[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]
SAVINGS AND INVESTMENT PROVISIONS IN THE ADMINISTRATION'S FISCAL YEAR
1998 BUDGET PROPOSAL
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
__________
MARCH 19, 1997
__________
Serial 105-43
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
48-616 cc WASHINGTON : 1998
_______________________________________________________________________
For sale by the U.S. Government Printing Office,
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
hearing records of the Committee on Ways and Means are also published
in electronic form. The printed hearing record remains the official
version. Because electronic submissions are used to prepare both
printed and electronic versions of the hearing record, the process of
converting between various electronic formats may introduce
unintentional errors or omissions. Such occurrences are inherent in the
current publication process and should diminish as the process is
further refined.
C O N T E N T S
__________
Page
Advisory of March 4, 1997, announcing the hearing................ 2
WITNESSES
Congressional Research Service, Jane G. Gravelle, Senior
Specialist, Economic Policy.................................... 55
______
American Council for Capital Formation, Mark Bloomfield.......... 46
American Family Business Institute, Harold I. Apolinsky.......... 122
American Farm Bureau Federation, Charles E. Kruse................ 136
Apolinsky, Harold I., Small Business Council of America, and
American Family Business Institute............................. 122
Biotechnology Industry Organization, Tom Wiggans................. 74
Bloomfield, Mark, American Council for Capital Formation......... 46
Christensen, Hon. Jon, a Representative in Congress from the
State of Nebraska.............................................. 16
Communicating for Agriculture, Wayne Nelson...................... 119
Conine Residential Group, C. Kent Conine, as presented by Mark
Kalish......................................................... 205
Connective Therapeutics, Tom Wiggans............................. 74
Cox, Hon. Christopher, a Representative in Congress from the
State of California............................................ 31
Danner, Dan, National Federation of International Business....... 115
Davis, J. Morton, D.H. Blair Investment Banking Corp............. 222
Dean Witter Financial, James F. Higgins.......................... 149
Deutsch, Hon. Peter, a Representative in Congress from the State
of Florida..................................................... 27
D.H. Blair Investment Banking Corp., J. Morton Davis............. 222
DRI/McGraw-Hill, David Wyss...................................... 59
Dreier, Hon. David, a Representative in Congress from the State
of California.................................................. 24
Dunn, Hon. Jennifer, a Representative in Congress from the State
of Washington.................................................. 12
Ettline Foods Corp., and Food Distributors International, Martin
J. Whelan...................................................... 108
Gale, William G., Brookings Institute............................ 180
Higgins, James F., Dean Witter Financial, and Securities Industry
Association.................................................... 149
Kalish, Mark, Michael T. Rose Associates, presenting statement of
C. Kent Conine................................................. 205
Kruse, Charles E., Missouri Farm Burea Federation, and American
Farm Bureau Federation......................................... 136
McCarthy, Hon. Karen, a Representative in Congress from the State
of Missouri.................................................... 29
McCrery, Hon. Jim, a Representative in Congress from the State of
Louisiana...................................................... 6
Michael T. Rose Associates, Mark Kalish, presenting statement of
C. Kent Conine................................................. 205
Missouri Farm Bureau Federation, Charles Kruse................... 136
National Association for the Self-Employed, Bennie L. Thayer..... 144
National Association of Home Builders, C. Kent Conine, as
presented by Mark Kalish....................................... 205
National Association of Realtors, Richard Woodbury............... 67
National Federation of International Business, Dan Danner........ 115
Neal, Hon. Richard, a Representative in Congress from the State
of Massachusetts............................................... 9
Nelson, Wayne, Communicating for Agriculture..................... 119
Peterson, Hon. Collin C., a Representative in Congress from the
State of Minnesota............................................. 34
Pomeroy, Hon. Earl, a Representative in Congress from the State
of North Dakota................................................ 37
Regalia, Martin A., U.S. Chamber of Commerce..................... 198
Savings Coalition of America, Bennie L. Thayer................... 144
Securities Industry Association, James F. Higgins................ 149
Small Business Council of America, Harold I. Apolinsky........... 122
Thayer, Bennie L., National Association for the Self-Employed,
and Savings Coalition of America............................... 144
U.S. Chamber of Commerce, Martin A. Regalia...................... 198
Whelan, Martin J., Ettline Foods Corp., and Food Distributors
International.................................................. 108
Wiggans, Tom, Connective Therapeutics, and Biotechnology Industry
Organization................................................... 74
Woodbury Corp., and National Association of Realtors, Richard
Woodbury....................................................... 67
Wyss, David, DRI/McGraw-Hill..................................... 59
Yakoboski, Paul J., Employee Benefit Research Institute.......... 156
SUBMISSIONS FOR THE RECORD
American Alliance for Software Exports, and BMC Software, Inc.,
Houston, TX, John W. Cox, joint statement...................... 232
American Bankers Association, statement.......................... 237
Association of Proprietary Colleges, David Rhodes, statement..... 241
Independent Bankers Association of America, statement............ 243
Investment Company Institute, statement.......................... 247
Miles, Craig, Thedford, NE, letter............................... 249
National Apartment Association, and National Multi Housing
Council, joint statement....................................... 250
R&D Credit Coalition, and Pericom Semiconductor Corp., San Jose,
CA, Patrick Brennan, joint statement and attachments........... 259
Thomas, Hon., Bill, a Representative in Congress from the State
of California, statement....................................... 5
SAVINGS AND INVESTMENT PROVISIONS IN THE ADMINISTRATION'S FISCAL YEAR
1998 BUDGET PROPOSAL
----------
WEDNESDAY, MARCH 19, 1997
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:04 a.m. in
room 1100, Longworth House Office Building, Hon. Bill Archer
(Chairman of the Committee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
FOR IMMEDIATE RELEASE CONTACT: (202) 225-1721
March 4, 1997
No. FC-5
Archer Announces Hearing on
Savings and Investment Provisions
in the Administration's Fiscal Year
1998 Budget Proposal
Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
and Means, today announced that the Committee will hold a hearing on
the savings and investment provisions in the Administration's fiscal
year 1998 budget proposal. The hearing will take place on Wednesday,
March 19, 1997, in the main Committee hearing room, 1100 Longworth
House Office Building, beginning at 10:00 a.m.
Oral testimony at this hearing will be heard from both invited and
public witnesses. Also, any individual or organization not scheduled
for an oral appearance may submit a written statement for consideration
by the Committee or for inclusion in the printed record of the hearing.
BACKGROUND:
The Administration's fiscal year 1998 budget proposal includes
three savings and investment provisions: an exclusion (up to $500,000)
of capital gains on the sale of a principal residence, an expansion of
Individual Retirement Accounts (IRAs), and a modification to the estate
tax.
In announcing the hearing, Chairman Archer stated: ``In his budget
proposal, the President has recognized the need for tax incentives for
savings and investment. I heartily concur in this need. I believe our
country has an unacceptably low savings rate, and increased savings and
investment will ultimately mean better employment prospects for
Americans and a higher standard of living for our children and
grandchildren. I also believe that reining in Federal spending and
balancing the Federal budget will help to increase our national savings
rate. Replacing our current tax system with a broad-based consumption
tax remains my ultimate goal. I am convinced that this would be a more
lasting way to encourage savings and investment and produce a stronger
economy. But until that goal can be reached, we should enact changes to
our tax system that reduce disincentives to save and invest.
Accordingly, we should discuss not only the implications of the
President's proposals but also more broad-based alternatives to the
President's proposals.''
FOCUS OF THE HEARING:
The focus of the hearing will be the savings and investment
provisions (e.g., capital gains exclusion, IRA expansion, and estate
tax relief) of the Administration's budget proposal for fiscal year
1998 and broad-based alternatives to those proposals.
DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:
Requests to be heard at the hearing must be made by telephone to
Traci Altman or Bradley Schreiber at (202) 225-1721 no later than the
close of business, Tuesday, March 11, 1997. The telephone request
should be followed by a formal written request to A.L. Singleton, Chief
of Staff, Committee on Ways and Means, U.S. House of Representatives,
1102 Longworth House Office Building, Washington, D.C. 20515. The staff
of the Committee will notify by telephone those scheduled to appear as
soon as possible after the filing deadline. Any questions concerning a
scheduled appearance should be directed to the Committee on staff at
(202) 225-1721.
In view of the limited time available to hear witnesses, the
Committee may not be able to accommodate all requests to be heard.
Those persons and organizations not scheduled for an oral appearance
are encouraged to submit written statements for the record of the
hearing. All persons requesting to be heard, whether they are scheduled
for oral testimony or not, will be notified as soon as possible after
the filing deadline.
Witnesses scheduled to present oral testimony are required to
summarize briefly their written statements in no more than five
minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full
written statement of each witness will be included in the printed
record, in accordance with House Rules.
In order to assure the most productive use of the limited amount of
time available to question witnesses, all witnesses scheduled to appear
before the Committee are required to submit 300 copies of their
prepared statement and a 3.5-inch diskette in WordPerfect or ASCII
format, for review by Members prior to the hearing. Testimony should
arrive at the Committee office, room 1102 Longworth House Office
Building, no later than Monday, March 17, 1997. Failure to do so may
result in the witness being denied the opportunity to testify in
person.
WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit at least six (6)
copies of their statement and a 3.5-inch diskette in WordPerfect or
ASCII format, with their address and date of hearing noted, by the
close of business, Wednesday, April 2, 1997, to A.L. Singleton, Chief
of Staff, Committee on Ways and Means, U.S. House of Representatives,
1102 Longworth House Office Building, Washington, D.C. 20515. If those
filing written statements wish to have their statements distributed to
the press and interested public at the hearing, they may deliver 200
additional copies for this purpose to the Committee office, room 1102
Longworth House Office Building, at least one hour before the hearing
begins.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a
witness, any written statement or exhibit submitted for the printed
record or any written comments in response to a request for written
comments must conform to the guidelines listed below. Any statement or
exhibit not in compliance with these guidelines will not be printed,
but will be maintained in the Committee files for review and use by the
Committee.
1. All statements and any accompanying exhibits for printing must
be typed in single space on legal-size paper and may not exceed a total
of 10 pages including attachments. At the same time written statements
are submitted to the Committee, witnesses are now requested to submit
their statements on a 3.5-inch diskette in WordPerfect or ASCII format.
2. Copies of whole documents submitted as exhibit material will not
be accepted for printing. Instead, exhibit material should be
referenced and quoted or paraphrased. All exhibit material not meeting
these specifications will be maintained in the Committee files for
review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a
statement for the record of a public hearing, or submitting written
comments in response to a published request for comments by the
Committee, must include on his statement or submission a list of all
clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the
name, full address, a telephone number where the witness or the
designated representative may be reached and a topical outline or
summary of the comments and recommendations in the full statement. This
supplemental sheet will not be included in the printed record.
The above restrictions and limitations apply only to material being
submitted for printing. Statements and exhibits or supplementary
material submitted solely for distribution to the Members, the press
and the public during the course of a public hearing may be submitted
in other forms.
Note: All Committee advisories and news releases are available on
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.
The Committee seeks to make its facilities accessible to persons
with disabilities. If you are in need of special accommodations, please
call 202-225-1721 or 202-225-1904 TTD/TTY in advance of the event (four
business days notice is requested). Questions with regard to special
accommodation needs in general (including availability of Committee
materials in alternative formats) may be directed to the Committee as
noted above.
Chairman Archer. The Committee will come to order. The
Chair would invite guests, staff, and Members to take seats. We
have a very, very important witness to lead off the hearing
today, and we want to be able to be sure and hear him.
Actually, we have three very important witnesses at the witness
table. Today, the Committee continues our series of hearings on
the tax provisions in the President's budget. Today's hearing
will focus on incentives for savings and investment.
In the President's budget proposal, he includes a capital
gains exclusion for principal residences and an expansion of
IRAs and changes to the rules for deferred payments of estate
taxes on farms and small businesses. In this hearing, we will
examine not only these incentives but more broad-based
alternatives as well. In particular, I welcome the support we
will hear today from Democrats for a broad-based capital gains
and estate tax relief.
The reduction in the capital gains tax and the death tax is
not and should not be a partisan issue. All Americans will
benefit from greater savings and investment. I look forward to
a bipartisan effort to change our tax system to one that
encourages, rather than deters, savings and investment.
[The opening statement of Mr. Thomas follows:]
[GRAPHIC] [TIFF OMITTED] T8616.022
Chairman Archer. Our first witness this morning is a
gentleman well known to the Committee, a Member of the
Committee, the gentleman from Louisiana, Jim McCrery.
You may proceed, Mr. McCrery.
STATEMENT OF HON. JIM MCCRERY, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF LOUISIANA
Mr. McCrery. Thank you, Mr. Chairman.
Mr. Chairman, in the last Congress, I, along with a few
others on the House side and Senator Dole on the Senate side,
introduced the Family Business Protection Act. In the House, it
was H.R. 2190. We had about 175 or so cosponsors and had
bipartisan support for the bill. A version of H.R. 2190, in
fact, a pretty close version, was included in the
reconciliation bill that was sent to the President and vetoed
by the President.
Since the beginning of this Congress, I have been working
with several Members of this Committee and others on a new
version of the Family Business Protection Act, and we will be
introducing this soon. Essentially, the components of the new
bill will include a $1.5 million exclusion from the estate tax
for closely held family businesses, family farms, and the like.
We will index that exclusion for inflation, and any excess
value over that exclusion will be taxed at a rate 50 percent
less than the current rate.
Second, the legislation will make the unified credit a real
exemption from the estate tax. What does that mean? That means
that we will, in effect, move the tax rates applicable to
estates up to begin at the level of the exemption. In other
words, in the current law, you exempt $600,000 of the estate
from taxation, but the initial rate of tax is not 18 percent,
which is the lowest estate tax rate; it is 37 percent. What we
do in this bill is we move the rates up to correspond with the
first tax dollar of the estate so that the initial rate applied
to the estate is 18 percent above the exemption.
And we also include an increase in the unified credit from
the current law level of $600,000 up to $1 million over a 5-
year period, and then, we index that exemption or that unified
credit for inflation. And finally, working with Mr. Herger and
Mr. Houghton and others, our legislation will offer some
additional changes dealing with the election of the special use
valuation for family farms and ranches, conservation easements,
and historic property.
Mr. Chairman, the estate tax has become a burden on average
families in this country, particularly families that have saved
and invested and built small businesses, family farms. I do not
think the estate tax was ever meant to be a burden on those
families. It needs to be addressed. I am hopeful this Congress
will do it.
Thank you.
[The prepared statement follows:]
Statement of Hon. Jim McCrery, a Representative in Congress from the
State of Louisiana
Thank you Mr. Chairman for giving me the opportunity to testify
before the Committee today. I appreciate the time you have allotted my
colleagues and me to talk about one of the greatest disincentives to
lifetime savings that exists in the tax code today--the estate and gift
tax.
There has been a direct connection between death and taxes for
about 200 years. In fact, the year 1797 was the first time the United
States government imposed a death duty in the form of a stamp tax.
Between 1797 and 1916, the year Congress first enacted a federal estate
tax, inheritance duties were imposed twice to raise revenue during
times of war. Both instances collected very little money, even by that
day's standards.
As members of this committee, we have listened to hours of
testimony describing the dismal savings rate of the U.S. population. We
have proposed and even passed legislation that created incentives in
the tax code for savings. Yet by some perverse logic, our tax code
punishes those people in death who have done exactly what we hope the
rest of the country will do during their lifetime--save and invest.
Mr. Chairman, conventional wisdom suggests that most people believe
they are never going to be subject to estate taxes. In their minds,
only the very wealthy have estates large enough. I believe, however,
more often than not, conventional wisdom is being proven wrong and that
we are at the beginning of a period in our history where average
Americans who have built family businesses, operated ranches and farms,
and saved frugally and invested wisely for most of their lives, will be
unfairly subjected to estate taxes.
In fact, in a letter to you dated January 21, 1997, the Joint
Committee on Taxation said that since 1993, estate and gift receipts
have been averaging double digit rates of growth. They laid out four
possible reasons: first, the amount of wealth exempt from the estate
and gift tax was not indexed to inflation; second, we have witnessed an
unusually large increase in the value of the stock market. This means
that the value of estates that would already be subject to tax has
increased tremendously and more estates have been bumped into taxable
status; third, the number of people who are 85 years old or older is
growing at a rate of 3.5% annually, thereby increasing the mortality
rates for this decade. And fourth, the 100% marital deduction included
in the 1981 Economic Recovery Tax Act delayed the payment of estate tax
until the surviving spouse died. On average, spouses tend to live 10
years longer than their mates, and therefore this decade will see more
estates that used the marital deduction, subject to tax.
Since the 103rd Congress, I have introduced legislation that would
address the estate tax burden imposed upon closely held family
businesses and farms. According to the Small Business Administration's
Office of Advocacy, more than 70% of all family businesses do not
survive through the second generation and fully 87% do not make it to
the third generation. Further, according to the Tax Foundation, high
estate taxes looming on the horizon provide a disincentive for owners
of family owned businesses to expand their operation and create new
jobs. In fact, current estate tax rates produce the same disincentives
to growth as a doubling of current income tax rates.
In the 104th Congress, H.R. 2190, the Family Business Protection
Act, had 175 cosponsors and enjoyed wide bipartisan support from both
urban and rural members as well as conservative Republicans and liberal
Democrats. A modified version of this legislation was included in the
reconciliation bill which was vetoed by President Clinton.
Since the beginning of this Congress I have been working with a
group of members on this committee to expand the provisions of the
Family Business Protection Act to incorporate sections that address
many of the underlying reasons that, if nothing is done, many more
average families will be subject to the estate tax.
Essentially, the components of the ``Family Business Protection
Act'' will include a $1.5 million exclusion, indexed for inflation,
from estate tax for the value of a closely held family owned business.
The excess value over the $1.5 million would be taxed at 50% of the
current rate.
Second, our legislation will make the unified credit a real
exemption. You may be asking what is the difference? The difference is
that we talk about the fact that there is a unified credit of $600,000,
but that really is not true.
The tax code provides for a bottom rate of 18%. In reality, no one
ever pays that. The unified credit only gets rid of the tax liability
on $600,000, so currently the lowest rate that anyone would ever pay is
37%. Essentially, if today a person had an estate of $600,001, of that
$1.00, 37 cents would go to the Treasury. What we are proposing is that
the credit be made an exemption so that the lowest rate of 18% applies
to the first dollar of value in a person's estate upon which they
actually pay the tax. The rates would then be graduated, as under
current law.
In conjunction with this, our legislation will also include an
increase the unified credit from the current law level of $600,000 to
$1,000,000 over five year, indexed for inflation.
Finally, our legislation will offer some additional changes to
current law dealing with the election of the special use valuation for
family farms and ranches, conservation easements, and historic
property.
Mr. Chairman, the estate tax was never intended to be a burden on
average families who have wisely saved and invested over their
lifetime. What we are finding, however, is that for families all over
this country this tax is indeed becoming a burden. They are having to
sell their homes, businesses, and farms to meet a tax bill that is
imposed because someone passed away. Our bill is targeted to give
relief to those families.
Again, thank you for this opportunity to testify. I will be happy
to take any questions at the appropriate time.
Chairman Archer. Thank you, Mr. McCrery.
Mr. Rangel, would you like to make any sort of a
preliminary statement and extend your own welcome to the panel
of witnesses?
Mr. Rangel. That is very kind of you, Mr. Chairman. I would
like to join with you in hoping that both the Republicans and
the Democrats, taking suggestions and recommendations made by
our Members, will come up with a bill that will present to the
American people a balanced budget that we all can agree to.
This is especially so since your leadership has suggested
removing tax cuts from the budget discussion, temporarily, at
least, and all my colleagues share that feeling.
Thank you.
[The opening statement follows:]
Statement of Hon. Charles B. Rangel, a Representative in Congress from
the State of New York
I am delighted to be here with my colleagues today to talk
about the choices we will have to make if we are to balance the
budget in the next several years.
I am pleased to listen to today's witnesses about cuts in
capital gains taxes, expanded IRA accounts, and estate and gift
tax relief in the contect of reducing our deficit.
A good case will be made for each of these tax cut ideas
from the viewpoint of its proponents.
We will hear about the potential that each of these
proposals has for increasing savings and investment in this
country. We may hear some skepticism.
Tax cuts are popular. Somebody always benefits from a tax
cut. And, this will be reflected in the enthusiasm that some of
our witnesses may have for various cut ideas.
I am, like any politician, in favor of cut cuts. In fact, I
have said that I could even be in favor of a capital gains tax
cut if it were in the context of a fair and balanced plan. So,
I am here today to listen to the reasons why we should include
them in whatever budget bill we may end up with this year.But,
tax cuts should not come at the wrong time and they should be
focused on those who need them most.
And, tax cuts must be paid for . . . that is, they must be
paid for if we are serious about reducing the deficit at the
same time.
Who will pay for these tax cuts? Will it be the large
corporations who eloquent and sophisticated representatives sat
in this room last week and opposed the President's revenue
raisers? Or will it be the poor and the disadvantaged who have
only begun to feel the effects of the policies enacted in the
last 2 years to pay for other initiatives?
In the end, it is all about choices.
We will have to make difficult choices about how to spend
our scarce resources. We will have to decide what is best for
our economy and for our citizens. Not just what will make them
feel good next April 15 when they fill out their tax returns,
but instead what will add to their changes for prosperity year
after year.
I have made my choice. I have come to the conclusion that
the best thing for our country right now is deficit reduction.
This will help to keep interest rates down and to control
the pressure on the future generations who will have to pay for
the debts of our generation. And it will prevent any unfairness
in the way any possible tax cuts are paid for.
The ``Blue Dog'' Democrats have made their choice. They
have put forth a plan for a balanced budget without any tax
cuts. They have said that deficit reduction is more important
right now. I am glad we agree on this issue.
Apparently, Speaker Gingrich has made his choice, too.
Yesterday's Washington Post reported that the Speaker has given
up on his ``crown jewel.'' He has dropped the idea of including
a tax cut in the budget bill.
I am glad that the Speaker has come around to that
conclusion because the task of deficit reduction ids made
undeniably easier if there are no tax cuts in the final
package.
If we can first get our fiscal affairs in order, then we
can begin to consider how best to enhance the opportunities for
prosperity of each of our citizens.
I prefer the idea of investing in human capital. Some of
the proposals we will consider today will support tax relief
for investing in physical and/or financial capital. That is not
enough. Nor is it the correct focus, in my opinion.
A Wall Street Journal survey of 1,500 economists indicated
that the vast majority of them do not believe that proposals
like the ones before us today will do much, if anything, for
the economy. However, they gave much higher marks to the notion
of investing in education in order to improve the abilities of
our own workforce.
I believe in that. I believe in making people capable
themselves of improving their circumstances in life.
If government is going to maintain the ability to help our
citizens do that, then we must be cautious. We must craft our
proposals carefully and spend our money wisely.
We must be prepared to make the tough choices.
Mr. McCrery. Mr. Chairman, I beg your forgiveness. I did
not request that my written testimony be included in the
record. I will do so at this time.
Chairman Archer. Without objection, as usual, the written
testimony of every witness in the hearing today will be
included in the record.
Mr. McCrery. Thank you.
Chairman Archer. And all witnesses are encouraged to keep
their verbal testimony to within a 5-minute limit.
Our next witness is the gentleman from Massachusetts, also
a well-known Member of the Committee, Richard Neal.
Mr. Neal, welcome to your own Committee.
Mr. Neal. Thank you.
Chairman Archer. And you may proceed.
STATEMENT OF HON. RICHARD NEAL, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF MASSACHUSETTS
Mr. Neal. Thank you, Mr. Chairman.
I want to talk to you this morning about an issue that has
been important to me since I arrived in the Congress, and that
is the issue of savings for retirement. Alan Greenspan has said
time and again--and I know it sounds trite on the surface, but
nonetheless, it is critical, that the number one economic
problem that faces America today is our low national savings
rate. As the baby boomers grow older, they are faced with many
difficult financial decisions, such as the cost of long-term
care for elderly parents, the expense of higher education, and
saving for retirement.
The May issue of the Atlantic Monthly coined the phrase
social insecurity. We are beginning to face what has commonly
been referred to as the graying of America. Within 30 years,
one out of every five Americans will be over 65, and in 15
years, the baby boomers will begin turning 65. The baby boomer
generation consists of 76 million members, and this will result
in Social Security beneficiaries doubling by the year 2040.
Less than half of all Americans are currently covered by
private sector pensions, and 51 million Americans have no
pension plan at all.
We have an opportunity to encourage these individuals to
begin to save. Congressman Thomas and I have introduced
bipartisan, comprehensive individual retirement account
legislation, commonly referred to as the Super IRA. We have 110
cosponsors in the House, including 18 Members of this
Committee, and Senators Roth and Breaux have companion
legislation in the Senate, and they now have 49 sponsors. Those
who watch tax policy have dubbed this the year of the great tax
cut compromise. And while it is still doubtful that we are
going to reach a total agreement this year, I do believe there
is real consensus on the expansion of IRAs. Both the Senate
Democratic and Republican leadership have introduced
legislation which expands IRAs. The House Democratic bill is
being introduced today. President Clinton has included expanded
IRAs in the new type of IRAs in his budget.
Most of us agree that IRAs will help to increase savings
and make individuals more personally responsible for their
retirement. Deputy Secretary Summers testified before the
Senate Committee on Finance and said during his testimony that
there are two general ways to address the effect of the low
national savings rate on economic growth and retirement income
security. The first way is to reduce the deficit, and the
second is to improve current incentives to promote savings,
especially retirement savings. President Clinton's proposal
expands income limits, creates new backloaded IRAs, and
eliminates the 10-percent penalty for early withdrawal under
certain circumstances. These purposes are to pay postsecondary
education; to purchase a first-time home, to cover the cost of
unemployment, and also to cover medical expenses of certain
close relatives who are not dependents.
Under our Super IRA legislation, all Americans would be
eligible for fully deductible IRAs by the year 2001. Taxpayers
would be offered a new choice called the IRA-Plus Account.
Under the IRA-Plus Account, contributions would not be tax
deductible; however, earnings on the IRA-Plus Accounts can be
withdrawn tax free if the account is open for at least 5 years
and the IRA holder is 59\1/2\ years old. A 10-percent penalty
would apply to early withdrawals unless the withdrawal meets
one of three special purpose distributions. These special
distributions are to buy a first-time home; to pay educational
expenses; or to cover any expenses during the period of
unemployment compensation for at least 12 weeks.
These are all legitimate purposes. Otherwise, the
contributions would be locked up for retirement. IRA and 401(k)
contributions would not have to be coordinated. It seems to me
this legislation is one of the best options that is available
to all of us, and I believe it is important to enact some sort
of incentive this year to help individuals save for retirement.
As Professor Stephen Venti of Dartmouth testified recently
before the Senate Finance Committee, the long-term benefits of
the provision far outweigh the revenue costs.
Mr. Chairman, this legislation in previous sessions was
known, I believe, as the Bentsen proposal some years back, and
a former Member and colleague on this Committee, Jake Pickle,
also offered this proposal many times before. It seems to me
that we have a unique opportunity, given the discussion that is
occurring today about entitlement reform, and just as
importantly, it is consistent with all discussions we have had
about personal responsibility. This is a critical issue as we
proceed to the new century, and I hope Members of this
Committee, 18 of whom have already signed onto this
legislation, will, I think, have the opportunity to promote
this legislation as it comes before the full Congress.
[The prepared statement follows:]
Statement of Hon. Richard Neal, a Representative in Congress from the
State of Massachusetts
Mr. Chairman, first of all I would like to thank you for
allowing me to testify about an issue which is of vital
importance to our economic security. This issue is savings for
retirement. Chairman Alan Greenspan of the Federal Reserve has
stated our number one economic problem is our low national
savings rate.
As baby boomers grow older they are faced with many
difficult financial decisions such as the cost of long-term
care for elderly parents, the expense of higher education, and
saving for retirement. The May issue of Atlantic Monthly coined
the phrase ``social insecurity.''
We are beginning to face what has been commonly referred to
as the graying of America. Within thirty years one out of every
five Americans will be over sixty-five. In fifteen years, the
baby boomers will begin turning sixty-five. The baby boomer
generation consists of 76 million members and this will result
in Social Security beneficiaries doubling by the year 2040.
Less than half of all Americans are covered by private sector
pensions. Fifty-one million American workers have no pension
plan.
We need to encourage individuals to save. Congressman
Thomas and I have introduced bipartisan comprehensive
Individual Retirement Account (IRA) legislation, commonly
referred to as the ``Super IRA.'' We have over 110 cosponsors
in the House, including eighteen Members of this Committee.
Senators Roth and Breaux have introduced companion legislation
in the Senate and they now have forty-nine cosponsors.
Those who watch tax policy have dubbed this year as ``The
Year of the Great Tax Cut Compromise.'' It still is doubtful if
we will reach agreement this year, but I believe there is real
consensus on the expansion of IRAs. Both the Senate Democratic
and Republican leadership have introduced legislation which
expands IRAs. The House Democratic leadership is introducing
legislation today. President Clinton has included expanded IRAs
and a new type of IRAs in his budget. Most of us agree IRAs
will help increase savings and make individuals more personally
responsible for their retirement. Recently, Deputy Secretary of
the Treasury Lawrence Summers testified before the Senate
Committee on Finance. During his testimony, he stated there are
two general ways to address the effect of the low savings rate
on economic growth and retirement income security. The first
way is to reduce the deficit and the second is to improve
current incentives to promote savings, especially retirement
savings. We can accomplish both of these goals by enacting a
budget which balances by 2002 and includes an expansion of
IRAs.
President Clinton's IRA proposal expand income limits,
creates new backloaded IRAs, and eliminates the 10 percent
early withdrawal for certain purposes. These purposes are to
pay post-secondary education costs, to purchase a first home,
to cover costs of unemployment, and to cover medical expenses
of certain close relatives who are not dependents. Under the
backloaded IRA, contributions would not be tax deductible, but
if contributions remain in the account for at least five years,
distributions of the earnings on the contribution would also be
tax-free.
Under the Super IRA legislation, all Americans would be
eligible for fully deductible IRAs by the year 2001. Taxpayers
would be offered a new IRA choice called the ``IRA Plus
Account.'' Under the IRA Plus Account, contributions would not
be tax deductible. However earnings on IRA Plus Assets can be
withdrawn tax-free if the account is open for at least 5 years
and the IRA holder is at least age 59 and . A 10 percent
penalty would apply to early withdrawals unless the withdrawal
meets one of the three special purpose distributions. The
special purpose distributions are: to buy a first time home, to
pay educational expenses, or to cover any expenses during
period of unemployment compensation for at least 12 weeks.
These are legitimate purposes. Otherwise, the contribution
should be locked up for retirement. IRA and 401(k)
contributions would not have to be coordinated.
I believe the super IRA legislation is the best option
before us. However, I believe it is important to enact some
type of incentive to help individuals save for retirement.
Individuals need to become more personally responsible for
their retirement. Professor Stephen Venti of Dartmouth
testified before the Committee on Finance that IRAs work. He
stated: ``The long-term benefits of the provision far outweigh
the revenue costs.''
There is skepticism among economists about IRAs generating
new savings. Professor Venti testified that many of those who
contribute to IRAs are saving funds they would not otherwise be
saving. One of our panelists will testify today that IRAs do
not create new savings and just cause a shifting of funds. I
believe there is enough evidence that IRAs promote savings. I
cannot think of a better alternative. IRAs do create new
savings and the shifting of savings usually locks up existing
savings for retirement.
Another import aspect of increasing savings is
marketability. Individuals have to want to save. We need to
offer products that they want and will make savings easy for
them. Deputy Secretary Summers testified that IRA proposals
must be designed to reinforce and encourage psychological
factors that could increase the efficiency of IRAs in promoting
savings. A 1990 Gallup survey done for Fidelity Investments
showed 71 percent of the respondents preferred expanding the
tax incentives for IRAs to close the gap between their
retirement needs and their retirement checks from institutional
sources. This same answer was given by 69 percent of the
respondents in a 1996 Luntz-Lake survey conducted for the
Savings Coalition.
IRAs provide the right type of vehicle for long term
savings for retirement. Those who invest in IRAs usually invest
for the long term. For example, 86 percent of IRA assets at
Fidelity are invested in equity funds, as compared to an
average of 56 percent in non-retirement accounts. This shows
individuals can make intelligent investments for their
retirement. Most IRA account holders are truly thinking about
retirement when they make their investment decisions.
Millions of Americans do not have adequate retirement
savings and are worried about their retirement. Even with
Social Security, a couple earning $50,000 a year needs to have
saved about $225,000 by retirement to maintain their standard
of living over a 35 year retirement. A USA Today/CNN Gallup
Poll showed four out of ten Americans sets aside less than
$1000 a year for retirement.
The Super IRA legislation is based on legislation crafted
by Congressman Pickle and Senator Bentsen. This legislation is
not a panacea for social insecurity that we will inevitable
face, but it is a reasonable, concrete solution to make
retirement savings easier. I encourage you to work with me on
the passage of expanded tax incentives for IRAs. This type of
proposal will have a drastic impact on millions of Americans.
The bottom line is more Americans will be able to be personally
responsible for their retirement.
As the graying of America continues Congress will have to
face many difficult decisions about the future of Social
Security, but in the meanwhile, we can and must all agree on
making retirement savings easier.
Chairman Archer. Thank you, Mr. Neal.
Our next witness is also a Member of the Committee, the
gentlelady from the State of Washington, Jennifer Dunn.
You may proceed.
STATEMENT OF HON. JENNIFER DUNN, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF WASHINGTON
Ms. Dunn. Thank you, Mr. Chairman.
And my colleagues, I appreciate the opportunity to testify
before you today on two matters that I believe are critical to
the economic security of every American: The estate tax and
capital gains relief. My message is quite clear: The
President's budget simply does not add up in a way that is fair
to taxpayers. First, it adds up to a tax increase over 10
years. Second, it doesn't add up to a balanced budget. Both a
balanced budget and meaningful tax relief are desperately
needed.
I have introduced legislation, the Return Capital to the
American People Act, the ReCAP Act, which provides a capital
gains reduction for both individuals and for corporations. This
is legislation that is sponsored in the Senate by Senator Mack,
and Mr. Herger has joined me in proposing this legislation. I
won't go into the specifics of the bill since you have a
detailed description, but I do want to briefly point out that
the measure is broad based, and the capital gains measure
includes a 50-percent capital gains deduction, indexation of
assets to eliminate inflationary gains, and venture capital
incentives to help cash-starved small and startup businesses.
I will tell you that I believe an across-the-board cut in
the capital gains rate for both individuals and corporations
will do more to boost our Nation's economy, more to create
jobs, more to enhance U.S. competitiveness worldwide, and more
to increase savings and investment than any other single piece
of legislation we can enact. While there are many reasons to
support a reduction in the capital gains rate, I would like to
highlight what I believe to be the most compelling parts of the
ReCAP Act.
One: A low capital gains rate benefits all Americans. My
proposal is fair to all income groups and sectors of our
economy. Two: Low capital gains is important for our future and
our Nation's ability to save and to invest. Three: Lowering the
capital gains rate unlocks investment and America's true
economic potential. Four: Lower capital gains will increase
Federal revenues, just as was done in the twenties, the
sixties, and the eighties, and help us reach the goal of a
balanced budget. Finally, with respect to capital gains, I
would suggest that sound tax policy and economic considerations
argue for the inclusion of a corporate capital gains rate
reduction comparable to the percentage of the individual rates
cut.
Second, on the estate tax; this is also called the death
tax, or, some of the people I represent call it the agony tax.
One of the most compelling aspects of the American dream is to
make life better for your children and your loved ones. Yet,
the current tax treatment of estates is so onerous that when
one dies, their children are many times forced to sell and turn
over more than half their inheritance simply to pay the taxes.
This is wrong, and I hope we can all agree that something
should be done.
More than 70 percent of family businesses and farms do not
survive through the second generation. Eighty-seven percent do
not make it through the third generation. By confiscating
between 37 and 55 percent of a family's aftertax savings, the
estate tax punishes lifelong habits of savings. It discourages
entrepreneurship and capital formation. It penalizes families,
and it has an enormous negative effect on other tax revenues.
By today's tax system, it is easier and cheaper to sell the
business before death rather than to try to pass it on after.
I would like to talk briefly about solutions. I am a strong
advocate of the elimination of all estate tax, and I have
cosponsored two separate pieces of legislation in the 105th
Congress to provide for that repeal. One is the Crane-Hulshof
bill; the other is the Cox bill. Unfortunately, a complete
repeal of the estate tax is not a viable option, considering
the President's opposition. I am working with a number of our
colleagues on the Committee to draft a bipartisan proposal. I
believe such a proposal should be based on a three-pronged
approach: One, increase in the unified credit; two, targeted
relief for family businesses and farms; and three, to make it
broader, some level of rate reduction.
I had hoped we would have introduced our bipartisan
proposal at the time of this hearing, but it could not occur.
However, I am confident that through our continued vigilance,
we can draft a bipartisan proposal that will be a vehicle for
relief as the Congress moves forward.
Thank you, Mr. Chairman, for your leadership in both of
these areas, and thanks to the Committee for your attentiveness
this morning.
[The prepared statement follows:]
Statement of Hon. Jennifer Dunn, a Representative in Congress from the
State of Washington
Thank you, Mr. Chairman.
My colleagues, I appreciate the opportunity to testify
before you here today on two matters that I believe are
critical to the economic security of every American--estate tax
and capital gains relief.
My message is quite clear--the President's budget simply
does not add up in a way that's fair to taxpayers. First, it
adds up to a tax increase over 10 years. Second, it doesn't add
up to a balanced budget. Both a balanced budget and meaningful
tax relief are desperately needed.
Capital Gains
On March 12th, I introduced the Return Capital to the
American People Act (ReCAP Act). This legislation provides a
capital gains reduction for both individuals and corporations
and will do more to boost our nation's economy, more to create
jobs, more to enhance U.S. competitiveness worldwide, and more
to increase savings and investment than any other single
legislative change we can enact.
For established, successful businesses, for struggling
entrepreneurs, and for middle-class families across the
country, this measure represents the most serious effort to
unlock billions of dollars in investment providing for expanded
growth and job creation. I will not go into many specifics of
my bill, as a detailed description is provided for in the
materials before you. I will, however, briefly point out that
the measure is broad-based and includes: a 50 percent capital
gains deduction, indexation of assets to eliminate inflationary
gains and venture capital incentives to help cash-starved
start-up and small businesses.
While there are many reasons to support a reduction in the
capital gains rate, I would like to highlight what I believe to
be the most compelling case for enactment of the ReCAP Act.
A low capital gains rate benefits all Americans. This bill
is fair to all income groups and sectors of our economy. Many
of the so-called ``rich'' who would benefit from a cut in
capital gains taxes are only rich for one year. A family in
Eatonville that sells its house, an owner in Issaquah who sells
a small business, a worker in Bellevue selling stock received
through an employee stock option, and a retiree in Auburn
selling an asset and planning to live off the proceeds would
all be considered wealthy on current ``tax distribution''
tables. For example, a review by the Joint Committee on
Taxation on capital gains realizations for the period 1979-1983
shows that nearly 44% of tax returns claiming a capital gain
during that 5 year period claimed only one capital gain. Most
of these people aren't rich, regardless of what statistics say.
They merely have one year of inflated income because they
realized a big capital gain.
Furthermore, an analysis of 1993 tax returns found that
nearly 50% of the tax returns reporting capital gains were
filed by taxpayers with less than $40,000 in adjusted gross
income. Of tax returns claiming a capital gain, nearly 60% of
those returns are filed by taxpayers with less than $50,000 in
adjusted gross income.
Low capital gains rate is important for our future and our
nation's ability to save and invest. Americans do not save
enough. If you look at our tax laws, you will see why. Instead
of encouraging people to save, the tax code often punishes
people who save and invest. This is primarily due to the fact
that the income tax hits savings more than once--first when
income is earned and again when interest and dividends on the
investment supported by the original savings are received. This
system is inherently unfair because the individual or company
that saves and invests pays more taxes over time than if all
income were consumed and no savings took place. We need to
change this. Without savings, a person cannot buy a house, a
business cannot purchase new equipment, and our economy cannot
create jobs. Unless we can raise our national savings rate, our
standard of living, and our children's and grandchildren's
standards of living will not grow.
Lowering the capital gains rate un-locks investment and
America's true economic potential. High capital gains taxes can
prevent someone from selling an asset and paying the tax. This
is the ``lock-in effect'': when a person will not sell an
investment and reinvest the proceeds in a higher paying
alternative if the capital gains taxes he or she would owe
exceed the expected higher return on the original investment.
This lock-in effect limits economic growth and job
creation. Capital stays locked in an investment instead of
being free to go to a person who wants to hire new employees in
her consulting business. Lower capital gains taxes will reduce
the lock-in effect and free up capital for small businesses,
first-time home buyers, and entrepreneurs.
Lower capital gains will increase federal revenues and thus
help reach the goal of a balanced budget. History indicates
that lower capital gains taxes have a positive impact on
federal revenues. During the period of 1978 to 1985 the
marginal federal tax rate on capital gains was cut from almost
50 percent to 20 percent--but total individual capital gains
tax receipts increased from $9.1 billion to $26.5 billion.
After surging to $326 billion in 1986 (the year before the 1986
rate increase took effect), capital gains realizations have
trended down and remained at less than $130 billion per year in
the 1990s.
Given the increases in the stock market, inflation and
growth of the economy since the late 1980s, realizations and
taxes paid are certainly being depressed by the current high
capital gains rates.
Rather than discouraging American workers and businesses,
the Federal government ought to simply get out of the way.
Lower capital gains taxes--as embodied in this bill--leave more
vital capital in the hands of businesses, investors and
entrepreneurs. They know a lot more than the Federal government
ever can or will about creating jobs and products in a
competitive marketplace.
I would also point out that sound tax policy and economic
considerations argue for inclusion of a corporate capital gains
rate reduction comparable to the percentage as individual rates
are cut.
History proves that capital gains tax reduction is the
right course to take. In the past, reductions always have
boosted the nation's economy and increased tax revenues to the
federal government. If a goal of this Congress is to pass
legislation promoting economic opportunity and growth in
America, then common sense suggests that we enact the ReCAP
Act.
Estate Tax Relief
One of the most compelling aspects of the American dream is
to make life better for your children and loved ones. Yet, the
current tax treatment of estates is so onerous that when one
dies, their children are many times forced to sell and turn
over more than half of their inheritance to just pay the taxes.
This is wrong and I would hope that we all can agree upon that
and that something must be done.
More than 70% of family business and farms do not survive
through the second generation. 87% do not make it through the
third generation. By confiscating between 37% and 55% of a
family's after tax savings, the estate tax punishes life-long
habits of savings, discourages entrepreneurship and capital
formation, penalizes families, and has an enormous negative
effect on other tax revenues. By today's tax system, it is
easier and cheaper to sell the business before death rather
than try to pass it on after.
I would like to talk briefly about solutions. I am a strong
advocate of elimination of all estate taxes and have
cosponsored two separate pieces of legislation in the 105th to
provide for that repeal. Unfortunately, a complete repeal of
estate taxes is not a viable option considering the President's
position.
I am working with a number of our colleagues on the
Committee to draft a bi-partisan proposal. I believe that such
a proposal should be based upon a three-pronged approach: 1)
increase in the unified credit, 2) targeted relief for family
businesses and farms, and 3) some level of rate reduction.
I had hoped that we would have introduced our bi-partisan
proposal by the time of this hearing. Unfortunately, this could
not occur. However, I am confident that through our continued
vigilance we can draft a bi-partisan proposal that will be a
vehicle for relief as the Congress moves forward.
Thank you, Mr. Chairman for your leadership in both these
areas. And thank you to the Committee colleagues for your
attentiveness this morning.
Chairman Archer. Thank you, Ms. Dunn.
Our final witness in this panel is another well-known
Member of our Committee, Congressman Jon Christensen from
Nebraska.
Mr. Christensen. Thank you, Mr. Chairman.
Chairman Archer. Mr. Christensen, you may proceed.
STATEMENT OF HON. JON CHRISTENSEN, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF NEBRASKA
Mr. Christensen. Thank you.
This past week, I had the opportunity to convene a death
tax roundtable in my district, in Omaha, Nebraska, and we had
people from all sectors: From the accounting field; from the
small business area; from the estate tax area; and financial
planning. We listened to a lot of the stories they had
experienced personally, and we had one individual who shared a
good comment. Doug Kulak from Omaha said: ``Jon, I can prove
two things to you. I can prove that Uncle Sam is not a blood
relative; and second, I can prove that Uncle Sam squanders his
inheritance.'' And I thought that that comment rang true in
terms of what we are looking at today, a truly bipartisan group
of people. You have never seen as many witnesses from both
sides want to testify about an issue that is onerous; that is
taking capital formation away; taking away the thriving
opportunity to start and to continue a business.
So, Mr. Chairman, I really believe we have an issue here
that cuts across young, old, rich, poor, black, white, and that
we can work together in a bipartisan fashion. More than 70
percent of family farms do not make it to the second generation
because of the death tax. As a matter of fact, 87 percent do
not make it to the third generation. By confiscating between 37
and 55 percent of a family's aftertax savings, the estate tax,
which I like to call the death tax, punishes life-long habits
of thrift, discourages entrepreneurship and capital formation,
penalizes hard-working families, and has an enormous negative
effect on other tax revenues.
This past year, 1 year ago last week, I lost my father, who
died unexpectedly of cancer. I have seen what my mother has
gone through in terms of preparing the estate, going through
all of the various tax and accounting and legal situations, and
she spent upward in the neighborhood of $40,000 to $50,000 in
just preparation and getting ready to go through the whole
process. I have seen a lady who was not used to this whole
process, who spent her life being a housewife, a farm wife, and
all of this has gone on for the Federal Government to bring in
1 percent. One percent of the Federal Treasury comes in from
death taxes. Out of a $1.5 trillion budget, we are talking
about $12 to $15 billion. And I have seen some studies where it
showed that if you took the amount of money that was spent in
second-to-die life insurance policies, which I made a living
in, and attorney's fees, accountants fees, if you took all of
the fees and added them up and allowed the individual to save
that money and to invest it, to put it back into their
business, to create jobs and opportunities, you would see more
money generated from the income taxes and from Social Security
taxes and the other areas for the Federal Government that would
far outweigh the amount of money that was collected from the
death tax alone.
So, we have an issue here that I believe we can work
together in a bipartisan fashion and achieve some kind of
incremental reform. Now, I support the Hulshof-Crane bill; I
support the Cox bill. But I also realize that the President
isn't willing to go as far as we would all like to go. Now, we
have had an opportunity to work with Erskine Bowles on the
issue, and I applaud his leadership in starting to make some
incremental reform in this area. But we need to go a lot
further than the President has started. I believe an
incremental form of raising the unified credit, from $600,000
upward in the neighborhood of $1 million; indexing it to
inflation. As a matter of fact, if it had been indexed to
inflation, currently, it would be at $830,000 today.
Second, I would agree with Ms. Dunn that we need to create
an exemption for the family owned business. We also need to
give some meaningful relief to family farms, ranches, and
family owned businesses. Last, I believe we need to begin a
reduction, a slight reduction, over the 55 percent, bring it
down gradually over time: 55 to 54 to 53. Make some small steps
in this area if we cannot go with a full repeal this year.
I have a family friend out in western Nebraska, in Max,
Nebraska, in Congressman Barrett's district. They were telling
me about an issue where they had three siblings, four siblings
in the family. Only one of them farmed. And so, therefore, they
did not buy a large enough life insurance policy to be able to
keep the one individual farming. They are struggling. They do
not want to sell the farm. Yet, that happens every day in
America, whether it is a small business or whether it is a
family farm.
Mr. Chairman, this is an issue we can agree on; we can work
together on, and I applaud your leadership, and hopefully, we
can get something passed in the 105th Congress.
[The prepared statement follows:]
Statement of Hon. Jon Christensen, a Representative in Congress from
the State of Nebraska
Mr. Chairman, I want to thank you and my other colleagues
of the Ways and Means Committee for this opportunity to testify
on the savings and investment provisions in the
Administration's budget. I want to focus in particular on the
estate tax.
The estate or death tax is killing family farms and small
businesses. Today, more than 70 percent of all family farms and
businesses do not survive through the second generation and 87
percent don't make it to a third generation. How sad. According
to the National Federation of Independent Business (NFIB), 90
percent of small businesses which fail after the death of their
founder are literally torn apart because the inheritance tax
burden falls at a difficult time of transition. By confiscating
between 37 percent and 55 percent of a family's after-tax
savings, the estate tax punishes lifelong habits of thrift,
discourages entrepreneurship and capital formation, penalizes
hard-working families, and has an enormous negative effect on
other tax revenues. Since the $600,000 unified credit, enacted
in 1981, is not indexed for inflation, it is worth only about
$377,000 in 1981 dollars. Every year the death tax brings more
and more family farms and small businesses under its death
sentence.
I have witnessed how the estate tax can kill a family farm.
In Max, Nebraska, a strong community in Congressman Bill
Barrett's district, the Gardner family lives on a modest plot
of land. They raise some cattle and grow wheat, corn and
alfalfa. The land that the Gardners live on once belonged to
Mr. Gardner's father who passed away two years ago. Before the
elder Gardner passed away, he planned for his death. The
Gardner family employed an attorney, an accountant, and a
financial planner to assist them in their estate tax planning.
They did everything that the lawyers and accountants told them
to do and yet they still might lose their farm.
Since the elder Gardner deeded his farm to his four
children, and only one child and his family work on the farm,
it has placed the other three siblings in an awkward situation.
The Gardners did not purchase enough life insurance on their
father, and when he died, there was not enough money to pay off
the three siblings. If the siblings sell their land to the
brother and his family, who work on the farm, they will pay
exorbitant amounts in capital gains taxes. The son and his
family who work on the farm are forced to lease the land from
the other three siblings who do not work on the farm, making it
nearly impossible to even keep up with the bills.
The Gardners would be better off if they sold their whole
farm to the highest bidder. They have land, cattle, and
machinery worth about $1.8 million. But, the Gardner family is
having a tough time making ends meet. I have asked Phyllis
Gardner why they don't sell the farm. She, like almost every
farmer and rancher I have ever known, is committed to keeping
her family farm going--even if that means barely staying
afloat. The federal government is destroying American family
farms, ranches and small businesses. What the Gardner family
has spent a lifetime working for, the federal government wants
to take away.
Many people assume that the estate tax, unlike the income
tax, will affect them only if they have large estates. In a
way, they are right. The estate tax won't directly hit you
unless you have an estate with a taxable value of $600,000 or
more (including any taxable gifts you've made during your
lifetime). But, these days owning a home, a modest investment
portfolio, life insurance, retirement benefits, a family farm
or business can easily knock you into the estate tax realm. In
1993, estates from $10 million to $20 million paid 18 percent
in that year; those over $20 million paid just 12.6 percent.
However, more than half the government's total estate tax
revenue came from estates of $5 million or less.
Others believe that the estate tax law won't affect them
because they are leaving all of their property to their
spouses. The tax law provides an unlimited marital deduction
that allows you to leave all of your property to your surviving
spouse free of federal estate tax. However, many people die
without a surviving spouse. What happens if your surviving
spouse dies, or if your spouse dies before you? The use of the
marital deduction does not eliminate estate tax, it simply
defers it until the surviving spouse dies.
The estate tax accounts for roughly 1 percent of the
federal government's tax receipts a year, but eats up 8 percent
of Americans' savings each year. That's $15 billion that could
be invested in expanding the economy. It the estate tax had
been abolished in 1971, our national stock of savings would
have been $399 billion larger in 1991, the gross domestic
product would have be $46 billion higher and we would have
262,000 more jobs.
I support a full repeal of the federal estate tax and am a
cosponsor of bills introduced by my good friends Rep. Crane,
Hulshof, and Cox. However, I understand that not everyone
agrees with me. To get meaningful tax relief passed by Congress
and signed by President Clinton, we need to make incremental
reforms. I believe that we need to do three fundamental things
in reforming the estate tax. First, I believe we need to
increase the unified credit and tie it to inflation. Currently,
the estate tax credit is at $600,000. Had it been indexed in
1981, it would be worth around $830,000 today. Second, I
believe we need to create a family-owned business exclusion to
the federal estate tax. Last, I think we need to look at an
across-the-board reduction in the statutory estate and gift tax
rate--a rate that reaches as high as 55 percent.
Although the Administration's budget proposal provides
estate tax relief, we need to take an ax to the estate tax and
the Administration has handed us a butter knife. Under current
law, estate tax attributable to certain interests in closely
held businesses may be paid in installments over a 14-year
period. A special four-percent interest rate is provided for
the tax deferred on the first $1 million. The regular IRS rate
on tax underpayments applies to values over $1 million. A
special estate tax lien applies to property on which the tax is
deferred during the installment payment period. Interest paid
on the deferred estate tax is allowed as a deduction against
either the estate tax or the estate's income tax deduction. The
administration's proposal would increase the cap on interest
rates so that it applies to the tax deferred on the first $2.5
million of value of the closely held business. The current 4
percent rate would be reduced to 2 percent, and the rate on
values over $2.5 million would be reduced to 45 percent of the
usual IRS rate on tax underpayments. The interest paid on
deferred estate tax would not be deductible for estate or
income tax purposes. While I applaud the Administration's first
step, I believe that we can go much, much further in providing
meaningful estate tax relief.
In closing, I want to again thank you, Chairman Archer, and
my colleagues on the Ways and Means Committee for the
opportunity to testify before you today. The death tax is a
disincentive for owners of family businesses and farms to
expand their operation and create jobs. Repealing it would
eliminate 82 pages of the tax code and 300 pages of regulations
that American taxpayers are forced to follow. I believe as a
society we are already taxed too much. We pay property taxes,
sales taxes, gasoline taxes, and income taxes, just to name a
few. The federal death tax is a tax on money that has been
taxed at least once, if not more. Repealing or modifying the
death tax will help ensure economic fairness for all American
families and businesses, as well as provide economic growth and
prosperity for the nation as whole.
Thank you.
Chairman Archer. Thank you, Mr. Christensen.
My compliments to each of you for, I think, excellent
presentations.
Does any Member of the Committee wish to inquire?
Mr. Rangel. I guess my question to Ms. Dunn will be a very
general question that everyone does not have to answer: What
estimate do you have of the capital gains tax cuts that would
please you--over a long period of time.
Ms. Dunn. We do not have an estimate yet on our bill, but
our bill includes some facets of other bills, and it could be
as high as $60 billion over 10 years.
Mr. Rangel. In estimates of many capital gains proposals,
there is an increase in revenues in the early years and then, a
large decrease in revenue in the later years. Proponents of
cutting capital gains taxes complain about the method of
calculating revenue losses. They claim you do not actually lose
revenue. Notwithstanding that point of view, we must use the
methods of CBO and the White House. So, how do you explain when
people say that is a great idea, how you are going to pay for
it? How do you respond to that? Since I have been here, the
biggest argument against capital gains tax cuts that have been
demanded has been the shortfall in revenue.
Ms. Dunn. Mr. Rangel, I do believe that static scoring is
not an interpretation of behavior, and I think that is a
shortfall in our scoring system. I would like to see our bill
scored under dynamic scoring, but that is not an opportunity
for us right now, and that is why I gave you the number I did,
because that is under static scoring, as close as we can come
together with the facets of our bill, which, as I said, has not
been scored since we introduced it just a week or so ago.
My belief is based on history. In the twenties and the
sixties and the eighties, consistently, we saw that when people
were allowed to have some kind of rate reduction in capital
gains, this unlocked assets. It caused and will cause a larger
degree of trading of these assets. Somebody sells a home; that
commission is given to a realtor. The realtor takes it to a
local hardware store; the hardware buyer buys groceries and so
forth, and that creates an increase in revenue.
Mr. Rangel. I do not want to debate the merits. If you and
I agree that dynamic scoring is not available to you and it is
not available to me, then we put that issue aside. I would not
want to discuss the merits regarding what positive impact it
would have on the economy because you can line up the
economists and get no concensus on that subject.
But when it reaches the point that we have got to make
certain that we come up with a revenue-neutral bill, that is
when we look around and wonder, Who ``behind the tree'' are we
going to tax in order to pay for a capital gains tax cut? Every
time we talk this way, some program designed to give assistance
to the poor not only comes up on the radar screen but stays
there. Other ways of paying for it come and go. The President
has a whole lot of revenue raisers that will not stand the
light of day in this Committee. But he has proposed them as
revenue raisers.
So, I guess we do not have an answer today. Although I want
so badly to work with both sides, it just seems to me that we
cannot even consider the merits seriously until we find a way
to raise the money so we end up with a revenue-neutral bill.
Ms. Dunn. Mr. Rangel, I appreciate your point of view, and
I agree with you. We do need to come up with the revenues. And
in a broad context, I would say that that is where spending
cuts come from. But in addition to that, as I say, there is
revenue that is actually produced from the particular tax
relief package that is contained entitled ``capital gains.''
Chairman Archer. Does any other Member of the Committee
wish to inquire?
Mr. Becerra.
Mr. Becerra. Mr. Chairman, thank you; I will be brief. I
just have one question, and I offer it up to anyone on the
panel. If we get into the discussion of dynamic scoring and
what we consider investments that pay off more than they will
cost us, I was wondering if any of you would be willing to
comment on the whole issue of programs such as Head Start and
prenatal care. We have been told in the past that if we invest
$1 in Head Start, we can prevent a child from becoming an at-
risk youth and ultimately an adult offender; that individual
who may go on to college and be more productive than just a
high school graduate.
We know that a $1 spent on prenatal care probably saves you
$3 in after-birth costs of infants who are born with some
abnormality or problem that could be prevented. I know we just
had a debate last week on the whole issue of drugs and Mexico
certification, and I saw some studies that showed that for
every $1 we invest in preventing drug use and providing for
drug rehab, we save $11 necessary to do drug interdiction and
$23 to do drug eradication in foreign countries.
Your thoughts on if we were to ever go toward some form of
dynamic scoring, how we should score programs like Head Start
or prenatal care.
Mr. Christensen. Mr. Becerra, I think what you have touched
on is a much deeper issue, and the issue goes to the
fundamental question of what is the proper role of the Federal
Government rather than the dynamic scoring issue.
Mr. Becerra. But, then, no comment in terms of the dollars
or the investments?
Mr. Neal. I agree with you, Mr. Becerra, and believe that
having children who can read and write is real national defense
as well as what we do around here every day in providing for
what we commonly refer to as the national defense.
Mr. McCrery. I do not disagree with Mr. Neal entirely.
There are all kinds of investments that we make as individuals
and that we make as a government. I think, though, to be able
to predict a return on the investment gets more difficult as
you get into the programs such as those you mentioned. But
certainly, some of those could be considered investments. But
when you have to score it, it gets very difficult.
Ms. Dunn. Mr. Becerra, I would just say that I know there
are groups right now who are putting together plans for dynamic
scoring. I think it would be very interesting for all of us to
hear from them. I do not know the answer to your question. I
would like to know the answer. When I think about what could
pay for programs like what we have advocated today, though,
there are certainly areas that do not have to do with Head
Start or other areas that many of us do support that could be
cut, and I would offer up one, the Government Printing Office,
as an example of something that we have barely touched, and
privatization, securing for the Government and the GPO the
ability to contract out, that there is a cut just minimally at
$1.5 billion over the next 5 years is how that has been scored.
But certainly, when you come to dynamic scoring, you have
to look at the change in behavior, and so, what you asked about
Head Start as an example is going to depend on the welfare
system and how well our changes are enacted and accepted there.
But I simply say that behavioral scoring is very important. I
realize we have to have a mix of the two, because you do not
want to get out there too far, but people are putting together
a plan, and it would be interesting at least for me to hear
from those folks.
Mr. Becerra. Thank you, Mr. Chairman.
Chairman Archer. Mr. Portman.
Mr. Portman. A brief question for the panel on the estate
tax issue. I appreciate the testimony from all my colleagues
and sympathize with your position on the estate tax. I think,
as Mr. Christensen said, it is more likely that we can reform
it this year than repeal it, and I think some of these
proposals make a lot of sense.
My concern is simply on the issue of complexity and how you
go about defining in particular family businesses and family
farms. I have always believed that that would not only cause
the IRS a lot of problems, and we are all finding out about the
IRS' inability to administer our current code, but also our
taxpayers. And it would, perhaps, Mr. Christensen, put a lot
more money in the pockets of those tax planners you talked
about and the lawyers and accountants and so on trying to
figure out how to define your business in that way and to meet
those criteria.
Mr. McCrery, you had a thoughtful statement this morning,
and I know you have thought a lot about this issue, so I will
ask you: Why not--and perhaps this is simply a revenue issue--
why not simply raise the exemption, as you have suggested, to
$1 million or even $1.5 million, change the provisions of the
exemption to a real exemption so that the tax rate that applies
is the lowest rate after that amount, and index it to inflation
to be able to catch up to what would now be about an $830,000
exemption had it been indexed for all Americans and not to try
to define and to carve out these special categories within the
tax law?
Mr. McCrery. Well, I think the families that are being hurt
the most by this are the ones that have invested in businesses,
that have built their family businesses over generations, and
some of the data we have seen recently talked about by Ms. Dunn
and Mr. Christensen indicate that it is very, very difficult
these days for those small businesses to survive generational
transfer because of the estate tax. In a recent survey, the
number one reason for small businesses and family farms ceasing
to exist was the estate tax. That is why I have chosen to
target those family businesses, family farms for relief. I
think as Ms. Dunn and Mr. Christensen said, I, too, am for the
abolition of the estate tax, but that is just not a realistic
goal, I think, in the short term.
So, when we start talking about limited revenue that we
have for tax cuts, I wanted to target a proposal that would
have minimal loss of revenue and do the most good: Get the most
bang for the buck. And I think we do that when we target family
businesses, family farms, family ranches for relief.
Mr. Portman. And how do you respond to the concern that we
may have difficulty defining those entities and that there may
be the ability for taxpayers to shift assets around or even
change forms of business to be able to qualify? And how can we
avoid those problems?
Mr. McCrery. You cannot avoid them.
Mr. Portman. Is there a simple way to define what is a
closely held or family business?
Mr. McCrery. We have chosen the simplest way, which is not
simple, and it is subject to interpretation. However, in the
legislation that we are writing for introduction soon, we do
expand the definition to bring in the greatest number of
entities that one would normally think of as a family business.
So, you are never going to be able to have a definition that is
not subject to interpretation by the IRS or by us. But that is
no reason not to endeavor to give relief to those folks.
Mr. Portman. Thank you, Mr. Chairman.
Chairman Archer. Mr. Jefferson.
Mr. Jefferson. I have an ever-so-brief question. I am
trying to see--Jim, is it fair to say, if you have read
Jennifer's proposal on estate tax relief, that yours is less
broad than her proposal? Or are they more similar than I read
them? She talks about unified credit, targeted relief for
family farms. It is a level of rate reduction. You are talking
about raising the exclusion to $1.5 million; you talk about a
real unified rate. The first dollar over $600,000 you would tax
at 18 percent. And I think another provision--I have kind of
forgotten what it was.
Mr. McCrery. Perhaps you would be interested in the
historic property provision, Mr. Jefferson.
Mr. Jefferson. I'm sorry?
Mr. McCrery. Perhaps you would be interested in the
historic property provision.
Mr. Jefferson. Yes, sir; that would be appealing to me,
sir.
But what is the difference, sir, between what you are
proposing and what Jennifer is proposing on estate tax relief?
Mr. McCrery. Actually, Ms. Dunn and I worked together for a
long time developing a new bill, and we ended up deciding to
introduce two different bills. The primary difference is the
approach on estate tax relief. She chooses to reduce rates from
the top down, basically; I choose to reduce rates from the
bottom up. So, I target more relief to the smaller businesses,
the smaller estates than she has chosen to in her bill. I do
not disagree with her approach. I would love to do that. I just
think the people in this country who are getting hurt most by
the estate tax are your smaller businesses, smaller farms, and
I want to target relief as much as I can to those folks with
the limited revenue that we are going to have available to use
in any tax cut portion of reconciliation.
Mr. Jefferson. Consequently, yours is less expensive in
that area than hers is. It is more targeted and less expensive.
Mr. McCrery. Yes.
Ms. Dunn. Mr. Jefferson, let me just add that mine is
similar to Mr. McCrery's, but we have a broader approach in
that we also do the rate reduction. And my thought, even though
we haven't filed the bill yet, is that we would, at some point
in the near future, begin a rate reduction of 1, 2, or 3
percent a year on the top rate. But responding to Mr. Portman,
too, I would just say there are lots of ways to go about this,
and one would make estate taxes comparable to regular income
taxes. I think that could simplify the system, if you took away
the entire rate that is currently in place on estates and make
estates, inheritance, subject to regular income tax rates.
Chairman Archer. Mr. Jefferson, have you concluded your
inquiry?
Are there any other Members who wish to inquire?
If not, the Chair would just conclude by making a couple of
small requests: Mr. McCrery, do you have a revenue estimate on
your proposal?
Mr. McCrery. Not yet, Mr. Chairman. We are having
legislation written as we speak.
Chairman Archer. OK.
Mr. McCrery. We will get that to the Joint Committee on
Printing as soon as possible.
Chairman Archer. Mr. Neal, do you have----
Mr. Neal. We do not have a final one.
Chairman Archer. You do not either.
Ms. Dunn mentioned her revenue----
Mr. Christensen. No, Mr. Chairman, we are waiting.
Mr. McCrery. Mr. Chairman.
Chairman Archer. Yes.
Mr. McCrery. The bill we had introduced last year was $6
billion over the 5-year budget window. We expect this year's
bill to be very close to that.
Chairman Archer. OK; thank you very much and thank you
again for your testimony.
Our next panel is a number of our own colleagues from other
Committees, and if you will take your seat at the witness
table: Hon. David Dreier, Christopher Cox, Collin Peterson,
Peter Deutsch, Earl Pomeroy, and Karen McCarthy.
Gentlemen and Ms. McCarthy, a warm welcome to each of you.
Mr. Dreier, if you would be our leadoff witness for this panel,
we would welcome you, and you may proceed.
STATEMENT OF HON. DAVID DREIER, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF CALIFORNIA
Mr. Dreier. Thank you very much, Mr. Chairman, and let me
say I am somewhat embarrassed to be here before you advocating
any tax on capital whatsoever. The fact of the matter is that
you and I share a view that there should not be a tax on
capital, and I think it is very important to recognize that
what we are proposing is, I believe, a very good compromise
position.
I have talked at length with you, with Charlie Rangel, with
Mr. Crane, other Members of this Committee, Mr. Jefferson just
yesterday, on this issue, and I think it is a very, very
important one. On the opening day of the 105th Congress, your
Committee Member Phil English and I joined with my colleague,
the former Chairman of the Ways and Means Committee of the
Missouri State Legislature, Congresswoman Karen McCarthy, Jim
Moran of Virginia, and Ralph Hall of Texas--more Democrats than
Republicans on the opening day--and we are joined today by
Peter Deutsch from Florida, another Democrat, who has joined
along with 90 Democrats and Republicans in cosponsoring the
bill we introduced on the opening day, which takes the top rate
on capital gains from 28 percent to 14 percent and indexes.
Now, I have been listening to the testimony of the other
panel, and I think that some important things have been said
which I believe need to be underscored, and I would like to try
and maybe answer some of the questions that were posed by
Members of the Committee as we proceed.
