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56–020—PDF 2008

S. HRG. 110–1037

TAX: FUNDAMENTALS IN ADVANCE OF REFORM

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

SECOND SESSION

APRIL 15, 2008

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

MAX BAUCUS, Montana, Chairman

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

DEBBIE STABENOW, Michigan

MARIA CANTWELL, Washington

KEN SALAZAR, Colorado

CHUCK GRASSLEY, Iowa

ORRIN G. HATCH, Utah

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

PAT ROBERTS, Kansas

JOHN ENSIGN, Nevada

JOHN E. SUNUNU, New Hampshire

RUSSELL SULLIVAN, Staff Director

KOLAN DAVIS, Republican Staff Director and Chief Counsel

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C O N T E N T S

OPENING STATEMENT

Page

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

on Finance ............................................................................................................ 1

WITNESSES

Shaviro, Dr. Daniel N., Wayne Perry professor of taxation, New York University School of Law, New York, NY ...................................................................... 4

Graetz, Dr. Michael, Justus S. Hotchkiss professor of law, Yale Law School,

New Haven, CT .................................................................................................... 6

Furman, Dr. Jason, director, The Hamilton Project, Brookings Institution,

Washington, DC ................................................................................................... 9

Carroll, Dr. Robert, vice president for economic policy, The Tax Foundation,

Washington, DC ................................................................................................... 11

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

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

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 33

Carroll, Dr. Robert:

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

Prepared statement .......................................................................................... 34

Furman, Dr. Jason:

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

Prepared statement .......................................................................................... 41

Responses to questions from committee members ......................................... 51

Graetz, Dr. Michael:

Testimony .......................................................................................................... 6

Prepared statement with attachment ............................................................. 57

Responses to questions from committee members ......................................... 85

Grassley, Hon. Chuck:

Prepared statement .......................................................................................... 91

Salazar, Hon. Ken:

Prepared statement .......................................................................................... 92

Shaviro, Dr. Daniel N.:

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

Prepared statement .......................................................................................... 94

Responses to questions from committee members ......................................... 105

COMMUNICATION

Ryesky, Kenneth H., ‘‘Tax Simplification: So Necessary and So Elusive,’’

Pierce Law Review, Vol. 2, No. 2, June 2004 .................................................... 113

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TAX: FUNDAMENTALS IN ADVANCE OF

REFORM

TUESDAY, APRIL 15, 2008

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Bingaman, Kerry, Wyden, Salazar, Hatch,

Snowe, and Bunning.

Also present: Democratic staff: Bill Dauster, Deputy Staff Director and General Counsel; Cathy Koch, Senior Advisor, Tax and Economics; Tiffany Smith, Tax Counsel; and Tom Louthan, Detailee.

Republican staff: Mark Prater, Deputy Chief of Staff and Chief Tax

Counsel; and Ellen McCarthy, Tax Counsel.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

Albert Einstein said, ‘‘The hardest thing in the world to understand is the income tax.’’ Regrettably, the tax code has not gotten

any easier. Even so, every year the government requires pretty

much everyone in the country to take a test. We have to take a test

on that hardest thing in the world. The government requires us all

to complete that test by April 15.

So this April 15 we thought that it was high time we started

talking again about how to make taxes easier. Another reason to

start thinking about tax reform is the year 2010. Significant sections of the tax code expire at the end of 2010. The law that has

been in place since 2001 will no longer be the law. It will revert

back to the law before 2001. Pretty much nobody wants the law to

swing back to pre-2001 law in its entirety, so that is another reason to start talking again about tax reform.

Tax reform sounds simple because it is two little words, but

those two little words can represent a huge task for Congress. It

is a task that requires a lot of cooperation and a lot of working together.

Today we will start to address that daunting task. We will start

by discussing our current system. We will discuss what has led to

the current complexity. Justice Felix Frankfurter wrote, ‘‘A tax can

be a means for raising revenue or a device for regulating conduct,

or both.’’ Congress clearly has chosen both. Congress has often choVerDate 11-MAY-2000 14:16 May 25, 2010 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 56020.000 TIMD PsN: TIMD
2

sen to use the tax code to implement social and economic policy,

and doing so has led to complexity.

We will discuss how Congress has used the tax code for social

policy. The tax code has multiple provisions to encourage people to

do one thing or another. For example, you get a charitable deduction for donations because Congress wants to encourage donations.

The tax code also has a tax deduction for mortgage interest and

real property taxes because Congress wants to encourage home

ownership.

We will discuss how our Congress has used the tax code for economic policy. A recent example of this is the economic stimulus

package that Congress passed in February. In that case, Congress

used the tax code to give a boost to a sagging economy.

The last time the Congress reformed the tax code from top to bottom was 1986. That year we enacted a comprehensive reform bill

that was meant to set us on a stable course. Since then, however,

Congress has passed tax bill after tax bill, and that has caused confusion and complexity for taxpayers and the IRS alike.

As a result, some folks state that tax reform is like mowing the

lawn: you have to do it pretty regularly because it keeps growing

back. Pretty clearly, it is time to get out the lawn mower.

So let us try to make it so it does not take an Einstein to fill

out a tax form. Let us see what it would take to get tax law back

to being mostly a means for raising revenue rather than mostly a

device for regulating conduct. Let us start the process of making

tax law a little easier, because wouldn’t it be nice some April 15th

not to be subjected to the hardest thing in the world?

I might say, because I have to leave pretty quickly as a conferee

on the farm bill and meeting with Chairman Rangel to find a way

to raise revenue to pay for the tax title, I will not be able to be

here for most of the hearing. But I want to say to everyone here

just how important I think this endeavor is.

I am committed to do all we possibly can in this committee this

year to set the stage for significant tax reform in 2009. We are

going to begin with, it is kind of like a graduate course in the tax

code. It is kind of like spring training before we get into the regular

season, which will be next year.

That is, I believe that virtually no one in the Congress has a sufficient grasp of the code to know whether a proposed amendment

or bill is really a good or a bad idea with any kind of framework,

because I do not think there is much of a framework. There is a

kind of a framework in a tax bill, but not a lot. So an early part

of these hearings will be kind of like that, a kind of graduate school

in tax law, a kind of refresher course, a kind of spring training so

we have a better idea of what we are doing.

Then after that, I would like to reform the code in various ways,

with social policy, economic policy, and whatnot, with some emphasis looking at the 1986 provisions—did they work, did they not

work, was that a good idea or not, and the degree to which moving

off of 1986 has or has not caused a problem.

I do not begin this endeavor with any preconceived notions, any

bias, any belief as to what kind of code we should have. I just think

that the code is so creaky, it is so top-heavy, that fairly soon it is

going to fall of its own weight. That is a bad analogy, just like

3

* For more information, see also, ‘‘Overview of the Federal Tax System as in Effect for 2008,’’

Joint Committee on Taxation staff report, April 14, 2008 (JCX–32–08), http://www.jct.gov/publications.html?func=startdown&id=1308.

asset bubbles. We all know the bubble is going to burst sometime

but we do not know when. I am not saying that this is an asset

bubble, but some kind of complexity bubble that at one point is

going to burst, and you do not know when. But I think it is important to start earlier rather than later.

As I also said, whoever is elected President is going to have to

make major recommendations to the Congress and the country, because the expiration of the 2001 tax law, the expiration of the 2003

tax law, Federal and State taxes being zeroed in 2010, it is sort of

a train wreck that is going to meet in 2010. The AMT, the 1,000-

pound gorilla, is going to be a 10,000-pound gorilla by 2010. So,

whoever is President is going to have to make a huge, significant

recommendation to Congress in his or her budget submission in

January or February of ’09 that contemplates changes in the code.

So, we have to address it for that reason as well.

I am not above looking at consumption taxes, flat taxes, all kinds

of different regimes. I think we should also be aggressively looking

at American competitiveness, and how is our tax code helping or

hurting American companies versus the competition. But, as I said

at the outset, this is a serious endeavor. This is not just a bunch

of hearings on tax reform because everybody thinks the tax code

is complex. Rather, this is an effort to do something very significant so that this committee can make a significant recommendation

in 2009 and make a major contribution in 2009, which I think the

people who elect us really want.*

I would like, now, to introduce the panel.

Senator SALAZAR. Mr. Chairman?

The CHAIRMAN. Yes?

Senator SALAZAR. May I just say a quick comment?

The CHAIRMAN. Yes.

Senator SALAZAR. One is, I know that you have to leave this

hearing to go and continue the work on the farm bill. I just want

to say thank you for all the great work that you have been doing

in trying to get the farm bill pushed across the finish line. I think

with your efforts this morning, we frankly will be in a position

where we are getting closer and closer and closer, and I just wanted to say thank you for doing that. Thank you also for this hearing

this morning.

The CHAIRMAN. You are very welcome. Thank you, Senator.

I would now like to introduce the panel. The first witness is Daniel Shaviro, professor at New York University’s law school. I might

say parenthetically, when I was a lawyer at the Securities and Exchange Commission, I thought I would get an advanced degree in

tax and I looked at New York to get a Master’s degree in tax. I

started that for a while, but I thought, no, it is a little too much.

I cannot do it all. So, I have a soft spot for New York University.

The second witness is Michael Graetz, professor at Yale University’s law school. Welcome back, Professor Graetz. Then we have

Jason Furman, who is director of The Hamilton Project at the

Brookings Institution. Thanks. Welcome back again, Jason. And

4

Dr. Robert Carroll, vice president for economic policy, The Tax

Foundation.

Thank you all for coming. As you all know, we ask you to summarize your testimony in 5 minutes, and your statements will automatically be included in the record.

Professor Shaviro, you are first.

STATEMENT OF DR. DANIEL N. SHAVIRO, WAYNE PERRY PROFESSOR OF TAXATION, NEW YORK UNIVERSITY SCHOOL OF

LAW, NEW YORK, NY

Professor SHAVIRO. Well, thanks. Good morning, Mr. Chairman,

members of the committee. Thanks for the opportunity to testify on

alternatives for comprehensive U.S. Federal income tax reform.

