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29–691—PDF 2005

S. HRG. 109–559

ENCOURAGING SAVINGS AND INVESTMENT:

STAY THE COURSE OR CHANGE DIRECTION?

HEARING

BEFORE THE

SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT

OF THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

JUNE 30, 2005

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT

JON KYL, Arizona, Chairman

TRENT LOTT, Mississippi

ORRIN G. HATCH, Utah

OLYMPIA J. SNOWE, Maine

MIKE CRAPO, Idaho

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

JAMES M. JEFFORDS (I), Vermont

MAX BAUCUS, Montana

KENT CONRAD, North Dakota

BLANCHE L. LINCOLN, Arkansas

CHARLES E. SCHUMER, New York

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Kyl, Hon. Jon, a U.S. Senator from Arizona, chairman, Subcommittee on

Taxation and IRS Oversight ............................................................................... 1

Jeffords, Hon. James M., a U.S. Senator from Vermont ...................................... 2

WITNESSES

Harding, G. Scott, president and CEO, F.B. Harding, Incorporated, Rockville,

MD ......................................................................................................................... 4

Weinberger, Robert A., vice president, government relations, H&R Block,

Washington, DC ................................................................................................... 5

Malpass, David, chief economist, Bear Stearns, New York, NY .......................... 7

Toder, Dr. Eric, senior fellow, The Urban Institute, Washington, DC ................ 9

Entin, Stephen J., president and executive director, Institute for Research

on the Economics of Taxation, Washington, DC ................................................ 11

Graff, Brian, executive director and CEO, American Society of Pension Professionals and Actuaries, Arlington, VA ................................................................. 13

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Prepared statement .......................................................................................... 37

Entin, Stephen J.:

Testimony .......................................................................................................... 11

Prepared statement .......................................................................................... 39

Graff, Brian:

Testimony .......................................................................................................... 13

Prepared statement with attachments ........................................................... 49

Responses to questions from committee members ......................................... 104

Grassley, Hon. Charles E.:

Prepared statement .......................................................................................... 108

Harding, G. Scott:

Testimony .......................................................................................................... 4

Prepared statement .......................................................................................... 109

Jeffords, Hon. James M.:

Opening statement ........................................................................................... 2

Prepared statement .......................................................................................... 113

Kyl, Hon. Jon:

Opening statement ........................................................................................... 1

Prepared statement with attachments ........................................................... 115

Malpass, David:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 124

Responses to questions from committee members ......................................... 134

Santorum, Hon. Rick:

Prepared statement .......................................................................................... 136

Toder, Dr. Eric:

Testimony .......................................................................................................... 9

Prepared statement .......................................................................................... 139

Responses to questions from committee members ......................................... 151

Page

IV

Weinberger, Robert A.:

Testimony .......................................................................................................... 5

Prepared statement .......................................................................................... 158

Responses to questions from committee members ......................................... 162

COMMUNICATIONS

Edward D. Jones and Company, L.P. .................................................................... 165

Employee-Owned S Corporations of America (ESCA) .......................................... 169

(1)

* For more information on this topic, see also, ‘‘Present Law and Background Information on

Certain Expiring Tax Provisions,’’ Joint Committee on Taxation staff report, June 27, 2005

(JCX–50–05).

ENCOURAGING SAVINGS AND INVESTMENT:

STAY THE COURSE OR CHANGE DIRECTION?

THURSDAY, JUNE 30, 2005

U.S. SENATE,

SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 2 p.m., in room

SD–215, Dirksen Senate Office Building, Hon. Jon Kyl (chairman

of the subcommittee) presiding.

Also present: Senators Hatch, Thomas, Crapo, Jeffords, and

Wyden.

OPENING STATEMENT OF HON. JON KYL, A U.S. SENATOR

FROM ARIZONA, CHAIRMAN, SUBCOMMITTEE ON TAXATION

AND IRS OVERSIGHT

Senator KYL. Welcome, all of you, to this hearing. I would like

to announce preliminarily that you are all privileged to be in attendance at the very first hearing in this beautiful hearing room

since it has been refurbished.

I mention that to confirm that with Senator Grassley’s staff, who

said, gee, I hope everything works out all right. So if there are any

problems here, we will attribute it to this being the shake-down

cruise for this refurbished hearing room. But, welcome to you all

to this hearing of the Subcommittee on Taxation and IRS Oversight.

Our hearing today is entitled, ‘‘Encouraging Savings and Investment: Stay the Course or Change Direction?’’ I think we will start

by noting the fact that, in coming years, Congress will be faced

with an avalanche of expiring tax provisions, and so we must begin

the process, anyway, of deciding which provisions to keep and

which ones should be allowed to expire.

While most of the widely used provisions, those that apply to

broad classes of taxpayers, expire at the end of 2010, a handful of

such provisions expire between 2006 and 2008.*

Today’s hearing is designed to review whether four particular

policies that expire before the 2010 date are accomplishing what

Congress intended, and if the cost is worth the economic benefit.

2

This type of oversight is essential for Congress to undertake if

we are to pursue sound tax policies, and I do hope that we will do

more of it here in the Senate Finance Committee.

Our first witness, Scott Harding, will talk about the importance

of Section 179 expensing to small businesses. This provision, which

allows up to $100,000 worth of property to be expensed per year,

expires at the end of 2007, at which time the amount would revert

back to $25,000.

Our second witness, Robert Weinberger, will discuss the effectiveness of the saver’s credit in encouraging retirement savings by

lower-income taxpayers. This credit expires at the end of 2006.

The remainder of our witnesses, David Malpass, Eric Toder, Stephen Entin, and Brian Graff, will all speak to the 15-percent individual rate for most dividends and capital gains.

While I expect we will hear some disagreement over whether the

lower rates should be continued, or even made permanent, I think

the trends we are seeing for revenues coming into the Treasury

and the sustained economic growth we are experiencing argue

strongly that these rates must be made permanent.

In fact, the Republican leadership of the Senate is committed to

extending the lower rates for dividends in capital gains as part of

reconciliation later this fall, and to making these rates permanent

as soon as possible.

Before we begin, I want to ask unanimous consent to put a survey, conducted by the Securities Industry Association, in the

record. Is there any objection?

Senator JEFFORDS. No objection.

Senator KYL. If not, so ordered.

[The survey appears in the appendix on page 116.]

Senator KYL. I certainly look forward to hearing from all of our

witnesses.

At this time, let me call upon Senator Jeffords, the Ranking Minority member, for any statement he would wish to make.

OPENING STATEMENT OF HON. JAMES M. JEFFORDS,

A U.S. SENATOR FROM VERMONT

Senator JEFFORDS. Thank you, Mr. Chairman, for calling today’s

hearing. Thanks to all the witnesses for offering their views on how

best to encourage savings and investment in our country.

The personal savings rate in our country is now close to zero.

Perhaps even more troubling, that rate has been on a steady downward trend for the past 2 decades.

Many households, of course, have experienced a growth in their

net worth as a result of asset appreciation in stocks and real estate, but many others are living paycheck to paycheck, only one

layoff or illness away from financial disaster.

We all want to encourage people to save and invest, but we also

want to be able to help those people who lack the means to do so,

and give them the foundation for success.

I supported the tax cuts in 2001. I did so because taxes had

reached almost 21 percent of the GDP and we thought we had a

10-year surplus on the order of $5 trillion. In my mind, a surplus

of that magnitude gave us the room, both to cut taxes and bolster

3

Social Security, and a healthy margin of error, since we knew that

the projections might not materialize.

Of course, that did not come true. There is no need to rehash

why. It is enough to recognize that, instead of a large surplus, we

are looking at a $2-trillion deficit over the coming decade.

In the face of these changed circumstances, Congress must decide

whether the tax cuts, begun in 2001 and accelerated in 2003, still

make sense today. I suppose it is old-fashioned, but I think deficits

do matter: $400 billion here, $300 billion there, pretty soon you are

talking some real bucks.

Also, President Bush has warned that the Social Security system

is on the road to bankruptcy because, in 40 years, it will only be

taking in 70 cents of every dollar that it was supposed to pay out.

Well, if you accept that definition of the path to bankruptcy, the

Federal Government has already arrived. Setting aside Social Security, the Federal Government took in just 70 cents for every dollar

it spent last year; budget receipts were $1.3 trillion, but outlays

were $1.9 trillion, almost $600 billion of red ink.

And these are in the good times. The baby boom is just in its

peak earning period and has not yet begun to retire. How will we

cope from a fiscal standpoint in the next 10 or 20 years if we do

not regain some fiscal discipline now?

All the provisions we will discuss today are attractive, for good

reasons. There is not a politician alive who does not like to cut

taxes. But I think it is time that Congress stop digging itself into

a deeper hole.

The cost of extending the provisions that are the topic of today’s

hearing is more than $200 billion over the next 10 years, and we

will soon be considering proposals on the AMT extenders and the

estate tax. All told, they could easily top a trillion-dollar loss in

revenues.

Finally, beyond the cost of all of these items are the questions

of equity. The Joint Committee on Taxation estimates Americans

will realize $327 billion in capital gains this year; $307 billion of

these gains, almost 94 percent, will go to taxpayers making more

than $100,000. Taxpayers with income of under $50,000 will see

less than $5 billion of these gains. I think those figures speak for

themselves.

All of us would like to lower tax rates, but in a time of chronic

deficits, cutting taxes just dumps more debt on our children.

Mr. Chairman, I thank you, and look forward to today’s testimony.

Senator KYL. Thank you very much, Senator Jeffords.

Let me, just very briefly, introduce each of our witnesses. Then,

since you are all on the same panel, just ask each of you to testify

in the order from my left to your right.

Mr. G. Scott Harding is president and CEO of F.B. Harding, Incorporated, in Rockville, MD. I indicated what each of you would

be testifying about, so I will not repeat that.

Mr. Robert Weinberger is vice president of government relations

at H&R Block here in Washington.

Mr. David Malpass is chief economist at Bear Stearns in New

York.

4

Dr. Eric Toder is senior fellow at The Urban Institute in Washington, DC.

Mr. Stephen Entin is president and executive director of the Institute for Research on the Economics of Taxation in Washington.

Mr. Brian Graff is executive director and CEO of the American

Society of Pension Professionals and Actuaries, in Arlington, VA.

Mr. Harding, we will begin with you. I think you are being

shown right now how you push the button, as Strom Thurmond

used to say, to make the machine work.

Mr. HARDING. Yes, sir.

Senator KYL. Thank you.

STATEMENT OF G. SCOTT HARDING, PRESIDENT AND CEO,

F.B. HARDING, INCORPORATED, ROCKVILLE, MD

Mr. HARDING. Good afternoon. I am Scott Harding, president and

CEO of F.B. Harding Electrical Contractors located in Rockville,

MD. I am very proud to say that our company has been in business

since 1949.