I agree with Jennifer Dunn that the reduction of that rate
on capital gains would do more than almost anything to boost
the economy. There are three things we have been focusing on in
a bipartisan way in this Congress. They include trying to
balance the budget, increasing the take-home pay of working
Americans, and spurring economic growth. And as we look at
halving the capital gains tax rate, it seems to me we can
successfully address every single one of them.
This argument that has been made by so many, and I think
Charlie Rangel very appropriately asked about the cost factor,
is one that needs to come forward, but we also have to look at
the benefit that is going to be accrued to the economy. We are
at a point where I think we should recognize that the economic
growth we are enjoying today is not going to continue ad
infinitum, and I think a capital gains tax rate reduction is
going to be pivotal to our attempt to ensure that we do not
move into recession.
We all know the chairman of the Federal Reserve has made a
very strong statement on the issue of capital gains, and so, I
think a capital gains tax rate reduction would be a federally
friendly reduction, which I think is something that also needs
to be addressed.
And also, I am gratified by the fact that we very rarely
hear the argument that was so prevalent during the last several
years, that being that reducing the top rate on capital gains
would be nothing but a tax cut for the rich. The arguments that
were made by the last panel, I think, very appropriately put
forward the fact that 40 percent of capital gains taxes are
realized by people who earn less than $50,000 a year. Peter
Deutsch, I suspect, might mention something that he said to me
the other day: 63 million American families have mutual funds
today. So, this is something that I believe is very important
for us.
To specifically get into Charlie's question on the cost
factor, we have scored with CBO and Joint Tax a $44 billion
cost over that 5-year period, although, as I just said, I think
it is important to recognize that we should look at the
benefits. This ``cost'' would be less than half of the proposal
in the President's cost, and I think if you look at more
realistic scoring, we several years ago formed what I call the
Zero Capital Gains Tax Caucus, bipartisan, bicameral, and I
think that over a 7-year period, if we look at this, we could
have a gain of $211 billion in revenues to the Treasury.
Mr. Rangel, you and I have often talked with our mutual
friend Jude Wanninski on this--yes, well--[Laughter.]
Mr. Dreier. The fact is that we do both talk to him, and I
think that it is no secret that we do, and there is going to be
a real benefit. Frankly, Bill Jefferson, I know, has raised
this. Xavier Becerra has raised this; you have raised this, the
need to address the challenges that exist in the inner city and
other areas. I believe that what we are proposing would go a
long way toward getting the needed capital into the areas where
you and I are very, very concerned, and I hope very much that
the Committee will proceed with this and, again, recognizing
that we have broad, bipartisan support.
The President is great in focusing on the issue of capital
gains reduction in the area of human capital, his education
area. But we also have to look at the other half of the
equation, and that is physical capital that goes along with it,
and that is why an across-the-board proposal, I think, would be
very beneficial.
Thank you very much for inviting me to be here, Mr.
Chairman. I am used to looking at you in the Rules Committee,
and so, it is nice to have a chance to come before you and all
of the other distinguished members of this panel.
[The prepared statement follows:]
Statement of Hon. David Dreier, A Representative in Congress from the
State of California
Mr. Chairman, Members of the Committee, thank you for
holding this important hearing on the tax proposals in
President Clinton's fiscal year 1998 budget submission. I am
grateful for the opportunity to take a few minutes to discuss
the President's proposal for a very limited modification in the
capital gains tax, and my support for a major reduction in this
anti-investment, anti-growth and anti-savings tax.
I believe that we must judge any tax proposal on its
ability to address two of our most pressing economic needs--
increasing real economic growth and raising the wages of
working Americans. Cutting the capital gains tax rate in half
offers one of the most reliable, fair and fiscally responsible
methods of achieving those two goals.
On the first day of the 105th Congress I joined with a
bipartisan group of our colleagues to introduce H.R. 14,
legislation to cut the maximum tax rate on capital gains to 14
percent, reduce the lower tax rate from 15 percent to 7.5
percent, and end the taxation of capital gains due solely to
inflation. Today, over 90 of our colleagues have sponsored this
bipartisan bill.
A capital gains tax cut should not be a partisan issue.
Reducing the tax on investment puts good public policy ahead of
politics. Promoting investment in new factories, equipment,
machine tools and technologies will benefit working people of
every income level. Cutting the capital gains tax rewards
homeowners, farmers, small business people, entrepreneurs and
mutual fund holders, not Democrats or Republicans.
Mr. Chairman, balancing the federal budget by 2002 is a
goal I share, and I know you share, with President Clinton and
the majority in Congress. This is clearly a top fiscal
priority. At the same time, the balanced budget passed by
Congress the past two years, as well as the President's FY 1998
budget proposal, illustrates the clear fact that tax cuts and a
balanced budget are not incompatible. The President's budget
includes nearly $100 billion in tax cuts. Although I prefer a
more aggressive tax cutting agenda, I believe that we can do
much to improve our economy, raise living standards, and help
balance the budget with tax reductions totaling $100 billion
over five years.
A broad-based capital gains tax cut such as that embodied
in H.R. 14 would account for less than half of the President's
$100 billion tax cut target. Most important, it is a tax cut
that is likely to help us attain a balanced budget by 2002.
Even if Congress and the President agree on a bipartisan
balanced budget this year, a recession between now and 2002
will derail the process. A capital gains tax cut is the best
antidote to a balanced budget-killing recession.
Mr. Chairman, fiscal policy, budget policy, and tax cuts do
not occur in a vacuum. There is no question that the Federal
Reserve Board's interest rate policy can make or break the
success of any balanced budget plan that cuts taxes. If the Fed
believes that a given tax policy raises the prospect of
inflation or fails to increase real economic productivity, it
is possible that monetary policy will not be supportive.
Therefore, I was very encouraged by the comments of Federal
Reserve Board Chairman Alan Greenspan before the Senate Banking
Committee last month. He said:
I think while all taxes impede economic growth to one
extent or another, the capital gains tax, in my judgment, is at
the far end of the scale. And so, I argued that the appropriate
capital gains tax rate was zero. And short of that, any cuts
and especially indexing would, in my judgment, be an act that
would be appropriate policy for this Congress.
Mr. Chairman, I know you share the view of Chairman
Greenspan that the best capital gains tax rate for the overall
health of the economy would be zero. I share that view, and I
organized the bipartisan, bicameral Zero Capital Gains Tax
Caucus in the 103rd Congress to raise that issue. However,
given that the President has not proposed reducing the current
tax rate, I believe that totally eliminating this anti-
entrepreneur tax is not politically feasible. However, we can
split the difference. Cut the 28 percent rate in half, to 14
percent.
The capital gains tax has become a political football
because of charges that it is a tax cut for the rich. While I
don't think punitive, politically motivated, class-warfare
goals ought to determine our tax policy, I would argue that the
charge is simply incorrect. As The New York Times detailed in a
major report in December, the capital gains tax ``is becoming
largely academic to the nation's wealthiest taxpayers.'' That
report quoted David Bradford, an economist at Princeton
University, expressing a view too many families on Main Street
USA share. ``The Government can adopt rule after rule after
rule--but the people who will get stuck paying capital gains
taxes will be the ordinary investors,'' said Bradford.
Mr. Chairman, forty percent of annual capital gains are
realized by people with incomes of less than $50,000. Regular
people--farmers, small businessmen, families with some savings
in mutual funds, small investors with rental property--are the
ones who face the bite of the capital gains tax. They are left
out in the cold by the President's very narrow capital gains
tax proposal that places good politics over sound economic
policy by selectively targeting one type of investment.
Even though many middle income Americans will directly
benefit from a broad-based reduction in the capital gains tax,
we must move beyond looking at who gets the tax cut and focus
of the economic benefits of any tax change. At the very top of
our priority list must be ensuring that we, as a nation, make
the investments needed to help working families raise their
living standards.
While I am not convinced that President Clinton's education
tax credits will work, I cannot argue with his goal of using
the tax code to promote investments to raise the skill-level of
new workers and help current workers learn new skills.
Economists would call that investment in human capital. His
proposals deserve a serious look.
At the same time, investment in the skills of working
people only addresses half the equation. It is also critical
that we encourage the private sector to invest in the machines,
technology and tools that will raise the productivity of
American workers, and thus their wages. Cutting the capital
gains tax rate in half will do just that. Economists call this
pro-worker tax reform investment in physical capital.
Cutting the tax rate on capital gains will lower the cost
of investing in the kind of tools and technology that makes
American workers the most productive in the world--and that
means higher pay. A 1993 study by the Institute for Policy
Innovation predicted that cutting the capital gains tax rate to
15 percent and indexing the rate to inflation would boost the
wages of the average American worker by $1,500 over seven
years. Those are gains that don't expire at some future date
like some self-advertised pro-family tax cuts. Of course, the
tax cut will also bring immediate relief to small investors,
small business owners, family farmers, homeowners, and the
elderly.
Mr. Chairman, there is much to be done to get our economic
house in order. We must balance the budget because mounting
debt saps life from the productive sectors of our economy and
strangles resources needed for important government programs.
We must also help the working families that have seen their
incomes stagnate as they try to prepare their children to get
good 21st century jobs. While the President is proposing tax
credits to help with college costs--a commendable goal--we also
owe those working families a broad-based capital gains tax cut
to ensure that plentiful technology, tools and high-wage jobs
are available in coming years.
Thank you again for giving me the opportunity to testify
this morning.
Chairman Archer. Thank you, Mr. Dreier.
Mr. Deutsch, since your name has been mentioned in Mr.
Drier's testimony, we would be pleased to recognize you.
Welcome to the Ways and Means Committee. You may proceed.
STATEMENT OF PETER DEUTSCH, A REPRESENTATIVE IN CONGRESS FROM
THE STATE OF FLORIDA
Mr. Deutsch. Thank you, Mr. Chairman. I appreciate it. I'm
glad you remembered what we talked about, which is a good sign.
We are clearly living through an incredible age in American
history and in world history, in a sense, a blessed age to be
living through, a renaissance of the American economy. The
American economy has leapfrogged other economies in the world,
and we literally, whether we acknowledge it or not, are in a
new age in terms of economics. We are an economic powerhouse.
We have transcended the age, and we are in an information age,
and where it is going to end, we do not know.
And access to capital is critical in this age. We have the
ability, as the U.S. Congress, to grow the economy more, and we
have the ability on the capital gains issue to do that
specifically.
I am going to focus a little bit, though, on the fact, and
I think it is appropriate to talk a little bit about how this
issue has come to us today in the present form that it is, that
capital gains cuts too often have been viewed, I think, in a
demagog way really by my own party, that a capital gains cut is
a cut that just benefits the wealthy, and that's why some
people, on occasion, have spoken against it.
I think that that attitude is changing and is also just
flat wrong. Obviously, growth in the economy affects everyone
directly, but there are just some fascinating things that have
happened in the economy. First, just the statistics themselves,
I think, are important. Another number, even below the $50,000
threshold, in 1993, 37 percent of U.S. taxpayers reporting
capital gains and income of $30,000 or less. But the phenomenon
of mutual funds and the fact of the investments of middle-class
Americans in mutual funds is a phenomenon that really did not
exist 10 years ago. Sixty-three million American households
have investments in mutual funds. It is an incredible
statistic, an absolutely incredible statistic. A majority of
these households have incomes ranging from $35,000 to $75,000.
The growth has been unbelievable: 20 percent growth since
1994, 800 percent growth since 1990. It is a phenomenon that if
we do not acknowledge as policymakers, I think we are missing
something very important. Again, I am going to speak to my own
party and really to the President: I think not to support
across-the-board capital gains cuts misses this entire group of
people; essentially misses the middle class of America. If we
are looking for a middle-class tax break in the United States
of America in 1997, what we really ought to be talking about is
capital gains cuts. If you tie it into the phenomenon of mutual
funds, there are literally hundreds of billions of dollars, in
a sense, of phantom income that people are paying tax on, and
the phantom income I am describing, because the typical
situation, where it is a mutual fund that is a retirement fund,
but mostly middle-class people, and you can look to yourself
and your friends whom you know and your constituents. What are
they doing with their capital? For most Americans, where are
they putting their capital that they are earning on a daily
basis, a monthly basis? An incredible percentage, 90 percent of
capital, in the last several years has been going into this
phenomenon.
And the phantom income, in a sense, is people are getting
taxed on the appreciated gains, but generally, they are not
selling the mutual fund in terms of paying that tax. That is
coming out of their disposable income. And it is a phenomenon
that people are seeing. And I think as an institution, this
Congress is missing the boat. It is missing a phenomenon in the
American economy not to be changing the capital gains tax for
the broad-based economic reasons that we are talking about, to
grow the economy.
But also, if we are talking about middle-class tax cuts,
for 63 million American households, the numbers speak for
themselves. If we want to give people more money back in their
pockets; if we want to help the hard-working people who are the
core of our economy and the core of our society, then, that is
what we need to do, and I urge this Committee to take that
action, and I urge my colleagues in the Congress in general to
support an across-the-board capital gains cut.
Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Representative Peter Deutsch, a Representative in Congress
from the State of Florida
Mr. Chairman, Members of the Committee, thank you for this
opportunity to discuss with you what I see as perhaps the most
important issue in U.S. tax policy--the capital gains tax.
President Clinton's budget calls for a targeted modification to
the capital gains tax. I would argue that our economy would be
served better by a comprehensive capital gains reduction. This
reform would be good for the American people, good for the
national economy, and can be accomplished in the context of a
balanced budget.
I have worked in Congress to eliminate the federal deficit,
balance the budget, and promote an equitable economic package
for my constituents in South Florida and the American people.
While we have made great strides in reducing the deficit and
committing in principle to balance the budget by 2002, we have
failed to address capital gains reform. Reducing the tax can
only benefit the economy and the public. Such a move will
encourage savings and investment and is necessary if we as a
nation are going to compete globally and have a healthy
economy.
What many fail to see is that a capital gains tax reduction
would benefit all Americans. In fact, 40 percent of capital
gains are realized by individuals with incomes less than
$50,000. Now more than ever, capital gains is an issue that
crosses socioeconomic borders. Consider the massive movement
toward mutual funds which has become the preferred savings and
investment vehicle for more and more Americans. Today, an
estimated 63 million Americans and 37 million households are
invested in mutual funds. That figure represents a 20 percent
growth since 1994 and an 800 percent jump since 1980. The
majority of these households have incomes ranging from $35,000-
$75,000--a true example of how middle income America is now
affected by the capital gains tax. Eighty-four percent of
mutual fund investors are primarily investing for retirement.
Middle aged Americans comprise the largest bloc of mutual fund
investors as 35-64 year olds own 77 percent of the mutuals.
With the explosion of mutual funds among middle class families,
Congress should encourage more savings and investment by
reforming the capital gains tax.
The appropriate way to meet the needs of a growing market
and the public's changing attitude towards investment is to
incorporate real capital gains relief into any economic package
that we support. I am a cosponsor of H.R. 14--The Capital Gains
Tax Reduction Act of 1997--a bipartisan bill which is
cosponsored by over 90 of my colleagues. H.R. 14 would cut the
maximum tax rate on capital gains to 14 percent, reduce the
lower rate to 7.5 percent, and index for inflation. This
legislation represents a strong, comprehensive effort to attack
an issue that threatens to hinder the potential growth of the
U.S. economy.
It is time that members of Congress get serious about
capital gains tax reform--Republicans and Democrats alike.
Reducing the tax on capital gains should not be a partisan
issue or used as a political tool. As a Democrat who supports a
reduction in the capital gains tax, I am working with my
Democrat colleagues to forge a consensus on this issue. Some of
my colleagues believe that a capital gains tax reduction would
solely benefit the rich. It is apparent that is simply not the
case. I am currently spearheading an effort to form a consensus
within the Democratic Caucus by openly calling for my Democrat
colleagues and President Clinton to address capital gains
relief within the context of a balanced budget.
Mr. Chairman, thank you again for this opportunity. I look
forward to continuing our efforts to encourage more savings and
investment for more Americans.
Chairman Archer. Thank you, Mr. Deutsch.
The Chair next recognizes Congresswoman Karen McCarthy, who
is also a cosponsor of H.R. 14.
Ms. McCarthy, welcome to the Ways and Means Committee.
STATEMENT OF HON. KAREN MCCARTHY, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF MISSOURI
Ms. McCarthy. Mr. Chairman, I thank you. I am very honored
to be here on behalf of H.R. 14 to express my support in this
bipartisan effort. It is critical, as you have heard from the
numerous Members who have already testified, that we in the
105th Congress address tax relief. This particular legislation
will help homeowners, working families, and will also help the
private sector promote job growth.
I wanted to speak very briefly about what that will mean
for the small businesses in my district and around the Nation,
because they are very concerned about their businesses as it
relates to capital gains. A survey of the 3,000-plus members of
the Greater Kansas City Chamber of Commerce reflects that a
primary concern of businessowners is the reduction of the
capital gains tax rate. Under the status quo, financial
resources are trapped and precluded from benefiting our economy
as a whole.
In the metropolitan Kansas City area, which I represent, we
know that a majority of the job growth will come from existing
firms. So, with the relief that is provided in H.R. 14, job
growth will be enhanced, not prohibited. Mr. Chairman, whether
the legislative vehicle is H.R. 14 or one designed by your
Committee in its wisdom, I believe we must address this issue,
build on the bipartisan agreement we have in place through our
President and our legislative leaders on both sides of the
rotunda, and pass a capital gains tax reduction in the 105th
Congress. Working men and women in my district and around the
country would benefit from a meaningful capital gains tax
reduction, because the investments, savings, and the economy
would all gain from unleashing these captured resources.
You have my written testimony, Mr. Chairman. I very much
appreciate the responsibility you have in moving this issue
along, and I, therefore, would refer you to that and would be
happy to answer any questions when time permits.
[The prepared statement follows:]
Statement of Hon. Karen McCarthy, a Representative in Congress from the
State of Missouri
Mr. Chairman, Members of the Committee, thank you for
holding this hearing on the President's tax proposals, and for
allowing me to address the committee on this important subject.
As many of my colleagues have testified, I also believe we
should pass middle-class tax relief during the 105th Congress,
especially for homeowners and working Americans. As an original
cosponsor of HR 14, the Capital Gains Tax Reduction Act of
1997, I would like to note the bipartisan support that is
building for this legislation. Our proposal will bring
immediate relief to working families, small business owners,
individual investors and seniors.
As we work to develop a balanced budget that is reasonable
and fair to all Americans, we must ensure that we, as a nation,
make the investments needed in human capital to help working
families raise their standards of living. President Clinton
proposed a capital gains exclusion on the sale of a principal
residence, which will help homeowners, in addition to proposing
much needed investments in education to grow the skill level of
new workers while helping enhance the abilities of the current
workforce.
These investments are an important step, but only address
part of the equation. It is also critical that we encourage the
private sector to invest in the physical capital of machines,
technology and tools that will increase the productivity of
American workers and our economy. H.R. 14, the Capital Gains
Tax Reduction Act of 1997, cuts the top tax rate on capital
gains from 28% to 14%, the lower tax rate from 15% to 7.5% and
indexes assets to inflation. This will help homeowners and
working families, but also help the private sector promote job
growth. Many of the small business owners in my district and
around the Nation are very concerned about their businesses as
it relates to the capital gains tax rate. A survey of the 3,000
plus members of the Greater Kansas City Chamber of Commerce
reflects that a primary concern of business owners is the
reduction of the capital gains rate. Under the status quo,
financial resources are trapped and precluded from benefitting
our economy as a whole. In the metropolitan Kansas City area,
we know that a majority of the job growth will come from
existing firms. With the relief provided in H.R. 14, job growth
will be enhanced and not inhibited.
The overall benefit of a capital gains rate reduction will
be felt in each and every household which we are privileged to
represent. An increasing number of Americans have become
investors in mutual funds, stocks, bonds, and other securities.
These individuals are trying to provide for a better future for
themselves and their families. Even without extraordinary gain
in the capital markets, they are trapped in their investments
with the current tax structure. Looking a step further, one
finds that our citizens are participating in pension plans
which could benefit from the passage of H.R. 14.
It is time to move beyond politics and make the investments
needed to raise the incomes of working families and ensure a
growing economy. This year's important bipartisan agreement on
priorities for the 105th Congress between President Clinton and
congressional leaders included both education initiatives and
tax relief. Whether the legislative vehicle is HR 14, or Mr.
Matsui's HR 420, the Enterprise Capital Formation Act of 1997,
of which I am also a cosponsor, we should build on that
bipartisan agreement and pass a capital gains tax reduction in
the 105th Congress. Working men and women in my district and
around the country would benefit from meaningful capital gains
rate reduction because the investments, savings, and the
economy would all gain from the unleashing of these captured
resources.
Chairman Archer. Thank you very much, and I understand that
you were Chairman of the Ways and Means Committee in the
Missouri Legislature, so you can understand the
responsibilities that go along with this.
Ms. McCarthy. I am very respectful and mindful of those
responsibilities, Mr. Chairman, and I appreciate the task that
you are about.
Chairman Archer. Thank you for your testimony.
Our next witness is Hon. Chris Cox of California. Welcome
to the Committee. We are delighted to have you, and we will be
pleased to receive your testimony.
STATEMENT OF HON. CHRISTOPHER COX, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF CALIFORNIA
Mr. Cox. Thank you, Mr. Chairman, and I, too, am a sponsor
of H.R. 14 and any other legislation to the same effect. Often,
and this morning is no exception, when we talk about reducing
tax rates, we confuse the discussion with reducing tax
revenues, and the question arises: How are you going to pay for
it?
There are two problems with this. One is that the
presumption that an adjustment in tax rates is going to cost
revenue to the Treasury is often false, and second, the use of
the personal pronoun ``you'' is ambiguous. When we ask the
question, How are you going to pay for it, it is not clear who
you is. I would suggest that we would be just as well advised
to have the antecedent of you be the American people as the
Government of the United States, because the Government will
never be fiscally sound over the long term if the economy which
supports it is not.
And so, if we have not figured out how the American people
are going to pay for this, we have an even bigger problem than
if we have not figured out how the government is going to pay
for it. On the first point, on the false premise that reducing
tax rates is going to lead inexorably to lower revenues to the
Treasury, I would cite only our own experience with the Joint
Committee on Taxation and with the estimates of past revenue
legislation. We are talking this morning about capital gains,
and it is a perfect example, probably the best example. You all
know--and some of you served on this Committee in 1978 when
this happened--that when STIGR was proposed, Joint Tax told us
it was going to cost a bundle. It was going to cost a lot of
money to reduce the capital gains tax rate by almost half, as
we did in 1978.
But Joint Tax was wrong. It did not cost a bundle. In 1979
and 1980, revenues went up. Then, we heard testimony before
this Committee that this was a one-time phenomenon; there was
sort of a fire sale effect. Well, of course, with all of this
pent-up, locked-up capital, you would get an immediate effect
from reducing the rate of tax on capital gains, but it could
not last. And yet, in 1981, when this Committee passed the
Economic Recovery Tax Act, and Joint Tax told us that surely,
reducing the rate further, from 28 percent down to 20 percent,
phased in between 1981 and January 1, 1983, surely, that would
really cost a bundle. And they were wrong again; it did not
cost a bundle. It, in fact, raised a bundle. From the base year
of 1978, when we started reducing the rate of tax on capital
gains to 1986, the last year of sound tax policy on capital
gains in this country, revenues to the Treasury did not go down
as Joint Tax told us and as it was scored for budget purposes
in this Congress. They went up over 500 percent. And just in
case you wanted empirical data the other way, Congress tried
the experiment in the opposite direction, and we jacked up the
rate of tax on capital gains to its present level in 1986, and
in the following year, revenues fell from $50 to $33 billion.
So, we ought not listen to a debate about static or dynamic
modeling; we ought to stop the fraud. We ought to get accurate
numbers. We are not using them. We live in a fantasy world
here. And I raise the same point with respect to the estate
tax, the death tax. It raises less than 1 percent of Federal
revenues. And I make an impassioned plea: Please do not raise
the exemption if you are interested in simplifying taxes
because it does nothing to simplify taxes. In one fell swoop,
with something that accounts presently for less than 1 percent
of Federal revenues, you can eliminate over 80 pages of the
Internal Revenue Code and over 200 pages of regulations.
You know that rich people do not pay this tax, or rarely do
they pay it, because, like Jacqueline Kennedy Onassis, they can
form a state-of-the-art trust to avoid it or avoid most of it.
It is not even the small businesses and the family farms and
the family ranches that we should be concerned most about. It
is the low-wage workers at these businesses who pay a 100-
percent tax rate when their jobs are destroyed, when the
property, because this is essentially a property tax, must be
liquidated in order to pay the death taxes.
It has been estimated that our capital stock in this
country will increase by two-thirds of $1 trillion over 8 years
if we repeal this tax. Let's grow the economy and help the
Government in that way rather than destroying the economy in
order to help the government.
I thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Rep. Christopher Cox, a Representative in Congress from
the State of California
On Balancing the Budget in a Low-Tax Environment
Chairman Archer, I want to commend you for your leadership
in holding these hearings today, and I welcome the opportunity
to talk about the urgent need for tax cuts. I know most of my
colleagues on this Committee agree with me that it is
absolutely essential that the budget be balanced in a low-tax
environment.
We are all working in this Congress to achieve a balanced
budget, but to do this without tax cuts would be a grave
mistake. A balanced budget in and of itself will do little to
encourage economic growth in this country if it is based upon
high rates of taxation and government spending.
Taxes which directly tax savings and investment are even
more detrimental to our economy--by increasing the cost of
capital they slow the rate at which the economy can expand and
they make it more difficult for all Americans to save.
The key to an effective balanced budget is the level of
taxation we can tolerate, not the amount of spending we want.
It is imperative that we determine the appropriate amount of
spending from the amount of tax disruption that spending
causes, not by how many programs we like here in Washington
D.C.
I'd like to focus my testimony today on the capital gains
tax and the estate tax--the source of much of our tax code's
bias against savings and investment. The current capital gains
tax and estate tax dramatically increase the cost of capital,
penalize savings, disproportionately damage small businesses--
slowing economic growth and hurting federal payroll and income
tax collections that would otherwise take in more under a
healthier economy.
Specifically, I'm here to call for a 50% cut in the capital
gains rate and complete repeal of the federal estate tax. These
two elements should be a crucial part of our goal of balancing
the budget in a low-tax environment. I hope that this Committee
will make it a priority to approve cuts in both of these anti-
growth, unfair taxes, so that we can send legislation to
President Clinton this year.
These two tax cuts complement each other in a number of
ways, aside from their inherent damage to our nation's growth.
The effect on revenue from cutting these taxes will, far from
hurting federal tax collections, in fact lead to increased
revenues, especially in the short term from increased capital
gains realizations, and in the long term through increased
payroll, income taxes, and corporate tax collections that will
arise from more vigorous economic growth.
The historical evidence is irrefutable--carefully-crafted
capital gains rate cuts can increase tax revenues:
In 1982, the capital gains tax rate was cut to
20%. The Joint Committee on Taxation predicted a massive loss
in government revenue. Yet, over the next five years, capital
gains realizations increased by 362%; federal revenue from the
capital gains tax grew 385%, from $12.9 billion in 1982 to
$49.7 in 1986.
Precisely the opposite phenomenon occurred in 1986, when
Congress decided to increase the capital gains tax rate.
In 1986, the capital gains tax rate was hiked from
20% to 28%--an increase of almost 40%. The Joint Committee on
Taxation told us that this would be a great way to raise more
funds for the U.S. Treasury. Yet, in the first year alone, both
realizations and revenues plummeted, falling 56% and 34%
respectively. This was hardly a one-time phenomenon: even in
1996, the 28% tax rate was still producing revenues
significantly less than the 20% rate that had been in effect in
1986.
Cutting the current capital gains tax rate in half, as
Republicans proposed last year, could generate $20 billion in
additional revenues over the next six years, according to
testimony presented to the House Small Business Committee.
Repeal of the federal estate tax, by contrast, would have
its greatest effect on the economy and on federal tax
collections just as the initial effects of reducing the capital
gains tax rate are beginning to stabilize. Repeal of the estate
tax will allow vast reserves of capital to be put to their most
productive use--not hidden away, diverted from business
operations for estate planning, or not driven into less
efficient uses as estates are liquidated to pay the tax man.
These burdens--compliance and enforcement costs, and
litigation--consume 65 cents for every dollar collected by the
estate tax.
Repeal of the estate tax will lead to dramatically
increased federal tax collections from income and payroll taxes
after a few years:
Repealing the estate tax this year would boost
annual economic growth by $11 billion, create 145,000 new jobs,
and raise annual personal income by $8 billion, according to
the Heritage Foundation.
As a result of this additional economic growth,
federal payroll and income taxes will be more than enough to
offset any short-term revenue loss from estate tax repeal.
A retrospective study of the economy over the last
20 years showed that net annual federal revenues would have
been $21 billion higher if the estate tax had been repealed 20
years ago.
Mr. Chairman, too many people inside the beltway seem to
think that they know what is best for the American people
better than the American people do. This kind of thinking
results in dangerous concepts such as paying for tax cuts, as
though the money belongs to the government rather than to the
people.
Our tax code today punishes savings, rewards spending, and
double (and sometimes triple) taxes income, making it virtually
impossible for parents to provide for their children and save
for the future. It is basic human nature that after we have
taken care of our immediate needs--food, clothing, shelter and
the like--we want to make life better for our children and
loved ones. I work, you work, and every American in this
country works not just for himself or herself, but for his or
her family, for those we care about.
Rather than seek to reverse human nature, which the death
tax and the capital gains tax do, our tax code should tap this
force as a powerful engine for wealth creation.
Again, Mr. Chairman, thank you for giving me the
opportunity to testify before you today.
Chairman Archer. Thank you, Mr. Cox.
Our next witness is Hon. Collin Peterson from Minnesota,
one of our colleagues familiar to us.
Welcome to the Committee, and you may proceed.
STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF MINNESOTA
Mr. Peterson. Thank you very much, Mr. Chairman, and I
appreciate the opportunity to appear here today and testify,
and we appreciated your coming over and visiting with our Blue
Dog group the other day. A lot of us are interested in your
idea of reforming the overall tax system and look forward to
working with you on that.
As you are aware, we have spent a lot of time within our
group trying to put together a budget that we think gets us to
balance, and we have put off, as you know, tax cuts until after
we get the budget balanced for a number of different reasons,
most of which it is very hard to get this accomplished and make
all of the numbers work, given the way we have to score things.
We are not against tax cuts, however. We just think we ought to
put them off until after we get the budget balanced.
And so, we have been advocating for a long time that we
should split this process up, and we should take the budget. As
one vote and one bill and take the tax cuts as another bill. We
are very gratified to see that there appears to be some
interest and some movement in that direction, and we think that
would be very useful. We think that that would be a way we
could maybe get through this whole situation and actually get a
balanced budget put in place.
Obviously, we think we have the best budget out there. We
have a CPI, consumer price index, change in our budget which
allows us to do some things that we think are very positive,
some of which have not gotten a whole lot of notoriety. We are
proposing taking the Social Security Trust Fund offbudget in
the year 2005 and putting it back in its own fund like it used
to be and taking the other trust funds offbudget by the year
2007. One of the reasons we are able to do that is because we
have the 0.08 change in the CPI in our budget.
So, having said all of that, we have a task force we have
set up to work with you and your Committee and also to work
with the administration, and we are ready to do that. However,
what I am going to say now is going to be my own views, because
we have not come to any conclusion on where we are at within
the Blue Dog group. I have looked at the President's tax
proposals. I think some of the education things maybe make some
sense, but in my mind, the most important thing we need to do
is if we are going to look at tax cuts, we need to focus on the
things that are going to do the best for the economy, and I
think those things are capital gains changes, estate tax
changes, and I would add to that some changes in the
alternative minimum tax.
I can go into a lot of reasons why I think the capital
gains change makes a lot of sense, but in my district, the most
important thing is most farmers are 58 years old, and they are
having a hard time turning over their operations to their kids
or to the neighbors. It is this capital gains structure that we
have now which is locking up a lot of assets that would be
better off if they were turned over. We have got a lot of
apartment buildings out there that have owners who really do
not want to own them any more, who bought them for tax
shelters, and that was screwed up in the 1986 Tax Reform Act.
They are not being turned over because of the capital gains
situation. There are just a lot of reasons, in my view, why we
need to change the capital gains provisions.
And the one thing I would say that I personally would
prefer that we look at, not at an across-the-board capital
gains change, but I think we ought to phase it in based on the
length of time that you own an asset. Maybe a simple way to do
it would be that you get a 10-percent exclusion from income for
every year that you own the asset, so, you would get the 50
percent if you owned the asset 5 years. I think that that would
be a more equitable way to put a capital gains provision in
place, and there are a number of folks within the Blue Dog
group who agree with me on that. We are asking Joint Tax to
score that and see what that looks like.
There are also a number of us, myself included, who think
we need to make changes in the estate tax, that we need to
raise the unified credit; we need to look at the rates; we need
to look at, potentially, some targeted relief for small
businesses and for family farms who are having the same kinds
of problems they are having with capital gains in the estate
tax area. And I also think we need to look at the alternative
minimum tax. I am a former tax preparer and personally get
involved with this AMT, alternative minimum tax, every year,
and there are just a lot of problems in that area. I think we
need to look at taking depreciation out of there or, if not
taking it out, making some changes, and I think that is an area
that needs to be looked at.
And I also think, from my perspective, that we need to take
a look at section 1245 gains. That is something you do not hear
a lot about, but I think that is something that could be a lot
of benefit for people in my district. Farmers, especially, get
all tangled up with that provision.
So, there is a lot of support within our group, and I think
on the Democratic side, for changes in the estate tax, changes
in the capital gains rate. We think it would be good for the
economy; we think it would be good for the country. But, having
said that, I think most of us are going to say if we are going
to do these things, they need to be paid for. We would like to
see them done in a separate bill and done in a way that they
are scored so they are not going to cost the Treasury any
money. And if we can split these two things up, and if we can
figure out how to pay for them, I think you will find quite a
bit of support on the Democratic side for that.
Thank you.
[The prepared statement follows:]
Statement of Hon. Collin C. Peterson, a Representative in Congress from
the State of Minnesota
First of all, I want to thank the Chairman and the
Committee for giving me the opportunity to present this
testimony today. The Blue Dog Coalition, of which I am a
member, met with Chairman Archer recently to discuss our
commitment to overall reform and our willingness to work with
the Chairman and the Committee on these issues. To that end,
the Blue Dog Coalition has formed a Tax Reform Task Force to
work with this Committee and with the Administration. The
Coalition position which we have been advocating for a long
time is that tax cuts should be split from the rest of the
budget and the two issues should be voted on separately; in our
view, any tax cuts must be paid for by cuts in spending or by
changes in entitlements. Although we are not in favor of
cutting taxes until we balance the budget, we are not opposed
to tax cuts as long as they can be paid for with spending cuts
or entitlement changes, and we can balance the budget in an
honest way.
I am Co-Chairman for the Tax Reform Task Force for the
Coalition. However, the testimony that I am giving today is my
own position. I strongly believe that if we are going to have a
tax cut, and if we can pay for it, that it makes sense to have
a tax cut which will be beneficial to the productivity of our
economy. If there is to be a tax cut which we can pay for, the
top priority should be to make capital gains changes, estate
tax changes, and some modification of the alternative minimum
tax.
Capital Gains
I think it was a mistake to eliminate the capital gains
preference in the 1986 Tax Reform Act. I know that in my
district, the 7th District of Minnesota, there are a lot of
long-term capital assets that need to be turned over. We have
family farms where parents want to turn over the farm to their
children. Small family-run businesses and apartment owners also
want to turn over their assets to their families; however,
these changes are not occurring because of the current capital
gains structure. If we create an incentive for families to turn
over their assets, the turnovers will result in increased
productivity of the assets and increased vitality for the
economy. The new owners will upgrade the assets by putting more
money into them, improving their value, and making them more
productive.
However, we should not return to the capital gains
provisions that were in place prior to 1986. Instead, we need a
program which rewards long-term investments in capital assets
and capital markets. To that end, I believe that it makes sense
to structure a capital gains reduction based on the length of
the owner's holding of their asset. This would not make Wall
Street happy, but they have not had a problem in attracting
capital in the last few years. The reduction could be simply
structured so that the exclusion from income increases along
with each successive year that the owner holds the asset. The
structure would involve a 10% exclusion from income for the
first year. This reduction would increase to 20% in the second
year and so on until reaching 50% after five years. This
structure would not only be less expensive to maintain, but
would also reward capital invested over a long period of time
from those people who build up small family businesses or farms
for over a period of years.
In addition, we could better target our capital resources
by eliminating depreciation in the calculation of alternative
minimum tax. We also should take a look at how we treat section
1245 gains. The current provisions are having a negative impact
on capital formation and the long-term viability of certain
businesses.
Estate Taxes
Along with the changes in capital gains, we need to also
consider increasing the present-law unified estate and gift tax
credit amount. We are open to suggestions on what the amounts
of increase should be, and how they should be implemented;
however, the bottom line is that these increases in exemptions
and credits must be paid for. We also should consider making
additional exemptions for small family-owned businesses and
family farms when these assets are transferred within the
family unit.
Conclusion
In making these changes, I believe that we will generate
positive economic activity. By unlocking assets through changes
in the capital gains structure, increasing the estate tax
exemption, and making changes to the alternative minimum tax,
we can increase the value and productivity of these assets, and
raise considerable revenue for the Treasury. I believe that
these changes would be good for the economy of the country, and
good for the people of my District. also think we need to look
at the alternative minimum tax. I am a former tax preparer and
personally get involved with this AMT, alternative minimum tax,
every year, and there are just a lot of problems in that area.
I think we need to look at taking depreciation out of there or,
if not taking it out, making some changes, and I think that is
an area that needs to be looked at.
Chairman Archer. Thank you, Mr. Peterson.
Our last witness in this panel is Hon. Earl Pomeroy. We are
happy to have you with us, and we will be pleased to receive
your testimony.
STATEMENT OF HON. EARL POMEROY, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF NORTH DAKOTA
Mr. Pomeroy. Thank you, Mr. Chairman. I will summarize my
testimony as briefly as I can.
For the last year, I have focused on the growing concern
about whether Americans are saving enough for retirement. There
is some frightening data out there that suggests that our
savings rates are falling far short of what Americans will need
for their retirement. In fact, the savings rate in this country
has fallen by about half of what it was in the years between
World War II and 1980 to now dipping under 4 percent in 1994.
One in three baby boomers, as estimated by Merrill Lynch,
is on track with their private savings to augment their
retirement needs, and the use of the individual retirement
accounts has mirrored these trends. Since the 1986 Tax Reform
Act, rates of taxpayers contributing to IRAs has fallen by 75
percent. In my testimony this morning, the component of the
President's tax relief proposals I am talking about, obviously,
relates to his proposals to expand the individual retirement
account, which I believe is a critical strategy in terms of
helping step up the rate of private retirement savings for
people in this country.
Social Security was never intended to be the sole source of
people's retirement income, and it certainly is not going to be
able to meet that as baby boomers move into retirement. The
tax-preferred individual retirement accounts are an excellent
way to encourage such savings, and I think, really, the only
discussion we have relative to that is how much IRA expansion
can we afford? I suggest we apply two priorities to expanding
the IRA: First, expanding access for middle-class Americans so
they can step up their retirement savings rates and do so by
enjoying the tax savings of a tax-deductible IRA; second, we
need to reach those who are not able to save for retirement and
devise new strategies that encourage savings among these
taxpayers.
The President's plan with respect to expanding access to
the IRA, I think, does an excellent job. Doubling the income
limits of households and individuals able to contribute to an
IRA and deduct the amount from their taxable obligation would
take it to $100,000 per household, $70,000 per individual. You
would make 20 million more Americans able to have a tax benefit
from contributing to an IRA under this recommendation, and that
is an excellent start. I am convinced it will step up IRA
participation and retirement savings.
In the area of what else we do, you have to look, I think,
at how much you can afford. There is a proposal introduced in
the Senate and House relative to open-ended IRAs, no limit on
the top-end deduction. The scoring, at least to date, is that
that would cost you about $25 billion, compared to the
President's package, costing about $5.5 billion. I think you
need to look at the area where you do not have people
contributing to savings, and, of course, common sense tells us
just what the data shows us: Those who cannot afford to save
for retirement are those who are struggling to meet the needs
of normal living expenses.
In fact, of workers with incomes of less than $25,000,
fully 42 percent report no retirement savings; 18 percent no
retirement savings in income ranges between $25,000 and
$40,000; 9 percent with incomes over $40,000. Now, I believe we
need to devise a strategy to incent those at lower earning
levels to also do something for their own retirement savings
needs, and a feature of legislation that I have introduced,
H.R. 17, would do just that. It would allow for individuals
earning less than $35,000 and households earning less than
$50,000 a 20-percent, nonrefundable tax credit for whatever
they contributed to the IRA. In other words, if they
contributed $1,000 to an IRA, they would actually have their
final tax liability reduced by $200. I think you could market
this as a $1-in-$5 match by the Federal Government, very
analogous to an employer match in a 401(k) situation that has
proven so very successful at incenting additional participation
in private retirement savings.
A final note, Mr. Chairman: If the purpose of IRA expansion
is to incent retirement savings, the more early access you
allow to the IRA accounts, the less retirement savings you are
going to have at the end of the day. Therefore, I am concerned
the President has proposed a number of exceptions that allow
early access to the funds that you are actually undercutting
what you are trying to achieve, and that is accelerate private
retirement savings so that people have their own assets to help
with retirement income.
I thank you, Mr. Chairman, for hearing me and wish the
Committee well in its difficult deliberations.
[The prepared statement follows:]
Statement of Hon. Earl Pomeroy, a Representative in Congress from the
State of North Dakota
Chairman Archer, members of the Committee, thank you for
the opportunity to appear before you this morning. As we all
recognize, the topic we discuss today--how to stimulate savings
and investment while maintaining progress toward a balanced
budget--is one of critical importance to the economic health of
our people and our nation.
While this morning's hearing touches on three different
components of President Clinton's fiscal year 1998 budget
proposal--the expansion of individual retirement accounts
(IRAs), the broadened exclusion for capital gains and the
modification of the estate tax, I wish to focus my remarks
exclusively on IRA expansion.
Americans are not saving adequately for retirement. For
most of the post-World War II period, personal savings as a
percent of disposable income in this country averaged nearly
8%. Yet in recent years, personal savings rates have fallen
dramatically, even dipping below 4% in 1994. Use of individual
retirement accounts by the American people has mirrored these
trends. While 16.2 million individuals made IRA contributions
in 1986, this number dropped--by nearly 75%--to 4.3 million in
1994. Much of this reduction was attributable to the Tax Reform
Act of 1986, which substantially curtailed the number of
individuals who could claim the tax benefits of IRAs.
Mr. Chairman, I have devoted much of my time in Congress to
the issue of retirement security, and I firmly believe that we
must pursue a national strategy to reverse these trends and
encourage greater savings for retirement. While we wrestle with
the difficult question of how to reform the Social Security
system to ensure its long-term solvency, we must remember that
Social Security was never intended to be the sole source of
retirement income. Rather, it was intended to augment personal
savings and an employer pension. Given this critical role that
personal savings plays in assuring financial security in
retirement, and given the inadequacy of Americans' savings
efforts, we must make encouraging private retirement savings a
top priority.
Tax-preferred individual retirement accounts are an
excellent means to encourage such savings, and we must take
steps to expand access to these accounts. The only question is
how much IRA expansion we can afford given the need to balance
the federal budget by 2002. As we grapple with these questions
of affordability, I suggest that our priority for IRA expansion
must be two-fold. First, we must expand the number of middle
income households who have access to this important incentive
to save for retirement. And second, we must find ways to
encourage use of IRAs by those working families who are
presently unable to save.
The data demonstrates that middle income families are
simply not saving enough for retirement. In fact, only one in
three baby-boomers is on track for a financially secure
retirement according to a recent study by Merrill Lynch. And
with the first of the baby-boomers turning 50 this past year,
their window to save for retirement is rapidly closing. To help
these and other middle income Americans reach financial
independence in retirement, we must take steps now to
accelerate the rate of private retirement savings.
With respect to this first priority--expanding IRA access
for middle income families--I believe the President's FY98
budget proposal achieves this goal in a responsible way. I have
long advocated for and fully support the President's proposal
to double the amount that individuals with workplace retirement
plans may earn--to $70,000 for individuals and $100,000 for
households--and still qualify for tax-deductible IRA
contributions. In fact, my own IRA legislation, the IRA Savings
Opportunity Act of 1997--H.R. 17, would make this same reform.
With this single step of doubling income eligibility levels, we
can restore the tax benefits of IRAs to as many as 20 million
middle income families.
Whether to raise the income eligibility levels further than
this is really a question of what we can afford in the current
budget climate. While the doubling of the income caps has been
scored at a cost of $5.5 billion over five years, the outright
removal of the income caps--as authorized in the Super IRA
legislation introduced in the House and Senate--has been scored
at a five-year cost of nearly $25 billion. My belief is that it
would be better to devote some of these funds to achieving the
second priority of encouraging IRA use by working families who
are presently unable to save.
When it comes to this second priority, I believe the
President's budget could do more. Statistics confirm what
common sense tells us--that savings correlates with disposable
income and that low-wage workers have great difficulty saving
for retirement. According to a recent study by the Public
Agenda Foundation, among workers with incomes of less than
$25,000, fully 42% reported no retirement savings whatsoever.
In contrast, only 18% of those with incomes between $25,000 and
$40,000 and 9% of those with incomes over $40,000 reported
being unable to accumulate retirement savings. IRA
participation rates tell the same story. In 1982 when the IRA
tax deduction was available to all taxpayers, 56% of households
with earnings greater than $50,000 contributed to an IRA
compared to only 19% of households with earnings between
$20,000 and $25,000. These IRA participation disparities have
continued even as eligibility for the IRA deduction has been
curtailed for those at higher income levels.
Mr. Chairman, what these statistics tell us is that
families at the lower end of the wage scale must be given a
little extra help if they are to be able to save for their own
retirement. Providing such help is in all of our interests. It
will not only create new savers who will help spur the economy
but it will also reduce the number of individuals who must
later turn to the government for assistance when Social
Security alone proves insufficient to meet their basic needs.
My IRA legislation, H.R. 17, attempts to provide this help
by giving an added tax incentive for low-wage workers to
contribute to an IRA. Under my bill, individuals earning less
than $35,000 and households earning less than $50,000 would be
entitled to a non-refundable tax credit equal to 20% of the
amount contributed to an IRA. For example, a taxpayer in this
income range who contributes $1,000 to an IRA would see his or
her final tax liability reduced by $200. This tax credit
component of my bill resembles the employer match feature of
401(k) plans, which has proven so effective in encouraging low
and moderate income workers to contribute to retirement plans
in the workplace. The effect of the tax credit is that for
every $5 the taxpayer puts toward retirement savings, the
federal government kicks in an additional dollar. I believe
this tax credit approach will prove effective at achieving the
second priority of IRA expansion--creating new savers among
those who are not saving today.
Addressing these two key priorities--expanding access to
IRAs for middle income families and encouraging IRA use by
those not presently able to save--will require substantial
resources. If we are able, however, to devote additional funds
to IRA expansion after reaching these goals, there are
certainly additional reforms that would help working and middle
income families accumulate adequate retirement savings. One
measure I have included in my IRA Savings Opportunity Act would
allow middle income individuals without access to a workplace
retirement plan--a group for whom personal retirement savings
is especially important--to double their annual IRA
contribution to a total of $4,000. Another measure I have
included in my legislation would remedy a glaring inequity in
current IRA law by allowing an individual to take an IRA
deduction irrespective of whether his or her spouse is covered
by a workplace retirement plan. For the first time, this reform
would allow working women whose husbands are covered by a
workplace retirement plan to deduct contributions to their own
IRA. Another helpful reform, which is contained in the
President's FY98 budget proposal, would be to index both the
income eligibility levels for IRA deductions and the $2,000
annual IRA contribution amount so that inflation will not eat
away at the IRA benefits we restore to middle income Americans.
The President's IRA proposal and a number of others include
authorization of a limited number of penalty-free withdrawals.
I believe these proposals require us to reevaluate the basic
purpose of the IRA tax incentive. If the purpose of the
incentive is to encourage savings for retirement--as I believe
it is--then I am concerned that by providing access to the
accounts for non-retirement purposes we will undercut the
ability of the IRA to achieve its policy objective.
Mr. Chairman, members of the committee, as you move forward
to consider the various IRA expansion proposals put forth by
the President and others, I encourage you to focus your efforts
on addressing the two key priorities of expanding access to
IRAs for middle income families and encouraging IRA use by
those not presently able to save. I thank you for your time
this morning, and I look forward to working with you in the
coming weeks and months to craft a budget plan which contains
targeted and meaningful savings incentives.
Chairman Archer. Thank you, Mr. Pomeroy, and the Chair
compliments each of the witnesses for their presentation, and I
think each of them has been exceedingly constructive in moving
us to what I hope will be the ultimate goal, which is a zero
tax on savings in the United States of America. But every
movement that we can get in that direction is a very
constructive one.
Do any Members wish to inquire?
Mr. Christensen.
Mr. Christensen. Mr. Chairman, I just wanted to applaud Mr.
Deutsch, even though he is not here, on his testimony. I have
never heard it quite so eloquently put by a Member of the other
side on the confiscatory nature of capital gains and how
punishing a tax it really is on savings and investment. I
really want to applaud his leadership, and I really look
forward to working with him on this issue.
Congressman Cox, I wanted to ask you a quick question:
Obviously, I applaud your efforts both on capital gains and on
the death tax issue. If you were to have to choose between the
two, and hopefully, we would never have to do that, but if you
were to focus your efforts on one or the other, which would be
the better of the two to work on to try to get this country
going, and in terms of a confiscatory task, what would be your
comments on that?
Mr. Cox. Well, to put it the other way, I think it is the
same question answered from either angle: Which of these taxes
would you most like to keep? I would say that that question is
logically equivalent to asking me whether I would prefer to be
hit by a truck or a bus. Neither of these taxes has any place
in a rational system where tax policy animates the Code. But
let me explain from the premise of tax policy why the death tax
is even worse than the capital gains. I like to call the
capital gains tax a penalty tax on savings and investment. That
is a more apt description than capital gains, which is some
Internal Revenue Code jargon. Capital gains really does
penalize savings, and it penalizes investment, and it is a
penalty tax.
And since our savings rate is so abysmally low, I was just
mentioning to Congressman Dreier here that Alan Greenspan has
told us the average financial assets owned by an American
between the ages of 45 and 53 is--anybody want to guess? David
and I are the same age; we are 44; we will turn 45 next year.
So, next year, we will graduate into this class of 45- to 53-
year-olds. And according to Greenspan, the average financial
assets held by Americans between the age of 45 to 53--and guess
yourself what that number was.
Mr. Dreier. Tell them what my guess was.
Mr. Cox. My guess was $10,000. It is $2,300, and when you
hear this aggregate statistic of America's low savings rate
compared to everybody in the world, this is a great way to
personalize it: $2,300 in financial assets for Americans
between 45 and 53. So, a tax that penalizes savings and
investment is doing grave damage to our economy.
But the estate tax goes beyond being a penalty tax on
savings and investment. It is certainly that, but it has been
called a virtue tax. Sometimes, in Ways and Means, you talk
about sin taxes. Let's tax alcohol, tobacco, what have you. If
you have got to tax something, why not tax sin? But the estate
tax is a virtue tax, because not only is it a penalty tax on
savings and investment, but it also penalizes work. The Code
calls capital gains passive income, but if you continue to work
beyond what is required to put clothes on your back, a roof
over your head, food on the table so that you can take care of
your loved ones, which is a human urge, you are penalized by
the estate tax. You are penalized for doing what we want you to
do, which is to continue to work, continue to provide for other
people, continue to pay taxes, quite frankly. And, at the same
time, you are rewarded for sin: You are rewarded for
conspicuous consumption; you are rewarded for early retirement.
None of these things should be incented by our Tax Code.
And so, while I go back to my original analogy, which is
that this is like getting hit by a truck or a bus, if you ask
me which is worse, capital gains or the death tax, I would get
rid of the death tax.
The red light is on. I just want to share with you one very
poignant story. A city council member in my district--it is a
part-time city council--in his real life is an estate tax
lawyer, and he came to see me the other day about city
business, but he said I really am glad that the Congress is
looking to repeal the death tax, because while I do this for a
living, I have to tell you: I hate what I do for a living in
many ways. Just the other day, I spent several hours at the
bedside of one of my clients who passed away that day, and this
happens not infrequently, because this is what I do for a
living. And he said what I was doing with this man, and it took
me the better part of 1 hour, was getting him to sign documents
to create nothing in economic reality but tax avoidance so that
he would not pay the estate tax. And the consequence of my
being there was that if he signed the documents, he would not
have to pay these taxes, but if he did not sign the documents,
he would. Otherwise, there is no economic reality.
He signed the papers, and I went home, and he died, and I
talked to his wife and his kids on the way out, and I thought
how sad that our government creates a situation in which this
dying man is spending his last hours on Earth with me, the tax
lawyer, instead of with his wife and his kids. This is an
awful, immoral, grotesque tax, and I would repeal it.
Mr. Christensen. Well, thank you, and I applaud Congressman
Dreier and H.R. 14, and I equally echo your sentiments that I
would like to see them both repealed.
Thank you, Mr. Chairman.
Chairman Archer. Thank you, Mr. Christensen.
Mr. English.
Mr. English. Thank you, Mr. Chairman.
This has been an extremely impressive panel. I must say it
has been one of the best discussions we have had before this
Committee since I have been on it on a variety of tax issues
that really affect the dynamics of the economy. I appreciate
all three of you who are still here for staying here, and
particularly, I appreciate Representative Peterson bringing up
the alternative minimum tax, which I think is a terribly
antigrowth provision in our Tax Code, a dead drag on our
economy, and one that frequently gets dropped out of the
discussion, so I am most grateful.
Representative Dreier, it has been a privilege to work with
you to push for broad-based capital gains relief. There is a
discussion as we move toward tax cuts as to whether it is
better to have broad-based capital gains relief or try to carve
out some areas where the capital gains tax is particularly
punitive. And so, there have been a number of proposals for
targeted capital gains relief. I wonder if you could briefly
generalize on how strongly you feel about broad-based relief
and why it is essential that it be in any tax package we do.
Mr. Dreier. Well, thank you very much, and as I said in my
statement, I appreciate the fact that you responded to my call
last fall when we looked to put this whole package together,
and I appreciate your leadership on it. I mentioned in my
statement this issue of human capital juxtaposed to physical
capital, and I am one of those who has a very difficult time
with having the government make choices as to whose capital
should be taxed at a different rate. I am convinced that when
we look at this proposal, it is going to boost wages overall if
we bring this about. A study that was done in 1993 found that
we could boost wages by $1,500 for working Americans over a 5-
year period, and we continue to hear about family tax cuts.
Remember, those expire, and these do not.
So, that is why I think this broad-based package is not
something that is going to simply target individual areas, but
it is going to have an overall benefit in wages to people. So,
that is a reason that is not often discussed as to why a broad-
based reduction would be beneficial. But again, I laud the
President for focusing on education. We are all very concerned
about it, but it is only half of the equation. We have got to
make sure that job opportunities are out there, and this kind
of investment will go a long way toward doing that. And then,
again, I mentioned earlier this recession problem that we might
potentially have, and I see this as an insurance policy to help
avoid recession. So, I think that on an overall basis, it can
be very, very beneficial for us.
Mr. English. Thank you; that is a very powerful summary,
and I appreciate it.
Representative Cox, you gave a history of revenue under
changes in the capital gains tax that, in my view, is
absolutely unanswerable, and I wish this message were pounded
into people more not only in this institution but also within
the news media and the general public. I wonder: Reflecting on
that, and having been here much longer than I have, and having
seen the process of tax reform move forward, I think you and I
both would support real tax reform right now. Do you believe
that dynamic scoring is an important thing to move toward now
as part of our effort to get toward tax reform that will really
work and will really grow the economy?
Mr. Cox. I think honest scoring is what we need for a
change. The debate about dynamic and static has gone off in an
odd, tangential direction. It means to some people adjusting
data or cooking the books or guessing. The truth is that what
we actually do, and I do not know what you want to call it,
whether you want to call the status quo static or what have
you, but the current arrangement between CBO and Joint Tax,
whatever its label, is characterized chiefly by its false
results. It is a fraud. It is so far off the mark that it
should be rejected out of hand for almost any other system.
The empirical data, which I cited, is readily available to
this Committee and to this Congress, but it goes well beyond
our experience from 1978 to 1986 and our experience then
forward from 1986 to now. We have, of course, the Kennedy tax
cuts. We have the Mellon tax cuts. We have Mexico's experience.
We have Canada's experience. We have empirical data coming out
our ears, and the only thing we know about our arrangements
with CBO and Joint Tax is that they produce consistently false
promises. They overpromise and cheat the Treasury when it comes
to taxes, because they tell us that by keeping the capital
gains tax rate where it is, we will get revenues that, frankly,
we are not going to get or alternatively that, by reducing that
rate, we will lose revenues where, in fact, we would eclipse
the current levels.
We are cheating the Treasury. We are cheating the Treasury.
It is not a question of being able to give more tax relief to
the American people than we presently do. The government of the
United States is being cheated out of revenues because of this
system. That is not a conservative system; that is a stupid
system.
Mr. English. Thank you, and thank you, Mr. Chairman.
Chairman Archer. Does any other Member wish to inquire?
Mr. Crane. May I just make a comment?
Chairman Archer. Mr. Crane.
Mr. Crane. First of all, I want to congratulate all of our
witnesses for their commitment to strong tax policy and equity
in our Tax Code, and I want to congratulate Chris Cox on his
efforts to eliminate the death tax and on his commitment to
eliminate the stupid capital gains tax.
One observation I wanted to make relates to an article, and
I think I may have sent it out to you already from Investors
Business Daily with regard to the death tax, pointing out that
it brings in 1 percent of our total revenues annually. Over 7
years, they say, and these are projections by former Treasury
economists, if you eliminated it, you would lose about $100
billion in revenues, but you would cause a creation of $630
billion in increased capital. I cannot help but believe that
anyone who sits down and analyzes these figures cannot reach
the same conclusions that you presented eloquently in your
testimony, Chris.
So, I encourage you--I have been a cosponsor of your bill;
Kenny Hulshof and I have one in, too, that eliminates that
death tax, and I would hope we would get the growing bipartisan
consensus that Collin referred to and guarantee that we do
ultimately abolish the tax. Of course, it must be within the
context of a balanced budget, too, but we must provide this
kind of meaningful relief for overburdened Americans.
Mr. Cox. Chairman Crane, I would just add that precisely
for the reason you stated, the so-called loss in revenue over a
period of years is not, in fact, that loss in revenue, because
that is not all that happens. This is not a closed system in
which all that exists is a death tax. We have plenty of other
taxes, and if you are increasing economic growth by $11 billion
a year, then obviously, you get to tax all that growth, and
that offsets it. It is the same thing as if we zero out capital
gains. Nobody thinks we are going to lose revenues to the
Treasury--or, at least, I should not say nobody; but most
people do not think that. But, of course, we would lose them
from capital gains taxes, because there would not be such a tax
any longer. We would just pick it up elsewhere.
Likewise, if we repeal the income tax, and we have a
consumption tax, it is not that the Government gets zero
revenues; it gets them from a different place.
Mr. Dreier. If I could just add to that, Phil. In 1993 I
mentioned that to the Zero Capital Gains Tax caucus that we put
together. We found that over a 7-year period, a rate that
actually ends up right around what we have in H.R. 14, which is
a 14- to 15-percent rate, would over that period of time
increase the gross domestic product by $1.3 trillion, create 1
million jobs, and generate $220 billion in revenues to the
Treasury. And where we are is actually the rate that, it seems
to me, would optimize those revenues to the Treasury
specifically from capital gains revenue.
Mr. Crane. Well, I have argued for years that taxing
capital gains, taxing interest, taxing dividends, all those
taxes do violence to all of the moral values we were taught and
we try to instill in our kids, notwithstanding these penalties
in place. I have seen economic reports in the past which
suggest that, but if your objective is to maximize revenue on
the one hand and the creation of capital on the other, the
ideal rate is somewhere between 9 and 12 percent. Now, I do not
know where the economists reached those conclusions. I would
like to see it all eliminated 100 percent.
Mr. Dreier. Right.
Mr. Crane. But you might go back and revise your bill and
ratchet it down.
Mr. Dreier. OK.
Mr. Crane. Thank you.
Mr. Dreier. That is just in the interest of Chairman
Archer, I know.
Chairman Archer. Mr. Rangel.
Mr. Rangel. Thank you.
David, these estimates that are so positive that you and
Congressman Cox and my friend Phil and others talk about are
the numbers I want. I want to make certain they are accepted by
the House, the Senate, and the President. I do not see how we
can talk day in and day out, year after year, about this and
not be reading from the same rule book. I mean, why do we do
this to each other?
Now, either we have got to get rid of the way we estimate
revenue losses or we have to live by the rules as they now
exist. I am not saying the estimates are always accurate. I
think any economist would have a difficult job no matter what
they estimate. But why would we debate the issue of estimating
methodology when we are forced to go by the rules as they are
today? And your alternative rule book is not commonly accepted.
Mr. Dreier. Well, first, Chris and I have been making the
case for accuracy, and I appreciate the fact that you recognize
some validity to it. But let's go--and I tried to respond to
you in my testimony on that--let's look at this whole package
that we had. The President's budget says he can bring it in
balance with $100 billion of tax cuts. H.R. 14 has been scored
by CBO and Joint Tax at $44 billion. It seems to me that if we
look at the tremendous benefits, which I have tried to outline
here, along with what you are convinced, and based on the
scoring we have gotten, which I disagree with, but we have
gotten it playing by those rules. It is a $44 billion cost.
So, that is why I think being less than half the
President's, it is a responsible way to proceed, because, as
Jennifer Dunn said in her statement, this is the most important
item we can do in trying to deal with this issue of balancing
the budget, economic growth, and increasing wages.
Mr. Rangel. OK; as long as when we finish, we are reading
from the same rule book that----
Mr. Dreier. Well, I am just trying to read from your book
right now, Charlie.
Mr. Rangel. Well, it is not my book. It is the one that
they have given me, and I just hate, once I understand that
book, for people to start changing rules, even if I like your
way better. You can be more creative; have more imagination
and----
Mr. Dreier. And accurate.
Mr. Rangel. If I found some way to agree with you about
this scoring, if I can say that if we make an investment in the
future of our children, we will get a dividend that we can
depend on--for example, if we could project that a better
educated child is going to make more money, be more successful,
stay out of trouble, and be a good citizen, then I could like
that kind of scoring. And I think that is one solution to the
scoring debate--that is, if people want to use dynamic scoring,
they take a broad range of things into consideration on the
outlay side, as well as the revenue side. But until the
estimators use a system like that, we might as well play by the
rules that now exist. If the estimators are saying that your
bill will cost $44 billion, then we must find a way to pay for
that.
Mr. Dreier. I am glad you will find it.
Thank you, Mr. Chairman.
Chairman Archer. Thank you, gentlemen. One last, quick
question, and then we will excuse you and go to our next panel.
In your bill H.R. 14, what do you do about the recapture of
depreciation?
Mr. Dreier. We do not have any change in depreciation at
all. We simply have indexation along with that reduction of the
top rate from 28 to 14 and then the lower rate from 15 to 7\1/
2\.
Chairman Archer. But let me be sure I understand. Then, you
would require the recapture of depreciation of ordinary income,
at the 28-percent rate.
Mr. Dreier. Right, right; that is correct.
Chairman Archer. Which current law does----
Mr. Dreier. That is correct.
Chairman Archer [continuing]. Before you compute the
capital gains rate.
Mr. Dreier. That is correct.
Chairman Archer. Thank you very much and thank you for your
excellent testimony.
Mr. Dreier. Thank you very much, Mr. Chairman.
Chairman Archer. The Chair would inform the Members of the
Committee, as well as future witnesses or anybody else
concerned, that it is the intention of the Chair to recess at
12 noon for 1 hour and to reconvene at 1 p.m. to continue the
hearing today.
So, the Chair invites our next panel: Mark Bloomfield, Jane
Gravelle, David Wyss, Richard Woodbury, and Thomas Wiggans to
come to the witness table.
Mr. Bloomfield, the Chair recognizes you as our first
witness, and in the event you were not here earlier in the day,
we would encourage you to keep your verbal presentation to 5
minutes or less, and without objection, your entire statement
in writing will be inserted in the record.
Mr. Bloomfield, welcome. We will be pleased to hear your
testimony.
STATEMENT OF MARK BLOOMFIELD, PRESIDENT, AMERICAN COUNCIL FOR
CAPITAL FORMATION; ACCOMPANIED BY DR. MARGO THORNING, SENIOR
VICE PRESIDENT AND CHIEF ECONOMIST
Mr. Bloomfield. Thank you, Mr. Chairman. My name is Mark
Bloomfield; I am president of the American Council for Capital
Formation, and I am accompanied by Dr. Margo Thorning, our
senior vice president and chief economist. We are very grateful
for the opportunity to present testimony to the Committee on
the subject of capital gains taxation.
Mr. Chairman, I would like to make three points today.
First, let me set the predicate for a well-crafted capital
gains tax cut. That predicate has two parts. One, trends in
U.S. capital formation are not encouraging. Slow growth in the
United States over the past two decades can be partially
attributed to low levels of investment. A recent international
comparison by the World Bank suggests that countries with high
levels of investment grow faster than countries with relatively
low levels of investment. The United States, for example, was
in the bottom quarter of 16 countries surveyed in both the
level of investment and average real GNP growth. Two, tax
policy, Mr. Chairman, has an important impact on capital
formation and economic growth. To those who would like to
encourage individual and business decisions to save and invest,
stimulate economic growth and create new and better jobs,
capital gains and other forms of savings should not be taxed at
all. This view was held by top economists in the past and by
many mainstream economists today.
Second, let me summarize the positive macroeconomic impact
of a sound capital gains tax cut, and I am drawing on two new
analyses of two types of proposals before this Committee. The
first, basically, is a 20-percent maximum capital gains tax for
individuals and a 25-percent corporate tax rate. The second
would be a 14-percent individual rate, a 28-percent corporate
rate and indexing for inflation. This is the proposal of Mr.
Dreier and others. These studies that I am mentioning were done
by mainstream economists Dr. Allen Sinai, chief global
economist, Primark Decision Economics, and DRI/McGraw-Hill, the
prominent economic analysis firm represented by David Wyss on
the panel today. Their results, I believe, would be helpful to
address the questions of Mr. Rangel, Mr. English, Ms. Dunn, and
others on the Committee today about the revenue impact and
economic impact of a capital gains tax cut.
A soundly crafted capital gains tax cut, number one, would
increase jobs and economic growth. New analyses by Alan Sinai
and DRI/McGraw-Hill show that a broad-based and carefully
crafted capital gains tax cut for individuals and corporations
reduces the cost of capital, increases investment, GDP,
productivity growth, and employment. In addition, such a cut
would essentially be revenue neutral when unlocking and
macroeconomic consequences are included.
Number two, it would benefit middle-class taxpayers. A 1996
CBO draft report documents the widespread ownership of capital
assets among middle-income tax payers. According to the CBO
report, in 1989, 31 percent of families with income under
$20,000 held capital assets, not including personal residences,
and 54 percent with incomes between $20,000 and $50,000 held
capital assets.
Number three, encourage entrepreneurship. Capital gains has
a particularly powerful impact on the Nation's entrepreneurs,
and is a major driving force for technological breakthroughs,
new startup companies, and the creation of high-paying jobs.
