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74–611—PDF 2011

S. HRG. 112–437 

HOW DO COMPLEXITY, UNCERTAINTY, 

AND OTHER FACTORS IMPACT 

RESPONSES TO TAX INCENTIVES? 

HEARING 

BEFORE THE

COMMITTEE ON FINANCE 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

MARCH 30, 2011 

( 

Printed for the use of the Committee on Finance 

COMMITTEE ON FINANCE 

MAX BAUCUS, Montana, Chairman 

JOHN D. ROCKEFELLER IV, West Virginia 

KENT CONRAD, North Dakota 

JEFF BINGAMAN, New Mexico 

JOHN F. KERRY, Massachusetts 

RON WYDEN, Oregon 

CHARLES E. SCHUMER, New York 

DEBBIE STABENOW, Michigan 

MARIA CANTWELL, Washington 

BILL NELSON, Florida 

ROBERT MENENDEZ, New Jersey 

THOMAS R. CARPER, Delaware 

BENJAMIN L. CARDIN, Maryland 

ORRIN G. HATCH, Utah 

CHUCK GRASSLEY, Iowa 

OLYMPIA J. SNOWE, Maine 

JON KYL, Arizona 

MIKE CRAPO, Idaho 

PAT ROBERTS, Kansas 

JOHN ENSIGN, Nevada 

MICHAEL B. ENZI, Wyoming 

JOHN CORNYN, Texas 

TOM COBURN, Oklahoma 

JOHN THUNE, South Dakota 

RUSSELL SULLIVAN, Staff Director 

CHRIS CAMPBELL, Republican Staff Director 

(II) 

C O N T E N T S 

OPENING STATEMENTS 

Page 

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

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

Hatch, Hon. Orrin G., a U.S. Senator from Utah ................................................. 3 

WITNESSES 

Chetty, Dr. Raj, professor, Department of Economics, Harvard University, 

Cambridge, MA .................................................................................................... 5 

Carroll, Dr. Robert, principal, quantitative economics and statistics, Ernst 

and Young, LLP, Washington, DC ...................................................................... 8 

Toder, Dr. Eric J., institute fellow, Urban Institute, and co-director, UrbanBrookings Tax Policy Center, Washington, DC ................................................. 10 

ALPHABETICAL LISTING AND APPENDIX MATERIAL 

Baucus, Hon. Max: 

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

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

Carroll, Dr. Robert: 

Testimony .......................................................................................................... 8 

Prepared statement .......................................................................................... 35 

Chetty, Dr. Raj: 

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

Prepared statement .......................................................................................... 46 

Responses to questions from committee members ......................................... 60 

Hatch, Hon. Orrin G.: 

Opening statement ........................................................................................... 3 

Prepared statement .......................................................................................... 64 

Toder, Dr. Eric J.: 

Testimony .......................................................................................................... 10 

Prepared statement .......................................................................................... 67 

Responses to questions from committee members ......................................... 83 

COMMUNICATIONS

American Benefits Council, et al. ........................................................................... 91 

Employee Benefit Research Institute (EBRI) ........................................................ 93 

Insured Retirement Institute (IRI) ........................................................................ 103 

National Restaurant Association ............................................................................ 120 

National Roofing Contractors Association (NRCA) ............................................... 128 

Profit Sharing/401k Council of America ................................................................ 132 

Third Way Progressives .......................................................................................... 136 

(III) 

(1) 

HOW DO COMPLEXITY, UNCERTAINTY, 

AND OTHER FACTORS IMPACT 

RESPONSES TO TAX INCENTIVES? 

WEDNESDAY, MARCH 30, 2011 

U.S. SENATE, 

COMMITTEE ON FINANCE, 

Washington, DC. 

The hearing was convened, pursuant to notice, at 10:06 a.m., in 

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

(chairman of the committee) presiding. 

Present: Senators Wyden, Carper, Cardin, Hatch, and Snowe. 

Also present: Democratic Staff: Russ Sullivan, Staff Director; Lily 

Batchelder, Chief Tax Counsel; Tiffany Smith, Tax Counsel; Holly 

Porter, Tax Counsel; and Joseph Scovitch, Detailee. Republican 

Staff: Chris Campbell, Staff Director; Mark Prater, Deputy Chief of 

Staff and Chief Tax Counsel; Jim Lyons, Tax Counsel; and Preston 

Rutledge, Tax Counsel. 

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

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE 

The CHAIRMAN. The hearing will come to order. 

Albert Einstein once said, ‘‘Make everything as simple as possible, but not simpler.’’ 

There is a limit to how simple certain things can be, but today’s 

tax code can certainly be simplified. And the complexity of the code 

has significant consequences. 

At the last hearing we held, we looked at unintended consequences of the complications in our tax code. Our witnesses laid out 

undesirable distortions that may prevent growth and job creation. 

For example, they discussed how the tax bias toward debt in the 

tax code may have contributed to the financial crisis. 

But some of the tax code’s complexity is a result of incentives inserted in the code. That intentional complexity is what we are discussing today. 

Today we will ask our expert witnesses how to measure the effectiveness of a tax incentive, including our current incentives. We 

will ask how to best structure incentives so people respond as we 

intended. 

We will ask how we can get the most bang for our buck. In the 

words of Dr. Einstein, ‘‘How do we keep it simple, but not too simple?’’ 

Today we have all sorts of incentives in the code. Many are 

meant to encourage or discourage certain behavior. The research 

2 

and development credit is meant to encourage innovation and create jobs. Higher education incentives are meant to help students 

pay for college. The retirement savings incentives are meant to encourage savings for those later years. 

In 2010, we used $109 billion for more than a dozen different incentives to help Americans save for retirement. We used $91 billion 

to promote homeownership through the mortgage interest deduction. All in all, incentives in the income tax code cost more than 

$1 trillion each year. That is about the same as the total amount 

raised by the income tax code. 

Studies show that the way tax incentives are presented and 

structured affects the way individuals respond to them. Take retirement savings tax incentives, for example. Studies have found 

that taxpayers save more of their money for retirement when they 

receive a contribution that matches their own rather than receiving 

a tax refund at the end of the year. 

Tax incentives are also more effective when they are offered immediately. Programs like Cash for Clunkers showed that on-thespot incentives are more effective than a tax credit individuals received when they filed their tax returns. More people purchased 

energy-efficient cars more quickly through that program because 

the money was in their hands right away. 

Today we will ask our witnesses what makes a well-designed tax 

incentive. Do taxpayers respond less to complex incentives? What 

about the responses to temporary tax incentives? 

There are certainly many complex and overlapping tax incentives. For example, there are more than 15 provisions to assist with 

the rising costs of higher education. The sheer number of options, 

and choosing between them, often overwhelms taxpayers. 

Does this complexity discourage young people from enrolling in 

college? 

There are also a huge number of temporary tax incentives, and 

the prevalence of these temporary provisions has risen dramatically over the past decade. There are now 141 temporary provisions 

that expire nearly every year. These temporary tax incentives 

hinder taxpayers’ ability to plan. As a result, they may only benefit 

those people who would have acted anyway. 

Ultimately, the desirability of any tax incentive will depend on 

whether we want to encourage that activity in the first place. If 

Congress is going to encourage certain activities through the code, 

we need to know how to most effectively achieve the intended policy goals. 

We need to know how to structure tax incentives that are simple 

enough to generate a response, but not so simple that they are not 

well-targeted. 

I look forward to the discussions today. 

[The prepared statement of Chairman Baucus appears in the appendix.] 

Senator Hatch? 

3 

OPENING STATEMENT OF HON. ORRIN G. HATCH, 

A U.S. SENATOR FROM UTAH 

Senator HATCH. Well, thank you, Mr. Chairman. As we continue 

our march through the potentials and pitfalls of tax reform, this 

hearing stood out. 

The tax code should send clear signals to taxpayers. This way, 

individuals and corporations can make rational decisions about 

what they do with their money. Unfortunately, as several of our 

witnesses will explain today, the Internal Revenue Code has become so complex that it is colliding with human nature. 

On balance, taxpayers are inclined to behave according to the political economic theory of Rod Tidwell, the star wide receiver in the 

film ‘‘Jerry Maguire.’’ Tidwell operated by a simple philosophy— 

‘‘show me the money.’’ 

In some ways, that is the philosophy of the American taxpayer. 

Families and businesses, when considered in the aggregate, would 

prefer to allocate their capital based on the tax treatment of various activities. 

If the code taxes capital, capital formation will become more difficult. If the code taxes consumption, savings will go up. 

What this hearing addresses is how inefficiencies in the Internal 

Revenue Code impact the otherwise rational responses of taxpayers. 

In short, the code has become so complex that even when lawmakers attempt to extend preferences for certain activities, businesses and families do not respond. It is critical then that we restructure the code to provide a more rational and less complex system for American taxpayers. 

I would like to reiterate a few key principles for this reform. 

First, I believe that our entire tax system, not just the corporate 

tax system, needs to be reformed. We cannot simply raise taxes on 

flow-through businesses, a large portion of which are small businesses, by taking tax incentives away without lowering tax rates 

in return. 

Now, this is both just and politically necessary. Can you imagine 

if someone told you, ‘‘I am going to reform the law in a way that 

directly impacts your life and livelihood? Now here is what I am 

going to do. I am going to take something away from you and you 

are not going to get anything in return.’’ You will not find many 

people willing to accept a terrible deal like that one. Yet, that is 

the offer that some would like to extend to these businesses. 

Second, tax reformers need to take into account the shrinking of 

the base on the individual side. Considering that even the liberal 

Tax Policy Center found that 47 percent of households in 2009 did 

not pay any income taxes, we cannot ignore the individual income 

tax system when we look at tax reform. 

And we need to keep in mind that this 47-percent figure will 

grow significantly higher in 2014 when the health insurance premium refundable income tax credit goes into effect. It makes you 

wonder. And we know that 47 percent is just the beginning, because that does not include all of the people on welfare nor does 

it include a raft of others. 

4 

Again, it is a matter of fairness. And I might add that many in 

the 47 percent get money back from the government with no real 

skin in the gain. 

So, as a matter of fairness, would it not make more sense if all 

citizens paid at least something in income taxes? We hear a lot 

about sharing responsibilities from the other side. Well, this would 

be a start. And I am convinced that it would help us in our fight 

against excessive Federal spending. You get a lot of takers if they 

want more of something and you tell them it is free. 

