INVITATIONAL CONFERENCE ON TAX LAW SIMPLIFICATION

SPONSORED BY

American Bar Association Section of Taxation
American Institute of Certified Public Accountants
Tax Executives Institute

Tuesday, December 4, 2001

Cannon House Office Building
Caucus Room

PROCEEDINGS

[9:03 a.m.]

[1] MR. ASHBY: Good morning. I am Bob Ashby, President of Tax Executives Institute. With my colleagues, Pam Pecarich of the AICPA and Dick Lipton of the ABA Tax Section, I am pleased to welcome you to the Joint Conference on Tax Simplification.

[2] TEI is an association of tax professionals who work in the tax department of companies throughout the United States, Canada, and Europe. TEI's 5,300 members know that the tax system will never be truly simple for them and their companies. But we sincerely believe that the tax code can be simpler—for individuals, small business, entrepreneurs, and large corporations.

[3] More than two years ago, TEI joined with the AICPA and ABA to recommend changes that will simplify the law not only for taxpayers—both large and small—but the government as well. Several of these recommendations—such as repeal of the alternative minimum tax and the PEP and Pease provisions of the Code—were included in the study released earlier this year by the staff of the Joint Committee on Taxation.

[4] That study will be the focus of the four panels that you will hear today on individual, business, and international taxation.

[5] Lindy Paull and the Joint Committee staff are to be commended for providing us with a comprehensive and thoughtful analysis of the tax law. Many of the recommendations would be in the category that we might categorize as "no brainers": They are straightforward and would be relatively inexpensive to enact. Others may be more controversial. And still others may represent a modest beginning where many of us think bolder action is required.

[6] In the business world, we struggle not to have the perfect be the enemy of the good. If you have a problem and a solution, after eight months of inaction we would ask, "Why hasn't there been more progress?" The answer, of course, is complicated, and perhaps too subtle for many of us to understand. This conference is an attempt to move us forward by bringing a greater focus on the need for simplification of the tax law. We hope that the discussions will serve as a spring board for action.

[7] Simplification is a critical component of an effective tax system. The Joint Committee study provides the map by which Congress can take us down the road to simplification. Together with the ABA and AICPA, TEI pledges its support for changes that will make the tax law simpler for all of us. Thank you.

[8] I'd now like to turn the microphone over to Dick Lipton of the ABA Tax Section.

[9] MR. LIPTON: Thank you very much, Bob, and I will try to keep my opening remarks very brief so that we can hopefully have plenty of time for the panel discussions.

[10] On behalf of the American Bar Association Tax Section, it is indeed a pleasure to be here with the representatives of Tax Executives Institute and the AICPA at this joint conference on tax simplification.

[11] The tax section, as many of you know, consists of 20,000 tax lawyers in the United States, and we are part of the larger, more than 400,000 lawyers, who are members of the American Bar Association, which is the national representative of the legal profession.

[12] The tax section is very pleased this year when the ABA added tax simplification to one of its limited lists of major legislative priorities for this year, and we hope for the foreseeable future, until tax simplification has been accomplished.

[13] The tax section has long worked to promote tax simplification. We believe this is a bipartisan effort that is in everyone's best interest. Just as Bob indicated, TEI's great pleasure with the report put out by the Joint Committee, I want to echo that on behalf of the ABA tax section. We think that the staff did a marvelous job and it is fitting to have that report be the focus of this presentation today.

[14] The tax section is committed to devoting its resources and the resources of our members to help the Congress, to help the staffs and to help the administration work in a bipartisan manner to promote tax simplification.

[15] Like Bob, we feel that some steps have been made in the right direction. We were very pleased to see the repeal of PEP and Pease that were included in the legislation that was signed earlier this year. We may have wished the repeal was effective immediately, but we're certainly happy to have the repeal coming in the future than not at all.

[16] We also will encourage Congress, as I have done previously in testimony, to address many of the individual issues that need to be focused upon, matters such as the AMT, simplifying rate structures, simplifying credits, simplifying the definition of a family. Many of these issues will be discussed today. We look forward to getting a thorough analysis of them.

[17] But most importantly, as Bob indicated, we think the most important thing today is to keep the momentum moving forward towards tax simplification, and this conference we hope will be one more step towards that goal.

[18] It is now my pleasure to introduce Pam Pecarich, chair of the AICPA Tax Division.

[19] MS. PECARICH: Thank you, Dick. Welcome everyone and thank you for being here. As you might imagine, we had some trepidation about the scheduling of this conference, but the importance of the subject matter and our desire to keep it in front of everyone, given the Joint Committee study, led us to proceed; and we very much appreciate your attendance.

[20] The AICPA has been involved in simplification efforts since the 1980s. The AICPA is the professional accounting association with 300 and some thousand members, and I am chair of the Tax Executive Committee, which represents the tax practice CPA, 25,000 in number, and CPAs practicing in industry across the country.

[21] We've long had this goal, despite the fact that many might argue that complexity benefits us. It's not the kind of complexity that we as professionals want to benefit from, if you will. We've sponsored and co-sponsored conferences on simplification with our colleagues from the Bar and other organizations. We've testified, submitted testimony to Congress, and have made many specific proposals over the years for simplification to particular provisions.

[22] In 1992, we proposed the "Blueprint for Tax Simplification" which provided an analytical framework for assessing complexity in specific provisions, and in legislative proposals, so we were heartened when we saw the enactment of the complexity analysis that the Joint Committee is required to do now during the legislative process.

[23] We acknowledge it's imperfect and not totally supported by those who have to undertake the analysis, because of its difficulty and subjectivity. But we have to say to you all that we believe it's very critical to somehow get the consideration of complexity involved in the legislative process. Without a focus on this element, we're concerned that our laws continue to become more complex, and not always with justification, not always with a policy goal that couldn't be met some other way.

[24] Today in your packet you will have a copy of our just released tax policy concept statement entitled, "Guiding Principles of Tax Simplification." It identifies the cost of complexity and suggests approaches for analyzing how to get to simpler legislation and simpler regulations.

[25] Despite these efforts on the simplification front, the results have been disappointing. Dick mentioned that we have seen incremental improvements, and we're most grateful for that. And we recognize that there are some factors in play that make simplification very difficult to achieve in practice.

[26] I'm reminded always of Senator Moynihan's remark in the last Congress in which he served. He said at one point, "There's nothing like a deadline to focus the mind," and that's what we're missing in this debate, unfortunately. We have no deadline to enact simplification.

[27] Probably just as important, or perhaps more important, is the lack of political will—because the effects of complexity are not directly or easily observable, and the constituency is not militant. There are costs, of course, but they are not always easy to measure. You'll hear about some of those today.

[28] We're starting to get estimates from tax policy studies about the non-productive person hours that are involved in tax complexity that doesn't need to be there. And there is what I call "stealthy" noncompliance. For those of us who live outside the beltway and deal with all manner of normal life, we see the opportunity daily for lots of noncompliance with the tax laws. I believe there's a great deal of lost productivity involved in this entire process. More importantly, though intangible, is a lost respect for, quote, "the system."

[29] To address the other point, the constituency for simplification, there is one. In a way we're the stand-ins for your constituents and the clients that we work with, who complain to us, but unfortunately, seldom write to Congress.

[30] Today we think we have the opportunity for a new beginning, because we have something we haven't had before, and that is a general consensus on what and how to simplify. The provisions causing the most problems for the most taxpayers have been identified. There's great consensus about how to address those problems.

[31] We had a comprehensive study, thanks to the Joint Committee. It provides analysis, background, options and many recommendations that need to be considered for moving forward. So we're hoping that the conference today can begin a discussion about how to do that, and we hope some energy for action next year on a simplification agenda.

[32] Again, we thank you for your attendance and participation, because we recognize that simplification cannot happen without the congressional staff, and without your support and your help. So thank you.

[33] I'm now going to introduce Lindy. For those of you who haven't had the pleasure of working with Lindy over the years, I'm very honored because I've known Lindy, probably from the beginning of her time on the Hill, and it's been a long and wonderful association.

[34] Lindy Paull is the Chief of Staff of the Joint Committee and has been since 1998. Prior to that time, she served on the Senate Finance Committee Republican staff in positions ranging from Tax Counsel, starting in 1986, to Chief Tax Counsel and Staff Director, 1993 to 1998.

[35] Lindy is a lawyer and a CPA. She has practiced in both fields, and in addition to all her other duties has found time to teach at Georgetown as an adjunct professor on tax policy issues. We're very grateful to have Lindy with us today and thank her and her staff for the study that provides the basis for our work.

[36] Lindy.

[37] MS. PAULL: Thank you, Pam, and thank you for those great comments about our study. As you know, it took us 18 months to do that report, and maybe somewhat ironically, it was issued in the 75(superscript: th) anniversary year of our staff's existence. One of the original missions of the Joint Committee staff was to make recommendations on simplifying the tax code back in 1926, when the tax code was in its infancy. We drew from some of the work that was done back then as well as much of the work that was done by the American Bar Association, AICPA and TEI, as well as many other organizations that have been making recommendations and studying these issues over the last several decades.

[38] I also would be remiss if I didn't thank our colleagues at the GAO and the CRS. They did a lot of legwork for us on this report. We also had tremendous help from two groups of advisors, a group of distinguished former governmental officials who have been always highly involved in tax policy issues, and another very distinguished group of academics in the tax arena.

[39] So, I thank everybody for their collaborative work.

[40] It took us 18 months to do the work on this report in- between doing our legislative responsibilities. There was a terrific effort among our staff to get this report out.

[41] Really the report stems from five years ago when the IRS Restructuring Commission started its work and held hearings all over the country. Ultimately the Commission's work led to a comprehensive report and broad-based recommendation about restructuring the IRS and putting into place the things that Pam mentioned, such as a complexity report to go with legislation.

[42] With respect to the complexity report, we have had complaints about it not being timely enough, and we are certainly interested in suggestions on ways to make these reports more timely. The IRS Restructuring Commission also recommended an annual report requirement by both the Commissioner and National Taxpayer Advocate, and also our report.

[43] We obviously concluded—I don't think it would be a surprise to anybody—that the tax code and the federal tax system is quite complex, and that there's really no one reason for this. There's no quick fix for it, either. This is something that has to be addressed on all fronts. It is everyone's responsibility is to be attentive to this issue. The folks who write the tax laws, which our staff assists with; folks who administer the tax laws and interpret the tax laws; the professionals who advise taxpayers; and the taxpayers themselves.

[44] It's great that you're holding this conference today. Hopefully there will be more conferences to keep the spotlight on this subject. It is evident that individual taxpayers, even if they have a very simple tax situation, end up going to tax return preparers because they're intimidated by the instructions and the forms. They don't understand how to do their returns even though they probably should be able to. So this is a widespread problem.

[45] I don't have the time today to go through our report in detail, but let me just highlight the main features of our report. The report is in three volumes with over 1,300 pages. It includes a description of the methodology we used for the report, a section on the overall state of the tax code, a section on the sources of complexity, which I think is really an interesting piece of the report that sometimes is overlooked, and the effects of complexity on taxpayers and everybody involved in the tax system.

[46] By going through the tax code page by page, we identified those provisions that we felt we could make a recommendation on without fundamentally altering the policy that the Congress was trying to achieve with those provisions. We viewed our task not to alter policy, but to recommend a simpler way to do it.

[47] We also identified two dozen structural issues in the tax code that we did not make specific recommendations on, but would certainly be the starting point for further work in this area. The reason we did not make recommendations on these subjects was that it would be difficult to make recommendations in that area without fundamentally changing the policy of the provision. Instead, we left a roadmap for future work and have talked to the two tax-writing committees about authorizing us to pursue some of these issues further. They certainly could authorize us to do that.

[48] I would echo somewhat what Pam about how do you get simplification. There's no quick fix. It's something you have to be attentive to at all times. And you need a constituency for simplification, which is a difficult thing to achieve.

[49] Hopefully, these kinds of conferences, and the continuing work of the sponsoring organizations will be able to generate the constituency for change that we have been unable to achieve in the past. What it really takes is grit and determination, and an incremental approach to try and make some progress in this area.

[50] I will conclude by thanking you for the opportunity to be here today. Our staff really appreciates the opportunity to participate in this conference, and the attention that you're giving to and our report.

[51] Thank you.

[52] MS. PECARICH: Thanks, Lindy.

[53] It's also my pleasure to introduce our keynote speaker, Eugene Steuerle, well known to many of us; and we are very honored with his presence today.

[54] Gene is a senior fellow at The Urban Institute, president of the National Tax Association, and a columnist, who's published over 600 briefs for Tax Notes magazine, The Urban Institute and Financial Times. A very hard worker always.

[55] Earlier in his career he served in various positions in the Treasury Department under four different Presidents, including the position of Deputy Assistant Secretary of the Treasury for Tax Analysis. Between 1984 and 1986, he served as the economic coordinator and the original organizer of Treasury's tax reform effort, for which Treasury and White House officials have written, "Tax reform would not have moved forward without Gene's early leadership."

[56] This also produced a two-volume study, as I recall, that was very helpful in focusing agendas on what structurally needed to be changed in our tax system.

[57] A former IRS Commissioner wrote, "During the past decade, few people have had greater impact on major changes in the tax law, and the principal improvements in tax compliance and administration." That is one of the features that many of us who have worked with Gene on projects have always appreciated, his willingness to pay attention to tax compliance and tax administration effects.

[58] Dr. Steuerle is also author, co-author or editor of many books, reports and articles. One of his books was, The Tax Decade, a New World Fiscal Order, which is a really seminal piece. Dr. Steuerle served as principal consultant to the West Virginia Governor's Commission on Fair Taxation.

[59] He's done work for the International Monetary Fund. He was the recent chair of the Social Security Technical Panel, has been a resident fellow at the American Enterprise Institute, and serves as advisor/consultant to board members on a host of organizations, including the American Tax Policy Institute.

[60] He's advised the Joint Committee on Taxation. He's been a board member for the Community Tax Law Project and worked with the Congressional Budget Office and the General Accounting Office, among others.

[61] So, please join me in welcoming Gene Steuerle.

[Applause.]

[62] DR. STEUERLE: Thank you, Pamela. It's interesting that Pamela would introduce me, because I think probably my very first effort at tax simplification was with Pamela. I shouldn't confess this, but I think it was 1978 when we were going to simplify the earned income tax credit. So, I think they invited me here because of our past success.

[Laughter.]

[63] DR. STEUERLE: It's also interesting to be here—fun to be here when I'm actually given the opportunity to give my entire talk. I constantly have been subject to time pressures when I have appeared on the Hill before.

[64] One time I remember appearing at the Senate Finance Committee. It was one minute to twelve. Several panels had been on before us. There were five of us on this last panel. We got up there and the only Senator left in the room was Senator Moynihan.

[65] He looked at his watch and said in all seriousness, "I'd like to end this at noon."

[Laughter.]

[66] DR. STEUERLE: So, it's unusual to be able to actually read most of what I've been able to put together here.

[67] I'd like to thank the Tax Executives Institute, the American Institute of Certified Public Accountants, and the American Bar Association Section of Taxation, for this opportunity to address you. I really do think that this type of meeting is important, not just for the substance of what you're dealing with, but for the fact that you are raising the issue to an important level.

[68] It is said that in the courtroom, the witness who speaks against his or her own interests often has the highest level of credibility. That your three organizations often promote a better and simpler tax system, even if such a system works against members' interests, speaks volumes. After all, dealing with complexity is what many tax experts are paid to do.

[69] I guess you're wondering why it is that some groups unite to try to serve some public interest, when so many other associations appear to come together primarily in the advocacy of their own special interests—often with little regard for social policy as a whole.

[70] Perhaps it is your training as professionals that overrides other considerations of self-interest. Perhaps your powerful bent for analysis, maybe coming from the schools you went to, shoves aside other thought patterns—and after all who could analyze this tax code honestly without concluding that simplification would benefit the public?

[71] Or as one colleague facetiously stated to me, "Maybe so little success at tax reform, to date, means that a professional can afford to be virtuous at little cost." As for me, I will continue to believe the best, that your training and character often teaches you to seek out what is good public policy.

[72] On a personal note. I guess I, in this day and age, I just would like to believe in the fundamental goodness of people, whether dealing with issues large or small.

[73] My job as keynote speaker is presumably to make the case for tax simplification. I feel somewhat like I'm asserting the obvious. At one level I feel like I should stand here, say, "Simplicity is a virtue," and then sit down. After all, who can be against virtue? Who would argue against simplification?

[74] Alternatively, I suppose I could just ramble on, as did the interviewee, who kept talking on and on in response to a pollster—his only excuse being, "How do I know what I'm thinking until I've heard what I have to say."

[Laughter.]

[75] DR. STEUERLE: But given the illustrious panels you have set up today, it's clearly not in anyone's interest for me to ramble on, even on the simplifications I might favor. This leaves me, then, with two tasks. First, to put simplification in perspective, relative to other principles that apply to taxation; and second, to make the case that simplification requires reform of the legislative process as much as anything else.

[76] I will close with an argument, not unlike Yogi Berra's when he stated that 90 percent of baseball was mental, and the other half was physical. I would suggest that complexity of our tax system today increases the probability that we will get some simplification in the future.

[77] If we look at recent legislative activity, of course, simplification has won a few races. The titles of bills themselves do not convey complexity. You will not find rolling off the tongue of every school child such names as the Economic G growth—I have to look down at this every time that I read it—"Economic Growth and Tax Relief Reconciliation Act of 2001," otherwise known as EGTRRA. Try that acronym out at your next dinner party.

[78] EGTRRA was only one in a long series of major tax laws complicating an already byzantine tax system. Ever the bridesmaid, simplification never seems to get the attention it deserves, no matter which political party is in power, mainly because broader agendas are always being pursued.

[79] Here, however, we must be careful. It would be a mistake to fault elected officials for pursuing broader agendas. That is their job. Government does not exist to simplify itself.

[80] It is entirely appropriate and necessary for tax policy to be the handmaiden to broader budgetary and economic policy, whether the issue is fighting a recession, providing incentives for growth, reducing the deficit, or serving the needs of the poor. I'm dodging for the moment, whether we do any of these other tasks well. I'm merely stating that they deserve precedence.

[81] Put another way, some complexity is usually the inevitable consequence of government action to pursue other ends. These pursuits are often of a higher order than mere simplification.

[82] Simplification, therefore, is not the primary role of government. Instead, it is a principle that should help to guide government action. Yet even here it competes with other worthy principles. Progressivity is one example commonly cited.

[83] Flat, rather than progressive rates, could simplify things a bit, although the gains, I believe, are exaggerated. It's quite possible to assess flat taxes on a large percentage of the population, as do Social Security and some value-added taxes; and then apply progressivity more narrowly to a smaller group of taxpayers.

[84] Moreover, government must always take from those with more means to help those with greater needs. If it doesn't do it on the tax side of the budget, it would simply have to do it on the expenditure side.

[85] Another principle due homage, but often leading to greater complexity, is equal justice, horizontal equity or the equal treatment of equals. In my view, nothing affects debates over public action more than this consideration. But determining who are equals under the law, and what constitutes equal treatment is not easy. It requires defining people by some criterion, such as income, and them making sure that large exceptions are not made for certain groups.

[86] Debates inevitably arise over whether one criteria or another is adequate. Maybe we should tax on the basis of income and consumption, if we can't decide which is better. Perhaps we should make an exception for this extraordinary expense or that extraordinary expense.

[87] Any lobbyist worth his salt also knows how to appeal to this principle. "My company does not want a special break for itself, so much as equal treatment with another company that has its own tax break," he will assert.

[88] Efficiency is yet another important principle. At times, taxing all sources and uses of income equally may be computationally complex, but it also reduces distortions created mainly through favoring one source or use over another. Efficiency concerns also arise over the influence of government policy on growth. Perhaps favoring certain types of efforts such as research can be justified on the grounds that too little research would otherwise be undertaken, since many of the gains do not inure to the benefit of the researcher.

[89] I could continue on how principles compete in determining optimal policy. Adhering to other principles, means that tax systems have to accept some level of complexity. Even when principles compete, however, many choices are clearly less than optimal.

[90] Think of two principles as points that form a line. On that line connecting the two points, one can move closer to one principle at the cost of moving away from another, and vice versa. Continuing the analogy, however, there are many other points in the plan containing that line that do not minimize the distance between the two principles. I was a math major, if you can't tell.

[Laughter.]

[91] DR. STEUERLE: In effect, there are movements, simplifications in this case, that could be enacted with little or no cost to the other principle or principles at stake.

[92] As the legislative history illustrates, it is in compromising among principles, or among different interpretations of the same principle, that Congress often creates complexity. A classic example is trying to apply progressivity and phase-outs throughout every provision rather through the rate structure and personal credits and exemptions. Does this mean we need to throw in the towel? Hardly.

[93] In pursuing better objectives and balancing principles, almost everyone would agree that simplicity has been given far too little weight in the legislative process. Many items in the tax law add significant complexity, with little or no gain in achieving any other legislative goal.

[94] If designing the code from scratch, almost no one would introduce many of the provisions now in current law. But now that they are there, these complexities are harder to remove.

[95] It's a problem, too, that complexity creates waste, not merely cost. Here one must distinguish between cost that provide benefits and those that do not. A transfer of one dollar from me to you may cost me one dollar, but there is an offset in the one dollar that you gain. Waste, including extra time and effort, involves resources that are lost forever to everyone.

[96] Professor Joe Slimrod of Michigan and the National Tax Association concluded that for each $100 of tax collected, we spend about $10 in time, effort and administrative cost. Another cost, although more subtle, is taxpayers' resentment from filling out an unreasonable number of forms. Needless tax complexity increases their cynicism toward government and frustrates a healthy relationship between the citizenry and the government.

[97] If I'm correct that simplification is given too little weight in the legislative process, then fixing the problem means more than identifying some policy alternatives. Process reform, itself, is probably the only sure way to increase the attention given to simplification.

[98] When some people talk about process reform, they think of grand, constitutional changes, or difficult to breach rules, such as super majority voting. But process reform can be far more subtle. It can entail nothing more or less than the acceptance of some standard or practice by the Treasury Department, or by the chairs of the tax- writing committees. These standards might be explicitly legal, but they can be also implicit in determining how affairs are conducted.

[99] Let me then briefly consider some ways in which a more fiduciary-like responsibility to achieve simplification can be assessed and formalized. I will discuss two types of process reforms. Those that would involve periodic reporting on the existing law and those that would apply to new legislation.

[100] Of course, in the end, what makes any process work is the good-will of the parties involved to see that its spirit is maintained.

[101] My first suggestion is a status upgrade to the biannual report for a study of the overall state of the federal tax system. I commend the Joint Committee highly on putting this report out, but I believe it should be published every year, much as the Congressional Budget Office used to publish potential expenditure cuts and tax increases to deal with the deficit problem.

[102] Then we should receive continued updates and options over time, and should be spelled out in greater detail and variety. Sorry, Lindy, I know you've already spent a year and a half on it.

[Laughter.]

[103] DR. STEUERLE: But I really believe that these studies do have an impact.

[104] Just by way of example, the Treasury study in '84, as Ron Pearlman could testify, or Buck Chapotin—I don't know if Buck is here—was thought by many to be unimportant, and we had fights with the staff in order to even to pay attention to it. Studies can make a difference. They are processes that set up important agendas.

[105] But it's not just the Joint Committee and this particular complexity study that deserves more attention. The Government Performance and Results Act of 1993, so-called GPRA—we're great for acronyms in this town— required a performance plan review that has been extended on a trial basis to Treasury's tax expenditure budget.

[106] Treasury has made some very, very tentative steps here, although, officials complain about the lack of data. While it would be foolish to think the Treasury could study each of these programs adequately each year, a cycle could be established to review each periodically. By programs I mean things such as the charitable contribution deductions, or the research and development credit. These rate provisions should be thought of as programs of the government.

[107] As a closely related matter, I believe that the IRS needs to organize its research and information systems, so as to provide the public with regular reports on enforcement problems. Treasury's complaints about inadequate information for GPRA purposes, and some of IRS' continual internal management problems, reflect a fundamental failure in the IRS' administrative structure.

[108] That defect is the IRS' failure to organize itself, at least partly, by program instead of by tax-return category or type of taxpayer. The agency prepares few analyses of its programs, and takes no responsibility for their success or failure because its measure of success is focused upon itself as tax collector. Only indirectly do we find out about these programs, as when the IRS measures error rates by line item on returns.

[109] The IRS sometimes excuses itself by saying that it is in charge of administration, while the Treasury and the White House set policy. A sympathetic, but fairly weak argument. No one can properly administer a program without understanding how target efficient it is, and analyzing the cost of administration for both government and its customers.

[110] The IRS does not have to make any judgment on the policy itself, just on the allocation of the program benefits, the cost of administration and the extent of reporting error. In effect, it is responsible for better developing an disseminating information it acquires in administering its programs.

[111] Unless a regular reporting schedule is mandated, moreover, IRS will fear accusations that the timing of the release was politically motivated, and it will do little about this problem.

[112] Next I want to turn briefly to methods for giving simplicity greater weight in the legislative process. I believe that testimony on proposed bills should always include at least some witnesses, who focus solely on simplification and administrative issues.

[113] Moreover, when the markup of the bill occurs, one individual at the witness table should have sole responsibility for providing information on the administrative aspects of the bill. This individual could be from the IRS, the Treasury or the Joint Committee on Taxation

[114] Before going to Conference, the IRS should produce mock tax forms showing exactly what has been wrought from those bills produced in both Houses. Changes in the number of users or forms and line items should also be provided, when possible.

[115] In Conference Committee, one person at the witness table should be held responsible for providing information only on the simplification aspects of potential conference compromises.

[116] Finally, the Joint Committee is required to provide a tax law complexity analysis after reports on bills are filed. The status of this assessment on the legislative process somehow or other needs to be raised and be given more timely attention. One option might be to devote a full day of hearings to this type of analysis near the completion of a tax bill.

[117] I'm not arguing that the processes that I'm suggesting are the only ones that could be enacted. I'm simply arguing that you have to put in place these types of processes if you want simplification to be given more attention.

[118] In sum, if simplification is important, the processes must be set up to ensure that they are given attention, and that needed resources are devoted to tracing potential and actual failures. Of course, no process reform guarantees that simplification will occur.

[119] As I noted in my opening remarks, "Should simplification be the only factor under consideration?" But a lesser combination of some, if not all, of these procedures could help deter new sources of unnecessary complexity.

[120] Despite the trend toward increased complexity, I see a ray of hope and am here to suggest that significant tax simplification has even a good chance of being passed some time in the near future.

[121] The first Secretary of the Treasury, Alexander Hamilton, had it right. "The truth," he asserted, "in human affairs there is no good, pure and unmixed. Every advantage has two sides."

[122] The seed that could sprout into major simplification is in one of the worst phases of recent legislation, the extraordinary growth scheduled in the number of taxpayers subject to the alternative minimum tax (AMT). According to the Joint Committee, the number of taxpayers subject to this AMT could grow to as much as 35 million by 2010.

[123] What puts more and more taxpayers under the AMT are not the tax shelters it was originally designed to expose, but such simple items as dependent exemptions, and state and local tax deductions, which the AMT doesn't allow. But let's play the scenario out a bit.

[124] As millions of taxpayers get added to the AMT, the level of protest is going to rise quite significantly. Nothing arouses public ire more than perceived unfair treatment. Americans do not take kindly to the notion that their dependents and forced payments of taxes to state and local governments are to be treated just like tax shelters for AMT purposes.

[125] Take my word for it, something will be done to fix the AMT, despite all of the difficulty. The issue, though, is what type of tax bill will affect change. A large AMT fix by itself would mainly lower taxes for those with incomes above $70,000, still well above the average household income.

[126] Previous Presidents, including President Bill Clinton and President George H.W. Bush, as well as both Democratic and Republican Congresses, have shied away from a bill that would cater only to higher income taxpayers. Even the 2001 EGTRRA legislation, despite all the debates over its distributional benefits, was pitched as applying to taxpayers in all income classes.

[127] Any politically feasible AMT fix, therefore, probably has to be in a bill that has something for taxpayers in the middle and lower income classes. AMT reform is not a natural fit with expanding welfare benefits or offering special deductions for the middle class. The most logical and maybe the only logical way to offer help to the less well off, in the context of AMT reform, would be across-the- board simplification.

[128] Congress and the President are going to have to simplify taxes, one way or the other. Moreover, another issue is at stake: being in control of the agenda. There are going to be a lot of tax proposals put forward in the near future. Simplification offers the President, as well as congressional leaders, some chance of channeling this momentum, limiting the amount of special interest tax legislation, and keeping the focus on attaining a more efficient tax system.

[129] Smart politicians will see a personal opportunity in taking the lead in setting the agenda. If Hamilton could see a national blessing in national debt, then surely some modern President, Secretary of the Treasury, or congressional leader will recognize that, rising tax complexity itself presents an opportunity to advance tax simplification legislation before taxpayers rebel.

[130] In conclusion, simplification is achievable if given enough attention and effort. Process reforms can accord simplification, some weight and more weight in the legislative process, in Treasury analysis, and in IRS research. The good news in all this bad news is that the tax system has become so complicated that it's really not that hard for new legislation to make taxes simpler, on balance.

[131] And the mandate for AMT relief could catalyze a much broader attack on the complexity of the tax system for all taxpayers from poor to rich. As a practical matter, simplification offers the President and congressional leaders a focus that could channel what could otherwise become a more chaotic tax policy process into an effort producing significant efficiency gains for the American economy.

[132] Thank you.

[Applause.]

[133] MR. PEARLMAN: While everyone's being seated—let's try again. I've never been chairman before, this is sort of fun.

[Laughter.]

[134] MR. PEARLMAN: While everyone is getting settled, but in order to maximize time, let me just begin by saying our panel is the first of two panels this morning focusing on proposals to simplify individual provisions in the tax law.

[135] I suspect when I look at colleagues in the audience that if I were to ask you, how many of you can specifically identify, not in general, but with specificity, the problems with the earned income tax credit; and how many of you can specify perceived problems—complexity problems occasioned by the Supreme Court's decision on INDOPCO, that I would get more information from you—you certainly would from me—about INDOPCO than you would about the earned income tax credit.