Now, I was asked to offer a bit of background on two questions:

one is, why we have an income tax, and the other is to say something about the rate differentials for dividends and capital gains.

So I will start with both of those issues, and then I will go on to

other main features of my testimony.

In terms of why we have an income tax, it is kind of a historical

question. If you go back to when the decision was made, it was considered to be a fair and more progressive system, and it was something you would collect from individuals, not just from businesses,

which meant you could have graduated, or differentiated, rates.

Now, in fact, there are answers for consumption tax proponents

to all those things today. Essentially an income tax is considered

a better annual measure and a consumption tax a better long-term

measure. Also, it is now known you really can collect the consumption tax from individuals. So, I think that is an option that merits

consideration, but I realize it is not really at the—I got the sense,

for example, from what happened at the Tax Reform Panel a couple

of years ago, that policymakers are not really convinced of this

point, so I think we are probably in an income tax world.

One thing I will say is, very often being halfway between the two

poles is worse than being in either system. You have some assets

being treated like income tax, others like consumption tax. You create distortions, and that is not very good for efficiency. The other

big problem is having kind of consumption tax treatment on the income side, but income tax treatment of deducting interest on the

borrowing side. That can be pretty bad. So it can be a real mess

to be between the two systems rather than in one or the other, and

that is an important design feature to keep in mind.

About the expiring 15-percent rate for dividends, just very quickly, I want to say that there is a pretty widespread academic consensus that double taxation of equity-financed corporate investment does not really make a lot of sense, but there is a lot less consensus about whether a shareholder-level low rate is the right way

to address it.

A few things to keep in mind. One is, you kind of want to be confident you are collecting tax effectively at the corporate level. The

second point is that the debt-equity distinction, which is preserved

when you have a low rate for dividends rather than attempting corporate integration by some other means, makes very little sense.

Financial engineers can kind of get whatever financial features

they want and call the instrument whatever they want. IncreasVerDate 11-MAY-2000 14:16 May 25, 2010 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 56020.000 TIMD PsN: TIMD
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ingly in today’s world, the choice between debt and equity for the

sophisticated players is really just a way of deciding whether you

want to pay tax at the company’s marginal rate or your own. It

does not really make sense to create that type of election in our

system.

A further thing is, I think both sides of the aisle have at times

expressed interest in lowering corporate rates due to international

tax competition for tax base for both investment and for what people report as income. If that is done, then you need to think about

the owner level rather than the entity level as the place to address

distributional concerns.

So I think it is important to distinguish the question of corporate

integration, for which there is widespread support, from the particular way of doing it through a low rate for dividends.

On capital gains, although it is an ancient debate, I am not going

to end it here today. There are a lot of arguments for it that I personally feel—and I can elaborate—do not make a lot of sense, but

it is certainly clear that the revenue tends to disappear from raising the rate a lot faster for capital gains than for ordinary income.

That is an important design feature one has to keep in mind.

So even 10, 15 years ago when the Democrats and the Republicans were battling about what capital gains rate would raise the

most revenue, they really were not that far apart. It was kind of

below some rates we would consider for individual income.

Turning to the main themes of my testimony, they are basically

threefold. The first thing is that tax reform is all about base broadening, about a broader base and lower rates. Issues of distribution

and issues of how much money we want to raise are really distinct

because tax reform base broadening makes sense no matter what

you think of those things.

This is why, in 1986, the Democrats and Republicans were able

to agree about a tax reform that was designed to be revenue- and

distribution-neutral, because they figured, even if we disagree

about any of these other issues, it is just obvious that you get big

benefits, big social and economic efficiency benefits and perceived

fairness benefits from having a broader base and lower rates to do

the same thing.

Now, there are some very popular items on the individual side

that this involves addressing, but they do not have to be repealed

in order to address them. There are kinder, gentler ways, if you

will, of getting those done, and I discuss that in my testimony.

The final two points I want to make, as I see my 5 minutes is

vanishing fast——

The CHAIRMAN. You could take one or two more.

Professor SHAVIRO. All right. Thank you.

One point is that the way we tax business enterprises is messed

up in a lot of ways, and there are a lot of big problems that need

to be addressed. One thing I would point to is the big book-tax gap:

that companies tend to report high financial accounting income to

the SEC and low taxable income to the IRS. It does not mean they

are cheating, it means they are using the rules to their advantage.

But when that is going on, it tells you that, kind of, something is

wrong on the financial reporting side and/or on the taxable income

side.

6

By the taxable income side, I mean taking advantage of tax planning opportunities that no one really intended and that may not be

very desirable. I have suggested a partial adjustment between the

two, which was done in 1986 in the Alternative Minimum Tax as

a way of addressing that. But I think whether that proposal were

done or not, it is something that needs to be looked at.

The second point I want to make is about corporate integration.

The system is kind of not in equipoise right now. I think the debtequity distinction is just fun and games for financial planners to

decide how they want to strip out income and where they want to

pay the tax, at what rate. That is not really good policy and certainly needs to be addressed.

Also, the U.S. rules for outbound investment by U.S. multinationals are pretty messed up. People are well aware that the two

classic approaches are exemption and full worldwide taxation. We

have kind of managed to be in the middle, with a set of rules that

is really probably worse than either, and that raises very little revenue relative to its complexity. So, I think the international area

is well worth addressing.

Finally, on April 15th, having gone through my own Turbo Tax

nightmare—nightmare would be overstating it, but it was not enormously fun—I think this is a good day to keep in mind how easy

it would be to ease the burdens on lower- and middle-class taxpayers because there is so much needless complexity and anxiety

associated with the system. There are a lot of ideas out there.

My colleague, Michael Graetz, has one idea to take people off the

rolls. Joe Bankman of Stanford Law School experimented with

something in California called Ready Return, which would make

things easier. There are also a lot of other proposals out there.

There just actually are a lot of ways to make life easier for lowand middle-class taxpayers in a revenue-neutral way that will really make them better off, and no one worse off. I think that is something the Congress really ought to look at. Thanks.

The CHAIRMAN. Thank you, Professor. I note with some interest

that a tax professor at a prestigious law school uses Turbo Tax to

figure out his tax returns.

[The prepared statement of Professor Shaviro appears in the appendix.]

The CHAIRMAN. Next is Michael Graetz, professor at Yale University law school.

Professor Graetz?

STATEMENT OF DR. MICHAEL GRAETZ, JUSTUS S. HOTCHKISS

PROFESSOR OF LAW, YALE LAW SCHOOL, NEW HAVEN, CT

Professor GRAETZ. Thank you, Mr. Chairman. If we are in the

confession mode, I should confess that I filed my extension request

yesterday with the help of my accountant. I could tell you more

about that, but I do not want to use my 5 minutes for that.

Thank you for inviting me to talk about this difficult subject. I

want to remark that I began working off and on with this committee almost 40 years ago, and this committee has a tremendous

history of bipartisanship. I think it is very important that tax reform proceed on a bipartisan basis. I want to compliment you and

the members for beginning this process today.

7

As you said, Mr. Chairman, our tax system is badly broken. No

one quarrels with that. You mentioned the train wreck coming in

2010 and the complexity of the system. I want to mention three

other reasons that I believe it is broken. The first is that, although

the U.S. is a low-tax country compared to the rest of the world, we

are not a low income tax country. Our income tax is comparable

to those around the world. The difference is that we fail to tax consumption.

All of the low-tax countries of the world—Ireland, Hong Kong,

Eastern Europe—all of them manage to achieve low income taxes

by taxing consumption, and all of them do it in the same way,

which is through what they call a value added tax, or what Canada

calls a goods and services tax. So, I think we need to think about

taking better advantage of our low-tax status.

The CHAIRMAN. Mr. Graetz, I regret I have to leave. I have asked

Senator Bingaman to chair this hearing.

Professor GRAETZ. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you.

Professor GRAETZ. Second, there is an issue of the adequacy of

revenues. I do not believe that is a short-term problem. But for the

long term, we need a system that will raise revenues in a way that

is conducive to economic growth and promotes American workers

and businesses to be competitive in our international environment.

Third, I want to mention what I describe as the ‘‘chicken soup’’

problem, which is that the Congress, Presidents, political candidates, and presidential candidates as well, all use the tax system

the way my mother used chicken soup, which is as a cure-all for

whatever ails society or the economy at the given moment. One

could cite the higher education provisions of the code, one could cite

the health insurance provisions of the code, proposals for dealing

with long-term care, and the recent legislation on housing.

The one thing that is clear is that these provisions are a lot like

putting a Band-Aid on cancer: they really do not work. We need to

find a way to get the Congress and get the country out of the business of relying on income tax provisions this way.

After a lot of study, I have concluded that the only way to do

that is to get most people out of the income tax and to return the

income tax to the system that we had before the second World War,

when the income tax was a small tax on relatively high-income taxpayers and the masses were not burdened by it, but instead paid

consumption taxes—at that time in the form of tariffs. But now we

have much better forms of consumption taxes around the world.

I do want to endorse Professor Shaviro’s point about distributional and revenue neutrality. Those were important constraints in

1986, and I think it would be useful for this committee to look at

proposals on that basis.

Which brings me to tax reform alternatives. There are a number

of alternatives. I talk about them in my statement. I apologize to

the committee that my statement was so long; to paraphrase Justice Holmes, if I had had more time it would have been shorter.

[Laughter.]

But I do discuss the alternatives in my statement, and I discuss

them in a recent book that I think I have sent to most members

8

of the committee and to many of the staff, but, if anybody wants

a copy, I am happy to send more.

The basic point is that there are really two directions that have

been proposed for tax reform. One is income tax reform. Senator

Wyden and Congressman Emanuel on the House side have an important proposal. The President’s Commission actually had an important proposal. There are very good things in both of those proposals, and there are also very controversial things in both of those

proposals.