Third, we cannot ignore the pending tax increases at the individual level that will go into effect if Congress does not act. The 

bottom line is that, if Congress does not intervene, taxes are scheduled to go up significantly on January 1, 2013. If President Obama 

and the congressional Democratic leadership have their way, the 

top two tax rates would already be at 36 percent and 39.6 percent. 

It might be a convenient talking point to suggest that these are 

cost-free tax increases on the rich. But in reality, the nonpartisan 

Joint Committee on Taxation tells us that 50 percent of all flowthrough income is subject to these proposed tax rate hikes. 

Now, these tax rate increases would be especially harmful to 

small businesses, because most small businesses are organized as 

flow-through business entities, such as partnerships, S corporations, or limited liability companies. 

And, since we all seem to agree that we need to provide certainty 

to businesses and other taxpayers so that they can go ahead and 

plan their affairs, including hiring new workers, it would make a 

lot more sense to go ahead and prevent these tax rate hikes now 

rather than waiting until 2012, a presidential year, to act. 

Finally, we need to be careful about what we are identifying as 

tax incentives. Are we talking about a true tax incentive or are we 

really talking about spending being done through the Internal Revenue Code? 

If a provision resulted in an outlay by the Federal Government, 

the amount of the outlay is actually spending under the Congressional Budget Act. It is not a tax cut. 

For example, almost three-fourths of the refundable income tax 

credit from the health spending bill is not a tax cut, but is actually 

spending done through the tax code, according to the nonpartisan 

Joint Committee on Taxation. 

As we continue down the road of tax reform, these principles will 

continue to inform my analysis of the challenges that we face. With 

respect to tax incentives and whether they introduce inefficiencies 

into the tax code and counterproductively distort economic behavior, it is important that we not lose sight of what should be our ultimate goal—the need for comprehensive reform that lowers the 

burden of taxation on individuals and businesses. 

I want to thank you, Mr. Chairman, and I look forward to hearing the testimony of our witnesses. 

The CHAIRMAN. Thank you, Senator. 

[The prepared statement of Senator Hatch appears in the appendix.] 

The CHAIRMAN. I will look forward to the witnesses. This is 

where it gets fun. 

5 

First is Dr. Raj Chetty, professor of economics at Harvard. Welcome, Dr. Chetty. I appreciate your coming here. 

Dr. Robert Carroll, who is a principal of quantitative economics 

and statistics at Ernst and Young, served previously as Deputy Assistant Secretary for Tax Analysis at the Treasury Department. 

Thank you, Dr. Carroll, very much for your perspective. 

And Dr. Eric Toder is a fellow at the Urban Institute, and codirector at the Urban-Brookings Tax Policy Center. Thank you very 

much, Dr. Toder. 

Each of you will have your statement included in the record 

automatically, and I ask each of you to speak 5 or 6 minutes, whatever seems appropriate. 

Why don’t you begin, Dr. Chetty? 

STATEMENT OF DR. RAJ CHETTY, PROFESSOR, DEPARTMENT 

OF ECONOMICS, HARVARD UNIVERSITY, CAMBRIDGE, MA 

Dr. CHETTY. Thank you, Chairman Baucus, Ranking Member 

Hatch, and members of the committee. Thank you for asking me 

to appear before your committee today. It is a pleasure to share my 

views on the complexity of the tax code and its implications for taxpayer behavior and tax policy. 

Economists and policymakers have traditionally focused on the 

financial incentives created by the tax code when predicting its effects on the economy. However, recent research shows that the salience and transparency of tax incentives matters as much or more 

than the financial incentives themselves. 

In this testimony, I will review some examples of this recent evidence and then discuss their implications for tax policy. I will focus 

primarily on the taxation of individuals and households, but many 

of the lessons that I am going to discuss also apply to the taxation 

of corporations and small businesses. 

So let me start. I am going to do this with the aid of some charts. 

With the first chart, the point I want to make is that the tax code 

in the U.S. is highly complex and is becoming increasingly so as 

reforms are implemented piece by piece. 

So figure 1 here depicts the Federal income tax schedule faced 

by a single earner with two children in the U.S. in 2006. The figure 

plots the marginal tax rate, that is, the tax rate on a family’s last 

dollar of earnings, which is relevant for a broad range of economic 

choices ranging from work decisions to IRA contributions to home 

mortgage decisions. 

So what this figure shows you is that marginal tax rates vary 

considerably with income. And moreover, the figure does not account for transfer programs that further affect incentives, or provisions such as the Alternative Minimum Tax. 

In addition, families also pay many other taxes beyond the income tax, such as sales taxes, property taxes, excise taxes, all of 

which further complicate decisions. 

So the complexity of the tax system today raises the possibility 

that many families may not fully account for the tax implications 

of their economic decisions, and there is now quite a bit of evidence 

suggesting that the lack of transparency does, in fact, affect behavior. 

6 

So let me give you a few examples, if I can move to the next 

chart. So I will start with a very simple example, one that—in 

some sense, the simplest taxes we have—— 

The CHAIRMAN. But in the last chart, what you show is just the 

variations of the marginal rates. 

Dr. CHETTY. The variation of marginal rates by income. 

The CHAIRMAN. By income and how people—they probably do not 

even know what their marginal rates are. 

Dr. CHETTY. That would be my guess, for many people, yes. 

The CHAIRMAN. Thank you. 

Dr. CHETTY. So to illustrate how even relatively simple taxes 

may not be fully perceived by consumers, let me give you the following very simple example. So States levy sales taxes on the purchase of many goods. My colleagues and I ran a very simple experiment where—normally, when you go, say, to a grocery store and 

buy something, you pay sales tax at the register, but the price that 

you see on the shelf does not include the sales tax that you would 

pay at the register. It is added later on. Right? 

So we did a simple experiment where, for 1,000 products in half 

an aisle of a major grocery store, we posted the tags that you see 

here, a very simple tag that tells you what the tax-inclusive price 

is. It just tells you information that, in a sense, you might already 

have known if you were paying attention to this tax. 

So, for example, you can see on this chart we tell you that the 

total price of that hairbrush in the upper right is $5.79, plus California sales tax, is $6.22. And so we then tracked the amount of 

demand for these products before and after this experiment to see 

if just telling people what the tax-inclusive price of the good is affects their consumption behavior. 

What you find is that sales of these products fall by about 8 percent when you simply post this information, showing that taxpayers were not fully taking into account the fact that the sales tax 

was affecting the price of the good, when it was not explicitly posted. 

So even a very simple tax does not seem to be fully perceived by 

consumers, suggesting that the much more complicated income tax 

code—it is unlikely that people fully recognize the incentives that 

it creates. 

Now, you see this kind of effect even for larger purchases. So, for 

instance, a recent study has shown that tax credits for buying hybrid cars that are given at the time of purchase of the car—so like 

a sales tax reduction—have 7 times as large an effect as a reduction in income taxes that is given later on for buying the same car. 

So you have exactly the same financial expenditure by the government, but you have 7 times as large an effect if the consumer 

sees the money that they are getting at the time of purchase as opposed to getting it later on as part of their income tax refund. 

Let me turn now to another example in the context of the income 

tax, if I can move to the next chart. So this chart here shows you 

how the earned income tax credit in the U.S. varies—the size of the 

earned income tax refund varies with earnings. And you can see 

this pyramid shape where, as you earn more, the size of the refund 

gets bigger. That is the incentive to encourage low-income families 

7 

to work more, to make work pay, in some sense, and then the credit is phased out at higher levels of income. 

Now, when you do surveys of families who received the earned 

income tax credit, what you find is that, while many people have 

heard of the EITC, most people have very little idea about how the 

size of their refund varies with the amount that they earn, which 

is a necessary condition for them to start earning more because of 

this program. 

So, if you survey people, less than 5 percent of people know that, if you are earning less than $10,000, the more you earn, the bigger 

the refund you get. And I think that is partly owing to its complexity, where the parameters of this refund vary substantially depending upon your family structure, the number of kids you have, 

whether you are married or not, and so forth. 

Now, in another experiment, we provided simple information to 

families about the incentives created by the EITC, and we found 

that just giving 5 minutes of information, saying something like, 

‘‘the EITC creates an incentive to work; for every $10 you earn, the 

government gives you $4, so effectively, your wage rate becomes 

$14 an hour instead of $10 an hour,’’ that simple information induced substantial changes in earnings behavior by households, 

showing that you can make the program much more effective just 

by increasing its transparency. 

We can move on now to the next chart. Now, because information 

about the EITC is so limited, the responses to the program vary 

substantially across the U.S., even though it is a Federal program. 

So the incentives are basically uniform across States in the U.S. 

But what this chart shows you is that responsiveness is much 

greater in some parts of the U.S. So the dark shaded areas here 

are areas where people are responding much more to the credit by 

changing their earnings, increasing their earnings in response to 

the credit. And you see that in certain States, such as Texas, there 

is a substantial response; but in other States, like North Dakota, 

it is almost like people are not aware of the program at all. 

The evidence seems to be consistent with diffusion of information, where, in some places, people seem to be informed about this 

program and are responding to it; in other places, the government 

is spending substantial money on this program, but is having relatively little impact on behavior. 

The CHAIRMAN. It means up in our State, Montana—— 

Dr. CHETTY. Yes. 

The CHAIRMAN [continuing.] That people just do not know about 

it. 

Dr. CHETTY. This chart does not directly tell you that people do 

not know about it, but what we can see in the data is that people 

do not seem to be responding to it in the sense that their earnings 

are not increasing to reach the point where they would maximize 

their EITC refund. 

The CHAIRMAN. Theoretically, the EITC is as available in Montana as it is in Texas. 

Dr. CHETTY. Exactly. Exactly. That is right. 

I am actually going to skip to the last chart, if that is all right. 

So I have shown you a few examples of how transparency and 

salience affect the impacts of the tax code. Let me sum up by just 

8 

talking about a few policy implications, and I am happy to go into 

more detail on each of these. 

So I think one simple lesson from this evidence is that we want 

to minimize non-transparent tax incentives. So, when we have a 

program that is intended to incentivize some behavior, but essentially the people who would have already done that behavior would 

take advantage of the program and we do not end up changing 

other people’s behavior, we are spending money, but not really having any impact on the economy. 

