable 
deductions, exemptions, and credits--as well as by administrative 
features of the tax code. The three most discussed tax bases are 
income, wages, and consumption. Holding the other features of the tax 
system constant, income is the most difficult of the three bases to 
tax. Income may be decomposed into its sources--wages and capital 
income--or its uses--consumption and saving. For a wide variety of 
measurement and timing reasons, it is generally easier to tax wages 
than capital, and easier to tax consumption than saving.
    Tax rates are typically either graduated, like the current income 
tax, or flat, like the payroll tax. Flat-rate taxes can have lower 
compliance costs than graduated taxes. The presence of graduated rates 
gives taxpayers incentives to avoid taxes by shifting income over time 
or across people. And flat-rate taxes allow more efficient 
administrative structures to function. Taxes imposed at flat rates can 
be easily collected at source, since the rate does not vary across 
taxpayers.
    Exemptions, deductions or credits that are universal create little 
complexity. However, targeted provisions require clear definitions of 
eligible taxpayers and activities, and can create compliance headaches. 
Finally, different ways of administering taxes may affect complexity. 
For example, withholding taxes at source or eliminating the requirement 
to file a tax return could reduce compliance costs for 
individuals.(4)
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    \4\ However, as we discuss below, some of those costs may be 
shifted to employers, other businesses, or government agencies.
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    The discussion above suggests that, other things equal, the 
simplest system would tax consumption at a flat rate with universal 
deductions, credits or exemptions, and with withholding at source. Yet, 
the U.S. and many other countries tax income on a graduated basis, with 
numerous targeted credits and deductions, and with withholding at 
source only for certain types of income. Given the prevalence of these 
alternative systems, and absence of any country that taxes only in the 
simplest way described above, it is instructive to ask why existing 
systems deviate so strongly from the simplest structure.
D. Why are taxes complex?
    Any plea for simpler taxes has to start by addressing a basic 
problem: If everyone thinks taxes should be simple, why are taxes so 
complicated? At least four factors help explain why taxes become 
complicated and suggest keys to making taxes simpler.
    The first, and most important, is conflict among the consensus 
goals of tax policy. Although almost everyone agrees that taxes should 
be simple, most people also agree that taxes should be fair, conducive 
to economic prosperity, and enforceable. Even if all parties agree on 
these goals, they do not typically agree on the relative importance of 
each goal. As a result, policy outcomes usually represent efforts to 
balance one or more goals against the others. That is, sometimes a 
certain amount of complexity is created or permitted in order to help 
achieve other policy goals. For example, attempts to make taxes fairer 
often conflict with attempts to make taxes simpler. Most countries 
tailor tax burdens to the characteristics of individual taxpayers. This 
may improve tax equity, but it also creates complexity. It requires 
tracing income or consumption from the business sector to the 
individual. It requires reporting and documenting individual 
characteristics such as marital status, number of dependents, and age, 
as well as the composition of expenditures or income. It allows tax 
rates that vary with individual characteristics, creating opportunities 
for tax avoidance.
    In this context, tax complexity is like air pollution: it is an 
unfortunate and undesirable consequence of products or services that 
we, as a society, desire. Just as the optimal level or air pollution is 
not zero--since that would mean that many of the goods and services 
society cherishes could not be produced--the optimal level of tax 
complexity is not zero. And just as we should seek the most efficient 
ways to reduce air pollution, we should also seek the most effective 
ways to make taxes simpler.
    The second factor that generates tax complexity is the political 
process. Politicians and interest groups have interests in targeted 
subsidies that reduce taxes for particular groups or activities. But 
targeted subsidies inevitably make taxes more complex by creating more 
distinctions among taxpayers and among sources and uses of income.
    Third, some complexity is necessary to deter tax avoidance. 
Taxpayers have every right to reduce their taxes by any legal means. 
But this activity inevitably raises questions about whether particular 
activities or expenditures qualify for tax-preferred status. The 
Treasury Department responds with complex rules designed to limit 
avoidance. Taxpayers in turn respond by inventing complex transactions 
to skirt the new rules. This can create a vicious cycle that leads to 
more and more complex rules and increasingly sophisticated and complex 
avoidance strategies.
    Fourth, many complicated provisions were enacted to raise revenue 
or limit revenue losses during times of rampant budget deficits. For 
example, the landmark Tax Reform Act of 1986 (TRA)--a remarkable 
accomplishment in many respects--fell short of its goal of simplicity 
to meet the requirement of ``revenue neutrality.'' TRA created several 
complicated phase-outs and hidden taxes in order to raise revenue and 
meet distributional targets. Insofar as complexity has arisen from 
efforts to limit revenue loss, the surplus that existed at the 
beginning of this year and the political consensus in favor of some 
sort of tax cuts created an opportunity to simplify taxes. In that 
regard, and as discussed further below, the recent tax act is not only 
a missed opportunity for simplification, but may also have used up 
whatever funds would otherwise have been available to support 
simplification efforts.
E. Implications for thinking about tax simplification
    Recognition of these factors has several important implications for 
the study of tax complexity.
           First, the fundamental question is not the overall 
        level of complexity, but whether particular tax provisions, tax 
        systems (or alternative means of providing government services, 
        such as spending or regulations) provide good value for the 
        complexity they create. This depends on the magnitude and 
        incidence of the costs and benefits of complexity, where the 
        benefits include the extent to which complexity aids in 
        achieving other policy goals.
           Second, the factors that generate complex tax 
        systems--policy trade-offs, politics, and taxpayers' desire to 
        reduce their own tax burdens--are not features of tax policies 
        per se. They will likely remain in force even if the tax system 
        were reformed or replaced. As a result, an analysis of the 
        extent to which policy changes can affect tax complexity should 
        incorporate these factors.
           Third, there is an important distinction between 
        private and social gains or costs. Suppose everyone had to fill 
        out five extra lines of the tax form to receive a $1,000 tax 
        cut. Each person might regard that as ``good complexity,'' 
        worth the cost of providing extra information. But, holding tax 
        revenues constant, the revenue would still have to be raised 
        from somewhere, so the net tax cut would be zero--that is, 
        everyone's tax ``cut'' would be from a higher initial tax 
        liability and net taxes would be the same. Thus, from a social 
        perspective, the sum of all individuals' ``good complexity'' 
        could be zero or negative.
II. Simplification and the new tax law
A. Provisions
    The Economic Growth and Tax Relief Recovery Act (EGTRRA) was signed 
into law by President Bush on June 7, 2001.
    Both the most important and most novel aspect of EGTRRA is the 
general provision that the entire bill ``sunsets'' at the end of 2010. 
All provisions of the bill are eliminated and the tax code at that 
point reverts to what it would have been had the tax bill never been 
passed.
    The act also contains numerous specific provisions. Some of these 
are listed in table 1 and described here along with their effective 
phase-in and phase-out dates. They are listed in order of the tax cut 
provided when fully phased in.
             Reduce marginal income tax rates of 28 percent or 
                    higher:
    The 28, 31, and 36 percent tax rates (which apply to married 
households with taxable income above $45,200, $109,250, and $166,500, 
respectively) will each fall by 3 percentage points, and the 39.6 
percent top rate (which applies to married households with taxable 
income above $297,350) will fall to 35 percent. Each of these rates 
declines by 1 percentage point as of July 1, 2001, a second point in 
2004, and the reductions are completed in 2006.
             Eliminate the estate tax:
    The effective exemption in the estate tax is raised from $675,000 
currently to $1 million in 2002, and then gradually to $3.5 million in 
2009. The top effective marginal tax rate is reduced from 60 percent 
currently to 50 percent in 2002 and then gradually to 45 percent in 
2009. The credit for state-level estate taxes is gradually phased out 
between 2002 and 2005, after which it is replaced by a deduction. This 
change finances about one-quarter of the cost of the entire reduction 
in federal estate taxes. In 2010, the estate and generation-skipping 
transfer taxes are repealed, the highest gift tax rate is set equal to 
the top individual income tax rate, and the step-up in basis for 
inherited assets that have capital gains is repealed.
             Create a new 10 percent income tax bracket:
    A new tax bracket of 10 percent is carved out of the first $6,000 
of taxable income for singles, and the first $12,000 of taxable income 
for married couples. This income is currently taxed at a 15 percent 
rate. Starting in 2002, the 10 percent bracket is implemented by 
changing the tax rate and withholding schedules. In 2001, the 10 
percent bracket is implemented by providing an advance credit for 2001 
taxes. The advance credit is a one-time payment of the minimum of the 
taxpayer's 2000 income tax payment (the payment due on April 15, 2001) 
or $300 ($600) for singles (married couples). This payment is intended 
to substitute for the 10 percent tax bracket in 2001, but for some 
taxpayers it will serve more as a rebate of the previous years' taxes 
because taxpayers who do not owe taxes in 2001 but did owe them in 2000 
will not have to repay the rebate they receive.
             Increase and expand the child credit:
    The child credit is gradually increased, from $500 currently to 
$1,000 by 2010. The child credit is also made refundable to the extent 
of 10 percent of a taxpayers earned income above $10,000 for 2001-4 and 
15 percent for subsequent years, with the $10,000 amount indexed for 
inflation. Refundability improves the access to, and amount of, child 
credit benefits for low-earning households.
             Partially address the marriage penalty:
    The standard deduction for married couples gradually rises from 174 
percent to 200 percent of the standard deduction for singles in the 
years 2005 to 2009. The top income level in the 15 percent bracket for 
married couples gradually rises from 180 percent to 200 percent of the 
similar level for singles from 2005 to 2008. The beginning and ending 
of the EITC phase-out will gradually increase by $3,000 by2008, and 
will be indexed for inflation thereafter.
             Repeal of limitations on itemized deductions and 
                    phase-outs of personal exemptions:
    The repeals are phased in between 2005 and 2009.
             Pension and IRA provisions
    Contribution limits for Individual Retirement Accounts and Roth 
IRAs will rise to $5,000 by 2008 and be indexed for inflation 
thereafter. Contribution limits to 401(k)s and related plans will rise 
gradually to $15,000 in 2006 and then be indexed for inflation. 
Additional so-called ``catch-up'' contributions of up to $5,000 for 
anyone over the age of 50 will be permitted. Roth 401(k) plans can be 
established starting in 2006. A non-refundable credit for retirement 
saving for low-income taxpayers will be available between 2002 and 
2006.
             Education provisions
    Taxpayers may take an above-the-line deduction for qualified higher 
education expenses, but only for the years 2002 to 2005. Effective in 
2002, the contribution limit on education IRAs rises to $2,000 from 
$500. The definition of qualified expenses from education IRAs is 
expanded. Pre-paid tuition programs will now benefit from tax-free 
withdrawals as long as the funds are used for education. Deductions for 
student loans are made more generous.
             Temporarily, limited AMT relief
    Between 2001 and 2004, the exemption amount in the individual AMT 
is increased by $2,000 for single taxpayers and $4,000 for married 
taxpayers. This provision is abolished at the end of 2004.
B. Effects of EGTRRA on tax complexity
    It would be an understatement to say that simplification was not 
one of the goals of EGTRRA. In fact, the overall net impact of the new 
tax law will be to make taxes more complicated over time.
    There are three bright spots for simplification. First, for the 
earned income credit, the bill simplifies the definition of earned 
income, the definition of a qualifying child, and calculation of the 
credit. This is an important set of changes since it allows benefits to 
be provided to low-income households in a manner that is easier to 
understand.
    Second, the bill repeals the limitations on itemized deductions and 
the phase-out of personal exemptions will simplify taxes for high-
income taxpayers. These provisions are hidden taxes that serve no 
purpose that could not be generated by rate adjustments. In fact, the 
repeal was implemented in exchange for a smaller reduction in marginal 
tax rates for the highest income taxpayers than would otherwise occur. 
This trade-off--giving up explicit rate reductions in exchange for 
provisions that simplify the tax system--could provide a useful model 
for dealing with the problems created by the alternative minimum tax in 
the future.
    Third, the reduction in income tax rates will indirectly help to 
simplify tax planning.
    Increasing the number of tax brackets does not generally make 
compliance more difficult; taxpayers will continue to look up their tax 
liability in a tax table. But lower tax rates simplify tax compliance 
indirectly by reducing the incentive to avoid taxes or find tax 
shelters.
    Despite these changes, however, the overwhelming net effect of the 
bill will be to make tax filing and tax planning more complex.
(1) Complexity due to increased uncertainty: Sunsets and phase-outs
    As noted above, the most novel feature of the bill is the 
sunsetting of all provisions as of December 31, 2010. In addition, 
various features of the bill phase-in and phase-out at different times. 
Taken at face value, these provisions make tax planning more complex, 
since the tax rules will be changing on a near constant basis, giving 
taxpayers incentives to shift the level, form and timing of their 
income and deductions. The good news is that few people take the sunset 
provisions at face value. The bad news, though, is that not taking them 
at face value makes tax planning even more complex, since it is not yet 
known what will replace the sunset and phase-out provisions, or when 
such provisions will be altered. The prevailing sentiment may be best 
summed up by Washington Post columnist Al Crenshaw (2001) who noted 
that ``The new tax law doesn't make planning unnecessary, it just makes 
it impossible.''
    While sunsets and phase-outs create planning difficulties for any 
situation, they appear to have particularly egregious effects in at 
least two areas: estate planning and pension choices. Taxpayers may end 
up having to make their wills and estate plans contingent on the year 
in which they die, because the provisions are legislated to change so 
massively on a year-to-year basis. For pensions, a key goal is to raise 
employer sponsorship of plans. But employers will naturally be 
reluctant to incur the fixed costs of creating new plans and educating 
their employees about the plan, if there is a chance that the plan, or 
the particular provisions that made the plan worth offering, may not be 
in existence after a few years.
(2) Complexity due to increased number of choices
    Complex rules or documentation procedures are a common source of 
tax complexity. However, a new and increasing source of complexity 
might be termed ``choice'' complexity. This occurs when taxpayers are 
given numerous subsidies but may only use one or a few of them. This 
type of complexity has proliferated with regard to retirement saving, 
where taxpayers have been able to choose to allocate contributions 
among traditional, Roth, and education IRAs for several years. Under 
the tax bill, they will soon be able to choose to allocate 401(k) 
contributions between traditional and Roth plans as well. Similar 
issues apply to the variety of education subsidies that exist today, 
and which were expanded in EGTRRA.
    In economic models that feature fully informed consumers who make 
choices without incurring transactions costs, having more options is 
always preferable to having fewer options. However, in designing tax 
policy it is not necessarily the case that more options are always 
worth the added costs. First, the differences in benefits to a 
household between choosing one of a set of options versus another in 
the same set may be smaller than the costs of determining which the 
best option. But of course the household does not know that until it 
has undertaken the cost. Second, having more choices, for example with 
respect to retirement saving, requires more record-keeping by the 
taxpayer and the government.
(3) Alternative minimum tax
    The AMT is a parallel tax system that was created to prevent high-
income taxpayers from aggressively using tax shelters and deductions to 
eliminate their tax burdens. Taxpayers must calculate the AMT if their 
regular income tax liability is less than their AMT liability. The AMT 
is quite complex and requires tax filers to make many detailed 
calculations. Currently, fewer than 2 million taxpayers face the AMT.
    There are (at least) two ``AMT problems'' facing the tax code 
currently. The first is that, even without the new tax law, the number 
of taxpayers facing the AMT is scheduled to rise to about 20 million by 
2011. This occurs primarily because the AMT exemption amounts are not 
indexed for inflation. In addition, the overwhelming reason why these 
taxpayers will end up facing the AMT is that the personal exemptions 
and state tax deductions that they take in the regular income tax are 
not allowed in the AMT. Thus, the AMT will increasingly be capturing 
more people, and from the perspective of curtailing tax sheltering, the 
wrong people over time. While the new tax law does not make this 
problem worse, it does not do anything to fix it, either.
    The second problem is created by the new tax law. By 2010, when the 
law is fully phased in, JCT estimates that about 35 million taxpayers 
will face the AMT. This occurs because the tax law reduces regular 
income tax but not (in years after 2004) AMT.
    The bill offers only temporary, partial relief against the AMT, but 
that provision sunsets after four years. As a result, any gains in 
simplicity arising from lower income tax rates would be offset several 
times over after 2004 because lower rates would subject millions of 
taxpayers to the individual alternative minimum tax.
(4) The estate tax
    Abolition of the estate tax sounds, on the surface, like a 
simplifying measure, but in the tax bill it is not. The bill stipulates 
three stages for estate taxes: from 2002 to 2009, the tax is modified 
in many ways. In 2010, the estate tax is abolished and step-up in asset 
value for inherited assets is repealed. In 2011, the estate tax is 
reinstated, as is the step-up in asset value for inherited assets.
    This creates several sources of complexity. The first is the sunset 
provision, as noted above. The second is the transition period before 
the estate tax is abolished. The estate tax phase-out is slow and 
involves several changes between now and 2009: the exemptions are 
raised, the tax rates are reduced, the credit for state taxes is 
abolished and replaced with a deduction, and gift tax limits are 
dramatically changed. Both the sunset and the transition make effective 
estate planning quite complex between 2002 and 2011.
    The third issue is the repeal of basis step-up at death. Under 
current law, when an heir receives an asset from an estate, the basis 
price is ``stepped up'' The new bill features ``basis carryover:'' 
heirs inherit an asset's original basis price. Implementing carryover 
raises vexing issues. For example, some families would have to keep 
records for generations to keep track of asset purchase prices and 
improvements. Carryover basis would raise taxes on many heirs compared 
with current law unless modest gains are excluded from the new rule. 
But exempting a portion of capital gains would create a great deal of 
complexity. For example, under current law, it is easy for a parent to 
split an estate equally among his or her children. Under basis 
carryover, the estate would have to decide how to allocate a capital 
gain exclusion among the children. The assets inherited by children who 
received equal bequests, but different exclusion amounts, would be 
worth different amounts on an after-tax basis. A carryover basis 
provision was enacted in the late 1970s, but was repealed before it 
took effect because taxpayers complained about the new complexities and 
problems in implementation. There is no reason to think these issues 
would be any easier to deal with now.
(5) Expansion of targeted subsidies (mainly in education and retirement 
        saving)
    Targeted subsidies complicate taxes. Each program require precise 
definitions of eligible taxpayers,income levels, and qualifying 
expenses. Many of the proposed incentives would require separate 
worksheets or tax forms. The possibility of honest mistakes or fraud 
would rise commensurately. The government would need to spend more on 
monitoring or auditing taxpayers, and the programs would likely send 
more lower--and middle-income households to paid tax preparers. The 
main culprits along these lines in the tax bill are the education 
subsidies. As one example, one provision of the bill will let people 
buy computers, educational software, and internet access for their 
school-age children with tax-preferred funds.
C. Effects of EGTRRA on prospects for tax simplification
    Besides directly complicating the tax code, EGTRRA has 
substantially dimmed prospects for tax simplification in the future, 
because the tax act allocates revenues that could otherwise have been 
used for simplification.
    Significant tax simplification almost has to be associated with net 
tax cuts. The Tax Reform Act of 1986, for example, substantially 
simplified individual income taxes but also cut the revenue collected 
from such taxes. The overall act was deemed revenue-neutral because net 
taxes collected at the corporate level were slated to increase.
    Simplification has proven difficult in the past because eliminating 
loopholes and preferences in a revenue-neutral package of individual 
income tax changes means that taxes on some people and some activities 
will rise, while taxes on others will fall. This naturally raises 
difficult political issues. Achieving simplification in a tax cut 
package, however, could avoid the politically difficult offsetting 
revenue increases, giving everyone lower and simpler taxes.
D. Effects of new tax proposals on complexity
    In the aftermath of EGTRRA, the Ways and Means Committee has 
approved HR 7, which among other things would allow households who do 
not itemize their deductions to take an above-the-line deduction for 
charitable contributions. Perhaps the most notable feature of this 
proposal is the tiny contribution limits involved: the provision would 
allow for up to $25 per person for this deduction in 2002, rising to 
$100 per person in 2010.
    This proposal could simplify matters for the 2 percent of taxpayers 
who currently itemize, but whose deductions other than charity are less 
than the standard deduction. But for the roughly 70 percent of 
taxpayers who take the standard deduction, the change would add 
complexity. They would need to keep records of contributions, which 
might be difficult if the contributions are small or in cash. A similar 
deduction in the early 1980s created serious compliance problems, with 
many taxpayers claiming undocumented deductions. Both the cap on non-
itemized charitable deductions and the interaction of this provision 
with the phase-out of itemized deductions for high-income taxpayers 
would complicate choices for some taxpayers and require more auditing 
and monitoring by the IRS. It is hard to see how the complexity 
engendered by these provisions would be worth the costs, and lawmakers 
might consider simply raising the standard deduction instead of 
providing an above-the-line deduction for charitable giving.
III. Simplifying the existing tax system
    Despite the setback that EGTRRA represents for actual and 
prospective simplification efforts, there are a number of options 
available to policy makers who are interested in simplifying the 
existing tax system.
A. Principles
    The key to tax simplification is to make fewer distinctions across 
economic activities and personal characteristics. Taxes should be 
imposed on a broad base at relatively low rates that do not vary by 
income source or expenditure type. Progressivity should be embodied in 
the rate structure and the tax base, not in the design of specific 
provisions. Universal exemptions, deductions, or credits are much 
simpler than targeted ones. Broadening the base by eliminating targeted 
preferences and taxing capital gains as ordinary income directly 
removes major sources of complexity. Using the revenue raised to 
increase standard deductions removes people from the tax system, and 
using the revenue to reduce tax rates reduces the value of sheltering 
and cheating. Increasing the number of people that face the same 
``basic'' rate facilitates withholding of taxes at the source, which 
further simplifies taxes and raises compliance. In short, broadening 
the base and reducing the rates, which in general may be considered 
efficiency-enhancing, would also simplify taxes (see Pechman 1990, 
Slemrod 1996, Slemrod and Bakija 1996, Gale 1997, 1998).
    Slemrod (1996) refers to such plans as ``populist simplification.'' 
That is, they make taxes simpler for a large number of taxpayers, but 
the overall saving in compliance costs may not be very large. Not all 
structural reforms, of course, have the same impact on compliance 
costs. Slemrod (1989b) found no significant saving from changing to a 
single-rate tax structure. In contrast, eliminating the system of 
itemized deductions would result in a substantial reduction in 
expenditures on professional assistance; the impact on total compliance 
costs, though, varied depending on the model used.
B. Specific Reforms
    The following reforms could make taxes simpler as well as fairer 
and more conducive to economic growth.
    Address the Uncertainty Created by Sunset and Phase-out Provisions 
of EGTRRA The most urgent simplification need is to clean up the tax 
planning problems, complexities and uncertainties created by EGTRRA 
with regard to seemingly capricious phase-in and phase-outs of 
provisions and the sunsetting of the entire bill. Either the provisions 
should be made permanent or they should be abolished. Having numerous 
tax provisions dangle for an indefinite period does not simplify the 
tax code. (On a related note, it would also make sense to decide 
whether to keep permanently or to abolish the entire set of temporary 
tax provisions that existed even before EGTRRA.)
    Reform the Individual AMT To spare middle-income people who were 
never its target, the AMT should be indexed for inflation, deductions 
should be allowed for dependents and state and local taxes, and all 
personal credits should be available against the AMT. Any proposal that 
cuts regular income tax liabilities should be required to make 
conforming adjustments to the AMT so that more taxpayers are not 
subjected to the alternative tax. Some would argue that the AMT should 
be eliminated altogether. But a reformed AMT would prevent the very 
wealthy from eliminating their tax liability, and legislators will 
probably want to be spared the embarrassment of seeing how successfully 
the well-advised can exploit loopholes.
    Eliminate (or at least Co-ordinate) Credit Phase-Outs A number of 
credits phase out across different income ranges. Each credit requires 
separate worksheets and tax calculations. The phase-outs create hidden 
taxes over the phase-out range, and diminish the effectiveness of the 
credits in encouraging the activities they are designed to spur.
    Coordinate and Consolidate Provisions with Similar Purposes In a 
number of areas, numerous provisions--each with slightly different 
rules--apply to the same general activity. Coordinating or 
consolidating the following provisions would simplify taxes, often with 
little or no forgone revenue:
     EITC, Dependent Exemption and Child Credit Several recent 
proposals would combine features of the tax code that deal with 
families with children. Coordinating the three tax subsidies--and 
adopting a common definition of ``qualifying child''--could make taxes 
much simpler for low-income households.
     Education Subsidies Choosing among the alternative tax 
subsidies for college education requires college algebra and a lawyer's 
attention to detail. These choices could be made far simpler through 
consolidation into two subsidies, one focusing on saving incentives for 
education, and one on either deductions or credits for current 
educational expenditures.
     Saving Incentives Independent of employer-provided 
accounts, households may save in Individual Retirement Accounts (IRAs), 
Roth IRAs, educational IRAs, and Keogh plans. Rules concerning 
contribution limits and withdrawal patterns vary by program. 
Consolidating these options into one or two non-overlapping options 
with simple and broad rules on eligibility, contribution, and 
withdrawal rules would simplify tax planning for retirement.
     Capital Gains Capital gains will eventually be taxed at up 
to eleven different rates, depending on the asset, the owner's income, 
when the asset was purchased, and how long it was held. It would be 
much simpler to replace this confusing hodge podge with an exclusion of 
a set fraction of capital gains from taxable income--say 50 percent--as 
was done prior to 1987.
    Reduce the top tax rates and tax capital gains as ordinary income 
This was the cornerstone of the deal struck in 1986 that allowed 
substantial simplification of the individual income tax. It would 
massively reduce incentives to shelter funds and the need to engage in 
complex tax planning.
C. Simplify Filing and Record-Keeping
    Thirty-six countries administer some sort of ``return-free'' tax 
system. Under such a system, the taxpayer or the taxpayer's employer 
supplies a few information items to the tax authorities, which 
calculates the tax due and bills the taxpayer. Up to 52 million 
taxpayers (and many more if the standard deduction were significantly 
increased) could be placed on a return-free system with relatively 
minor changes in the structure of the income tax. These include filers 
who have income only from wages, pensions, Social Security, interest, 
dividends, and unemployment compensation; who do not itemize deductions 
or claim credits other than the EITC or the child credit; and who are 
in the zero or 15 percent tax bracket (Gale and Holtzblatt 1997).
    Nevertheless, the net cost savings may not be great. Over 80 
percent of the affected taxpayers currently file the relatively simple 
1040A and 1040EZ returns and the others file 1040s but have relatively 
simple returns. Taxpayers subject to a return-free system would still 
have to provide information to tax authorities on a regular basis. Some 
administrative costs would merely be shifted from taxpayers to 
employers, other payers, and the IRS. And if state income taxes were 
not similarly altered, many taxpayers would still need to calculate 
almost all of the information currently needed on the federal 
return.(5)
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    \5\ Another option is to subsidize electronic filing (Steuerle 
1997). Electronic filing may help reduce error rates because returns 
are often prepared using computer software programs with built-in 
accuracy checks, and it prevents key punch errors that could otherwise 
occur at the IRS. The IRS restructuring act establishes a goal that 80 
percent of tax returns should be filed electronically by 2007. In 
February 2000, the Clinton Administration proposed a temporary 
refundable credit for electronic filing of individual income tax 
returns to help achieve this goal. The proposal was not enacted in 
2000.
---------------------------------------------------------------------------
    Another way to reduce the costs of filing and record-keeping would 
be to expand the standard deduction significantly. This would curb 
administrative costs by reducing the number of households that itemize 
their deductions. It would also provide a tax cut for many low- to 
middle-income households. Estimates suggest that if the number of 
personal exemptions each household was granted were reduced by one 
andthe standard deduction was raised by $4,000, the number of itemizers 
would fall by one-third, revenues would be maintained, and 
progressivity would be enhanced (Aaron and Gale 1996).
D. Procedural changes
    Procedural changes in the tax policy process might indirectly help 
to simplify taxes by raising the visibility and explicit consideration 
of simplicity and enforcement issues. For example, the recent IRS 
restructuring legislation requires the IRS to report to Congress each 
year regarding sources of complexity in the administration of Federal 
taxes. The Joint Committee on Taxation (JCT) is required to prepare 
complexity analysis of new legislation that impacts individuals or 
small businesses.
    Another way to increase the visibility of simplification issues is 
for the Treasury or a Congressional agency to release an annual list of 
simplification proposals. A Treasury ``blue book'' released in 1997 
contained over 50 proposals for simplification, two of which were 
enacted later that year. The IRS restructuring act requires the JCT to 
include simplification proposals in biennial reports on the state of 
the Federal tax system.
E. Fund simplification experiments
    Finally, a serious commitment to tax simplification could be 
established if Congress and the Administration would devote a small 
amount, say 0.5 percent, of the size of any proposed tax cut to conduct 
experiments and trial runs to show what type of simplification 
taxpayers would like and how best to establish such procedures. Given 
the magnitude of tax cuts recently enacted, 0.5 percent would go toward 
funding a very large amount of new efforts to make taxes simpler.
IV. Complexity in the current tax system
A. Compliance costs in the income tax
    The complexity, or total resource costs, of the current tax system 
can be divided into several components: the amount of time it takes 
individuals and businesses to comply with the tax system, the valuation 
of that time, the out-of-pocket costs incurred by taxpayers, and the 
administrative costs borne by government.
    Three surveys, conducted during the 1980s and described in table 2, 
provide data on the time taxpayers needed to comply with federal taxes. 
Slemrod and Sorum (1984) surveyed 2,000 taxpayers in Minnesota in 1983. 
Weighting the responses to reflect national averages, they estimated 
that taxpayers spent 2.1 billion hours filling out their 1982 federal 
and state income tax returns. Blumenthal and Slemrod (1992) repeated 
the survey in 1990 and found that time requirements for 1989 returns 
had increased to 3.0 billion hours. Unlike the earlier survey, the 
latter survey's estimates include time spent arranging financial 
affairs to minimize taxes.
    The largest survey, commissioned by the IRS and conducted by Arthur 
D. Little (ADL, 1988), asked 6,200 taxpayers by mail about time spent 
preparing 1983 federal income tax returns. ADL also surveyed 4,000 
partnerships and corporations and their paid preparers. ADL used the 
results to develop models that could be used with readily available 
data to estimate compliance costs in future years. To develop the 
models, the time for each activity (e.g., learning about tax law) 
associated with each form was assumed to be a linear function of the 
number of items on the form, the number of words of instructions and 
references to the IRC and regulations, or the number of pages in the 
form. Based on these models, ADL estimated that taxpayers spent 1.6 
billion hours on 1983 individual income tax returns and 1.8 billion 
hours on 1985 returns. For partnerships and corporations, the estimates 
were 2.7 billion hours for 1983, and 3.6 billion hours for 1985.
    The IRS currently uses the ADL models to estimate the time required 
to complete forms and schedules. These estimates are published with the 
tax forms as part of the ``Paperwork Reduction Act Notice.'' For FY 
1997, OMB (1998) estimates that taxpayers needed 5.3 billion hours to 
comply with the requirements of all tax forms and IRS regulations. This 
estimate applies to businesses and individuals, and includes all 
federal taxes, not just income taxes.
    Several features of the ADL/IRS model are problematic, however. 
Most obviously, complexity can be related to many factors other than 
the number of lines or words on a form. When complexity is related to 
the length of instructions on the form, the ADL model may get the sign 
wrong. For example, if instructions were moved off of a form and into a 
separate publication, the ADL model would show compliance costs falling 
when the change may well have actually increased compliance costs. 
Another set of concerns focuses on the business model (Slemrod 1996). 
The model does not adjust its cost estimate for the scale of the 
business. Inexplicably, it overstates survey estimates of hours by 
partnerships, corporations and their preparers by a factor of four or 
more. And the ADL study may not be very representative; it only 
includes one corporation with assets in excess of $250 million, and 
only 9 with assets over $10 million.
    Given an estimate of the number of hours individuals and businesses 
spend complying with the tax system, the next component of compliance 
cost requires placing a value on taxpayers' time. The surveys above did 
not inquire about this issue. Instead, analysts have generally imputed 
some measure of opportunity cost to individuals. Different 
methodologies result in widely varying estimates of the value of 
taxpayers' time (table 3). Vaillancourt (1986) uses the taxpayer's pre-
tax wage, on the grounds that this is the cost to society. Slemrod 
(1996) argues that taxpayers are more likely to forgo leisure than work 
to complete a tax return, and so uses after-tax wages. Payne (1993) and 
Hall (1995, 1996) value individual and business taxpayers' time by 
averaging the hourly labor costs of one of the major accounting firms 
and the IRS. This approach undoubtedly overstates the appropriate costs 
for individual taxpayers. The implicit assumption that a taxpayer and 
tax professional operate at the same level of efficiency when 
completing a tax return is doubtful, and ignores the expertise the tax 
professional has developed. And the vast majority of taxpayers do not 
face tax situations anywhere near as complicated as those seen by an 
accountant at a major firm or an IRS examiner.
    Estimates of the total resource costs of operating the income tax 
vary widely (table 2). Payne (1993) estimates costs of $277 billion 
(1995 dollars) for 1985.(6) Hall (1996) estimates costs of 
about $141 billion in 1995. Slemrod (1996) estimates costs of $75 
billion in 1995. The differences between these estimates are driven 
largely by two factors: whether to use the results from the ADL 
business model or the business survey, and how to value the time spent 
by businesses and individuals. Both Payne and Hall use the results from 
the ADL model, which appears to overstate the relevant costs. Slemrod 
uses the results from the survey. Both Hall and Payne value taxpayer 
time at the cost of tax professionals' time, which is problematic for 
reasons stated above. Slemrod values taxpayers' time at the after-tax 
wage.
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    \6\ Payne calculates a total cost of $514 billion, but about $237 
billion is primarily attributable to ``disincentives to production,'' 
or the excess burden caused by distortions in relative prices. These 
costs are generally not included in compliance estimates.
---------------------------------------------------------------------------
    Given the existing data, it is possible to suggest a range of 
plausible estimates of the annual costs of operating the income tax. 
Slemrod's $75 billion estimate provides a realistic lower bound. An 
upper-bound estimate of $130 billion is obtained by adjusting Hall's 
estimate for the value of time (using Slemrod's estimate of $15 an hour 
rather than Hall's estimate of $39.60), and adding individuals' out-of-
pocket expenditures ($8 billion that Slemrod and Payne include) and tax 
administrative costs ($5 to $7 billion).
    All of these estimates are based on taxpayer surveys. However, 
although they may provide the best available information to date, the 
survey results should be interpreted with caution. All of the surveys 
have low response rates. They do not distinguish between permanent and 
transitory costs. The surveys omit compliance costs imposed on 
taxpayers after returns are filed (except for Payne, who provides only 
a rough estimate of audit costs). It is unclear whether survey 
respondents have netted out the cost of non-tax activities, or 
distinguished the costs of one tax from other taxes. In addition, the 
surveys were undertaken in the 1980s and are now dated. Several major 
and minor tax bills have become law over the last 15 to 20 years. It is 
not evident that the IRS methodology captures these changes. Over the 
same period, technological change has generally worked to reduce 
compliance costs. For example, when the IRS initiated the first pilot 
of electronic filing in 1986, a handful of professional tax preparers 
electronically transmitted 25,000 returns. By 2000, over 35 million 
taxpayers filed electronically. In many cases, they filed from home by 
telephone or personal computer. The cost savings from electronic filing 
are not reflected in the compliance cost estimates.(7) All 
of these considerations suggest the need for a new, comprehensive 
survey of taxpayer compliance costs.
---------------------------------------------------------------------------
    \7\ The IRS web site, launched in 1996, enables taxpayers to 
download forms and publications and registered 968 million ``hits'' 
during the 2000 filing season.
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B. The distribution of tax complexity
    Measures of resource costs indicate the total administrative burden 
of taxes, but provide no information about which taxpayers bear the 
biggest burdens. Just as the distribution of tax payments is central to 
policy discussions, the distribution of the burden of tax complexity is 
also worth considering.
    For many taxpayers, direct contact with the income tax is 
relatively simple. In 1998, 17 percent of taxpayers filed the 1040EZ, a 
very simplified version of the standard 1040 form.(8) An 
additional 21 percent of taxpayers filed the 1040A. Relative to the 
1040EZ, the 1040A requires more information and contains several more 
complicated provisions, but it is still fairly simple.(9) 
The remaining taxpayers filed the standard 1040 form. About 8 percent 
of taxpayers filed the 1040 but were eligible to file a 1040A or 
1040EZ. An additional 6 percent did not itemize their deductions, did 
not claim capital gains or losses, and did not have business income 
(defined to include business net income or loss, rents, royalties, farm 
net income, farm rental income, partnerships, S-corporations, estates 
and trusts). The figures above show that in 1998, over half of 
taxpayers either filed a simplified form or filed the 1040 but did not 
itemize deductions, have business income or report net capital gains. 
Thus, for most taxpayers, filling out an income tax form is relatively 
straightforward.
---------------------------------------------------------------------------
    \8\ To be eligible for the 1040EZ, taxpayers must be single or 
married filing jointly, have taxable income below $50,000, have income 
only from wages, salaries, tips, taxable scholarships, unemployment 
compensation, and interest, with taxable interest income below $400. 
Filers of the 1040EZ can claim personal exemptions, the standard 
deduction and the earned income tax credit (EITC) for workers who do 
not reside with children.
    \9\ To qualify for the 1040A, taxpayers' income must come from only 
from wages, taxable scholarships, pensions, IRAs, unemployment 
compensation, social security, interest and dividends. Taxpayers may 
report IRA contributions, student loan interest deductions, personal 
exemptions, the standard deduction, the EITC, the child tax credit, the 
child and dependent care tax credit, education tax credits, and the 
credit for the elderly and disabled, and exemptions for the elderly and 
blind. Taxable income must be below $50,000. Some of the issues arising 
for 1040A filers include head of household filing status, dependency 
rules, child-related credits, and in rare cases the AMT.
---------------------------------------------------------------------------
    Survey estimates support these findings. Blumenthal and Slemrod 
(1992) found that, while the average taxpayer reported spending 27.4 
hours on filing income tax returns and related activities, 30 percent 