Thank you, Chairman Kyl and Ranking Member Jeffords, for giving me the opportunity to speak to you today on behalf of the National Federation of Independent Businesses regarding Section 179

of the Internal Revenue Code.

As a business owner, I am very pleased to see that the committee

is interested in addressing this important issue. Small business

owners do our jobs using our hard-earned experience and applied

common sense. In business, we make many decisions daily that affect the life of our companies, and thus the livelihood of our employees and their families.

Business, like life, can get complicated. When it comes to complications, the U.S. tax code ranks among the top. I am sure most

small business owners would agree with me on that.

So when I heard that Section 179 limits had been increased, I

was eager to understand how our business could benefit from this

legislation.

Working together with President Bush, Congress enacted into

law the Jobs and Growth Tax Relief Reconciliation Act of 2003,

which increased the limits on expensing from $25,000 to $100,000.

This was a positive step to help small business owners, and is

one of the most significant changes to our tax code in years. The

old threshold of a $25,000 limit was, quite frankly, restrictive, outdated, and simply unfair.

Under current law, Section 179 allows small business owners to

expense—that is, fully deduct from taxable income—$100,000 of

the cost of new business equipment in a year.

This tax benefit is limited by a provision stipulating that the expensing amount is phased out, dollar for dollar, for any amount of

investment above $400,000 in a given year.

However, in 2007, the law expires, and small businesses will only

be able to expense up to $25,000 in new investment per year. Additionally, the $400,000 limit will be reduced to $200,000, severely

limiting the number of small businesses that can qualify for this

important revision.

In order to assist small business owners as they make investments necessary to grow and expand their businesses, I would sugVerDate 11-MAY-2000 15:19 Sep 08, 2006 Jkt 095484 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 29691.000 SFIN1 PsN: SFIN1
5

gest three proposals: number one, make permanent the current law

of allowing $100,000 to be expensed in a given year; number two,

make permanent the $400,000 investment limit; and number three,

index both of these, the $100,000 and the $400,000 limits for inflation.

Allowing small business owners to expense our critical investments immediately is a key component to the expansion of the

economy. It will put money into the hands of small business owners

so they can hire new workers. It will put money directly into the

economy, as owners will be more likely to purchase new equipment.

By indexing the limits to inflation, the bill provides stability for

small business owners. It assures owners that they will not have

to come back to Congress and ask for additional increases to keep

up with inflation. This helps us to do our long-term planning.

In my business specifically, last year alone we spent $106,000 on

our capital expenditures. We were able to purchase tools, computers, and four vehicles. The expansion of Section 179 made these

investments much more prudent for our business and helps us to

compete in the marketplace.

Under the old rules, we would have only been able to expense

$25,000, which is paltry, considering a new vehicle uses up nearly

all of that limitation. Under the expanded rule, we were able to expense $100,000.

This translated into a tax savings of approximately $27,000. In

other words, because of the increased limits, we were not penalized, but given the incentive to invest in our business.

As business people, we are risk takers. We do not take extra

money and hide it under the mattress. When given the opportunity, we will spend. When given the incentive, we will invest.

This is how you create more jobs and grow your business. In fact,

according to the U.S. Small Business Administration, small business has generated 60 to 80 percent of net new jobs annually over

the last decade.

If small business benefits, the employees benefit. The government ultimately benefits because more money is pumped into the

economy. That is what makes America a great place.

I commend the committee for holding this hearing, and I look forward to working with the Congress and the President in the future

to help make Section 179 permanent.

Thank you for the opportunity to testify on this important issue,

and I will be happy to take any questions that you may have.

Senator KYL. Thank you for that testimony, Mr. Harding.

[The prepared statement of Mr. Harding appears in the appendix.]

Senator KYL. Mr. Weinberger?

STATEMENT OF ROBERT A. WEINBERGER, VICE PRESIDENT,

GOVERNMENT RELATIONS, H&R BLOCK, WASHINGTON, DC

Mr. WEINBERGER. Mr. Chairman, members of the committee,

thank you for the invitation to appear. H&R Block serves nearly

20 million taxpayers, most at 11,000 offices spread out across

America, including 252 in Arizona, 22 offices in Vermont, 105 offices in Utah, 25 offices in Wyoming, and 137 offices in Oregon.

6

In our 50th year, we are evolving from a firm devoted to helping

families with taxes to one also advising them on financial issues,

including the need to save for retirement.

Our recent experience with the Retirement Saver’s Credit and a

new Saver’s Match study may be helpful to the committee.

Enacted in 2001, the Saver’s Credit provides a non-refundable

tax credit of up to 50 percent for contributions to 401(k)s, IRAs,

and similar retirement plans. It covers taxpayers who have incomes up to $50,000, and who have income tax liability.

Millions of eligible taxpayers were unaware of the credit when it

was first enacted. We put on a full-court press to advise our tax

clients and develop a low-cost ‘‘Express IRA’’ to help more clients

save.

As a result, we have helped 1.2 million clients a year use the

credit to save, about 25 percent of all savers credits claimed. They

saved an average of $529 yearly, and received a credit averaging

$167. This includes nearly 21,000 Arizonans, who saved $19.5 million, and 2,800 Vermonters, who saved $3 million.

While most use the credit to match contributions to an existing

401(k), IRA, or other retirement plan, nearly a quarter of a million

clients opened a new IRA through us. A majority were first-time

savers with an average income of $27,000 a year; two-thirds were

Earned Income Tax Credit recipients; and half were considered

‘‘unbanked.’’

The credit has been successful for at least five reasons. First, it

relies on personal responsibility and requires a commitment to

save. Second, it leverages tax time to promote savings, drawing on

refunds averaging $2,100, and professional advice. Third, it supports existing private retirement accounts, a system in place already. Fourth, its top credit rate is large enough to encourage existing savers and to jump-start new savers. Finally, it targets benefits to those most in need by giving a higher match to savers with

lower incomes.

To improve it, we encourage the committee to consider extending

the credit beyond 2006; simplifying it with a single 50-percent rate

or easing the steep cliffs that drop benefits as income rises; excluding retirement savings from asset tests that deny benefits like food

stamps to those who save $2,000, penalizing thrift; and expanding

it to cover more low- and middle-income taxpayers.

Making the credit refundable would enable it to reach the 40 percent of households, including families of four with incomes of up to

$41,000, who, as a result of recent tax cuts, no longer have income

tax liability.

For example, Mr. Chairman, in Arizona, about 20 percent of our

clients eligible by income for the credit used it. Of the 80 percent

who did not, over half were shut out by having no tax liability to

offset.

Mr. Chairman, to test new ways to encourage savings by lowand middle-income families, H&R Block participated in a 2005

study led by a respected group of scholars.

The study of 15,000 Block clients at 60 offices in St. Louis found

that dollar matches of up to 50 percent increased savings take-up

rates by 6-fold and increased savings amounts 4 to 8 times, as compared to a zero-match control group.

7

The study confirmed that savings incentives are most effective

when they are clear and understandable, coupled with low-cost, accessible savings vehicles, linked to tax refunds, and facilitated by

a knowledgeable tax professional.

You may want to also consider a Saver’s Match program based

on the St. Louis results. Savers could deposit $1,000 to $2,000 in

a 401(k), IRA, or similar vehicle and receive a 50-percent match

from employers or financial institutions, which would be reimbursed through a tax credit for the match and a small administrative fee.

A Saver’s Match would have several advantages. It is based on

what somewhat saves, not what he or she earns. It immediately deposits the match into the savings account rather than delivering it

later as a tax refund that can be used for other aims. It broadens

the Saver’s Credit audience, but under the same $50,000 cap to ensure focus. And it encourages employer involvement and adds to

their match of 401(k) savings.

Mr. Chairman, we know from our experience that the Saver’s

Credit works, and so does the Saver’s Match. As you discuss ways

to spur savings, we encourage you to consider these kinds of permanent and expanded financial incentives to help low- and middleincome families save for retirement. Thank you.

Senator KYL. Thank you very much. Those are exactly the kinds

of constructive suggestions we are trying to get out of this hearing.

Thank you very much.

[The prepared statement of Mr. Weinberger appears in the appendix.]

Senator KYL. Now, our next four witnesses will all be talking

about capital gains and dividends provisions, primarily, so we will

focus on those, starting with Mr. Malpass.

STATEMENT OF DAVID MALPASS, CHIEF ECONOMIST,

BEAR STEARNS, NEW YORK, NY

Mr. MALPASS. Thank you, Mr. Chairman and Senator Jeffords,

Senator Hatch, and members of the subcommittee. It is a privilege

to testify to you today.

I am the chief economist of Bear Stearns in New York. The views

I express today are my own and not necessarily those of my employer.

I stepped away moments ago to hear about the outcome of the

Federal Open Market Committee meeting. Apparently, they raised

interest rates by 25 basis points, and there were no major changes

in the statement that we could detect yet.

Turning to the tax issues, the 2003 tax cut was a critical part

of the recovery from the 2001 recession. One of the bill’s most important features was the reduction in the tax rate on dividends and

capital gains.

This reduction in the cost of capital is a key to the economy’s fast

growth since then. When you tax something less, you get more of

it, in this case, dividends, capital, capital gains, and the associated

jobs and economic growth that go with it.

The cuts in the dividend and capital gains rates are also a structural improvement in the economy. They allow an improved allocaVerDate 11-MAY-2000 15:19 Sep 08, 2006 Jkt 095484 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 29691.000 SFIN1 PsN: SFIN1
8

tion of capital, which will provide increasing growth benefits over

time.

The graph on the first page of my written testimony shows that,

when the taxes were cut, the stock market began going up immediately, and these are sizeable gains, $1 trillion in just the first 2

weeks after the tax cut materialized, and $3 trillion in the 9

months after the tax cut materialized.

If the existing rates are allowed to increase, I would expect a

large negative reaction—in other words, we will undo some of the

benefits that came out of the tax cut—in the economy and equity

market, reversing some of those gains.

Higher dividend and capital gains taxes would unwind the improvement in the capital structure. It would likely lead to less economic growth, slower job creation, and stock market losses.

In my view, this impact would not drag out over a 10-year budget horizon, but would hit the economy and markets immediately.

As Congress considers extending the existing dividend and capital gains rates, I hope it will also consider the flaws in the 2003

tax scoring process.

That process completely ignored the growth and asset price benefits of the tax cut. That left Congress to make a major tax decision

based on partial information. You had extensive cost data about

the Federal Government’s assumed revenue loss, but you did not

have any official information on the benefits to the government and

the private sector from making that tax cut.

The rest of my testimony goes through two sections, and I would

like to summarize quite briefly. In 2003, I think it was predictable

that the tax cut would have big benefits for the economy and stock

market. We wrote about those at the time, pointing out that even

in the first weeks after the tax cut there were extensive gains in

the economy.

I testified in April of 2003, showing that when you cut the capital

gains tax rate on housing, house prices went up substantially in

the aftermath. So, we have a predictable process: when you cut the

tax on assets, the assets are immediately more valuable because

people price assets on an after-tax basis.