[136] I think one of the reasons for that is that so many of us, in our practices, simply don't have the experience and thus the expertise on the individual side of the tax law that permits us to be informed about the extraordinary complexity that's faced by millions and millions of taxpayers, and so often taxpayers who are the least able to undertake an adequate understanding of the tax law.

[137] So this panel is an effort to get at least some of the rules of complexity that impact individuals, with the hope that all of us will appreciate more what the simplification potential on the individual side may be.

[138] Our responsibilities, as identified in the program, are the dependency exemptions—a little narrow in its description - that income-based things, outstanding income tax credit, and the child credits. We've got a wonderfully knowledgeable panel to conduct this discussion.

[139] I'm going to introduce the panel, very, very briefly, in the order in which they're going to make their presentations, and then I'm just going to let them go, one after the other.

[140] Our Joint Committee panelist is Carolyn Smith, Associate Deputy Chief of Staff on the Joint Committee on Taxation. Carolyn has been both intimately and intensely involved in the Joint Committee Simplification Project, and she's going to be leading our discussion by discussion of the Joint Tax proposals.

[141] Our academic participant is Professor Janet Spragens, Professor of Law at The American University Washington College of Law, and director of the law school's tax clinic.

[142] As most of you know, Janet, through her clinic experience has become one of the most knowledgeable people in the country on the problems of individual taxpayers, and particularly, low income taxpayers. So she's both an advocate—and a very effective advocate—and a wonderful resource for our panel.

[143] Our third panelist, our private sector panelist, although herself an academic professor, Annette Nellen, from San Jose State University. She's going to make some comments about the Joint Committee proposals. But in addition, and as importantly, she's going to describe individual simplification proposals that have been made by the sponsoring organizations.

[144] We're now going to turn to what I call our tax administration panelist. As you can tell from the program, we were to be joined on this panel by Nina Olson, an old friend of a lot of us and the current Taxpayer Advocate.

[145] Nina's son is having some surgery this morning, and as a consequence, she wasn't able to be with us. We wish Nina and her son well.

[146] In her place, we welcome Candice Cromling. Candice is the IRS National Program Manager for the earned income tax credit. They say the EIC, the earned income credit program. And as such, brings experience and expertise related to the earned income credits. So we welcome Candace.

[147] Then last, but certainly not least, our two congressional commentators, Barbara Pate, Legislative Director and Tax Counsel to Congressman Rob Portman; and Mick Prucker, the Legislative Director to Congressman Richard Neal.

[148] So, Carolyn, you're on.

[149] MS. SMITH: Good morning. As far as Ron's comment about he was never chairman before, I've been on the staff here for 15 years. We've never been allowed to sit up on the dais before.

[Laughter.]

[150] MS. SMITH: I wasn't sure we were allowed.

[151] I'm just going to run through our simplification proposals, highlight them and how we got there. We spent a lot of time focusing on individual tax issues, because they affect, obviously affect, so many, many people. While all the recommendations, we feel, are important, I think we considered the individual especially key because of the multitude of taxpayers that they affect.

[152] One thing that we hit on immediately was the issue of children, and the tax benefits that are associated with children under the Internal Revenue Code. Now there are five main provisions, the dependency exemption, the earned income credit, the child credit, head of household filing status, and the dependent care credit.

[153] As many, many people have pointed out—Janet and others—the issue is how you define a child that qualifies the taxpayers for these provisions. One of the problems that has been identified for well over a decade is the differences in these definitions, and that while people may try their darnedest to determine whether or not they properly qualify, they make mistakes.

[154] It is all too easy to do one determination and say, "Oh, this child is my dependent; therefore, assuming I meet the other requirements I get the earned income credit, head of household status, et cetera," without me knowing if that is really true. It would be a great boon to taxpayers as well as to the IRS to try to simplify these definitions, so that people don't get involved in such inadvertent errors.

[155] Another problem in this area is that in determining whether someone has made an error in trying to correct it. The IRS has to ask a lot of questions, intimate questions. The IRS ends up asking questions which, if the Service came and asked us these things like, "Well, how many people really live in your house;" and "How many nights do they stay there," we would get a little upset. Nevertheless, they have to do that.

[156] While some of that, perhaps, is ultimately unavoidable, at least we can try to simplify the definition so taxpayers are not running through several different sets of personal questions to determine whether or not they qualify. .

[157] So we basically took the approach under the earned income credit in present law which is a residency test whereas the dependency exemption is a support test. We adopted, basically, a residency test where if a child, who is a certain age lives with you during the year or a portion of the year, they may qualify you for these various provisions.

[158] We adopted a residency test over a support test, because by and large it is easier. While, of course, there will be issues as to whether or not a child lives with you for the requisite period of time in certain situations, it is a lot easier to determine and to know if a child lives with you than it is to deal with support. Because you can't really deal with support by people outside your own household and government payments and that sort of thing.

[159] So we adopted the residency approach. Basically, this says if the child lives with you for more than one-half the taxable year and they're under the requisite age that they're considered to be your—a qualifying child.

[160] We also adopted a new tie-breaking rule, which basically under the present law an earned income credit is an AGI of approach. We decided that the tie goes in favor first to the person with whom the child lives with for most of the year, then it would go to a parent. Again this tries to simplify these determinations because you might not know the AGI of the other person.

[161] We also said that the tie-breaking rules apply only if, in fact, more than one person actually claims the benefit, thereby avoiding you know the issue, if only one person who is qualified, in fact, claims the benefit.

[162] We did not allow any sort of shifting of benefits. As you know, under the present law the dependency exemption, through support or divorce agreements or separation agreements, you can in effect shift the dependency exemption. We propose that existing agreements would be still be effective, but basically took the position that allowing that transfer was an additional complification [sic]—complification ha!

[Laughter.]

[163] MS. SMITH: I'll let that stand, I guess. You know what I mean.

[164] And in our proposal, we recommended that we not allow taxpayers to shift benefits. This is one of the areas where we certainly think that there can be a lot of comment, particularly by the domestic relations lawyers and others. This is one of those things where—you know, I know Lindy—I didn't hear her this morning, but Lindy has said that we expect that simplification should be a deliberative process. People just shouldn't take our recommendations and enact them, even though we certainly stand by them.

[165] There still may be issues that there should be some reaction to, and this is one where we took a position but we thought that it would be helpful to get comments from people about whether or not this was really the most appropriate approach. Again, we made the decision based on simplification period. But there are certainly other factors to consider.

[166] I want to say that in this area the child definition we've heard a lot from Members of Congress who are kind of surprised about why we don't do this. Some of the members say, "Gee, we have these different definitions, why don't we fix this? Isn't this just a no-brainer?" Gene has given the story of why simplification is not necessarily all that easy.

[167] We made some other recommendations in the earned income credit, some of which were picked up in EGTRRA, to try to simplify further the application of those rules. But I think we view a core element of simplification in the earned income credit the adoption of a uniform definition of child. Again, our recommendation follows most closely what the earned income credit already.

[168] There are some things that we didn't do in the study—in our recommendations. One of them, things that Lindy highlighted for us as a staff to look at in reviewing the code was, were there overlapping provisions, where there were several provisions that give similar tax benefits to similar groups of people. Why do we have to have two separate sets of rules?

[169] And this area has that characteristic. I won't call it a fault, but characteristic. In particular, if you look, we do have the earned income credit, the dependency exemption, the child care credit, which all go at more or less the same thing. The earned income credit is targeted more specifically, but even you just look at the dependent care credit and the child care credit—if you read the legislative history of the child care credit, that basically says that this is basically to perform the same functions as the dependency exemption.

[170] There's also been a lot of literature about combining several of those things together with a unified approach, and in our general comments we suggested to Congress that might be a good thing to look at, because it doesn't really make sense to have several provisions giving similar tax benefits.

[171] We did not go further and say, "This is what we think you ought to do," because we felt constrained by existing present law policies. If you look just at the dependency exemption and the child care credit, the main difference is the refundability aspect of the child care credit. We felt that it was too much for the Joint Tax Committee to either say, "Gee, the child care credit shouldn't be refundable, or you should make the dependency exemption completely refundable." But we nevertheless identified this as an issue, an important one that should be addressed, in addition to a more cohesive policy about these provisions.

[172] The other things, I will just follow up—I mean, I think what is on our agenda is phase outs as one of the things we're supposed to discuss. Phase outs seem like no-brainers because almost all the groups say we should get rid of them. They're almost all still here. PEP and Pease, as you know, the repeal is included in the tax bill but not starting until 2006, and then they phase down and then they both come back when the sunset comes in.

[173] We basically recommended—we agreed with many, many comments of you all and others that this is—I almost said it again—complification— complexity and that they all should be, or most of them, should be eliminated.

[174] We actually studied each one and there were a few that we said, "Well, these are inherent to the provisions," for example, the earned income credit, but that basically the phase outs should be removed, and that would make the administration of tax code and just filling out the forms a lot easier.

[175] And if people wanted a similar result, the way to address those things, the policies behind the phase outs, would be in the rate structure, from the simplification perspective. PEP and Pease are the easy ones. Most people can easily see you can turn those into rate increases and accomplish a very similar effect—not exactly the same, but very, very similar.

[176] MR. PEARLMAN: Thank you.

[177] MS. SPRAGENS: Good morning everybody.

[178] When people talk about complexity or a simplification of the tax system, it's common for people to talk about it as a single concept. But I think it's helpful to talk about complexity for different classes of taxpayers; and that complexity for low-income taxpayers—I guess maybe because I deal with them on a regular basis—to me is a much more serious problem than complexity for other classes of taxpayers. I hope everyone can hear me.

[179] Complexity for low-income taxpayers, to me, is a much more serious problem than complexity for high-end taxpayers because the latter have the resources to get professional assistance.

[180] So what I wanted to start out with is just a description of who low-income taxpayers are in our system, and what we're asking them to do. Also, what happens if they make a mistake. I think you will see they have a very different profile than high income taxpayers.

[181] As many of you know, I am the Director of a Tax Controversy Clinic, and so we get a constant stream of low-income people coming in who are being audited, who have cases pending in the Tax C; court, and a very large number of our audits involve these issues, particularly the child benefit issues: the earned income tax credit, dependency exemptions, head of household status, dependent care and so on.

[182] Many of are clients are immigrants, recent immigrants to this country. We call them "ESL" taxpayers which stands for, "English as a second ." But the reality is that many of them don't speak English at all, or are barely fluent in English. That is a general barrier in their lives, but it's an especially great barrier when it comes to complying with their tax obligations.

[183] Those taxpayers oftentimes come from countries that have no annual filing tradition. They frequently are non-filers. They have low and minimum-wage jobs. A lot are wage earners, but many are also entrepreneurial. They have small businesses that they start.

[184] I often like to say that if you go down to Connecticut Avenue and Eighteenth Street or Pennsylvania Avenue, you see all these people selling hot dogs and Tee-shirts on the streets, those are our clients.

[Laughter.]

[185] MS. SPRAGENS: We know a lot of those people. They have import businesses, restaurants, all kinds of small businesses. They don't keep records. They usually use cash for their transactions. They don't have bank accounts. They don't have credit cards.

[186] They also tend to come from traditions of—they don't want to argue with the government. They are fearful of the government so, if they get an audit notice from the IRS, even if they are entitled to a benefit that is being questioned, they will often disregard it and throw the letter away. Or they will just send in a check. Because they just don't want to fight with the government. They fear some immigration-related penalty or are just generally fearful.

[187] Even if taxpayers are English speaking, you tend to find the same pattern. They don't keep very good records. They frequently don't even have copies of their tax returns when they come in to see us.

[188] In addition, because of the cost of housing, they have unusual living arrangements. You're not going to find the kind of "Ozzie and Harriet" style, two parents, two children households at these income levels. They oftentimes have children without being married, different fathers for different children, and multi-generational households. They are also oftentimes getting some form of public assistance, whether it's Section 8 housing assistance, food stamps, or TANF.

[189] They tend to work odd hours, sometimes double shifts. They don't necessarily have phones, so getting hold of them is difficult. They also tend to have limited education literacy levels.

[190] I would like to say that this group of people is not audited in our tax system. The enforcement system focuses on people with a lot of money and not people with these meager resources. In fact, however, these people have the highest audit rate, as recent newspaper reports have written about.

[191] So these people are a huge focus of the tax system. Now, what are asking these people to do? As Carolyn said, we're giving them in the tax system a lot of child benefits, directing child benefits to them. Each one of these benefits contains its own requirements including a different definition of a child. They also are—we're also requiring recordkeeping of them, which is just not happening.

[192] Something that people haven't mentioned, and that is that the tax system is changing every year, and that's a huge burden for these people. These people don't have computers. They don't have tax software. They can't import the data from one year to another.

[193] They have to re-create it every year, and if they're filling out their own tax returns, they can't even use last year's return as a template, because it's different every year. So the constant change in requirements from one year to the next is also a significant problem.

[194] People talk about errors in the earned income tax credit and over-inclusion and fraud, too much money going to the wrong people in the credit. But I would suggest to you that there is a lot of under-inclusion, too. People who just don't claim it because it's too complicated, or because they're fearful of being audited, or they are audited in one year and they don't want to face it the next year and they just give up with those benefits that they might be entitled to.

[195] The audit issues that this community is facing are legion. The earned income tax credit, head of household filing status, dependency exemption and child credits are among the top issues. But there are worker classification issues, tip income, self-employment tax, charitables, automobile recordkeeping, innocent spouse, gambling income—a hundred different issues.

[196] So if you think that low-income people aren't audited, only high-income people are audited, and their returns are easy to fill out, it's a huge mistake. These are the people who have to grapple with the tax system and hen in large numbers have to support the complicated positions they took on their return.

[197] One result of all of this is that these people are increasingly going to paid preparers, as I think everyone in the system is. The complexity is driving everyone to get tax preparation assistance.

[198] The preparer community that serves this population, as I said in my written remarks, ranges from excellent, to incompetent, to totally fraudulent. There is no requirement to hang out a shingle and say you're a tax preparer.

[199] The low-income people who go to the institutional preparers tend to get pretty good help in our judgment. The people who go to the storefronts can get any range of services. I mean, you see people coming in with these returns prepared by "Rocket-Fast Tax Refunds"—and you think I'm making that up, but I'm not. That's an actual preparation service in the city.

[200] The problems that come up with respect to non-English speakers, reach another level of complexity. Because there you have borrowed, shared, or made up Social Security numbers; resident alien spouses who are illegal and the requirements for people who file joint returns to get certain benefits, and they can't do it without Social Security numbers, and that kind of goes around and around.

[201] I want to speak, generally, to the importance of simplification. If we do simplification for anyone, we have to do simplification for this group of taxpayers. But I want to speak, specifically, to the Joint Committee proposals, which—and I want to applaud the staff for the hard work and thoughtful proposals that they have put forward in their report.

[202] Using the residency test over a support test to define a qualifying child for various child benefits is a big iprovements if there is to be a uniform test and a uniform definition of a child. It totally eliminates the need for excessive records that these people don't have.

[203] Under current law there is an interpretation of the support test that if a recipient receives some kind of public assistance, or receives an excess amount of public assistance, that they will be denied the dependency deduction because the conclusion is that that person isn't supporting their child, the state is supporting that child. And I can tell you people do not understand that.

[204] They're spending every dime that they have on these children, and the IRS is telling them that they don't support their children, because they're getting some food stamps or something. The residency test would get rid of this rule. Even if we keep a support test, we need to get rid of that rule, in my judgment.

[205] The residency test is also easier to prove, although it does, as Carolyn pointed out, lead to fairly intrusive audits. I mean, what you're asking people is, who lives with whom. We get into definitions of household because of the tie-breaker rule, when there are various people who, based on a residency test, can claim a child for the earned income tax credit. The tie-breaker rule in the EIC says that the person with the highest AGI in the household is the one entitled to the benefit.

[206] Under that test, the question then arises: what is a "household?" you know, you try and show what is a household. Is a household made up by the four walls of an apartment, or can you have more than one "household" within a single apartment if , for example, you have a boarder or a multi-generation family living together. So you may get into questions of who sleeps in what bedroom—very intrusive, very personal questions to prove residency.

[207] The uniformity of the Joint Committee test is also going to create a "winner take all" system. That is, if there's a unified definition of "child" as opposed to the current multiple definitions. Now, one person is going to get the earned income tax credit, head of household status and all of the dependency exemptions and child benefits.

[208] Whereas now, the dependency exemption may be taken by the non-custodial parent and the EIC by the custodial parent. That will change if they both move to a residency test. But I would also put forward at this time Nina Olson's proposal.

[209] I've heard her say it several times. I don't know if she's written it down anywhere. There is a concern that if you take all the benefits away from non-custodial fathers, who are paying child support—child support is also not deductible under current law. They are paying out a great deal of money and not getting any tax benefits at all. Nina has suggested giving non-custodial parents, who pay child support, head of household filing status. I like that.

[210] Another issue with respect to these proposals goes to the current law rule which allows the dependency exemption to be tradeable. Under the Joint Committee report, it's not tradeable. All the benefits go to one party and there's no room for negotiation or waiver, or trading of those benefits. I would suggest that this be reconsidered. The tradeoff, of course, is complexity versus being able to give people some leeway in assigning benefits to custodial and non-custodial parents.

[211] The Joint Committee's tie-breaker rule is a much better rule than what exists currently in the EIC, and I think I'm going to stop there. Is that enough?

[212] MR. PEARLMAN: Yeah.

[213] MS. NELLEN: Good morning. My comments are going to address the importance of simplification from the practitioner perspective, some discussion of the simplification proposals in this area that have been suggested by the AICPA, ABA and TEI, and you will see there's a fair amount of common ground with the Joint Committee proposals in this area, and finally I will comment on some perspective on simplification that tend not to be voiced enough.

[214] I'd like to start out with my favorite quote on this topic: "It may fairly be urged that our present system on federal income taxation is unduly complex. At any rate, little in the way of simplification has thus far been accomplished by revision. Each successive act has been more elaborate than its predecessor and the maze of administrative and judicial technicalities surrounding the taxpayer has been steadily thickening."

[215] What makes this quote so interesting is that it's from an article written by an econ professor in 1923, a time when only about 12 percent of adults actually filed income tax returns.

[216] While complexity has been around for decades, I don't think it's something that has to exist to the extent it does today. Of course, there will always be some complexity because there are complex transactions. However, millions of individuals are subject to or are entitled to the provisions that this panel is talking about, and the current level of complexity that exists today really needs to be significantly reduced for these taxpayers.

[217] Now, what are some of the concerns practitioners have with this complexity? First, complexity creates uncertainty. It makes it difficult to explain the law to your clients. It increases the risks of filing incorrect tax returns. And, as noted in testimony a couple years ago by the National Association of Enrolled Agents, complexity can lead to reluctance to take clients who are entitled to an earned income credit.

[218] Second, complexity takes time away from helping clients manage their finances. Three, complexity results in practitioners seeing many more individuals who fear the tax system. They are intimidated by the complexity that results in 1040-EZ instructions that are 32 pages long; 1040-A instructions that are 64 pages long; and 1040 instructions that are 122 pages long, in addition to publications they may need to read, as well.

[219] Fourth, complexity results in practitioners seeing more clients, who have declining respect for the system. Practitioners are the ones who hear the complaints from individuals about complexity and confusion over rules that change every year. They likely hear far more complaints in this area than do Members of Congress.

[220] Practitioners hear complaints about the loss of tax benefit due to phase-out ranges that often make little sense to low- to-middle income taxpayers who thought they were entitled to some of these benefits.

[221] Also, tax preparation and planning costs are high due to the extra time it takes to advise clients, prepare returns, to keep up with changes and to figure out the continual changes, and complexity causes more and more individuals to seek tax prep assistance.

[222] I just want to also give an example here. The new complexity we see in 2001, I want to read this new provision for refundable child credit to emphasize the complexities that exist and continue to be added to the family tax provisions.

[223] I want to quote to you part of a new code section 24(d)(1): "In general, the annual withholding credits allowed to a taxpayer under subpart C shall be increased by the lesser of (a), either credit, which would be allowed under this section, or that regarded to the subsection and limitation of section 26(a); or (b), the amount by which the amount of credit allowed by this section would increase, if limitation posed by 26(a) were increased by the greater of, (i), 15 percent, or 10 percent in the case of tax years beginning before January 1, 2005 of so much of the taxpayers earned income, which is taken into account in computing taxable income to the tax year that exceeds $10,000."

[224] I'll leave the rest of 24(d)(1) for you to read. I doubt if any of us would be eager to explain this to a client, or to an individual visiting a VITA site.

[225] I want to emphasize this revision is for low-income individuals. It will most likely require new worksheets and/or new forms, and more pages of the 1040 instructions. More forms means that individuals will incur costs when going to practitioners for assistance, or perhaps, forego the benefit, due to complexity, of the numerous forms involved.

[226] Practitioners will spend a lot of hours figuring out this new rule, yet not feel 100 percent confident that they are getting it right.

[227] A refundable child credit is an important relief provision. So I'm not suggesting that this should not have been created. Instead, the purpose of the provision should have been examined in the context of, whether its purpose is similar to an existing provision which then, perhaps, could have been increased.

[228] Also, much of the complexity of this type comes from ensuring that a small group of individuals do not get too large of a benefit, but is that concern big enough to warrant complexities for the whole group, and the risk that some of the benefit will go unclaimed due to the complexity?

[229] I want to look at some of the simplification recommendations of the AICPA, ABA and TEI in this area dealing with family tax provisions. These three groups have submitted joint simplification proposals to Congress, because these groups do share a common goal of simplifying and rationalizing the tax system.

[230] Before noting those proposals, I do acknowledge that a few of them actually were included in the 2001 tax bill. It was good to see that happened.

[231] First, proposals dealing with filing status, dependency exemptions and family credits from these three groups include, one, the eligibility criteria should be simplified and harmonized, very similar to the Joint Committee proposal.

[232] Two, a safe harbor test should be created to determine eligibility for the dependency exemption, head of household status, earned income credit, child credit and dependent care credit by allowing the custodial parent or guardian to claim the benefits—similar to the Joint Committee report, but then one additional point that we make is, the custodial parent or guardian should be allowed to transfer the dependency exemption to a non-custodial parent.

[233] Three, one standard for qualification of dependent child and head of household status should be applied that combines a support test with the requirement to divide over half the cost of maintaining the taxpayer's household.

[234] Four, the child credit should be repealed and the amount of the dependency exemption and dependent care credit should be increased.

[235] Five, a uniform credit rate for the dependent care credit should be established.

[236] Six, the dependent care credit should be refundable; and seven, head of household status should be extended to non-custodial parents, who can demonstrate their payment of more than nominal child support.

[237] The simplification recommendation regarding phase-outs is that all phase-outs should be eliminated, and no new ones should be created. Alternatively, cliffs should be substituted for phase-outs.

[238] The way a cliff might work is that, for example, the provision might no longer apply once income passes, say, the $60,000 level, rather than having it phased out over a range of incomes. The advantage of a cliff is that it is easier to understand. You just know it's going to end once your income hits a certain point.

[239] If some phase-outs are to be retained, the income should be measured, consistently, for all those phase-outs; and if they are to be retained, the phase-out ranges and methods should be similar.

[240] I want to note two additional perspectives and simplifications that I don't think are mentioned enough. First, actually like the comments Pam made this morning, was that there is a constituency for simplification in this area. Continual suggestions for simplification regarding family tax revisions that come from practitioner groups, should be viewed as stemming from the concerns they hear from their individual taxpayers and the complexity issues they face in filing returns for those individual taxpayers.

[241] Also, individuals who fail to claim tax relief provisions due to complexity, should be viewed as constituency calling for simplification. This is a very large group. It's been estimated that perhaps up to 35 percent of eligible individuals failed to claim an earned income credit.

[242] Also, the constituency calling for simplification exists in the individuals that Janet mentioned that get called for audit in this area.

[243] Second, complexity costs money, so, why not consider simplification as a form of economic stimulus. Estimates of the compliance costs range from 10 to 15 percent of the tax collected, and perhaps as high as 19 percent for income taxes. Also, complexity increases non-compliance and evasion. Simplifying the federal tax rules will free up some compliance dollars for better purposes.

[244] In conclusion, the Joint Committee report is a tremendous plan for simplifying the federal tax system. The AICPA, ABA and TEI have also made extensive and well thought out proposals for simplification, and have and will provide input to the Joint Committee on its proposals.

[245] The suggestions for simplifying family tax provisions affect millions of individuals who want and need simplification. As stated in the AICPA report sitting on your tables there on guiding principles for tax simplification, simply begins, "Simplification is needed to ensure the continued viability of our self-assessment approach. We need to both simplify existing rules, and to avoid new complexities."

[246] As stated in the AICPA report, "Simplification must be a priority. It would benefit individual taxpayers, businesses, tax agencies and the economy."

[247] Thank you.

[248] MR. PEARLMAN: Thanks, Annette.

[249] Candice?

[250] MS. CROMLING: Well, I'm happy to be here today to represent Nina Olson a little bit, but mostly to talk about EITC and different family-related credits from the perspective of the Internal Revenue Service. I feel kind of interesting sitting up on this panel. I feel like I should say, "I'm here from the government, and I'm here to help." But we'll see.

[Laughter.]

[251] MS. CROMLING: Low-income taxpayers and maybe all taxpayers generally think about income tax only once a year, when it's time to file their tax return. And their view of filing a tax return is that it's a chore. Something they have to get done and they often feel ill equipped to be able to get that chore completed.

[252] It probably starts with trying to determine what filing status they have. Determining marital status is not always an easy thing for an individual to do in the diverse society like we live in today. But right or wrong, taxpayers often choose head of households filing status. I'm sure you know that. Because they know, they are head of their household, and the tax definition of head of household is immaterial, because they just know that they are head of household.

[253] As they move on to complete their return, they must determine what exemptions they can claim, and that includes dependent exemptions. Taxpayers, again, don't often understand the definitions under the tax code for dependent exemption, but they know that child is their child, and they feel like they should be able to claim that child. Again, the definition in the tax code takes a backseat to what they fee and know.

[254] If they look at tax credits like the earned income credit, which is so close to me, and child tax credit, both of them call for a qualifying child. But that qualifying child is determined or defined differently for each one of those things.

[255] Even tax professionals that I meet, whether I talk to people who are representing taxpayers, or when I go to public forums like this, tax professionals will flip back and forth when talking about EITC and the dependent child instead of the qualifying child. So we're all confused. We might know the law, but we're sometimes confused when we try to speak it.

[256] Again, many taxpayers do go to a paid professional to get their tax return done. Part of it is because it's so confusing for them. But part of it, too, is that they feel like they need to go so they don't overlook something that they're entitled to.

[257] Many years ago when I was working in a district office for the Internal Revenue Service and preparing tax returns, I actually did a tax return for a taxpayer, with earned income credit. After the interview and after I prepared the tax return, I turned it around so they individual could sign it and she looked at it and she said, "Is that all the refund I'm going to get?" And I said, "Well, yes, unless you have any additional information." And she said, "Well, never mind. I'm going to take it to a tax preparer so I can get more."

[258] So, you know, people have an idea of what they should be getting as opposed to what they are entitled to by law.

[259] As IRS works with taxpayers explaining the tax law and helping to prepare tax returns, and explaining our notices and our forms and publications, sometimes taxpayers are at a loss to understand what we're trying to tell them. Oftentimes they're trying to match up what they believe was the intent of the law with the way that the law is being explained to them, and it's not a good fit for them; and it's difficult for them to understand.

[260] When the IRS corrects a tax return for an issue like a non-eligible EITC claim, taxpayers tend—and Janet mentioned this, too—not to claim it in subsequent years. I would like to pat myself on the back and say, it's because we're choosing the right people to audit. But I also know it's because people don't understand, or they determine they don't want to take the government on.

[261] The IRS continues to fulfill its role as a resource to taxpayers, trying to provide them with information before they file their return. We continue to work to improve the instructions, hopefully, not lengthening them any more than they already are, try to do them in ways that taxpayers understand what it is that they need to do.

[262] We clearly try to work hard on answering our toll-free lines, and the questions of anybody who comes into our offices. We provide training to volunteer groups who are going to prepare tax returns, such as the VITA community; and we work with the professional community, as we have been doing, and also looking for feedback from the professional community on what might be wrong with our process, that maybe you can tell us so we could fix something that maybe isn't legislative in nature, but is a roadblock.

[263] We provide taxpayers with multiple options on how they can file their return, whether it be electronic or paper, and work with individuals and tax professionals after a return has been selected for examination.

[264] We're currently trying to improve the quality of the correspondence that we send out to taxpayers so that it's more understandable. And we're also trying to provide as much information as we can on taxpayer rights, including appeal rights.

[265] One thing that I would be remiss if I didn't mention is that, as you know, Nina Olson is the Taxpayer Advocate. She will soon issue a Taxpayer Advocate report. She has an annual report that she will be issuing, and I believe it will be going out very soon, within the next month or so.

[266] In that, she will have also some legislative proposals that tie into family issues. So, when that comes out, I would certainly take a look at it. Because I think it is right in line with some of the things that the panelists have already mentioned.

[267] With that, let me send you to Barbara.

[268] MS. PATE: Hello. Mike and I have, I think, the easier part on this panel. We get to comment and provide the reality check. So, we enjoy that role and we will try to do that.

[269] When Lindy mentioned that in 1926 the Joint Committee had charge of tax code simplification, it reminds me of Sisyphus who pushed that, you know, rock up the mountain—simplification—and it rolls back down again. Simplification is just a never-ending thing.

[270] But I'm delighted to see that we have a focus on simplification as we do today with this great crowd. As some of you know, my boss, Congressman Rob Portman, was one of the co-chairs of the Commission to Restructure the IRS. One of the things that the Commission did was take a close look at simplification.

[271] It was interesting because I don't think simplification was in the original instruction that set out what the Commission was supposed to do. But as we went out in the field and talked to practitioners, stakeholders, the IRS, we noticed then that a lot of what was wrong with the IRS could be directly related to the complexity of the law.

[272] Congressman Portman and other commissioners felt very strongly that we have a simplification component in the report. We were, of course, proud to see that the Commission's report led to legislation, which included this Joint Committee report that's being presented today and a Commissioner's report. Every year the IRS Commissioner comes to the table and lets us know what the most complex items are in his or her view. And the Commission report recommended the the complexity analysis. I think Gene mentioned that.