Starting new businesses involves not only entrepreneurs but
also informal investors, venture capital pools, and a healthy
public market.
Number four, it would promote U.S. savings and investment.
The United States taxes capital gains more harshly than almost
any other industrial country, according to an OECD survey of 12
industrialized countries. Most of these countries also have had
higher rates of investment as 1 percent of GDP than the United
States over the past two decades.
Let me conclude with the case for a soundly structured,
broad-based capital gains tax cut. By reducing the cost of
capital, it would promote the type of productive business
investment that fosters growth, output, and high-paying jobs.
By increasing the mobility of capital, it would assure that
scarce saving is used in the most productive manner. By raising
capital values, it would help support values and capital asset
markets in general and the stock market in particular. By
increasing the availability and lowering the cost of capital,
it would aid entrepreneurs in their vital efforts to keep the
United States ahead in technological advances and translate
those advances into products and services that people need and
want. By reducing taxes on their savings, it would treat fairly
those thrifty Americans who must bear a heavier tax burden than
the profligate, and because of the combined impact of unlocking
and the macroeconomic feedback from mainstream economic firms,
a broad-based capital gains tax cut is likely to at least not
be a revenue loser and maybe even increase Federal revenues.
[The prepared statement follows:]
Statement of Mark Bloomfield, President, American Council for Capital
Formation
Introduction
My name is Mark Bloomfield. I am president of the American
Council for Capital Formation (ACCF). I am accompanied by Dr.
Margo Thorning, our senior vice president and chief economist.
The ACCF represents a broad cross section of the American
business community, including the manufacturing and financial
sectors, Fortune 500 companies and smaller firms, investors,
and associations from all sectors of the economy. Our
distinguished board of directors includes cabinet members of
prior Republican and Democratic administrations, former members
of Congress, prominent business leaders, and public finance
experts.
The American Council for Capital Formation has led the
private-sector Capital Gains Coalition since 1978, when the
first major post-World War II capital gains tax cut was
enacted. The Coalition brings together in support of capital
gains tax relief diverse participants from all sectors of the
business community venture capital, growth companies, timber,
farmers, ranchers, small business, real estate, securities
firms, and the banking and insurance industries.
This testimony begins with a discussion of trends in U.S.
capital formation and productivity growth, and the impact of
tax policy on economic growth. Then we specifically address the
macroeconomic effects of capital gains tax reductions. We
conclude our testimony by setting forth three criteria that a
good capital gains tax cut should meet: it should make economic
sense; it should be fair; and it should be fiscally
responsible.
We commend the emphasis that Chairman Archer has placed on
the impact of capital gains taxation on the cost of capital,
saving and investment, and economic growth. A capital gains tax
cut will help reduce the burden on capital formation imposed by
current U.S. tax policy. That tax policy must be revised if
real wages for U.S. workers are to increase, living standards
are to advance at a faster pace, and the United States is to
maintain the economic strength necessary to sustain its leading
role in world affairs.
Trends in U.S. Capital Formation, Productivity Increases, and Economic
Growth
Slow growth in the United States over the past twenty years can be
partly attributed to low levels of investment. A recent international
comparison by the World Bank suggests that countries with high levels
of investment experience faster growth than countries with relatively
low levels of investment. This relationship is clearly demonstrated in
Table 1 and Figure 1.
International comparisons aside, even more disturbing is the fact
that net annual business investment in this country has in recent years
fallen to only half the level of the 1960s and 1970s. As shown in Table
2, that rate dropped from an average of 8.9 percent of GDP in the 1960s
and 1970s to 4.8 percent in the 1990s.
Harvard Professor Dale W. Jorgenson, one of the nations foremost
public finance economists, emphasizes the overwhelming importance of
investment in plant and equipment for economic growth in his recent
volume, Productivity Postwar U.S. Economic Growth. Professor
Jorgenson's study analyzes economic growth between peaks in the
business cycle over the 1948-79 period. Allocating increases in output
to three sources growth in the capital stock, labor supply, and
multifactor productivity he found that increases in the capital stock
had the strongest impact on growth in output.
Studies by University of California Professor J. Bradford De Long
and Deputy Secretary of the Treasury Lawrence H. Summers also conclude
that investment in equipment is perhaps the single most important
factor in economic growth and development. Their research provides
strong evidence that, for a broad cross section of nations, every one
percent of GDP invested in equipment is associated with an increase in
the GDP growth rate itself of one-third of one percent, a very
substantial social rate of return.
Tax Policy and Economic Growth
To those who favor a truly level playing field over time to
encourage individual and business decisions to save and invest,
stimulate economic growth, and create new and better jobs, capital
gains (and other forms of saving) should not be taxed at all. This view
was held by top economists in the past and is held by many mainstream
economists today.
This is primarily because the income tax hits saving more than once
first when income is earned and again when interest and dividends on
the investment financed by saving are received, or when capital gains
from the investment are realized. The playing field is tilted away from
saving and investment because the individual or company that saves and
invests pays more taxes over time than if all income were consumed and
no saving took place. Taxes on income that is saved raise the capital
cost of new productive investment for both individuals and
corporations, thus dampening such investment. As a result, future
growth in output and living standards is impaired.
A consumption-based tax system, under which all saving and
investment would be exempt from tax, would be more favorable toward
capital formation and economic growth than is our current income tax
system, according to analyses by top public finance scholars over the
past decade and a half. Studies by Stanford University's John Shoven
and Lawrence Goulder, Harvard's Dale Jorgenson, the University of Texas
Don Fullerton, and Joel Prakken of Macroeconomic Advisers have used
macroeconomic models that incorporate feedback and dynamic effects in
simulating the impact of adopting a consumption tax as a full or
partial replacement for the income tax. These studies, which use
different types of general equilibrium models, conclude that U.S.
economic growth would be enhanced if we relied more on consumption
taxes, or replaced the income tax with a fundamental tax restructuring
plan similar to those proposed by several prominent members of the U.S.
Senate and House of Representatives in recent years.
In addition, at a recent forum on dynamic revenue estimating
sponsored by the Joint Committee on Taxation, the majority of the
economic modelers concluded that if the United States switched from the
existing income tax to a broad-based consumption tax, the rate of
economic growth would increase significantly.
Macroeconomic Impact of Capital Gains Tax Reductions
In their search for methods of stimulating saving,
investment, and economic growth, policymakers should give
strong consideration to lightening the tax burden on investment
through a significant capital gains tax reduction.
Low capital gains taxes not only treat savers more fairly
but also help hold down capital costs. Public finance
economists refer to the tax on capital gains as a tax on
retained income. It is retained income that funds a large part
of business investment. The higher the capital gains tax, the
more difficult it is for management to retain earnings (rather
than pay out dividends) for real investment in productive
projects.
Although the short-term outlook for the U.S. economy is
favorable, worries about the future appear to be multiplying.
For example, many public finance experts such as Professor John
Shoven conclude that this country's long-term strength and
economic stability depend on increasing saving and investment
to ensure that the retirement of the baby boom generation does
not sink the economy into a sea of red ink. A cut in the
capital gains tax to a top marginal rate of 15 to 20 percent
would by no means act as an economic panacea. However, it would
surely help encourage saving, help maintain the values of
capital assets (e.g. real estate and stocks), promote
investment by both mature and new businesses, and more fairly
tax individual savings.
Substantial reductions in capital gains taxes for
individuals and corporations would have important economy-wide
consequences:
Increase Jobs and Economic Growth
A new study by Dr. Allen Sinai, president and chief global
economist at Primark Decision Economics and the WEFA Group and
a highly respected economic forecaster, concludes that a well-
crafted, broad-based capital gains tax rate reduction has
significant benefits for the U.S. economy.
Dr. Sinai's analysis demonstrates that a broad-based
capital gains tax proposal providing a 50 percent exclusion for
individuals and a 25 percent corporate capital gains tax rate
would reduce the cost of capital (defined as the pretax return
required by investors) by almost three percent. Reduced capital
costs lower the hurdle rate for new business investment and
induce increases in the rate of growth of capital formation,
investment, productivity, GDP, and employment (see Table 3).
Lower capital gains taxes support the value of equities as well
as other capital assets.
A capital gains tax reduction would also tend to shift the
financing of business activity from debt to equity, and induce
portfolio allocations by households toward equity to take
account of changes in expected after-tax returns on stocks and
bonds.
Benefit Middle-Class Taxpayers
Investments in capital assets are widely held by the middle
class. According to data compiled by the Investment Company
Institute, almost 60 percent of households with income of
$50,000 or less own mutual funds. A 1996 Congressional Budget
Office (CBO) draft report also documents the widespread
ownership of capital assets among middle-income taxpayers.
According to the CBO report, in 1989, 31 percent of families
whose incomes were under $20,000 held capital assets (not
including personal residences) and 54 percent with income
between $20,000 and $50,000 held capital assets.
Middle-and low-income taxpayers also hold a significant
share of the total dollar value of capital assets, even when
personal residences are excluded. The CBO study shows that 30
percent of the dollar value of such assets (excluding housing)
was held by families with incomes of $50,000 or less in 1989.
Encourage Entrepreneurship
Capital gains taxation has a particularly powerful impact
on this nations entrepreneurs. These individuals are a major
driving force for technological breakthroughs, new start-up
companies, and the creation of high-paying jobs. Starting new
businesses involves not only entrepreneurs but also informal
investors, venture capital pools, and a healthy public market.
All taxable participants are sensitive to after-tax rates of
return, which is why the level of capital gains taxation is so
important.
Foremost is the entrepreneur. If the tax on potential
capital gains is a higher rate, either the pool of qualified
entrepreneurs will decline or taxable investors will have to
accept a lower rate of return. In either case, the implications
for the U.S. economy are clearly negative. To be successful,
the entrepreneur needs capital. Fledgling start-ups depend
heavily on equity financing from family, friends, and other
informal sources. Professors William Wetzel and John Freear of
the University of New Hampshire, in a survey of 284 new
companies undertaken in the late 1980s, found taxable
individuals to be the major source of funds for those raising
$500,000 or less at a time. The point to be stressed is that
individuals providing start-up capital for these new companies
pay capital gains taxes and are sensitive to the capital gains
tax rate.
Small businesses and entrepreneurs face higher capital
costs than Fortune 500 companies. For them, a significant
capital gains tax differential can make a big difference in
their decisions affecting jobs and growth.
Raise Tax Receipts
Critics of lower capital gains taxes argue that such cuts
will reduce federal revenues and thus add to the budget
deficit, absorb national saving, and raise interest rates and
capital costs. Both economic analysis and experience
effectively refute this view.
Scholars have researched and debated two elements affecting
capital gains tax revenues, the unlocking of unrealized gains
and the macroeconomic impact of a low tax on capital gains.
Revenue estimates used in congressional and Treasury
Department analyses ignore macroeconomic impacts but do
incorporate an unlocking or behavioral response on the part of
taxpayers to changes in capital gains tax rates. Estimates of
unlocking are extremely sensitive to assumptions about the
elasticity of taxpayer response. Very minor differences in
assumptions can result in large differences in expected
revenues.
In the late 1980s, experts at the prestigious National
Bureau of Economic Research (NBER) examined the question of the
revenue-maximizing capital gains tax rate: At what point is
there sufficient unlocking to compensate for the static revenue
loss resulting from a reduction in the tax? The NBER study by
former Harvard Professor Lawrence Lindsey (a recently retired
member of the Board of Governors of the Federal Reserve), which
was based on academic models of the responsiveness of taxpayers
to changes in the capital gains tax rates, found that the
revenue-maximizing rate ranged between 9 and 21 percent. The
NBER study did not take into account the additional revenue
stemming from the positive macro consequences of increased
employment and growth which result from a significant reduction
in capital gains tax rates.
Although government revenue estimates do not factor in the
macroeconomic consequences of lower capital gains tax rates on
U.S. capital costs, investment, and economic growth, previous
research indicates these effects can have a favorable impact on
overall tax revenues. In addition, the new dynamic analysis by
Dr. Sinai shows that the government could gain revenue from a
capital gains tax reduction (see Table 3).
Actual experience also indicates that lower capital gains
taxes have a positive impact on federal revenues. The most
impressive evidence involves the period from 1978 to 1985.
During those years the top marginal federal tax rate on capital
gains was cut almost in half from 35 percent to 20 percent but
total individual capital gains tax receipts nearly tripled,
from $9.1 billion to $26.5 billion annually.
Promote U.S. Saving and Investment
Our international competitors recognize the contribution a
lower capital gains tax rate can make in promoting capital
formation, entrepreneurship, and new job creation. The United
States, on the other hand, taxes capital gains more harshly
than almost any other industrial nation. A survey by the OECD
of twelve industrialized countries shows that the U.S. capital
gains tax rate on long-term gains on portfolio securities
exceeds that of all countries except Australia and the United
Kingdom, and these two countries index the cost basis of an
asset (see Table 4). Germany, Japan, and South Korea exempt or
tax only lightly capital gains on portfolio stock. Not only do
virtually all industrialized as well as developing countries
tax individual capital gains at lower rates than the United
States, they also accord more favorable treatment to corporate
capital gains (see Figure 2).
It is important to note that most of the countries shown in
Table 1 have had higher rates of investment as a percentage of
GDP than the United States over the past two decades. This fact
may in part reflect the encouragement of saving and investment
due to their lower capital gains tax rates.
Conclusion
A soundly structured, broad-based cut in tax rates on
capital gains would significantly benefit all Americans. By
reducing the cost of capital, it would promote the type of
productive business investment that fosters growth in output
and high-paying jobs. By increasing the mobility of capital, it
would help assure that scarce saving is used in the most
productive manner. By raising capital values, it would help
support values in capital asset markets in general and the
stock market in particular. By increasing the availability and
lowering the cost of risk capital, it would aid entrepreneurs
in their vital efforts to keep the United States ahead in
technological advances and translate these technological
advances into products and services that people need and want.
By reducing taxes on their savings, it would treat fairly those
thrifty Americans who must bear a heavier tax burden than the
profligate. And, because of the combined impacts of unlocking
and macroeconomic feedback, a broad-based capital gains tax cut
could increase federal revenues.
Mr. Chairman, the case for an early broad-based cut in
capital gains tax rates is exceedingly strong. We urge this
Committee and both Houses of Congress to enact such legislation
at the earliest feasible time.
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Ms. Johnson [presiding]. Thank you, Mr. Bloomfield.
Ms. Gravelle.
STATEMENT OF JANE G. GRAVELLE, SENIOR SPECIALIST, ECONOMIC
POLICY, CONGRESSIONAL RESEARCH SERVICE
Ms. Gravelle. Madam Chairman, Members of the Committee, I
would like to thank you for the opportunity to appear before
you today to discuss the President's capital gains tax cut
proposals and the implications of capital gains tax cuts for
savings and investment.
The President's capital gains tax cut is directed at owner-
occupied housing. For most individuals, it would effectively
eliminate capital gains tax on the sale of a principal
residence. Because of the many ways to avoid paying this tax
currently, a relatively small number of homeowners are subject
to the tax. The President's tax proposal would have modest
effects on savings and investment for two reasons: First, the
provision is a small one, costing only $200 to $300 million per
year according to administration estimates. The main benefits
of the proposal are not so much in its effects on savings and
investment but rather that it would relieve most homeowners of
the onerous recordkeeping requirements, prevent people from
making decisions based on tax avoidance motives, and perhaps be
fairer to individuals who have a need to sell.
Even if the scope of the economic effect of the capital
gains tax cut is larger, for example, because more general
capital gains provisions might be considered, there is little
reason to believe that significant effects on savings and
growth will occur. First, we cannot be sure whether cutting
capital gains taxes on capital income will increase savings. It
may surprise you to know that economists have long recognized
that the response of savings to the rate of return is
theoretically uncertain due to the opposing forces of income
and substitution effects. When the rate of return rises, a
substitution effect might cause an individual to prefer more
consumption in the future and save more, but at the same time,
the income effect allows him to actually save less to reach a
particular target.
Therefore, because of this theoretical ambiguity, it is
necessary to turn to the empirical research. Unfortunately, the
body of empirical research does not suggest a large positive
effect on savings from increasing the rate of return, and,
indeed some studies find a negative effect; that is, some
studies indicate that cutting capital gains taxes might even
reduce savings.
The process of altering the capital stock through change in
the savings rate is also a very slow one, so that one would not
expect large effects in the short run even with a large
response. And finally, this type of tax cut would not have a
large effect on output because it is not large in itself. This
is true even for a broader capital gains tax cut, such as a 50-
percent exclusion accompanied by indexing. I estimate that were
that directly translated into reduction of the cost of capital,
the exclusion would reduce the cost of capital by 9 basis
points and with the addition of indexation by about 16 basis
points, very small effects. That is simply because the capital
gains tax is not a very large part of our current tax system.
I would also like to briefly summarize the results of the
simulation model I have developed that traces over time the
response to a tax cut of this magnitude. In doing this
estimate, I used those results from the literature that were
actually conducive to a larger positive, in other words, they
were very generous to a larger positive effect. Even after 5
years, I found the capital stock increased by less than two-
tenths of 1 percent; the output level by only one-twentieth of
1 percent. After 110 years, output increased by only half of 1
percent.
To see why these effects are so small, let me discuss the
first year. We might find the rate of return rising by about 4
percent. Using even a generous savings response, the increase
in the savings rate would only be 1.6 percent, but savings is
only about 2 percent of the capital stock, which means the
capital stock will increase by only three-one hundredths of 1
percent and the output by one-one hundredth of 1 percent. Thus,
even under optimistic assumptions, the effects of a larger
capital gains tax cut are small.
Models that find very large effects of capital gains tax
cuts are using very large elasticities and very fast adjustment
periods that simply are not consistent with the economic
evidence. I would like to also add that arguments that have
been made that a capital gains tax cut will stimulate
investment in the short run by causing a rise in stock market
prices and lowering equity, in my view, are not consistent with
correct economic modeling, because they do not trace the
process by which this asset price occurs.
There have also been arguments that capital gains tax cuts
may be important for venture capital. That may be true, but
venture capital is a very, very small part of total investment
in the economy. In the latest data I saw, it accounts for
seven-tenths of 1 percent of total investment in the economy.
Most capital gains tax cuts will not go to venture capital.
I do not mean by this discussion to imply that capital
gains tax cuts are not desirable. There are arguments for and
against them. But I think the important point for this
Committee to remember is that probably the most direct and
certain route to increasing savings is to increase the public
sector savings by decreasing the deficit or increasing a
surplus, should we ever have one. And in this context, I would
like to add that the current revenue estimating by the Joint
Tax Committee for capital gains is not static estimating; it
includes a very generous dynamic estimate, and, in fact, that
dynamic estimate might be a little too generous. So, I think it
is very important to keep your eye on the revenue costs when
you are considering capital gains taxes, if you are interested
in the effect on long-run growth and savings.
Thank you.
[The prepared statement follows:]
Statement of Jane G. Gravelle, Senior Specialist, Economic Policy,
Congressional Research Service
Mr. Chairman and Members of the Committee, I am Jane G.
Gravelle, a Senior Specialist in Economic Policy at the
Congressional Research Service of the Library of Congress. I
would like to thank you for the opportunity to appear before
you today to discuss the President's capital gains tax cut
proposals and the implications of capital gains tax cuts for
savings and investment.
The President's capital gains tax cut is directed at owner-
occupied housing. For most individuals, it would effectively
eliminate capital gains tax on the sale of a principal
residence by allowing a $500,000 exclusion for a married couple
and a $250,000 exclusion for a single person or head of
household. This exclusion can be used once every two years.
This proposal would replace two existing provisions. One
provision allows deferral of gain that is rolled over into a
new residence--if the new residence costs as much as the old,
all gain is deferred. The second provision allows a one time
$125,000 exclusion for individuals aged 55 and over. And, of
course, like any capital gains tax, the tax can be avoided
completely if the asset is held until death.
Because of the many ways to avoid paying the tax, a
relatively small number of homeowners are subject to the tax.
These taxpayers are likely to fall into two categories: older
individuals whose gains exceed the exclusion or who have
already used the exclusion and younger individuals who are not
eligible for an exclusion. In both cases, these would be
individuals who desire to reduce their investment in housing,
perhaps by buying a smaller residence or perhaps by moving into
a rental unit or other living facility. In many cases, these
individuals may be facing adverse circumstances (loss of
health, or a decline in economic circumstances) that causes
this contraction in housing consumption.
The President's tax proposal will have modest effects on
savings and investments for two reasons. First, the provision
is a small one, costing only $200 to $300 million per year
according to Administration estimates. The main benefits of the
proposal are not so much in its effects on savings and
investment, but rather that it would relieve most homeowners of
onerous record-keeping requirements, prevent people from making
decisions based on tax avoidance motives, and perhaps be fairer
to individuals who have a need to sell.
Note, however, that even though this provision is directed
at housing, it might make more capital available to business
use by reducing the lock-in effect of the housing capital gains
tax. For example, individuals moving from a high cost to a low
cost area may feel less pressure to reinvest in a large house,
and individuals who would like to downsize and invest the
proceeds elsewhere would be freer to do so.
In fact, this provision might have a larger behavioral
effect than implied by its revenue cost, because it
influences--and imposes an implicit burden on--those who do not
pay tax. Indeed, the principal argument for simply allowing an
exclusion for most people is that the current law, while
collecting very little revenue, is costly because of its
influence on behavior, as individuals seek to avoid the tax.
Even if the scope of the economic effect of a capital gains
tax is larger, either because the current treatment has an
implicit cost or because more general capital gains tax
provisions might be considered, there is little reason to
believe that significant effects on savings and growth will
occur.
First, it may be surprising to some to learn that we cannot
be sure whether cutting taxes on capital income will increase
savings. Economists have long recognized that the response of
saving to the rate of return is uncertain due to the opposing
forces of ``income'' and ``substitution'' effects. When the
rate of return rises, a substitution effect might cause an
individual to prefer more consumption in the future (because
the price of future consumption has fallen in terms of foregone
present consumption) and increase savings. At the same time,
there is an income effect--the higher rate of return can allow
savings to be smaller and still increase consumption in the
future (and in the present as well). For example, if an
individual were saving a certain amount for retirement, he
could obtain that objective with a smaller amount of savings
when the rate of return goes up.
Because of this ambiguity, it is necessary to turn to
empirical research to determine whether private savings will
increase, and empirical evidence would be necessary in any case
to determine the magnitude of any effect. While it is very
difficult to perform this analysis, this body of research
suggests that effects of higher rates of return on savings have
small positive effects on savings behavior and, in some
studies, negative effects.\7\ That is, some studies indicate
that cutting capital gains taxes might even reduce savings.
---------------------------------------------------------------------------
\7\ For a summary of this literature, see Jane G. Gravelle, The
Economic Effects of Taxing Capital Income, Cambridge, Mass., MIT Press,
1994, p. 27.
---------------------------------------------------------------------------
The process of altering the capital stock through a change
in the savings rate is a very slow one that takes many years.
Even with a large percentage increase in savings, the effect on
the capital stock and on economic output will be modest because
savings is very small relative to the capital stock.
Finally, it is likely that the effect of the capital gains
tax cuts on economic output and growth will be modest, even
with a large response, because the tax change itself is not
that large relative to the economy. This is true even for a
capital gains tax cut of much broader scope than that of the
President's. For example, by my calculations, a fifty percent
capital gains exclusion has the effect of reducing the cost of
capital by 9 basis points, and the combination of the exclusion
and indexation reduces the cost by about 16 basis points.\8\
---------------------------------------------------------------------------
\8\ This information and the simulation that follows was presented
in greater detail to The Committee on Finance, United States Senate,
February 15, 1995. The calculation of basis points relfected
realizations in 1992; the effects might be somewhat larger because
realizations may have been depressed in that year, but the magnitudes
will be similar.
---------------------------------------------------------------------------
I would like to briefly summarize some results of a
simulation model that traces, over time, the response to a
broader capital gains tax cut of this general magnitude,
equivalent to a two percentage point reduction in the capital
income tax rate, or a reduction in the cost of capital of 18
basis points. While taking my estimated responses from the
economics literature, I used those results favorable to a
larger positive effect of the tax. A savings response at the
upper end of the estimates in the empirical literature is
chosen. This response is in the form of a savings elasticity
(the percentage change in the savings rate divided by the
percentage change in the rate of return), and is set at 0.4.
This estimate was reported by Michael Boskin in one of the
earlier studies of savings response.\9\ Such a measure implies
that a ten percent increase in the rate of return will lead to
a four percent increase in the savings rate.
---------------------------------------------------------------------------
\9\ Michael Boskin, Taxation, Savings and the Rate of Interest,
Journal of Poilitical Economy, vol. 86, January 1978, pp. S3-S27.
---------------------------------------------------------------------------
Several aspects of this simulation were chosen to be
favorable to a large effect, including not only a larger, and
positive, savings elasticity, but also an assumption that any
revenue losses are recouped through some mechanism that does
not otherwise alter the economy's economic behavior. Even after
five years, however, the capital stock increased by less than
\2/10\ of a percent, the labor supply by \1/100\ of a percent,
and the output level by \1/20\ of a percent. Even after 110
years, output increased by only one half of one percent.
Eventually, the process reaches a final equilibrium, which
results in a 2.25 percent increase in the capital stock, a .07
percent increase in the labor supply, and a 0.62 percent
increase in output.\10\
---------------------------------------------------------------------------
\10\ In the long run, our concern is about changes in standard of
living, that is available consumption in the steady state. Since the
savings rate must be higher to maintain the normal growth of the higher
capital stock, the percentage increase in consumption is slightly
smaller, at 0.49 percent.
---------------------------------------------------------------------------
It is relatively straightforward to see why these effects
are so small in the short run. Consider the first period after
the rate of return rises. Suppose it rises by about 4 percent.
That implies an increase in the savings rate of 1.6 percent (4%
times the elasticity of 0.4). But savings is about two percent
of the capital stock, which implies that the capital stock will
increase by only \3/100\ of a percent. Finally, given that
capital contributes only twenty-five percent of output, the
effect on output is less than \1/100\ of a percent.
Thus, even under optimistic assumptions, the effects of
even a much larger capital gains tax cut on savings appears to
be small.
It is important to note that models that have found very
large effects on the capital stock of tax cuts, including the
capital gains tax cut, use the assumption of a very large
savings response and a rapid adjustment period. Such an
assumption is not grounded in statistical evidence from the
economics literature.\11\
---------------------------------------------------------------------------
\11\ Note also that one argument used to justify a large savings
response, international capital inflows, is not germane to this usse,
since the capital gains tax applies to residents regardless of the
location of capital and does not apply to foreign investors.
---------------------------------------------------------------------------
More recently, arguments have been made that capital gains
tax cuts will stimulate investment in the short run by causing
a rise in stock market prices, which would make equity finance
cheaper to firms. A consistent model of the economy would
suggest two important limits on this process. First, total
asset prices (of stocks and bonds) cannot rise unless there is
some increase in overall purchases, which should be preceded by
an increase in savings. Shifts between the two will do nothing
for the cost of capital. Some attempts to model the effect of a
capital gains tax cut begin by simply translating a lower
capital gains tax into a higher stock market price, without
taking account of the effects on interest rates. But asset
prices are not set exogenously--they are a consequence of
supply and demand, and depend on the nature of those supply and
demand factors. If anything, a capital gains tax cut is a
relatively indirect route to subsidizing investment, as, say,
compared to an investment subsidy, since it first requires a
bidding up of stock prices and then an expansion in equity
finance.
Secondly, there is no reason to expect a permanent rise in
stock market prices due to a capital gains tax cut. Even if
asset prices increased, the value would fall until stock prices
again reflected the value of underlying assets. The expectation
that this price effect would be transitory should moderate its
effect in the first place.
Some have argued that capital gains tax cuts would be
effective in increasing the amount of venture capital. Of
course, there are already some provisions in the tax law that
benefit new stock issues in small firms. In general, however,
it is important to note not only that very little direct
evidence for a strong response of venture capital exists, but,
more importantly, only a very small part of capital gains tax
relief would go to venture capital. According to data on
venture capital commitments reported in a study by Poterba,
formal venture capital accounted for only \7/10\ of one percent
of total investment. Moreover, most of the suppliers of venture
capital are not subject to capital gains taxes, particularly
individual capital gains taxes. (Individuals accounted for only
12 percent of funds).\12\
---------------------------------------------------------------------------
\12\ James M. Poterba. Venture Capital and Capital Gains Taxation.
In Tax Policy and the Economy, National Bureau of Economic Research,
Cambridge, MIT Press, 1989.
---------------------------------------------------------------------------
Returning to the general savings analysis, under less
favorable assumptions (e.g., effects on the budget deficit are
not offset and/or the relationship between savings and the rate
is return is negative), the capital gains tax cut could
contract the economy and slow economic growth by reducing
national savings.
This discussion is not meant to imply that capital gains
tax cuts are not desirable. There are some efficiency arguments
in favor of capital gains tax cuts, particularly for corporate
stock. Some people have reservations about cutting capital
gains taxes, however, because of the distributional and revenue
consequences. But as a route to increased savings, the evidence
from economics--both theoretical and empirical--suggests some
reservations about the efficacy of lower capital gains tax
rates in increasing savings.
What alternatives might be more successful in increasing
savings? Some highly stylized economic models suggest that tax
provisions that benefit only new physical investment, as would
occur with a shift to a consumption tax, might have a
pronounced effect on savings. While these types of tax
revisions might be more successful than tax cuts that benefit
old capital, there is little evidence that such dramatic
responses are likely. Periods in history that were
characterized by such changes were not accompanied by the
dramatic savings responses, especially in the short run, that
some of these models predict.
While this analysis suggests that it is difficult to
influence private savings via tax revisions, most economists do
agree that there is one relatively straightforward way in which
the government can increase national savings--increasing public
sector savings. Reductions in the deficit or additions to a
surplus would be likely to translate directly into increased
savings. For that reason, most economists believe that it is
important to ensure that adoption of tax incentives do not add
to the budget deficit, if increases in national savings is an
important goal.
Chairman Archer [presiding]. Thank you, Ms. Gravelle.
Mr. Wyss, we would be pleased to receive your testimony.
STATEMENT OF DAVID WYSS, RESEARCH DIRECTOR, DRI/MCGRAW-HILL,
LEXINGTON, MASSACHUSETTS
Mr. Wyss. Thank you, Mr. Chairman, Members of the
Committee.
Chairman Archer. Did I pronounce your name correctly?
Mr. Wyss. Yes; it is W-y-s-s.
Chairman Archer. Thank you.
Mr. Wyss. I would like to thank you for inviting me to
discuss capital gains taxation and its impact on the economy. I
should start by saying that DRI has normally been pretty
skeptical about ideas that tax cuts will raise enough revenue
to pay for themselves, but I think capital gains is one area
where this is true. The capital gains cut is one tax that does
have enough leverage to increase the economy enough to pay its
own bill, and it is one area where dynamic scoring, I think, is
really required.
Generally, dynamic scoring is the correct way to look at
any change in the tax rates, but historically, it has fallen
into disfavor because of overpromising, because it becomes an
exercise in competitive dynamism, as everyone tries to
outpromise everyone else. And, therefore, we have moved away
from it. I really feel that by a consistent use of mainstream
economics, looking at a variety of economic models, it would be
possible to use it, but I realize that that is not the task of
today's Committee meeting.
The capital gains tax is revenue neutral, not only or even
primarily because of its impact on increasing economic growth.
We actually feel the impact on the economy is relatively small
because the capital gains tax is relatively small compared with
the economy. You are talking about a tax reduction on the order
of $15 billion. Even with a lot of leverage--and we think
capital gains does have a lot of leverage--our analysis
indicates that real GDP is only increased by about 0.4 percent
at the end of 10 years.
That does not sound like a lot, but I would like to remind
people that that is about $60 billion at that time, and if you
think that is small enough not to pick up, I will be happy to
take a finders fee on it. [Laughter.]
Mr. Wyss. It is also very large not just in absolute
magnitude, but it is very large relative to the size of the tax
cut. This means we are getting a multiplier of about four on
the size of the tax cut. That is not enough to make it revenue
neutral by itself, but it is a good start. Ordinary taxes paid
on that are an offset to a good part of the capital gains cut.
The real leverage on revenues, however, comes not just from
the impact on the economy but the impact of the capital gains
tax in increasing asset values and increasing capital
realizations. On the question of asset values, I do not think
there is any mystery: Any investor is going to equalize the
aftertax rate of return on various classes of assets. If you
lower the rate of taxation on equity, for example, the price of
equity has to go up in order to equalize the return between
that and, say, Treasury bonds, which I see no reason to be
affected by capital gains taxes. That means that increase in
asset value eventually comes back to the Treasury. It is clawed
back, to use a Briticism, in terms of higher capital gains
receipts, albeit at the lower rate.
The third source of revenue comes from the increased
turnover that you are likely to get as people are less locked
in to their existing capital. The current capital gains tax
creates inefficiencies in the market because people do not want
to sell an inferior asset for fear of having to pay tax on it.
Obviously, if you have complete capital gains in an asset, and
you are being taxed at 28 percent, any asset you buy has to
yield about 40 percent more than the asset you are selling just
to make up for the tax payment you have to make up front to the
Treasury. If this lock-in effect is diminished, people will
turn over their assets more quickly, and this creates some
additional tax revenue, particularly up front.
That additional revenue is important in the short run,
because it is an offset, particularly in the first 5 years.
There is an enormous amount of unrealized capital gain out
there to turn over. Current estimates are that we have between
$6 and $7 trillion of unrealized capital gains in this economy.
Even a very small increase in turnover would yield a large
amount of tax revenue.
Overall, we believe that a moderate capital gains
reduction, and the primary analysis we did was on S. 66, the
Hatch-Lieberman bill, would result in neutral or, in our
estimate, slightly positive revenue change. In other words, the
bill is revenue positive. It raises more revenue than it loses
on a static basis. If you reduce rates too much, this is no
longer true, because you are clawing back at lower rates.
Clearly, if you reduce tax rates to zero, the volume is not
going to make up for the reduction in rates.
Exactly where the revenue maximizing rate lies, I am not
certain. Our analysis suggests that it is below 28 percent;
probably close to 20 percent. But we would like to do some more
analysis over time to figure out where it should be.
The final analysis, though, is that even if it is only
revenue neutral, the tax law change helps the economy. It helps
productivity. It helps, obviously, the owners of capital,
because they are taxed at a lower rate. It helps the workers
because of the increase in capital stock, the increase in
productivity, and the increase in employment. It raises enough
revenue to pay for itself, so it hurts no one. If you have a
bill which helps most people and hurts nobody, what is the
possible reason for not doing it.
Thank you.
[The prepared statement follows:]
Statement of David Wyss, Research Director, DRI/McGraw-Hill, Lexington,
Massachusetts
Mr. Chairman, members of the Committee:
Thank you for inviting me to discuss capital gains taxation
and its impact on the economy. DRI/McGraw-Hill has long been
skeptical about any claims that tax cuts will raise more
revenue than they cost. The capital gains tax is the one tax,
however, where this may be true. At least for moderate changes
in the capital gains tax rate, our analysis indicates that the
impetus the lower rate gives to asset valuation and to the
economy roughly offsets the lower static tax revenues. Within a
reasonable range of tax rates, the capital gains tax rates
appears roughly revenue neutral.
This is one area where dynamic scoring really seems
required. Dynamic scoring is, generally, the correct way to
look at any form of taxation, but the problem with it
historically has been the ability to distort the dynamic scores
by letting wishful thinking dominate economic analysis. We feel
by consistent use of economic techniques it is possible to do
dynamic scoring. It is questionable whether it is possible to
do it within a political framework.
The capital gains tax is revenue neutral not primarily
because of its impact on the economy, but because of its impact
on asset values. In general, we believe that the impact on the
economy is relatively small. This would be expected. After all,
the capital gains tax cut is only worth about $15 billion on a
static basis, and even with substantial leverage it is hard for
$15 billion to have an enormous effect on a $7 trillion
economy. Our analysis suggests that, even after ten years, the
impact on overall GDP is 0.4%, clearly not an enormous number,
but hardly a trivial one. In fact, over that ten year period,
real GDP would be raised by an aggregate of over $200 billion.
This may be a small share of GDP, but it is certainly a
very large share of the $15 billion annual static cost of the
capital gains tax. Moreover, some additional tax revenue will
come from the higher value of existing assets. When the capital
gains tax rate is cut it increases the value of owning shares
of stock. As the price of those shares rises, owners pay taxed
on that increased amount. Those additional taxes offset the
static revenue loss.
Additional revenue also comes from higher turnover. Capital
gains taxes lock owners into their stock positions. People are
unwilling to sell stock because if they sell the stock, they
will have to pay capital gains at a 28% rate. Sub-optimal stock
positions are thus locked.
The estimates of higher turnover are probably the most
questionable part of any analysis of the impact of capital
gains. In the past, capital gains cuts have usually come as
part of larger tax packages. It is very difficult to
disentangle turnover from the overall impact of the rest of the
tax code. Moreover, capital gains realizations depend heavily
on what has been happening in the stock market which is also
moved sharply by changes in the capital tax. The unlocking
effect seems clear from anecdotal reports and simple logic but
its magnitude is somewhat questionable. We feel our estimates
are conservative--additional turnover of only 5% of unrealized
capital gains over the next ten years.
There will be some negative effect as taxpayers shift
income away from ordinary income and into capital gains. If the
capital gains rate is reduced, people have a greater incentive
to take income in the form of tax-advantaged capital gains
rather than ordinary income. The restriction of passive loss
deductions, however, makes this a more difficult game to play
than in the 1980s. We estimate the impact at about $2 billion a
year. Prior to the 1986 tax law we would have estimated a
substantially higher figure, $5 to $10 billion annually.
Overall, we believe that a moderate capital gains
reduction, on the order of that proposed in the Hatch-Lieberman
bill, will result in a small gain in revenue. Too large a cut
in rates, however, is no longer revenue neutral. Much of the
clawback from revenue comes from applying the capital gains
rate to the higher asset values. If the rate is reduced too
far, the tax on the rise in assets is not sufficient to offset
the static revenue loss. Our analysis of HR14, for example,
indicates that the bill would be a significant revenue loser,
costing well over $100 billion on net over a ten-year period.
The Dreier bill would have a greater impact on the economy and
on the stock market, but because the stock market gains are
taxed at a lower rate, it would not raise enough revenue to
offset its cost.
This is not an argument against indexation. Indeed, our
study suggests that indexation is more effective, dollar-for-
dollar, than rate cuts. Indexation cuts rates only on future
gains, and does not reward the past. We do caution against
trying to cut the rate and introduce indexation, however.
One argument against a capital gains rate cut is that it
accrues only to the rich. Although it is certainly true that
the rich have more capital than the poor, the poor don't lose
in a capital gains cut. Pension portfolios will gain in value,
and the middle class have a rising portfolio of 401K plans. The
great bulk of the assets of the middle class, and particularly
the younger middle class, is tied up in their homes. More
direct relief on capital gains in housing could spread the
benefits more equally. But even if households have no capital
assets themselves, they will benefit from the higher investment
and resulting higher productivity created by the capital gains
rate cut.
The capital gains cut helps most people and hurts no one.
The overall impact on the economy, though small, is clearly
positive. Reducing capital gains will not remake the economy,
but it helps modestly at no cost to the Treasury. We find it
difficult to understand why the bill should not be passed.
The Capital Gains Tax, Its Investment Stimulus, and Revenue Feedbacks
The impact of a capital gains tax cut on the economy and on
tax collections has been investigated for decades. The evidence
suggests to almost all economists that a capital gains cut is
good for the economy and roughly neutral for tax collections.
Although static analysis of the tax suggests the federal
government loses revenue, a dynamic analysis suggests that the
government can gain revenue. Such dynamic gains depend on the
time interval examined and on the feedback effects from a
stronger economy. By encouraging investment, a capital gains
tax reduction becomes a true supply-side tax cut, and perhaps
the only cut that really might fully pay for itself.
Cutting the capital gains tax will boost investment by
lowering the cost of capital to businesses. The only
preferences now offered for individuals are a maximum rate of
28% for gains versus 39.6% for ordinary income, and the
deferral of taxation on accrued gains until the underlying
asset is sold. A new preference that included just 50% of the
gain in ordinary income would thus cut the effective top
marginal rate paid by capital gains recipients to 19.8% from
the current 28%. Together with a reduction in the corporate
rate on gains from 35% to 25%, this shift would, in a static
analysis, lose about $15 billion of federal revenue per year.
(From the perspective of an investor facing both state and
federal capital gains taxes, the current marginal tax rate on
capital gains is 32%, assuming a 6% state and local rate
deductible against the federal income tax. The new effective
rate would be 23.5%.)
The lower tax rate on capital gains unambiguously raises
the value of assets subject to the tax because the same,
related stream of pre-tax earnings is now worth more after-tax
to the investor. This affects the stock market most. DRI
analyzes share prices as the after-tax, discounted present
value of dividends and capital gains (driven by retained
earnings).
If all holdings were subject to the tax, the proposed lower
tax rate on gains would need to raise share prices 8% to
equalize the risk-adjusted rate of return on shares with that
on bonds. This calculation assumes that bond yields would not
be affected by the lower capital gains rate. It assumes that
all of the correction required to avoid an unjustifiable yield
differential is produced by a rise in the price-earnings ratio
of stocks. This assumption of unchanged bond yields is
reasonable when considering a solitary change in capital gains
taxation. That is because bond yields represent the discounted
value of future short-term interest rates, adjusted for risk,
and there is no immediate reason why short-term rates should be
affected by the solitary tax change.
However, we recognize not all asset holdings are subject to
capital gains taxes. Tax-sheltered investments (such as pension
funds and 401K and IRA holdings) and foreign investments now
account for about half of all equity holdings. Assets passed
through an estate without a sale before death escape capital
gains taxes, although heavy estate taxes apply to any accrued
appreciation plus the original principal invested.
As share prices rise in response to a tax rate cut in the
above-noted scenario, the expected pre-tax rate of return of
equity would drop, inducing non-taxable investors to shift into
bonds. If we assume that the degree of risk aversion, and thus
the trade-off between risk and return, is the same for these
investments as for non-tax-exempt holdings, the impact on share
prices will be reduced by their ratio to total holdings. This
implies that in an environment with half the investors exempt
from taxation, equity price-earnings ratios will rise by only
4%, half the 8% gain calculated above. Note that this would be
a permanent increase in the price-earnings ratio corresponding
to any given bond yield. Experience suggests that the move will
not occur until the bill is signed by the President, but then
it will come quickly.
The capital-gains tax cut would lower the net cost of
capital by about 3%. This 3% estimated reduction is a blend of
an 4% reduction in the cost of equity and an unchanged cost of
debt finance. The core cost of equity equals the dividend yield
(reduced 4%, as indicated above) plus expected dividend growth
(assumed to be unchanged at about 6%). Other factors equal,
this shift would raise the level of business spending by about
1.5%, or $18 billion in 2007. Over a 10-year period, the
capital stock would rise 1.2% above its baseline level,
increasing productivity by roughly one-third this percentage,
or 0.4%.
Budget Impact
The effect on capital gains tax collections is complicated
and potentially controversial. However, a decomposition of the
impact into discrete components can replace some of the emotion
in the debate with rationally discussible magnitudes:
1. In a static analysis, the lower rates will reduce tax
revenues proportionately.
2. However, lower rates unlock assets, creating higher
turnover and increasing collections in the short run.
3. The higher value of assets, and thus asset prices,
raises total capital gains, and thus increases revenue.
4. Income reclassification from ordinary income to capital
gains will cut revenue.
5. The stronger resulting economy and higher GDP raises
total tax revenue.
The static loss is easy to calculate since it is simply the
change in the tax rate times the level of capital gains
receipts. There are only two complications: first, there may be
an impact on state tax revenues that are tied to federal income
definitions and, second, capital gains taxes are not broken out
separately in the statistics. Using estimates based on 1991
returns, the lower rate would lose about $11 billion per year.
Based on gains since 1991, we estimate the current impact at
$15 billion.
The unlocking/higher-turnover effect will increase revenues
in the early years of the program. When the capital gains tax
rate is reduced, assets become more liquid in the sense that
the tax loss involved in selling them is a lower percentage of
the asset's value. This switch makes individuals ready to sell
more often, and by increasing the turnover raises revenue in
the early years of the program. Estimates based on past CBO
papers suggest that this unlocking could add $10 billion to
revenue in the first year. The additional revenue would
diminish rapidly, however, since the change only moves forward
the realization of capital gains. Under some models, the impact
turns negative in the third and fourth year. In the long run,
there is still some positive effect in our analysis because a
higher turnover implies that fewer capital gains expire on the
death of the owner.
The higher asset value will be the primary positive
contributor to tax revenues. A 4.0% share price increase will
raise total stock market valuation by $280 billion. If 15% is
sold within the first year (about the current turnover rate in
the stock market) and taxed at 19.8%, this effect would raise
capital gains revenue by $8 billion. Taxable gains on other
assets (primarily privately held businesses) might rise by
about one-half this amount.
The increased gap between the ordinary income and capital
gains rates will induce individuals to reclassify income in
order to lower their tax liability. This income
reclassification was, in fact, one of the primary reasons cited
for going to an equal treatment in the 1986 tax bill. There is
evidence to suggest that the change was successful in widening
the income-tax base. Reversing this 1986 reform would clearly
increase the incentive to convert ordinary income into capital
gains, for example, by deferring income in closely held
enterprises or shifting from wage income to stock options. The
size of the impact is uncertain, but it could easily cost $5
billion per year in reduced tax revenue. At least, this was the
magnitude cited in 1986 when the change was made in the
opposite direction. We have assumed only half this effect,
since we believe the changes in passive loss rules make income-
shifting less easy.
The stronger growth of the economy produced by a solitary
change in capital gains taxation will add to both capital gains
and ordinary income tax collections. Our model suggests that
after 10 years real GDP could be 0.4% higher than in the
baseline, because of the capital gains tax rate change and its
repercussions on investment. In 1992 dollars, this extra growth
would add $34 billion to national income. In 2007 dollars, the
impact would be $116 billion, adding $30 billion to federal
revenue.
The usual static analysis does not consider either the
increase in asset values or the impact of a stronger real
economy. Only the rate reduction and the higher turnover and
income reclassification are usually included in the analyses
done by the Congressional Budget Office or other government
agencies. The difference between the estimates illustrates the
importance of using dynamic estimates of the impact of tax
changes. Much of the literature from the extreme right, which
indicates that the capital gains tax is a huge money-maker,
illustrates the dangers as well.
This analysis so far has examined only the macroeconomic
implications. The distribution of the benefits is also an
important political and economic issue. A narrow view of the
capital gains tax cut is that it will favor the wealthy, who
have more capital than the poor. Although the rich get most of
the gains, no one loses. Often overlooked benefits flow to all
workers and middle income citizens, and the overall economy
wins. The middle class will benefit from greater appreciation
in their pensions, now increasingly structured as defined
contribution plans in which all investment returns are captured
by the employee. Small businessmen will gain from more generous
tax treatment of the gains on their enterprise. And all
employees will see wage gains tied to investment-driven higher
productivity.
Table 1. Estimated Impact of a 50% Capital Gains Exclusion
(Federal revenues, billions of 1997 dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
Static Impact.................. ($14) ($15) ($15) ($16) ($16) ($17) ($18) ($18) $(19) ($20) ($168)
Higher Turnover................ $15 $8 $5 $3 $2 $3 $3 $3 $3 $3 $48
Asset Prices................... $13 $12 $10 $9 $8 $8 $8 $8 $8 $8 $92
Income Reclassification........ ($2) ($4) ($2) ($2) ($2) ($2) ($2) ($2) ($2) ($2) ($22)
Higher GDP..................... $0 $1 $2 $3 $5 $7 $9 $10 $12 $14 $63
Total........................ $12 $2 ($0) ($3) ($3) ($1) $0 $0 $2 $3 $13
--------------------------------------------------------------------------------------------------------------------------------------------------------
Table 2. Estimated Impact of Indexing Capital Gains with 14% Top Rate
(Federal revenues, billions of 1997 dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
Static Rate Impact............. ($23) ($24) ($25) ($26) ($27) ($28) ($29) ($30) ($31) ($33) ($276)
Indexing....................... $0 $0 $0 ($2) ($3) ($4) ($5) ($6) ($7) ($8) ($35)
Higher Turnover................ $16 $8 $5 $3 $2 $3 $3 $2 $2 $2 $47
Asset Prices................... $14 $13 $11 $9 $7 $7 $7 $7 $7 $7 $87
Income Reclassification........ ($2) ($3) ($3) ($3) ($3) ($3) ($3) ($3) ($3) ($3) ($29)
Higher GDP..................... $0 $2 $3 $5 $8 $11 $14 $15 $18 $21 $95
Total........................ $4 ($4) ($9) ($15) ($16) ($15) ($14) ($15) ($14) ($14) ($112)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Table 3. Cumulative Impact of Tax Reductions in S. 66
[Total 1998-2007]
------------------------------------------------------------------------
------------------------------------------------------------------------
Real GDP (billions of 1992 $).............................. $185
Real capital spending (billions of 1992 $):
Business equipment....................................... $83
Total fixed investment................................... $103
Capital stock (% difference)............................... 1.1
Output per hour (% difference)............................. 0.4
Cost of capital (% difference) (pretax return required by
an investor).............................................. -3%
Total federal tax receipts (billions of current $)......... +$13
------------------------------------------------------------------------
Indexing Capital Gains
The proposal to index capital gains has a similar impact to
the exclusion from tax. It also cuts the cost of capital to the
firm, and raises the value of assets, including especially
common stocks. The impact will depend on the amount of
inflation expected by the market, and on the details of the
law.
Over the past, inflation has accounted for about half of
capital gains. That average, however, includes the high-
inflation 1974-1985 period. We believe the market is currently
discounting a 3% inflation rate, which would only account for
about one-third of anticipated capital gains.
Our analysis assumes the indexation comes on top of a
reduction in the capital gains rate to 14%, as in HR 14. Thus,
the impact, or the cost of capital, is less than half as great
as if it were done on its own. It also, of course, loses only
half the revenue it would otherwise. Unfortunately, because the
higher stock values are clawed back at a much lower tax rate,
the dynamic scoring of the bill does not offset its static
loss.. A net loss of about one-third the static loss results.
This is not an indictment of indexation. In fact, our model
indicates that indexation gives a greater impact on investment
per dollar of tax revenue lost. The analysis does, however,
suggest that although capital gains rates are revenue-neutral
for moderate changes, if they are reduced too far they will
lose revenue.
The additional static tax loss is very small in the near
term, since the bill does not index for past (pre-1997)
inflation. The impact builds over time, however, as more of the
gains can be indexed. By 2007, the static loss from indexing is
estimated at $8 billion.
Asset prices will rise proportional to the effective
reduction in the capital gains rate in future years. This means
that although indexation has little immediate impact on the
effective capital gains tax rate, it does have full impact on
asset prices and capital costs. The increase in turnover is
difficult to estimate in this bill. In general, indexation
would have only a small near-term impact on turnover, since
pre-1997 inflation is not forgiven.
Income reclassification is less likely with indexation than
with exclusion. There is no advantage to reclassifying income
as capital gains unless the underlying asset is held long
enough and its base price is high enough to make the inflation
adjustment attractive.
The impact on the economy is proportional to the impact on
asset values. The economic impact results from the lower cost
of capital to business, which increases investment. The
marginal impact of adding indexation to the 50% exclusion is
about one-third the impact of the exclusion. (Note that these
magnitudes would have changed if done in the opposite order.)
Summary
Our analysis shows that the Hatch Lieberman bill is
essentially revenue-neutral. The static losses are largely
offset by the increase in the value of assets and the stronger
domestic economy over the ten-year period. Our analysis shows a
marginally positive result, but well within the margin of
error.
In essence, the bill does nobody any harm and does business
and does a capital owner some good. The proposal lowers capital
costs and thus raises business investment improving
productivity and income growth in the long run. The higher
incomes raise tax revenues offsetting about one-third of the
static revenue loss. Most of the rest of the revenue loss is
offset by the higher turnover of capital assets and by the
increase in the value of the assets caused by the lower tax
rate.
Combining a sharper reduction in the rate with indexation,
as in HR 14, is not revenue neutral. There is a proportionate
impact on the economy, and the stronger domestic economy
offsets nearly one-third of the rise of the static revenue
loss, as in our analysis of Hatch-Lieberman. Asset values also
rise, but these are clawed back at a lower tax rate and,
therefore, do not offset as much of the revenue. Similarly, the
higher turnover is taxed at only 14% instead of 19.8%, yielding
a smaller impact on revenues. We, thus, find that the bill
loses $112 billion over a ten-year period, with only about two-
thirds of the static loss made up by income gains elsewhere.
Chairman Archer. Thank you, Mr. Wyss.
Our next witness is Richard Woodbury. If you will identify
yourself for the record, we would be pleased to receive your
testimony.
STATEMENT OF RICHARD WOODBURY, PRESIDENT, WOODBURY CORP.,
SALT LAKE CITY, UTAH; ON BEHALF OF NATIONAL ASSOCIATION
OF REALTORS
Mr. Woodbury. Thank you, Mr. Chairman. My name is Rick
Woodbury, president of Woodbury Corp., a real estate brokerage,
management, and development firm located in Salt Lake City,
Utah. I appear today on behalf of the National Association of
Realtors, but part of my comments are also presented on behalf
of several other national real estate organizations which are
listed at the end of my statement.
First, I will comment on President Clinton's proposal
related to owner-occupied residential real estate, then, on
some issues of concern to commercial and investment real estate
owners and investors. It is important to note that issues
pertaining to capital gains on the sale of a principal
residence are very different from capital gains issues
pertaining to commercial and investment real estate. The
proposal that taxpayers filing a joint return be permitted to
exclude up to $500,000 of gain on each sale of a principal
residence is a dramatic simplification of the current law and
should be viewed and supported on its merits as a
simplification.
Under current law, rollover rules permit a homeowner to
exclude the gain on sale of a personal residence from taxation
so long as the proceeds of the sale are reinvested in homes of
equal or greater value within 2 years. Also, there is a one-
time exclusion of $125,000 if the taxpayer is over 55 years of
age. Although these rules have served families well, they are
the source of very burdensome recordkeeping requirements over a
long period which are often ignored or, at best, very poorly
understood by the taxpayers. The new rule would largely
eliminate this problem, because only 2 percent of the existing
home sales occur at prices above $500,000. In order to have a
gain of $500,000, you would have to have a sale of
substantially higher than that. The new rule would eliminate
tax considerations and potential IRS conflicts and thus major
recordkeeping burdens in almost all home transactions.
In addition, rollover rules have been criticized as forcing
people to buy even more expensive housing, even if they do not
need it or even if they do not really want to incur the debt
load necessary to carry it. It also creates dilemmas for
homeowners who relocate from high cost areas to lower cost
housing areas.
Under the new proposal, housing decisions would be based on
family needs, not on the Tax Code. This is a good policy. A
family could still trade up, but it could also move down to
smaller or less expensive homes when no longer needed. We also
view home equity as a principal source of saving and a safety
net for most Americans. The new proposal would allow most
people to realize all of the benefit of that saving. This may
be important for families in reduced circumstances who are
forced to sell a home due to lost employment or medical
emergencies. Such families would not need to incur a tax cost
if they sold their homes at a time of greatest need and decided
to rent for awhile rather than reinvest.
Even though the National Association of Realtors supports
the proposed residential exclusion, we do not believe it can
substitute in any way for an across-the-board capital gains tax
cut. The commercial investment industry and a host of
individual investors and owners as well firmly and
unequivocally support an across-the-board capital gains tax cut
with at least two criteria: Number one, that the rate cut be
substantial enough to be a meaningful incentive and number two,
that it apply equally among all types of capital assets. The
equal application of capital gains treatment is especially
critical to owners of real estate. For some time it has been
rumored, and we even had a discussion on this in the previous
testimony, that a final capital gains bill would include
adverse changes to rules for depreciation recapture. Now, my
staff just pointed out to me that we do not understand that
H.R. 14 does not have depreciation recapture changes, even
though the previous panel said so, and we think they may have
misunderstood the question, Mr. Chairman, but maybe we misread
the bill.
But in any case, there have been discussions that the
reduction of taxable basis due to straight line depreciation
will not receive the full benefit of capital gains tax
reduction. The real estate industry vigorously opposes any
proposal that would adversely change depreciation recapture
rules. Real estate is intrinsically a wasting asset which, due
to natural deterioration, wear and tear from use and
obsolescence, does not, unlike wine or cheese or art, gain
value through use or through time lapses. Straight-line
depreciation is a time-honored, fair, and reasonable allowance
for this reasonable effect. Increases in the price of real
estate result from inflation or extrinsic economic factors
which are treated as capital gains as relates to all other
capital assets.
Again, real estate supports a broad-based capital gains tax
reduction but opposes any change to current law on depreciation
recapture which we believe would put real estate on an unlevel
playingfield in relation to other types of capital assets. One
of the benefits of a capital gains rate cut is that it would
produce an unlocking of assets as taxpayers rearrange their
portfolios to release gain and to redeploy their capital to
maximize return. Data released on March 12, 1997, by the Joint
Committee on Taxation illustrates vividly just how locked in
the real estate industry has become. These data measure
reported capital gains transactions for all asset types. The
data show that between 1989 and 1994, both the number of real
estate sales transactions and the dollar volume as a percentage
of total capital gains transactions declined tenfold.
Obviously, then, real estate markets seem frozen, and
investor assets are locked in. Additionally, a chart presented
at the end of this statement illustrates what the value of $1
invested in real estate and in stock in 1986 would be worth
today. The chart also plots inflation during that period. Real
estate prices have not even kept up with inflation, while the
value of stocks has soared 400 percent. Real estate markets are
healthier today than they were 5 years ago, but price
appreciation has not been a hallmark of real estate investments
since the 1986 Tax Reform Act.
These data help substantiate another fact about the real
estate market: Price Waterhouse has studied commercial real
estate sales since 1985 and reports that during the period from
1985 to 1996, 60 percent of those sales occurred at prices that
were below the original purchase price. If the proposed
depreciation recapture proposal were to be enacted, any
property sold below purchase price would not experience any
benefits of the capital gains cut. What does that mean? It
means that if real estate receives fewer benefits from a
capital gains cut relative to assets, there would be little or
no unlocking of real estate investment and no new jobs created.
No one can predict just how much unlocking would occur after
the capital gains cut; however, from my experience, buildings
are often upgraded after a sale. For every $1 million spent in
upgrades, 27 jobs annually are created. Using Department of
Commerce data, we can speculate that the sale and upgrade of
even 2,000 buildings nationally might create as many as 300,000
annual jobs.
In closing, we urge you to recognize the unique features of
residential and commercial real estate. We urge you to adopt
President Clinton's simplification proposal for the treatment
of the sale of a principal residence, but we also urge a broad-
based capital gains cut as critical for growth and jobs
creation. It must apply equally to all assets. There is no
reason to penalize real estate investors, owners and developers
by changing recapture rules and robbing the real estate
industry of an equal opportunity to continue to improve itself.
Thank you very much.
[The prepared statement and attachments follow:]
Statement of Richard Woodbury, President, Woodbury Corp., Salt Lake
City, Utah; on Behalf of National Association of Realtors
The National Association of Realtors (NAR) appreciates the
opportunity to testify concerning President Clinton's Fiscal
Year 1998 Budget. This statement is presented on behalf of
NAR's approximately 720,000 members. NAR represents virtually
every facet of the real estate industry, including residential
and commercial Realtor brokers and salespersons, developers,
counselors, appraisers and property managers.
Real estate contributes about 16% of the goods and services
that comprise our national economy. The industry has repeatedly
demonstrated its capacity to lead the nation out of recession
into economic recovery and growth. NAR supported the 1995
Contract With America provisions that would have reduced the
tax rate on capital gains, recognized capital losses on the
sale of a principal residence, indexed the cost basis of
capital assets for inflation, permitted first-time home buyers
to make penalty-free withdrawals from their Individual
Retirement Accounts (IRAs), and increased the amount of the
unified gift and estate tax credit. Unfortunately, President
Clinton vetoed these important measures. We believe that his
veto was detrimental to our members, and, moreover, that it had
the effect of keeping many Americans locked into investments,
and barred them from rearranging their portfolios to make the
most productive use of their savings and their real estate
holdings.
Capital Gains and Real Estate
NAR enthusiastically and actively supports all efforts to
restore a meaningful capital gains differential. An exclusion
and indexing are both important elements of a differential, and
we fully support both approaches. NAR supports S. 66, a bill
introduced in the Senate by Senators Hatch (R-UT) and Lieberman
(D-CT).
NAR would not object to an approach such as that included
in S. 306, offered by Senator Wendell Ford (D-KY), and its
companion bill, introduced in the House by Mr. Bentsen (D-TX).
This approach would create a sliding scale capital gains tax
rate. The rate for an asset held for one year would be 28%. The
rate would be reduced by 2 percentage points for each
succeeding year, down to a minimum rate of 14% for an asset
held 8 years or more.
One of the things that we know about American is that they
buy real estate. Generally, they buy as much real estate as
they can afford. They buy homes, condos, cottages at the lake,
hunting lodges, speculative parcels, a safe new home for mother
and farms and ranches.
The incidence of the ownership of real estate is more
widespread than one might expect. Federal Reserve data in the
Survey of Consumer Finances show a remarkably high incidence of
ownership of real estate by all individuals, and especially in
income classes below $50,000. The 1992 Survey shows that 63.8%
of all families own a principal residence, and that 20% of all
families own investment real estate. Among families with
$25,000-$50,000 of income, 69% own a home, and a surprising 20%
also own investment real estate. Among families in the $50,000-
$100,000 income category, 85% own their home, and 30% own
investment real estate.
The reasons for ownership are varied, and some of those
reasons, we fully admit, are likely to be influenced by the tax
effects of ownership. The important fact to note is that
nonowner occupied real estate is more widely held than CDS,
mutual funds, or stocks and bonds. Since real estate is so
widely held, the markets for it are large and diverse. (Source:
1992 Survey of Consumer Finances, Federal Reserve Bulletin,
Oct., 1994.) We strongly believe that the power of those
markets can be augmented through the unlocking power of reduced
capital gains taxes.
$500,000 Exclusion on Sale of a Principal Residence
President Clinton has proposed that taxpayers filing a
joint return be permitted to exclude up to $500,000 of gain
($250,000 on a single return) on the sale of a principal
residence. Owners qualify if the home has been used as a
principal residence for two of the five previous years. Gain in
excess of these amounts will be taxable at capital gains rates.
Thus, a homeowner who filed a joint return and realized a gain
of $600,000 would receive $500,000 tax-free, and $100,000 of
gain would be taxable at capital gains rates.
Under current law, the so-called ``rollover'' or deferred
gain rules of Internal Revenue Code Section 1034 govern
transactions involving the sale or exchange of a principal
residence. Under the rollover rules, a taxpayer may exclude all
gain on the sale of a personal residence from taxation, so long
as the proceeds of the sale are reinvested in a home of the
same or greater value. Each time a homeowner sells and
reinvests, he/she is required to calculate the deferred gain,
and make an adjustment to the purchase price of the new home to
reflect the deferred gain in the tax basis of the home. In
addition, the tax basis must be adjusted by the cost of any
improvements that are made to the home. The taxpayer is
required, for this purpose, to differentiate between repairs
and improvements. Over the course of a lifetime, all this
record keeping becomes subject to error, omission, and
misunderstanding. In addition, the documentation becomes
burdensome to maintain over the course of a lifetime. Not
surprisingly, the IRS has indicated that taxpayer compliance
with these requirements is low.
The rollover rules of current law have also been criticized
for their impact on housing decisions. Critics have alleged
that current law forces people to over-consume housing. Stated
another way, the rules have the effect of forcing people to buy
ever more expensive housing, even though they might not need
it, and even though they may not want to incur the debt load
needed to carry it. In addition, homeowners who relocate from
high housing cost areas are perceived as driving up the cost of
housing when they relocate to lower cost areas.
As homeowners grow older, they currently have the option to
make a once-in-a-lifetime exclusion of up to $125,000 of gain
on the sale of their residence at age 55 or older. While this
provision enjoys a broad base of support, it has been
criticized because it applies only once, and because spouses
who take the exclusion and are subsequently widowed are not
permitted to use the exclusion again, even if the individual
remarries someone who has never used the exclusion.
Now, President Clinton has proposed replacing the rollover
and $125,000 exclusion rules with a single $500,000/$250,000
exclusion that may be used as often as once every two years by
homeowners of any age. NAR supports this proposal. First, it is
an exceptional simplification of current law. In fact, we
believe that it merits support for this reason alone. Next,
this is the ultimate ``Get the IRS out of your life'' proposal.
Only a very small number of transactions annually will be
taxable, so nearly all taxpayers will be relieved of the
burdensome record keeping requirements of current law. In
addition, this proposal preserves the savings value of the
home. For most individuals, their home is the primary source of
savings. Finally, the proposal has the great advantage of
allowing individuals to make their housing decisions based on
their circumstances, and not on the basis of the tax code. For
the first time, the proposal would allow individuals to trade
up, stay in roughly the same circumstances, or trade to a
smaller and/or less expensive home. This is of critical
importance to boomers and to empty-nesters who wish to change
the configuration of their savings and housing arrangements.
Today, less than two percent of all existing home sales
occur at price levels above $500,000. Thus, in order for the
gain to exceed $500,000, the sales price will generally be
substantially higher than the $500,000 amount. The practical
effect of this provision is to provide substantial record
keeping and simplification relief to all but a very small
number of taxpayers. Table I (attached) illustrates the volume
of sales in different price categories nationally and
regionally.
NAR commends the Administration for developing this
remarkable simplification proposal. We view it principally as a
simplification provision that happens to fall within the
capital gains regime. We view it as a proposal that is
desirable and supportable on its own merits as a
simplification. We do not view it as a substitute for a broad-
based capital gains reduction, and we believe it should be
evaluated as separate from that debate.
Loss on Sale of a Principal Residence
The early 1980's saw the beginning of a phenomenon that
came to be known as ``rolling recessions,'' in which different
regions of the country experienced recessions, even though the
national economy was performing reasonably well. This
phenomenon was accompanied by a circumstance that had not
occurred widely during the entire post-World War II period. For
the first time, homeowners in these regions experienced losses
on the sales of their personal residences. Over the last 15
years, this situation has occurred in regions as diverse as the
oil belt, the Rocky Mountain states, New England and, most
recently, California (and southern California in particular).
Since the purchase of a home has generally been considered
a personal expenditure, losses on the sale of a personal
residence have not been recognized for tax purposes. Chairman
Archer has sought for many years to ameliorate this
circumstance as a matter of fairness. After all, a home is
generally the greatest source of individual savings. Taxpayers
who are in the difficult position of incurring a loss on that
sale are often in an economically vulnerable posture. In 1995,
the Chairman proposed and Congress passed provisions that
allowed these taxpayers to receive capital loss treatment if
their home sold at a loss. Earlier versions of a relief
provision allowed a basis adjustment at the time of purchase of
a replacement residence. NAR supports either method of
providing relief in these circumstances.
NAR wishes to bring the Committee's attention a situation
that is becoming increasingly common in areas where the market
value of housing is declining. In many circumstances in some
regional markets, homeowners are found to be ``under water'' or
``upside down'' on their mortgages: they owe more on the
mortgage than they can realize on the sale of a principal
residence. First-time homeowners who have purchased under low
down payment programs are especially vulnerable. If an
individual purchases a home with a 3%-5% down payment, and the
market value declines by 10%, then the individual is
technically ``under water.'' If those individuals were forced
to sell, they could easily come out of the transaction owing
more than they would realize. An example can illustrate this
problem.