In addition—I am on page 4, now—the faster growth in the economy was marked. In June of 2003, when you were making the tax

cut, the consensus expectation of the economy for the third quarter

was that it would grow 3.2 percent.

In reality, it grew 7.4 percent, more than double what the expectation was. In the subsequent 2 quarters, that pattern continued,

with the economy growing well above expectations. That creates a

huge stimulus for the economy and for job growth.

As we have seen, tax receipts surged after the passage of the tax

cut. Job growth surged—I am on page 5, with a graph of the gains

in jobs, the gains in dividends that are paid.

So, one of the side benefits of this tax cut, actually a principal

benefit, is when you cut the tax on dividends, companies begin disgorging dividends, so you have unlocked the locked-in capital.

For example, one major software maker was able to do a gigantic

dividend in December of last year based on the lower tax rate. That

is great for capital mobility, meaning they are dumping cash out

9

of corporations that do not need it, and it finds its way into small

businesses that do need it.

The graph on page 6 shows you the gains in income for small

businesses in America after the tax cut. When you add it up, the

2003 tax cut ended up with $3 trillion of gains in market capitalization in just the 3 quarters, and more since then. GDP was $160 billion above the consensus expectation; employment grew by 1.3 million in those first 9 months, and this compares very favorably, in my view, to the $350 billion scoring estimate for the 10-year cost to the government of the cut.

On the final 2 pages of my testimony, I described the risk: if you

do not extend the existing tax rates, you run the risk of reversing

some of these benefits.

I think it is also important to make the tax law permanent.

If you embark on this every-2-years kind of extension process, it

creates an uncertainty that drags on the economy. We will go into

that, I am quite sure, in 2006 and 2007 if you have not already extended the existing tax law.

The final point I will make is that scoring goes to the heart of

this problem. The current scoring system blocks effective tax reform because it assumes tax changes do not improve the economy

or asset prices.

You are making major tax changes, and the explicit assumption

of the scoring is that there will be no impact on the economy. Well,

then why will you do anything? Of course you are making tax

changes to improve the economy. But that, simply, is not scored.

In my view, if you were able to make an improvement in the

scoring system, you would come up with better tax law, you would

have more honest information on what the effects of the tax

changes would be. That, by itself, would be an important structural

improvement for the U.S.

We would start having better tax law, and that would be priced

in by the markets and by the economy quite quickly if you were

able to make that change.

Thank you, sir.

Senator KYL. Thank you, Mr. Malpass. I especially appreciate

the last minute or so of editorial comment about the totally artificial, negative, and I think quite unproductive, scoring that we have

to contend with here, which most of us do not believe properly evaluates the consequences of our tax decisions, but which, under current law, we are required to take into consideration. It does distort

our decision-making process considerably. And, as the facts demonstrate, the end result to the economy can be quite different.

Thank you.

[The prepared statement of Mr. Malpass appears in the appendix.]

Dr. Toder?

STATEMENT OF DR. ERIC TODER, SENIOR FELLOW,

THE URBAN INSTITUTE, WASHINGTON, DC

Dr. TODER. Thank you very much, Chairman Kyl, Ranking Member Jeffords, and members of the subcommittee. Thank you for inviting me to testify today at this hearing on extending incentives

for saving and investment.

10

I will comment on lower tax rates for capital gains and dividend

income, and my testimony also addresses, briefly, the Saver’s Credit and the deduction for qualified post-secondary education.

I, first, address lower rates on dividends and capital gains. Because corporations cannot deduct dividends to shareholders, dividends can be taxable to both corporations and individuals. Capital

gains on corporate shares also represent a second level of tax.

However, much corporate income is less than fully taxed, and a

significant portion of dividends and capital gains go untaxed at the

shareholder level as well. The current and prior administrations

have proposed double tax relief, either by itself or as part of broader tax reform.

The current partial exemption of dividends and capital gains differs from these previous proposals in two important ways. Tax relief on dividends and capital gains is provided without regard to

whether any tax was paid at the corporate level.

In contrast, prior proposals, including the current administration’s 2003 proposal, sought to provide credits or exemptions only

to offset corporate taxes actually paid.

The proposal, by itself and in conjunction with the other proposals in the bill, increases the Federal budget deficit and provides

disproportionate relief to high-income taxpayers.

In contrast, the Ford and Reagan integration proposals were included in larger tax reforms that were revenue-neutral and maintained the distribution of the tax burden, and the Treasury report

in the first Bush administration included an option that actually

raised revenue by eliminating corporate interest deductibility.

These differences are important, because, instead of moving toward a system in which all capital income is taxed once, the current provisions create new distinctions among taxation of different

forms of income. I go into that in the testimony.

Finally, I guess another point is that extending the current tax

cuts on dividends and capital gains will provide disproportionate

benefits to the highest-income taxpayers, and tables on the distributional effects are presented in my written testimony.

Seventy-two percent of the benefit goes to taxpayers with income

over $200,000, and 46 percent to taxpayers with over $1 million of

income.

Proposals to reduce or eliminate double taxation of corporate income could be part of a tax reform that reduced preferences and

set rates to maintain revenue and keep the tax system from becoming less progressive.

The President has endorsed the goal of revenue neutrality and

a progressive system in his instructions to the Tax Reform Commission. It is in this context, I believe, that double tax relief should

be considered.

I also want to comment a little bit about the growth issue. Cutting taxes on savings certainly can increase saving, but it also creates offsetting effects that may not increase saving.

The research on the relationship between saving and after-tax

returns is very divided. Certainly, if you are increasing public dissaving by increasing the deficit, the net effect is probably that national saving will decrease. A number of the economic models, both

11

private and public, that looked at the 2003 Act, indeed, found that

the Act would reduce economic growth in the long run.

I would now comment, just very briefly, on the Saver’s Credit.

The credit provides a match of up to 50 percent for contributions

to qualified retirement savings plans by taxpayers with income

below certain amounts. By providing a larger subsidy rate for lower

income taxpayers, the credit differs from other incentives that are

worth more to taxpayers in higher tax brackets.

We do not know if IRAs and 401(k)s raise private saving or

merely cause people to shift assets to tax-preferred accounts, but

research suggests that deposits to accounts by low-income individuals are more likely to represent new saving.

Bob has described the work that H&R Block has done and the

research experiment. I do believe this is a credit that potentially

could be effective in increasing saving among low-income people

who now save little, and encouraging more people to provide for

their own retirement needs. In my statement, I have a few suggestions on how it might be made more effective.

In conclusion, I appreciate the opportunity to present my views

before the committee. Thank you.

Senator KYL. Thank you very much, Dr. Toder.

[The prepared statement of Dr. Toder appears in the appendix.]

Senator KYL. Now, Mr. Entin?

STATEMENT OF STEPHEN J. ENTIN, PRESIDENT AND EXECUTIVE DIRECTOR, INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION, WASHINGTON, DC

Mr. ENTIN. Chairman Kyl, Ranking Member Jeffords, and members of the subcommittee, I thank you for the chance to testify on

the importance of extending recent tax reductions that affect capital formation, wages, and employment.

Three key provisions of the 2001–2003 tax cuts helped to end the

recession and spur the recovery by turning around a severe slump

in investment: the 15-percent top tax rate on dividends and capital

gains that will expire at the end of 2008; the marginal income tax

rate cuts enacted in 2001 and accelerated to full effect in 2003, that

will expire at the end of 2010; and the 50-percent expensing provision in the 2003 Act that was unfortunately allowed to expire at

the end of 2004.

Allowing the remaining investment incentives to expire would

jeopardize the economic recovery. Extending them now would reduce uncertainty and would boost investment spending, employment, and wages starting now, not 3 to 5 years down the road. People look ahead.

The main cause of the 2001 recession was the sharp drop in investment. If you take a look at Chart 1 of my testimony, you will

see the various twists and turns that investment spending has

made in recent years. The 2001 tax cut was passed in May of 2001,

but investment spending continued to slip. The bill did little in the

short run for investment. The marginal rate cuts were largely deferred; only half a percentage point was effective in 2001.

The 2002 tax cut had a special 30 percent ‘‘bonus’’ expensing provision for investment in equipment and software, but not for structures. The second half-point step in the income tax rate cuts was

12

effective that year. Investment in equipment and software, but not

structures, began to recover modestly over the next 4 quarters, as

the graph indicates.

Look at the effect of the 2003 Act. It upped special expensing to

50 percent for equipment and software. It brought forward the remaining 2- to 3.6-percentage point cuts in marginal income tax

rates. Most importantly, it cut tax rates on dividends and on capital gains through 2008.

Investment in equipment and software shot up almost at once.

Investment in non-residential structures abruptly stopped falling,

and rose by a slight amount. Investment and growth remained

strong throughout 2004. Employment and wage growth began to

advance, and we ended the notion of a jobless recovery.

The 50-percent expensing provision expired at the end of 2004.

Investment growth seems to have slowed since then, knocking off

about half of its rate of improvement since last year.

Let me explain that the tax cuts worked mainly by lowering the

service price of capital. Failure to extend them would raise the

service price and reduce GDP. The size of the capital stock and the

level of investment depend on what we call the service price of capital, which is the cost of capital that David referred to, plus a return for the replacement of the investment as it wears out.

The service price is the rate of return that an investment must

earn to pay the taxes owed, cover its cost and its depreciation, and

yield a normal after-tax rate of return to the owner.

A tax increase on capital income raises the service price and

blocks investment projects that cannot meet the higher service

price; a tax reduction does the opposite.

Chart 2 and Table 1 show the service prices of various types of

capital in the corporate and non-corporate sectors under 2004 law,

with all these investment incentives in place, and what would happen to service prices if you allowed them to expire. They cover the

private business sector, which is about 80 percent of GDP.

The tax changes of 2003 lowered the service price of private sector capital in 2004 by about 2.5 percentage points. This may seem

like a small number, but it is not. You have a roughly corresponding impact on GDP over time.

The biggest reductions were due to the 15-percent rate cap on

dividends and capital gains, which reduced the double taxation of

corporate income. This was followed in size by the marginal rate

tax reductions on the shareholders, and then the expensing provision.

Allowing the expensing provision to expire eliminated about 8

percent of the added incentive to invest in 2004; allowing the 15-

percent rate cap on dividends and capital gains to lapse would

eliminate about 56 percent of the cut in the service price of capital;

and allowing the marginal rate reductions to expire would eliminate the rest.

Each percentage point reduction in the service price of capital increases the capital stock over time by about 1.5 percent and private

GDP rises by about the same percent, or about $140 to $150 billion. Ninety-five to $100 billion of that goes to labor.

That is far greater than the tax reductions in the burden tables

that appear to go to the upper income. Labor benefits the most

13

from reductions in taxes on capital, because such capital taxes are

generally shifted to labor.

