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95–053 PDF 2004

THE U.S. TAX CODE’S IMPACT ON REVENUE

PROJECTIONS AND THE FEDERAL BUDGET

HEARING

BEFORE THE

COMMITTEE ON THE BUDGET 

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

HEARING HELD IN WASHINGTON, DC, JULY 22, 2004

Serial No. 108–23

Printed for the use of the Committee on the Budget

(

Available on the Internet: http://www.access.gpo.gov/congress/house/house04.html 

(II)

COMMITTEE ON THE BUDGET 

JIM NUSSLE, Iowa, Chairman 

CHRISTOPHER SHAYS, Connecticut, 

Vice Chairman 

GIL GUTKNECHT, Minnesota 

MAC THORNBERRY, Texas 

JIM RYUN, Kansas 

PAT TOOMEY, Pennsylvania 

DOC HASTINGS, Washington 

ROB PORTMAN, Ohio 

EDWARD SCHROCK, Virginia 

HENRY E. BROWN, JR., South Carolina 

ANDER CRENSHAW, Florida 

ADAM PUTNAM, Florida 

ROGER WICKER, Mississippi 

KENNY HULSHOF, Missouri 

THOMAS G. TANCREDO, Colorado 

DAVID VITTER, Louisiana 

JO BONNER, Alabama 

TRENT FRANKS, Arizona 

SCOTT GARRETT, New Jersey 

J. GRESHAM BARRETT, South Carolina 

THADDEUS MCCOTTER, Michigan 

MARIO DIAZ–BALART, Florida 

JEB HENSARLING, Texas 

GINNY BROWN–WAITE, Florida 

JOHN M. SPRATT, JR., South Carolina, 

Ranking Minority Member 

JAMES P. MORAN, Virginia 

DARLENE HOOLEY, Oregon 

TAMMY BALDWIN, Wisconsin 

DENNIS MOORE, Kansas 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

ROSA DELAURO, Connecticut 

CHET EDWARDS, Texas 

ROBERT C. SCOTT, Virginia 

HAROLD FORD, Tennessee 

LOIS CAPPS, California 

MIKE THOMPSON, California 

BRIAN BAIRD, Washington 

JIM COOPER, Tennessee 

RAHM EMANUEL, Illinois 

ARTUR DAVIS, Alabama 

DENISE MAJETTE, Georgia 

RON KIND, Wisconsin 

PROFESSIONAL STAFF

RICH MEADE, Chief of Staff 

THOMAS S. KAHN, Minority Staff Director and Chief Counsel 

(III)

C O N T E N T S

Page 

Hearing held in Washington, DC, July 22, 2004 .................................................. 1

Statement of: 

Douglas Holz-Eakin, Director, Congressional Budget Office ........................ 6

Pamela F. Olson, partner, Skadden, Arps, Slate, Meagher & Flom, LLP, 

Former Assistant Secretary of the Treasury for Tax Policy ...................... 36

Peter R. Merrill, Ph.D., Director, National Economic Consulting Group, 

PriceWaterhouseCoopers LLP ...................................................................... 42

William G. Gale, Ph.D., Senior Fellow, the Brookings Institution ............... 52

Prepared statement: 

Mr. Holtz-Eakin ................................................................................................ 9

Ms. Olson .......................................................................................................... 39

Mr. Merrill ........................................................................................................ 45

Mr. Gale ............................................................................................................ 55

(1)

THE U.S. TAX CODE’S IMPACT ON REVENUE 

PROJECTIONS AND THE FEDERAL BUDGET 

THURSDAY, JULY 22, 2004

HOUSE OF REPRESENTATIVES, 

COMMITTEE ON THE BUDGET, 

Washington, DC. 

The committee met, pursuant to call, at 10 a.m. in room 210, 

Cannon House Office Building, Hon. Jim Nussle (chairman of the 

committee) presiding. 

Members present: Representatives Nussle, Brown, Garrett, Barrett, Diaz-Balart, Spratt, Moore, Scott, Capps, Thompson, Baird, 

Cooper, and Emanuel. 

Chairman NUSSLE. Good morning. Welcome, everybody, to today’s Budget Committee hearing regarding the impact of our current Tax Code on Federal revenue projections and the Federal 

budget. We are very pleased to have back before us as our first witness the Congressional Budget Office Director Holtz-Eakin. 

Dr. Holtz-Eakin, thank you again for being part of our Budget 

Committee hearing. Thank you and thank your staff for the good 

work that you do. We really do appreciate all of the good work 

throughout the year that the Congressional Budget Office does on 

our behalf. We appreciate that. We want to make sure your folks 

back at CBO know that as well. 

I would also like to welcome our second panel witness Pam Olson 

who will be here, who is former Secretary of the Treasury for Tax 

Policy; Dr. Peter Merrill, who is the director of the National Economic Consulting Group at PriceWaterhouseCoopers; and William 

Gale, a senior fellow at the Brookings Institute. 

I will begin today with a brief overview of why the many problems and complexities of our current Tax Code are of particular 

concern to the Budget Committee and why we think it is critical 

to begin the discussion now. The first is, I guess, simply that the 

budget process and the Tax Code are inextricably linked. We collect 

Federal taxes to pay for Federal spending. The way I describe it 

to constituents back home is it is a bill. We do a lot of things out 

here in the Federal Government, and we present a bill to people 

for those services. Spending drives the process typically, so we need 

to know if we are consistently spending more than we are taking 

in and, if so, to what extent we are spending beyond our means, 

as well as what are we taking in in revenue and taxes in order to 

meet those obligations, and if the Code, the Tax Code, and the revenue is producing the revenue we need in order to meet those obligations. 

2

In short, receiving reliable revenue data is one of the most basic, 

essential parts of the budgeting process. So for this committee to 

put together a reasonable budget, it is critical that the Tax Code 

allow for reasonable estimates of revenue. 

What we have heard consistently over the years is just that 

statement: It is critical that the Tax Code allow for reasonable estimates of revenue. We get very frustrated, and I will be the first 

to admit that I am one of them who gets frustrated, with our analysts for the projections. But if they have an underperforming, or 

a nonperforming, or a very difficult to gauge any performance when 

it comes to a Tax Code, we are actually blaming the wrong—we are 

blaming the messenger and shooting the messenger as opposed to 

looking at the root cause. 

In all fairness, estimating revenue is notoriously difficult for 

many reasons, but it is made even more difficult with all the wrinkles and complexities that the Congresses have added over the decades. And I know Mr. Scott will want to mention that as well. And 

I would certainly be interested, as he would, in how many of those 

pages have been added since Republicans took control, Democrats 

took control. We could have a good conversation about that. 

The fact of the matter is over on that table is not even the whole 

story. We couldn’t get the whole story here of what you need to 

know if you really want to be in complete compliance with the Tax 

Code. Just to give you an idea, there are stacks of 22 volumes that 

make up the IRS Code. That is the brown books, kind of in dead 

center over there, is the IRS Tax Code. Then you have 20 volumes 

of Treasury regulations that are supposed to fill in the gap, so to 

speak, because apparently 22 volumes are not enough to explain 

everything. 

We wanted to bring in the judicial rulings of the Tax Code that 

are supposed to explain all the other stuff when taxpayers and the 

IRS actually disagree and go to court over it, but they fill up a 

whole wall at the Library of Congress. So we brought there a couple of volumes just to kind of identify them if you ever want to go 

over to the wall in the Library of Congress and look them up. We 

couldn’t really find a truck big enough to get them all over here. 

On top of that, there are thousands of pieces of what you call administrative guidance that are issued by the IRS, with more coming out probably on a daily basis. These are revenue rulings, revenue procedures, notices, announcements, private letter rulings, 

technical advice memoranda, but, of course, we did not have a 

hearing room big enough to hold all of those. 

Suffice it to say it is very complicated. It is voluminous. And that 

is in part why we have a problem. It is this complexity and it is 

the level of fairness in transparency that makes this very difficult. 

I will be the first to admit, Mr. Scott, and anybody else, that 

every time we talk about simplification, unfortunately we add 

pages. And getting to the root cause of that problem, whether it is 

Republicans or Democrats, is something we do have to come to 

grips with. We are not here to blame anybody, and I hope that 

we—certainly if that is what Members want to do. I think what we 

want to do today is learn about how to do a better job, whether it 

is Congress or forecasters or whoever it is, do a better job of getting 

3

the information we need in order to make decisions. That is what 

today and today’s hearing is about. 

You have heard me complain about this before. I have heard 

other Members suggest that we talk about what we can do in Congress to get our arms around this so that we have better revenue 

data to make our decision. 

Secondly, and probably more important, is the problems of the 

Tax Code are really not new, and it is pretty much always a reasonable time to talk about the problems, specific problems, within 

the Tax Code. So why is this important right now? Well, I think 

we have a window of opportunity that Mr. Spratt talks about all 

the time and other Members are quick to remind everybody about. 

There are several major factors that will be coming to a head over 

the next few years, including retirement of the baby boomers, expiring tax provisions, and, of course, the individual alternative 

minimum tax, or AMT. 

As circumstances have dictated, we have almost taken on the 

whole—we have also taken on a whole host of large, relatively new 

demands on our budget over the past years, such as greatly increasing homeland security and defense spending, and, of course, 

we are also resolved to continue our commitment to long-standing 

domestic priorities, education, health care, environment, veterans 

benefits just to name, obviously, only a few. 

None of these demands are going away right away or any time 

soon, and appropriately so. To add to all of this is the fact that we 

currently have a budget deficit, again not news to anyone, which 

has incurred in response to extraordinary sets of challenges, everything from obviously homeland security and national defense to 

economic downturn and, yes, purposefully reducing taxes in order 

to jump-start the economy, which has occurred finally. 

To figure out how we are going to begin to address these problems, we need to have some sort of reasonable guide as to just 

what our revenue potential is. We need to know not just how to 

control spending, but by how much, just how big of a problem that 

is. 

Again, I want to make it clear that the intent of this hearing is 

not to try and rewrite the Tax Code—even attempt to fix, for that 

matter, anything today—but to actually learn some of the problems. 

Well, if you want to fix something today, Mike, we can do that. 

I am happy to entertain fixes, too. But part of the problem we have 

got is so many Members just assume that there is a Tax Code, we 

ought to have good data about it so we can make our decisions. 

What we consistently hear from our analysts is it is pretty difficult 

to make determinations about our Tax Code because of its complexities. 

So there are great temptations to fix things piecemeal. We have 

tried to do that in the past. They really haven’t worked. We have 

changed one part, and, however well-intentioned, it has had impact 

on other parts. It makes, obviously, the decisions of making the 

revenues and projecting revenues even more complicated. 

Finally, I know we are in the season, I know there is ample opportunity for partisan bickering, and we can do that, but I really 

did want to have an opportunity to invite some experts in here to 

4

learn what we can do from a more objective standpoint; not one 

particular tax cut or another or tax increase or another or tax provision or another, what can we truly do in order to make our revenue projections better regardless of what party is in control or 

what tax provision is being proposed. 

So I don’t want to waste this opportunity, and I do want to give 

Members the opportunity to learn today. 

So with that, I turn it over to Mr. Spratt for any comments he 

would like to make. Then we will hear from Dr. Holtz-Eakin. 

Mr. SPRATT. Thank you, Mr. Chairman and Dr. Holtz-Eakin. 

Thank you again for coming in. Thank you for your testimony this 

morning and the good work that CBO continually does. 

Mr. Chairman, I want to applaud you for holding this hearing because I think it is useful, and timely, and probably overdue. We 

have several issues, as I see it, that we should be pursuing this 

morning. The first you have already touched upon, and that is how 

do we make revenue projections more predictable? How do we get 

timely estimates of revenues that we can expect in the near term 

in order to base our budgets upon them? 

In this regard I think it is always a revelation to come on this 

committee or the Ways and Means Committee and find out how 

long it is before we have a handle on a break-out, breakdown of 

revenues coming in to the Internal Revenue Service, how much is 

capital gains, how much is payroll taxes, how much is income 

taxes, and to what extent are current revenues exceeding or lagging what we expected. Surely that ought to be something that all 

of the budget community in Washington is trying to do, and that 

is get a much, much better handle on timely revenue projections 

and break-outs. 

Secondly, with respect to reliability, I don’t think we should too 

quickly exonerate ourselves. When the Office of Management and 

Budget and the Congressional Budget Office both present us blue 

sky estimates that give rise to surplus projections of $5.6 trillion, 

sometimes a credulous Congress is all too willing to buy into those 

blue sky estimates and to make big budget decisions based upon 

them. 

We warned at the time that we shouldn’t bet the budget on these 

forecasts, these blue sky forecasts, and we also pointed to some elements in the recent past that—upon which these forecasts were 

based. For example, for 8 straight years in the 1990s, tax revenues 

grew at a faster rate than taxable incomes. Everybody knows that 

can’t go on forever. After 8 years it was about ready to peter out. 

Secondly, there was a phenomenal increase in capital gains taxes 

in the 1990s. Capital gains taxes grew over a period of 5 years, 

1995–2000, from about $40 billion to about $120 billion, and everyone knew that with the downturn in the stock market, that, too, 

was going to change. It was overdue when we got our estimates of 

the economy in 2001. 

That is one thing we need to keep in mind, that we bought into 

it, and we need to be wary ourselves and learn from this experience 

about betting the budget big time on revenue estimates and economic projections that may not obtain. 

Secondly, we are told now that the projected surplus of $5.6 trillion was wrong by as much as 55 to 60 percent due to economic 

5

factors and technical factors, and the larger of those two is technical factors. So the question we have to ask is are we refining our 

technical forecasting tools so that we don’t make those mistakes 

again? 

Third, we should always be asking, because we haven’t spent 

nearly enough time on all the ad hoc tax measures that we are taking up here, doing what we did in 1985 and 1986, and that is 

cleaning out the closet. We have got an enormous amount of tax 

expenditures, tax credits, tax conditions, tax preferences that have 

built up in the Code over the last 20 years. It is about time, past 

time, we went back to the Code and clean the Code out, had a good 

closet cleaning. 

In doing that we need to take care to do two things that most 

people don’t understand are really sort of at opposite ends of each 

other. One is make the Code more equitable. The other is make it 

more simple and efficient. The two are not necessarily achieved in 

the same manner. They are awfully hard to do. But that question 

ought to be always before us, how do we make it more equitable, 

and how do we make it more efficient. Finally, as the books over 

there attest, how do we make it simple so that the average American doesn’t get cynical about the Tax Code and say only the little 

guys pay taxes. 

There is one thing that we should be wary of as we start taking 

up revenues; that is, about our expectations for the near term. We 

have been told that our revenues are below historical levels and 

our budget is in deficit partly because of the economy, but looking 

at CBO’s analysis of a couple months ago, which indicated that the 

contribution of the economic cycle—economic cycle to our current 

revenue shortfall is really pretty small, it is about $25 billion in fiscal year 2004 and is actually expected to be negative in fiscal year 

2005; in other words, a problem right now in going forward with 

the—is not the economy, and the problem is likely to persist in the 

coming years. In terms used by CBO, revenues are down today and 

into the near-term future not because of economic factors, but because of technical factors. If I am wrong about that, I would appreciate you correcting me. 

In other words, it is probably not a revenue pot at the end of the 

rainbow that is going to resolve our problems. We will have to do 

it ourselves with tough decisions. And revenues based upon a pickup in the economy are not likely to bail out the budget problems 

that we have today. 

That is a full plate to talk about today, and, Mr. Director, we 

look forward to your testimony. I appreciate your participation. 

Chairman NUSSLE. Before we begin, let me also mention for our 

benefit that Tom Kahn is going to get married here August 1—he 

and his fiancee Suzy, we wish them all the very best. Now the date 

is set, and she is actually going through with it. 

We welcome you, Director Holtz-Eakin. Thank you so much for 

spending your time with us today. Pleased to receive your testimony. 

6

STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, 

CONGRESSIONAL BUDGET OFFICE 

Mr. HOLTZ-EAKIN. Thank you, Mr. Chairman and Mr. Spratt, 

members of the committee. We are pleased to have a chance to be 

here today. Let me add my congratulations as well, Tom. A man 

of your advanced age getting married is quite an accomplishment. 

I really do want to thank the chairman and the ranking member 

for their very kind remarks about the CBO staff, who, in my opinion, do a simply incredible job with very little public recognition, 

and to get a little bit of that is nice. I appreciate it. 

Before turning to my remarks, I would also like to encourage the 

chairman if he has to choose between blaming the messenger and 

shooting the messenger, we prefer blame. 

My goal today is to talk about the challenges that the current 

Tax Code presents for budget projections, particularly at the CBO, 

but I think that in doing so, it is useful to the discussion in the 

larger context of economic policy, decision-making, and then budgetary presentation and think about where the possibilities of tax 

reform fit in that mix. 

Stepping back, clearly the first and threshold decision being 

made by Congress is which programs to fund and at what scale, 

how much to spend on those different programs. That is the key 

economic policy decision that we discussed in testimony last year 

before this committee about the threshold costs presented in the 

Federal Government. 

From a budgetary perspective, it would be useful to have a clear 

presentation of those commitments—to know what commitments 

have been made on the part of the Congress to command resources 

from the private sector and make sure that those commitments are 

presented in a clear and transparent fashion to allow policymakers 

to undertake trade-offs in looking at the relative costs of different 

programs. 

We have worked with members of this committee for many years 

to look at some of the tougher and difficult issues in on- versus offbudget presentations and the presentation of economically equivalent, but apparently different, transactions—under, for example, 

the Credit Reform Act, which balanced the playing field between a 

direct loan and a loan guarantee—to make sure that the economically equivalent commitment of resources was reflected that way in 

the budget. And one could imagine even further discussions in that 

area on a wide variety of financial transactions or even such things 

as when a tax credit is really economically equivalent to a spending 

program on the part of Congress. Determining that would be a step 

forward in the presentation of that economic policy in a budgetary 

context. 

Step 2 in that, of course, is to finance those programs at the lowest possible overall social cost, which includes costs of administration of the Tax Code, costs by taxpayers in complying with the Tax 

Code, costs in unfairness of the Tax Code from the perspective of 

policymakers, and, most fundamentally, interference of the Tax 

Code with economic decisions that lead to distortions that lower the 

overall efficiency of the economy and represent economic waste. 

From that perspective it is useful to have a budgetary presentation that makes clear the kinds of resources that are being raised 

7

in the Tax Code to finance spending programs and the likely receipts that will come with them, and also, where important to Congress, who really pays for those tax resources. 

What is the state of affairs? We provided written testimony that 

focuses on three different pieces of the current Tax Code and the 

difficulties in budgetary presentation. The first is, looking forward 

over our budget window, the combination of sunsets, phase-ins, and 

then expiring provisions, and the difficulties that raises in budgetary projections; the second key aspect being the volatility of the 

tax base and decisions that have been made in the past and could 

be made in thinking about tax reform, about what would be in and 

not in the tax base; and then, finally, the differential taxation of 

economic activity across either different kinds of income or different kinds of activities, and also across individuals—which makes 

it more difficult to project the overall receipts that might come 

from the Tax Code as it is configured. 

Let me begin with a discussion of the sunsets, the phase-ins, and 

the various expiring provisions. And a key issue here is what the 

private sector believe about the future of the Tax Code. If it is the 

case that member of the private sector firmly believes the Tax Code 

as written in current law with expirations, for example, of tax rates 

on dividends and capital gains in 2008, the entire sunset in 2011, 

then they will undertake to shift their economic activities, whether 

in real terms by actually doing things in different years, or at least 

in reporting terms by reporting transactions, realizing capital 

gains, and doing a variety of other things in response to that perception. And that will make it far more difficult to anticipate the 

likely receipts from the Tax Code. 

On the other hand, it may be the case that the private sector 

doesn’t believe that at face value. That raises a very difficult question in doing our budget baseline projections. The budget law is 

very clear that we should take and apply on the spending and tax 

side current law as it is written. However, it would be desirable to 

have that baseline dictum consistent with the underlying economic 

forecast. 

One could imagine that the private sector believes that the Tax 

Code will evolve exactly as it is written, and, if so, we can construct 

an economic forecast based on that and then layer on top of it the 

current tax law to get the receipts that would likely come in. However, I think it is fair to say that is far from likely, that there are 

lots of at least pieces of the current sunsets and phase-ins and expiring provisions that the private sector doesn’t believe will go as 

planned. If we try to put in the economic forecast that builds in the 

private sector’s actual expectations, we will layer on top of it a 

budget law which is inconsistent with the underlying economic 

forecast. 

And to make it worse, it is really impossible to say exactly what 

the private sector expects. So we are faced with a dilemma in simply constructing the baselines in the current environment. We have 

chosen to imagine that the tax law will evolve as it is written for 

economic as well as budgetary projections and are cognizant that 

that leads us to make mistakes in a very mechanical sense that 

will, looking back, appear to be unnecessary volatility. That kind 

of volatility, broadly speaking, is a cost. It is an uncertainty to polVerDate 0ct 09 2002 17:09 Oct 26, 2004 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 X:\HEARINGS\108TH\108-23\HBU204.000 RYAN PsN: RYAN
8

icymakers about what is coming in and why, and it is uncertainty 

to the private sector in thinking about what will the Tax Code look 

like. 

That is a situation that is probably not unique to the current environment. It is exacerbated by the variety of provisions at the moment. But general uncertainty about the Tax Code is something 

that the private sector has to deal with all the time, the prospect 

of change in the future. To the extent that the Tax Code was set 

in place and left alone for a while, revenue projections would probably improve, and private sector costs would be lower as well. I 

think that is an important consideration in terms of thinking about 

this topic. 

On the volatility of the tax base, the CBO is painfully aware of 

how volatile things can be. For example, in 2001 capital gains receipts were $100 billion. By 2002, they had fallen to $57 billion. 

The inclusion of capital gains in the tax base as a result delivers 

some uncertainty into the revenue projections. 

Capital gains are a piece that has gotten particular attention, 

but there are many other aspects that are imbedded in the 

technicals, as you mentioned, which are difficult to project with a 

lot of precision, and which raise the uncertainty about our technical forecasts. 

Going forward, one could imagine lots of decisions made about 

the tax base for which different rates would be applied, and they 

would have different consequences for volatility. Some—a broadbased income tax would include capital gains, and that piece would 

contribute to volatility. Some would exclude capital gains. Some tax 

reforms might allow firms to entirely expense their investments in 

the first year. Investment is a notoriously volatile activity. We 

would have to deal with that in the revenue projections. 

One can imagine some pieces—the compensation of employees 

through stock options and bonuses, which would be in any flavor 

of broad-based fundamental tax return—which would remain as a 

challenging projection issue for the CBO. 