I have to say that I have become convinced over the years, having watched the 1986 Act unravel, that, while Senator Wyden is

correct when he describes his bill as a good cleansing of the Internal Revenue Code, it will get rapidly dirty once again, and probably

quicker than the last time. So, I am not optimistic about reforming

the system and creating return-free income taxes or the like.

Let me say something about the consumption tax alternatives

which I describe in my statement. I think some of them are simply

political documents; I regard the flat tax and the fair tax much

that way. In any event, they both would redistribute the tax burden from very high-income taxpayers down the income scale and,

given the inequality of wealth and income in the United States,

this seems an odd time for us to do that. The retail sales tax at

a 30-percent level, which is the fair tax proposal, is unheard of anywhere in the world, and I believe it cannot be collected.

Most of these proposals, including the President’s Panel’s Growth

and Investment Tax, as they called it, which was a hybrid between—I will say this and it is a technical term—a subtractionmethod value added tax and a tax on capital income, are untested

in the world. More importantly these consumption tax alternatives

do not fit well with international arrangements.

The President’s Panel admitted that, not only would its proposal

have to go through Congress and be signed by a President, but we

would have to renegotiate the general agreement on trade and tariffs and all 86 of our bilateral income tax treaties. In my view this

is not realistic. We need to have a system that fits well with international arrangements.

Now, I see my time is basically up. Let me say just two more

things. First is, I think the corporate tax has become very different

today in the global economy than it was in the past. There is a lot

of economic evidence that it is being paid largely by workers, not

by owners of capital, because workers cannot move the way that

capital does in the modern economy.

I think that we are disadvantaging ourselves in many ways,

which I am happy to talk about, by having high nominal corporate

rates. Not only do we make the U.S. a less-good place for corporate

investments by both domestic and foreign suppliers of capital, but

we also create a great incentive for shifting deductions to the U.S.

and income elsewhere, even if you do not move any plant or equipment. So, we are bearing the burden of low rates around the world

that we do not have ourselves.

Finally, as many of you know, and as I hope I will get a chance

to testify as the committee really considers serious alternatives, I

have advanced a plan myself, in this book and elsewhere, for enacting a value added tax, and for using it to create a $100,000 exempVerDate 11-MAY-2000 14:16 May 25, 2010 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 56020.000 TIMD PsN: TIMD
9

tion from the income tax, to remove 150 million people from the income tax altogether, to have a low-rate income tax above $100,000

at a 20- to 25-percent rate, and to have a corporate rate of 15 to

20 percent, and I have suggested payroll tax offsets and debit

cards—I called them Smart Cards, but I have learned since they

are debit cards—as a way of delivering things like the Earned Income Tax Credit which are now delivered through the income tax.

So with that I will stop, but I do want to conclude just by saying

that, if my proposal were enacted today, April 15th, for 150 million

Americans, would be just another spring day.

Senator BINGAMAN. Thank you very much.

[The prepared statement of Professor Graetz appears in the appendix.]

Senator BINGAMAN. Dr. Furman, go right ahead.

STATEMENT OF DR. JASON FURMAN, DIRECTOR, THE HAMILTON PROJECT, BROOKINGS INSTITUTION, WASHINGTON,

DC

Dr. FURMAN. Sure. Thank you for inviting me to testify at this

hearing. In my remarks, I want to focus on one fundamental reform issue which I think illuminates a lot of issues in tax reform,

and that is the concept of tax neutrality.

The basic concept is simple. Generally the tax system should

strive to be neutral so that people are making decisions on the

merits and not for tax reasons. In some cases this neutrality is impossible and policymakers have to accept a certain level of distortion to behavior as inevitable. In other cases neutrality may be undesirable if policymakers intend to promote specific goals like contributions to charity, health insurance, or discouraging specific activities like smoking or the emission of carbon.

Tax neutrality is the motivation for the canonical tax reform,

broadening the base and lowering the rates. Both halves of that tax

reform make the code more neutral about the choice between different activities and the choice between working and not working.

The tax base is narrowed substantially due to tax expenditures.

In the last budget, the Treasury listed a total of $987 billion of tax

expenditures. If, for example, half of these were eliminated, it

would be enough to permit a 32-percent reduction in all individual

and corporate income tax rates. A few specific proposals have been

made that embody these basic principles, including Senator Ron

Wyden and Congressman Rahm Emanuel’s Fair Flat Tax Act.

In some cases, however, the code is deliberately non-neutral in

order to encourage desired activities like home ownership, a college

education, or health insurance. In many of these cases these are

worthwhile goals, but to accept tax expenditures is not to defend

how they are presently structured. For years, tax analysts of widely differing philosophies have written about the benefit of shifting

tax expenditures from deductions to uniform refundable credits. A deduction of $1 is worth 35 cents to someone in the 35-percent

marginal tax bracket, and only 15 cents to someone in the 15-

percent bracket. A uniform credit, by contrast, provides the same

tax subsidy regardless of one’s tax bracket, and a refundable credit

provides that subsidy even if the credit exceeds one’s tax liability.

10

For years people have thought of credits in terms of fairness, but

I think the more fundamental issue is economic efficiency. For example, we spend about $200 billion annually on tax expenditures

for health care that are larger than they need to be to encourage

high-income people to purchase health insurance, but not nearly

large enough for low-income households, leaving tens of millions

uninsured, all while providing an inefficient subsidy to spend more

on more generous health insurance.

Converting the exclusion to a progressive tax credit can provide

more of an incentive to purchase insurance, especially for households with lower incomes, but also make the tax code more neutral

vis-a`-vis purchasing more generous health insurance plans. Reforming this tax expenditure could be a useful part of broader

health reform, as the Healthy Americans Act introduced by Senators Ron Wyden and Bob Bennett does.

I now want to turn to how the concept of neutrality can apply

to thinking about the taxation of capital income, and in particular,

corporate income. Lately, significant attention has been focused on

the fact that the United States now has the second-highest corporate tax rate in the world. Less attention has been focused on the

fact that the United States also has the fourth-lowest corporate

revenue collections of any OECD country measured as a share of

the economy.

The reason for this, according to a report by the Treasury, is the

‘‘narrowness of the U.S. corporate tax base,’’ including accelerated

depreciation allowances, special tax breaks, and the general manner of taxing debt that Professor Shaviro discussed.

This narrow tax base manifests itself in substantial and very inefficient non-neutralities in the way capital is taxed. The overall

tax rate on capital income is 14 percent, but debt-financed corporate investment is taxed at a negative 6-percent rate. That is,

debt-financed corporate investment is not taxed, it is subsidized.

In contrast, equity-financed corporate investment is taxed at the

corporate and individual rates, and faces a combined rate of 36 percent. There are also large differences in the tax treatment in different forms of housing, corporate and non-corporate businesses,

different assets, and whether or not investors are located in the

United States or overseas.

Moving towards more neutral taxation of business income need

not require increasing the deficit or reducing the overall progressivity of the tax system. There are a number of models policymakers could consider, the most comprehensive being the Business

Enterprise Income Tax developed by Ed Kleinbard.

In conclusion, a number of considerations are important in tax

reform. The large increase in income inequality provides a rationale for making the tax code more progressive. The tax code could

be substantially simpler. And—the topic of my testimony today—

the tax code could be more efficient if it were more neutral vis-a`-

vis different economic activities, and if deviations from neutrality

were better designed, for example, by converting deductions to

credits and making the taxation of business income more uniform.

Thank you.

Senator BINGAMAN. Thank you very much.

11

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

Senator BINGAMAN. Dr. Carroll?

STATEMENT OF DR. ROBERT CARROLL, VICE PRESIDENT FOR

ECONOMIC POLICY, THE TAX FOUNDATION, WASHINGTON, DC

Dr. CARROLL. Thank you very much for the opportunity to speak

to the committee on the important issue of tax reform. The economic sluggishness we read about each day in the newspapers and

see on the TV has prompted many suggestions of short-term economic fixes, but tax reform remains one of the most important

long-term economic challenges.

Without a doubt, the tax system is complex, as the other panelists and Senator Baucus indicated. There are a vast array of provisions, a vast array of exclusions, credits, and deductions that result

in enormous complexity for taxpayers filling out their tax returns

during the spring filing season.

The Alternative Minimum Tax adds to complexity, and that parallel Alternative Minimum Tax is, in some sense, a poster child for

full reform. That is an issue that is only going to get more difficult

as time goes on.

The compliance burden of the income tax is roughly about $140

billion annually. That is one of the ways of thinking about the cost

of the complexity. But to put it in real terms, often the statistic is

that 60 percent of Americans use paid preparers when filling out

their returns, and another roughly 25 percent use tax preparation

software. Another way to phrase that is to point out that only 1

in 8 Americans still fills out their own tax returns in an unassisted

way. So, clearly we have a tax system that is, without a doubt, very

complex and needs reform.

I want to focus on a couple of issues in my remarks in summarizing some of the points in the testimony. One, I want to focus on

kind of a fundamental choice that proposals to reform the tax system usually face and take on, a fundamental choice of whether the

tax system should be based on one that attempts to tax income or

attempts to tax consumption.

In a sense, the key difference between consumption-based taxes

and income-based taxes is that consumption-based taxes do not tax

the returns of savings or investment. In some sense, when someone

refers to a consumption-based tax it is, in effect, code. It is a way

of speaking in code and pointing to the notion of a tax system that

taxes savings and investment more lightly or not at all.

To be clear, our current system is neither an income tax nor a

consumption tax. It is an income tax in name only. It is very much

a hybrid tax, as some of the other panelists have alluded to. It deviates from income tax principles in important ways, primarily by

offering tax-free savings accounts in the forms of IRAs, 401(k)s,

and defined benefit plans, and also allowing accelerated depreciation, primarily for equipment. In fact, about 35 percent of household financial assets receive consumption tax treatment according

to some estimates, so the current income is very much somewhere

in between a pure, comprehensive income tax and a pure, comprehensive consumption tax.