spent less than 5 hours, and 15 percent spent between 5 and 10 hours. 
At the high end, 11 percent spent 50-100 hours and 5 percent spent more 
than 100 hours. Out-of-pocket costs averaged $66 (in 1989 dollars), but 
49 percent of filers had no such costs and another 17 percent had costs 
below $50. Slightly over 7 percent spent more than $200. Expenditures 
of time and money were highest among high-income and self-employed 
taxpayers.
    Information on the use of paid preparers may provide additional 
evidence on how complex individuals find the system to be. In 1998, 53 
percent of tax filers used paid preparers. Among those who filed the 
1040, 64 percent used preparers. Even among 1040A and 1040EZ filers, 35 
percent used preparers. At first glance, these figures suggest that 
most taxpayers do not believe they have simple tax situations. However, 
it is not entirely clear how to interpret the figures. Some individuals 
use preparers to obtain quicker refunds through electronic filing. 
Also, with relatively high income and often little leisure, many 
families pay others to clean their homes, plan their retirement nest 
egg, etc.; that they have turned to professional tax preparers as well 
may not provide any evidence about complexity.
C. Complexity and corporate taxes
    The factors most likely to create high compliance costs for large 
corporations include depreciation rules, the measurement and taxation 
of international income, the corporate alternative minimum tax, and co-
ordinating federal and state income taxes (Slemrod and Blumenthal, 
1996). In addition, the largest firms are almost continually audited, 
and final resolution of corporation tax returns can stretch over 
several years. Nevertheless, the magnitude of compliance costs and the 
impact of tax complexity on firm operations is controversial.
    At one end of the spectrum, company representatives have testified 
in Congress that it cost Mobil $10 million in 1993 to prepare its U.S. 
tax return, which comprised a year's worth of work for 57 people. These 
costs sound astonishingly high at first glance, but closer examination 
suggests otherwise. In 1993, Mobil operated in over 100 countries and 
had worldwide revenues of $65 billion and profits of about $4 billion. 
Mobil's revenues exceeded the GDP of 137 countries and 22 of the states 
in the United States. Mobil's self-reported costs of compliance were 
about 0.015 percent of revenues and 0.25 percent of profits. Viewed in 
this context, the burden imposed by compliance with the U.S. income tax 
appears relatively small.(10) In contrast, a recent study of 
the Hewlett-Packard corporation concluded that ``[a] large U.S. 
multinational company can complete an accurate corporate tax return 
with the functional equivalent of three full-time tax professionals'' 
(Seltzer 1997, p. 493). It would be interesting to know why Mobil's 
return required so many more resources than Hewlett-Packard's. To the 
extent that the problem lies in the tax system, it would be useful to 
know which features caused the problems.
---------------------------------------------------------------------------
    \10\ In the same year, Mobil paid $19 million in U.S. income taxes 
and its total world-wide tax burden was $1.931 billion.
---------------------------------------------------------------------------
D. Compliance costs and complexity in the estate tax
    Estimates of the compliance cost of the estate tax vary enormously, 
partly because the methodologies are suspect. Munnell (1988) is cited 
as claiming that ``the costs of complying with the estate tax laws are 
roughly the same magnitude as the revenue raised'' (Joint Economic 
Committee 1998). But Munnell actually wrote that compliance costs ``may 
well approach the revenue yield.'' Even this more modest conclusion, 
however, is based on a number of rough calculations and more or less 
informed guesses, rather than hard evidence.
    Munnell noted that, at the time, the American Bar Association 
reported that 16,000 lawyers cited trust, probate, and estate law as 
their area of concentration. Valuing their time at $150,000 per year on 
average and assuming they spend half the time on estate taxes yields 
$1.2 billion in avoidance costs, compared to estate tax revenues of 
$7.7 billion in 1987. To get from $1.2 billion to close to $7.7 
billion, Munnell refers to ``accountants eager to gain an increasing 
share of the estate planning market,'' financial planners and insurance 
agents who devote a considerable amount of their energies to minimizing 
estate taxes, and the efforts of the individuals themselves, and 
concludes that the avoidance costs ``must amount to billions of dollars 
annually.'' It is also worth noting that Munnell's estimates are now 
out-of-date and that estate tax revenues have risen dramatically during 
the intervening period. Thus, even if compliance costs at that point 
were almost equal to revenues, they may not be today.
    Davenport and Soled (1999) estimate tax planning costs by surveying 
tax professionals about average charges for typical estate planning in 
six different estate size classes and applying these estimates to the 
number of returns filed in 1996. This yields estimated costs for 
planning of $290 million. Using fairly ad hoc but not implausible 
adjustments for such factors as the number of nontaxable decedents that 
do tax planning and tax planning that has to be repeated when tax laws 
change, they estimate planning costs of $1.047 billion in 1999. They 
add $628 million for estate administration costs, based on taking one-
half of the total lawyers' fees and other costs reported on estate tax 
returns, and reducing that number by 45 percent to reflect the tax 
deductibility of the costs. (Note that the last reduction is 
inappropriate for measuring the social, rather than private, costs of 
the activity.) The sum of their estimates for planning and estate 
administration comes to $1.675 billion in 1999, or about 6.4 percent of 
expected receipts. They allocate another 0.6 percent of revenues for 
the administrative costs of IRS estate tax activities, for an estimated 
total cost of collection of 7.0 percent of revenues.
    The Davenport-Soled (DS) estimate is more recent and more detailed 
than Munnell's. Although both estimates require some arbitrary 
assumptions, it is difficult to see how the basic DS methodology could 
be redone with an alternative set of reasonable assumptions to yield an 
estimate that avoidance costs are anywhere close to 100 percent of 
revenues. The estimates above are based on suppliers of estate tax 
avoidance techniques. Another approach would be to survey the demanders 
of the service, the wealth owners. This approach has been employed with 
some success for the U.S. individual income tax (Slemrod and Sorum 
1984, Blumenthal and Slemrod 1992), and the corporation income tax 
(Blumenthal and Slemrod 1996). As a point of comparison, based on such 
studies, Slemrod (1996) concludes that collection costs for the U.S. 
individual and corporate income tax is about 10 percent of the revenue 
collected.
    Unfortunately, no reliable and comprehensive survey research has 
been carried out for the estate tax. What does exist applies only to 
businesses, and may be considered suspect. Astrachan and Aronoff (1995) 
surveyed businesses in the distribution, sale, and service of 
construction, mining, and forestry equipment industry, and separately 
surveyed businesses owned by African-Americans. Each of these are very 
special and small subsamples of the estate tax population, and the 
methodology employed is worrisome on a number of dimensions. For 
example, the authors include as a cost of avoidance the amount spent on 
insurance premiums to provide liquidity for paying the estate tax. This 
expense is properly thought of as pre-paying the tax liability, and to 
consider it as a cost in addition to the tax liability itself is surely 
inappropriate double counting.
    Astrachan and Tutterow (1996) survey 983 family businesses in a 
variety of industries and find that family business owners have average 
expenditures of over $33,000 on accountants, attorneys, and financial 
planners working on estate planning issues; family members averaged 
about 167 hours spent on estate planning issues over the previous six 
years (the timeframe for the dollar expenditures is not made clear). 
However, these estimates include life insurance fees that represent 
prepayment of estate tax liabilities. In addition, an unknown fraction 
of the costs is due to estate planning, inter alia about 
intergenerational succession of the business, that is unrelated to 
taxation. Repetti (2000), while corroborating in surveys of estate tax 
attorneys the broad magnitude of the Astrachan and Tutterow results, 
argues that a significant portion of these costs would be incurred even 
in the absence of estate taxes.
    In sum, there is some evidence on the costs of estate planning for 
small businesses, but the estimates are marked by conceptual problems 
and disagreement about the fraction of costs due to the estate and gift 
tax as opposed to non-tax factors or other taxes. For the broader 
population, there is no informative evidence from surveys of wealth 
owners.
V. Simplification and the national retail sales tax
    A national retail sales tax has been proposed recently by 
Congressmen Dan Schaefer (R-CO) and Billy Tauzin (R-LA) and by a group 
called Americans for Fair Taxation (AFT).(11) The sales tax 
base would include almost all goods or services purchased in the United 
States by households for consumption purposes. The imputed value of 
financial intermediation services would also be taxed.(12) 
To tax households' consumption of goods and services provided by 
government, all federal, state, and local government outlays would be 
subject to federal sales tax. The tax would exempt expenditures abroad, 
half of foreign travel expenditures by U.S. citizens, state sales tax, 
college tuition (on the grounds that it is an investment), and food 
produced and consumed on farms (for administrative 
reasons).(13)
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    \11\ See H.R. 2001, ``The National Retail Sales Tax Act of 1997.''
    \12\ For example, households purchase banking services through 
reduced interest rates on their checking account, and the value of 
these implicit payments would be included in the tax base.
    \13\ Retail sales occur when a business sells to a household. Thus, 
purchases of newly constructed housing by owner-occupants would be 
taxable, but resales of existing homes would not be.
---------------------------------------------------------------------------
    The sales tax would provide a demogrant to each household equal to 
the sales tax rate times the poverty guideline, the annual income level 
below which a family of a given size is considered in poverty. States 
would collect the sales tax, and businesses and states would be 
reimbursed for tax collection efforts. The IRS would monitor tax 
collection for businesses with retail sales in numerous states.
    The required tax rate in a national retail sales tax merits 
attention. Tax rates can be described in two ways. For example, suppose 
a good costs $100, not including taxes, and there is a $30 sales tax 
placed on the item. The ``tax-exclusive'' rate is 30 percent, since the 
tax is 30 percent of the selling price, excluding the tax. This rate is 
calculated as T/P, where T is the total tax payment and P is the pre-
sales-tax price. The ``tax-inclusive'' rate would be about 23 percent, 
since the tax is 23 percent of the total payment, including the tax. 
This rate is calculated as T/(P+T). Sales taxes are typically quoted in 
tax-exclusive rates; this corresponds to the percentage ``mark-up'' at 
the cash register. Income taxes, however, are typically quoted at tax-
inclusive rates. The reported tax-inclusive rate will always be lower 
than the tax-exclusive rate and the difference rises as tax rates rise.
    The AFT proposal assumes a 23 percent tax-inclusive rate (30 
percent tax-exclusive). The Schaefer-Tauzin proposal assumes a 15 
percent tax-inclusive rate (17.6 percent tax-exclusive). The difference 
in rates in the two proposals is due to the different taxes slated for 
abolition. Both proposals would abolish taxes on individual income, 
corporate income and estates. The AFT would also eliminate payroll 
taxes, which raise considerable sums currently, while the Schaefer-
Tauzin proposal would eliminate excise taxes, which raise little 
revenue.
    The actual required rates would be much higher, however, for 
several reasons (Gale 1999). First, the plans stipulate that government 
must pay sales tax to itself on its own purchases but fail to allow for 
an increase in the real cost of maintaining government services. Fixing 
this problem alone raises the required rate in the AFT proposal to 35 
percent on a tax-inclusive basis and 54 percent on a tax-exclusive 
basis (Gale 1999). Second, the plans do not allow for any avoidance or 
evasion, though it is universally acknowledged that both will occur. 
Third, the plans propose to tax an extremely broad measure of 
consumption, but political and administrative factors would very likely 
require a narrower base. Conservative adjustments for these factors 
raise the required tax-inclusive rate to 48 percent and the tax-
exclusive rate to 94 percent in the AFT proposal, and 35 percent and 54 
percent, respectively, in the Schaefer-Tauzin proposal (Gale 1999). 
Related analysis by the Joint Committee on Taxation (2000) reaches 
similar conclusions.
A. Sources of complexity
    As a flat-rate consumption tax with a universal demogrant, the 
sales tax contains many of the features that generate simpler taxes. In 
principle at least, the simplicity gains could be impressive. Most 
individuals would no longer need to keep tax records, know the tax law, 
or file returns. The number of taxpayers who would have to file would 
decline significantly, and would include only those sole 
proprietorships, partnerships, and S--and C-corporations that made 
retail sales. The complexity of filing a return would decline 
dramatically as well.
    Nevertheless, a NRST could create new areas of complexity. The 
demogrant is based on the HHS poverty guidelines, which rise less than 
proportionally with the number of family members. Forexample, in 1998, 
the poverty level was $8,050 for a single individual, plus $2,800 for 
each additional family member. Thus, the poverty level for a family of 
four was $16,450, just over twice the level for an individual. This 
structure will create incentives in many households for citizens to try 
to claim the demogrant as individuals rather than families. It is also 
not obvious from AFT descriptions how the demogrants would be 
administered, or even which agencies would be responsible for 
determining eligibility and monitoring taxpayers. Thus, the compliance 
and administrative costs of ensuring that the appropriate demogrant is 
paid could be significant.
    Another area of potential complexity stems from tax avoidance and 
evasion behavior. The primary way to avoid sales taxes would be to 
combine business activity with personal consumption. For example, 
individuals may seek to register as firms, individuals may seek to 
purchase their own consumption goods using a business certificate, and 
employers might buy goods for their workers in lieu of wage 
compensation (GAO 1998). Ensuring that all business purchases are not 
taxed and all consumer purchases are taxed would require record-keeping 
by all businesses, even though only retailers would have to remit taxes 
in a pure retail sales tax. The AFT proposal deviates from a pure 
retail sales tax by requiring that taxes be paid on many input 
purchases and that vendors file explicit claims to receive rebates on 
their business purchases. This would raise compliance costs further.
    A second source of tax avoidance and evasion concerns the 
importation of goods and services from abroad. Imported purchases of up 
to $2,000 per year per taxpayer would be exempt from the sales tax. 
This feature is likely to be exploited fully by many taxpayers, not 
because they travel abroad but because it would be very simple for 
firms to set up off-shore affiliates, warehouses, or mail order houses 
and ship goods to domestic customers. Moreover, it would be very 
difficult to monitor such arrangements and it seems quite likely that 
taxpayers could end up importing more than $2,000 per person on a tax-
exempt basis. Some related evidence on the potential extent of these 
problems comes from the experience with state-level ``use'' taxes under 
which taxpayers voluntarily make tax payments on goods purchased in 
other states. Enforcement of such taxes has been ``dismal at best'' 
(Murray, 1997). The development of electronic commerce could raise many 
additional avoidance and evasion problems for the sales tax.
B. Compliance cost estimates
    There are no rigorous estimates of the compliance and 
administrative costs associated with a high-rate NRST. Some evidence is 
available with respect to state sales taxes. Slemrod and Bakija (1996) 
report that administrative costs were between 0.4 and 1.0 percent of 
sales tax revenues in a sample of 8 states, and compliance costs were 
between 2.0-3.8 percent of revenues in 7 states. Hall (1996) cites a 
Price-Waterhouse study that found that retailers spent $4.4 billion 
complying with state retail sales taxes in 1990. Adjusting for 
increased retail sales between 1990 and 1995, he asserts an NRST with 
no demogrant would have administrative costs of $4.9 
billion.(14)
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    \14\ Adopting IRS time estimates of the costs of completing the 
schedules for interest and dividends, the child and dependent care tax 
credit, and the EITC, Hall estimates that adding a demogrant would cost 
$6.3 billion and thus raise the total cost to $11.2 billion. Hall 
(1996) estimated that taxpayers would spend $8.2 billion to comply with 
the Schaefer-Tauzin NRST. The estimate was also based on experience 
with state sales taxes. It does not include the compliance costs of 
payroll tax credits, used in the Schaefer-Tauzin plan, to rebate sales 
taxes.
---------------------------------------------------------------------------
    Unfortunately, as Slemrod and Bakija (1996) note, compliance cost 
estimates from state sales taxes are likely to vastly understate the 
analogous costs in a NRST for several reasons. First, at 4 and 6 
percent, state sales tax rates are an order of magnitude lower than the 
required rate in a NRST. The higher rates in an NRST would encourage 
more taxpayers to engage in time-consuming taxpayer avoidance and 
evasion activities than under the existing state sales taxes, and this, 
in turn, would increase the required tax rate and compliance and 
administrative costs. Second, state sales tax bases are very different 
from the proposed federal base. States sales taxes typically include a 
significant amount of business purchases (Ring 1999). This reduces 
compliance costs, since distinguishing business and retail sales is 
costly. To avoid taxing business in a NRST may require all businesses 
to file returns and receive rebates, which would raise costs. State 
sales taxes often exclude hard-to-tax sectors. All states exempt 
financial services from their retail sales taxes, but the NRST would 
not. Third, states do not provide demogrants.
    On the other hand, states often exempt from taxation goods such as 
food, housing, rent, and health care, for political or social reasons. 
This increases compliance costs relative to taxing a broader base 
because defining the boundaries of the exemption (for example, 
distinguishing ``food'' and ``candy'') can be difficult, and record 
keeping requirements can be extensive. However, if a NRST required high 
rates, there would be massive political pressure to exempt goods like 
food, health care, and rent.
C. Other sales taxes
    To address administrative problems and other concerns with the 
retail sales tax, many countries have employed value-added taxes 
(VATs). VATs are paid by businesses and impose taxes on all sales, 
including business-to-business transactions. Each business owes taxes 
on its sales and receives deductions or credits to account for the 
taxes it paid on its purchases. Controlling for administrative factors, 
the net economic effect of a VAT should be the same as an NRST. The key 
administrative advantage of a VAT over an NRST is that the existence of 
a paper trail can improve compliance rates. The chief disadvantage is 
the added compliance costs created. See Cnossen (1999) for further 
discussion.
    Mieszkowski and Palumbo (1998) describe a ``hybrid NRST'' which 
would add the following features to a retail sales tax: (a) taxes would 
be due on all sales of multi-purpose goods and services used as final 
consumption goods or business inputs, (b) businesses would file for 
rebates for the taxes collected on business inputs, and (c) sales taxes 
would be withheld at pre-retail stages of production and distribution, 
such that taxes collected at one stage of production and distribution 
are credited at the next stage.(15) This system would 
improve compliance relative to the NRST by developing a more extensive 
paper trail to identify suspicious returns and facilitate tax audits. 
However, the tax would also be more complex. A system of cross-checks 
and cross-reporting would be needed to limit fraud. The number of firms 
required to file would rise much closer to VAT levels than NRST levels. 
And businesses would file more frequently, perhaps on a bi-weekly or 
even weekly basis, in order to claim refunds. Mieszkowski and Palumbo 
concur with those who claim, as we do above, that the compliance 
experience of state sales tax is not very relevant for formulating cost 
estimates for a high-rate national sales tax. They note that the 
compliance costs of a hybrid NRST would likely be ``several multiples'' 
of the $20 billion compliance cost estimates they cite for an NRST. 
Note that if several equals ``four,'' the costs of complying with and 
administering this system would be as high as Slemrod's estimated costs 
for the income tax.
---------------------------------------------------------------------------
    \15\ See also Gillis, Mieszkowski, and Zodrow (1996), and Zodrow 
(1999).
---------------------------------------------------------------------------
VI. Simplification and the flat tax
    Originally developed by Robert Hall and Alvin Rabushka (1983, 
1995), the flat tax has been proposed in legislative form by 
Representative Richard Armey (R-TX) and Senator Richard Shelby (R-
AL).(16) Under the flat tax, businesses would pay taxes on 
the difference between gross sales (including business-to-business 
transactions) and the sum of wages, pension contributions, and 
purchases from other businesses, including the cost of materials, 
services, and capital goods. Individuals would pay taxes on their wages 
and pension disbursements, less exemptions of $21,400 for a married 
couple ($10,700 for single filers) and $5,000 for each dependent. Both 
individuals and businesses would pay the same flat tax rate, estimated 
by Treasury (1996) to be 20.8 percent (on a tax-inclusive basis). As 
with the sales tax, realistic versions of the flat tax will require 
higher rates. Unlike the sales tax, however, the required rate estimate 
for the flat tax already incorporates evasion and avoidance and does 
not assume that government tries to raise revenue by taxing itself. The 
only significant adjustments are for transition relief and the possible 
retention of some major deductions and credits due to political 
pressures. Adjusting for those factors, the required rates range 
between 21 percent and 32 percent (Aaron and Gale 1996).
---------------------------------------------------------------------------
    \16\ See H.R. 1040 and S. 1040, ``Freedom and Fairness Restoration 
Act of 1997.''
---------------------------------------------------------------------------
A. Sources of complexity
    As with the sales tax, the proposed flat tax would change the tax 
base to consumption, flatten tax rates, eliminate all deductions and 
credits in the tax code, and vastly simplify tax compliance. For 
taxpayers who were not self-employed, the individual filing requirement 
could probably be eliminated. For those that did have to file, the tax 
form could be a relatively short postcard with simple calculations. The 
tax would eliminate individual-level taxation of capital gains, 
interest and dividends and the individual AMT.
    Any well-functioning business already retains records of wages, 
material costs and investments, so tax filing would impose little 
additional cost. The flat tax would eliminate the differential 
treatment of debt versus equity, the uniform capitalization rules, the 
corporate alternative minimum tax, depreciation schedules, rules 
regarding defining a capital good versus a current input, depletion 
allowances, corporate subsidies and credits, the potential to arbitrage 
across different accounting systems, and a host of other issues. The 
tax distortions currently caused by inflation would vanish.
    Nevertheless, the flat tax would retain some existing sources of 
complexity and exacerbate others. It would also create entirely new 
areas of complexity, and the types of complexity it would abolish could 
easily creep back into the code. Some areas of the existing tax code 
are also common to the flat tax and would prove just as difficult as 
ever. These include rules regarding independent contractors versus 
employees, qualified dependents, tax withholding for domestic help, 
home office deductions, taxation of the self-employed, and non-
conformity between state and federal taxes. The treatment of travel and 
food expenses might also cause problems. To the extent they are a cost 
of doing business, the expenses should be deducted in the flat tax. To 
the extent they are a fringe benefit, they should not. Making this 
determination may prove difficult. Graetz (1997) emphasizes the 
numerous problems in the existing system that would be retained in the 
flat tax.
    A potentially more troubling issue is that, since the flat tax 
makes different distinctions than the existing system does, the flat 
tax will create new ``pressure points,'' and so could create a host of 
new compliance and sheltering issues. For example, under the existing 
income tax, a firm must pay taxes on interest income as well as income 
from sales of goods. In the business portion of the flat tax, receipts 
from sales of goods and services are taxable, but interest income is 
not. This creates an important incentive in transactions between 
businesses subject to the flat tax and entities not subject to the 
business tax (households, governments, non-profits, and foreigners): 
the business would like to label as much cash inflow as possible as 
``interest income.'' The other party (not subject to the business tax 
component of the flat tax) is indifferent to such labeling. The same 
possibility occurs for cash outflows from businesses. Outflows that are 
labeled purchases of goods and services or capital investments are 
deductible, while outflows that are labeled interest payments are not 
deductible. This creates obvious incentives for businesses to label as 
``purchases'' as much of their cash outflow as possible, and possibly 
seriously erode the tax base and tax revenues. Thus, while it equates 
the tax treatment of debt and equity flows, the flat tax creates a new 
wedge between inflows labeled ``sales'' and those labeled ``interest,'' 
and a new wedge between outflows labeled ``purchases'' and those 
labeled ``interest expense.'' Concerns that these wedges would be 
easily manipulated led McLure and Zodrow (1996) to conclude that the 
business tax ``contains unacceptable opportunities for abuse.''
    Another new area of complexity concerns wages, fringe benefits, and 
current operating expenses. Under the current system, all are 
deductible to firms. Under the flat tax, however, fringe benefits are 
not deductible. Gruber and Poterba (1996) speculate that this wedge 
could bring back the ``company doctor.'' In the flat tax, a firm's 
contribution for health insurance would not be deductible, but its 
payment for in-house doctors, nurses, and medical equipment would be 
deductible.
    Some flat tax rules will exacerbate existing tax complexities. The 
sheltering of personal consumption, especially durable goods, through 
business would become more important due to the more generous deduction 
for expensing. Conversion of business property to individual use ought 
to generate taxable income for the business, but would be hard to 
monitor.
    The tax treatment of mixed business and personal use raises a 
number of issues. A family who rents rooms in its home or has a 
vacation home must currently follow fairly complex rules for allocating 
expenses and depreciation between personal and rental use. The flat tax 
is based on cash flow, however, so it is not clear how such items would 
be handled. Suppose a taxpayer bought a home in year 1 and in year 5 
decided to begin renting a room in the house. What deduction for the 
cost of the capital good would the homeowner be able to take? The 
answer should not be ``none'' since depreciation is a legitimate 
business expense. Nor should the answer be ``expensing'' since the flat 
tax is based on cash flow and the house did not become a business 
property until year 5, during which there was no house purchase. But 
any other answer will lead to a potentially complicated new set of 
rules (or the same rules that currently exist). Also, if a deduction 
were allowed, then the decision to stop renting the room or the 
vacation home after a period of time would implicitly convert a 
business asset to personal use and so should be taxed at the business 
level under the flat tax (Feld 1995).
    Current law imposes limits on how taxes or losses may be allocated 
among different taxpayers. These provisions regarding consolidated 
returns, S-corporations, and partnerships stop firms from merging 
solely for tax purposes. They appear to have no counterpart in the 
proposed flat tax. However, as Feld (1995, p. 610) notes: ``the logical 
conclusion of unregulated allocation of deductions would allow free 
transferability of losses. Historically, however, the outcry against 
the opportunity by wealthy businesses to purchases exemption from 
income tax has produced the existing restrictions on the transfer of 
loss corporations and repeal in 1982 of the finance lease provisions of 
the 1981 tax act.'' It thus seems likely that a complex set of laws 
would have to be imposed to stop such behavior.
    Taxpayers may also create pressure to find ways to transfer income 
between wages and business income. Under the flat tax, business and 
wage incomes are recorded on separate forms. Thus, a business loss may 
be carried forward, but--unlike in the current system--it can not be 
used to offset current wage income.
    The flat tax would create several incentives regarding cross-border 
flows. Firms would have incentives to engage in transactions that 
shifted interest expense offshore and interest income into the United 
States. Transfer pricing would probably work to encourage firms to 
locate more profits in the United States, since the tax rate would be 
lower here than in most other industrialized countries. Both of these 
issues would be easy to exploit and would drain revenues from foreign 
countries. Some sort of retaliation, adjustment or treaty negotiation 
might be expected, which would then require changes in the tax 
treatment of international flows under the flat tax (Hines 1996).
    Feld (1995) highlights a variety of additional concerns with the 
business tax, including the role of in-kind transfers to a corporation, 
the definition of a business input (and the possible need to exempt 
passive assets from the definition), and possibly complex rules for 
hedging transactions to distinguish those that are part of the business 
from those that are investments by the individual.
    Despite its apparent simplicity, the individual tax also creates 
some potential areas of complexity (Feld, 1995). First, the flat tax 
would effectively renegotiate every alimony agreement in the country. 
Under the flat tax and other reform proposals, alimony payments would 
no longer be deductible and alimony receipts would no longer be 
taxable. Second, suppose that Victim earns money and then Robber takes 
it away. Under the flat tax, Victim is still liable for taxes, and 
Robber is not. Under the income tax, it is the other way around. Third, 
prize money won by contestants would be deductible by the sponsoring 
organization as an expense, but does not appear to be taxable as wages. 
Addressing any of these problems would make the flat tax more complex.
    Lastly, a new system will inevitably create unintended loopholes 
that will need to be addressed via corrective tax measures. It would be 
a mistake to underestimate the creative ingenuity of America's 
accountants, attorneys, and tax planners.
    To be clear, all of the concerns noted above could be resolved by 
writing carefully detailed rules covering each contingency. But of 
course that is what the current system already does. There is little 
reason to believe that the ultimate resolution of most of these issues 
will be simpler under the flat tax than in the current system. Feld 
(1995) concludes that to avoid losing revenues, the flat tax will 
either generate complicated business transactions (to skirt the simple 
rules) or complicated tax laws (to reduce the gaming possibilities), or 
both. This conclusion seems quite reasonable to us.
    All of the discussion above focuses on the pure flat tax. However, 
if the flat tax were implemented, ``[w]e should expect near unanimity 
that it will be necessary to provide transition relief'' (Pearlman, 
1996). Zodrow (2000) concurs that some transitional relief is 
``virtually inevitable.'' Pearlman and Zodrow discuss the various types 
of transition relief that could be provided, including compensating 
firms for lost depreciation deductions and carry forwards of AMT 
credits, net operating losses and foreign tax credits. The treatment of 
interest deductions will also require attention. More generally, 
because taxes are embedded in the fabric of existing legal contracts, 
transitioning to a new tax system could potentially affect numerous 
aspects of agreements in other areas. The effect on alimony, noted 
above, is one such example. Pearlman concludes (p. 419) that 
``inevitably, any approach [to transition relief] will make the new law 
more complex for a long time.''
    Another potential source of complexity is the reintroduction of 
social policy into the tax code. The pure flat tax would be devoid of 
all social policy initiatives. Thus, the flat tax would not only change 
tax policy, but also reduce the generosity of subsidies toward housing, 
the charitable sector, family and children, education, health 
insurance, state and local governments, etc. For each existing 
deduction and credit, however, a political case would be made that the 
subsidy should be retained. To the extent that social policy creeps 
back into the flat tax, there will be added complexity. Notably, 
because the flat tax has an individual component--whereas the sales 
tax, for example, does not--social policy in the flat tax can be 
tailored to individual circumstances. However, credits for children, 
child care, and education all raise issues of eligibility, compliance 
and phase-outs. Retention of popular deductions would require 
additional record-keeping, reporting and monitoring. Retention of the 
mortgage interest deduction, in a system that does not tax interest 
income, could create arbitrage opportunities and added record-keeping 
costs. Corporate subsidies for research, environmental clean-up, and 
other goals could easily wend their way back into the business tax. And 
to the extent that the demand for any of these programs remained and 
the tax system was able to remain clean, there is a possibility that 
the programs would return as spending or regulatory initiatives.
    A third source of complexity in a modified flat tax concerns the 
real and perceived distributional effects. Families in the very highest 
income or consumption strata would see tax burdens fall dramatically 
(Gale, Houser, and Scholz 1996). The flat tax would make poor families 
worse off, because it would eliminate the earned income tax credit, but 
the increased burdens on the poor would not be as large as the reduced 
burdens on high-income families. The difference would be made up by 
increased taxes on middle-class families (Dunbar and Pogue 1998; Gale, 
Houser and Scholz 1996; Gentry and Hubbard 1997; Mieszkowski and 
Palumbo, 2000).(17)
---------------------------------------------------------------------------
    \17\ Fullerton and Rogers (1996) and Metcalf (1997) show that the 
distributional impacts over taxpayers' lifetime are not as extreme as 
those on an annual basis. The relevance of this finding for political 
support of the flat tax, however, is debatable.
---------------------------------------------------------------------------
    It seems unlikely that these distributional effects will pass 
political muster. Retaining the earned income tax credit would reduce 
much of the distributional loss of the pure flat tax (Gale, Houser, and 
Scholz 1996), but would raise compliance costs. Moving to a Bradford-
style X-tax (which would use the flat tax base, but has graduated tax 
rates on wages and sets the business tax rate at the highest wage tax 
rate) would provide more progressivity, but would also create 
administrative and compliance problems. It would significantly increase 
the revenue loss from transition relief. This would require higher tax 
rates on the remaining tax base. It would re-introduce taxpayer 
incentives and attempts to redistribute income across people or over 
time to exploit tax rate differentials. By raising tax rates at the 
high end of the income distribution, it would increase political 
pressure to restore popular itemized deductions.
    A number of issues regarding what economists might describe as 
perceptions of fairness also arise. For example, there will be an 
inexorable tendency to compare the flat tax to an income tax because 
both are collected from individuals and businesses. Despite the fact 
that taxes on capital income will be collected at the business level, 
the non-taxation of capital income at the individual level may upset 
citizens who are used to seeing people remit taxes directly to the 
government on the capital income they receive.(18)
---------------------------------------------------------------------------
    \18\ The flat tax would not tax the normal return to capital, only 
the excess return. That reduction in the effective tax rate on capital 
income may be a source of added controversy in the flat tax, but it is 
distinct from the issue addressed in the text, which concerns whether 
taxes on capital income are remitted by individuals or businesses.
---------------------------------------------------------------------------
    Several perception issues arise in the business tax. Unlike the 
current corporate or individual business taxes, the business tax in the 
flat tax does not attempt to tax profits. Changing the entire logic and 
structure of business taxation will create several situations that will 
be perceived as problems by taxpayers and firms, even if they make 
perfect sense within the overall logic of the flat tax.
    First, some businesses would face massive increases in their tax 
liabilities. For example, Hall and Rabushka (1995) note that General 
Motors' tax liability would have risen from $110 million in 1993 under 
the current system to $2.7 billion under a 19 percent flat tax. Despite 
economists' view that individuals-not businesses--bear the burden of 
taxes, there will likely be massive resistance at the business level to 
such changes. Businesses who oppose such change will demand reductions 
in the tax base or other types of relief.
    Second, some businesses with large profits will pay no taxes. 
Profit (before federal taxes) is equal to revenue from sales and other 
sources less deductions for depreciation, interest payments, materials, 
wages, fringe benefits, payroll taxes, and state and local income and 
property taxes. The tax base in the business tax, however, is equal to 
revenue from sales minus materials, wages, pension contributions, and 
new investment. Thus, if a firm had large amounts of revenue from 
financial assets (i.e., not from sales of goods and services), it could 
owe no taxes or even negative taxes under the flat tax even though it 
reported huge profits to shareholders. This situation is consistent 
within the context of the flat tax. But in the past, precisely this 
situation led to the strengthening of the corporate and individual 
alternative minimum taxes, which are universally regarded as one of the 
most complex areas of the tax code. It is hard to see why those same 
pressures would not arise in the flat tax.
    The third issue is the flip side of the second: some firms with low 
or negative profits may be forced to make very large tax payments. For 
example, a firm with substantial amounts of interest expense, fringe 
benefits, payroll taxes, and state and local income and property taxes 
could report negative profits, but since these items are not deductible 
in the flat tax, the firm could still face stiff tax liabilities. 
Again, this makes sense within the context of the flat tax, but will 
not be viewed as fair by firm owners who wonder why they have to pay 
taxes in years when they lose money and who will push for reforms. 
Misunderstanding of this point could be very important. For example, 
the Wall Street Journal editorial board (February 5, 1997), a strong 
supporter of the flat tax, nevertheless complains about a German tax 
that can force companies to pay taxes ``even when they are losing 
money.'' The flat tax, however, would do exactly the same thing for 
some firms. This will lead to efforts by businesses to retain currently 
existing deductions for health insurance, payroll taxes and state and 
local income and property taxes. Taken together, these deductions would 
cut the business tax base by more than half.
B. Compliance cost estimates
    Slemrod (1996) and Hall (1996) have attempted to quantify the 
compliance costs of the pure flat tax. Both authors' estimates ignore 
transition issues and the potential reemergence of social policy. Using 
the ADL model for taxpayer hours described above and valuing taxpayer 
time at $39.60 per hour, Hall estimates that the costs of record-
keeping, learning about the tax law, form preparation, and packaging/
sending would equal $8.4 billion. The projected 93 million individual 
returns are estimated to take an average of one hour and eight minutes. 
The projected 24.4 million business returns are estimated to take an 
average of three hours and 24 minutes to complete.
    Hall's estimates seem both significantly too large in some respects 
and significantly too small in others. For example, valuing 
individuals' time at $15 per hour and business time at $25 per hour, as 
Slemrod does, would reduce the estimate by about half. On the other 
hand, some of the time estimates seem implausibly low, and possibly off 
by orders of magnitude. Individual taxpayers are estimated to spend an 
average of 2.4 minutes per year doing record keeping for tax purposes. 
Businesses are estimated to spend only 2.3 hours per year on record 
keeping for tax purposes. Remarkably, especially in light of the 
discussion above on possible areas of complexity, businesses are 
estimated to spend an average of only 18 minutes learning about the tax 
law, and 24 minutes gathering all the relevant documents and preparing 
the return. In addition, Hall's estimate leaves out many components of 
compliance costs, such as tax planning and auditing.
    Slemrod concludes (1996, p. 375) that ``it is impossible to 
confidently forecast the collection cost of the business part of the 
flat tax on the basis of observable systems, because none exists.'' 
Instead, he offers an educated guess that the flat tax would cut 
business compliance costs (which were $17 billion in the individual 
income tax and $20 billion in the corporate tax) by one-third, and cut 
individual filing costs by 70 percent (from $33 billion to $10 
billion), for total compliance costs of about $35 billion. This is $35 
billion less than his compliance cost estimate for the income tax, or 
about 0.5 percent of GDP in 1995.(19)
---------------------------------------------------------------------------
    \19\ Calegari (1998) and Weisbach (1999) make a variety of points 
similar to those above and extend the analysis in a number of 
directions in their insightful analyses of administrative issues in the 
flat tax.
---------------------------------------------------------------------------
VII. Conclusions
    As a purely technical matter, tax complexity and tax evasion can be 
reduced, and tax administration can be made more just and efficient. As 
a political and policy matter, however, making these improvements have 
proven quite difficult. Efforts to simplify the tax system typically 
run up against conflict with other tax policy goals, political factors, 
taxpayers' efforts to avoid and evade taxes, and revenue requirements. 
Each of these factors tends to shape the base, credits, deductions, 
rate structure and administrative aspects of the tax system in ways 
that raise complexity. Efforts to reduce evasion sometimes run into 
similar problems.
    To the extent that simplicity is a goal of tax reform, many 
improvements could be made within the existing system. Pure versions of 
both the national retail sales tax and the flat tax could be vastly 
simpler than even an improved income tax. But realistic versions of the 
flat tax and especially the sales tax would require tax rates much 
higher than advertised by their proponents. These higher rates 
complicate tax compliance and enforcement. The sales tax would face 
potentially serious problems with enforceability and political pressure 
for exemptions. The flat tax would face the same political pressures, 
and while enforceability is not a major issue, the tax would likely 
become significantly more complex than currently proposed.
    Thus, simplification is an important goal of tax reform, but 
lasting and significant simplification may prove difficult to 
establish. Policy makers and voters should, therefore, weigh the costs 
and benefits of simplification against the other goals of tax policy.
                                 ______
                                 