The volatility also figures into the final topic in our testimony, 

which the differential taxation across activities. At present, in 

rough terms, wage income is taxed in the aggregate at an effective 

rate of about 20 percent, whereas other compensation in the form 

of fringes at zero percent. Capital gains are taxed roughly at 15 

percent. The return to investment in equipment is taxed at roughly 

half the rate, at the moment, as the return to investment in structures is. Those investments that take place in a C corporation are 

taxed at a rate that is probably about 10 percentage points higher 

than those investments that are done in the form of an S corporation. All of those features make it necessary to examine not just 

the level of taxation, but where the economic activity takes place 

in order to accurately project the receipts. 

The same is true for individuals. Accordingly to data that is in 

the CBO’s publication on effective tax rates, which we put out for 

many years, in 2001 the combined effective tax rate from the individual and corporation income tax in the bottom quintile, the lowest 20 percent, was ¥5.3 percent. Moving across quintiles to the 

top, it rises to .7, .45, 7.9, and 19.2 percent. So not only is it important to forecast the level of economic activity and the income that 

9

it generates, it is becoming increasingly important in the baseline 

to forecast who gets the income and the effective rate at which they 

will be taxed. This raises the challenge for CBO in providing accurate revenue forecasts. 

Going forward, there are two important transition issues that 

will be associated with thinking about fundamental tax reform. The 

first, and certainly the most important, will be the transition in the 

private sector and the impact on the economy of the adjustment 

costs in moving to a new tax system, and measuring the benefits 

of a new tax system net of those adjustment costs is a fair way to 

think about it. The same would be true in budgetary presentation: 

that, moving forward, there could be tremendous gains over time 

in the stability of the bases and the ability to project revenues accurately, but during the transition it is unlikely that the CBO or 

other entities interested in forecasting revenues would be able to 

do so with any great precision when we move from one Tax Code 

to another. 

The focus, I think, on the whole, however, should be on the private sector. It is the case that to the extent that there is volatility 

in tax receipts and that volatility is not symptomatic of a fundamental imbalance, the U.S. Government has access to credit markets unparalleled in the globe and can smooth that volatility at a 

very low cost. Picking the basic level of spending, picking the basic 

level of taxes to finance that spending, and deciding upon the 

structure of those taxes to meet the overall goals of efficiency and 

equity are really core issues, and the volatility around that, I 

think, is manageable from both a budgetary and economic perspective. 

That was the short version of the remarks that we submitted. 

We would be happy to elaborate to answer any questions you might 

have. 

[The prepared statement of Mr. Holtz-Eakin follows:]

PREPARED STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, CONGRESSIONAL

BUDGET OFFICE

Mr. Chairman, Congressman Spratt, and members of the committee, I am grateful for the opportunity to appear before you this morning to discuss comprehensive 

tax reform. I want to begin by emphasizing that my remarks focus on the Federal 

budget, with emphasis on the problems that the current tax system poses and that 

the reform of the system would pose for projecting revenues. These remarks do not 

extend to the merits or drawbacks of specific proposals. 

From an economic perspective, the central role of the government is to provide 

services to the public that only it can provide (or provide adequately). Therefore, the 

threshold budgetary decisions faced by policymakers are about which services to 

provide and how much to spend on them. Those expenditures must be financed, and 

the challenge for tax policy is to provide adequate financing in a fair and efficient 

fashion. At present, the bulk of general tax revenues to the Federal Government derives from individual income taxes and corporate income taxes. In recent years, the 

combined contribution from those income taxes has been about 50 percent to 60 percent of Federal receipts, or about 8.5 percent to 12.5 percent of gross domestic product. Payroll taxes constitute another roughly one-third of receipts. But under current law, those taxes are linked to outlays for Social Security and Medicare. For 

that reason, I will ignore payroll taxes, although one could envision a comprehensive 

tax reform that encompassed them. The remaining sources of receipts are less than 

a tenth of Federal revenues. In light of the dominance of income taxes as a share 

of Federal receipts, discussions of tax reform are largely about reforming income 

taxes. 

Its name notwithstanding, the underlying base of the U.S. income tax system departs significantly from definitions of income. Indeed, a chief difference among many 

10

reform proposals is the question of the appropriate tax base. There are two useful 

benchmarks. One is a tax on comprehensive income (often referred to as a HaigSimons income tax). Comprehensive income includes all labor compensation earned 

during the year (regardless of whether it is actually paid or deferred) and all capital 

income (again, regardless of whether it is realized or not). Comprehensive income 

measures the additions to an individual’s potential to purchase consumption items. 

Actual purchases may fall short of that amount if he or she instead chooses to save 

part of the income, or purchases may exceed that amount if he or she spends out 

of past or expected future income. 

The other benchmark is a consumption tax, or consumed income tax. It differs 

from a comprehensive income tax by excluding from the tax base that portion of income that is saved and by subjecting to taxation an individual’s purchases. Because 

comprehensive income and consumed income differ only as a result of individuals’ 

saving and investment decisions, it is possible to implement a consumed income tax 

by two means: by excluding saving from taxation or by excluding the income generated from saving and investment. Both variants have been proposed. 

The current U.S. income tax system is a hybrid of those two benchmarks, albeit 

an incomplete one that excludes from taxation some items that would be taxed in 

either system. The current system relies principally on an income tax but embodies 

some elements of a consumption tax by excluding income saved for retirement and 

other uses. Some of the problems that arise with the tax system—both in terms of 

its effects on the economy and the difficulties it presents for budget projections—

stem from that mixing of characteristics of income and consumption taxes. Many 

more difficulties derive from the ways in which the tax system departs from both 

concepts. For example, employer-provided health insurance, which is currently not 

taxed, would be taxed under either a pure consumption tax or a pure income tax, 

as would many of the expenditures that taxpayers are allowed to deduct in arriving 

at taxable income. Consequently, although some of the issues I discuss here might 

be addressed by the choice of income versus consumption as the tax base, many will 

arise in either case, because they are either unavoidable or the consequence of various policies that are independent of the choice of a base. 

I will focus on four issues. The first three are general attributes of the current 

income tax system that impede reliable revenue projections: sunsets and expiring 

provisions, the volatility of income sources, and differential taxation. The fourth is 

transition effects—a consideration that must be taken into account in projections 

when any major change to the system occurs. Clearly, the most important consideration in evaluating the merits of a tax reform is its effects on the economy, and not 

the repercussions for Federal revenue projections. However, knowing the effects on 

projections illuminates the real costs to the economy because the two types of effects 

often stem from the same phenomena. 

SUNSETS AND EXPIRING PROVISIONS

Under current law, the Tax Code contains a number of new provisions that take 

effect in phases and a number of expiring provisions. A few of the latter—notably 

the provision allowing partial expensing of equipment—were enacted to be temporary with a specific economic purpose in mind. The countercyclical effect of investment incentives such as partial expensing was enhanced by its temporary nature. 

Indeed, its future use as a tool to manage aggregate demand in the economy could 

be compromised by now extending it. But most of the expiring provisions were enacted as a step toward making them permanent or extending them indefinitely. 

There are essentially two groups of expiring provisions. First, there are the roughly 30 so-called extenders: special provisions of the Code that have been extended a 

few years at a time and are regularly expected to be continued (see table 1). Most, 

if extended, would diminish revenues—altogether, by about $175 billion over the 

Congressional Budget Office’s (CBO’s) 10-year projection period. Among the most 

significant of them is the credit for research and experimentation, which has been 

extended nine times since its enactment in 1981. 

Second, there are the many provisions in the Economic Growth and Tax Relief 

Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). They include all of EGTRRA’s income and estate tax 

provisions, which are set to expire at the end of 2010, and JGTRRA’s reduced dividend and capital gains tax rates, at the end of 2008. But they also include provisions such as the child tax credit, the expanded standard deduction, the 10 percent 

and the 15 percent brackets, and the increased exemption under the alternative 

minimum tax, which are scheduled to be reduced in 2005 (see table 2). While people 

hold diverse views on the future of those provisions, it is reasonable to expect that 

at least some will be extended. 

11

Those scheduled changes in the Tax Code create a multitude of challenges for projecting receipts. In projecting baseline receipts, CBO is required to assume current 

law, a stricture that might normally coincide with ‘‘current policy.’’ However, at 

present, that requirement dictates that all of the legislated provisions are assumed 

to be phased in and to expire as scheduled in law, even though those required assumptions may differ greatly from expectations of current policy. Thus, even when 

CBO’s baseline projections are accurate, the presence of those expirations reduces 

transparency about just what to expect concerning the future course of the government’s fiscal condition. 

An even more problematic feature of the gap between current law and expectations of policy is that budget estimates are based on the former and economic activity is influenced by the latter. In projecting revenues, one strategy for dealing with 

the problem is to assume that the public believes that all changes to the Tax Code 

will occur as scheduled. That approach has the virtue of being consistent with the 

baseline assumption of current law. Unfortunately, it has the drawback of divorcing 

the underlying assumptions about the economy from reality. 

Assuming that the public expects the Tax Code to change as scheduled also complicates revenue projections. Expected changes in the Tax Code induce significant 

shifts in taxable economic activity from year to year. Some of that activity represents changes in behavior that lead to real changes in income, prices, interest 

rates, and other aspects of economic performance. Some is just reporting or accounting-shifting bonuses into the next or previous year, for example. Those shifts—real 

or reporting—lie at the heart of the desirability of tax reform; the fact that households and firms alter their behavior in response to taxes demonstrates the importance of tax policy. But such shifts in measured activity resulting from the scheduled changes in the Tax Code make projections more sensitive to policy than they 

would otherwise be—and do so unnecessarily if, indeed, the Code ultimately does 

not actually change. 

Another way to deal with the problem of scheduled changes in the Tax Code in 

making projections is to assume that firms and individuals do not believe that tax 

provisions will change as scheduled but have their own view of how policy will 

evolve. That approach may make the underlying economic projections more realistic, 

but it renders them inconsistent with the rule that budget projections reflect a baseline under current law. 

And here again the existence of scheduled changes in the Tax Code complicates 

projections. The approach makes it necessary to discern what the public expects and 

to factor in the effects of the public’s uncertainty. EGTRRA and JGTRRA contain 

many provisions that interact in a complicated manner, and predicting which provisions the public expects to lapse and which it expects to be made permanent is a 

complicated matter of judgment. Regardless of which approach is taken, baseline 

revenue projections are made less reliable by the existence of expirations that few 

people expect to occur as written in current law. 

Those difficulties for revenue projections are reflections of the costs to the economy introduced by expiring provisions. When households and firms shift the timing 

of their economic activity for tax purposes instead of market fundamentals, the efficiency of economic performance is impaired. Advancing or delaying the recognition 

of income and expenses uses real resources. And although it may be worth it to a 

taxpayer to incur those costs in order to save on taxes, the resources used are lost 

to society with no offsetting gain. Similarly, the uncertainty caused by expiring provisions for revenue projections mirrors the uncertainty that they introduce into all 

economic affairs. That uncertainty imposes real costs in the economy as well, as resources are used to avoid it and as taxpayers’ choices are influenced by it. 

And those costs from expiring provisions are not limited to explicit sunsets. Even 

without provisions that are scheduled to be phased in or to expire, frequent changes 

in the Tax Code inflict analogous costs. If EGTRRA were not scheduled to expire 

or if it had not been enacted, similar uncertainty about taxes could exist. The public 

has incentives to evaluate policymakers’ propensity to make changes to the Tax 

Code and to adjust its economic behavior accordingly. And the perception itself, even 

if nothing is actually changed, is enough to impose costs on the economy. Those 

costs can be reduced only by allowing the system some repose. 

The propensity to change the tax system is reinforced in part by the many exceptions and preferences already built into it. Its mixed attributes of income tax and 

consumption tax bases and the many exceptions and preferences that cause the system to deviate from both concepts mean that there is no bright line dividing new 

provisions that would be consistent with the tax system and those at odds with its 

underpinnings. One special interest claim for preferential treatment may seem as 

legitimate as any other, making changing the Tax Code easier and leading to further instability in it. 

12

1 Because the Tax Code is scheduled to change, those rates depend on which tax year is assumed.

THE VOLATILITY OF TAX BASES

Any comprehensive tax system will include some tax bases that are inherently 

more volatile than others. The current income tax embodies relatively stable sources 

of income such as regular wages and salaries, which yield relatively stable receipts. 

However, other sources of income swing more widely, which imparts volatility to receipts and makes projecting revenues more difficult. The current tax base, for example, includes capital gains, which are extremely volatile and unpredictable. Even 

though capital gains are taxed at substantially lower rates than most other income 

is, they nonetheless produce large swings in revenues. For example, as a consequence of a major adjustment in the stock market, receipts from gains realizations 

fell from $100 billion in fiscal year 2001 to $57 billion in fiscal year 2002. Because 

stock prices are impossible to forecast, the decline in gains was not foreseeable. And 

even after the stock market’s behavior became evident, the impending change in receipts was highly uncertain because stock prices do not translate directly into gains 

realizations. 

Capital gains are taxed under the current tax system because they are a form of 

income. However, under a comprehensive income tax, gains would be taxed as they 

accrued instead of upon realization. That change would not alter the fundamental 

difficulty of projecting fluctuations in the stock market, but it would eliminate the 

necessity of predicting taxpayers’ decisions to realize capital gains. In contrast, neither variant of a consumed-income tax would tax gains; therefore, both presumably 

would avoid that source of volatility and unpredictability. For much the same reason, both variants of a consumed-income tax would tend to avoid the volatility that 

characterizes profits in general. 

However, volatility is not necessarily more characteristic of one approach to tax 

reform than another. Instead, the details of implementation matter. While consumption is less volatile than income, most proposed tax systems retain some volatile 

sources in their tax bases. Those that exempt saving (sales and value-added-style 

taxes) include durable consumer goods in their base, for example, which imparts volatility. Proposals that exclude income from capital still have volatility from bonuses 

and stock options, which are one of the sources of volatility under the income tax. 

Moreover, under some consumption taxes, business income is taxed net of full expensing for capital outlays. Because aggregate investment can be more volatile than 

business profits, the business income tax base under such a tax can be at least as 

volatile as it is under an income tax. 

In addition, volatility within a year may also be a consideration. Currently, most 

tax liabilities are paid as they accrue. Because wages are such a large part of income, withholding serves to match payments closely with the activity that generates 

them. Other forms of income should result in payments of estimated taxes through 

the year, but those liabilities can be harder to determine. Consequently, final settlements of liability are necessary at the time returns are filed. The current tax system 

results in ‘‘April surprises’’ that would not arise with some other tax systems, such 

as a wage tax or sales tax. Some consumption taxes, such as those for which the 

tax is collected at the point of sale, would reduce those surprises. Other consumption taxes, such as those that permit a deduction from income of contributions to 

qualified savings accounts, might be more difficult to pay as liabilities accrued, leading to potentially larger April surprises. 

DIFFERENTIAL TAXATION

The existing Tax Code taxes different kinds of income at different effective tax 

rates (including, in many cases, a rate of zero). For example, in the aggregate, the 

effective tax rate on wage income (from the individual income tax) is about 20 percent. It would be lower if calculated on compensation, which includes untaxed fringe 

benefits. Yet capital gains income is taxed at about 15 percent. Corporate income 

tax rates also vary, with the return on investment in equipment now taxed at about 

half the effective rate of that on structures. The combined corporate and individual 

income taxes result in tax rates of about 25 percent to 30 percent on corporate income (which may be subject to both taxes), less than 20 percent on noncorporate 

business income (which is subject only to the individual income tax), and zero for 

the implicit income generated by owner-occupied housing (which is subject to neither).1

As a consequence of differences in effective tax rates, even an accurate forecast 

of overall income can yield an inaccurate projection of receipts if it is not allocated 

13

correctly among various activities or individuals. The variation occurs across two dimensions. First, there are different tax rates depending on the different kinds of income and consumption. Compensation in the form of wages and salaries is subject 

to taxation, while fringe benefits, which serve the same purpose of compensating 

workers for their labor, are not taxed. Profits accruing to C corporations—but not 

those of proprietorships, partnerships, or S corporations—are subject to the corporate income tax. Capital gains are subject to lower rates and sometimes no taxation at all. Similarly, taxpayers’ patterns of expenditures generate different effective tax rates. For instance, expenses for mortgage interest, charitable contributions, 

or state and local taxes reduce Federal tax receipts. As a result, projections of receipts depend on projections of the components of income and expenditures, each introducing yet another potential source of error in receipts projections. 

The corresponding economic effect of that more complicated and less accurate 

budget projecting is the economic inefficiency associated with those differential tax 

rates. Firms and workers have incentives to tilt compensation toward untaxed 

fringe benefits. Capital flows toward lower-taxed sectors of the economy, forgoing 

higher gains to society that would accrue if invested elsewhere. Such incentives distort economic activity and lower overall efficiency. In addition, the preferences require higher rates to be applied to other forms of income, exacerbating the inevitable disincentives that income taxes cause for work effort. The effect is real and 

potentially substantial; incomes are lower than they would be without the distortions caused by the differential tax rates. 

The second dimension is who earns the income. Some owners of capital—notably 

tax-exempt organizations—pay no taxes, so, overall, income from interest and dividends yields much lower revenues than profits and wages do. In addition, the progressive structure of the tax rates means that the effective tax rate depends on 

whether the income accrues to someone of higher or lower income. Consequently, 

to project receipts, it is necessary to estimate how much income accrues to tax-exempt entities and to forecast the income distribution among taxpayers. 

Again, the budgetary challenge reflects an underlying challenge posed by the Tax 

Code. In addition to minimizing interference with economic decisions, exhibiting 

fairness is another metric by which a Tax Code is measured—often manifesting 

itself in the desire to tax higher levels of income at higher rates. However, as the 

desired progressivity of the Tax Code increases, a premium is placed on accurate 

projections of the distribution of income. For example, the share of taxable income 

taxed in the highest marginal rate bracket (39.6 percent) under the personal income 

tax rose from 12 percent in 1994 to 25 percent in 2000; so taxes were almost $60 

billion higher in 2000 than they would have been had the share taxed in each bracket remained constant (not including the effects of capital gains). While some forecasts may have anticipated an increasing concentration of incomes between those 

years, few would have anticipated such a large change. 

TRANSITION EFFECTS

The previous three considerations point to how the current tax regime makes projecting receipts more difficult. My fourth point builds on the fact that all projection 

methods rely on history to a certain extent. And the current system has some track 

record. In contrast, any major reform involves major uncertainties about how the 

new tax system will function and how much it will yield. As a result, following the 

introduction of any significantly reformed system, revenue projections would probably become less reliable in the near term. 

Again, the problems introduced for projections are reflections of factors at work 

in the real economy. The desirability of moving to a new Tax Code cannot be determined just by comparing what the world looks like now with what it would be like 

under a different code. The desirability of the reform also depends on the process 

of getting there. And the costs of the change could be significant. There are costs 

to reallocating resources to their best employment. In addition, some tax reform proposals, because of the effects they would have on prices, would create challenges for 

macroeconomic stabilization policy. Moreover, transition costs may generate perceptions of unfairness that lead reform proposals to incorporate relief to those most affected by the transition. But because such transition relief may mitigate the efficiency gains from reform, any tax reform proposal must be evaluated in light of the 

possible problems created by the transition from the old tax regime. 

CONCLUSION

Budget planning is aided by accurate projections of receipts, but the current U.S. 

Tax Code has several features that make accurate projections difficult. Of course, 

ultimately the issue of tax reform is not about what the tax system or tax reform 

14

does to analysts’ ability to project revenues. It is about what taxes do to the economy. Nevertheless, some of the current challenges in making projections reflect the 

underlying costs imposed by the Tax Code.

Chairman NUSSLE. First let me ask unanimous consent that all 

Members be allowed 7 days to submit statements for the record at 

this point. I know there are a lot of Members that have an interest 

in this. So unless there is objection, so ordered. 

Let me start, Director, by asking you to take the gloves off. Your 

three comments, your three main areas, obviously tax bases, 

where—how people generate their income and the volatility of that 

income, is not something that is managed very often here in Washington. It is just a fact of a changing economy. But the other two 

appear to be something that is determined here in Washington by 

one entity or another. So go ahead and take the gloves off as far 

as why these problems—sunsets, phase-ins, expiring provisions, 

differentiating tax, all of that is complication added here. 

Let’s go to Mr. Scott’s point and others’ point that we add this 

complication ourselves, whether it is Republicans, Democrats, Congress, President. Take the gloves off. Where does this complication 

come from, and how does—can you give an example of how something that seeming—maybe seemed innocuous at the time, but has, 

as a result, made it very difficult to forecast accurately the resulting revenue picture from a provision. If you have an example on 

your hit parade just to give Members an idea of what you are talking about, that would be helpful. 

Mr. HOLTZ-EAKIN. I will give you a current events example which 

is drawn from today’s New York Times, in which there is a discussion of Microsoft paying out $32 billion in dividends. Those dividends, at least according to the article, ares timed in part due to 

uncertainty about the future of the tax rates for dividends. And as 

a result, the decisionmakers at Microsoft thought they would pay 

it now as opposed to face anything in the future which might be 

a higher tax rate on dividends. 

That is one tiny example of a calculation that is done myriad 

number of times in the private sector about financial transactions, 

about economic activity. And it would show up as receipts now that 

we wouldn’t have gotten in our baseline because we didn’t build in 

uncertainty about a new Tax Code next year. Our baseline said 

Tax Code on dividends will be the same until 2011. 

So there you go. That is the kind of volatility that is out there 

underneath due to uncertainty about the future of the Tax Code. 

Some of that uncertainty at the present time, in your words, to 

take the gloves off, strictly driven by policy decisions about the Tax 

Code. We have lots of expiring provisions, lots of sunsets, some 

phase-ins. 

The private sector is going to look at that and do its calculation 

about what is likely to evolve and make economic and financial decisions that are in its interest. We will have to figure out what that 

might be and guess what the receipts are. 

It is actually in all three of the areas. To the extent that there 

are differential rates across time and differential rates across activities, say, dividends versus capital gains, there will be incentives 

to shift the composition of the tax base. There is always some underlying economic activity determining their compostion, but if we 

15

are shifting the composition of the tax base toward components 

that are more volatile, capital gains, because people can realize 

them when they choose to, instead of dividends which are paid out 

by the firms, that is a result of policy as well. So there are many 

features of policy that figure into this. 

Chairman NUSSLE. Can you walk through the timing as well—

and I am going to ask Secretary Olson this as well. Can you walk 

through the timing from—obviously we want to know what is coming in right now as an example. We want to know what the revenue picture is right now, or, for that matter, in order to make a 

budgetary decision for next year’s budget as we are writing it, let’s 

say. 

When will we—so you are using projections. When will those projections become final reality, this is what actually did occur during 

that period of time, so that you can have a look back and see—

what is the time frame? I have heard some people describe it as 

much as years, not days, weeks, or months. So could you describe 

the timing on that? 