12

In some sense, one of the benefits of not taxing the return to savings, the key benefit, is it encourages more savings and more investment, which results in more capital formation, increases labor

productivity, and results in larger living standards in the long run.

In some sense, Congress has kind of made a fairly clear choice not

to create a pure income tax system and to provide some rather substantial benefits to lower the tax on the return to savings and investment through the various savings and accelerated depreciation

provisions that I mentioned.

A lot of the debate on tax reform focuses on where we ought to

be between an income tax and consumption tax, whether we ought

to move further towards a consumption tax base or move back towards an income tax base.

A very important element in the discussion is the distribution of

the tax burden. It is an empirical fact that a great deal of the capital stock is held by higher-income individuals, and moving to a

consumption tax which would relieve the tax on the return to those

investments would have significant distributional effects.

Some of the criticisms that Professor Graetz mentioned with regard to the fair tax and the flat tax proposals that have been considered in the past have been on distributional grounds. Consumption-based taxes are often viewed as regressive.

But I think the key point is, and this is embodied in some of the

work of the President’s Tax Panel several years ago, and also to

some extent in the ‘‘Competitiveness Report’’ released by Treasury

in December, consumption-based taxes can be progressive. You can

have a consumption-based tax with a progressive rate schedule.

Then, more important than that, perhaps, as Dr. Furman mentioned, is that the current tax base is extraordinarily narrow relative to either a comprehensive income base or a comprehensive

consumption base. The current tax base is only about 50 percent,

55 percent of a comprehensive income tax base and about 70 percent of a comprehensive consumption tax base. So what that means

is that the various special tax provisions, the health exclusion, the

housing tax subsidies, the charitable deduction, and the various

other provisions, result in a much more narrow tax base.

If one were to move towards a consumption tax base, one could,

in fact, address the distributional concerns by limiting those provisions for higher-income taxpayers to address distributional concerns through the definition of the tax base and the limitation of

those provisions rather than through higher tax rates or a higherthan-necessary tax on the return to savings and investment.

I wanted to just spend a few seconds on one additional point to

really amplify one of the points that Professor Graetz mentioned.

Another key element to consider with respect to the U.S. tax system is how it does fit in globally. One thing that I think the committee does need to focus on is the extent to which the U.S. business tax system may be becoming out of line globally, and how this

may in the future affect our ability to attract investment and jobs.

The Treasury, of course, released a report in December on this subject as a follow-up to Secretary Paulson’s July conference.

One metric that analysts often use in comparisons of the U.S. to

other countries is the U.S. statutory corporate tax rate. The U.S.

now has the second-highest corporate statutory tax rate among

13

OECD nations, and importantly the world continues to change. We

had a very low statutory corporate tax rate relative to the OECD

in the late 1980s and the early 1990s.

A series of tax rate reductions among those nations—Ireland,

Eastern Europe, and now Germany and France, and some of the

larger economies—has resulted in a world where the U.S. is, in

fact, perhaps falling behind. What is particularly important is, as

the world continues to change, the U.S. is standing still, and that

is something that I think deserves some attention.

Thank you.

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

Senator BINGAMAN. Thank you all very much. Thanks for your

excellent testimony.

Let me start with a few questions. Dr. Graetz, your suggestion

that we could shift to a system where 150 million Americans would

not have to pay taxes, as I understand it, would not be subject to

the income tax: what has been the push-back against that suggestion? Where do you see the arguments? Are there credible arguments that have been made to oppose your proposal, or is it just

too big a change? What are the problems?

Professor GRAETZ. It is a difficult position you put me in, Senator, to announce the objections to my proposal without announcing

the advantages.

Senator BINGAMAN. Well, give us a few advantages.

Professor GRAETZ. But I will take the question. I think the advantages of it are that it would be an enormous simplification, that

it would put the U.S. in a much better position for economic

growth, and it really takes advantage of our low tax status.

The push-back is that, politically, in the United States there has

been a great deal of resistance to a value added tax. This was true

in Canada for a long time, it was true in Japan for a long time.

But today there are 141 countries in the world that have value

added taxes. We are the only member of the OECD that does not

have a value added tax.

Larry Summers, when he was Secretary of the Treasury, quipped

that ‘‘Democrats hate a value added tax because they believe it’s

regressive, and Republicans hate a value added tax because they

believe it’s a money machine, and when they each understand the

other’s position they’ll both come around.’’

Now, whether that is true or not, I do not know. But there is

some resistance that I have actually tried to take into account in

this proposal. For example, if you use a value added tax to buy

down the income tax, essentially to return us to the pre-World War

II tax system that we had, then that limits its ability to become

a money machine. I also spend a chapter in my book detailing how

to avoid regressivity of a value added tax.

The final objection, Senator, that I would mention is that, in the

1970s when Richard Nixon was thinking about a value added tax,

the Governors of the States said, we tax sales and consumption.

That is our tax base, not the Federal tax base. So, I do spend a

chapter trying to deal with the issue of State/Federal relationships

and so forth.

The States have objected in the past and that has been a barrier,

but Canada, I think, has shown very clearly that a Federal level

14

value added tax, and a provincial level sales tax in Canada, can operate together without difficulty. What my proposal does is, it basically brings us into line with the OECD, closer into line with Europe in terms of our overall tax on sales of goods and services, and

makes us into one of the lowest income tax countries in the world.

Instead of having 13 percent of our GDP devoted to the income tax,

we would have about 4.5 percent.

Senator BINGAMAN. Mr. Shaviro, let me ask you. I know we are

talking about all of the tax structure here in this hearing, but, if

you just take the corporate tax and try to think of replacing the

corporate income tax with something like a value added tax or a

corporate activity tax, would it make sense? I mean, even if we

could not get consensus as to moving in that direction with regard

to individual income taxes, to do something on the corporate side

that would get us out of an income tax and shift that to a corporate

activity tax or a value added tax, or whatever?

Professor SHAVIRO. The real problem is, if you have an income

tax at the individual level and you do not tax corporations on an

income basis, then corporations in effect become a tax shelter for

avoiding the current income tax. If you have a consumption tax

through and through—and I am not saying that we are going to get

there—then that is not a problem because, in effect, that is sort of

the intended working.

You do not want really to have an income tax that applies unless

you keep the money in corporate solution. That is the one problem,

is integrating that. I think actually I personally might be willing,

if I were the decider, to go towards a comprehensive progressive

consumption tax, but even within a purely income tax world, I

think a lot can be done to reform it even without making it less

of an income tax.

Senator BINGAMAN. All right. My time is up.

Senator Bunning?

Senator BUNNING. Thank you, Mr. Chairman.

I would like to ask each of you about our business tax system,

and in particular the corporate income tax. In the view of most observers, businesses pay business taxes, we do not. But some of you

say that that is not the case. You say that, because of the increased

mobility of capital, businesses are able to shift the burden of the

U.S. corporate income tax to U.S. workers who pay it in the form

of lower wages. Can each of you elaborate on this and explain why

it might be important to this committee?

Professor SHAVIRO. Well, it is inherently true that only people

can pay taxes. Businesses are owned by people, and it could be that

the people owning the businesses pay the taxes. There are 40 or

50 years of economics literature trying to figure out which people

really bear the corporate tax. At one time the wisdom was, it was

mainly the owners not only of corporate stock but of capital generally.

As Professor Graetz alluded to, there is research suggesting that

it is more borne by workers today. The basic mechanism is that

corporations can more easily shift their investment from one country to another in a much more global world. So the fact, in terms

of the chairman talking about an economic seminar or something,

if there are two parties and there is a tax, and one of them can

15

run away and the other one cannot, the one who cannot run away

is the one who ends up bearing the tax. So that is basically the

mechanism for that.

The other point, I think, also made by Professor Graetz, is that

even if the company stays in the U.S. it can kind of shift all of its

taxable income abroad by playing games with paper, and that is

not tremendously good news for the U.S. Treasury or taxpayers.

Senator BUNNING. Professor Graetz?

Professor GRAETZ. I do not have much to add to what Professor

Shaviro said, except agreement. Paul O’Neill, when he was Secretary of Treasury, was fond of saying corporations do not pay

taxes, they collect taxes. So the question is, who are they collecting

the taxes from? There are really three possibilities: one is that the

tax reduces the return to capital; another is that it is increases

prices being paid by consumers; and a third is that it lowers the

wage rate and is being paid by workers.

As Professor Shaviro said, while it was in dispute always, and

no one has ever achieved complete agreement on who pays the corporate tax, the basic understanding until recently was that perhaps

owners of capital paid it. If that were true, then it is playing an

important role in the distribution of the tax burden because the

owners of capital are higher-income and higher-wealth people than

workers or consumers, on average, would be. If, in fact, as the new

studies are suggesting, much of the tax is borne by labor in the

form of lower wages, then the tax itself is not serving the distributional purpose that it might have served in the past because of

international flows of capital.

I think it has always been the case that economists and lawyers

who have thought about the corporate tax have never thought it is

a very good tax. They have felt, as Professor Shaviro said, that, if

you are going to tax income at the individual level, not taxing at

the corporate level is an invitation simply to shift the income to

corporations. So it is not a very good tax, and now it is probably

not a progressive tax.

Senator BUNNING. Dr. Furman?

Dr. FURMAN. I agree, analytically, with what Professor Shaviro

said. Just to put it in a broader context though, I think it would

be an overstatement to say that there is anything resembling a

consensus or definitive evidence within the economics profession on

how the corporate tax is distributed. There have been one or two

studies recently, but they are still in working paper form, for example, and have not been published.