[273] I'm not sure if the complexity analysis is doing exactly what most of the—many of the commissioners had hoped it would do, but that may be something that we can take a look at down the road. Gene mentioned some things that we might do with the legislative process and that may affect the complexity analysis.

[274] Here's my first reality check—the reality check is that the process doesn't work as smoothly as we might hope it could. There's always a time factor, a time crunch. It would be nice to be able to have a day of simplification hearings and have an expert sit at the table and tell us how legislative proposals can be implemented, or what forms we need, and so forth.

[275] But the reality is that in the political and legislative process that we have, it just doesn't happen. So, that's reality check number one on the process. I think that's something that we can continue to look at, and maybe look for ways to make the complexity analysis better.

[276] Another thing which Candice mentioned is the Advocate's report. As many of you remember, the first Advocate's report was really just paper. Since that time the report has become meaningful with a number of suggestions on how we might simplify the code with actual legislative proposals.

[277] So at least from Mr. Portman's perspective, it's beneficial that the Advocate has to come to the table with suggestions on how we might simplify the code to make life easier for taxpayers.

[278] We're also pleased excited that the Ways and Means Committee has held hearings on simplification. The Oversight Subcommittee and Select Revenue Subcommittee held hearings earlier this year. So, now, what do we do?

[279] When Mr. Portman first got on the Ways and Means Committee, he set up a task force back home, which Don Korb participates in. We have representatives from small and large business. We have a CPA and a practitioner who handle income tax returns for low-income folks. So there is a really wide spectrum of people.

[280] During our very first meeting Rob asked the group what we should do for simplification? Two people out of the ten mentioned the AMT. Everyone else's idea of simplification was to do nothing for five years, pass no laws for five years.

[281] But, obviously—reality check number two, that hasn't happened and isn't going to happen. So now what can we do?

[282] I think Mr. Houghton put it in a great way at the hearing. He said, "While you're waiting for the bank heist, you ought to knock off a couple of gas stations in the meantime." I kind of like that approach.

[Laughter.]

[283] MS. PATE: It would be great if we could do a massive simplification project and a massive simplification bill, but the reality check is that's probably not going to happen. The reason? Revenue.

[284] For example, looking at the revenue tables—and I'm probably going to have to get Carolyn to bail me out on this, the Pease provision costs $24.8 billion over the period. The personal exemption provision was $8.1 billion. The EITC provision was very costly. So these simplification items are incredibly expensive to do.

[285] If we're now looking at a situation with no surplus, how are we going to pay for these simplification items? Are we going to do it on a budget neutral approach? You know what happens then. Somebody's got to pay, and that often leads to even more complications. It's a difficult thing.

[286] So, again, I think I'm on the gas station approach—let's do what we can where we can. You know we had some progress earlier this year. Carolyn pointed out all that we've already done. There are other things that we can do. Carolyn said the Joint Committee report includes a hundred provisions that don't cost anything. They're deadwood and so forth, and could be something that we might really take a look at.

[287] But having said all that, Rob Portman may have a "bank heist" approach coming up. We are putting together a bill that would be a comprehensive simplification bill. It will include a lot of the same old suspects, like the AMT, perhaps, taking out the phase-outs and so forth.

[288] What won't be in the bill is internatonal tax simplification. Mr. Houghton is taking the lead on that. I think he's putting together a comprehensive package. And then we won't have pension simplification in this bill because we're planning a separate Portman-Cardin bill.

[289] Hopefully, we'll be able to move forward with the simplification package some time after the first of the year. So, if you've got any suggestions or anticipations about it, please feel free to come by.

[290] I'm going to take one minute to just comment on some of Janet's remarks. Janet spent a lot of time working on how low-income taxpayers are affected by legislation and the law. I think she makes excellent points. We ought to focus more on them. In fact, we have funding for low-income taxpayer clinics in the Treasury Appropriations bill.

[291] But I do get a little bit nervous about thinking that we need to look at simplification legislation based on who has the resources to be able to deal with the law. That in itself sometimes leads to more complexities. So, I wouldn't want to necessarily take that approach, initially, in writing the law. But I do think Janet makes an excellent point that we need to think about low-income taxpayers.

[292] Janet mentioned the "winner-take-all" approach where if we combined all these different definitions then somebody gets all the benefit. She says perhaps that's not fair. That reminds me of Bobby Shapiro's phrase, "Fair's not simple, and simple is not fair." So, we do face these sorts of issues in dealing with simplification.

[293] I guess I'll stop at this point and let Mike go. So, why don't we just say here's hoping next year that we will knock off a few more gas stations.

[294] MR. PRUCKER: Thank you, Barbara.

[295] Now I have to do I do the normal disclosure that whatever I say is my own personal views, and that --

[296] MS. PATE: Oh, I needed that, too, Mike.

[Laughter.]

[297] MR. PRUCKER: For Barbara, as well.

[298] It doesn't reflect, necessarily, the beliefs of my member, the committee, the House, or any other intelligent life force.

[Laughter.]

[299] MR. PRUCKER: I'm also going to talk very quickly, which I'm not used to doing. So I apologize to all of you and I'm going to range beyond the jurisdiction of this panel, so I apologize to the panel. I think I've included everyone.

[300] I agree with everything that's been said, basically. There's lot of room to simplify the tax code. With the Joint Tax Committee report we've got lots of suggestions about how to do it, lots of policy options to consider. The question is, how do we keep this extremely important body of work from becoming just another CBO annual report.

[301] Sorry, Gene, but my view of those reports is that every year they come out and suggest the same spending cuts. They suggest the same revenue increases. After a couple years you put the report on your shelf, note that it came in, and you never saw it again. How do you prevent that from happening?

[302] There are two ways, and I'm going to do sort of a long discourse on it—maybe not so long. What I want to do is talk just briefly about what I've learned working on tax simplification for Mr. Neal, or describe briefly the problems we ran into Even before you get to the real simplification.

[303] April of 1999, Mr. Neal introduces the Individual Tax Simplification Act. It repeals the AMT, repeals the personal exemption phase-out, repeals the itemized deduction phase-out—which, by the way, are my two favorite provisions from last year's bill. Because the phase-outs are phased in and the repeal's repealed.

[Laughter.]

[304] MR. PRUCKER: The other provisions were: collapses all phase-out schedules for non-refundable personal credits into one phase-out schedule. Not repealed, but the next best thing; and it replaces the capital gains rates with a 38 percent exclusion. All revenue neutral.

[305] The capital gains rate was set to be revenue neutral, according to the Joint Tax Committee. The collapse of the phase-out rates was revenue neutral. Some of the phase-out rate went up, some went down.

[306] The repeal of AMT, PEP and Pease was paid for by adjusted gross income surcharge. There was a one percent surcharge on AGI between $120,000 and $150,000, and a 2.08 percent surcharge on $150,000 of AGI and above. That basically made the bill revenue neutral, and can be done either in a budget surplus situation, or in a budget deficit situation.

[307] Those breakpoints were chosen not only for revenue reasons, but because they mimic what happens to taxpayers right now. It's basically what the hidden rates are now.

[308] We estimate that it eliminated about 210 lines from individual tax forms and schedules and worksheets, which is one measure—perhaps a crude measure—of tax simplification, but it's one way to look at it.

[309] So to repeat, there's no loss of revenue. No attempt to shift tax burdens between economic groups. No attempt to tax the wealthy, and no takers.

[Laughter.]

[310] MR. PRUCKER: Why?

[Laughter.]

[311] MR. PRUCKER: This is where political reality comes in. Democrats generally aren't interested in lowering taxes, significantly, on very wealthy taxpayers. So revenue offsets were included for that reason as well.

[312] Republicans generally are not interested in raising revenues in any context, for any reason.

[Laughter.]

[313] MR. PRUCKER: Both are perfectly reasonable policy positions to take. So revenue offsets are a non-starter. So even before you get to some of the basic provisions of tax simplification that are in everybody's recommendations, you've got the two parties at loggerheads.

[314] As I said, there are two ways to go. One is the "big bang" theory, that Barbara referred to, where you try to put a large number of simplification proposals together and see if you can get it through Congress.

[315] The key question is, how do you jump-start those proposals? How do you jump-start tax simplification? While everybody in here is a strong proponent of tax simplification, there's a lot of competing interests out there that aren't necessarily quite so worried about simplification.

[316] How do you compete with the tax rebates, the marriage tax penalty, the estate tax, the repeal of all those items? How do you get tax simplification on the table? How do you do it in a major way? When you find out, tell me.

[Laughter.]

[317] MR. PRUCKER: For better or worse, there is one historic guide, and that's the Tax Reform Act of 1986. Now you can argue that the bill went too far in some areas. You can argue that we've unraveled a lot of it. You can argue that for some taxpayers life is much more complex than before that law. But it did contain some simplification proposals.

[318] It got, I think, six million taxpayers off the roles. It reduced tax sheltering, dramatically. There were some good simplification features to it. But the key point is that it was originated and pushed by the Reagan Administration and had full political and policy support of the Treasury Department. It had an administration that was willing to expend political capital in Congress to make sure it would pass and it had a bipartisan aspect to it.

[319] That, I would suggest, is probably one way you get the "bing bang" notion of tax simplification through Congress. And I do think, as you see more and more people advocating tax simplification, and more and more Members of Congress responding, that there is some chance during the next election or just after it that you—there is enough political juice for tax simplification to come back onto the table somewhat like in 1986.

[320] The second way to go is incremental reforms, which we've all been talking about today, and you can see some items passing, for example, allowing the child credit and the education credit against the AMT has become a tax-extender item. The policy decision is made. That's not going to get reversed.

[321] People have mentioned the simplification proposals of the earned income tax credit that were in last year's bill. This year we have to re-authorize the TANF program in welfare reform. That's a natural place to put additional tax simplification items on the earned income credit.

[322] We have a bill on the Floor today on the suspension that didn't come through the committee, but it's a bill to simplify reporting requirements for colleges and universities on education credits.

[323] And, if you want a real barometer of tax simplification, a number of lobbyists have started to make tax simplification. One argument for what they want to do anyhow. It doesn't matter whether it makes the tax code more complex, as long as it's simpler for them.

[324] So, I would say that maybe the next step, after Barbara's bill get in, is that everybody who's been invited to participate in this program get together and try to form some type of a task force to try to figure out what kind of low-cost, high-impact proposals can be agreed to by everybody, and see if that group of members, staff, and practitioners can get that on the table for consideration at the end of this year or in the next Congress.

[325] I'll quit there.

[326] MR. PEARLMAN: Okay, thank you very much.

[327] Before we evaporate, we've got about nine minutes on that time that's intended to be devoted to comments or questions from any of you. So, are there any?

[No verbal response.]

[328] MR. PEARLMAN: None. I'm not going to let you out of here with nine minutes. I'm going to ask one, then.

[329] Oh, I'm sorry. Excuse me, I thought you were leaving. I didn't realize you wanted to ask a question.

[Laughter.]

[330] QUESTION: The study that was done, has shotgun approaches. Here's an item we can simply. Let's see how we can simplify? What can we do to make it simpler. I like Mike's low-cost, high-impact approach a little better.

[331] Last month the IRS issued the 1999 statistics of income and it shows that 85 percent of the revenues from the income tax were raised from 34 percent of the tax returns that were filed. Of 103 million tax returns, the 1040s that were filed, 68 million returns were in the 15 percent bracket, and those 68 million returns raised $127 billion, with an average tax collected on those returns of under seven percent.

[332] So my question is, do we need an income tax or income tax filing to collect under seven percent on people who are in the 15 percent bracket? Remember that 15 percent bracket now means, "married, filing jointly." In 1999, $55,700, married, joint; $43,000, single.

[333] Can we make something else, some sort of a withholding or a flat tax on the majority, as Gene said, and some progressivity on some smaller group? The original purpose of the income tax, when passed in 1894 and 1913 was simple, progressivity.

[334] MR. PEARLMAN: That kind of proposal is not a new one, as you're probably aware. In fact, I think Mike Gratz has suggested just that. It's a little more complicated when you put a refundable credit in the system.

[335] I don't know what the data are, but I would suspect that the number with zero tax returns, which are filed solely to claim the earned income credit, are probably pretty significant. Do you know what they are, Candice?

[336] MS. CROMLING: I can't tell you the number, but it is very high. There's about 20 million people who file for earned income credit, and the vast majority of them do not owe another tax.

[337] MR. PEARLMAN: Anyone want to make a comment?

[338] MS. SMITH: It's something that, people brought attention to in the course of our study. I mean, certainly it would be laudable to reduce the number of people that actually have to go through and file returns. But I think there would be a lot to get to do to go from here to there.

[339] You know, I mean, anything should be considered. I think that as a practical matter, if you start with the existing system and work out from it, you have more of a chance of getting there. But certainly, you know, I love to reduce paper myself.

[340] MR. PEARLMAN: Yes, ma'am.

[341] QUESTION: In your discussions about definitions for dependency, qualifying child and so on, you talked about using residency. I'm seeing more and more cases where you have divorced parents, where the child—the parents actually have joint, legal custody.

[342] In New York, the courts are moving towards that as the ideal, and children actually spending equal time in both homes. I think that we need to—when you look to residency, I think that is not as simple as some of you seem to indicate. Because many children can have more than one residence in this complicated world, and I just think we need to consider that the test needs to be thought out very carefully, if it's going to be a residency test.

[343] MS. SMITH: Well, I think that's obviously a very good point. Our study, basically, adopts residency as its more simpler than a support test, although obviously, there are issues that may arise, and this is one I think we all have alluded to.

[344] Half year—I mean ours was residency for more than half the year. This really gets into the whole question, I think, of do you allow people to decide amongst themselves who are going to get these benefits, as opposed to having the law decide, "Okay, you get it," and you don't.

[345] As I mentioned earlier in my remarks, this is an area where I think we all recognize that this is definitely something that needs a lot of input. It's not clear there's any right answer and it does need to be looked at further.

[346] MR. PEARLMAN: It seems, you know,—well, one thing, and I think that comment illustrates it, if you don't give some flexibility by agreement, my guess is you'll create, on the basis of eliminating some degree of complexity I guess, you're going to get a lot of that complexity back in terms of transactional complexity.

[347] That is, maybe the next deal in New York is not 50/50, but 49/51, so that someone can claim the exemption.

[348] MS. SMITH: Right, and I think, this is one of the reasons for the glib statement: "Simplification isn't simple." You are affecting people's lives in a sense, or what people do, and you can't really do any kind of major simplification without changing, to some extent, who gets a benefit or whether they get it.

[349] Once you do that, by its very nature, you get into policy issues and questions of fairness that are never very easy to resolve, and that's why it takes a long time before anything can happen at all.

[350] QUESTION: The tax code has been changed to allow, if two parties in an adversarial situation determine that a payment is alimony, it's alimony.

[351] I think we need to give, in a sense, more power to the people in situations like that. If they determine in the negotiation that one party or the other is entitled to the exemption, and not based upon support, then residency should not be an issue. If it's a negotiation, you've got basically differing positions between the parties.

[352] The alimony rules have worked immensely, and I think it's eliminated a lot of activity where the government has come in after the fact, the IRS has come in after the fact and re-characterized payments, and I think we need to work more and more to those kinds of—providing those kinds of opportunities to taxpayers.

[353] MS. SPRAGENS: I just wanted to make a comment on that, too.

[354] I have to say that the question is correct that we've—I personally experience a lot of audits where we take a calendar and we try and figure out how many days a child spent with two parties, or a grandparent, or abroad or something, but you're trying to figure out the exact number of days that a child spent in two different places.

[355] The problem with that is, however, that right now we have a residency test for the earned income tax credit. We have a support test for the dependency exemption. For head of household we've got a mix. You have to provide a household, which is a support. And we also have a residency test to take head of household status, and people don't understand that when they have a child and there are child benefits in the code, the child is defined differently for every one of these benefits, and that they're entitled to some and not others.

[356] It causes mistakes. It causes confusion. It causes frightening audits, and it's difficult, despite the fact that I think you're right, that the resident test is not problem-free, either.

[357] MR. PEARLMAN: Okay, well, thanks to all of the panelists, and thank you.

[Applause.]

[358] MS. PECARICH: We're now ready to begin our second panel. Thank you for being prompt in getting your refreshments during the break.

[359] Let me start off by explaining our topics and the procedure that we're going to follow; and then I'll do the brief introductions. Our topics are the individual alternative minimum tax, education incentives, and the personal interest deduction.

[360] Essentially, we have decided that it makes more sense, given the kind of diversity of these topics, to discuss each topic separately. I'll ask you to hold your questions until the end of our hour. We will save time for Q&A, just as we did on the last panel. So, make a note of the questions that arise and we'll handle all the questions on all the topics at the end.

[361] Starting at my right, your left, Professor Deborah Schenk is here from New York University. She's been on that faculty since 1983 and has prepared the paper that you have in your binders for providing the basis for our discussion. She's also editor-in-chief of the Tax Law Review, which is a tax policy journal. She's the author of many articles, and three very impressive books on tax matters, detailed in her bio, which is in your folder, as well.

[362] She's also an active member of the Bar, and I'm impressed with the nature, extent and depth of your activities, Deborah. It's really marvelous. I said today that I'd read her works from the time I worked on the Hill, over all these years, and we've never met in person until today. So that's a real treat, too. Thank you for being with us.

[363] To my left, your right, Phil Mann, Miller & Chevelier, a prestigious member of that firm, and chair of their Executive Committee.

[364] Phil has a broad tax practice that includes legislation and policy work with Treasury and IRS. In past lives, Phil was tax legislative counsel at the Treasury Department, and he has served twice on the IRS Commissioner's Advisory Group.

[365] Sitting next to Professor Schenk is Mary Schmitt, who many of you will know as Deputy Chief of Staff of the Joint Committee on Taxation. Mary's been on the Joint Committee staff since 1982, but before that, she worked for the IRS in the Office of Chief Counsel. Mary worked in the Employee Plans and Exempt Organizations Divisioon. Obviously, the breadth of her mission is much, much broader today.

[366] To her right is Don Keifer, Director of the Office of Tax Analysis at the U.S. Department of Treasury.

[367] Don was formerly the Chief of the Economics Division at CRS in the Library of Congress, and served in the CRS for many years. We're gratified that he could be with us today, given Treasury's very difficult workload, as well.

[368] To the far left is Russ Sullivan. He's the Chief Tax Counsel for the Senate Finance Committee, reporting to Chairman Max Baucus.

[369] In his prior congressional service, he was Tax Counsel and Legislative Director for Senator Bob Gramm of Florida, and then served as Democratic Chief Tax Counsel at the Senate Finance Committee for Senator Patrick Moynihan.

[370] Russ is both a lawyer and an accountant. He came to the Hill from Vinson & Elkins, but he had worked at KPMG prior to getting his law degree.

[371] Bob Winters, sitting to Russ' right, has been the Tax Legislative Aide to Bill Thomas for 20 years. I said, did you come to the Hill the same year I did? No, he was a few years after me, I will say, but he's now Special Counsel to the Ways and Means tax staff, and we very much appreciate Bob's presence here, as well, because we all know what busy schedules these folks have.

[372] So, with that, we will get started on our first topic. Deborah is going to introduce the topic of the alternative minimum tax for individuals.

[373] MS. SCHENK: My charge was to talk about the complexity of the AMT, discuss the JCT proposals and criticize them. So, let's actually start with a thought experiment.

[374] Let's imagine that you were a congressman or a congresswoman, and you were actually going to say to Joe and Mary Middleclass of Middletown, New York, "In calculating your federal income taxes, be sure to do the following things: take exemptions for those five children you are supporting, because children are our future.

[375] "Since you've been especially prolific, you're entitled to an additional, refundable tax credit for your children. Since one of them is seriously ill and you have extremely large medical expenses, deduct the extraordinary portion, that is the extent to which they exceed 7.5 percent of your income.

[376] "And, we're delighted you have gained the American dream and that you own a house. So deduct your real estate taxes. While you're at it, deduct your New York income taxes, as well. Although we're not going to allow you to deduct much of your miscellaneous employee expenses, you can deduct the amount that exceeds two percent of your AGI.

[377] "And since we know you will need to use a tax preparer to figure this out, throw her fee into this calculations, as well."

[378] "Done?" "Well, not quite. We'd like you to do this all over again. But this time, skip those exemptions for the five children. We've decided the government should have a piece of the funds used to support them. On second thought, your medical expenses don't seem so extraordinary after all. Just deduct the portion that exceeds ten percent of your AGI.

[379] "And those real estate taxes that you included in calculating carrying charges, well, you shouldn't have done that, because we've changed our mind. And those hefty New York income taxes, well, anybody could have told you that Peoria is a better place to live than New York.

[380] "And, yes, we understand, without the deduction for medical expenses, real estate taxes and income taxes, you would have taken the standard deduction, but forget it. You can't have that either. And I guess you'll have to pay the preparer even more to figure this out, but you needn't worry about the fee for those extra six hours, what we couldn't kill with the two percent rule, we'll eliminate now—no miscellaneous itemized deductions.

[381] "When you're done, tally it up and add the bottom line to your tax bill. Wait! There's one more thing. That refundable child credit we promised you for being so prolific, offset that against this additional tax."

[382] Forget it. No, we can't actually imagine a Congressperson saying this to her constituent, can we? But that's exactly what it would sound like if she did try to explain the AMT to somebody.

[383] At one time the AMT might have been justified as a politically acceptable way to attack tax shelters. But that purpose has long since been expanded to cover items that are used by those who have never heard of tax shelters—for example, the standard deduction and the various itemized deductions that are eliminated in calculating the AMT.

[384] The AMT exemption amounts and rate brackets have not been indexed for inflation. Lower capital gains rates have resulted in lower regular taxes that now trigger an AMT; and finally, the child credit is not a feature of the AMT.

[385] The result, as the Joint Committee points out, is that millions of middle-income taxpayers now pay the AMT, and that number is expected to soar. A significant number of taxpayers do not owe the AMT, but their personal tax credits are reduced or limited by the AMT. And of course, millions of taxpayers whose tax liability is not that affected must calculate their tax liability twice to make that determination.

[386] The Joint Committee staff recommended that the individual AMT be repealed. Who could argue with that, at least on simplicity grounds? Well, let me suggest three possible problems, that's what the academic role is supposed to be, to propose some problems.

[387] First, a case can be made on revenue grounds. The JCT staff estimates that the revenue from the individual AMT could hit $36 billion in 2011. That's not small change we're talking about.

[388] Second, a case could be made that repeal standing alone may have unfortunate equity consequences that should be weighed against the simplicity gains. Repeal without corresponding changes to the normal income tax, might have serious distributive effects that would decrease the progressivity of the income tax.

[389] If we believe the current level of progressivity is just right—I'm not suggesting it is, but if you believe that then you shouldn't support stand-alone repeal of the AMT. It would need to be accompanied by rate changes that brought the level of progressivity back into line.

[390] The efficiency case is somewhat more complex. If Congress believes that tax preferences are being over used or too generous, the far simpler approach is simply to cut back on them. But if this alternative is not on the table, inclusion in the AMT might actually result in better allocative effects than the only other politically viable alternative, which is leaving the preference intact without limit.

[391] Of course, it might apply to the wrong taxpayers, or it might encourage a change in behavior in ways that avoid the AMT. It's hard to know whether an indirect limitation, like the AMT, has positive or negative allocative effects. The point is, we simply can't be sure that stand-alone repeal is second-best.

[392] At the same time, we should not assume that it's good policy to put us in the same position vis-a-vis the normal tax as we would be in if we kept the AMT. Some preferences really aren't preferences, and should not be limited.

[393] Finally, there are several fallback simplicity arguments that the Joint Committee did not recommend. They could easily be supported on simplification grounds. The most important of these would be to index of the exemption amounts and the thresholds for inflation. This statutory addition would contribute to simplification, because it would substantially decrease the number of taxpayers subject to the AMT.

[394] Another obvious possibility is to repeal the provisions that would require calculation of the AMT without regard to the standard deduction and the personal exemption. In terms of ability- to-pay or distributional concerns, one would think that whatever arguments support the standard deduction and the personal exemption in the normal tax would apply equally well in the AMT.

[395] A similar kind of argument can be made for repeal of the preference for state and local taxes. If you believe that an argument can be made for deducting these taxes because it's a better measure of economic income, you would favor eliminating this preference. And the same thing is true for eliminating the cutback on the medical deduction. If a medical deduction is normative, it makes no sense to cut it back in the AMT.

[396] Finally, it's really difficult to think about the treatment of miscellaneous itemized deductions with only a focus on the AMT. Their treatment in the normal tax is so wrong-headed that the AMT result just adds insult to injury. Although the two percent rule can be defended as an extremely rough way of eliminating subsidization of consumption benefits, or as a simplification measure, if that's so, the same rule should apply for AMT purposes.

[397] MS. PECARICH: Thank you, Professor.

[398] Now, Phil Mann.

[399] MR. MANN: Deborah's written quite a good paper on this, and I don't think that we probably disagree that the AMT really ought to hit only provisions that are at odds with a supposedly normative tax base. But I guess where we might disagree is what you do if you find that you do have some items in there that are inconsistent with that goal.

[400] My view is fairly straightforward. They ought to be corrected directly. There are too many unintended consequences that you get into for doing indirectly through the AMT what you ought to be doing, directly. The current spectacle of people being subject to the AMT, due to the dependency exemptions in the EITC, I think, are easy for most people to understand.

[401] But these are by no means all of the distortive kinds of effects that can occur. And I don't believe that indexing will fix it, and I think that while eliminating some of the items in there, that are really normative, is progress. I just don't think it's enough.

[402] My view is that it ought to be repealed, and if you don't like the slope of the progression of the tax system at that point, for political or other kinds of reasons, I think you ought to attack that straightforwardly through the rates. It has always seemed to us at the Tax Section that that ought to be possible, but I'll leave the politics of that to Russ and Bob.

[403] MS. PECARICH: Thank you, Phil.

[404] Mary?

[405] MS. SCHMITT: I'll just make a couple of comments. Deborah kind of sets out the problems with the AMT pretty clearly. Why did the individual become a problem? Well, because there was a decision made at some point in time not to index the exemption amounts—increase the exemption amounts that are normally indexed for inflation. So what we have is a creeping tax system that each year sweeps in more and more individual taxpayers.

[406] Deborah mentioned that our report points out that AMT revenues are projected to be $36 billion in 2011. In reality, that number has gone up because of the tax legislation passed this summer. So, by 2011 or 2010, we'll have a much larger number of individual taxpayers subject to the alternative minimum tax.

[407] It's particularly difficult to achieve the repeal of the individual AMT because of the revenue involved. I know our commentators on the first panel this morning made a pitch for doing what they referred to as low-cost, high-impact simplification proposals. Well this is a high-impact, but it's not a low-cost simplification proposal.

[408] But, if you don't start to look at some of the fundamental issues that lead to significant complexity in the present law system, you're never going to achieve true simplification.

[409] Some have argued—I know Deborah mentioned this and Phil does, too, that you may need to adjust tax rates in order to maintain the distributional neutrality of the present law system, if you repeal the individual AMT.

[410] I just want to point out, if you're a single taxpayer in a low-cost state and you don't have any children, you don't want to be on the receiving end of that distributional neutrality adjustment, because the rate increases are going to affect you and you don't get any benefit from repeal of the individual AMT.

[411] So, it's something to keep in mind, it's okay to talk about distributional neutrality, but just keep in mind that there are winners and losers when you make an adjustment to rates as a manner of achieving that neutrality.

[412] Finally, I'd be interested in hearing what Russ and Bob have to say. It seems to me that because repeal of the individual AMT is so expensive, that it may be necessary to start approaching repeal on a piecemeal basis and try to do it in increments, but it just may be too difficult to achieve in one single legislative package.

[413] MS. PECARICH: Thank you, Mary.

[414] Don Kiefer?

[415] MR. KIEFER: I agree with the problems that have been pointed out with the AMT. I'd like to tell you that I brought a solution to it with me today, but I didn't.

[416] I think that probably over the next couple of years, the individual alternative minimum income tax is going to become known as one of the biggest policy problems we have to deal with in the income tax. It's effect, in terms of the number of taxpayers that it will affect is going to grow enormously.

[417] Our estimates are that post EGTRRA, the tax bill adopted earlier this year, the number of taxpayers that will come under the AMT now by the end of this decade is about 35 million. The figure given earlier of $36 billion in revenue brought end by the end of the decade has now grown to $135 billion.

[418] Our estimates are that the cost of repeal is upward of $600 billion over the ten-year budget horizon. That's going to grow as soon as we move into the next year, and the budget window extends out to 2012 rather than 2011. That will grow, probably, by another hundred plus billion dollars.

[419] So, this is an enormous issue. It's not one I think that the political system will deal with easily. But it is acknowledged and recognized that the tax affects now will in the future affect many, many people it was never intended to affect in ways that it was not intended to affect them.

[420] So, it is something that I think we have to deal with. We're in the unfortunate situation that there's no longer any money on the table for dealing with issues like this. We're not looking at surpluses anymore. We're looking at deficits as we look into the future. And there is a strong political distaste for increasing taxes on anyone. Given that combination, it's very difficult to deal with an issue like this that is extraordinarily expensive.

[421] But I think conferences like this and anything else the professional community can do to begin building awareness of the issue; and begin building awareness among the population as a whole, that this is an issue that's going to have to be dealt with, and that the solutions will not be pleasant and will not be popular, is an important step to getting to the point where we can deal with it.

[422] MS. PECARICH: Thank you, Don.

[423] Our commentators—I'll let you rotate, why don't you start first, this time, Bob, and then Russ, and then next time we'll reverse it.

[424] MR. WINTERS: I guess I'd have to begin by saying that it's not as though Congress is unaware of what's coming with the AMT, particularly with what the House tried to do when bills passed earlier this year.

[425] There were systematic attempts made to try and hold folks harmless with each of the changes that were made in terms of rates, the marriage penalty, the child credit, but I think the other panelists correctly noted that cost is part of the problem here.

[426] It's very expensive—it certainly was very expensive even before last spring's tax bill—to try and shoot for complete repeal. I think the more fundamental problem that I see looking forward, aside from the revenue which is clearly an issue, is the whole set of norms that permeate the income tax.