Mr. HOLTZ-EAKIN. One might like to think that in putting together our summer update, which will be out in a month or so, that 

we will be looking at complete 2003 data and projecting forward 

from that. That is not the case. We are building off of the——

Chairman NUSSLE. So we don’t even have last year’s data. 

Mr. HOLTZ-EAKIN. No. We are building off data from 2001 as our 

fundamental detailed facts about the individual income tax, for example. So the first thing we have to do is project a couple of years 

of history and then build a 10-year budget projection on top of that. 

So timely access to comprehensive data is something that I think 

anyone in this business would argue would be very useful. It won’t 

be a panacea, but it would be a very useful——

Chairman NUSSLE. But it is 3 years old. 

Mr. HOLTZ-EAKIN. Yeah. 

Chairman NUSSLE. So we are just now—I mean, most Members 

do not know that we are 3 years behind getting actual data for 

what occurred even—I mean, we are not getting today’s data. We 

are getting data that occurred back in 2001 as final, close-the-books 

actuals of what is going on. And based on that you then begin to 

use that as a way to project what is going to happen in 2005 and 

beyond. 

Mr. HOLTZ-EAKIN. More fairly, that is the access to detailed individual tax return data, so we know the distributions across people, 

for example. We do know more recent information on receipts that 

has come in the Treasury reports, daily Treasury statements, 

monthly Treasury statements. But those totals don’t reveal some of 

the distributions that I tried to emphasize can be very important. 

For example, as firms send in their tax payments, we don’t know 

the division between those tax payments which are for payroll 

taxes, Social Security, and off-budget items versus those which are 

income taxes. 

When that money comes in, it is divided based on historical patterns, and we try to guess that division. But simply knowing that 

division would be extremely useful in distinguishing between those 

things that are meat and potatoes, wages and salaries, which give 

16

you payroll taxes and other aspects of economic activity. So we are 

working with data which is incomplete in many ways. 

Chairman NUSSLE. Is that data—I am sorry, my time has expired. I want to finish this line, and that is has the timeliness improved at all over your experience or your time of observing this; 

has it closed at all in, let’s say, this 3-year lag, or is there any effort under way that you are aware of to try and close that gap? 

Mr. HOLTZ-EAKIN. I am not aware of any effort. In the past 3 

years, for example, it has been about the same system. I am not 

knowledgeable going back about what changes have been made. 

Chairman NUSSLE. Mr. Spratt. 

Mr. SPRATT. Thank you, Mr. Chairman. Going back to my opening statement, as you will recall, the CBO and OMB both projected 

a surplus between 2002 and 2011 of $5.6 trillion. That was January, February of 2002. What is CBO’s current estimate of how 

much that surplus, baseline surplus, has to be adjusted due to economic and technical divergences from what you expected due to 

economic and technical factors? 

Mr. HOLTZ-EAKIN. Well, there are a variety of different answers. 

If you go back and look at what was projected for, say, 2004, in 

that period, in—say, in the year 2000 versus what we expect now, 

the difference breaks out roughly into 40 percent economic and 

technical and then 60 percent legislation divided evenly in the tax 

and spending side. That composition differs depending whether you 

do it over the 10-year window or whether you do it for a particular 

year in that window. But broadly speaking, think of it as a 50–50 

divide as economic and technical and then other things——

Mr. SPRATT. Fifty to 55 percent over a 10-year period? 

Mr. HOLTZ-EAKIN. As a rough—we can get you the numbers for 

every year. It differs depending on the horizon. 

Mr. SPRATT. About 60 percent of that is technical misestimation, 

and 40 percent is economic misestimation. 

Mr. HOLTZ-EAKIN. The 40 percent reflects a combination of economic and technical. That dividing line—to anyone who doesn’t do 

this—is far from obvious. You might think of capital gains realizations as an economic phenomenon, but they fall in the technical 

category. The way the math is actually done is this: We look at our 

macroeconomic forecast for overall GDP and then at what wages 

and salaries, things like that. We explain as much as we can with 

that. The residual what is left falls into the technical category. And 

so there are many economic phenomena in there, shifts in the income distribution, capital gains. 

Mr. SPRATT. To the extent that the economy doesn’t grow as you 

expect it, you can assign that shortfall to economic factors. 

Mr. HOLTZ-EAKIN. We do. 

Mr. SPRATT. The remaining shortfall is assigned to a residual 

called technical factors, and you can’t really sort out all of the technical reasons that you are not seeing revenues or spending perform 

as you projected. 

Mr. HOLTZ-EAKIN. We go through each year, and, doing our baseline updates, we try to identify the different technical factors, but 

we can never exhaustively——

Mr. SPRATT. Do you make adjustments going forward for the 

technical factors then? 

17

Mr. HOLTZ-EAKIN. Yes, we do. 

Mr. SPRATT. As I recall—it has been a while since I looked at 

them closely—as you go forward in time, there is a convergence, a 

reconvergence so that the estimate of the economy tends to return 

to what it was originally. In other words, your technical and economic adjustments in the outyears tending to less than those in the 

near term. Is that clear? 

Mr. HOLTZ-EAKIN. On the economy, it is fairly straightforward. 

We make an attempt to forecast the business cycle for 18 months, 

2 years; beyond that make no attempt to forecast business cycles. 

It is beyond the capability of the science. We estimate the average 

performance over that period. 

On the technical front, we review the technicals, and any new information that you get during the year you have to decide the degree to which what you have learned in the past year is actually 

informative about 10 years out. If you really believe there has been 

a fundamental change in the structure of the economy, then it 

would be appropriate to change the forecast 10 years out. If not, 

then you will phase it out over the 10-year window. It is a difficult 

part of doing the projections. 

Mr. SPRATT. In the year 2011, according to your current projections, you are not making 55 percent in the original projection surplus for that year, I don’t believe. 

Mr. HOLTZ-EAKIN. OK. We can check that. 

Mr. SPRATT. What you are assuming is that those misestimations 

become smaller and smaller over time. I guess the question I am 

asking is can we be sure that is the case? 

Mr. HOLTZ-EAKIN. No. But I guess I would point to a different 

piece of evidence on that, which is that we also display in our projections the range of uncertainty surrounding them. It is clear that 

the fan chart of likely outcomes expands as you go forward just due 

to uncertainty about the how the economy and technicals will 

evolve. We don’t move our point estimates for something 10 years 

away by an enormous amount based on a little bit of evidence in 

1 year, but we do acknowledge the additional information and try—

in the sense of providing good risk management skills to the Congress—to show the range of possible outcomes. 

Mr. SPRATT. Let me ask you specifically with respect to revenues, 

you put out a publication in May called the ‘‘Cyclically Adjusted 

and Standardized Budget Measures,’’ which was must reading for 

everybody. 

Mr. HOLTZ-EAKIN. Pleased to hear that. 

Mr. SPRATT. Table A(1) in particular shows that the shortfall of 

economic performance relative to the economy’s capacity is about 

$25 billion in revenues in the current fiscal year, 2004. But by 

2005, next year, you show that the economic cycle will actually add 

revenues. So the economic factors’ contribution to the deficit will 

have disappeared in the next fiscal year. All of it then becomes 

structural. 

Mr. HOLTZ-EAKIN. That calculation is the answer to the following 

question: Suppose I could snap my fingers and make GDP and the 

economy move from its current level to the level that we estimate 

to be its potential, its capacity. If I just did that, I didn’t change 

any of the technical factors, didn’t change legislation, how much 

18

more in receipts would come in? The answer is about $25 billion 

based on our calculations. 

Mr. SPRATT. One final question. Do you think that we should 

change the projecting rule by which you assume that tax cuts were 

built in, expiration dates, popular tax cuts with built-in sunset 

dates are soon to expire and not be renewed? 

Mr. HOLTZ-EAKIN. The question, I think, is really what is most 

informative to Members. At least to my eye, the notion of extrapolating current laws is meant to capture what current policy dictates 

about the likely future fiscal outlook. When current law doesn’t 

match a Member’s view of the future, the future of current policy, 

I don’t know quite how to resolve that. 

Our approach has been to provide a variety of alternatives so 

that members of this committee and Congress in general can understand what the different likely outcomes are for different pieces 

of the budget where there is some uncertainty about how it will actually evolve. Having good information on the future is the key, I 

think, and making sure it is transparent and people can evaluate 

the path on which we are currently headed. 

Mr. SPRATT. Thank you. 

Chairman NUSSLE. Mr. Brown. 

Mr. BROWN. Thank you, Mr. Chairman. 

Mr. Director, under the current Tax Code, we see the books laying over there, and I know there has been a lot of effort in Congress to try to simplify the process. Have you seen any of the plans 

that are there that you think might be more workable than the system we have now, flat tax or some other scheme? 

Mr. HOLTZ-EAKIN. We have looked—at the CBO and in my career 

prior to coming to CBO—at many of the prototypes for broad-based 

income taxes, for a flat tax which would be a consumption-style 

tax, value-added taxes. Each of those prototypes would involve a 

different set of trade-offs along the issues that I discussed in terms 

of what is in the tax base, volatility, the degree to which different 

activities are taxed at different rates. 

But the common characteristics they have are that most prototypes have broad bases, and they have relatively low rates, so differential taxation is largely eliminated: Things in the base are 

taxed at the same rate. And they make a choice about the kind of 

tax base to which they aim. 

Another characteristic they all share is they are all prototypes, 

and a comparison of the current tax system to a prototype model 

is not an apples-to-apples comparison. The real question is, what 

is a real live version of any of these tax reforms that we might see 

going forward? And that is an important question in thinking about 

how it would affect our ability to do the projections. 

Mr. BROWN. Do you plan in your tenure to try to bring a recommended new plan? 

Mr. HOLTZ-EAKIN. No. The CBO will not recommend a tax reform, but if Members would be interested in looking through the 

implications of any of those, we would be happy to work with you 

on that. 

Mr. BROWN. Thank you. 

Chairman NUSSLE. Mr. Moore. Oh, we will come back to Mr. 

Moore. 

19

Mr. Scott. 

Actually Mr. Moore was next. He is here. Mr. Moore. 

Mr. MOORE. Thank you, Mr. Chairman. Good morning. I appreciate you being here this morning. 

What is the current deficit projected. 

Mr. HOLTZ-EAKIN. Our current projection, published projection, 

for 2004 was $477 billion. Based on what we know through this 

point in the year, we would expect it to come in below that. My 

guess would be for it to come in south of $450 billion somewhere. 

Mr. MOORE. How does that rank in terms of relative deficits we 

have had over the years in our Nation’s history? 

Mr. HOLTZ-EAKIN. In dollar terms it is large. Relative to GDP it 

is not the largest. 

Mr. MOORE. In dollar terms is it about the highest we have had? 

Mr. HOLTZ-EAKIN. Yeah. 

Mr. MOORE. Does that include funding for Iraq? 

Mr. HOLTZ-EAKIN. The 2004 numbers that we put together include the $87 billion in appropriations for Iraq plus reconstruction 

in Iraq and Afghanistan. 

Mr. MOORE. Have you heard there might be a request for additional or supplemental funding for Iraq? 

Mr. HOLTZ-EAKIN. We are aware of requests and appropriations 

and/or authorizations for $25 billion. 

Mr. MOORE. That is not included in the $450 billion you gave us, 

or is it? 

Mr. HOLTZ-EAKIN. No. 

Mr. MOORE. So that would put it up to $475 [billion] again if that 

turned out to be correct? 

Mr. HOLTZ-EAKIN. If it turned into outlays in 2004, it would be 

included in that number, but it would be highly unlikely that that 

sum could be spent that quickly. 

Mr. MOORE. Is there a trust fund for Social Security? 

Mr. HOLTZ-EAKIN. There is an accounting known as the trust 

fund, but there are no real economic resources sequestered in any 

meaningful way to pay those liabilities. 

Mr. MOORE. You are aware of what lawyers are required to do 

in terms of keeping a trust fund, I take it? 

Mr. HOLTZ-EAKIN. Yes. 

Mr. MOORE. The trust fund for an attorney means a trust fund. 

If somebody violates that trust by taking money out of that fund, 

they can be prosecuted and/or disbarred; is that correct? 

Mr. HOLTZ-EAKIN. That is my understanding. 

Mr. MOORE. That doesn’t happen in Congress, does it? 

Mr. HOLTZ-EAKIN. That is also my understanding. 

Mr. MOORE. So if we go into the Social Security trust fund and 

spend that money on tax cuts or other spending matters, that is 

just the way it is. Congress has the authorities to do that; is that 

correct? 

Mr. HOLTZ-EAKIN. The unified budget allows resources to be 

spent on all kinds of demands. 

Mr. MOORE. So that is a yes? 

Mr. HOLTZ-EAKIN. I think so. 

Mr. MOORE. How are tax cuts that we enact now paid for? 

20

Mr. HOLTZ-EAKIN. In the end, all budgetary resources, spending, 

tax cuts are—the underlying source of all that is the U.S. economy. 

So independently of how you do the labeling, that is how we pay 

the bills in all public and private settings. 

Mr. MOORE. OK. But Social Security funds then are used to pay 

for tax cuts now; is that correct? 

Mr. HOLTZ-EAKIN. There is no one-for-one linking between tax 

cuts. We know that the net budgetary outcome at the moment is 

negative. 

Mr. MOORE. You said there is not a separate Social Security fund 

technically except for under an accounting procedure; is that correct? 

Mr. HOLTZ-EAKIN. That is correct. 

Mr. MOORE. So right now technically money that is taken for Social Security is used to pay, along with other money, for tax cuts; 

is that correct? 

Mr. HOLTZ-EAKIN. I don’t think you can say that in the very mechanical way. The payroll taxes come into the budget along with 

other resources, spending goes out, the net effect is negative. Linking dollars coming in to dollars going out is not something that can 

be done in a deep economic sense. 

Mr. MOORE. You are aware of the term PAYGO, correct? 

Mr. HOLTZ-EAKIN. I am. 

Mr. MOORE. Is that a budget enforcement rule? 

Mr. HOLTZ-EAKIN. Yes. 

Mr. MOORE. There was PAYGO in effect—what does PAYGO require? 

Mr. HOLTZ-EAKIN. PAYGO requires that when Congress undertakes expansions of mandatory spending or cuts in taxes, that they 

be offset in the budgetary projections in a dollar-for-dollar fashion. 

Mr. MOORE. That was the rule in effect until 2002; is that correct? 

Mr. HOLTZ-EAKIN. Yeah. 

Mr. MOORE. It expired at that time? 

Mr. HOLTZ-EAKIN. Yes. 

Mr. MOORE. You are aware of the new rule that requires PAYGO 

or pay-as-you-go for only spending, but not new tax cuts; is that 

correct. 

Mr. HOLTZ-EAKIN. We don’t actually have such a rule in place, 

but there have been obvious discussions in different parts of the 

Congress. 

Mr. MOORE. That is what this Budget Committee is trying to do, 

at least the leadership? 

Chairman NUSSLE. Does the gentleman have any questions about 

revenue projections he would like to ask? He can hold a press conference. 

Mr. MOORE. I have 48 seconds, if I might, Mr. Chairman, please. 

Chairman NUSSLE. You asked me a question, so I thought I 

would ask you a question back. 

Mr. MOORE. I was just looking at you. 

Chairman NUSSLE. And I was just looking back. 

Mr. MOORE. Thank you, Mr. Chairman, with all respect. Would 

you agree with Chairman Greenspan that it might be advisable to 

enact the PAYGO rules we had up until 2002 when they expired? 

21

Mr. HOLTZ-EAKIN. My own view is that if you look at the evidence, the key is not the rules, the key is what the policy objectives 

of the Congress are. And once a consensus is developed about those 

objectives, then rules can be put in place that will support that. 

But in the absence of a consensus about fiscal policy objectives, it 

is unlikely that rules will suffice. 

Mr. MOORE. I am not sure I understand that, but thank you very 

much. 

Chairman NUSSLE. Are there any other Members who would like 

to be recognized to ask questions about revenue projections? 

Mr. Garrett. 

Mr. GARRETT. I will not be looking at you. I will be looking over 

here. 

Chairman NUSSLE. That is fine. 

Mr. GARRETT. Thank you. 

Before I begin, let me—in your written testimony you didn’t use 

this language in your testimony here, but I just took note of it. You 

are talking about the Federal Government here, not the other governments. In your opening line the second paragraph is; ‘‘From an 

economic perspective the central role of the government is to provide services in public that only it can provide or provide adequately.’’ That is from an economic perspective, obviously not from 

a real-life perspective, because we provide all sorts of services that 

the States could be providing and that business and communities 

could be providing as well, right? 

Mr. HOLTZ-EAKIN. Yes. 

Mr. GARRETT. Does that impact upon the rest of the testimony 

then? 

Mr. HOLTZ-EAKIN. To the extent that the Federal Government 

chooses to undertake an activity, it has to be financed, and the 

commitment to spend those moneys raises the necessity of more receipts. You can solve that with either a broader base or higher 

rates. That figures into the kinds of feedback you get in the budget. 

Mr. GARRETT. Mr. Spratt had an interesting comment. He said 

at the very beginning, which I think was right, that having a fairer 

Tax Code or simpler Tax Code may end up driving you in different 

directions. I mean, a fairer Tax Code might be a much more complicated Tax Code; is that correct? 

Mr. HOLTZ-EAKIN. Certainly a core trade-off in tax policy is often 

presented as efficiency versus equity. That desire for higher tax 

rates on higher-resource individuals for the purposes of fairness 

leads to greater incentives for tax avoidance, shifting the way you 

do your economic transactions, or even evasion. The incentive 

would be to shift money from high-tax parents to their children, for 

example. That is the trade-off. 

Mr. GARRETT. I am concerned about fairness for the people that 

I represent, specifically New Jersey, which is an affluent State, one 

of the most affluent States in the country, and has one of the worst 

rates of returns as far as on the other side, the expenditure side. 

I just learned the other day that the average income for a two- income couple is around $75,000–$78,000 in the United States, but 

due to cost-of-living factors in a State such as New Jersey, that you 

would have to have around $134,000 in order to have the same cost 

of living. 

22

Assuming that is true, or ballpark figures, the individuals in that 

first category in the average number would be paying at a certain 

Federal tax rate, whereas the individuals that, presumably in New 

Jersey, would be at the higher tax rate, at the $134,000, we would 

be paying a disparate amount of income tax, right? 

Mr. HOLTZ-EAKIN. Mechanically, yeah. 

Mr. GARRETT. So in order to alleviate that problem, it would be 

a more complex code, but would the fairer system be to have some 

sort of a cost-of-living index in the Federal Tax Code either on a 

regional basis or State basis or county basis or some other census 

figure basis to apply to those richer States so that we pay a fair 

amount and not pay more amount than any other States? 

Mr. HOLTZ-EAKIN. You could imagine a system that attempted to 

adjust for real purchasing power in some way across geography or 

anything else, but you could also imagine the complications involved in what happens when people move, and a whole variety of 

other things that may make that unworkable in practice. 

Mr. GARRETT. On the expenditure side of the equation, of course, 

a State likes ours always gets the short end of the stick. I always 

used to say 50 out of 50, but when you include the District of Columbia, we are actually 51 out of 51 as far as the return on the 

dollar. So isn’t that exacerbated by the fact that we are paying at 

a higher level and getting back at a much lower level then, without 

having some sort of factor in there? 

Mr. HOLTZ-EAKIN. Well, in the same way that moneys come in 

in one form and go out in another, coming in from one State and 

going out to that State is really a policy call. What New Jersey gets 

in terms of outlays in the programs is something that is controllable by policy, and I think not really driven by configuration of the 

Tax Code. 

Mr. GARRETT. But the first half of the equation is figured by Tax 

Code as far as us having a higher cost of living and necessarily 

being in a higher tax level because of that; that is, as far as the 

Tax Code. 

Mr. HOLTZ-EAKIN. Be cognizant, however, if individuals are 

savvy, and I would stipulate that there are a lot of savvy individuals out there, they are going to recognize when they choose to live 

in New Jersey that that is a consideration. So overall, there might 

be an impact on bidding for house prices and prices might be lower 

otherwise because residents face this other burden. They might 

have chosen to live there and be just as happy living in the New 

Jersey. 

Mr. GARRETT. Yes, but the cost of prices of houses in New Jersey? 

Mr. HOLTZ-EAKIN. Actually I lived in New Jersey for 10 years. 

This is a fundamental conundrum in tax policy that will not be resolved here. Do you want to measure things on the basis of what 

comes in or comes out? 

Mr. GARRETT. One last question. Your comment is if we leave the 

overall system alone, you have less as far as economic impact on 

the system and less cost to the system. You said complexity will 

add to the cost of the system, and changes to the system will—

changes, incremental changes, will drive up the costs of the system. 

23

So if we were to make any changes along the line, as Mr. Spratt’s 

opening comment saying we should start clearing out the closet of 

these things, that would add costs to the system, whereas if we 

leave it alone, we will have a flat cost overall as far as intermediary cost to the system as far as changes are concerned. 

Mr. HOLTZ-EAKIN. Well, the real issue is how often do you 

change. 

Mr. GARRETT. Yes. 

Mr. HOLTZ-EAKIN. If you change once, hold the system stable in 

a way that has lower compliance and economic efficiency costs, 

then that net benefit could very well be positive. If you change 

every year, you are imposing an uncertainty and economic cost on 

the private sector that you should certainly be cognizant of. 

Mr. GARRETT. Thank you. 

Chairman NUSSLE. Now, Mr. Scott. 

Mr. SCOTT. Thank you, Mr. Chairman. 

You are familiar with this chart? 

Mr. HOLTZ-EAKIN. I think I saw it in a previous visit to this committee. 

Mr. SCOTT. You are going to be seeing it a lot. The curious thing 

about this, if we go to the next chart, is that according to the information we have been given, in February 2001 we thought this 

year’s budget surplus would be $268 billion. A year later, in February 2002, we thought it would be almost balanced, but a little 

bit in deficit, $14 billion. Now, maybe September 11, could have 

done that. 

But from February 2002 to February 2003, this year’s budget looked like it was going to be $300 billion in the hole. Now you are 

saying $400 [billion], depending on what happens with the extra 

money for Iraq—$450 [billion], or $475 [billion]. 

What happened after February 2, that caused such a total collapse in the budget estimates, or do you disagree with these estimates? 

Mr. HOLTZ-EAKIN. Well, these are all of these estimates, so I am 

not familiar with the details of them. The CBO estimates over the 

same period have a comparable profile, and as I have mentioned 

to Congressman Spratt, the difference between what one sees at 

the beginning, say, February 2001 and what the outlook might be 

today in 2004 is divided between economic and technical, typically 

something like 40 percent and then legislative initiatives on the interim, on both the spending and the tax side. 

Mr. SCOTT. But I think it is clear, you can’t blame September 11, 

on anything that happened after February of February 2002. 