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Econometric Analysis. Public Finance Quarterly 17(1): 3-27.
    Slemrod, Joel. 1996. Which is the Simplest Tax System of Them All? 
In Economic Effects ofFundamental Tax Reform, edited by Henry J. Aaron 
and William G. Gale. Washington, DC: Brookings Institution Press, 335-
391.
    Slemrod, Joel and Jon Bakija. 1996. Taxing Ourselves: A Citizens 
Guide to the Great Debate Over Tax Reform. Cambridge, MA: MIT Press.
    Slemrod, Joel and Marsha Blumenthal. 1996. The Income Tax 
Compliance Cost of Big Business. Public Finance Quarterly 24(4): 411-
438.
    Slemrod, Joel and Nikki Sorum. 1984. The Compliance Cost of the 
U.S. Individual Income Tax System. National Tax Journal 37(4): 461-74.
    Slemrod, Joel and Shlomo Yitzhaki. 2000. Tax Avoidance, Evasion, 
and Administration. NBER Working Paper No. 7473. Cambridge, MA: 
National Bureau of Economic Research.
    Steuerle, C. Eugene. 1997. Paying Taxpayers to File Electronic 
Returns. Tax Notes October 27: 477-478.
    Office of Management and Budget. 1998. Draft Report to Congress on 
the Costs and Benefits of Federal Regulations. Federal Register 
63(158): 44034-44099.
    Vaillancourt, Francois. 1986. The Administrative and Compliance 
Costs of the Personal Income Tax and Payroll Tax System in Canada. 
Toronto: Canadian Tax Foundation.
    Weisbach, David A. 1999. Implementing the Flat Tax. Mimeo. 
University of Chicago Law School, July 20.
    Zodrow, George R. 1999. The Sales Tax, the VAT, and Taxes in 
Between--Or, Is the Only Good NRST and 'VAT in Drag?'. National Tax 
Journal 52(3): 429-42.
    Zodrow, George R. 2000. Transitional Issues in the Implementation 
of a Flat Tax or a National Retail Sales Tax. Mimeo.