[427] People tend to forget that the way we got into this position was folks thinking that some people did not pay enough that some preferences ought to be identified as preferences and removed. There were progressivity or equity or economic income arguments, whatever you want to use in particular instances to justify these things, knowing that they're built into the code, they're part of the baseline.

[428] When you start thinking about what the best solution might be, folks would certainly say repeal's the easy way out. But then you resurrect all of those normative issues again, I don't think any of us who spent more than, you know, ten years looking at this process and remember how we got here to some degree, can expect those arguments to be easily resolved.

[429] As soon as you talk about repeal, we'll be right back having people say, "Well, that's not his real income. He makes too much money. That deferral's inappropriate." The normative judgments you have in the income tax will only move back toward complexity, or at least keep us from being able to achieve the results we might otherwise achieve, unless we can find a very easy source of revenue for total appeal.

[430] Anyone who thinks this is something simple to deal with, even putting the money on the table, I think, really ought to take a close look at the economic stimulus debate underway today.

[431] If you look at the arguments about the corporate AMT, in large measure, they are the same arguments that led to its creation in 1985 and '86. People saying corporations should pay taxes. This complicated system should be there as a backstop against the regular income tax. The argument hasn't changed.

[432] In fact, it's the same group of people making the argument. I think it's the norm as much as the revenue that contributes to the complexity issue. Some people want certain things out of the tax code, and they use the norm to justify the complexity. That's not going to go away simply by finding the revenue.

[433] MR. SULLIVAN: I agree with everything Bob has said. Let me just supplement with a few other comments. I think Congress will ultimately deal with this issue, as one of the panelists point out, as it begins to affect a higher percentage of our American taxpayers.

[434] I think there are going to be some compliance issues prior to that time, as it does begin to affect more middle income taxpayers. I also think that we're kidding ourselves if we think that repeal of the individual AMT has achieved the political ump to actually become law.

[435] I think we saw this very clearly this past spring in the tax bill. If we think there is a better opportunity than what we faced last spring for dealing with the individual AMT, I'm not sure what those parameters are. We had $1.35 trillion to distribute as tax cuts.

[436] The problem was, George W. Bush did not run on a platform of eliminating the individual AMT. Why did he not? Because he thought that a platform and a campaign of lowering rates was more popular. So, that's what happened.

[437] Most of the members on the Finance Committee on both sides of the aisle would say they support repeal of the individual AMT. But when it comes down to actual decisions ab out allocation of tax-cut funds, most if not all chose differing provisions than reducing or eliminating the AMT.

[438] I was privileged to be in many of the conference meetings on the tax bill this past year, this past spring, and saw decision after decision where the choice was to put significant revenues in reducing the individual AMT, or reducing rates further or quicker. The choice, clear, reduce rates lower or quicker. This was not just on the Republican side.

[439] On the Democratic side, the choice being education incentives that we're about to talk about, or putting more resources into reducing or eliminating the AMT. The choice? Education incentives, pension law reductions. The Democrats made the same choices.

[440] So, until we figure out a way to mobilize more grass roots where the members, from talking to their constituents, feel like dealing with this AMT is more important than these other policy initiatives, we won't have significant adjustment in the individual AMT.

[441] MS. PECARICH: Thank you.

[442] Now Professor Schenk will introduce the topic of education incentives for us.

[443] MS. SCHENK: Let's do that by another thought experiment. Let's return to Mary and Joe Middleclass, the couple with five children.

[444] Let's just assume that market forces and learning for learning's sake is just not sufficient to direct their disposable dollars towards education. Or let's assume that they save all those disposable dollars toward education and it's not quite enough.

[445] So we say to Joe and Mary, "The federal government would like to help you out. We want to tip the balance in your decision whether to send your kids to college. Now we could do that by subsidizing universities." A great idea! "Or we could devise interest-free loans, or we could just send you a check. But, no, we want to do this through the tax system.

[446] "The trouble is, we're not sure what's going to work, so we're going to try everything. We're going to offer you a menu of education incentives. But unlike a Chines menu, you can't necessarily have one from column A and one from column B. It depends on which you choose.

[447] "Presumably, you'll choose the combination that gives you the most bang for your buck, but sorry, you'll have to figure that out for yourself. So, Joe and Mary, you can choose among the following:

[448] "You can consider contributions to an education IRA, or you can consider contributions to a qualified state-tuition program, or you can pay tuition and take the HOPE Credit, or you could pay tuition and take the Lifetime Learning Credit, or you could borrow and deduct the interest on a student loan, or you could borrow and ask your children to take a public-interest job when they graduate so the loan will be forgiven, or you can take a job which will give you excludable education assistance, or you can purchase an education savings bond, or you can withdraw funds from your regular IRA to pay tuition, or you can just hope that your children win scholarships so they don't have to worry about it."

[Laughter.]

[449] MS. SCHENK: Although much of this complexity of education incentives is due simply to the sheer number of options, the provisions themselves are really quite complex, and their interaction adds a good deal of complexity. I've outlined all of this in the paper.

[450] This lack of uniformity creates significant transactional complexity for taxpayers, or at least theoretically it does. It's extremely difficult to keep track of the various expenses, and to calculate the benefit provided by any given provision. Calculating which benefit is most beneficial is almost impossible. I strongly suspect that the average person simply doesn't do this.

[451] The Joint Committee staff recommended a number of simplification provisions. For example, they recommended adopting a uniform definition of qualifying higher education expenses because that qualifies for the benefit varies widely across this provision.

[452] They recommended combining the HOPE Credit as a Lifetime Learning Credit. They recommended repealing the restrictions on the use of education tax incentives, based on other incentives and various provisions being used. Taking as a give that Congress should encourage education by subsidizing the cost for certain taxpayers, the initial inquiry should be "is this the best way go to about it?" What evidence do we have that we are getting much incentive gain for the complexity buck? In order to sensibly figure out whether tinkering is a better approach than outright repeal we need to know the extent to which these various provisions are being used, and how they've changed behavior at the margin. I strongly suspect that for the truly poor, the tax system has virtually no impact on the decision whether to spend for education, because they are unable to use any tax incentive other than the exclusion for scholarships.

[453] As to the middle class, it's hard to know whether behavior actually changes, or whether the subsidies are simply provided for those who would save in any event. I give you several examples in my paper where I think it's highly unlikely that there will be any change of behavior at the margin. If this is true, the provisions seem inefficient to me, and it seems the complexity is unwarranted.

[454] Second, since the Joint Committee staff did not want to make policy calls, it did not recommend combining the education saving incentives into a single program. As the staff rightly points out, a number of decisions would have to be made with respect to the design of a given program. Given the current existence of multiple options with long-term effects, there will be serious transition questions, as well, such as how to avoid windfalls and losses for current savers. But similar issues are faced whenever incentives are eliminated or changed, and if this transition issue is allowed to carry the day, then simplification is a lost cause.

[455] Absent a willingness to consider policy changes, the JCT staff decision to recommend the combination of the HOPE and the Lifetime Learning seems abouot as far as it could go in this direction. I suggest that it might be worthwhile to consider combining other programs.

[456] The staff also recommends providing a uniform definition of qualifying higher education expenses, and this strikes me as imminently reasonable. Once again, it doesn't make much difference what the definition is, so long as its uniform, since most simplification would be obtained from consistency rather than any particular definition.

[457] The staff recommendation to provide a uniform interaction rule would clearly eliminate transactional complexity. It would not only enable taxpayers to take full advantage of the available incentives, but it would increase the likelihood that decisional complexity would not scare them away. But curiously to me, this seems to involve a policy question of the sort the staff usually avoided. Perhaps it's clear from the maze of overlapping rules that Congress intended that the same expense could not qualify under more than one provision. But this is just another way of asking the extent to which Congress wanted to provide education incentives. Was Congress simply trying to provide a lot of options? Or might it also have been trying to provide a lot of incentive. The only sure way and the simplest way to determine that would be for Congress to design one or perhaps two education programs that provide the extent of the incentives that Congress deems appropriate.

[458] MR. MANN: Well, again, I largely agree with Deborah. I think this "grab bag" of targeted tax incentives that we have doesn't reflect any generally agreed to notion about what it is that ought to be federally supported, or are these programs subject to any kind of rigorous scrutiny for effectiveness, administrative cost or appropriate coverage.

[459] I wonder if the better thing to do is not just to start all over again, but either go the direction that Deborah suggested of two different subsidies through the tax code, or what I'm more inclined to believe it would be better to do, is to have a direct grant program or loan program for the people who need the assistance.

[460] I think the way that this system is designed now, you're probably just transferring money from one middle income person to another.

[461] MS. SCHMITT: Well, Deborah alluded to the fact that one of the principles that the Joint Committee staff employed in developing simplification recommendations was that we would not make a recommendation when we felt that the underlying policy of the provision was being altered by doing so.

[462] That's the reason I'm going to digress from education for one minute, just so you'll understand where we were coming from. There was a reason for this decision, two reasons, really. One, they didn't believe that it was part of the mandate, the statutory mandate, that we received in the IRS Restructuring and Reform Act.

[463] But second, we thought that if we started down the path of exploring possible simplification recommendations that would alter policy decisions that had been made, that we would have to explore whether alternative tax systems would be preferable to the current system, and we did not believe that that was within our charge under the statute.

[464] I'd also, if we had gone down that path, we wouldn't be having this conference today, because our report would still be probably 18 months from publication.

[465] Education was a difficult area for us, because we had trouble deciding whether all of the education provisions were the result of underlying policy decisions that had been made.

[466] Ultimately, we decided that we could make some simplification recommendations. We recognized that they were relatively modest. But we did also note that there is a variety of saving incentives for education, and that consideration ought to be given to trying to find a way to consolidate and make more uniform those incentives.

[467] So, we didn't avoid the issue, we just didn't feel we could go down that path.

[468] MR. KEIFER: Well, I think anybody who has looked at this area has to come away with a sense that it's an area crying out for simplification. I remember a briefing earlier this year as we were preparing Assistant Secretary Mark Weinberger to come up for one of the markups in front of Ways and Means Committee.

[469] In that particular briefing, we were focusing on the education incentives. A couple of the lawyers on our staff spent probably 20 minutes to a half hour going through all the details of all the incentives.

[470] At some point the briefing stopped and we all just broke out in laughter. We couldn't really believe how complex it all was. Maybe crying would have been a better response.

[Laughter.]

[471] MR. KEIFER: But how anyone sorts through these things and tries to figure out what they ought to do and what's the best approach is beyond me.

[472] I think Deborah's right. That probably some of these incentives don't serve their intended purpose. I think she's probably right that a lot of people don't understand how they relate to each other, and probably make sub-optimum choices.

[473] The difficulty is in trying to get consensus on what ought to be done to change the bewildering group of incentives that are there. Because, as Mary refers to, there are different people who prefer different incentives, and have put them forward for one reason or another and trying to get consensus is difficult.

[474] In terms of—I think Deborah's also right in defining the transition issues that it's difficult, but you have to get through it. Because in the transition, you can have winners and losers. That's something that's difficult for the political system to work with.

[475] It's easy when you've got a lot of money on the table, and you can simply raise everyone up to the highest level, so that there are no losers, there are only winners. When you don't have a lot of money on the table to deal with, and the only way to simplify is inevitably wind up with some winners and some losers, that's a lot harder. So we're right back to the money issue.

[476] I do think that this is an area where you can sort of start small and move through to the larger issues, and certainly focusing on trying to come up with a uniform definition of qualifying expenses seems to me a place that's very logical to start the process. So I would hope that some progress could be made in that area.

[477] MR. SULLIVAN: Let's be a little provocative. I disagree with the panelists.

[478] Let me give you a disclaimer here that in 1996 and '97 I worked for Senator Bob Graham, and actually drafted for him the original 529 proposal that is now currently embodied in the law. Let me give you a little background, but I'm going to make a statement, first.

[479] In contrast to the individual AMT, we were—Senator Graham, Senator Moynihan, nor Senator Baucus, in the time I worked for them had received a single letter or communication from any constituent saying he had too many choices for these education tax incentives for us, "Would you please simplify it so we have less choices?" Not a single communication.

[480] So, let me tell you the history of why I think it's so complex. I don't disagree that it's complex. I think this is a case of federalism at work, and particularly in the Senate.

[481] In the same way that Congress struggles, and I guess as currently— most recently struggled with respect to transportation funding as to whether states were going to decide how transportation funds are going to be spent within their state, or Members of Congress are going to designate exactly how those funds are going to be spent.

[482] I think we've seen the same thing in the education and tax area. During the '70s and '80s when tuition inflation was fairly high, a number of governors called for the federal government to increase the federal support for education at the higher levels, at the collegiate level.

[483] We even felt like there was not an adequate response, probably because budgets were tight here in Washington. What happened then was the evolution during that period of the state plan, where states designed their own plan for their particular state. The co- RAINs became popular and flourished, to a great extent.

[484] So that when President Clinton proposed the HOPE credit, while that was geared at one purpose, which was assisting those who are currently going to college, there's a whole 'nother group of people that Members of Congress were concerned about, and that is those whose children are aged three, four and five.

[485] So, the ideas to deal with those issues sprang from both the state programs, making those programs attractive from a tax perspective, tax free, and the Coverdell Education accounts' idea of a national fund in which one could save for college.

[486] The dynamics here were that over the long haul every one was successful, including the states whose state treasurers like Mary Landrieu, who set up the Louisiana program, and ultimately came to Congress to the Senate, and so supported those incentives while other people, Senator Torricelli and Senator Coverdell, supported these other ideas.

[487] That's why we have the mishmash that we do right now, and I think it's a logical evolution, based upon how the federal government responded to the issue, and the power of the states in this context.

[488] MR. WINTERS: I guess it's my turn to be agreeable, as much as that's out of character for me.

[Laughter.]

[489] MR. WINTERS: For some of us who are a little bit older, and can remember having to pay that tuition check out of our own pockets, it's still a struggle to realize that a once auditable personal expenditure is now to be filtered by the tax system.

[490] It's a brand new area in a lot of ways. I still have trouble understanding why I didn't get to deduct it and other people might. Having passed through that, though, I think if you look at the various incentives that are in the code today, they were obviously structured with different classes of beneficiaries in mind.

[491] We have folks who have current tuition problems. You've given them some deduction. We have folks who are trying to accumulate resources, which is where the whole idea of the—we call it, the "Coverdell IRA" comes in, with the savings initiatives that you get with the bonds. Really very different groups of people, and as I think Don suggested, it's going to be a while before we sort out how all of those things work together to conclude who the winners and losers in each class happen to be.

[492] As uncomfortable as it is, I'm going to have to agree with Russ on one thing that he said about Senator Baucus' mail because I think it tracks what Chairman Thomas gets.

[493] Nobody complains about a multitude of opportunities in the tax code. I don't think in the time that I spent in Mr. Thomas's personal office that we got a lot of folks writing to him about things they could choose from. It never really happened. And because the territory is so relatively uncharted, it may be a while before people decide at the political level, what an appropriate simplification or complexity reduction might be.

[494] Until that time, we're going to have these things on the books, and so far, people seem to be quite happy about them. Or perhaps just simply not fully aware of their options. We don't know yet.

[495] MS. PECARICH: Well, I'll reserve comment on that until later, but yes, I think that's right. We don't know enough.

[496] Our tax topic is personal interest, and Deborah will lead off, again.

[497] MS. SCHENK: So one last time let's visit Joe and Mary Middleclass. True to their name, they're classic middle-class Americans, which means they borrow to finance consumption, their home and even occasionally to acquire investment assets. They've owned their farm for 20 years and it has appreciated in value. The local banker has convinced them that now is a good time to borrow on that appreciation, and their local stockbroker has told them they should buy stock or bonds now while prices are low, even if it means they need to borrow.

[498] Joe wants to finance the purchase of a $20,000 tractor. Mary wants to purchase $10,000 of stock and $10,000 in New York State Thruway bonds, and they both want to take the entire family to Disneyworld, which will set them back $10,000.

[499] So, should they take out a home equity loan? Should they put the house at risk? Should they borrow against the farm and put their livelihood at risk? Should they buy the stock and bonds on margin? Should they just go with whoever gives them the best pre-tax interest rate? Can they figure out the after-tax interest rate?

[500] Only the answer to the last question is clear. The odds of their calculating the best after-tax interest rate are exceedingly small since some interest is deductible and some is not. Which is and which isn't depends on how they finance their purchases.

[501] Joe and Mary will either stumble into the right answer, will blunder into the wrong answer, or will simply deduct it all, because they can't figure it out.

[Laughter.]

[502] MS. SCHENK: Complexity with respect to personal interest arises because of two fundamental problems. One is the failure to accept an over-arching theory with respect to interest, which results in limitations on the deduction of some interest and not others, and a failure to accept that money is fungible.

[503] A system in which some interest is deductible and some is not is doomed to failure, because money is fungible. Since there's no way to eliminate game playing. No matter how complex the rules are designed to prevent it, it's going to happen. Thus, transactional and rule complexity are given here.

[504] A simpler approach would be to permit the deduction of all interest or to prevent the deduction of all interest. The latter clearly is not going to happen, since everyone would agree that deducting investment and business interest is normative; and the former is probably not going to happen because of revenue concerns.

[505] So if we take it's a given that not all interest dollars are the same, despite the economic dislogic of that statement, we must be able to distinguish between the good dollars and the bad dollars.

[506] The Joint Committee staff made no recommendation with respect to personal interest, although it did have a good discussion of the issue. It's very easy to criticize the approach taken by the Joint Committee staff. The interest rules are so unbelievably complex, you couldn't find anything to simplify?

[Laughter.]

[507] MS. SCHENK: On closer examination, however, I don't think that criticism is warranted. Unlike the education incentives, where I think there are piecemeal approaches that could be taken, it's very difficult to figure out what to do with interest.

[508] With respect to tracing of interest, it's not clear that any alternative is preferable to any other alternative. It's clear that the tracing incentive currently in the regulations doesn't work.

[509] But proportional allocation, done properly, would not be any less complex. Stacking would probably be simpler, but would permit significant tax arbitrage, even where the borrowing and tax- favored asset were linked. It's not clear to me that simplification is a more important goal than limiting arbitrage.

[510] Any change with respect to the home mortgage interest deduction that might cut back on the deduction does not appear worth the time to discuss. So I have nothing to say on that subject.

[511] Home equity indebtedness might appear to be insupportable on its own, but in fact it's closely linked to the deduction for acquisition indebtedness. Once interest on acquisition indebtedness is deductible, inequities can be created if home equity indebtedness is not treated similarly. There are significant allocation problems that arise in connection with the refinancing of a principal mortgage if you don't deal with home equity indebtedness.

[512] There are a couple possible of simplification options that might be on the table. One derives from the fact that complexity results if the taxpayer's home equity is less than $100,000. In that case, the interest is limited to the debt equal to the difference between the fair market value and the outstanding debt. Fair market value is obviously subjective, and it seems to me there's a good deal of evidence that home equity loans are granted without regard to the value of the home. Just as another experiment, I went to my local bank and stated the fair market value of the home and asked what kind of loan I could obtain. Without blinking an eye, I was handed—I didn't really take it, but I was offered a loan that bore no resemblance to the fair market value of my home.

[513] The Service doesn't have the manpower to question the value, so it seems to me that now that the indebtedness might be capped at $100,000 without regard to the equity in the home. This is clearly another way of just permitting a deduction of consumer interest on up to $100,000. I admit, without any obvious policy justification, but it's clearly simpler than the current rule. Another possibility is to cap the amount of interest rather than the amount of debt.

[514] Another proposal warranting attention, which the Joint Committee staff considered but apparently rejected, would be to aggregate investment and personal interest with a single ceiling. You could substitute for the home equity deduction a provision that would permit individuals to deduct personal interest, plus investment interest, up to the amount of their investment income from the year.

[515] Another possibility is to allow them to deduct interest up to an amount—a flat dollar ceiling. This kind of proposal could be justified on the basis that money is fungible and therefore interest is fungible, i.e., it's impossible to determine whether a taxpayer who has investment assets—who has investment assets, has borrowed to finance the holding or the acquisition of consumer purchases.

[516] Objections to this proposal usually center around carry over rules, that is, we presume we carryover investment interest, but not personal interest, and therefore, we'd still have to distinguish between them.

[517] A simple alternative would be to consider a proposal like this, but with a flat carryover of all interest or no carryover at all of interest.

[518] MS. PECARICH: Thank you.

[519] Phil?

[520] MR. MANN: I think Deborah's paper and her remarks today demonstrate the truth that there is no difference between personal interest, investment interest, home mortgage interest—they're just interest. Interest is a share of the revenue stream to which one party who furnishes capital to another is entitled. It ought to be taxed to the recipient, but we've made some policy choices in the code where we do not tax certain kinds of interest, or at least, not currently.

[521] So I think if there's a problem with interest, it's on the income side, it's not on the deduction side. I think it requires a very simple math proof to demonstrate that denying an interest deduction is just unfair to people who have to borrow capital by comparison with people who already have capital, and I wouldn't do that.

[522] Now, perhaps Deborah's right, and no one follows the rules. So you don't need to get too worried about it, but I wouldn't bet on that, and I would particularly not bet that there aren't people out there in the taxpayer community and the tax preparer community who don't try to figure out these complex rule, which I think are just totally inappropriate.

[523] MS. PECARICH: Mary?

[524] MS. SCHMITT: Well, I think Deborah has done an excellent job of summarizing the issues on interest. I will say that if anyone has tried to get through our full study, I applaud you, and I think that it would take years to read every word.

[525] Certainly it's all written in dry Joint Committee style, so you don't really get a flavor for some of the internal debate that we have on particular issues, and it would have been nice if we could have highlighted some of the issues got us all really agitated and required us to have some very heated and spirited debate, and finally, ultimately we asked Lindy to come in and make a decision that would help us move along.

[526] Interest was one of those areas. The other one was—the particular one that comes to mind—was repeal of the two percent floor for miscellaneous itemized deductions.

[527] But, you know, if we could show the report, we probably had blood stains on some of the pages where those issues came up.

[528] MR. KEIFER: I do think Deborah's done a good job of laying out the issues here. Anyone who has looked it knows that all the rules relating to treatment of interest in the tax code are very messy.

[529] But when you try to sort through it and figure out what do we do about it, it's also very difficult to get from here to there. And some of the notions that underlie the various treatments in the tax code, even though they may not be entirely logical or consistent, are deeply ingrained, and you confront those every time you try to sort through what we might do about the area. So, it is a difficult problem.

[530] I would also say, in our work on simplification at the Treasury, for one reason or another, this is an area that hasn't received a lot of interest. There's a lot of concern about a lot of areas of the tax code in terms of simplification. I don't know whether this is one that the people thought about it long enough, or just simply had given up or thrown up their hands, it just doesn't seem to be the most pressing area. But it is one that sort of lies below the surface, I think, in terms of the real attention focused on simplification.

[531] MR. WINTERS: I'd have to agree with the last commentator. This isn't an area that a great deal of attention and the only thing I can attribute that to is, frankly, that we've had the home equity rules in place now for what, 15, 16 years. People have adjusted to that approach to personal interest.

[532] We don't hear an awful lot of complaints from folks who can no longer deduct the interest on their credit cards. If it's not there, one wonders what the reason for that might be. It would basically be that people are content with the system they've got in front of them and don't worry about the rules.

[533] MR. SULLIVAN: The interesting thing to me has been the tension between Members of Congress who want to promote savings in lieu of promoting debt, and the fact that incentives for both have somewhat flourished since 1986, when there were some cutbacks.

[534] We've seen that on the savings side with the pension provision, or some of the education tax provisions and medical savings accounts. But we've also, when we faced the education bill this year, we enhanced the deduction for student loan interest. Again, we see progress on both sides in the code.

[535] MS. PECARICH: Thank you, and thank you to the entire panel for a very thorough discussion of the issues we were assigned. So, thank you all.

[536] We have a good 15 minutes for questions, so I hope you will come up and ask them. There's a microphone, a couple of them, in the audience, if you would like to ask one or all the panelists a question.

[537] The person who is taping has asked, also, if you would identify yourselves for purposes of the record.

[538] MR. LIFSON: I'm not getting up to leave, no.

[Laughter.]

[539] MR. LIFSON: I'm David Lifson from New York City. On the AMT issue, it seems to me that a great deal of the $32 or $40 billion, however it turns out to be, of money that would be raised through the AMT, a preponderance of it—although I don't have the resources to prove this—is from the non-deductibility of state and local taxes and real estate taxes.

[540] It seems to me that this is a little bit like the three percent disallowance of itemized deductions, which I think, most tax practitioners have managed to tell their clients that the top rate of income tax is about —just less than 41 percent on unearned income, and 42 percent on earned income, rather than explain to them how Congress got to those percentage tables.

[541] So, part one is that it seems to me it would be much simpler and probably not radically different to simply have a real 41 and 42 percent rate, and not have a three percent disallowance of itemized deductions.

[542] And if it's too complicated to have two systems, maybe the real issue here is letting government decide whether the state and local deductions are in the future going to be deductible. Maybe we just eliminate the regular tax system and use the AMT system. It's much simpler.

[543] Any comment?

[544] MS. PECARICH: Who would like to respond to that?

[545] MR. WINTERS: Are you sure you're from New York?

[Laughter.]

[546] MR. WINTERS: The reason I say that, in jest, is because the New York folks were among the most—how does one say this, politely—striking advocates of regular tax deductibility of state and local tax payments during 1985 and '86.

[547] The AMT had already looped those things out, so we are where we are in part because on the regular tax side the folks in the New York area were very committed to retaining the deduction. I don't know that anyone in Congress has ever speculated about the value of raising rates to take care of the high-tax states' AMT problem, nor do I expect to be alive when that happens the first time.

[Laughter.]

[548] MS. PECARICH: Mary, did you want to add—okay.

[549] Dick?

[550] MR. LIPTON: It is Dick Lipton from Chicago. Actually, I was going to pick up on what Dave Lipson said, although I think Bob covered it in part. It was very interesting the way he phrased it, being a New Yorker.

[551] From the New York perspective, to eliminate just the state and local income component of the AMT, works wonders for the people from New York, but those of us who live near Peoria, where we pay almost no state income tax, find nothing broken in this part of the AMT system.

[552] And then my one real concern, and I sort of address it to the panel at the AMT level, is that if you pick out one or two pieces, and especially if you pick up as Mr. Keifer said, that you're going to need to be winners or losers, if you just are focused on something like this state income tax component, you're going to be doing something good for individuals in New York and California, but something bad, potentially if you fix it by the rates, for individuals throughout the rest of the country.

[553] That's one of the reasons why when I thought about the AMT, unfortunately, it sort of pushes you to the—you have to go after the whole salami to try to fix, because then at least the winners and losers will be averaged out a bit.

[554] I'd be curious what our congressional commentators might think about those points.

[555] MR. SULLIVAN: I would say I think that's why the best opportunity for AMT reform was in this past spring's bill. Because we had the capacity to not create winners and losers, but in one area where we may create some winners by eliminating an AMT preference or the entire AMT would also include other provisions that benefitted those that did not benefit from the potential provision.

[556] And the absence of those revenue sources, I predict it will be much more difficult to accomplish those goals.

[557] MS. PECARICH: Mary, did you want to comment about winners and losers, again? I think you made that remark.

[558] MS. SCHMITT: No, I made the point before that trying to address distribution neutrality through rate changes we certainly would have winners or losers. Certainly trying to achieve offsetting revenue will have a similar effect, and that's what makes it so much more difficult to achieve.

[559] MS. PECARICH: Bob?

[560] MR. WINTERS: I think I'm the one guilty of making the winners and losers comment. I also think that conferences like this are helpful because it begins to create the awareness that this is a problem.

[561] I think it goes back to something Russ said: that if you put money on the table and you ask Members of Congress what they're going to be willing to vote for, dealing with the AMT lost every time to all of the other items, rate cuts, education benefits or whatever.

[562] I think the reason for that is that most of the 35 million taxpayers who are going to be paying the AMT in 2010 don't know that they're going to be paying it, and they're not aware of the difficulty and complexity they're going to come under.

[563] There are very few, relatively few, people paying it now. When people become aware that they're going to be paying the AMT, suddenly the alternatives and what we might have to do in a policymaking sense to deal with it in creating the winners and losers becomes much more viable.

[564] So, we can either go down the road a fair piece and let a certain percentage of those people begin paying the AMT and suffering the pain, and their neighbors beginning to realize that they're going to be in the same situation in a year or two, if they're not now, or we can try to create the awareness before we get there.

[565] But it's difficult to create a constituency for giving up pain in the future instead of resolvling pain today. That's why you don't get a political consensus to deal with it now.

[566] MS. PECARICH: Don, can I clarify your earlier remarks about the estimates that are being done since the 2001 act that increased the cost of repealing the AMT so much in the future.

[567] I'm guessing that's primarily because of the rate reductions that are being phased in over time. Would one possibility be to phase down the AMT rate at the same time? Was that ever discussed?

[568] MR. KEIFER: Well, I mean, there are lots and lots of possible ways to deal with it. They're all costly.

[569] Phasing down the AMT is one way to deal with it, but it still costs money. I mean, none of them are cheap. I mean, when you look at all the options and you begin looking at who the winners and losers are, it's a different picture, depending on how you do it.

[570] Then you could wind up with equity considerations, distributional considerations as well. So, there are a lot of alternative ways to deal with it, or partially deal with it. But it's hard to decide which way you go until you begin building your consensus.

[571] MS. PECARICH: Deborah?

[572] MS. SCHENK: I just wanted to add that there's sort of a flip side to what people feel is the pain argument, which is that the revenue estimates go up dramatically as time passes.

[573] So, as time passes and more people feel the pain, you're also collecting more revenue and the addiction problem—meaning Congress is addicted to the revenue—also gets harder each year as we wait, too.

[Laughter.]

[574] MS. PECARICH: I wonder if it reminded anyone in this room of the Windfall Profits Act?

[Laughter.]

[575] MS. PECARICH: Now we understand their point of view better.

[576] Yes, Jay.

[577] MR. STARKMAN: I'm Jay Starkman from Atlanta, Georgia. We had comments here about the—out from Mary on how the education programs got to be so complex, how everyone got their particular pet project enacted.

[578] We had Russ tell us that he's never received a single letter complaining about too many choices in the education credits. Bob said that nobody complains about a multitude of opportunities.