Family A purchases a home under a low down payment program
that requires only a 3% down payment The purchase is for
$100,000, with $3,000 down and mortgage indebtedness of
$97,000. (This configuration is often typical of VA and FHA
mortgages.) After a few years of ownership, A must sell the
home. At the time of the sale, the outstanding mortgage is
$92,000. A is able to realize only $89,500 on the sale. A must
pay closing costs and commissions, even though there is not
enough cash to satisfy the mortgage or to make these payments.
A successfully works out an arrangement with the lender in
which A will pay $88,000 on the note, and be forgiven $4,000 of
the debt. Thus, A has a loss on the sale of $10,500, and at the
same time has incurred a tax liability on the $4,000 of
forgiven debt.
This situation occurs in about 3% of the sales currently
being closed in California. It can even occur, in some
locations, in situations where the homeowner has made down
payments of 10% or more. It defies logic that the homeowner
would incur a loss, and at the same time generate a tax
liability. Thus, NAR believes that the loss on sale provisions
should also address this circumstance. Since the loss on sale
provisions are based on fairness and equity, it seems that this
discharge of indebtedness problem should be dealt with in the
same context.
Broad-based Capital Gains Cuts
The capital gains issues that affect residential real
estate are substantially different from those that affect
commercial and investment real estate. Even after the $500,000
exclusion, loss on sale and discharge of indebtedness
provisions are favorably resolved, the more fundamental issue
of capital gains taxes for all capital assets, not just real
estate, will linger.
Before its repeal in 1986, the capital gains exclusion
operated as a sort of rough justice to give taxpayers some
incentive to hold property for the long haul, while giving an
imprecise recognition to the effects of inflation on an
investment. Real estate tends to be a very illiquid investment,
so it was particularly important to the holders of real estate
that some means of mitigating the impact of inflation would be
available. The repeal of the capital gains exclusion in 1986
destroyed even that imprecise mechanism. Lower tax rates simply
did not overcome the impact of removing the exclusion.
The dirty little secret of current law is that middle
income Americans who have the good fortune to realize a capital
gain are not treated as favorably as higher income individuals.
The effect of the higher tax rates enacted in 1993 was that one
class of upper-income taxpayers enjoys a tax benefit equivalent
to a 30% exclusion. Individuals in the 15% and 28% tax brackets
pay that rate on the full amount of any capital gain they might
realize. By contrast, individuals in the 31%, 36% and 39.6%
brackets pay no more than 28% tax rates on the full amount of
any of their capital gains. For individuals in the 39.6%
bracket, this rate differential is the equivalent of a 30%
exclusion.
A significant volume of capital gains transactions occurs
for individuals in the 15% and 28% brackets, which reach to
about $85,000 on a joint return. This income group has the
largest number of capital gains transactions by volume, even
though the dollar amount is relatively small. Many of those
taxpayers will have only a limited number of capital gains
transactions in a lifetime, yet their limited number of assets
is presently taxed less advantageously than the larger,
diversified portfolio of an upper income individual. A broad-
based capital gains cut, accomplished by an exclusion or a
sliding scale rate cut, and combined with indexing, would
redress the fundamental unfairness of having two classes of
taxpayers--those with a capital gains differential, and those
without a differential.
NAR fully subscribes to the view of capital gains advocates
that a cut in capital gains tax rates would unlock significant
amounts of investment that would be plowed back into ever-more
productive uses. We cannot quantify what the volume of new
transactions would be. Measuring pent-up demand is all but
impossible, because there is no baseline that can be fixed for
transactions that don't occur. Every Realtor we meet, however,
has stories to tell about properties that would have sold,
except that the tax beating of current law would be too great.
Realtors have hardship stories, as well, about people in
reduced circumstances forced to sell their assets, only to face
large tax bills.
Indexing--NAR supports proposals that permit indexing on
the sale of assets. While many of our members would hope to
have a look-back provision, we acknowledge that such a
provision would be costly to enact, and difficult to
administer. We take no position on the choice of index used,
but simply urge that the compliance provisions associated with
administering an indexing scheme be as simple as possible. We
look forward to working with the IRS to develop record keeping
and compliance programs that will be easily understood by
taxpayers. Taxpayers will need some education about the record
keeping challenges posed by an indexing scheme, and we are
committed to doing our part in assisting in that effort.
Depreciation Recapture
For more than a year, rumors have circulated that a capital
gains cut would create new rules for depreciation recapture.
This rumor was confirmed in a Wall Street Journal story on
February 14, 1997, noting that Joint Tax Committee Chief of
Staff Ken Kies was urging that previously-allowed depreciation
deductions be recaptured and taxed at 28%, with any remaining
gain taxed at the new, reduced rate. His rationale is that
current law, which permits capital gains treatment of
depreciation recapture, creates unfair advantages for real
estate and could lead to tax sheltering. We reject this view,
and further urge that current law as provided in Code Section
1250 be retained.
After the Tax Reform Act of 1986, commercial real estate
values plummeted. Since 1990, that market has been
recapitalized. Between 1990 and the present, however, there has
been very little, if any, appreciation for commercial real
estate. According to analysis performed by Price Waterhouse,
about 60 percent of all commercial real estate transactions
between 1985 and 1995 have occurred at a price that is less
than the original purchase price. If the depreciation recapture
rate were to remain at 28% or more, the owners of those
properties would receive no benefit whatever from the capital
gains cut. Thus, they would be at a disadvantage relative to
other assets that receive the full benefit of rate reduction
and they would not, at present, be inclined to sell or improve
those properties.
Even today, real estate assets are locked in, as owners are
reluctant to sell and pay the high taxes associated with a real
estate transaction. Data released on March 12, 1997 by the
Joint Committee on Taxation illustrate vividly just how locked
in the real estate industry has become. These data measure
reported capital gains transactions. Between 1989 and 1994,
both the number of real estate sales transactions and the
dollar volume of those transactions declined tenfold. If the
full benefits of a capital gains rate cut are not extended to
the real estate industry and investors because of changes to
recapture, no unlocking of assets and capital would occur, and
no new jobs would be created.
We also note that owners who invested for long holding
periods would be seriously disadvantaged, because they would
bear disproportionate recapture burdens. Holding the recapture
rate at 28 percent has the effect of raising the tax rate on
the entire investment, no matter how long it is held. Where the
asset has been held for long periods of time, the recapture
amount could be quite large as a proportion of the total amount
of gain in excess of adjusted basis. The greater the proportion
of recapture to gain, the more the tax rate would be distorted
(and increased relative to other assets) under the rumored
proposal.
A fundamental principle in the past 20 years of capital
gains debates has been that all capital assets should be
treated in the same manner, and that no industry or class of
assets should be singled out for discriminatory treatment. We
believe that the proposed recapture regime does not satisfy
this standard. We believe that it discriminates against real
estate. Given the performance of real estate markets in recent
years, we believe it would be singularly unfair to impose real
estate-specific taxes on an industry that is still somewhat
fragile.
Table 2 illustrates that very fragile condition and
compares it with the price volatility in the stock market, as
measured by the Dow Jones and Standard Poor's indices. The
chart shows the value of a dollar invested in real estate in
1985, and compares it with the value of a dollar invested in
securities. The chart refers to price effects only, and not to
rate of return. What it does illustrate, however, is the
extraordinary surge in the market value of securities over that
period, compared with a very flat real estate market. Notably,
this chart is not adjusted for inflation. Thus, it shows that a
dollar invested in real estate in 1985 is worth less than a
dollar if the property sold today, while a dollar invested in
the stock market in 1985 would yield about $4 today. If the
chart were adjusted for inflation, the real estate price in
1996 would be even less than shown on the graph.
Because of the continuing interest in simplification and
tax reform, we feel obligated to note that the proposed
recapture regime would be very complex. Even as presently
drafted, recapture is, at best, very complex. The proposed
regime would graft yet another layer of complication onto this
already-burdensome set of rules. We believe that it is
inappropriate to advocate complex solutions at this time,
particularly when those complexities do not improve the
fairness of the code or enhance the performance of an
individual's business or the national economy.
We therefore believe that the proposed recapture regime
would achieve none of the unlocking of gain that is envisioned
by capital gains advocates. In many markets, there has been
little appreciation in real estate for several years.
Accordingly, individuals who sold properties under the proposed
regime would find that much, if not all, of their gain was
attributable to depreciation recapture, and not to
appreciation. Thus, a taxpayer who experienced minimal
appreciation would not be any better off than under current
law, while the owners of appreciated non-real estate capital
assets would receive far more benefit from a capital gains tax
rate reduction. Only a scheme that retains existing Section
1250 recapture taxes would keep all asset owners on a level
playing field.
Individual Retirement Accounts
President Clinton, Mr. Thomas and Chairman Roth all have
all offered proposals to expand the classes of taxpayers
eligible to make tax-deductible contributions to an Individual
Retirement Account (IRA) and/or to a new tax-deferred ``back-
loaded'' savings vehicle. NAR supports these proposals, because
they expand the savings pool. Expanded national savings should
have beneficial effects in keeping interest rates low. No
sector of the economy is more sensitive to interest rates than
housing, and so we support these endeavors.
In the context of improved and expanded IRA provisions, we
urge that the Committee include a provision that has passed the
House at least 3 times this decade, twice in 1992 and again in
1995. This provision permits a penalty-free withdrawal from an
IRA or 401(k) plan for use as a down payment by a first-time
home buyer. Significantly, it also permits a parent or
grandparent to make penalty-free withdrawals to assist a child
or grandchild in making a down payment for a first-time home
purchase. NAR actively advocated this approach in earlier
years, and strongly believes that the ``parent and grandparent
pass-through'' is crucial to making any new IRA plan a genuine
vehicle for advancing first-time home purchases. NAR's research
shows that young people are increasingly relying on family
members to fund some portion of their home purchase down
payments. Accordingly, this parent/grandparent feature of the
proposal is a critical feature of the efforts to permit IRA
withdrawals to further home ownership.
Table 1. Total Existing Single Family Home Sales by Price Class--1996
----------------------------------------------------------------------------------------------------------------
Percent of
Region Price Class No. of Sales Sales
----------------------------------------------------------------------------------------------------------------
United States.................................. $0 to $250,000.................... 3,627,142 88.77
$250,000 to $500,000.............. 377,955 9.25
Above $500,000.................... $80,903 1.98
Total........................................ 4,086,000D
Northeast...................................... $0 to $250,000.................... 513,315 84.15
$250,000 to $500,000.............. 78,873 12.93
Above $500,00..................... 17,812 2.92
Total........................................ 610,000 .............
Midwest........................................ $0 to $250,000.................... 992,242 94.77
$250,000 to $500,000.............. 49,628 4.74
Above $500,00..................... 5,130 0.49
Total........................................ 1,047,000 .............
South.......................................... $0 to $250,000.................... 1,393,659 91.93
$250,000 to $500,000.............. 103,088 6.8
Above $500,00..................... 19,253 1.27
Total........................................ 1,516,000 .............
West........................................... $0 to $250,000.................... 725,314 79.53
$250,000 to $500,000.............. 147,653 16.19
Above $500,00..................... 39,034 4.28
Total........................................ 912,000 .............
----------------------------------------------------------------------------------------------------------------
Chairman Archer. Thank you, Mr. Woodbury.
Our last witness for this panel is Thomas Wiggans, and if
you will identify yourself for the record, we will be pleased
to receive your testimony.
STATEMENT OF TOM WIGGANS, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, CONNECTIVE THERAPEUTICS, INC., PALO ALTO, CALIFORNIA;
ON BEHALF OF BIOTECHNOLOGY INDUSTRY ORGANIZATION
Mr. Wiggans. Thank you, Mr. Chairman. My name is Thomas
Wiggans, and I am the president and chief executive officer of
Connective Therapeutics, which is a biotechnology company based
in Palo Alto, California. I appreciate this opportunity to
discuss the merits of capital gains incentives on behalf of the
700-member companies and organizations of the Biotechnology
Industry Organization, and a coalition of eight groups that are
representing more than 15,000 entrepreneurial firms in all 50
States.
I suppose you would expect an entrepreneur to cut to the
bottom line, and that is what I am going to do. We support
enactment of an across-the-board capital gains incentive
accompanied by much needed improvements to the current law
providing incentives for direct investment in stocks of
emerging companies. In particular, H.R. 420, the Matsui-English
bill and H.R. 1033, the Dunn bill, seem to be particularly well
crafted, appropriate, and elegant solutions to this issue.
So, that is who I represent and what I represent. What I
would like to do for just a couple of minutes is tell you who I
am, where I come from, and what people like me do out there. I
have heard a lot of comments this morning about ``dynamic''
versus ``static'' scoring. I will tell you about what I believe
is a very dynamic segment of our economy.
I am an entrepreneur. I run a company that has been funded,
so far, with $50 million in investor capital, starting with
venture capital investment, patient capital that is held for
years and years. We are using that investment to develop
products to treat serious skin and connective tissue diseases.
I work with remarkable technology, brilliant scientists,
extremely committed employees and investors who are willing to
invest and lock up their investment for years at a time.
Our company is a young biotechnology company. One of our
first products has shown great promise in the treatment of a
condition called scleroderma. It is a very serious,
debilitating, untreatable condition that affects women, has a
5-year mortality rate of 50 percent and, as I mentioned, is
untreatable. So, while I am here in a tax forum, let me remind
you, and try to emphasize, what freeing up capital to firms
like mine ultimately results in: New therapies for very sick
patients and new job creation.
Connective Therapeutics has 60 employees, up from zero 4
years ago when it was founded. We occupy a facility in Palo
Alto that previously housed a pioneering biotechnology company
developing cancer therapies. It subsequently became successful
and moved out into larger facilities now employing hundreds of
people. We are around the corner from a small building with a
simple plaque on it that indicates it is the site where the
first integrated circuit was developed. So, I come from a part
of the country where new technologies and new medical advances
arise on a daily basis.
I think all of us out there are living the great American
dream. We are combining great ideas with talented people; throw
in a little terror associated with the possibility of total
failure, and the exhilaration of developing therapies for
people who have no hope, and you have an equation that works.
Where I come from, there is no shortage of great ideas; there
is no shortage of great science, remarkable vision, or
limitless energy. Companies rely on equity and sweat equity to
achieve their goals. There is no shortage of sweat equity;
however, equity capital is the single, most precious, limiting
factor to our success.
Capital to fund ideas has made America great; capital to
fund my company has brought exciting new therapies to patients,
and unleashing capital will further turbocharge America's
entrepreneurial engine. We ask you to give us the tools we need
to form new investment and bring these therapies forward.
From where I come from, the call here in Washington for
capital gains incentives seems to have reached a deafening
roar. But for the entrepreneurs I work with in Silicon Valley
and for entrepreneurs throughout America, it is not the call,
but who answers the call; it is who steps up and gets the job
done. What I am here to ask you to do is step up and get the
job done and pass these incentives to release capital and fund
companies like mine.
Thank you very much.
[The prepared statement and attachments follow:]
Statement of Tom Wiggans, President and Chief Executive Officer,
Connective Therapeutics, Inc., Palo Alto, California; on Behalf of
Biotechnology Industry Organization
Mr. Chairman and Members of the Committee:
My name is Tom Wiggans and I am President and CEO of
Connective Therapeutics, a biotechnology company based in Palo
Alto, California that develops products to treat diseases of
the skin and connective tissues. I appreciate this opportunity
to discuss the merits of capital gains relief for venture
capital investments.
I am proud to be able to speak to you as an entrepreneur
whose firm has been funded by $50 million in investor capital.
Without investors taking risks by buying stock in firms like
mine, much life-saving biomedical research will go unfunded,
and America's technological leadership will falter.
My firm is a member of the Biotechnology Industry
Organization (BIO), an association of 700 biotechnology
companies. I am honored to say that the capital gains
incentives for entrepreneurs and emerging companies of the type
I will describe here have also been endorsed by the Alliance
for Business Investment (an association of money-center
commercial banking corporations whose venture capital
subsidiaries fund small and medium-sized emerging companies),
American Entrepreneurs For Economic Growth, American
Electronics Association, Council of Growing Companies, National
Association of Small Business Investment Companies, National
Venture Capital Association, Software Publishers Association,
and the American Bankers Association. These organizations
together represent over 15,000 entrepreneurial firms in all 50
states.
Recommendations for Capital Gains Relief
As all entrepreneurs must do, let me start with the bottom
line: we support enactment of an across-the-board capital gains
incentive accompanied by needed improvements to the current law
incentive targeted at direct investments in the stock of
emerging companies. The 1995 Balanced Budget Act included a
two-tiered capital gains incentive similar to what we propose
here. This Committee will consider several bills in the course
of your deliberations on capital gains relief. We especially
call to your attention H.R. 420, introduced by Representatives
Bob Matsui, Phil English, and Jim McCrery, and H.R. 1033,
recently introduced by Representative Jennifer Dunn.
Connective Therapeutics
Connective Therapeutics is a young biotechnology company
whose first product is being tested for the treatment of a very
serious, untreatable disease. This product is a compound that
did not show clinical effectiveness in its first medical
indication in research by a major pharmaceutical company, but
it has now been shown to hold great promise for the treatment
of scleroderma, a rare, debilitating and untreatable condition
affecting skin connective tissue and a condition which almost
always continues to worsen and result in death.
Scleroderma primarily affects women between the ages of 20
and 50, and the five year mortality rate is 50 percent. We also
are researching products to treat other progressive, often
fatal fibrosis of the lungs, kidneys, and liver. We recently
completed our first clinical trial involving scleroderma
patients.
The original developer of this compound had the foresight
to make it available to my new company. However, it was
investors who were willing to put their capital at risk who
allowed our company to begin testing the compound in
scleroderma patients. What we have at my company is an exciting
story about the entrepreneurial biotechnology industry and the
hope and risk associated with development of a breakthrough
drug.
From 1992 to 1994 I served as Chief Operating Officer of
CytoTherapeutics, a biotechnology company based in Providence,
Rhode Island, which is developing cell transplantation
technology for the treatment of serious central nervous system
disorders, such as Parkinson's Disease and Alzheimer's Disease.
I have a BS in Pharmacy from the University of Kansas and an
MBA from Southern Methodist University.
Capital Formation to Fund Research
You need to understand one simple fact about the
biotechnology industry: most of our firms fund research on
deadly and disabling diseases from investor capital, not
revenue. Without investors taking the risk of buying the stock
of our companies, much of our vital research would end. Now you
understand why our industry cares so much about capital gains
incentives and about incentives for venture capital in
particular.
Almost without exception, our industry cannot borrow
capital. Our principal, and for most of us, our only source of
capital is equity capital. This is why a capital gains
incentive focused in part specifically on direct equity
investments in stock is so exciting to us and to other
entrepreneur-led industries.
It is also important to emphasize that capital gains taxes
affect the value of founder's stock and employee stock options.
They are direct equity investors in an entrepreneurial firm.
Approximately 78 percent of biotechnology firms provide stock
options to all of their employees. And we have such a young
industry that many founders are still in charge. The leadership
of founders and the talent of employees motivated by stock
options are critical to innovations by entrepreneurial firms.
Bringing a biotech drug product to the market today is both
a lengthy and expensive process. From the initial testing of
the drug to final approval from the Food and Drug
Administration can take 7-12 years, and this process can cost
anywhere from $150 to $359 million. Both the length and cost of
this process are a tremendous impediment for small
biotechnology companies attempting to bring a product to the
market. Patient capital is critical. Investors have already
invested $50 million in my company and they will have to wait
several more years before we and they will know whether the
products we have under development will generate a reasonable
rate of return.
International Competitiveness and Foreign Competition
As is the case with many of the high-tech industries that I
represent today, the United States currently has the dominant
biotechnology industry when compared with any other country in
the world. Precisely because the U.S. is preeminent in the
field of biotechnology, it has become a target of other
country's industrial policies. In 1991, the Office of
Technology Assessment (OTA) found that Australia, Brazil,
Denmark, France, South Korea and Taiwan (Republic of China) all
had targeted biotechnology as an enabling technology.
Furthermore, in 1984, the OTA identified Japan as the major
potential competitor to the United States in biotechnology
commercialization.\1\ The Japanese government has aggressively
helped fund and support the development of their private
sector. For instance, they instituted a policy whereby existing
drugs would have their prices lowered, while allowing premium
prices for innovative or important new drugs, thus forcing
companies to be innovative and to seek larger markets.\2\
---------------------------------------------------------------------------
\1\ U.S. Congress, Office of Technology Assessment, Biotechnology
in a Global Economy 243 (October 1991).
\2\ Id. at 244-245.
---------------------------------------------------------------------------
The competitiveness of the U.S. biotechnology industry
means that U.S. patients with rare deadly and disabling
diseases have hope. It means that they can look to American
biotech companies to develop the therapies and cures which will
ease their suffering.
Capital Gains Incentives
The entrepreneurial sector strongly endorses broad-based
capital gains relief paired with a venture capital incentive.
We believe that these two capital gains incentives are
complementary and will ensure that venture capital is available
for America's entrepreneurs and emerging companies. The 1995
Balanced Budget Act included a two-tiered capital gains
incentive similar to what we propose here. This Committee will
consider several bills in the course of your deliberations on
capital gains relief. We especially call to your attention H.R.
420, introduced by Representatives Bob Matsui, Phil English,
and Jim McCrery, and H.R. 1033, recently introduced by
Representative Jennifer Dunn.
Including a venture capital incentive recognizes that not
all investments in capital assets are the same. Venture capital
investments typically involve more risk, and potentially
provide greater economic and social benefits, than other types
of investments. Venture capital investors are more likely to
lose some or all of their principal. Moreover, the holding
periods for these investments tend to be quite long, stretching
over several years at least. At the same time, venture capital
investments can be the most productive, economically and
socially, creating whole new industries and revolutionizing our
standard of living.
The Existing Venture Capital Gains Incentive Does Not Work As Intended
In 1993, Congress enacted Section 1202 of the Internal
Revenue Code in an effort to provide an added capital gains
incentive for investments in qualifying small business stock.
Unfortunately, this provision as finally enacted ended up with
several limitations on its usefulness, and thus it is not
working as intended. Nevertheless, the concept of an incentive
for new, direct, long-term investments in small company stock
is sound.
Section 1202 provides a 50-percent exclusion for gain from
the sale of qualified small business stock. To qualify, stock
must be acquired at original issuance and held for 5 years. The
principal limitations in Section 1202 include a capitalization
limit of $50 million not indexed for inflation; availability of
the incentive only to individual taxpayers; a per taxpayer
limit of 10 times the basis of the investment or $10 million
(whichever is greater); an exemption for only half of the
excluded gains from the alternative minimum tax (AMT); a
required five year holding period; and substantially modified
definitions dealing with working capital requirements.
Section 1202, because of the limitations it contains, has
been completely ineffective in forming capital for
entrepreneurs and emerging companies. The working capital
requirement definitions are unworkable. The AMT provision is
unduly burdensome, as the AMT recaptures the capital gains tax
benefits and for many taxpayers cancels out any incentive to
make the investments. Corporations, as well as individuals, are
a vital source of venture capital. It is essential that
incentives for further growth in new businesses reduce taxes on
corporate investments in the same manner as on investments by
individuals.
Proposed Improvements to Section 1202
The Balanced Budget Act of 1995, vetoed by the President,
would have provided a number of needed improvements to Section
1202. This year, several measures have again been proposed to
deal with the problems in existing law.
H.R. 420 would modify Section 1202 by increasing the
exclusion to 75 percent for direct investments held for 3 years
(instead of 5 under current law). Favorable treatment would
extend to the stock of a corporation with capitalization of up
to $100 million (increased from $50 million today). Section
1202 investments would be exempt from the AMT, which is
critical to attract the type of investments entrepreneurs need.
H.R. 420 would permit corporations to invest in qualified small
business stock. Finally, it includes an incentive for investors
to rollover their gains into another qualified incentive. H.R.
1033 contains substantially the same provisions as H.R. 420.
Because Section 1202 is current law, the revenue cost for
these proposed amendments is modest. Amendments similar to the
ones we propose here (found in S. 959) were found in 1995 by
the Joint Tax Committee to cost $200 million over five years,
$400 over seven years, and $700 million over ten years. This
means that amending Section 1202 to make it an effective
incentive is an extraordinarily cost effective proposal.
Benefits of a Workable Venture Capital Incentive
Entrepreneurs create jobs and capture markets. The
electronics, biotechnology, and other high technology
industries have changed our economy and changed our lives. The
venture capital incentive in H.R. 420 applies to a variety of
businesses which raise capital with stock offerings, and it
will be utilized by high technology firms that are capital and
research intensive and have no other source of capital
available, as well as by other dynamic venture-backed
businesses that create jobs all across the country.
The role of entrepreneurs in creating jobs and economic
growth in our economy is documented in a research analysis I
have appended to my testimony. Let me cite just a few of the
findings:
Comparison to Fortune 500: Between 1980 and 1990
U.S. private sector employment grew by 19 million jobs, but
employment in the Fortune 500 firms dropped by 3 million jobs.
This means that employment in the non-Fortune 500 firms had to
grow by 22 million jobs to make up for the loss with the larger
firms.
The Inc. annual survey of the 100 fastest growing
small public companies documented the same point. The median
five year sales growth for the companies was an astounding
2,239% and the median sales had grown from $1,796,000 to
$47,144,000 in five years. The median number of employees had
risen from 31 to 260 in five years and the median productivity
of the employees had risen from $52,289 to $167,310 in five
years. The top ranked firm, AmeriData Technologies, sells
computers and integrates computer systems and its sales had
grown 135,647% in the past five years.
Venture Capital-Backed Firms: Venture capital-
backed firms are prolific creators of jobs. Venture-backed
firms increased employment by an average of 20% per year from
1990 to 1994 at a time when Fortune 500 firms lost nearly 1% of
their employees per year. By the time a venture-backed firm is
six years old, it typically employs 282 people. The percentage
of these jobs taken by engineers, scientists, and managers is
61%, four times the percentage of the workforce as a whole.
The staggering research intensity of high
technology firms is confirmed each year in the Business Week
survey on Research and Development expenditures. The survey
measures the percentage of increase in absolute terms and also
the research intensity as a percentage of sales or on a per
employee basis. The 1995 survey finds a 14% increase in R and D
by electrical and electronics firms, which spent $9.6 billion
on research, 5.7% as a percentage of sales, and $8,257 per
employee. Office equipment and sales firms spent $15,898 per
employee on research, health care firms spent $18,451 per
employee, and chemicals spent $10,289 per employee. The all
industry averages are 4% increases, 3.5% as a percentage of
sales, and $7,651 per employee.
Staples, the office supply superstore, is today
the country's biggest retailer of office supplies. Sales in
1995 were $3.1 billion; net income was $73.7 million. By the
end of 1995 it employed 22,000 people and expected to hire an
additional 10,000 in 1996. It paid $44.5 million in state and
federal income tax in 1996. In 1987 Staples had one store in
Brighton, Massachusetts, and needed capital to expand. A small
business investment company was willing to step in and provide
the needed equity financing, $1.5 million.
These stunning facts and those in the appendix demonstrate
the need to enact a capital gains incentive including
improvements to the 1993 venture capital incentive.
Entrepreneurial firms are the ones which can dramatically
change our whole health care system, clean up our environment,
link us in international telecommunication networks, and
increase our capacity to understand our world. The firms are
founded by dreamers, adventurers, and risk-takers who embody
the best we have to offer in our free-enterprise economy.
The Need for Capital Gains Relief
We support a two-tiered incentive. A broad-based capital
gains incentive that applies to currently held assets is vital
to unlocking the current ownership of capital assets. Reducing
the penalty for sale of these assets will free up capital to be
invested in more productive investments. In addition, many
other sectors of the economy do not rely on direct equity
investments and there is a powerful rationale for providing a
capital gains incentive for these investments.
America's entrepreneurs rely on equity investments to fund
research and development. Most of them have no sales and,
therefore, no ability to borrow funds. To raise capital they
must issue stock, to angel investors, to venture capitalists,
or to investors in public offerings. Capital raised from equity
offerings does not involve carrying costs. It tends to be
patient capital, precisely what struggling entrepreneurs need.
This is exactly the type of capital formation covered by H.R.
420.
An incentive focused on direct purchases of stock provides
an incentive for founders and company employees who acquire
stock through the exercise of stock options. Founders and their
employees take a major risk when they leave established firms
to found start-ups. They often take a major cut in pay with the
hope that the value of their stock will justify their decision.
We must provide an incentive for outside investors, but it may
be even more important to provide an incentive for founders and
their employees. No one is more valuable to our economy than
our entrepreneurs.
Conclusion
In conclusion, we support a broad-based reduction in
capital gains taxes and we believe it should be paired with
improvements to the targeted venture capital incentive in
current law. We believe this combination will be the most cost-
effective incentive for capital formation for entrepreneurs.
Thank you again for the opportunity to testify. I am happy
to answer your questions.
Venture Capital Gains Incentive: H.R. 420, Matsui/English/McCrery
Enacted in 1993 Budget Reconciliation Bill:
50% capital gains exclusion for new investments--
not sale of previously acquired assets--new investments made
after effective date, August 1993
only if investments made directly in stock--not
secondary trading, founders stock, stock options, venture
capital, public offerings, common, preferred, convertible
preferred
only if made in stock of a small corporation--
defined as a corporation with $50 million or less in
capitalization--ceiling not indexed for inflation
only if investment held for five years
only if investment made by an individual
taxpayer--not by a corporate taxpayer
50% of the excluded gains not covered by the
Alternative Minimum Tax (AMT)
limit on benefits per taxpayer of 10 times basis
or $10 million, whichever is greater
technical problems--redemption of stock, spending
speed-up provision
H.R. 420--Eight proposed amendments to incentive:
(1) 75% capital gains exclusion--up from 50%
only new investments--same
only if direct investments--same
only if investment in stock--same
(2) only if investment held for three years--same
(see rollover provision below)--reduction from five years
(3) define small corporation as one with $100
million in capitalization and index for inflation--up from $50
million with no indexing
(4) apply to corporate taxpayers--now only
applies to individual taxpayers
(5) 100% exemption from AMT--now 50% exemption
(6) delete 10 times or $10 million limitation
(7) fix technical problems--modify redemption of
stock, spending speed-up provision
(8) add rollover provision--provide for a
deferral of gains taxes for those who reinvest proceeds from
sale of a qualified venture capital asset in another qualified
venture capital asset
Summary of 1995 Balanced Budget Bill
Capital Gains Incentives (Conference Bill)
1. Broad-Based Capital Gains Tax Relief
1) Individual taxpayers would be allowed a deduction of 50
percent of any net capital gain for capital assets held for at
least one year. The top effective tax rate on capital gains
would thus be 19.8 percent. Gains rate of 7.5 percent for
taxpayers in 15 percent tax bracket. Repeals current 28 percent
capital gains maximum rate. Same as in House-passed bill, H.R.
1215, and S. 959.
2) Does not apply to sale of collectibles.
3) Applies to sale of previously acquired assets sold after
the effective date of the incentive (unlocking effect) and to
new investments held for at least one year.
3) Capital gains of corporate taxpayers would be subject to
a maximum capital gains rate of 28 percent.
5) Indexing of the basis of capital assets is not included.
6) None of the deduction is included as a preference item
in the Alternative Minimum Tax (AMT).
7) Gains provision would be effective for sales of capital
assets held for at least one year after January 1, 1995.
2. Venture Capital Gains Incentive
1) Provides a maximum 14 percent venture capital incentive
for investments in the stock of a small business held for at
least five years. (Senate bill provided a 75% exclusion--a 9.9%
rate)
2) Applies only to new investments made after August 10,
1993 (the original effective date for the venture capital
incentive included in the 1993 Budget Reconciliation Act) and
held for at least five years. (Does not reduce holding period
to three years.)
3) Small business must have $100 million or less in
aggregate gross assets and stock must be purchased directly
from the company (does not include secondary trading of stock).
4) Capital gains of corporate taxpayers would be subject to
a maximum capital gains rate of 21 percent.
5) Indexing of the basis of capital assets is not included.
6) None of the deduction included as a preference item in
the Alternative Minimum Tax (AMT).
7) Repeals and amends various restrictions in 1993 venture
capital provision.
8) Does not include rollover provision from Senate bill.
Summary of 1995 Balance Budget Bill
Capital Gains Incentives (Conference Bill)
------------------------------------------------------------------------
Venture Capital Gains
Broad-Based Gains Incentive Incentive
------------------------------------------------------------------------
Applies to investments in any capital Applies to investments in
asset. stock of small corporation
Includes both common or
preferred stock issued by
corporation
Only purchases of stock
directly from company--does
not cover secondary trading
Corporation must have $100
million or less in
aggregate gross assets
50% of gains not taxed (effective top tax Sets 14% maximum gains rate
rate of 19.8%). (no use exclusion approach)
Must hold investment for at least one year Must hold investment for at
least 5 years
Applies to sale of assets after January 1, Applies to sale of assets
1995. acquired after August 10,
1993 (effective date for
1993 venture capital
incentive)
Applies to sale of assets acquired before Does not apply to assets
January 1, 1995, if held for at least one acquired before effective
year (unlocking effect). date
None of untaxed gains included in None of untaxed gains
Alternative Minimum Tax. included in Alternative
Minimum Tax
Individual and corporate investors covered Individual and corporate
investors covered
Maximum corporate gains tax rate is 28%... Maximum corporate gains rate
is 21%
Does not include Senate
rollover provision
------------------------------------------------------------------------
Senate 75% Exclusion and Rollover Provision (Dropped in Conference)
The Senate budget bill in 1995 went to the conference with
a venture capital incentive which was modified in the
conference.
1. 75% Exclusion: Senate bill provided for a 75% capital
gains exclusion for venture capital investments--contrasted
with a 50% exclusion for non-venture capital investments.
The effective rates were 9.9% for venture capital
investments and 19.8% for non-venture capital investments.
In the conference the 50% exclusion for non-venture capital
investments was retained, but the 75% exclusion was modified to
a 14% maximum rate.
One can set a capital gains incentive either as an
exclusion or a maximum rate or both.
The 14% maximum rate provides only a 1% incentive to
taxpayers in the 15% tax bracket. An exclusion is the better
way to provide an incentive to these taxpayers.
2. Rollover Provision: The Senate bill provided that
taxpayers which realized gains on a venture capital investment
could defer paying tax on the gains if they rollover their
investment over into another venture capital investment within
a short period of time. This rollover provision then provided
that the holding period on the next and subsequent venture
capital investments would be one year, not five years.
This provision was dropped in the conference.
The provision provides an incentive for investors to keep
their investments at work and not to divert them to non-venture
capital investments.
3. Revenue Scores: The Hatch-Lieberman bill, on which the
Senate bill was based, included a 75% exclusion, the rollover
provision, a complete exemption from the AMT for both broad-
based and venture capital investments, and it was scored as
losing $700 million over seven years. The rollover provision
was scored as losing less than $50 million over seven years.
Amendments to 1993 Venture Capital Incentive Included in H.R. 420
H.R. 420 amends Section 1202, the venture capital incentive
enacted as part of the 1993 Budget Reconciliation Act, in the
ways described below. With these amendments the incentive will
be effective in forming capital for entrepreneurs.
The amendments do the following:
1. Capitalization Ceiling:
increase the capitalization ceiling from $50 million to
$100 million and index the ceiling for inflation (defines which
companies stock qualifies for the gains incentive)--increasing
ceiling includes stock offerings of more capital intensive
companies
2. Corporate Taxpayers: apply venture capital incentive to
corporate taxpayers--increases capital investments in small
companies by corporate taxpayers
3. Holding Period: Reduces holding period from five to two
years.
4. Per Taxpayer Benefits Limit: eliminate the 10 times or
$10 million per taxpayer limitation on benefits per gains
realization--permits taxpayers to offset losses on risky
investments with winnners on others
5. Alternative Minimum Tax: exempt all of the excluded
gains from the alternative minimum tax--avoids zero sum game of
granting exclusion and then recapturing benefits of exclusion
by AMT
6. Working Capital Rules: fix the working capital rules
which require that 50% of the capital raised be expended within
two years and bars companies from redeeming stock even if it is
for a business purpose--companies which violate these rules
invalidate any tax benefits for investors--rules have been
unworkable rules and prevent any use of the 1993 incentive to
form capital
7. Capital Gains Rollover: provide for a deferral of gains
taxes (a rollover provision) for those who reinvest proceeds
from sale of a qualified venture capital asset in another
qualified venture capital asset--encourages investors to
maintain commitment to venture capital investments
8. Exclusion Differential: increase capital gains exclusion
from 50% to 75% (both individuals and corporations)--provides
differential with broad-based capital gains exclusion.
Revenue Implications of Amendments: The Joint Committee on
Taxation has ruled in 1995 that amendments similar to these
(found in S. 959, Hatch-Lieberman bill) would lose the
following amounts of revenue: $200 million--over five years;
$400 million--over seven years; and $700 million--over ten
years.
Role of Entrepreneurs in America's Economy (Excerpt from
``Entrepreneurs Agenda'' \3\
Fundamental American Values
The role of entrepreneurs cannot be entirely described in
economic terms. It is critical to understand that entrepreneurs
epitomize the fundamental American values of the rights of the
individual, freedom of speech and choice, democracy and
restraints on bureaucracy and concentrations of power, and
private ownership of property.
---------------------------------------------------------------------------
\3\ The Entrepreneurs Agenda was published by the Entrepreneurs
Coalition in June of 1996. The Coalition is composed of the
Biotechnology Industry Organization, Council of Growing Companies, the
Nasdaq Stock Market, National Venture Capital Association, and Software
Publishers Association.
---------------------------------------------------------------------------
These are the values which have characterized America from
its founding and define our values in relationship to the rest
of the world. These are the values which characterize--and are
championed by--entrepreneurs.
The Declaration of Independence states that all men have
certain unalienable rights among which are life, liberty, and
the pursuit of happiness. Among the grievances listed in the
Declaration are the cutting off of our trade with all parts of
the world and among the rights asserted were the rights to
establish commerce.
Our country was founded to secure economic, not just
political, freedom from England and the Constitution we adopted
focuses on such commercial issues as regulating commerce and
trade, regulating bankruptcies, coining money, fixing the
standard of weights and measures, establishing post offices,
and promoting the progress of science and useful arts with
patents and copyrights.
We are the land of opportunity and there are no Americans
which utilize these opportunities like entrepreneurs.
Entrepreneurs see opportunities where others do not. They turn
the opportunities into reality for themselves, their employees,
their customers, and the society as a whole.
Those who champion change always meet resistance. They are
confronted by skeptics, roadblocks, bureaucracies, defenders of
the status quo, and hostility. But, they persevere and fashion
a new reality. We can laugh at the initial thoughts of some of
America's most successful entrepreneurs and scientists.
``The phonograph...is not of any commercial value.'' Thomas
Edison, 1880.
``There is no likelihood that man can ever tap the power of
the atom.'' Robert Millikan, Nobel Prize winner in physics,
1920.
``There is no reason for any individual to have a computer
in their home.'' Ken Olsen, President of Digital Equipment
Corporation, 1977.
``I think there is a world market for about five
computers.'' Thomas J. Watson, Chairman of IBM, 1943.
``It is an idle idea, to imagine that...automobiles will
take the place of railways in the long distance movement
of...passengers.'' American Road Congress, 1913.\4\
---------------------------------------------------------------------------
\4\ Entrepreneurs: Architects of Innovation, Paradigm Pioneers and
Change, Eric K. Winslow and George T. Solomon, Journal of Creative
Behavior, Second Quarter 1993 at 80-81.
---------------------------------------------------------------------------
Fortunately, these entrepreneurs and many others are
capable of brilliant insights and have a profound capacity to
learn from their mistakes and preserve.
Entrepreneurs are often unconventional, idiosyncratic,
restless, even odd. They have passion and a vision of the way
the world ought to be. Entrepreneurs thrive in ambiguous
environments.\5\
---------------------------------------------------------------------------
\5\ ``Where is the Passion...and Other Elements of Innovation,'' F.
Hertzberg, in Key Issues in Creativity, Innovation, and
Entrepreneurship, Bruce G. Whiting and George T. Solomon, 1989.
---------------------------------------------------------------------------
Fundamental to the growth of a free and open society is the
need for an informed electorate and freedom of thought and
expression. Entrepreneurship is the embodiment of those
democratic values. It is all about pluralism and diversity.
Entrepreneurs threaten and challenge stifling bureaucracies.
They check concentrations of power. They champion the
creativity and independence of individuals.
Entrepreneurship is all about choice. Entrepreneurship is
the outgrowth of the free expression of ideas. Entrepreneurship
is the outgrowth of a capitalist economy that rewards
initiative. By definition, entrepreneurship requires for its
very existence a social and political system that fosters
individuality, freedom, creativity, growth, and change.
Fostering entrepreneurship in turn fosters the growth of
American values and our abiding faith in progress. A rising
standard of material wealth, a sense of progress, and a believe
in opportunities for individuals is indispensable for our
political, economic and social stability.
Freedom and choice makes the entrepreneurial behavior
possible. Entrepreneurship in turn makes freedom and choice
possible. The synergy is fundamental to our nation's successes
and leadership.
Studies of entrepreneurs find that the primary, driving
motivation of the entrepreneur is independence. The motivation
is not money as is popularly assumed.\6\ There can be no more
American value than the value of independence--first for our
country and always for the individual.
---------------------------------------------------------------------------
\6\ Albert Shapeero, Taking Control, commencement address at Ohio
State University, 1982 (cited in Public Policy Affecting
Entrepreneurship, Venture Capital, and Technology, Gerald L. Feigen,
Small Business Administration).
---------------------------------------------------------------------------
The economic definition of an entrepreneur can be abstract
and sterile. One definition of ``entrepreneurship'' focuses on
``the process activity of creating value by bringing together a
unique combination of resources for the purpose of exploiting
an opportunity.'' \7\ A simpler definition is that provided by
Peter Drucker, legendary business observer: ``An entrepreneur
is someone who gets something new done.'' \8\ These formal
definitions do, however, focus on quintessential American
values--resourcefulness, action, and practicality.
---------------------------------------------------------------------------
\7\ ``Sustaining the Entrepreneurial Society,'' Michael H. Morris,
prepared for the Small Business Foundation of America.
\8\ ``Flashes of Genius,'' Inc. (Special Issue: State of Small
Business, May, 1996) at 43 (italics in original).
---------------------------------------------------------------------------
Candidates and policy makers should support the
Entrepreneurs Agenda because it reflects fundamental American
economic and social values and benefits the individual, the
economy, and the community.
Entrepreneurs Create Jobs
Entrepreneurs are synonymous with jobs. This is the common
view in America, but it is also the view of economists who have
documented it in numerous studies.
Comparison to Fortune 500: The bottom-line is dramatically
stated: between 1980 and 1990 U.S. private sector employment
grew by 19 million jobs, but employment in the Fortune 500
firms dropped by 3 million jobs.\9\ This means that employment
in the non-Fortune 500 firms had to grow by 22 million jobs to
make up for the loss with the larger firms.
---------------------------------------------------------------------------
\9\ ``Risk and Innovation: The Role and Importance of Small High-
Tech Companies in the U.S. Economy,'' National Academy of Engineering,
1995, at v.
---------------------------------------------------------------------------
We are seeing an accelerating decline in the ability of
Fortune 500 firms to maintain their competitiveness. The
replacement rate for Fortune 500 firms was approximately 8% in
the 1960s, jumped to 30% in the 1980's, and approached 40% in
the 1990s. Almost half of the largest industrial firms are now
replaced by new firms every five years. For high technology
firms approximately 25% of the firms are replaced every five
years.\10\
---------------------------------------------------------------------------
\10\ A Profile of Small High Technology Business in the United
States, Office of Science and Technology Policy, Executive Office of
the President, Joseph S. Broz, David C. Cranmer, and Mark DeSantis,
1992, at 18.
---------------------------------------------------------------------------
Rate of Growth: In 1994 small-business-dominated industries
added jobs to the economy at 1.3 times the national rate of
increase of 3.5% while large-business-dominated industries
added jobs to the economy at one-third the national rate (only
a 1% increase).\11\
---------------------------------------------------------------------------
\11\ Small Business Administration data.
---------------------------------------------------------------------------
Number of firms: The Office of Science and Technology
Policy (OSTP) estimated in 1992 that there are 75,000 to
100,000 small high-technology firms in the United States with
1.75 to 2 million direct employment.\12\ This figure does not
include the suppliers, retailers, or service personnel whose
employment is dependent on these businesses. OSTP puts these
statistics in perspective as follows:
---------------------------------------------------------------------------
\12\ A Profile, OSTP, at 1.
---------------------------------------------------------------------------
While the small high technology business sector represents
only a few percent of the total small business sector work
force, the economic, technological, and social impact of these
technically based firms is profound (due to the impact of their
products on our daily lives).\13\
---------------------------------------------------------------------------
\13\ Profile, OSTP, at 1.
---------------------------------------------------------------------------
OSTP found that the ``small high-tech firms are dynamic in
the creation of new jobs.'' In the decade from 1976 to 1986, it
found that ``employment growth in the high-tech sector was the
highest of any sector of the economy.'' \14\ Small high-tech
firms contributed over one-third of the increase in new jobs
for the entire high-tech sector and firms with fewer than 20
employees ``accounted for fully half of this growth.'' In
aggregate numbers, the high technology firms contributed
``nearly four times their expected share of new jobs.'' \15\
---------------------------------------------------------------------------
\14\ A Profile, OSTP, at 2.
\15\ A Profile, OSTP, at 2 (citing Paul Hadlock, Daniel Hecker, and
Joseph Gannon, High Technology Employment: Another View, Monthly Labor
Review July 1991 and Bruce D. Phillips, The Increasing Role of Small
Firms in the High-Technology sector: Evidence from the '80's, Business
Economics January 1991)
---------------------------------------------------------------------------
Comparison to Basic Industries: The comparison between
small and medium-sized high technology firms and the ``once
dominate basic U.S. industries, such as steel, autos, and
consumer electronics'' is particularly startling. From January
1989 to September 1991, ``durable goods manufacturers lost 8.3%
in total employment. In contrast, during the same period, small
and mid-sized technology manufacturers increased employment by
10.6%.'' \16\
---------------------------------------------------------------------------
\16\ A Profile, OSTP, at 2 (citing CorpTech, Inc., 1991, and U.S.
Department of Labor, Bureau of Labor Statistics, Statistical Abstract,
1991).
---------------------------------------------------------------------------
Hot Growth Companies: The Business Week annual survey of
100 ``hot growth'' companies provides graphic evidence of the
growth potential of entrepreneurial firms.\17\ This year's
survey found average sales increases of 60%, average profit
increases of 140%, and average rate of return increases of 27%.
The total market capitalization of the 100 firms companies is
$40 billion. Of the 100 firms, 33 were ranking on the same list
the year before. The top ranking growth companies included
Remedy (ranked no. 1), a software company with a 160.5%
increase in sales, a 272.9% increase in profits, and a 43.4%
increase in return on capital. Software and computer-service
providers made up 23 of the listed companies, while semi-
conductors, components, and telecommunications added 10 more.
As the article states in bold type, ``Unslackable demand for
technology fueling many of this year's highfliers.'' \18\
---------------------------------------------------------------------------
\17\ To qualify for the list a company must excel in a three year
average growth of sales, profits, and return on invested capital.
Companies must have had annual sales of more than $10 million and less
than $150 million, a current market value of more than $1 million, a
current stock price of greater than $2, and be actively traded in a
public capital market.
\18\ Hot Growth Companies: Corporate America is Slowing? Don't Tell
These Dynamos, Business Week, May 27, 1996, at 110-126.
---------------------------------------------------------------------------
The Inc. annual survey of the 100 fastest growing small
public companies documented the same point.\19\ The median five
year sales growth for the companies was an astounding 2,239%
and the median sales had grown from $1,796,000 to $47,144,000
in five years. The median number of employees had risen from 31
to 260 in five years and the median productivity of the
employees had risen from $52,289 to $167,310 in five years. The
top ranked firm, AmeriData Technologies, sells computers and
integrates computer systems and its sales had grown 135,647% in
the past five years.\20\
---------------------------------------------------------------------------
\19\ To qualify for the list companies had to be independent,
publicly held companies, had to have gone public no later than December
31, 1995, there had to be an active market for their stock, and they
had to have had sales of no less than $200,000. The only criteria for
ranking was sales growth.
\20\ Show Time: Thirty-one of this year's Inc. 100--the fastest-
growing small public companies in American--became public just last
year. Next year, expect more, Inc., May 1996, at 34-42.
---------------------------------------------------------------------------
Critical Technologies: Many of the new technologies and
industries seen as critical to the Nation's future economic
growth are closely identified with small business.\21\ And, the
establishment of these firms is relatively recent. Even though
the late 1980s saw a sharp decline in the company formation
from the earlier part of the decade, almost half of all U.S.
high-tech companies operating in 1993 were formed since
1980.\22\
---------------------------------------------------------------------------
\21\ Science and Engineering Indicators--1993 (U.S. National
Science Board, 1994) at 185.
\22\ Science and Engineering Indicators--1993 (U.S. National
Science Board, 1994), at 185.
---------------------------------------------------------------------------
For example, the Board reports that 60% of the computer-
related, biotechnology firms and software firms were founded
since 1980. The 1980-1993 period saw the founding of 490
automation companies, 358 biotechnology companies, 1,253
computer hardware companies, 243 advanced material companies,
296 photonics and optics companies, 3,395 software companies,
807 electronic component companies, 593 telecommunications
companies, and 7,246 in chemicals, defense-related, energy,
environmental, manufacturing equipment, medical,
pharmaceutical, subassembly and components, test and
measurement, and transportation companies. Fully 48 percent of
the total of 22,728 companies in these fields were founded
between 1980 and 1993.
These statistics may drastically understate the growth in
these sectors. For example, while the Science Board reports the
creation of 358 biotechnology companies during this period, the
keeper of the most reliable statistics on this subject--Ernst
and Young--reports that 974 biotechnology companies were
founded between 1980 and 1993 \23\--a difference of 272%.
---------------------------------------------------------------------------
\23\ Biotech 96: Pursuing Sustainability: The Tenth Industry Annual
Report, Kenneth Lee and Steven Burrill, September 1995 at 43. This
report covers both public and non-public companies.
---------------------------------------------------------------------------
Venture Capital-Backed Firms: Venture capital-backed firms
are prolific creators of jobs. Venture-backed firms increased
employment by an average of 20% per year from 1990 to 1994 at a
time when Fortune 500 firms lost nearly 1% of their employees
per year. By the time a venture-backed firm is six years old,
it typically employs 282 people. The percentage of these jobs
taken by engineers, scientists, and managers is 61%, four times
the percentage of the workforce as a whole.\24\
---------------------------------------------------------------------------
\24\ Economic Impact of Venture Capital Study, Coopers and Lybrand
(Sixth Annual study), 1996.
---------------------------------------------------------------------------
Nasdaq-Listed Companies: Companies traded on the Nasdaq
Stock Market make up four tenths of one percent of all public
and private companies in the United States and have an
employment base of approximately three million people (2.5% of
the U.S. total), but in the period from January 1990 through
June 1994 they created over one-half million new jobs or more
than 16 percent of all new jobs. During the same time period
Fortune 500 firms lost about 200,000 jobs per year. Compared to
a national growth rate of about 3 percent, 51 percent of the
Nasdaq companies are growing at 20 percent or higher. This is
equivalent to a 100 person firm growing to at least 145
employees in a four and a half year period. Fully 80 percent of
this explosive job growth comes in Nasdaq firms with 1,000 or
more employees. The key seems to be firms with an average
revenue base of $100 million--a take-off point for growth.\25\
---------------------------------------------------------------------------
\25\ The Role of Nasdaq Companies in the U.S. Economy, Cognetics,
Inc., June 1, 1995.
---------------------------------------------------------------------------
Women-Owned Businesses: Growth in the number of women-owned
businesses has been particularly spectacular. The number of
women-owned sold proprietorships, partnerships, and
subchapter's corporations has risen from 2.6 million in 1982 to
5.889 million in 1992. For this entire decade the increase is
125 percent or 8.5 percent compounded annually--more than twice
the rate of all businesses. When the 511,000 women-owned
subchapter C corporations are added, the total rises to 6.4
million firms. In 1992 women owned 32.1 percent of all firms in
the United States. Women-owned firms with employees constituted
11 percent of the total of new businesses between 1987 and
1992, a 32 percent growth rate. These firms with employees
provided 94 percent of the total revenue for the women-owned
business sector--receipts which totaled $1.5 trillion in 1992--
and now make up one-fifth of all the 6.4 million women-owned
firms.\26\
---------------------------------------------------------------------------
\26\ U.S. Census and Small Business Administration data.
---------------------------------------------------------------------------
Software Industry Trends/Competitiveness: Although the
software industry boasts some large, well-known companies, a
recent survey showed that more than 80 percent of the industry
is actually made up of software companies with annual revenues
under $10 million.\27\ The employment of large numbers of
highly skilled workers, heavy investment in research and
development, and high growth of production and exports further
qualify the U.S. software publishing industry as an excellent
example of a developing entrepreneurial industry.
---------------------------------------------------------------------------
\27\ 1996/1997 Software Business Practices Survey, Price Waterhouse
LLP, Massachusetts Software Council, Software Publishers Association,
and Information Technology Association of America (6th Annual)(1996),
at 38.
---------------------------------------------------------------------------
Between 1987 and 1993, the annual average growth rate for
the industry increased by 20 percent. During this five year
period, international sales grew by an average annual rate of
13 percent per company, representing $26,665, and 48 percent
for the entire period. The growth in international sales would
be much larger, at least double by conservative estimates, if
it were not for widespread international piracy of software.
Protection of intellectual property rights is a high priority
for the Entrepreneurs Coalition.
The U.S. has nearly 500,000 people directly employed in
software development, and the numbers are growing rapidly.
According to statistics developed by the U.S. Department of
Commerce and the WEFA Group, between 1987 and 1993 software
industry employment increased by 10.5 percent annually.\28\
---------------------------------------------------------------------------
\28\ Economic Contribution of the Packaged Software Industry to the
U.S. Economy, August, 1994; WEFA Group, at 15.
---------------------------------------------------------------------------
Employee compensation, a highly important criterion for
measuring the industry's contribution towards the economy, also
reflects the software industry's prosperity and growth. Labor
compensation grew at an annual average rate of 8.4 percent, or
$18,256, between 1987 and 1992, and the average compensation
measured by total payroll grew at an annual rate of 20.1
percent during the same five year period.\29\
---------------------------------------------------------------------------
\29\ Ibid.
---------------------------------------------------------------------------
Stability and Growth: Inc. found in 1996 that
entrepreneurial firms are remarkable durable. It surveyed the
entire Inc. 500 group from the class of 1985 and found that
only 19% were no longer in business or could not be located.
Another 275 had been sold to a new owner, six percent had gone
public, and 48% were still privately held under the same
ownership. The companies had generated $7.4 billion in revenue
in 1984 and $64 billion in 1994 and 29,000 employees in 1984
and 127,000 in 1995. The 32 companies which went public grew by
$18.9 billion in revenues from 1984 to 1994, and they created
59,900 new full-time jobs. That's an average of 30% revenue
growth per year and an average of 1,872 new jobs created by
each company each year. Microsoft is one of these companies,
along with Oracle, Solectron, Tech Data Corp., and Merisel--all
high technology companies. In this process 10,000 jobs were
lost at the 95 companies which no longer exist or could not be
found, but this was dwarfed by the job gains at the 233
companies which survived and remained independent of 92,000--a
net job growth of 81,900.\30\
---------------------------------------------------------------------------
\30\ Martha E. Mangelsdorf, The Startling Truth About Growth
Companies, Inc. (Special Issue: State of Small Business, May 1996), at
85.
---------------------------------------------------------------------------
Workplace Quality of Life: In the age of ``economic
anxiety'' there are powerful reasons to work for
entrepreneurial firms. In a major survey of attitudes towards
their workplace quality of life, Inc. found that employees of
small entrepreneurial firms were more likely to say that they
had an opportunity ``at work to learn and grow,'' that the
mission of their employer makes them ``feel your job is
important,'' that they used a higher percentage of their
ability, that they wanted to be a leader in their firm someday,
that the management did ``what is necessary to make your
company a great place to work,'' and that their company was a
``good workplace for all of the people (and not) for only the
privileged few.'' \31\
---------------------------------------------------------------------------
\31\ Jeffrey L. Seglin, The Happiest Workers in the World, Inc.
(Special Issue: State of Small Business, May 1996), at 62.
---------------------------------------------------------------------------
Stability was a hallmark of these companies. In another
survey by Inc. 68% of these firms still have their headquarters
in the same town and a majority of those that had relocated
moved less than 20 miles away. Only 4% had moved their
headquarters across state lines.\32\
---------------------------------------------------------------------------
\32\ Martha E. Mangelsdorf, The Startling Truth About Growth
Companies, Inc. (Special Issue: State of Small Business, May 1996), at
85.
---------------------------------------------------------------------------
High Tech Sector Job Growth: Small high technology firms
with 500 or fewer employees created over 400,000 jobs in 1990,
four times their expected share of new jobs. In one recent one-
year period 40% of the jobs created were in the computer-
related industries and seventy-six percent of the total number
of high technology jobs created were in firms of between 50 and
500 employees.\33\ The study found that small, high-technology
firms create more new jobs than any sector of the economy--and
they keep producing jobs.
---------------------------------------------------------------------------
\33\ A Profile, OSTP, at.
---------------------------------------------------------------------------
Entrepreneurial firms continue creating new jobs because of
growth of the existing firms and growth of the number of firms.
The OSTP study found small, high-technology firms are 300
percent more likely to create a new job than any other type of
firm. The rate of job growth changes by the size of the firm:
Number of High Technology Firms by Employment Size in 1976-1986
----------------------------------------------------------------------------------------------------------------
Number of Business
Employment Size -------------------------------- Annual Growth
1976 1986 Rate (%)
----------------------------------------------------------------------------------------------------------------
1-99............................................................ 50,245 8350,245 5.22%
100-499......................................................... 2,554 3,789 4.02%
500-999......................................................... 292 459 4.63%
1,000-9,999..................................................... 432 520 1.87%
10,000 & up..................................................... 133 135 0.15%
-----------------------------------------------
Totals........................................................ 53,656 88,453 * 5.13%
----------------------------------------------------------------------------------------------------------------
* A Profile, OSTP, at 17 (emphasis added)(citing William K. Scheirer, ``The Population and Birth Rates of High
Technology Firms, 1976-1986,'' study commissioned by U.S. Small Business Administration).
The more entrepreneurial the firm, the more growth in jobs.
The highest job growth is focused in a small group of high-
growth entrepreneurial firms--10 percent of small companies
created 75 percent of new jobs created since 1970.
Job growth rates of 10-12 percent as a yearly average for
high technology companies are common according to a CorpTech
study based of the NSF Science and Engineering Indicators. This
study shows net growth of jobs by industry:
------------------------------------------------------------------------
Employment Growth No. of Jobs
Rate Last Year Created Last Year
------------------------------------------------------------------------
Automation........................ 12.6 58,471
Biotechnology..................... 10.6 16,468
Computer hardware................. 14.5 148,304
Computer software................. 13.9 103,479
Advanced materials................ 5.8 32,452
Photonics & optics................ 8.4 27,654
Telecommunications................ * 12.7 61,280
------------------------------------------------------------------------
* A Profile, OSTP study, at 20.
Impact of Job Growth: Over 400,000 jobs were created in the
high technology sector by small technology firms in 1990
alone.\34\ Small high tech firms created four times their
expected share of new jobs and in a one-year period, 40% of the
jobs created were in computer-related industries.\35\ The OSTP
study found that small high-tech firms contributed 38% of the
2.2 million new jobs in the entire high technology sector
between 1976-1986. These figures are twice as high as the
growth rate for the economy as a whole.\36\
---------------------------------------------------------------------------
\34\ A Profile, OSTP study, at 30 (citing Science and Engineering
Indicators--1991).
\35\ A Profile, OSTP study, at 30.
\36\ A Profile, OSTP study, at 30.
---------------------------------------------------------------------------
In the period of 1977-1987 employment in computer and data
processing firms grew by an astonishing 252%, creating 450,000
new jobs. Employment in firms producing scientific and
measuring instruments grew 210%, medical and ophthalmic goods
grew 62%, office and computing equipment grew by 35%, and
electronic components and accessories grew 25%. This compares
to a drop in employment for firms producing general industrial
machinery of 9%, a drop of 44% for engines and turbines, a drop
of 40% for Radio, TV, and communications equipment, and a drop
of 47% for firms in construction and related machinery.\37\
---------------------------------------------------------------------------
\37\ State of Small Business Report, 1992, Small Business
Administration, at 83.
---------------------------------------------------------------------------
Economic Stars: These entrepreneurial new businesses grow
and can become the nation's largest and most successful
corporations. Microsoft, Hewlett Packard and Genentech are all
billion-dollar businesses that began as entrepreneurial
startups. Today these firms employ more than 100,000 employees.
Almost half of the largest industrial firms in the United
States are now replaced by ``upstarts'' every five years. Of
the 1,400 largest high-technology firms in the United States,
41 percent have been created since 1980, 31 percent since 1983
and 14 percent since 1987--clearly age and size are not a
protection. The new startup of today may be the billion-dollar
corporation of tomorrow.
Self-Made Wealth: Ten years ago, 40% of the Forbes Four
Hundred Richest People in America were entrepreneurs, self-made
individuals who created their own wealth rather than inheriting
it. By 1994, 80% of the wealthiest were self-made.\38\
---------------------------------------------------------------------------
\38\ William E. Wetzel, ``Economic Policy in an Entrepreneurial
World,'' Venture Capital Journal, August 1995, at 53.
---------------------------------------------------------------------------
High-Wage Jobs: The industries comprising the Coalition are
prime examples of this subject. The average salary in the U.S.
biotechnology industry is $50,000. Biotech companies directly
employ over 108,000 jobs in the U.S. Over two thirds of
biotechnology companies employ less than 50 workers.\39\ The
percentage of highly skilled engineers, scientists, and
managers generated by young venture capital-backed companies is
over 4 times the percentage of skilled jobs created in the
economy as a whole (61% vs. 14%).\40\ At small businesses with
less than 500 employees, 54.8% earn more than $21 per hour as a
starting salary, vs. only 45.2% at firms with more than 500
employees. This indicates that recently hired workers in small
firms are obtaining a major share of high-wage jobs. Large
firms continue to shed high-wage jobs, particularly management
jobs.\41\
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\39\ Biotechnology Compensation and Benefits Survey, Radford
Associates/Alexander and Alexander Consulting Group (1995) and Biotech
'96: Pursuing Sustainability, Ernst and Young (10th Annual Survey).
\40\ Sixth Annual Economic of Venture Capital Study, NVCA/Coopers
and Lybrand LLP., 1996.
\41\ The Third Millennium: Small Business and Entrepreneurship in
the 21st Century, Small Business Administration, Office of Advocacy,
from data compiled by Joel Popkin and Company (Special publication
prepared for delegates to the 1995 White House Conference on Small
Business).
---------------------------------------------------------------------------
In addition to high wages, entrepreneurial firms use
incentive stock options to compensate and motivate employees.
These stock options tend to be granted to all employees, not
just the elite management. For example, in the biotechnology
industry 80% of the firms had stock option plans and 82% of
these were company wide.\42\
---------------------------------------------------------------------------
\42\ Biotechnology Compensation and Benefits Survey, Radford
Associates/Alexander and Alexander Consulting Group, 1995.
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Quality of Life Impact: These entrepreneurial firms create
new products that in themselves create or stimulate new
industries. Entrepreneurial companies have a multiplier impact
on the creation of jobs and new economic growth. For example
the creation and growth personal computer and biotechnology--
whole new industries--resulted from the catalyst of
entrepreneurial firms. Changes in job growth also signal
changes in the structure of the larger economy. The growing
significance of entrepreneurial firms to job growth signals a
change of the economy and appreciation for the underlying
strength and dynamism of the economy. We are in a massive
restructuring of the American economy--the transition from a
declining industrial/manufacturing economy to an emerging
entrepreneurial/innovation-driven economy.
Entrepreneurs are Leaders in Research and Innovation
Research and innovation is one of the keys to economic
growth and American high-technology firms are the word's
leaders in innovation.
Technological Change: The State of Small Business Report
finds that technological change is responsible for a
significant portion of increases in the standard of living.\43\
The Office of Science and Technology Policy reports, A large
and growing body of research indicates that new, small firms
are the major force for technological change in our economy by
innovating more efficiently than their larger counterparts.\44\
---------------------------------------------------------------------------
\43\ State of Small Business Report, 1994, Small Business
Administration, at 109.
\44\ A Profile, OSTP, at 2.
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The Council of Economic Advisors finds that advances in
knowledge contribute importantly to the Nation's real economic
growth; about one-half of all growth in output per capital has
been attributed to the technological knowledge and managerial
and organizational know-how \45\ and that technology changes
alone are responsible for about 30 percent of the increases in
gross domestic product between 1947 and 1992.\46\ It has found
that technological change has played a central role in economic
growth \47\ and that these innovations have led to a
transformation of society over the past two centuries.''\48\
---------------------------------------------------------------------------
\45\ Economic Report of the President, 1989, U.S. Council of
Economic Advisors, at 223.
\46\ Economic Report of the President, 1994, U.S. Council of
Economic Advisors, at 44.
\47\ Economic Report of the President, 1990, U.S. Council of
Economic Advisors, at 111.
\48\ Economic Report of the President, 1992, U.S. Council of
Economic Advisors, at 111.
---------------------------------------------------------------------------
Research Intensity: Small firms tend to be more research
intensive. This research intensity is critical to our standard
of living. The estimated rate of return on private R and D
spending range from 20% to 50%, but the rate of return to
society has been estimated to be about double the private rate
of return.\49\
---------------------------------------------------------------------------
\49\ Economic Report of the President, 1989, U.S. Council of
Economic Advisors, at 223.
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The percentage of domestic employees who were R and D
scientists and engineers was 6.41 percent in small R and D
firms and 4.05 percent in large firms and R and D funds as a
percentage of domestic net sales were 4.25 percent in small
firms and 3.89 percent in large firms.\50\
---------------------------------------------------------------------------
\50\ State of Small Business Report, 1994, Small Business
Administration at 115-117 (citing U..S. Census data).
---------------------------------------------------------------------------
One study of intellectual property finds small technology
firms to be more research-intensive than larger firms. The
median R and D expenses as a percent of sales was 5% of less
for large firms with intellectual property and 11% for small
firms.\51\ 14% of the small firms having R and D expenses which
were more than 40% of sales and there were no large firms with
R and D expenditures of this magnitude.\52\
---------------------------------------------------------------------------
\51\ State of Small Business Report, 1994, Small Business
Administration, at 117.
\52\ State of Small Business Report, 1994, Small Business
Administration, at 117.
---------------------------------------------------------------------------
The staggering research intensity of high technology firms
is confirmed each year in the Business Week survey on R and D
expenditures.\53\ The survey measures the percentage of
increase in absolute terms and also the research intensity as a
percentage of sales or on a per employee basis. The 1995 survey
finds a 14% increase in R and D by electrical and electronics
firms, which spent $9.6 billion on research, 5.7% as a
percentage of sales, and $8,257 per employee. Office equipment
and sales firms spent $15,898 per employee on research, health
care firms spent $18,451 per employee, and chemicals spent
$10,289 per employee. The all industry averages are 4%
increases, 3.5% as a percentage of sales, and $7,651 per
employee.