                                Table 1

 The Economic Growth and Tax Relief Reconciliation Act: Effective Dates and Revenue Costs of Selected Provisions
----------------------------------------------------------------------------------------------------------------
                                                                 Highest              Phase-
                           Provision                              Annual  2001-2011     in     Phase-in   Phased
                                                                 Tax Cut   Tax Cut    Begins   Complete   Out By
----------------------------------------------------------------------------------------------------------------
Reduce marginal income tax rates...............................     63.0      420.6     2001       2006     2011
Abolish estate tax.............................................     53.9      138.0     2002       2010     2011
Create 10 percent bracket......................................     46.0      421.3     2001       2002     2011
Double child credit............................................     26.2      171.8     2001       2010     2011
Marriage penalty...............................................     11.0       63.3     2005   -varies-     2011
Repeal restrictions on itemized deductions and personal              9.4       33.0     2006       2010     2011
 exemptions....................................................
Pension and IRA provisions.....................................      6.7       49.6            -varies-
Nonrefundable credit...........................................      2.1       10.0     2002       2002     2007
Roth 401(k)s...................................................      0.4       -0.3     2006       2006     2011
AMT Relief.....................................................      4.6       13.9     2001       2001     2005
Deduction for education expenses...............................      2.9        9.9     2002       2004     2006
All provisions.................................................    187.0    1,348.6            -varies-     2011
----------------------------------------------------------------------------------------------------------------
Source: Joint Economic Committee on Taxation JCX-50-01. ``Summary of Provisions Contained in the Conference
  Agreement for H.R. 1836, the Economic Growth and Tax Relief Reconciliation Act of 2001''. May 26, 2001.

                                Table 2

                                       Surveys of Individual Taxpayer Time
----------------------------------------------------------------------------------------------------------------
                                                                                               Blumenthal and
                   Survey                       Arthur D. Little      Slemrod and Sorum           Slemrod
----------------------------------------------------------------------------------------------------------------
Data Source................................       National random       Random survey of       Random survey of
                                                  survey of 6,200        2,000 Minnesota        2,000 Minnesota
                                                    individuals a              residents             households
Response Rate..............................                 65.3%                  32.7%                  43.4%
Sample Size b..............................                 3,750                    600                    708
Types of Returns...........................   1983 federal income       1982 federal and       1989 federal and
                                                                            state income           state income
Hours Per Activity (in billions)
Recordkeeping..............................                   0.7                    1.3                    1.7
Learning...................................                   0.3                    0.2                    0.4
Time with Preparer.........................                    --                    0.4                    0.2
Preparing Return...........................                   0.5                    0.1                    0.5
Sending....................................                   0.1                     --                     --
Rearranging Financial Affairs..............                    --                     --                    0.3
Total Hours................................                   1.6                    2.1                    3.0
Value of Time..............................                    --   $10.65/hour in 1982$         $10.09 in 1989
                                                                    $13.69/hour in 1989$                      $
Out-of-Pocket Costs........................                    --    $44/return in 1982$     $66/return in 1989
                                                                    $57/return in 1989$ c                     $
Total Costs for Individuals................                    --       $26.7 billion in       $37.6 billion in
                                                                                   1982$                  1989$
                                                                        $34.1 billion in   $34.8 billion w/ same
                                                                                   1989$     activities as 1982
Adjustments to Survey (if any).............   Survey results were   Weighted nationally.   Weighted nationally.
                                             used to obtain models  Accounting for biases
                                                   for estimating   in estimates, authors
                                                 taxpayer burden.      suggest estimates
                                             Estimates above from     could be as low as
                                                          models.           $17 billion.
----------------------------------------------------------------------------------------------------------------
a Arthur D. Little also surveyed 4,000 corporations and partnerships, with a response rate of 36.8 percent.
  Businesses found to spend 1.6 billion hours on recordkeeping, 0.1 billion hours on learning, 0.1 billion hours
  on obtaining materials, 0.1 billion hours on finding and using a preparer, 0.7 billion hours on preparing the
  return, and 0.1 billion hours on sending. Total business time: 2.7 billion hours.
b The sample size was reduced by incomplete or inconsistent responses, as well as nonrespondents.
c Blumenthal and Slemrod report that the average out-of-pocket expenditure for 1982 taxpayers (in 1989 dollars)
  was $45. This appears inconsistent with the estimate shown in the Slemrod and Sorum study, which shows that
  the average out-of-pocket expenditure for 1982 taxpayers was $44 in 1982 dollars--which would be consistent
  with $56.5 in 1989 dollars.

                                Table 3

                             Estimates of Costs of Operating Income Tax System: 1995
----------------------------------------------------------------------------------------------------------------
                                                                                               Payne (1985 in
                  Components                        Slemrod 1995           Hall a 1995             1995$)
----------------------------------------------------------------------------------------------------------------
Individuals
Hours Data....................................        Blumenthal and      OMB estimates of   ADL models for 1985
                                                             Slemrod    average hours (ADL
                                                                          models for 1995)
Total Hours...................................           2.8 billion           1.2 billion           1.8 billion
Valuation.....................................   $15/hour (after-tax   $39.6/hour (average     $40/hour (average
                                                        hourly wage)     labor cost of IRS     labor cost of IRS
                                                                                and Price-  and Arthur Andersen)
                                                                               Waterhouse)
Value of Time.................................           $42 billion           $46 billion           $73 billion
Out-of-Pocket.................................            $8 billion                    --            $8 billion
Total Costs...................................           $50 billion           $46 billion           $81 billion
Businesses
Hours Data....................................    ADL survey in 1983      OMB estimates of   ADL models for 1985
                                                                        average hours (ADL
                                                                          models for 1995)
Total Hours...................................           800 million           2.4 billion           3.6 billion
Valuation.....................................              $25/hour   $39.6/hour (average     $40/hour (average
                                                                         labor cost of IRS     labor cost of IRS
                                                                                and Price-  and Arthur Andersen)
                                                                               Waterhouse)
Total Costs...................................           $20 billion           $95 billion          $145 billion
Other Taxpayer Costs..........................                  N.A.                  N.A.         $27 billion b
                                                                                            (avoidance, evasion)
                                                                                                     $18 billion
                                                                                            (enforcement burden)
Total Compliance Costs........................           $70 billion          $141 billion          $271 billion
Total Administrative Costs....................            $5 billion                    --            $6 billion
Total Operating Costs.........................           $75 billion                    --          $277 billion
----------------------------------------------------------------------------------------------------------------
a Hall includes individual income tax returns with Schedules C and F in the business category. The other
  estimates include these returns in the individual category.
b Payne would include $236 billion that he estimates represents the distortionary effects of the income tax.
  Such costs are not typically included in the operating costs of the tax system and are not included in the
  table.

                                