The shifting occurs because the capital stock is highly sensitive

to taxation and will shrink if taxed more heavily. That reduces the

productivity and wages of labor. The effect on labor is greater than

on capital returns.

I would suggest, as a procedural step, that you get the Joint Tax

Committee to give you, with each revenue estimate, an estimate of

the effect of your bills on the service prices of capital.

They will not go on to tell you how much that is going to affect

the economy because they are still studying that, but at least they

will give you the initial impetus, and you can decide how much of

an effect it will have on GDP. I think it will have a fairly large one,

if you look at the historical record.

The burden tables only show you the initial incidences of tax.

They are really incidence tables, not burden tables. To get the burden on the economy, you have to judge what happens to people’s

after-tax incomes after everything adapts, including the demand

for labor and wages.

The revenue estimates have been covered by David. I will not go

into them very much, except to say that when the Joint Tax Committee considers tax relief for dividends, capital gains, and even

marginal tax rates for individuals, they try to take certain behavior

changes into account, but not others.

On the dividends side, they will try to guess how many more

dividends might be paid as a result of the rate cut, but they will

not tell you how much the relief on dividends will boost capital formation, wages, and employment, so you will not get that revenue

feedback into the revenue estimate.

With capital gains, they will try to tell you how many more gains

people will take because the rate has gone down. That is the realizations effect. They tend to underestimate that, but they try. They

will not, however, calculate the reduction in the service price of

capital and the gains for GDP and employment, and the added

taxes that you get from wages from the payroll tax and the income

tax.

However, if they will at least tell you what you have done to the

service prices, and possibly the marginal tax rates on labor, you

will have an idea what direction your bill is moving. If it moves adversely in these areas, you are going to be throwing people out of

work.

Thank you.

Senator KYL. Very interesting, Mr. Entin. Thank you very much.

[The prepared statement of Mr. Entin appears in the appendix.]

Senator KYL. Finally, Mr. Graff. Thank you.

STATEMENT OF BRIAN GRAFF, EXECUTIVE DIRECTOR AND

CEO, AMERICAN SOCIETY OF PENSION PROFESSIONALS AND

ACTUARIES, ARLINGTON, VA

Mr. GRAFF. Thank you, Mr. Chairman, Senator Jeffords, and

other members of the subcommittee, for allowing me to speak on

this important subject affecting the retirement security of American workers.

14

My organization, ASPPA, is a national organization of over 5,500

retirement-plan professionals who help small businesses offer retirement plans covering millions of American workers.

I am also, today, speaking on behalf of the Small Business Council of America. The SBCA is a national organization representing

the Federal income tax, estate tax, pension, and other benefit interests of privately held and family-owned businesses.

Not all savings is alike. For many years, Congress has been clear

that encouraging long-term retirement savings comes first. This

message has been consistently sent by providing the best tax treatment to workplace retirement plans.

However, in the last few years, Congress has focused more on incentives for saving outside of traditional retirement plans. These

incentives include reduced tax rates for capital gains and dividends, a primary focus of this hearing.

We also have good reason to expect proposals soon to eliminate

taxes on capital gains and dividends as part of the upcoming tax

reform debate.

Today I will focus on the impact these proposals would have on

long-term retirement savings and how further capital gains and

dividend tax cuts could upset the critical balance required to sustain our longstanding and successful workplace retirement plan

system.

Our policy to promote long-term retirement savings has encouraged a significant number of Americans of modest means to save

for retirement. Almost 70 percent of American households own

their mutual funds through a retirement plan. Retirement plans

have made American workers part of the ‘‘ownership society’’ to

which the President often refers.

Simply put, retirement plans are the only effective means to get

low- to moderate-income workers to save. According to the Employee Benefits Research Institute, workers who are earning between $30,000 and $50,000 are 20 times more likely to save when

covered by a workplace retirement plan—yes, 20 times.

Small business owners incur a substantial cost when offering a

retirement plan. This cost is due to mandatory contributions for

employees which are required in order for the owner to save.

For a small business with less than 25 employees, the costs of

these mandatory contributions can typically be at least 30 cents for

every dollar that the owner wants to save. Effectively, these costs

are like a tax that must be paid in order for the owner to participate in the plan.

As discussed in more detail in my written testimony, assume a

small business owner, instead, chooses to invest his or her savings,

plus the cost of these mandatory contributions for employees, outside of a plan on an after-tax basis.

Assuming a 7-percent rate of return, the 15-percent capital gains

rate will produce 30 percent more in accumulated after-tax savings

after 15 years; at a zero-percent capital gains rate, this differential

grows to over 40 percent.

ASPPA members have currently been able to rebut this math to

small business owners by arguing that the 15-percent rate is temporary, whereas the tax incentives for qualified plans have been

around for decades.

15

The permanent extension of the 15-percent rate will make that

rebuttal more difficult. A further reduction in the tax rate of capital gains to zero will make it virtually impossible to convince a

small business owner to adopt a retirement plan.

I am not trying to say that all small business owners are greedy;

however, the reality is that most small businesses have been operating quite successfully without a retirement plan.

The decision to adopt the retirement plan will only be made if

it makes financial sense for the small business owner to do so. Reduced tax rates for capital gains and dividends will make that no

longer the case, consequently, the future retirement security of millions of small business employees will be at risk.

For these reasons, ASPPA believes that long-term retirement

savings must come first over all other forms of savings. Therefore,

we urge you to adopt three principles as part of our Nation’s savings policy.

First, increasing savings by moderate- and low-income workers

must be a priority. These are the Americans who save the least

and whose future financial security is most at risk. I note that,

based on IRS data, less than 5 percent of American households

benefit from the reduced tax rates on capital gains and dividends.

Second, long-term retirement savings must be favored over all

others. If not favored, workers will instead save on a short-term

basis, if at all, where there is ready access to the money, making

it less likely it will be there for retirement.

Third, workplace retirement plans play a critical role in achieving the first two principles. They are by far the most effective way

to get these workers to save, and expanding retirement plan coverage must be emphasized.

We urge you to carefully consider proposals to reduce tax rates

on capital gains and dividends, since their impact over time could

be to drive small business owners away from workplace plans.

With no plans, the evidence strongly suggests small business

workers will not save on their own. With retirees living longer and

the strain on Social Security evident, we must take steps to promote small business retirement plans, not push them out of existence. ASPPA remains committed to helping you make sure workers

can secure a comfortable retirement.

Thank you.

Senator KYL. Thank you very much, Mr. Graff.

[The prepared statement of Mr. Graff appears in the appendix.]

Senator KYL. Now, Senator Hatch has asked that he be permitted to ask a couple of questions out of order here. Senator

Wyden, you are the only one I have not checked with who would

agree to this. Do you object to Senator Hatch?

Senator WYDEN. Absolutely.

Senator KYL. All right. Fine.

Senator Hatch?

Senator HATCH. Well, thank you, Mr. Chairman.

Let me just go to you, Mr. Weinberger. H&R Block’s experience

with the Saver’s Credit is very interesting. It seems obvious that

strong incentives do have a powerful effect on encouraging even

lower-income individuals to save.

16

Now, as you probably know, there is quite a debate going on in

Congress right now over personal accounts to enhance Social Security, whether they be carve-out accounts or add-on accounts.

I am working on a proposal that would create a new add-on account that would offer a Federal match of up to 100 percent of the

first $1,000 saved by workers each year, for those making $20,000

or less.

The match would gradually go down, up to those earning $80,000

a year, and then it would be phased out for those earning over

$80,000, but they would still have the tax-free ability to save.

Now, in your experience, how compelling would a 100-percent

match be for lower-income workers if there were no income tax limitations, and how might the take-up rate for such a program compare with the results of your St. Louis study?

Mr. WEINBERGER. Well, I would have to defer to the scholars on

how it would compare fully with the St. Louis study, but the proposal you described sounds attractive. It has one very positive feature, that as income goes down, the savings incentive goes up.

I think our experience is that the lowest-income individuals have

the greatest difficulty saving, so that would be appropriate. The

match also sounds attractive, as you describe it, as a compelling incentive to encourage people to save.

One of the important aspects of the current saving structure that

is an impediment to saving is its non-refundability.

For example, under the Saver’s Credit, about 59 million Americans are eligible to save based on income. But because the credit

is not refundable, only one-seventh are eligible to save at the maximum rate, and then only 43,000 people, or less than one-tenth of

1 percent, are able to get it at the full rate.

If your proposal expands eligibility to get to this 40 percent of

Americans who, as a result of tax cuts today, do not have income

tax liability, I think it would be all the more attractive.

Senator HATCH. Well, that is interesting. I wish I could ask you

some more questions. In fact, I wish I could ask all of you some

questions.

But let me just ask you, Mr. Entin. It is good to see you back

up here. We appreciated you when you were here. I notice you have

not changed much in your economic outlook, and that is great.

Recent data from the Treasury Department showed that lower

rates on dividends and long-term capital gains saved 24 million

taxpayers an average of $950 on their 2004 taxes, including 7 million seniors, whose average tax savings exceeded $1,200.

Now, given the importance of dividend income to retirees, could

the failure to extend these rates not be considered a ‘‘senior’s tax’’?

Mr. ENTIN. They certainly do receive a disproportionate share of

the dividends. If they get used to them or they plan their retirement on what they are currently able to take from them, then removing it would be an extraordinary inconvenience, I think that

would be fair to say.

I must, by the way, mention that I have been talking with you

about these issues since 1977. It was a pleasure to work with you

then, and it is a pleasure to work with you again.

17

Senator HATCH. Well, we are pleased to have you before the committee. I want to compliment the Chairman and the Ranking Member.

Could I ask just one more question?

Senator KYL. Yes.

Senator HATCH. Just one more of you, Mr. Entin. I wish I could

ask of all of you, because you have all been very excellent. But

stock ownership is rising most quickly among low-income households, as I view it.

According to Federal Reserve data analyzed by the American

Shareholders Association, there was a 91-percent increase between

1995 and 2001 in the number of households in the bottom quintile

owning stock.

Now, those in the second quintile saw ownership rates increase

by 35 percent during that time. Now, how important do you think

the zero-percent rate that starts in 2008 will be to encourage continued increases in savings and investing among low- and middleincome families?

Mr. ENTIN. It increases the reward to the saving and investment,

which makes it more attractive relative to consumption. I think it

would have to have an impact. We believe that all income levels

respond to incentives, and this is a powerful one.

Let me also note, the Treasury figures look even stronger if you

look over time. People may take capital gains only occasionally. In

any one year, a small group may appear to be taking the gain and

getting the immediate benefit, but over several years, many more

people are taking gains and getting the benefits. The Treasury

panel studies would make the argument that you are making here

today even more powerful, I believe, if you would take a look at

those.

Senator HATCH. Well, thank you.

Thank you, Mr. Chairman. I appreciate you letting me go because of my schedule.

Senator KYL. You are welcome, Senator Hatch.

Let me turn, now, to Senator Jeffords.