Let me ask you another question. 

Mr. HOLTZ-EAKIN. It can—it is partly fractional and partly legislation differences on the year. 

Mr. SCOTT. When you consider tax cuts, do you consider which 

taxes are cut in terms of how it will effect the economy? 

Mr. HOLTZ-EAKIN. Yes. If one cuts marginal tax rates, that has 

some economic—beneficial economic feedbacks in the individual 

and aggregate level, if it is sufficiently large. If one cuts something 

that is not a marginal tax rate, it has a different impact in terms 

of inducement to spend more in consumption. We try to figure that 

into our economic——

24

Mr. SCOTT. But it could be better or worse. 

Mr. HOLTZ-EAKIN. We would expect in a recession, for example, 

the impact of additional consumption is sometimes beneficial, that 

would provide support. 

Mr. SCOTT. Did you consider the Joint Committee on Taxation 

analysis of the 2003 tax cut that showed there would be a shortterm spike in jobs, but long term would be worse off as a direct result of the 2003 tax cut—would have fewer jobs as a direct result 

of bypassing the 2003 tax cut? You are not familiar with that analysis? 

Mr. HOLTZ-EAKIN. We didn’t adopt that in any way. I am sure 

the staff has looked at it. I personally have not, and we try to include the current tax laws in all our projections going forward at 

any point. 

Mr. SCOTT. Could I have the next chart? 

We have kind of gone over this a little bit. As I understand it, 

you are projecting a 16.9 percent of GDP as revenues for next year? 

Mr. HOLTZ-EAKIN. Sounds about right. 

Mr. SCOTT. Other than the previous 2 years, when is the last 

time we have had a 16.9 percent percentage of GDP in terms of receipts? 

Mr. HOLTZ-EAKIN. I don’t know the exact year, but the postwar 

average is a little above 18 percent, and this is below that. 

Mr. SCOTT. Fifty years? 

Mr. HOLTZ-EAKIN. Well——

Mr. SCOTT. You are projecting a good economy, too? 

Mr. HOLTZ-EAKIN. In our most recent projections from March, we 

had a robust cyclical recovery in 2004 and 2005. And after that, we 

project sustained economic growth at something about 2.8 percent 

per year. 

Mr. SCOTT. And so I guess you are calling that a good economy. 

Mr. HOLTZ-EAKIN. We had a robust cyclical recovery in 2004, 

2005. After that we project sustained economic growth at something about 2.8 percent per year. 

Mr. SCOTT. So I guess you are calling that a good economy? 

Mr. HOLTZ-EAKIN. 4.8 percent in 2004 and 4.2 percent in 2005 

is a robust economic recovery. 

Mr. SCOTT. You are only projecting a 16.9 percent GDP at a level 

that you haven’t seen since 1959? 

Mr. HOLTZ-EAKIN. I agree on your word. On the date we can 

check. 

Mr. SCOTT. With these lowest receipts, we haven’t done much on 

lowering outlays, is that true, in terms of GDP? I am looking at the 

graph. It is right in the middle, and the receipts are way under the 

line. 

Mr. HOLTZ-EAKIN. Depending on how the outlays are constructed 

going forward, that depends on your definition of discretionary, 

which CBO increases by inflation. I am not sure if that was the 

question. 

Mr. SCOTT. I think the graph speaks for itself. We have low income and high outgo, so that explains the first chart that we 

showed. 

I don’t have any further questions. Thank you, sir. 

25

Chairman NUSSLE. Yes. If you could leave that chart up there, 

I think it says prepared by the Democratic staff, and we are not 

talking about revenue projected by the Democratic staff today. We 

are talking generally about how revenue is projected. 

Mr. SCOTT. Well, do you disagree with the numbers? For the good 

of the bench. 

Chairman NUSSLE. I was pointing that out for the good of the 

order. 

Mr. SCOTT. We will make it his projection if he would answer the 

question. 

Chairman NUSSLE. All I am suggesting, there are probably comments to be made on both sides, and we are not here to talk about 

revenue projections made by the Democratic staff. 

Mr. Barrett. 

Mr. BARRETT. Thank you, Mr. Chairman. 

Mr. Director, thank you for coming here today. I will try to keep 

it on what the topic is today. I am from South Carolina, and we 

think things should be simple. I have only been in Washington a 

couple of years, and I guess I am not quite cynical enough to think 

that we can’t do that. 

Is it possible, Mr. Director, to have a paradigm shift? I mean, let 

us talk about policy, and let’s talk about politics, and let us, you 

know—the political end is, when you talk to people in South Carolina, when you talk to people across the Nation, 80, 90, 95 percent 

of the people say, please make it simpler. 

And I am talking about the tax cut, and I think that is a universal theme, and I think that is what we are talking about here 

today, something that we can make simple, something that we can 

have data accurately and quickly, rather than 3 years later. 

You have got to tell us if there is a plan, or is it possible to have 

a plan? I have seen the plans. Is it possible to have a plan, a consumption plan or a flat tax plan, that can accomplish what we 

want to do? 

I am not talking about the politics. Take the politics out of it. Is 

it possible to have a policy that we can have that can move this 

country forward, that can be simple, that people can sit down and 

figure out their taxes by themselves without having H&R Block 

come in and all of these other things—I mean, it is beyond my comprehension that we can’t, whether it is a paradigm shift, whether 

we do it in stages or whatever. Enlighten me just a minute. 

Mr. HOLTZ-EAKIN. From the perspective of the economics, certainly many of the broad-based income or consumption tax plans 

that have been proposed would be much simpler to understand. 

They would have beneficial economic effects in reducing economic 

inefficiencies. Whether they would be simpler to comply with, everyone suspects the answer is yes. But for a person who has life 

a W–2 that with his or her wages, salary and income and who does 

not have a very complicated financial life, probably not much would 

change, quite frankly. 

And, you know, the real issue is how to move including the politics from the current system to that when in the deeper sense it 

is desirable public policy. But from a economics perspective, it is 

hard to imagine not seeing the potential for gains from a more efficient Tax Code. 

26

Mr. BARRETT. Let us say we wave the magic wand and we went 

to a consumption tax. Do you think it would be possible to do a 

total shift within 1 year, or would it be something that would probably have to be phased in, Mr. Director? 

Mr. HOLTZ-EAKIN. There are many different flavors of consumption taxes. You could go to an extreme where you did a national 

retail sales tax, where you taxed all consumption purchases at the 

individual level. That is a very big change in the administration, 

the compliance, the collection, and one would be hard pressed to 

imagine this happening quickly. 

There are other flavors of consumption tax that could be administered in a fashion that is much closer to our two-part taxation of 

income at the individual and at the corporate levels. That kind of 

transition one could imagine occuring much more quickly. It really 

would depend on the way one went about doing that. Not all the 

consumption tax plans are the same in that respect. 

Mr. BARRETT. The chairman made reference earlier if we brought 

all the regulation, litigation, all the paperwork that was required, 

it would probably fill up this room. I have seen so many estimates 

of the costs of implementing these regulations. Tell me your estimate, what CBO has said the cost of making sure that people comply with it, with the Tax Code, is. 

Mr. HOLTZ-EAKIN. We don’t have an estimate, to be honest. 

There are widely varying estimates that are in the literature. Quite 

frankly, the next panel is better equipped to answer that. We 

would be happy to look at it for you if you like. 

Mr. BARRETT. Would a shift like that, if we could make it simpler, would it be easier for you to bring projections to us so we 

could make intelligent decisions or better decisions, I will say, on 

how we spend our money and what we spend it on? 

Mr. HOLTZ-EAKIN. First, on the outlay side, how you make a decision of how you spend your money is how you present the alternative program. So that is an ongoing issue. 

Mr. BARRETT. Sure. 

Mr. HOLTZ-EAKIN. On the receipt side, it will depend on the transition where, quite frankly, it is likely we do worse. In the new 

world transition in the private sector, we are trying to guess and 

respond to how people reported, and then to the extent that the 

Tax Code settled down. And I think an important issue is why the 

Tax Code is complicated now; what are the incentives to make it 

complicated? Well, there are sometimes pay-offs to have taxes complicated, so it is desirable. But making it settle down would make 

our job easier. So there is a trade-off. 

Mr. BARRETT. Thank you, Mr. Chairman. 

Chairman NUSSLE. I thank the gentleman. 

Mr. Baird. 

Mr. BAIRD. I thank the chairman for holding this meeting. 

Mr. Holtz-Eakin, we always appreciate your frank and informative conversation with us. I mean that sincerely. I share the chairman’s astonishment at this issue which came up at the end of a 

hearing about a year ago. 

When you get money, it is almost as if it is giant sacks, and you 

don’t know how much should go to Social Security, how much to 

27

Medicare, how much came in from corporate taxes. We have broad 

numbers, but no specifics; is that accurate? 

Mr. HOLTZ-EAKIN. When income and payroll tax withholdings 

comes into the Treasury, the receipts are lumped together. In some 

cases companies do report voluntarily, but there is no requirement 

that the money come in labeled for the tax—in particular Social Security versus other—for which it is sent in. So we don’t really know 

on an ongoing basis. 

Mr. BAIRD. What puzzles me about this is when I calculate my 

taxes, I have got to sort out how much I owe in Social Security. 

A business does as well, if I have to calculate my quarterly estimates. Why is it that that is not tracked electronically or physically 

in some fashion? 

Mr. HOLTZ-EAKIN. I actually do not know. 

Mr. BAIRD. Mr. Chairman, I would hope and offer to work with 

you on this that we could really to find a way with you. Maybe the 

Ways and Means Committee will get less excited about jurisdictional issues, but it is just common sense. 

It seems to me if you were to tell the American people this, if 

you ran your own budget or business budget, you just wouldn’t run 

your business or home that way. If we run our company or home 

that way, it is not surprising that you folks give us 3-year-old numbers and we see more dramatic shifts of $40 [billion], $50 [billion], 

sometimes $60 billion a year. 

You know, when you are doing your estimates, one of the things 

I am puzzled about, you hear statements about dynamic scoring of 

taxes. Do you ever dynamically explore expenses? 

Mr. HOLTZ-EAKIN. We do not incorporate macroeconomic feedback into our cost estimates on the outlay side. We do, and I think 

it is a fair statement to say that the joint committee does, on the 

tax side look at individual-level behavior and the incentives that 

would be in an outlay bill for whoever might be affected to change 

their behavior. So it is not that our cost estimates are static in the 

sort of naive sense that you assume the world is fixed, but there 

are certain feedbacks that we do not explicitly incorporate, and 

they are largely macroeconomic. 

Mr. BAIRD. OK. So for example, if you were to say what are the 

net long-term benefits from expenditures on education or expenditures on transportation, that is not allocated? 

Mr. HOLTZ-EAKIN. We leave the future cost of GDP explicitly unchanged in doing estimates. So it is explicitly off the table. 

Mr. BAIRD. OK. Following our discussion a year ago, someone explained to me that many corporations have separate earnings reports. In other words, they report one set of earnings for the purpose of taxation, and a separate set for their stockholders. Is that 

accurate, and how—does it make sense, and how does it affect your 

work? 

Mr. HOLTZ-EAKIN. There are different financial reporting versus 

tax reporting. Our focus is on the tax side. 

There are a few instances where we have tried to look at the financial reporting to bring extra information. Stock options, for example, stand out. In looking at the late 1990s and then the most 

recent couple of years, the large run-up in bonuses and options and 

then the drop-off in those kinds of things do affect receipts. 

28

Supplementary information out of the financial reporting is 

something we have tried to get our hands on in order to better understand the future of the tax receipts. It is a challenge. 

Mr. BAIRD. I raise that issue because it seems to be congruent 

of our discussion today of the complexities in the Tax Code to some 

extent and also with how we predict revenues. 

I don’t have any further questions. 

I guess I would just, Mr. Chairman, appreciate it if we could 

work on this issue. 

Chairman NUSSLE. Yes, and it may take—and we may want to 

talk to Ms. Olson, who is probably as versed in this as anyone, and 

someone I have spoken to about this before, as well as the Ways 

and Means Committee. My understanding is this May take a legislative fix or adjustment, in addition to the fact that we shouldn’t 

be complicating the Code. 

But so this is something that I am very happy to work on. You 

are right. It may have some extrajurisdictional complications, but, 

hey, you and I have done that before. 

Mr. BAIRD. Mr. Chairman, I applaud you for that leadership. 

Chairman NUSSLE. So we can add to that pile any time we want. 

You have nothing further then. 

OK. Let us see, who is next on my list? 

Mr. Emanuel. 

Mr. EMANUEL. Thank you, Mr. Chairman, for holding the hearing. 

There was a recent report, I think it was picked up by a number 

of—both the Wall Street Journal and New York Times. There is 

some $311 billion, on a low estimate—I met with the IRS commissioner, he said that was a low estimate—underreported and not 

collected in tax returns, mainly high-end individuals that companies just don’t—either hide money, don’t file, don’t return, don’t 

pay. And the complexity, I mean, for all of us who struggled on 

dealing with the issue of a balanced budget, the complexity has led 

to a situation, in fact, where, in fact, what is owed to the government is not being paid. 

There is some earned income tax credit earned. In terms of the 

complexity there leads, I think, to what we call—some would use 

the term fraud. I would not use the term fraud. It is the complexity 

to let people, A, not filing who do deserve it, and, B, those who file 

wrong because of the complexity, notintentionally, but that is the 

end result. But the $311 billion would get us more than halfway 

toward eliminating the deficit, the annual Federal deficit. 

Since 1994, we have added about 10,000 pages to the Code and 

made about 3,500 changes. So in the last 10 years you can think 

about 350 changes a year in the Code and added about—if my 

math works correctly—about 1,000 pages’ worth of changes to the 

Code. 

So when we hold that up as a symbol of the complexity, we are 

part and parcel—what happens is, as you know, about every 20 

years we try to simplify it, and then we try to make social changes 

with it, adding the idea of a deduction for higher education or 

health care, et cetera, and try to achieve some policy changes that 

we don’t do through government spending, which adds credit, then 

complexity, and we just go backwards. 

29

I am open to the idea of tax reform, I have opened my own proposal about taking the earned income tax credit, the per child, dependent care, collapsed down to a single credit, have it down to 12 

questions and eliminate well over 200 pages of the Code. But the 

truth is that simplicity costs money, and you can’t do it on the 

cheap. 

One of the questions I have here is, A, how do we do a better job of dealing with that $311 billion that goes underreported or not 

paid and is hidden and using the Tax Code against the fairness 

that is expected in the tax system? 

I will start there, and then I have a follow-up question. 

Mr. HOLTZ-EAKIN. Well, I think the good news is that the tax 

policy community in general, the research community and practitioners all believe the U.S. Tax Code is the best in the world. The 

bad news is it relies heavily on voluntary compliance. And in the 

face of incentives to not comply or inability to comply, or reasons 

we just don’t understand, we will see underperformance of the Tax 

Code relative to expectations—and also there are very hard to 

measure issue of people’s faith in the Tax Code and their willingness to comply. That has emerged in recent years, I think, as the 

theme about concerns over the U.S. Tax Code. 

The first step, of course, is to make sure if you are going to rely 

on voluntary compliance, that it is understandable and that there 

are incentives to comply; and the second step is to enforce proper 

auditing and collection mechanisms. I have no particular expertise 

in that latter category. 

Mr. EMANUEL. Let me ask you another question, what you said 

about complexity to the sales tax, but you could also bring simplification to the tax definitions that would lead to an easier process. 

Have you ever looked at the notion of a hybrid, that is X tax for 

X income, and basically a flat income tax for anything above a certain number, and then eliminate definitions so you get away from 

loopholes, phase-in, phase-out, and that you basically stop differentiating types of income? Because one of the problems is, if you look 

at the Tax Code especially over the last 3 years, we have made the 

burden harder on work and less on worth and less on capital investment. 

I think that is fundamentally wrong, because when somebody 

gets an investment income versus what they get for salary, they 

don’t make a distinction. Yet we are the Tax Code, and yet that 

is a reflection of our values. 

So rather than say one is hard and the other one is easier, coming together with a hybrid that has a national sales tax, but an income tax, a flat number for all income regardless of type from that 

point forward. 

Have you looked at a hybrid like that? 

Mr. HOLTZ-EAKIN. I haven’t seen that. I have seen plans that are 

a combination of value-added taxes, which, at least in concept, are 

just a multistage sales tax. It is a collection of the same base in 

different stages, following income tax. There are a variety of 

themes and variations that are out there in the literature. 

Mr. EMANUEL. I will send you a copy of what has been out there 

just as food for thought as a way to go, maybe something to look 

30

at as we talk about simplification. I think it is a case for simplification would add the revenue and also add to the point where others 

don’t feel they are cheating the system while they carry a bigger 

burden. 

Thank you, Mr. Chairman, for this hearing. 

Chairman NUSSLE. Just to follow up on that, does the complication itself make it difficult for enforcement? I mean, it is probably 

just as obvious that it is difficult to pay the tax because of the complication; it is also difficult to enforce the Tax Code because of complication as well? 

Mr. HOLTZ-EAKIN. Certainly. With respect to sales taxes, labeling 

something a sales tax does not necessarily make it simpler. The 

States’ experience in trying to administer their sales tax, I think, 

is very illustrative. There are the same kinds of complexities and 

difficulties, particularly if one does not choose to make it comprehensive and tries to carve out typical classes of sales, like medical necessities, and the dividing line between necessity and purchase becomes harder. Complexity will depend not so much on the 

label, but on the form the tax takes, whether it is a sales tax or 

another type. 

Mr. EMANUEL. That will then also apply—if you don’t mind, Mr. 

Chairman? 

Chairman NUSSLE. No. 

Mr. EMANUEL. If you apply it on income, to somehow having definitions of income, therefore, would actually help you lower the rate 

as long as it was universally applied? 

Mr. HOLTZ-EAKIN. Yes. There is no question, whether income or 

consumption tax. One of the first things that one teaches in tax 

policy is that we have a constitutional amendment that made taxing income possible, but it doesn’t define taxable income. 

Mr. EMANUEL. Thank you, Mr. Chairman. 

Chairman NUSSLE. Mrs. Capps. 

Mrs. CAPPS. Thank you, Mr. Chairman, for calling this hearing. 

The 2 years I have been on the Budget Committee, we have been 

struggling with or dealing with a budget deficit that has been exploding during this current leadership. Given that our children and 

grandchildren will be paying for it, we all want to focus on what 

we can do to bring it under control, assuring that we have the most 

accurate estimates of revenues as part of that picture. 

As my colleague Mr. Baird has pointed out, it is tough to know 

how to get something when you are driving blindfolded and don’t 

have the data in front of you. 

Thank you very much to all of our witnesses for your testimony, 

but especially Mr. Holtz-Eakin. 

Last night I was reading a paragraph from your testimony that 

I would like to quote from, because I believe—and you have said 

it this morning, it reflects the priorities we have in mind when constructing the budget. This is what you say: ‘‘The central role of the 

government is to provide service to the public that only it can provide or provide adequately. Therefore, the threshold budgetary decisions faced by policymakers about which services to provide and 

how much to spend on them. These expenditures must be financed, 

and the challenge is for tax policy is to provide adequate financing 

in a fair and efficient fashion.’’

31

I think you have laid out a process, which is good. First, figure 

out what our government needs to do; second, figure out how much 

it will cost; and third, figure out how to pay for it. But unfortunately we now find ourselves in the position with our current leadership that we have first figured out what kind of tax cuts to push. 

We then have a deficit that we have to face, and then we come to 

the body and say the deficit is forcing cuts, and we get down to programs like military housing and others that we have really wrestled with here and made, I believe, the wrong—because of the 

wrong kind of priorities—the wrong kind of decision. 

I want to focus now and ask you a question, finally, on two of 

the provisions we use in budgeting, which make it difficult, I think, 

to assess revenues. Over the past 3 years the Congress and President have tried to shoehorn the maximum amounts of tax cuts into 

what budget limits we have had by using phase-ins and sunset provisions. The result has been a measured cost that was only a small 

fraction of what the Treasury would lose if those tax cuts were put 

out in full effect and continued indefinitely. The proponents of 

these tax cuts, of course, have every intention that the cuts become 

permanent even while writing the provisions that make the law expire. 

My question will be what will be the additional as yet 

unmeasured cost if all of the 2001–03 tax cuts become permanent? 

Mr. HOLTZ-EAKIN. I don’t remember the exact number, but I am 

sure that in our March report or January report we showed the implications for the 10-year budget window for extending all of the 

tax cuts. It is on the order of 2 percent of GDP out in 2014 or a 

little bit above. We could certainly get you the number. 

Mrs. CAPPS. Alright. I appreciate that. 

Then I guess my second question is—because we are about budgeting in this committee—what do those sunset and phase-in provisions do to the evolving revenues, which is the heart of what you 

are about? 

Mr. HOLTZ-EAKIN. As I mentioned in my opening remarks, it 

really has presented us with some great difficulties in understanding the future path of, first, the economy—what does the private sector believe about the future of tax policy? And then, conditional on that, what is the best way to present the budgetary implications: following current law, which might not be consistent with 

the economy, or projecting the economy in a way that is not consistent with what the private sector expects and put the law on 

top? It has been a tough call. 

Mrs. CAPPS. Again, as my colleagues have said, you wouldn’t be 

able to run a business this way. One could say, if one is cynical, 

it is an attempt to cloud and make fuzzy as to what our budget situation is, because certain things are being phased in over time, and 

other things are being sunsetted out. 

In actuality it is a gimmick, and you are faced with having to try 

to make some sense out of it. I think it is really hard for us to understand. I think it is even harder for our constituents to get a 

handle on it. 

Would you mind, for one final question in the few seconds that 

I have, to tie this feature of our budgeting process to what difference it would make if we did really apply, as my previous quesVerDate 0ct 09 2002 17:09 Oct 26, 2004 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6602 X:\HEARINGS\108TH\108-23\HBU204.000 RYAN PsN: RYAN
32

tioner asked you about the pay-as-you-go method, to both taxes and 

spending revenues? If this were applied to taxes, what would it do 

to the phase-in and phase-out qualities that we now have there? 

Mr. HOLTZ-EAKIN. From the perspective of CBO, that is not really the central issue. What we are trying to do in our baseline projections is give you a neutral benchmark against which you can 

measure policy changes, to take the current law and do our best 

to extract implications, thus allowing you to measure impact on a 

bill-by-bill basis. PAYGO would apply in that bill-by-bill basis—on 

any decisions you might make, PAYGO would apply to that, to that 

bill-by-bill decisionmaking and those things that the Congress 

chose to do or chose not to do. It is hard for me to speculate how 

that would play out. 

Mrs. CAPPS. I think we make your job tougher than it should be. 

I yield back the balance of my time. 

Chairman NUSSLE. Thank you, gentlelady. 