    Chairman Houghton. All right. Well, thanks very much, Mr. 
Gale. Let me start off though, if I could, a minute. And I 
don't know how the others in the panel feel about this, but you 
know I think when you get into form and structure and basic 
concepts, I think we are dealing with something which is very, 
very difficult. When we are even dealing with policy, that is 
difficult. What I am thinking about is just the mechanics, just 
some of the detailed mechanics of simplification and redundancy 
and things like that. And the reason I say that is that if you 
know, 1 to 10, if 10 is the overall tax structure and 1 is the 
individual return, if we can just do a few things, as I like to 
say, waiting for the bank heist, why can't we knock off a 
couple of gas stations. And if we can do something simple it 
would be far better because I have a feeling that if you look 
back in years past nothing has ever gotten done. There have 
been so many different tax proposals, so many different 
suggestions, and we never have gotten off the dime here.
    It would seem to me if we could do two things, and I am 
just talking for myself, if we could look at those specific 
things which some of you have mentioned in your testimony, so 
we could do them tomorrow, I mean, I don't mean next week, I 
mean tomorrow, that are not subject to legislation but as sort 
of an administrative fix, then also we can begin to make 
Congress aware of the fact that they are really the culprit, 
because Congress does these things. And as a Member, I 
criticized President Clinton for this and it was unfair of me 
because we do the same thing. I can remember him giving one of 
his State of the Union speeches, saying we have got to get rid 
of tax credits, they are a curse on the tax system, and next 
thing that came up there were 28 different tax credits. We do 
the same thing ourselves. We never think of the cost-benefit. 
We never think of this.
    So if there could be a beginning of the recognition of our 
part in this whole puzzle but also get together certain 
specifics so at the end of this year we can look back and say 
we did something, it wasn't very much but it was a start. That 
is what I am looking for. I don't know whether you gentlemen 
have any comment on that or not?
    Mr. Steuerle. I agree with you, Mr. Chairman. I think often 
the perfect is the enemy of the good. It seems to me, as you 
are arguing and as Mr. Gale emphasized this in his testimony, 
there are a lot of the tax laws that are inevitably going to be 
complex. It is not just policy, it is also that taxes are based 
on transactions, that people have to record transactions. When 
one promises the world simplicity and can't deliver it, then at 
least politically one is worse off almost than doing nothing; 
whereas if one promises a modest amount of improvement and 
delivers on it, I think that becomes quite believable.
    I do think the types of simplifications that the Joint 
Committee put forward are exactly of that latter. I think they 
are quite doable. I do think also, however, as I emphasized, I 
think there are two processes that you have to think about. One 
is the process with respect to legislation that is already 
passed. Here I think one would emphasize things like the Joint 
Committee report. Mrs. Thurman emphasized this, I think, in her 
questions to Lindy Paull: you think about the processes that we 
undergo when we pass due legislation. Before we pass a bill 
can't we just put one person at the table whose only job is to 
report on simplification? It is not that simplification would 
always win out, but it would be given great weight in the 
process.
    Have the IRS there, force them to produce any tax form they 
can in time before you pass the bill. I can tell you a lot of 
enactments would not be made if you actually just saw the tax 
form. I actually did this once as Deputy Assistant Secretary of 
the Treasury. It changed some legislation at the last minute. 
So first is process reform with respect to current legislation.
    Second, past legislation is harder. If you act as in the 
last tax bill, and you can't create any losers, it is very hard 
to get simplicity because you are always patching on to an 
existing system. And patches usually add complexity. I give an 
example in my testimony of what happened with the child credit, 
the refundable child credit. If there was going to be 
refundability, everybody, left and right, conservative and 
liberal, agreed that the simpler way to do it would have been 
just to phase out the earned income credit more slowly. But for 
a variety of political reasons that wasn't on the table. So you 
got into this world of having to do it through the refundable 
child credit. And then there was a particular set of potential 
losers who were families with three or more children. We 
couldn't let them lose, so we had to keep their refundable 
credit, too. We ended up with this maze.
    Chairman Houghton. Well, listen, thank you very much. My 
time is really up. I would like to ask Mr. Coyne.
    Mr. Coyne. Thank you, Mr. Chairman. Mr. Gale, are you 
familiar with the attempts that were made, in fact included in 
the recent tax bill, tax legislation, relative to simplifying 
the earned income tax credit provision?
    Mr. Gale. Yes, in terms of simplifying the income 
definitions and the phase-outs, yes.
    Mr. Coyne. What are your thoughts on that and I wonder if 
could you tell us what more you think needs to be done in the 
area of the earned income tax simplification?
    Mr. Gale. I think that the two bright spots in the tax bill 
for simplification were first the earned income tax credit 
(EITC), simplifying and clarifying the income definition in 
terms of the various parts of the program and, second, the 
repeal of the personal exemption phase-outs and the limitations 
on itemized deductions. Those two bright spots of course are 
swamped by the sunset provisions and the phase-in and phase-out 
provisions which introduce an enormous amount of complexity or 
uncertainty in tax planning. I think the EITC itself is not 
tremendously complex right now. I think there is additional 
potential to simplify tax issues for low income households by 
combining the earned income credit, the child credit and the 
personal exemptions. Particularly if you have the same 
definition of a qualifying child for all three programs, there 
is no reason why when someone has stated their income and their 
number of kids that they shouldn't be able to kick right into 
all three of those programs at the same time without having to 
do separate worksheets. In the grand scheme of things that 
might not be the most important issue, but as the Chairman 
mentioned, we need to address these issues one at a time, and 
that is probably a very good place to start.
    Mr. Coyne. Did you include that in your written testimony?
    Mr. Gale. There is a reference to it, yes.
    Mr. Coyne. We could get you to elaborate on that.
    Mr. Gale. Certainly.
    Mr. Coyne. Thank you.
    Chairman Houghton. Mr. McNulty.
    Mr. McNulty. No questions.
    Chairman Houghton. Mr. Brady.
    Mr. Brady. Just briefly, Mr. Chairman. Like you, I have 
been excited and looking forward to this hearing. 
Simplification is such a key issue and of course like most 
things in life, as soon as you getexcited about a hearing your 
schedule gobbles up all your time and you miss the testimony. I don't 
know if that ever happens to you, but I apologize for not being here.
    I think one of the debates we have been having is whether 
we spend our time working to improve and simplify the Tax Code 
we have today, attacking the recommendations like our Chairman 
has spoken about or go after fundamental reform. I am convinced 
we have to do both, that we have to have two tracks, improve 
the product we have today in whatever area we can, as soon as 
possible, maybe using the criteria that the Joint Committee set 
out today or your own criteria. And I really am convinced that 
as long as we have an income-based and the income interpreted-
based tax system we are going to have these problems. And at 
some point I think unless we have a sunset date for this Tax 
Code, that our grandchildren will be sitting here debating ways 
to simplify the current Tax Code. My experience is unless we 
set a date to sunset the Tax Code, whether it is 4 or 6 or even 
10 years from now, my experience is if we set the deadline for 
midnight we will start working on it about 11:00. We will 
likely get done at 2:00, maybe later in the morning. But we do 
end up finishing that job. And I am convinced without some date 
certain that we have to really sit down, debate, work through 
this Tax Code in some time where we have a good thoughtful 
debate on it, perhaps removed from the immediacy of this 
election or this election cycle, that without both those tracks 
working that we will end up with very little in the end run.
    Any comments from the panel?
    Mr. Gale. Sure, just a couple. I think we would all like to 
see a simpler tax system. Personally I am concerned about 
proposals to sunset the Tax Code. I understand that saying we 
will make a decision by date X is a good model for a business 
with a hierarchal framework but I think a Congress is sort of 
535 businesses all meeting at the same time, all with different 
objectives. And it is not obvious to me that if we sunset the 
Tax Code at a certain date that we would actually get a new Tax 
Code. There is no procedural guarantee that we could even come 
up with a new Tax Code. I think the risks inherent in that 
process are very large.
    Mr. Brady. Let me ask you this. Do you think we will get a 
Tax Code without a sense of urgency, a timetable in which to 
move? What would possibly motivate us to do that since there 
has not been an example of us doing that effectively to date?
    Mr. Gale. Well, the best example I could put forward is the 
Tax Reform Act of 1986. It may be that we never do as much base 
broadening and rate reduction and simplifying again as we did 
then. But as Mr. Steuerle mentioned, I don't think we should 
let the perfect be the enemy of the good. I think that would be 
an excellent model to build on. And if sunsetting the Code 
would get us to a new Code and that new Code was guaranteed to 
be simpler, then sure, I would be in favor of it. But I think 
what sunsetting the Code does is put every single tax provision 
in the Code in play and essentially tells lobbyists now is the 
time to go out there and defend your tax provision. I think it 
would concentrate efforts to keep the Tax Code complicated 
rather than enhance efforts to simplify the system.
    Mr. Keating. Well, I think I would disagree here. I agree 
with you, Congressman. I think that it does make sense to take 
steps that have been identified now and move forward. The Joint 
Committee has suggested many useful proposals to simplify the 
tax laws, and I think more can be done as far as process. The 
fact that the Joint Committee had these recommendations even as 
late as April 27, I think was the exact date, a couple of very 
useful provisions made its way into the tax legislation. I 
think that is in part because they were already suggested and 
vetted by the Joint Committee on Taxation.
    To the extent we have additional recommendations and we can 
induce competition between the various bureaucratic agencies, I 
think that might be useful.
    One of the more revealing experiences that I had on the 
National Commission on Restructuring the Internal Revenue 
Service, with Mr. Coyne and Mr. Portman, was that whenever we 
had a hearing or an initiative come up before the Commission, 
wouldn't you know, the Treasury Department, that day or the day 
before, announced some new initiative to reform and restructure 
the IRS. I believe the mere existence of our Commission helped 
the Treasury and the IRS think harder about how they can do a 
better job.
    The Joint Committee on Taxation for years has been tasked 
with the job of suggesting simplifications, but until this 
report came out, I don't remember anything quite so substantive 
from the Joint Committee.
    A quadrennial commission, as I suggested in the testimony 
and as the National Commission on Restructuring the IRS has 
suggested, would bring private-sector input of people who would 
be appointed by the President or the Congress. Such a panel 
might help the Treasury Department and the Joint Committee stay 
on its toes and offer additional suggestions for 
simplification.
    These are interim steps.
    I do think that a sunseting of the Tax Code could work. I 
am not saying it would work. Of course, there are no 
guarantees, but the fact is that if Congress, on a bipartisan 
basis, approved legislation committing to fundamental overhaul 
of the Tax Code, that is a very important political statement. 
It sets into motion the machinery at the Treasury Department 
and the Joint Tax Committee and elsewhere to produce 
recommendations for simplification and fundamental overhaul.
    It could prove useful, but I think what is most likely to 
happen if we are to see fundamental reform, it will be led from 
the White House, whoever is President. We saw that in the mid-
eighties, and I think we may see it again sometime soon.
    Mr. Brady. Thank you. Thank you, Mr. Chairman.
    Chairman Houghton. Thanks very much. Mrs. Thurman.
    Mrs. Thurman. Thank you, Mr. Chairman.
    Mr. Brady, I would tell you that I actually had an 
experience in the State of Florida where we actually sunsetted 
the codes, and I can tell you that by the time we came back, 
because we had about a year to look at it, we ended up with 
basically the same Tax Code we started with and nothing really 
took place.
    Mr. Brady. Shame on you.
    Mrs. Thurman. Well, no, it wasn't shame on me because, 
quite frankly, we tried to make some suggestions that were 
based on what we thought was sound policy. And in fact, it was 
all those other people coming back to the legislature saying, 
oh, no, don't touch us, we are not the culprit, go find 
somebody else to touch. So, you know, the politics do play in 
the policy.
    Mr. Keating, let me ask you a question because it was 
alluded to in one of the answers here to one of the questions 
that I asked. Would you believe, then, that--and I think the 
Congress did try to do something correctly on simplification 
with the analysis. Other than the fact it is at the end instead 
of the beginning, would you believe that that would be a good 
place to start?
    Mr. Keating. You mean the analysis----
    Mrs. Thurman. I mean at the beginning, as we go through the 
changes, as versus at the end in the Committee report.
    Mr. Keating. Yes, I think so. If you look at the tax 
complexity analysis on this most recently passed tax 
legislation, I said it was a disappointment and an 
embarrassment. It was amazing to me that the analysis itself 
didn't even point out the positive things that were in the 
bill. There was no mention of the repeal of the phase-out of 
the personal exemption and itemized deductions. I don't think 
they talked much about the earned income tax credit 
simplification. So clearly it was the very last thing. It was 
put in there only because someone had to write something. I 
very much doubt it had any impact at all.
    Mrs. Thurman. The other thing----
    Mr. Keating. I think the numbers--perhaps there is 
something that could be done with the numbers. The joint tax is 
required to score----
    Chairman Houghton. Mrs. Thurman, did you want to say 
something?
    Mr. Keating. Year by year, but there is no requirement that 
they score; and I don't know how you would do it exactly, but 
we need something that would analyze how complexity would 
change with this legislation. So much of this is number driven 
to meet these targets, and if there are no targets for 
simplification, nothing to meet, it tends to take a back seat.
    Mrs. Thurman. And I would say to you, I think that while we 
talked about policy and the complexity over the last couple of 
years, or the last several years, has been driven from 
Congress--and I do believe that that is very true--my outcome 
is different, though. I think it has been a numbers game. I 
think when some group has wanted something to be done, we have 
gone into the Tax Code, we have taken something out of the Tax 
Code or added something into the Tax Code to meet a number, to 
pay for a program, to do something different as versus just, 
you know, changing policy up here, I think. And I think that 
has caused part of the complexity.
    Which goes to the second part of this, then; and that is--
and I think you said this, Mr. Keating, and I think that we got 
this report on April 27. My guess is that there could have been 
some conversations before we did the tax bill that was signed 
just before Memorial Day; that we in fact could have picked up 
some of those issues and used them in this recent tax bill 
signed into law that would have helped us with the complexity 
and, I think, would have straightened out many of the issues 
out there.
    And if anybody would like to comment on that because, quite 
frankly, the second question to that is in reviewing this--and 
one of the questions I didn't get to ask Mrs. Paull was on the 
money. We are not talking about just walking in and changing 
some policy and walking away. You could be talking about some 
serious dollars that would have to be laid on the table to 
change the complexity of these Tax Codes.
    Anybody want to give me an idea of what you think some of 
the costs would be? Have you done any of that or--you know, you 
don't have to answer. I mean, I kind of know the answer about 
the end of it; you know, that we should have looked at it in 
the tax bill in the beginning, but----
    Mr. Keating. Well, I think the fact that it came so late in 
the process limited the report's usefulness. And Gene talked 
earlier in his statement about the need to institutionalize 
these recommendations. When we had these huge budget deficits, 
each year the Congressional Budget Office was tasked with the 
job ofcoming up with examples of spending cuts and tax 
increases. I think if the Committee and the Finance Committee tasked 
the Joint Committee with coming up each year with ways to simplify the 
tax laws--and hopefully the report is done by December 31 so when the 
Congress starts its new session, it can use those ideas when the 
inevitable tax legislation comes up.
    Mrs. Thurman. But I need to say this, because I think some 
of those spending cuts you are talking about could have been 
done if we had used the surplus more wisely in paying down the 
debt. Because part of--it is not just spending on 
appropriations bills. It has been spending on the interest that 
we have had to pay on the deficit which has also caused us a 
huge problem that we can't cut.
    Mr. Steuerle. Mrs. Thurman, I totally agree with you on the 
importance of process reform, but I do think there is a certain 
extent to which Congress sets up rules. A lot of them are 
implicit; some of them are explicit. Sometimes the rule is ``we 
have got 500 billion over 5 years.'' It is amazing how the 
entire process will revolve around that, and if $2 changes are 
made here then $2 has to come in over there.
    Or they will set up a rule like the Senate did.
    They had the Byrd rule which led to sunsetting the bill in 
the 11th year. It is amazing how rules do affect process. 
Suppose a rule--I am not saying this is the right rule--said 
after we pass legislation, we are going to take a day aside and 
only hear simplification testimony. I am not saying I would 
always want to do that, but if that was the rule and you knew 
you had to go through with it, then would you go through it? If 
you are not sure you have to go through it, you probably won't. 
The poor chairperson of the Subcommittee or Committee is trying 
to get all the votes together and is probably wracking his 
brain. The Joint Committee is working through the night. Nobody 
wants something added to their plate unless they know it has to 
be there.
    So I think there are things that have to institutionalize a 
simplification process. As I mentioned, the Congressional 
Budget Office's (CBO) report on deficit reduction options, 
because it was constantly being there and hammered away at 
people, helped a lot. And I think raising the status of this 
Joint Committee report, putting a lot more in and getting 
outside help, would help a lot.
    Finally, I think to do all this is going to require some 
level of additional resources. The Joint Committee and Treasury 
staffs are overworked, especially at tax bill-writing time; so 
there is a resource issue that has to be addressed at the same 
time.
    Mrs. Thurman. And I would say to you that this Chairman has 
actually met with some of the IRS people and the Commission in 
trying to figure out how we best can do that. So I give him a 
lot of credit for that, along with Mr. Coyne.
    Chairman Houghton. Thanks very much, Mrs. Thurman. Look, 
you know, big issue, big problem. And I just hope we don't stub 
our toe or look out the window on December 31 and think we have 
done a good job when we haven't.
    I think we are really going to get into this, and I 
appreciate very much your testimony. We will continue it, and 
any other suggestions, please let us know. The hearing is 
complete.
    [Whereupon, at 4:36 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]
             Statement of the American Bankers Association
    The American Bankers Association (ABA) is pleased to have an 
opportunity to submit this statement for the record on ``Tax Code 
Simplification.''
    The American Bankers Association brings together all categories of 
banking institutions to best represent the interests of the rapidly 
changing industry. Its membership--which includes community, regional 
and money center banks and holding companies, as well as savings 
associations, trust companies and savings banks--makes ABA the largest 
banking trade association in the country.
    The federal tax system is greatly in need of simplification and 
reform. Many of the current rules have not kept pace with technological 
advances and changes in the global economy. Others have been in place 
for a number of years and do not adjust for inflation or no longer 
serve their original purpose. As a result, they have become 
increasingly restrictive on a broader base of taxpayers than originally 
intended when enacted by Congress or are so overly complex that they 
are rarely used.
    Tax Code simplification is an extremely important goal, and we 
commend you for holding this hearing. We look forward to the upcoming 
simplification hearings and plan to provide more extensive comments in 
connection therewith. Our testimony covers a broad range of issues, 
some of which are included in the Joint Committee on Taxation's ``Study 
of the Overall State of the Federal Tax System and Recommendations for 
Simplification.''
SIMPLIFY THE INTERNATIONAL TAX REGIME
    As technology and expanding trade opportunities change the global 
market place, financial institutions have had to make rapid adjustments 
in order to remain competitive with foreign financial entities. With 
respect to the international operations of U.S.-based financial 
institutions, the tax law has not kept pace with technological advances 
and changes in the global economy.
    The ABA supports the enactment of legislation that would simplify 
the international tax law and that would assist, rather than hinder, 
U.S. financial institutions' global competitiveness. We agree with the 
observation that we cannot afford a tax system that fails to keep pace 
with fundamental changes in the global economy or that creates barriers 
that place U.S. financial services companies at a competitive 
disadvantage. In that regard, the ABA would like to commend 
Representatives Amo Houghton (R-NY) and Sander Levin (D-MI) for 
introducing the ``International Tax Simplification for American 
Competitiveness Act'' (H.R. 2018) in the 106th Congress. We 
understand that similar legislation is expected to be introduced in 
this Congress.
             Permanent enactment of the Subpart F ``active 
                    finance'' provision
    ABA urges permanent enactment of the active finance exception to 
Subpart F. Under general income tax principles, the foreign income of a 
foreign corporation is generally not subject to tax even if it has been 
organized by a U.S. taxpayer. The U.S. taxpayer would not pay tax until 
the income is repatriated to the U.S. (e.g., as a dividend). We commend 
Representatives Jim McCrery (R-LA) and Richard Neal (D-MA), for 
introducing H.R. 1357 to permanently enact the subpart F active finance 
provision. We also commend Senate Finance Committee Chairman Max Baucus 
(D-MT) and Senator Orrin Hatch (R-UT) for introducing S. 676 in the 
Senate.
    Subpart F was enacted to prevent passive foreign income (dividends, 
rents, interest, etc.) from escaping taxation through use of the 
deferral principle. As a result, it provides that passive income items 
are not eligible for deferral. However, Congress enacted an exception 
for such income if derived in the active conduct of a banking, 
financing or similar financial services business. This financial 
services exception was enacted in the Taxpayer Relief Act of 1997 as a 
temporary measure. It was later extended and modified by the Tax and 
Trade Relief Extension Act of 1998. The financial services exception 
reflects the belief of Congress that financial services businesses are 
``active'' and should have appropriate deferral benefits. This 
temporary provision is scheduled to expire December 31, 2001.
    Permanent enactment of the active financing provision is sorely 
needed to level the international business playing field, increase 
competitiveness and allow proper planning by U.S. financial services 
companies for the long term.
             Simplify the foreign tax credit limitation for 
                    dividends from 10/50 companies
    The foreign tax credit rules impose a separate foreign tax credit 
limitation (separate baskets) for companies in which U.S. shareholders 
own at least 10 but no more than 50 percent of the foreign corporation. 
The old law 10/50 rule imposed an unreasonable level of complexity, 
which Congress sought to correct in the 1997 Tax Relief Act by 
eliminating the separate baskets for 10/50 companies using a ``look 
through'' rule. However, the 1997 Act change is not effective until 
after year 2002. We commend Representatives Sam Johnson (R-TX) and 
Robert Matsui (D-CA) for introducing H.R. 1357 to accelerate 
application of the look-through approach.
    The ABA supports the Joint Committee's recommendation to 
immediately apply the look-through approach to all dividends paid by a 
10/50 company irrespective of when the earnings constituting the makeup 
of the dividend were accumulated. Such change would dramatically reduce 
tax credit complexity and the administrative burdens on financial 
institutions doing business internationally. It would also help level 
the playing field with respect to global competitors.
SIMPLIFY ROUTINE CORPORATE REORGANIZATIONS UNDER SECTION 355
    Internal Revenue Code Section 355 allows a corporation or an 
affiliated group of corporations to spinoff a business on a tax-free 
basis provided certain requirements are met. The rule requires that 
each of the divided corporate entities be engaged in the active conduct 
of a trade or business. For groups ofcorporations that operate active 
businesses under a holding company, the Code provides a ``look-
through'' rule. However, the look-through rule requires that 
``substantially all'' of the assets of the holding company consist of 
stock or active controlled subsidiaries, effectively preventing holding 
companies from engaging in spinoffs if they own almost any other 
assets. However, corporations that operate businesses directly can own 
substantial assets unrelated to the business and still engage in tax-
free spinoff transactions. Holding companies that hold other assets 
must first undertake one or more costly and burdensome preliminary 
reorganizations solely to comply with this language of the Code. For 
many purposes, the Code treats affiliated groups as a single 
corporation. There is no tax policy reason in this instance to treat 
affiliated groups differently than single operating companies.
    We commend Senator John Breaux (D-LA) for introducing S. 1158 in 
the Senate to modify the active business definition relating to 
distributions of stock and securities of controlled corporations. That 
bill would treat all corporations that are members of the same 
affiliated group as a single corporation and would do much to simplify 
routine corporate reorganizations.
ELIMINATE THE QUALIFIED SMALL-ISSUER EXCEPTION FOR CERTAIN BANK-
        QUALIFIED TAX EXEMPT BONDS
    The Joint Committee report recommends that the small-issuer 
exception for bank-qualified bonds be eliminated and states that it is 
largely irrelevant given the availability of State bond pools. The ABA 
strongly disagrees with that recommendation.
    Internal Revenue Code section 265(b) generally disallows the 
interest expense allocable to tax-exempt obligations acquired by a 
bank. However, the Code provides an exception for certain small 
issuers, allowing them to issue $10 million per year of ``qualified 
tax-exempt obligations'' (QTEOs), and allows banks to deduct the 
interest expense.
    Elimination of the qualified small-issuer exception would greatly 
impede the quality of services small municipalities could provide to 
their citizens. Community banks rely upon QTEOs to provide finance 
services to small municipalities, many of which do not have access to 
State bond pools. The 1999 ABA Bank Portfolio Managers Survey Report 
results shows that tax-free municipal securities were ranked among the 
most common type of security in banks' investment portfolios, 
comprising an average of 16 percent of the total portfolio. (The most 
common security was callable agency securities, which comprised an 
average of 22 percent of a bank's portfolio.) Generally, smaller banks 
tend to hold larger investment portfolios than larger institutions, 
relative to their total assets. Accordingly, one might expect that the 
QTEO portfolio composition of smaller banks would be larger than the 
survey indicates.
    Indeed, the ABA Community Bankers Council's Special Report of 
January, 2000, Compliance, Competition and the Community Bank Tax 
Burden: Blueprint for Reform, urges further expansion of QTEOs and 
points out that the 15 year old volume cap should be raised and indexed 
for inflation.
S CORPORATION SIMPLIFICATION
    The ABA supports enactment of the Subchapter S Corporation 
Modernization Act of 2001 (H.R. 2576; S. 1201), a bill that would allow 
more community banks to convert to Subchapter S corporations. We 
commend Reps. Clay Shaw (R-FL.), Robert Portman (R-OH), and Robert 
Matsui (D-CA) for introducing a comprehensive subchapter S improvement 
bill (H.R. 2576) in the House of Representatives. Identical legislation 
(S. 1201) was introduced in the Senate by Senator Orrin Hatch (R-UT) 
along with Senators Wayne Allard (R-CO), John Breaux (D-LA), Phil Gramm 
(R-TX), Blanche Lincoln (D-AR) and Fred Thompson (R-TN). S. 1201 
incorporates many provisions from S. 936 that Sen. Allard introduced 
May 23. Both H.R. 2576 and S. 1201 contain numerous subchapter S 
simplification provisions, including the Joint Committee's 
recommendation that the special termination rule for certain S 
corporations with excess passive investment income should be 
eliminated.
SIMPLIFY TAX INFORMATION REPORTING
    The financial services industry files the bulk of all information 
returns on behalf of the IRS. Modifications to the tax laws and 
regulations governing information reporting occur frequently, and most 
of these changes require significant and costly system upgrades along 
with additional administrative burdens. The ABA strongly believes that 
simplification in the area of tax information reporting is needed and 
could be accomplished with little or no revenue or administrative 
impact upon the IRS.
    Some of the tax reporting simplification items recommended by ABA 
include eliminating changes to the backup withholding rate reductions 
as mandated by the Economic Growth and Tax Relief Act of 2001; raising 
the dollar threshold on form 1099-MISC; and making Form W-8BEN 
certifications permanent for businesses, foreign trusts and estates.
REPEAL THE ALTERNATIVE MINIMUM TAX
    The ABA supports the Joint Committee's recommendation to repeal the 
Alternative Minimum Tax (AMT). We agree with the Joint Committee that 
the AMT no longer serves the original purposes for which it was 
intended and adds unnecessary complexity, time and expense to 
compliance with the federal tax laws. The problem is that the AMT is 
now reaching many more taxpayers than it was ever intended to reach.
SIMPLIFY ESTATE AND TRUST TAXATION
    The ABA supports the Joint Committee's recommendation that the 
qualification and recapture rules contained in the special-use 
valuation and family-owned business deduction provisions should be 
conformed and believes it would improve these rules. However, without 
further simplification, the qualified family owned business provisions 
will continue to be overly complex and burdensome and will continue to 
be rarely used.
    While the concepts behind these rules are certainly positive, in 
practice the family-owned business deduction provision has been too 
difficult to be used. In general, it is very burdensome and complex. 
The difficulty of fitting within the definition and maintaining that 
status, along with the paperwork required, has led to an unwillingness 
to utilize this provision. Certainly conforming the qualification and 
recapture rules would help move the process in the right direction. 
Hopefully in the future, further improvements can be made.
    The Joint Committee recommended the elimination of the two-percent 
floor on miscellaneous itemized deductions. We agree that this 
provision has proven to be particularly troublesome to bank trust 
departments and is in need of immediate resolution.
    Over the years, the two-percent floor has resulted in litigation 
and questions regarding what are appropriate miscellaneous itemized 
deductions. It would be a very beneficial move towards greater tax 
simplification to eliminate this floor. In one recent case before the 
U.S. Court of Appeals, the ABA prepared an amicus brief regarding 
whether certain costs were appropriate to not include within the two-
percent floor. The briefs and discussion by the Court focused on the 
highly subjective test of determining whether and which costs would not 
have been incurred if the property were not held in a trust or estate. 
Subjective tests are very difficult to administer because of the many 
potential interpretations. Such provisions do not make good tax law, 
and should be removed from the books.
JOINT COMMITTEE ON TAXATION REFUND REVIEW THRESHOLD
    No refund or credit in excess of a specified dollar threshold of 
any income tax, estate or gift tax, etc., may be made until 30 days 
after the date a written report on the refund is provided to the Joint 
Committee. The report contains a brief history of the tax situation of 
the taxpayer and an explanation of the causes of any refunds. Attached 
to the report are supporting documents prepared by the IRS. These 
documents discuss the amount of, and reason for, all the adjustments 
considered by the IRS for taxable years under review. The Community 
Renewal Relief Act of 2000 (Public Law 106-554; H.R. 5662) raised the 
threshold from $1,000,000 (where it had been set since 1990) to 
$2,000,000. While we welcome the increase in the threshold, the ABA 
believes the review threshold should be further increased to accelerate 
the issuance of refunds and to free up significant resources of the 
IRS, the staff of the Joint Committee on Taxation and corporate 
taxpayers. We believe such increase would not materially impair the 
Joint Committee's ability to monitor problems in the administration of 
the tax laws.
OTHER SIMPLIFICATION RECOMMENDATIONS
    We also believe the following simplification is sorely needed:
           Depreciation
               Eliminate the mid-quarter convention
               Establish minimum capitalization rules
               Use the same methods of depreciation for all 
        taxpayers
           Eliminate the communications excise tax
           Conform the prohibition on the use of private 
        activity bond proceeds
CONCLUSION
    The ABA appreciates having this opportunity to present our views on 
simplification of the federal tax system. We look forward to continuing 
to work with you on these most important matters.