So I think it makes sense to minimize non-transparent incentives. And, second, invest to some extent in marketing so that we 

really reach out and explain to people in very simple terms what 

the key provisions are of the tax code and how that should affect 

their behavior. 

One way to do that is to build tax incentives into prices so people 

pay attention to prices. You know how much you are spending on 

something. You know how much you get paid when you work. So 

you can make tax incentives much more powerful if people do not 

even have to think about the tax incentive, they can directly look 

at the price and the tax has already been built in there. 

Another tool one can use is defaults with an opt-out clause. So, 

have a default where people automatically are saving some money 

for retirement. They can opt out of that, but you are more likely 

to influence behavior in that way. 

Skipping to number 5, I think these tax complexity issues can 

potentially have substantial effects on the income distribution. So 

there is evidence that lower-income individuals might be less likely 

to take up or figure out a complex tax provision than higher-income 

individuals. And so complexity creates distributional effects. 

By changing transparency, we change the extent to which tax 

burdens are shared between consumers and businesses. That is another important factor to take into account. 

Lastly, tax policy, because of these issues, may often have smaller effects in the short run than in the long run, as people start to 

understand these incentives, and that is very important to keep in 

mind when evaluating the effectiveness of various tax policy incentives. 

So I will stop there. 

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

The CHAIRMAN. Thank you very much, Dr. Chetty. 

Dr. Carroll, you are next. 

STATEMENT OF DR. ROBERT CARROLL, PRINCIPAL, QUANTITATIVE ECONOMICS AND STATISTICS, ERNST AND YOUNG, 

LLP, WASHINGTON, DC 

Dr. CARROLL. Chairman Baucus, Ranking Member Hatch, and 

distinguished Senators on the committee, I thank you for the opportunity to testify today regarding complexity, uncertainty, and 

the evaluation of tax incentives. 

I have had the opportunity to consider tax expenditures and 

other special tax provisions included in the Internal Revenue Code 

from a number of different perspectives, inside and outside the government, in the context of broad reform of the code, how the proviVerDate Nov 24 2008 17:55 Jun 25, 2012 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 R:\DOCS\74611.000 TIMD
9 

sions affect household and business decisions, and who receives 

their benefits. 

Tax expenditures, of course, represent a broad array of provisions 

and priorities of the Congress in the development and evolution of 

the code since the inception of the income tax a century ago. 

The code includes nearly 200 tax expenditures that total roughly 

$1.1 trillion annually. These provisions affect large segments of the 

U.S. economy, touch upon many aspects of household and business 

decisions, and significantly narrow the tax base, thereby requiring 

higher tax rates to raise a given amount of revenue. 

Many of these provisions are longstanding provisions that have 

been part of the code for many years, but others reflect more recent 

priorities. These provisions were carefully considered and debated 

at the time of their enactment and added to the code to meet specific objectives. 

Tax expenditures are, in part, receiving closer scrutiny due to the 

growing imbalance between what the Federal Government spends 

and collects in revenue, projected over the next several decades. 

With these increasing fiscal pressures, they are seen by some as a 

potential source of revenue to help stem the fiscal gap and reform 

the tax system. 

In addition, there is also a growing recognition that reevaluation 

of spending priorities ought to also take into account related spending that occurs through the tax code. 

Two of the most important factors that may influence the effectiveness of special tax provisions is their complexity and their uncertainty. The design and delivery of a special tax provision can 

have profound effects on its effectiveness. Provisions that have 

complex eligibility requirements and other rules can impose substantial compliance costs that detract from their benefits. 

In some areas, duplicative provisions require taxpayers to understand and consider the tax benefits from several related provisions 

and choose the one that best meets their needs. For example, there 

are a number of provisions to encourage saving, but these provisions have different income thresholds, different spousal participation rules, different effective contribution limits, different withdrawal rules, and different minimum distribution rules. 

There are other similar examples in the areas of health care, 

education, family provisions, work incentives, and so on. The reliance on tax advisors to navigate these provisions and their rules 

increases compliance costs and further detracts from the benefits 

they are intended to provide. 

There are also a large number of provisions, expiring provisions, 

often extended a year or two at a time. In principle, the periodic 

extension of expiring provisions provides Congress an opportunity 

to reconsider and reevaluate their effectiveness, but the lack of 

their permanence makes it difficult for taxpayers to rely upon and 

base decisions on the benefits they provide. 

Moreover, expiring provisions are no longer limited to the several 

dozen primarily business tax provisions, but now also include the 

Alternative Minimum Tax patch and the 2001 and 2003 tax cuts. 

The result is a tax system where large portions of the code are, in 

effect, temporary. 

10 

Special provisions narrow the tax base and require higher tax 

rates to raise a given amount of revenue. These higher tax rates 

impose additional economic costs themselves that also need to be 

understood and weighed against the special provisions included in 

the code. 

This committee should be commended for focusing on these 

issues as part of their dialogue and deliberations on tax reform. A 

better understanding of the effect of these provisions and who they 

benefit would be valuable inputs into the policy debate as the Congress reevaluates various priorities on both the spending and tax 

sides of the budget to meet the Nation’s challenges. 

I thank you, and would be pleased to address any questions you 

may have. 

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

The CHAIRMAN. Thank you, Dr. Carroll. 

Dr. Toder? 

STATEMENT OF DR. ERIC J. TODER, INSTITUTE FELLOW, 

URBAN INSTITUTE, AND CO-DIRECTOR, URBAN-BROOKINGS 

TAX POLICY CENTER, WASHINGTON, DC 

Dr. TODER. Chairman Baucus, Ranking Member Hatch, and 

members of the committee, thank you for inviting me to testify 

today on taxpayer responses to incentives in the individual and corporate income taxes. 

The views I express are my own and should not be attributed to 

the Tax Policy Center or the Urban Institute, its board, or funders. 

My written testimony addresses the following questions: what 

traditional economic theory tells us about the effects of tax incentives on behavior, what we have learned from statistical studies of 

major tax incentives, how new research in the field of behavioral 

economics by Dr. Chetty and others has affected our views on how 

to influence the behavior of individuals, and how the complexity of 

the current income tax alters the effectiveness of tax incentives. 

Senator Baucus mentioned Dr. Einstein. So I would offer another 

quote. He said, ‘‘The hardest thing to understand is the income 

tax,’’ and, of course, it has gotten more complicated since he made 

that statement. 

I will discuss three aspects of complexity. First, some tax incentives are so complex that even well-advised and sophisticated taxpayers find it hard to figure out how best to use them. Some examples are the multiple tax incentives for higher education, multiple 

forms of savings incentives and the need to choose between Roth 

and deductible, phase-outs and limitations on tax incentives that 

reduce their benefits over various income ranges, interactions of 

tax incentives with the Alternative Minimum Tax, and complex eligibility requirements for some incentives, such as the earned income credit. 

Second, the overall complexity of the entire tax system makes 

even simple tax incentives less transparent. Today, in response to 

this complexity, about 90 percent of taxpayers use either preparers 

or software to calculate their tax liability. Assisted methods reduce 

the cost of complying with the tax law and help taxpayers use 

available tax benefits, given their economic behavior. 

11 

But, because taxpayers now have less understanding about how 

their taxes are calculated, they may be less likely to change their 

economic behavior in response to incentives. They just claim the 

benefit after the fact. And, because of how various incentives interact, taxpayers are also likely to be less aware of the marginal tax 

rates they face, as was discussed before. 

Third, most of our tax law has become temporary. So people facing economic choices may have no good way to predict the tax consequences of their actions. Provisions that will expire in the next 

2 years include the entire individual tax rate structure, relief for 

capital gains and dividends, marriage penalty relief, the payroll tax 

holiday, the temporary patch that keeps millions of taxpayers off 

the AMT, and numerous tax incentives for businesses, including 

the research and experimentation credit. 

We can now say that the individual income payroll tax and corporate tax are all temporary taxes today. 

In addition to this, as long as we continue to face a prospective 

explosion of the national debt, taxpayers will wonder whether higher future taxes might be part of the solution and, if so, which tax 

provisions will be affected. 

So it is hard to respond to a tax law when you do not know what 

it is going to be. 

Despite very important and exciting new research in the field of 

behavioral economics, there are still vast gaps in our knowledge of 

how people respond to tax incentives. And the increased complexity 

of the tax code and the temporary nature further reduces the extent to which we can rely on targeted incentives to influence behavior. 

I conclude, therefore, that we should, when possible, resist temptations to use the tax code for complex social engineering schemes 

and instead move to promote tax reforms that treat taxpayers with 

the same incomes in an equal and evenhanded way. 

I thank you, and I look forward to your questions. 

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

The CHAIRMAN. Thank you, Dr. Toder; very provocative, which 

prompts a question. 

In your experience or in your study and analysis, was there sort 

of the same kind of lead-up to 1986? That is, was there an accelerated number of new provisions in the code which created complexity and uncertainty leading up to the 1986 tax reform or not? 

Because it is my understanding, and I have forgotten the number, 

but since 1986, I think we have had—do you remember the number, how many thousands of new additions to the code—close to 

15,000 changes to the code since 1986. And I saw a chart recently 

of the number of expiring provisions, and it has accelerated quite 

significantly in the later years. 

I am just wondering, for my own information, if today is in any 

way comparable to the lead-up to 1986. 

Dr. TODER. Thank you. I do remember 1986. I am old enough to 

know that. I think, certainly, complexity was a factor. And in the 

Treasury report, the word ‘‘simplicity’’ had a prominent place in a 

description and the purpose of their reforms. 

However, I think other factors were also very important, one of 

which was we still had a top marginal rate of 50 percent on indiVerDate Nov 24 2008 17:55 Jun 25, 2012 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 R:\DOCS\74611.000 TIMD
12 

viduals and 46 percent on corporations—and we had come down a 

bit from the World War II rates, but people wanted to come down 

further. And we had this proliferation of tax shelters, particularly 

in the early 1980s, which led to great concerns about the fairness 

of the tax system, and that was largely driven by various incentive 

provisions that had been put into the tax law. 

So I think those were more motivating factors—to produce more 

fairness and to get the top rates down—than simplicity, but simplicity was certainly a component of it. 