Mr. Cooper. 

Mr. COOPER. Thank you, Mr. Chairman. 

The next panel will have Ms. Olson on the roster. I think she has 

perhaps given this committee two of the most important sentences 

to testimony that I have seen in my tenure on the committee. I 

would like to read those aloud. 

It refers to tax loopholes. Of course, a loophole is what somebody 

else gets, but if you get it yourself, it is an element of essential tax 

fairness. She says, ‘‘In recent years the Internal Revenue Code has 

been amended repeatedly with provisions intended to encourage, 

reward or reduce the costs of certain activities through exclusions, 

deductions, exemptions, special rates and credits. While the goals 

of some of the provisions may be admirable, they represent uncapped, unverified and, in a large measure, unverifiable direct 

spending programs.’’

That is a powerful statement to me, because it basically means 

that these tax expenditures or tax loopholes make it almost impossible for someone like you to estimate. So that means, to me, that 

the worst direct spending program is still probably preferable to 

the best indirect spending program, because at least you can measure and verify the direct spending program. 

But these indirect spending programs through the Tax Code 

amount to a blank check, because if they are uncapped, unverified 

and unverifiable, we have lost complete control, and almost every 

day in this body we are tempted by some group or another to give 

them a tax break. To our friends on the Ways and Means Committee, those will seem like real deals. 

I know that President Reagan and others had a thing that ‘‘there 

was no such thing as a tax expenditure, it was all your own money 

anyway,’’ and some of my friends on the other side may perhaps 

believe this. But for Ms. Olson to say this, and I believe she was 

a political appointee of the Bush administration, the George W. 

Bush administration, to me, she is speaking the truth. 

This spending is uncapped, unverified and unverifiable. That is 

perhaps the most damning statement I have ever heard, and yet 

this Congress and previous Congresses engaged in these programs 

wholesale. 

33

So, what am I missing here? Do you have a secret mechanism 

for verifying these unverifiable spending programs, the number of 

which we could barely count if we had an encyclopedia? In fact, 

most of the documents that are listed over there are full of these 

very loopholes. So we don’t even have a clue about how much revenue we are missing or how much of a subsidy we are offering to 

these individual beneficiaries. 

If these are, in fact, as Ms. Olson is about to testify, uncapped, 

unverified and unverifiable, what am I missing? 

Mr. HOLTZ-EAKIN. I will leave Ms. Olson to defend her alliteration. I think the issue is an important one. As I said, just at the 

conceptual level, presenting a budget where you can make tradeoffs and see all programs for their resource cost is important, and 

the degree to which things are treated differently on one side or 

the other is not helpful, at our end, when one does these targeted 

sorts of tax policies. That falls into that very difficult category of 

technicals. It is a composition of activity in the economy not captured by just whether—we have got full employment GDP. When 

we are wrong, we have technical restimates, and we see that all 

the time. 

Mr. COOPER. Dr. Olson—in your little time remaining, I think 

what—you are mistaken here. I am talking about what Ms. Olson 

seems to be claiming are the biggest loopholes in American history. 

These are uncapped spending programs, unverified and unverifiable. How on Earth do the advocates of these loopholes know what 

they are costing? How can you make a cost/benefit analysis if you 

have no idea of the cost? 

You know, this is uncharted water, it seems like, if Ms. Olson is 

correct, and she was a top trusted official in this administration. 

This is to say one of the most damning statements I have ever 

heard, and she has been brave enough to put it in plain English. 

She is, I assume, on the other side of the aisle. This is an amazing 

thing. These loopholes you are describing are so big you could drive 

a truck through them. 

There is barely enough law left to hold all the loopholes together 

if her claim is verified, uncapped, that these programs are 

unverified and unverifiable. You are making some nice, technicalsounding statements, but if her claims are correct, you cannot do 

your job with thousands of these in the budget, in the Tax Code. 

Mr. HOLTZ-EAKIN. Again, to look at the details, I am looking at 

the cost in a budget sense. In the sense of introducing such a tax 

loophole that would be a job that the Joint Committee on Taxation 

would have to do, and that is a highly professional group. They will 

do the best they can under these circumstances. 

Mr. COOPER. Which is no good. Which is no good. 

Mr. HOLTZ-EAKIN. Your characterization. 

Mr. COOPER. Well, Ms. Olson’s. 

Mr. HOLTZ-EAKIN. Ms. Olson’s. 

At the CBO we don’t have to do that. We have to take that law 

when it is in place and project what will be collected. We do not 

have to calculate how much of the loss is varifiable behavior. What 

we have to do may be hard, but not as hard as that particular 

problem. These are very difficult projections in the revenue projections. 

34

Mr. COOPER. Say you had a special mortgage tax break for blue 

houses, you got a double mortgage deduction. Wouldn’t you get—

you would have a lot more blue houses? 

Mr. HOLTZ-EAKIN. Absolutely. 

Mr. COOPER. People would suddenly like that color. Then in 

order for you to do your job, you would have to count the number 

of blue houses and new blue houses in America in order to estimate 

the revenue you could anticipate. Who is out there doing that 

counting? No one. 

These are uncapped, unverified and unverifiable spending programs through the Ways and Means Committee, not the Appropriations Committee, which is a much more accountable body. So 

this to me is an outrage. But my time is up. 

Chairman NUSSLE. Reserving the right to object on the question 

of whether the Appropriations Committee is more accountable than 

Ways and Means. Yes, we won’t go there. 

Mr. COOPER. Seriously, Mr. Chairman. 

Chairman NUSSLE. You don’t have to make up an example about 

blue houses. There is the earned income tax credit that probably 

may be the mother of all good examples. 

Mr. Diaz-Balart. 

Mr. DIAZ-BALART. Thank you, Mr. Chairman. 

I have the highest respect particularly for colleagues in this committee, but I think all of us, including me, we kind of get confused 

by our own minutiae. The government tends to do that a lot. I have 

just heard, for example, tax cuts are a gimmick. In other words, 

the government taking less money from the American people is a 

gimmick. 

We all know government taking less money from hard-working 

Americans is government taking less money from hard-working 

Americans; by the way, doesn’t stimulate the economy. I think 

there is a consensus on that. 

But also, now, I am rather kind of concerned about this unverifiable amount of money that I guess we have in tax cuts, I guess, 

if all we are concerned about is government, and then we should 

probably just take every single penny that Americans earn, and 

then we could definitely verify how much money there is. But ultimately, again, we have to remember that the people in small business and hard-working Americans are not here to serve governments. Government is here to supposedly serve the people. 

So the fact that—and I know it wasn’t many members of this 

committee that actually made that original quote, but the fact that 

this thing about unverifiable, again, that we can’t verify, and it is 

unverifiable, and it is unverified, it would seem to me that if that 

is the—heck, let us just take everybody’s money, 100 percent of it, 

because if we are concerned about—if the only thing we are concerned about is how much the government can figure out how 

much we are or are not taking, and that is what we are concerned 

about, man, we are getting the wrong role rule here. The role 

should be to take every penny. 

The bottom line is, the reason I mention that, I think we sometimes get confused in our own minutiae, and the bottom line is tax 

cuts are taking money from the American people. Tax cuts in the 

complicated Tax Code is again taking less money from American 

35

people, and I agree that is not spending it. When you take less 

money from the American people, that is not spending; the government isn’t spending anything, but we are taking less of their 

money. 

And I do have a question. You know, one of the things that is 

interesting is that the alternative minimum tax that was enacted 

in the 1970s has obviously been expanded periodically, has never 

been indexed, as far as I know, to inflation. As a result my understanding and projections indicate a massive growth of the number 

of taxpayers paying the AMT in the future, which would make 

sense. Does that AMT complicate revenue projections? And also it 

would seem that predicting what the taxpayers will have to pay, 

how much AMT, would be difficult. Is that correct; is that accurate? 

Mr. HOLTZ-EAKIN. The AMT is another part of our challenge, for 

revenue projections. We have the AMT rising to nearly 30 million 

taxpayers in our baseline. Again, we look at the composition of 

their income, look at the composition of their deductions, and then 

look to see whether it will be on the AMT based on nominal incomes, because the AMT is not indexed. 

Mr. DIAZ-BALART. Mr. Chairman, we have seen again—looks like 

from 2001—the errors in the CBO projections that resulted more 

from economic factors, assumptions and technicals than from actual legislation, and that is what my understanding is. Is there 

anything we can do regarding our tax system to reduce those economic and technical forecasting errors, or is that something that is 

beyond our control? 

Mr. HOLTZ-EAKIN. I think that the underlying economic uncertainty, the fact that there are business cycles over that period—it 

is a particularly difficult period because of a turning point which 

is very hard to forecast. But, in general, that part won’t go away. 

Technicals depend in many ways on these policy issues where 

you have incentives to shift the composition of your activity, or that 

the Tax Code explicitly favors one activity over another. Having 

those simplified might help somewhat, along with better data. Simply having more information to both permit the analysis of past 

technical errors and also timely projection of the likely future of 

tax receipts—those are all things that would help. 

We have worked very hard at CBO to try to understand this better. We had a conference last year. We brought in experts on literally the year-by-year technicals and examined what the nature of 

the construction of those were—top down, bottom up, the use of 

supplementary information from States, a wide variety of issues. 

Nothing stood out as a silver bullet. I mean, this is just a hard 

area. 

Chairman NUSSLE. I thank you. 

Director, thank you very much for your testimony today. As we 

move forward, I think you can tell from a bipartisan smattering of 

questions and comments that we are interested in getting better 

data. If CBO has any recommendations regarding giving data, 

whether that is access to better information from whether its 

Treasury or Joint Tax, whatever it may be, we want to make sure 

that the Congress has the best information in order to make decisions. It may not be day old or week old or even monthly, but 3 

years is difficult. And as we have heard today, I think Members are 

36

interested in doing what we can, even if it required internal or legislative changes that we can make in order to get better information. So we appreciate that. 

If you have recommendations, we would be very interested in receiving them as we move forward. 

Mr. HOLTZ-EAKIN. Thank you, Mr. Chairman. 

Chairman NUSSLE. I thank you. 

Now we will invite the second panel to come forward. We have 

three distinguished panelists, the Honorable Pam Olson, Dr. Peter 

Merrill and Dr. William Gale, and we will take a brief 2-minute recess while we are changing the names and inviting our guests to 

come forward. 

[Recess.] 

Chairman NUSSLE. Our second panel, we are pleased to have at 

the panel table. We are pleased, I am pleased, to invite Pam Olson, 

often quoted. We appreciate you being here, we appreciate your 

service. 

As a member of the Ways and Means Committee, I have to say, 

I was always very appreciative of your testimony before our committee as Under Secretary. We miss you, but we are certainly glad 

to have you here today to be able to present us with your ideas regarding revenues projections. So you may proceed as you see fit. 

STATEMENTS OF PAMELA F. OLSON, PARTNER, SKADDEN, 

ARPS, SLATE, MEAGHER & FLOM, LLP, FORMER ASSISTANT 

SECRETARY OF THE TREASURY FOR TAX POLICY; PETER R. 

MERRILL, PH.D., DIRECTOR, NATIONAL ECONOMIC CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP; AND 

WILLIAM G. GALE, Ph.D., SENIOR FELLOW, THE BROOKINGS 

INSTITUTION 

STATEMENT OF PAMELA F. OLSON 

Ms. OLSON. Thank you, Mr. Chairman, for that warm welcome, 

a welcome maybe a little warmer than I would have liked. Mr. 

Chairman, Mr. Spratt and members of the committee, I do appreciate the opportunity to be here to discuss the tax system, particularly on the budget side. 

The ideal tax system would raise the revenue to fund the operations of the government with the least adverse impact on the 

economy. It would be neutral, transparent, stable and certain. Our 

tax system falls short of the ideal system in several respects, and 

it is those shortcomings my testimony addresses. Before turning to 

that topic, however, it would be useful to focus for a moment on 

the budgetary impact of the increasing tendency to spend through 

the Tax Code. We have already heard a little bit about that in this 

hearing. 

I guess I won’t reread the two sentences that have already been 

read into the record, but let me explain what I meant by uncapped, 

unverified and unverifiable. Expenses or amounts that we spend 

through the Tax Code are uncapped because any taxpayer satisfying the applicable requirements may claim the resulting tax deduction or outlay. While targeting the benefits of the provisions to 

particular classes of taxpayers may hold down the budgetary imVerDate 0ct 09 2002 17:09 Oct 26, 2004 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6602 X:\HEARINGS\108TH\108-23\HBU204.000 RYAN PsN: RYAN
37

pact, it does so at the expense of simplicity, a point that is worthy 

of further discussion. 

The multiplication of these provisions prompted a waggish Treasury Department economist a few years back to design the ‘‘tax 

credit for the taxpayer who didn’t get a tax credit’’ in an effort to 

stave off the development of further credits. 

These spending programs are unverified because taxpayers need 

not establish to the Internal Revenue Service their eligibility for 

the tax reduction or outlay before claiming it on their tax return. 

They are largely unverifiable because neither the Treasury Department nor the Congress has been able to devise mechanisms that 

would permit the Internal Revenue Service to efficiently and effectively determine taxpayers’ eligibility for the special provisions. 

There is, of course, an IRS audit program, but as we have heard 

an awful lot in the press lately, we don’t begin to cover the number 

of taxpayers that we perhaps ought to be covering. Certainly we 

will never get to the point where we cover them all, at least not 

so long as we insist on adding complications to the Code that can’t 

be readily verified by information provided by a third party, for example. 

This inability to verify presents another serious issue for the 

Congress. We cannot assess the efficacy of the expenditures in 

achieving our desired goals. 

As the late former Treasury Secretary William Simon observed, 

the United States should have a tax system which looks like someone designed it on purpose. No tax system ever devised has included so many things unrelated to tax collection. While one or two 

exceptions might be reasonable, the weight of all the exceptions 

puts at risk the basic goals of the tax system. 

Spending through the Tax Code presents particular challenges to 

our ability to make accurate budgetary projections. It also affects 

economic growth and, this is really important, deprives the tax system of the neutrality, transparency and certainty that would make 

for a better system. 

With respect to minimizing the impact of the tax system on the 

economy by, removing resources from the private sector, the tax 

system slows the growth of the private sector of the economy. If we 

want to minimize the effect on the economy, we should have a system that minimizes its impact on decisions to work, save and invest. We can best foster economic growth with low rates, a broad 

base—that is, few exceptions, equally applied—eliminating barriers 

to deploying and redeploying capital and labor and a stable system. 

The amounts that we spend through the Tax Code have considerably narrowed the tax base in recent years, particularly since we 

did a house cleaning back in 1986. The myriad sunsets of current 

law are the opposite of the stability that allows taxpayers to plan 

their affairs. 

It is important to have a system that is as uncomplicated as possible, a standard that the current Tax Code fails miserably. Resources spent complying with the tax laws, which the Internal Revenue Service estimates for individuals alone—this is the issue that 

was raised earlier—totaled between $70 [billion] and $95 billion 

annually. These are resources that are unavailable for more productive investments and endeavors and are a drag on the economy. 

38

Turning now to the other principles that should guide us in designing our tax system. First, neutrality. The tax system should 

apply on a neutral basis, that is, without discriminatory treatment. 

Investment decisions made on a basis other than maximizing 

pretax returns reduce national income to the detriment of all. The 

best rules are rules that apply equally without regard to industry, 

activity, type of entity, or form of investment. The Internal Revenue Code fails the neutrality principle on multiple scores. 

Second, transparency. Transparency in the tax system has been 

described as certainty about what the rules are, how they will be 

applied, and that they will be applied fairly. Transparency matters 

because it gives taxpayers confidence in the system. A system that 

is too complex loses its transparency because of the difficulty of administering and complying with it. That, in turn, will erode confidence in the system and voluntary compliance. 

The U.S. tax system is nothing short of opaque; that is, the opposite of the transparent system we should be seeking. It is impossible for any one person to understand all of the Tax Code’s provisions, and the Internal Revenue Service cannot assure compliance 

or consistent application. 

It is my view that the growing complexity of the system has reduced compliance because many taxpayers simply throw up their 

hands in despair. Perhaps even more important is that complexity 

creates shadows, concealing those inclined to avoid their responsibilities. In short, the opacity of the current system is a danger to 

our self-assessment system. 

Third, certainty. Decisionmaking is difficult. This committee is 

certainly aware of that. Decisions involve expectations about the 

future, but the future is uncertain. The greater the uncertainties, 

the greater the risk. The greater the risk, the greater the premium 

required by the decision maker. We can reduce decision makers’ 

risk premiums by giving them greater certainty about the future. 

At a minimum, we should not add to the risk premium attached 

by the decision maker with provisions that go in and out of the Tax 

Code like yoyos. A system that is stable will reduce the risk premium and result in more productive decisions. 

There are particulars I want to draw to the committee’s attention. The first relates to the efficacy of spending through the Tax 

Code. 

Simply stated, the Tax Code is not a good delivery vehicle for 

many of the programs we have added over the years. In order to 

deliver the benefits intended by the various spending provisions 

added to the Tax Code, a taxpayer must be aware of the benefits 

and capable of claiming them, and the Internal Revenue Service 

must be capable of administering them. The complexity of the Tax 

Code, coupled with the educational level of many of the individuals 

to whom benefits are targeted, makes the Tax Code a poor delivery 

mechanism for many intended benefits. The fact that eligibility is 

determined after benefits are claimed adds an unhealthy uncertainty about whether an outlay will have to be repaid or whether 

additional taxes might be due at some point down the road. 

Benefits delivered through the Tax Code are sometimes highly 

particularized, requiring the Internal Revenue Service to make determinations about eligibility that it is without the expertise to 

39

make. Consider, for example, the expertise required to administer 

provisions in the tax laws relating to the environment, conservation, or energy production. The resources required to administer 

such provisions appropriately are significant and detract from the 

Internal Revenue Service carrying out its primary tax collection 

function. 

The second relates to projecting corporate receipts. Over time 

corporate receipts have proved difficult to project and a volatile 

source of revenue. Receipts’ trending down in an economic downturn is desirable because of the countercyclical effect, but it may 

be advisable to consider whether there is a base that would 

produce more predictable revenues than our current income tax 

base does. 

I was interested to hear the question about the difference between financial statement reporting and the amountes reported on 

tax returns. As the years have passed, we have increased the number of disparities between book income and taxable income. And 

taxpayers do have to follow the tax laws when preparing their returns. Removing the disparities between financial statement incomes and taxable incomes might reduce some of the volatility that 

we see. It might also have the effect of making it easier for corporate tax receipts to be projected. On the other hand, an entirely 

different base might be considered, such as a business activities 

tax. 

Finally, our current savings rate is abysmal. It seems clear that 

the complexity of the savings provisions in the Tax Code prevents 

many taxpayers from taking advantage of those opportunities. 

Some complexity stems from the best of intentions: the desire to 

provide as many options as possible. As behavioral economists have 

demonstrated, however, having too many options can actually reduce the take up rate. Taxpayers spend too much time trying to 

understand their options under the tax rules. It would be better if 

they put that time into making wise investment decisions. If we 

want people to get off the spending couch and into the savings 

gym, we need to make it easier for them to do so. 

Although our tax system is sometimes said to be a hybrid of income and consumption taxes, it favors spending over saving except 

to the extent that taxpayers can avail themselves of the complicated and illiquid savings provisions in the tax law. In other 

words, under our tax law today, virtue carries a cost rather than 

a reward. Although current budget shortfalls dominate many discussions, the long-term shortfalls stemming from unchecked Medicare and Social Security spending is a far more serious problem. 

The problem can be eased by increasing our savings rate. That 

means creating a Tax Code that encourages, not penalizes, those 

who save. 

I would be happy to answer the committee’s questions. 

[The prepared statement of Ms. Olson follows:]

PREPARED STATEMENT OF PAMALA F. OLSON, PARTNER, SKADDEN, ARPS, SLATE, 

MEAGHER & FLOM, LLP, FORMER ASSISTANT SECRETARY OF THE TREASURY FOR

TAX POLICY

Chairman Nussle, Ranking Member Spratt, and distinguished members of the 

Committee, I appreciate the opportunity to appear this morning to discuss current 

problems facing our tax system. I am here today at the request of the Committee. 

40

1The Treasury Department and the Joint Committee on Taxation each prepare an annual tax 

expenditure analysis, which is far broader in concept than the issues described below. The 

Treasury Department has devoted considerable effort in recent years to revising its tax expenditure analysis, some of which is described in the President’s two most recent Budgets, to address 

inconsistencies and limitations of the analysis. 2What appeared to be an effort a few years back to ‘‘put a tax credit in every pot’’ led a Treasury Department economist to design the ‘‘tax credit for the taxpayer who didn’t get a credit’’ 

in an effort to stave off further proposals. 

I am currently a partner in the law firm, Skadden, Arps, Slate, Meagher & Flom, 

LLP, but I am not appearing on behalf of any client or other organization, and the 

views I offer are solely my own. 

I. INTRODUCTION

The ideal tax system would raise the revenues to fund the operations of the government with the least adverse impact on the economy—that is, it would be neutral, 

transparent, stable, and certain. Our tax system falls short of the ideal system in 

several respects, and it is those shortcomings my testimony addresses. Before turning to that topic, however, it would be useful to focus for a moment on the budgetary 

impact of the increasing tendency to ‘‘spend’’ through the Tax Code.1

II. SPENDING THROUGH THE CODE

In recent years, the Internal Revenue Code has been amended repeatedly with 

provisions intended to encourage, reward, or reduce the cost of certain favored activities through exclusions, deductions, exemptions, special rates, and credits.2

While the goals of some of the provisions may be admirable, they represent uncapped, unverified, and, in large measure, unverifiable indirect spending programs. 

They are uncapped because any taxpayer satisfying the applicable requirements 

may claim the resulting tax reduction or outlay. While targeting the benefits of the 

provisions to particular classes of taxpayers may hold down the budgetary impact, 

it does so at the expense of simplicity, a point worthy of further discussion. 

They are unverified because taxpayers need not establish to the Internal Revenue 

Service their eligibility for the tax reduction or outlay before claiming it on their 

tax returns. They are largely unverifiable because neither the Treasury Department 

nor the Congress has been able to devise mechanisms that would permit the Internal Revenue Service efficiently and effectively to determine taxpayers’ eligibility for 

many of the special provisions. 

The inability to verify presents another serious issue: We cannot assess the efficacy of the expenditures in achieving the desired goals. 

As the late former Treasury Secretary William Simon observed, ‘‘The United 

States should have a tax system which looks like someone designed it on purpose.’’ 

No tax system ever devised has included so many things unrelated to tax collection. 

While one or two exceptions might be reasonable, the weight of all the exceptions 

puts at risk the basic goals of the tax system. 