                                

 Statement of the Association of Financial Guaranty Insurors, Albany, 
                                New York
    Chairman Houghton and Chairman McCrery, the Association of 
Financial Guaranty Insurors (AFGI), a trade association of financial 
guaranty insurors,1 appreciates the opportunity to submit 
testimony to your Subcommittees as you examine the complexity of the 
Internal Revenue Code of 1986, as amended, (the ``Code''). In 1998 
Congress amended the Code to add Section 8022(3)(b), to require the 
Joint Committee on Taxation (the ``Joint Committee'') to report at 
least once during each Congressional session on the overall state of 
the Federal tax system, including recommendations with respect to the 
possible simplification of the Code. In April of this year, the Joint 
Committee released its Study of the OverallState of the Federal Tax 
System and Recommendations for Simplification, Pursuant to Section 
8022(3)(B) of the Internal Revenue Code of 1986.\1\ Volume II of the 
three-volume study, titled Recommendations of the Staff of the Joint 
Committee on Taxation to Simplify the Federal Tax System (the ``Joint 
Committee Recommendations'') together with the rest of the study will 
be reviewed by the Subcommittees at your July 17th hearing.
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    \1\ The members of AFGI are ACA Financial Guaranty Corporation, Ace 
Guaranty Re. Inc., AMBAC Assurance Corporation, AXA Re Finance S.A., 
Enhance Reinsurance Company, Financial Guaranty Insurance Company, 
Financial Security Assurance, Inc., MBIA Insurance Corporation, RAM 
Reinsurance Company, and XL Capital Assurance, Inc.
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    The Joint Committee at Part VIII.E of its Recommendations (pages 
377-78), proposes the elimination of Section 832(e) of the Code which 
it criticizes ``as giving rise to complexity that achieves no Federal 
income tax goal, but rather, only a particular accounting result.'' The 
purpose of this testimony is to express AFGI's concern, for the reasons 
set out below, with Joint Committee's recommendation to eliminate 
Section 832(e) of the Code.
Background
    Section 832(e) of the Code is a provision that addresses a serious 
financial problem faced by certain insurance companies in a manner that 
is revenue neutral to the United States Treasury. The financial problem 
was caused by material reserve requirements for losses not yet incurred 
(so-called ``contingency reserves'') established by state insurance 
regulators. These contingency reserve requirements had the unintended 
impact of diminishing the statutory capital of the subject insurance 
companies. It was not practicable to change the statutory accounting 
rules in various states in order to address this impairment of capital. 
Instead, Section 832(e) was crafted with the support of the state 
insurance regulators to create a statutory asset equal to the tax 
benefits that would be realized by insurance companies if and when 
actual losses occurred. More specifically, and as described in more 
detail below, Section 832(e) allowed the insurance company to deduct 
its contingency reserves for Federal income tax purposes, provided that 
the insurance company ``invests'' the tax savings from such deduction 
in non-interest bearing treasury notes called ``tax and loss bonds'' 
which, in turn, are treated as assets of the insurance company for 
statutory accounting purposes. Since the tax savings from the deduction 
are loaned to the Treasury on an interest-free basis, this arrangement 
is revenue-neutral to the Treasury. It remains impractical to change 
the statutory accounting rules in various states in order to address 
the concern currently addressed by Section 832(e). Section 832(e) of 
the Code remains the simplest answer to a complex problem, without cost 
to Treasury. Accordingly, AFGI respectfully submits that this provision 
remain in place.
Description of Section 832(e)
    Pursuant to section 832(e) of the Code, insurance companies writing 
mortgage guaranty, lease guaranty, and tax-exempt bond guaranty 
insurance may, subject to certain conditions, take a deduction for 
federal income purposes for their contingency reserves representing 
amounts required by state law to be set aside in a reserve for losses 
resulting from adverse economic cycles. The deduction cannot exceed the 
lesser of (i) the insurance company's taxable income or (ii) 50 percent 
of the premiums earned on such guaranty contracts during the year. Such 
a deduction represents advantageous treatment for such companies 
because, under the general tax principles otherwise applicable, the 
companies would not be able to deduct such reserved amounts until the 
losses actually arose. The companies may take such a deduction, 
however, only to the extent that they purchase so-called ``tax and loss 
bonds'' in an amount equal to the income tax savings attributable to 
it.
    The Internal Revenue Code does not specify the terms of the tax and 
loss bonds. Per the legislative history underlying section 832(e), they 
are non-interest bearing obligations issued by the U.S. Government. An 
insurance company may present the bonds for redemption only as and when 
it restores to income the associated deduction for contingency 
reserves. Reserves are restored to income as and when they are applied, 
per state regulations, to cover loss or to the extent the company has a 
net operating loss in a subsequent year. See Code sections 832(e)(5)(B) 
and 832(e)(5)(C). Further, the reserve deduction taken in any 
particular year with respect to mortgage and lease guaranty insurance 
must be fully restored to income in 10 years. The reserve deduction 
taken in a particular year with respect to tax-exempt bond insurance 
must be fully restored in 20 years. See Code sections 832(e)(5)(A) and 
832(e)(6).
Legislative Origins of Section 832(e)
    Section 832(e) of the Code was originally enacted in January 1968, 
effective January 1, 1967.2 At that time it applied only to 
mortgage guaranty insurance. It was then amended in 1974 to include 
lease guaranty and tax-exempt bond insurance after state insurance 
regulators imposed contingency reserves on those lines of insurance. 
According to the legislative history, it was adopted in response to 
high contingency reserve requirements imposed by state regulatory 
authorities. These reserve requirements ranged up to as high as 50% of 
earned premiums and were often required to remain in reserve for as 
long as 15 years. According to the legislative history, imposition of a 
current federal income tax on the reserved amounts, when combined with 
the effect of operating expenses and a loss experience of approximately 
30% of non-reserved premium, could impose a serious burden on the 
insurance company's working capital. In such circumstances, the 
company's federal income tax obligation could easily exceed the cash 
remaining from available--i.e., unreserved--funds after payment of 
expenses and loss.
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    \2\ Before Section 832(e) was enacted in 1968, mortgage guaranty 
insurers relied upon a number of private letter rulings allowing them 
to deduct their contingency reserves as if they were unearned premium 
reserves (with respect to which a deduction was already allowed). Upon 
revocation of these rulings in 1967, Section 832(e) was enacted as a 
result of the express concern of Congress that the inability to deduct 
contingency reserves could impair an insurer's capital. See S. Rep. No 
918, 90th Cong. 1st Sess. (1967), reprinted in 1967 U.S. Code Cong. & 
Admin. News, 2698-99. The provision was designed to ``solve this unique 
problem created by unusual State requirements.''
---------------------------------------------------------------------------
    In response to this problem, Congress decided to allow such 
insurers to take a deduction for these contingency reserves. However, 
because the reserve requirements imposed by the state regulatory 
authorities were substantially in excess of that suggested by 
experience, deferral of tax on such reserves could result in an 
unwarranted windfall for the companies. As a result, Congress permitted 
the deduction only to the extent the insurance companies invested the 
tax benefit there from in non-interest bearing tax and loss bonds. 
Because the bonds were expected to qualify as assets for state 
financial regulatory purposes, this would relieve the cash flow 
problems the companies could experience. At the same time, because the 
bonds did not bear interest, it was believed that the U.S. Treasury 
would also be unaffected. Indeed, at the time of the 1974 amendment, 
the U.S. Department of the Treasury stated with respect to the 
legislation that:

          ``[f]rom the Treasury's standpoint, the deduction for 
        additions to the special contingency reserve is only temporary, 
        and the non-interest-bearing obligations give the Treasury at 
        all times the unrestricted use of the deferred tax dollars as 
        if there were no deduction and as if taxes were in fact paid.'' 
        (Emphasis added)

    From an economic perspective with regard to the regular income tax, 
the U.S. Treasury remains in essentially the same position after the 
application of Section 832(e) as it would have been had that provision 
not been enacted. Although its nominal tax revenue is reduced at the 
time the deduction for reserves is claimed, it receives, on an 
interest-free basis, an amount equal to foregone taxes through the 
purchase of the tax and loss bonds. So, its economic position at the 
time the contingency reserve deduction is taken (and the bonds 
purchased) is no different from what would otherwise have been the 
case. Similarly, although it will have to redeem those bonds at some 
later time when the reserve is restored to income, that also will not 
adversely affect its economic position from what it otherwise would 
have been. If the reserve was restored because of a loss, the amount 
paid to redeem the bonds will exactly equal the amount by which its tax 
revenues would otherwise decline had a net deduction for that loss been 
permitted.3 If, on the other hand, the reserves are restored 
to income at the end of the 10- or 20-year time limitation because they 
had not been fully absorbed by the losses experienced up until then, 
the amount paid to redeem the bonds will simply offset the increased 
taxes attributable to the restoration of the reserve to income.
---------------------------------------------------------------------------
    \3\ Ordinarily, if a taxpayer has a loss, it will be able to claim 
a deduction and, as a result, will experience a reduction in what its 
income taxes otherwise would have been. Under section 832(e), however, 
a loss does not lead to such a decline in income tax revenue. Although 
the insurance company will claim a deduction for the amount of such 
loss, this deduction will be offset by the amount of the reserve 
restored to income. As a result, there will be no net change in taxable 
income, or tax revenue, at that time. Instead, the government will 
redeem an amount of tax and loss bonds equal to the tax savings the 
company experienced when it claimed the reserve deduction in an earlier 
year. Assuming tax rates have not changed in the interim, the amount 
paid to redeem the bonds will equal the amount by which taxes would (as 
a result of the loss) have declined had section 832(e) not been 
involved.
---------------------------------------------------------------------------
Conclusion
    The interaction between the Code and the state insurance regulators 
in the treatment of contingency reserves is a long and intricate one, 
beginning with the issuance of private letter rulings by the Internal 
Revenue Service when state insurance laws first imposed contingency 
reserves on mortgage guaranty insurance, and continuing with 
implementation of Section 832(e) in 1968 when those rulings were 
revoked and a revision to Section 832(e) in1974 when state insurance 
laws imposed contingency reserve requirements on lease guaranty 
insurance and tax-exempt bond insurance. In fact, the relationship has 
become so well established that the State of New York, when it enacted 
legislation in 1989 providing that financial guaranty insurance was 
subject to contingency reserves, specifically authorized the insurers 
to invest in ``tax and loss bonds (or similar securities) purchased 
pursuant to Section 832(e) of the Internal Revenue Code (or any 
successor provisions).''
    Even if one concedes that the Joint Committee's assertion that 
Section 832(e) of the Code and related use of tax and loss bonds does 
``give rise to complexity,'' it is a long-established complexity that 
permits financial guaranty insurers to comply with state-imposed 
contingency reserve requirements without impairing their capital--a 
result that benefits the insurance companies, the parties whose 
obligations are insured, and the investing public that owns those 
obligations.
    Elimination of Section 832(e) will greatly increase the 
complexities faced by the insurers who would be forced to attempt to 
change the statutory accounting rules in various states and should they 
fail to do so, which is likely, would face the possibility of 
impairment of their capital, a detrimental result for the insurers, the 
insureds and the beneficiaries.
    AFGI respectfully submits that Section 832(e) not be eliminated.

                                

     Statement of the Group Health Incorporated, New York, New York
Introduction
    Group Health Incorporated (''GHI'') is pleased to submit this 
written statement on tax simplification to the Subcommittees on 
Oversight and Select Revenue Measures of the Ways and Means Committee, 
for inclusion in the record of the joint hearing that was held on 
Tuesday, July 17, 2001.
    GHI is a New York not-for-profit health service corporation. It 
provides insured health benefits coverage for about 2.2 million people. 
GHI supports the goals of tax simplification which include reducing the 
complexity of the tax code, lessening taxpayer costs to comply with the 
code and, where appropriate, tax reductions achieved through 
simplification. Towards these objectives, GHI strongly supports the 
elimination of the Alternative Minimum Tax (AMT), in particular as it 
applies to not-for-profit health plans.
Background
    Until 1986, not-for-profit health plans were not subject to federal 
income tax. This was based on the fact that that they were often 
locally based health insurers that were the insurers of last resort for 
low-income individuals and small groups. Frequently they had open 
enrollment periods where they accepted applications from people without 
regard to their insurability.
    In 1986, the tax code was amended to provide that not-for-profit 
health plans like GHI and most of the nation's Blue Cross-Blue Shield 
plans were to be taxed on a basis similar to commercial insurers. 
However, recognizing their past, and continuing, community-based 
charitable missions, the formerly tax exempt not-for-profit health 
plans were also accorded special recognition in Section 833 of the 
Internal Revenue Code. This Section allowed these plans to take a 
special deduction from their income that was not available to 
commercial insurers. The special deduction is equal to 25% of claims 
and related expenses less the not-for-profit insurers adjusted surplus 
on January 1st of the tax year.
    Not affected by the 1986 change in the tax code were certain not-
for-profit HMOs. They continue to be exempt from federal income taxes.
Elimination of the AMT--Alternative Approaches
    All businesses, including not-for-profit health plans, must 
calculate their federal income taxes in at least two different ways. 
The first is under the regular tax method. The second is under the 
alternative minimum tax method. As set forth by many other 
commentators, including the Joint Committee on Taxation (''JCT''), 
forcing taxpayers to calculate their taxes under the AMT creates 
unneeded complexity and is bad tax policy.
    There are several ways the tax code could be changed to eliminate 
the AMT.
A. Complete Repeal of the AMT for All Businesses
    The first way to reform and simplify the current tax system would 
be to completely repeal the corporate AMT as it applies to all 
businesses. This is an approach recommended by the Staff of the Joint 
Committee on Taxation in their recent study and strongly supported by 
GHI.
B. Repeal the AMT as it Applies to Not-For-Profit Health Plans
    The second alternative would be to eliminate the AMT just for not-
for-profit health plans as defined in Section 833 of the tax code. This 
approach would be more focused and aimed at providing much needed 
relief for those not-for-profit health plans that have chosen not to 
convert to for-profit status and have continued their evolving not-for-
profit mission. Accordingly, this approach would be less costly to the 
U.S. Treasury and would result in targeted tax relief for a small 
segment of an industry; that segment that has chosen not to pursue 
conversion to for profit status.
Rationale for Eliminating the AMT for Not-for-Profit Health Plans
    In addition to the JCT staff's arguments in favor of eliminating 
the AMT for all businesses, there are several unique arguments for 
eliminating the AMT for not-for-profit health plans. They include the 
following:
    (1). No Economic Profit. The alternative minimum tax was enacted to 
address concerns that companies who earn an ``economic profit'' were 
avoiding Federal income tax. This reasoning does not apply to ``not-for 
profit'' organizations. Unlike a profitable ``for-profit'' corporation 
that derives economic income (income over expenses) that is then 
available for distributions to shareholders, a ``not-for-profit'' 
organization does not have economic income and has no shareholders. 
Under state law, most not-for-profit insurance organizations calculate 
a ``surplus'' which is generally required by law to either be set aside 
for reserve purposes or to be returned to policyholders generally in 
the form of reduced premiums or increased benefits. Moreover, there is 
no incentive for a not-for-profit to be profitable. Rather, the goal of 
a not-for-profit is to be viable, and to meet their not-for-profit 
mission.
    (2). No State Income Tax or AMT Tax. Most not-for-profit health 
plan organizations are not taxed at the state level for income tax or 
AMT purposes, and should not be subject to the alternative minimum tax 
at the Federal level.
    (3). Access to Capital. Unlike commercial insurers that have easy 
access to capital through the equity markets, not-for-profit health 
plans have limited access to the capital markets. Raising capital to 
invest in new products, computer systems and human capital has always 
been and remains a challenge for not-for-profit health plans especially 
as these plans must modify systems to address new legislative and 
regulatory incentives, such as HIPPA. This need to access capital issue 
has been one of the primary arguments made by health plans converting 
to for-profit status. Elimination of the AMT would allow not-for-profit 
health plans to use money that would otherwise be paid in taxes to 
reinvest in the operations of the plans and to compete more effectively 
in the marketplace.
    (4). Level the Playing Field. Elimination of the AMT would help 
level the playing field between not-for-profit health plans and not-
for-profit HMOs. The products of not-for-profit HMOs (as well as for-
profit HMOs) and not-for-profit health plans have substantially 
converged over the years. In response to market conditions and customer 
demands, HMOs now offer many open and direct access products with 
limited, or non-existent, gatekeeper functions. Not-for-profit health 
plans, on the other hand, have added managed care features to their 
products in order to help control costs. In many markets it may now be 
nearly impossible to distinguish between an HMO, PPO or managed fee-
for-service health plan without careful scrutiny of the plan documents. 
The current tax code, however, only grants full tax-exempt status to 
not-for-profit HMOs. Eliminating the AMT for not-for-profit health 
plans would have the practical effect of treating not-for-profit health 
plans and not-for-profit HMOs the same for Federal income tax purposes.
    (5). Competitive Disadvantage. Retention of the AMT would leave 
not-for-profit health plans at a competitive disadvantage. Since such 
plans would not be able to benefit from a tax preference granted by 
Congress, while the current tax code still permits tax exempt status 
for similar plans (not-for-profit HMOs) in the same industry.
    (6). Public Policy Need for Not-For-Profit Health Plans. The 
retention of not-for-profit health plans is an important public policy 
goals since such plans provide a competitive benchmark against which to 
measure for-profits in prices, coverage, competitive market 
innovations, efficiency and administrative costs. As a matter of public 
policy it should be desirable to maintain financially strong, 
competitive, not-for-profit health plans in the marketplace. 
Eliminating the AMT will help achieve this worthy public policy.
    (7). Revenue Costs. The cost to the Treasury of eliminating the AMT 
for not-for-profit health plans would be relatively insignificant given 
the limited number of existing not-for-profit health plans. As a point 
of information, the number of not-for-profit health plans has been 
declining given the continuing conversion of not-for-profit Blue Cross-
Blue Shield plans and other plans to for-profit status. The elimination 
of the AMT for not-for profit plans would serve as an incentive to 
encourage not-for-profit plans to maintain their mission.
    For the reasons stated above, GHI strongly believes that Congress 
should eliminate the corporate AMT, or at the very least eliminate the 
AMT for not-for-profit health plans. GHI wishes to thank the 
Subcommittees for considering its recommendations to eliminate the 
Alternative Minimum Tax and would be happy to work with the 
Subcommittees further on this important issue.

                                