Senator JEFFORDS. Dr. Toder, you argue that lowering the rate

on capital gains and dividends, without offsets in spending or

taxes, will likely reduce national savings and economic growth.

Would you explain that?

Dr. TODER. Sure. Basically, when you are lowering the tax rate

on dividend income, you are having two effects on people. One, you

are raising their rate of return they get from an additional dollar

of saving, and that does make consumption in the future, saving

for that, more attractive than consuming today, and tends to cause

saving to increase.

You have a second effect: you are making them wealthier. Then

for any target of wealth they want to have, they do not have to

save as much, they can consume more. So, those are offsetting effects.

Empirically, a number of people have studied the return to saving. Some studies have shown a positive effect of after-tax returns,

some have shown zero effect. So, there is a very mixed result from

studies on that.

18

What we do know for sure is that, if you are increasing the Federal deficit, that is directly a reduction in national saving. So I believe that any reasonable estimate of how much private saving

would be increased would be swamped by the reduction in public

saving, and there would be less national saving, higher interest

rates, more borrowing from overseas, and so forth, and, by the way,

an increase in the cost of capital as a result of that.

Senator JEFFORDS. Thank you very much.

Senator KYL. Thank you, Senator Jeffords.

Just to follow up on that, let me ask what some of the rest of

you think about the last observation of Dr. Toder.

Mr. Malpass, in your testimony, it appears to me that you pretty

much directly contradict that point of view, and I wondered if you

would like to speak to the issue.

Mr. MALPASS. I would, Senator, in one way. It seems to me that

it follows from Dr. Toder’s argument that any type of gains that

are made in the economy will end up reducing the savings rate.

Senator Jeffords was talking about the savings rate being close

to zero. One powerful part of that is because, in calculating the

savings rate, they do not include the gains going on in the economy.

Capital gains, for example, or pension payments, are not counted

in income. So the better the economy is doing, the more it pushes

down that recorded savings rate. One of the things that I would

wonder about with Eric’s work, he is saying the national savings

rate goes down, but what I would be looking at is the accumulated

savings of the economy. I think it would be going up rapidly.

If the economy grows, the amount of total savings in the economy

will go up, and that is a very powerful positive effect from these

lower tax rates. But the recorded savings rate is going to go down

because the government does not count gains in calculating the

savings rate.

Senator KYL. Could I ask Mr. Entin something about your testimony that labor, as opposed to capital, benefits the most from the

reduction in the cost of capital. Would you explain what you mean

by that, how that works, why that is true, and why the dividends

and capital gains reductions would therefore impact that observation?

Mr. ENTIN. Charts 3, 4 and 5 are the ones that apply to that argument in the testimony. A reduction in the service price of capital

will cause people to want to add more capital to the economy.

You are going to get more plant, equipment, buildings, residential and non-residential, and so forth. The higher capital stock

makes labor more productive. Wages are tied to productivity. More

people will be hired and the wage will be higher with a higher capital-to-labor ratio.

One of the main reasons that living standards have risen over

the centuries is that we have had more capital to work with and

it has let us accomplish more, and wages go up to match. Those

gains in wages are a part of the effect in the change of the tax, and

the burden of a tax is the change in people’s incomes.

Let me give you an example of a small trucking company. Suppose you have a company with five trucks. The fifth truck is only

being run part-time. It is barely earning its keep. It is wearing out.

19

You take a change in the tax law. Instead of writing the truck

off over 3 years, you are now going to make the owner write the

truck off over 5 years. You have changed the depreciation rules.

The truck which was marginally profitable before is now marginally unprofitable. The owner decides not to replace it. He is barely

inconvenienced; he was not getting much of a revenue stream from

the truck anyway. But let me ask you, what happens to the wages

of the fifth truck driver? That is how the taxes on capital are shifted to labor.

When GDP goes up by a dollar because of some increase in investment, of that increase in the dollar of GDP, pre-tax, about twothirds goes to labor and about one-third goes to capital.

But after taxes, here is the split: a little bit more than half goes

to labor after tax; State, local, and Federal Government taxes take

in a little over 30 percent. You have about 15 percent left. About

10 percent is depreciation on the new capital that has to be set

aside to replace it. About a nickel goes, net, to the owners of capital. The government gets 6 times as much, and the workforce gets

10 times as much, after tax.

That is how taxes on capital are shifted to labor. That is why

fundamental tax reform generally consists of lowering the excess

layers of tax we currently place on capital and treating capital

more neutrally relative to consumption.

To tax capital that is more sensitive to taxation higher than anything else, more heavily than anything else, is utterly absurd, and

it hurts all the other factors of production.

Senator KYL. Just in the half a minute I have left, let me ask

you, Mr. Harding, what is the effect of uncertainty with respect to

somebody that has to deal with investment decisions and worry

about the bottom line from day to day? Uncertainty of the tax code.

Mr. HARDING. Well, in the construction business, sometimes I

say, Mr. Chairman, it is an adventure every day. We have a lot of

problems that we run into. So any time that we can bring certainty

to anything, it is extremely important to us.

That is what I pointed out in my testimony: we can index for inflation and make it permanent. Taxes are a huge cost of doing business. Sometimes people do not realize that, but it is a huge cost

of business.

So, if we can get our arms around what it is going to be and still

benefit when given the incentives, that makes it much easier for

us to plan. I thought the gentleman’s example of the truck was a

beautiful example of how business looks at things. We are going to

make an investment here, and taxes are a big cost of the investment. If taxes are lower, we are going to want to invest more.

Senator KYL. Have you ever faced a decision like that in your

business?

Mr. HARDING. Oh, absolutely. We have tools, computers, trucks.

We have looked at everything like that, and we always do.

Senator KYL. All right. Thank you. I am over my time.

Senator Thomas is next.

Senator THOMAS. I will pass at this time.

Senator KYL. All right.

Let me ask Senator Wyden, then. You can be reloading while he

is shooting. How is that?

20

Senator WYDEN. Thank you, Mr. Chairman. I commend you for

an excellent hearing.

What seems to me, though, has been missing, is a discussion now

of choices. Because what we have entered into is a world where you

cannot have it all. I have always said that the most important

choices are areas that promote saving and investment, ones devoted to cut capital gains, devoted to cut the estate tax, because I

want to be a Democrat who supports growth. If we have growth,

that generates revenue for some of the social needs that I care

about: kids, seniors, schools, and the like.

So I want to ask you all about what I think is the overriding

choice as it relates to saving and investment. That is, that if the

Congress now passes on renewing the President’s proposal to extend the personal tax cut, it seems to me you free up vast sums

for the kind of saving and investment that is being talked about,

and even have some left over for deficit reduction and other kinds

of areas.

Our calculation is that, if you look at the President’s two tax cuts

to date, upwards of $1 trillion has been used for the personal tax

cut. That is where the big chunk of money went.

I find very few of my wealthy constituents say, gee, Ron, I want

to have the personal tax cut again. What they talk about is what

you all are talking about, which is more saving and investment.

So I think what I would like to do is ask the four of you who

have been talking about capital gains and savings and investment—and I would welcome the other two as well to chime in if

they want—what do you think of the idea of the beneficial ramifications of Congress passing on renewing the personal tax cut and

using some of those dollars to work in a bipartisan way for some

of the saving and investment incentives that are being discussed

here, and even have some left over for deficit reduction?

Why do we not start with you, Mr. Malpass, and go down the

row? The other two are certainly welcome to chime in. I do not

want to discriminate against you, either.

Mr. Malpass?

Mr. MALPASS. Thank you, Senator Wyden. I commend you for the

idea of promoting savings and investment, and growth. I think that

is a very good starting point for dialogue and discussion.

On the specific issue, though, I think the top marginal rate is

simply very important to the growth in the economy. It may be

that some of the recorded benefits, the direct benefits, can end up

going to the wealthy or to people with higher incomes, but the top

marginal rate is also paid by many sole proprietors, small businesses, and by both big and small corporations that create jobs

within the economy.

If you are planning to take a big chunk of what someone earns,

they are not going to work in the same way, they are not going to

create jobs in the same way.

In my view, one of the very effective uses of limited resources is

to hold down the top marginal rate because it is not really the loss

that you think. You are looking at a $1 trillion loss to the government, but the reality is, there is a huge growth benefit associated

with that.

21

I would note that I have heard talk of people proposing what is

called a HOT tax, which is a Higher Optional Tax rate. In other

words, on the 1040 Form, you could put a box for those that would

like to pay a higher rate, and they would have the certainty that

that money would go to the government so they could fill in a higher rate. I do not think very many would take advantage of that

kind of opportunity.

I really want to emphasize that we are talking about your assumption of $1 trillion.

Senator WYDEN. That is the CRS’s figure.

Mr. MALPASS. Yes. I think you have to ask, what would happen

to the growth rate of the economy and to the job creation of the

economy if you raised taxes that much.

Senator WYDEN. Nobody is talking about raising taxes that

much, sir. What I am talking about, is whether or not you take

some of that money that affluent people tell me is not much of a

factor in their saving and investing and put it into areas that I

know produce economic growth, such as the capital gains reductions and investment incentives. That is what we are talking

about.

Let us go to Dr. Toder.

Dr. TODER. Well, thank you. That is a very thoughtful question,

and it illustrates that we certainly do have trade-offs in tax policy.

I think we ought to be thinking about this realistically in the context of the structure of the tax system, how we want to raise revenues, as opposed to thinking that something is a free lunch. So, I

am glad you raised the question in that form.

I do agree with David that marginal tax rates do have adverse

effects on the economy and adverse effects on efficiency, so I would

not take the position that we should unrestrictedly raise tax rates

on labor income or on income generally and use that for targeted

incentives. I think you have to be very careful about what the

structure of the incentives are and whether they really work.

Senator WYDEN. Again, what I want to make clear is, I think the

debate is about growth and how we are going to best bring it about.

What I am interested in doing is getting on the record what you

all think about the choice of a direct kind of incentive, which I

think is the capital gains break, dividends, and some of the areas

that I have been voting for as opposed to what my most affluent

constituents tell me is not a factor in their investment decisions.

Mr. Chairman? I guess we have got lots of chairmen up there.

We have got Chairman Jeffords. We lost Chairman Kyl. Maybe I

will just, if it is all right with my colleagues, will let these two finish up. Then I know colleagues want to ask questions.

Let us go to our next witness.

Mr. ENTIN. Senator, in theory, you can switch from an income

tax, which has several layers of tax on capital, to a consumed income tax, or consumption-based tax, which is more even-handed,

and do less damage to the economy for the same revenue.

So you could, in a sense, stand a slightly higher rate structure

on the remaining tax base and still come up with the same GDP,

which is another way of saying you can, indeed, make efficiency

gains within the tax system.

22

The very top rates on labor do have a powerful influence on the

length of time worked and the number of small businesses, and so

forth, as David has mentioned. I would be careful about raising tax

rates at the top much past the mid-30s. You begin to see reactions

at that point.