The CHAIRMAN. You made a point, it was kind of interesting, or 

one of you did—actually, it might have been you, Dr. Chetty—that 

incentives tend to have the greatest bang for the buck in the short 

term and, after a while, may not have quite the same effect, if I 

understood your points, which raises just one example that we are 

faced with often here in the committee, and that is the research 

and development tax credit. 

Some businesses claim they have to have it. If they do not have 

it, we are going to lose our American competitive edge. Well, we 

are losing it anyway in research. Then I hear others say, we would 

do the research anyway, we do not have to have the credit. 

Of course, they like the credit; it helps. But do any of you have 

any thoughts on the utility of the R&D tax credit? I guess it raises 

the deeper question. What about research? Many people think the 

more there is research in America as opposed to other countries, 

the more that is good on the margin and tends to help American 

competitiveness and helps create jobs, et cetera. 

Do any of you want to take a shot at that? 

Dr. CARROLL. I think that the research and development credit 

kind of points to one of the problems with expiring provisions. Having expiring provisions does give the opportunity to the Congress 

to reevaluate their effectiveness, but at the same time, particularly 

with the research and development credit—where it occasionally 

has been allowed to lapse, occasionally it is extended retroactively—it is very hard, I think, for companies to use provisions 

that are very highly uncertain. Oftentimes, the people in companies 

making the investment decisions are not the people who have a 

very well-developed understanding of the tax treatment or how 

things work in Congress. 

So, even though the R&D credit is pretty routinely extended, it 

still may be very difficult for companies to reflect the likely extension of the R&D credit year after year after year into their 

decision-making. 

It also plays into how these provisions are reflected in the financial statements. It affects earnings per share. It affects the market’s perspective on a company. Uncertain provisions, provisions 

that are extended retroactively—it is very difficult for those provisions to be incorporated into financial statements. 

The CHAIRMAN. You are probably not well-qualified to answer my 

next question, which is, basically: let us say we do, magically, with 

transition rules—because it is going to be difficult to change—move 

to a regime that is much more simple, maybe to a few tax expenditures, much more permanency, less complexity. 

The Congress always meets, and there are lots of groups in this 

country that want—they say, ‘‘Well, I understand the general rule, 

13 

but, in my case, I need a little different treatment,’’ and Congress 

tends to respond to those entreaties. 

How in the world—and, again, you are probably not wellqualified to answer this—how do we stop that or how do we minimize that? I suppose if there is some standard that people could 

agree to as to when something should be changed or not changed, 

that might help a little bit. 

I am asking probably the unanswerable question when it comes 

down to discipline around here, but just any thoughts you might 

have on any kind of system or any kind of something to set up so 

that we are less likely to keep changing it all the time? 

Dr. Chetty? 

Dr. CHETTY. Thanks. That is a very interesting idea. So, while 

it is very hard to figure out how you would deal with that systematically, I think one thing that could help is if we have in mind an 

explicit cost to adding a new provision that creates complexity in 

the same way that one would consider the financial costs of a 

change in tax incentives. 

If we have in mind essentially a dollar cost to saying, ‘‘I am willing to consider this provision, but it is going to have a certain cost 

in terms of increasing complexity,’’ I think that would create a 

clearer way to assess which types of changes in the code have benefits that outweigh the added complexity costs. 

Now, that is something one can try to do systematically, measure 

the costs of complexity. There is research that is ongoing on that. 

But I think having something numerical in mind so that it is not 

just something that is disregarded qualitatively could potentially—— 

The CHAIRMAN. Well, my time has expired. But you do make a 

good point. It is very important to quantify these standards. Otherwise, it is just—the impression is in the eyes of the beholder. But 

if it is quantified, it makes it a little bit easier. 

My time has expired. 

Senator Hatch? 

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

Dr. Carroll, tax rates are high, and they are set to go up further 

unless Congress acts. Today, the top tax rate is 35 percent, but this 

rate will rise to 39.6 percent in 2013 unless Congress acts to prevent this particular listed tax increase. 

Now, the health spending law will increase the Medicare hospital 

insurance tax effective January 1, 2013. And most States also impose their own income taxes, which raises marginal tax rates even 

further. 

Now, how high can tax rates really go before we need to be concerned about how they will interfere with household and business 

decisions and the drag that they might place on the economy? 

Dr. CARROLL. Thank you for the question. I think that is a very 

interesting question. When you look back after the 1986 act, the 

top rate was set at 28 percent; and then, a few years later, in 1990, 

it went up to 31; in 1993, it went up to 39.6; and, in 2001, it came 

back down to 35, where it is today. 

But it is, of course, beholden to the periodic extension of the 

2001/2003 tax cuts. And the rate does not just stop there. You have 

14 

to add in State tax rates, as you point out. In 2013, the Medicare 

tax increase plays into the effective rate. 

So, when you add all the rates together, we could well face an 

effective rate of over 50 percent, depending on what State you live 

in. It looks like rates that we have not seen in quite a while. 

One thing that I think is clear from the economic research is that 

very high tax rates do affect decision-making. They affect them in 

important ways, affect decisions to work, to save, to invest, and 

that is a significant concern. 

Another effect of those high tax rates is they do cause the tax 

base to contract, to shrink, which has an effect on revenues. My 

recollection from when I was at Treasury is, when Treasury estimates the revenue effect of changes to the top two rates, they incorporate a revenue feedback of about 25 percent. So, for every dollar in revenue that Treasury would collect on the top two rates, 

they would assume that about 25 cents on the dollar is lost due to 

behavioral responses. 

I am not sure exactly what the Joint Committee assumes, but 

that is kind of another way to think about kind of the economic 

cost to the government fisc. 

It is not just the ordinary rates. The dividend tax rate will also 

go up, and, here, I think you have to think a little bit more broadly. 

You have to look at both the corporate and individual income taxes 

together. And the effective tax rate on dividends in 2013 will be upwards of 68 percent. 

When you think about it from the perspective of a dollar invested 

in the corporate sector and paid out as dividends, what rate would 

that be? When you take into account the corporate tax, the 

investor-level taxes on dividends, then tax to 39.6 percent, the 

Medicare tax, and the State tax, a 68-percent tax rate on dividends, I would think, is very high. 

One would expect it to have a pronounced effect on companies’ 

dividend payment policies, which could have impacts on corporate 

governance. 

The other thing I would mention is, it is not just the individual 

side, but you also have to think of this very globally. It makes it 

very, very hard when thinking about reform, but we also have a 

very high corporate tax rate, as you know, relative to other nations, 

currently the second-highest among OECD nations. Japan may or 

may not be lowering its corporate tax rate. 

That is another consideration: how we compare to other countries, which is particularly important in the business area. 

Senator HATCH. This is for Dr. Carroll and Dr. Chetty, and it is 

about the research and development tax credit. If Congress wanted 

to focus on one aspect of it or change one aspect of it that would 

really improve its incentive effect—if we could improve this effect, 

what would that be? What aspect would you change? 

Allow me to give you just a few possible choices on how to improve the incentive effect of the credit: making it permanent—I 

would like to make it permanent so they can rely on it year after 

year after year; increasing the Alternative Simplified Credit, or the 

ASC, percentage from 14 percent to 20 percent; clarifying the definition of ‘‘qualified research’’ so that there is more of a bright line 

between what is qualified research and what is not qualified reVerDate Nov 24 2008 17:55 Jun 25, 2012 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 R:\DOCS\74611.000 TIMD
15 

search or, more precisely, targeting the credit on qualified research. 

That would not happen but for the credit’s availability. 

Which one of those things is perhaps most important in improving the incentive effect of the R&D tax credit, or would it perhaps 

be something else that I just have not mentioned? 

Dr. CHETTY. I think all of these are great ideas that you suggested, Senator. If I were to pick one of them, I would probably 

pick making it permanent, because evidence shows that changes in 

the rates, like, from 14 to 20 percent, probably has some impact, 

but has less impact than something like stability or knowing that 

you will definitely have access to this credit and be able to count 

on it, understand it well. 

I think the kind of provision that really does not make sense that 

was mentioned earlier is retroactive R&D credits, because, there, 

you are basically giving money to companies that chose to do something and not really changing behavior on the margin. 

So, if I were to pick one, I would pick making the credit permanent and perhaps making it, also, clearer. What exactly counts as 

research and development and what does not? 

Senator HATCH. Do you agree, Dr. Carroll? 

Dr. CARROLL. I think, as Dr. Chetty suggests, an uncertain tax 

code undermines the effectiveness of tax provisions. I think the 

R&D credit is probably an excellent example of—the temporary nature of that provision in particular undermines its effectiveness. 

Senator HATCH. Thank you. Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you, Senator. 

Senator Carper, you are next. 

Senator CARPER. Thanks, Mr. Chairman. Welcome, one and all. 

Senator Wyden and I were at a meeting earlier this morning 

with some folks from some—I guess they were the business 

media—and they were asking questions of a number of us. We had 

a good conversation. 

One of the questions that we got into was the right balance of 

revenues as part of the deficit reduction plan, and we talked a bit 

about the need for businesses that are sitting on a lot of cash to 

have certainty with respect to a broad range of policy issues—tax 

reduction, energy policy, transportation policy, tax policy, and the 

list goes on. 

So we talked a fair amount about how helpful some certainty on 

the tax side would be to businesses that are looking for certainty 

in a lot of ways, and I think I have heard that repeatedly from 

businesses: give us some predictability, give us some certainty, get 

out of the way, and we will do the rest. 

Hopefully, we will do that. Hopefully, we will do that. And maybe 

the triumph of man is hope over experience, but I am encouraged 

we just might. 

I would like to ask you, within that context of providing certainty 

with respect to taxes, would each of you pick one or two provisions 

of the tax code, in addition to all that might be part of that certainty message, that would be especially helpful to bolster economic 

growth? 

I would like to say, as much as I believe we need to reign in 

spending on domestic discretionary, defense discretionary, entitlement program spending, I do not know that we can just cut our 

16 

way out of this deficit. We have to grow our way out of the deficit. 

We need some additional revenues, and we need to grow the economy. 

So would each of you pick one or two provisions of the tax code 

that you think, as we go through this deficit reduction debate and 

tax reform debate, that we change, preserve, amend in some way 

just to promote economic growth? 