             Statement of the Investment Company Institute
    The Investment Company Institute (the ``Institute'')1 is 
pleased to submit this statement to the House Committee on Ways and 
Means Subcommittee on Oversight and Subcommittee on Select Revenue 
Measures for the first in the series of hearings on the need for 
simplification of the Internal Revenue Code and review of the Joint 
Committee on Taxation's study of the overall state of the Federal tax 
system. In its study, the Joint Committee recommended a number of 
simplifications that would affect retirement savings vehicles and other 
long-term savings vehicles, including education savings vehicles. The 
Institute strongly supports efforts by Congress to simplify the rules 
applicable to retirement and other long-term saving incentives, thereby 
increasing opportunities for Americans to save for their retirement and 
other long-term goals, including saving for their children's education.
---------------------------------------------------------------------------
    \1\ The Investment Company Institute is the national association of 
the American investment company industry. Its membership includes 8,444 
open-end investment companies (``mutual funds''), 490 closed-end 
investment companies and 8 sponsors of unit investment trusts. Its 
mutual fund members have assets of about $6.868 trillion, accounting 
for approximately 95% of total industry assets, and over 83.5 million 
individual shareholders.
---------------------------------------------------------------------------
    Approximately 88 million Americans use mutual funds to save for 
retirement and other long-term financial needs. Two-thirds of all 
mutual fund owners have household income under $75,000.2 
Mutual funds are a significant investment medium for employer-sponsored 
retirement programs, including section 401(k) plans, 403(b) 
arrangements and the Savings Incentive Match Plan for Employees 
(``SIMPLE'') used by small employers, as well as for individual savings 
vehicles such as the traditional and Roth IRAs. As of December 31, 
2000, mutual funds held about $2.4 trillion in retirement assets, 
including $1.2 trillion in Individual Retirement Accounts (``IRAs'') 
and $766 billion in 401(k)s. We estimate that about 46% of all IRA 
assets and 45% of all 401(k) assets are invested in mutual 
funds.3
---------------------------------------------------------------------------
    \2\ ``U.S. Household Ownership of Mutual Funds in 2000,'' 
Fundamentals, Vol. 9, No. 4 (Investment Company Institute, August 
2000).
    \3\ ``Mutual Funds and the Retirement Market,'' Fundamentals, Vol. 
10, No. 2 (Investment Company Institute, June 2001).
---------------------------------------------------------------------------
    For savings incentives to work, the rules need to be simple. All 
too often, however, frequent legislative changes have led to 
complicated tax rules that are extremely difficult for taxpayers to 
understand. Frequent changes in law also create uncertainty. These 
considerations are important not only to taxpayers, but to financial 
institutions when they are considering whether to make long-term 
business commitments. Take, for example, changes to pension laws. Since 
the passage of the Employee Retirement Income Security Act in 1974, 
there have been over a dozen major amendments to pension laws and the 
related tax code sections. Since 1994 alone, Congress has passed five 
substantial pieces of pension-related tax legislation--the Uruguay 
Round Agreements Act of 1994, the Uniform Services Employment and 
Reemployment Rights Act of 1994, the Small Job Protection Act of 1996, 
the Taxpayer Relief Act of 1997 and the Economic Growth and Tax Relief 
Reconciliation Act of 2001. A number of these legislative changes, many 
supported by the Institute, have provided new opportunities for saving 
by increasing contribution limits to plans and IRAs and creating new 
savings vehicles, including Roth IRAs, SIMPLE plans and 529 plans. Many 
amendments to our pension laws, however, also have added unnecessary 
complexity and administrative burdens that serve as a disincentive to 
employers to sponsor retirement plans and to individuals to save for 
retirement. Easing these burdens will promote greater plan coverage and 
result in increased retirement savings.
    The Institute has long supported efforts to enhance retirement 
savings and other long-term savings for Americans, including efforts 
that would simplify the rules applicable to IRAs and qualified plans, 
and enable individuals to better understand and manage their retirement 
assets. In general, we support the recommendations contained in the 
Joint Committee's report regarding simplification of various retirement 
and education savings vehicles. While the report made numerous 
recommendations worthy of support, we focus our testimony on three 
basic areas: (1) IRA eligibility rules; (2) individual account plan 
rules; and (3) education savings vehicles.
I. IRA Eligibility Rules
    The Joint Committee's report recommends eliminating phase-outs 
relating to IRAs and eliminating the income limits on the eligibility 
to make deductible IRA contributions, Roth IRA contributions and 
conversions of traditional IRAs to Roth IRAs. The Joint Committee also 
recommends that the age restrictions on eligibility to make IRA 
contributions should be the same for all IRAs. Further, the Joint 
Committee recommends eliminating the nondeductible IRA. The Joint 
Committee's report states that the IRA recommendations would reduce the 
number of IRA options and conform the eligibility criteria for 
remaining IRAs, thus simplifying taxpayers' savings decisions. We 
strongly support these changes. We wish to emphasize, however, that the 
nondeductible IRA should be eliminated only if the other recommended 
changes are made.
    Simplification of the IRA rules responds to an urgent need. Current 
IRA eligibility rules are so complicated that even individuals eligible 
to make a deductible IRA contribution are often deterred from doing so. 
When Congress imposed the current income-based eligibility criteria in 
1986, IRA participation declined dramatically--even among those who 
remained eligible for the program. At the IRA's peak in 1986, 
contributions totaled approximately $38 billion and about 29% of all 
families with a household under age 65 had IRA accounts. Moreover, 75% 
of all IRA contributions were from families with annual incomes of less 
than $50,000.4 However, when Congress restricted the 
deductibility of IRA contributions in the Tax Reform Act of 1986, the 
level of IRA contributions fell sharply and never recovered--to $15 
billion in 1987 and $8.4 billion in 1995.5 Even among 
families retaining eligibility to fully deduct IRA contributions, IRA 
participation declined on average by 40% between 1986 and 1987, despite 
the fact that the change in law did not affect them.6 The 
number of IRA contributors with income of less than $25,000 dropped by 
30% in that one year.7
---------------------------------------------------------------------------
    \4\ Venti, Stephen F. ``Promoting Savings for Retirement 
Security,'' Testimony prepared for the Senate Finance Subcommittee on 
Deficits, Debt Management and Long-Term Growth (December 7, 1994).
    \5\ Internal Revenue Service, Statistics of Income.
    \6\ Venti, supra at note 4.
    \7\ Internal Revenue Service, Statistics of Income.
---------------------------------------------------------------------------
    Indeed, fund group surveys show that almost fifteen years later, 
many individuals continue to be confused by the IRA eligibility rules. 
For example, in 1999 American Century Investments surveyed 753 self-
described retirement savers about the rules governing IRAs. The survey 
found that changes in eligibility, contribution levels and tax 
deductibility have left a majority of retirement investors 
confused.8 This confusion is an important reason behind the 
decline in contributions to IRAs from its peak in 1986.
---------------------------------------------------------------------------
    \8\ American Century Investments, as part of its ``1999 IRA Test,'' 
asked 753 self-described retirement ``savers'' ten general questions 
regarding IRAs. Only 30% of the respondents correctly answered six or 
more of the test's ten questions. Not a single test participant was 
able to answer all ten questions correctly.
---------------------------------------------------------------------------
    For these reasons, the Institute strongly supports a repeal of the 
IRA's complex eligibility rules, which serve to deter lower and 
moderate income individuals from participating in the program. A return 
to the ``universal'' IRA would result in increased savings by middle 
and lower-income Americans.
    The return of the ``universal IRA,'' together with the availability 
of the Roth IRA, would eliminate the need for the nondeductible IRA--
thus, further simplifying the IRA program. However, it is important to 
note that, in the absence of the Joint Committee's other changes, the 
nondeductible IRA serves an important purpose--enabling those 
individuals not eligible for a deductible or Roth IRA to save for 
retirement. Consequently, the nondeductible IRA should be eliminated 
only if Congress repeals the income limits for traditional and Roth 
IRAs.
II. Individual Account Plan Rules
    Employer-sponsored retirement plans are a key part of the system of 
incentives and opportunities we provide for American workers to save 
for their retirement. However, as is the case with IRAs discussed 
above, the complexity of the rules applied to employer-sponsored plans 
frequently deters employers from establishing plans and workers from 
using them. By simplifying the rules governing retirement plans, 
Congress would encourage retirement savings.
    The Joint Committee's recommendations, in part, focus on the rules 
applicable to various individual account type programs. This is a good 
place to start, as many Americans are confused by the various plan 
types, each with its own set of rules. Specifically, the Joint 
Committee recommends conforming the contribution limits of tax-
sheltered annuities to the contribution limits of comparable qualified 
retirement plans. The Joint Committee notes that conforming the limits 
would reduce the recordkeeping and computational burdens related to 
tax-sheltered annuities and eliminate confusing differences between 
tax-sheltered annuities and qualified retirement plans. The Joint 
Committee also recommends allowing all State and local governments to 
maintain 401(k) plans. This, according to the Joint Committee's report, 
would eliminate distinctions between the types of plans that may be 
offered by different types of employers and simplify planning 
decisions. Indeed, Congress recently acted on some of these 
recommendations in recently enacted tax legislation.9 More, 
however, can be done to simplify these plans and their rules.
---------------------------------------------------------------------------
    \9\ See, for example, Sections 611 and 615 of the Economic Growth 
and Tax Relief Reconciliation Act of 2001.
---------------------------------------------------------------------------
    The Institute supports such efforts to reduce the complexity 
associated with retirement plans--especially for workers, who struggle 
to understand the differences between 401(k), 403(b) and 457 plans. The 
ability of workers to understand the differences among plan types has 
become even more important as a result of the enactment of the 
portability provisions of the Economic Growth and Tax Relief 
Reconciliation Act of 2001.10 These provisions enhance the 
ability of American workers to take their retirement plan assets to 
their new employer when they change jobs by facilitating the 
portability of benefits among 401(k) plans, 403(b) arrangements and 457 
state and local government plans and IRAs. The Institute strongly 
supports efforts by Congress to simplify and conform rules that apply 
to different plan types in order to assist workers in understanding 
their retirement plans.
---------------------------------------------------------------------------
    \10\ See Sections 641-643 of the Economic Growth and Tax Relief 
Reconciliation Act of 2001.
---------------------------------------------------------------------------
III. Education Savings Vehicles
    The Joint Committee recommends several simplifications related to 
education savings vehicles. First, the Joint Committee recommends 
eliminating the income-based eligibility phase-out ranges for the HOPE 
and Lifetime Learning credits. As with IRAs, we believe the phase-outs 
unnecessarily complicate these programs and serve to deter 
participation among those eligible.
    Second, the Joint Committee recommends that a uniform definition of 
qualifying higher education expenses should be adopted. A uniform 
definition would eliminate the need to taxpayers to understand multiple 
definitions if they use more than one education tax incentive and 
reduce inadvertent taxpayer errors resulting from confusion with 
respect to the different definitions.
    Third, the Joint Committee also supports simplifying the HOPE and 
Lifetime Learning credit programs by combining them into a single 
credit. Combining the two credits would reduce complexity and confusion 
by eliminating the need to determine which credit provides the greatest 
benefit with respect to one individual and to determine if a taxpayer 
can qualify for both credits with respect to different individuals. If 
Congress considers implementing this recommendation, it should take 
care not to reduce the total benefits available to individual taxpayers 
under the programs.
    Finally, the Joint Committee recommends eliminating the 
restrictions on the use of education tax incentives based on the use of 
other education tax incentives and replacing them with a limitation 
that the same expenses could not qualify under more than one provision. 
The Joint Committee states in its study that this recommendation would 
eliminate the complicated planning required in order to obtain full 
benefit of the education tax incentives and reduce ``traps for the 
unwary.'' We note, however, that Congress has improved the coordination 
of the HOPE and Lifetime Learning credits as a result of the recently 
passed tax legislation.11
---------------------------------------------------------------------------
    \11\ See Sections 401(g) and 402(b) of the Economic Growth and Tax 
Relief Reconciliation Act of 2001.
---------------------------------------------------------------------------
    We support Congress's efforts to simplify the rules applicable to 
various education savings vehicles. Savings for their children's 
education is a top priority for many working Americans. We applaud 
efforts to streamline the rules relating to education tax incentives. 
By reducing the complexity surrounding these various tax incentives and 
education savings vehicles, Congress will enable more Americans to take 
advantage of opportunities to save for their children's education.
IV. Conclusion
    Today's individual and employer-sponsored retirement system has 
evolved into a complex array of burdensome requirements and restrictive 
limitations that can serve as barriers to retirement savings. The same 
holds true for education savings programs. Simplifying the rules 
relating to retirement and education savings vehicles would encourage 
greater savings by American workers.

                                

          Massachusetts Software & Internet Council
                                Boston, Massachusetts 02116
                                                      July 19, 2001
Allison Giles, Chief of Staff
Committee on Ways & Means
1102 Longworth House Office Building
Washington, DC 20515

RE: Alternative Minimum Tax on Incentive Stock Options

    Dear Ms. Giles:
    On behalf of the Massachusetts Software & Internet Council, I would 
like to submit this statement for inclusion in the printed record of 
the hearing held on July 17 on Tax Code Simplification.
    Incentive stock options (ISOs) were originally intended to 
encourage employees to maintain a long-term stake in their companies. 
An added benefit to the employee is the fact that the exercise of an 
ISO generally does not result in a taxable event.
    This benefit is in contrast to the exercise of a nonqualified stock 
option, which results in the immediate recognition of compensation 
income, even if the stock purchased by exercising the option is not 
sold.
    The favorable regular tax treatment for ISOs, however, is 
undermined by unfavorable treatment of ISOs for alternative minimum tax 
(AMT) purposes. Under the AMT, the gain between the grant price and 
theexercise price is treated as a preference item to be included in AMT 
income.
    The AMT causes an acceleration of the taxable event for an ISO. For 
regular tax purposes, there is no taxable event until the ISO shares 
are sold. But the AMT causes a portion of the total tax to be moved up 
to the year of exercise. This result discourages employees from holding 
their options as a stake in their companies.
    Moreover, because AMT calculations are so complex, a growing number 
of employees who have exercised ISOs, but who have seen the market 
value of their options decline below the exercise price, are now faced 
with significant AMT tax liability without having the resources needed 
to meet this liability.
    This harmful consequence of AMT complexity is not limited to the 
employees of large companies. Thirty-eight companies, whose names are 
listed below, have authorized the Council to record their opposition to 
the AMT being applied to ISOs. Only a few of these companies are 
publicly held; most are privately held startups. Of these thirty-eight 
companies, thirty-two grant ISOs to eighty percent or more of their 
employees.
    Because employees should be encouraged to acquire and hold stock in 
their employers, the Council recommends that the Internal Revenue Code 
be simplified by repealing the application of the AMT to ISOs.
            Sincerely,
                                           Joyce L. Plotkin
                                                          President

About the Massachusetts Software & Internet Council
    The Massachusetts Software & Internet Council was founded in 1985 
to promote the Massachusetts software and Internet industry, to help 
executives start, grow, and manage companies, and to help companies 
compete successfully in global markets. Currently there are 775 member 
companies. The Council organizes more than 50 meetings a year on the 
business aspects of managing software and Internet companies; conducts 
research on the industry; represents the software and Internet industry 
on technology-related public policy issues; creates innovative programs 
to deal with the shortage of skilled workers; and promotes 
Massachusetts as a center of technology leadership and innovation. 
Additional information about the Council can be found at http://
www.msicouncil.org

         Council members supporting repeal of the AMT on ISOs:

    Trellix, Concord
    Chamelon Network, Waltham
    Endeca, Cambridge
    Bitpipe, Boston
    Torrent Systems, Cambridge
    Framework Technologies, Burlington
    TimeTrade Systems, Waltham
    Eprise, Framingham
    Into Networks, Cambridge
    Axiomatic Design Software, Inc., Boston
    Nexus Energyguide, Wellesley
    KeyCommerce, Inc., Nashua, NH
    QuadrantSoftware, Mansfield
    Media 100, Marlboro
    Authoria, Waltham
    Zoesis Studios, Newton
    Passkey, Quincy
    IConverse, Inc., Waltham
    Predictive Networks, Cambridge
    FabCentric, Inc., Newton
    e-Dialog, Lexington
    Windstar Technologies, Inc., Norwood
    MOCA Systems, Inc., Newton
    CommercialWare, Inc., Natick
    Acorn Communications Corp., Boston
    SensAble Technologies, Inc., Woburn
    WorkplaceIQ Ltd., Waltham
    INTEGRA Technology Consulting Corp., Waltham
    Funk Software, Inc., Cambridge
    Blue Fang Games, Lexington
    Sitara Networks, Waltham
    Molecular, Watertown
    XYVision Enterprise Solutions, Inc., Reading
    Verilytics, Waltham
    Incentive Systems, Inc., Bedford
    Cerida Corporation, Andover
    Moldflow Corporation, Wayland
    Delphi Technology, Inc., Cambridge

                                

          Statement of Mortgage Insurance Companies of America

                       Introduction and Overview

    This testimony outlines the comments of the Mortgage Insurance 
Companies of America on the Joint Committee on Taxation's proposal to 
eliminate Internal Revenue Code (''IRC'' or ``Code'') section 832(e). 
Without impacting the Federal Treasury, IRC section 832(e) embodies a 
series of special deduction rules that apply specifically to mortgage 
and lease guaranty insurance and to insurance of state and local 
obligations.
    The Mortgage Insurance Companies of America (MICA) is a national 
trade association of the private mortgage insurance industry. The 
organization's members help loan originators and investors make funds 
available to home buyers with as little as 3-to-5 percent down--and 
even less for qualified borrowers--by protecting these institutions 
from a major portion of the financial risk of default. The private 
mortgage insurance industry's mission is to help put as many people as 
possible into homes sooner for less money down, and to ensure that they 
stay in those homes. By insuring conventional low down payment 
mortgages, MICA members have made homeownership a reality for more than 
20 million families.
    MICA strongly urges Congress to reject the Joint Committee on 
Taxation's (''JCT'' or ``Committee'') suggestion that Congress 
eliminate IRC section 832(e). Further, MICA believes that several of 
the premises upon which JCT bases its suggestion are inaccurate or fail 
to adequately reflect the true value of IRC section 832(e) for the 
mortgage insurance industry and its customers.

 Description of Current Law and Joint Committee on Taxation's Proposal

Current Law
    Congress enacted IRC section 832(e) in 1967 to address financial 
pressures on the mortgage guaranty insurance industry and related 
insurers resulting from States mandating the creation of contingency 
reserves for extraordinary losses arising during adverse economic 
periods. In many States, up to 50 percent of premiums received in any 
one year have had to be set aside for these contingency reserves. The 
size of these reserves created a substantial drain on the working 
capital of these insurers. Prior to enactment of IRC section 832(e), it 
was unclear whether the Code permitted companies to take a tax 
deduction to offset the cost of additions to these reserves. Without a 
tax deduction for these reserves, the companies were required not only 
to set aside massive funds for the reserves, but also to pay taxes on 
such reserved funds. Accordingly, since the portion of annual earned 
premiums required to be set aside in the reserves could not be used to 
pay current losses and other expenses, a current tax on premiums thus 
set aside further depleted the companies' assets and created a drain on 
working capital. A drain on working capital means that a mortgage 
insurer's ability to continue to insure more loans and thus expand 
homeownership opportunities for lower income families would be limited.
    The Code addresses the strain these State rules place on a mortgage 
guaranty insurer's working capital through a unique statutory provision 
that was carefully drafted to meet the concerns of both the federal 
government and the insurance industry. Specifically, IRC section 832(e) 
allows companies to deduct payments made to such reserves, subject to 
the following limitation: the deduction can be no greater than the 
lesser of (i) the company's taxable income or (ii) 50 percent of the 
premiums the company earned on guaranty contracts for the same taxable 
year. Deductible amounts added to the reserve must be restored to 
income no later than the close of 10 years, regardless of loss 
experience or a State's funding requirements.
    Congress determined, however, that insurers should not realize an 
economic benefit from this deduction, in large part because the State 
reserve requirements were so substantial. Further, Congress wanted to 
accomplish this requirement in a way to minimize the financial hardship 
on insurers. Accordingly, IRC section 832(e) requires insurers who take 
the deduction to purchase non-interest-bearing tax and loss bonds equal 
to the amount of tax savings attributable to the related deductions. 
The bonds cannot be redeemed without the amounts in the reserve fund 
being restored to income (and therefore made subject to the federal 
income tax), either because of heavy, catastrophic losses or through 
operation of the 10-year rule mentioned above. Amounts received in 
redemption of the bonds are typically used to pay income taxes 
resulting from inclusion in income of the previously deducted amount 
Congress knew that the economic impact of purchasing the tax and loss 
bonds would be ameliorated since the bonds qualified as assets for 
State financial regulatory purposes. In summary, IRC section 832(e) 
denies mortgage guaranty insurance companies the benefit of tax 
deferral with respect to amounts deducted, but does not create a drain 
on the company's assets since the bonds are recognized as assets for 
relevant state regulatory and accounting purposes and, therefore, 
mortgage insurers can continue to expand homeownership opportunities 
for families who do not have sufficient resources to save for a large 
down payment.
Joint Committee on Taxation Proposal
Description of Proposal
    The Joint Committee on Taxation has suggested that IRC section 
832(e) be eliminated. The Committee believes the section provides ``no 
Federal income tax goal, but rather, only a particular financial 
accounting result.'' Contrary to the Committee's belief, however, IRC 
section 832(e) does in fact address the primary policy goal recognized 
by Congress in 1967, by helping to alleviate the burdens placed on the 
mortgage guaranty insurance industry through compliance with State and 
local reserve requirements. This in turn promotes home ownership. Any 
reduction or elimination of this important section of the Code would 
significantly impair the industry's ability to provide mortgage 
guaranty insurance.
Reasons for Maintaining Current Law
    Although IRC section 832(e) could be viewed as adding some 
complexity to the Code, the few companies that actually utilize and 
depend on the section believe it is a fair, workable and necessary 
provision. Unlike Code provisions for many other industries, the 
current tax system for the insurance industry takes into account how 
State-mandated statutory accounting principles impact the industry's 
ability to operate and compete effectively. In particular, IRC section 
832(e) reflects Congress' full appreciation of the burdens such State 
requirements place on the mortgage guaranty insurance industry, while 
also recognizing the economic realities of this business. Congress' 
original rationale for enacting Code IRC section 832(e) remains valid, 
and the same conditions, i.e., adverse economic cycles and the State 
regulatory system for the mortgage guaranty industry, continue to 
exist.
    IRC section 832(e) also strikes a delicate balance between the 
business realities of the industry and the revenue needs of the Federal 
government. The deduction makes it easier for companies to fund their 
State-mandated reserves, thereby setting aside funds in good years that 
can be used to pay claims for losses that may arise many years later.
    The balanced compromise in IRC section 832(e) should not be 
disturbed. The industries' need for funded loss reserves has been 
addressed under a compromise that requires companies to purchase non-
interest-bearing tax and loss bonds in an amount equal to their tax 
savings attributable to the deduction. Purchase of the bonds provides 
the Federal government with an immediate receipt of funds, while 
companies are permitted to use the bonds to offset the high costs of 
funding the reserves required by their long-term economic risks. The 
tax and loss bonds qualify as assets for State financial regulatory 
purposes and offset working capital problems insurance companies would 
otherwise experience.
    Importantly, the private mortgage guaranty insurance industry's 
main competitor is a tax-exempt agency of the federal government, the 
Federal Housing Administration (``FHA''). Any elimination of IRC 
section 832(e) would reduce the private mortgage guaranty insurance 
industry's ability to compete fairly with the FHA.

                               Conclusion

    An elegant solution for a unique situation, IRC section 832(e) has 
worked well for more than 30 years. IRC section 832(e) continues to 
help stabilize the mortgage guaranty insurance industry through periods 
of economic instability. It recognizes the conservative capital 
requirements imposed on the industry through State-required contingency 
reserves. Its intent is to provide a methodology to ameliorate the 
effects of these reserves on the working capital of the insurers. It 
achieves this at no cost to the Federal Treasury. Thusly, mortgage 
insurance companies are able to continue to expand homeownership 
opportunities by helping millions of American families afford 
homeownership. For these reasons, MICA urges Congress to reject any 
proposal that would limit or eliminate IRC section 832(e).

                              Contact List

    1. Suzanne C. Hutchinson, Executive Vice President, Mortgage 
Insurance Companies of America, 727 15th Street N.W., 12th Floor, 
Washington, D.C., 20005 (202) 393-5566, (202) 393-5557 (fax)
    2. Joe Komanecki, Mortgage Guaranty Insurance Corporation, P.O. Box 
488, 270 East Kilbourn Avenue, Milwaukee, WI 53201, (414) 347-6706, 
(414) 347-6832 (fax)
    3. Don Alexander, Akin, Gump, Strauss, Hauer & Feld, LLP, 1333 New 
Hampshire Avenue N.W., Suite 1000, Washington, D.C. 20036, (202) 887-
4064, (202) 887-4288 (fax)
    4. Janet Boyd, Akin, Gump, Strauss, Hauer & Feld, LLP, 1333 New 
Hampshire Avenue N.W., Suite 1000, Washington, D.C. 20036, (202) 887-
4068, (202) 887-4288

                                