The bottom tax rates are the ones you can play with with the

least effect, but we have an equity problem with that. But, nonetheless, if you do rearrange the tax system in certain ways, you

can, indeed, get efficiency gains.

I think that is why, when the Europeans decide to carry their tax

system from 30-some percent of GDP up to 45, they would use the

value-added tax, which is a consumption tax, rather than tinker

with income taxes that discourage saving and investment excessively.

I would be careful doing it. As you do it, please look at the aftertax returns to the various labor groups and the savers, because if

you do not lower those tax rates and raise the after-tax returns,

you will not get the good benefits.

Senator WYDEN. I will tell you again, I did not ask the question

about a value-added tax. I asked the question with respect to

where that personal income tax reduction money was going. So, I

hope that we can continue to work with you on that proposition

and not these various other things about value-added taxes.

One last witness.

Mr. GRAFF. Let me give it a shot. I do agree with you, that it

is a question of priority. I think, as I said earlier, from my standpoint the priority has to be increasing savings rates by low- and

moderate-income working Americans.

We have seen some great history and statistics that Mr. Weinberger talked about in terms of the impact of the Saver’s Credit.

I think that should be greatly expanded to cover more middle-income Americans.

Right now, for families making $32,501, the credit drops down to

10 percent, like a cliff. It also does not cover a lot of working families, as Mr. Weinberger said, because it is not refundable.

We think that the Saver’s Credit really works. If we can expand

it even more, we could have a real effective government matching

program that would seriously increase savings rates among a very

large number of working Americans, possibly covering 70 million

American households.

That is quite a contrast to what the impact of the reduced capital

gains and dividends tax rates is, which basically benefit less than

10 percent of American households. So I do agree with you, it is

a question of priorities. Increasing saving should be a priority, and

we think the Saver’s Credit is a great way to do that.

Senator WYDEN. My time is up. I knew if I asked the question

of enough people, somebody would pick up on essentially what my

theme has been. I think the first three thought that I was interested in pitting wealthy people against people in more modest income.

I am not interested in that at all. I am interested in saying,

there is a fixed number of dollars, and it seems to me that there

are some sure-fire investment winners.

23

Capital gains incentives, which I have been voting to reduce consistently, strike me as a very good example of that. I am more interested in seeing if we can target there rather than to just kind

of go in on automatic pilot and keep going forward with the personal tax cut, which my most affluent constituents tell me they do

not really see as a particularly important investment tool.

They all say, just like you said, they would love to have it. Nobody is going to volunteer not to have it. But if we are going to

have a debate about investment, it has to be a debate about

choices. That is why I asked the question, and I thank my colleagues.

I know Senator Crapo has been waiting, and I have imposed on

his time, and I thank him for it.

Senator CRAPO. Thank you.

Chairman Kyl indicated that he had to step out for a moment to

go to another hearing. He wants to come back and ask some more

questions as well.

But let me ask my questions while we are waiting for him to return. I know we need to go back to Senator Jeffords as well.

I am going to focus in a different way. Mr. Malpass, I noted with

great interest that a part of your testimony which you presented

here in your written testimony related to the scoring system that

Congress uses for evaluating tax cuts.

When you included that in your testimony, you hit a very favorite topic of mine, so I want to go through that with you a little bit,

because I have had a tremendous frustration with the way we score

and analyze tax cuts as we debate them here in Congress.

Frankly, I believe that we create a false impression to the American public about what the impact of what we are doing really is,

and we create hurdles for the development of proper tax policy by

essentially creating numbers about what the impact of the tax cuts

will be that we know are inaccurate. It seems to me that that is

what your opinion is as well, from what I can tell from your written testimony.

Mr. MALPASS. Yes, sir.

Senator CRAPO. I was interested that you said that, by itself, a

better scoring system in Congress would actually constitute a very

helpful, pro-growth structural reform. Would you elaborate on that

a little bit?

Mr. MALPASS. Yes, Senator. Thank you for the question and the

opportunity. As the economy thinks about how much it is going to

grow, it is making a constant evaluation of what the future tax climate is going to be.

Right now, the way taxes are written, Congress has explicitly ignored whether a tax change is going to affect the growth of the

economy. That makes it very hard for you to pass, for example, a

tax simplification.

Let us say there was a major tax simplification which everyone

agreed was good for the economy. Let us say there was bipartisan

support, but it would not score very well because, the way that tax

changes are scored now, they would concentrate on the loss of immediate revenues to the government rather than the gains to the

economy and the faster growth that would come out of the simplification.

24

We are in a system where it is unlikely that we can actually improve this tax code that we all labor under. It is an abomination,

as people have called it. Yet, there is no way out, because you do

not get to score the benefits of what you are proposing.

Senator CRAPO. One thought that I have had is, if we move to

a more dynamic system, we ought to be evaluating at least two factors.

One, the net cost of the tax cut to the Federal budget. In other

words, there are going to be losses of revenue from the loss of tax

revenue through a tax cut, and then that is going to have some

kind of an impact on the economy, and theoretically that will generate some more tax revenue coming in. The net figure would be

the true cost to the Federal Treasury. It seems to me that that is

the one obvious change that we should seek in developing a dynamic scoring system.

But it also seems to me that we should try to put some kind of

figure or some kind of analysis into the impact on growth in the

economy that will occur as opposed to simply the impact in the

budget numbers that we deal with here in the Federal Government.

Is that doable? In other words, do we have the ability to evaluate

in the way that we are discussing here?

Mr. MALPASS. I think it can be a goal. I think the problem with

economics is, even though it is portrayed often as a science, it is

a very abstract and a very soft science. So if you get a group of

economists in a room and say, what will happen to the economy if

we have tax simplification, you are not going to find agreement on

the amounts. There have been efforts over the years to begin to

bring economic growth into the equation.

Also, asset prices should be considered. In 2003, when you cut

the tax on capital gains and on dividends, the value of stocks in

the Nation went up by $3 trillion in just 9 months, and it has gone

up from there. A chunk of that is directly attributable to the tax

change, and yet not in any way comprehended within the scoring

process.

I think perhaps you could phrase it—well, Senator Wyden is

gone. He had said he was in favor of the capital gains tax cuts.

That can help then allow tax cuts in other areas because of the

benefits from these higher asset prices.

I think what you could consider doing would be challenging the

CBO and Joint Tax Committee to present systems that could take

economic changes into account and then have some kind of an open

process to say, how much is tax simplification actually worth to the

economy?

I think we have to go from a starting point that, if you had a

major tax reform that simplified the U.S. code, you would be adding a quarter of a percent, half a percent, or three-quarters of a

percent to the expected growth rate.

My point here is, that would be immediately picked up in the

stock market, in people’s investment decisions, and you would start

getting a positive impact just from embarking on this structural

change.

Senator CRAPO. Thank you very much.

25

Senator JEFFORDS. I would ask to place members’ opening statements in the record.

Senator KYL. Absolutely. Senator Jeffords, if you would like to

resume questioning now, please go ahead.

Senator JEFFORDS. Yes, please. Thank you.

Dr. Toder, I was interested to read your findings about the mixed

results of the rate resulting from cuts in the capital income.

Have you seen any evidence that the lower tax rates have led to

an increase in these investments by ordinary taxpayers or even an

increase in an overall national savings rate? If we continue to cut

taxes on capital income, what do you think this means for taxpayers who rely exclusively on wage income?

Dr. TODER. All right. There are two parts to your question.

Senator JEFFORDS. Yes.

Dr. TODER. One, I would have to say, I am always cautious about

trying to make an interpretation from one event causing an event

at the same time. You have cut the taxes on interest and dividends.

There are lots of factors that are driving the savings rate one way

or another.

It is true that, since those cuts, the personal saving rate has actually continued to drop, so there is no evidence that it has moved

up. But again, there could be other factors going in either direction

that are resulting in that.

I would not expect, for the reasons I stated before and also because low- and middle-income people get a very small proportion of

the dividends and capital gains, that that would really have too

much effect on their behavior.

People do own a lot of stocks in the middle class, but a good deal

of that is owned through IRAs and 401(k) plans and other tax-exempt retirement savings vehicles, so the cut in the capital gains

and dividends does not really have much influence on them.

What was your second question?

Senator JEFFORDS. Wage income.

Dr. TODER. Yes. Would it benefit wage earners, these cuts.

Senator JEFFORDS. Yes. Right.

Dr. TODER. Thank you for asking that, because I do want to respond to some things that Steve has said. I really do not know of

anybody who thinks that a cut on capital income at the individual

level—the story is a little different for corporate tax cuts—is going

to have an effect, a significant beneficial effect, on labor income, or

will have a significant amount of shifting.

The reason is simple. We live in an international economy and

capital income taxes are not all of one type. Capital income taxes

are either taxing residents on their income from worldwide sources

or they are taxing investment that is located in the United States

and not located in other places.

When you are taxing residents on their worldwide income, even

if they did not save more, it is not clear at the margin how much

of that saving would flow, in an open economy, into increased capital in the United States.

When you change the rates on capital that is sourced in the

United States, and the corporate tax largely does that, you could

arguably have an effect, if corporate income and investment goes

overseas because of higher rates in the U.S. or lower rates in the

26

U.S. that attracts capital from overseas, we could have a larger

capital stock, and that benefit would in turn be shifted to labor. So,

it really depends on the kind of tax.

But as for the particular provisions, I see very little shifting of

those provisions to labor income. I think most economists would

support my point of view. Maybe not the people in this room, but

outside.

Senator JEFFORDS. I have one for Mr. Graff.

Senator KYL. Go ahead.

Senator JEFFORDS. Mr. Graff, when it comes down to retirement

savings, I think we do need to change direction, not by working

against the employer-based system, but by maybe strengthening it.

My hunch is that the small business owners are not indifferent,

but their employees probably rank a retirement plan behind wages

and health insurance, and other benefits. Is that your experience?

If so, how do we turn it around?

Mr. GRAFF. It is. I mean, unfortunately the retirement plan is

the last thing that the employer or the employees think about before they adopt a plan. They are worried about their health care.

They are worried about their wages. So, they need some motivation.

Frankly, from a cost perspective, it is a lot more costly for a

small business to pay for a plan than it is for a larger firm, because

they cannot spread the costs over a larger number of workers. The

smaller number of workers you have, the more cost per employee

goes up.

So one idea that was worked on by this committee, actually

passed this committee, passed the Senate in 2001 as part of the

2001 tax bill, was a tax credit for new small business retirement

plans.

It provided a 50-percent tax credit for qualified retirement plan

contributions on behalf of lower-paid workers by new small business retirement plans for the first 3 years of the plan. It was well

supported by this committee.

It was dropped in conference for revenue reasons having to do

with other costs associated with the 2001 bill. We think that proposal would do a great deal in terms of increasing small business

retirement plan coverage, which would allow a lot more small business workers to have a meaningful opportunity to save.