Dr. TODER. I will start then. I think one of the big mistakes that 

was made 2 years ago was not starting with addressing the question of what tax cuts would and would not be extended really very 

early on in the session. 

I think what is going to happen, if you do not deal with the expiring tax cuts and the AMT very quickly, you are going to end up 

waiting until 2012, and then you will have yet another temporary 

extension of various provisions. 

So I think the fact that we have this expiring tax code, which is 

really a new phenomenon—we had not had it before 2001 and, of 

course, in 2001, it was 10 years in the future, so people were not 

worrying about it. 

I think without saying whether you should extend all of the cuts, 

some of the cuts or none of the cuts, I think a decision on that 

early would be very desirable. 

Senator CARPER. All right. Thank you. 

Dr. CARROLL. I would agree with Dr. Toder that having a more 

certain tax code, obviously, is going to be extraordinarily helpful. 

As Dr. Toder said, we pretty much now have a tax code where 

a large fraction of it is extended every few years. It is in flux. It 

makes it extraordinarily difficult for businesses and households to 

make decisions. And starting the process as early as possible so 

that households and businesses can have a certain tax code that 

they can incorporate into their decision-making, their planning, is, 

I think, critical. 

Senator CARPER. That is not really my question, though. I think 

we agree we need some certainty, some predictability. But within 

that, are there a couple of provisions of the tax code that you would 

especially ask us to take a look at—— 

Dr. CARROLL. I think it is very important to—— 

Senator CARPER [continuing]. Either preserving or changing? 

Dr. CARROLL. I think it is very hard to pick a couple provisions 

out, because such a large fraction of the tax code is changing. We 

have the rates changing on ordinary rates, on dividends, on capital 

gains. 

We have the estate taxes in flux, as well. We have all the expiring provisions on the business side and some on the individual 

side, more traditional expiring provisions. 

So I think it is really hard to—I think you have to evaluate each 

one. 

Senator CARPER. That is why we have you guys here. 

Dr. CARROLL. That may not be helpful, but—— 

Dr. TODER. I really do not think that picking one of those elements of the tax code is really going to do very much good if you 

do not address the whole rate structure. 

I might say the AMT, if you push me to the wall and ask me to 

talk about one thing, but that is—— 

17 

The CHAIRMAN. We just pushed you. You were just pushed. 

Dr. TODER. And I just said it. 

The CHAIRMAN. On AMT, which is? 

Dr. TODER. To make the patch permanent. 

Senator CARPER. Dr. Chetty? 

Dr. CHETTY. So I am now going to try to give you an example 

on the business side. 

Senator CARPER. Please. 

Dr. CHETTY. I think it is one of many examples, as has been suggested. 

So I think the variation in dividend tax rates over time induces 

firms to do things that they would not otherwise do if they had a 

stable system. So, for instance, lots of companies try to pay special 

dividends right before they know that a dividend tax increase is 

going to occur or right after a cut occurs. 

You saw this right after the 2003 dividend tax cut that was enacted, when there was uncertainty about how long it would last. 

That kind of behavior is perfectly rational on the business side, 

but it induces sort of wasted effort and re-timing the point at which 

you distribute cash to shareholders. It distorts investment decisions. 

As another example related to that, when you have, say, tax holidays to repatriate profits to the United States, that, again, basically creates uncertainty about how should I time things, when 

should I bring money back. 

So I think, especially on the business side, having stability in 

specific things like the dividend tax rate, or the tax rate on repatriation of profits, would be quite valuable. I think that is what the 

evidence suggests. 

Senator CARPER. Thank you all. 

The CHAIRMAN. Thank you, Senator. 

Senator Wyden, you are next. 

Senator WYDEN. Thank you. Thank you, Mr. Chairman. I think 

it is very appropriate, Mr. Chairman, that you are having this 

hearing on the complexity of the tax code right now. 

I saw something from the Internal Revenue Service just recently 

that indicates that Americans spend 6 billion hours a year complying with the tax law, and it costs us $160 billion a year. So the 

chairman’s scheduling of a hearing on complexity when what we 

ought to be trying to do is give the American people their springtime back, I think this is very appropriate, Mr. Chairman. I am 

really glad you are holding this today. 

The question I have for you, Dr. Toder and Dr. Chetty, in particular: is there any reason, on the individual side of the tax law, 

why our country should not have a 1-page 1040 form? 

This has been recommended by Democrats and Republicans for 

just ages, and I would be interested to get your thoughts on why 

there should not be a 1-page 1040 form. 

Dr. TODER. I guess my thoughts on that are maybe not what you 

are looking for. I actually do not think—— 

Senator WYDEN. We can just move on. [Laughter.] 

Dr. TODER. I actually do not think—— 

Senator WYDEN. Seriously, I want to hear what you think. 

18 

Dr. TODER. I actually do not think the form matters that much 

anymore. Most people are using assisted methods, and the biggest 

source of cost in complying with the tax law for individuals is recordkeeping, actually figuring out what all these numbers are. 

So the structure of the form when you do it in an automated 

way, which is what the people with complicated returns are 

doing—the people with simple returns are already using 1040–EZ, 

so they already have a 1-page form. 

But the people with complicated returns are having their form 

automatically populated. So it is not really a matter of what is on 

the form so much as what are the numbers of things you need to 

do in order to get at your tax liability; what are the kinds of 

records you have to keep; what are the kinds of data requirements. 

Senator WYDEN. Just on that point, and then we will go to you, 

Dr. Chetty, I was really struck, and you have said that the 1040– 

EZ form—folks are using it. 

In the ‘‘oops’’ list that the Internal Revenue Service puts out, 

they said that many of the people who worked in 2009 could not 

figure out how to claim the Making Work Pay Credit on their form 

1040–EZ. 

So, in effect, here the Congress passes tax legislation with hundreds of billions of dollars worth of tax breaks, the system is so 

complicated, people cannot even claim the breaks that Congress authorizes. And you cited the 1040–EZ form, and the IRS puts out on 

their ‘‘oops’’ list that people thought it was too complicated to take 

the Making Work Pay Credit. 

Dr. TODER. Well, absolutely, but that is a 1-page form. So I guess 

that is my point. It is not the length of the form. It is what you 

are asking people to do. 

Senator WYDEN. Let us ask your colleague. Dr. Chetty? 

Dr. CHETTY. Thank you, Senator Wyden. So let me make three 

points. I think the observation you made about the very large compliance costs, the number of hours that the taxpayers spend filling 

out these forms, in a way, actually, understates the cost of complexity, because of what you said, for instance, about the Making 

Work Pay Credit. 

The compliance cost just measures how long it takes people to fill 

out these forms, but I think the bigger cost is that we are spending 

a lot of money on these programs without actually having incentive 

effects and changing the amount people work when we have the 

Making Work Pay Credit. 

I think, in order to make those programs more effective, it is not 

necessarily the length of the form, per se, which is what Dr. Toder 

was, I think, getting at. It is more about making these credits, 

when we enact them, very transparent to people. 

So I think, to some extent, separating, say, even from the 1040, 

having direct information given to people about how the Making 

Work Pay Credit works and how you can go about claiming it, can 

greatly increase the effectiveness of such programs independent of 

the length of the forms required to be filled out. 

Third, coming back to a point that Senator Baucus made earlier 

in terms of why we cannot end up having just a 1-page form, there 

are always going to be various contingencies where some people 

19 

want to promote saving for retirement or promote work, and you 

are going to want to target those programs in certain ways. 

It is hard to get all of that to fit into a 1-page form. So I think 

the focus should be more on, how do we make the relevant group 

that we are targeting understand exactly what we are trying to accomplish with these incentives, rather than minimizing the length 

of the form. 

Senator WYDEN. Mr. Chairman, is my time up? I cannot tell. 

The CHAIRMAN. Your time is up, but you can go ahead and ask 

another question. 

Senator WYDEN. Well, just staying with this complexity issue. I 

guess you all have reservations about this 1-page 1040 form, or at 

least you do, Dr. Toder. 

The commission that was set up by the Bush administration, 

they recommended it. It has been recommended in the past by 

Democrats. What would you like to see in terms of making the system simpler? 

I guess maybe for you, Dr. Toder. I think Dr. Chetty is perhaps 

more sympathetic to this. But what would you like to see to make 

the system simpler for people? 

Dr. TODER. I think there is a huge number of proposals that have 

been recommended by the taxpayer advocates and others. There 

were some that were in the President’s Economic Recovery Board 

report. There were some that were in the tax reform panel in the 

Bush administration. 

But a lot of things that would eliminate phase-outs of benefits, 

reduce the number of alternative incentives people have to use for 

saving or education, eliminate the AMT or reduce the scope of that; 

in other words, provisions that just simply make the determination 

of your tax liability simpler, and there is a very, very long list of 

those things that are possible to do without really changing the distribution of tax burdens or the overall broad incentive structure. 

Senator WYDEN. Whatever the clock says, Mr. Chairman, I must 

be over my time, and I thank you. 

The CHAIRMAN. You are welcome, Senator. 

Senator Cardin, you are next. 

Senator CARDIN. Thank you, Mr. Chairman. Let me thank our 

panel of witnesses. 

As I listened to your exchange with Senator Wyden, it just reinforces my concern as to whether we really can save this tax code 

that we have today. In 1986, we tried to simplify it. We tried to 

make it fairer, and it lasted less than a year before changes came 

about. 

You mentioned the efficiency of the tax provisions that we have 

enacted, as to the purpose for which we put those provisions in the 

code, and I think that is a very good point as to whether we are 

getting the efficiency factor for the revenues that are being expended as tax expenditures. 

But let me try to give a different angle to it which really troubles 

me, and get your view on it. Our overall tax code is so complicated 

that two families living next door to each other in the exact same 

financial circumstances do not believe they are being treated equally under our tax code. 

20 

Therefore, when we pass a tax provision which, in many respects, depends upon voluntary compliance as far as the rules are 

concerned, the taxpayer believes that he or she can go beyond the 

edge because their neighbor has gone beyond the edge. 

So I guess my question to you—is there any way of solving that 

under our current income tax code; that is, the public perception 

that there is a lack of fairness in the code? And, therefore, where 

we depend upon voluntary compliance for much of the information 

we receive, will we ever get that level of voluntary compliance that 

gives us reason to believe that what we are doing is right? 