Spending through the Tax Code presents particular challenges to our ability to 

make accurate budgetary projections. It also affects economic growth and deprives 

the tax system of the neutrality, transparency, and certainty that would make for 

a better system, points to which I will now turn. 

III. MINIMIZING THE TAX SYSTEM’S ADVERSE IMPACT ON THE ECONOMY

By removing resources from the private sector, the tax system slows the growth 

of the private sector of the economy. Minimizing the effect on the economy requires 

a system that minimizes its impact on decisions to work, save, and invest. 

We can best foster economic growth with low rates, a broad tax base (i.e., few exceptions equally applied), eliminating barriers to deploying and redeploying capital 

and labor, and a stable system. The amounts spent through the Tax Code (discussed 

previously) have narrowed the tax base. The myriad sunsets of current law are the 

opposite of the stability that allows taxpayers to plan their affairs. 

It is important to have a system that is as uncomplicated as possible, a standard 

the current Tax Code fails miserably. Resources spent complying with the tax laws, 

which the Internal Revenue Service estimates for individuals alone total between 

$70 billion and $95 billion annually, are resources unavailable for more productive 

endeavors and are a drag on the economy. 

The Tax Code’s adverse effect on economic growth deserves Congressional attention. 

41

3 A transparent system is the opposite of one in which the taxpayer negotiates his tax liability. 

IV. NEUTRALITY

The tax system should apply on a neutral basis, that is, without discriminatory 

treatment. Investment decisions made on a basis other than maximizing pre-tax returns reduce national income to the detriment of all. Consequently, we should avoid 

rules that discriminate, thus biasing investment decisions. The best rules are rules 

that apply equally, without regard to industry, activity, type of entity, or form of 

investment. The Internal Revenue Code fails the neutrality principle on multiple 

scores. 

V. TRANSPARENCY

Transparency in a tax system has been described as certainty about what the 

rules are, how they will be applied, and that they will be applied fairly.3 Transparency matters because it gives taxpayers confidence in the system. A system that 

is too complex loses transparency because of the difficulty of administering and complying with it. That, in turn, will erode confidence in the system and voluntary compliance. It goes without saying that reduced compliance means higher tax rates for 

compliant taxpayers. 

The U.S. tax system is nothing short of opaque, that is, the opposite of the transparent system we should be seeking. It is impossible for any one person to understand all of the Tax Code’s provisions, and the Internal Revenue Service cannot assure compliance or consistent application. Using income for our tax base ensures 

some complexity because income is inherently difficult to measure. However, we 

have exacerbated the problem with special rules that increase the disparities between taxable income and conventional determinations of income, such as financial 

statement income. 

Although reliable information on compliance levels is hard to come by, it is my 

view that the growing complexity of the system has reduced compliance because 

many taxpayers simply throw up their hands in despair. The multitude of special 

provisions leaves taxpayers uncertain whether they have correctly claimed the allowable tax benefits, worrying they have missed some hidden provision, and wondering whether they paid more than their fair share. Perhaps even more important 

is that complexity creates shadows concealing those inclined to avoid their responsibilities. 

In short, the opacity of the current system is a danger to our self-assessment system. Although the decline of the tax system on account of complexity has been predicted for decades, I believe that we are at a critical juncture. If we do not begin 

soon with significant steps to simplify the tax laws, I believe the system may collapse of its own weight. 

VI. CERTAINTY

Decision-making can be difficult. Decisions involve expectations about the future 

but the future is uncertain. The greater the uncertainties are, the greater the risk 

is. The greater the risk is, the greater the premium required by the decision-maker. 

We can reduce decision-makers’ risk premiums by giving them greater certainty 

about the future. At a minimum, we should not add to the risk premium attached 

by the decision-maker with provisions that go in and out of the Tax Code like yoyos. 

A system that is stable will reduce the risk premium and result in more productive 

decisions. I would urge you to go to work now to create a tax system that is not 

subject to annual revision. 

VII. PARTICULARS

I want to note for the Committee three particular budget issues. 

The first relates to the efficacy of spending through the Tax Code. In order to deliver the benefits intended by the various spending provisions added to the Tax 

Code, the taxpayer must be aware of the benefits and capable of claiming them, and 

the Internal Revenue Service must be capable of administering them. The complexity of the Tax Code coupled with the educational level of many of the individuals to whom benefits are targeted makes the Tax Code a poor delivery mechanism 

for many intended benefits. The fact that eligibility is determined after the benefits 

are claimed adds an unhealthy uncertainty about whether an outlay will have to 

be repaid or additional taxes will be due at some point down the road. 

Benefits delivered through the Tax Code are oftentimes highly particularized, requiring the Internal Revenue Service to make determinations about eligibility that 

it is without the expertise to make. Consider, for example, the expertise required 

42

4 In an upscale grocery store experiment, researchers set up a jam-tasting booth, first with 

six jars of jam from which shoppers could choose, and then with 24 jars of jam. When the shoppers had only six jars from which to choose, 40 percent tasted and 30 percent made a purchase. 

When the number was increased to 24, the percentage tasting increased to 60 percent, but the 

number buying dropped to 3 percent. More choices are not always better. 

to administer provisions in the tax laws relating to the environment, conservation, 

or energy. The resources required to administer such provisions appropriately are 

significant and detract from the Internal Revenue Service carrying out its primary 

tax collection function. 

The second issue relates to projecting corporate receipts. The fact that corporate 

receipts have declined as a percentage of all receipts has received considerable attention of late. The decline may be traced to a number of factors: 

• The growth of pass-through entities such as partnerships that has shrunk the 

corporate sector’s share of gross receipts. 

• Expensing of stock options. 

• Increased use of indebtedness as a more tax efficient capital structure. 

• A decline in corporate profitability. 

Over time, however, corporate receipts have proved difficult to project and a volatile source of revenue. Receipts’ trending down with an economic downturn is desirable because of the countercyclical effect, but it may be advisable to consider whether there is a base that would produce more predictable results than our current corporate income tax base does. Removing disparities between financial statement and 

taxable income might reduce some volatility. An entirely different base, such as 

business activities, might be considered as well. 

Finally, our current savings rate is abysmal. It seems clear that the complexity 

of the savings provisions in the Tax Code prevents many taxpayers from taking advantage of those opportunities. Some complexity stems from the best of intentions: 

the desire to provide as many options as possible. As behavioral economists have 

demonstrated, however, having too may options can actually reduce the take up 

rate.4 Taxpayers spend too much time trying to understand their options under the 

tax rules. It would be better if they put that time into making wise investment decisions. If we want people to get off the spending couch and into the savings gym, 

we need to make it easier for them to do so. 

Although our tax system is sometimes said to be a hybrid of income and consumption taxes, it favors spending over saving except to the extent taxpayers can avail 

themselves of the complicated and illiquid savings provisions in the tax law. Over 

time, for example, two families who are identical except that one saves diligently 

will bear different tax burdens. The family that saves will see its income tax burden 

increase relative to the burden of the taxpayer who spent. In other words, virtue 

carries a cost, not a reward. Although current budget shortfalls dominate many discussions, the long-term shortfall stemming from unchecked Social Security and 

Medicare spending is a far more serious problem. The problem can be eased by increasing our savings rate. That means creating a Tax Code that encourages, not penalizes, those who save. 

Thank you for inviting me to testify today. I would be happy to answer any questions.

Chairman NUSSLE. I thank you for your testimony, and the 

warm welcome was meant—I can tell just again by your testimony 

today versus when you maybe had your hands tied speaking a little 

bit just for the administration, it is even better. So I appreciate it. 

Dr. Merrill, welcome to the committee, and we are very pleased 

to receive your testimony. Just so everyone knows, your full testimony will be made part of the record, and you may proceed as you 

see fit. 

STATEMENT OF PETER R. MERRILL 

Mr. MERRILL. Thank you, Mr. Chairman, Mr. Spratt and members of the committee. I am Peter Merrill, director of the National 

Economic Consulting Group of PriceWaterhouseCoopers. I am testifying today on my own behalf and not as a representative of any 

organization. The focus of my testimony is on the competitiveness 

43

of the U.S. tax system, how it compares with the tax systems of 

other major industrial countries. 

In the global economy, tax policy is one of the ways that the 

United States competes for investment at home and for the success 

of U.S.-owned companies abroad. The United States is a relatively 

low-tax country, according to OECD statistics. Federal, State and 

local combined was lowest among the OECD countries in 2001. 

The favorable tax burden reflects the smaller role that the government plays in the United States economy. Government expenditures relative to GDP also were fourth lowest among the OECD 

countries. According to the 2001 OECD statistics, the U.S. Government’s public debt as a share of GDP was less than the OECD average by about 12 percentage points. However, based on CBO projections, the U.S. public debt-to-GDP ratio will exceed the current 

OECD average within the next 10 years if all the expiring income 

tax relief projections in the Code are extended. 

While the United States is a relatively low-tax country, it relies 

more heavily on taxes on income and profits, both as a share of 

total taxation and as a share of GDP, than the average OECD 

country. Combining all levels of government, income and profits 

taxes accounted for about half of U.S. revenues in 2001 compared 

to 36 percent for the average OECD country. At the Federal level 

the government is even more reliant on income and profit taxes as 

there is no broad-based Federal consumption tax as there is in 

every other OECD country. 

The top Federal U.S. tax rate on individual income is now 30 

percent, less than the OECD average of 37.6 percent. However, unlike most of the OECD countries, U.S. residents typically are subject to income tax on State or local levels of government. Unless it 

is extended, the top individual Federal income tax rate will increase from 35 to 39.6 in 2011, to put the top Federal individual 

income tax rate at 2 percentage points above the current average 

for OECD countries. 

Immediately following the Tax Reform Act of 1986, which lowered the U.S. income tax rate from 46 to 34 percent, the U.S. corporate rate was quite attractive. This is no longer true. The U.S. 

corporate income tax rate increased to 35 percent in 1991, while 

the average OECD country’s corporate rate fell to 29.3 percent in 

2003. In other words, the average OECD country’s average tax rate 

is 5.4 percent percentages points less than the U.S. rate. If you 

look at the 25 members of the newly expanded European Union, 

the average corporate tax rate is about 27 percent, 8 percentage 

points less than the U.S. corporate rate. The U.S. is tied with 

Spain and Greece for third highest corporate income tax rate 

among OECD countries. High corporate income tax rates discourage businesses from operating in regular corporate form. 

While the 2003 Tax Act reduced the shareholder level tax on corporate tax dividends, this relief is scheduled to sunset after 2008. 

If it does sunset, the U.S. will join Switzerland as the only OECD 

country without double taxation relief, and the top rate on income 

tax on dividends, combining Federal and individual-level taxation, 

would increase from about 45 percent today to 60 percent after 

2010. 

44

Payroll taxes provide, of course, a primary source of funding to 

the U.S. for the Social Security, Medicare, and unemployment systems. The social insurance and payroll taxes represent about onefourth of revenues in the United States, which is actually quite 

similar to other OECD countries. 

Like many other advanced industrial economies, the future obligations of the U.S. social insurance system exceed the dedicated 

revenue streams. In 2003, the GAO estimated that future liabilities 

for the U.S. Social Security and Medicare systems would exceed future revenues for these programs by about $21 trillion in present 

value, and that didn’t include the Medicare prescription drug expansion that was done this year. That unfunded liability is about 

71,000 for every U.S. citizen. So it is obviously a significant longterm challenge. 

Looking at multinationals, the United States imposes higher 

taxes on U.S.-based multinationals than competitor countries impose on their multinationals. As a result, U.S. multinationals will 

lose global market share. 

A decline in global market share of U.S. multinationals will obviously affect domestic workers—I will not go into all of the written 

testimony on this—but competitiveness of U.S. multinationals 

abroad is directly related to employment at home. 

Aside from the relatively high U.S. corporate income tax rate, 

there are a number of other features of the U.S. system of taxing 

foreign-source income that depart from international norms. Over 

half of the OECD countries have dividend exemption, or so-called 

territorial tax systems, under which the parent company generally 

is not subject to tax on the income earned by its foreign subsidiaries. 

The U.S. foreign tax credit, which is intended to limit or prevent 

double taxation, has a number of defects that increase the complexity and prevent double tax relief. 

Moving to complexity, the burden of the tax system includes both 

taxes paid and compliance costs. The Tax Foundation has estimated that the cost of complying with the Federal income tax 

raises the total tax burden by about 20 percent, that is, 194 billion 

in 2002. There are lower estimates of this as well; they vary on 

how you value the time that people spend filling out returns. 

Just by comparison to a 20 percent compliance cost, typical estimates of the cost of complying with consumption taxes are on the 

order of 3 to 4 percent of revenue. 

One source of complexity that has been mentioned here several 

times earlier today is the alternative minimum tax which requires 

calculation of tax liability under two different systems. In principle, 

dual calculation is required whether or not you actually owe the 

AMT. The individual AMT is becoming far more pervasive because 

the dollar amount of the AMT exemption was not indexed in 1986 

and the regular tax rates, but not the AMT rate, were reduced in 

2001, as Doug Holtz-Eakin told you earlier, CBO estimates that by 

2010 there will be 29 million households that face AMT one way 

or another. 

Fixing the AMT is a very serious budget challenge. CBO has estimated it would cost about 400 billion to index the AMT exemption 

to 2004 levels over the next 10 years. 

45

Another source of complexity that has been mentioned before is 

Tax Code instability. The frequency of change in the Tax Code imposes costs, as Doug Holtz-Eakin mentioned, it affects taxpayer behaviors in ways that are very difficult to predict. According to the 

Tax Foundation, from 1995–2000, the Tax Code increased by 182 

pages, which is about half the pages of the entire 1954 code. At this 

rate, the Code will increase from about 1,700 pages in 2000 to 

about 2,600 pages in 2010, and who knows where it will end. 

Tax Code instability is also due to the adoption of tax provisions 

on a temporary basis to comply with budgetary scoring rules, and 

that is an example of how rules that were designed to promote fiscal responsibility have the unfortunate side effect of creating instability in the tax system. 

In summary, U.S. residents currently pay a smaller share of 

GDP in total taxes than do residents of most other OECD countries. However, the present U.S. tax structure does not generate 

sufficient revenue to meet projected Federal spending in the long 

run. 

Closing the fiscal gap by raising income and profit taxes would 

cause the U.S. tax system to depart even further from international 

norms, as the U.S. already relies more heavily on income and profit 

taxes, as I said, both as a percent of GDP and percent of total 

taxes, than the typical OECD country. 

The cost of complying with the Federal income tax system, which 

is roughly 20 percent of income taxes raised, is much higher than 

the cost of complying with consumption taxes by most estimates. 

Obviously, the AMT is a very important issue in the future as a 

source of complexity for taxpayers. 

Finally, the U.S. international rules, the rules that tax the income of our multinationals are very much out of step with competitor countries. They are very complex, and they impose very high 

compliance costs relative to revenue raised. 

Thank you. 

Chairman NUSSLE. Thank you. 

[The prepared statement of Mr. Merrill follows:]

PREPARED STATEMENT OF PETER R. MERRILL, DIRECTOR, NATIONAL ECONOMIC

CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP

I. INTRODUCTION

I am Peter Merrill, Principal and Director of the National Economic Consulting 

group at PriceWaterhouseCoopers LLP. I am testifying today on my own behalf and 

not as a representative of any organization. 

The focus of my testimony is on the competitiveness of the U.S. tax system, which 

I assess through a comparison of the structure of the U.S. tax system with that of 

the 30 member countries of the Organization for Economic Cooperation and Development (OECD). In a global economy, differences in tax systems can affect international capital flows-to the benefit or detriment of a country’s workers and investors. 

In some instances, U.S. rules regarding the taxation of both domestic and foreign 

income are out of step with the tax systems used by other major industrial countries. 

II. TAX COMPETITIVENESS IN A GLOBAL ECONOMY

Much of the U.S. tax system was developed when the United States dominated 

the global economy. This is no longer the case. In the 1960s, the U.S. economy represented 40 percent of global GDP and U.S. multinationals accounted for 50 percent 

of cross-border investment. In 2003, the U.S. economy represented 30 percent of 

46

global GDP and U.S. multinationals accounted for less than 22 percent of cross border investment (see Exhibit 1). 

The U.S. economy is also far more open to trade and investment than was the 

case just a few decades ago. Merchandise trade (imports plus exports) has increased 

from less than 7 percent of GDP in the 1960s to 18.6 percent over the last 4 years. 

From 1980 to 2002, the stock of U.S. direct investment abroad increased (in nominal 

dollars) from $390 billion to $1.84 trillion (370 percent), while foreign direct investment in the United States increased from $130 billion to $1.50 trillion (1,080 percent). The growth in the stock of cross-border portfolio investment is even more 

staggering. From 1980–2002, private investment in foreign securities increased from 

$62 billion to $1.8 trillion (2,855 percent), while foreign private investment in U.S. 

securities increased from $90 billon to $3.2 trillion (3,500 percent) (see Exhibit 1). 

As a result of the growing importance of international capital flows, U.S. tax policy is no longer insulated from global market forces. Increasingly, one of the considerations in the design of a country’s tax system must be how it compares with that 

of its major trading partners. And, there is little doubt that governments react to 

changes in the tax systems of their trading partners. For example, the reduction in 

the U.S. corporate income tax rate from 46 percent to 34 percent under the 1986 

Tax Reform Act precipitated similar reductions in many other OECD countries. Another example is the spread of the value-added tax systems from the European 

Union to over 120 countries worldwide. 

Competitiveness is one of a number of criteria by which to judge the U.S. tax system—other traditional criteria include fairness, simplicity, efficiency, and revenue 

adequacy. The focus of this testimony is on how the U.S. tax system compares with 

that of other major industrial countries. 

III. INTERNATIONAL COMPARISON OF TAX STRUCTURES

A. Aggregate Revenues and Expenditures 

The United States is a relatively low tax country. According to OECD statistics, 

as of 2001, the total tax burden in the United States—federal, State, and local combined—was 28.9 percent of GDP, fourth lowest among the 30 OECD countries (see 

Exhibit 2). The favorable tax burden reflects the smaller role that government plays 

in the U.S. economy, where government expenditures relative to GDP were fourth 

lowest among the OECD countries. The publicly financed share of expenditures on 

health and post-secondary education generally is higher outside the United States 

and correspondingly greater government revenues are required to finance these outlays. 

In January of this year, the Congressional Budget Office estimated that Federal 

Government revenues would fall short of Federal Government expenditures by 3.0 

percent of GDP in fiscal year 2005, but that the Federal Government deficit would 

be eliminated by 2014. This forecast, however, assumes that all of the temporary 

provisions in EGTRRA and JGTRRA expire as scheduled and excludes the Medicare 

prescription drug benefit enacted earlier this year. 

B. Aggregate Debt 

According to 2001 OECD statistics, outstanding marketable debt of the United 

State government was less than the average OECD country by 12.7 percent of 

GDP.1 In January of 2004, CBO projected that by 2009, Federal debt held by the 

public would increase by 7.6 percentage points of GDP relative to the 2001 level. 

This forecast assumes that all expiring provisions expire as scheduled and excludes 

the new Medicare prescription drug benefit. 

C. Composition of Revenues 

While the United States is a relatively low tax country, it relies more heavily on 

taxes on income and profits-both as a share of total taxation and as a share of 

GDP—than the average OECD country. Combining all levels of government, income 

and profits taxes accounted for about 48 percent of U.S. revenues in 2001 as compared to 36 percent for the average OECD country (see Exhibit 3). Income and profits taxes collected at all levels of government amounted to 14.1 percent of GDP in 

the United States in 2001 as compared to 13.4 percent for the average OECD country (see Exhibit 4). 

The Federal Government is even more heavily reliant on income and profits taxes 

as there is no broad base consumption tax, like the retail sales tax used in 45 states 

and the District of Columbia. Indeed, the United States is the only OECD member 

country that does not have a national value-added or goods and services tax. 

From a trade perspective, heavy reliance on income taxes relative to consumption 

taxes may be viewed as disadvantageous because World Trade Organization (WTO) 

rules only permit border tax adjustments (i.e., exemption of exports and taxation of 

47

imports) on indirect taxes. Absent border adjustments, taxes may distort the composition if not the volume of trade.2 An important reason to avoid over-reliance on 

income and profits taxes is that they discourage savings and investment, and thus 

suppress long-run economic growth. 

D. Personal Income Tax 

The average OECD central government imposed a top personal income tax rate 

of 37.6 percent in 2003 (see Exhibit 5). In the United States, the top Federal tax 

rate on ordinary income is 35 percent, less than the OECD average. However, unlike most of the OECD countries, individuals in the United States typically are subject to income tax by both Federal and state levels of government. 

Unless the sunset in the 2001 Act is removed, the top Federal individual income 

tax rate will increase to 39.6 percent in 2011. This would put the United States 2 

percentage points above the current average for OECD countries. 

High marginal income tax rates discourage savings and work effort-particularly 

of secondary workers-and encourage tax avoidance and evasion. Moreover, countries 

with high personal income taxes are unattractive places to locate facilities with 

high-paying jobs such as corporate headquarters and research facilities. 

E. Corporate Income tax 

Immediately following the Tax Reform Act of 1986, which lowered the U.S. corporate income tax rate from 46 to 34 percent, the U.S. rate was relatively attractive. 

This is no longer true today. The U.S. corporate income tax rate increased to 35 percent in 1991, while the average OECD country’s corporate rate fell to 29.3 percent 

in 2003-5.7 percentage points less than the U.S. rate. The average corporate rate 

for the 25 members of the newly expanded European Union is just 26.3, 8.4 percentage points less than the U.S. rate (see Exhibit 6). The United States is tied with 

Spain and Greece for third highest corporate income tax rate among the 30 OECD 

countries. Unlike most OECD countries, the United States imposes corporate income 

taxes at the state and, in some cases, local levels of government. Taking into account multi-level corporate income taxes, the disparity between the U.S. rate and 

the OECD average is likely greater. 

Despite relatively high rates, the U.S. corporate income tax raises relatively little 

revenue. In 2001, U.S. corporate income tax receipts amounted to just 1.9 percent 

of GDP compared to the OECD average of 3.5 percent of GDP). U.S. corporate income tax receipts were suppressed in 2001 by the recession, the fall in the stock 

market, the terrorist attack of September 11, and the temporary adoption of bonus 

depreciation and extended loss carrybacks. 

High corporate income tax rates are economically unattractive for a number of 

reasons. First, high corporate income tax rates make the United States a relatively 

unattractive location for corporate investment. In a global economy, countries with 

high corporate income tax rates may suffer a declining share of worldwide investment and reduced employment opportunities for local workers. Second, high corporate income tax rates encourage the shifting of income abroad. Within the limits 

of existing rules, companies have an incentive to establish inter-company prices and 

corporate financial structures that locate income away from high-tax jurisdictions. 