---------------------------------------------------------------------------
\53\ ``Blue-Sky Research Comes Down to Earth,'' Business Week, July
3, 1995, at 78-80.
---------------------------------------------------------------------------
In terms of spending per employee the top ten firms were
all high technology firms: Biogen (biotechnology), $210,654 per
employee; Genetics Institute (biotechnology), $114,943;
Genentech (biotechnology), $112,030; Immunex (biotechnology),
$102,719; Amgen (biotechnology), $91,266; S3 (multimedia
chips), $82,548; Cyrix (computer hardware) $80,113; Adobe
Systems (software), $70,993; Platinum Technology (hardware and
software), $69,787; and Altera (hardware and software),
$68,956.
In relation to sales the top research firms were Genetics
Institute, 82.6%; Biogen, 65%; Platinum Technology, 54.2%;
Immunex, 53.7%; Chiron (biotechnology), 44.7%; Genentech,
40.8%; Continuum (software), 34.3%; Viewlogic Systems
(hardware), 30.8%; Alza (biotechnology), 29.2%; and MacNeal-
Schwendler (software), 29.2%.
In terms of total spending on research the top firms were
General Motors, $7 billion; Ford Motor, $5.2 billion; IBM, $3.4
billion; AT&T, $3.1 billion; Hewlett-Packard, $2 billion;
Motorola, $1.9 billion; Boeing, $1.7 billion; Digital
Equipment, $1.3 billion; Chrysler, $1.3 billion; and Johnson
and Johnson, $1.3 billion.
Another study regarding firms with new products found that
small firms obtained more patents per sales dollar than larger
firms even though small firms were less likely to obtain
patents than larger firms, indicating that the finding
understates the point.\54\
---------------------------------------------------------------------------
\54\ State of Small Business Report, 1994, Small Business
Administration, at 119 (citing a study by John Hansen, Utilization of
New Data for the Assessment of the Level of Innovation in Small
American Manufacturing Firms, study commissioned by the SBA, 1989).
---------------------------------------------------------------------------
Biotechnology Industry Research: The biotechnology industry
is one of the most research intensive industries in the
civilian manufacturing sector. The average biotechnology
company spends $71,000 per employee on research, more than nine
times the U.S. corporate average of $7,650.\55\ Ernst & Young
\56\ reports that biotechnology companies spent $7.7 billion on
research and development in 1995, up eight percent over 1994.
---------------------------------------------------------------------------
\55\ Back to Basics, Business Week, July 3, 1995, at 78.
\56\ A fiscal year for Ernst & Young is from July 1 through June
30. Therefore, 1995 indicates July 1, 1994 through June 30, 1995.
---------------------------------------------------------------------------
Software Industry Research: The success of the software
industry, and its growth of high paying, high-skill jobs is
attributable to its heavy investment in research and
development of new products. Approximately 85 percent of the
products sold by U.S. software companies are developed in-
house. At the typical U.S. software company, the largest
department, in terms of number of employees, is the research
and development department. U.S. software companies spend
approximately 15 percent of their revenue on R&D, with half of
R&D expenditures going to salaries and benefits for employees.
Only by maintaining high levels of R & D spending can U.S.
software companies retain their global technological
leadership.
The industry as a whole designates 20 percent of employee
resources for research and development of new products. A
recent study found that small and mid size companies allocate
more resources to R&D than do their larger counterparts in the
industry. Specifically, companies with revenue less than $1
million and between $1-$10 million designate 30 and 23 percent
of their respective labor resources.\57\
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\57\ 1996/97 Software Business Practices Survey, Price Waterhouse
LLP, Massachusetts Software Council, Inc., Software Publishers
Association, Information Technology Association of America (sixth
annual) 1996, at 38.
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Research at Venture Capital-Backed Firms: Venture capital-
backed companies tend to be research-intensive. By the time a
typical venture-backed company is five years old, it has
already invested $13.5 million to create breakthrough products
and services. From 1990 to 1994 these firms increased their R
and D investment by 36%, compared to only 11% for Fortune 500
firms. The average R and D per employee is $20,000, compared to
only $9,000 for a Fortune 500 firm. Over the past five years,
venture-backed companies increased their investment in R and D
at twice the rate of Fortune 500 companies, 30% compared to
14.7%. \58\
---------------------------------------------------------------------------
\58\ Economic Impact of Venture Capital Study, Coopers and Lybrand
(Sixth Annual), 1996.
---------------------------------------------------------------------------
Firm-University Ties: The relationship between
entrepreneurs and research-intensive universities is found in
another study. New small technology-based firms were found to
be much more likely to be formed close to these universities,
non-profit research institutions and other high technology
firms.\59\
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\59\ State of Small Business Report, 1994, Small Business
Administration, at 120 (citing a study by Stephen Geoffrey Graham, The
Determinants of the Geographical Distribution of the Formation of New
and Small Technology-based Firms, 1981 Michigan State University Phd.
Dissertation).
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Research intensity is directly related to innovations which
can change our economy and change our lives. It is no surprise
to find that research-intensive firms are prolific innovators.
Small Firms as Innovators: The Small Business
Administration has completed a comprehensive study of 8,074
innovations in 363 industries from 46 technology, engineering,
and trade journals and found that small firms were responsible
for 55 percent of the innovations.\60\ The study found that
small firms produce twice as many product innovations per
employee as large firms and twice as many significant
innovations per employee.\61\ A previous study has estimated
that the ratio is 2.45 innovations per employee of small to
large firms.\62\
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\60\ State of Small Business Report, 1994, U.S. Small Business
Administration, at 113.
\61\ State of Small Business Report, 1994, at 114.
\62\ Earl E. Bomberger, The Relationship Between Industrial
Concentration, Firm Size, and Technology Innovation (SBA commissioned
report cited in 1994 State of Small Business Report at 114, note 20.)
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List of Innovations: The Small Business Administration has
prepared an impressive list of important innovations brought to
market by small firms.\63\ The list includes air conditioning,
air passenger service, the airplane, artificial skin, assembly
line, audio tape recorder, biomagnetic imaging, catalytic
petroleum cracking, continuous casting, cotton picker,
defibrillator, DNA fingerprinting, double-knit fabric,
electronic spreadsheet, FM radio, geodesic dome, gyrocompass,
heart valve, helicopter, human growth hormone, hydraulic brake,
integrated circuit, microprocessor, optical scanner, oral
contraceptives, outboard engine, overnight national delivery,
pacemaker, personal computer, photo typesetting, polaroid
camera, portable computer, prestressed concrete, pressure
sensitive cellophane tape, programmable computer, quick-frozen
foods, safety razor, six-axis robot arm, soft contact lens,
solid fuel rocket engine, strobe lights, supercomputer, vacuum
tube, xerography, X-ray telescope, and the zipper. There are
undoubtedly tens of thousands of other examples.
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\63\ State of Small Business Report, 1994, at 113.
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The reasons for high innovation levels in small, high-tech
firms are varied. Some studies focus on the greater economic
incentive to innovate in small firms and the bureaucracy of big
firms. Other studies suggest large firms may over-specialize
and cite reduced contact between customers and developers.
Whatever the reasons, the data clearly show the effectiveness
of innovation of small, entrepreneurial, high-technology firms.
Entrepreneurs Are Competitive
High technology firms provide the competitive advantage
American needs in new, high-growth industries. Success in this
competition is critical to America's economic prospects and
standard of living.
Level of Competition: Americans have the perception that
the level of competition has increased the pressure on U.S.
firms. This perception is accurate and arises from the fact
that the share of our gross national product that is involved
in internationally traded goods has doubled from 1950 to 1990
and now stands at 22.3 percent.\64\ This percent is projected
to rise to one-third during the next decade. There is increased
pressure.
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\64\ Data Resources Inc. projections.
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Competition is increasing from both developed and
developing countries and our vulnerability to pressure from
imports and our dependence on exports is growing. There is
pressure for higher quality and lower prices, better service,
and more innovation. The life-cycle of products, and the
ability of the innovator to maintain dominance in a given
market, has decreased.
Entrepreneurial firms are able to handle this pressure to
compete.
Venture Capital-Backed Firms: Venture capital-backed firms
aggressively grow export sales to improve our balance of
payments. Their average export sales growth was 57% (1993-
1994), up from 11% (1991-1992). This shows that these firms are
exploiting newly opened markets. The average venture-backed
firms grew its sales to employee 9 percent each year, more than
three times the productivity growth rate for the Fortune 500
companies.\65\
---------------------------------------------------------------------------
\65\ Economic Impact of Venture Capital Study, Coopers and Lybrand
(Sixth Annual), 1996.
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Our high technology firms are ready, willing, and able to
compete in international markets and they are our greatest
single economic strength in an increasingly competitive world
economy.
Biotechnology Industry Competitiveness: A case study of
American competitiveness is the biotechnology industry. The
United States currently has the dominant biotechnology industry
when compared with any other country in the world. Precisely
because the U.S. is preeminent in the field of biotechnology,
it has become a target of other country's industrial policies.
In 1991, the Office of Technology Assessment (OTA) found that
Australia, Brazil, Denmark, France, South Korea and Taiwan
(Republic of China) all had targeted biotechnology as an
enabling technology. Furthermore, in 1984, the OTA identified
Japan as the major potential competitor to the United States in
biotechnology commercialization.\66\
---------------------------------------------------------------------------
\66\ U.S. Congress, Office of Technology Assessment, Biotechnology
in a Global Economy 243 (October 1991).
---------------------------------------------------------------------------
The OTA also identified the manner in which Japan had
targeted biotechnology. The report stated,
In 1981, the Ministry of International Trade and Industry
(MITI) designated biotechnology to be a strategic area of
science research, marking the first official pronouncement
encouraging the industrial development of biotechnology in
Japan. Over the next few years, several ministries undertook
programs to fund and support biotechnology.
One of the Japanese ministries, the Ministry of Health and
Welfare (MHW), instituted a policy whereby existing drugs would
have their prices lowered, while allowing premium prices for
innovative or important new drugs, thus forcing companies to be
innovative and to seek larger markets.\67\
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\67\ U.S. Congress, Office of Technology Assessment, Biotechnology
in a Global Economy 244-245 (October 1991).
---------------------------------------------------------------------------
It is widely recognized that the biotechnology industry can
make a substantial contribution to U.S. economic growth and
improved quality of life. For example:
The National Critical Technologies Panel,
established in 1989 within the White House Office of Science
and Technology Policy by an Act of Congress, \68\ calls
biotechnology a ``national critical technology'' that is
``essential for the United States to develop to further the
long-term national security and economic prosperity of the
United States.'' \69\
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\68\ National Competitiveness Technology Transfer Act, Pub. L. No.
101-189, 103 Stat. 1352 (42 U.S.C. Sec. 6681 et seq.).
\69\ White House Office of Science and Technology Policy, Report of
the National Critical Technologies Panel 7 (1991).
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The private sector Council on Competitiveness also
calls biotechnology one of several critical technologies that
will drive U.S. productivity, economic growth, and
competitiveness over the next ten years and perhaps over the
next century.\70\
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\70\ Council on Competitiveness, Gaining New Ground: Technology
Priorities for America's Future 6 (1991).
---------------------------------------------------------------------------
The United States Congress' Office of Technology
Assessment calls biotechnology ``a strategic industry with
great potential for heightening U.S. international economic
competitiveness.'' OTA also observed that the ``wide-reaching
potential applications of biotechnology lie close to the center
of many of the world's major problems--malnutrition, disease,
energy availability and cost, and pollution. Biotechnology can
change both the way we live and the industrial community of the
21st century.'' \71\
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\71\ U.S. Congress, Office of Technology Assessment, New
Developments in Biotechnology: U.S. Investment in Biotechnology-Special
Report at 27 (July 1988).
---------------------------------------------------------------------------
The National Academy of Engineering characterizes
genetic engineering as one of the ten outstanding engineering
achievements in the past quarter century.\72\
---------------------------------------------------------------------------
\72\ National Academy of Engineering, Engineering and the
Advancement of Human Welfare: 10 Outstanding Achievements 1964-1989 2
(1989).
---------------------------------------------------------------------------
Global Competiveness of the Software Industry: The software
industry is another example of a competitive U.S. industry. The
software industry is a modern and evolving electronic industry
with revenues of more than $200 billion and a growth rate of
13% a year. Software is now one of the world's largest and
fastest-growing industries. Before the mid-1980's, most
computers were mainframes and minis that were sold with
proprietary software created by the manufacturer for the
computer. The hardware and operating systems software were
bundled together (the software was placed in the hardware), and
the customer usually paid for the software through the price
that was paid for the computer.
The development of personal computers spawned independent
software companies that sold software separately to PC buyers.
At the time, mainframe and mini hardware manufacturers began to
unbundle their products presenting independent software
companies with the opportunity to compete by offering ``open
systems'' of software for mainframes and minis that offered
customers more flexibility, performance and features.
Since then, the growth and competitiveness of the U.S.
software industry has exploded. The software industry
(prepackaged software, custom computer programming services,
and computer integrated design) contributed $36.7 billion of
value to the U.S. economy in 1992. Employment in the software
industry increased at double digit rates through much of the
1980's. It is estimated that nearly 500,000 people are
currently employed in the software industry.
Beyond the core industry, it is estimated that nearly 2
million U.S. jobs are tied to software programming, a number
which clearly eclipses all of our major international
competitors.
The U.S. software industry is also an export engine. The
U.S. makes an estimated 75% the pre-packaged software sold
worldwide, an amount exceeding $100 billion.
Foreign Sales Exports of U.S. Industries
------------------------------------------------------------------------
Industry 1994 (billions)
------------------------------------------------------------------------
Chemicals and allied products........................ $51.6
Agricultural sector.................................. 42.6
Automotive parts and accessories..................... 37.1
Aerospace............................................ 35.8
Computers and peripherals............................ 30.4
Petrochemicals....................................... 26.6
Prepackaged Software Sales........................... 26.3
Food and kindred products............................ 25.6
Electronic components and accessories................ 24.5
Motor vehicles and car bodies........................ 22.0
Semiconductors and related devices................... 18.0
Organic chemicals.................................... 12.3
Telecommunications equipment......................... 12.3
Paper and allied products............................ 11.1
Drugs................................................ 7.6
Textile mill products................................ 5.2
------------------------------------------------------------------------
These same themes can also be stated for wages. In 1992,
the average compensation per employee in the software industry
was over $55,000. Compensation grew at an annual rate of 8.4
percent from 1987 to 1992. Auto industry compensation grew at
the annual rate of only 4.6 percent, while the motion picture
industry wages grew at the rate of only .7 percent. Total
software industry payroll grew at an annual rate of over 20
percent from 1987 to 1992, going from little over $2 billion to
over $5 billion. By contrast, the recorded music industry grew
at the rate of only 4 percent, going from $266 million to $328
million., The motion picture industry payroll grew at the
relatively lackluster rate of 7.7 percent.
Small Firm Competitiveness: The OSTP study summaries the
way in which small firms enhance U.S. competitiveness in
international markets.
The importance of small high-tech firms to the U.S. economy
cannot be overstated; competition in the global economy will
inevitably mean that many of the most successful technology
firms will eventually succumb to competitive pressure, and as a
consequence, a viable pool of smaller firms must be available
to replace these firms with newer, updated technology
products.\73\
---------------------------------------------------------------------------
\73\ A Profile, OSTP study, at 2.
---------------------------------------------------------------------------
Foreign Acquisitions: However, American ownership of these
high technology firms is an issue. The OSTP study found that
outlays by foreign-owned firms to acquire U.S. high technology
firms rose sharply from 1988-1992, with Japan buying 65% of the
total including 40 advanced material companies, 19 aerospace
companies, 25 chemical companies, 93 computer companies, 33
electronics companies, 30 semiconductor equipment companies, 51
semiconductor companies, 31 telecommunications companies, 17
biotechnology companies, and 60 other high tech companies--a
total acquisition of 399 companies in a four year period.\74\
The United Kingdom was second in acquisitions with 65, France
acquired 41, Canada acquired 14, Germany acquired 17,
Switzerland acquired 14, and Taiwan acquired 11.
---------------------------------------------------------------------------
\74\ A Profile, OSTP study, at 24 (citing Economic Strategy
Institute database).
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Chairman Archer. Thank you, Mr. Wiggans.
In order to determine whether to ask this panel to come
back after lunch or whether to release them, are there Members
who wish to inquire?
I hate to ask you to come back after lunch in order to
respond to one Member, but the Chair is constrained. I have to
conduct a luncheon. So, what I will do is permit Mr. English to
Chair the Committee so that he may inquire and, subsequent to
his inquiry, release this panel. And then, the Committee will
return for the next panel at 5 minutes after 1 p.m.
Mr. English [presiding]. I thank the panel for staying. I
will keep this relatively brief, and I will consider this a
lesson to myself for inquiring. [Laughter.]
First of all, I am going to briefly have, at this point,
read into the record of the Committee a very thoughtful letter
that I had received from the American Business Conference that
speaks to some of the issues that we are addressing today,
particularly the effect of changes in the Tax Code, instability
in the Tax Code on capital gains, and the consequences it has
for the economy in general, and at this point, I will, without
objection. [Laughter.]
[The information follows:]
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Mr. English. Thank you.
Mr. Wiggans, I very much appreciated your testimony and
your reference also to the targeted capital gains bill that Mr.
Matsui and I have been promoting. I wonder if you could amplify
on your remarks and talk about how the capital gains tax
affects entrepreneurs who are trying to enter capital markets,
trying to finance innovations in the economy, and recognizing
that their ventures involve a fair amount of risk, How does the
capital gains tax affect people in your situation and your
ability to attract investors?
Mr. Wiggans. Well, first of all, let me thank you for your
support of these bills, because as I mentioned, they do seem to
be the solution to some of these issues. Let me simply say that
the investments that investors need to make in companies like
mine are unique. It requires patient capital; it requires
locked-up capital. As you pointed out, it is high risk capital.
So, it is a very unique type of investment that should
correspond with a different tier or a different type of
incentive.
Investors who originally made an investment in my company
or any biotechnology company for that matter must be willing to
not only risk that capital but at a minimum, have it locked up
for extended periods of time. There is no liquidity to venture
investments. If you invest in General Motors today and decide
you have changed your mind, you can sell it tomorrow. The
founding investors, the founding venture capitalists in my
company, cannot get their capital out. They are locked up for
years and years. So, I hope that answers your question.
Mr. English. That does, and I am grateful for that answer,
because it speaks directly to one of my concerns about the
capital gains tax, that it falls disproportionately on those
parts of our economy and even those communities, such as
depressed, inner-city areas that are least able to attract
investment because of the risks associated with it.
Mr. Bloomfield, I wonder, following through on this line of
questioning, in your view, is a capital gains incentive more
important to small businesses than to large businesses, and, in
your view, why?
Mr. Bloomfield. I do not think there is any doubt that
companies like Mr. Wiggans' may have more difficulty attracting
capital, but I think the extent to which we reduce overall
capital costs has big macro impact, which helps the economy as
a whole, in addition to certain segments. But if you talk about
the concerns Mr. Wiggins has about finding scarce capital, I am
not sure how many of you have seen this interesting article
that appeared in the Wall Street Journal about 2 or 3 weeks ago
called Found Money. When David Wyss refers to the fact that he
would take a finder's fee for finding $50 billion, in other
words, this is the true free lunch. What this article in the
Wall Street Journal suggests is we really have a lot of locked
up capital in the markets now that may not be reflected in a
lot of the revenue estimates. Let me give you an example: In
the period 1982 to 1985, realizations as a percentage of the
total value of equities in the United States were between,
let's say, 5 and 8 percent in that period. The stock market at
that time, or the value of equities, was about $2.2 trillion.
If you go a decade later, to 1995, you will find that
realizations as a percentage of total value of equities was not
between 5 and 8 percent but only 2 percent. If you apply that
same ratio of realizations, and you say that realizations
should have been at 7 percent, instead of revenues coming to
the Treasury in the range of $40 billion, revenues would have
been $70 billion. And when I am talking about the value of
equities being, in 1995, about $7 trillion, they are now $9
trillion.
What I am basically saying is that there is a heck of a lot
of locked up capital out there which might be unlocked which, I
think, would change a lot of the equations about the revenue
impact. That unlocking would provide capital for all Americans
but in particular would help capital-starved, risky enterprises
like Mr. Wiggans.
Mr. English. I wonder: Directed to all of the panelists,
and this will sound like, perhaps, an unusual question, Are any
of you familiar with the tax treatment under the capital gains
tax of dairy cows? Are any of you familiar with it? I must say,
2 years ago I had a new conference with a dairy cow in my
district named Bonnie, since deceased. No causal connection, I
might add. [Laughter.]
Mr. English. And I had discovered that dairy cows are taxed
as a capital gain at sale unless they are slaughtered. And what
typically happens in a situation like we are experiencing now
in northwestern Pennsylvania, where a lot of dairymen are under
enormous economic pressure, they are selling some of their
stock, and on tax day, they are getting slaughtered. So,
stipulating that the capital gains tax has, in many ways,
unforeseen and unpredictable effects on different parts of the
economy and given that, perhaps, the equity issues associated
with capital gains are not as clear cut as they frequently seem
to be in debate, I wonder if each of you could offer
observations as to what types of individuals and businesses
would most benefit from a capital gains tax reduction, starting
perhaps with Mr. Wiggans.
Mr. Wiggans. Well, I would point out that in the
biotechnology industry, it is very common practice to give all
employees stock options. Even the largest biotechnology
company, Amgen, still gives stock options to every single
employee. In many cases, that is in lieu of pension plans. So,
your sweat equity and your stock option equity are your
retirement plan. So, if I could focus, maybe, my answer on that
specific segment, from top to bottom in the company, from the
highest paid to the lowest paid, stock options are a tremendous
incentive economically, and the capital gains changes that you
have contemplated would have, I think, tremendous impact on
these employees.
Mr. English. Mr. Woodbury.
Mr. Woodbury. In the real estate industry, there are
several groups that might very well benefit. One is the most
creative people, because they will be the ones who will create
the projects that will end up with the most profit and the most
gain. And I think you do, as a matter of public policy, want to
reward those people who are creative and who produce value for
your economy.
Contrary to popular belief, our statistics show that there
are a large number of middle-income tax payers who hold real
estate capital assets, investment assets. Twenty percent, I
think, of those who report adjusted gross incomes under $50,000
a year hold real estate investment assets, and more than 30
percent of those who report income between $50,000 and $100,000
hold investment real estate assets. So, I think that it would
be a broad-based application to middle-income tax payers.
Last, it would help--and this is the locking effect that
people are referring to--people, probably, who have held assets
for a long time, who have run out of ideas; who are lazy. They
are just holding them because they do not know what to do with
them, and they do not want to pay the tax. By reducing the
capital gains tax, having a broad-based cut, I think it would
allow these people, motivate these people to sell, and it would
put those assets, again, in the hands of people who would maybe
renovate and improve the assets, which would increase the value
to the whole economy.
Thank you.
Mr. English. Mr. Wyss.
Mr. Wyss. I would divide it into three categories,
beginning with corporations. On the corporate side, what the
capital gains tax does is makes it more difficult to acquire
capital. Therefore, it penalizes the companies that are growing
the most rapidly and the companies that need the capital in
order to expand. I do not think it is primarily big companies
versus small companies; it is growing companies versus static
companies.
On the individual side, we do have to accept the fact that,
on average, the rich have more capital than the poor. The tax
cut is biased toward the high end of the income spectrum. That
is reality. It does not mean the poor lose; it just means they
do not gain as much as the wealthy. One exception to that is
the housing deduction, and I think this is a critical point for
the elimination of capital gains on housing, because you are
now hitting that time when the baby boomers are getting rid of
their kids. Maybe I am speaking too much as an individual, but
all I know is that my kids are both gone; my wife and I share a
bedroom; the cat does not need the other four bedrooms. But I
am not going to sell the house because I do not want to pay 28
percent on the sale value of that house, nor do I want to find
a condo downtown that is worth as much as my current house is.
That unlocking of capital is almost free. We are collecting
almost no revenue on it now, because I am not selling the
house. And why do we not use that capital a little more
productively than having the empty bedrooms.
Mr. English. Ms. Gravelle.
Ms. Gravelle. Well, I think the data show that there are
two kinds of assets that are responsible for virtually all the
capital gains taxes: Corporate stock and real estate. Those
shares fluctuate depending on how the stock market versus the
real estate market is doing. Right now, I think the big
fraction is in corporate stock. Most corporate stock is issued
by large corporations; therefore, most of the capital gains tax
cut would have to do with the owners of shares of large
corporations.
You mentioned earlier small businesses. A lot of small
businesses are not incorporated, so they would not have an
effect. And, of course, small businesses issuing new shares are
already eligible for a 50-percent exclusion. So, I would say
basically, large corporations, and although many middle-income
people have shares in large corporations, the assets,
particularly equity assets, are concentrated at the higher end
of the scale.
Mr. English. Mr. Bloomfield.
Mr. Bloomfield. Mr. English, I would make four points. The
first point is, Who owns capital assets. And, as I indicated,
CBO points out that 31 percent of people with incomes of
$20,000 or below actually have capital assets excluding their
home. If you talk about from zero to $50,000, you get an even
higher amount. So, a lot of middle-class people have capital
assets.
The second point I would make is, When the Joint Committee
or CBO occasionally talks about income distribution, they may
artificially inflate a person's income because he may have once
or twice or three times in his lifetime have a capital gain.
Mr. English. On that point, Mr. Bloomfield, I understand
that roughly 44 percent of the people who pay the capital gains
tax have had only one realization during the prior 5-year
period. Does that suggest to you that many of the people who
pay the capital gains tax in fact are not large investors but
individuals who have a single asset, which they sell, that puts
them temporarily in a different income category?
Mr. Bloomfield. I think that data is true, and there is
even more recent data by CBO which looked at people with an
income of $50,000, and they only had a capital gain 3 out of 10
years. So, people do occasionally have capital gains, and a lot
of people have capital gains.
The third point I would make is David Wyss' point about who
benefits. In reference to Ms. Gravelle's comment about
corporate stock, the Investment Co. Institute recently released
data that indicated of those people with incomes of $50,000 or
less, 60 percent of those families have mutual funds. So, we
are talking about a growing percentage. Mutual funds as a
percentage of capital gains realizations, quite frankly, is one
sector that has grown dramatically, from 3 percent of all
capital gains to 13 percent. So, individuals benefit from
capital gains and capital gains reduction because of their
pensions.
Second, there are a lot of people who have dairy cows or
other small businesses who benefit because of the tax treatment
of their investment in small businesses. And finally, which is
also very, very important, as Dr. Wyss pointed out, the average
American benefits from the higher productivity of a lower tax
on capital. Finally, Mr. English, unfortunately, I do not have
any personal knowledge of dairy cows, but I did read in the
paper the other day about a painter who said that he supported
a capital gains tax cut because he had never been hired by a
poor person. And so, I think both directly, in terms of what
they own, or indirectly, because of its economic impact, all
Americans benefit from a lower tax on capital or capital gains.
Mr. English. Thank you. One final question I would like to
pose to the entire panel, and it has to do with the fact that
we are contemplating with limited revenue opportunity, perhaps,
a capital gains reduction this year as part of an overall tax
package. I wonder, starting again with Mr. Wiggans, in summary,
in your view, What are the most important issues for the
Committee to keep in mind in designing a capital gains
reduction?
Mr. Wiggans. I guess I would answer it two ways. I think
the macroeconomic data on the productivity and the job creation
and the benefits of a broad capital gains tax is clearly one
set of issues. I would then focus on the specific issues
associated with the capital required to fund small, emerging
companies; the technology generated, and the innovation in
those small companies; the new therapies, life-saving therapies
in many cases, is the second category.
So, clearly, there are macroeconomic benefits. I think
those situations at least here seem to be well documented. The
targeted gains for emerging companies where the innovation
occurs, where biotechnology companies bring new therapies
forward, there is also the human element of that, the very real
human element of that in addition to the economic benefit.
Mr. English. Mr. Woodbury, which issues would you like us
to keep in the front of our minds as we consider capital gains
tax reduction?
Mr. Woodbury. As I said in my testimony, we feel there are
two basic criteria. One is that, besides the principal
residence proposal, which we think is a separate issue and is a
simplification issue more than anything else, we believe the
capital gains reduction should be broad based and apply equally
to all industries and then, let the private sector determine,
based on a risk-reward basis, where to put that capital. It
should also have enough differential between the ordinary
income tax rate to provide an incentive, and I think several of
the bills, H.R. 14, the 50-percent reduction, is a broad enough
basis to provide that, and those are the two criteria.
Mr. English. Thank you, Mr. Woodbury.
Dr. Wyss, what issues should we keep first and foremost?
Mr. Wyss. Well, first of all, I am very much in favor of
keeping the tax law simple. Getting rid of the capital gains on
housing as much as possible is a good step in that direction,
since that is a complication which yields no revenue. But on
the rest of the capital gains, I would also tend to echo the
same sentiments of the previous speaker: Keep it simple by
keeping the same rate across the board, and let the market
decide where the money should go rather than to try to target
capital gains in a way that favors one sector over another.
Mr. English. Ms. Gravelle.
Ms. Gravelle. Well, I do think one thing the Committee
ought to be very careful about is to pay attention to the
revenue costs of these proposals. As I indicated at the
beginning and ending of my testimony, the Joint Tax Committee
already includes a very generous dynamic offset for capital
gains, and there has been some recent evidence that suggests
that even that offset may actually be too large. And if we add
to the deficit, I think we are doing it in a way that is very
costly for savings.
The other important thing is to keep track of the cost over
time, because even though you might have a realizations
response or possibly even an asset response, that is a
transitory effect, and these provisions will likely cost much
more revenue in the future. I think it is very important to
have a longtime horizon; look out beyond 5 years and to try to
think about the future. That is particularly true if you talk
about prospective capital gains tax cuts, such as indexing or
exclusions for any new assets that tend to grow very fast.
So, I think the revenue issue, as we all know, is a very
important one to pay attention to, and I think there are lots
of issues. There are issues of equity, efficiency, and
simplicity. But I do urge you to not forget about simplicity
along the way and, in particular, the efforts of some kinds of
tax changes. For example, indexing would be much more
complicated than an exclusion in terms of tax compliance. I
think those are issues that tend to get swept aside sometimes,
and they are sort of important to remember.
Mr. English. Thank you.
Mr. Bloomfield.
Mr. Bloomfield. Mr. Chairman, let me suggest three areas
that you ought to look at to make sure or to increase the odds
that you will enact a sensible capital gains tax cut. The first
issue is one of being fiscally responsible, and I do not think
there is any doubt, none of us here or none of those on this
Committee would want to do anything that would be fiscally
irresponsible. I think David Wyss and others have indicated
that this is one of those few tax cuts that is a free lunch.
I would point out, with some disagreement with Ms.
Gravelle, it is true that the Joint Committee does take into
account the unlocking factor. It takes into account the
reclassification of income from ordinary into capital gains.
But it does not take into account the macroeconomic impact of a
higher GDP, nor does it take into account the impact of higher
asset values. If you look at a mainstream economic model like
Alan Sinai's or DRI--take, for example, the Hatch-Lieberman
bill--what you would find is a revenue gain in the range of
between $8 billion under David Wyss' analysis and up to $40
billion under Alan Sinai's.
So, I think you need to look at that, and I think that is a
fair way to look at capital gains. You need to be revenue
responsible. I do not think you are going to lose money, and
you might pick up money.
Second, I think you need to be fair, and by being fair, I
do not think you should favor one asset over another. I would
encourage you to make sure the dairy cows of your congressional
district are eligible assets, as well as the new biotech
developments in Silicon Valley.
And finally, a proposal needs to make economic sense, and
to do so, it needs to meet only four criteria: You should
reduce the capital costs, encourage the mobility of capital,
prevent the taxation of inflationary gains, and you ought to
encourage entrepreneurship. If you meet those four criteria,
you are doing something worthwhile. I would caution, however,
if you do not meet those criteria, or the tax cut is so small
it is negligible, a capital gains tax cut in name may not be
worth much in reality.
Mr. English. Thank you, Mr. Bloomfield, and I want to thank
the entire panel for providing this very enlightening, diverse,
and extremely--in each case--thoughtful testimony. I
appreciate, really, the responses you provided, because I think
they point the way for this Committee to make some significant
changes, hopefully this year, in the Tax Code that will create
new incentives for investment back into the economy and
hopefully unlock assets that could be more productively used
elsewhere.
In my view, this is a very important issue, and we very
much appreciate the contribution this panel has made to our
deliberations. With that, without objection, I am going to
recess the panel until 1:05 p.m.
Thank you.
[Whereupon, at 12:32 p.m., the Committee recessed, to
reconvene at 1:05 p.m., the same day.]
Chairman Archer [presiding]. The Committee will come to
order.
The Chair apologizes to our witnesses for being 5 minutes
late, but hopefully, that is good enough for government work.
We are happy to have you with us today, and we look forward
to the testimony from each one of you.
Mr. Whelan, would you lead off, identify yourself for the
record----
Mr. Whelan. Yes, sir.
Chairman Archer [continuing]. And then you may proceed.
Hopefully, all of you will limit your oral testimony to 5
minutes, and your entire printed statement will be inserted in
the record.
STATEMENT OF MARTIN J. WHELAN, PRESIDENT, ETTLINE FOODS CORP.,
YORK, PENNSYLVANIA; ON BEHALF OF FOOD DISTRIBUTORS
INTERNATIONAL, FALLS CHURCH, VIRGINIA
Mr. Whelan. Good afternoon, Mr. Chairman and Members of the
Committee. I am Martin Whelan, president of Ettline Foods
Corp., a privately owned distributor of food service products
located in York, Pennsylvania's, 19th District, and a member of
Food Distributors International.
At the request of the Committee, I will limit my testimony
to a few short minutes. Food Distributors International has
provided the Committee with my written comments, which we would
like to appear in the official record of this hearing.
Mr. Chairman, I am very pleased to have the opportunity to
appear before you today to discuss estate taxes which the food
distribution industry prefers to call death taxes. I commend
you for holding these hearings on this very important subject
matter.
You may recall that one of my colleagues in the food
distribution industry, William Eacho, had the opportunity to
testify before this Committee during the 104th Congress on the
same issue, and our message remains the same: The tax should be
repealed.
Ettline Foods Corp. is a privately owned distributor of
food service products. Ettline was founded in 1889 by Oscar
Ettline and was at that time a general store whose customers
were farmers and local people. Today, 109 years later, the
company is a broad-line food service distributor, serving over
1,300 customers in three States. Our customers are restaurants,
institutional food service users, and grocery and convenience
stores.
Over the years, Ettline has remained a family owned and
operated company. My family purchased the company 8 years ago,
following the retirement of Doyle Ankrum, and we became the
fourth family to own this business. When I purchased Ettline in
1989, the company employed 48 people. I am very proud to say
today, we employ 105 people.
My family has reinvested all of our aftertax profits into
facilities, equipment, and working capital. Additionally, I
have chosen to limit my compensation in order to support the
growth of the business. Over the past 2 years, we have invested
approximately $4.5 million in additional capital, and as a
result of all these efforts, we have more than doubled the
sales volume of our business and added more than 20 full-time
employees to our payroll.
Mr. Chairman, there is a very personal reason for my being
interested in the death tax issue. I have a terminal illness
that mandates constant planning for the managerial succession
of my business and the financial security of my family after my
death.
As a result, I spend several thousand dollars each year to
keep on retainer an estate tax lawyer and a tax accountant who
assist in keeping me abreast of any changes in tax regulations,
as well as reviewing changes in my company's assets.
I cannot help but feel that this is a nonproductive use of
assets. It could be used to continue to grow the business and
create more jobs in York. Estate planning is a time-consuming
and expensive process. However, in my case, it is a very
necessary process.
Yet, when all is said and done, I still worry knowing that,
after all this money and effort, the continuity of my family's
business continues to be at risk.
I have four children, three of whom are still in college.
One of my children has expressed an interest in working in the
family business, and I want to ensure that if my daughter so
chooses, she inherits a financially sound company.
If at my death Congress has yet to act on this issue, my
company's capital structure may very well be impaired, causing
at best the stagnation of Ettline, and at worst, the demise of
my family business and the loss of a significant number of
jobs.
Privately held independent businesses are the backbone of
our free enterprise system. Small businesses, which for the
most part are family owned, are where two-thirds of all new
American jobs are currently being created.
Therefore, it is ironic to me that the Federal Government
would penalize family owned businesses with an unfair and
confiscatory tax. If small businesses are so important to the
growth of this Nation, then companies such as mine should be on
a level playingfield with larger public companies that are not
subject to estate or death tax burdens.
President Clinton in his budget proposal provides estate
and gift tax relief. However, in my opinion, his proposal falls
short of ensuring that privately held family owned businesses,
such as my own, will be able to survive being passed on to
future generations.
Earlier during this hearing, we heard arguments for
reducing the capital gains tax rate. While the food
distribution industry certainly supports reducing the capital
gains tax rate, we point out that there is an even greater
justification for lowering the death tax rate. I say that
because capital gains are realized through the voluntary sale
of a business or other asset. Whereas, estate transfers are the
result of a death, which is involuntary.
I am not a wealthy man. I sit before you today, a humble
man from York. In my business, the days are long, the work is
hard, the profits are slim.
When I bought my company 8 years ago, I also bought a piece
of the American dream. I would like to think I represent what
is still good about this country of ours, the spirit of
entrepreneurship and hard work. With the low profit margins in
our industry, Ettline is simply not liquid enough to be able to
pay this burdensome tax. At a top tax rate of 55 percent, my
family and many others would simply be unable to maintain the
continuity of the business.
With the small amount of revenue that is generated by the
tax, the economic devastation hardly seems worth it. The death
tax costs the government and taxpayers almost as much in
administrative and compliance fees as it raises in revenue.
I am not only concerned for the well-being of Ettline and
our employees, but also the hundreds of family owned
restaurants and mom-and-pop grocery and convenience stores who
are my customers. I would be remiss if I did not commend those
lawmakers here in the House who have introduced legislation to
repeal the Federal death tax.
The food distribution industry applauds their tough stand
against this onerous tax. It is my understanding that Members
of this Committee are working together to craft bipartisan
legislation that provides significant relief from death taxes
by using a three-pronged approach: Increasing the unified
credit, providing a special family business carve-out, and
reducing the estate tax rates. Of these three approaches, it is
obvious that rate reduction is the only true and viable
approach that is on the path to full repeal.
Therefore, short of repeal, the food distribution industry
strongly urges this Committee to rally its support around this
type of approach. I strongly believe it is incumbent upon this
Congress to enact meaningful death tax relief legislation this
year. To do otherwise is simply unconscionable. However, by
doing so, this Congress would be sending a message to the
American people that recognizes the importance of family owned
business and the contributions that they make to this great
Nation.
The future of Ettline's employees and the millions of
employees of other family owned businesses rest in your hands.
Thank you for having me here, and I look forward to
answering your questions.
[The prepared statement and attachment follow:]
Statement of Martin J. Whelan, President, Ettline Foods Corp., York,
Pennsylvania; On Behalf of Food Distributors International, Falls
Church, Virginia
Introduction
Good morning, Mr. Chairman and members of the Committee, I
am Martin J. Whelan, President of Ettline Foods Corporation and
a member of Food Distributors International. I am very pleased
to have the opportunity to appear before you today to discuss
estate taxes, which the food distribution industry prefers to
call death taxes.
I commend you, Mr. Chairman, for holding these hearings on
death taxes, as well as the other savings and investment
provisions included in the Clinton Administration's Fiscal Year
1998 budget proposal. You may recall that one of my colleagues
in the food distribution industry, William Eacho, III, had the
opportunity to testify before this Committee last Spring,
during the 104th Congress, on the same issue. Our message
remains the same--the death tax should be repealed.
Background on Food Distributors International
Food Distributors International (FDI), the group that
represents the interests of Ettline Foods Corporation in
Washington, DC, is an international trade association comprised
of food distribution companies which primarily supply and
service independent grocers and foodservice operations
throughout the United States, Canada and more than 20 other
countries. FDI's 266 member companies operate 1139 distribution
centers with a combined annual sales volume of $142 billion.
Their members employ a work force of over 350,000 and, in
combination with their independently owned customer firms,
provide employment for several million more people.
Roughly 30 percent of FDI's members are small, privately
held family-owned businesses. They provide employment for over
22,000 people, and have a combined annual sales volume of over
$7.5 billion. These businesses, along with FDI's other member
companies, supply and service thousands of family-owned grocery
stores and restaurants across the country.
FDI is also a member of the Family Business Estate Tax
Coalition, which is made up of approximately 100 organizations
who support the elimination of the estate tax. I have attached
an ad on the death tax that FDI placed in the March 3rd edition
of The Washington Times.
Background on Ettline Foods Corporation
Ettline Foods Corporation is a privately owned distributor
of foodservice products, located in York, Pennsylvania. Ettline
was founded in 1889 by Oscar Ettline, and was at that time a
general store whose customers were farmers and local people.
Today, 109 years later, the company is a broadline foodservice
distributor serving over 1,300 customers in three states. Our
customers are restaurants, institutional foodservice users, and
grocery and convenience stores.
Over the years, Ettline has remained a family-owned and
operated company. The Whelan family purchased the company 8
years ago, following the retirment of Doyle Ankrum, and became
the fourth family to own the business. When I purchased Ettline
in 1989, the company employed 48 individuals. I am proud to say
that today we employ 105 people.
My family has reinvested all of the after-tax profits into
facilities, equipment, and working capital. Additionally, I
have chosen to limit my compensation in order to support the
growth of the business. Over the past two years, we have
invested approximately $4.5 million in additional capital and,
as a result of all of these efforts, have more than doubled the
sales volume of our business and added more than 20 full-time
employees to our payroll.
Ettline's number one goal for 1997 is to give all of its
employees the opportunity to exercise their skills, and to
provide training and continuing education so that they are able
to advance their careers. At Ettline, we strive to create a
family-oriented environment, by holding such annual activities
as an Easter egg hunt, a company-wide picnic, and an end-of-
the-year holiday party. All of our employees are encouraged to
bring their entire families and to participate in these events.
At Ettline, we also believe it is important to give
something back to the community that has supported our business
over the years. Therefore, we encourage our employees to become
involved in community-based activities. Of the many things that
Ettline quietly does within the community, I would like to
mention that each week my company contributes its excess
inventory to the York City Food Bank. I am also a board member
of Our Daily Bread, a soup kitchen located in York.
The Need for Estate/Death Tax Relief
Mr. Chairman, there is a very personal reason for my being
interested in the death tax issue. I have a terminal illness
that mandates constant planning for the managerial succession
of my business, and the financial security of my family after
my death. As a result, I spend several thousand dollars each
year to keep on retainer an estate tax lawyer and a tax
accountant, who assist in keeping me abreast of any changes in
tax regulations, as well as reviewing changes in my company's
assets.
I cannot help but feel that this is a non-productive use of
assets that could be used to continue to grow my business and
create more jobs in York. Estate planning is a time-consuming
and expensive, but--in my case--necessary process. Yet, when
all is said and done, I still worry knowing that all of this
prudent planning will not alleviate my heirs of a heavy tax
burden, and that the continuity of my family's business is at
risk.
I have four children--ages 25, 22, 21 and 20, three of whom
are still in college. One of these four children has expressed
an interest in working in the family business, and I want to
ensure that, if my daughter so chooses, she inherits a
financially sound company.
Unfortunately, if we do not act now to provide family-owned
businesses substantive relief from the death tax, my daughter
just might be unable to move our company forward in the next
millineum. If, at my death, Congress has yet to act on this
issue, my company's capital structure may very well be
impaired, causing, at best, the stagnation of Ettline and at
worst the demise of my family business and the loss of a
significant number of jobs.
We continue to hear that privately held, independent
businesses are the backbone of our free enterprise system.
Small businesses, which for the most part are family-owned,
comprise 99 percent of the private sector, employ 60 percent of
all working Americans, and are responsible for 50 percent of
gross domestic product and 30 percent of U.S. exports. Finally,
these small businesses are where two-thirds of all new American
jobs are currently being created.
Therefore, it is ironic to me that the federal government
would penalize family-owned businesses with this unfair,
confiscatory tax. It would seem to me that if small businesses
are so important to the growth of this nation, then companies
such as mine should be on a level playing field with larger
public concerns--companies that are not subject to estate/death
tax burdens.
According to a letter Senator Phil Gramm sent to an FDI
member, unless we achieve significant changes in the estate tax
law, this nation ``will be put in the position where virtually
every family farm and every family business would have to be
sold or severely penalized to pay taxes on wealth that has been
built up over the years with after-tax income.'' \1\
---------------------------------------------------------------------------
\1\ Letter from Senator Gramm to member of Food Distributors
International.
---------------------------------------------------------------------------
The Disincentive Effects of the Estate/Death Tax
Mr. Chairman, the food distribution industry agrees with
your statement--in announcing these hearings--that an overhaul
of the current tax system would provide ``a more lasting way to
encourage savings and investment and produce a stronger
economy, and that until that goal can be reached, we should
enact changes to our tax system that reduce disincentives to
save and invest.'' I am glad we agree that the death tax
provides such a disincentive.
President Clinton, in his Fiscal Year 1998 budget proposal,
provides estate and gift tax relief by increasing the amount of
property eligible for a favorable interest rate on deferred
estate tax, and eliminating certain distinctions based on form
of ownership. In my opinion, the President's proposal falls
short of ensuring that privately held/family-owned businesses,
such as mine, will be able to survive being passed on to future
generations.
I was raised to believe that hard work would be rewarded.
How can--in good faith--instill that same message in my
children, when I know that upon my death the government will,
in effect, confiscate the value of my lifetime of work? Is that
how I am to be rewarded? Is that really the message this
Congress wants to send to America's aspiring entrepreneurs?
Believe me, I am not searching for a ``hand out,'' I just want
the ability to pass down to my heirs--unencumbered--what is
rightfully theirs.
Earlier during this hearing, we heard arguments for
reducing the capital gains tax rate. And while the food
distribution industry certainly supports reducing the capital
gains tax rate, we point out that there is an even greater
justification for lowering the death tax rate. I say that
because capital gains are realized through the voluntary sale
of a business or other asset, whereas estate transfers are a
result of death, which is involuntary. Simply put, Mr.
Chairman, death taxes steal from America's family-owned
businesses.
Impact of Estate/Death Taxes on Small Businesses
Since last year, I believe we have made significant headway
in dispelling the notion that death taxes affect only the
wealthy. We cannot afford to let demagoguery and class warfare
overshadow the merits of reducing a tax that kills. This issue
is far too important to succomb to those sorts of attacks.
I am not a wealthy man. I sit here before you today a
humble man from York. In my business, the days are long, the
work is hard, and the profits are slim. When I bought my
company 8 years ago, I also bought a piece of the American
dream. I would like to think that I represent what is still
good about this country of ours--the spirit of entrepreneurship
and hard work.
The food distribution industry as a whole is not a
particularly ``wealthy'' industry. It is important to note that
in 1995, profits before tax as a percent of sales for
foodservice distributors were only 2.2 percent--the highest
level since 1987. This measure for wholesale grocers was 1.3
percent--down from 1.6 percent in 1994.\2\ Similarly, the
profit margin in the restaurant and grocery business is also
narrow.
---------------------------------------------------------------------------
\2\ 1996 Distributor Productivity Financial Report Falls Church,
VA: Food Distributors International, 1996
---------------------------------------------------------------------------
Again, as I stated earlier, my family has invested all of
its after-tax profits into facilities, equipment, and working
capital. It is commonplace for companies such as mine to
reinvest their profits into the business, in order to grow that
business. Most small businesses would be unable to survive
without the reinvestment of profits.
Therefore, it should become painfully clear that businesses
such as Ettline are simply not liquid enough to be able to pay
this burdensome tax. At a top tax rate of 55 percent, my
family--and many others--would simply be unable to maintain the
continuity of the business.
For the small amount of revenue generated by the death tax
(approximately one percent of all federal revenues), the
economic devastation hardly seems worth it. Furthermore, the
death tax costs the government and taxpayers almost as much in
administrative and compliance fees as it raises in revenue. To
be more precise, these fees account for 65 percent of every
dollar collected.
I would like to make it clear that I am not only concerned
for the well-being of Ettline and our employees, but also the
hundreds of family-owned restaurants and grocery and
convenience stores who are my customers. These businesses rely
upon Ettline to supply their needs, and their customers--the
American people--rely on them for the food they eat everyday.
Conclusion
I would be remiss if I did not commend Representatives
Christopher Cox, Phil Crane, Wally Herger, Amo Houghton, Kenny
Hulshof, Bob Livingston, Mike Pappas, Joseph Pitts, Gerald
Solomon, Bob Stump, William Thomas, and William Thornberry \3\
for sponsoring legislation to repeal the federal death tax. The
food distribution industry applauds their tough stand against
this onerous tax.
---------------------------------------------------------------------------
\3\ Various Estate/Gift Tax Legislation Introduced in the 105th
Congress by the following Members of the U.S. House of Representatives:
Representative Cox (R-CA)--H.R.902 Representative Crane (R-IL)--H.R.525
Representative Herger (R-CA)--H.R. 64 Representative Houghton (R-NY)--
H.R. 195 Representative Hulshof (R-MO)--H.R. 525 Representative
Livingston (R-LA)--H.R. 683 Representative Pappas (R-NJ)--H.R. 245
Representative Pitts (R-PA)--H.R. 249 Representative Solomon (R-NY)--
H.R. 324 Representative Stump (R-AZ)--H.R. 348 and H.R. 736
Representative Thomas (R-CA)--H.R.495 Representative Thornberry (R-
TX)--H.R. 802.
---------------------------------------------------------------------------
It is my understanding that members of this Committee are
working together to craft bipartisan legislation that provides
significant relief from death taxes by using a three-pronged
approach: increasing the unified credit, providing a special
family-business carve-out, and reducing the estate tax rates.
Of these three approaches, it is obvious that rate reduction is
the only true, viable approach that is on the path to full
repeal. Therefore, short of repeal, the food distribution
industry strongly urges this Committee to rally its support
around this type of approach.
As I previously mentioned, a colleague of mine testified on
this issue during the 104th Congress. On behalf of the food
distribution industry, he urged lawmakers to enact some form of
estate tax relief. As all of you are aware, that did not
happen. It would be a shame if we let another year go by
without addressing this problem.
Again, short of repeal, I strongly believe it is incumbent
upon this Congress to enact meaningful death tax relief
legislation this year--to do otherwise is simply
unconscionable. However, by doing so, this Congress would be
sending a message to the American people that it recognizes the
importance of family-owned businesses and the contributions
that they make to this great Nation.
The future of Ettline's employees and the millions of
employees of other family-owned businesses rests in your hands.
Thank you for having me. I look forward to answering your
questions.
[GRAPHIC] [TIFF OMITTED] T8616.023
Chairman Archer. Thank you, Mr. Whelan.
Our next witness is Dan Danner. If you will identify
yourself for the record, we will be pleased to have your
testimony.
STATEMENT OF DAN DANNER, VICE PRESIDENT, FEDERAL GOVERNMENT
RELATIONS, NATIONAL FEDERATION OF INDEPENDENT BUSINESS
Mr. Danner. Thank you, Mr. Chairman.
For the record, I am Dan Danner, vice president of Federal
Government relations for NFIB, the National Federation of
Independent Business.
NFIB represents 600,000 small businessowners in all 50
States. We thank you for the opportunity to testify here today.
I will submit longer testimony, but in the brief time I have
here, I would like to leave you with three points. First,
providing small businessowners relief from the death tax is
NFIB's top legislative priority. Second, the proposal in the
President's budget is well intentioned but does not go far
enough. Third, we encourage Congress to go well beyond the
President's proposal in this Congress.
Providing relief now is our top priority. Today, the death
tax represents a huge disincentive for growth for family
businesses. It means lost opportunities, lower productivity,
and fewer jobs. Nearly 60 percent of businessowners report they
would add more jobs in the year ahead if death taxes were
eliminated. Three out of four family businessowners report that
long-term growth is made significantly more difficult or
impossible by the death tax.
For those that do attempt to plan well for death taxes, the
costs are staggering and often result in cash flow problems and
ultimately failure. All of this is why elimination of the death
tax was the number four recommendation out of 60 adopted by
President Clinton's White House Conference on Small Business,
but all of these are just numbers.
Let me mention just two of the many NFIB member stories.
Clarence Tart is the owner of a fourth generation farming and
lumber business in Dunn, North Carolina. Tart & Tart employs 70
people. He wonders why his family will have to buy back the
business from the Federal Government for the fourth time and
how his son will ever afford the estimated $1.5 million tax
without eliminating many of the jobs when his son's salary is
only $30,000 a year.
Wayne Williams runs a business that makes fiberoptic
equipment in Spokane, Washington. His parents started the
business over 15 years ago with nothing and have grown the
business to over 500 employees. Williams, who fights along with
his parents to remain competitive against Japanese and German
rivals, wonders how the astronautical cost of his legal and
life insurance fees benefits this country when he sees the
beneficiaries as his foreign competitors.
And how do we help these families? The President's proposal
does not go far enough. The President's proposal to modify the
existing 14-year loan program by lowering the interest rate for
closely held businesses is a very small Band-Aid for a very
large problem.
Small businesses will still be left with massive debt and
huge cash flow problems to pay the death taxes of up to 55
percent.
With the children in a family business who are struggling
to buy back half of their own business from the Government,
this proposal is like throwing a life raft to a sinking ship
after shooting a hole in its bow. It still results in lower
productivity and often failure of the business. That is why
family businesses are becoming an endangered species. More than
70 percent do not survive the second generation, and 87 percent
do not make it to the third generation. Death taxes are
increasingly becoming a death sentence for their businesses.
Finally, Congress should address the death tax in a
significant way in this Congress. Certainly, our first choice
would be elimination of the death tax. It is the fairest and
the simplest method. A tax doesn't make sense, and we should
eliminate it.
Short of repeal, we want the most relief possible for
family businesses, farmers, and ranchers in this Congress. We
need to at least begin the transition toward eliminating the
death tax in a meaningful way. Short of repeal, we support
increasing the unified credit and reducing death tax rates. We
further propose that the value of a closely held business,
farm, or ranch, should be exempted from death taxes altogether.
Mr. Chairman, on behalf of the NFIB's 600,000 members, I
want to thank you again for the opportunity to testify. There
isn't any issue that NFIB members feel stronger about than the
death tax and the devastating impact it has on their
businesses, the jobs they provide, and the communities they
support.
We urge you and the Committee to take real steps now toward
elimination of the death tax on family businesses, and we urge
the President to consider expanding on his proposal to provide
real relief now.
Thank you, and I look forward to your questions.
[The prepared statement follows:]
Statement of Dan Danner, Vice President, Federal Governmental
Relations, National Federation of Independent Business
The National Federation of Independent Business appreciates
the opportunity to testify on the Administration's 1998 Budget
Proposal, and, specifically, the issue of federal death taxes
and their impact on small businesses. NFIB is the nation's
largest small business organization representing 600,000 small
business owners from all fifty states. NFIB sets its public
policy positions through regular polling of the membership.
The process the Committee and the Congress is now engaged
in presents an historic opportunity to relieve America's small
business owners from government-imposed burdens and open the
door to economic expansion and job creation in the small
business sector. The federal death tax represents perhaps the
greatest burden today on our nation's most successful small
businesses.
At roughly one percent of annual revenues, this tax is
hardly worth the devastation it causes to family businesses and
farms, incentives for entrepreneurship, and our nation's
international competitiveness. The costs of such damage to
small businesses and our nation's economy is unquestionably
high.
Small Business: America's Path to Jobs and Independence
Evidence continues to suggest clearly that small business plays a
rather remarkable role as a job creator and provider of personal
opportunity, security and independence for millions of Americans.
Consider the following:
Jobs. Since the early 1970s, small firms have created two of every
three net new jobs in this country (created jobs minus lost jobs). The
nation's small business job machine has shown a capacity to produce in
either good or tough times. From 1989 to 1991, a period of minimal
economic growth, firms with fewer than 20 employees created all net new
jobs in the country. Firms of all other sizes lost employment during
that period.
Demographics. Almost all businesses are small businesses. There are
approximately five and one half million employers in the United States.
About 99 percent of them are small employers (with under 500
employees), and almost 90 percent employing fewer than 20 employees.
Small business as a whole employs more than half of the private sector
workforce. Most small firms are not set up as C corps, but as
proprietorships, partnerships, and subchapter's corporations.
Values. Small business holds out to our citizens' great hope. Small
business offers a road map to the American dream that allows any
American with a good idea and talent to follow it to economic freedom
and security by starting their own business and working hard to make it
a success. And possibly the ultimate American dream is to be able to
pass that successful business on to one's children.
Evidence indicates that the vast majority of America's small
closely-held businesses are family businesses. Although it is difficult
to precisely define a family business, there are clear characteristics
of the family business which distinguish it from others. While other
businesses are usually driven entirely by return on investment, the
family business is most often driven first by other priorities--like
relationships and longevity. Family businesses are generally much
smaller than publicly-traded corporations, but possess certain
advantages over these larger businesses. For instance, being private,
family businesses do not have to worry about quarterly earnings reports
for stock analysis, and can instead focus on long-term value
enhancement, even if it means losing money in the short-term in some
cases. Additionally, family businesses operate without a rigid
bureaucracy, consequently, they can respond quickly and intuitively to
changes in business environments. On the other hand, because of
personal considerations, such as a desire to pass the business on to
one's children, a family business may not always make purely rational
decisions in a market-driven sense. Family businesses play a far
greater role in this nation's economy than many might think--estimates
indicate that they produce roughly half of our nation's gross domestic
product.
The Need for Death Tax Reform
NFIB considers death tax reform to be crucial to the continued
survival of the small American family business. Current death tax rates
cripple a small business passed on to heirs, and often force them to
liquidate a business they have worked in their whole lives. High death
taxes may provide government revenue in the short run, but the long-run
losses far outweigh the gains--a productive business is extinguished,
many jobs are lost, and the American dream of growing a business and
preserving it beyond one's lifetime by passing it on to heirs becomes
impossible to achieve.
Because all assets are included in determining death taxes, such as
the decedent's home and other personal assets, many productive
businesses worth far less than the current exemption level become
victims of the death tax. Because so many small businesses operate on
cash flow, often with extremely small or negative profit margins,
current law allowing small businesses to spread their tax liability
over fourteen years does not provide adequate relief. The 1995 White
House Conference on Small Business voted death taxes as the fourth
greatest problem to small business needing reform.
Small businesses are also particularly vulnerable to the
intricacies of death tax law. Although some owners can ensure a
successful transfer to heirs by purchasing life insurance and through
other methods, many cannot afford this kind of planning or do not have
the time to meet with estate planners because most of their energies
are directed toward keeping the business running. Unfortunately, unlike
a publicly traded corporation, which continues operation regardless of
how shareholders plan for their death, a closely held business, unless
there has been careful planning, is usually devastated by the death of
an owner.
Impact on Small Business
Current death tax rates range from 37 to 55 percent. Faced with the
tremendous burden imposed by this tax upon their death, a business
owner will react in several of the following ways:
The business owner will not expand the business. Especially in
later years of the business owner's life, large capital expenditures
for long term growth make little sense when the family will soon be
forced to sell or liquidate the business. This disincentive to growth
means lost opportunities, lower productivity, and lost jobs. In fact,
the existence of death taxes can deter many potential entrepreneurs
from starting a business at all.
2) The children will not participate in the business. Knowing that
taxes will prevent children from continuing operation of a family
business, the business owner will often discourage their children from
working in the business and encourage them to gain experience
elsewhere. If the children do actively participate in the business,
their experience and knowledge will often go to waste when the business
is forced to be sold off. A survey of family businesses by Mass Mutual
Life Insurance showed that in 1995 only 57 percent of owners planned on
keeping the business in the family, down from 65 percent a year prior;
taxes were cited as one of the prime reasons for plans to sell out.
3) The business owner will pay dearly in death planning costs. Even
if the business owner has the foresight to plan early for their death,
the expense of this planning, in insurance, legal and accounting costs,
can be enough to eliminate a business' small profit margin. These extra
insurance, legal and accounting costs are especially burdensome because
small businesses survive on cash flow, not profit. In an NFIB survey of
Small Business Problems and Priorities of NFIB members, cash flow
ranked as one of the top ten highest problems for small business.
Coming up with the cash to pay bills and make payroll is a constant
challenge in a small firm. Money left in the business--cash flow--is
the difference between life and death for most new businesses. The
costs to small business and society as a whole are high--instead of
using these funds to expand, create new jobs, and become more
productive and competitive in the international marketplace, small
businesses must spend the money on death planning costs.
4) Heirs may not be able to afford tax payments.Despite some
planning, heirs are often still imposed with some significant tax
burden. Even paid out over time, taxes may be too much of a burden to
survive in an internationally competitive marketplace.
Fire-Sale of the Family Business
What this means is that all too often the family business is sold-
off, either before the owner's death or by the estate. Most often, a
ready market does not exist for the sale of a small family run
business. Consequently, the business is subject to a fire-sale--either
liquidated entirely or sold intact for a price far below its true
value. Additionally, much of the value of a family business often comes
from the experience and know-how of those who run it--the family
members. Their stewardship often makes the difference between a
profitable, successful business enterprise, and a dying one.
All too often, the family business or farm will be bought-up by a
large business such as a corporate conglomerate, at a price that's a
fraction of the real value of the business. While the large business
may gain some of the assets of the small business, most of the real
value of the former business is lost--the entrepreneurial spirit, know-
how and ingenuity, the small business' flexibility, and, usually, most
if not all of the jobs. What might have become an Apple Computer
instead becomes another division of a large cash register sales
company.
Contrast this with what happens when a shareholder in a corporation
traded on the New York Stock Exchange dies. Because there is a ready
market for the stock, the estate can easily sell off enough to pay
taxes. The value of that stock does not decline because of the death.
Although the stock may have new owners, the operation of the
corporation continues completely unaffected by the shareholder's death.
Public Policy Reasons for the Death (Estate) Tax?
The philosophy behind the death tax started with early Americans
who were trying to prevent the pooling of too much wealth in too few
families, as had occurred in Europe. Today, however, this philosophy is
fundamentally flawed. When applied to closely-held business assets,
ironically, the tax produces just the opposite result--often forcing
family-owned businesses to sell-off to larger public corporations,
further concentrating the wealth and power of this country, and
encouraging monopolistic controls on markets. This philosophy also
ignores the tax's impact on communities that are dependent on these
businesses, and its deleterious impact on our nation's international
competitiveness against foreign countries like Japan and Germany who do
not impose this kind of death tax burden, and who encourage the
continuation of family-run enterprises.
The Administration's Death Tax Reform Proposal
NFIB appreciates the President's acknowledgment, through his
proposal to expand the Section 6166 loan program, that family
businesses need relief from death taxes. What our members tell us,
however, is that loans to pay exorbitant death taxes do not deliver the
kind of relief needed.
The President's proposal would modify existing law, which allows
death taxes to be paid over up to a 14 year period and grants a four
percent interest rate for taxes attributable up to $1 million of a
qualified closely held business. The 1998 Budget Proposal drops the
interest rate to 2 percent and raises the attributable amount to $2.5
million, but would make the interest paid on the 14 year loan non-
deductible against income taxes. Unfortunately, for the children in a
family business who are struggling to buy back half of their own
business from the government, this proposal is like throwing a life
raft to a sinking ship after shooting a hole in its bow.
We urge the President to work with the Congress to significantly
enhance the relief from this tax for America's employers and employees.
We believe that this tax should be eliminated altogether. If budget
constraints do not allow for that to happen right away, however, it is
important to emphasize that America's family businesses and the people
they employ need relief from this confiscatory tax now. To this end,
short of repealing the tax we have supported increasing the unified
credit and reducing death tax rates. We further propose that the value
of a closely-held family business, farm or ranch be exempted from death
taxes altogether.
Exempting closely-held business, farm and ranch assets from death
taxes would ensure that the business will continue and that the jobs of
its employees will be protected. Moreover, this exemption would
eliminate the strong disincentive that now exists for business owners
to continue to develop their business and create jobs as they reach
their later years in life. A recent study by the Tax Foundation found
that today's death tax rates have the same disincentive effect on
entrepreneurs as a doubling of current income tax rates.
Total federal death tax revenue represents only about $15 billion
annually. Business assets represent roughly 12 percent of this $15
billion--about $1.8 billion a year. In other words, for $1.8 billion
annually, every closely-held farm, ranch, and small business in America
could be exempt from the federal tax collector's axe.
By restoring incentives to continue operation of closely-held
businesses in the family, this proposal would fuel economic growth in
the sector which produces more than half of our nation's gross domestic
product. Any loss of revenue by static analysis would likely be more
than compensated by a greater tax base in the small business sector.
Conclusion
Current death tax rates impose an often overwhelming burden on our
nation's small family-run businesses. The small amount of revenue this
tax generates is hardly worth the long term damage impacted on these
enterprises--in the long run the tax means less economic activity, job
loss, and prevention of the continuation and fulfillment of the
American dream of operating one's own business and passing it on to
one's children.
Eliminating the death tax for family businesses would remove the
single greatest government burden imposed upon small family businesses,
setting national priorities where they should be: encouraging the
continued operation and expansion of family businesses through
generations.
Chairman Archer. Thank you, Mr. Danner.
Our next witness is Wayne Nelson. If you will identify
yourself for the record, we will be pleased to hear your
testimony.
STATEMENT OF WAYNE NELSON, PRESIDENT, COMMUNICATING FOR
AGRICULTURE, FERGUS FALLS, MINNESOTA
Mr. Nelson. Thank you, Mr. Chairman, Members of the
Committee.
My name is Wayne Nelson. I am a farmer from Winner, South
Dakota. I am also president of Communicating for Agriculture, a
membership association representing farmers, ranchers, and
rural small business people in all 50 States.
The estate tax reform is very important to all our members,
and especially to me. For years, Communicating for Agriculture
has considered meaningful estate tax reform one of our highest
priorities. As you well know, heirs wanting to carry on family
businesses all too often have to sell land or other assets to
pay for Federal estate taxes.
To eliminate or reduce the impact of the estate tax, we
have been an active member of the Family Business Estate Tax
Coalition for the past 2 years. The coalition represents
approximately 80 groups representing more than 6 million owners
of family businesses, including farmers, ranchers, and business
people. We are very familiar with the various approaches which
have been put forth during this time.
Although we salute the President for his initiative in
addressing the problem, the solution only extends to the amount
of time heirs have to pay the tax. It doesn't address the basic
unfairness of the estate tax, which as you know quickly becomes
confiscatory.
Delaying the inevitable is not the answer. Repealing or
implementing broad-based, meaningful reform is desperately
needed.
Just as in urban areas, small family owned businesses are
integral to the health of their local economies. We supply
jobs. We pay the taxes which support our schools and other
public services. We provide the opportunities which help
prevent the flight of our children because they can't find work
at home. Because our communities are small, every business that
shuts its doors sends shockwaves through the area.
We also have to face the issue of age. In my area of South
Dakota, the average age of our farmers is 59. This generally
holds true across the Nation where the farm population is
considerably older than our urban counterparts. What happens
when this generation is gone? Who will be there to take over
the job of feeding our Nation and much of the world, if not our
children?
The estate tax is a slap in the face to a farmer or small
business person who devotes every waking hour to building a
business and paying taxes, only to have their life's work
severely downsized or in some cases even eliminated because of
a death tax which quickly reaches 55 percent. It isn't even
index for inflation.