There is a range of other studies with different findings. In recognition of that, the Congressional Budget Office continues to make

the assumption that corporate taxes are borne in proportion to

ownership of capital. I believe that is the featured assumption that

the Treasury uses, for example in the President’s Federal Panel on

Tax Reform. Dr. Carroll can correct me if I am wrong.

I am not saying that is the right treatment, I am just saying

there is a substantial amount of uncertainty as to what fraction is

borne by capital and what fraction is borne by workers. There is

also uncertainty about timing, so it might be that initially it is

borne more by owners of capital, and then over time the burden

16

shifts to workers. We do not need to answer this question, though,

if you want to have, for example, a revenue-neutral distribution.

Senator BUNNING. What if we want to change it? We do.

Dr. FURMAN. If you want to do what Secretary Paulson outlined

and what Chairman Rangel outlined, both of whom had revenueneutral corporate tax reforms, in a sense, regardless of what you

assume about the distribution, that you are raising the same

amount of corporate revenue in a more efficient manner, it is going

to be distributed the same way.

Senator BUNNING. Dr. Carroll?

Dr. CARROLL. Yes. The literature on the incidence of the corporate income taxes is very interesting. It has always been uncertain, as the other panelists have indicated. It dates back to kind

of a seminal piece in 1962 by Arnold Harberger that basically the

profession kind of reached the conclusion back in the 1960s that

the corporate income taxes are reasonably probably borne by owners of capital.

But interestingly, as early as the late 1980s, even Arnold

Harberger had come forward with some work suggesting that in an

open economy framework, in which we very much live today and

in an increasingly global open economy, the corporate income tax

is much more likely borne, in significant portion, by labor. He actually made the case that perhaps more than 100 percent of the corporate income tax could be borne by labor in the late 1980s and

in the 1990s.

What is particularly powerful is this more recent literature that

draws on the experience of corporate rate reductions among OECD

nations over the last 2 decades, and finds that those countries that

have lowered corporate tax rates the most have had the largest increase in manufacturing wages, which is highly suggestive of a

linkage between taxes and corporate taxes and wages, and suggestive of the notion that a significant portion of the corporate income

tax is borne by labor.

A researcher at the Congressional Budget Office put out a working paper a couple of years ago, in 2006, I believe, where, in a more

theoretical model, that paper kind of broadly suggested that a reasonable assumption might be that 70 percent of the corporate income tax is borne by labor.

The work at Treasury, which I could speak to to some extent, although I am no longer with Treasury, has also evolved. It used to

be very traditional for Treasury to produce distribution tables assuming that the owners, that the corporate income tax is borne by

owners of capital. When we did the work when I was there on the

President’s Tax Panel, we decided to supplement the traditional

analysis with a set of tables that included an alternative incidence

assumption that assumed that some of the corporate income tax is

borne by labor, really pretty much in recognition of some of the

more recent work in the academic world.

More recently in the ‘‘Competitiveness Report’’ issued in December, we had a more detailed analysis that assumed that a significant portion of the corporate income tax would be borne by labor.

I think it is fair to say that, as time goes on, the profession is

thinking that it is quite likely because labor tends to be a lot less

17

mobile internationally than capital, that a sizeable share of the corporate income tax is borne by labor.

After going through all that, why does this matter? It probably

does not matter a great deal when one is comparing a reform, a

revenue-neutral reform of the corporate income tax that involves a

base broadening and lower corporate tax rates, for example. But it

does make a difference when one is comparing a reform that replaces the corporate income tax with a value added tax. In that

type of proposal, it does make a difference. Some of the results in

that regard are reported in the Treasury’s December report.

Senator BUNNING. Thank you.

Senator BINGAMAN. Thank you.

Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman.

All of you have been excellent, and I have questions for each of

you.

In our Fair Flat Tax legislation, Congressman Emanuel and I

have put out a 1-page 1040 form. We sent it over as part of an article to the people at Money magazine, and they used our 1-page

1040 form and they filled their taxes out in, like, 15, 20 minutes.

Now, I am thinking of what people are going through now and

are going to go through until midnight, this mindless, relentless,

needless tax torture, where they are just shoveling their way out

from under this avalanche of forms.

I have a question about the simplicity issue, and I want to start

with you, Professor Shaviro, because I know you were involved in

the 1986 legislation.

Congressman Emanuel and I have been at this since 2005, and

people generally say, here are a couple of sharp guys, they have a

good proposal, but, you know, tax reform is just impossible. It cannot happen. In fact, Bill Bradley always reminds me that tax reform is absolutely impossible until 15 minutes before it actually

comes together.

So my first question to you is, given what a difficult task this is

in terms of building a bipartisan coalition, would it not make sense

to make the touchstone of reform, the starting-off point, simplicity?

To be able to tell people, look, we are going to go through a variety

of issues, but we are going to start by getting you out from under

this unbelievable hassle. I compared it yesterday on the floor to

prolonged root canal work. I mean, would it not make sense to

start with the simplicity issue? Question for you.

Professor SHAVIRO. I think that is a great place to start because

it is something that the public can see. So much of the root canal

that they are going through really is not necessary for any policy

goal. Whenever we talk about tax reform, it is very difficult politically. There are all these trade-offs. What about the social goals of

one proposal or another? So much of that can really be put aside

here.

Now, that said, I think you could have simplicity for individuals

as a leading edge, although, if it is not losing revenue, it probably

means some will pay more and some pay less.

But I think that it is also true that reforming business taxation

is very important, and that does become very painful. The public

does not see it, but it does have pay-offs in terms of economic effiVerDate 11-MAY-2000 14:16 May 25, 2010 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 56020.000 TIMD PsN: TIMD
18

ciency. It is controversial, if only because of the revenue-neutral

form. If it is not exactly the same as the law before, then inevitably

there are winners and losers. That is kind of less salient, it seems

to me, than the first. But they are kind of linked, and I think leading with the first is a very good idea.

Senator WYDEN. Thank you. I will come back to you in a minute.

Professor Graetz, you do such fine work on a variety of issues.

I just want to take up one issue that I do not think you and I have

talked about. You make a very valid point about how, well, you go

forward with tax reform, you ‘‘cleanse’’ the code, as I characterize

it, and then you say, but gosh, it is going to get dirty all over again.

Your proposal is that the progressive consumption tax is a way to

really make reform stick.

My question to you is, as I have looked at this, one of the areas

I have been interested in is saying that it is critically important,

when you get tax reform, to set in place a new set of procedures

so you cannot unravel the work of tax reform. I think there is a

lesson to be learned, for example, in what has been done on the

spending side with respect to earmarks. It is going to be tougher,

for example, to get earmarks in the days ahead.

So what would you think of the idea of, if you get tax reform—

and when you get it, if Congressman Emanuel and I have our

way—you say, it is going to be accompanied this time by a new set

of procedures that make it vastly tougher to go out and rifle-shot

all of these tax breaks in once more. As you know, we have had

16,000 tax changes since the last big reform. It comes to three for

every working day in the last 20-some years.

I want to make it tougher to do that again when we reform the

tax code. For example, you could say that any set of tax changes

would have to have a recorded vote, anything other than, say, technical changes. Would that be responsive, at least to some degree,

to your point of trying, when you cleanse the code, to actually keep

it from getting dirty again?

Professor GRAETZ. Senator Wyden, that is a terrific question. I

was involved in negotiations in the 1990 Budget Act, which created

procedures that I think, for at least a decade, kept the Federal

Government’s budget in closer balance. So, I am a believer that

procedures matter in these regards. Certainly putting in sunlight

and recording votes would help on what you describe as these rifleshot provisions. I think that that is correct.

But that is not the problem that I have been concerned with of

late, having watched the unraveling of the 1986 Act. I should say

the first thing I wrote on this subject was intended to be a defense

of the income tax and to call for a reform, much like the WydenEmanuel reform. I ended up where I did because of the proliferation of general interest provisions.

The education incentives are a perfect example. I was trying to

figure out my children’s education incentives. There are seven education incentives. There are two different credits; one covers room

and board and one does not cover room and board. You cannot

draw down out of an education savings account if you take one of

the credits. I have tried to teach this to Yale students: you cannot

possibly understand these provisions.

19

The reason is that everybody has a little different idea, but the

goal is not a narrow goal. The goal is to lower the cost of higher

education for a broad segment of the American people who have

faced rising higher education costs that are only second to rising

health care costs in the United States. So, there is a real problem.

There is a real need, and we have seven tax provisions to deal with

it. These were done in sunlight and subject to filibusters. You do

not need a reconciliation bill in order to get these things passed.

Everybody is for them.

The reason people are for them is that they then claim, well, we

have solved the problem of higher education. So my concern, which

I really have come around to, is that, if you keep the vast majority

of the American people within the income tax, a 1-page form or a

postcard form will soon begin to have a whole series of credits and

deductions and so forth that are not rifle-shot provisions, but are

designed to help people with real problems. I really think this is

not a solution, not an approach that has been working for the

American people.

Senator WYDEN. My time is up on this round. I want to say, I

want to explore this with you further because I think it is possible

to do both. I think it is possible to shed the sunlight on the costs

of unraveling the code and have a debate on the more general interest kinds of provisions.

Regrettably, that has not happened, even during the Clinton

years. I think we will all recall, Bill Clinton talked about reforming

the tax system because it had been a long time since 1986, and

then he went forward with exactly the kind of general interest provisions that you are talking about, the changes in the tax code. But

it really did not become part of a broader debate about what we

needed for individuals and businesses in our country, and I think

that could happen if we reformed the tax code and made the right

kinds of changes in our rules. We are seeing that happen with earmarks on the spending side. The spending side of the budget is

really starting to change. It is obviously not going to affect everything; it does not affect entitlements, but it is a start.

I am going to come back to you, Dr. Furman—you have done

great work over the years, and you Dr. Carroll, as well—when I get

a second round.

Senator BINGAMAN. Let me pick up one of the suggestions that

you made, Dr. Furman, the idea that we should eliminate deductions and go to credits. I think you said we should go to uniform

refundable credits.