Senator JEFFORDS. Well, thank you. That is very helpful.

Senator KYL. First of all, I think we have three pure economists

here. I guess we are all economists of a sort, but three, at least,

with credentials. Now, we have had an assertion by Dr. Toder

about, most people would agree with him and disagree with Mr.

Entin.

Mr. Malpass, you are the decider here. Does a reduction in capital gains and dividends help labor at least as much, if not more,

than capital?

Mr. MALPASS. I think it does. Clearly, we have to somehow bring

into the debate and the discussion the lower cost of capital. If I reduce the cost of capital, I am going to get more of it. Somehow, I

think that is missing in the discussion. The lower cost of capital

elicits more capital, and that is vital in creating higher labor income.

27

If your worker is able to use a machine, you are going to pay that

worker more than if they are not able to use a machine. So, if you

lower the cost of capital and you get more machines, you are going

to have higher-paid workers.

I think that is clear in American history. As we applied more

capital, the living standards have gone up. You can think of it as

a cause-and-effect kind of a step. If we look outside the U.S., countries that do not have capital, do not have a friendly climate for

capital, maybe they tax capital more heavily, their workers are

simply paid less.

Senator KYL. Dr. Toder, since I have picked on you here, let me

give you a chance to respond. But is that last comment not absolutely true? If you look at the societies in which people are laboring

with their hands and without the aid of a lot of capital versus societies like ours in which capital has enabled us all to become more

productive, has it not benefitted everyone, including those in labor,

to have the lower tax rates that provide the capital liquidity that

permits that to occur?

Dr. TODER. Well, there is a long chain of reasoning there, and I

certainly do not disagree that capital is very valuable to the productivity of the economy. I also do not disagree that policies that

lower the cost of capital would help labor.

What I am asserting is, these particular policies will not significantly lower the cost of capital. The reason is 2-fold. The people

who are getting the tax cuts are not likely to be saving much more

on that, and also those tax cuts are not going based on capital supplied in the United States, they are based on capital that is being

supplied in a worldwide economy.

So, it is not likely to cause much more investment in the U.S.

and much of a reduction in U.S. capital costs. That is the basis of

my argument. In fact, I believe capital is a very important ingredient in economic growth. I think everyone in my profession would

say so.

Senator KYL. All of the economists would agree with that.

Mr. Entin?

Mr. ENTIN. Eric has made a good point. You have to take the

international sector into account. In other writing, I have mentioned how that interacts with these contentions.

The small business, or non-corporate sector, which is less likely

to be involved in cross-border transactions, is about 26 percent of

GDP, and the corporate sector is about 56, I think I said.

The corporate sector, some of which is very much engaged with

the world, could put a plant anywhere. If I save more, General Motors might borrow it and put the plant in Turkey instead of in Kentucky. Well, that can happen.

But many corporations are more domestically oriented. There is

a tendency of shareholders to buy stock in the known local companies rather than in the global market, so you have to look at where

the marginal investor is in any of this. The marginal saver and investor in the United States is more likely to be the marginal lender

to the individual trying to invest here in the United States.

Having said that, if we improve the tax treatment of capital here

with the dividend rate relief and avoid taxing foreign shareholders,

they may put more money into the U.S., just as we are putting

28

more money into global mutual funds. So, the attraction goes in

both directions.

Having said all of that, it is also important to lower the corporate

rate and to speed the write-off of plant and equipment located in

the United States, so that when we do do our saving and the firms

do borrow the money, they have the incentive to put the plant in

Kentucky rather than Cambodia.

For that, you need to address the corporate side as well as the

individual side. I am not suggesting that you just do one. I was

only asked to testify on one thing here today. But, definitely, you

need to look at the global consequences of this.

I would suggest to you that this is why the European countries,

in the last 20 years, have been lowering their corporate taxes, even

while they have been increasing their value-added taxes and making other reshufflings in their tax systems to try to remain competitive while they are burdening their labor with the most incredible tax rates for social insurance and income, and scrambling not

to have a complete collapse of their growth rates as they attempt

to claw their way up to 40 and 50 percent of GDP in the money

they take through government. They have been aware of the international consequences.

We have had, fortunately, a much lower tax burden in the

United States, and this has perhaps made us a little bit lackadaisical about how we regard international capital flows in the tax

treatments of corporate income.

I would suggest, for starters, that when you really do a job on

corporate reform, that you have a territorial system rather than a

global one, and go to expensing and get the investments here, while

letting our companies actually compete abroad so that our foreign

subsidiaries can buy things produced here to finish abroad and

compete with third country companies. Thank you.

Senator KYL. I have a feeling that some of those concepts are

going to be discussed in the recommendations of the President in

the so-called Mack-Breaux Commission. At least, that is my understanding, having talked to some of them.

I have a couple of other questions. But Senator Jeffords, if you

have some at this point, I would be willing to defer to you.

Senator JEFFORDS. I have no further questions.

Senator KYL. All right. Thanks.

Senator JEFFORDS. This has been very informative. I want to

thank the panel for the exceptional answers that have helped us

very much in understanding the problem.

Senator KYL. I agree. This is very helpful. It is like an economic

seminar in school, but it is more fun than it seems like it was back

then.

Senator JEFFORDS. Mr. Harding, do you want to say a word?

Mr. HARDING. Yes.

Senator KYL. We are not done here. I have some other things,

too. But go ahead, Mr. Harding.

Mr. HARDING. Well, thank you, Senator. I just want to say, I am

certainly not a world-class economist and do not belong up here

with these fine gentlemen, but let me just address a couple of

things about how somebody behaves on the ground in business,

versus some of the comments I have heard.

29

Number one, if we have a chance to invest, we are going to go

out there and spend more money. If we spend more money and

grow, then labor, people that work for our companies, have a

chance to get better, move up through the ranks, and earn more

money. So, certainly, any time we have a chance to invest, people

get a chance to grow and earn more money, period. It is just that

simple.

I was a little surprised that the gentleman at the end, with all

due respect, said that as business people, we are discouraged from

wanting to have retirement plans.

It is tough to get qualified workers today. The way you get qualified workers is to have good benefits and a good retirement plan.

So, we are always going to be encouraged to do those things, if we

want to last. We have been in business since 1949.

I always say, if we are going to stay around another 50 years,

another 60 years, whatever it is, we have to do the things that are

smart, take care of our people, and get a chance to grow. That is

the longevity.

I mean, that is on the ground, what we look at. I am not smart

enough to know all the graphs and everything, but that is how we

behave. So, I apologize if I am out of order.

Senator KYL. No, no. Thanks.

Senator JEFFORDS. Those are excellent comments.

Senator KYL. Yes. I was reminded, those of us who are not economists, we have our favorite little sayings about economists, one of

which is that an economist sees something working in practice and

wonders if it will work in theory. [Laughter.]

Now, let me apply that. Here is one where we may get unanimity. Mr. Harding has talked about the practical problems with

uncertainty in the tax code. I wonder if our experts would agree,

and each would be willing to make a little comment, about the impact of uncertainty.

Let me precede that with this confession. One of the reasons why

we have these temporary provisions in the tax code is that we have

not had the consensus to get 60 votes on some of these provisions,

which would be the necessary number of votes to effectuate permanent policy.

So instead, we work within the budget window. If we have a 5-

year budget, then we can do a tax policy that is good for only 5

years. If we have a 10-year budget, we can have a tax policy that

is good for only 10 years. Well, it is as good as we can do without

60 votes, but it sure creates some problems, as Mr. Harding suggests.

I wonder what that kind of uncertainty means, both as a matter

of theory and practice, from those of you who work on this every

day, and therefore what recommendations you have with respect to

policies, such as the dividends and capital gains rates, which in

fact do expire in the year 2008 unless they are dealt with? That

is to say, the 15-percent rates expire at that time.

Mr. Weinberger, let me start with you and just go on down the

panel.

Mr. WEINBERGER. Well, Senator, there may be some virtue to

those windows, because as circumstances change, there is an opporVerDate 11-MAY-2000 15:19 Sep 08, 2006 Jkt 095484 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 29691.000 SFIN1 PsN: SFIN1
30

tunity to make adjustments. It is the functional equivalent, I guess,

of a sunset law.

For example, with the Saver’s Credit, as we were discussing

today, which expires in 2006, we are before you essentially looking

at the evidence to see whether it works, whether there are better

alternatives, what the evidence actually shows.

I think that can be a healthy process, especially so knowing how

sometimes late at night, when tax bills are cobbled together and

various considerations are at play, they may not always get the

same thoughtful consideration that time allows. If certainty is a

virtue, so is flexibility in adjusting, I think, to changed circumstances.

Mr. MALPASS. Senator, I am a little concerned that a growing

portion of the tax code is going to get subjected to this budget window constraint that you are working on. The R&D tax credit seems

to be under it. It looks as if the 2003 tax cut will be under it, and

might even be out into the future. There is a growing problem that

you are addressing, so I think that it’s good to think about it as

a problem.

It would be very good for long-term capital formation in the U.S.

to make permanent the lower rates on dividends and capital gains.

I think that would be a good goal. I do not know how you can work

that out with the rules that you are dealing with now.

With regard to uncertainty, it is worse than you might think. If

something is uncertain, and half the people want one outcome and

half the people want the other outcome, as long as you do not decide the outcome, then both of them may be paralyzed. Neither side

may want to make the decision as long as the uncertainty persists.

It actually turns out that uncertainty stops decision making, as

well as changes people’s decisions. I think that is a growing problem. You can imagine business executives around the country saying, I am going to wait to make this decision until I see what the

tax code is going to look like in 2011.

Senator KYL. Thank you.

Dr. Toder?

Dr. TODER. Thank you. I really do share your concerns about the

overuse of sunset provisions in the tax law, for a number of reasons. One, obviously, is the uncertainty it provides to business

planning and people knowing what their tax circumstances will be

3 or 4 years from now, and how the provisions will affect them.

I also think, as someone who is concerned about long-term deficits and fiscal responsibility, that it gives the illusion of fiscal responsibility, because provisions sunset. But, in fact, it is very difficult, once you have cut taxes on someone, to raise them back

again.

So, particularly I am thinking of provisions like the AMT, which

is a time bomb for the tax system. But when you extend relief

1 year at a time, it really looks like it does not cost much money.

But if you did that every year, it really would cost a lot of money.

It is something that I would hope the Congress would face up to

at some point and deal with.

David Malpass mentioned the R&D credit. I had to smile when

he said that, because that was actually enacted in 1981, originally.

It has been with us for 25 years. I would guess, probably, business

31

thinks it is permanent by now, since you always tend to extend it.

So why not just do it?

Senator KYL. A 1-year credit.

Dr. TODER. Right. Right. So I guess, even though I do not share

the other witnesses’ views on extending this particular provision,

I think it would be, again, better to deal with it one way or another

than to have a 3-year extension.

Senator KYL. Mr. Entin?