      Statement of National Association of Professional Employer 
              Organizations (NAPEO), Alexandria, Virginia
    The National Association of Professional Employer Organizations 
(NAPEO) appreciates the opportunity to submit this statement for the 
record of the Subcommittees' July 17, 2001 hearing on the need for 
simplification of the Internal Revenue Code. We congratulate the 
Subcommittees for their interest in these important issues and their 
willingness to reexamine the complex tax law for ways to reduce 
unnecessary compliance burdens and traps for the unwary that face many 
taxpayers today.
    We anticipate that most of the comments that the Subcommittees will 
receive will focus on the need for broad-brush simplification of the 
Internal Revenue Code, and we applaud efforts in that regard. We wish 
to focus, however, on a narrow issue peculiar to the professional 
employer organization or ``PEO'' industry. That issue is the need for 
answers on how to apply the tax law to the unique situation presented 
by our industry. Of course, simplification can take many forms. The 
simplification that our industry needs is that which comes from 
eliminating the uncertainty of current law and specifying precisely how 
to apply the tax law to our particular situation.
    A PEO assists mainly small- and medium-size businesses in 
fulfilling their responsibilities as employers by assuming the human 
resource function of its customers. The PEO generally assumes 
responsibility for paying wages and employment taxes to all the workers 
of its client companies. It maintains employee records, handles 
employee complaints, and provides employment information to workers, 
such as an employee handbook. Most significantly, the PEO provides 
workers a variety of benefits, including retirement (usually a 401(k) 
plan), health, dental, life insurance, and dependent care. For many of 
these workers, the provision of such benefits by the PEO represents 
their first opportunity to obtain these benefits.
    PEO clients tend to be smaller businesses; as recent statistics 
show, these are the businesses least able to offer retirement and 
health benefits. The average number of employees that a NAPEO member's 
customer has is 18; the average annual wage is less than $20,000. PEOs 
can provide benefits to these workers on a more affordable basis 
because they can aggregate the workers of all of their customers 
together into a larger group, thereby obtaining economies of scale that 
enable them to maintain qualified plans. Moreover, PEOs have the 
expertise to operate these plans in compliance with a rather complex 
set of requirements imposed by the tax code and ERISA. Significantly, 
PEOs also bring workers under the protection of federal laws applicable 
only to large employers, providing workers such benefits as COBRA 
health care continuation coverage and benefits under the Family and 
Medical Leave Act--protections that would not otherwise been available 
to those workers.
    As small- and medium-sized businesses have increasingly sought out 
the services of PEOs over the past decade, the industry has expanded to 
meet this demand. At the state level, NAPEO has in many cases sought 
recognition for PEOs and supported regulation, such as licensing, to 
ensure that the industry could grow in a manner that ensured quality 
services. At the Federal level, however, PEOs have been confronted with 
a tax code that was written long before the development of our 
industry. Therefore, the current rules governing who can collect 
employment taxes and provide benefits do not neatly fit a PEO, its 
customer and workers. In fact, under some interpretations of the tax 
law, PEOs could not do the very things that small businesses want and 
need--namely, collecting employment taxes and providing retirement, 
health and other benefits.
    What the PEO industry and the IRS need is a map leading us through 
the intricate web of rules that govern employee benefits and the 
payment of payroll taxes. We are very pleased that Representatives 
Portman and Cardin have continued their efforts to help craft that map.
    As many of the members of these subcommittees will recall, those 
efforts began with H.R. 1891, sponsored by Representatives Rob Portman 
(R-OH) and Ben Cardin (D-MD) in the 105th Congress. That legislation, 
the Staffing Firm Worker Benefits Act of 1997, was a comprehensive bill 
introduced in June 1997 aimed at answering a broad array of questions 
related to the tax status of a wide range of staffing firms. Comparable 
provisions were included in S. 2339 (105th Congress), bipartisan 
comprehensive retirement savings legislation introduced by Senators Bob 
Graham (D-FL) and Chuck Grassley (R-IA) in July 1998. In early 1999, 
however, serious concerns surfaced with respect to certain changes 
proposed in H.R. 1891 and S. 2339, including especially the elements of 
the bill affecting certain staffing firms other than PEOs.
    Since the PEO industry felt that the concerns raised did not appear 
to directly affect PEOs (or could be dealt with through more careful 
drafting), we went back to the drawing board to try and come up with a 
narrower approach to our problem. The goal of this effort was to 
address the concerns that had been raised with respect to the 
comprehensive legislation, while still allowing PEOs to do what we 
werealready doing for small businesses--providing benefits and 
collecting taxes. The result was a narrowly crafted bill, which was 
introduced in the last Congress by Representatives Portman and Cardin 
as the Professional Employer Organization Workers Benefits Act (H.R. 
3490). Companion legislation was introduced in the Senate by Senators 
Graham and Connie Mack (R-FL) as S. 2979.
    Since then, we have continued our extensive discussions with all 
interested parties and further refinements to the legislation have been 
made. These changes have led IRS Commissioner Rossotti to state that 
the revised bill would greatly improve tax administration. We are 
pleased to present the fruits of those efforts--a revised proposal that 
we believe addresses the concerns raised with respect to the original 
proposal.
    Let me emphasize that this revised legislation is a completely 
different approach from the bill that was considered in 1997. Most 
significantly, the revised bill applies only to PEOs, i.e., 
arrangements where the PEO accepts responsibility for all or almost all 
of the workers at a worksite. It does not have anything to do with 
temporary staffing agencies or similar arrangements. Further, this bill 
by its terms applies only to two areas of the tax law--employment taxes 
and employee benefit law. It does not affect any other law, nor does it 
affect the determination of who is the employer for tax law or any 
other purpose. The bill specifically provides that it creates no 
inferences with respect to those issues. We hope that with this narrow 
focus, this legislation can be considered quickly on its own merits and 
will not be caught up in other unrelated issues.
    In brief, what the new proposal provides is a safe harbor for PEOs 
which elect to meet certain certification requirements designed to 
protect the government against financial loss. A PEO that meets those 
requirements would be permitted to assume liability for employment 
taxes with respect to worksite employees and to offer retirement and 
other benefits to such workers. Significantly, the legislation 
explicitly prevents a customer from obtaining any better treatment 
under the tax code's nondiscrimination or other qualification rules 
under this proposal--a PEO's plans would be tested under these rules on 
a customer-by-customer basis.
    Earlier this year, the Ways and Means Committee, and 
Representatives Portman and Cardin in particular, took the lead in 
substantially improving and streamlining the rules governing retirement 
plans. We are very pleased that President Bush signed those changes 
into law in June. That pension reform effort involved a variety of 
changes in the law that appeared complex on their face only because the 
existing law was so complex. In reality, however, the pension reforms 
contained in the June tax bill will result in a substantial 
simplification of the law through a lifting of a variety of duplicative 
and unnecessary administrative burdens that had been placed on 
retirement plans and by providing clearer answers on a number of 
issues.
    Just as with the pension bill that Representatives Portman and 
Cardin authored, the changes needed for PEOs appear complex because the 
underlying law is so complex. In reality, needed legislation will 
substantially simplify the law for PEOs and the IRS by clearing up 
uncertainty and ambiguity in the current law in a manner that ensures 
not only that PEOs can continue to provide important employee benefits, 
but also that other important public policies are protected.
    We ask the members of these subcommittees to work with 
Representatives Portman and Cardin to ensure that this PEO legislation 
is enacted as quickly as possible. This clarification of PEOs' ability 
to offer retirement and health benefits will permit our industry to 
continue to provide the workers of small and medium sized businesses 
with the benefits they need and deserve. With this legislation, current 
PEO customers will breathe a sigh of relief that the PEO plans in which 
their workers are currently participating will not be disqualified. 
PEOs will be able to establish new employee benefit plans under clear 
tax code rules. The marketplace's creative response to the difficulties 
of affording and providing benefits in a small business context will be 
allowed to flourish without the uncertainty imposed by outdated tax 
rules. We believe this represents an ideal model of the public-private 
partnership that can help address the impending retirement savings 
crisis as well as the immediate health care problem presented by the 
number of uninsured Americans, and we urge your support of that effort.

                                

        Statement of the National Council of Farmer Cooperatives
    The National Council of Farmer Cooperatives (''NCFC'') is a 
nationwide association of cooperative businesses owned and controlled 
by farmers. Its members include nearly 70 major farmer marketing, 
supply and credit cooperatives.
    In connection with the Subcommittees' hearings on the need for 
simplification of the Internal Revenue Code (the ``Code''), NCFC would 
like to bring to the Subcommittees' attention a proposal that would 
significantly simplify the tax treatment of dividends paid by 
cooperatives to shareholders that furnish start-up and expansion 
capital to such cooperatives. The proposal is contained in H.R. 2280, 
introduced by Representative Wally Herger and co-sponsored by 
Representatives Phil English, John Lewis, Jim Ramstad, Karen Thurman, 
J.D. Hayworth, Earl Pomeroy, and Fortney Stark. H.R. 2280 would allow 
cooperatives to pay dividends on capital stock or other proprietary 
capital interests without those dividends reducing net earnings 
eligible for the patronage dividend deduction to the extent that the 
cooperative's articles of incorporation, bylaws, or other contracts 
with patrons provide that such dividends are in addition to amounts 
otherwise payable to patrons from patronage sourced earnings during the 
taxable year. This bill is identical to a provision that was originally 
introduced as H.R. 1914 by Congressman Bill Thomas and included in a 
vetoed tax bill (H.R. 2488) of the 106th Congress.
    NCFC believes that modifying the dividend allocation rule in the 
manner proposed by H.R. 2280 will promote the overall goals of tax 
simplification. Accordingly, NCFC urges the Subcommittees to consider 
including this bill in any future tax simplification measures.
Modification of the Dividend Allocation Rule Promotes Tax 
        Simplification
    Both the Joint Committee on Taxation and the Ways and Means 
Committee have articulated criteria to be used to determine whether a 
proposal satisfies the goals of tax simplification. (See Exhibit B.) 
NCFC believes that a modification of the dividend allocation rule in 
the manner contained in H.R. 2280 would satisfy all of the criteria for 
tax simplification.
    First and foremost, H.R. 2280 would further the underlying policy 
of Subchapter T of the Code by ensuring that patronage income is 
subject to one level of tax. (See Exhibit A.) Second, as the current 
rule is mechanically complex and costly to administer, H.R. 2280 would 
achieve simplification and improved efficiency, understandability, 
feasibility and enforceability of Subchapter T of the Code. This 
simplification would reduce the burdens imposed on taxpayers, tax 
practitioners, and tax administrators and would greatly outweigh the 
costs of making a statutory change. Third, the solution proposed by 
H.R. 2280 would not create opportunities for abusive tax planning by 
providing an opportunity for nonpatronage income to be converted to 
patronage income and would comport with generally accepted tax 
principles. Fourth, H.R. 2280 would avoid the dislocation of tax 
burdens that occurs when the distribution of nonpatronage income to 
shareholders results in a third level of tax that falls on the 
cooperative (and, derivatively, all the members) and not only on the 
shareholders that are receiving the dividend. Finally, the revenue 
effect of modifying the dividend allocation rule (approximately $16 
million over ten years) would comport with current budgetary 
constraints. Based on these reasons, NCFC submits that H.R. 2280 meets 
all of the criteria set forth by the Ways and Means Committee and 
should be adopted as a tax simplification measure.
Conclusion
    The dividend allocation rule is fundamentally inconsistent with the 
policy goals of Subchapter T of the Code and adds complexity to the 
Federal tax laws, which should be removed by modifying the rule in a 
manner consistent with H.R. 2280. Accordingly, NCFC urges this 
Subcommittee to consider including H.R. 2280 in any future tax 
simplification measures.

                               EXHIBIT A

       POLICY GOALS OF SUBCHAPTER T AND DIVIDEND ALLOCATION RULE

    One of the overall policy goals of Subchapter T of the Internal 
Revenue Code (the ``Code'') is to subject a cooperative's ``patronage 
income'' to one level of tax and ``nonpatronage income'' to regular 
corporate income taxation. Patronage income is income derived from the 
cooperatives' business done with or for its patrons, and ``nonpatronage 
income'' is all of the other income of the cooperative. The single 
level of tax on the cooperative's patronage income is achieved by 
allowing the cooperative to take a patronage dividend deduction for the 
distribution of its net patronage income annually to its patrons based 
on their patronage business with the cooperative during the year. No 
similar deduction exists for the distribution of nonpatronage income. 
Thus, nonpatronage income is subject to two levels of tax.
The Dividend Allocation Rule
    Under current Treasury Department practice and a predominance of 
the case law, if a cooperative pays a dividend on its capital stock or 
its other proprietary capital interests, the dividend is subject to the 
``dividend allocation rule.'' The ``dividend allocation rule'' requires 
this dividend to be treated as if it came from both patronage and 
nonpatronage operations of the cooperative and the allocation is made 
by employing the following calculation.
    First, the dividend is treated for tax purposes as coming from the 
patronage and nonpatronage operations of the cooperative in proportion 
to the amount of business the cooperative has done in each of these 
operations. (For most cooperatives, this will mean that it will be 
treated as predominantly patronage income.) Second, the amount 
allocated to the patronage operation is then used to artificially 
decrease the cooperative's net patronage income (for deduction 
purposes), thus reducing the amount of the patronage dividend deduction 
and leaving patronage-sourced net earnings subject to tax at the 
cooperative level. See Treas. Reg. Sec. 1.1388-1(a)(1)(iii). This 
creates an additional tax at the cooperative level, in effect a triple 
tax, merely because the cooperative has distributed a dividend on its 
capital stock.
    The effect of the dividend allocation rule on a cooperative's 
taxation is illustrated by the following example:
EXAMPLE
    A cooperative has gross income from patronage business of $200 and 
from nonpatronage business of $22. It has patronage expenses of $65 and 
nonpatronage expenses of $7, so that its patronage net earnings are 
$135 and its nonpatronage earnings are $15. It pays a tax of $5 on its 
nonpatronage earnings, leaving $10 in retained earnings from its 
nonpatronage business. This $5 is the first tax paid on the earnings.

----------------------------------------------------------------------------------------------------------------
        Patronage Sourced Income (90%)                            Nonpatronage Business (10%)
----------------------------------------------------------------------------------------------------------------
Income from patronage business:                     $200         Income from nonpatronage business         $22
Patronage expenses                                  [65]                     Nonpatronage expenses         [7]
Patronage earnings                                  $135                    Nonpatronage earnings:         $15
                                                                            Corporate taxes on $15         (5)
                                                                                After tax earnings         $10
----------------------------------------------------------------------------------------------------------------

    Due to the ``dividend allocation rule,'' if the cooperative pays a 
Capital Stock Dividend of $10 (the after-tax profits from its non-
patronage business, i.e., retained earnings), the $10 will be prorated 
between the patronage earnings and nonpatronage earnings (which are 
$135 to $15, a 9 to1 ratio). Thus, $9 of the $10 of retained earnings 
will be deemed to come from the patronage net earnings, reducing the 
available patronage dividend from $135 to $126, which reduces the 
amount of patronage dividend available to the farmer member, a decrease 
of approximately 7%. This reduction in the patronage dividend deduction 
means that an additional $9 will become subject to tax. The cooperative 
has a full $135 in patronage net earnings and it only gets a patronage 
dividend deduction for $126; the difference ($9) becomes subject to tax 
at the cooperative level. Therefore, the cooperative pays a second 
corporate tax of say, $3, due to the reduction of the allowable 
patronage dividend deduction.

----------------------------------------------------------------------------------------------------------------
               Patronage Sourced Income (90%)
----------------------------------------------------------------------------------------------------------------
Patronage earnings                                                   $135
Dividend Allocation Rule                                          [9] ($3       After tax earnings         $10
                                                                     tax)
Patronage deduction                                                  $126
----------------------------------------------------------------------------------------------------------------

    When the $10 Capital Stock Dividend is received by the 
stockholders, they are subject to tax on the receipt of this income, 
say $3 in tax. This $3 is the third tax paid on the earning and 
distribution of this income.

------------------------------------------------------------------------
                    After Tax Earnings
------------------------------------------------------------------------
Dividend to Stockholders $10                                        $10
Tax to stockholder on distribution                                  (3)
------------------------------------------------------------------------

    From the original $15 of nonpatronage earnings to be distributed by 
the cooperative, approximately $11 or 73 percent has been paid in tax. 
At the cooperative level, $8 of the $15 or 53 percent is paid in tax, 
rather than $5 or 33 percent that would have been paid, but for the 
dividend allocation rule. These high percentages arise only because the 
cooperative paid a dividend on its capital stock. The effect of this 
calculation is to create a triple tax for the cooperative and the 
recipients of the dividend on capital stock, rather than the usual 
corporate double tax. It is a penalty imposed on the cooperative for 
paying a dividend on capital stock.
    We urge the Committee to simplify the Code by eliminating this 
mandatory calculation for cooperatives paying dividends on capital 
stock or other proprietary capital interest, and allowing cooperatives 
to pay dividends on capital stock from their nonpatronage earnings and 
have these earnings subject only to the double tax which should apply 
to such earnings.

                               EXHIBIT B

                    CRITERIA FOR TAX SIMPLIFICATION

    In April 2001, the Joint Committee on Taxation released its Study 
of the Overall State of The Federal Tax System and Recommendations for 
Simplification Pursuant to Section 8022(3)(B) of the Internal Revenue 
Code of 1986 (the ``Study''). In Volume I of the Study, the Joint 
Committee set forth the following criteria that it used to analyze 
possible simplification recommendations:
           the extent to which simplification could be achieved 
        by the recommendation;
           whether the recommendation improves the fairness or 
        efficiency of the Federal tax system;
           whether the recommendation improves the 
        understandability and predictability (i.e., transparency) of 
        the Federal tax system;
           the complexity of the transactions that would be 
        covered by the recommendation and the sophistication of 
        affected taxpayers;
           administrative feasibility and enforceability of the 
        recommendation;
           the burdens imposed on taxpayers, tax practitioners, 
        and tax administrators by changes in the tax law; and
           whether a provision of present law could be 
        eliminated because it is obsolete or duplicative.\1\
---------------------------------------------------------------------------
    \1\ The Study, Vol. I., at p.9.
---------------------------------------------------------------------------
    In addition, the Joint Committee applied the following overriding 
criterion to each simplification proposal: whether the recommendation 
would fundamentally alter the underlying policy articulated by Congress 
in enacting the provision.
    The considerations of the Joint Committee on tax simplification 
generally follow the considerations enunciated by the Ways and Means 
Committee. In 1990, the Ways and Means Committee articulated the 
following criteria to be used to determine whether a proposal satisfies 
the goals of tax simplification:
           whether the proposal would significantly reduce 
        mechanical complexity or recordkeeping requirements;
           whether the proposal would significantly reduce 
        compliance and administration costs;
           whether the proposal would preserve underlying 
        policy objectives of current law and not create or reopen 
        opportunities for abusive tax planning;
           whether the proposal comports with generally 
        accepted tax principles;
           whether the proposal would avoid significant 
        dislocations of tax burdens among taxpayers;
           whether the simplification that the proposal would 
        achieve outweighs the instability resulting from making any 
        statutory change, as opposed to statutory repose; and
           whether revenue effects of the proposal would 
        comport with current revenue and budget constraints.\2\
---------------------------------------------------------------------------
    \2\ Committee on Ways and Means, U.S. House of Representatives, 
Written Proposals on Tax Simplification, 101st Cong., 2nd Sess., WMCP: 
101-27, p. III-IV (May 25, 1990).
---------------------------------------------------------------------------
    [An Additional attachment is being retained in the Committee 
files.]

                                

 Statement of the Hon. Charles B. Rangel, a Representative in Congress 
                       from the State of New York
    The tax laws have become more and more complex. Something needs to 
be done. Tax simplification is at the top of everyone's ``agenda'' but 
not on the Republicans' real ``action plan.''
    IRS data show that, in 1998, it took the average taxpayer nearly 8 
2 hours to complete a simple Form 1040A (includes recordkeeping, 
learning about the law, preparing the form, and copying, assembling and 
sending the form to the IRS.) In comparison, this process took about 6 
2 hours in the 1990s. (Similarly, the average low-income taxpayer 
filling out a Form 1040A and Schedule EIC (earned income tax credit) 
took about 8 hours and 48 minutes to complete the process.) This is 
just too long.
    Some hoped that 1998 IRS reform requirement--that the Joint 
Committee on Taxation provide a ``tax complexity analysis'' on all tax 
legislation reported to the House--would encourage tax simplification 
at least for new tax proposals. But, I guess it has not had the desired 
result.
    The President's recently-enacted tax cut bill, the Taxpayer Relief 
Act of 2001 creates significant additional complexity for taxpayers. 
The bill creates complexity in many areas, for example: uncertainty 
with sunsets of numerous provisions during the next nine years, and of 
the entire package of tax cuts at the end of 2011; growth in the number 
of taxpayers subject to the alternative minimum tax in comparison to 
prior law; confusing education tax provisions that apply to few 
taxpayers but require comparative review with previously-enacted 
provisions to determine the most beneficial option; and estate tax 
phase-out and reinstatement which may require annual review of estate 
plans.
    The entire tax cut bill is sunset at the end of nine years.
    Other provisions start late, end even earlier, or both. Not only is 
this budget gimmickry, it imposes complexity on taxpayers and the IRS.
    The bill does nothing to protect millions of taxpayers from having 
to calculate tax twice--once for regular tax purposes and once for the 
alternative minimum tax. A recent Business Week article states: 
``Nothing better illustrates this tax bill's wallet-on-a string tricks 
than the alternative minimum tax provision. . . . The relief only lasts 
through 2004; by 2010, the new law will double the number of taxpayers 
subject to the AMT to 35.5 million. Clearly, today's lawmakers are 
punting this problem for future Congresses.''
    The bill does nothing to simplify, but rather makes more complex, 
the myriad of education tax benefits.These provisions actually have 
become a ``trap for the unwary.'' It is almost impossible to figure out 
whether one should use the Education IRAs, HOPE or Lifetime Learning 
Credits, or Qualified Tuition Plans. The wrong decision could result in 
a family paying more tax. The bill contains a confusing and complex 
array of tax changes designed to benefit parents with children in 
college or who are saving for college. Since a number of the new 
benefits require taxpayers to choose among old or new incentives, 
families that rush out to use the new provisions may find that they 
would have been better off had they simply used the tax benefits 
available under prior law.
    The bill's ``estate tax repeal'' provisions are incredibly complex. 
The bill creates an extremely complicated estate tax planning system, 
given the slow phased-in repeal of the tax (with full repeal effective 
in 2010), retention of the gift tax, partial carry-over basis, and 
sunset after full phase-in (in 2011). The provisions have been called 
``estate tax planners' full employment act of 2001.'' The Democrats 
suggested a simple approach to reducing the tax B increasing the 
exemption amount B but the Republicans rejected this approach.
    The tax cut bill attempted to provide some simplification relief 
relating to the earned income tax credit, phased-in repeal of the 
current law phase-out of personal exemptions (called ``PEP''), and 
phased-in repeal of the current limit on itemized deductions (called 
``Pease'').
    The bill simplified, to some degree, the rules for the earned 
income tax credit. More needs to be done and we need to complete the 
task. The IRS Taxpayer Advocate, the Joint Committee on Taxation, the 
American Bar Association, accounting groups and many others have 
recommended simplification of the EITC. In fact, the Democrats have 
proposed simplification measures that the Republicans have rejected. 
There is no reason for further delays. Most EITC filers have their 
returns prepared by professionals in order to deal with this 
complicated area. The EITC laws are so complex that even tax 
professionals can't get it right. The ``most common error'' on paid-
preparer returns relates to the EITC.
    Two other problem areas that have been identified for many years 
relate to the personal exemption phase-out and limit on itemized 
deductions. The tax cut bill fails to resolve this problem immediately. 
Instead, taxpayers face a phased-in repeal over several years and 
benefit from full repeal for only one year (2010). They face sunset of 
the repeal for years 2011 and later.
    Tax law complexity is not something that simply was created a 
decade ago and remains unresolved. Rather, the complexity of our tax 
laws is a continuing problem and process. The Congress tried to stop 
the piling-on of more and more complex tax provisions through a 
provision included in taxpayer rights legislation enacted in 1998.
    Beginning with the 105th Congress, the Joint Committee 
on Taxation has been required to provide a ``tax complexity analysis'' 
of tax legislation approved by the Committee on Ways and Means. (At the 
end of each Committee report, one can see the JCT's analysis.) The 
JCT's tax complexity analysis reports, for tax legislation approved by 
the Committee over the past several years, do not show a commitment to 
tax simplification. Instead, the tax laws are becoming more difficult, 
burdensome and complex.
    The most recent example of new tax code complexity was approved 
just last week B the Republican-designed non-itemizer tax deduction for 
charitable donations. For the first two years, the deduction for more 
than three quarters of taxpayers is worth $3.75 per person or less. In 
order to qualify for this tax benefit, according to the Joint 
Committee, taxpayers will need to read additional information on how to 
claim the deduction, fill out an additional line on the tax return, and 
keep records justifying their $25-$50 charitable contributions. Every 
year or so, the amount of eligible contribution changes, so taxpayers 
need to be careful to avoid mistakes and IRS audits. An obvious, more 
simple way to provide this tax benefit would have been to increase the 
standard deduction (e.g., by $20 to $25 for singles and $35 to $50 for 
couples in the first years).
    In conclusion, it is one thing to talk about tax simplification. It 
is another to act. The time to simplify the tax law was yesterday. We 
need to develop a package of individual tax simplification measures and 
enact them on a bipartisan basis. Also, because the recent tax cut 
legislation utilized most of the available surplus, we will need to 
develop revenue offsets to the extent simplification measures have a 
cost associated with them.
    Simplification does not come for free. There has to be a commitment 
to pay for the resulting reforms. You can count on me to support such 
an effort, if it is real. Hearings are nice and make everyone feel 
good. However, the public knows when simplification is ``all talk and 
no action.'' They know on April 15th when they fill out 
their tax returns (or more likely when they have a preparer do it for 
them) whether the tax laws are more complex.
    I encourage all Members of the Committee to work together and 
develop a tax simplification package for enactment this year. The 
public expects and deserves no less.

                                

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