Dr. TODER. That is a very complicated question. Certainly, the 

perception of fairness does hurt compliance. I do not have an estimate of how much it hurts compliance, but it is certainly a negative factor. 

I think if you look at voluntary compliance, you might be surprised at how low it really is. The compliance rates that the IRS 

estimates are about 85 percent, but, when you break that down, it 

is more like 99 percent for wages and salaries and 95 percent for 

interest and dividends; that is, for items of income for which there 

is withholding or information reporting or matching, it is extremely 

high. 

For other items where there is not such information reporting, 

such as business income, it is quite a bit lower. 

Senator CARDIN. That is my point. 

Dr. TODER. That is a very difficult issue to deal with. 

Senator CARDIN. And my point is exactly that. For a lot of the 

provisions we are talking about on efficiencies, it requires voluntary compliance in order to receive that particular tax provision. 

Historically, we have had a very high percentage of voluntary 

compliance with our tax code. As we become more complicated, I 

believe that the voluntary compliance, other than where we have 

reporting, has gotten worse. 

The question is, can you save it under this tax code that the public perceives as being basically so complicated that they do not 

know whether they are being treated fairly? 

Dr. TODER. Well, I mean, I guess that is an interesting question 

because, in some sense, the fairness is coming—the perception of 

unfairness is coming about because of programs that the Congress 

wants to enact, and they want to use the tax code to enact those 

programs. 

So, if they are giving a farm subsidy payment to somebody, somebody is getting money from the government, but it is not reducing 

their tax liability. So people do not see it as unfair that somebody 

is getting this payment from the government and someone is not. 

But, if they are getting an earned income tax credit or they are 

getting a mortgage interest deduction, then it is coming through on 

their tax form and they are paying less taxes than somebody else. 

So substantively, when you do things through the tax code, you 

are creating this perception, but part of the reason is you actually 

do want to have these programs. 

So it is a conundrum. 

Senator CARDIN. And I appreciate the frankness of your answer, 

and you are absolutely correct. 

21 

I guess one of the points that I have been bringing up is whether 

it is time to fundamentally change the way we bring in the revenue 

in this country. 

Dr. TODER. And I am very sympathetic to your point of view. I 

think we would have to do something on the order that Senators 

Wyden and Gregg have proposed, or something even more radical, 

to move to a system where taxes are just, more simply, based on 

people’s income and there are fewer tax benefits, and we keep rates 

lower as a consequence. 

Senator CARDIN. And, of course, we also have to come to the conclusion that the tax code’s purpose is to raise revenue. 

Dr. TODER. Correct. 

Senator CARDIN. Which is not exactly where we are today. 

Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you. 

Before I turn to Senator Snowe, there was one interesting observation here that was mentioned, Dr. Toder, which was 99 percent 

compliance on, what, dividends? 

Dr. TODER. Wages. 

The CHAIRMAN. Wages, and 97 percent compliance—— 

Dr. TODER. Ninety-five on dividends and interest. 

The CHAIRMAN. On dividends, and that is because of reporting 

requirements. Going to Senator Cardin’s point, there is a lot of income not collected that has nothing to do with the perception of 

fairness. It is just that people cheat. They know they are cheating. 

I am talking about under-reported income. Some people know 

they are under-reporting income that maybe goes to—I am talking 

about—I do not want to get myself in too much trouble here—and, 

also, over-expensing, and that is the largest part of the tax gap. 

And I do not know how much that is based upon people’s belief 

that the tax code is unfair. I think it is, some people are just trying 

to figure a way, because there are no reporting requirements, that 

they can figure out a way to not pay their fair share. 

Senator CARDIN. Would you just yield for one moment? My understanding is, if you go back in time on collection of revenues 

under the tax code, when we did not have as much of the information reports that were made available, there was much higher voluntary compliance, including reporting income where there were no 

reports to the government, that there was a higher percentage of 

compliance than there is today. 

The CHAIRMAN. I am talking about different income groups, not 

the income that Dr. Toder is mentioning. The last—I think it was 

Treasury, with the tax gap assessment—it was back quite some 

years ago, and that was $300-and-some-billion annually. That was 

back then. 

Anyway, clearly, we have work to do. 

Senator Snowe, you are next. 

Senator SNOWE. Thank you, Mr. Chairman. 

In the health care law, there is a new section that added a small 

business tax credit to help small businesses pay for health care 

coverage for their employees, and this credit can mean as much as 

35 percent of the insurance premiums small businesses pay for 

medical coverage for their employees. And it also took effect in the 

taxable year of 2010. 

22 

I heard about this through many of my constituents, but one example really stood out, and that was the case of an accountant who 

was determining whether or not he himself would be eligible for 

this tax credit, and it took him 9 hours to figure out whether or 

not he was eligible for that tax credit, and discovered at the end 

of that calculation that he was not. 

In fact, accountants are recommending to their clients not even 

to bother to hire professional help to determine whether or not they 

are eligible for this tax credit, because the cost of that professional 

advice would be greater than the value of the tax credit itself. 

We changed that tax credit from what it was originally to what 

occurred on the floor, where they changed the number of employees, for example, from 50 or fewer employees where a small business would be eligible to 25, and then the employer had to pay at 

least 50 percent of the employees’ health insurance. 

We have a chart here just to show and demonstrate how complicated this tax credit is. This is not my chart. It was one that was 

used in the Ways and Means Committee on the House side. 

But I think it makes the point about the complexity of this tax 

credit that is probably virtually useless for many small businesses 

who clearly do not have that kind of wherewithal within their 

small entities to make those determinations. 

If an accountant cannot do it in 9 hours, then clearly there is 

something wrong in the way we are crafting these initiatives. 

So, Dr. Carroll, would you care to comment on what we ought to 

be doing differently? I am certainly mindful here that we should be 

conscious of how complex—every time we are making revisions in 

provisions, that it results in this kind of complicated calculation 

and computation. 

Dr. CARROLL. One of the things you see is, when you look at compliance costs by size of business, when you are looking at—there 

are a certain amount of fixed compliance costs associated with businesses, and when you are relating those compliance costs to assets 

or receipts, as a percentage of assets or receipts, they are much 

higher for smaller businesses. 

It is just kind of the way it works. It has to do with the fixed 

nature of complying with the business tax system. And so the code 

has kind of dealt with that or the Congress has dealt with that in 

some respects by having some special provisions that make things 

a bit easier for some small businesses. 

Section 179 expensing, for example, would be kind of a perfect 

example, where smaller businesses can write off 100 percent of 

their—most of their—purchases of equipment immediately and do 

not have to worry about keeping track of the depreciation over a 

period of time. And there are some other provisions. 

But this particular provision, looking at your chart, goes in the 

opposite direction. 

Senator SNOWE. Well, it certainly does, and maybe what we 

ought to be doing differently in Congress, that is for sure, is to 

show these types of charts and exactly what the tax credit looks 

like before it is enacted, because, clearly, if that had presented 

itself on the floor of the Senate, I think that there would have been 

a general reluctance to vote for a tax credit that would look like 

this in the final analysis. 

23 

Dr. Chetty or Dr. Toder, do you have any comments on that, any 

advice for Congress? 

Dr. CHETTY. Senator Snowe, precisely as you suggested, I think 

one thing that would be useful is to, when enacting a law like this, 

do sort of a pilot study and try to anticipate how many hours would 

it take an accountant to figure this credit out for a representative 

business, and if you find that, in many cases, it is 9 hours and the 

costs are going to exceed the benefits, I think quantifying those 

costs, as we were discussing earlier with Senator Baucus, would be 

a valuable input to the legislative process and might make such 

legislation less likely to happen. 

Senator SNOWE. I appreciate that. 

Dr. Carroll, you mentioned several weeks ago in a hearing before 

a Ways and Means subcommittee one of the issues that I have expressed, as well, and that is on the issue of tax reform exclusively 

on the question of corporate tax rates. 

I know that Secretary Geithner was before the committee a 

month or so ago and talking about having corporate tax reform, 

without recognizing what the impact will also be on flow-through 

entities. And one of the suggestions that he was making is somehow to revoke the longstanding practice of subchapter S to pay individual tax rates on their business income, which, obviously, 

would have a great effect on 27 million small businesses, not to 

mention that more than $3 trillion in additional capital would be 

subject to higher tax rates. 

Could you give us some comments on that whole issue, because 

that clearly is a problem, requiring flow-throughs to be, obviously, 

double-taxed, both at the entity level and the individual level, rather than just simply paying one tax rate. 

Dr. CARROLL. I guess I would start out with the observation that 

the corporate income tax is in need of reform. The corporate tax 

rate is certainly high from a global perspective. It is increasingly 

high as other countries lower their tax rates. 

So that is an issue that I think is appropriately getting a lot of 

focus. But I think it is very difficult, given the way the business 

sector is arranged in the United States, to do corporate tax reform 

by itself. It is very difficult. 

The flow-through sector is simply very large. It is not just S corporations. It is partnerships, it is sole proprietorships, it is LLCs 

and LLPs. They employ about 54 percent of the private sector 

workforce. They report about 35–36 percent of business receipts. 

About 44 or 45 percent of all business taxes are paid on flowthrough income by the owners of those flow-throughs when they 

file their individual tax returns. 

So it is a large sector. If one were to finance or pay for a corporate rate reduction by repealing all business tax expenditures, 

that would have a substantial increase on the tax paid on that 

flow-through income. It would go up by about 8 percent. 

About 22 percent of business tax expenditures are claimed by 

flow-through entities. So I think it is very hard to deal with one 

without dealing with the other, dealing with the corporate tax 

without dealing with other business taxes at the same time. 

If one were to have special treatment—if one were to try to just 

repeal the corporate tax expenditures alone, then it would be a 

24 

very complicated system to try to apply one set of depreciation 

rules to C corporations and other depreciation rules to the other 

types of flow-through entities. 

Another, I think, very large consideration is the role of the corporate tax and the role of flow-throughs. One of the advantages of 

the flow-through form is it affords businesses and business investment one single layer of tax. 

For businesses that are operating in the flow-through form, they 

are not subject to the double tax, and the double tax carries with 

it a lot of important tax biases. It affects business decisions in important ways. It discourages the incentive for companies to pay out 

profits as dividends, which affects corporate governance. It affects 

the debt-equity choice. It raises the overall cost of capital in the 

economy. And those are all considerations that I think need to play 

into that discussion. 