Adding insult to injury is that it taxes assets which have
already been taxed at least once, and in some cases, twice. Our
system layers taxes on top of taxes so we have the highest cost
of dying in the world for the farmer and the small business
person.
Unfortunately, my own experience is typical. I farmed with
my father until his death in 1993. He was confident that his
estate plan was adequate to keep the farm operation going and
to reduce the estate tax upon his death. Unfortunately, the
plan proved inadequate, and the estate owed a great more tax
than what we had prepared for. We had to sell several parcels
of land to pay the Federal estate taxes.
As most farmers, my father also had existing debt against
the land, which meant that more land had to be sold to generate
enough cash to help pay this tax.
Consequently, after all this, I consider myself very
fortunate to be able to continue farming, even if it is on a
more limited scale. Many farmers and small businesses are not
so fortunate, and their heirs are forced to cease operations
after selling assets to pay these estate taxes. The old saying
that farmers live poor and die rich speaks to the great
investment we have in the land and the burden of higher values
in our estates at the death of owner.
As you know, Congress last addressed the estate tax issue
in 1981, raising the exemption to $600,000. This might have
been enough to cover most small- and mid-sized farms and
ranches. That was then and this is now, and now inflation has
taken its toll to where $600,000 today is not what it was 15
years ago.
In many areas of the country, medium-sized and even smaller
farms have equity exceeding the $600,000 exemption. Estate
planning can help limit our tax liability, but is very costly
and complicated in its own right. Even the best plans are not
easily changed if circumstances warrant it.
The added cost of this planning diverts money which should
be reinvested in capital improvements and job growth. Many
farmers and small business people look to life insurance to pay
their estate tax, but this is an expensive option which further
diverts money which could have been reinvested in the business.
The irony is that more planning money is spent to prevent
family businesses from being destroyed by the estate tax than
is actually collected under the law.
The impact of the estate tax has prompted bipartisan
support in Congress to remedy the situation. We appreciate the
fact that a dozen bills have been introduced in the House and
eight in the Senate, which address either repealing or
reforming the estate tax.
Mr. Chairman, we in Communicating for Agriculture are
hopeful that Congress and the administration can finally
address this barrier to America's future prosperity during this
session. Please correct this misguided tax policy which has
forced many family farms and businesses to cease operation
after lifetimes of work, job creation, and support for our
communities and Nation through the taxes that we have paid. It
isn't fair to our children. It isn't fair to America.
Thank you very much, and we look forward to your questions.
[The prepared statement follows:]
Statement of Wayne Nelson, President, Communicating for Agriculture
Mr. Chairman and members of the Committee. Thank you for
asking me to testify today. My name is Wayne Nelson and I am a
farmer from Winner, South Dakota. I am also President of
Communicating for Agriculture, a membership association
representing farmers, ranchers and rural business people in all
50 states. Estate tax reform is very important to all our
members and especially to me. For years, Communicating for
Agriculture has considered meaningful estate tax reform one of
our highest priorities. As you well know, heirs wanting to
carry on family businesses all too often have to sell land or
other assets to pay for Federal estate and state inheritance
taxes. To eliminate or reduce the impact of the estate tax, we
have been an active member of the Family Business Estate Tax
Coalition for the past two years. The Coalition represents
approximately 80 groups representing more than six million
owners of family-businesses including farmers, ranchers and
rural business people. We are very familiar with the various
approaches which have been put forth during this time. Although
we salute the President for his initiative in addressing the
problem, his solution only extends the amount of time heirs
have to pay the tax. It doesn't address the basic unfairness of
the estate tax, which as you know quickly becomes confiscatory.
Delaying the inevitable is not the answer. Repealing or
implementing broad-based, meaningful reform is desperately
needed.
Just as in urban areas, small family-owned businesses are
integral to the health of their local economies. We supply
jobs. We pay the taxes which support our schools and other
public services. We provide the opportunities which help
prevent the flight of our children because they can't find work
at home. Because our communities are so small, every business
that shuts its doors sends shock waves throughout the area.
We also have to face the issue of age. In my area of South
Dakota, the average age of our farmers is 59. The generally
holds true across the nation where the farm population is
considerably older than our urban counterparts. What happens
when this generation is gone? Who will be able to take over the
job of feeding our nation and much of the world if not our
children. This is not an intellectual exercise for us. It's a
real issue which we face today.
The estate tax is a slap in the face to a farmer or small
business person who devotes every waking hour to building a
business and paying taxes only to have their life's work
severely downsized or even eliminated because of a death tax
which quickly reaches 55%. It isn't even indexed for inflation.
Adding insult to injury is that it taxes assets which have
already been taxed at least once and in many cases twice. Our
system layers taxes on top of taxes so we have the highest cost
of dying in the world for the farmer and small business person.
Unfortunately, my own experience is typical. I farmed with
my father until his death in 1993. He was confident that his
estate plan was adequate to keep the farm operating and reduce
the estate taxes due upon his death. Unfortunately, the plan
proved inadequate and the estate owed a great deal more tax
than we had prepared for. We had to sell several parcels of
land to pay the federal estate and state inheritances taxes. As
most farmers, my father had existing debt against the land
which meant more land had to be sold to generate enough cash to
pay this death tax. Consequently, after all this, I consider
myself very fortunate to be able to continue farming, even if
it is on a more limited scale. Many farmers and small
businesses are not so fortunate and their heirs are forced to
cease operations after selling assets to pay estate and
inheritance taxes.
The old saying that ``farmers live poor and die rich''
speaks to the great investment we have in the land and the
burden of higher valued estates at the death of the owner.
As you know, Congress last addressed the estate tax in
1981, raising the exemption to $600,000. This was enough to
cover most small and mid-size farms and ranches. That was then.
This is now. Inflation has taken its toll. $600,000 today isn't
what it was 15 years ago. In many areas of the country, medium
size and even smaller farms have equity exceeding the $600,000
exemption.
Estate planning can help limit our tax liability but it is
very costly and complicated in its own right. My father
invested in a plan which he thought would work. Even the best
plans are not easily changed if circumstances warrant. The
added cost of this planning diverts money which should be
reinvested in capital improvements and job growth. Many farmers
and small business people look to life insurance to pay their
estate tax but this is an expensive option which further
diverts money which could have been reinvested in the business.
The irony is that more planning money is being spent to
prevent family businesses from being destroyed by the estate
tax than is actually collected under the law. This makes no
sense at all.
The impact of the estate tax has prompted bi-partisan
support in Congress to remedy the situation. We appreciate the
fact that a dozen bills and have been introduced in the House
and eight in the Senate which address either repealing or
reforming the estate tax.
Mr. Chairman, we in Communicating for Agriculture are
hopeful that Congress and the Administration can finally
address this barrier to America's future prosperity during this
session. Please correct this misguided tax policy which has
forced many family farms and businesses to cease operation
after lifetimes of work, job creation and support for our
communities and nation through the taxes we've paid. It isn't
fair to our children. It isn't fair to America.
Thank you.
Chairman Archer. Thank you, Mr. Nelson.
Our next witness is Harold Apolinsky. Mr. Apolinsky has
been before the Committee before. We welcome you back again. If
you will officially identify yourself for the record, we will
be pleased to receive your testimony.
STATEMENT OF HAROLD I. APOLINSKY, VICE PRESIDENT FOR
LEGISLATION, SMALL BUSINESS COUNCIL OF AMERICA; AND GENERAL
COUNSEL, AMERICAN FAMILY BUSINESS INSTITUTE
Mr. Apolinsky. Thank you, Mr. Chairman.
Harold Apolinsky. I am an estate tax lawyer from
Birmingham, Alabama. I present my testimony on behalf of the
American Family Business Institute and its Committee To
Preserve the American Family Business and the Small Business
Council of America. Our groups come together because of our
desire to help family businesses continue within a family.
As I mentioned, I am an estate tax lawyer, an estate
planning lawyer. That is what I have been doing for over 30
years. I also teach estate planning and estate gift tax at both
the University of Alabama School of Law and the Cumberland
School of Law. I have been teaching there for 26 years. Thank
you for having me back.
As the Chairman knows, since January 1995, when I first
came and appeared before the Small Business Committee and urge
that they repeal this estate tax, I have been trying to put
myself out of business; close down my estate planning practice.
I am running into resistance, however, which either reflects a
love of lawyers, which would be nice, because we don't have
that back home as much as we should, or a lack of
understanding. I think there has been a real awakening which
makes me very proud. In the last 2 years I have a better
understanding of how this tax works.
I guess we could not have heard a more chilling discussion
than what Mr. Whelan just said and how he reviewed the
situation. You have heard this morning from Mr. Whelan and
others of the damage this tax does. So I really won't dwell on
that.
What I would urge, however, is that--and I believe what
your Committee does is truly the most important as the
constitutionally charged Committee for taxation--that you not
enact again a family business carve-out; that you not enact
another 2033A as happened in the 1995 Balanced Budget Act. From
an estate tax perspective, it was good the bill was vetoed. I
am afraid it would have made people feel they had done
something really beneficial for family businesses and family
farms.
I know people are well meaning. They want family businesses
and family farms to continue. They understand this tax keeps
them from continuing. I have tried to work for years with 203A
which is a farm carve-out that you recall became into the law
in 1976. It is the underpinning of 2033A they proposed. In
fact, 2033A, as it was originally introduced and made it
through the process, incorporates some 12 provisions from the
farm carve-out, 2032A. I have devoted quite a bit of my written
testimony to an analysis of 2033A. I would urge that you not
spend the amount of human capital and resources to work to make
something like that useful because it will not ever be useful.
It just will not be useful, irrespective of the changes made.
When proposed 2032A was first introduced, one national
accounting firm estimated it would benefit some 400 family
businesses. I think there are about 100,000 family businesses
worth between, say, $5 and $100 million nationwide. That would
be less than half of 1 percent.
Look at 2032A. The Internal Revenue Service has attacked it
often. There have been 134 reported court cases which I have
listed in my testimony. The IRS has won most of them. The
Commerce Clearinghouse says, appropriately, lawyers are scared
to death of this section because of malpractice. I mention it
to my students. I do not teach it. I tell them to be on the
lookout for it. It would take an entire semester to teach it.
Passage of 2033A or a similar provision would be great for
my business. We looked at the number of family businesses and
farms my firm represents. We have eight trust and estate
lawyers. We have some 200-such family businesses. For us to
explain it, test it, document participation and monitor, we
would have to charge about $15,000 apiece. It would create $3
million of legal fees for us, which would be great. I think it
would probably help me send my grandchildren through
professional school, and I am just one firm.
You could easily extrapolate that to 1,000 lawyers. There
are 2,600 senior trust and estate lawyers in the American
College of Trust and Estate Counsel. I believe you could have
$3 billion of legal fees testing this for less than half of 1
percent of the family businesses and farms.
My hope would be, first, if you could find the money, that
you move forward and repeal the death tax. It is the kind of
thing you have to hurry. You cannot put it off because someone
dies, and that is when the tax is due. If the money is not
available, you reduce the tax rate and you raise the tax-free
amount. What a great opportunity for simplification. If you
could repeal it, you could get the IRS off the back of
families. I appreciate it, Mr. Chairman, and applaud your
desire to do that.
I have attached a complete report from the Family Business
Institute in Kennesaw State. They did a study of equipment
distributors and minority owned businesses. They said this
thing was counterproductive, significantly limiting economic
growth, development, and job creation. They said minority
businesses will never grow because they get sliced 55 percent.
They will never get to be of any size.
I know probably some Members are concerned that it will be
perceived as prorich instead of profamilies and projobs.
Representative Cox was telling me that in California, as you
may know, they had a referendum someone put on the ballot and
repealed their inheritance tax. Massachusetts repealed their
death tax 3 years ago because people were moving to Las Vegas,
Nevada, and to Florida. They put it on the ballot in
California. They voted to repeal the inheritance tax in
California. That, to me, is a cross-section of the country. It
shows that people really believe you should tax money once and
not twice or three times.
Thanks for letting me share my views with you, and I look
forward to some questions.
[The prepared statement and attachments follow:]
Statement of Harold I. Apolinsky, Vice President for Legislation, Small
Business Council of America; and General Counsel, American Family
Business Institute
Mr. Chairman and Members of the Committee, I am Harold I.
Apolinsky, General Counsel of the American Family Business
Institute and Past Chair of the Small Business Council of
America (SBCA) and currently Vice President-Legislation. I am
also a practicing tax attorney (over 30 years) who specializes
in estate planning and probate. For over 20 years, I have
taught estate planning and estate, gift and generation-skipping
taxation as my avocation to law school seniors at both the
University of Alabama School of Law in Tuscaloosa, Alabama and
the Cumberland School of Law in Birmingham, Alabama. I am here
to present our views on meaningful estate, gift and generation-
skipping relief.
SBCA is a national nonprofit organization which represents
the interests of privately-held and family-owned businesses on
federal tax, health care and employee benefit matters. The
SBCA, through its members, represents well over 20,000
enterprises in retail, manufacturing and service industries,
which enterprises represent or sponsor over two hundred
thousand qualified retirement and welfare plans, and employ
over 1,500,000 employees.
The American Family Business Institute is a recently formed
non-profit organization and a successor to the Committee to
Preserve the American Family Business. The Committee for a
number of years has been working for estate tax relief. Our
members are family businesses throughout the United States
facing forced sale or liquidation because of the 55% death tax.
Throughout the first two months of the 105th Congress,
numerous members have introduced legislation that seeks to
address the very serious problems that the federal estate tax
laws cause family-owned businesses, farms and capital. Many of
the Bills introduced have a significant number of co-sponsors.
The legislation drafted by your Committee on Ways and Means
will be the most important in securing meaningful estate, gift
and generation skipping tax relief.
We are delighted and heartened by the overwhelming response
that this issue has evoked from Members of Congress and their
staffs. It is indeed refreshing to observe the level of
understanding and commitment that individual Members have
demonstrated. In the past, the existence and harm of the 55%
death tax has not been generally known other than to estate tax
lawyers and families who have suffered the loss of a loved one
owning more that $600,000 of assets.
We submit that the time has come for Congress to repeal the
estate, gift, and generation-skipping taxes. If this is not
possible because of budgetary constraints, then the exemption
at which assets are not subject to any estate taxes should be
increased dramatically as some bills suggest to $1 Million to
$2 Million. We also submit that not only should the exemption
be increased, but that the tax rates be significantly reduced
and the tax brackets expanded.
An estate tax due nine months after death is imposed on the
transfer to children or other heirs of the taxable estate of
every decedent who is a citizen or resident of the United
States ($600,000 of assets are exempt). The graduated estate
tax rates begin effectively at 37% and increase to a maximum
rate of 55% (see Exhibit A for how the tax is calculated).
Taxes on bequests to spouses may be deferred until the last-to-
die of husband and wife.
A gift tax is levied on taxable gifts (excluding $10,000
per donee per year) as a back-stop to the estate taxes. The
graduated rates are the same. (The $600,000 exempt amount may
be used during life for gifts or at death.)
An extra, flat 55% generation-skipping tax is imposed on
gifts or bequests to grandchildren ($1,000,000 is exempt).
Combined income and estate taxes frequently consume 75% or
better of retirement plan accounts at death (see chart attached
as Exhibit B).
The 1995 White House Conference on Small Business
recommended repeal of estate and gift taxes. In fact, ranked by
votes, this was the number four (out of sixty) recommendation
to come out of the Conference.
President Clinton has expressed the desire to retain and
increase jobs. Repeal or a significant cut back and phase out
of this deadly tax would accomplish this. AFBI and SBCA contend
that any suggestion to solve the problem by simply extending
the time period by which payment of the estate taxes is due is
no solution at all. If a farm owes $5,000,000 in estate taxes,
does it really matter if the payment of this amount can be
spread over a period of time slightly longer than before? We
submit that it is not the time period that is critical, it is
the exorbitant amount of the tax that is critical.
Only 30% of family business and farms make it through the
second generation. Seventy percent (70%) do not. Only 13% make
it through the third generation. Eighty-seven (87%) do not. The
primary cause of the demise of family businesses and farms,
after the death of the founder and the founder's spouse, is the
55% estate tax. It is hard for the successful business to
afford enough life insurance. (Premiums are not deductible and
deplete working capital.)
A recent study by the research company, Prince and
Associates, for National Life of Vermont reviewed the history
of 749 family businesses which failed within three years after
the death of the founder. The Prince study reinforced and
supported the conclusion of the deadly effect of estate taxes.
The businesses could not continue as a result of the tax drain
on working capital needed to effectively compete and cover
errors in judgment made by new and younger management. Jobs
were lost in the communities. Key families in the community
lost the family business as their base of power and faded away
as leaders in that community.
The estate tax took its present form primarily in the early
30's. The express purpose was to break-up wealth. One must
question whether this is consistent with a free enterprise
economic system and a very competitive world economy? Also, is
it consistent at a time when the projected standard of living
for our children will be worse than it is for their parents?
The estate and gift tax cannot be justified as playing an
important role in financing the federal government; it now
brings in less than 1.2 percent of total federal revenues. The
expense of administering this system probably offset 75% or
more of the revenue.
The estate tax system certainly cannot be justified when it
is breaking up family farms and family businesses. Years ago, a
family working hard on their farms or in their businesses
making a modest income would probably not have run into this
tax. Now with inflation rich assets, such as that owned by
farmers, ranchers, timber companies, even small Mom and Pop
stores, it is commonplace for people that few would think of as
wealthy to be hit hard by the estate tax. These people who pay
a lot of income tax year in and year out, now for the privilege
of transferring these assets to their children will be subject
to estate tax rates of 37% and higher--as high as 55%. This is
a combined tax of over 80%.
If the estate tax were repealed, we believe based upon
studies conducted by Professor Richard Wagner of George Mason
University, by the Heritage Foundation and by Kennesaw State
College (portions of which are attached as Exhibit C) that the
beneficial effect on the economy would be significant.
According to the study conducted by Professor Richard Wagner of
George Mason University, the effect of the estate tax on the
cost of capital is so great that within eight years, a U.S.
economy without an estate tax would be producing $80 billion
more in annual output and would have created 250,000 additional
jobs and a $640 billion larger capital stock.
The Heritage Foundation study utilizing two leading
econometric models also found that repealing the estate tax
would have a beneficial effect on the economy. The Heritage
analysis found that if the tax were repealed in 1996, over the
next nine years: The nation's economy would average as much as
$11 billion per year in extra output; An average of 145,000
additional new jobs could be created; Personal income could
rise by an average of $8 billion per year above current
projections; and The deficit actually would decline, since
revenues generated by extra growth would more than compensate
for the meager revenues currently raised by the inefficient
estate tax.
We submit if repealing estate taxes accomplished only half
of these things, even a third or a fourth of them, then the
country would be significantly better off than staying under
the current draconian estate tax system. The estate tax system
raises very little revenue at a heavy cost to the economy. It
generates complex tax avoidance schemes, it promotes spending
instead of saving and it promotes people giving up on the
family business or farm.
The hardest hit by the tax are small business people who
work hard to pass on their farm or business to their children.
To this end, a complex family business carve out has been
introduced into legislation, S. 2. It is similar to the 2033A
which was in the Balance Budget Tax Act of 1995. The problem is
that this carve-out is much too complicated. Optimistic
estimates are that it will not help more than 10% of the family
businesses or farms hurt by estate taxes and will not save many
of the jobs lost when a company dies. There are several hoops a
business or farm must jump through before this carve out can
help it. First, the business must comprise at least 50% of the
estate. Sometimes this is the case, but often it is not.
Second, the decedent must have materially participated in the
business for a specified number of years prior to death. Just
think of the litigation resulting from the words, materially
participated.... Third, the business must be left to one or
more qualified heirs, these are designated family members and
long time employees and those people must continue to actively
participate in the business for at least ten years after
receiving the stock from the decedent. Again, imagine the
litigation resulting from the words--active participation ....
Surely, there must be a better way to protect our country's
family farms and businesses.
Overall, a carve-out will have very limited application but
will definitely create the need for spending many more dollars
on estate tax attorneys and accountants. Small businesses have
already spent more than enough on this problem. They need their
working capital to keep their businesses viable and to continue
to provide jobs.
The tax services list 133 cases where the IRS has denied
relief under the last carve-out for family farms--2032A (which
has not worked to save these farms). The new suggested
provision 2033A incorporating 12 provisions of 2032A will send
my grandchildren through professional school. I am grateful but
urge that funds available be spent toward a total phase out of
the death tax over time, not to a gift to tax lawyers and
accountants. A more extended study of 2033A is attached as
Exhibit D.
The Kennesaw State College Study on the Impact of the
Federal Estate Tax, prepared by Astrachan and Aronoff, studied
in detail the impact of the estate tax on members of the
Associated Equipment Distributors (AED), an association
composed of capital-intensive family-owned distribution
businesses and on newly-emerging, minority-owned family
enterprises selected from lists published by Black Enterprise
Magazine. The study showed that for the AED group:
Nearly $5 million is spent annually in life
insurance premiums in order to have proceeds available to meet
their estate tax liability. The survey shows an average of
$27,000 per year expended by distributors on such insurance.
$6.6 million has been spent on lawyers,
accountants and other advisors for estate tax planning
purposes. On average companies spent nearly:
$20,000 in legal fees
$11,900 in accounting fees
$11,200 for other advisors
In addition to the protection provided by life
insurance premiums, roughly 12% of the AED respondents reserved
over $51 million in liquid assets for the purpose of having
cash available for the payment of the estate tax.
I do not think we need to be an expert in anything to
realize this is an awful lot of money not being spent in a
particularly useful fashion when viewed through the eyes of our
society. Probably worse, this same study found that 71% of the
AED respondents would not have taken the actions they did but
for the estate tax--in other words, actions were being taken
that served no business purpose, they only served to alleviate
the draconian effect of the estate tax. 46% of this group
restructured the ownership of the company because of estate tax
considerations (this statistic could be read to mean that 46%
of them had restructured themselves right out of the so-called
family business carve out which is one more problem with that
solution). 11% have actually slowed down the business to limit
estate tax burdens. Worse, the study showed that 57% of the
businesses felt that the imposition of the estate tax would
make long term survival of the business after the death of the
current owner significantly more difficult and 9% thought it
would make it impossible. They are not wrong--the statistics
show it is extraordinarily difficult to have the family
business survive the death of the first generation.
Congress should repeal the estate tax in 1997. It will
greatly assist family capital and family businesses of all
kinds. If dollar constraints and the need to balance the budget
limit what Congress can do at this point, then increasing the
tax free amount (the exemption amount), while bringing the
rates down and expanding the brackets is the best solution. For
instance, the estate tax system could call for a 15% tax rate
on all estates between the exemption level and ten million and
then impose a 20% rate on all estates between 10 and 20 million
and have a tax rate of 30% on all estates over that amount. We
submit this kind of change will save the family farms and
businesses and keep the jobs that all of these businesses
provide. It will also prevent massive wealth from being
transferred without any taxation at all. It should also bring
the capital gains and estate tax system into a neutral stance
so that desired actions are not postponed until death.
The transfer tax provisions represent 82 pages of the
Internal Revenue Code and 289 pages of Regulations issued by
the Internal Revenue. The transfer tax system forces many
estates, the Internal Revenue Service, and the Department of
Justice to expend funds in court. The number of transfer tax
cases now total 10,247 representing some 13,050 pages of the
Commerce Clearing House Tax Publication.
Australia repealed their estate and gift tax laws in the
mid-1970's. It was felt that these transfer taxes were an
inhibitor on the growth of family businesses. The legislative
body of Australia sought more jobs which they believed would
come if family businesses grew larger and were not caused to
sell, downsize, or liquidate at the death of the founder to pay
estate taxes. More recently, Canada has also repealed estate
taxes for the same reasons.
The SBCA has a legal and advisory board comprised of the
top legal, accounting, insurance, pension and actuarial
advisors to small business in the country. It is contrary to
the financial interests of these board members in their tax
practice and advisory businesses to urge repeal of these
transfer taxes. We stand firmly behind repeal or significant
reform, however, because it is the right thing to do to help
grow family businesses, provide jobs and encourage the
entrepreneurial spirit needed for small businesses to become
large businesses.
We applaud the bills introduced by Congressman Cox (HR 902)
AND Senators Kyl (S-75) and Lugar (S-30) to repeal these taxes.
The country will be far better off if any of them become law.
As a country, we cannot stand by and see one more farm or one
more small business get torn apart because of an obsolete tax
supposedly in place to redistribute massive wealth. Part of the
problem with estate taxes is that many of the families who are
ultimately destroyed by the estate tax are not even aware that
it exists. Many times no one in the family has ever been
subjected to it.
The 55% death tax (the highest in the world) does the most
harm to capital of any tax we have. Once it leaves the family
at death and goes to Washington, it never seems to come back to
provide jobs back home.
Exhibit A, Calculation of Estate Taxes
Gross Estate (fair market value at death of all assets, including
real estate, stock, cash, life insurance, retirement accounts, etc.).
Deductions:
1. Debts and expenses.
2. Marital (assets left to spouse if citizen).
3. Charitable.
C. Taxable Estate.
D. Add Prior Taxable Gifts.
E. Total transfer to heirs (life and death).
F. Apply Rates: 18% to 55%.
G. Less credit ($192,800*)
H. Net tax (effective 37% to 55% [plus 5% for larger estates] due 9
months after death.
I. Extra 55% tax for bequests to grandchildren in excess of $1
million.
*This is tax on $600,000 taxable estate.
The complexity for filing the estate tax return is demonstrated by
the 35 hours and 83 minutes estimated pursuant to the Paperwork
Reduction Act Notice.
Exhibit D, American Family Business Institute, Small Business Council
of America
Concerns With Existing Code Section 2032A and Any Business Carve Out
Based Thereon
The family-owned business provisions of S.2 (i.e., the
proposed Section 2033A) mirror the statutory scheme that
currently exists in Section 2032A of the tax code. In fact, the
proposal repeatedly refers to various subsections of the
existing provision to resolve various details relating to
definitions, the treatment of different types of taxpayers,
etc.
The technical experts and practitioners that AFBI met with
expressed serious reservations about basing estate tax reform
on the existing Section 2032A. It is believed that the Section
is much too complex and restrictive to ever be of significant
benefit to the family farms that it originally was designed to
help. Its applicability also has proven to be subject to
relentless attacks from the Internal Revenue Service. Commerce
Clearing House tax publications describe Section 2032A as
follows:
Code Sec. 2032A is a very technically complex statute that
is generally interpreted with nit-picking narrowness by the
IRS. The possible exposure to malpractice liability for failure
to perfect a Code Sec. 2032A election or the giving of
incorrect advice regarding recapture tax is a serious concern.
The same publishers have described the IRS' unrelenting
attacks on Section 2032A as follows:
Congress has expressed concern that the IRS is interpreting
2032A in a more restrictive manner than contemplated by
Congress. See Estate of Davis v. Commissioner [Dec. 43, 105],
86 T.C. 1156, 1164 (1986). United States Senator Alan J. Dixon
of Illinois noted the tension between Congress' purpose in
enacting 2032A and the IRS' administrative policy under that
section in a Senator floor amendment in which he proposed the
perfection provision contained in Code 2032A(d)(3).
Congress wants to continue the family farm and small
family-owned enterprises. Congress does not want the death of
one owner of a family farm or a small family-operated business
to force the sale of that farm or business if the family wants
to stay in farming or the small business. The idea was to not
permit the federal estate tax to destroy the farms or small
businesses.
There seems to be people at the IRS, however, who are not
interested in preserving the family farms and small business,
and who want to use the slightest technically to prevent an
estate from being valued under the provisions of Section 2032A.
The practitioners summarized their principal concerns about
using the existing Section 2032A as the basis for estate tax
reform as follows:
1. Benefits may be outweighed by heavy costs. Because of
the unusual complexity in Section 2032A, family-owned
businesses could incur substantial additional legal and
accounting costs (easily an average increase of $15,000 in
professional fees for each such business) for every estate plan
for or to determine applicability of the proposed Section
2033A.
2. Constant litigation could result. Section 2032A (from
which Section 2033A has been cloned), though rarely elected,
has been the subject of more than 130 litigated cases between
taxpayers undertaking to elect the intended benefits of the
section and the Internal Revenue Service which, contrary to the
remedial nature of the statute, is continuously and
successfully undertaking to limit its applicability and
restrict its remedial benefits. A listing of the cases is
attached as Exhibit 1. There may be an equal number not yet
concluded and reported.
3. Family planning could be more difficult and costly. Not
only could estates attempting to utilize Section 2033A become
involved with costly disputes with the IRS, heirs could
likewise become entangled in various personal traps and
disputes. For example,
a. If the value of business interests declined during the
ten-year estate tax recapture period, heirs could owe more in
recaptured estate taxes than the gross proceeds realized upon
disposition of such business interests.
b. Heirs could unwittingly bear disproportionately large
percentages of the overall estate tax in situations in which
all heirs bore the initial tax on non-excluded estate assets
proportionately, but qualified heirs who received excluded
business interests would alone share the entire burden of an
recapture tax.
4. Qualification is unduly complex and uncertain. The
qualification computation itself is unreasonably complex and
cumbersome, requiring at least five obscure variables in the
numerator (e.g., liquid assets in excess of reasonably expected
day-to-day working capital needs) and at least six obscure
variables in the denominator of a fraction which must exceed
50% of the A.G.E., so that the miscalculation of one of such
eleven factors could have devastingly adverse consequences of
the estate. See Exhibit 2, attached.
5. Benefits could be too limited. In 1995, the proposed
Section 2033A was severely restricted by Congress as it worked
its way through the legislative process. The benefits were
reduced so much in 1995 (valuation reductions were limited to a
maximum of $1,750,000) that the planning costs, complexities,
uncertainties, and continuous predictable attacks from the IRS
were far too great to justify such a limited benefit.
6. Non-elective mandate forces unwilling participation and
costs. Proposed section 2033A's application is mandated, and is
not, like even section 2032A, elective. As written, compliance
costs and fees can easily exceed any benefit from section
2033A, yet businesses would be forced even against their will
to deal with the statute's complexities and bear such added
out-of-pocket expenses.
7. Planning is uncertain and inflexible. Unlike most family
farms, business interests are more likely to be the subject of
complex transactions such as incorporations, mergers and other
forms of reorganizations and recapitalizations effecting subtle
shifts in financial interests, etc. The ramifications of these
complex transactions would be difficult to deal with under
section 2033A.
Proposed Changes to Section 2033A
As noted above, we asked the group of practitioners and tax
experts what changes would be required to simplify the proposed
Section 2033A to make it at least arguably workable in the
field. Numerous suggestions were made, but it was agreed that
at least the following would be required to correct the
legislative text:
1. Expand definition of trade or business. Whether or not
an activity and related estate assets constitute a trade or
business is necessarily a question of fact and could be a
source of constant litigation. For example, based on IRS
interpretation of Section 2033A, tree farming encompassing the
planting, ownership and maintenance of forest lands in
anticipation of future harvesting would not constitute a trade
or business whereas professional gambling would be a trade or
business. In order to qualify their forestry activities for
traded or business purposes, tree farmers would be required to
initiate timber cutting activities, even if such cutting was
premature and ill-advised for both business and environmental
purposes. Similar problems exist for other nature resource-
based businesses, and businesses developing, owning and
managing intangibles and other tangible property. The proposed
statute must greatly expand the traditional definition of a
trade or business to specifically incorporate such activities
by utilizing a more relaxed active asset management test. We
recognize that administrators have legitimate concerns
regarding an overly broad definition, but the current approach
is unworkable.
2. Exclude Recapture on Ordinary Asset Sales. Sale of
business assets, including inventory, plant and equipment,
timber, crops, minerals, etc. in the ordinary course of a trade
or business during the recapture period must not trigger
recapture of estate tax. Recapture under such circumstances
eliminates intended benefits, and would cause continuous
filings and massive professional fees clearly providing a net
negative impact on the small business.
3. Eliminate Material Participation. The material
participation requirement should be eliminated. Businesses,
even more so than family farms, need competent professional
management. It should be contrary to public policy to impose
tax penalties for replacing aged, inform or incompetent family
management with competent, professional non-family managers if
necessary to maintain the economic health and viability of the
business. So long as the family continues to own, operate and
invest in the business, society continues to benefit from the
stability and commitment inherent in such ownership.
4. Expand the Definition of Family. After the second
generation, it would be difficult for any family to qualify for
the heirship or for material participation purposes as family
is currently defined. Expand the definition of family by at
least adopting the 447(e)(1) definition.
5. A qualified heir should be permitted to receive his or
her interest through a trust.
6. Eliminate 50% of A.G.E. Test. There are numerous
complexities and unfair results arising from this very high-
percentage cliff approach. It's easy to see the unfairness that
would result comparing the family that owns 49% with the family
that owns 51% particularly when valuation of such qualifying
interests is so subjective and the source of continuous
litigation. The cliff approach assures constant litigation with
the IRS. There is also concern that a business suddenly may be
worth much less due to the loss of its driving force, while the
values of the non-business assets may be unaffected by the
death.
7. If any A.G.E. cliff test remains, a number of experts
suggested that it be changed from a 50% to a 10% test.
8. If any A.G.E. test remains the value of the principle
residence should be eliminated from the computation of the
adjusted gross estate. For small businesses, the value of the
residence could be a significant factor in determining
eligibility under any percentage of adjusted gross estate test.
9. If any A.G.E. test remains, then language should be
provided to ensure that the creation of ESOPs for gifts of
qualifying business interests or gifts to charity do not
prevent families from availing themselves of the provisions of
this legislation. There are two sections where you might
consider taking transfers to ESOPs and charities into
consideration. First, is the section relating to eligibility
for the exclusion, i.e., the 50%-of-adjusted-gross-estate test.
Language should be added to apply any such test only to that
portion of the ownership interests not held by a qualified ESOP
or charity. Second, in the section dealing with disqualifying
dispositions, transfer of ownership interests to a qualified
ESOP or charity should not trigger the recapture provisions.
10. If any A.G.E. test remains, include the gifts of the
spouse in determining the adjusted taxable gift component in
the 50%-of-adjusted-gross-estate test. Many married couples
make separate, lifetime gifts of business interests (or they
utilize the gift-splitting provisions under which they are
deemed to have made separate gifts). If only the decedent's
gifts of family business interests are counted in determining
adjusted taxable gifts, many family businesses will fail to
qualify under section 2033A simply because of the form chosen
for lifetime gifting.
11. If any A.G.E. test remains, then modify the calculation
of the adjusted-gross-estate test to ensure that the
determination of the denominator does not count certain assets
twice. An example helps demonstrate how this could happen:
Assume the spouse receiving the gifted assets (donee) is the
first to die and all of the assets are placed into a QTIP trust
for the benefit of the surviving donor spouse to take advantage
of the marital deduction. Upon the death of the second spouse,
the assets of that spouse plus the QTIP assets will be included
in the estate tax return of the second spouse. Apparently, in
determining the adjusted gross estate under Section 2033A, the
previously gifted assets themselves must again be included in
the calculation, even though the value of the assets themselves
already is included in the gross estate of the second spouse by
way of inclusion of the QTIP assets. At a minimum, this
provision should be modified to somehow exclude those assets
that were gifted and subsequently added back to the estate of
the donor because of the workings of the marital deduction. An
even better result would be to eliminate the spousal gift
portion of the calculation altogether.
12. If any A.G.E. test remains, then clarify that various
family-owned business interests may be aggregated for purposes
of meeting the percentage of adjusted-gross-estate test. It is
common for various components of family-owned businesses to be
held in different forms of entities (including entities that
are unrelated). Any one of the companies may not constitute the
necessary percentage of the adjusted gross estate. Provisions
similar to those in Code Section 6166(c) would have to be
considered.
13. Redraft restrictions on working capital. The current
language will produce litigation and unfairness. The tree
farming business provides a useful illustration. The expansion
of one's timber holdings requires significant amounts of cash
and companies and requires many years to accumulate sufficient
funds to effect their next purchase (the unanticipated
withdrawal of federal timberlands from the Northwest timber
base has created a need for companies to more aggressively
acquire private lands to insure adequate timber supply). Any
impartial observer, probably even the IRS, would agree that
cash being accumulated for such appropriate business purposes
was acceptable. But such accumulations would not necessarily
meet the day-to-day test in the bill. Some commenters suggested
flat percentage tests, but that would allow for no flexibility
to reflect the very different capital needs of differing
businesses. It appears that ``reasonable business needs'' test
would provide more flexibility, but would still be a source of
continuing uncertainty and litigation.
14. Integrate the proposed Section 2033A general exclusion
with the generation-skipping transfer tax.
15. Integrate the proposed Section 2033A general exclusion
with the gift tax credit provisions. One can envision a
situation where a gift tax has been paid in certain years on
amounts that (although above the annual gift tax exclusion)
would not have been subject to tax had the assets been retained
in the estate. The estate should get credit for the gift taxes
already paid (or a refund if they exceed the estate tax owed).
In the absence of this clarification, passage of proposed
Section 2033A would create an incentive not to begin the
transfer of the business to the next generation during the life
of the deceased. That would seem to defeat our desire to
facilitate the smooth transfer of family business ownership to
the next generation.
16. Redraft sections to clarify which persons are
responsible for payment of any recapture tax. Under the current
draft language, the experts envision planning costs and
difficulties as well as family disputes over efforts to fairly
distribute the overall estate tax burden where qualifying
business interests do not pass proportionately to all family
members. At this point, it remains unclear how best to redraft
this section.
17. Minimize the family-owned tests. Reducing ownership
percentages to as little as 10% would still limit applicability
to only intended circumstances. Utilizing ownership tests
involving ownership by other families can create severe
complications for planning purposes.
18. Ease strict prohibition on public ownership of
securities. Growing family businesses should not be penalized
for seeking essential capital in public financial markets.
Public ownership of 30% of a company's stock in no way removes
the liquidity needs or provides a reasonable market for 70% of
the business still held by the family.
Preferred Alternatives
As discussed above, there are significant problems with the
current draft of Section 2033A. Significant changes would have
to be made to make it workable for the estate planning
professionals in the field. Rather than spend time and effort
to fix or draft something which will not help a significant
number of family businesses and farms (but will enrich tax
lawyers and accountants) we suggest:
1. Increase the unified credit (tax free amount)
significantly. Consider a phase in (as occurred in 1982 Tax
Act--ERTA) to $5,000,000.
2. A phased reduction in the Estate Tax Rates. Target zero
as soon as affordable.
3. Expansion of the Existing Rate Brackets. Broaden the
brackets so that the highest rates would not kick in as soon.
Exhibit 1
1. C.I.R. v. McCoy, 484 U.S. 3, 108 S.Ct. 217, 98 L.Ed.2d 2, 60
A.F.T.R.2d 87-6150, 87-2 USTC P 13,736 (U.S., Oct 19, 1987) (NO. 87-75)
2. Ernzen v. Ernzen, 105 F.3d 669 (Table, Text in WESTLAW),
Unpublished Disposition, 1997 WL 7276, 97 CJ C.A.R. 115 (10th
Cir.(Kan.), Jan 09, 1997) (NO. 95-3145)
3. LeFever v. C.I.R., 100 F.3d 778, 78 A.F.T.R.2d 96-7335 (10th
Cir., Nov 13, 1996) (NO. 95-9022)
4. In re Estate of Lucas, 97 F.3d 1401, 78 A.F.T.R.2d 96-6911 (11th
Cir.(Fla.), Oct 23, 1996) (NO. 95-2370)
5. Estate of Hoover v. C.I.R., 69 F.3d 1044, 76 A.F.T.R.2d 95-7305,
95-2 USTC P 60,217 (10th Cir., Nov 01, 1995) (NO. 94-9018)
6. Estate of Hudgins v. C.I.R., 57 F.3d 1393, 64 USLW 2044, 76
A.F.T.R.2d 95-5401, 95-2 USTC P 60,202 (5th Cir., Jun 28, 1995) (NO.
94-40211)
7. Estate of Klosterman v. C.I.R., 32 F.3d 402, 74 A.F.T.R.2d 94-
5193, 74 A.F.T.R.2d 94-7453, 94-2 USTC P 60,172 (9th Cir., Jul 05,
1994) (NO. 93-70349)
8. Minter v. U.S., 19 F.3d 426, 73 A.F.T.R.2d 94-1721, 73
A.F.T.R.2d 94-2365, 94-1 USTC P 60,160 (8th Cir.(N.D.), Mar 23, 1994)
(NO. 92-3745ND)
9. Estate of Doherty v. C.I.R., 982 F.2d 450, 61 USLW 2429, 71
A.F.T.R.2d 93-2155, 93-1 USTC P 60,125 (10th Cir., Dec 31, 1992) (NO.
919013)
10. Poisl v. C.I.R., 978 F.2d 1261 (Table, Text in WESTLAW),
Unpublished Disposition, 1992 WL 321001 (7th Cir., Nov 04, 1992) (NO.
92-1080)
11. Williamson v. C.I.R., 974 F.2d 1525, 61 USLW 2201, 70
A.F.T.R.2d 92-6244, 92-2 USTC P 60,115 (9th Cir., Sep 14, 1992) (NO.
89-70506)
12. McAlpine v. C.I.R., 968 F.2d 459, 70 A.F.T.R.2d 92-6216, 92-2
USTC P 60,109 (5th Cir., Aug 04, 1992) (NO. 91-4699)
13. Estate of Wallace v. C.I.R., 965 F.2d 1038, 70 A.F.T.R.2d 92-
5349, 92-2 USTC P 50,387 (11th Cir., Jul 13, 1992) (NO. 91-7318)
14. Bartlett v. C.I.R., 937 F.2d 316, 68 A.F.T.R.2d 91-6015, 91-2
USTC P 60,078 (7th Cir., Jul 12, 1991) (NO. 89-2237)
15. Estate of Wood v. C.I.R., 909 F.2d 1155, 59 USLW 2097, 66
A.F.T.R.2d 90-5987, 90-2 USTC P 50,488, 90-2 USTC P 60,031 (8th Cir.,
Jul 26, 1990) (NO. 89-2366)
16. Brockman v. C.I.R., 903 F.2d 518, 65 A.F.T.R.2d 90-1249, 90-1
USTC P 60,026 (7th Cir., Jun 05, 1990) (NO. 89-1559)
17. Prussner v. U.S., 896 F.2d 218, 65 A.F.T.R.2d 90-1222, 90-1
USTC P 60,007 (7th Cir.(Ill.), Feb 15, 1990) (NO. 88-1933)
18. Smoot v. U.S., 892 F.2d 597, 58 USLW 2401, 65 A.F.T.R.2d 90-
1177, 90-1 USTC P 60,002 (7th Cir.(Ill.), Dec 27, 1989) (NO. 88-2058)
19. Heffley v. C.I.R., 884 F.2d 279, 64 A.F.T.R.2d 89-5909, 89-2
USTC P 13,812 (7th Cir., Aug 17, 1989) (NO. 88-1929)
20. Foss v. U.S., 865 F.2d 178, 63 A.F.T.R.2d 89-1524, 89-1 USTC P
13,793 (8th Cir.(Minn.), Jan 09, 1989) (NO. 88-5152)
21. Estate of Thompson v. C.I.R., 864 F.2d 1128, 63 A.F.T.R.2d 89-
1515, 89-1 USTC P 13,792 (4th Cir., Jan 03, 1989) (NO. 88-3981)
22. McDonald v. C.I.R., 853 F.2d 1494, 62 A.F.T.R.2d 88-5995, 88-2
USTC P 13,778 (8th Cir., Aug 17, 1988) (NO. 87-2389)
23. Mangels v. U.S., 828 F.2d 1324, 60 A.F.T.R.2d 87-6145, 87-2
USTC P 13,734 (8th Cir.(Iowa), Sep 16, 1987) (NO. 86-1647)
24. Whalen v. U.S., 826 F.2d 668, 60 A.F.T.R.2d 87-6127, 87-2 USTC
P 13,729 (7th Cir.(Ill.), Aug 13, 1987) (NO. 86-2997)
25. Estate of McCoy v. C.I.R., 809 F..R.2d 87-1207, 87-1 USTC P
13,707 (6th Cir., Jan 23, 1987) (NO. 86-1008)
26. Schuneman v. U.S., 783 F.2d 694, 54 USLW 2439, 89 A.L.R. Fed.
85, 57 A.F.T.R.2d 86-1530, 86-1 USTC P 13,660 (7th Cir.(Ill.), Feb 10,
1986) (NO. 84-2651, 84-2888)
27. Martin v. C.I.R., 783 F.2d 81, 54 USLW 2440, 57 A.F.T.R.2d 86-
1527, 86-1 USTC P 13,659 (7th Cir.(Ind.), Feb 03, 1986) (NO. 85-2077,
85-2088)
28. Estate of Sherrod v. C.I.R., 774 F.2d 1057, 56 A.F.T.R.2d 85-
6594, 85-2 USTC P 13,644 (11th Cir., Oct 25, 1985) (NO. 84-7682)
29. Estate of Cowser v. C.I.R., 736 F.2d 1168, 84-2 USTC P 13,579
(7th Cir., Jun 13, 1984) (NO. 83-2329)
30. Rath v. U.S., 733 F.2d 594, 84-1 USTC P 13,573 (8th Cir.(Neb.),
May 09, 1984) (NO. 83-2552)
31. Ernzen v. Ernzen, 1995 WL 261131 (D.Kan., Apr 03, 1995) (NO.
CIV. A. 94-2265-EEO)
32. Ernzen v. Ernzen, 878 F.Supp. 190 (D.Kan., Feb 28, 1995) (NO.
CIV. A. 94-2265-EEO)
33. Gettysburg Nat. Bank v. U.S., 806 F.Supp. 511, 72 A.F.T.R.2d
93-6769 (M.D.Pa., Nov 19, 1992) (NO. CIV.A.1:CV-90-1607)
34. Simpson v. U.S., 1992 WL 472023, 92-2 USTC P 60,118 (D.N.M.,
Aug 31, 1992) (NO. CIV-90-827 SC)
35. Gettysburg Nat. Bank v. U.S., 1992 WL 472022, 70 A.F.T.R.2d 92-
6229, 92-2 USTC P 60,108 (M.D.Pa., Jul 17, 1992) (NO. 1:CV-90-1607)
36. Parker v. U.S., 1991 WL 338264, 68 A.F.T.R.2d 91-6056, 91-2
USTC P 60,082 (E.D.Ark., Jul 31, 1991) (NO. CIV. J-C-89-91)
37. Collins v. U.S., 1991 WL 496861, 91-1 USTC P 60,060 (W.D.Okla.,
Jan 31, 1991) (NO. CIV-90-324-P)
38. Parker v. U.S., 1990 WL 300672, 90-2 USTC P 60,038 (E.D.Ark.,
Aug 17, 1990) (NO. J-89-91)
39. Parker v. U.S., 1990 WL 300673, 90-2 USTC P 60,028 (E.D.Ark.,
May 30, 1990) (NO. J-89-91)
40. Miller v. U.S., 680 F.Supp. 1269, 61 A.F.T.R.2d 88-1370, 88-1
USTC P 13,757 (C.D.Ill., Mar 09, 1988) (NO. 86-3245)
41. Foss v. U.S., 1987 WL 49368, 63 A.F.T.R.2d 89-1503, 88-1 USTC P
13,762 (D.Minn., Dec 21, 1987) (NO. 6-86-711)
42. Voorhis v. U.S., 1987 WL 49370, 88-1 USTC P 13,749 (C.D.Ill.,
Nov 20, 1987) (NO. 86-3150)
43. Smoot v. C.I.R., 1987 WL 49387, 63 A.F.T.R.2d 89-1533,TC P
13,748 (C.D.Ill., Nov 16, 1987) (NO. 85-2431)
44. Prussner v. U.S., 1987 WL 47915, 87-2 USTC P 13,739 (C.D.Ill.,
Oct 13, 1987) (NO. 85-2442)
45. Bruch v. U.S., 1986 WL 83454, 58 A.F.T.R.2d 86-6383, 86-2 USTC
P 13,692 (N.D.Ind., Sep 03, 1986) (NO. CIV. A. F 83-410)
46. Mangels v. U.S., 632 F.Supp. 1555, 58 A.F.T.R.2d 86-6361, 86-2
USTC P 13,682 (S.D.Iowa, Apr 22, 1986) (NO. CIV. 84-10-D-2)
47. Whalen v. U.S., 1985 WL 6355, 86-1 USTC P 13,661 (C.D.Ill., Nov
14, 1985) (NO. 84-3020)
48. Bixler v. U.S., 616 F.Supp. 177, 56 A.F.T.R.2d 85-6532, 85-2
USTC P 13,623 (D.S.D., May 31, 1985) (NO. CIV. 84-1059)
49. Schuneman v. U.S., 1984 WL 2810, 57 A.F.T.R.2d 86-1545, 84-1
USTC P 13,561 (C.D.Ill., Jan 31, 1984) (NO. 82-4027)
50. Schuneman v. U.S., 570 F.Supp. 1327, 83-2 USTC P 13,540
(C.D.Ill., Sep 14, 1983) (NO. 82-4027)
51. Teubert v. U.S.A., 1983 WL 1615, 83-1 USTC P 13,513 (D.Minn.,
Jan 31, 1983) (NO. 3-82-43)
52. In re Morgan, 1990 WL 208790 (Bankr.E.D.Okla., Jan 22, 1990)
(NO. 89-70816)
53. Matter of Moellenbeck, 83 B.R. 630, Bankr. L. Rep P 72,144
(Bankr.S.D.Iowa, Mar 01, 1988) (NO. 87-1258-D)
54. Matter of C.R. Druse, Sr., Ltd., 82 B.R. 1013 (Bankr.D.Neb.,
Feb 05, 1988) (NO. BK87-346)
55. Estate of Trueman v. U.S., 6 Cl.Ct. 380, 54 A.F.T.R.2d 84-6514,
84-2 USTC P 13,590 (Cl.Ct., Oct 04, 1984) (NO. 309-82T)
56. Carmean v. U.S., 4 Cl.Ct. 181, 84-1 USTC P 13,551 (Cl.Ct., Dec
23, 1983) (NO. 328-82T)
57. Hohenstein v. C.I.R., T.C. Memo. 1997-56, 1997 WL 34996, 73
T.C.M. (CCH) 1886, T.C.M. (RIA) 97,056 (U.S. Tax Ct., Jan 30, 1997)
(NO. 22282-94)
58. Estate of Neumann v. C.I.R., 106 T.C. No. 10, 106 T.C. 216, Tax
Ct. Rep. (CCH) 51,280, Tax Ct. Rep. Dec. (P-H) 106.10 (U.S. Tax Ct.,
Apr 09, 1996) (NO. 11060-94)
59. Estate of Kokernot v. C.I.R., T.C. Memo. 1995-590, 1995 WL
735295.M. (CCH) 1559, T.C.M. (P-H) 95,590 (U.S. Tax Ct., Dec 13, 1995)
(NO. 16088-94)
60. Ripley v. C.I.R., 105 T.C. No. 23, 105 T.C. 358, Tax Ct. Rep.
(CCH) 50,986, Tax Ct. Rep. Dec. (P-H) 105.23 (U.S. Tax Ct., Nov 08,
1995) (NO. 26209-93)
61. Estate of Sequeira v. C.I.R., T.C. Memo. 1995-450, 1995 WL
558728, 70 T.C.M. (CCH) 761, T.C.M. (P-H) 95,450 (U.S. Tax Ct., Sep 21,
1995) (NO. 16264-91)
62. LeFever v. C.I.R., T.C. Memo. 1995-321, 1995 WL 422679, 70
T.C.M. (CCH) 98, T.C.M. (P-H) 95,321 (U.S. Tax Ct., Jul 19, 1995) (NO.
19915-92)
63. Estate of Monroe v. C.I.R., 104 T.C. No. 16, 104 T.C. 352, Tax
Ct. Rep. (CCH) 50,539, Tax Ct. Rep. Dec. (P-H) 104.16 (U.S. Tax Ct.,
Mar 27, 1995) (NO. 9819-93)
64. Tate; Lyle, Inc. v. C.I.R., 103 T.C. 656, Tax Ct. Rep. (CCH)
50,241, Tax Ct. Rep. Dec. (P-H) 103.37 (U.S. Tax Ct., Nov 15, 1994)
(NO. 740-92)
65. LeFever v. C.I.R., 103 T.C. No. 31, 103 T.C. 525, Tax Ct. Rep.
(CCH) 50,206, Tax Ct. Rep. Dec. (P-H) 103.31 (U.S. Tax Ct., Oct 26,
1994) (NO. 19915-92)
66. Estate of Hoover v. C.I.R., 102 T.C. No. 36, 102 T.C. 777, Tax
Ct. Rep. (CCH) 49,919, Tax Ct. Rep. Dec. (P-H) 102.36 (U.S. Tax Ct.,
Jun 21, 1994) (NO. 18464-92)
67. Estate of Einsiedler v. C.I.R., T.C. Memo. 1994-155, 1994 WL
125924, 67 T.C.M. (CCH) 2647, T.C.M. (P-H) 94,155 (U.S. Tax Ct., Apr
13, 1994) (NO. 4461-91)
68. Estate of Climer v. C.I.R., T.C. Memo. 1994-29, 1994 WL 17919,
67 T.C.M. (CCH) 2017, T.C.M. (P-H) 94,029 (U.S. Tax Ct., Jan 24, 1994)
(NO. 21678-91)
69. Stovall v. C.I.R., 101 T.C. No. 9, 101 T.C. 140, Tax Ct. Rep.
(CCH) 49,183, Tax Ct. Rep. Dec. (P-H) 1019 (U.S. Tax Ct., Jul 29, 1993)
(NO. 19432-91, 19434-91, 19436-91, 19438-91, 19433-91, 19437-91, 19435-
91)
70. Rockwell Inn, Ltd. v. C.I.R., T.C. Memo. 1993-158, 1993 WL
112452, 65 T.C.M. (CCH) 2374, T.C.M. (P-H) 93,158 (U.S. Tax Ct., Apr
13, 1993) (NO. 21842-91)
71. Fisher v. C.I.R., T.C. Memo. 1993-139, 1993 WL 9 T.C.M. (CCH)
2284, T.C.M. (P-H) 93,139 (U.S. Tax Ct., Apr 05, 1993) (NO. 9383-90,
9416-90, 9417-90)
72. Estate of Mapes v. C.I.R., 99 T.C. No. 27, 99 T.C. 511, Tax Ct.
Rep. (CCH) 48,609, Tax Ct. Rep. Dec. (P-H) 99.7 (U.S. Tax Ct., Oct 29,
1992) (NO. 1038-89)
73. Estate of Dooley v. C.I.R., T.C. Memo. 1992-557, 1992 WL
231695, 64 T.C.M. (CCH) 824, T.C.M. (P-H) 92,557 (U.S. Tax Ct., Sep 22,
1992) (NO. 11131-88, 23026-88, 23027-88)
74. Estate of Klosterman v. C. I. R., 99 T.C. No. 16, 99 T.C. 313,
Tax Ct. Rep. (CCH) 48,496, Tax Ct. Rep. Dec. (P-H) 99.16 (U.S. Tax Ct.,
Sep 10, 1992) (NO. 27652-89)
75. Ann Jackson Family Foundation v. C. I. R., 97 T.C. No. 35, 97
T.C. 534, Tax Ct. Rep. (CCH) 47,736, Tax Ct. Rep. Dec. (P-H) 97.35
(U.S. Tax Ct., Nov 12, 1991) (NO. 28883-89)
76. Estate of Holmes v. C. I. R., T.C. Memo. 1991-477, 1991 WL
188869, 62 T.C.M. (CCH) 839, T.C.M. (P-H) 91,477 (U.S. Tax Ct., Sep 26,
1991) (NO. 27129-89)
77. Shaw v. C. I. R., T.C. Memo. 1991-372, 1991 WL 148902, 62
T.C.M. (CCH) 396, T.C.M. (P-H) 91,372 (U.S. Tax Ct., Aug 08, 1991) (NO.
5219-89)
78. Estate of Hughan v. C. I. R., T.C. Memo. 1991-275, 1991 WL
102698, 61 T.C.M. (CCH) 2932, T.C.M. (P-H) 91,275 (U.S. Tax Ct., Jun
17, 1991) (NO. 23221-88)
79. Estate of McAlpine v. C. I. R., 96 T.C. No. 6, 96 T.C. 134, Tax
Ct. Rep. (CCH) 3963, Tax Ct. Rep. Dec. (P-H) 96.6 (U.S. Tax Ct., Jan
24, 1991) (NO. 28298-87)
80. Estate of Wallace v. C. I. R., 95 T.C. No. 37, 95 T.C. 525, Tax
Ct. Rep. (CCH) 46,977, Tax Ct. Rep. Dec. (P-H) 95.37 (U.S. Tax Ct., Nov
14, 1990) (NO. 22960-88)
81. Estate of Doherty v. C. I. R., 95 T.C. No. 32, 95 T.C. 446, Tax
Ct. Rep. (CCH) 46,929, Tax Ct. Rep. Dec. (P-H) 95.32 (U.S. Tax Ct., Oct
18, 1990) (NO. 5568-88)
82. Estate of Merwin v. C. I. R., 95 T.C. No. 13, 95 T.C. 168, Tax
Ct. Rep. (CCH) 46,817, Tax Ct. Rep. Dec. (P-H) 95.13 (U.S. Tax Ct., Aug
21, 1990) (NO. 23398-88)
83. Estate of Pattison v. C. I. R., T.C. Memo. 1990-428, 1990 WL
112409, 60 T.C.M. (CCH) 471, T.C.M. (P-H) 90,428 (U.S. Tax Ct., Aug 08,
1990) (NO. 26805-87)
84. EsC. I. R., T.C. Memo. 1990-359, 1990 WL 96986, 60 T.C.M. (CCH)
137, T.C.M. (P-H) 90,359 (U.S. Tax Ct., Jul 16, 1990) (NO. 37390-87)
85. Hight v. C. I. R., T.C. Memo. 1990-81, 1990 WL 14579, 58 T.C.M.
(CCH) 1457, T.C.M. (P-H) 90,081 (U.S. Tax Ct., Feb 21, 1990) (NO.
21390-88)
86. Estate of Slater v. C.I.R., 93 T.C. No. 41, 93 T.C. 513, Tax
Ct. Rep. (CCH) 46,114, Tax Ct. Rep. Dec. (P-H) 93.41 (U.S. Tax Ct., Oct
30, 1989) (NO. 7844-88)
87. Bank of West v. C.I.R., 93 T.C. No. 37, 93 T.C. 462, Tax Ct.
Rep. (CCH) 46,084, Tax Ct. Rep. Dec. (P-H) 93.37 (U.S. Tax Ct., Oct 11,
1989) (NO. 23220-88)
88. Williamson v. C.I.R., 93 T.C. No. 23, 93 T.C. 242, Tax Ct. Rep.
(CCH) 45,954, Tax Ct. Rep. Dec. (P-H) 93.23 (U.S. Tax Ct., Aug 21,
1989) (NO. 33059-87)
89. Estate of Maddox v. C.I.R., 93 T.C. No. 21, 93 T.C. 228, Tax
Ct. Rep. (CCH) 45,924, Tax Ct. Rep. Dec. (P-H) 93.21 (U.S. Tax Ct., Aug
10, 1989) (NO. 9134-87)
90. Estate of Headrick v. C.I.R., 93 T.C. No. 18, 93 T.C. 171, Tax
Ct. Rep. (CCH) 45,914, Tax Ct. Rep. Dec. (P-H) 93.18 (U.S. Tax Ct., Aug
07, 1989) (NO. 21659-86)
91. Estate of Evers v. C. I. R., T.C. Memo. 1989-292, 1989 WL
63156, 57 T.C.M. (CCH) 718, T.C.M. (P-H) 89,292 (U.S. Tax Ct., Jun 15,
1989) (NO. 33808-86)
92. Estate of Wood v. C.I.R., 92 T.C. No. 46, 92 T.C. 793, Tax Ct.
Rep. (CCH) 9246, Tax Ct. Rep. (CCH) 45,604 (U.S. Tax Ct., Apr 12, 1989)
(NO. 48020-86)
93. Estate of Strickland v. C.I.R., 92 T.C. No. 3, 92 T.C. 16, Tax
Ct. Rep. (CCH) 45,412, Tax Ct. Rep. Dec. (P-H) 92.3 (U.S. Tax Ct., Jan
10, 1989) (NO. 41553-85)
94. Estate of Grimes v. C.I.R., T.C. Memo. 1988-576, 1988 WL
135011, 56 T.C.M. (CCH) 890, T.C.M. (P-H) 88,576 (U.S. Tax Ct., Dec 20,
1988) (NO. 33429-84)
95. Estate of Nesselrodt v. C.I.R., T.C. Memo. 1988-489, 1988 WL
98625, 56 T.C.M. (CCH) 452, T.C.M. (P-H) 88,489 (U.S. Tax Ct., Oct 11,
1988) (NO. 38921-84)
96. Estate of Christmas v. C.I.R., 91 T.C. No. 49, 91 T.C. 769, Tax
Ct. Rep. (CCH) 45,118, Tax Ct. Rep. Dec. (P-H) 91.49 (U.S. Tax Ct., Oct
06, 1988) (NO. 12926-86)
97. Estate of Donahoe v. C.I1988-453, 1988 WL 96218, 56 T.C.M.
(CCH) 271, T.C.M. (P-H) 88,453 (U.S. Tax Ct., Sep 21, 1988) (NO. 28311-
85)
98. Cokes v. C.I.R., 91 T.C. No. 19, 91 T.C. 222, Tax Ct. Rep.
(CCH) 44,972, Tax Ct. Rep. Dec. (P-H) 91.19 (U.S. Tax Ct., Aug 15,
1988) (NO. 7435-84)
99. Estate of Killion v. C.I.R., T.C. Memo. 1988-244, 1988 WL
52652, 55 T.C.M. (CCH) 1004, T.C.M. (P-H) 88,244 (U.S. Tax Ct., May 31,
1988) (NO. 38967-84)
100. Estate of Bartberger v. C.I.R., T.C. Memo. 1988-21, 1988 WL
1958, 54 T.C.M. (CCH) 1550, T.C.M. (P-H) 88,021 (U.S. Tax Ct., Jan 19,
1988) (NO. 36710-85)
101. Estate of Di Fiore v. C.I.R., T.C. Memo. 1987-588, 1987 WL
49178, 54 T.C.M. (CCH) 1168, T.C.M. (P-H) 87,588 (U.S. Tax Ct., Nov 25,
1987) (NO. 3340-85)
102. Estate of Thompson (James U.), Taylor (Susan T.) v.
Commissioner of Internal Revenue, 89 T.C. No. 43, 89 T.C. 619, Tax Ct.
Rep. (CCH) 44,200 (U.S. Tax Ct., Sep 17, 1987) (NO. 9879-86)
103. McDonald (Gladys L.) v. Commissioner of Internal Revenue;
Estate of McDonald (John), Cornelius (C.F.) v. Commissioner of Internal
Revenue 89 T.C. No. 26, 89 T.C. 293, Tax Ct. Rep. (CCH) 44,118 (U.S.
Tax Ct., Aug 18, 1987) (NO. 37673-84, 37694-84)
104. Estate of Heffley (Opal P.), Heffley (Timothy S.) v.
Commissioner of Internal Revenue, 89 T.C. No. 23, 89 T.C. 265, Tax Ct.
Rep. (CCH) 44,103 (U.S. Tax Ct., Aug 11, 1987) (NO. 3201-85)
105. Estate of Johnson (Curtis H.), Johnson (Kirby) v. Commissioner
of Internal Revenue, 89 T.C. No. 13, 89 T.C. 127, Tax Ct. Rep. (CCH)
44,048 (U.S. Tax Ct., Jul 20, 1987) (NO. 37085-85)
106. Estate of Coffing v. C.I.R., T.C. Memo. 1987-336, 1987 WL
40391, 53 T.C.M. (CCH) 1314, T.C.M. (P-H) 87,336 (U.S. Tax Ct., Jul 08,
1987) (NO. 20452-81)
107. Estate of Ward (Rebecca), Emerson (Floral), Harris (Reba) v.
Commissioner of Internal Revenue, 89 T.C. No. 6, 89 T.C. 54, Tax Ct.
Rep. (CCH) 44,031 (U.S. Tax Ct., Jul 08, 1987) (NO. 20600-80)
108. Estate of Rothpletz v. C.I.R., T.C. Memo. 1987-310, 1987 WL
49207, 53 T.C.M. (CCH) 1214, T.C.M. (P-H) 87,310 (U.S. Tax Ct., Jun 24,
1987) (NO. 38934-84)
109. Estate of Gunland (Carl C.), Gunland Commissioner of Internal
Revenue, 88 T.C. No. 81, 88 T.C. 1453, Tax Ct. Rep. (CCH) 43,955 (U.S.
Tax Ct., Jun 04, 1987) (NO. 968-85)
110. Estate of Brandes v. C.I.R., 87 T.C. No. 33, 87 T.C. 592, Tax
Ct. Rep. (CCH) 43,330 (U.S. Tax Ct., Sep 08, 1986) (NO. 27513-84)
111. Estate of Gardner v. C.I.R., T.C. Memo. 1986-380, 1986 WL
21590, 52 T.C.M. (CCH) 202, T.C.M. (P-H) 86,380 (U.S. Tax Ct., Aug 18,
1986) (NO. 28332-83)
112. Estate of Pliske v. C.I.R., T.C. Memo. 1986-311, 1986 WL
21519, 51 T.C.M. (CCH) 1543, T.C.M. (P-H) 86,311 (U.S. Tax Ct., Jul 24,
1986) (NO. 35008-04)
113. Estate of Nesselrodt v. C.I.R., T.C. Memo. 1986-286, 1986 WL
21992, 51 T.C.M. (CCH) 1406, T.C.M. (P-H) 86,286 (U.S. Tax Ct., Jul 14,
1986) (NO. 24902-82)
114. Estate of Davis v. C.I.R., 86 T.C. No. 67, 86 T.C. 1156, Tax
Ct. Rep. (CCH) 43,105 (U.S. Tax Ct., Jun 11, 1986) (NO. 2383-82)
115. Estate of Clinard v. C.I.R., 86 T.C. No. 68, 86 T.C. 1180, Tax
Ct. Rep. (CCH) 43,106 (U.S. Tax Ct., Jun 11, 1986) (NO. 6345-84)
116. Estate of Bettenhausen v. C.I.R., T.C. Memo. 1986-73, 1986 WL
21472, 51 T.C.M. (CCH) 488, T.C.M. (P-H) 86,073 (U.S. Tax Ct., Feb 18,
1986) (NO. 24133-82)
117. McCoy v. C.I.R., T.C. Memo. 1985-509, 1985 WL 15131, 50 T.C.M.
(CCH) 1194, T.C.M. (P-H) 85,509 (U.S. Tax Ct., Sep 26, 1985) (NO.