Third, the incentive to engage in tax planning increases the higher the tax rate, 

which reduces the corporate revenue yield and diverts valuable resources away from 

more economically productive activities. 

DOUBLE TAXATION OF CORPORATE INCOME

In a tax system where corporate income is taxed a second time when paid as dividends to shareholders, high corporate income tax rates discourage businesses from 

operating in regular corporate form. While the 2003 Act reduced the shareholder 

level tax on corporate dividends, this relief is scheduled to sunset after 2008. If dividend relief is allowed to sunset, the United States would join Switzerland as the 

only OECD countries without double taxation relief and the top rate of income tax 

on dividends-combining Federal and individual level taxation-would increase from 

44.75 percent today to over 60 percent after 2010 (see Exhibits 7 and 8). 

F. Payroll Taxes 

Payroll taxes provide the primary source of funding for the Social Security, Medicare, and Federal and state unemployment insurance systems. Social insurance and 

payroll taxes represent about one-fourth of government revenues in the United 

States, similar to the average for all OECD countries. While the expenditures from 

social insurance programs are progressive, the payroll tax is regressive. However, 

the regressivity of the Federal payroll tax is mitigated by the earned income tax 

credit, which is a refundable income tax credit targeted at low-income workers. In 

48

addition, the portion of the Federal payroll tax dedicated to hospital insurance (imposed at 1.45 percent rate on employees and employers) is not subject to the wage 

cap that applies to the balance of Social Security taxes (imposed at a 6.2 percent 

on employers and employees). 

FUTURE REVENUES AND OUTLAYS OF THE SOCIAL INSURANCE SYSTEM

Like many other advanced industrial economies, the projected increase in the obligations of the U.S. social insurance system are far greater than the revenue stream 

that will be generated by existing funding sources. In 2003, the General Accounting 

Office estimated that future liabilities for the Social Security and Medicare systems 

would exceed future revenues for these program by $20.7 trillion in present value, 

not including the new Medicare prescription drug benefit enacted earlier this year 

(see Exhibit 9).3 This unfunded liability amounts to over $71,000 for every U.S. citizen. 

G. Consumption and Excise Taxes 

The United States is one of the few countries that does not have a national level 

value-added or goods and services tax. The main form of consumption tax is the retail sales tax which is imposed by 45 states and the District of Columbia as well 

as approximately 7400 local jurisdictions. The retail sales tax system has a number 

of disadvantages as compared to the VAT. In particular, the retail sales tax excludes 

most services and, unlike the VAT, cannot be fully recovered by business purchasers, with the result that the tax can cascade through the production/distribution 

chain. 

IV. TAXATION OF INCOME FROM U.S. DIRECT INVESTMENT ABROAD

A. Do the Foreign Operations of U.S. MNCs Hurt the Domestic Economy? 

If taxes make the United States an unattractive location to headquarter a multinational corporation, then U.S. multinationals will lose global market share. This 

loss in global market share can happen in a variety of ways. First, U.S. individual 

and institutional investors can choose to invest in foreign rather than U.S. 

headquartered companies. Second, in a cross-border merger, the transaction may be 

structured as a foreign acquisition of a U.S. company rather than the reverse. By 

choosing to be headquartered abroad, the merged entity can invest outside the 

United States without being subject to the complex and onerous U.S. rules that 

apply to the foreign source income of U.S.-headquartered companies.4 Third, and 

most starkly, a number of U.S. companies have structured transactions in which 

their U.S. parents are acquired by their own foreign subsidiaries. Such ‘‘inversion’’ 

transactions, like foreign acquisitions of U.S. companies, allow new foreign investments to be structured as subsidiaries of a foreign parent corporation and thus not 

subject to U.S. rules relating to the taxation of foreign source income. Fourth, new 

ventures can be incorporated at inception as foreign corporations. 

A decline in the market share of U.S. multinationals would adversely affect domestic workers. U.S. multinationals play an important role in promoting U.S. exports and creating high-wage jobs. According to the U.S. Commerce Department, in 

2001, U.S. multinationals were directly responsible, through their domestic and foreign affiliates, for $425 billion of U.S. merchandise exports-almost 60 percent of all 

merchandise exports. The role of multinationals in promoting exports is corroborated by an OECD study which found that each dollar of outward foreign direct investment is associated with $2.00 of additional exports.5 Dartmouth professor 

Mathew Slaughter has found that over the 10-year period 1991–2001, jobs added 

by U.S. multinationals abroad were matched almost two for one by U.S. jobs added 

in their parent operations.6 Moreover, Slaughter finds that U.S. multinationals increased their domestic employment at a faster pace than U.S. companies without 

foreign affiliates-evidence that the foreign operations of U.S. multinationals increase 

domestic job growth. As noted by David Riker and Lael Brainard: 

‘‘Specialization in complementary stages of production implies that affiliate employees in industrialized countries need not fear the multinationals’ search for evercheaper assembly sites; rather, they benefit from an increase in employment in developing country affiliates.’’7

U.S.-based multinationals account for 20 percent of domestic employment, and locate 77 percent of their global production and 80 percent of the global capital spending at home.8 In addition, multinational companies pay their domestic workers more 

than comparable U.S. companies without international operations.9

49

B. Comparison of U.S. and Foreign Country Rules for Taxing Multinational Income 

Compared to major competitor countries, the United States is a relatively unattractive jurisdiction in which to locate the headquarters of a multinational company. 

Quantitative evidence of this comes from a study published by the European Commission in 2001 which found that, on average, U.S. multinationals bear a higher effective tax rate-ranging from three to 5 percentage points—when investing into the 

European Union than do multinationals headquartered in the EU (see Exhibit 10). 

Aside from the relatively high U.S. corporate income tax rate, there are a number 

of features of the U.S. system of taxing foreign source income that depart from 

international norms. 

Worldwide tax system. Over half of the OECD countries have dividend exemption 

(‘‘territorial’’) tax systems under which a parent company generally is not subject 

to tax on the active income earned by a foreign subsidiary (see Exhibit 11). By contrast, the United States generally taxes income earned through a foreign corporation 

when repatriated.10 Moreover, the United States is the only OECD country that 

does not exempt the foreign earned income of its citizens who reside abroad, making 

it more expensive for U.S. multinationals to send employees on international assignments.11

Foreign tax credit limitations. The U.S. foreign tax credit, which is intended to 

prevent double taxation of foreign source income, has a number of deficiencies that 

increase complexity and prevent full double tax relief, including:12

• Over allocation of U.S. interest expense against foreign source income due to 

failure to take into account foreign debt. This reduces the foreign tax credit limitation and can cause income that has been subject to foreign tax at a rate of 35 percent or more to be subject to additional U.S. tax; • Asymmetric loss recapture rules that have the effect of restoring U.S. but not 

foreign income, thereby reducing the foreign tax credit limitation; • The limitation on foreign tax credits to 90 percent of alternative minimum tax 

liability; • The limited carryover period for foreign tax credits (two years back and 5 years 

forward); and • The complexity associated with the numerous separate foreign tax credit limitations and the ‘‘high-tax kick out’’ rules that move certain income out of the passive 

basket. 

U.S. anti-deferral rules. Another difference from the multinational tax rules of 

other countries is the unusually broad scope the U.S. anti-deferral rules under subpart F. While most countries tax passive income earned by controlled foreign subsidiaries, the United States is unusual in taxing a wide range of unrepatriated active income as a deemed dividend to the U.S. parent, including:13

• Foreign base company sales income; • Foreign base company services income; 

• Foreign base company shipping income; and 

• Active financial services income (a temporary exclusion of this income from Subpart F will expire for taxable years beginning after 2006). 

Moreover, the U.S. anti-deferral system is extraordinarily complex, with multiple 

and overlapping rules including separate regimes for: controlled foreign corporations 

(CFCs), passive foreign investment companies (PFICs), foreign personal holding 

companies (FPHCs), foreign investment companies (FICs), and Personal Holding 

Companies (PHCs).14

The net effect of these differences between U.S. tax rules and international norms, 

is that U.S. multinationals frequently pay a greater share of income in foreign and 

U.S. tax than do competing multinationals headquartered outside of the United 

States. 

C. Recent Legislative Proposals 

The ETI replacement bills adopted earlier this year by the House and Senate contain international tax reform provisions that would address many of the aspects of 

U.S. tax law that depart from international norms in ways that adversely affect the 

competitiveness of U.S. multinationals. 

Foreign tax credit.-Both bills alleviate the double taxation of foreign source income through measures addressing interest allocation, recharacterization of domestic losses, and removing the 90-percent limitation in the AMT. The House bill also 

reduces the number of separate foreign tax credit limitation categories, while the 

Senate bill extends the carryforward period for foreign tax credits to 20 years, consistent with net operating losses. 

Anti-deferral rules. Both bills reduce the taxation of active foreign income that is 

reinvested abroad by ‘‘looking through’’ payments between related CFCs to determine their character and by excluding certain active foreign shipping and aircraft 

50

income from Subpart F. Both bills also simplify compliance with Subpart F by repealing the FPHC and FIC rules and the PHC rules applicable to foreign corporations. In addition, the Senate bill simplifies compliance by increasing the de minimis 

exemption from Subpart F. 

V. COMPLEXITY

The burden of the tax system includes not only the amount that taxpayers are 

obliged to remit to the government but also the time and money cost of compliance, 

including researching and monitoring changes in tax laws and regulations, collecting information required for return preparation, preparing and filing the return, 

record retention, and responding to audits. Compliance costs were estimated by the 

Tax Foundation to increase the burden of the Federal income tax by 20.4 percent, 

or $194 billion in 2002.15 By comparison, estimates of the compliance costs imposed 

by the retail sale taxes typically are on the order of 3–4 percent of revenues.16

Some of the complexity of the income tax system is inherent in measuring taxable 

income in a technologically advanced and globally integrated economy. There are 

few remedies for this inherent complexity short of adopting an alternative basis of 

taxation, such as consumption. 

PROLIFERATION OF SPECIAL PURPOSE DEDUCTIONS, CREDITS, AND EXEMPTIONS

One important source of complexity is a policy choice-the use of special purpose 

deductions, credits, and exemptions in the Code to encourage certain types of economic activities or to redistribute income to specific groups of taxpayers judged 

needy of assistance. Many of the policy objectives underlying these special purpose 

deductions, credits and exemptions could be achieved through Federal spending programs, subject to the Congressional authorization and appropriations process, and 

administered by Federal agencies other than the IRS. 

ALTERNATIVE MINIMUM TAX

Redesigned in 1986, the alternative minimum tax (AMT) for individuals and corporations operates like a parallel tax system. Taxpayers compute tax liability twice: 

under the regular system and under the AMT system, with its own separate tax 

base and rates. AMT liability is equal to the excess, if any, of tax liability under 

the AMT system over the regular system. Certain AMT payments may be carried 

forward and used to offset regular tax in future years to the extent in excess of liability determined under the alternative system. 

On its face, the AMT system is inherently complex as it requires calculation of 

tax liability under two different systems. It imposes compliance burdens on all taxpayers-whether or not AMT is owed-because, in principle, they must calculate hypothetical liability under the alternative system to determine whether AMT is due and 

whether the use of tax credits under the regular tax system is constrained by the 

AMT. 

Worse still, for individuals, the AMT is becoming far more pervasive because (1) 

the dollar amount of the AMT exemption was not indexed in 1986, and (2) the regular tax rates but not the AMT rates were reduced in 2001 and 2003. As a result, 

CBO estimates that the number of returns affected by the AMT will increase from 

3 million in 2004 to 29 million in 2010.17

Fixing the AMT is a serious budgetary challenge. The Congressional Budget Office has estimated that indexing the AMT exemption amount at 2004 levels would 

cost $376 billion over the next 10 years.18

TAX CODE INSTABILITY

Another source of compliance burden is the frequency of changes in the tax Code. 

According to the Tax Foundation, from 1995 to 2000, the tax Code increased by 182 

pages, about half the pages of the entire 1954 Code. At this rate, the Code will increase from 1670 pages in 2000 to about 2600 pages in 2010. 

Tax Code instability also is due to the adoption of tax provisions on a temporary 

basis to comply with budgetary scoring rules. These sunsets create uncertainty and 

impose real costs on taxpayers. The most absurd example is the scheduled repeal 

of the estate and gift tax in 2010 and re-enactment in 2011. This is an example of 

how rules designed to promote fiscal responsibility have had the side effect of creating tax structure instability. 

FOREIGN SOURCE INCOME

As noted in the administration’s fiscal year 2003 budget, one of most complex aspects of corporate taxation is the treatment of foreign source income. A survey of 

51

Fortune 500 companies found that 43.7 percent of U.S. income tax compliance costs 

were attributable to foreign source income even though foreign operations represented only 26–30 percent of worldwide employment, assets and sales.19 These 

high compliance costs are a hidden form of taxation that discourages small U.S. 

companies from operating abroad and makes it more difficult for larger companies 

to compete successfully with foreign multinationals. 

VI. SUMMARY

This testimony supports the following conclusions: 

• U.S. residents currently pay a smaller share of GDP in total taxes than do residents of most other OECD countries. 

• However, the present U.S. tax structure does not generate sufficient revenue to 

meet projected Federal spending in the long run. 

• Closing the fiscal gap by raising income and profit taxes would cause the U.S. 

tax system to depart even further from international norms, as the United States 

already relies much more heavily on income and profit taxes-both as a percent of 

GDP and as a percent of total taxes-than the average OECD country. 

• The U.S. corporate income tax rate is tied with Greece and Spain as third highest among the OECD countries. 

• If the 2001 and 2003 Act sunsets are not reversed, the top central government 

individual income tax rate in the United States will by 2011 jump to 2 percentage 

points above the current average for OECD countries. 

• According to the Tax Foundation, the cost of complying with the Federal income 

tax system increases the U.S. tax burden by 20 percent. This is much higher than 

estimates of the cost of complying with VAT and retail sales tax systems. 

• A particularly worrying source of tax complexity is the estimated increase in the 

number of individual returns affected by the AMT from 3 million in 2004 to 29 million in 2010. 

• The U.S. international tax rules are out of step with competitor countries. The 

U.S. system of taxing worldwide income is extremely complex and imposes high 

compliance costs relative to revenue raised. 

ENDNOTES

1OECD, OECD in Figures: Statistics on the Member Countries, 2003. 

2 A theoretical framework is set forth in, Martin Feldstein and Paul Krugman, 

‘‘International Trade Effects of Value Added Taxation’’ (with Paul Krugman) in Taxation in the Global Economy, Assaf Razin and Joel B. Slemrod, (eds.), the University 

of Chicago Press, 1990. Consistent with the standard theoretical model, empirical 

research finds there is no export or trade advantage for countries with greater reliance on value-added taxes. In fact, Hines and Desai find a negative relationship 

which the authors attribute to two implementation features of VAT systems: VATs 

tend to be imposed at higher rates on traded than non-traded goods and exporters 

often receive incomplete VAT rebates See, James R. Hines, Jr. and Mihir A. Desai, 

‘‘Value Added Taxes and International Trade: The Evidence,’’ (November 2002) presented at December 2002 Brookings/ITPF conference on Tax Systems and International Trade (www.itpf.org/presearch—itpindex.htm). 3 U.S. General Accounting Office, Financial Statement of the United States Government, 2003. 4 Note that, absent restructuring, the existing foreign operations of a U.S. company acquired by a foreign company remain subject to U.S. tax rules. 5OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, p. 50 (1998). 6Mathew J. Slaughter, ‘‘Globalization and Employment by U.S. Multinationals: A 

Framework and Facts,’’ Daily Tax Report, March 26, 2004, section J, pp. 1–7. 7David Riker and Lael Brainard, U.S. Multinationals and Competition from Low 

Wage Countries, National Bureau of Economic Research Working Paper no. 5959 

(1997) p. 19. 8Laura D’Andrea Tyson, ‘‘Why The Trade Deficit May Not Loom So Large,’’ Business Week, June 7, 2004 9Doms and Jensen find that U.S. plants of companies without foreign operations 

pay production workers 10–15 percent less and nonproduction workers 5–7 percent 

less than comparable plants of U.S. multinational companies, controlling for industry, size of company, and state where the plant is located. See, Mark Doms and 

Bradford Jensen, Comparing Wages, Skills, and Productivity between Domestic and 

Foreign-Owned Manufacturing Establishments in the United States, mimeo. (October 1996). 

52

10 I am unaware of any OECD country that requires formula apportionment of domestic interest expense to exempt foreign dividends with the result that this portion 

of domestic interest expense is nondeductible. Grubert and Mutti find that adoption 

of a dividend exemption system with formula apportionment of domestic interest expense would actually increase the U.S. tax burden attributable to foreign source income. See, H. Grubert and J. Mutti, Taxing International Business Income: Dividend Exemption versus the Current System, American Enterprise Institute, 2001. 11See, Price Waterhouse, ‘‘Economic Analysis of the Foreign Earned Income Exclusion,’’ 1995. 12See, National Foreign Trade Council, U.S. International Tax Policy for the 21st 

Century, vol. 1, Part II, 2001 13 Ibid., vol. 1, Part I. 14See, Carl A. Dubert and Peter R. Merrill, Taxation of U.S. Corporations Doing 

Business Abroad: U.S. Rules and Competitiveness Issues (Second Edition), FEI Research Foundation, 2001. 15Scott Moody, ‘‘The Cost of Tax Compliance,’’ Tax Foundation, February 2002. 

Using a different methodology, Prof. Joel Slemrod estimated the private sector collection cost of the U.S. income tax system at $125 billion in 2004. See, Joel Slemrod, 

‘‘Written Testimony submitted to the Committee on Ways and Means, Subcommittee 

on Oversight, Hearing on Tax Simplification,’’ June 15, 2004. 16Tax Administrator News, 1993. 17 CBO, The Budget and Economic Outlook, Fiscal Years 2005 to 2014, January 

2004, p. 81. 18 Ibid. pp. 5–7. 19Marsha Blumenthal and Joel Slemrod, ‘‘The Compliance Costs of Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy Implications, International Tax and Public Finance, vol. 2, no. 1, 37–54 (1995).

Chairman NUSSLE. Dr. Gale, welcome back to the committee. We 

are pleased to receive your testimony. As I said, your full written 

testimony will be made part of the record, and you may summarize. 

STATEMENT OF WILLIAM G. GALE 

Mr. GALE. Thank you, Mr. Chairman and members of the committee, for inviting me to testify. It is always an honor to appear 

here. I want to start by highlighting the fact that on behalf of policy wonks and budget analysts everywhere, I applaud the committee’s efforts to focus on the important role of uncertainty in shaping 

budget outcomes and policies. 

My testimony will be both capped and verifiable. 

Chairman NUSSLE. Just pay-as-you-go, too, will you? 

Mr. GALE. I would like to address four topics. The first is, how 

good are the growth assumptions and baseline projections made by 

the CBO. 

I think it is fair to say that CBO does a very good job of forecasting future economic activity and its relation to revenues and 

spending. It is a fact that the projections are often wrong, sometimes by sizable amounts. It is also a fact that it is very hard to 

understand when the economy changes directions. But my understanding is that CBO does as well or better than anyone else who 

tries to define the economic future. So in this case, CBO is not the 

cause of the uncertainty; they are just the messenger. 

Doug Holtz-Eakin gave you the choice of shooting or blaming the 

messenger. I would suggest we not even blame the messenger. My 

sense is that CBO is doing a very good job on this score. 

The second question is, if it is not CBO, what is it that is causing 

the baseline budget projections to be so uncertain? And here I 

think the dominant form of uncertainty is uncertainty about the future of the economy. Future GDP is difficult to predict precisely, 

53

and small differences in the future GDP turn into big differences 

in budget deficits. 

So, for example, CBO in January predicted a real growth rate of 

3 percent over the next decade. That is a perfectly reasonable estimate, but it is also an uncertain estimate. And if the growth rate 

is off by three-tenths of a percentage point, the difference in the 

budget deficit is about $700 billion over the next decade. So relatively minor changes in the growth rate of GDP make big differences in the projected budget deficit. 

Given the size of the economy, uncertainty about other economic 

factors is also important. In the 1990s, the shifting distribution of 

income, the enormous capital gains in the stock market and 

changes in inflation and interest rates had a significant effect on 

budget outcomes. Usually, however, these impacts are not as large. 

The late 1990s and the early part of this decade were unusual in 

that respect. 

The third factor is the actual structure of tax policy. I don’t have 

access to the detailed models that CBO does, but my sense is, given 

the size of the economy, given the structure—in terms of interest 

rates, inflation rates, the level of the stock market—the actual 

structure of tax policy doesn’t contribute that much additional uncertainty to the budget forecast. 

For example, it would be wonderful if we taxed different activities at the same rate and we reduced the disparity across activities 

in the indifferential taxation. But even if we did, we would still 

face enormous amounts of budget uncertainty; that would not solve 

the problem. So I think we are stuck with uncertainty and have to 

deal with it. 

The second issue dealt with uncertainty in the baseline. A third 

issue is, even if we got the baseline right, the baseline is becoming 

an increasingly useless measure of realistic actual budget outcomes. That is, even if you know exactly what the baseline is, you 

still have no idea these days what a realistic policy is going to turn 

out to be. And this relates to concerns that both of the other witnesses mentioned. 

I want to highlight three issues in particular. One is the enormous increase in the use of expiring tax provisions and sunsets in 

the Tax Code. So we know how the baseline treats them. What we 

don’t know is what is a good, realistic way to think about them. 

The second issue is the existence of specific unsustainable policies. And here the AMT is a perfect example. Nobody believes that 

we are going to end up with 30 million people on the AMT by 2010 

and almost 40 million people by 2014, but that is what is built into 

the budget forecast. And so it increases uncertainty between the 

baseline and what the actual budget outcome will be. 

The third issue, which is even harder to address, is the existence 

of an overall unsustainable fiscal policy; that is, everyone who looks 

at the current trajectory of spending and taxes says, This can’t go 

on. But that is what the baseline has in the current-law trajectory. 

So all three of those factors mean that even if we got the baseline 

exactly right, the baseline is increasingly becoming less useful as 

a measure of budget outcomes. 

54

The last issue is, what do we do about uncertainty? There are 

really two issues here: How do we reduce it and how do we deal 

with whatever uncertainty is left? 

Reducing uncertainty is pretty straightforward—in theory, at 

least. It is easy for me to say and tell you how to reduce it, but 

it will involve some pretty difficult choices. The way to reduce it 

is to undo the features of the Tax Code that create uncertainty, so, 

for example, a budget-conscious fix to the AMT problem, some fix 

to the unsustainability of fiscal policy generally, and in particular, 

these issues will all come to a head in thinking about whether to 

make the tax cuts permanent. 

At first glance, you might think that making the tax cuts permanent would reduce uncertainty because it tells people that there is 

a commitment to lower tax rates for the long term. But, remember, 

one of the issues that generates uncertainty is the existence of an 

unsustainable fiscal policy. And if you cut taxes you make the fiscal 

gap, the unsustainability of fiscal policy, even worse. 