Senator SNOWE. I appreciate that. Either one of you, any comment, Dr. Chetty or Dr. Toder? 

Dr. TODER. I would certainly agree with most of what Dr. Carroll 

said, and really note that the ideal way to tax business income is 

the way we tax S corporations. We would like to attribute the income to the owners, and the only reason we have a corporate tax 

is, for large and frequently traded companies, it is very hard to do 

that and identify the owners who would pay the tax. 

But where you can do that, we should do that. And so that is the 

right treatment. I also believe that we cannot look at corporate tax 

reform in isolation without looking at the effect on the flowthroughs and, also, the effect on the taxation of corporate income 

at both the individual and the corporate level. 

Part of the reason we have given tax breaks to individuals—very 

low capital gains and dividends rates—is to adjust for the double 

taxation of corporate income. And so, if we are going to reduce the 

corporate rate, we might think about how we tax individuals, and 

maybe we do not need to give them as much preferential treatment. 

But I think putting things in a box, corporate tax here and individual tax there, is not the right way to go. 

Senator SNOWE. Thank you. Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you, Senator, very much. 

It is interesting. The flow-through is a problem, clearly. What 

about the reporting requirements of C corps, which do provide a 

certain benefit to the public, 10(k)s and reports, et cetera? Those 

are large corporations, have a certain number of shareholders. 

I do not know this. I am asking the question. How many flowthroughs are as large in size as, say, a reporting company, a reporting C corporation? Because, if I am a C corp, I have to file, but 

I do have certain liability protections if I am a C corp, whereas, if 

I am a flow-through, I do not have to file. I do not have to tell anybody what I am doing, except pay my taxes, and I do not have the 

same liability protection that a C corp has. 

So I just wanted to try to figure out—I do not know the answer 

to this question—what are the size—are there large flow-throughs, 

whether they are hedge funds, they are private equity firms, partnerships, really, that are as large as many C corps? Are there or 

are there not? I just do not know. 

25 

Dr. CARROLL. Again, I guess I would approach that issue from 

the perspective of broadly looking at our business tax system. We 

kind of have a line that is drawn between the corporate sector and 

the non-corporate sector, and where you draw that line really depends on how much business activity do you want the double tax 

to apply to. 

As Dr. Toder indicated, there are different approaches of dealing 

with the double tax. One could relieve the double tax at the investor level by having larger reductions in capital gains and dividends 

taxes. But I think the way to think about it is, how much of the 

activity do you want the double tax to apply to? 

So, if you were to bring some of the—there are large S corporations, there are large flow-through entities, clearly. They employ a 

lot—a fair number of people. I do not know the statistic off the top 

of my head, but I can get that to you. 

If you were to extend the corporate tax to them, it would raise 

the cost of capital, raise taxes on them. 

The CHAIRMAN. I understand. I understand. You made that point 

very clearly. That gets into the complication of the question. 

Dr. CARROLL. Right. 

The CHAIRMAN. What about—well, let us take education. We may 

be getting ahead of ourselves a little bit, because what I want to 

do is take the major tax expenditures, not today, but at a future 

date, and drill down more on the effectiveness of them or a cluster. 

Let us take education, for example. I think there are 15 credits 

and deductions, incentives for higher education. They are very confusing. 

A group of educators was in my office just a couple, 3 weeks ago, 

and I asked them which of these makes most sense and helps students the most and helps families the most. They had no idea. 

They had no idea what they were. That is a bit of exaggeration, 

but I was, frankly, surprised at the degree to which they did not 

know what the various provisions were. Even they did not. These 

are officials, administrators at colleges and universities in our 

country. 

But off the top, I suppose you would say make it simple, upfront, 

transparent. But your thoughts? And when we do get into, for example, education, how do you think we should change incentives 

for higher education? 

Dr. CHETTY. I think there is actually quite a bit of evidence 

showing that, in particular, programs that require you to fill out 

the Free Application for Federal Student Aid (FAFSA) to qualify— 

that is such a complicated form. People are talking about the complexity of the income tax code. It is even more complicated. 

The CHAIRMAN. It is very complicated. 

Dr. CHETTY. Yes. 

The CHAIRMAN. I have firsthand experience with that. 

Dr. CHETTY. So there is evidence that State-level programs that 

are much more streamlined, they are sort of contingent on a smaller set of things, have a much greater bang for the buck. So a dollar 

spent through those State-level programs increases college attendance rates much more than equivalent Pell grants or Stafford 

loans. 

26 

So I think restructuring programs so that—the State programs, 

such as the ones enacted in Georgia, for example, provide good examples of the types of structures that one might consider using at 

a Federal level. 

The CHAIRMAN. Why are they more efficient? 

Dr. CHETTY. I think they are more efficient simply because there 

is a simpler set of eligibility requirements. So one might argue that 

they are less targeted, in a way, because they are less contingent 

on the assets that you have. 

The reason for the complexity in the FAFSA is that it depends— 

qualifying for a Pell grant depends upon a whole host of things, 

and, basically, the Georgia program reduces the number of things 

that matter to a much smaller set of variables. 

Now, that might make the program a little bit less well-targeted, 

if it is not going to low-income folks that you want to target the 

program at, but it comes, I think, at the benefit of tremendously 

increasing awareness of the program and impacts on college attendance rates. 

The CHAIRMAN. Well, that is interesting, because it gets a bit to 

the question Senator Snowe was asking about the small business 

health care credit. This committee worked on that, and it gets to 

the two, opposing goals in tax policy. One is simplicity, and the 

other is equity. And in this case, we are trying to also make it equitable; that is, help smaller businesses—try to help the business 

with employees whose salary is a little lower, and so forth. 

That was the goal. Now, perhaps this committee went and made 

it too complex, but at least that was the goal of that provision. 

Senator SNOWE. Mr. Chairman, may I add a comment to that? 

Actually, the committee did have much the simpler approach to the 

tax code. It was changed on the floor. 

The CHAIRMAN. Was it really? 

Senator SNOWE. Yes. 

The CHAIRMAN. But the main point is, we struggled in the committee to try to figure out how to address the opposing goals of equity and simplicity. 

Dr. CHETTY. If I could add? I think one point related to that, Senator Baucus, is that complexity may directly affect equity in the 

sense that complex programs are less likely to be taken up by 

lower-income individuals, thus affecting the equity of the program 

itself. 

So I think rather than thinking that—what the new research 

shows is, rather than thinking of it as a pure tradeoff between simplicity and equity, there might actually be a direct connection between those. 

The CHAIRMAN. That is probably true. Yes. I think there is something to that. And, also, we want to be efficient, and that gets to 

the same point. 

Senator Thune? 

Senator THUNE. Thank you, Mr. Chairman and Senator Snowe, 

for holding this important hearing, and to all of you for being with 

us and sharing your insights. 

I think buying a home, giving to charity, producing renewable 

fuels, purchasing health care are just a few of the many things that 

our current tax code is designed to incentivize. And, while working 

27 

through tax reform, it is essential that we think about not only 

which activities we want to continue to incentivize but, also, how 

effective are those incentives. 

So I appreciate your testimony and responses today. And I wanted to focus, if I might, and I guess I would direct this to Dr. Carroll, and if others would care to comment as well. 

But, Dr. Carroll, in your testimony, you discussed why certain 

tax incentives are efficient as judged by the fact that positive external effects are not reflected in market decisions or prices absent 

the tax incentive. 

You mentioned the R&D tax credit is a good example of this. I 

would note another compelling example of this situation, which is 

the charitable giving deduction. Increased charitable giving has 

enormous benefits to our society. For example, taxpayers bear less 

of a burden as fewer Americans are forced to rely on government 

assistance. 

So I guess my question is, would you agree that the tax deduction for charitable giving is a good example of tax policy that promotes economic efficiency by more effectively taking into account 

the societal benefits of an activity? 

Dr. CARROLL. I guess the way I would answer that is, I think 

Congress has kind of determined over the evolution of the Internal 

Revenue Code and the income tax system over 100 years, there are 

a whole host of provisions like the charitable deduction, like the 

home mortgage deduction, a number of other provisions, where 

there is a perception out there of benefits that warrant the presence of those provisions in the code. 

If one were to reconsider any of them, one, I think, would need 

to carefully evaluate the effects of any reengineering or changes to 

the provisions, how they would affect various groups and how they 

would affect, in your question, the level of giving. 

That is also an issue in the estate tax, where the estate tax is 

another lever that drives charitable giving. It is something that did 

come up in discussions of the estate tax, changes in the estate tax 

over the last decade. 

Senator THUNE. And to follow up on that, as you may know, the 

President’s budget proposes to limit the value of itemized deductions by limiting the tax value of these deductions to 28 percent for 

high-income taxpayers. 

Assuming that the societal benefits of charitable giving are substantial, would limiting the value of this tax incentive be expected 

to make our tax code more or less efficient? 

Dr. CARROLL. I think you would have—I think it is clear that if 

you lowered the tax benefit of charitable giving or limited it to 28 

percent or some lower amount, it would in all likelihood reduce the 

amount of giving. 

I think Dr. Toder has some mention of the tax treatment of charitable giving and its incentive effects in his written testimony. So, 

yes, I think it would certainly have an effect. 

Senator THUNE. And what about capping the charitable deduction and maybe discussing a little bit how that might decrease the 

marginal incentive to give, if you want to elaborate on that. 

Dr. Toder, if you want to add to that discussion, too, that would 

be—I would welcome your input on that. 

28 

Dr. TODER. So, just a few comments. Certainly, capping deductions to 28 percent for high-income taxpayers is one of those types 

of proposals that makes the tax law a lot more complicated in 

terms of how you have to calculate your tax liability, and it is the 

kind of fine-tuning I am generally not too happy with. 

On the other hand, one of the issues that has been raised with 

the charitable deduction is, it is giving a match of 35 cents on the 

dollar to high-income people who give, and it is giving a match of 

15 percent to middle-income people who give, and nothing to people 

who do not itemize. 

So you are encouraging the kinds of charities that a certain set 

of the population prefers relative to other charities. Maybe that is 

a policy choice you may choose to make, but I think you should understand that that is a consequence of the way the charitable deduction is structured. 