[579] How—this is standard that people will not complain about complexity, and they will not send a—because they get a benefit from it and they will not send a letter saying. "The tax law is too complex, let's simplify it and take away some of my benefits."

[580] How is Congress going to stay focused on tax simplification? Given that there's the pressure for making the laws complex, there's no downside from getting complaints; and how do you weigh this fact that you don't get any complaint level? You obviously feel that it's important that you don't get complaint letters.

[Laughter.]

[581] MR. SULLIVAN: Honestly, in the short term, I think that it will be the answer that Congress won't deal with this in the short term, but over time, Members do pay a great deal of focus on the administration of these provisions and evaluating them. I think we rely to a great extent on Treasury and IRS' assessment of whether people are actually benefitting as intended here, and there will be a number of Members who are very interested in that.

[582] I think there will be another issue that forces looking at these provisions that has to do with the interaction between the tax incentives and our higher education grant and loan programs. I'm not sure any of us are quite clear about the interaction and overlap of those provisions, and I think we will, hopefully, in the next couple years see some studies to see if we are actually providing sort of a relative parity of benefit to people from the low income, middle income and other income areas with respect to higher income—or higher education costs.

[583] That will, I think, provoke an examination of these and may lead to some simplification and coordination, both tax and non- tax.

[584] MS. PECARICH: That's an interesting, Russ, and I—to clarify my thought when Bob was talking about the education incentives earlier and saying that, at this point at least, people don't realize, maybe, that they have all these choices. But in any case, they're not complaining about it.

[585] I think it's really critical that you all continue to press the IRS to provide you the statistics that you need to look at these things post-mortem, if you will, to see what the claiming rate is, whether they're the people that you think would be claiming them. Which ones they're using. Because I think that would be very valuable information in terms of what's having any effect, if you will, in Deborah's analysis.

[586] MS. SCHMITT: I'm gong to make one point.

[587] One of the things that we looked at in the course of our study, and Lindy alluded earlier to it in her remarks, was that we were seeing the increased use of tax return preparers. There's been a substantial increase in the use of tax preparers over the last ten years.

[588] The other big increase is in the use of computer software for tax return preparation. And some people have suggested that using computer software really masks for individuals the complexity of the individual tax system. And then in reality, many individuals don't understand the complexities with which they're faced because they've got Turbo Tax or some tax preparation software that's helping them through the process.

[589] I do my own tax return every year, and part of the reason that I do it mainly is just to remember how hard it can be, and you know, it's sort of unfortunate because I think in trying to develop a constituency for simplifying the current system, the people that you need to be there, the individual taxpayers, writing letters to Members of Congress. You know, over time, that may become less and less of a problem.

[590] You know, I sort of wonder whether people even understand how the AMT is affecting them, as more and more number—the number of people who get thrown into it, if there is a computer software to prepare their returns.

[591] MS. PECARICH: A fair point.

[592] Yes?

[593] MR. LICKMAN: David Lickman from Dallas.

[594] I find this conversation fascinating and I'd like to really talk to Bob and Russ, because I understand it would have been easier to have solved this problem in the spring of last year, whenever the big cut took place. But that's passed us. We can't do anything about that.

[595] It seems to me we have a disaster waiting to happen. Maybe it's not going to be next year or in the next three to five years, but if he's right, 35 million taxpayers are going to be subject to this, and then there's going to be an avalanche of questions coming in.

[596] My question is, you know, my experience tells me that you can't win something with nothing up here. What are y'all going to be about it at that point in time? I mean, what would you advise your Members? I mean, when you talk to your Members and they say, "Well, we're not going to do it now," what are you going to tell them they're going to be doing five years from now or ten years from now?

[597] Because it seems to me that's when—and the real problem, it seems to me, is that everybody virtually agrees that something should be done with this. I mean, you know, if it's phasing it down, or if it's doing something to solve the problem.

[598] But I'm just curious what you see five years from now, how to solve this problem, without winners and losers, or without a huge revenue loss?

[599] MR. SULLIVAN: I think it's a cousin to the Social Security debate. It's the same concept that we know that there's a baby-boom, a time that an avalanche is coming in the future, and the Members would all say, "We need to prepare for that. We need to do some things with respect to Social Security or retirement savings, or our health programs," or whatever, for our retirement years, but have a great deal of difficulty reaching consensus on those issues, because they are so far out into the future.

[600] I think this is another one of those kinds of issues—I know I haven't answered your question. I'm trying to think of something that has happened during my tenure here that was predicted, you know, 10 or 15 years ago that we faced. Give me a few more minutes, maybe I'll come up with something.

[601] MR. WINTERS: A little different position than Russ'. Chairman Thomas has been an advocate of overall reform, with the understanding that we're probably going to have to make tradeoffs as part of the new system. He's been very interested in shifting the system away from an income tax, to a more rebateable tax that would make us more competitive in our overseas markets.

[602] That would require us to do away with and exchange things in the current code for a new system, and that's the approach he's been thinking about trying to take.

[603] If we stay with the income tax, it's not just the AMT that we're looking at. There are other problems out there, particularly for those of you who do business returns. We still have capitalization issues we haven't come to grips with. We have a wide variety of things out there that permeate the code that really ought to be addressed, and the only way to really get down and deal with them is probably to get into another reform debate, and to do it relatively soon.

[604] Absent that, you're waiting for additional revenue, and frankly that means that some people are going to propose doing things that most of you would deeply, deeply, deeply dislike.

[605] MS. PECARICH: I really don't want to end on that note. Oh, thank you, Gene.

[Laughter.]

[606] DR. STEUERLE: I just wonder if we got our history lesson right. I say this reluctantly, but you know, in the '70s when I first got into tax policy, I was always told how we needed more revenue, we needed more revenues, we had to give more things away and that's how we were going to buy reform.

[607] If you go through the history of the '70s, we hardly got any reform. Then in the '80s, when revenues were really tight and we had a big budget problem, there were all sorts of tax reform, and it wasn't just tax reform in '86, a lot of it was led by Bob Dole in '82 and '84 on a variety of areas, because revenues were tight.

[608] The lesson that I learned on this was that, when things were really tight, Congress was almost more willing—and maybe even the administration—to do the things, you know, in a more fair and equitable way than they were when the times were loose, which has in this day, tended to act more like they're on the expenditure side of the budget and just sort of get money rolling, like in the story we had on these education cuts.

[609] "Well, you know, if we can have 10, maybe we have 11, maybe we can have 12." And the issue of whether it was fair or even didn't work out. So I wonder if we really got our history lesson right on, we have to buy our way to reform?

[610] MS. PECARICH: Russ?

[611] MR. SULLIVAN: I guess I would point out, and correct me if my history's wrong, but I think that President Reagan, when he ran for re-election in 1984, made a strong emphasis on reform, and that was a central part of what he said he was going to do in a second term.

[612] We've had a number of Presidential candidates run on the platform that they're going to reform the tax code, simplify it, eliminate it. offer different proposals like the flat tax. Those candidates have not won.

[613] I think reform of this kind of magnitude requires a President who has committed to it in the campaign, and follows through, then, when in office; and that's the next reform could happen.

[614] MS. PECARICH: Okay, then, on that note I guess we do have to conclude. Before we leave the room I have some instructions for lunch, but Bob has to leave, so, let's give the panel a hand, please.

[Applause.]

[615] MS. PECARICH: Lunch is going to be served in this room, buffet style. They're going to set up in the back. So we're asking that you move all of your papers to on your chair, or under your chair, to make room.

[616] Chairman Thomas is scheduled to join us for the Luncheon Address, immediately following lunch.

[Recess for lunch to reconvene at 1:40 p.m.]

[617] MR. LIPTON: We are very pleased, and it is my pleasure to be able to introduce Chairman Bill Thomas, of the House Ways and Means Committee, as our luncheon speaker.

[618] But before I introduce him, I do want to emphasize the bipartisan nature of tax simplification that we've been discussing today. We've not only fortunate enough to have members of the staff representing members of both parties on the panels, Senator Baucus, obviously Democrat, who chairs the Senate Finance Committee, sent his regrets, but he has sent some remarks, which are included in your materials.

[619] But, we're particularly pleased that Chairman Thomas was able to take time out of his busy schedule today to join us.

[620] Bill Thomas is a Republican from Bakersfield, California. He represents California's 21(superscript: st) Congressional District. He was elected to be Chair of the House Ways and Means Committee beginning this year. Prior to his election as Chair of the committee, he served as Chairman of the Ways and Means Health Subcommittee, where he was instrumental in the passage of the Health Insurance Portability and Accountability Act of 1996, as well as the author of the Medicare Preservation Act.

[621] In 1998, Chairman Thomas was appointed Administrative Chairman of the National Bipartisan Commission on the Future of Medicare. Throughout his congressional career, Mr. Thomas has been recognized for his legislative effort to eliminate the federal deficit and he's been awarded numerous awards by "watchdog" groups in that capacity.

[622] He is married, has two grown children, and most importantly, he has been committed to the cause of tax simplification and for that reason, if not for many others, we're very pleased to have him here today as a speaker.

[623] I promised his staff that he would be out of here in 20 minutes. The rest of the time is his.

[Applause.]

[624] MR. THOMAS: I noticed the bio said, "grown children," not financially independent.

[Laughter.]

[625] MR. THOMAS: We can measure the one, but the latter may never ever occur. Some of you are more familiar with that state than I am.

[626] Yeah, you know, I'm really jealous. If I actually wrote this stuff down, I could have sent a speech instead of showing up. So, I get penalized for not writing this stuff down.

[627] I'd like to address you in a general sense, for just a couple minutes, and then throw it open to questions so that we can maximize the use of our time, and I can try to respond to what it is that is on your mind. If somebody gets up, and in your opinion, asks the main question and is not doing what you thought should have been done, it's not that person's fault, it's yours. Because you didn't get up and ask your really good question that should have been asked, that you're determining somebody else should have asked, so, it should have been you. Okay, those are the ground rules.

[628] All right. This stuff gets so far off track so quickly, it's sometimes helpful to start talking about something else, entirely, before you start talking about taxes.

[629] For example, the idea that reforming the tax code is a bipartisan effort is so far out for me that I'd have to really think about it for a minute or two. So let's talk about something I'm really familiar with, and that's building race cars.

[Laughter.]

[630] MR. THOMAS: Because there's an old adage in building race cars that, no matter how much you want to try to avoid, you cannot. It's kind of like physics. I went to a class where it was metaphysics, and I got to a point where I finally said, "Okay, deny the wall and start walking." Because at some point you've got to confront reality, and then the guy gives me the impetus, more space than matter; and if we can do this, and if we can do that. No, no, no, no.

[631] Deny the wall and start walking. If you're going to build a race car, what people want is a race car that is fast, reliable and cheap. And the answer every time is, "You can have two of the three. Which two do you want?" But you can never have all three.

[632] I got started, formally, in this business on the committee when somebody came up to me and said, "We're going to re-do the tax code. We're going to have fairness, simplicity and growth." The answer at that time should have been, "You can have two of the three, but you can't have three."

[633] And here we are holding conferences still talking about doing things in ways that aren't going to happen, and we're making requests in ways that won't produce what you say it is you want to produce. One of the difficulties is that we have a tax system that deals with taxation on a different number of things, entities and the rest.

[634] Now if you go back to the very beginning, the Ways and Means Committee is probably the most appropriately named committee in the House. Our job is to figure out ways of separating people from their means.

[Laughter.]

[635] MR. THOMAS: That's what we do.

[636] Once we decided that means was going to be a personal income tax, you cannot avoid dealing with morality, societal norms, the desire to change the world, and we've still got people today saying, "We shouldn't use the tax code to try to affect behavior." Well, what the hell do you think you do?

[637] When you say, I'm going to tax income at this point and not others, what would be appropriate points of taxation. So if you really want to get into this business, you have to go back to square one, the real square one. Which is, what is it all about? It is a wall. It's a reality that the government has to raise revenue to carry on the functions that the society believes are appropriate that government carries on. Okay? We've got to raise revenue.

[638] It doesn't say you've got to raise revenue in a stupid way that you've got to raise revenue that does you damage and not your competitors. That it is confiscatory. That it is demoralizing and all of the other things that the current code is about. None of that is required to raise the revenue for the government to do the kinds of things that society thinks it should carry out.

[639] In fact, if you were really smart about it, you'd try to figure out a way to get that money in the least painful, least damaging, and most rewarding for us against them—and I don't care who "them" is. It's always us against them. Them changes. Us should not.

[640] But what happens in our tax code is, that "us and them" becomes "us," and it separates us and we wind up fighting over each other, and half the battle's a political class warfare on who gets taxed. We don't need to do any of that.

[641] It really diminishes our ability to reach our goal, which is to maximize the ability of individuals to do what they want to do in a way they want to do it with what it is that they've produced. So, you say, "My God! We can't go back that far." Fine, we don't have to go back that far.

[642] Alternative minimum tax. Let's choose individuals to begin with. The Tax Reform Act of 1985, reason for change. The committee believes that the minimum tax should serve one overriding objective to ensure that no taxpayer with substantial economic income can avoid significant tax liability, by using exclusions, deductions and credits. Although these provisions may provide incentives for worthy goals, they become counterproductive, when taxpayers are allowed to use them to avoid virtually all tax liability.

[643] The ability of high-income taxpayers to pay little or no tax undermines respect for the entire tax system, and thus, for the incentive provisions themselves. In addition, even aside from public perceptions, the committee believes that it is inherently unfair for high-income taxpayers to pay little or no tax, due to their ability to utilize tax preferences. Man, is that a loaded paragraph.

[644] Why don't you just go back and get rid of the exclusions, the deductions and the credits. Then you wouldn't have to create an alternative minimum tax. Did you ever hear a physicist now talk about the way the world is where you have matter, because they're so hung up on the basic, conceptual arrangement which created matter? The other stuff they keep bumping into is called what? Anti-matter. Now what in the hell is "anti-matter?" It's what matter isn't.

[645] So why would you go to an alternative minimum tax, if your current tax system is unfair, inappropriate, leaves perceptions to people actually using the credits, the deductions and exclusions that are law and in the tax code, and wind up not paying taxes? So we've got to have a completely different tax system for them, although it wasn't completely different. Look what happened with the '93 bill and the rest? The two are marching in different directions.

[646] To the point now that to correct them, you're going to have to find a half trillion dollars. This is so fundamentally different a taxing structure, which is doing more damage, when all you had to do was realize you couldn't have all three, and that you were going to have to do the kind of thing that's hard to do, and that is address it realistically, and make the changes that need to be made.

[647] That if the credits, although worthy in some instances, aren't worthy for high-income people, or that the incentives were incentives for some and not for others, then, go in and change that and you would never, ever have gotten us into the situation that we're in today.

[648] So when you're talking about simplification, don't accept the ground rules. That is, you've got to start with today's bill and try to figure out how to simplify it. You don't have to.

[649] Now when it comes to corporate taxes, that's a whole 'nother ball of wax, which has as its predicate, somehow, fictitious people, and created the deal with the question of liability. And how you get other people to be able to pool their money without saying, "The hell with you! I'm not going to take that kind of a personal risk," suddenly becomes, not a fictional person so that you can create an economic structure, but a person that you can tax to raise revenue.

[650] It doesn't work. Because it isn't what people have said it is. That wall is there. Now I know theoretically you can get me through it, but I— and you know I see—I like "Star Trek," but that's fiction. That's fiction. The problem is, the personal AMT is real. Corporate tax is real. And we did it.

[651] So, one of the ways in trying to change it is maybe not to deal on the margin and play with modest adjustments that simplify. If you simplify it, it may not be fair. If you try to meet simplification and fairness, it may not produce growth in any combination of the three. You cannot get where you need to go, if you accept the premise, we're going to play with what we've got. I accepted that a long time ago.

[652] So, when I talk to people, I talk about, you know, the classic argument is to pull the entire IRS Code up by its roots. I refuse to believe that it is a living thing. Okay? That's anthropomorphic. It ain't living. People who are working deals for their own causes and got them in there didn't have somebody else in opposition to them, because they had a higher goal.

[653] So when you get everybody adding this up, you get into real problems. The answer is, at some point, can we say, "Time out. Let's take a look at where we are, and let's not be phoney and assume that we aren't about making sure that we get taken care of?"

[654] But, look, here's depreciation. I guess at some point it made some sense. Now I know why there's a third of a century in there for private property. Because I was in the room when it was done. You know why? Because that was using an accordion to figure out how much revenue we needed to fill the slot. How's that for theory.

[655] I mean, you go to college kids, and you say, "The reason it's that much is because that's how much revenue we needed." That's how we built something as serious and responsible on how long you've got to carry on the books the write-off of something that's essential.

[656] And so, look, what is it that you'd love to get rid of in the code that doesn't make any sense? That doesn't meet anybody's normative standard or any of the others? Okay? And how are you willing to be taxed to replace that revenue? And how is a smart way to do it that doesn't inhibit your ability to go out and do what it is that you tried to do?

[657] How many people can we get together to talk about where can we get replacement revenue to get rid of the dumb stuff, with the understanding that we have got to have the revenue to make the decisions in the government, but you help us tax smart, and then see what the two piles look like.

[658] To the degree we can aggregate two piles of revenue—remember revenue is what we're after—to the degree we can aggregate two piles of revenue. One is dumb, current law, and the other one is smart and where we need to go, then, let's go.

[659] Of course, the argument is, what's the standard for where we need to go? How about things like international competitiveness? I mean, that's a bit better measuring stick. Now, you notice I've left out individual income tax.

[660] If you want to do normative stuff, then let's just only screw up one portion of the tax code.

[Laughter.]

[661] MR. THOMAS: That is in the entire tax code.

[662] When you found out they were successful in these other areas, let's go back and visit that and I think you'll find that we can make some significant changes there. Because the government's going to get its money. Remember? Two things are certain in this life, death and taxes.

[663] Then we ought to build a tax system which is based upon what we say is inevitable. We will get our money. Don't get it in the way that discourages others from doing things that create a larger pot for all. That's what the income tax does.

[664] There are other ways of having counting posts by which you say you owe money. This event occurred. You owe money. Obviously, we create taxable events. But using income as the key taxable event ain't smart.

[665] I'll end on this. We've been fighting world wars. One of the things so devastating about September 11 was we had it actually occur on our shore. Look at what's happened to most of the rest of the world because of wars. They lost their industrial capacity. That's bad. We re-built it for them with the newest, available technology. We didn't get to do that. They had to reinvent societal relationships. Japan had to reinvent itself.

[666] Sometimes we wonder if hidden in these facades of restructuring of business relationships if the old Japanese culture and society isn't more manifest there than serves us well—and maybe that's true, but they got to reinvent those. We never got to reinvent anything.

[667] We've had to reinvent, kind of akin to rewiring an aircraft carrier while we're conducting airplane landings. On our industrial, we're able to do that. Change the way in which we had our industrial base, modified it, did a whole bunch of other things.

[668] The one thing we haven't addressed, because of all those hangups on normative, it's fundamental that we do away with our tax code. Nobody else has declared they a hundred years ago. You say, "We don't have one." Yes, we do, except we just have more of it.

[669] You know, we've gone from three pages of the 1040 form to 35, to 117. We've gone to a thousand forms. We have the same fundamental structure. We ought to change it.

[670] How's that for a 15-minute time limit.

[Laughter.]

[671] MR. THOMAS: Okay, anybody. Question. What do you want to know of me, out of me that I know that you don't get to know unless you ask me a question?

[672] So, all I'm saying is, think big. Look for more fundamental stuff. Think about making bigger changes. Don't say, "Oh, we can't do that." Yes, we can. You know why? We have to. If trade is going to be the battleground for the 21(superscript: st) century, which I believe it is, we are totally disarmed, both internally and internationally.

[673] Why in the world would we take a product that we make or service we deliver and embed in that product our social welfare costs? Social Security and Medicare, embedded in the product, because of the way we structure it. And those dollars for our social welfare costs are embedded in that product no matter where it goes, because we didn't have a tax system that gets to reverseit at the border.

[674] It goes wherever our product goes. It goes on the shelf in Germany. Now, the German product, built in Germany, has their social welfare costs in it, as well. So we have an equal competition. Right? Oh, no, because the Germans, i.e., the "you," slap a tax on top of that at the border to cover their social welfare costs that we have to carry that their product doesn't.

[675] A German product comes to the U.S. There's our product, with the social welfare costs embedded in it. The German product gets its tax rebated at the border. Then it comes into our country and we don't attach a tax to it. So they have a tax advantage over us on our own shelves.

[676] And so we complain about the Japanese. We complain about the Germans. We complain about everybody else. But the people responsible for the taxes embedded in our products on our shelves, that's us. We just have to get serious about it.

[677] To the degree people went about it because it's immoral, it's a normative, people should be doing this. We can't change it because it's not fair. Then, we're stupid and we lose. We've got to get serious about how to raise revenue to run this government, and the services people ask for, in the least painful way possible. You couldn't design a worse system than the one we now have in dealing with that.

[678] Still general, and not specific. You guys have no specifics. Okay? Behind closed doors, we'll try to negotiate some specifics coming out of the stimulus package, because I thought one of the things that might be useful, which would at least strike a small blow for freedom, is if the alternative minimum tax is stupid and doesn't make a lot of sense, we ought to get rid of it.

[679] I can get rid of it at the corporate level for about $25 billion. I can't get rid of it on a personal level for less than half a trillion. So, which one do we do? We do what we can do.

[680] Our goal will be to try to get rid of the corporate AMT in the stimulus package. Other people are saying, "Gee, we shouldn't do that. We should be doing other things." Every time we have a chance to strike a blow for freedom, you ought to. The question's whether or not they're going to let us do it.

[681] So, if you folks would talk about all of the subsets of things that you do, and I know a report is going to be issued and you're going to collect all the good ideas, and then nothing is going to happen. If you would just take all those ideas, save the trees—on one sheet of paper say, "There are a lot of things that we thought would simplify the tax code, but between now and when Congress leaves this session, getting rid of the alternative minimum tax for corporations would be the one measurable simplification that this conference came up with, and is urging Congress to deliver up."

[682] And then we'll figure out other things you can do the next time you meet. Maybe we can rifle-shot this thing into some fundamental change.

[683] Good luck to you. More importantly, you guys wish me good luck.

[Applause.]

[684] MR. LIPTON: Thank you very much. We know you have a time limitation, but thank you, Mr. Chairman.

[Applause.]

[685] MR. LIPTON: I think we should have our third panel of the day come up. I believe the agenda goes straight into the panel. Is that correct? I don't have may agenda in front of me. That's correct.

[686] Could we have the third panel, then, come up please?

[687] MR. MILLERICK: We're going to go ahead and get started.

[688] Good afternoon everyone and welcome. My name is Rick Millerick. I'm from Freddie Mac out in McLean, Virginia. I'm also the chair of the TEI's Corporate Tax Management Committee. Welcome this afternoon.

[689] This morning we focused and ended on simplification in the context of individual taxation. This afternoon we're going to turn our attention to the context of business taxation.

[690] In the first session of the afternoon, we're going to focus on three particular topics, cost, capitalization, what have been called by many people, "INDOPCO," issues, cost recovery or depreciation, and the corporate AMT.

[691] But before I get any further along, let me introduce our panel. In the interest of time, I'm going to keep the introductions brief. So, if you want more information than I provide, there are bios in the handout materials.

[692] In no particular order, David Weisbach, a Professor from the University of Chicago Law School; Jerald Cohen, from Sutherland Asbill & Brennan, and former IRS Chief Counsel from 1979 to 1981; Brian Meighan, an Accountant from the Joint Committee on Taxation; Pamela Olson, Deputy Assistant Secretary, Treasury Office of Tax Policy; Drew Lyon, Deputy Assistant Secretary, Treasury Office of Tax Analysis; Mark Prater, the Senate Finance Committee Republican Tax Counsel; and John Buckley, House Ways and Means Committee, Democratic Chief Tax Counsel.

[693] We're going to use a slightly different format for our session than the last—than our predecessors. Rather than sort of going from individual to individual with prepared remarks, what we're going to do is ask David Weisbach to introduce the three topics of capitalization, cost recovery and AMT. Take about ten minutes to do that, and then we're just going to have an interactive panel discussion on each of those three topics, allocating about half an hour to cost capitalization, five or ten minutes to depreciation, and 10 or 15 minutes to AMT. At the end we anticipate having about 10, 15 minutes left for questions.

[694] So, with that, let me turn it over to David.

[695] MR. WEISBACH: Okay, so, Rick has given me ten minutes to do all of capitalization, all the depreciation and the AMT, which shouldn't be a problem. He also made me promise not to say anything to Brian, as far as the comments I'm about to say. So, he's promised to let me be outrageous, and I will try to do that, as well.

[696] While I'm the academic up here—and I can fulfill that role quite well—let me start by saying I'm not going to say much about the AMT. We happen to have Drew Lyon on the panel. Drew has literally written the book on the corporate AMT. When I was asked to write some more about it, I started reading his book and decided I had nothing else to say, so I'm not going to say too much on that at all.

[697] Let me turn briefly then to capitalization, which is where I focused most of my efforts.

[698] I could start with a discussion of current law, but most everyone nowadays—knows a lot about current law, probably more than I do, so I'm not going to spend any time describing current law. But let me talk about what my conclusions are when I evaluate current law, which is that it's a mess.

[699] Let me be more specific about that. I think there are really four problems with current law. The first is the obvious one, which is there's a high level of administrative or compliance costs with current law. We see as the evidence of this the high level of audit activity and litigation activity.

[700] The Treasury Department has said that in some industries 25 percent of all exam resources are being used on capitalization issues.

[701] The second is the law is extremely uncertain. Capitalization is not my area of expertise, and I only began studying this about a year ago when the ABA asked me to look at this issue, and I can tell you coming in, whenever I look at a set of facts, I could never guess what the outcome of the case was. No matter how hard I try, I would always be wrong. I could never figure out why cases came out the way they were, and I imagine lots of people have this same experience.

[702] The law is also extremely complex. When you try to write down what the doctrine is, you learn that it's something that is unbelievably byzantine. You have distinctions that don't seem to make sense, and you have exceptions to distinctions and exceptions to the exceptions to the exceptions. It's unbelievably complex.

[703] Finally, the issue that concerns me a lot is I don't think it really clearly reflects income. There are many costs that have long-term benefits that are expense. There are many things that have relatively short lives that end up being capitalized and never depreciated. So, there are examples of items that are significantly over taxed, and items that are significantly under taxed.

[704] So, to the casual observer like myself, the current law seems almost random except a lot worse because it's extremely expensive, as well. So there's a lot of room for reform here. I think the government Bar should focus on fixing these flaws. There is almost certainly something relatively simple and something relatively certain, and that reflects income better than current law.

[705] Chairman Thomas said that we can fix a few things but not everything. You can have two out of the three. I think we can do just a lot better than current law. We can just have an improvement fixing on almost every ground. We can be simpler, more certain, and better reflect income. I'd be cautious, however, about a proposal that doesn't make things a lot simpler.

[706] For example, look at the INDOPCO Coalition proposal. It is an extremely good effort. It fixes some things. It makes the system more certain. It essentially codifies current law, to some extent, and overrules a few cases, but it comes close to codifies current law.

[707] Well, if you think current law is too complex, then what you end up with when you codify current laws is an unbelievably complex proposal; and I think that shows when you look at it. It's 50, 60 pages long and it's unduly complex. If you want to focus on fixing all the flaws in the current law, you've got to focus on simplifying.

[708] Another way of thinking about that is that there's no pure simplification—no pure simplification here in the sense the Joint Committee report had, which are things we could fix that didn't really hurt anybody where there weren't any real policy choices.

[709] I think in INDOPCO you've got to make policy choices. You've got to decide what's going to be capitalized and what's not; and that it's going to hurt some people and help others.

[710] All right, with that introduction, let me just briefly talk about some of the economics of capitalization and then talk about a proposal.

[711] I have two hypotheses about the economics of capitalization, which I think are somewhat surprising, at least to a lot of people, and they are as follows: the first one is that there's much less at stake than capitalization than you might initially thing.

[712] I'm sure everyone knows the basic equality which is that an immediate expensing of an item with a long-term benefit which is equivalent to exempting the return on that item from income. That makes it seem like there's a lot at stake in capitalization.

[713] If you deduct something as a long-term benefit, you're choosing not to tax it at all. But it turns out there's much less at stake than you might initially think. The reason why is that, if you decide to capitalize something, it turns out you're still not taxing very much.

[714] The recent developments in the economics of income taxes show that in fact all that you get, when you capitalize something, when you tax it under an income tax, is taxation of the risk-free rate of return, and in our case also inflation, because we don't allow inflation adjustments.

[715] Inflation is fairly low now. It turns out, historically, that a risk-free rate of return is extremely low. Which means that taxing something under an income tax system (that is capitalization) doesn't end up picking up that much; and that means we may not care that much about being particularly accurate.

[716] Now what's the intuition behind this conclusion? If you have assets with risky returns, and assets with low-risk or risk-free returns, and you impose a tax, an income tax, individuals, or corporations can adjust their portfolios of those assets or projects in such as way as to eliminate the tax on the risky return. This conclusion has been used to justify a switch to a consumption tax, but it also has implications for a capitalization decision. We don't have a lot of money in trying to be accurate.

[717] The second economic conclusion, which I think is also somewhat surprising, is it turns out durability doesn't matter. We care as much about capitalizing one-year assets as 30-year assets. I think this is extremely counter-intuitive, at least it was to me when I first came across it. What's the reason why it's true? The relevant measure in terms of measuring distortion in the economy from getting things wrong is the effective tax rate on an asset. That's what determines deadweight loss from taxing something incorrectly.

[718] The effective tax rate, it turns out, changes exactly the same way for a one-year asset as for a 30-year asset when you go from deducting to capitalizing and depreciating it, which is as it goes from the effective tax rate of zero to the full statutory tax rate, if you economically depreciate it.

[719] So the deadweight loss or the cost of getting it wrong is just as much for one-year assets as for 30-year assets. Therefore, we can't have a system and we don't want to have a system that necessarily biases toward short-term assets.

[720] This was extremely surprising to me, but after thinking about it for a while I'm convinced this is correct, and therefore fowe should be careful about getting it right for all different assets, or assets of all different durabilities.