And so that not only raises uncertainty about how and when the 

fiscal gap will be closed, but at some point it can raise uncertainty 

about whether the fiscal gap will ever be closed. And at that point 

it is not an issue of the economy creating uncertainty in the budget; it is an issue of the budget creating uncertainty in the economy. 

That is a completely gratuitous uncertainty that is particularly 

damaging to the economy. 

Besides fixing the specific policies that lead to uncertainty in the 

Tax Code, there are a number of other things policy-makers could 

do to reduce the impact of uncertainty. One is simply to give realistic budget projections more weight in the policy process than they 

currently have relative to the baseline. 

In 2001, for example, it was mentioned we had a baseline sur- plus of $5.6 trillion; realistic budget surpluses puts it between $1 

trillion and $1.7 trillion over the decade, which obviously is quite 

different from 5.6 trillion. 

A second issue is to distinguish between projections that are 

more certain than those that are less certain. If you know how 

many 50-year-olds there are now, you can make a pretty good 

guess how many 70-year-olds there will be in 20 years. However, 

if you know the size of the economy now, you don’t have a clue as 

to how much it is going to grow in the next 20 years. So certain 

things like demographics, at least over the medium term, are uncertain, but are relatively certain compared to things variation in 

economic growth. 

So, for example, the long-term fiscal crisis that the Nation faces 

is subject to an enormous amount of uncertainty, yet almost everyone that looks at the reasonable magnitudes of uncertainty decides 

that we still have a fiscal crisis even after adjusting for that. 

The third issue I would suggest is to think about how families 

respond to uncertainty. Families face pervasive uncertainty about 

jobs, about future income, future spending needs, future health 

needs; and typically they respond to that by trying to establish a 

reserve fund. That might be very difficult given the way the Federal budget is set up to literally establish a reserve fund, but one 

thing Congress could do is not allocate every available dollar to tax 

cuts and spending increases and try to establish and hold on to a 

55

budget surplus on an ongoing basis. That would also help with the 

national saving issue that Pam Olson mentioned. 

My last point is just that I want to end where I started, which 

I think it is very important that the Budget Committee does consider uncertainty. And I applaud your efforts in that regard. There 

is a danger though. Because of uncertainty things could end up a 

lot better than they are, they could end up a lot worse than they 

are. 

The danger is that people use uncertainty as a method of procrastinating or avoiding dealing with the serious issues. I think it 

is fair to say that almost everyone who has looked at the fiscal situation facing the country thinks that we can’t just grow out of it, 

it won’t just go away on its own. But as soon as one invokes uncertainty there is the conceptual possibility that it could. 

So let me just close by saying, focusing on uncertainty is very important, but it would be unfortunate if that appropriate focus led 

to the inappropriate willingness to procrastinate and avoid facing 

the real fiscal problems. 

Thank you. 

[The prepared statement of Mr. Gale follows:]

PREPARED STATEMENT OF WILLIAM G. GALE, SENIOR FELLOW, THE BROOKINGS

INSTITUTION, TAX POLICY CENTER

Arjay and Frances Fearing Miller Chair, Economic Studies Program, and Co-Director, Tax Policy Center. The views presented are my own and should not be taken 

to represent the views of the Brookings Institution or the Tax Policy Center.

Chairman Nussle, Ranking Member Spratt, and members of the committee: 

Thank you for inviting me to testify today. It is always an honor to appear before 

this committee. I applaud the committee’s efforts to focus on the important role of 

uncertainty in shaping budget outcomes and policies. I’d like to address four questions. 

The first question is how good are the growth assumptions and baseline projections made by the Congressional Budget Office? I think it is fair to say that the 

CBO does a very good job of forecasting future economic activity and its relation 

to revenues and spending. The CBO’s projections are often wrong, sometimes by sizable amounts. It is particularly difficult to predict and understand turning points. 

But my impression is that CBO does as well as, or better than, anyone else who 

tries to divine the economic future. 

The second question is what causes the baseline projections to be so uncertain? 

The primary source of uncertainty in the baseline projection is uncertainty regarding the overall size of the economy in the future. Not only is future GDP difficult 

to predict precisely, but small differences in assumed growth rates can generate 

large changes in budget outcomes. 

For example, in January, CBO predicted a real growth rate averaging 3.0 percent 

per year over the next decade. This is a reasonable estimate, but everyone would 

agree there is substantial uncertainty surrounding the exact figure. If the annual 

rate of economic growth turns out to be just three-tenths of a percentage point larger or smaller than CBO projects, the difference in the deficit will be about $700 billion over the next 10 years (CBO, Economic and Budget Outlook for Fiscal Years 

2005–14, January 2004, Appendix B). 

Compared to the size of the economy, uncertainty about other economic factors is 

usually significantly less important in generating budget projections. Such factors 

include the rate of inflation, the level of interest rates, and the level of the stock 

market. While it is true that changes in capital gains have significantly influenced 

revenues over the past several years, it has required enormous, atypical changes in 

capital gains to have that effect, and the effects have been far smaller than those 

due to changes in the size of the economy. Typical changes in inflation, interest 

rates, and the stock market generate modest changes in budget projections. 

Given the size of the economy, and given the other economic factors—like capital 

gains, inflation, and interest rates—the actual structure of tax policy plays a very 

small role in generating uncertainty in the baseline projections. To be more specific, 

the current tax system taxes different people and different forms of income at difVerDate 0ct 09 2002 17:09 Oct 26, 2004 Jkt 000000 PO 00000 Frm 00059 Fmt 6633 Sfmt 6621 X:\HEARINGS\108TH\108-23\HBU204.000 RYAN PsN: RYAN
56

ferent rates. Even if we taxed everyone at the same rate on all activities, the great 

majority of uncertainty would still be present in budget projections. 

A third issue is that the baseline projection is becoming an increasingly misleading measure of realistic budget outcomes. This increases everyone’s uncertainty 

regarding what the actual budget outcome will be, given the baseline. This trend 

is due to several factors, most notably: (i) the enormous increase in the use of expiring tax provisions and sunsets in the Tax Code; (ii) the presence of specific 

unsustainable policies, like the built-in growth of alternative minimum tax, which 

no one believes will be allowed to persist; and (iii) the presence of an overall 

unsustainable fiscal policy stance, such as we now face. When policy-makers enact 

laws that are fiscally unsustainable or that are designed in a blatant manner to 

skirt budget rules, the effect is to increase uncertainty about the course of future 

Federal policy. This likely has negative effects on the economy. 

The fourth issue is what to do about uncertainty in the budget projections. There 

are two policy questions: how to reduce uncertainty and how to respond to whatever 

uncertainty is left in the system. 

If the main source of uncertainty is the economy itself, then policy-makers will 

always face a significant amount of uncertainty. But policy-makers can still reduce 

uncertainty in several ways. The best way to reduce uncertainty is avoid creating 

fiscally unsustainable policies. A second way is to avoid creating artificial sunsets. 

These issues will come to a head in dealing with whether to make the 2001 and 

2003 tax cuts permanent. At first glance, one might think that making the tax cuts 

permanent would reduce uncertainty since it indicated a long-term Congressional 

commitment to lower tax rates. Making the tax cuts permanent, however, will substantially increase the severity of the fiscal gap between revenues and spending and 

hence it will serve to increase uncertainty about how and when the overall fiscal 

gap will be closed. In fact, making the tax cuts permanent in light of the current 

fiscal situation is sufficiently irresponsible that it may lead to investors wondering 

not just how and when the fiscal gap will be closed, but whether it will ever be 

closed. That is, several knowledgeable observers, most notably Treasury Secretary 

Robert Rubin, have raised the concerns that ever-increasing Federal debt projected 

for the medium- and long-term could seriously disrupt financial markets and the 

broader economy. 

In contrast to extending the tax cuts, letting them expire would reduce uncertainty about the tax system as well as reduce uncertainty about the overall fiscal 

gap. Likewise, establishing a budget-conscious solution to the AMT problem would 

go a long way toward reducing uncertainty about future tax rates and reduce uncertainty regarding whether, how, and when the fiscal gap will be closed. 

Policy-makers should also shape policies explicitly in light of the fact that uncertainty is present. First, I think that realistic budget projections should be given 

more weight in the policy process than they currently are. The baseline is useful 

for understanding the effects of legislation, but is extremely misleading as a guide 

to what likely budget outcome are going to be. The reason why is that the baseline 

is constructed according to certain fixed rules for projecting spending and revenues 

that do not reflect likely or plausible outcomes. If policy-makers paid more attention 

to alternative, realistic forecasts of likely budget outcomes rather than the baseline, 

they would not be so surprised by many of the changes in the budget projections. 

Second, policy makers should distinguish between projections that are more certain and those that are less uncertain. Population growth, for example, is relatively 

certain in the medium term. If you know how many 50 year olds are alive today, 

chances are you can make a pretty good guess at how many 70 year olds will be 

alive in 20 years. On the other hand, if you know the size of the economy today, 

that may provide very little guidance for estimating the change in the size of the 

economy over the next 20 years. Along similar lines, almost every study finds that 

the nation faces a substantial long-term fiscal shortfall, even though there is substantial uncertainty about many economic factors over the long-term. Simply put, 

population aging and health care technologies will create budgeting problems under 

almost any scenario. 

Third, Congress should consider ways to adopt budget rules that not only limit 

both tax cuts and spending increases but also do so in a way that does not let every 

available dollar be allocated as soon as it appears. Families face substantial economic uncertainty about future wages, health, asset returns, and so on. They often 

manage that uncertainty by trying to keep a financial reserve. A literal financial 

reserve might be hard to establish at the Federal level, but budget rules that limited the extent to which policy- makers could create future tax cuts and spending 

increases would be a step in the right direction. 

My last point is that perhaps the biggest danger in acknowledging the importance 

of uncertainty is that it will allow policy makers to shrug off any potential fiscal 

57

problems with the insight that the problems might go away on their own. Current, 

plausible budget projections suggest significant medium-term deficits and very sizable long-term deficits. But the presence of uncertainty suggests that these problems could conceivably go away on their own. This observation might tempt politicians to delay seeking solutions, hoping to avoid the daunting economic and political 

risks associated with large-scale tax increases and spending cuts. Indeed, in the last 

few years, the majority of legislators have chosen not only to ignore the long-term 

fiscal problems but to make them substantially worse by enacting and advocating 

significant tax cuts and spending increases. But it is extremely unlikely that the 

current fiscal problem will resolve itself without policy actions, and delays in addressing the issue will only make the eventual solutions more extreme and painful. 

It would be a travesty if the explicit recognition of uncertainty in the policy process 

led policy-makers to choose to avoid dealing with the serious fiscal problems the 

country faces.

Chairman NUSSLE. Mr. Baird. 

Mr. BAIRD. I thank the chairman for bringing together this outstanding group of panelists. I also in sincerity want to commend 

the chairman. As I heard some of the testimony, it would suggest 

to me that some of the ways we have gone about passing some of 

the tax cuts in the last couple of years have actually enhanced the 

complexity and the uncertainty in the Tax Code and thereby distorted the decision-making process and certainly the predictability 

process. The use of expiring tax cuts as a way to say that the deficit and fiscal implications will be smaller than they might actually 

be creates not only a false impression, but a difficult thing in predicting and some strange impacts in terms of budget deficits, et 

cetera. 

One of the questions I would have, and I will direct this perhaps 

initially to Ms. Olson, it seems to me, to sort of an average commonsense kind of person, that most folks would say, look, people 

who make income by taking their lives and their time and working 

their guts out, it is reasonable to say that maybe they should face 

a different level of taxation or different kinds of taxation on that 

income than somebody who, let’s say, was given a million and the 

million generates a lot of income for them while they go play in the 

surf or something. 

Are you suggesting that we should treat the income from the million dollars given to someone as the same as the income for somebody who has to work every day of their life and leave their family 

and go risk their lives and time? 

Ms. OLSON. Well, I guess I am not sure that I would use the Tax 

Code to try to achieve a social objective, if what we are trying to 

do is to say—essentially what we are doing is redistributing the tax 

burden on the basis of somebody being born with wealth versus 

somebody not being born with wealth and having to work for a living as I do. But——

Mr. BAIRD. And 99 percent of my constituents do. 

Ms. OLSON. I think 99 percent of the people I know do as well. 

But one of the things that the Tax Code does—let’s set aside somebody who was born with $1 million and instead consider somebody 

who, because they have chosen not to spend everything they earned 

but——

Mr. BAIRD. I would agree with that distinction. 

Ms. OLSON [continuing].—accumulated a nice nest egg. What 

happens under our tax system over time is that that person who 

is deferring spending, delaying gratification, which I think we 

would all say is a virtue, is going to end up carrying a larger share 

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of the tax burden in this country. I am not sure that is the right 

message for us to be sending people. It seems to me it is a bad 

civics lesson. 

So then if you go back and you try to figure out how would you 

make it different, do you really want to have something that goes 

back and asks whether somebody was born with money or had to 

work to get it? That is a kind of intrusiveness on the part of the 

government that I find somewhat troublesome. 

Mr. BAIRD. I think government by nature has to be somewhat intrusive. It is an illusion to believe we are not. The absence of policy 

is in fact an influence on behavior whether or not we like it. 

Don’t most Americans pay more in payroll taxes now than in income taxes? Isn’t it somewhere around 80 percent pay more in payroll tax than income tax? 

Mr. GALE. That is basically right. Some of those numbers, it depends on whether you attribute the employer portion to worker or 

not. But most studies suggest that the employer portion is borne 

by workers in lower after-tax wages, so it is reasonable to do that. 

Mr. MERRILL. I believe about 30 percent of households do not pay 

income tax on that basis. 

Mr. BAIRD. So for a significant number of people, we have a de 

facto hybrid system and a flat tax. In a sense, you have a flat tax 

on the base level of your wages and an income tax on something 

on top of that. If you live in a State with sales tax, you have a sales 

tax in addition to that. Is that more or less accurate? 

Mr. GALE. It is more or less accurate. It is very difficult to characterize the existing system in simple terms because the system 

itself is so complicated. There is some question as to whether it is 

appropriate to call what we have an income tax because so many 

forms of saving are actually exempted. 

Mr. BAIRD. It would seem that one of the questions we would 

face in this body—we could sit around and maybe in a few weeks 

or months come up with a better system, and then some—there 

would be a little tap on the door by a lobbyist who would say, but 

you know, we could make it better. 

Chairman NUSSLE. Little tap on the door? 

Mr. BAIRD. There would be 4,000 of them tapping, Mr. Chairman. And it sort of becomes whose—the one point that I would 

close with is, you would be insane, literally, to defend the current 

Tax Code, not only just as a politician but just as a normal rational 

human being, say that is really the best way to do things, the best 

of all possible worlds. And yet we seem unable to resolve it. We use 

it on both sides, frankly, for partisan—we will attack you, you attack us, and somewhere that tapping of the lobbyist may have 

something to say about why we don’t change that in more constructive ways. I thank the Chair very much. 

Chairman NUSSLE. We have a series of votes. What I would like 

to do is have Mr. Cooper—I will make a couple comments or questions, then we will dismiss the panel. Mr. Cooper. 

Mr. COOPER. Thank you, Mr. Chairman. 

If I were to propose to my colleagues that someone give me an 

unlimited number of blank checks that I would hand out pretty 

much as I would like, I would pretty much be laughed out of this 

body. But when I read in Ms. Olson’s testimony that tax expendiVerDate 0ct 09 2002 17:09 Oct 26, 2004 Jkt 000000 PO 00000 Frm 00062 Fmt 6633 Sfmt 6602 X:\HEARINGS\108TH\108-23\HBU204.000 RYAN PsN: RYAN
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tures are uncapped, unverified, and unverifiable, that sounds like 

an unlimited number of blank checks. So suddenly an aura of respectability is given to an otherwise ridiculous program just because it goes through the Ways and Means Committee and is a tax 

break. Those sorts of ridiculous programs get covered with the 

speech material that we heard some of our colleagues mention a little earlier. 

And when my colleague from Washington mentions the 4,000 

knocks on the door that we get from various tax loophole lobbyists, 

they are essentially, every one of them, asking us for an uncapped, 

unverified, and unverifiable bunch of blank checks. 

So, Mr. Chairman, I know that you serve on the Ways and 

Means Committee, it sounds like we might need to curtail the jurisdiction. 

Chairman NUSSLE. Oh, I would be happy if you want to do a little bet here. I will bet you there are a lot more Members of this 

Congress that sign on to those as cosponsors than just the Ways 

and Means Committee members. I bet I could check your record on 

that, too. I wouldn’t just blame the appropriators or the Ways and 

Means Committee. 

Mr. COOPER. I am not saying blame anyone here. I think we need 

to try to cure it for all Americans. Before we can get to the important issues, Mr. Merrill and Mr. Gale, issues, macro issues and 

international issues, we have to solve the problem of how these tax 

breaks get inserted into the Code every day, every week, every 

year. It is now so chock full of them, we need to worry about curtailing the process. 

So I wanted to ask any of the witnesses if you know, you gave 

us a great figure, Mr. Merrill did, perhaps about 20 percent of the 

cost of the Tax Code trying to figure it out or implement it, the taxpayer nightmare that we all face. Is there any good data on how 

much is spent on K Street and other parts of Washington, DC, trying to lobby Congress for these uncapped, unverified, and unverifiable tax breaks? 

Because if you just think of it as an economic proposition, it must 

be so worthwhile for various interests around the country to pay 

folks to hang out in Gucci Gulch to get these uncapped, unverified, 

and unverifiable benefits, that it is essentially a good investment 

on their part to try to lobby us to get these unlimited number of 

blank checks. 

But who is keeping data on, for example, how much money 

Skadden Arps makes or Merrill Lynch or PriceWaterhouseCoopers 

or all the other firms that are involved in this activity? How are 

we getting a handle on that expenditure and the results that are 

procured from these lobbying expenditures? Does anybody have any 

data on that? 

Ms. OLSON. I don’t have any data on that, but my guess is you 

capture a lot of it in the lobbying reports that are required to be 

filed. 

Mr. COOPER. We know how much they spend to try and influence 

us, but we don’t know the benefits that are resulting for their clients. 

Ms. OLSON. That is right. We don’t. We can only make estimates 

of it. I only want to say one thing on the unverifiable. There was 

60

a qualifier there, which was largely unverifiable. And to the extent 

that you are talking about the folks who have enough money to actually come and knock on your door regularly, those folks are all 

part of the IRS’s continuous examination program. So they are not 

likely to be able to get away with something without it at least 

being verified. That doesn’t mean that there is a cap on it, however. 

Mr. GALE. There have been a series of papers in a journal called 

Tax Notes the last year or so that goes through what different 

firms spend on lobbying, and tries to link that recent legislation. 

The author of the articles is named Marty Sullivan. I could track 

those down if you are interested. 

I also want to mention a couple of things. If you talk to analysts 

who are not on the lobbyists’ payroll, you will find nearly universal 

consensus among economists that broadening the base and cleaning out the loopholes is a good idea. And I put that on the table. 

Second, the way these programs work, uncapped, unverified et 

cetera, it is essentially the way entitlement spending works. You 

set up the rules and then if you are eligible you qualify. The difference is that entitlement spending is for broad-based, wide 

swaths of the population. It is consistent with consensus, domestic 

policy goals, and it is out in the open; it is a spending program, 

whereas these subsidies are hidden deep, deep in the recesses of 

the Tax Code. 

Mr. COOPER. I would agree. Entitlement programs are uncapped, 

but there is usually a verifiable measure such as, for example, 

turning age 65 that enables you to be a beneficiary. So these are 

verified and verifiable programs. 

Chairman NUSSLE. Ms. Olson, what would you say is the largest 

tax provision that is unverified, largely unverifiable? 

Ms. OLSON. Well, a lot of the—there are a lot of provisions on 

the individual side that are largely unverifiable. For example, the 

earned income tax credit. And there are a lot of difficulties with the 

earned income tax credit that make it an ineffective program, like, 

for example that it cannot function on an advance basis. If you 

really want to increase somebody’s income on a constant basis, 

which would be our goal with the credit, generally speaking, we 

cannot do it. The reason is most taxpayers do not opt to claim the 

advanced earned income tax credit because they are concerned that 

their income is going to go too high and they will end up having 

to repay it at the end of the year, so they prefer to wait and make 

the claim on their tax return. 

Were you to ask for the same kind of a benefit from the government through some other program, you would have walked into an 

office in advance and had your eligibility for it verified before you 

would actually get the check. That is not the way the earned income tax credit functions. It is an outlay on the basis of what you 

reported on your return. It is only if the IRS has some reason to 

suspect the accuracy of the return that they actually will freeze the 

money, not pay it out, and do a verification beforehand. But doing 

that has been very controversial. 

So that is one example. There are a number of provisions affecting business taxpayers as well, probably not of that magnitude, but 

where it is very difficult for the IRS because it doesn’t get thirdVerDate 0ct 09 2002 17:09 Oct 26, 2004 Jkt 000000 PO 00000 Frm 00064 Fmt 6633 Sfmt 6602 X:\HEARINGS\108TH\108-23\HBU204.000 RYAN PsN: RYAN
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party records or some other way of verifying the item in the filing 

of the return. 

Chairman NUSSLE. We have only 4 minutes left. Part of the reason why I wanted to have the opportunity of this hearing is to have 

you walk us through for members part of the reason why it take 

3 years for information to get to us in a verifiable form and a final 

form. I don’t know if it is possible for you to do that for the record, 

just to kind of give us an idea of how that might work. I don’t think 

we have time to do it right now on the record because we have a 

vote with 3 minutes left. But I know I would be interested in that 

as well as any recommendations you would have for myself, Mr. 

Baird, or other members who are interested, and possible legislative ideas in order to do that. Because I understand some of the 

great ideas you were talking about, about how Congress complicates the Code. It is kind of like the gentleman was just saying: 

Don’t be shocked, there are politics in Washington, there is lobbying in Washington, just like there is gambling in Vegas. I don’t 

think we are going to get rid of that anytime soon. 

Are there things we can do in the process of projecting that can 

help in this regard? And my understanding is that there may be. 

And I guess, finally, I would just observe that I don’t believe I have 

ever had a tap on my door from a lobbyist with regard to EITC. 

Probably a few other ones have tapped for other reasons, but for 

the largest one I don’t think I ever had that tap. So I think there 

are probably a lot of areas that we can work on here. So those 

would be the requests I would have. 

I appreciate the three panelists for participating in today’s hearing as well as from members who asked, I think, some great questions regarding how we can get our arms around this. And if there 

is nothing more to come before the committee, we will stand adjourned. 

[Whereupon, at 12:35 p.m., the committee was adjourned.]

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