Dr. FURMAN. It depends on the context. In some cases that is appropriate, in other cases it is not.

Senator BINGAMAN. Let me just ask some of the other panelists

if you agree that, as a general matter, it would be a good practice

for us to shift from deductions to credits. To the extent that we are

going to try to favor a particular activity, to the extent that we are

going to write these rifle shots into the tax code, would it make

sense to say that, as a general matter, we ought to do it by the enactment of credits rather than the enactment of deductions? Dr.

Carroll, do you have a point of view on that?

Dr. CARROLL. Yes. I guess I have always been intrigued by the

notion of replacing some of the deductions with credits. I would

20

point to really two areas. The housing tax subsidies in the code and

the health care area, as well as the employee exclusion for

employer-provided health insurance, are two areas where that approach might make sense. I would make two points. One, by converting those provisions to credits, it redirects and rechannels the

benefits that underlie those subsidies a great deal. So, if one wanted to maintain distributional balance in a broad proposal, one

would need to consider what to do.

As you reduce the benefits going to higher-income individuals,

when you convert those deductions into credits, do you then lower

tax rates for higher-income individuals, flattening the rate schedule, which would, in and of itself, provide some economic benefits

by removing or reducing the distortionary effect of taxes? So that

is one consideration: how does one think about distributional balance in that context?

But the other point is, I think, fundamentally, those provisions

are designed to increase home ownership and provide assistance to

those who are purchasing health care. In the current tax code, the

current tax treatment is such that the housing tax subsidies, in

large part, encourage individuals to buy larger homes and to basically have a higher degree of leverage when they purchase those

larger homes.

In today’s economic environment, we probably would not want to

suggest that that be curtailed. At a point in time when the housing

market was not in distress, it might be appropriate. In fact, when

you look at the housing market or if you turn the clock back 3, 4,

or 5 years to the early part of the decade, you could equally argue

that the tax bias and the business tax system for debt finance

might have amplified some of the distress in the business community during the last recession.

On the health care side, it is the same sort of thing, I think, that

the current tax provision, the current tax treatment, encourages individuals to purchase more generous policies, more generous health

insurance policies. The nature of the provision, the exclusion for

employer-provided health insurance, carries with it a number of biases. Reconfiguring that provision in the form of a credit would rechannel the benefits to lower-income individuals who are much

more likely to be uninsured, so it probably directs the benefits to

those who are in more need, and it probably would address a number of important distortions that are introduced from the current

tax treatment.

Senator BINGAMAN. Professor Graetz?

Professor GRAETZ. I think it depends on the specific question. For

example, I would be inclined to agree with both Dr. Furman and

Dr. Carroll on health care and home ownership, although there are

lots of dislocations on home ownership. On the other hand, the

charitable contribution deduction, I think, is very importantly a deduction and not a credit because I think the elasticity of giving is

much more important at the high income levels. I think it has

much more bang for the buck in terms of stimulating giving.

The point is, we do not want to tax an amount that has been diverted to charity as if it were consumed by, or income of the individual who gave it. The way to do that is through a deduction. I

would say the same thing about the current benefits for pensions,

21

IRAs, and 401(k)s. I think when you are eliminating barriers that

the income tax may create for a particular kind of activity, sometimes deductions make sense.

Accelerated depreciation would be another example that I think

would be better than the Investment Tax Credit in some circumstances, although probably a mix of the two is appropriate. But

I think in general, if you want something that goes to everybody

and you want it to go to people who pay no income taxes as well,

then a refundable tax credit is the way to deliver it, if you insist—

I am going to come back to my conversation with Senator Wyden—

on using the tax system as the way to do this.

Senator BINGAMAN. Good.

Senator Bunning?

Senator BUNNING. Thank you very much.

Professor Graetz, this is for you. I would like to ask you about

tax, trade, and exchange rates. As you pointed out, many foreign

governments are able to rebate taxes on their exports and impose

them on our imports. We cannot because of the structure of our

corporate income tax and the rules of the WTO. Some economists

say this lack of so-called border adjustment is not important because exchange rates will adjust.

But as you point out, that has not happened in the case of China.

Would you say that, as a result of China’s currency policies that

have kept the yuan between 30 percent and 40 percent undervalued, products imported from China are less burdened with tax

than domestic products produced here in America?

Professor GRAETZ. Senator Bunning, I think it is fair to say that

all economists—I have never met one who does not—agree that

currency exchanges will deal with the economic problem from taxing imports and exports, but they do assume that currencies adjust

freely. The point that I made in my testimony is that, when you

have a very big, bilateral relationship with a country like China

that is not allowing its exchange rate to float, then one must take

that point with a little skepticism. So, I come to it with a little

skepticism.

I want to say one other thing, though, about border adjustments.

I think they are extremely important in terms of the compliance

with a consumption tax. This was the judgment of the President’s

Panel. They did not dispute the currency adjustment point, but instead concluded, based on work by David Weisbach at the University of Chicago and others, that you need to have border adjustments in order to make a consumption tax work. Were we to get

out of line with the rest of the world and impose a consumption tax

on all production in the U.S. while other countries do not impose

a consumption tax on exports and impose it only on imports, it

would cause major problems of enforcement and compliance.

The final thing I would say is that I think politically, explaining

to an American businessman that U.S. tax on the full value of his

production in the U.S. is going to be imposed, but on the value of

imports, the U.S. would tax only the U.S. markup, would be difficult. An automobile, for example, made in the U.S. is going to pay

the full U.S. tax, but an import is only going to pay tax on the dealer mark-up. All economists in the world can tell that businessman

that the currency rates are going to make him just as well off, and

22

he would say, thank you very much, I would appreciate a border

adjustment, and I would rather tax the imports and exempt the exports.

So, I think this is a very important point for enforcement reasons, for political reasons, and because, in the real world, sometimes countries tinker with the value of their currency rather than

allowing it to float, as the economists assume. But the analysis is

simply mathematical. That is, it is not controversial among economists that, if exchange rates flow freely, that they would take care

of this problem. It just does not seem to me to answer the question

about border adjustments.

Senator BUNNING. Thank you very much.

Thank you, Mr. Chairman.

Senator BINGAMAN. Senator Kerry?

Senator KERRY. Thank you very much, Mr. Chairman.

Senator BINGAMAN. I am the closest thing we have to one right

now.

Senator KERRY. Well, we like you.

Senator BINGAMAN. Go ahead.

Senator KERRY. As Senator Wyden said to me, ‘‘The inmates are

running the institution.’’ [Laughter.] Here we are.

Thank you for being here, everybody. This is a big topic, one that

we have revisited so many times. Senator Bingaman and I were

here during the great 1986 tax simplification. I remember Russell

Long pointing the tax gun at the real estate industry, with a lot

of warnings from others, that it would create a crisis. Indeed, we

saw the savings and loan outgrowth from that. We have gone

through various permutations since then.

I can remember voting for Ronald Reagan’s tax simplification—

I think it was rates of 28 percent and 15 percent, if I recall—which

we quickly had to revamp and put a firm rate into because it just

did not work, and then that went up to 39.6 percent, whatever,

from where we had been.

But the thing that confounds everybody—obviously I am sure you

have heard some of this today—is that in 1940, the 1040 tax instructions were about 4 pages long, and now there are a hundred

pages of instructions just for the 1040, and thousands and thousands of pages for different specialized deductions and so forth.

Most Americans agree that this system is insulting to them and

to a sense of equity, fairness. So there seems to be a consensus

gathering that we need ‘‘tax reform.’’ There is not a consensus,

however, about what that means, so this is a worthwhile discussion.

Let me ask you, all of you, if you would sort of comment as a

framework, perhaps. Generally speaking, when we are talking big,

broad swaths of tax reform, we sort of say, well, would it not be

great if we just made the system fair, had three, four simple rates,

everybody understands what they are, get rid of all these deductions except for, and then you get into the critical sort of, lowincome housing credit, charitable mortgage deduction, a few of

those.

Are there some inviolable deductions that really do matter in

terms of the economy and how money, capital behaves, or are they

23

just inviolable politically, or both, perhaps? That is a powerful combination. If so, what are they? That is what I want to say.

Dr. Carroll?

Dr. CARROLL. Sure. I think that is a very interesting and terrific

way to kind of ask us to frame the issue. Yes. I think it depends

on which provisions one is talking about. I think that some of the

provisions are politically very difficult to tackle. The home mortgage deduction would be a very, very obvious example. When I was

at Treasury after the Tax Panel report was released, we probably

got more letters on the home mortgage proposal that the Tax Panel

had put forward in some of their recommended options than any

other, followed by, perhaps, some of the life insurance provisions.

So, I think it very much depends on which provisions one is talking

about.

I think one way to approach it, to really frame the current tax

reform discussion and put it into historical context is, back in 1986

we were starting from a point where rates were fairly high. We had

rates at 70 percent prior to 1981, and we had the top rate on the

individual side at 50 percent prior to 1986. Then the task was, how

much lower could we get the rate? There was a lot of room to

broaden the base and lower rates.

But now we are in a world where the rates are not at those levels. Today the top rate is, of course, 35 percent, soon to go up, perhaps, to 39.6, but not nearly at the level. So in terms of trying to

bring the rates down and broaden the base, it is very hard to do

that. I think some of the proposals that have come forward in the

last several years kind of make that point in the structure of the

proposals. The top rates in a lot of the proposals we have seen remain not that very different from the 35 percent rate in place, the

top rate in place today.

Senator KERRY. But you have to look behind the rate, do you

not?

Dr. CARROLL. Yes.

Senator KERRY. As Warren Buffet has said. Warren Buffet has

challenged any CEO in America who can show him that they are

paying an effective tax rate that is higher than their secretary,

that he will give them a million dollars. Nobody has collected.