19540-83)
118. Estate of Rubish v. C.I.R., T.C. Memo. 1985-406, 1985 WL
15027, 50 T.C.M. (CCH) 685, T.C.M. (P-H) 85,406 (U.S. Tax Ct., Aug 12,
1985) (NO. 15051-81)
119. Estate of Pullin , Black v. Commissioner of Internal Revenue,
84 T.C. No. 52, 84 T.C. 789, Tax Ct. Rep. (CCH) 42,060 (U.S. Tax Ct.,
May 01, 1985) (NO. 18606-82)
120. Martin by Martin v. Commissioner of Internal Revenue, 84 T.C.
No. 40, 84 T.C. 620, Tax Ct. Rep. (CCH) 41,998 (U.S. Tax Ct., Apr 02,
1985) (NO. 10122-82, 10740-82)
121. Estate of Raab v. C.I.R., T.C. Memo. 1985-52, 1985 WL 14685,
49 T.C.M. (CCH) 662, T.C.M. (P-H) 85,052 (U.S. Tax Ct., Feb 04, 1985)
(NO. 7327-83)
122. Estate of Flora J. Abell, Deceased, Juanita Abell Pyle,
Executrix, Harry A. Waite, Executor, Petitioner v. Commissioner of
Internal Revenue, Respondent, 83 T.C. No. 39, 83 T.C. 696 (U.S. Tax
Ct., Nov 19, 1984) (NO. 24370-81)
123. Estate of Gardner v. Commissioner of Internal Revenue, 82 T.C
82 T.C. 989, Tax Ct. Rep. (CCH) 41,293 (U.S. Tax Ct., Jun 25, 1984)
(NO. 28332-83)
124. Estate of Williams v. C.I.R., T.C. Memo. 1984-178, 1984 WL
15498, 47 T.C.M. (CCH) 1479, T.C.M. (P-H) 84,178 (U.S. Tax Ct., Apr 10,
1984) (NO. 25089-82)
125. Estate of Sherrod v. Commissioner of Internal Revenue, 82 T.C.
No. 40, 82 T.C. 523, Tax Ct. Rep. (CCH) 41,084 (U.S. Tax Ct., Mar 26,
1984) (NO. 5531-82)
126. Estate of Young v. C.I.R., T.C. Memo. 1983-686, 1983 WL 14674,
47 T.C.M. (CCH) 324, T.C.M. (P-H) 83,686 (U.S. Tax Ct., Nov 17, 1983)
(NO. 29433-81)
127. Estate of Coon v. Commissioner of Internal Revenue, 81 T.C.
No. 32, 81 T.C. 602, Tax Ct. Rep. (CCH) 40,478 (U.S. Tax Ct., Sep 22,
1983) (NO. 5758-81)
128. Estate of Boyd v. C.I.R., T.C. Memo. 1983-316, 1983 WL 14302,
46 T.C.M. (CCH) 328, T.C.M. (P-H) 83,316 (U.S. Tax Ct., Jun 06, 1983)
(NO. 28651-81)
129. Estate of Cowser v. Commissioner of Internal Revenue, 80 T.C.
783, Tax Ct. Rep. (CCH) 40,054 (U.S. Tax Ct., Apr 25, 1983) (NO. 14699-
82)
130. Estate of Geiger v. Commissioner of Internal Revenue, 80 T.C.
484, Tax Ct. Rep. (CCH) 39,936 (U.S. Tax Ct., Mar 07, 1983) (NO. 7354-
81)
131. Estate of Gill v. Commissioner of Internal Revenue, 79 T.C.
437, Tax Ct. Rep. (CCH) 39,318 (U.S. Tax Ct., Sep 09, 1982) (NO. 21286-
80)
132. Morris v. C.I.R., T.C. Memo. 1982-508, 1982 WL 10800, 44
T.C.M. (CCH) 1036, T.C.M. (P-H) 82,508 (U.S. Tax Ct., Sep 08, 1982)
(NO. 1144-77)
133. Estate of Smith v. Commissioner of Internal Revenue, 77 T.C.
326 (U.S. Tax Ct., Aug 11, 1981) (NO. 16500-79)
134. Estate of Hankins v. C.I.R., T.C. Memo. 1981-326, 1981 WL
10627, 42 T.C.M. (CCH) 229, T.C.M. (P-H) 81,326 (U.S. Tax Ct., Jun 24,
1981) (NO. 8448-78)
Exhibit 2, An Example of How To Qualify Under Section 2033A
Aggregate Value of all qualified family owned business
interests that are included in the gross estate and are
acquired by or passed to a qualified heir from decedent (AV) =
$11,000,000
Adjusted Taxable Gifts of qualified family owned business
interests to family members if still held by family member
(ATG) = $2,000,000
Gifts Not covered by Annual gift tax Exclusions made within
3 years of death (GNAE) = $3,000,000
Cash or marketable securities that exceed reasonably
expected day-to-day working capital needs, i.e., Excess
Liquidity (EL) = $1,000,000
Total Indebtedness of decedent (TI) = $5,000,000
Qualified acquisition indebtedness for personal residence,
i.e. Personal residence Mortgage (Mort) = $2,000,000
Debt to pay Education or Medical expenses (EdMed) =
$200,000
Other Debt up to $10,000 (OD) = $10,000
Decedent's Gross Estate without regard to Section 2033A
(GE) = $15,000,000
Gifts to Spouse within 10 years of death (other than GNAE
above) (GSP) = $1,000,000
Nontaxable Gifts within 3 years of death (NTG) = $500,000
[GRAPHIC] [TIFF OMITTED] T8616.052
Chairman Archer. Thank you, Mr. Apolinsky, for some very,
very incisive testimony.
Our last witness on this panel is Charles Kruse, and if you
will identify yourself for the record, we would be pleased to
receive your testimony.
STATEMENT OF CHARLES E. KRUSE, PRESIDENT, MISSOURI FARM BUREAU
FEDERATION; AND MEMBER, BOARD OF DIRECTORS, AMERICAN FARM
BUREAU FEDERATION
Mr. Kruse. Thank you very much, Mr. Chairman.
My name is Charlie Kruse. I am a fourth generation farmer
and operate a corn, cotton, soybean, and wheat farm in Stoddard
County, Missouri. I serve on the board of directors of American
Farm Bureau Federation and as president of Missouri Farm Bureau
Federation. My statement today is made on behalf of the 4.7
million families who belong to the American Farm Bureau
Federation.
Production agriculture is a capital intensive industry with
total assets of more than $1 trillion. Yet, despite its size,
it is an industry dominated by family businesses, many of which
are multigenerational.
As I attend farm meetings across Missouri and the United
States, I realize that many others like me are concerned about
transferring our farm businesses to our sons and daughters when
we die. Like me, they worry about the negative impact of estate
taxes.
When you consider that 47 percent of farm and ranch
operators today are 55 years or older, you realize that
agriculture is fast approaching a transformation.
The Farm Bureau's position on estate taxes is very
straightforward. We recommend repeal. Until repeal is possible,
we support increasing the exemption to $2 million and indexing
it for inflation. For assets over $2 million, the tax rate
should be cut in half.
Farmers and ranchers work long, hard hours over a lifetime
to build their businesses. Along the way, they paid income
taxes on their earnings, and it is wrong to tax those earnings
again at death.
Two million dollars may seem like a lot of money, but for
many farmers and ranchers, it is simply a family business. A
typical example of this would be a California family farm that
may involve 1,000 or 2,000 acres. When you combine $2,400 an
acre farmland with the value of the other business assets, the
total worth of a farm supporting one or two families can easily
top $2 million.
Failure to increase the exemption discourages the
continuation of family farms in this country. Often, farm heirs
must sell business assets to pay estate taxes. When taxes drain
too much capital from a farm business, the profitmaking ability
of the farm is destroyed, and the farm business dies.
A Missouri Farm Bureau member recently shared his story
with me. His family's farm was purchased in 1919 for $3.50 an
acre. Today, the farm has an appraised value of $1.7 million.
The land, now planted with trees, happens to be located near
the city of Branson, with its value based not on agriculture
use but on commercial value. This family can donate the
property to a church or even to a university with little or no
tax liability. However, if the land is passed onto their
children, the estate tax has been estimated at more than $\1/2\
million. Their heirs would be forced to sell a large portion of
the farm just to pay the tax, bringing into question the
economic viability of the smaller farm operation.
The estate tax has essentially precluded this farm from
being passed onto a fourth generation and will simply
accelerate its transition into development and out of
agriculture.
While the focus of this panel is estate taxes, I would also
like to make a comment or two regarding the capital gains tax
because cutting this tax is also a priority for the Farm
Bureau.
The Farm Bureau supports repeal of capital gains taxes.
Until repeal is possible, we support cutting the rate to no
more than 15 percent. Also, capital gains should be indexed for
inflation.
Capital gains taxes result in the double taxation of income
from capital assets. I don't know any farmers who have bought
farmland, buildings, equipment, or livestock with untaxed
dollars. It is wrong to tax earnings twice. The practice
interferes with the sale of farm assets and causes asset
allocation decisions to be made for tax reasons rather than
business reasons.
Capital gains taxes affect the ability of new farmers and
ranchers to enter the industry and expand their operations.
While many think of the capital gains tax as a tax on the
seller, in reality, it is a tax on the buyer. Older farmers and
ranchers are often reluctant to sell assets because they don't
want to pay the capital gains taxes. Therefore, buyers must pay
a premium to acquire assets in order to cover the taxes
assessed on the seller.
American farmers and ranchers are the most productive in
the world, producing 16 percent of the world's food on just 7
percent of the land. Farm and ranch productivity allows U.S.
citizens to spend only 9.3 percent of their income on food, the
lowest percentage in the world.
Agriculture and related industries provide jobs for more
than 21 million people in this country. In order for farmers
and ranchers to continue this high level of productivity,
reforms must be made in capital gains and estate taxes. These
changes will benefit farmers, consumers, and the economy.
Mr. Chairman, I thank you for the opportunity to testify
before the Committee today and look forward to answering any
questions you might have.
[The prepared statement
Statement of Charles E. Kruse, President, Missouri Farm Bureau
Federation; and Member, Board of Directors, American Farm Bureau
Federation
My name is Charlie Kruse. I am a fourth generation farmer
who operates a 600-acre corn, wheat, cotton and soybean farm in
Stoddard County, Missouri. I serve on the Board of Directors of
the American Farm Bureau Federation and as president of the
Missouri Farm Bureau Federation. My statement today is made on
behalf of the 4.7 million families who belong to the American
Farm Bureau Federation.
Production agriculture is a capital intensive industry with
total assets of more than $1 trillion. Yet, despite its size,
it is an industry dominated by family businesses, many of which
are multi-generational. Like so many of my fellow farmers, the
operation of my business involves family members. My wife, Pam,
and children, Scott and Ben, are my partners and, in fact, keep
things going when I am away on Farm Bureau business.
As I attend farm meetings across Missouri and the United
States, I realize how many others, like me, are concerned about
transferring our farm businesses to our sons and daughters when
we die. Like me, they worry about the negative impact the
capital gains tax has on the operation of our businesses. When
you consider that 47 percent of farm and ranch operators are 55
years or older, you realize that agriculture is fast
approaching a transformation.
The timing of this hearing on estate and capital gains
taxes could not be better. The Administration's budget proposes
expanding the exclusion of capital gains on the sale of an
individual's principal residence and expanding the estate tax
extension provisions for closely held businesses. While we are
encouraged that the President raises the capital gains and
estate tax issue, the changes he proposes are inadequate to
address the needs of production agriculture. Narrowly targeted
changes will not provide the relief needed by farmers, ranchers
and other rural agricultural businesses.
Estate and capital gains taxes greatly impact the efficient
use of farm capital and the transfer of assets from one
generation to another. Estate and capital gains tax reform is
long overdue. Thank you for providing this forum where the
reasons for reform can be put forward and for allowing me to
speak today.
Estate Taxes
Farm Bureau's position on estate taxes is straightforward.
We recommend repeal. Farmers and ranchers work long, hard hours
over a lifetime to build their businesses. Along the way they
paid income taxes on their earnings and it is wrong to tax
those earning again at death. Farmers and ranchers should be
able to save for the future without having to worry about
sharing the outcome of their efforts with the federal
government after already paying a lifetime of income taxes.
Family farms and other family businesses should be passed from
generation to generation without complex and costly estate
planning.
Until repeal is possible, Farm Bureau supports increasing
the exemption to $2 million and cutting the tax rate by half
for assets over $2 million. The gift tax should be increased
from $10,000 to $50,000 per year. These changes would lift the
burden of estate taxes for thousands of farmers and ranchers.
Internal Revenue Service figures show that by increasing the
estate tax exemption to $1 million, over 37,000 estates, 54
percent of the returns filed, would no longer have to file
estate tax forms.
A $2 million exemption would eliminate the tax on most
farms and ranches. Failure to increase the exemption
discourages the continuation of family farms. Often, farm heirs
must sell business assets to pay estate taxes. When taxes drain
capital from a farm business, the profit-making ability of the
farm is destroyed and the farm business dies.
The story of a Fauquier County, Virginia, farmer makes
clear the need for estate tax reform. His wife inherited an 85-
acre beef farm that he now operates with his family. Through
extensive estate planning and use of Section 2032A special use
valuation, a portion of the farm was passed from father to
daughter. The family wants to continue to farm but will be
unable to pay the estate taxes on the mother's portion because
the tax due will exceed their ability to pay. When asked if
selling a part of the farm to obtain cash was an option, he
said, There won't be much left.
The estate tax exemption hasn't been increased since 1987.
Since then, average prices in the U.S. economy have increased
by 35 percent. Farm Bureau believes that the exemption should
be increased to $2 million and indexed for inflation. This
would provide the same protection from inflation as is provided
by the adjusting of income tax brackets, personal exemptions
and the standard deduction.
Two million dollars may seem like a lot of money to some.
But for many farmers and ranchers, it is simply a family
business. According to USDA estimates, average farmland in
California in 1996 was valued at about $2,400 an acre.
A multi-generation family farm may involve 1,000-2,000 acres.
One thousand acres of land at $2,400 per acre is worth $2.4
million. That doesn't include buildings, livestock, farm
equipment and other assets whose value would easily be worth
another third of a million dollars on a 1,000-acre farm.
Some people argue that estate taxes do not impact small
business if estate planning is effectively used. While
sometimes effective at protecting farm businesses from estate
taxes, estate planning tools and life insurance are costly and
constantly drain resources that could be better used by farmers
and ranchers to upgrade and expand their operations.
The situation of an orchard and farm market operation in
Allegheny County, Pennsylvania, illustrates this point. Knowing
that the estate tax burden will be great, this family operation
of a mother, father and four children has developed an estate
plan requiring money to be set aside for estate taxes. The
amount of money that the business puts into a trust each year
is almost as great as the individual earnings of each of the
children. According to the family, this significantly reduces
funds for things that the farm could use to operate more
efficiently, like equipment purchases and building
improvements.
The Virginia and Pennsylvania examples show that the estate
tax is not a tax on the rich, as opponents of estate tax cuts
argue, but rather a penalty on middle-class men and women who
chose to make their living by operating their own businesses.
Internal Revenue Service data from 1995 clearly shows that
those with the greatest worth are also the best at using estate
tax planning to reduce or eliminate taxes at the time of death.
While farmers spend hundreds of hours and thousands of
dollars for estate plans and life insurance, relatively little
revenue is generated for the federal government. In fact,
Internal Revenue Service figures for 1995 show 54 percent of
returns (37,000 estates) had assets of less than $1 million and
generated only $650 million. The estate tax raised a total of
about $17.2 billion in fiscal year 1996, as reported by the
Office of Management and Budget. But, the estate tax can also
cause huge revenue losses. People who believe they will be
subject to the estate tax seek ways to transfer assets to avoid
the tax. That often includes investing in less productive
assets that reduce taxable income in the short term.
It follows that one of the reasons that revenue collected
from the estate tax is low is that not very many people pay the
tax. During 1995, 31,565 estates paid estate taxes. This is
roughly 1.4 percent of the estimated 2.3 million adults who
died that year. Opponents of estate tax reform say there is no
reason to change a tax that affects so few middle-income
Americans. But each death affects children, grandchildren and
other close family members. The impact is greatest for
multi-generation family farms and ranches and other family
businesses.
Farm Bureau supports changes in Section 2032A of the tax
code that allows land to be appraised at its agricultural value
for estate tax purposes. While beneficial to farms that operate
near towns and parks, the amount that land value can be reduced
is limited to $750,000. Use valuation is sound public policy
and the limit should be removed so that the program can be
applied to all farm and ranch land.
In addition, Section 2032A requires that the land be kept
in agricultural production and operated by the heirs for 10
years. The rules have become so complex that some choose not to
use the program because they fear they may not be able to
comply with all the rules. Farm Bureau recommends improvements
in the law so that cash leasing to family members and the
harvest of timber does not trigger the recapture of estate
taxes.
Farm Bureau also supports the deferral of estate taxes
until a farm is sold outside the family. In addition, land
protected by a conservation easement or participating in a
farmland preservation program should not be subject to estate
taxes.
Capital Gains Taxes
Farm Bureau supports repeal of capital gains taxes. Until
repeal is possible, Farm Bureau supports cutting the rate to no
more than 15 percent. Capital gains taxes result in the double
taxation of income from capital assets. I don't know any
farmers who have bought farmland, buildings, equipment or
livestock with untaxed dollars. It is wrong to tax earnings
twice. In addition, the tax interferes with the sale of farm
assets and causes asset allocation decisions to be made for tax
reasons rather than business reasons. The result is the
inefficient allocation of scarce capital resources, less net
income for farmers and reduced competitiveness in international
markets.
Farmers need capital gains tax relief in order to ensure
the cost and availability of investment capital. Access to
affordable capital influences agriculture's ability to compete
with overseas production. Most farmers and ranchers have
limited sources of outside capital. It must come from
internally-generated funds or from borrowing from financial
institutions. The capital gains tax reduces the amount of money
available for reinvestment by farmers and ranchers. Financial
institutions look closely at financial performance, including
the impact of the capital gains tax on the profit-making
ability of a business.
Capital gains taxes affect the ability of new farmers and
ranchers to enter the industry and expand their operations.
While many think of the capital gains tax as a tax on the
seller, in reality it is a penalty on the buyer. Older farmers
and ranchers are often reluctant to sell assets because they do
not want to pay the capital gains taxes. Buyers must pay a
premium to acquire assets in order to cover the taxes assessed
on the seller. These higher costs for asset acquisition
negatively impact the ability of new and expanding farmers and
ranchers to make a profit and compete in international markets.
Farm Bureau supports adjusting capital gains for inflation
so that only real gains in the value of assets would be taxed.
Under current law, many farmers and ranchers pay an effective
tax rate that is extreme and sometimes end up paying more in
capital gains taxes than the increase in the real value of the
assets. Farmers and ranchers are reluctant to sell land and
farm assets and reinvest in other assets, even when that may
make the best business sense. For assets held for long periods
of time, adjusting their value for inflation is a matter of
fairness.
Farmland provides a good example. Farmers and ranchers on
average hold farmland for about 30 years. In 1966, farmland in
Missouri was selling for an average of $142 per acre. In 1996,
the average was $948. A farmer who bought 300 acres of land in
1966 for $42,600 and sold it in 1996 would have a taxable gain
of $241,800 and owe $67,704 at a 28 percent tax rate. Average
prices in the U.S. economy are now 4.26 times what they were 30
years ago. This means that the real increase of value on those
300 acres was $102,924, making the effective tax rate on the
real capital gain 66 percent.
Farm Bureau supports allowing receipts from the sale of
farm and ranch assets to be placed directly into a pre-tax
individual retirement savings account (IRA). Withdrawals would
be taxed at the regular applicable income tax rate. Farm and
ranch assets accumulated over a lifetime are often the
``retirement plan'' for farmers and ranchers. Allowing these
funds to be placed into a pre-tax account would treat farmers
and ranchers in the same manner as other taxpayers who
contribute to IRAs throughout their working life.
A similar result for yearly income could be achieved by
allowing farmers and ranchers to establish individual risk
management accounts. Taxes on money placed in these accounts
would be deferred, as with IRAs. Farmers and ranchers could
manage risk by saving during profitable years for those years
that are not. Funds would be taxed at the holder's regular tax
rate at withdrawal. Because farmers and ranchers could save
money before taxes in high-income years and draw that money out
in low-income years, they would pay taxes at a rate similar to
people earning the same aggregate amount with more stable
incomes.
Farm Bureau also believes that the current once-in-a
lifetime exclusion of $125,000 on the sale of a primary
residence by a taxpayer over 55 years of age should be
increased to $500,000 and expanded to include farms and
ranches. The exclusion should not be limited to a single use by
a taxpayer over age 55 and, if not used, should be added to an
individual's estate tax exemption.
Tax Reform
Farm and ranch concerns over capital gains taxes and estate
taxes raise many questions about the need to fundamentally
reform the current tax system. Consideration should be given to
a new and different taxing systems that encourage savings,
investment and entrepreneurship. Changes are needed to simplify
tax laws, reform Internal Revenue Service rules and regulations
and simplify tax forms. Fundamental tax reform which completely
replaces the current personal income tax and corporate income
tax should eliminate estate taxes and capital gains taxes.
Conclusion
American farmers and ranchers are the most productive in
the world, producing 16 percent of the world's food on just 7
percent of the land. Farm and ranch productivity allows U.S.
citizens to spend only 9.3 percent of their income on food, the
lowest percentage in the world.
Agriculture and related industries provide jobs for more
than 21 million people. Nearly 3.5 million people operate farms
or work on farms. Another 3.6 million produce the machinery and
inputs used on the farm or process and market what farmers
produce. More than 14 million work in wholesale or retail
businesses helping get farm products from the farm to
consumers.
In order for farmers to continue this high level of
productivity, reform of estate tax and capital gains tax laws
is needed without delay. The results will benefit farmers,
consumers and the economy.
Chairman Archer. Thank you, Mr. Kruse.
I compliment each of you for your testimony. We would
prefer to go on to the questioning, but I want it to be clear
in the record that when I came to Congress in 1971, I had the
goal of repeal of the estate tax, now the death tax, which is
what we should all call it today because that is what it is,
and the repeal of the capital gains tax, completely and
totally. We haven't gotten that done in the 26 years that I
have been in the Congress, but I think we are closer today than
we have ever been toward that ultimate goal.
I fear that we will not get it by incremental changes in
the current Income Tax Code, and that is one of the reasons why
I have made the decision that the only way to go is to abolish
the income tax and abolish the death tax, completely and
totally, and replace it with a tax on consumption.
This country should not have any taxes on capital savings
anywhere on the books if we want to prosper and create jobs and
a better opportunity for Americans in the years to come.
In one fell swoop, we could eliminate all of it by
eliminating the corporate income tax, the individual income
tax, and the death tax. We are in a tax trap in the United
States today. The longer you work, the harder you work, the
more you pay to the Government; and the more you pay to the
Federal Government, the more the Congress spends, and then the
sequence continues, and the more they spend, the more you have
to work and the longer you have to work and the more you have
to pay. It shouldn't be that way. It should be that the more
you spend, the more you pay, which is a far fairer system. But
my goal is to completely get rid of the capital gains tax, the
death tax, and to get the IRS completely and totally out of the
lives of every individual American.
I particularly applaud Mr. Apolinsky because it takes a
true patriot to come before this Committee and argue against
his own personal best financial interest. That is very rare,
indeed, in this country, and I compliment you for that.
I don't have any questions of you because we are in
harmony. It is just a question of how much we can get done, but
I am sure there are other Members of the Committee that would
like to inquire.
Mr. Hulshof.
Mr. Hulshof. Thank you, Mr. Chairman.
First of all, we appreciate your testimony. Mr. Kruse, in
particular, you and I have known one another for years, and I
see that you have got a strong contingent from the show-me
State that are here to support your efforts, and it is great to
see some constituents and others from the show-me State here.
As you know, Charlie, as the only son of a Missouri farm
family, I know firsthand some of the effects of the death tax,
and particularly as those of us who have worked for the
American dream, suddenly that American dream turning into a
nightmare as we wake up to the fact of whether it is small
business or having to liquidate its assets or having to sell
off a piece of farm and having it auctioned on the auction
block just to pay the Federal Government.
I know our family, as well as many other hard-working men
and women across this country, have invested not only our
money, but our hearts and souls into something that we would
like to pass on as a legacy to our descendants. We have taken
the risks. We have navigated those treacherous straits of
regulations, and then, just as we see open seas and hopefully
calmer waters ahead of us, then the Federal Government sends a
tidal wave crashing over our bows, and there we go.
So I appreciate, Mr. Kruse, all you and the Farm Bureau are
doing to help us get that message out across the country, and
the rest of you as well.
Mr. Danner, I also note from your testimony you mentioned
section 6166 and the loan program. I am a bit disappointed with
the administration's proposal just to expand this loan program.
I have spoken personally to members of the administration that
this does not nearly provide the tax relief we need in this
area. Each of us, I think, probably brings horror stories to
bear, but just this past weekend, when I was back home in the
District, an individual, a 64-year-old man, told me about the
fact he was in his 10th year of an installment loan that he had
to take out just to pay the tax, and he is disabled and now is
looking to pass on that small business to his son, and that he
was trying to create some innovative way so that his son would
not have to rely upon taking out a loan to pay the tax bill.
As a final comment, maybe a couple of questions, Mr.
Apolinsky, and this is the kind of information I have been
looking for as far as the actual amount of moneys. You
mentioned the Kennesaw State College study regarding the
Associated Equipment Distributors, and I note that--is it just
for that AED group, that about $5 million was spent in life
insurance premiums and another $6.5 million on lawyers and
accountants and other services?
Mr. Apolinsky. Yes.
Mr. Hulshof. Any data or survey information? Can we
extrapolate that number out across the United States in some
sort of an estimate? Do any of you have that information as to
how much money hard-working families either spend on insurance
policies or that hire your services, Mr. Apolinsky, or others
in an effort to legally try to avoid the estate tax? Do we have
a figure or an estimate as to how much money we have to expend
in that regard?
Mr. Apolinsky. I have never seen that number quantified. It
is, as you anticipate, a huge industry today. If you combine
the accounting fees, the legal fees, the financial planning
fees, the last-to-die life insurance, which is only sold for
estate taxes--I have got a client. He told me I could share
with you his story.
He is a bottler in Birmingham. In order to try to get the
business through the third generation, they have purchased $180
million of last-to-die life insurance. The premium is $1.5
million after tax. Now, that business has stopped expansion.
It used to expand, provide more jobs, but that was the seed
money that they use for leverage to expand, and they are no
longer able to expand.
I see it as they did in Australia. In Australia, they
repealed the estate tax in 1977 because they wanted family
businesses, farms, capital to grow larger to provide jobs. I
really see that as businesses are sold and liquidated and farms
are sold, jobs are lost. We are not redistributing wealth, but
concentrating ownership in some large multinational companies
that are not affected by this tax. This tax is costing a lot of
jobs. It will be amazing over the next 20 years how many jobs
will be lost from this tax if we don't grab it now. I certainly
applaud what the Chairman said. Hopefully, we are so close to
getting it repealed. It is an exciting time from my
perspective.
Mr. Crane. Mr. Hulshof, would you yield for just a second?
Mr. Hulshof. I would be happy to yield.
Mr. Crane. I think it was Investors Business Daily, in a
January publication, that indicated that estate tax compliance
costs are estimated to be 65 cents for every dollar of revenue
in.
Mr. Hulshof. If the Chairman would yield just for a final
comment.
Mr. Crane, I appreciate the opportunity to join with you as
a new Member as we have introduced our own bills to completely
repeal the death tax.
Mr. Chairman, this is, of course, my first term, and I
certainly hope it doesn't take as long to get to that final
result as it has from your first term. I appreciate the
opportunity.
Thank you, panelists.
Chairman Archer. Does any other Member wish to inquire?
Mr. Ramstad.
Mr. Ramstad. Very briefly, Mr. Chairman.
I want to thank the witness from Missouri for sending us
our newest Member who is doing an outstanding job on the Ways
and Means Committee, and also, I want to thank you, Wayne
Nelson, for being here today from Minnesota and for all the
excellent work you do back home. I appreciate your contribution
to this effort.
I think working together in a collaborative way as we are,
we can get it done this year. So, we really appreciate your
being here and your help in this regard.
Thank you, Mr. Chairman.
Chairman Archer. I might say that Mr. Crane, who just
commented briefly, has been here slightly longer than I have,
and he has been trying even longer than I have to repeal the
death tax and the capital gains tax.
Mr. Crane. You have from the beginning.
Chairman Archer. Gentlemen, thank you very much for your
testimony. It has been exceedingly helpful. We wish you a good
day, and we hope we don't have to see you back here again.
Mr. Whelan. Thank you, Mr. Chairman.
Mr. Danner. Thank you.
Chairman Archer. Our next panel will prepare to take seats
at the witness table; James Higgins, Paul Yakoboski, Bennie
Thayer, and William Gale.
Welcome, gentlemen. As I said earlier, if you will make
every effort to limit your verbal testimony to 5 minutes, your
entire written statement will be printed in the record.
Mr. Thayer, would you like to lead off? Identify yourself
for the record, and then we will be pleased to receive your
testimony.
STATEMENT OF BENNIE L. THAYER, PRESIDENT, NATIONAL ASSOCIATION
FOR THE SELF-EMPLOYED; ON BEHALF OF SAVINGS COALITION OF
AMERICA
Mr. Thayer. Thank you very much, Chairman Archer. I am
Bennie L. Thayer. I am president of NASE, the National
Association for the Self-Employed. The NASE represents more
than 325,000 very small businesses, and these businesses
generally have between zero to four employees. The rest are
self-employed individuals that run their own businesses. They
reside in all 435 of the congressional districts.
I also appear here today on behalf of the Savings Coalition
of America. This is a coalition of 65 member organizations
supporting incentives to increase personal savings.
The NASE and the Savings Coalition, Mr. Chairman, are
committed to expanding individual retirement accounts. We
strongly support the features of H.R. 446, the Savings and
Investment Incentive Act of 1997.
As you are all aware, and especially you, Mr. Chairman, the
rate of personal saving in the United States has significantly
decreased in the past three decades, from 8 percent in the
sixties to about 4 percent to date. This is the lowest it has
been in the United States since World War II.
When compared to the other industrialized nations, the rate
of personal savings in the United States is one of the lowest.
Saving is also a key component of the National Economic
Policy. Increased personal saving rates not only benefit
individual Americans, but also provide the economy with the
investment capital it needs to grow. More saving equals more
funds available for lending, and for those of us in small
business, that represents more money for loans.
Let us talk about small business and retirement for the
moment. Retirement income comes from three source: First of
all, Social Security; second, pensions; and third, personal
savings.
We don't know what Social Security will be like in 20
years, that is for sure, but it is very unlikely that today's
structure of benefits and tax levels can be maintained.
What about the pensions? Despite the good work of this
Committee, Mr. Chairman, and the others in Congress last year,
when you passed the SIMPLE plan, the plain truth is that the
kind of entrepreneurs we represent within the NASE typically do
not have pensions. And that is a fact. Our members just don't
have pensions, nor do a great many of other small businesses in
America.
That leaves personal savings as the third category for
retirement. We have surveyed our NASE members on retirement
plans. Over 60 percent--60 percent of these typical smallest of
small business people have put away less than $50,000 for their
retirement, and 40 percent have saved less than $20,000. This
is even true for people who are now in their fifties. Yet, a
typical length of retirement today is about 15 years. Now, it
doesn't take a lot of higher mathematics to see that many small
business people are going to be in big trouble if we don't get
them to save more and to save more soon.
Due to the income limits on IRAs and the Tax Reform Act of
1986, IRA contributions have dropped by more than 40 percent
among those who continue to be eligible for tax-deductible
IRAs, largely because aggressive IRA marketing has declined.
IRAs have declined and have been restricted since 1986.
Before 1986 when tax-advantaged IRAs were available to
everyone, banks, mutual funds, brokerage houses, and insurance
companies all competed to sell savings. We need to have this
happen again in America. We really need to have this happen
again. An IRA that is available to all Americans will make it
happen again, and we firmly believe that.
The Savings Coalition and the NASE urges lawmakers to keep
IRAs simple and easy to understand. Therefore, we firmly
support H.R. 446.
Mr. Chairman, in conclusion, let me simply say this to you.
Regarding the tax benefits from the $2,000 cap that presently
exists for IRAs, you will hear that it is really there for the
rich. We say to you here today that for many Americans, that
$2,000 represents their only chance to save. It is for that
reason we support and ask you and this Committee to firmly get
behind H.R. 446 and assert to you today that we will do
everything within our power to support you.
Thank you.
[The prepared statement and attachment follow:]
Statement of Bennie L. Thayer, President, National Association for the
Self-Employed; On Behalf of Savings Coalition of America
Good Morning. My name is Bennie L. Thayer, and I am the
President of the National Association for the Self-Employed. I
submit this testimony on behalf of the Savings Coalition of
America. The Savings Coalition consists of 65 member
organizations representing the interests of tens of millions of
American savers. Established in 1991, the Savings Coalition
membership includes a wide variety of interests including
consumer, health care, education and business groups,
engineers, home-builders, realtors, trust companies, banks,
securities firms, insurance, and financial service companies.
The Savings Coalition supports incentives to increase the rate
of personal saving in the United States.
Expanded Individual Retirement Accounts
When Americans retire they rely on three sources of
income--Social Security, pensions and personal savings.
Individual Retirement Accounts (IRAs) fall in the category of
personal savings. The Savings Coalition is committed to seeking
the enactment of expanded IRA legislation and strongly supports
the features of H.R. 446, The Savings and Investment Incentive
Act of 1997. The Savings Coalition believes that tax and
economic policy should provide more opportunity and incentive
for Americans to save and invest for their futures. The Savings
and Investment Incentive Act of 1997 has features that provide
incentives and opportunities to save for all Americans. It also
provides the intangible values of responsibility and self-
reliance for people through those provisions.
Council for Economic Development Findings of Americas Retirement
Situation
In May 1995, the Council for Economic Development (CED)
released its report entitled, Who Will Pay For Your Retirement?
The Looming Crisis. In its findings, the CED found that this
countrys retirement system is in dire straits and unless
corrective action is taken soon, America will be confronting a
major economic crisis. The CED report concluded that Americas
retirement system is underfunded, overregulated, and soon to be
challenged by unprecedented growth in the retirement-age
population. Consequently, our nation will confront a major
crisis in financing the needs of the elderly at the beginning
of the twenty-first century unless policies are reformed to
make retirement saving a top priority. One of the
recommendations of the CED is the implementation of tax
incentives and regulatory reform to encourage individual
retirement saving and to achieve increased funding of, and
coverage by, private pensions. H.R. 446 provides all Americans
with the savings incentives for retirement which are critical
when one considers the problems illuminated by the CED in its
report.
Low Rate of Saving in the United States
Saving is a key component of economic policy. Increased
personal saving rates not only benefit individual Americans,
but also provide the economy with the investment capital it
needs to grow. Improving the saving rate increases the nations
store of funds available for lending that helps small
businesses when they need loans.
The rate of personal saving in the United States has
significantly decreased in the past three decades--from 8% in
the 1960s to hovering around 4% today. This current rate is the
lowest it has been in the United States since World War II.
When compared to other industrialized nations, the rate of
personal saving in the US is one of the lowest. Americans are
saving less than one-half as much as the Germans and one-third
as much as the Japanese. We can do something about the low rate
of saving by taking a bite out of our federal deficit. But, we
must also do something to change peoples attitudes towards
savings. The universally available IRA is the best vehicle we
currently have to get that done.
Over the past several years, a significant amount of
academic research on the effectiveness of IRAs has been
published. Top academic economists have found that IRAs
increase saving. The list includes Martin Feldstein (Harvard),
David Wise (Harvard), Treasury Deputy Secretary Lawrence
Summers (former Harvard economist), James Poterba (MIT), Steven
Venti (Dartmouth), Jonathan Skinner (University of Virginia),
Richard Thaler (Cornell) and Glenn Hubbard (Columbia).
It is less well-known that, because of the low personal
saving rate in the US, America has become increasingly
dependent on foreign investors to finance the US debt.
Regardless of the progress made toward balancing the budget,
the US must still finance an outstanding debt of more than $5
trillion by selling Treasury securities. In the past few years,
foreign investors have become the dominant force in the market
for these Treasury securities.
According to an analysis conducted by the Securities
Industry Association, in 1995, for instance, net purchases of
US Treasury notes and bonds by foreigners reached $134 billion.
The analysis further revealed that in 1996 the pace of foreign
acquisitions of Treasury securities accelerated. According to
the US Department of Treasurys Office of Market Finance, at the
end of 1996, foreigners owned 31.6% of the total private
holdings of US Treasury securities, up from 21.7% at the end of
1994.
This trend means that the favorable interest rate
environment that we have enjoyed in the US is vulnerable to the
vagaries of investing by foreigners. If they substantially
reduced their purchases of US Treasury securities, the interest
rate on such securities would probably rise and accordingly so
would interest rates on corporate bonds as well as mortgages
and bank loans. In other words, a key component of economic
health in the US is heavily influenced by the investment
decisions of foreign savers.
IRAs Should be Available to All Americans
An interesting effect of the implementation of income
limits on universally available IRAs in the Tax Reform Act of
1986 is that IRA contributions have dropped by more that 40%
for those who continued to be eligible for deductible IRAs. The
decline in IRA contributions is partially attributed to
misunderstanding on the part of Americans as to their
eligibility for IRAs and a decline in marketing of IRAs by
financial institutions. Before 1986, the IRA worked to increase
savings because we had banks, mutual funds, brokerage houses
and insurance companies competing to sell savings. Instead of
selling goods, Madison Avenue was selling investment. Universal
availability of IRAs--a savings incentive available to
everyone--is what led to the advertising of IRAs in the mid-
80s. This is the kind of advertising we need again if we are to
get people refocused on the importance of saving. An IRA that
is available to all Americans will reduce confusion on the part
of individuals and increase the marketing of IRAs on the part
of financial institutions. The Savings Coalition urges
lawmakers to keep IRAs simple and easy to understand. Limiting
IRA eligibility confuses people and scares them away from
establishing a pattern of savings that IRAs would otherwise
promote.
The Savings and Investment Incentive Act of 1997 benefits
all Americans--it gives an incentive to everyone who wants to
take advantage of it. The first home withdrawal features and
the IRA Plus account are very attractive to the young, even if
they do not have children. The education expansion provides a
strong incentive for people with children. The expanded
retirement savings vehicles in both the traditional IRA and the
IRA Plus are popular with people in their 50s and early 60s who
see retirement just around the corner.
Expanded IRAs Enjoy Broad Support and are Popular with Americans
Expansion of IRAs is not only an area of agreement on both
sides of the aisle in Congress, but also down Pennsylvania
Avenue between Congress and the White House. The 1996
Republican and Democratic National Platforms included expanded
IRAs.
In December 1995 and May 1996, the Savings Coalition
commissioned polls of registered voters regarding their
preference of items included in the tax cut proposals. In the
December 1995 poll conducted by Lake Research, 7 out of 10
registered voters said they would increase their rate of
personal saving if IRAs were expanded to allow Americans to
save. Also, middle class Americans choose expanded IRAs above a
child tax credit and the capital gains tax cut as the tax
proposal the country should adopt first. In May 1996 a
bipartisan poll was conducted by Lake Research and the Luntz
Research Companies. The results of the poll indicated that more
than 6 out of 10 American voters (64%) claimed that they would
increase their rate of personal saving if IRAs were expanded to
allow more Americans to save. In addition, the heart of the
American workforce, voters aged 30 to 64 favored the expansion
of IRAs (35%) to a cut in capital gains or a child tax cut.
In February 1997, the NASDAQ Stock Market, a member of the
Savings Coalition, surveyed investors and potential investors.
An interesting finding of the survey is that those who are
investing their money are relying on their personal investments
to fund their retirement. Forty-one percent of investors say
that most of the money for their retirement will come from
savings and investments, while just twenty-nine percent say it
will come from a retirement plan (25%) or Social Security (4%).
Americans plan to save and invest more for their retirement and
the provisions in H.R. 446 will provide them with an incentive
to do that.
In a 1995 poll conducted by Dr. Frank Luntz of Luntz
Research Companies for Merrill Lynch, one of the members of the
Savings Coalition, it was revealed that an overwhelming
majority of Americans do not believe that Social Security or
Medicare will provide them with peace of mind in retirement.
The poll also found that a majority of Americans feel that
government policies do not encourage retirement saving. Similar
to the results of the polls conducted by the Savings Coalition,
this poll found that among the various proposed forms of tax
relief, Americans believe that expanding the IRA should be the
highest priority.
Other members of the Savings Coalition have conducted polls
with similar results. In August 1995, Dean Witter, Discover;
Company conducted a survey of its clients on their attitudes
and behaviors towards savings, preparing for retirement and
opinions towards the IRA legislation being considered. Most of
the clients felt that the current tax laws do not encourage
enough savings and that the expansion of IRAs proposed by
Congress would encourage them to save more for retirement.
Another interesting finding in the survey is that the primary
reason cited by Dean Witter clients for not contributing to an
IRA is the lack of tax advantages for doing so. In a poll
conducted by the Institute of Electrical and Electronic
Engineers (United States) of its members, the majority of the
respondents favored expanded IRA provisions. In one day,
through an 1-800 number sponsored by USA Today and manned by
the International Association for Financial Planning, a member
of the Savings Coalition, 73,000 phone calls were made
requesting help with retirement planning. This is from a total
circulation of 2 million. These results reveal that Americans
are very concerned about their retirement. Provisions in H.R.
446 give them the incentive to help themselves.
By making the IRA available to all income levels, H.R. 446,
The Savings and Investment Incentive Act of 1997, encourages
all Americans to save. For those who claim that the benefits of
expanded IRAs should be directed to Americans at certain income
levels, the members of the Savings Coalition would like to
point out that (1) the saving rate in this country is low and
all Americans should be provided with incentives to save, and
(2) the IRA contribution is limited to $2000. The tax benefits
from this $2000 cap may not mean much to a high-income person--
it is a small tax break for them. However, the benefits for
everyone else that flow from universal availability (and the
resultant advertising) will more than offset the small tax
break for higher income individuals. Increasing the eligibility
of IRAs for Americans is a good public policy that is popular
with the American people, Congress and the White House.
[GRAPHIC] [TIFF OMITTED] T8616.020
Chairman Archer. Thank you, Mr. Thayer.
Our next witness is James Higgins. If you will identify
yourself for the record, we would be pleased to receive your
testimony.
STATEMENT OF JAMES F. HIGGINS, PRESIDENT AND CHIEF OPERATING
OFFICER, DEAN WITTER FINANCIAL, NEW YORK, NEW YORK; AND
CHAIRMAN, BOARD OF DIRECTORS, SECURITIES INDUSTRY ASSOCIATION
Mr. Higgins. Thank you, Mr. Chairman.
I am Jim Higgins, president and chief operating officer of
Dean Witter Financial, a unit of Dean Witter Discover Card. Mr.
Chairman, thank you for inviting me here to testify today on
the savings and investment provisions in President Clinton's
1998 budget.
I am testifying before you today in my capacity as chairman
of the board of directors of the Securities Industry
Association.
Before I summarize SIA's position, I respectfully ask that
you include my full written statement, along with a copy of an
SIA-sponsored study on IRAs in the record of this hearing.
Chairman Archer. That will occur.
Mr. Higgins. Thank you.
Mr. Chairman, SIA commends you for holding this hearing.
The securities industry shares your commitment for a balanced
budget, sooner rather than later. We believe there is room in a
balanced budget, however, for incentives to help all Americans
save and invest for retirement security.
Congress will consider few issues that are more important
than helping Americans repair for their retirements, especially
when you consider the following. The U.S. savings rate is at an
all time low. There are legitimate questions about Social
Security and employer sponsored pension plans as the primary
source of retirement income in the not too distant future. The
baby boom generation is not saving enough for a secure
retirement, even though the oldest among them will turn 65 in
just 15 years. The next generation of retirees will spend as
many years in retirement as they did working.
In light of these trends, Congress has a tremendous
opportunity to make a difference in every American's life by
giving them tools they can use to save enough to retire without
worry. IRAs are a savings incentive with a proven record of
success.
Mr. Chairman, I have spent my entire year, more than 25
years, at Dean Witter. My firm's client base is primarily
individual investors, the people who stand to benefit the most
from an enhanced IRA.
I served as a branch office manager during the eighties and
can attest firsthand to the popularity of IRAs among our
clients. According to industry statistics, one in six families,
many with incomes under $50,000, contributed annually to IRAs
when they were widely available. IRAs worked because they were
simple. Anyone could make a tax deductible contribution up to
$2,000 into an account that grew tax free until retirement.
In 1986 the Tax Reform Act transformed IRAs from a simple,
easy-to-understand investment to a more complex, less
accessible account. IRAs are not an attractive investment
option for many individuals because they have very low income
caps for deductible contributions. Eligibility is tied to an
individual or their spouses belongs to another plan, and there
are high penalties for withdrawals, for whatever reason.
Research shows, however, that people would contribute to an IRA
if they were widely available again.
In a survey of Dean Witter clients, we found that nearly
two-thirds are worried about their household's future financial
condition and whether they will outlive their retirement
savings. A large number of our clients have IRAs and many of
them still make contributions. But among those who no longer do
so, the overwhelming majority cited either the lack of tax
advantage or participation in other 401(k) type plans as their
primary reasons for stopping. When asked what would make them
start again, two-thirds answered ``restoring universal
availability on a fully tax deductible IRA, regardless of
income.''
Recent experience has shown that our clients respond to
positive changes in IRA. Last year, after Congress increased
the amount, a nonworking spouse could contribute to the full
$2,000. The industry has experienced a notable increase in new
IRA applications. We thank you for making this positive change
in the law. SIA encourages you to build on this accomplishment
with further enhancements to IRAs this year.
We are encouraged that the President included an expanded
IRA in his budget. His proposal addresses some of the
shortcomings of the current law by raising the income cap,
indexing the contribution limit to inflation, and creating a
flexible back-end IRA account. In our opinion, his proposal
falls short of restoring the IRA to a simple, universally
acceptable investment option. In addition, with its 5-year
sunset, it cannot possibly stimulate enough savings to provide
Americans with a secure retirement.
Instead, Mr. Chairman, SIA is pleased to support the
Thomas-Neal Super IRA Proposal. It brings the universal
availability, fully deductible IRA ``out of retirement.''
The Super IRA will do a number of things. It will restore
simplicity to the process. It will take inflation into account
by indexing the $2,000 annual contribution. It will add
flexibility by creating a back-end IRA that allows savers to
make nondeductible contributions up front in exchange for tax-
free withdrawals after retirement.
It will also appeal to younger people that will benefit by
being allowed withdrawals for major life events, like buying a
new home and college tuition.
SIA commends the sponsors, Mr. Thomas and Mr. Neal, for
their leadership. The bill has broad bipartisan support, with
over 100 cosponsors. The Super IRA is the type of savings
incentive that Americans want and need.
In conclusion, Mr. Chairman, I want to thank you for
holding this hearing and calling attention to the importance of
savings and investment as an integral part of the balanced
budget process.
I appreciate the opportunity to share SIA's views with you.
We stand ready to work with you to restore the IRA as an
investment option for all Americans, and I would be happy to
answer questions you may have.
[The prepared statement follows. The article, ``Journal of
Economic Perspectives,'' is being retained in the Committee
files.]
Statement of James F. Higgins, President and Chief Operating Officer,
Dean Witter Financial; and Chairman, Board of Directors, Securities
Industry Association
Chairman Archer, Mr. Rangel, members of the Committee, good
morning. I am James Higgins, Chairman of the Board of Directors
of the Securities Industry Association,\1\ and President and
Chief Operating Officer of Dean Witter Financial, a business
unit of Dean Witter, Discover; Co. Thank you for inviting me
here today to talk about the savings and investment incentives
in President Clinton's fiscal 1998 budget. SIA commends you for
holding this hearing. Congress will consider few issues of
greater importance than helping Americans save for a secure
retirement.
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\1\ The Securities Industry Association brings together the shared
interests of more than 760 securities firms throughout North America to
accomplish common goals. SIA members--including investment banks,
broker-dealers, specialists, and mutual fund companies--are active in
all markets and in all phases of corporate and public finance. In the
U.S., SIA members collectively account for approximately 90 percent, or
$100 billion, of securities firms' revenues and employ about 350,000
individuals. They manage the accounts of more than 50-million investors
directly and tens of millions of investors indirectly through
corporate, thrift, and pension plans. (More information about SIA is
available on its home page: http://www.sia.com.)
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We are not saving enough to remain globally competitive in
the long-term as a nation or financially secure as individuals.
The Clinton Administration's budget contains proposals to
encourage savings and investment through improved Individual
Retirement Accounts (IRAs) and narrowly targeted capital gains
tax cuts. SIA believes the Administration is on the right track
with these proposals, but ultimately that they will not
encourage the levels of savings and investment needed for
national economic growth and personal retirement income
security.
Mr. Chairman, your colleagues on the Committee have
introduced legislation, H.R. 446, that would help all Americans
save for retirement. SIA commends the sponsors--Mr. Thomas and
Mr. Neal--for their leadership. Similarly, we salute
Representative English, who, together with Representatives
Dreier, Hall, Moran and McCarthy, introduced H.R. 14--a broad-
based capital gains tax cut that treats all assets equally.
Both bills have attracted bipartisan support, with many co-
sponsors lined up across both sides of the aisle. SIA fully
supports these measures and urges Congress to enact them as
part of an overall plan to balance the budget by 2002.
The U.S. Savings Crisis
The United States faces a saving crisis. Americans today
are saving less than at almost any time since World War II. The
personal savings rate has plummeted from 8 percent of
disposable income in 1970 to only about 4.9 percent in 1996. In
fact, American households currently save less than half as much
as those in Britain and Germany and a third as much as those in
Japan and France.
This drop in personal savings has driven the decline in
U.S. national savings (defined as the sum of all savings by
households, businesses, and government), a fact some have
failed to recognize. Many policy makers believe that the fall
in national savings can be attributed to federal budget
deficits. To the contrary, statistics reveal that the fall in
personal savings has been a larger contributor to the drop in
national savings during the last 25 years than has been the
increase in the budget deficit. Net national savings fell from
an average of 8.5 percent of net national product during the
1970s to 4.7 percent during the 1980s, and to only 2.4 percent
so far during the 1990s.\2\
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\2\ Economic Report of the President. U.S. Department of Commerce.
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The overall economy and individual Americans alike are
being hurt by this drop-off in savings. At the national level,
the savings crisis saps the fuel for long-term growth, because
domestic savings is a vital source of capital for domestic
investment. In today's economy, the fall in personal savings
from 8 percent to 4 percent represents a loss of roughly $200
billion of capital that could have been put to work in the U.S.
economy. The cost of losing this capital is evident in the
steady declines of U.S. domestic investment. While domestic
investment averaged about 8 percent of NNP from the 1950s
through the 1970s, it fell to 6.1 percent in the 1980s and has
fallen further to just 3.1 percent so far in the 1990s. By
limiting investment in the American economy, the saving crisis
slows business growth and keeps living standards from rising.
The impact of the savings crisis is personal, as well as
national. As SIA member firms witness every day in our dealings
with clients across the U.S., low savings has direct and
serious implications for individual families. Simply stated,
Americans are not saving enough for a secure retirement. A
recent study of household finances found that half of all
American households has less than $1,000 in net financial
assets.\3\ Current trends indicate the likelihood that in the
next century, many Americans will spend as much time in
retirement as they did working. Moreover, the amount of
retirement income considered adequate is increasing because of
early retirements, longer life expectancies, and escalating
health care costs. These concerns are even more pronounced when
you consider that the first of the 76 million baby boomers will
reach retirement age in just 15 years. Research shows that this
generation is woefully unprepared for the future--on average,
they are saving at about one-third the rate necessary to
maintain a comfortable standard of living in retirement.\4\
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\3\ Anderson, Joseph M. The Wealth of American Families in 1991 and
1993. Capital Research Associates, December 1994. The study also found
that even older families, headed by individuals ages 45 to 54, had only
$2,600 in median net financial assets.
\4\ Bernheim, Douglas B. The Merrill Lynch Baby Boom Retirement
Index. Merrill Lynch, 1994. Dr. Bernheim compared the rate the Baby
Boomers are actually saving with what they should be saving in order to
retire at age 65 with the same standard of living they enjoyed during
their pre-retirement years. An Index of 100 percent would mean that
Baby Boomers are saving at the rate needed to retire at a consistent
standard of living. Dr. Bernheim's calculations place the Index at 35.9
percent, a little more than one-third the minimum rate.
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At the same time, fewer Americans believe they can depend
on the government or their employer as their primary source of
retirement income. The Nasdaq Stock Market, in a recent
investor survey, found that 41 percent of investors believe
that most of the money for their retirement will come from
personal savings and investment. In contrast, only 25 percent
are relying on a retirement plan, and just 4 percent on Social
Security to make up the bulk of their retirement income.\5\
This is a remarkable shift in attitude--when SIA testified on
these issues in 1993, only 11 percent of Americans believed
personal savings would be their prime source of retirement
income.
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\5\ Peter D. Hart Research Associates, A National Survey Among
Stock Investors: Conducted for The Nasdaq Stock Market. February 1997.
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For our part, SIA has taken the initiative to educate
Americans about the importance of savings and investment. We
developed two publications to help people make sense of
available investment options. The first--Investor Topics--is a
pamphlet that answers the basic questions people have when they
start investing. The second--Your Guide to Understanding
Investment--is a comprehensive and accessible guide that walks
the reader through the risks and rewards of investing. We have
also worked with the Securities and Exchange Commission in
their well-received series of investor town meetings across the
country.
Solving the Savings Crisis
Mr. Chairman, SIA believes America's economic future hinges
in large part on solving the savings crisis. Increased savings
is vital both to prepare the overall economy for strong growth
into the next century and to provide American households with
greater financial security today and into retirement. Expanding
IRAs would be a giant step toward reviving America's savings
habit. Congress started down this road last year, with passage
of the ``spousal IRA,'' which increases the amount a non-
working spouse can contribute to an IRA to $2,000. SIA commends
you for making this enhancement to the law. Already, it is
making an impact--the industry is seeing a significant upswing
in IRA applications since the law was signed last October.\6\
This shows that Americans do respond to improvements in IRAs.
SIA urges you to build on what you started and further expand
and simplify IRAs for all Americans.
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\6\ SIA is currently surveying its membership to determine the full
effect of the spousal IRA provisions on the market. Results of this
survey will be available later this year.
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IRAs Work
The restriction of IRAs played an important role in the
decline of U.S. savings. Indeed, the drop in annual IRA savings
is equal to about 40 percent of the decline in annual personal
savings since 1986. Annual IRA contributions peaked in 1985, at
just over $38 billion. They have fallen every year since,
reaching a level of just $8 billion in 1993.\7\ If the IRA had
not been curtailed by the Tax Reform Act of 1986, we
conservatively estimate that the total pool of IRA assets would
be $400 billion larger than it is today. SIA believes that a
revitalized IRA will be popular with the American people, will
lift the personal and national savings rates, and will provide
an important middle class tax cut.
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\7\ Hubbard, R. Glenn and Jonathan Skinner. The Effectiveness of
Savings Incentives: A Review of the Evidence, Paper sponsored by the
Faculty Research Fund of the Graduate School of Business of Columbia
University and the Securities Industry Association. January 1995.
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Popular Support. IRAs enjoy exceptional public support. In
fact, a survey conducted shortly after the 1994 Congressional
election found that IRAs were the single most popular tax
proposal included in the Republican Contract With America that
year.\8\ Despite the strong support for IRAs in Congress and by
the Administration, Americans do not believe Washington is
helping them save for retirement. Fully 70 percent of baby
boomers disagree with the statement, ``The government
encourages me to save.'' \9\ Market research conducted by
Opinion Research on behalf of Dean Witter supports this point.
We found that nearly two-thirds of our clients said they would
put money into an IRA if their contributions were tax
deductible.
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\8\ The Luntz Research Companies. February Omnibus Survey II:
Budget, Superfund, Medicare; Defense. February 22-23, 1995.
\9\ Engin, Eric M., William G. Gale, and John Karl Scholz. Do
Savings Incentives Work? Brookings Papers on Economic Activity. 1:1994.
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New Savings. Furthermore, IRAs represent new savings, and
are not simply assets shifted from one account to another.
Professors Glenn Hubbard of Columbia University and Jonathan
Skinner of the University of Virginia performed an extensive
analysis of the research on IRAs and savings patterns. They
concluded that a ``conservative estimate of the effect of IRAs
on personal saving would be about 26 cents per dollar of IRA
contribution.''\10\
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\10\ Hubbard and Skinner. Op. cit.
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Cornell University economist Richard Thaler contends it
doesn't matter if money is shifted into an IRA from other
savings because the withdrawal penalties make it much more
likely that savings in an IRA will accumulate over time.
``Money in a savings account can be splurged on a new car, but
money in an IRA is likely to stay put,'' Dr. Thaler
observed.\11\ IRAs will increase long-term savings because they
get money into an account where funds cannot be quickly spent,
even if the funds would have been saved anyway in another type
of savings account.
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\11\ Thaler, Richard H. Psychology and Savings Policies. AEA Papers
and Proceedings. May 1994. Page 186.
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Benefit the Middle Class. Improved IRAs will benefit the
middle class. From 1982-1986, IRAs were overwhelmingly used by
middle-income Americans. At the peak of the IRA's popularity in
1985 and 1986, 75 percent of IRA contributions were made by
Americans with incomes under $50,000. The IRA income limits
established in 1986 were not indexed for inflation, which is
why IRA eligibility continues to decline sharply. Among workers
whose spouses also work, 53 percent were eligible for a full
IRA deduction in 1987. This fell to 45 percent in 1991 and only
38 percent in 1995.\12\
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\12\ Employee Benefit Research Institute. Individual Saving for
Retirement. EBRI Fact Sheet. September 1995.
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The Tax Reform Act of 1986 transformed IRAs from a simple
investment option into a more complex product with many
eligibility requirements which limits its attractiveness. When
the eligibility requirements were tightened and the accounts
became more complex, financial institutions curtailed their
advertising. This is an important point, because advertising
contributed significantly to the widespread popularity of IRAs
during the early 1980s. A simple, universally available IRA
would undoubtedly encourage financial institutions to run
advertisements encouraging savings. This, in turn, will succeed
in getting many clients who used to contribute to IRAs back in
to the ``saving habit,'' as well as lead many new savers to
open IRA accounts. Indeed, Deputy Treasury Secretary Lawrence
Summers said such an increase in advertising ``could encourage
families to focus their energies on developing a savings plan,
even if they do not open IRAs.'' \13\
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\13\ Testimony of Lawrence H. Summers, Deputy Secretary of the
Treasury, before the Senate Committee on Finance. March 6, 1997.
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You only need to look as far as Canada to see how
significant a change in the advertising message can be. Walk
down a city street, and you will see financial institutions
advertising the opportunity to save in a Canadian tax-preferred
account. Contrast that message of savings with the U.S.,
however, where our financial services firms most often promote
more and better ways to borrow. The difference is striking, and
borne out in the fact that the household saving rate in Canada
is more than twice that of the United States. By restoring the
fully deductible IRA, Congress can literally change the
advertising message reaching the passer-by on countless streets
across America. The promotional efforts surrounding an improved
IRA would reemphasize the importance of savings to U.S.
consumers.
SIA Supports the Super IRA
SIA believes IRAs must be universally available, simple to
understand, must not penalize individuals who participate in
other retirement plans, and must not tie non-wage-earning
spouses' eligibility to whether their spouse has a pension
plan. The Administration's proposal is a good start toward
improving IRAs, but falls short of the mark on each of these
principles. The Administration doubles the current income caps
for deductible contributions to $50,000 for individuals and
$80,000 for couples. Although this is an improvement over
current limits, it is still not high enough to capture many
middle income families with two wage-earners.
The biggest problem with the Administration's IRA, however,
is its five-year sunset. Americans need a permanent solution to
the savings crisis--five years is not long enough to accumulate
sufficient savings for a comfortable retirement. In fact,
taxpayers who open a back-end IRAs under the President's
proposal would never get to take advantage of it's key
feature--tax deductible withdrawals after retirement--unless
they were at least 55 when they opened the account.
SIA believes Representatives Thomas' and Neal's ``Super
IRA'' proposal contained in H.R. 446 achieves our goals. Unlike
the President's plan, anyone--regardless of income or pension
plan or marital status--may make an annual $2,000 tax-
deductible contribution to an IRA. This contribution limit is
indexed to inflation.
The Thomas-Neal Super IRA proposal also creates a new kind
of IRA with a ``back end'' tax incentive. This feature would
allow savers to make deposits to the account from after-tax
dollars, while qualified withdrawals would be tax free.
Although ``back-end'' savings incentives and traditional
``front-end'' savings incentives are economically equivalent,
we believe the back-end account can offer important new
flexibility to Americans. We are pleased H.R. 446 gives
Americans the option to choose the type of account that best
suits their needs.
Furthermore, the expanded withdrawal features of the Super
IRA may attract savers who might not otherwise contribute to an
IRA. In particular, these features will appeal to younger
savers who--in addition to retirement--need a vehicle to save
for major expenses, such as a down payment on a first home or
college tuition.
Mr. Chairman, a revitalized IRA would create a vast pool of
new savings in the American economy. We believe that
contributions to a new and popular IRA program could accumulate
to more than $1 trillion in the first 10 years of the program.
These funds would represent not only $1 trillion in capital for
new investment by U.S. business, but also a $1 trillion nest
egg for American families. The federal budget would be a huge
beneficiary of increased savings, as the accumulation of
savings could lead to lower interest rates in the long run.
According to the Congressional Budget Office, every 50-basis-
point drop in interest rates would save the government more
than $25 billion annually in lower interest payments on
outstanding government debt alone.
Reducing the Tax Code's Bias Against Investment
The present tax system contributes to the savings crisis.
With few exceptions, taxes are imposed twice--first when salary
and wage income are earned, and again, when interest and
dividends on the investment financed by savings are received.
Corporate profits are taxed first at the corporate level, and
again after they are distributed to shareholders as dividends.
Capital gains are also singled out for harsh treatment--all
taxpayers except those in the highest tax brackets pay the same
rate for capital gains as ordinary income; inflationary gains
are subject to taxation; and though taxpayers must pay taxes on
all gains, they are allowed to deduct only $3,000 in capital
losses annually. The individual or company that saves and
invests pays more taxes over time than if all money were spent
on consumption and no saving took place.
In addition, the U.S. taxes capital gains more harshly than
almost any other industrialized nation. An OECD survey of 12
industrialized countries found that the U.S.'s capital gains
tax rate on long-term gains on securities is higher than all
countries except Australia and the U.K. Those countries,
however, index the cost basis of the asset. The countries
surveyed also treat corporate capital gains more favorably than
the U.S. Not surprisingly, most of these countries have higher
national and personal savings and investment rates than the
U.S.\14\
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\14\ Organization for Economic Cooperation and Development. OECD
Economic Outlook 57, June 1995, Annex Table 26, page A-29. Countries in
the OECD survey included the U.S., Japan, Australia, Belgium, Canada,
France, Germany, Hong Kong, Italy, the Netherlands, Sweden, and the
United Kingdom.
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Lower Cost of Capital. Taxes on income from investment
raise the cost of capital of new, productive investment for
both individuals and corporations. Studies show that the user
cost of capital for most types of productive equipment would be
15 percent lower if the Tax Reform Act of 1986 had not been
enacted. Moreover, a capital gains tax rate in the range of 15
to 20 percent would reduce the cost of capital by 4 to 8
percent. Lowering the cost of capital will encourage businesses
to make the kinds of investment in plant and equipment,
research and development, and new technologies that increase
productivity and create new jobs.
Encourage Small Business and Entrepreneurs. A lower cost of
capital is especially important for small businesses. According
to the U.S. Small Business Administration, small businesses
employ 53 percent of the private work force in the U.S.,
contribute 47 percent of all sales in the country, and are
responsible for 50 percent of the gross domestic product. Of
the 3.3 million new jobs created in 1994, an estimated 62
percent were produced by small businesses. Clearly, this is a
growing sector of the economy--indeed, the number of small
businesses has increased by almost 50 percent since 1982, with
800,000 new businesses incorporated in 1995 alone.
Many small businesses are newer, riskier enterprises that
do not have the same financing options or flexibility as
Fortune 500 companies. Much of the start-up money comes from
investors, venture capital pools, family members, and
acquaintances. Because these investors' return is in
appreciated stock, lower capital gains taxes will make people
more willing to risk their savings on new ventures. High
capital gains taxes, on the other hand, frustrate would-be
entrepreneurs and reduce the rate of return for investors.
Benefit All Investors. Capital gains tax cuts would benefit
all investors. Individuals are investing in the capital markets
as never before. More than one-third of all adult Americans
owns stock either directly or indirectly though a mutual fund,
corporate savings program, or a defined retirement contribution
plan. Investors now have more of their liquid financial assets
in capital market investments than in bank accounts. This cuts
across all income levels--IRS statistics show that more than
half of all returns reporting capital gains are from households
with incomes below $50,000. These statistics are not surprising
when you consider that 60 percent of households in this income
range own mutual funds.
Increased Revenue. Not only will lower capital gains taxes
encourage savings, investment, and entrepreneurship, they will
also bring in more revenue for the government in the long run.
There is an abundance of anecdotal evidence of investors who
hold on to assets that they would otherwise sell simply to
avoid paying capital gains taxes. Lower rates would ``unlock''
this capital by giving investors incentive to sell these
assets.
Beyond the anecdotes, however, every time Congress lowered
capital gains tax rates in the past, the Treasury saw an
increase in revenues. For example, from the years 1978 to 1985,
the marginal federal tax rate on capital gains was cut from
almost 50 percent to 20 percent. At the same time, total
individual capital gains tax receipts increased from $9.1
billion to $26.5 billion. Revenue estimates do not fully
consider the unlocking effect or other positive macroeconomic
effects (i.e., lower cost of capital, greater productivity,
increased jobs, stronger economy) when predicting that lower
capital gains taxes will be a money loser for the Treasury.
SIA Supports Broad-Based Capital Gains Tax Cuts
SIA supports a broad-based capital gains tax cut that
treats all investors and assets equally. The President's
proposal, however, only allows individuals to exclude up to
$250,000 profit from the sale of their home from capital gains
taxes. The amount of the exclusion rises to $500,000 for
couples. We believe this provision is far too narrow to produce
the considerable economic benefits that will result from a
broad-based cut. In addition, the President's budget includes
two proposals that will raise the effective tax rates on
securities transactions. SIA is opposed to the average cost
basis and short against the box proposals, and believes they
should be deleted from the budget at the outset.\15\
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\15\ SIA appeared before the Ways and Means Committee on March 12,
1997, to discuss its views on the revenue raising provisions in the
President's budget. SIA's testimony for that hearing sets out in detail
its opposition to 14 tax proposals in the budget, including average
cost basis and short against the box.
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Other proposals have been introduced in Congress to target
certain investments for favorable capital gains treatment or to
compute the rate on a sliding scale based on how long the
investor has held the asset. While both of these types of
proposals have some merit, SIA believes they do not go far
enough. The sliding scale approach would counteract some of the
effects of inflation and reward long-term investors. These
benefits, however, will be far outweighed by the complexity and
administrative burdens of different rates. In addition, tying
the tax rate to the length of time an asset is held draws
arbitrary lines that will distort investment decisions as much
as the current high rate.
Targeted tax cuts also draw arbitrary lines. Though we
understand the policy behind encouraging investments in small
business, venture capital, real estate, enterprise zones, and
farms, targeted cuts will not produce the same impact on the
economy as a broad-based cut. They are also unfair to holders
of ineligible assets. In recent testimony before the Senate
Finance Committee, former Federal Reserve Board Chairman Paul
Volcker said, ``The trouble is targeted reductions require
rather arbitrary distinctions, add greatly to administrative
complexity, and generate essentially unproductive efforts to
artificially meet the favored tax criteria.'' \16\
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\16\ Statement of Paul A. Volcker before the Senate Committee on
Finance. March 13, 1997.