[721] Let me add two footnotes to that. I'm an academic, so I'm allowed to do lots of footnotes. The first one is that it may be harder to identify certain assets, assets of, say, short-term durability; and therefore, once we add administrative costs to the balance, we may be more justified in allowing expensing or a different treatment for short-term assets than for longer-lived assets. But that's why we have to think about it—because of the high costs of identification rather than because of lower benefits to capitalization.

[722] We should care as much about getting it right for these short-term assets, capitalization is equally important. It's only a question of costs of identifying these things or getting them right that would make us have a different type of regime.

[723] The second footnote is that we can't allow expensing of items just because they're recurring. The recurring asset is wrong. Consider a business with another dollar to spend. That is the business is considering a marginal investment. Suppose they have two things they could spend the dollar on, an asset that's capitalized because it's not recurring and a recurring expense which is deducted. The recurring expense is more attractive because of taxes even if it would not be absent taxes.

[724] So you end up with distortion in business behavior—businesses picking things that are not smart choices—absent taxes—if you now allow expensing of recurring items. expenses. So I think the recurring expense theory is not correct. I'm happy to say the U.S. Freightways case, which came out about a month ago, now confirmed my views on this by rejecting the recurring expense theory.

[725] Those are the economic propositions. I've got about two or three minutes left, so let me discuss the proposal that is consistent, or roughly consistent, with these economic propositions. There are many proposals that one could come up with that are consistent with these ideas. I don't have any pride of authorship about this one. I'm happy to have other proposals, but here's an idea.

[726] The idea is we ought to have a list of items that are capitalized and everything else should be deducted. Only items that are specifically listed as a capitalized item are capitalized and everything else is immediately expensed. We get rid of the facts and circumstances test, altogether.

[727] We also have a cost-allocation rule that determines what costs are associated with the capitalized items, so we have the rule on that similar to 263A, but maybe much narrower. The rule that tells you what the costs are that go with something. Finally we have specific recovery periods.

[728] That is, we would replace facts and circumstances depreciationn like we have now in section 167, with rules like those in section 168. You'd have specified recovery periods rather than facts and circumstances.

[729] Within that sort of general framework, then, we can break things them out into a variety of different categories. One category might be with the separate and distinct assets, so we would have some definition of separate and distinct assets. A cost-allocation rule, I think we should follow or codify something like Idaho Power. I think that makes sense. And then, for anything that is not currently covered in the 168, we'd have to have specified recovery periods.

[730] A second category would be things I call "extraordinary transactions," these are things that are sort of not part of every-day business, things like mergers or extraordinary workforce restructurings. In these cases, we can identify these assets relatively cheaply. Because we can do that, we should do so. We should capitalize the cost of those assets, and then provide a specific recovery period for them.

[731] And finally, I have a rule for repairs. That would just be something like the ADR safe harbor for repairs. I think that proposal is relatively simple and breaks up the world in a relatively reasonable way. As I say, there are other ways to do it, but I just put it forward as a starting point.

[732] MR. MILLERICK: Well, thank you. That was right on time, too. It was exactly ten minutes.

[733] As I earlier suggested, we're going to throw the floor open to the panel members. Does anyone have any response to the wild- eyed academic here?

[Laughter.]

[734] MR. COHEN: One thing—is this on? Now is it on? That sounds too loud.

[735] I'm one of the very few clients who determine capitalization determinations as the economists think that they do. You really look at what their needs are, first, rather than whether they're going to be able to amortize something or depreciate something over a short or longer period.

[736] So I don't totally agree with everything that's being said. I like one thing, of course, and that is the shift on INDOPCO to say that expensing is the norm. I think that's probably—actually more realistic, and I like having the default period.

[737] One of the major problems have been, the battles that go on in the capitalization where there is no useful life, or maybe determinable useful life, which you can use so your default periods really work out. I don't know if you can get there simplifying into just a few categories. Because then the battleground's going to shift into trying to get things into the shorter-lived categories.

[738] You may—it may be true that the length of life has a very little number attached to it. But nobody out there believes that. So the perception is absolutely the opposite. So you've got to take that into account, if you're thinking about simplification.

[739] I guess that's enough.

[740] MR. BUCKLEY: One question. Who would make the list? I mean, if the list were made by the Internal Revenue Service, you would have a certainty, but not necessarily a result that everybody in the room would like.

[741] MR. WEISBACH: I don't think it could be done by statute. The the world changes too quickly for Congress.

[742] MR. BUCKLEY: That's interesting. In the 168 rules right now, there's actually revenue procedure. But somehow it seems to be invalid, because Treasury doesn't seem to be willing to go out and change it, even though they issued a report a year ago saying it's completely outdated.

[743] MR. WEISBACH: That's because Congress set forth the lives.

[744] MR. BUCKLEY: For certain things. But in 168, the few statutory items, most of them are done by cost life, which is set forth in the revenue procedure.

[745] MR. COHEN: Well, it was done.

[746] MR. WEISBACH: They've been precluded from amending the Rev. Proc. by Congress.

[747] MR. BUCKLEY: Oh, is that right?

[748] MR. MEIGHAN: Yes, and to some extent, it's an unhappy system, where the lives are really out of line with the economic, and it seems you wouldn't want to create that kind of situation when you get into capitalization. You need to have a flexible system.

[749] MR. WEISBACH: What I was thinking about is what I had envisioned was that Congress should give Treasury some regulatory authority. I think that Treasury needs to be able to overrule cases in order to write a decent set of regulations.

[750] Because if they have to sort of draw the line at the bottom of what one of our crazy, wild-eyed court has done, at the lowest possible level, then Treasury I don't think can write reasonable regulations, other than switching to a consumption tax—which is fine by me, but I don't think that is what is on the table.

[751] So I think that what Treasury is going to need authority in order to be really effective. But I'd rather see this done through regulations or revenue procedure than through statute.

[752] MR. MILLERICK: Yes?

[753] MS. OLSON: I guess I would note that section 263 right now does seem to give the Service considerable flexibility. But, if you read the words of section 263, they're really quite limited in terms of looking at what's required to be capitalized. Section 263 refers to structures, equipment and permanent improvements. Yet we've taken permanent improvements to the point where we argue that even a fee paid for a license that extends a few days beyond the end of the year is something that should be capitalized.

[754] I think that there's quite a bit of room under section 263 for the Service to write regulations, and I really think it's incumbent on us to use the authority under 263 to make some changes to the rules, so that we do clear up these problems.

[755] I thought, David, that you did an excellent job in the papers that you've prepared. Your paper on this topic summarizes just how confused the current state of the law is; and it's clear to anybody who reads these cases why we have so many disputes over what the right answer is in this area.

[756] I also think that the Joint Committee really did a service with its discussion of simplification. One of the things the Joint Committee's simplification study points out is that if a subject is the subject of dispute between taxpayers and the IRS, we have a subject that needs to be simplified. That's clearly what we have with the capitalization issue.

[757] And I do think that the burden is on Treasury and the IRS, at this point, to try to make some sense of the case law. We have, over the past few months, seen an awful lot of disagreement among the courts with respect to a number of different issues, including capitalization issues.

[758] What those differing cases illustrate, to me at least, is that litigation can be hazardous. I think it's hazardous, as a general matter, to try to use the courts to write the rules. If we think that we need rules, we ought to do that through the rulemaking process or the legislative process and not through the courts.

[759] In the case of capitalization, I think we have quite a bit of flexibility to act through the rulemaking process to set out what those rules should be. There could be a problem if we try to write rules that run counter to a case that has been decided, and in that instance, it's possible that we would have to come back to Congress and say, "We'd like you to give us some authority to reverse a court decision."

[760] But right now, I think we have considerable authority to act, to prescribe rules for capitalization for the things that really matter, to focus on the assets that we can identify, to focus on the costs that can be captured without tremendous administrative costs, and to prescribe rules that accomplish these objectives. That's part of an effort that we have underway right now.

[761] Over the course of the last ten years or so since the INDOPCO decision was handed down, we tried to establish rules in a couple of different ways—one by revenue rulings and revenue procedures, and the other by taking cases to court.

[762] The problem with continuing to address things on a situation by situation basis, as we have done with the rulings and the revenue procedures, is that we never get to a point where we have a consistent set of principles that we can look to for determining from one situation to another how a cost should be treated.

[763] So, I think it really is important that we try to articulate principles through regulations. Then we can go to what Lee Shepherd has termed, "the grocery list," which would be continuing to address specific situations.

[764] But, the first thing I think we need is a unifying set of principles for what we think should be capitalized; and then, of course, another part of that is what you've alluded to, David, about setting out a recovery period for the costs that are to be capitalized.

[765] MR. MILLERICK: Drew?

[766] MR. LYON: I just wanted to comment a little on economics.

[767] I think David makes a good point in that the difference between expensing and economic depreciation is whether you're taxing the ordinary rate of return to the asset. But that doesn't mean that precision or accuracy is totally irrelevant.

[768] I think many taxpayers are concerned that the capitalization rules they have are providing less than economic depreciation. In which case, you're taxing more than the normal rate of return. You're taxing the value of the asset, as well.

[769] In terms of the empirical studies about how important the distortions created by the differential cost rules, one of the studies I contributed to measuring the inefficiencies of the pre-1986 tax law, suggested that about 15 percent of total corporate revenue was—the efficiency loss was equal in magnitude to 15 percent of the corporate revenues.

[770] So, in other words, if you could eliminate that efficiency loss by taxing all assets at the same rate, you could lower the corporate rate by 15 percent, and be no worse off.

[771] Just one final point. Given the difficulty of measuring economic depreciation in the Treasury report discussed last yearj, one thing to keep in mind is that expensing is totally neutral across all assets. That always is an advantage, and the partial expensing proposal that's we've been talking about in the stimulus bill, if it were extended to all assets again, would have that feature of neutrality.

[772] MR. WEISBACH: I just wanted to comment on the Treasury report, and actually Drew's paper, which I have read and studied carefully, which is that, the key item that's causing the distortion in the Treasury report and Drew's paper is the tax is too low on intangibles.

[773] R&D and advertising were the two things you estimated, and advertising is the kind of thing you're talking about here. The study in the Treasury study, showed that the problem is that those things are taxed too low relative to other assets.

[774] So, I think that what that shows is the extent that there's a real problem here to worry about, and taxation of things that we may have taken for granted, at least if we're talking about the economics of this, rather than just the simplification piece.

[775] If we're concerned about deadweight loss, we need to worry about things like that, things we might have taken for granted as lawyers.

[776] MR. MILLERICK: Mark?

[777] MR. PRATER: I wouldn't disagree with most of what's been said here. I think in general, there's an understanding that - at least from our staff's perspective—that this is a difficult area of the law, and something that frustrates people. We do hear about it, periodically, in a kind of anecdotal form. We also have looked at the studies that have appeared over the years.

[778] But in terms of a kind of systematic statutory fix or anything like that, we're talking about a difficult proposition from a lot of angles. But I think that, at least, it's clear that there is some general awareness of the problem; but in terms of business taxation issues; however, , it's not something that rises very far up there on the Members' radar screens at this point.

[779] MR. MILLERICK: Brian?

[780] MR. MEIGHAN: I guess I'd just like to comment on various items and echo some people's comments. I do agree with others that I don't believe this is a legislative fix here.

[781] I think as Pam said, where Treasury issues guidance and they ultimately lose in the court system on a specific item, or if a court case has already come out unfavorable, Congress could assist in providing some type of legislative authority to Treasury.

[782] Irrespective, I think that the problem is so pervasive and broad that a fixed statute is not a long-term solution here. I think the solution is administrative guidance.

[783] With respect to the administrative guidance, I think Pam's comment that general principles of law that Treasury is going to follow would be very helpful. I think it's still going to be very complex for them to come to a solution, but I think it would be helpful.

[784] I also think the specific guidance is helpful, even though, outside of that specific guidance it leads to taxpayers picking and choosing whichever guidance gives them the most favorable answer. Hopefully that's where the general guidance would really help.

[785] If they had a general guidance framework to refer to when they issued the specific guidance using that framework to reach that conclusion, I think it would add a lot of certainty to extrapolating the results outside of the specifics that are covered. I think that's the right solution, issuing both the general and specific giodamce administratively.

[786] Just a couple of comments from David's paper. I agree with a lot of it. I guess the one area where I'm not sure the right solution is reached is with respect to the recurring items. I'll comment at the U.S. Freightways, I guess the sad part of that, to me, is that it was something that lasted six months beyond the tax year, and the litigation costs are just huge on debating this type of activity, and running it through the court system.

[787] Whether it's the right answer or the wrong answer for capitalization, expanding this to say a certain amount of advertising and training, where it gets more nebulous, whether there's actually a specific benefit beyond the year, is not the right answer. I think just keeping that a current expense, even though it may have an economic distortion, would be simpler and be more beneficial.

[788] I guess the only other comment I'd make is that, considering the difficulty in Treasury's coming out with just general principles, it may be very difficult to get the broad set of principles out. I think doing it piece-by-piece would continue to be helpful.

[789] I think that's a fair assessment of what I had to comment on the paper.

[790] MR. WEISBACH: A comment on U.S. Freightways, I thought it was an interesting case. It was actually written by a University of Chicago law professor, so I always think it must have the right outcome.

[791] One reason I liked that is it rejected the recurring expense theory, but it came up with a "greater than one- year" rule. A one-year rule may make perfect sense, but it shouldn't be applied just to recurring expenses.

[792] MR. MEIGHAN: I guess I could make one other comment, too, I think would be important, and that is, David highlights, throughout his paper the accuracy versus complexity, and where do you draw the line.

[793] I think that's not only important from a regulatory and legislatively, but also I think it's important at the agent level where the audits are going. People need to step back to see is it really worth getting into an argument with the taxpayer over a very short-lived asset. Would that bring back down the expended time on compliance with this? For a very short-lived asset, I think it would be helpful.

[794] Since I'm been with the government, I haven't been in the field much, but it seemed like that was a problem when I was out there, that even short-lived items would become very big issues. I think addressing that would be helpful.

[795] MR. MILLERICK: John?

[796] MR. BUCKLEY: Yeah, let me agree with Mark, that I doubt that this is an area for legislative action. And then I'd disagree with David. I think this is probably a bad idea whether it's in the statute or regulation. We need a more flexible system.

[797] The only question I would really have is whether this is not an area where you should start to look at greater book tax conformity. I mean, it does seem that there are certain areas of law where there are not explicit congressional decisions to provide a subsidy or benefit, and that the factual questions—and these are all factual questions. The question is, how to resolve them? Really it should be resolved consistently between book and tax.

[798] And if you're looking at the overall complexity of the system, it seems that whenever there's no really compelling reason to have different rules between the book side and the tax side, one really gets rid of a lot of the complexities to go with a greater book tax conformity.

[799] I would say this with greater assurance if I had any clue of what the rules were on the economy side, but --

[Laughter.]

[800] MR. BUCKLEY: But, since there's not much assurance of what the rules on the tax side are, it seems to me its an area where really Congress could look at that, and you will create competing pressures here that may wash a lot of the litigation out of the system. I mean, people will be forced to, in effect, have their on kind of compromise because it was different on both sides.

[801] So this is one area where I think looking at that is a solution that has some merit.

[802] MR. MILLERICK: Jerry, what do you think about tax conformity?

[803] MR. COHEN: I think that's a great idea. And I also think it's good to get the agents to look at whether the position being taken is sensible.

[804] I had to litigate a case that I thought was not sensible, and we did win. U.S. Freight Ways, I thought it was not sensible. It was not sensible to say there had never been a one-year rule, which I think is what really turned the judge around on appeal, because there had always been a one-year rule.

[805] It's interesting to me that you didn't mention that in your paper. You said you really ought to take into account the burden on business of capitalizing certain expenses and compare that to the benefit, to the fisc of having those expenses capitalized. I think that is something that is really important.

[806] It would be very good to take that into account in industry, by industry basis. The Service now has a program to settle out matters with industries. This was done, recently, with the airline industry in the repair, as you know. That's one approach.

[807] I don't think regs really would be the answer at all. I do think rulings, that a lot of rulings, will help. The rulings coming out after having met with industry people and trying to work this out.

[808] First, book tax conformity could go a long way. It certainly would help the fisc.

[809] MR. WEISBACH: Let me just summarize and actually put a question to the panel, then, because these are both two good questions.

[810] One of them is, book tax conformity, I think that's a great idea, but the standard response always is Treasury can't accede its authority to the FASB or the SEC. In fact, Judge Wood in the U.S. Freightways opinion rejected book tax conformity.

[811] I personally don't think it's that much of a problem in terms of acceding authority. They're both government agencies. There's one government. You know, I don't care who in the government does it.

[812] So I think John's idea is good. I didn't put it in my proposal.

[813] MR. BUCKLEY: I mean, I would suggest there would have to be give on both sides here, but I think if you're looking at complexity and simplification, to have one set of rules rather than two, obviously, is going to be better—no matter how complicated or not complicated the rules are.

[814] Then we'll create—you know, you'll force taxpayers to in effect have their own compromises in their positions because they have competing interests.

[815] MR. WEISBACH: Actually, I'd ask Pam about that. And then my second one is, I want to ask Pam about the industry-specific proposals.

[816] As you know, 168 has different lives for different industries, and the question is whether the same thing should follow for the capitalization decision itself, or whether we should have a more global decision.

[817] And Treasury, in its report on depreciation, didn't take a position on this. In fact, it sort of waffled on it. So I guess I'm interested in Pam's view on book tax conformity versus nationwide issues.

[818] MS. OLSON: Well, first, with respect to the book tax conformity issue, one of the things we're going to be trying to do is to reduce the heat on this issue right now in a way that gives us more options to explore down the road.

[819] Certainly, one of the things that attracts a tremendous of interest on the part of the Commissioner is book tax conformity because it would simplify administration and compliance. But it's important to think about book tax conformity, not just with respect to capitalization expenses, but also with respect to a number of other timing issues that run through the Code.

[820] Over the years we've created increasing numbers of disparities between book and tax income. Apparently we thought that as tax lawyers, tax accountants, or tax economists, we could do a better job of measuring income than the folks who devise the rules for measuring book income despite the fact that they have spent decades—centuries—figuring out how best to measure income.

[821] I think it might be a good idea at this point to go back and question the fundamental premise of the need for us to have separate rules; and I think that to the extent we could move toward greater conformity will be a tremendous help to taxpayers on the simplification front, and certainly to the Internal Revenue Service with respect to audit issues.

[822] I'm sorry, David, I just forgot what your second question was.

[823] MR. WEISBACH: Industries.

[824] MS. OLSON: Industries? Which?

[825] MR. WEISBACH: We had industry settlements.

[826] MS. OLSON: Yes, on the point about having different depreciation lives, depending on asset and which industry the asset is used in, that is true in some cases, but under a couple of recent court decisions, it's not true.

[827] I do think that the closer we could get to uniformity, the better off we would be. Otherwise we get a lot of results that doesn't make sense. We get some assets with a five-year life in one industry, but a 20-year life in other industries. There is that kind of disparity in some cases right now. So, I think that we should try in the capitalization area to drive towards consistent treatment across industries and avoid that result.

[828] I want to say one thing about section 263A. If we had our simplification druthers, we'd get rid of 263A. I wuld prefer not to see those rules principles extended to the intangibles area. I think they're hard enough to deal with when we're dealing with tangible assets such as inventory or structures. They're very complicated rules.

[829] I think that—at least based on the stories that I have heard— companies do their best to try to comply with the section 263A rules, but I don't think anybody feels completely comfortable that they're really complying with 263A. I know from anecdotes in the small business area that there are companies that work with their accountants to come up with some rought approximation of what section 263A requires to be capitalized. For example, they take ten percent of indirect costs and add it onto inventory so they have they tried to comply with 263A. But it's just so complicated that people really, I don't think, ever actually fully comply.

[830] So I would urge us not to look to 263A as the direction to go for determining what costs must be capitalized.

[831] MR. WEISBACH: We have about five minutes left on the time that we've allocated to capitalization. I guess one question that comes to my mind is that I've heard a lot of support for the notion of book tax conformity. Would that be something achievable through administrative guidance? Or would require legislation?

[832] I guess the corollary to that, which may provide the segue into the next topic is, we need—would that encompass book tax conformity for the cost recovery aspect of things, as well as the capitalization issue.

[833] MR. BUCKLEY: Let me say, I think you don't have book tax conformity when there's an explicit decision for a subsidy on the tax side. So, on capital cost recovery you have an explicit decision.

[834] My guess is that you would have to do something by statute to bring the two systems together. That's just a speculation of an old drafter, but others may have a different view.

[835] MR. PRATER: I think there are a lot of rules that would need to be addressed. We have different mark-to-market rules and you would have to amend those to bring them into line with the book side.

[836] MR. MEIGHAN: I guess I'm not sure. I don't know if we'd need a legislative fix or not. My initial reaction was, no, that if you can meet the clear reflection of income standard of 446, that you probably could follow your book tax conformity, so long as there wasn't an exclusive provision requiring you to use it, such as capital cost on the 168. But I'm not sure across the board I feel comfortable saying that you could just do it under the clear reflection of income.

[837] MS. OLSON: No, I think that's right. I think there are a number of other provisions in the Code, section 461(h), for example, comes to mind immediately that would get in the way of adopting it by anything other than a statutory change.

[838] MR. WEISBACH: Well, couldn't you say, I'm going to give you an election—if you follow your books for tax, we won't challenge you. So, issue a Rev. Proc. or a notice or something like that and just do it that way?

[839] MS. OLSON: We had talked about doing something like that on the capitalization front.

[840] MR. WEISBACH: That's what I meant.

[841] MS. OLSON: Yes, we might have the ability to do that but certainly not in some of the other areas where I think it's important to start looking at book tax conformity, as well.

[842] MR. BUCKLEY : I'm going to pitch for the other areas, the tax treatment of derivatives. I mean you have one very complicated system in the book rules, you have another complicated system in the tax rules. There's no explicit congressional policy in the tax rules, and it seems to me that's another area. But you would have to have statutory changes, I think.

[843] MR. MILLERICK: Well, let's switch to the cost recovery aspects of capitalization. Once we've capitalized the cost, how do we recover it?

[844] MR. WEISBACH: I don't have too much to add. There's too much out here. The Treasury report is excellent. I don't know if any of you had a chance to look at it, it's quite long.

[845] It concludes that tax lives don't reflect economic lives but not really having much of a proposal. They said we should try to do this better, but it turns out it's really expensive to figure out what the right lives are.

[846] The main thing that really stood out for me after reading the report was that intangibles are taxed at extremely low rates. The average tax rate of intangibles was estimated to be 3.8 percent, and the average corporate tax rate—I've got it in my paper here somewhere—was in the high 20s or low 30s, 32 percent or something like that.

[847] So, the real distortion, that is, if you want to count the things that are way off the charts, is with respect to intangibles. But in terms of fixing other laws, that is, if you're going to leave to leave intangibles, I really liked Treasury's proposal for partial expensing. I'd rather see partial expensing than accelerated depreciation.

[848] So, if you wanted to do something, I'd rather it be more partial expensing and less accelerated depreciation, keeping overall effective tax rates about the same.

[849] MR. MILLERICK: Any further comments on that?

[850] MR. COHEN: I was surprised at that on intangibles, because you know the thinking of a 15-year life for capitalization was intended to be neutral. Why was that?

[851] MR. WEISBACH: They're initially deducted. Section 197 really applies on the secondary market purchase.

[852] MR. COHEN: Right, but is the rule driven primarily by the deduction of advertising costs?

[853] MR. WEISBACH: The two items in the Treasury estimate, I believe—I wasn't there—I believe, from reading the report, were R&D expenses and advertising.

[854] MR. COHEN: It really is a policy determination in the advertising. Who knows what the life of that is? I think that may be distorted is what I'm saying.

[855] MR. WEISBACH: I guess I would suggest if you are going to capitalize those sorts of expenses, then you'd also want to prescribe a cost-recovery piece to cover the concerns such as you describe, about what is actually the useful life of advertising.

[856] MR. COHEN: Right, right.

[857] MR. MILLERICK: Brian, did you have something?

[858] MR. MEIGHAN: My only comment was going to be on the depreciation in 168. Compared to the capitalization issue, there are very few 168 disputes in depreciation. I don't see a lot of court cases coming across my desk as to taxpayers disputing that.

[859] And I think the one area where there are some disputes, and maybe there's some room for either congressional action or administrative action is that Rev. Proc. 88-22 hasn't been updated since 1988. Congress precluded the Treasury from adding to that, and, as such, there are a lot of issues in the legislative process where taxpayers are coming in and certain industries are getting "nitch" provisions in the code that give them a statutory life.

[860] Some of them weren't in existence in 1988, or they don't fit in the categories that are in the Rev. Proc. and I guess on depreciation, I think that's one area where, either the funds to do the study or to give them the authority to do amend the Rev. Proc. makes a lot of sense. It may stop these "nitch" provisions rolling through Capitol Hill, and get an overall fix as to what are the proper lives now.

[861] But I would say I think 168 in all its complexity works fairly well. There are not a lot of disputes. It's very mechanical, and if you fit into one of the Rev. Proc. categories, most taxpayers only have a few asset classes to deal with. So they have the general assets that's the furniture and fixtures, and then they're usually in an industry category that gives all of their other assets one life.

[862] So I find that somewhat fairly simple, even though the code is rather complex.

[863] MR. MILLERICK: Mark?

[864] MR. PRATER: Yes, I'k like to follow up on what Brian said. We had over the last few years, various proposals, kind of piecemeal changes to specific problems that have come up in terms of lives.

[865] The one that's reoccurring again this year is leasehold improvements. There are proposals with respect to different periods on that, and that proposal has been up many times before. We get various other kind of piecemeal things. For instance, we've look at clarification of natural gas, gathering lines, for instance, amidst some other things, little bits and pieces here and there.

[866] But, like a lot of other things, after a certain period, if these things keep reoccurring, they tend to happen. But again, I guess I'm going back to what I was saying earlier a little bit, there's no—there doesn't seem to be all that much interest in this area. At best there's a general acknowledgment of the frustration the taxpayers face with some of these things.

[867] The fact that we really haven't had a look at this in a long time, and there doesn't seem to be that much interest in a broad, general systematic change, especially when you consider the revenue consequences of some of this. The numbers out there are pretty daunting.

[868] But, again, I don't think it hurts for—at least from the policy person's perspective to continue the discussion and to develop the data. The data right now, as David's paper shows, is pretty lacking. We've got a lot more questions to ask, and a lot more things to muddle, discover and consider, and I expect that we'll spend some time doing that.

[869] I don't know exactly when we'll reach a conclusion on any of these things.

[870] MR. MILLERICK: Pam?

[871] MS. OLSON: I was just thinking as Brian was talking about the fact that—in my experience, at least, the number of disputes in the depreciation area is growing, and I think it's growing for a couple of reasons. The class life of a natural gas gathering system is a good example of that, because there's actually a litigated case—maybe a couple of litigated cases, one that went to a circuit court. It's something that's been in controversy between taxpayers and the IRS.

[872] There are a couple reasons for it. One is the failure, perhaps, to update the Rev. Proc. so that we've got lives that more closely match economic reality. But another issue is that there have been so many changes in business and the way business is done since the Rev. Proc. was last updated.

[873] What was at the heart of one of the natural gas gathering lives cases was that the taxpayer didn't do business the way it had in the past. So, the Service argued the taxpayers' assets belonged in a different class life. There are a growing number of disputes in that area, because of deregulation, or because a business is split up.

[874] We also have a growing amount of uncertainty about exactly where taxpayers fit in with different classes of assets. If we are dealing with a class life that might not necessarily match economic reality anymore, there is a greater incentive for taxpayers to try to move in the direction of shorter class lives, and, of course, the IRS is always trying to put them back into the longer life box.

[875] MR. MILLERICK: Well, thank you. With that, we need to devote the final ten minutes that we have here to the corporate AMT.

[876] Maybe I could suggest, Drew, since as David said, you did write the book, that you lead us off here.

[877] MR. LYON: Well, Chairman Thomas is a hard act to follow on this one, but in some ways, he was easy on it, on the AMT, in talking about the particular details.

[878] From a complexity/simplification perspective, I think again it's an easy case to be made that there's no reason for the AMT. It has the kinds of inefficiencies that David talked about in terms of the asset allocations. Some taxpayers get tax preferential treatment for their investments, other taxpayers don't.

[879] As a result of that the, AMT, I believe is likely to highly increase the amount of tax planning required. Because you don't want to be one of the investors that invest in the tax preferred assets and doesn't get the best tax benefits.

[880] On the individual AMT side, it's analogous to earning a private activity bond that's taxable under the AMT. In that case, you would have been better off just holding a taxable bond at the higher after-tax rate of return.

[881] So I think there are a number of activities that are affected by the AMT. The decision to lease versus own and the timing of when to undertake major investments. The AMT encourages diversification. Rather than being in a specialized industry where you might have all the tax preferences against one basket of income, it's far better to be diverse and spread those tax preferences out among other activities that you might be less qualified to undertake.

[882] So the person that's good at undertaking an activity is given an incentive to sort of not to do that activity, and others are given the incentive to do it.

[883] As has been discussed, more recently in the context of the stimulus bill, some industries tend to be more adversely affected by the AMT than are other industries, because small changes in profitability can easily trigger AMT.

[884] I was trying to think through an example of the complexity, just focusing on the depreciation side. The rules have been changing a lot over the past couple of years, but if you have an asset purchased before 1987, for the ordinary AMT rules, there was no depreciation preference. Different rules were in effect between '87 and ' 98, and then post-'98.

[885] At the same time, the rules governing those ordinary AMT calculations applied for a large period in that history, you had a separate calculation for adjusted current earnings—different rules, in effect, every couple years.

[886] Then on top of that, the depreciation deductions for many purposes have to be capitalized in the inventory. So, all those were depreciated and then pyramided on top of the inventory capitalization rules. And then, finally, for the AMT adjustment for current earnings preference, you're forced to use FIFO inventory valuation kind instead of LIFO. So, I honestly don't know how any taxpayer can in good faith actually make all those calculations and I'm sure many taxpayers don't.

[887] Why you'd set up a law that essentially you don't expect any taxpayer to follow, is a good symbol of complexity.