Dr. CARROLL. Right. So then I think the next point to make is

that it does matter a great deal whether certain types of income

are subject to much lower rates. In my written testimony I make

the point that one of the fundamental choices in tax reform is

whether you are trying to move towards an income tax base or

move towards a consumption tax base, recognizing that today we

are starting with a hybrid income consumption tax base where a

great deal of the return to savings and investment—perhaps much

higher than people think—already receives consumption tax treatment, where the return to savings and investment is not taxed; 35

percent of a household’s financial assets already receive that type

of treatment in the form of IRAs, 401(k)s, and defined benefit

plans.

Senator KERRY. But you have not gotten to the question of, can

you throw the rest of that out and just narrow it down, and are

there a group of inviolate deductions.

24

Dr. CARROLL. Well, I think one of the key choices is not so much,

how low are the overall rates, but at what rate do you want to tax

the return to savings and investment, with the notion that the tax

and the return to savings and investment is particularly important

to capital formation, labor productivity, and living standards in the

long run? And it is also related to an earlier discussion we had on

kind of the incidence of capital income taxes and who ultimately

bears those.

Senator KERRY. Dr. Furman?

Dr. FURMAN. Yes. I think, Senator, some of this is a question of

how you do it, not whether you do it. So, for example, it would be

terrible if we did not have anything in our fiscal system that encouraged people to have health insurance, in fact, to encourage everyone to have health insurance. You could do that outside the tax

system or you could do that inside the tax system. If you did it

within the tax system, you would want to do it very differently

than what you are doing today. I talked in my testimony about a

refundable progressive tax credit to replace the tax exclusion. Similarly, on savings we have about $200 billion a year of tax incentives to encourage people to save. A large fraction of that money

is spent as a windfall on people who would have saved anyway.

Very little of that money goes to low- and moderate-income families

whose savings decisions might really be affected if they had an incentive to save more. Since those were put in place, the personal

savings rate has plummeted and is, today, about zero. So again, I

think we need to do something to encourage retirement savings. I

think, in the absence of government policy, people would save too

little and be unprepared for their retirement.

I think the way that we do it right now, though, is highly inefficient. Again, we could solve that in the tax code by making it more

of a credit, taking the saver’s credit and making it refundable, reforming the existing deduction, or we could solve it outside of the

tax code. But I think to some degree it is, what goals do you want

to accomplish and what are the best ways to accomplish them, is

the way I would ask the question.

Senator KERRY. Anybody else want to add anything?

Professor GRAETZ. I would just add that I agree with what has

been said. I should say at the outset that a lot of these provisions

can be consolidated and revised to be more effective. Certainly you

need a substitute if you are going to get rid of the retirement savings or health care proposals in the code. I tend to think the home

mortgage provisions are more political than they are substantive,

but I will not linger over that one.

I would just like to talk about the charitable deduction for a moment. I have to say, I really feel that it would be a big mistake to

try and do the charitable deduction in some other way. I think it

would substantially change the system for providing money to

charity, even though the current system favors the charities of

high-income people versus the charities of middle-income people,

because the deduction is worth more to them. I think it stimulates

charitable giving.

It also has important aspects for particular kinds of charities

that would not otherwise receive as much money. Much of the giving that goes on by both high-, middle-, and lower-income people

25

would go on anyway, which is not to say that the charitable deduction could not be improved by a floor, for example, or by reforming

it in terms of the way it deals with appreciated property or other

things. But that is one that I would add to the list. I think this

is a very good way to think about these questions.

If you also ask, can we do this outside of the tax code or must

we do it inside of the tax code, I, Senator Kerry, have been emphasizing the education provisions. The education provisions that came

in in the 1990s are the largest amount of expenditure of the Federal Government on education since the GI bill. If you ask yourself,

which one of the two worked and which one of the two has worked

a lot less well, doing a lot of these things through the tax system

is simply not the best way to do it.

Senator KERRY. I know my time is up, but I have one more question. Is it possible——

Senator BINGAMAN. I think, Professor Shaviro, you are anxious

to add something.

Professor SHAVIRO. I was just going to say that, suppose we had

always had a broad-based income or consumption tax without all

these things. I think there is little doubt that, in many respects,

we would have been fine. So the issues are really politics, and also

transition, in the sense that, for example, if one yanked out the

home mortgage interest deduction overnight, obviously it does not

take a lot of imagination to see how that would be a bad problem.

But I would say, though, most of these things we really do not

need. It is just a question of how fast, how stably one could get rid

of them. But honestly, the health care situation in the U.S., as is

well known, is a huge pending crisis which has huge fiscal implications. So, without judging doing it through the tax system, that is

how we do it now and that is something that has to be addressed.

Senator BINGAMAN. Senator Wyden, were you waiting to ask another question?

Senator WYDEN. I was. But if Senator Kerry has one——

Senator BINGAMAN. All right. Go ahead, Senator Kerry, with

your question. Go ahead.

Senator KERRY. Thanks, Mr. Chairman. I appreciate it, and I

thank you, Ron.

The other question I would like to ask—I mean, there are obviously hundreds of questions and we could spend a long time going

through this. But just within the framework of this morning, I

would like to ask you this. I heard mentioned a moment ago when

I first came in this discussion of what happens abroad in other

countries. I have been concerned about this for some period of time.

I began to focus maybe 15 years ago on this offshore game that

gets played—the Cayman Islands, the brass plates. We have seen

it most recently with KBR, that used that as away to not pay Social Security, Medicare, and so forth.

But in effect, the globalization that has taken place in the last

20 years dramatically changes the competitive playing field. If I

were managing capital of large amounts or running a business, I

would have to sit here and take into account return on investment

and the best means of being competitive. You have to sit there and

figure out how, as a country, we are going to be able to best position ourselves.

26

We have never done that sufficiently, it seems to me, in how we

figure out our tax code. I am wondering to what degree now we

really have to do that. Some countries do not even collect taxes.

You can go to some European countries and they do a pathetic job

of actually holding people accountable, all kinds of games are

played. We all know the Bank of England, Jersey, Guernsey, the

offshore islands, and Channel Islands, you used to have Hong

Kong, and then you have all kinds of attractive entities for people

to hide money and avoid their responsibility, in a sense, corporate

citizenship. They can avoid responsibility and go offshore, and it

leaves the average American holding the bag.

When you add that to the discrepancy that has occurred in income—in the 1980s, 10 percent of America’s income went to the top

1 percent of income earners; in the 1990s, it was 16 percent; in

2005, it was 22 percent of America’s income that goes to the top

1 percent, the same people. So there is what the New York Times

has called the ‘‘New Gilded Age.’’ We see how hard it is now on the

average worker in America, and people struggling, the middle

class, and you have this competitive picture that is obviously a big

piece of this. But does that change how we need to think about our

tax code and how we need to go about tax reform?

Dr. FURMAN. I think if you look at our international tax system,

and by a lot of estimates it essentially loses money, so you could

eliminate taxes on all foreign operations of corporations. Do not let

the company take the deductions associated with those overseas operations, and they would end up paying more taxes than they are

paying today.

What I think is inefficient, and what I talked about in my testimony, is a lot of the lack of neutrality in the tax system. So, being

taxed on an overseas operation, you are paying much lower taxes

than you are paying in the United States. Because of these changes

in the global economy you alluded to, I think it would be important

to neutralize those taxes so we could lower taxes here and raise

taxes on the overseas operations of U.S. businesses.

I do not think the tax code should be encouraging you to go overseas. I do not think it should be discouraging you from going overseas either. I think it should be making it so that, as a business,

you can make decisions for purely economic reasons and not spend

all of your time thinking about this tax shelter in the Caymen Islands, or this way of locating your real investment or your financial

transactions overseas. I think if we did that, we could have lower

tax rates as part of the package that moved us towards a more

neutral tax system, one that you have obviously talked about a lot

in the past.

Professor SHAVIRO. I want to mention a bit of what I would call

low-hanging fruit that distracts from some of these tough choices

between, for example, a worldwide system where U.S. companies

are taxed at full U.S. rates on outbound investment and an exemption system. That is, we have a system of deferral now that results

in lots of inefficiency and in lots and lots of tax planning relative

to the revenue raised.

Some economists, Rosanne Altshuler and Harry Grubert, have

written about what they call a burden-neutral repeal of deferral,

that basically you repeal deferral but you lower the rates so that

27

basically the revenues and the burdens are the same as they were

before. Now, that might not be the ideal system because there are

arguments making it either higher or lower, but compared to what

we have now, by wiping out all the games associated with deferral,

it almost seems like a no-brainer.

Now, when I say it is easy, or low-hanging fruit, obviously if it

is burden-neutral or revenue-neutral, some companies are going to

win and some companies are going to lose, and I rather guess the

ones who will lose might have something to say about it. But from

a policy standpoint, it is a pretty easy call, I would say.

Professor GRAETZ. Senator Kerry, I guess I want to disagree. We

have been largely in agreement. I want to agree with the thrust

of your question and disagree with some of my panelists here. I

think that the investment flows in and out of the United States are

now 5 times—more than 5 times—greater than they were in 1986

when we dealt with tax reform by increasing taxes on corporations

and using it to fund individual income tax relief.

I think that we are at a point now where our domestic tax policy

and our international tax policy absolutely have to be thought of

together. I think that individuals are different from companies

when we think about this.

I think with individuals there may be ways to create entities and

put money offshore that is very difficult for us to collect, but there

may be ways, through information sharing and other multilateral

opportunities, to know where the money is and to tax it to people

who are living in the United States.

I think the corporate tax is really different than it was earlier

because you can create ‘‘tax people’’ by just incorporating new companies. To the extent that other countries in the world provide benefits for their companies to go overseas and build power plants in

China, or whatever example you want to use, we have to think

about what kind of system we want.

I do not believe that we can assume we are going to collect the

money by going down the road, saying, ‘‘Are we going to tax these

foreign operations the same as domestic operations?’’ Those operations will be conducted, but they will be conducted in a manner

where the company on top is not located in the United States.