So you might have more contributions to the arts, more contribution to higher education, less contribution to charities that help 

low-income folks or to religious organizations, by having it structured in that manner. 

So alternative designs—you could have a flat credit which gave 

the same incentive to everybody, and maybe you had some floor so 

you did not have to worry about people who gave $100 and are trying to claim small amounts which you could never monitor. 

So there are ways of reforming that that are certainly worth consideration and would not make the tax law more complicated. 

Senator THUNE. But do you think that for, let us say, people of 

the high-income categories, the volume of giving, at least, obviously, is going to be the higher-income people generally? I think 

the statistics bear this out, and I do not have it in front of me. 

But the incentive to give for somebody who is able to get today 

a 35-percent deduction against their taxes, if you lower that, do 

you—— 

I guess the point I am making, I do not think people give simply 

because there is a tax advantage to giving. But I do believe that 

it affects the amount that they give. 

So I guess the question is, if you were to cap that deduction that 

people can take, does that decrease the marginal incentive for people to give, and particularly—— 

Dr. TODER. No question it does. The question is, how much of an 

effect that would have, and I think that is uncertain. 

Dr. CARROLL. Clearly, to give a dollar to charity, somebody is facing a 35-percent rate; it only costs 65 cents to give that dollar because of the tax benefit. Yet, for somebody of a lower-income, where 

they are in, let us say, the 15-percent bracket, it would cost 85 

cents to give that dollar. 

I think that was the point that Dr. Toder was making. 

Senator THUNE. Right. 

Dr. CARROLL. There might be equity considerations. There are 

also complexity considerations with the administration’s proposal. 

It may be complex to try to engineer or limit, in their design, to 

28 percent. 

Senator THUNE. And I understand that. And I understand that 

if you have a—obviously, if you paid a higher tax rate, you get a 

29 

larger deduction against the charitable giving. So there is an equity 

argument, which you pointed out. 

I guess my question gets at, to what degree would we see a reduction in the amount of giving to charitable organizations if, in 

fact, we were to lower the cap to 28 percent? And, again, clearly, 

that would impact those people on the higher-income levels, but it 

would strike me, at least—and there are some studies that have 

been done on this and I think at this point, it is somewhat—you 

have to—there is a certain amount of maybe guesswork that is involved with it. 

Dr. TODER. Yes. I mean, there are many, many, many studies 

that have been done, and some of them might say you lose more 

than a dollar’s worth of giving for each dollar of revenue you gain 

from restricting the deduction, but others come to the opposite conclusion. 

Senator THUNE. To my chairman, my time has expired. So, thank 

you. Thank you all very much. 

The CHAIRMAN. Thanks a lot. 

I am going to list various incentives, and I would like you to tell 

me which ones, all things being equal, you think make most sense 

or have the most effect: deductions, itemized deductions, exclusions, nonrefundable credits, refundable credits, deferral—maybe 

some others. 

Dr. CHETTY. Let me make one simple comment on that. So just 

take deductions versus credits. What is the fundamental difference? Since we were talking about the charitable deduction, in 

order to figure out the value of that deduction to an individual, you 

need to know what your marginal income tax rate is, and you need 

to have a good sense of that in order to figure out the value of that 

deduction. 

A credit is different in the sense that, if I tell you you get a 20- 

percent credit if you spend a certain amount on college, and especially if it is a refundable credit, then I do not need to worry about 

what my tax liability is at all, and so it is, I think, likely to be 

much more transparent. And I think especially a credit that is 

given at the time that you make the decision as opposed to when 

you are filing income taxes up to, say, a year later—— 

The CHAIRMAN. You have to have income, though. You have to 

have income. 

Dr. CHETTY. That is right. But a refundable credit. 

The CHAIRMAN. You have to have income tax. 

Dr. CHETTY. Yes. Yes. I think credits that are very directly 

linked to people’s behavior at the time they are making those 

choices are likely to have the most impact. 

So on the list you had suggested, I would pick a refundable credit. 

The CHAIRMAN. Dr. Carroll? 

Dr. CARROLL. I think it is a hard question to answer. The comments that Dr. Chetty has made on salience and transparency, I 

think make a big difference here. If you look at the difference between, let us say, an exclusion and a deduction and a credit, yes, 

I think if you look at the exclusion for employer-provided health insurance, it has been my experience that that is not something that 

30 

is well-known, particularly when you travel beyond Washington, 

DC. 

I think a lot of people are unaware of exactly how that operates 

and the notion that a significant portion of their compensation is 

not included in their taxable income. It is not the way they think 

about it. 

The difference between a deduction and credit—I think there are 

very different equity considerations that come into play, which 

really require a lot of judgment on the part of—different individuals will approach equity and progressivity in very different ways. 

If you had 100 people in a room, you would probably have more 

than 100 different perspectives on that issue. So that is, I think, 

another consideration. 

The CHAIRMAN. Dr. Toder? 

Dr. TODER. Well, I would largely agree with Dr. Chetty’s comments. I think, in general, refundable credits are best, and to the 

extent they can be given at the time people are making the decision in real time. 

Just a couple of qualifications. I think, since deductions benefit 

high-income people more or incentivize them more, there might be 

circumstances—and charities have been mentioned as an example—where the responsiveness of high-income givers might be bigger than other givers. So you might actually want a deduction and 

have an uneven incentive, but that is something you would have 

to feel that you actually have some evidence that that is true. 

Also, I think one of the problems with credits that we have is a 

lot of them phase out as your income goes above a certain amount, 

which means something like that earned income credit—we tried 

in the Clinton administration to encourage people to use the advanced income tax earned income credit, and the take-up rate was 

about 1 percent on that. And that would have gotten the money 

into people’s hands right away, but I think they were afraid that 

they might get to the end of the year and find out that the credit 

was phased out and they would have to pay some income tax, and 

they were a little worried about that. 

So, to the extent that the credit is not going to be affected by 

your tax liability, it is helpful. 

The CHAIRMAN. In your experience—we have all talked about the 

American system. Do any other countries do it better with respect 

to complexity, uncertainty, all the things we are talking about 

today? 

Dr. TODER. There are certainly aspects of the British tax system, 

for example, which are significantly simpler. For example, I believe 

the way they handle mortgage interest is, they do it through the 

banks rather than through the individuals. 

Actually, that is the way they handle charities, as well—the 

money goes to the charity. That may not be feasible here for constitutional reasons, but you give money to charity and the government tops up the charity rather than giving you—so you do not 

have to—if you are in the basic tax bracket, you do not have to deal 

with it on your tax return. 

Dr. CARROLL. Just to add to that. The British have something 

more along the lines of a return-free system for a large segment of 

the taxpaying population, and that is actually driven—in some reVerDate Nov 24 2008 17:55 Jun 25, 2012 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 R:\DOCS\74611.000 TIMD
31 

spects, it has probably driven them to simplify some of the provisions and move kind of the nexus, where you get the deduction 

from the individual to the charity. Same thing with the home mortgage or the housing preference. 

So the way they have structured—how they structured the way 

the tax system interacts with taxpayers has kind of affected how 

they have structured some of the preferences. 

In order to operate a return-free system, we would have to organize our—we would have to provide preferences in a much different 

way than we do. 

The CHAIRMAN. What about other countries? I knew the percentage was high. I did not know it was that high, when Dr. Toder 

mentioned 90 percent of Americans have preparers or use software 

to fill out their income taxes. 

Is it that high in other countries? 

Dr. TODER. I do not know. 

Dr. CARROLL. I am not familiar with those statistics. But I would 

agree with Dr. Toder’s earlier comments that the use of technology 

has really changed the way one needs to think about compliance 

burdens because, if you go out and buy tax software for a fairly 

nominal price, and that allows you to comply with and fill out a 

complicated tax form, you do not really need to have as great an 

understanding of how the education provisions work, because the 

software will be doing it for you. 

Dr. CHETTY. I think another key difference in other countries is 

that there are a lot more prefilled returns. So there are many Scandinavian countries, for example, Denmark, where many taxpayers, 

except those with fairly complicated situations, would basically just 

have to sign a form when it arrived in the mail, saying this is how 

we calculated your tax liability. 

The reason for that is they have much better information reporting. So we talked about how information reporting is crucial to the 

high compliance rate in the U.S. And other countries go beyond— 

I think they have a U.S.-type system, but, on top of that, capital 

gains and various other things are directly reported and aggregated 

with modern technology and you basically get a form which you 

sign that tells you your tax liability, greatly reducing the compliance burden. 

The CHAIRMAN. Right. So in Denmark, the government sends you 

a form and tells you, ‘‘Here is your tax liability.’’ 

Dr. CHETTY. Yes. I think in various Scandinavian countries that 

is true, yes. 

The CHAIRMAN. Do you think that has potential? Do you think 

that is an approach we should pursue? 

Dr. CHETTY. I think that would simplify the compliance aspect. 

So the comment that was made before that it takes taxpayers 

many hours to actually fill out the tax forms, it would significantly 

reduce that time spent. But it would not solve the problem we have 

been talking about more broadly about getting people to respond to 

incentives. In some ways, it might even make that worse, because 

you just sign this form, and you have no idea of what determined 

your tax liability. 

32 

So this issue of, if we want to get people to go to college, and we 

want to use the tax system to encourage that, that is not going to 

be solved by a prefilled form. 

The CHAIRMAN. We are working way out in right or left field 

here. But does Denmark provide incentives for higher education? 

Dr. CHETTY. Now you are really stretching my knowledge of the 

Danish tax system. 

The CHAIRMAN. We can go to any other country you want. 

Dr. CHETTY. Well, I think a number of countries provide incentives for higher education in the sense that there are basically 

state-subsidized schools. So it is not necessarily through the tax 

system. 

The CHAIRMAN. That is very true. It is true in other countries. 

It is very true. 

Dr. CHETTY. Yes. 

The CHAIRMAN. Well, this has been very interesting, because we 

clearly have to—we clearly have a lot of work ahead of us, and you 

have provided a lot of guidelines and notes and stuff to us to keep 

plowing ahead, keep moving ahead. 

Thank you very, very much for the time you have taken. 

The hearing is adjourned. 

[Whereupon, at 11:47 a.m., the hearing was adjourned.] 

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74611107.eps