[888] MR. WEISBACH: One question for Drew. In your book on AMT, it's called, "Cracking the Code." I highly recommend it.

[889] Least of all, we don't need the AMT, but we may need the preferences. If we think the preferences aren't a good idea, we can eliminate them, directly. Since you're making this argument, but no one has a proposal you for repeal of the AMT, but maybe one for eliminating the preferences that it does limit.

[890] MR. LYON: Yes, and Chairman Thomas took that on, too. You don't need an AMT. If it's preferences you want eliminated, eliminate them, but the primary preference under the rules is depreciation, and right now we're putting in partial expensing, which would suggest we don't actually want to limit depreciation.

[891] So, you know, if you go through it one-by-one, I think most of the rules I know drop out. But Congress has made explicit preferences that they want to encourage those activities.

[892] MR. MILLERICK: John.

[893] MR. BUCKLEY: That's not a surprising comment on the issue, even if it may be a little inconsistent with what you got from your luncheon speaker.

[894] I think when you talk about tax simplification, your goal is not only a simple system, but a stable system. You really don't want uncertainty and to reach that goal you have to understand why certain provisions aren't in our tax law.

[895] Simply repealing those provisions may make you feel good, temporarily, but if you don't address the underlying issues, something else will come back. It may be more complicated than what you simply got rid of.

[896] I mean, I started drafting tax law in 1973, coincidentally, the year that Richard Nixon proposed an individual alternative minimum tax. I think there's not—there's virtually hardly been a year since I've been employed by the Congress that I didn't deal with minimum tax issues—up or down. I mean, they went up. They went down. It is all a matter of a cycle.

[897] It really comes down to the fact that Congress is not going to permit large corporations to zero out the tax law, regardless of whether you think these preferences are good or bad. I have to say, it's a terribly unhappy compromise, but the suggestion to repeal it without doing some repair to the underlying provisions would only suggest, in my mind, you're off to another cycle in the system.

[898] I don't think that it does anybody any good. It keeps us busy up on Capitol Hill, but I don't think it is in the long-run interest of simplifying our tax law. So I keep back to, you have to understand why the corporate minimum tax was there, why Richard Nixon proposed it on the individual side, why Ronald Reagan signed it on the corporate side; and unless those underlying factors are gone, we may just be on another cycle here, which I find unfortunate.

[899] MR. MILLERICK: Brian?

[900] MR. MEIGHAN: I just had a comment. I don't disagree with what John says, but at the same time, stability is excellent for taxpayers. If you look at what was done recently, Congress has gutted out some of the preferences in AMT for corporate. I think there was a '97 change where the depreciation lives were equalized, but the methods weren't.

[901] As much as a taxpayer may favor, that really does not help them. It may keep some people from going into AMT, but from just a recordkeeping complexity that Drew was referring to, it did absolutely nothing. It just changed the programs that they had to now keep track of.

[902] It seems like to me I would go the repeal route, even if it is in a cycle life. I guess I'd take the chance that doing away with it and having one system even if that means we need to slow the regular depreciation down. I still think that would be better than requiring taxpayers to keep GAAP, the regular tax, AMT, the ACE-type books, and then your 263A calculations, et cetera. This highlights what I think Pam referred to taxpayers just giving up and saying, "Well, 10 percent of my ending inventory is my 263A number."

[903] And then you're going one step further and saying, "That's 11 percent for AMT."

[Laughter.]

[904] MR. BUCKLEY: I agree entirely with you that minimum tax is a terribly unhappy compromise. I would say the minimum tax on both sides. I don't know how you would deal with the corporate minimum tax and not deal with the individual minimum tax.

[905] I mean, some of these small businesses are not in corporate form. So if you just simply repeal the corporate minimum tax, all of the complexities you're concerned about will be continued to be faced by most small businesses, and I just don't see how you sever them out.

[906] MR. MEIGHAN: I think it's arguable that the individual one is even more complex.

[907] MR. BUCKLEY: Just because the revenue is so much higher in the individual one. The complexity and the issues are absolutely the same between the two systems. It's just that one is now such a large—largely because of the enactment of the recent bill, such a large part of our revenue stream.

[908] I think there was a Treasury estimate of $133 billion a year in the out years that would be raised from the individual minimum tax, and it's not only complicated, it is extraordinarily unfair. And how you sever those two out and say we're going to do one and not the other, to me, is hard to defend.

[909] MR. PRATER: I guess, for many of you, there are a lot of good improvements we could make, even if repeal is not on the table in the end; and I think John makes a good point about the origins of the AMT and the reason that it's there.

[910] But there are a number of attributes, Brian alluded to a few of them, that I think we can take a pretty hard look at, both in terms of what we're trying to measure for purposes of this tax, and the impact on taxpayers from a compliance headache standpoint. I think we have to keep a focus on just what the purpose of this thing is, and what we are doing to folks.

[911] On the individual side, it's true that the legislation that we passed in May and then was signed in June, does send more people into the minimum tax. We, at least for the short term—and it is just for the short term through 2004, tried to hold harmless or improve the current situation, but it does not defer our need to focus on the long-term problem.

[912] Now under the current law, of course, all this is sunsetted. So there is a period there of five plus years where we're going to have serious minimum tax hell. I can tell you my boss and I think others on the committee are very serious about trying to address that before we get to that point.

[913] But it is, as John said, serious revenue, too. So, we're going to have to, I think, focus a little bit more on that. We're going to have to make leadership on all sides in both bodies even more sensitive to the problem for the long term.

[914] But it is a tremendous problem for the system, and I think that the participation and support for fixing it that comes from the Bar and the AICPA and other groups is helpful, and I encourage you to keep pounding the drum, because it's important.

[915] MR. MILLERICK: Jerry?

[916] MR. COHEN: I always thought that an alternative minimum tax was a recognition that your tax system doesn't work. I was very much in favor of getting rid—I'm going to agree with John, I don't know why you can't get rid of the corporate and then work on the individual.

[917] But the perception away from Washington, John, was that the corporate was stymied because of the give-away with the inventory credits. A number of us wondered why that just wasn't moved forward on a spread for a long period of time?

[918] MR. BUCKLEY: I did not construct the bill, so I can't answer that question.

[Laughter.]

[919] MR. BUCKLEY: I mean, I agree with everything you said. I agree that corporate minimum tax is a reflection there's an underlying problem, unless you're telling me you don't think there's an underlying problem.

[920] MR. COHEN: No, no.

[921] MR. BUCKLEY: All I'm suggesting is, if you get rid of the symptom of the underlying problem and not take care of the underlying problem, the next manifestation of the congressional response may be as equally complicated as the current one, and I don't think that gets us where I think is the way we should go. A simple, but stable system.

[922] MR. LYON: I guess I'd be willing to take on this underlying problem, whether there is one or isn't. I don't think we should be embarrassed that a large corporation pays nothing in tax. I've never seen a corporation enjoy a good meal. I've never seen a corporation go on vacation.

[923] Comparing the taxes a corporation pays to the janitors that they employ, to me isn't a meaningful comparison, and ultimately individuals are paying those corporate taxes. Even taking it back further, economists would say the overall rate of return to capital is what's affected by those corporate taxes.

[924] So, you know, if we can set up some general rules for how we think capital should be taxed, that's what we should be aiming for and not caring whether particular corporations pay certain amounts of that capital tax.

[925] MR. WEISBACH: I want to raise one more question. Reuven Avi-Yonah is in the audience here. He wrote a letter to Tax Notes about a month or two ago, suggesting that the AMT had something to do with tax shelters. Not being an expert in AMT, I thought maybe I'd ask the panel what they thought about that?

[926] MR. LYONS: Again, I think there's a misconception that the corporate AMT is automatically there as a stop gap to any tax shelter. Any newly designed tax shelter, we'd have to write the legislation to stop.

[927] So, I don't see how having the AMT there is a fix.

[928] MR. MILLERICK: Any further comments on AMT?

[No verbal response.]

[929] MR. MILLERICK: If not, with that we can open the floor to questions from the audience. There are a couple of microphones, and if you would for the benefit of the transcriber, please state your name.

[930] MR. LIPTON: My name's Dick Lipton from Chicago, and this is as much of a question for, particularly, the government representatives.

[931] In the corporate rule, we often hold on the corporate business side, we hold 197 out as a model of something that simplified and solved the problem. On the other hand, 197 has one of the most complex provisions, which is the anti-churning rules. It seems to be a good model or poster child for what's wrong with the way legislation gets enacted, because you have an anti-churning rule that is still in place now, even though the intangibles—it looks only to intangibles that were created prior to some date in the early 1990s.

[932] As any business person will tell you, any intangibles that existed back then are now completely worthless, to a large degree, yet we're still stuck with an anti-churning rule that will go on forever and ever and ever.

[933] Even if we can come up with a simple solution to deal with depreciation and capitalization, how do we get rid of what appears to be a congressional fixation with anti-churning; and, let alone, how do we sunset that type of a provision, and how would you deal with the 197 complexity that we're now facing?

[934] I think this is really primarily to John and Mark, but certainly to the Treasury representatives, as well.

[935] MR. BUCKLEY: I think the anti-churning rules were there to cut the revenue cost of the enactment of 197. I mean, that was just part of what you had to do to get to that result.

[936] Now if you're correct, the rules no longer have any really—any significant revenue constraint, maybe that's not a bad place to look. My guess is there's still a lot of intangibles, pre-'97 intangibles that have extraordinary value. So, I'm not certain I would agree with half of what you said, but that's motivation for the rules.

[937] MR. PRATER: I think it's worth taking a look at. You know, if the rule has outlived its effectiveness, from a revenue and a policy standpoint, we ought to not burden folks with the complexity and confusion of it.

[938] MR. MILLERICK: Brian?

[939] MR. MEIGHAN: My only comment was, I think that would highlight that maybe the legislative is not the best way to solve capitalization. Because once the rule gets there—I can't say I've heard anybody come up, at least to me, and say we should repeal that part of 197, or complain about it. But I'm sure they're complaining in the field and then having to do due diligence, et cetera.

[940] I think it highlights that if you do capitalization, legislatively, you're probably going to be stuck with rules ten years out that you don't like, or don't work.

[941] MR. MILLERICK: Any further comments?

[No verbal response.]

[942] MR. MILLERICK: Any further questions?

[No verbal response.]

[943] MR. MILLERICK: If not, I guess I've never been criticized for ending a meeting early. So, if there are no further questions, please join me in thanking the panel members for an excellent job.

[Applause.]

[944] MR. MILLERICK: Particularly, David. I think he handled the roll of a "wild-eyed" academic. I think he pulled it off.

[Applause.]

[945] MR. LIFSON: We've left the global issues to last. Our panel is going to go through international simplification, which of course, adds another layer of complexity dealing both with national interests and the interests of all the other countries and governments and interested parties in the world.

[946] We have a panel that consists of people from all walks of the tax world. To my immediate right, Reuven Avi-Yonah, who is an educator, who has written a paper giving some of his broad ideas in simplification. I've asked him to boil them down to, I think, it was 2,500 word or less. He's at the University of Michigan, and also a visiting Professor at New York University.

[947] To my left, Ray Rossi, who is in the private sector, who is Intel's Director of External Tax Affairs, he's TEI's International Secretary, and he has done a variety of tasks in his 18-to-20 years at Intel, venturing from site selections to discussing those legislative-specific legislative proposals.

[948] Oren Penn is second to my right. Oren is with Joint Tax. He's Legislation Counsel. He's both a CPA and an attorney, and has a background of a practicing attorney, as well as serving the government and its people.

[949] On my far right, Barbara Angus, who is Treasury's International Tax Counsel for the Office of Tax Policy. She has an extremely good background with Bakers, a partner in a big-Five accounting firm, PricewaterhouseCoopers, and a former partner in a larger law firm, Kirkland & Ellis, and she also teaches, and has a history as an adjunct professor at two schools in the Chicago area.

[950] Hugh Hatcher over there, second to my left, is known I think as well to many of us. He's a CPA. He's the trade and tax advisor to Amo Houghton, and a Treasury and IRS advisor for many years, and has a history, also, with large accounting firms before he got into, I guess, what's best described as government work right here.

[951] At my far left is Cary Pugh. She's Tax Counsel for the Senate Finance Committee, and she has also experienced working at Vinson & Elkins, a law firm.

[952] We thank you all, panelists, for coming here. We're going to try to let each member of our group have between five and ten minutes, as the topic warrants, to introduce their basic thoughts on simplification, and hopefully we have some people in government that will be here to give us a reality check, after we go off the edge. Hopefully, they'll bring us back, and also, let us know about what's going on in the political world right now.

[953] So, I guess we'll start. Reuven, we'll give you the floor. You have certainly a bunch of provocative ideas, some say simple, some say, not so simple. Help explain them to us.

[954] MR. AVI-YONAH: Thank you very much. It's an honor to be here. Basically, I view my role to be as kind of pushing the envelope as far as possible, and not kind of confined to the boundaries of the current law, though, some of these proposals are more radical, some less radical, and we will see how the discussion goes.

[955] Basically, I'm going to talk about four major headings, where I think there are significant problems. And I will focus on areas where I think that there is significant transaction complexity, which I think is where the payoff is likely to be. That is, I'm not going to—it doesn't matter too much how many words there are in the Internal Revenue Code, or even in the regulations, but what matter is what the impetus in the rule was.

[956] The first issue is sourcing and transfer pricing, which kind of go together. Basically, we have pretty elaborate source rules. These date to a period where economists and tax policy people believe that they could trace economic source of income. Nobody really believes that anymore.

[957] We still have the rules. The rules are different by category of income. The categories are manipulateable. Taxpayers can play games, and there's a lot of litigation, transaction complexity and the like. Just look at the software regulations, for example, as a recent example of how much work some of us put in this area.

[958] Basically, I think, the issue is, what are we trying to get at. There are two kind of fundamental principles that I think underlie the system that we have and that other countries have. One is the notion that income should be taxed once, no more, no less. The other one is the notion that, basically, the compromise that was reached in the 1920s, is that active incomes should be taxed, primarily, as source, and passive income, primarily, a precedence.

[959] If we look at the source rules, we see that they break up into source rules for passive and active income. For passive income, we as a social restriction have only residual interest in taxing. So, what we should focus on is administrability.

[960] So, basically, what I propose is that we have—the source will be for interest, dividends, capital gains and the like, whether it's deductible or not in the U.S., and that really would improve some of the administrability concerns, at least.

[961] For active income, I propose that the solution will be whether it's effectively connected with U.S. trade or business, which comes back to the question, what is effectively connected income. But that's where the transfer pricing proposal comes in.

[962] There's the other aspect of the source rules, and what I've said on that is, that it's not necessarily connected. This is, of course, the fact that source rules are also important to determine the foreign tax credit limitation, and I've said as other people have said, there's no particular reason why we should have the same source rules for those two different purposes. That is, determining tax restrictions for foreigners and determining foreign tax credit limitation.

[963] On this part, what I've proposed is that we just follow the source rules of the foreign country, since what we're trying to do is alleviate our tax burden. I'm sure the commentators will raise issues with these proposals, but I will wait with counter arguments until we get there.

[964] Now the key issue, I think, and the most difficult one in this area is transfer pricing. Here it depends who you talk with and what your assessment is. My own assessment is that the system is still broken, just like it was before the new regs were adopted, and we still get a lot of litigation. We still don't have an APA program that is attractive to most taxpayers, because they th ink their chances of winning in court is better.

[965] And I do think that there is some movement or potential movement in the direction of some disclosure to formulary apportionment. Personally I don't think that any of the common objections to that carry incredible weight, although, they're all entitled to some thoughts. I mean, the first one is that it doesn't apply well. Any formula you propose doesn't apply well to all industries, though, what I'm proposing is not a "single size fit all" proposal, but try with a different formula which will apply only in situations where an APA cannot be negotiated. So if you want to, you can negotiate something else.

[966] The second argument that is usually made is that the formula that is used is called "intangibles," and you cannot come up with a formula that fits intangibles. I actually view that as an advantage and not a disadvantage, because intangibles are quite manipulateable and you want to figure out things that are a little bit less manipulateable.

[967] Finally, the standard—and maybe the most weighty argument—is that we will never be able to persuade a trading partner to adopt the same formula that we do. On that I can say that there's been some movement. I mean, the OCD has accepted profit split, and in the APA context we've had formula apportionment and global trading, which was accepted by the U.K. and Japan, and most recently the OPM Commission has proposed something like formula for internal EU affairs.

[968] So I think that the distinction between arm's length and formulary is not as drastic as some people would have us do, and that would be obviously a very significant transaction simplification proposal. So that's the first part.

[969] The second part has to do with the treatment of passive income earned by foreigners and the withholding tax. Basically here one needs to distinguish between unilateral and multi-lateral approaches. I'm going to focus on what we can do unilaterally, just as the United States, without coordinating with anybody else.

[970] Because, unilaterally, many people have said—including me and others before me—that it would be a good idea for Congress to come up with, for example, withholding tax on interest in a coordinated fashion, so that we will not have the current situation where you have the interest flowing to tax havens and nobody taxing them, because information exchange is not affected.

[971] But that can't be done unilaterally. Certainly not now that we're back in deficit territory. So I'm not going to talk about that. Instead, the question is whether we need all of this withholding tax complexity and the very elaborate recent set of regulations. I think probably not.

[972] If you kind of think about the various categories of passive income, we don't tax capital gains, because of the source rule. We don't tax interest, because of the pro forma interest exemption, generally speaking, and because of treaties. We don't tax royalties because of treaties. Even for the dividends, we typically don't tax, because of the availability of derivatives, equities, SEPs and the like, which can be used to avoid the tax.

[973] So what do we tax? We tax dividends by subsidiaries to parents. That's a very unattractive source of tax. Because we've already taxed the subsidiary, and we have the withholding tax, then, the parent country— the residence country may tax, and then there may be another tax at the shorter levels. So it's one out of four taxes. I don't think that's a very good way of spending our resources, and I think that it will be a good idea to abolish the whole thing, altogether.

[974] The revenue—this is a high-impact, low-cost proposal. The cost is small. The impact, because of compliance by, you know, qualified intermediaries and all the rest of it, is very significant.

[975] The third point—now we get to the things that I was supposed to talk about, in terms of the assignment. That is deferring the foreign tax credit. So on deferral, here's where the Joint Committee made a big contribution, and more credit to them. They suggested, again, to eliminate four out of the six, and I think they went a little bit beyond the—I mean, those of you who are old enough will recall that a similar proposal was basically enacted twice in 1992—that is not enacted, but passed in Congress, with little formulated reasons.

[976] It's been pretty frustrating to function under all of this exempt and deferral regimes. Since then, I think that there's an improvement in the current proposal by the Joint Committee over the old one, and that is that they just propose keeping the current PFIC and CFC rules in place, basically, without changing them more, and abolishing the rest of them, and I think that's exactly the way we should go.

[977] The tough one, of course, is export tax, because this is the politically controversial one. My own view on that—let me just state it —is that, yes, there should be a residual, residence-based cessation of income that is not taxed somewhere else. Yes, the original separate tax proposal, or the original enactment, was premised on the notion that we will tax active income—we will tax passive income currently, and not active income.

[978] Because the assumption was that active income will be taxed somewhere else, and passive income will not, because of its greater mobility. I think this assumption is no longer true, especially now that we have the banking insurance and finance exception out there. That is very mobile, low-tax income.

[979] And, basically, what I propose is going back to something similar to what other countries do, namely, explicitly considering the tax rate in the source restriction, which is also something that the Treasury report endorsed; and I think that has significant advantages in terms of confining defer to those situations where defer doesn't give a huge economic advantage to the taxpayer.

[980] Now, of course, people will say, "Well, what about competitiveness?" And my response would be, "Well, okay, if competitiveness is"—and, again, I've only considered it at the moment in the unilateral proposal— "if competitiveness is the real issue, well then, what would be the U.S. response to, say, adopting the German rule or the U.K. rule or the French rule?"

[981] Since they have that provision, that is, they consider the foreign tax rate. They also have an out for real investment. That is, if income enjoys a tax holiday in the country for real investment, and doesn't pay tax, then—and, if they're really there, then, there's an out. I'm willing to give that if I can get the basic proposal, which is that, if income is very mobile and is not taxed somewhere else, it should be taxed in this country.

[982] Finally, the foreign tax credit, well here the issue is basically, do we need all of these baskets. I mean, I think that's really the source of most of the complexity. And my judgment is that we don't, and I've even gone so far as to say we don't need them at all. That is, we only need the overall limit.

[983] Basically, this depends on, first the proposition that, it's only companies that are in an excess credit position where having the baskets help preserve capital neutrality, which was the original rationale.

[984] Most American corporations now, we know from the statistical income, are at the limit or at an excess limit position, not an excess credit. Besides, I'm not sure that it makes sense to have such an elaborate regime, based on the particular order in which the taxpayer makes the investment. That is, first in the high-tax country, or first in the low-tax country.

[985] And since the underlying policy of the foreign tax credit is to preserve capital. It if violated by having the general limit in the first place, but you have to have a general limit. Because otherwise, the other country will just be tempted to raise taxes at your expense.

[986] I'm not sure that allowing taxpayers to average freely and therefore credit all their taxes would be such a big difference from the current regime in terms of its outcome, it certainly would save a lot of transaction costs. We've had, of course, a lot of years where we only had the overall limits.

[987] The U.K., up until recently, had practically the same result, and you know, the system did not collapse. So, I'm not sure that it's worthwhile to have all of the elaborate baskets out there.

[988] Although I have to say that the best defense that I know of anywhere of tax complexity is Charlie King's magnificent article on the foreign tax credit. He goes basket by basket and shows exactly what you can do if you don't have them. So, that's the other side on that one.

[989] And with that I will stop and let other people have their say against me.

[990] MR. LIFSON: Well, recognizing that both—we want to allow time for both counterpoint and for other people's global views, I will allow ten minutes for panel reaction on this.

[991] Barbara?

[992] MS. ANGUS: All right, ten minutes is not very long to give one's perspective on simplification in the international area. I think in ten minutes we can talk about one small proposal and get partway through it, and I won't do that.

[993] I think it makes sense to step back and—Reuven gave some of his big-picture perspectives, and I thought that I would follow suit and give some big-picture perspectives, as well. In terms of ways to think about simplification in the international area and things we can accomplish; and I think there is a lot to be accomplished in this area.

[994] The international tax rules of the U.S. have developed over the last 40 years. During that period, the world has changed a great deal. When the rules were first developed, they affected only a relatively few taxpayers, and only a relatively few transactions. That isn't true anymore.

[995] Today there's hardly a U.S. based company that's not faced with applying the international tax rules to some aspect of its business. This globalization puts evermore pressure on our international tax rules. This is true from a substantive perspective. There can be no doubt that re-examination of the U.S. international tax rules is appropriate, and timely.

[996] We need to look at the competing considerations that were taken into account in formulating those rules, in light of today's world; and re-calibrate the balance of those competing considerations to the extent that re-calibration is necessary.

[997] But focusing on simplification, the increasing pressure on our rules, on our international rules, is also true from the perspective of complexity. Rules that may have been appropriate when they were first developed and had limited application to only an occasional transaction, or only a handful of taxpayers, may no longer be appropriate when they apply across the board and should be revisited.

[998] In our international tax system, as in other areas, there are several competing principles at work, and I think when you think about simplification, we need to think about these competing principles.

[999] Tax rules shouldn't serve as a barrier to cross-border investment. Tax rules should not place undue burden on the competitive position of U.S. -based companies. Tax rules should minimize distortion of investment decisions. Tax rules shouldn't create a bias for or against a particular activity or activities. We certainly shouldn't create that bias except in situations where the tax rules are specifically being used to encourage a particular type of behavior, or to accomplish a particular objective.

[1,000] Minimizing compliance and administrative burdens is a separate principle that needs to be taken into account when we look at formulation of our international tax rules. But it also underlies each of these more substantive principles.

[1,001] Complexity can impose significant costs, both on taxpayers and on the government. Therefore, complexity itself can serve as a barrier to cross-border investment, or impose a burden on the competitive position of U.S.-based companies.

[1,002] As I said, there's much that can be done to reduce complexity of our international tax rules. Thinking about the issue of simplification in the international area, I think the standards or goals for simplification are a little bit different than they are when you think about simplification for individuals.

[1,003] When we think about the international area, I don't think we're just thinking about a matter of reducing the number of lines in the code, or eliminating one or more IRS forms. Now that isn't to say that both of those wouldn't be worthwhile accomplishments. But we shouldn't stop there.

[1,004] I think when we think about simplification, or reducing complexity —and maybe I should focus on a more achievable goal of reducing complexity, as opposed to achieving simplification. But when you think about reducing complexity in the international area, I think we need to think about reducing the instances in which the tax law drives taxpayers to engage in transactions, or to take steps, that otherwise are unnecessary or uneconomic.

[1,005] Because reducing complexity is about addressing rules that create economic distortions, I don't think we can think about simplification in a vacuum. There are, I think, several appropriate contexts in which to view international simplification, and each one of them is important.

[1,006] When I think about the underlying principles and goals of the particular provisions that create the complexity, we need to think about the way in which business is conducted, and the way in which business is changing. And, I think we also need to think about the way in which the U.S. tax system fits into the global economy. Because the issue of international simplification isn't something that we can or need to do, alone, there is much that can be done working with our treaty partners.

[1,007] Looking at simplification in the context of the goals of particular provisions means thinking about how to accomplish those goals in a different way, and thinking about exactly what the main focus of those goals are. Now this is maybe the most obvious point when you think about simplification, but I don't think it's one that we should overlook.

[1,008] On this one, I would say that as an example here I would point to something on which I agree with Reuven, and that is that the Joint Committee has had some important things to say about coordination of the anti-deferral regimes.

[1,009] We have a whole series of anti-deferral regimes, but each varies a little bit from the other, and goes after different types of income, or different types of taxpayers, but they're all designed to accomplish the same basic purpose. They just take a little bit different route in order to accomplish that, and they've developed over time, as what has become a complicated patchwork.

[1,010] I think it is important to think about coordinating those regimes. What was done in 1997 to eliminate the overlap between subpart F and the PFIC provisions for taxpayers that were subject to both, or for taxpayers that were U.S. shareholders for subpart F purposes, was an important first step. But I agree that we ought to be looking carefully at the Joint Committee's thoughts in this area to think about what more can be done to further coordinate that series of regimes.

[1,011] It's also a matter of looking at each of these regimes, individually. To take the PFIC regimes as an example. The PFIC regimes is accomplishing a particular objective, but when you look at the alternative routes under the PFIC rules, we started off with two alternative routes. The interest charge regime is a particularly harsh regime under the PFIC rules, so there is the ability to elect current inclusion. But that's not an option that's available to taxpayers that don't have the information available to make that election.

[1,012] So I think a big step was taken in 1997 to enact an alternative regime, the mark-to-market rules, for those that don't have the information to elect current inclusion, but have stock for which mark-to-market is appropriate. I think it's that sort of set that we need to be thinking about, both in coordinating the regimes, and in making the regimes that remain work most effectively.

[1,013] Another area where I think we need to look at the goals that the rules are aimed at accomplishing is the expense allocation rules. Reuven talked about the source rules, and he talked in on the income side. He didn't comment about the expense allocation rules.

[1,014] We have very complicated expense allocation rules in the U.S. They are aimed at accomplishing a matching of—an appropriate matching of income and expenses. I think we need to keep that goal in mind as we look at those rules, and think about ways in which we can ensure that those rules operate most effectively, and don't operate to create any sort of distortions.

[1,015] One area that we have been looking at is in the area of interest expense allocation. Those situations where it's appropriate to find a matching of interest expense and income.

[1,016] We recently put out a notice requesting taxpayer comments on the integrated financial transaction rules, the statutory authority for matching, for netting of income and expenses. The current regulations are relatively narrow and only apply in limited circumstances. It may be appropriate to expand that same netting principle to other transactions, and we are very much looking for comments from all of you about situations in which netting is appropriate and would lead to a better economic result than the alternative that applies under the regulations.

[1,017] Another way in which I think we need to look at simplification is in the context of how business is actually done. I think that's important, because it focuses then—focuses us on a simplification that will actually make a difference.

[1,018] As I noted at the beginning, there have been significant changes in the way business is done in the time that our international rules have developed. Just to mention two areas.

[1,019] Over recent years, we've seen a big increase in the phenomenon of doing business through the joint venture format, and we need to recognize that is an important paradigm in how U.S. companies do business overseas, and make sure that our rules operate to allow that business function.

[1,020] One step that was taken that deals with the joint venture situation in '97 was the treatment of dividends from 10-50 companies. The Joint Committee has proposed in its simplification project a fervor extension and cleanup of the rules for dividends from 10-50 companies. There's also the issue that we ought to be thinking about of other income—other forms of income from 10-50 companies, and whether there's more to be done in that area.

[1,021] Another development that's happened as we see increasing globalization is that we find companies are doing business, not just in a particular country, but in a particular region, and there are reasons to structure businesses that way. The subpart F rules traditionally have looked at same country concepts, and there are important reasons why the subpart F rules look at same country concept. But in the most recent amendments to subpart F, we've started to see a recognition that we need to look, in addition to same country concepts, not just at where the company is inpcorporated, but where it's doing business.

[1,022] We see that most specifically in the developments in the subpart F provisions for active financial services income that recognizes an expanded concept of "same country," and looks not just at the country of incorporation, but the countries where the company has a qualified business unit or branch. I think that's an important perspective that we need to think about as we look at where we should be going.

[1,023] Finally, I want to just touch very briefly on looking at simplification in the context of our place in the global economy. On the transfer pricing issue, in particular, what we do in the U.S. with our transfer pricing rules is only the start of the answer to the question for any taxpayer. What's equally important is what the other country or often countries are doing to the same transaction.

[1,024] It is very important that those rules be coordinated. We have made great strides in coordinating the transfer pricing rules across the OECD, and in fact, in encouraging other countries to adopt similar guidelines, so that taxpayers don't find themselves in the middle of disputes between countries over what's the appropriate source of income.

[1,025] There certainly is much to be done in that area. But I'm not sure that scrapping our rules that have developed, not just here in the U.S., but throughout the world is the right place to start there. I think that one place where we really can focus our attention, and this is something that we can't do alone, but we need to do with our treaty partners, is working to improve the procedures for resolving disputes, so the two countries are better able to resolve disputes quickly and efficiently, and not leave the taxpayer caught in the middle for an extended period of time.