Mr. ENTIN. You might try reforming the R&D credit the next

time you extend it. It is kind of a mess. But that is an aside.

Treasury is thinking about reinstituting the 30-year bond. Well,

even if they do not go that far, just think about the 20-year bond.

A new one being sold today extends well past the time that the

rates are supposed to go back up to the old pre-2001 levels.

What interest rate does a saver want to see so that he can get

a targeted after-tax return on that bond? Is he going to assume the

rates stay down? Is he going to assume the rates go up?

Is he going to give some probability distribution to it? Where is

the coin flip going to come down? Is he going to want a 4-percent

return on that bond, or 4.5 percent? You are going to see a change

on your budget right now from the failure to create certainty on

that bond over time.

What about the tax treatment of shareholders? What about the

dividend? What about the perceived cost of capital? What about the

perceived share price?

A company may be thinking of issuing new shares to build a new

factory. Maybe the machinery will wear out in 3 or 4 years, before

2011, so they can decide then whether to replace the machinery.

But the factory building may last 50 years, and you need a building

to put the machinery in. So, at least part of the investment is going

to be hit, as it earns its returns in the future, on what happens

to returns after these provisions expire. The tax outlook is going to

affect corporate planning today, and affect investment today, and

affect the number of people working in the United States today,

and what you get in payroll taxes and income taxes on wages.

So the more certainty you can create, the stronger these responses on investment are going to be, the more people will be put

to work sooner, at higher wages.

Yes, I think these provisions really need to be made permanent,

but to do so you are going to have to get a better understanding

of what they do for people, because the burden tables do not show

you that, and the benefit to the truck driver of having his boss

keep the fifth truck does not show up in the burden tables.

Senator KYL. That is one of the most useful things, at least to

me, that has come out of the hearing today.

Mr. Graff, you talked about the complexities and difficulties of

administering these plans, and I presume that uncertainty is another variable that you can factor in there as well.

Mr. GRAFF. Absolutely.

Senator KYL. We have a unanimous panel on at least this one

point.

Mr. GRAFF. Uncertainty. I suppose uncertainty and your views

on whether a provision sunsets or not, to some degree, depends on

whether you like it or not.

32

I think, with respect to many provisions in the tax code, obviously, it would be preferable that there not be a question as to

whether or not they are going to continue, certainly. The rules in

ERISA have been relatively constant. Although ERISA has been

amended 25 times, in general, most of the basic rules have remained unchanged.

However, I think there is some benefit associated with provisions

that do sunset, in that it allows Congress to decide what priorities

should be on a going-forward basis to reassess whether this makes

the most sense, or doing something else might be an opportunity

to achieve the policy objective in a more effective means. So, I do

think, to some degree, from a tax policy perspective, there are some

advantages.

If I could just take a moment to respond to something Mr. Harding said.

Senator KYL. Yes.

Mr. GRAFF. I have no doubt that his opinion is certainly genuine

with respect to his own firm, but our members’ experience has been

that profit-maximizing small business owners rarely adopt these

retirement plans due to employee pressure.

The small business has been operating quite successfully for

some time without the plan. Rather, the retirement security of the

owner generally is the driving force behind the adoption of the

plan, and the owner is fine to make contributions on behalf of the

workers, and likes to, if it makes financial sense for the owner to

do so.

However, assume a small business owner is thinking about

adopting a 401(k) plan for the first time. If I can go in and tell that

small business owner, like I used to do—I used to sell retirement

plans for a living at one point—and tell him or her that I can generate 30 percent more in accumulated savings after taxes by not

having a retirement plan, that owner is going to think long and

hard before adopting one of these plans, assuming all the costs,

and assuming the potential risk and liability that goes along with

having one of these plans.

Ultimately, I think the proof of my point is in the tax code itself.

I would refer you to code section 416, the top-heavy rules. These

rules, by operation, apply only to the smallest of small businesses,

those with less than 25 employees.

These rules mandate contributions be made on behalf of workers

if the owner wants to save in the plan. This rule has been around

for 23 years. Why would Congress mandate small businesses make

these contributions if it was not concerned that, without the rule,

small business owners might not feel the need to provide the benefits to workers?

We really do think this is a real issue and a concern, and we

hope you will consider carefully the potential risks to the retirement security of small business owners.

Senator KYL. Yes. Let me make this point, though. You have

complained, I think with some good reason, that Congress imposes

a lot of burdens on these retirement accounts that you have to set

up and administer, talk people into setting up, and so on.

You say, actually, you can compare favorably other kinds of investments to these kind of plans. But is the answer for us not to

33

remove the difficult burdens of the kind of section that you just

mentioned, and a lot of other complexities, to the creation and operation of these kind of plans rather than increasing a tax someplace, like dividends and capital gains?

And, in fact, is it not true that the substantial dividends that

were paid after we cut the dividend rate to 15 percent have benefitted these kinds of plans, the people who are in the plans, tremendously since we set it up?

Microsoft never paid dividends. If I am in one of these plans and

I had Microsoft stock, it did not do me any good. In that case, I

think you are right. You would want to have that stock outside of

the plan.

Once you have this kind of dividend rate and companies paying

that dividend rate, these plans are benefitting from that. They are

not losing from it. They are benefitting to the same extent as if you

had the investment outside the account.

So it seems to me that what we ought to do is get all the ideas

from you we can about how to make these plans simpler, less costly, easier to administrator, easier to establish, but not try to raise

taxes someplace else so that these plans will compete favorably

with some other kind of investment.

Mr. GRAFF. I understand what you are saying. I, like Senator

Jeffords, am all for cutting taxes. It is a great thing. The question

is priority and revenue dollars. There is no question that, as I said

before, 70 percent of American households own their mutual funds

through these retirement plans. They do not directly benefit from

a cut on tax, capital gains, and dividends.

Senator KYL. They do not?

Mr. GRAFF. They do not directly benefit. When the money comes

out of the retirement plan, it is taxed at ordinary income rates.

Senator KYL. Well, I understand. Our portfolio of stocks in the

country all benefitted from the reduction in dividends rates, even

though not all the corporations paid dividends out to their stockholders. Right?

Mr. GRAFF. There are a number of economists here. They can tell

you whether the incidental effect of the reductions in capital gains

and dividends have had a direct impact on the values of the stock

market. You may be right, to some degree it has. But is that the

most efficient way?

Senator KYL. Excuse me. Not to mention the effect on corporate

governance, the policies toward equity versus debt financing. I

mean, there were a lot of reasons why we did this.

Mr. GRAFF. Again, I am not differing with you. There are some

positive things, in general, about the concept of reducing capital

gains and dividends rates. That is not what I am concerned about.

What I am concerned about is, if we continue to provide added

incentives to those non-qualified investments, we have to, by definition, reduce the relative incentives for qualified plan investing. And

you are right. We need to look very hard at making sure that we

do not create disintermediation that is going to result in people

saving less——

Senator KYL. Excuse me for interrupting, but you have persuaded me. I will sign up for your plan to reduce the burdens on

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your kind of investments so they are just as low as the ones over

here. How is that?

Mr. GRAFF. It would be great. If we had unlimited resources, I

am with you.

Senator KYL. All right. Good. Thanks.

Mr. Entin?

Mr. ENTIN. In ordinary saving, you pay tax, then you take your

after-tax money and you put it into stock, and you are paying tax

every year on the dividends and any capital gain. So, you are basically paying two layers of tax on that saving.

In a qualified plan, you get to defer the tax on the principal, or

if it is a Roth-type plan, you pay it up front, but then do not pay

tax on the returns. The qualified plan is always going to do better

than the ordinary saving.

Even if you lowered the tax rate on the ordinary saving, it is still

not going to accumulate as much over time as if one or the other

of the taxes was completely removed. The relatives do shift, but

you do not end up being worse off in the qualified plan if the ordinary tax is simply reduced.

Now, the person about to buy the fifth truck does not care whether the bank got the money from someone who was putting it into

an IRA or an ordinary savings account. The truck driver, whose job

is spared because the fifth truck is kept, does not care where the

saving came from.

It may be nice to have people protected against poverty and old

age so they do not end up knocking on your door for welfare when

they get old, and that is a social concern which probably should be

addressed with personal accounts via the Social Security system.

But to try to restrict tax benefits only to retirement saving instead

of spreading it more widely so that all saving is not double-taxed,

and so we get more total saving, is a mistake because all saving

is good for growth and for wages.

Now, one of the things we have observed is that people are much

more likely to save out of an increase in pay than out of their current level of pay. Try to talk them out of consuming less and saving

more today without a raise. But if they get the raise, they are

much more likely to put it into the 401(k).

Increasing capital formation and increasing wages is a darn good

way to encourage people to save, and restricting favorable tax

treatment of saving is not the way to get there. I think all saving

should have neutral treatment, and we should not favor one type

of saving plan or one industry group over another. All the saving

should be treated the way it would be under a neutral tax system.

Senator KYL. I could go on here for a long time, but I think, in

the interest of everybody’s time, we should probably finish the

hearing.

If there are questions from members who could not be here, we

will take some of those for the record. I am not sure. We will leave

it open until close of business tomorrow, so some of you might get

some love letters from us wondering about some additional things.

But I really want, both on behalf of Senators Jeffords and myself,

to thank all of you for your contribution to this debate. The purpose

of this hearing was to figure out what kind of arguments there are,

pro and con, for extending the tax policies that we have been talkVerDate 11-MAY-2000 15:19 Sep 08, 2006 Jkt 095484 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 29691.000 SFIN1 PsN: SFIN1
35

ing about here, or terminating them, allowing them to lapse. I

think you know where I stand on that.

But, clearly, we are going to have some more debate about this

in the Congress, then probably at the time of the reconciliation bill,

take a lot of these things up. One of you started by talking about

the market today.

Mr. MALPASS. That was me.

Senator KYL. Mr. Malpass, yes. About the Federal Reserve rate

increase. Let me just send a little message, for whatever it matters,

to anybody who is listening to me.

That is, it has been my intention to demonstrate that the desire

to continue to extend rate cuts—such as the 15-percent capital

gains and dividends—for another couple of years—even though we

cannot do that permanently right now—should be seen as a signal

of our intention to continue, as we have with the R&D tax credit,

to make this an essentially permanent feature of our code, even

though we have not made it into permanent law.

So, that is my hope in achieving at least that degree of certainty

at this point, and we will just have to keep on working on all of

the other provisions.

By the way, almost all of them will now be coming due in 2010.

I think you were pointing out, Mr. Graff, that every now and then

it is a good idea to be forced to kind of look at these things. Well,

we are going to be forced to look at them, if not before, at least by

2010, when all of these things, including the marginal rate cuts,

would expire.

If there is nothing else then from our panelists, again, thank you.

Your testimony was terrific. We appreciate all of you being here.

I will declare this hearing adjourned.

[Whereupon, at 3:47 p.m., the hearing was concluded.]

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