The combination of technological changes—which I think, in fact,

are more important to the inequality point that you made earlier

than globalization—in combination, the technological changes and

globalization allow you to move money around at the drop of a hat,

to create entities at the drop of a hat, to stack them and devise

them in all sorts of ways, to create novel financial instruments that

we had not even thought of in 1986 as a way to game the rules

about source, that is, our source rules which say an interest is

sourced this way, and other expenditures are sourced that way.

Well, all I have to do is change the financial instrument and it is

no longer interest, it is something else.

I have concluded—and I have written a lot about international

income taxation down in the weeds of these provisions—but I have

concluded that the internationalization of the economy and the

question that you are raising really do make it important for us to

have a low statutory corporate tax rate so that companies do not

28

have the incentive, for example, to locate interest deductions here

and income in Ireland where the rate is 12.5 percent.

All that requires them to do is to borrow here instead of there.

The transfer pricing problem, which the IRS is devoting huge resources to, where related companies are jiggering the prices so that

the profits are moved around to the lowest tax entity, are problems

that we are not even beginning to solve.

I know the Joint Committee staff is beginning to study this question as well. These problems operate in the current environment to

the great disadvantage of the U.S. because of our high rate and

other countries’ low rates. What we really need to do is to create

a system where there are not those incentives. Now, the question

of where we find the revenue for that, and so forth, is a very difficult question. These issues are extremely difficult.

But I have to say, I am very concerned about the idea that a U.S.

company investing abroad is somehow substituting that investment

for an investment that it would make in the United States. That

was the view in 1963 when President Kennedy proposed a whole

series of international tax reforms. There is a lot of evidence—but

I am not saying that I am clear about it, I do not know the answer—that investment abroad and investment domestically are

complementary.

If you talk to the head of Caterpillar, for example, which is a

very successful exporter—and exports are driving the U.S. economy

at the moment—he will tell you that they have to be abroad, they

have to be in markets in order to produce the jobs here. I think

that it is a difficult question, when you want to credit that and

when you do not want to credit that. But I would be very cautious

about assuming that a dollar invested abroad is necessarily a problem for U.S. workers. Sometimes it is, but not always.

Senator KERRY. Thanks, Mr. Chairman.

Senator BINGAMAN. Sure. Senator Wyden?

Senator KERRY. Thank you, Senator Wyden.

Senator WYDEN. Thank you, Mr. Chairman.

Dr. Furman, I want to ask you a different question about the

1986 law. I think all of you know, over the last 3 years I have

asked all of the panelists who come before the Finance Committee

whether they essentially like the frame of the 1986 law, which was

to clean out the special interest breaks, broaden the tax base, and

hold rates down, in effect, while guaranteeing progressivity.

But today, since virtually everyone who has come before the Finance Committee has said yes, that those principles of 1986 do

make sense, I want to ask you a little bit of a different question,

Dr. Furman. That is, given this period where all the surveys indicate that there is this economic pessimism that has really set in

in our country, would an additional benefit of this kind of an approach that Congressman Emanuel and I are talking about not be

that it would give everybody an opportunity to get ahead?

In other words, it moves us away from what Senator Kerry has

been touching on in the debate about Warren Buffet and his secretary, and it allows everybody to say, we are going to have some

incentives to get ahead, and that that kind of attitude could well

help address the economic pessimism that we are seeing today.

29

Dr. FURMAN. First, I will say, allow me to put myself on the

record with the answer of yes to the first question that you did

not——

Senator WYDEN. I think you did it once before. But let the record

show, Mr. Chairman, I think I have now asked 17 witnesses who

have come before the Finance Committee over the last few years,

when Senator Baucus and Senator Grassley have been holding the

chair, whether they think the basic frame of 1986 is sound. Starting with Connie Mack and John Burr, they have all said yes. I am

happy to have a good, resounding ‘‘yes’’ from Dr. Furman as well.

Dr. FURMAN. As intelligent as a tax reform is, we could not design one under which, for example, everyone paid lower taxes but

we would collectively collect more revenue. So, there are certain

things that a tax reform cannot accomplish. But what it can accomplish is, for example, everyone has an easier time filing their taxes

than they have today, where everyone faces a set of incentives

around decisions they make related to going to college, saving for

retirement, buying health insurance that are more efficient and

less distorted than the incentives that they face today.

Finally, I think most importantly, a tax code that gives people

more confidence in their government and in their fiscal system as

a whole and just leaves them less frustrated, which I think is intangible but quite important, and tax reforms like yours, I think,

would accomplish a lot of those goals.

Senator WYDEN. I may have one additional question for you on

health care in a minute.

But Dr. Carroll, I want to ask you a question about what happened in 1986. I have really gotten the sense that in 1986, President Reagan and Bill Bradley—and there were others obviously involved—made the judgment that marginal rates are hugely important in terms of how people look at investment, but they also made

the judgment that preferences, by and large, were not. Preferences

were not such a big deal. That was really the cement for moving

to clean out a lot of the special interest breaks and all the stuff

that has mucked up the tax code over the years.

I still like that philosophy. I still subscribe to that, that marginal

rates, with the rate you pay for the last dollar you have earned,

that is a huge deal. The preferences, most of them, really are not.

Do you subscribe to that theory?

Dr. CARROLL. Generally I do subscribe to that. I think, as I mentioned earlier, one very big difference between the world of 1986

and the world today is that the starting off point in terms of how

high the rate was when we started was much higher, at 50 percent,

than it is at 35 percent now. The economic costs of high rates rises

disproportionately with the tax rate. Starting off with lower rates

means the economic cost today is not quite as great as it was back

in 1986 when we were considering those reforms.

Then the other point I would make is, I think a great deal of emphasis does need to be given to, what is the tax rate on the return

to savings and investment? I think there is a fair amount of evidence that suggests that that is important to capital formation and

that capital formation is important to labor productivity and rising

living standards in the long run.

30

It is also very important, as a number of the panelists have mentioned and a lot of the questions have forced us to consider, to

think about tax reform in an international context, where capital

can flow freely across borders, and the reduction in tax rates

abroad on the return to savings and investment through greater reliance on consumption taxes or lower corporate tax rates is another

important consideration.

Senator WYDEN. Dr. Furman, let me wrap up with you with a

question on the cap side of the health care debate. We now, in the

Healthy Americans Act, have 14 Senators sponsoring it, 7 Democrats, 7 Republicans. It is the first time in the history of the Senate

where there has been that kind of bipartisan support. Right at the

heart of it, in our view, is this question of the tax code and health

care. It really strikes me that you do not see anybody out on the

street driving a car from 1948, and yet in 2008 the employer-based

system is not all that different than what we had 60 years ago.

We want to give employers who choose to the opportunity to keep

offering it, but we do want to modernize the system. We want to

modernize the employer-employee relationship to hold down the

costs for the employer and to give the worker a more portable product, something that workers can take from job, to job, to job.

How important do you think it is to the American economy to

make reforms in the tax code as it relates to health care? I like the

way you put it, a question of making it more neutral. That strikes

me as beneficial. But it also strikes me as extremely important

that, for the first time, particularly for 153 million people who get

their health care through their employer, that people actually know

what is being spent in their name and have more options. How important do you think it is to make changes in the tax code as it

relates to health care?

Dr. FURMAN. It is interesting. One of the traditional topics in tax

reform has been the debate between a consumption tax and an income tax, and there have been thousands of papers written on the

topic. If you look at the quantitative estimates of how much of

what economists call ‘‘dead-weight loss’’ there is associated with

that choice, it actually is probably smaller than the dead-weight

loss associated with the problems caused by the current tax treatment of health care.

In other words, quantifying it in a traditional economic way,

there would be more gains to reforming the tax treatment of health

care, because you are leveraging up the way in which essentially

16 percent—17 percent this year, actually—of the economy is conducted, than all the other traditional concerns of tax policy. Whether or not that comparison is exactly right, it is certainly the case

that this is a very important area.

Senator WYDEN. I like your drift.

Dr. FURMAN. And it is an area that does not require us to necessarily raise taxes or raise revenue on net if we are willing to use

the resources that we are already putting into the system today,

just putting it in in a way that no one really designed or intended

to do. That is the way I think that we should be reforming the

health system, and something that is done in your legislation.

Senator WYDEN. I thank you for it. It is striking, because until

Senator Bennett and I really got into it, we did not even see the

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enormity of the resources. We had a briefing recently. It is usually

said that something like $200 billion on the health care side

amounts to revenue foregone. We just got a briefing where some

experts said they thought it was quite a bit larger than that. So

what you have is a system that is essentially 60 years old, rewards

inefficiency, rewards regressivity, and virtually nobody in the country knows anything about it.

When I am out talking about it, people sort of look at me blankly

when I mention the tax code and health care. Usually when I say

something like, well, the reality is that the top-line CEO can go out

and get a designer smile put on their face and write off the cost

of it on their taxes, and a hardworking woman in a local furniture

store who does not have a plan gets nothing but essentially the

right to subsidize Mr. High Flyer.

So if the four of you—and I noted the comments were made

about the health care portions of the tax code by several of you—

will help us weigh in loud and clear on this, this is a chance, in

my view, for Democrats and Republicans to come together. This is

something that I think will meld together Democratic philosophy of

covering more people and getting everybody decent, affordable

health care, with Republican theories about markets and incentives.

So this has been a terrific panel. I am looking forward to seeing

you four a lot as we tackle tax reform with Chairman Baucus and

Senator Grassley’s leadership. I am pretty partial to the current

Chairman today, too.

So, thanks for all the extra time, Mr. Chairman.

Senator BINGAMAN. Thank you all. I think it has been useful testimony. We will undoubtedly be calling on you as we proceed

through the rest of the year.

Thank you very much.

[Whereupon, at 11:51 a.m., the hearing was concluded.]

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