[1,026] I think there's much we can do in the way of simplification through our treaties, and let me just note two more things before I turn back to our moderator.

[1,027] One area is the issue of royalty characterization. That's an aspect of a transfer pricing question. It is an area where there is significant dispute, whether a particular item of income should be characterized as a royalty, and where that income belongs.

[1,028] Again, we need to improve our agreement procedures with other countries in order to resolve those disputes. But we can also lessen the pressure on the issue of characterization as royalties, the more we can advance in our treaties what is our preferred treaty position of eliminating withholding taxes on royalties. If we eliminate the withholding taxes on royalties, we eliminate a lot of those disputes.

[1,029] Where we're unable to get our treaty partner to agree to the elimination of withholding taxes, a reduction of the rate of tax on royalties helps to reduce what's at stake in these disputes and allow them to be settled more quickly.

[1,030] And with that I think I've overstated my position.

[1,031] MR. LIFSON: No, not at all.

[1,032] MS. ANGUS: Let me turn it back to you.

[1,033] MR. LIFSON: Thank you.

[1,034] Oren, you know, I think it's appropriate to introduce your thoughts on this, then. If you can find the "on" switch. There you go.

[1,035] MR. PENN: Thank you.

[1,036] Let me just start off by saying, I'm speaking on my own behalf, and my views are my own and not those of the Joint Committee on Taxation, just as a disclaimer. Both Reuven and Barbara mentioned the Joint Committee's Simplification Study, which we completed earlier this year.

[1,037] Many of you are fully aware of it and probably read every single page.

[Laughter.]

[1,038] MR. PENN: I won't quiz you.

[1,039] In the international section of the study, out of many other recommendations, there were only ten international recommendations. I would characterize those recommendations as fairly modest, and I have done so publicly before. For the reason being, there was a mandate for the study that our goal was not to significantly change the underpinning of the policy of the existing rules, but to look at the existing rules as they exist, and look at ways to simplify those rules.

[1,040] That is—if any of you have ever tried that kind of a task, it's difficult, if not impossible, so we were actually surprised we came up with ten.

[1,041] Of the ten, the main one which I'll mention—and Barbara was kind enough to mention a few of the others, which I won't go into—is the one that simplifies sort of the number of anti- deferral regimes that are really needed today.

[1,042] Over the last century, you know, there have been different points in time where anti-deferral regimes have been enacted, often for similar reasons. We looked at the '92 proposals and decided that things could be made much more simple by simply repealing or simply eliminating outdated regimes and focusing on the ones that really matter today, and that is CFC and PFIC. With the elimination, the helpful elimination of the overlap of the two regimes that should hopefully simplify lives for a lot of taxpayers.

[1,043] I will note, just for the record, that we did not go so far in our study to actually recommend repealing the oldest of them, the accumulated earnings tax, with respect to foreign corporations. That was after some internal debate. Reuven actually was an advisor and had some input, as well as other great input from others.

[1,044] We concluded that, if the accumulated earnings tax is going to remain around generally, that we didn't want to provide incentives to repeal it just for U.S. shareholders of foreign corporations. So, if there comes a day when policymakers decide the accumulated earnings tax should be repealed generally, we would fully support that in the foreign context, as well.

[1,045] Our focus in looking at simplification, even though our task was difficult, was mainly on subpart F and the foreign tax credit, which I think most would agree are the two main sources of complexity in the international tax area.

[1,046] We did make recommendations—although I won't go into details— we did make recommendations in other areas. And as Barbara has noted very articulately, there have been recently many international simplification steps that have been taken, including the CFC, PFIC overlap elimination.

[1,047] One of the conclusions that you can sort of take from our study is that there is much more in the way of simplification that we can do in the international area. Even though we felt we could only go so far in our study, we received more than numerous suggestions on ways to simplify the code. Most of those involved significant policy changes that we just felt we could not make recommendations in those areas, but I will just name a couple.

[1,048] Again, just to be clear, I'm not taking positions on any, but just throwing out some of the suggestions that were made, including in the subpart F area. We have heard, you know, from the business community similar proposals where you would simply look at subpart F and only tax passive income and allow deferral for active income. That's a little bit different than what Reuven's proposing—and that's an understatement.

[1,049] Others have suggested moving towards a territorial system. I don't think anyone would suggest a pure territorial system. I'm not sure if one actually exists. But something along the lines of an exemption of foreign income, but with a subpart F style regime for passive income.

[1,050] In the foreign tax credit area, many have suggested reducing the number of limitation baskets. When you look at the nine, as well as the other limitations on the foreign tax credit, including in the oil and gas areas, there have been suggestions to abandon them altogether. There have been suggestions to reduce them to two, an active and a passive basket; a high-tax and a low-tax basket. That could present complexity issues. We've also heard about eliminating certain baskets like the high withholding tax interest basket.

[1,051] Those are all ideas. There were many, many more that were considered. These are all ideas that involved policy issues that went beyond simplification and went into the realm of what I would call reform.

[1,052] Any time you go into the reform arena, as Barbara mentioned, you have to consider not only the complexity and simplification aspects of the proposal, but all of the other very important policy objectives that you have to carefully balance in the international area; and she went through each of those.

[1,053] So in sort of giving general remarks, one of the points that I wanted to make as we move forward, and I think the point of the study is that hopefully simplification will, even in times of economic stimulus and victims' relief and so on, simplification, hopefully, will remain in the minds of Members of Congress and policymakers.

[1,054] But we should also keep in mind that there are various pressure points in our international tax system, and those pressure points lead to sources of complexity that have evolved over time.

[1,055] When you attempt to reduce those sources of complexity through various proposals that we've heard about, you have to be careful that what you propose in replacement to fix that problem doesn't actually give rise to further cases of complexity. It's sort of like that game at the county fair where you have a hammer and you hit a bump, and you push that down, but five other bumps appear. So you need to really be careful about what it is you're doing.

[1,056] The idea in the abstract form may actually sound good, it may sound like, "Wow! That's a great simplification proposal." But when you really sit down and think about it—not just from a drafting perspective, but from the perspective of the government trying to implement a proposal and from what taxpayers actually have to do, the proposals may not in fact be simplification proposals.

[1,057] Here we'll talk, I'm sure, about international tax simplification in terms of bills that are introduced by Members of Congress. I'll note that the title of those bills has changed, because not all the provisions are in fact simplification provisions. But I do want to give just a couple of examples of what I mean, and I think this is an important point.

[1,058] We need to be careful that what we're calling simplification actually is simplification. That's the first step. The second step is, if it actually is simplification, does it run the gambit of the factors that Barbara mentioned, so that we've balanced everything and simplified taxpayers' lives.

[1,059] As a couple examples of this, I would throw out those that are proponents of a territorial tax system. They have claimed that this is going to lead to simplification. I'm not so sure that's the case. The essence of a—pure, but even a modified territorial system—the essence of taxation is on source of income. So source will be the key.

[1,060] That would mean increased accuracy of what is foreign and therefore exempt, and U.S. and therefore taxable. Those sourcing rules, whether it's income or whether it's expenses are going to be even more complicated.

[1,061] On top of that, the U.S. still would likely have an interest in taxing passive income. We would still retain subpart F style passive income rules. So in combination, I'm not sure we get to the point where we call that simplification.

[1,062] So, the folks who talk about a territorial system may want to talk about it in other terms, you know, that's something that's to be debated, generally. But from a simplification standpoint, I can see where that may not be a valid charge.

[1,063] With respect to Reuven, I don't want to get into too much of his paper, and Reuven has written quite a bit. But there seems to be a focus on active versus passive income, and sort of his fundamental principles that he lays out, sort of six steps to live by.

[1,064] Just as under a territorial system where you focus on source, focusing on active versus passive will lead to increased complexities, as well, and that's really only a prediction on my part. I can only say that because I had quite a bit of a role in the subpart F active financing income debate.

[1,065] Drawing lines as to what is active and what is not active can be very complicated. I can tell you that the active financing, the current active financing, under subpart Fexception is not by any means a model of simplicity.

[1,066] Secondly, there's a proposal dealing with the subpart F aspect of Reuven's view of the world that effectively would, if I understand it correctly, apply a mandatory effective tax rate test under subpart F. Which would say, if you have any amount of foreign income that is subject to an effective tax rate of less than 90 percent of the U.S. rate, you're under subpart F.

[1,067] Now we have under present law an elective, high-tax exception that's an effective tax rate test. It actually over the years has been complained to us as being one of the more complicated provisions in the code and regs. To actually expand that effective tax rate test more broadly to cover more types of subpart F income would not provide simplification— and I would actually disagree with the characterization of this rule as a low-tax kick-in—an effective tax rate of 28 percent is not a low tax.

[1,068] But I would caution those that, again, in the abstract, to call something simplification, it may in fact not be.

[1,069] Finally, just another aspect of the proposal with respect to sourcing rules, there was a suggestion that we should sort of scrap the sourcing rules we have, and in the outbound context simply source foreign income based on the way the foreign country sources the income.

[1,070] I can't imagine how that would be administered, honestly. If we're talking about the real world, countries should and do determine their own tax systems and their own source rules. In fact, oftentimes, their source rules simply don't necessarily correspond with economic activity. To actually try and have taxpayers and the government determine on a country-by-country basis, as countries change their laws year-by-year, I don't view that as very helpful simplification. It's just something to think about when we move forward to try an actually simplify taxpayers' lives and hopefully improve compliance.

[1,071] Just to sort of wind up here, and I hope I haven't taken up all my time, I would make one further note and that is that there seems to be a tension between simplification, which taxpayers want, and elective complexity, which taxpayers also want.

[1,072] To the extent that a rule is favorable, taxpayers are willing to expend the cost, no matter how complicated it is, to get that result. And to the extent that rule is not favorable, it's labeled anti-competitive. So I think there has to be a balance, one hand versus the other. A little fairness for both the government and taxpayers to understand that some rules can be—there is going to have to be some tolerable level of complexity in our system. These aren't—you know, these are very complicated business transactions, and companies that we're dealing with.

[1,073] I will just close with just two examples of proposals that companies want that aren't simplification, and some are contained in international tax bills.

[1,074] One has been mentioned, which is interest expense allocation. This is a very complicated area. Folks have been asking for changes in this area for years, and there was a bill that was passed by Congress to move from a water's edge to a worldwide approach. That is reform. It doesn't necessarily mean simplification.

[1,075] Similarly, we have very complicated overall foreign loss recapture rules. And out of fairness, taxpayers ask, plead, beg for similar recapture rules for overall domestic losses. Those aren't simple rules, either, to apply.

[1,076] So we need to look at this really in a broad context, looking at all the policy objectives and hopefully, hopefully, more attention will be placed on simplification issues, but in the end I think there's going to have to be careful analysis that what we are doing actually is simplification and that it is consistent with international tax policy.

[1,077] MR. LIFSON: Oren, I think your comment on elective complexity is the same thing they were talking about on education benefits earlier today. Nobody complains—very rarely do they complain about elective complexity.

[1,078] Ray, you know we've heard—we've learned at least two things so far. One is that when it comes to the blue-pencil reform, the editing reform, there seems to be some general agreement that we don't need six anti-deferral regimes to keep foreign income from being properly treated, we only need perhaps two.

[1,079] On the other hand, there are three very different approaches to global issues of tax simplification in the foreign environment. Speaking from the perspective of a guy who has to follow all these rules, what do you say, Ray?

[1,080] MR. ROSSI: I want to address this both from a practical and a policy standpoint. Because I think both impedes the bold strokes that Reuven suggested, as opposed to the ten international proposals out of a hundred that the Joint Committee came up with.

[1,081] Certainly ten percent of the Joint Committee recommendations may not be symbolic of the great need to simplify the international tax rules, which I wouldn't disagree with. There's a very great need to simplify them.

[1,082] However, I think the bold strokes that Reuven has suggested touch on practical considerations that businesses would have, as well as, policy implications.

[1,083] Oren mentioned the source rules, as one example. I wouldn't look forward to trying to understand foreign rules about what's domestic to them in order to decide whether it's foreign for us, foreign source for us.

[1,084] It also surprises me the thought that we would, in the foreign tax credit where it's U.S. concepts that dictate whether it's an income tax, effectively cede the sourcing determination to the foreign jurisdictions.

[1,085] So I think there are some policy implications there as well as practical implications. The policy implications might bother the folks here on Capitol Hill putting the thing in place. The practical aspects would bother companies trying to follow all these sourcing rules.

[1,086] In the same vein, I want to talk about the subpart F suggestion: the 90 percent of the U.S. rate rule, or its subpart F income. It seems to me that also has policy implications that are pretty serious. There is good concern on the Hill with trade implications, as well as tax implications, and they're one in the same in the minds of some here.

[1,087] Another word for trade is "competitiveness." Reuven mentioned that it would be this rate measurement, or possibly, it might be if you have real operations someplace, then it's whether you're taxable, rather than if you're taxed. Well, even that determination, if it's at a 90 percent is probably unreasonable when you consider that many jurisdictions that we have competitors in have systems where once it's outside the country, active business income is not taxed currently if at all.

[1,088] For a second fact, there's a tax sparing for some competitors where you haven't paid the tax but still get a credit for the tax you didn't pay. So there is a balancing here of trade policy that I think impedes the changed prooposed in the deferral area/anti- deferral area, as well as practical considerations because obviously, being non-competitive in our tax system is an extra cost on U.S. business trying to compete globally.

[1,089] I want to go to another area that Reuven talked about and that's formulary apportionment. In the paper you'll see it labeled as a "default" rule, a "default" mechanism; the default from not getting an APA, an advance pricing agreement.

[1,090] It strikes me as pretty interesting, because I would think that the default rule could easily become the general rule. There are very good reasons for not necessarily doing an APA. Also, if you just judge by experience, the APA percentage is relatively low, considering all the people who would have section 482 issues to comply with.

[1,091] Formularly apportionment from a taxpayer's standpoint at the state levels is not simple. It is very, very complex. If the model is formularly apportionment, as Reuven has suggested, in the states, the apportionment factors vary: what's apportionable and what's allocable is a determination that needs to be made; and intangibles are an issue. It's just not simple.

[1,092] The other thing that comes into play here is, at least for section 482, the goal is obviously to replicate arm's-length transactions. If you had a formula apportionment system, you could easily end up in situations where you're going to end up with tax of more than 100 percent of income, so you're going to have double taxation, depending upon whether jurisdictions adopt or not, and adopt the same formula or not.

[1,093] The other point on not adopting the same formula is, there are many reasons why, for example, states adopt their apportionment formulas, some having little to do with replicating third-party transactions. Economic development comes into play, which I'm not convinced wouldn't come into play, worldwide as well.

[1,094] What happens is some jurisdictions will try to encourage people to site there by giving a better answer under their formula. That could happen in the international context as well, and what happens then is, I think, less oriented to what 482 is all about, apportioned income based on third-party comparables or third-party models; and pretty soon what you're going to have is more situations of double-taxation, albeit for good non-tax reasons, possibly overloading the competent authority process.

[1,095] So I think we have a practical consideration there that I'm not so sure we wouldn't be replacing complexity with complexity, just a different kind.

[1,096] I want to touch on one other item that was mentioned this morning in the domestic context, rather than in the international context. That was the ability to, when appropriate, when it is simpler, to use GATT financial books as opposed to trying to make tax adjustments to those books.

[1,097] For reporting purposes for subpart F, and even in the context of non-controlled of 902 10-50 companies, I think there's significant simplification that can be gained by eliminating, to the extent possible, non-material, temporary kinds of adjustments, and those include things like currency translation, economic performance standards, R&D expense determinations, inventory adjustments beside UNICAP, which is in the Joint Committee study, like LIFO/FIFO.

[1,098] These are nightmarish kinds of tax adjustments that currently need be made but that are basically not that material and not that permanent a difference.

[1,099] So, to the extent that we can go to books—financial books rather than tax books—I think that's less bold, perhaps, than what you proposed said, Reuven, in some of your suggestions, but more bold, perhaps, than— not perhaps, but more bold—than what the Joint Committee suggested on UNICAP, and can produce significant simplification.

[1,100] The last point I want to make is that while these are bold steps that you've set forth, Reuven, I think they're going to take some time and some deliberation because of the pollicy considerations and the practical issues they raise. I don't think we should let the bold get in the way of incremental progress on simplification.

[1,101] I know Hugh's going to talk—and Cary—about some of the legislative issues underway. The last draft I saw of the simplification bill now has some 30 international items, as opposed to the ten the Joint Committee had. Let's not forget those 30 in the interest of making grand, sweeping changes.

[1,102] MR. LIFSON: Well, Hugh and then Carey, how does this get translated into action, and what's going on?

[1,103] MR. HATCHER: Well, let me make a few comments from the standpoint of a Member's office and the legislative process.

[1,104] But first picking up on what Oren said that he hoped Members didn't forget about simplification. Earlier this summer my boss and Mr. McCrery— who chairs the Select Revenue Subcommittee, my boss chairs the Oversight, had a hearing which was supposed to be the first of a series of hearings on simplification.

[1,105] Unfortunately with the events of September 11, that was put aside. I hope we resume that after the first of the year. Because we did want to keep this on the agenda. My boss, who is the only former Fortune 500 CEO in Congress, is very interested in simplification and continues to want to push it.

[1,106] It seems to me like this kind of boils down to the incremental approach versus some major overall. The latter means a territorial type system. Reuven's proposals are somewhere in the middle there, but we know a major, major overhaul would take a number of years. Maybe a catalyst might be the FSC issues or something, but even Chairman Thomas, I think, has said it's four or five years, at least, to do something like that.

[1,107] Well, Congressman Houghton really doesn't want to sit on the sidelines waiting, you know, for something to happen, just like Ray said. So Mr. Houghton and Mr. Levin and Mr. Johnson on the House side, and Senators Baucus and Hatch on the Senate side have introduced a series of international tax bills for the last few congresses. This year we have one that's about ready to be introduced for the 107(superscript: th).

[1,108] The bills take the incremental approach, which I think from a practical standpoint and a political standpoint, is what can be done. You do what is doable. We've had some successes in the past with this approach, in '97, and then we had some items in the '99 bill, which unfortunately was vetoed for other reasons.

[1,109] But what we've done is to focus on items that are simplification. There's a consensus on the item among a fairly large group. There also may be items that improve the competitiveness of U.S. multi-nationals abroad. Hopefully, these items usually have a modest price tag.

[1,110] Our approach has been to get these items enacted—as many as we can. They're stand-alone items so Members can, when they're doing a tax bill, kind of pick and choose from our bill.

[1,111] The upcoming bill does include a number of the Joint Committee recommendations and proposals that they've made, including the repeal of the foreign, personal holding company provisions, and expansion of the de minimus 90 percent limitation on offsetting the AMT tax.

[1,112] All and all, there are 31 provisions in the bill, and we think they are important ones. Then the question comes up, "Well, you know, you've been doing this for a number of congresses. How are you going to get this enacted?" and that of course, is always the question.

[1,113] Of course, the outlook for this year is probably not very favorable but next year there's a possibility. There is the other reality that you get into, and that is, you know, it's an election year; and when you're doing things that may be benefitting multi- nationals, that can get into the politics and it's fair game. I think you just have to look at the repeal of the corporate AMT proposal right now to see how that's played out.

[1,114] So, anyway, I think Ray is right. We're going to keep pushing for the incremental change, and you know, see where we go from there.

[1,115] MS. PUGH: I guess I'll clean up and be brief. First, I must note as Oren did that my views are my own and not Chairman Baucus', unless of course they're absolutely brilliant, and then you can attribute them to him anything you like.

[Laughter.]

[1,116] MS. PUGH: We, before we started, were having a little discussion here the Joint Committee study, I think, which was very helpful. It laid a lot of groundwork. I thought it was important that we include some of their ideas in the international simplification bill we've been working on.

[1,117] We also have the international simplification bill, but as you may see from Senator Baucus' remarks that are included—those are all well and good, but when we came down to the tax bill we passed in the spring, we didn't include much.

[1,118] So I was sitting here thinking, well, how do we get some of these items done? I think you can see success in the incremental approach, but I don't think it's right for us to stop there. I would like to see some good thinking done, some more—I don't know whether we can have hearings. I assume that Representative Houghton will push for those on the House side. Perhaps we can have some of those on the Senate side—to think about some of the ideas we've heard today, some of the bolder ideas.

[1,119] But even some of the more modest proposals, as Oren suggested, some of our ideas in the bill may not be really simplification. It also depends on how you measure simplification, whether it's simplifying transactions, administration or compliance. We need to analyze the provisions and try to build momentum.

[1,120] One thing that I have discovered since I got here is, Members are not going to be as interested in simplification unless you can translate it into something meaningful for them. I think that's why you hear so much about competitiveness. They seem to understand better trade issues and competitiveness issues.

[1,121] Simplification, unless we can translate it into something that matters to them when they go into meetings with their constituents, or company representatives, it's very difficult on the staff level to build momentum; and that means we need to look to Treasury to lead, or we're going to be trying to put in provisions that could ride along with some of the more fundamental reforms.

[1,122] An exception, in some respects, was interest allocation, which we could call simplification or not. But it was a big provision that had a lot of momentum. It meant a lot. It was a lot of dollars to a lot of people. That got into the '99 bill and we only had a handful of other provisions in the '99 bill.

[1,123] So, I'll leave you with that thought. Try to help us translate these ideas. We also need to have the good ideas and understand them and how they really will simplify things for companies.

[1,124] It is true a lot has changed in the last 40 years and it's time we re-evaluate the international tax rules, they apply to many more taxpayers. On the other hand, we have a very complicated economy, and a complicated world, so there are limits to what we can do.

[1,125] I'll leave it at that.

[1,126] MR. LIFSON: Reuven, there were two things that you brought up that seemed to be consistently challenged. One is the concept—and I was troubled by this in your paper—that we should eliminate all withholding taxes, which to me will be—will disarm us from the ability to negotiate fair and just treaties with the other hundred or so tax systems that we have to interact with.

[1,127] Also, the concept of the formulary method and the complexity that it might bring about. It might be in far more complex. It almost reminds me of unitary taxation in California, which was never too popular with any of our international trading partners, either.

[1,128] Could you comment on any of those and anything else that you jotted studious notes that you wanted to respond on?

[1,129] MR. YONAH: The withholding tax issue, actually you're the first one to bring this up. I say briefly in the paper that basically I don't think that this will disarm us from negotiating treaties, for the simple reason that there will be a lot of countries where we have treaties already. So the withholding taxes are generally down, and developing countries are not interested in reducing their withholding taxes, so that doesn't matter. But, we will see.

[1,130] Now let's talk a little bit about some of the other issues. On the sourcing rule for foreign tax credit purposes, that's something that's found in treaties quite frequently. That is that you defer to the sourcing rule of the source country in order to prevent double taxation. All they were saying, basically, is that if the other country taxes under those bases, then you can follow along with that; and I don't think that's particularly radical or particularly difficult to follow.

[1,131] I think the real objection that can be made against that is that it encourages consultant taxation. That is, they will tax just because they know they have the credit. That's why we have the consultant tax rule, and I think that needs to maybe extended a little bit.

[1,132] Oren said a couple of things about some of the problems in the proposal that I'm fully aware of, and to some extent, they are second best. How do you draw the line between active/passive and stuff like that; how do you determine the effective tax rate for purposes of the low or medium or whatever, less than 90 percent tax, kick in?

[1,133] Well, we have to do that for current purposes, also. As he mentioned, companies do that for book purposes, but if you really think that those are too problematic, then let's abolish them and get rid of that problem.

[1,134] Now, Ray on the other hand, of course, doesn't like that idea on competitiveness grounds. Now I've talked a little bit about that, but basically I think on that it's an empirical issue about how tough our rules are compared to those of other countries. My best judgment is that if we go to taxing only under subpart F we'd have by far the most lenient rule of any country in the world.

[1,135] And, by the way, if we go to territoriality, then, there's no question at all. If we go to territoriality without doing anything about the sourcing or transfer pricing rule, that would be a disaster.

[1,136] So, finally, the most controversial item predictably is formula apportionment. All right, so, here we go again. I think that there's a reason that we have a low APA rate, and the reason we have a low APA rate is that companies can abuse the current system. That's why they don't like to enter into APA.

[1,137] Now it's true that formula apportionment is complicated. To some extent, on the state level, it is I think less complicated if you have more consistent formulas, and that's what the Europeans are suggesting. But I don't think that you'll get an incredible amount of double taxation, if people have particularized incentives. Well, that's what they have today under the current system, also. That's not particularly different.

[1,138] What you could have is something like the states are also doing, which is a drawback rule that eliminates, at least, the low tax, if the formula results in too little tax and there's a residual taxation on residence basis. It's a judgment of different levels of complexity. I think the actual complexity on the state level is less.

[1,139] Now, the real issue is the one that Barbara brought up. That is, can we really do something that's different from what other countries do? What I have to say is, if we only follow what other countries do, we wouldn't have the foreign tax credit, we wouldn't have the CFC rules, we wouldn't have a lot of things where we are the pioneers. On this one, on this particular transfer pricing issue, why is it that ACD has, you know, the transaction margin method and profit split, because we were pioneers on that, too. So, we can be pioneers again.

[1,140] That's about the end of the walk.

[1,141] MR. LIFSON: Barbara? It begs an answer.

[1,142] MS. ANGUS: I guess I'd like to comment just on a couple of things. I share the concern about the issue of the withholding taxes, and on Reuven's point that on withholding taxes we have tax treaties with developed countries. We do have tax treaties with most of the developed countries in the world.

[1,143] I for one am not satisfied with the withholding rates in those treaties, and I think a lot of you are not either, and we have advances to make in reducing withholding taxes. And in reducing withholding taxes, it is not really just an issue of our withholding taxes on foreign investment in U.S., but obviously, the important issue of withholding taxes imposed on our taxpayers.

[1,144] On the issue of developing countries not being interested in reducing withholding taxes, I don't think that's true. Certainly developing countries have particular concerns about that issue. But they are developing countries, and in developing they are seeking to encourage investment in their countries to help them develop. One way to encourage investment is to not allow taxes, including withholding taxes, to stand as barriers.

[1,145] On the issue of the effective tax rate test for subpart F, Reuven commented that if we think that the effective tax rate test is too complicated, we should simply repeal deferral, and then noted that Ray Rossi would object to that. I would like to say that Ray is not the only one up here that would object to repealing deferral.

[Laughter.]

[1,146] MS. ANGUS: And finally on the formula apportionment issue and the fact that the U.S. has been a leader on 482 and transfer pricing and flexible methods, the U.S. has been a leader and we've accomplished a lot. I just would caution throwing all of that out and starting over.

[1,147] That isn't to say there isn't more that we can accomplish in coordinating rules across the world, but we really ought to build on our accomplishments.

[1,148] MR. LIFSON: Well, thank you.

[1,149] I can easily talk to all of you, indefinitely, but I will not indulge the audience in that. Certainly complexity is the same problem with different solutions for each area of the tax code and for each segment of our domestic and global economy.

[1,150] Dick Lipton would like to make some closing remarks. Thank you for your time here.

[1,151] MR. LIPTON: I do want to thank the last panel for their very good presentation.

[Applause.]

[1,152] MR. LIPTON: I want to thank all of you for taking the time out of your busy schedules to come here today for this invitational conference on simplification.

[1,153] As I was sitting in the audience, a few questions popped through my mind, I think, to wrap up very well what happened today.

[1,154] First of all, what did we accomplish? Well, it's certainly fair to say that no laws were passed here today. No simplification was enacted today. But I think we accomplished a piece of our goal, which is to put a focus on the simplification, to make people think about and explore in some more depth, the excellent report that was done by the Joint Committee, and to raise a number of the issues, some of which were raised in that committee's report, some of which were not because of their own limitations, or simply because of things that they may not have thought about.

[1,155] Where does this all lead? Well the one thing I know for sure is, I don't know. But I do think there are a couple things I'm sure of. First of all, we all have to take into account what Chairman Thomas raised, "Are we thinking enough outside the box?" Those are the types of questions we will have to be asking.

[1,156] The other thing, which I hope this will lead to, is there appeared to be a lot of consensus on some items that can be simplified, and hopefully by drawing attention to those items, some things, such as the definition of family, some of the educational issues, a lot on the individual side. There appeared to be a fair degree of consensus across the private practitioners, the government representatives and Treasury, that this is something where maybe there can be some incremental progress, even before you reach sweeping progress.

[1,157] What are the next steps to be taken? Well the one thing I know for sure is that the ABA Tax Section, the AICPA and the TEI will hopefully gather. Then we will consider, amongst ourselves after the holidays, what we can do to keep the focus on simplification, and to keep raising issues.

[1,158] The whole role of these organizations has been to maintain the spotlight on simplification, and I'm very comfortable in saying that I think this conference today served as a step in that direction.

[1,159] Finally and most importantly, what I want to do in concluding is give my thanks. First to all of the speakers who have made very helpful, enlightening and thoughtful presentations, specifically more than others, to the academic speakers, to Professor Spragens, Schenk, Weisbach and Avi-Yonah. They not only gave us their thoughts, but gave us their time and their papers, which will memorialize some of the thought process.

[1,160] To all of the government representatives, particularly those from the Treasury and the IRS, and all of the staffs from Ways and Means, Senate Finance and Joint Committee.

[1,161] And I want to thank the other organization. I want to thank the AICPA and its leader, Pam Pecarich, for devoting the resources. TEI, both Bob Ashby, its current president; and Betty Wilson, it's past president, who were very involved; and of course from the Tax Section, I want to thank our volunteers who were involved, David Glickman and Helen Hubbard.

[1,162] Then the people who really deserve the thanks are the staffs. On behalf of the AICPA, we really appreciate the work that Carol Ferguson and Gerry Padwe put into this program. From TEI, Mary Lou Fahey and Tim McCormally; and from the Tax Section, Chris Brunswick and Cathy Walker, who brought all the pieces here together.

[1,163] So, on behalf of the three organizations, thank you all for putting in the time, the listening. Thanks to the speakers for raising all the issues, and until we meet again, thank you.

[Applause.]

[Whereupon, at 5:00 p.m., the proceedings were concluded.]