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Legislation has been introduced in Congress, however, that
meets our objectives for a capital gains tax cut. H.R. 14,
introduced by Representative Dreier, together with Mr. English,
Mr. Moran, Mrs. McCarthy, and Mr. Hall, provides for an across
the board 50-percent exclusion for capital gains on assets held
longer than a year. Under their proposal, the top individual
capital gains rate would be reduced to 14 percent, while the
rate would fall to 7.5 percent for taxpayers in the lowest tax
bracket.
The broad-based cuts in H.R. 14 make good economic sense--
they will lower the cost of capital and help reduce the tax
code's bias against savings and investment. Broad-based cuts
are also fair to all income groups and all sectors of the
economy. And finally, SIA believes H.R. 14 will be at least
revenue neutral. As investors ``unlock'' existing capital
gains, they will make the types of investment that expand
businesses, create jobs, and spur economic growth.
Conclusion
In conclusion, Mr. Chairman, SIA commends you once again
for your emphasis on savings and investment in the context of a
balanced budget. Thank you for allowing me to share the
securities industry's views on these vitally important
subjects. Expanded IRAs and broad-based tax capital gains tax
cuts will go a long way toward increasing the savings rate in
the U.S., encouraging Americans to save for their retirements,
and expanding the economy. SIA looks forward to working with
you as you consider the role savings and investment incentives
will play in the debate.
Chairman Archer. Thank you, Mr. Higgins.
Our next witness is Dr. Paul Yakoboski. Did I get that
pronunciation pretty close?
Mr. Yakoboski. Yes, you did.
Chairman Archer. We are happy to have you before the
Committee, and if you will identify yourself for the record, we
will be pleased to receive your testimony.
STATEMENT OF PAUL J. YAKOBOSKI, PH.D., SENIOR RESEARCH
ASSOCIATE, EMPLOYEE BENEFIT RESEARCH INSTITUTE
Mr. Yakoboski. Thank you, Mr. Chairman.
My name is Paul Yakoboski. I am a senior research associate
at the Employee Benefit Research Institute, a nonprofit,
nonpartisan, public policy research organization based in
Washington, DC.
EBRI has been committed since its founding in 1978 to the
accurate statistical analysis of economic security issues.
Through our research, we strive to contribute to the
formulation of effective and responsible health and retirement
policies. Consistent with our mission, we do not lobby or
advocate specific policy solutions.
I am pleased to appear before you this afternoon to discuss
issues of individual retirement accounts and alternative tax-
qualified retirement savings plans.
The original objective in establishing IRAs was to provide
a tax-deferred retirement savings vehicle for those workers who
did not have an employment-based retirement plan. However, the
fact is that the vast majority of workers eligible for a tax-
deductible IRA contribution do not contribute.
According to our tabulations of 1993 current population
survey data, the latest data available, 89 percent of single
workers are eligible for a deductible IRA contribution, but
only 5 percent of these contribute. Fifty-six percent of dual-
income couples are eligible for a deductible IRA contribution,
but only 10 percent of these contribute. Seventy-two percent of
single-income couples are eligible for a deductible IRA
contribution, but only 9 percent of these contribute.
Participation rates are higher for those with greater incomes,
but still, the highest participation rate is 27 percent among
single workers with annual incomes of $50,000 or more.
Alternatives to IRAs exist that allow workers to save money
for retirement on the same tax-deferred basis enjoyed by fully
deductible IRA contributions. Such plans include the Federal
thrift savings plan, private sector 401(k) plans, SIMPLE plans
for small employers, public sector 457 plans, and 403(b) plans
for certain charitable organizations, public school and
university systems. These plans, referred to here as salary
reduction plans, are the employment-based, tax-qualified plans
offered at an employer's discretion and, therefore, are not
available to all workers.
Differences between IRAs and salary reduction plans include
the amount that can be contributed on a tax-deductible basis,
which is typically much higher through a salary reduction plan
than with an IRA. Salary reduction contributions may, however,
be limited by nondiscrimination standards, while IRAs are not
subject to such standards.
Some salary reduction plans allow loans to participants,
while IRAs are prohibited from offering loan features. IRA
money can be withdrawn at any time for any purpose, but it is
typically subject to a 10-percent penalty tax, in addition to
income taxation if withdrawn before age 59\1/2\.
Penalty-free IRA withdrawals can now be made to pay medical
expenses that exceed 7.5 percent of a taxpayer's adjusted gross
income. If a salary reduction plan does not allow loans or
withdrawals, a worker cannot access funds in his account until
he leaves that employer.
Salary reduction plans continue to grow as an important
element of the employment-based retirement income system.
According to our tabulations of the 1993 CPS, 65 percent of
workers with an employer who sponsors such a plan choose to
contribute, and this figure is up from 55 percent 5 years
earlier.
Why are participation rates among eligibles so much higher
for employment-based salary reduction plans than with IRAs? A
likely reason is that participation in a salary reduction plan
is generally more convenient. Since it is offered through the
workplace, it involves automatic contribution deductions from a
worker's paycheck.
Also, plan sponsors typically market the plan to their
employees and educate them as to the importance of saving for
their retirement income security through the plans. Employer-
matching contributions are also available in many salary
reduction arrangements.
Finally, it is possible that some workers who are eligible
for a tax-deductible IRA contribution may not be aware of their
eligibility or they may not appreciate the inherent tax
advantages offered by an IRA.
Thank you.
[The prepared statement and attachments follow:]
Statement of Paul J. Yakoboski, Ph.D., Senior Research Associate,
Employee Benefit Research Institute
I am pleased to appear before you this morning to discuss
issues of individual retirement accounts (IRAs) and alternative
tax-qualified retirement saving plans. My name is Paul
Yakoboski. I am a senior research associate at the Employee
Benefit Research Institute (EBRI), a nonprofit, nonpartisan,
public policy research organization based in Washington, DC.
EBRI has been committed, since its founding in 1978, to the
accurate statistical analysis of economic security issues.
Through our research we strive to contribute to the formulation
of effective and responsible health and retirement policies.
Consistent with our mission, we do not lobby or advocate
specific policy solutions.
IRA Usage
Through enactment of the Employee Retirement Income
Security Act of 1974 (ERISA), Congress established IRAs to
provide workers who did not participate in employment-based
retirement plans an opportunity to save for retirement on a
tax-deferred basis. U.S. tax law has substantially changed the
eligibility and deduction rules for IRAs since then. The
Economic Recovery Tax Act of 1981 (ERTA) extended the
availability of IRAs to all workers, including those with
pension coverage. The Tax Reform Act of 1986 (TRA '86) retained
tax-deductible IRAs for those who did not participate in an
employment-based retirement plan (and if married, whose spouse
did not participate in such a plan), but restricted the tax
deduction among those with a retirement plan to individuals
with incomes below specified levels. In addition, TRA '86 added
two new categories of IRA contributions: nondeductible
contributions, which accumulate tax free until distributed, and
partially deductible contributions, which are deductible up to
a maximum amount less than the $2,000 maximum otherwise
allowable. The Small Business Job Protection Act of 1996
increased the amount that may be contributed on a deductible
basis on behalf of a nonworking spouse (if the working spouse
is eligible for a deductible contribution) from $250 to
$2,000.\1\
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\1\ Under current law, individuals who are not active participants
(and, if married, whose spouse is not an active participant) in a
qualified employment-based retirement plan can make fully tax-
deductible contributions up to a $2,000 maximum per year to an
individual retirement account (IRA). Individuals who are active
participants or whose spouse is an active participant in a qualified
employment-based plan and whose adjusted gross income (AGI) does not
exceed $25,000 (single taxpayers) or $40,000 (married taxpayers filing
jointly) may make a fully deductible IRA contribution. Individuals who
are active participants or whose spouse is an active participant in a
qualified employment-based plan and whose AGI falls between $25,000 and
$35,000 (single taxpayers) and between $40,000 and $50,000 (married
taxpayers filing jointly) may make a fully deductible IRA contribution
of less than $2,000 and a nondeductible IRA contribution for the
balance, as follows. The $2,000 maximum deductible contribution is
reduced by $1 for each $5 of income between the AGI limits. Individuals
who are active participants or whose spouse is an active participant in
a qualified employment-based plan and whose AGI is at least $35,000
(single taxpayers) or at least $50,000 (married taxpayers filing
jointly) may only make nondeductible IRA contributions of up to $2,000;
earnings on the nondeductible contribution are tax deferred until
distributed to the IRA holder. The Small Business Job Protection Act of
1996 increased the amount that may be contributed on a deductible basis
on behalf of a nonworking spouse (if the working spouse is eligible for
a deductible contribution) from $250 to $2,000. Thus a single earner
couple, if eligible for a fully deductible IRA contribution, may
contribute $4,000. IRAs can also be established as rollover vehicles
for lump-sum distributions from employment-based retirement plans or
other IRAs.
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The overwhelming majority of those workers eligible to make
a tax-deductible contribution to an IRA currently choose not to
do so. This is true among single workers and among married
couples (both one earner and two earner couples). And it is
true across income groups, although those with higher incomes
are more likely to contribute when eligible (table 1).
According to EBRI tabulations of the April 1993 Current
Population Survey employee benefits supplement (CPS-ebs), in
1992, 89 percent of all single workers were eligible to make an
IRA contribution that was at least partially tax deductible.
All such workers earning less than $35,000 (86 percent of
single workers) were eligible. In addition, 22 percent of
single workers earning between $35,000 and $49,999 and 20
percent of those earning $50,000 or more were eligible for a
deductible IRA contribution.
Among single workers, only 5 percent of those eligible for
a deductible IRA contribution actually contributed to an IRA in
1992. The likelihood of making a contribution increased with
worker earnings. Only 1 percent of those eligibles making less
than $10,000 contributed, compared with 27 percent of those
making $50,000 or more.
Fifty-six percent of married couples with both spouses
working were eligible to make an IRA contribution that was at
least partially tax deductible. All such couples with combined
incomes of less than $50,000 were eligible, and 10 percent of
those with combined incomes greater than $50,000 were eligible.
Among eligible two earner couples, 10 percent made an IRA
contribution in 1992. Among eligible two earner couples, the
likelihood of making a contribution increased with the couples'
income. Among couples with a combined income of less than
$10,000, essentially none contributed, while 23 percent of
couples making $50,000 or more made an IRA contribution.
Married couples with one earner are more likely than those
with two earners to be eligible for a deductible IRA
contribution. Seventy-two percent of single earner couples were
eligible to make an IRA contribution that was at least
partially tax deductible. This included 100 percent of those
earning less than $35,000, 22 percent of those earning $35,000
to $49,999 and 16 percent of those earning $50,000 or more.
Among eligible single earner couples, 9 percent made an IRA
contribution in 1992. Six percent of those making less than
$10,000 made a contribution, compared with 22 percent of those
making $50,000 or more.
While IRAs were created to allow individuals without an
employment-based retirement plan to save for retirement on a
tax-deferred basis, the fact is that the vast majority of those
eligible to make tax-deductible contributions to an IRA choose
not to do so. It is often speculated that this is due to a lack
of money, but even among higher earning workers, those who are
eligible for a deductible IRA still do not, in general,
participate. It is also often speculated that individuals are
reluctant to tie up their savings in a vehicle where it is
beyond their reach, without significant tax penalties, should
they need the money before retirement.\2\
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\2\ Distributions from IRAs are taxed as ordinary income in the
year received, except for the portion of the total IRA distribution
that is attributable to nondeductible contributions, which are
excludable from gross income. Taxable distributions prior to age 59\1/
2\ are subject to a 10 percent penalty tax, unless they are taken as
part of a series of equal payments made for the life (or life
expectancy) of the IRA owner and his or her beneficiary, or the IRA
owner dies or becomes disabled.
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Salary Reduction Plans
Alternatives to IRAs exist that allow workers to save money
for retirement on the same tax-deferred basis enjoyed by fully
deductible IRA contributions. These plans, referred to here as
salary reduction plans, are offered through work at an
employer's discretion, and therefore are not available to all
workers. However, when they are available to workers, they do
have some advantages relative to IRAs as a retirement wealth
accumulation tool. These are discussed shortly.
Salary reduction plans include 401(k) plans, 457 plans,
403(b) plans, and the federal Thrift Savings Plan (TSP). The
Revenue Act of 1978 permitted employers to establish 401(k)
arrangements, named after the Internal Revenue Code (IRC)
section authorizing them. In 1981, the Internal Revenue Service
(IRS) issued the first set of proposed regulations covering
such plans. These proposed regulations provided some
interpretive guidelines for sec. 401(k) and specifically
sanctioned ``salary reduction'' plans. Through 401(k)
arrangements, participants may contribute a portion of
compensation (otherwise payable in cash) to a tax-qualified
employment-based plan. Typically, the contribution is made as a
pretax reduction in (or deferral of) salary that is paid into
the plan by the employer on behalf of the employee.\3\ In many
cases, an employer provides a matching contribution that is
some portion of the amount contributed by the employee,
generally up to a specified maximum. The employee pays no
federal income tax on the contributions or on the investment
earnings that accumulate until withdrawal. Some plans also
permit employee after-tax contributions; the earnings on these
contributions are also not taxed until withdrawal.
---------------------------------------------------------------------------
\3\ The Tax Reform Act of 1986 placed a $7,000 limit on pretax
employee contributions to private-sector 401(k) plans. This limit was
indexed to the consumer price index beginning in 1988. The 1997 limit
is $9,500.
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Public-sector employers can establish deferred compensation
plans under IRC sec. 457; charitable organizations qualified
under IRC sec. 501(c)(3) (for example, a tax-exempt hospital,
church, school, or other such organization or foundation) and
public school systems and public colleges and universities can
establish tax-deferred annuity plans under IRC sec. 403(b). The
1983 Social Security Amendments required that a new civil
service retirement system be established to cover federal
employees hired after December 31, 1983. The Federal Employees
Retirement System (FERS), which Congress adopted in 1986 and
which went into effect in January 1987, combines Social
Security, a defined benefit pension plan, and an optional tax-
deferred thrift plan similar to a private-sector 401(k)
arrangement. Employees hired before the end of 1983 were given
the option of joining the new system or remaining in the old
Civil Service Retirement System (CSRS) during a six-month
period ending in December 1987.\4\
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\4\ The thrift plan is available to workers covered by either FERS
or CSRS, but different rules apply to the two groups. FERS employees
are automatically covered under the thrift plan, and the government
contributes the equivalent of 1 percent of pay for each employee
whether or not the individual contributes. Employees may make further
contributions of up to 10 percent of base salary (up to the same dollar
maximum as 401(k) plans). The government will then match, dollar for
dollar, the first 3 percent of employee contributions and 50 percent of
the next 2 percent, with no match beyond 5 percent. CSRS participants
may contribute up to 5 percent of their salaries to the thrift plan but
are not entitled to government contributions.
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Comparison with IRAs
Salary reduction plans offer an advantage over IRAs in that
the amount that can be contributed on a tax-deductible basis is
much higher. The maximum deductible IRA contribution is $2,000
annually, compared with $9,500 for 401(k), 403(b) plans, and
the federal TSP, and $7,500 for 457 plans. Furthermore, the
limits on the salary reduction plans are indexed for inflation,
while the IRA maximum is not. However, nondiscrimination
standards for salary reduction plans in the private sector may
limit the amount that highly compensated employees \5\ can
contribute. In some instances such highly compensated employees
may not be allowed to contribute the dollar amount cited above,
and in extreme cases they may not be allowed to contribute
anything to the plan as a result. Since IRAs are not
employment-based, they are not subject to such
nondiscrimination standards.
---------------------------------------------------------------------------
\5\ 5. See IRC sec. 414(q) for definition of highly compensated
employee.
---------------------------------------------------------------------------
Employers will often provide matching contributions on a
certain percentage of the earnings that a worker chooses to
contribute (e.g., an employer may match 50 percent of the first
6 percent of pay that participants in the plan choose to
contribute). Such matching contributions are optional on the
part of the employer, and thus do not constitute an inherent
advantage for these plans over IRAs. They may, however, serve
as a strong incentive to participate, as will be discussed
later.
A second advantage of salary reduction plans over IRAs is
that the plan sponsor serves as a fiduciary filter for the
thousands of investment options available today. Salary
reduction plans offer participants a limited menu of investment
options from which to choose. The plan sponsor has a fiduciary
duty to choose the options offered in a prudent manner. In
essence, the sponsor has already done the first round of
screening for the participant.
Sec. 401(k) and 403(b) plans can allow loans to
participants. Whether a plan has a loan feature is at the
discretion of the plan sponsor. The federal TSP does have a
loan feature. Sec. 457 plans are not allowed to offer loans.
IRAs do not have loan features. However, IRA money can be
withdrawn at any time for any purpose (it is generally subject
to a 10 percent penalty tax if withdrawn before age 59, in
addition to income taxation). Salary reduction plans may allow
withdrawals in instances of ``hardship,'' but they are not
required to do so. If a plan does not allow loans or hardship
withdrawals, a worker would not be able to access the funds in
his or her account under any circumstances until the time he or
she leaves that employer.
Participation
Salary reduction plans continue to grow as an important
element of the employment-based retirement income system.
According to EBRI tabulations of the April 1993 CPS-ebs, the
percentage of civilian nonagricultural wage and salary workers
with an employer who sponsors a salary reduction plan (the
sponsorship rate) increased from 27 percent (27 million
workers) in 1988 to 37 percent (39 million workers) in 1993
(table 2). Over the same time period, the fraction of all
workers participating in such plans (the participation rate)
rose from 15 percent (16 million workers) to 24 percent (25
million workers). The fraction of participating workers among
those where a salary reduction plan was sponsored (the
sponsored participation rate) also increased, rising from 57
percent to 65 percent. The growth in salary reduction plan
sponsorship and participation has occurred across almost all
worker and job-related characteristics, including firm size.
The likelihood of salary reduction plan sponsorship and
participation increased with firm size (table 2). In 1993, 5
percent of those employed by a firm with fewer than 10
employees reported that their employer sponsored a salary
reduction plan, as compared with 54 percent of those employed
by firms with 1,000 or more employees. When a plan was
sponsored, the participation rate did not vary systematically
with firm size. In all but the smallest employer category, the
participation rate among workers where a plan was sponsored was
about two-thirds. In the smallest firms (fewer than 10
employees), almost three-quarters of workers where a plan was
sponsored chose to participate. Therefore, the positive
relationship between firm size and overall participation rates
was solely a function of the positive relationship between firm
size and sponsorship rates.
The higher a worker's earnings, the more likely he or she
was to have a plan available at work. Two-thirds of workers
earning $50,000 or more had an employer that sponsored a salary
reduction plan, compared with only 8 percent of workers earning
less than $5,000 (table 2). Furthermore, when a plan was
available, higher earning workers were more likely to
participate than lower earners. Twenty percent of workers
earning less than $5,000 contributed to a plan when one was
offered, compared with 83 percent of workers earning $50,000 or
more.
Discussion
As seen above, participation rates among eligibles are much
higher for employment-based salary reduction plans than for
IRAs. Why?
Participation in a salary reduction plan is generally more
convenient since it is offered through the workplace and
involves automatic contributions from a worker's paycheck
before he or she even sees the money. Plan sponsors will also
market the plan to their employees and typically educate them
as to the importance for their retirement income security of
participating in the plan. With IRAs, on the other hand, an
individual must make a conscious decision to seek out such
information on his or her own (unless it is offered through
work). Moreover, it has been speculated that some workers who
are eligible for a tax-deducible IRA contribution may not be
aware of their eligibility.
Another important reason is the availability of employer
matching contributions with salary reduction plans. Among
workers whose employer sponsored a salary reduction plan in
1993, 51.3 percent reported that their employer provided
matching contributions to the plan. The actual percentage was
likely higher because 30.2 percent did not know if their
employer matched contributions. Among those responding that
their employer did provide a matching contribution, the average
reported match rate was 65 percent (i.e., for every $1 the
employee contributed, the employer contributed 65 cents). Such
employer matching contributions are not available with IRAs.
Studies have found evidence that the availability of an
employer match does have an effect on participation. For
example, a 1995 Hewitt Associates' study of 401(k) plans found
an average participation rate of 76 percent in plans with an
employer match as opposed to an average of 59 percent in plans
with no employer match.\6\ Similarly, a 1996 Buck Consultants
study of 401(k) plans found an average participation rate of 67
percent in plans with no employer match, compared with
participation rates near 80 percent in plans with some form of
employer matching contribution.\7\
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\6\ See Hewitt Associates, Trends; Experience in 401(k) Plans, 1995
(Lincolnshire, IL: Hewitt Associates, 1995).
\7\ See Buck Consultants, 401(k) Plans: Employer Practices;
Policies, September 1996 (New York, NY: Buck Consultants, Inc., 1996).
---------------------------------------------------------------------------
Finally, the other notable point from the data presented
above is that, despite the rapid growth over recent years in
the number of salary reduction arrangements in small firms, it
is at the small plan level that a noticeable gap in plan
sponsorship remains. The question naturally arises as to what,
if anything, can be done to fill this void? SIMPLE IRAs and
SIMPLE 401(k)s were created by the Small Business Job
Protection Act of 1996 for this very reason. Time will tell how
successful they will be.
Table 1. Individual Retirement Account (IRA) Participation and Eligibility
----------------------------------------------------------------------------------------------------------------
Percentage Number
Eligible for Eligible for Percentage of
Number Deductible IRA Deductible IRA Eligible
(thousands) Contribution Contribution Contributing
in 1993 (thousands) in 1992
----------------------------------------------------------------------------------------------------------------
Single Workers
Total......................................... 40,151 88.9 35,684 4.7
Annual Earnings (1993)
Less than $10,000............................. 10,655 100.0 10,655 1.4
$10,000-$24,999............................... 17,974 100.0 17,974 4.7
$25,000-$34,999............................... 5,879 100.0 5,879 8.4
$35,000-$49,999............................... 3,547 21.6 766 12.1
$50,000 or more............................... 2,097 19.6 411 27.2
Married Couples, Two Earners
Total Households.............................. 19,389 56.4 10,934 10.0
Annual Earnings (1993)
Less than $10,000............................. 61 100.0 61 0.0
10,000-$24,999................................ 1,584 100.0 1,584 5.7
$25-$49,999................................... 8,398 100.0 8,398 9.5
$50,000 or more............................... 9,345 9.5 890 23.1
Married Couples, One Earner
Total Households.............................. 14,212 72.4 10,288 8.5
Annual Earnings (1993)..........................
Less than $10,000............................. 1,653 100.00 1,653 5.5
$10,000-$24,999............................... 5,331 100.0 5,331 6.3
$25,000-$34,999............................... 2,383 100.0 2,383 11.5
$35,000-$49,999............................... 2,443 22.2 542 17.3
$50,000 or more............................... 2,402 15.8 380 21.9
----------------------------------------------------------------------------------------------------------------
Source: EBRI tabulations of the April 1993 Current Population Survey employee benefit supplement.
Table 2. Civilian Nonagricultural Wage and Salary Workers, Ages 16 and Over, by Salary Reduction Plan Sponsorship and Participation, 1988 and 1993
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total Workers Sponsorship Rate a Participation Rate b Sponsored
(thousands) ------------------------------------------------ Participation Rate c
------------------------ -----------------------
1988 1993 1988 1993 1988 1993 1988 1993
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total................................................... 101,745 105,815 26.9% 36.8% 15.3% 23.8% 57.0% 64.6%
Firm Size
Less than 10.......................................... 13,561 14,032 3.0 5.1 2.2 3.8 74.3 74.3
10-24................................................. 8,164 8,466 8.0 12.1 5.7 8.4 70.9 69.5
25-49................................................. 6,781 6,716 14.2 20.1 7.8 12.7 55.2 62.9
50-99................................................. 5,563 6,185 18.0 29.9 11.0 20.9 61.2 69.8
100-249............................................... 7,497 7,775 22.8 39.0 13.3 25.0 58.4 64.2
250 or more........................................... 51,274 54,709 41.5 53.2 23.4 34.5 56.2 64.9
250-499............................................... (d) 5,471 (d) 49.9 (d) 32.5 (d) 65.2
500-999............................................... (d) 5,485 (d) 47.8 (d) 30.5 (d) 63.7
1,000 or more......................................... (d) 43,753 (d) 54.3 (d) 35.3 (d) 65.0
Annual Earnings, 1993 ($)
Less than $5,000...................................... 7,595 7,275 3.8 8.1 1.1 1.6 28.0 19.9
$5,000-$9,999......................................... 10,119 10,419 8.8 13.1 2.6 4.4 29.7 33.6
$10,000-$14,999....................................... 12,463 15,015 15.3 22.7 5.6 10.0 36.6 43.9
$15,000-$19,999....................................... 13,658 14,238 22.2 35.7 10.3 19.5 46.2 54.6
$20,000-$24,999....................................... 10,956 12,408 30.2 43.9 15.5 26.7 51.2 60.8
$25,000-$29,999....................................... 9,841 9,737 35.4 46.5 20.0 31.1 56.7 66.8
$30,000-$49,999....................................... 20,993 19,858 43.9 57.1 27.8 41.3 63.2 72.4
$50,000 or more....................................... 7,876 8,566 55.4 67.6 40.9 56.3 73.7 83.2
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: EBRI tabulations of the May 1988 and April 1993 Current Population Survey employee benefit supplements.
a The fraction of workers whose employer sponsors a salary reduction plan for any of the employees at the worker's place of employment.
b The fraction of all workers participating in a salary reduction plan.
c The fraction of workers participating in a salary reduction plan among those whose employer sponsors a plan for any of the employees at the worker's
place of employment.
d Data not available.
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Chairman Archer. Thank you, Dr. Yakoboski.
Our last witness is Dr. William Gale, who is also no
stranger to the Committee. We are happy to have you back before
the Committee. If you will identify yourself for the record, we
would be glad to receive your testimony.
STATEMENT OF WILLIAM G. GALE, JOSEPH A. PECHMAN FELLOW,
ECONOMIC STUDIES PROGRAM, BROOKINGS INSTITUTE
Mr. Gale. Thank you very much, Mr. Chairman, for inviting
me to testify. It is a pleasure to be here today to talk about
IRAs.
My testimony is based in part on the research I have
conducted over many years on the effect of IRAs on saving, and
let me start by saying that I think the low level of private
and national saving is one of the most important economic
problems we face in the United States today, but in terms of
thinking about IRAs, we need to think about IRAs in the larger
context of tax policy toward saving.
It has been noted many times in the hearings so far, that
certain forms of income are taxed at very high, even punitive
rates. What should also be noted is that a very large
proportion of capital income or saving is taxed at either zero
or negative rates. Currently, people can invest in IRAs,
defined benefit plans, defined contribution plans, 401(k)s,
Keoughs, 403(b) plans, 457 plans, Federal Government thrift
plans, SIMPLE plan, SEP plans, fixed and variable annuities,
and life insurance saving. There is no shortage, in short, of
opportunities for tax-deferred saving.
In fact, there is so much tax-deferred saving right now
that tax-deferred saving accounts for roughly 100 percent of
net personal saving in the last decade.
Over the last two decades, tax-deferred saving has gone up
rather dramatically, at the same time that the personal saving
rate has come down. If the contributions to tax-preferred
saving rates were, indeed, net additions to private saving, we
would expect that private saving would have gone up with this
surge in tax-preferred saving, but in fact, we see the
opposite. Private saving has either held constant or fallen.
One reason for that can be given by thinking about how
people make contributions to IRAs. There are basically two ways
to contribute to an IRA, a painless way and a painful way. The
painless way is pretty obvious. You take money from one
account, a taxable account, and move it into an IRA. You take
money you would have saved anyway, put it in an IRA, or you
borrow money and you put it in the IRA. Those are all painless
because they don't force you to reduce your current
consumption, but they do allow you to take advantage of the tax
benefit of having an IRA.
The painful way to contribute to an IRA is to raise your
saving; that is, to reduce your consumption and reduce your
current standard of living.
There has been a lot of research on this topic. I have been
part of that research, and my summary of the research is that
there are a number of statistical problems in this literature,
but studies that correct for the problems give the intuitive
and I think the correct result, which is that people so far
have contributed to IRAs in mainly the painless way; that is,
they have found ways to get a hold of the tax break without
reducing their living standards. I don't blame people for doing
this. It is exactly what I do when I contribute to an IRA or a
tax-deferred account, but as a matter of policy, it indicates
that the programs have not been as effective as they could be.
How big of an effect on saving might we expect if we
expanded IRAs? Well, in the ``golden years,'' before 1986, IRAs
were about 1 percent of GDP, but the expansion is only partial.
So let us suppose that contributions rise by about one-half of
1 percent of GDP. If half of those contributions are new
saving, which is an average from the literature, and then you
deduct out government saving, you get the national saving rate
going up by one-eighth of 1 percentage point of GDP. So the IRA
expansion would raise saving from 5 to about 5.12 percent.
That is only the effect of expanding the income limits. The
other part of these proposals would allow penalty-free
withdrawals for other purposes; for example, first-time home
purchase, unemployment, medical expenses, education expenses.
If this provision were to be enacted, I would caution that it
should not apply to preexisting balances. There are $1.2
trillion in preexisting IRA and Keough balances. If people
start taking that money out for other purposes, that will
reduce the saving rate, not raise it.
The problem here is the obvious one. You cannot encourage
consumption and saving at the same time. So, if withdrawals are
allowed for preexisting assets, the saving rate could very well
fall if we expand IRAs, as proposed by the administration.
As a matter of tax policy, expanding IRAs would definitely
make the system more complicated. I know, Mr. Chairman, that
you would like to get the IRS out of people's lives. I ask you
to envision what kind of IRS rules and procedures would be
required to verify that a certain IRA withdrawal was actually
made for a certain purpose, like unemployment or health or
education. That would, if anything, make the IRA more intrusive
or increase the level of evasion in the existing tax system.
So let me close by thinking about the bigger picture. There
is a case, a mixed case, to be made for removing taxes on all
capital income and moving more toward a consumption tax. That
raises a whole host of new issues, but I think there is a
legitimate case to be made, and there are legitimate issues to
be talked about.
The point I would like to leave you with is that moving
part way there, that is, increasing the crazy quilt of tax
policy toward savings, increasing the number of loopholes, can
actually be a step backward. Moving partway there can actually
be worse in terms of tax complexity, tax efficiency, tax
equity, than moving all the way there. Even if we think we
should move all the way there, it is not clear that moving
partway there is a good idea.
So what I would like to see the Congress do, returning the
focus on raising the national saving rate, is to focus on
financial education, to focus on pension reform, and to look
quite seriously at Social Security reform.
Modifying IRAs, even if it works, is not going to have a
large effect, and my suspicion is that is not going to work on
the basis of the evidence I mentioned earlier.
Thank you very much.
[The prepared statement and attachments follow:]
Statement of William G. Gale, Joseph A. Pechman Fellow, Economic
Studies Program, Brookings Institute
Mr. Chairman and Members of the Committee:
The views expressed here are my own and should not be
ascribed to the officers, trustees, or staff of the Brookings
Institute.
Discussion
Thank you for inviting me to testify today on the issue of
expanding Individual Retirement Accounts. The low level of
private and national saving is one of the most important
economic problems facing our country today and in the future.
American saving rates have been very low in recent years,
compared to other countries and by historical standards. On a
national level, more saving could finance increased investment.
This in turn can make workers more productive, and raise their
wages and standards of living. At the household level,
increased saving helps people prepare for retirement, provides
a cushion for financial downturns, and assists in meeting other
financial goals.
Many potential factors have been offered to explain the
saving decline. These include: increased intergenerational
transfers to the elderly; expansions of government programs
that reduce the need to save (including Social Security,
Medicare, Medicaid, unemployment insurance, workers'
compensation, housing guarantees, and student loans);
liberalization of debt markets; demographic changes; and the
slowdown in income growth since the mid-1970s. Tax
considerations are notably absent from this list; indeed, the
general tax and inflation environment facing savers may be at
least as favorable today as it has been in the past. The
highest marginal tax rates are relatively low by historical
standards and inflation, which raises the effective tax rate on
financial assets, is quite low. Despite these considerations,
tax policy is sometimes claimed to be an effective way to raise
the saving rate substantially.
Tax policy toward saving is inconsistent. Some assets are
taxed at high effective rates, while a large number are taxed
at rates that are very low and can even be negative. There is
no shortage of tax-preferred methods of saving. Current options
include IRAs, defined benefit pensions, defined contribution
pensions, 401(k) plans, Keoghs, 403(b) plans, 457 plans,
federal government thrift saving plans, SIMPLE plans, SEP
plans, fixed and variable annuities, and life insurance saving.
Moreover, housing and municipal bonds are also tax-favored, as
are the capital gains that accrue to unincorporated businesses.
Over the last several decades, as the personal saving rate has
fallen, tax-favored saving (via pensions, 401(k)s, IRAs,
Keoghs, and life insurance) has become an ever more important
component of total personal saving. Between 1986 and 1993,
saving in tax-preferred accounts constituted about 100 percent
of net personal saving (Table 1). This does not mean there was
no other saving activity, it just means that any gross saving
in other accounts was fully offset by withdrawals from those
accounts or by increases in borrowing.
Wide variations in effective tax rates on saving creates
opportunities for investors to shift funds into the most tax-
preferred accounts. The variation in rates, coupled with the
tax-deductibility of interest payments, creates opportunities
to game the system further by borrowing, deducting the interest
payments, and investing in a tax-preferred asset.
IRAs are just one more patch in the crazy quilt of saving
policy. Contributions of up to $2,000 per year are tax-
deductible for households with income up to prescribed limits.
Deductibility is then phased out as income rises further.
Balances accrue tax-free. Ordinary income taxes are due on any
withdrawals, and a 10 percent penalty is also assessed on
withdrawals that are not related to death or disability, but
occur before the account holder is 59.5 years old.
Several current proposals would amend IRAs in a number of
ways, including:
Raising the income limits on deductible IRA
contributions; indexing the income and contribution
limits.Creating back-loaded IRAs: In a back-loaded IRA, the
contribution is not deductible, but earnings and withdrawals
are free of taxes and penalties, provided the funds were held
in the account for a specified period, usually 5 years.
Allowing penalty-free (and income-tax-free)
withdrawals for specified purposes such as education, medical
expenses, first-time home purchases, long-term unemployment, or
business start-up expenses.
These proposals involve issues of tax policy, budget
policy, retirement income security, and saving policy.
Tax Policy Considerations
Expanding IRAs would be counterproductive tax policy. The
IRA proposals would make the tax system more complex and
intrusive. Serious consideration of how the IRS would verify
that a particular withdrawal was made for a particular purpose
suggests compliance and enforcement difficulties. Enforcing the
combined limits on IRAs and elective deferral plans would cause
further compliance headaches. Tax debates in 1996 correctly
emphasized the importance of broadening the base, removing
loopholes, and reducing rates in a revenue-neutral manner. As
we move into 1997, proposals that expand IRAs move in exactly
the opposite direction.
While IRAs are often described as tax-deferred saving, the
effective tax rate on IRAs is typically zero or negative. The
effective rate is zero if the tax rate that applies to the
deductible contribution is equal to the rate that applies to
the withdrawal. However, since marginal tax rates have fallen
since 1986, and since people typically face lower marginal tax
rates in retirement than during working years, the effective
tax rate for many IRA holders is likely to be negative. For
example, a household that deducts a $2,000 IRA contribution at
a 28 percent tax rate, holds the asset for 20 years at a 10
percent annual return, and withdraws the funds at a 15 percent
tax rate pays an effective tax rate of negative 9 percent on
the IRA. Punching a hole in the tax code to generate more
assets with negative effective tax rates is inefficient and
inequitable. Good tax policy would even out the taxation of all
forms of saving, and possibly reduce the overall level of
taxation on saving.
Budget Policy Considerations
Expanding IRAs would also be counterproductive budget
policy. First, it would create a new entitlement for anyone
with enough funds to place money in a designated account. The
fact that IRAs are tax rules rather than spending programs
should not blind us to the essential equivalence of an
entitlement set in the tax code and one set on the spending
side. Tax entitlements are just as costly (and often more
difficult to discern) than spending entitlements. The IRA
entitlement would accrue largely to households in the top part
of the income distribution, and would provide larger
entitlement payments (i.e., tax cuts) to wealthier households
who contributed more or faced higher tax rates. The key to long
run budget control is to eliminate or reduce entitlement
obligations rather than increase them.
Second, current budget procedures understate the cost of
back-loaded IRAs. The requirement of a 5-year holding period
before penalty-free withdrawals are allowed effectively places
most of the costs beyond the five-year budget window. Budget
policy should move toward more complete accounting of the costs
of government programs.
Third, for any given amount of contributions, allowing both
traditional front-loaded IRAs and back-loaded IRAs will prove
more expensive in revenue terms than having either one. Other
things equal, people who believe their tax rate will be lower
when they withdraw the funds than it is now will tend to choose
front-loaded IRAs, so they can take the deduction at the
relatively higher current tax rate. Likewise, people who
believe that their tax rate upon withdrawal will be lower than
their current rate will tend to choose back-loaded IRAs to
obtain the biggest tax cut.
Retirement Income Considerations
Expanding the conditions for penalty-free IRA withdrawals
would undermine the retirement income goals of IRAs, and could
reduce both saving and tax revenue. One can imagine the list of
favored uses of IRA funds expanding indefinitely. One can also
imagine the list of favored accounts expanding as well: if IRA
funds can be tapped, why not Keoghs, SIMPLE plans, SEPs,
401(k)s, pensions, or fixed and variable annuities? Moreover,
there would be difficult administrative problems associated
with minimizing abuse of these provisions. These problems will
make the tax code more complex, and will require the IRS to
gather more information, which could be quite intrusive, or
risk not enforcing the provisions.
If withdrawals are allowed for new, favored uses of funds,
two considerations are paramount. First, the withdrawals should
be allowed only for funds contributed after legislation is
enacted. As of the end of 1995, IRA and Keogh balances totalled
$1.2 trillion. These funds were placed in the accounts with the
understanding that they were to be held until retirement or
would face a penalty. If these funds become eligible for
penalty-free withdrawal, the saving rate could actually drop.
For example, suppose that in one year, 5 percent of these funds
were removed for other purposes. That would represent about a
withdrawals of about $60 billion, or about 20 percent of
personal saving. Second, funds withdrawn from deductible IRAs
should face income taxes, even if the penalty is waived.
Otherwise, the entire withdrawal will never have been taxed,
which would create obvious inequities and inefficiencies.
Saving Policy Considerations
All of these problems in tax policy, budget policy, and
retirement income policy might be worth the cost if IRA
expansions were certain to raise private and national saving
substantially. The effect of IRAs on saving is the subject of
considerable controversy, however, so it is useful to start
with some basics.
The single most important factor is that IRAs do not
provide incentives to save. Instead, IRAs provide incentives to
place funds in a designated account. The distinction is
crucial.
There are many ways to finance IRA contributions. One way,
of course, is to raise saving. This involves consuming less, or
to put it bluntly, reducing one's current standard of living.
This is the painful way of taking advantage of the tax breaks
afforded by IRAs. There are, however, relatively painless ways
to capture the tax break as well. For example, the contribution
may be financed by transferring existing taxable assets into
IRAs, by reallocating into an IRA current or future saving that
would have been done outside the IRA, or by increasing
household debt. These painless methods of contributing to an
IRA do not raise overall private saving. Thus, IRAs and other
so-called saving incentives do not require that contributors
save, or save more than they would have otherwise.
How are people likely to react to IRAs? Common sense
suggests that people will try to capture the tax breaks in the
least painful way possible. A reasonable conjecture is that one
reason IRAs are so popular with taxpayers is precisely because
taxpayers do not need to reduce their standard of living (raise
their saving) to claim the tax break.
Research findings back up this claim at the most general
level. Economists Joel Slemrod of the University of Michigan,
and Alan Auerbach of the University of California, surveying a
broad range of studies of the effects of the tax reform act of
1986, have concluded that similar phenomena arise in a host of
tax-related activities. They find that decisions concerning the
timing of economic transactions are the most clearly responsive
to tax considerations. The next tier of responses involves
financial and accounting choices, such as allocating a given
amount of saving to tax-preferred saving versus other saving.
The least responsive category of behavior applies to agents'
real decisions, such as changes in the level of saving. This
hierarchy of responses, applied to IRAs, suggests that most IRA
contributions are not new saving.
(A) What proportion of IRA contributions is new saving?
In recent years, a number of studies have examined the
effects of IRAs on saving and reached a variety of
conclusions.\1\ The crucial issue in this literature is
determining what households who had IRAs would have saved in
the absence of these incentives.
---------------------------------------------------------------------------
\1\ This section is based on Engen, Gale and Scholz (1966a,1996b),
which provides details and additional evidence for the points made
here.
---------------------------------------------------------------------------
Several factors, however, make this a difficult problem and
one subject to a series of biases that overstate the impact of
IRAs on saving. Analyses that ignore these issues overstate the
impact of IRAs on saving. No study that corrects for these
biases finds that IRAs raise saving. Rather, Engen, Gale and
Scholz (1996a, b) show that accounting for these factors
largely or completely eliminates the estimated positive impact
of IRAs on saving found in some studies.
First, saving behavior varies significantly across
households. Households that hold IRAs have systematically
stronger tastes for saving than other households. Thus, a
simple comparison of the saving behavior of households with and
without IRAs will be biased in favor of ``showing'' that IRAs
raise saving. To oversimplify somewhat, suppose there exist two
groups: ``large'' savers and ``small'' savers. We would expect
to see that IRA holders (where ``large'' savers are
overrepresented) would save more than non-IRA holders (where
small savers were overrepresented). But this would provide no
information about the effects of IRAs per se, unless there is a
way to control for the observable and unobservable differences
between large and small savers.
Even researchers that claim that IRAs raise saving
recognize that the heterogeneity of saving behavior is a
crucial factor in this literature. What is often overlooked,
however, is that the implication of heterogeneity is that
findings such as ``households with IRAs saved more than
households without IRAs,'' do not imply anything about whether
IRA contributions represent new saving, since those households
would have been expected to save more to begin with.
Due to heterogeneity in saving, studies that compare IRA
contributors with noncontributors tend to ``find'' that IRAs
raise saving (Hubbard 1984, Feenberg and Skinner 1989, Venti
and Wise, 1987, 1988, 1990, 1991). However, statistical tests
reject the validity of such comparisons (Gale and Scholz 1994.)
In contrast, studies that compare one group of contributors to
another tend to find much smaller or negligible effects of
IRAs, or expansions of IRAs, on saving (Gale and Scholz 1994,
Attanasio and De Liere 1994, Joines and Manegold 1995). By
comparing two groups of contributors, these studies more
effectively isolate groups with similar propensities to save
and hence provide a more valid comparison.
A second problem is that saving and wealth are net concepts
and are broad concepts. If a household borrows $1000 and puts
the money in a saving incentive account, net private saving is
zero. The data indicate that households with saving incentives
have taken on more debt than other households. Hence, studies
should focus on how saving incentives affect wealth (assets
minus debt), not just assets. Because financial assets are
small relative to total assets, studies that focus only on the
effects of saving incentives on financial assets may have
particularly limited significance.
Since the expansion of IRAs in the early 1980s, financial
markets, pensions, and Social Security have undergone major
changes. Pension coverage (other than 401(k)s) fell over the
1980s, and social security wealth was reduced in the 1983
reforms. Both of these factors would have caused people to have
accumulated more assets in the late 1980s or early 1990s than
in the early 1980s. Moreover, the reduction in inflation and
tax rates that occurred over the 1980s made financial assets
relatively more attractive than tangible assets (such as
housing). This led to strong increases in the stock market and
to shifts of wealth from nonfinancial to financial forms. For
all of these reasons, it is important to study the impact of
IRAs on broad wealth measures and to control for other events
that occurred during the 1980s.
Studies that examine only financial assets often find a
large impact of IRAs on saving (Venti and Wise 1992, 1996). But
extensions of those studies indicate that the effects disappear
when the analysis examines the impact on broader measures of
wealth that include debt or nonfinancial assets and include the
impact of events that occurred during the 1980s (Engen, Gale
and Scholz 1996a, b).
Third, IRA balances represent pre-tax balances; one cannot
consume the entire amount because taxes and perhaps penalties
are due upon withdrawal. In contrast, contributions to other
accounts are generally not deductible and one may generally
consume the entire balance in a taxable account. Therefore, a
given balance in a saving incentive account represents less
saving (defined either as reduced previous consumption or
increased future consumption) than an equivalent amount in a
conventional account.
Analyses that correct for these biases indicate that little
if any of the overall contributions to IRAs have raised private
or national saving. This conclusion arises consistently from
evidence and estimates from a wide range of methodologies,
including time-series data, cross-sections, panel data, cohort
analysis, simulation models, and analysis of evidence from
Canada (Engen, Gale, and Scholz 1996a, b).
(B) Who Contributed to IRAs and Why it Matters
Supporting evidence for this view comes from data on who
contributed to IRAs. Table 2 shows that households with IRAs in
1986 were very different from households that do not have IRAs.
In particular, compared to households without IRAs, the typical
IRA holder had seven times the non-IRA financial assets, four
times the overall net worth, and eight times the saving.
Although some of these differences are due to observable
characteristics, there is widespread agreement that households
with IRAs tend to have stronger unobservable tastes for saving
than do observationally equivalent households without IRAs.
Two types of households will be most able and hence most
likely to make painless contributions, that is, contributions
that do not raise private saving. The first is households that
have large amount of other assets. These households have more
existing assets to shift, typically have more current saving to
shift, and have less of a need to maintain all of their assets
as precautions against emergencies. The second is older
households, who are less likely to face a binding early
withdrawal penalty. In the extreme, people older than 59.5
years face no early withdrawal penalties. For each group, IRAs
are good substitutes for the saving those households would do
anyway, so the IRA contribution will be unlikely to represent
new saving.
Data from the 1980s show that households with non-IRA
financial assets \2\ over $20,000 in 1986 (about $28,600 in
1996 dollars) or who were 59 or older made more than two-thirds
of all IRA contributions in the 1983-6 period. Households who
had non-IRA financial assets in excess of $40,000 (about
$57,200 in 1996 dollars) or where the head was 59 or older made
half of all IRA contributions during this period. Thus, while
some people have argued that many of the accounts were held by
middle class households, the data show that most contributions
were made by households that would consider IRAs and other
saving good substitutes. This suggests that the overall effects
of IRAs on saving were likely to have been small at best.
---------------------------------------------------------------------------
\2\ Financial assets as defined here do not include employer-
provided pensions 401(k) plans, or after-tax thrift plans.
---------------------------------------------------------------------------
In contrast, contributions will represent a net addition to
saving only when they are financed by reductions in
consumption, which will occur only when IRAs and other saving
are poor substitutes for one another. This is more likely to
occur for households that have lower asset holdings, and are
younger. Thus, if IRAs are to be expanded, the expansion should
be targeted to lower-income groups. Higher income groups will
typically have higher assets and will find it easier to
substitute other assets into IRAs.
(C) Aggregate Effects of Expanded IRAs on Saving
How much would expanding IRAs raise national and private
saving? One can get some perspective on this issue by noting
that net national saving has fallen from 8 percent of net
national product in the 1950s, 1960s, and 1970s, to 4.1 percent
in the 1990s. Personal saving has fallen from 7 percent of
personal disposable income between 1950 and 1980, to under 5
percent in the 1990s.
One way to gauge the effect of all tax policy on saving is
to consider the effects of replacing the income tax with a
consumption tax. Estimates by Engen and Gale (1996) suggest
that a cold-turkey switch to a pure consumption tax--with no
personal exemptions or transition relief--would raise the
saving rate by about 1.5 percentage points in the short run and
by about 0.5 percentage points in the long run. Output per
capita would rise by about 1.5 percentage points over the first
10 years. These effects are positive, but are modest compared
to the decline in saving noted above.
The results also provide a useful perspective on what
targeted tax policy changes can achieve. If a complete overhaul
of the income tax system raises the saving rate by at most 1.5
percentage points, only a much smaller impact can be expected
of policies that tinker around the edges of the system.
The aggregate impact of expanding IRAs would be tiny. From
1982 to 1986, IRA contributions constituted about 1 percent of
GDP. Since then, however, tax rates have fallen and other
saving incentives have proliferated. Moreover, expanding income
limits for deductible IRAs would only affect a small portion of
the population. If contributions rose by 0.5 percentage points
of GDP and--splitting the difference among the studies--about
half of those contributions were new saving, private saving
would rise by 0.25 percentage points. But, assuming an
effective federal and state tax rate of about 25 percent,
government saving would fall by about one fourth of the
contributions, so the net increase in national saving would be
about 0.12 percentage points over the next few years.
Note that this estimate does not include the impact of
allowing penalty-free (and income-tax-free) withdrawals for
specified purposes. If these withdrawals are allowed from pre-
existing balances, or if the withdrawals are made free of
income tax, the impact on private and national saving of
expanding IRAs could well be negative.
(D) Short-run versus Long-run Effects of IRAs on Saving
Some commentators (including Engen and Gale 1993) have made
the point that the short-term effects of IRAs are likely to be
less favorable than the long-term effects. The idea is that
when IRAs are introduced, people will shift funds from taxable
sources into IRAs so the contributions at first will not be new
saving. After awhile, the people who contribute to IRAs may run
out of funds to shift so that IRA contributions may eventually
become new saving. For example, in a simulation model in Engen,
Gale, and Scholz (1994), IRAs reduce short-term saving, but
raise the long-term saving rate by 0.2-0.3 percentage points.
The crucial issue then becomes how long does it take until
the saving rate rises? In Engen, Gale, and Scholz (1994) it
takes 49 years for the wealth to income ratio to exceed its
original (pre-IRA value). Some IRA proponents have reasoned
that since the typical household has very little in pre-
existing financial assets, the transition period will be very
short: a year or less.
The logic of a short transition period is misleading for
two reasons. The first is simply that the typical household in
1986 did not have an IRA, so the typical household is
irrelevant to the debate about how long the transition will
last. The relevant households are those that contributed to
IRAs and in particular those that continued to contribute to
IRAs: Did these households have many pre-existing assets that
they could shift into IRAs? The answer here is a resounding
``yes.'' Table 2 shows that pre-existing asset balances are
high among household with IRAs. The typical IRA household in
1986 had over $20,000 in non-IRA financial assets. Among
households that contributed to the limit for three years in a
row, typical financial asset balances were $40,000. It is clear
that for these households, IRAs could be financed from pre-
existing asset balances for several years without raising
saving.
The second problem with the proponents' logic is even more
important: it ignores IRA contributions that are financed by
current or future saving that would have been done even in the
absence of IRAs. These contributions do not represent new
saving. The table shows that typical IRA households and 3-year
limit contributors have extremely high levels of other saving
relative to their IRA contributions and so could easily finance
contributions out of saving that would have been done anyway.
The median 3-year saving level for 3-year limit contributors in
the SCF was $60,000. Surely, it would not be difficult for many
of them simply to shift $12,000 of that into an IRA. The median
3-year saving level for the typical IRA contributor was
$23,000. This is certainly large enough to fund all or most of
a typical three years worth of contributions. These figures
suggest that among households that did contribute to IRAs,
there was a large on-going source of funds from which IRA
contributions could be financed without raising saving. There
is every reason to think the transition period could take a
very long time.
A second reason IRAs may raise long-term saving is that
workers who leave jobs often roll their pension balances over
into an IRA. Thus, the IRA provides a convenient way to keep
the money ``tied up'' rather than encouraging people to spend
the funds prematurely. Over long periods of time, the
cumulative effect of having fewer people cash out their pension
could raise the saving rate. Two caveats, however, should be
noted. First, any such effect does not seem to have occurred
yet. Second, this factor is already fully operable under the
existing IRA system. No expansion of IRAs is needed.
(E) Did Advertising Make IRA Contributions New Saving?
Some commentators have asserted that the heavy advertising
of IRAs means that IRA contributions were new saving. However,
while it seems likely that IRAs were advertised heavily by the
financial industry in the 1982-6 period, that fact provides no
information as to whether the source of IRA contributions was
new saving (reduction in living standards) or shifted assets,
redirected saving, or increases in debt. There is certainly no
evidence to support the notion that advertising for IRAs
affected the level of saving.
Looking at the ads themselves, however, suggests that
advertising may actually encourage asset shifting, rather than
new saving. Some ads explicitly advocated financing IRAs with
debt as an ``easy'' way to obtain the tax break (see Feenberg
and Skinner 1989). Aaron and Galper (1984, p. 5) report the
following ad from the New York Times in 1984:
Were you to shift $2,000 from your right pants pocket into
your left pants ``pocket,'' you wouldn't make a nickel on the
transaction. However, if those different pockets were accounts
at The Bowery, you'd profit by hundreds of dollars .... Setting
up an Individual Retirement Account is a means of giving money
to yourself. The magic of an IRA is that your contributions are
tax-deductible.''
For obvious reasons, advertising seems more likely to
emphasize the possibility of painless contributions, which
don't raise saving, rather than painful contributions that do
raise saving.
A second perspective on advertising is provided by the
recent avalanche of ads for mutual funds and the accompanying
massive inflows into those funds. Figure 1 shows that as mutual
funds have increased dramatically in recent years, personal
saving has not. Figure 2 shows that the increase in mutual fund
saving has been matched by a decline in individual holdings of
equities and bonds. That is, to a large extent households
appear to have shifted their assets from one form to another.
This is in no way a criticism of the mutual fund industry,
which is supplying a product that the pubic demands. The point
is just that the presence of massive advertising does not imply
that the subsequent contributions are new saving.
A similarly unproven assertion is that IRAs created a
``culture of saving,'' or would have if they had not been
curtailed in 1986. To some extent, this notion is based on
evidence about the persistence of IRA contributions over time.
Households that contributed in one year had a very high
probability of contributing in the next year as well. This led
to speculation that IRAs helped people create good saving
habits over time (Skinner 1992, Thaler 1994). The problem with
this conclusion is that the data on persistence are perfectly
consistent with standard models (Engen and Gale 1993). There is
nothing surprising about the persistence of contributions over
time. A purely rational model with no ``habit formation''
generates the same persistence as the data.
Moreover, other evidence makes it hard to believe that IRAs
created a culture of saving. The early 1980s featured lower
inflation, lower tax rates, high real interest rates, cuts in
social security as well as expanded IRAs, yet the saving rate
fell rather than rose during the ``golden years of IRAs.''
Conclusions
Expanding targeted tax-based saving incentives is unlikely
to raise the saving rate by very much if at all, but could have
real costs in terms of tax, budget and retirement income
policy. Excessive focus on tinkering with tax-based saving
incentives obscures other possibilities for raising private and
national saving. The surest way to raise national saving is to
reduce the budget deficit in ways that do not reduce private
saving.
Raising private saving may prove more difficult, but
several options are worth exploring. The most obvious candidate
is improved financial education of workers. There is serious
concern that a substantial fraction of the population will not
be adequately prepared for retirement. At the same time,
however, a large proportion of households do not use the saving
incentives that are already available to them. Everyone, for
example, can contribute to an IRA or a fixed or variable
annuity if they so choose and receive a tax-preference relative
to other saving. Only about two-thirds of workers eligible for
401(k) plans actually participate. Improved education would
also be worthwhile to provide needed assistance to American
households as the pension system moves away from defined
benefit plans and toward defined contribution plans, which
place more responsibility on workers, and as social security
reform is considered.
Another fruitful area of reform in my view is pension
legislation. An improved pension system would feature enhanced
pension coverage, simplified nondiscrimination rules with a
higher minimum contribution, higher maximum contribution
limits, and removal of taxes on excess payouts and excess
accumulations.
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Attanasio, Orazio, and Thomas De Leire. 1994. ``IRAs and Household
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Auerbach, Alan J., and Joel Slemrod. 1996. ``The Economic Effects
of the Tax Reform Act of 1986.'' Forthcoming, Journal of Economic
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Board of Governors of the Federal Reserve System. 1996. Flow of
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Engen, Eric M., and William G. Gale. 1996. The Effects of
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180.
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Illusory Effect of Saving Incentives on Saving. Journal of Economic
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National Tax Journal 37: 43-54.
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Evidence from a Panel of Taxpayers.'' Mimeo. USC.
Sabelhaus, John. 1996. ``Public Policy and Saving Behavior in the
U.S. and Canada.'' Mimeo. (February).
Skinner, Jonathan. 1992. ``Do IRAs Promote Saving? A Review of the
Evidence.'' Tax Notes (January 13).
Thaler, Richard. 1994. ``Mental Accounts and Household Saving.''
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Constrained Choice, and Estimation of Individual Saving.'' Review of
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[GRAPHIC] [TIFF OMITTED] T8616.001
Chairman Archer. Thank you, Dr. Gale.
I can see that my colleague, Mr. Neal, is just ready to
jump in and have a debate with you on this, but unfortunately,
unless he wants to stay and Chair the Committee while I go
vote, we are going to have to recess while both of us can go
vote.
Mr. Neal. Would you offer that to me on a permanent basis,
Mr. Chairman?
Chairman Archer. I don't think that would play too well.
Mr. Neal. Well, then we had better go vote.
Chairman Archer. Yes.
We will recess temporarily to go vote, and if you don't
mind, we will be back in about 5 or--well, maybe 8 or 9
minutes.
[Recess.]
Chairman Archer. Could I ask you to take your seats again
at the witness table.
Dr. Gale, I was hoping I could conclude my questioning
before Mr. Neal got back, but I see that I didn't succeed in
doing that. So I guess you still will be engaged by him in a
colloquy.
I would like to inquire particularly about what I think I
heard Dr. Yakoboski say, which is that today, 89 percent of the
single employed people are eligible for IRAs. Did I understand
you correctly to say that?
Mr. Yakoboski. That is correct. Of that 89 percent, not all
are eligible for the full $2,000 deduction. Some are only
eligible for a partial deduction, but 89 percent are eligible
for at least a partial deduction.
Chairman Archer. I would like to engage Mr. Higgins, then,
because you have suggested that we need a broader application
of IRAs in order to increase national savings, but if 89
percent of the people are already eligible, then will we only
increase it for 11 percent of the working single people if we
accept your suggestion for changes in the IRAs?
Mr. Higgins. Mr. Chairman, I think that is a good question.
I believe most Americans do not know whether they are, in fact,
entitled to a full or partial IRA. There is, I would say, a
lack of education. There clearly is a lack of advertising in
the post-1986 period on IRAs and the benefits to consumers from
IRAs, and that is why we feel quite strongly that we need a
simple IRA that every American can understand. We need as an
incentive, a tax-deductible contribution, that every American
can understand, and it has been my experience in the pre-1986
period that a large percentage of Americans would respond
positively to that and would move from consumption to savings
if they understood the proposition clearly.
Chairman Archer. Thank you.
My colleague, Congressman Bill Thomas from California,
because of other commitments, is unable to be here for the
hearing today, and he has asked that I submit to you, Mr.
Higgins, five questions in writing which may already have been
delivered to you, but for the record, I am submitting those to
you and we would appreciate your responses in writing.
Mr. Higgins. We will respond promptly, Mr. Chairman.
Chairman Archer. All right. Thank you very much.
[The followup answers were subsequently submitted by Mr.
Higgins to Congressman Thomas:]
[GRAPHIC] [TIFF OMITTED] T8616.040
[GRAPHIC] [TIFF OMITTED] T8616.041
Let me ask all of you, have you had an opportunity to look
at the entire Clinton budget proposal relative to taxation?
Have all four of you had a chance to do that? Have you only
looked at the IRA provisions?
Mr. Gale. The whole thing.
Mr. Higgins. The whole thing.
Mr. Yakoboski. I have just looked at the IRA provisions.
Chairman Archer. Only at the IRA provisions.
I wanted to get your input as to what you thought overall
of the Clinton tax proposals, relative to savings and
investment.
Mr. Thayer. Mr. Chairman, we have looked at it, and in
general, I think we would support greater tax relief than what
is there right now.
Our members, in general, in most of the surveys we have had
of them, have obviously gone right to that--wanting more tax
relief. We think the budget as it stands right now does not go
forward enough, and that would be the one thing we would submit
here today.
Chairman Archer. Well, what can you isolate in the Clinton
proposals that does impact favorably on savings and investment?
Mr. Thayer. Excuse me for consulting with my tax consultant
there. The issue is really----
Chairman Archer. As long as we have this code, you have to
do that.
Mr. Thayer. You have got to do that sometimes. That is
right.
This goes directly to those issues that you are very
familiar with and we have talked about before. Of course, that
is the self-employed deduction of the health insurance and
other tax issues that we have lobbied long and hard for, as you
very well know.
We also sent a letter over to the White House asking that
there be some tax relief for the self-employed and that the
home office deduction be included in the budget package itself.
Obviously, we didn't get that, but that would make life a
lot easier for us.
Chairman Archer. What did you get in the Clinton budget
package?
Mr. Thayer. I am still looking. We really are still
looking. We didn't get that much, and that is what we are
saying. The self-employed community really would have liked to
have seen some specific relief like the self-employed health
insurance deduction, the home office deduction, obviously
pension relief. We could have used more there. We didn't see
that. So that is why we have come at it from a different route,
as you very well know, Chairman Archer, thanks to many of the
things you have joined us on.
Chairman Archer. Thank you.
Mr. Higgins, Have you had a chance to evaluate the savings
and investment provisions in the President's budget, and if so,
What is in there that you particularly like? Obviously, it
doesn't go far enough from your testimony, but what is in there
that you think is positive?
Mr. Higgins. Mr. Chairman, the two components that we like
most are IRA provisions and capital gains relief, and in the
case of IRAs, we think the President's proposal is a step in
the right direction, but we think, quite frankly, it falls
woefully short of the mark in terms of what will change
behavior across the length and breadth of this country as it
relates to savings and investment.
Chairman Archer. I don't want to put words in your mouth,
but what I understand you to have just said is that the
President's proposal on IRAs really, in your opinion, will not
do anything to significantly improve the savings rate in this
country.
Mr. Higgins. Mr. Chairman, I would say that the impact will
be modest.
Chairman Archer. On capital gains, of course, the only
thing I can see in this proposal is something on principal
residences, and I would assume that that really does not strike
at the real need for investment capital to create jobs in this
country.
Mr. Higgins. That is correct, Mr. Chairman.
Chairman Archer. All right. Thank you very much.
Mr. Neal.
Mr. Neal. Thank you, Mr. Chairman.
Mr. Higgins, do you believe that carefully designed IRAs
will create new savings?
Mr. Higgins. Yes, I do.
Mr. Neal. Would you elaborate on that?
Mr. Higgins. Congressman, I believe the IRA account, as we
knew it prior to 1986, was a proposition that most, if not all,
Americans understood, and the features of the immediate tax
deductibility, coupled with tax-deferred gains, is a
proposition that was effective pre-1986 and will be, if
enacted, extremely effective going forward and should have a
meaningful effect on increasing savings rates in this country.
Mr. Neal. How do you respond to the suggestion in some
quarters that the IRA will only benefit the wealthy classes as
opposed to the middle class?
Mr. Higgins. Congressman Neal, I can only relate to some
surveys, some data that I have seen over the years that
indicate the primary beneficiaries are what I would call
middle-class Americans, not the wealthy, and I would say from
my own experience, our accounts at Dean Witter and Co. who have
IRA accounts have balances that average about $20,000 and
incomes that are less than $100,000.
Mr. Neal. Mr. Thayer, do you believe that IRAs will create
new savings?
Mr. Thayer. Do I believe--I am sorry?
Mr. Neal. Do you believe that IRAs will create new savings
if carefully designed?
Mr. Thayer. I certainly do if they are more universal. Let
me talk about what you just alluded to, Congressman, when you
talked about them being just for the rich.
As you and I know, frankly, $2,000 isn't too much for a
rich person, but even if it was, the benefits of making IRAs
universal far outweigh, as far as I am concerned, the
disadvantages.
Let us take the self-employed people. We often experience
large income fluctuations from year to year, and it isn't fair
and it isn't good economic policy to say to us that in the good
years, you can save money in an IRA, but in the bad years, you
can't. So we certainly believe that expanding it universally
would increase those people saving in America.
Mr. Neal. OK, thank you.
Now, Mr. Gale, Do you think we can ever have meaningful
entitlement reform without offering some incentives to citizens
as it relates to the national savings rate?
Mr. Gale. I think entitlement reform is a good idea. I
think raising the saving rate is a good idea.
I would submit to you that establishing a new IRA is
establishing a new entitlement. It is establishing the
entitlement on the tax side rather than on the spending side,
but it is an entitlement, nonetheless, and the entitlement
would go to anyone that had enough money to put funds in the
account.
If IRAs required you to actually save, then they could be
more accurately called the saving incentive, but as long as you
don't have to save, you don't have to reduce your consumption
to get the tax break associated with an IRA, then IRAs
essentially are an entitlement, and creating new entitlements
makes the entitlement problem worse.
Mr. Neal. Do you think a carefully designed IRA might
overcome some of the objections that you have raised?
Mr. Gale. It depends on what you mean by that. If you mean
an IRA that you cannot finance by borrowing money and putting
the money in the IRA, that you cannot finance by shifting
already-existing assets or current saving into an IRA, then the
answer is yes, but then, the question is how do you design an
IRA like that. I know of no one who has been able to come up
with such an animal.
Mr. Neal. So you are concerned about what might become kind
of a Christmas club effect?
Mr. Gale. Pardon me?
Mr. Neal. Put it in, take it out, put it in, take it out,
is that something that troubles you?
Mr. Gale. What troubles me most is the ability to put it
in, put the money in without sacrificing consumption.
Mr. Neal. Mr. Chairman, I know that the caution light is
on. The only thing I would suggest is that the term that has
been so popular around here now for the last 3 or 4 years has
been the term ``personal responsibility,'' and it seems to me
this is an opportunity for us to speak to that issue of
personal responsibility, and if we are to proceed down the road
to some sort of meaningful discussion about entitlement reform
and the national savings rate, that these are the kinds of
vehicles that we are going to have to put before the entire
membership of the House and hope that good sense will prevail
and that we might restore some of these incentives for
addressing what Alan Greenspan has suggested time and again. It
is the number one economic problem that faces the Nation, and
that is our low national savings rate.
Chairman Archer. Thank you, Mr. Neal.
Mr. Neal. Thank you, Mr. Chairman.
Chairman Archer. Mr. Rangel, do you care to inquire?
Mr. Rangel. No. I just want to thank the witnesses, Mr.
Chairman, for their comments on a policy option that is very,
very popular here, and of course, is quite controversial as to
whether it increases savings.
One thing that this Committee has to consider is, How much
does any policy cost, no matter how good any program is, or how
much revenue does it bring in.
So having the expert testimony of these witnesses and being
able to read it will be of great help to me and the rest of the
Committee. Thank you for your time and effort.
Chairman Archer. My compliments to all four of you. I think
it has been an exceedingly interesting exchange of two
different viewpoints, and that is what we need to hear before
the Committee as we make our decisions. We appreciate your
testimony, and you are excused.
The Committee will stand in recess while we vote, and I am
told that there will be another, maybe, 15 minutes after this
vote before we can reconvene for our last panel, but we will be
back as soon as we can get away from the House.
Thank you very much, gentlemen.
Mr. Gale. Thank you, Mr. Chairman.
[Recess.]
Chairman Archer. The Committee will come to order, and our
next panel of witnesses are invited to take seats behind the
witness table.
Our first witness is Martin Regalia--or Dr. Martin Regalia.
My apologies.
Welcome to the Committee. If you will identify yourself for
the record, we will be pleased to receive your testimony.
STATEMENT OF MARTIN A. REGALIA, PH.D., VICE PRESIDENT AND CHIEF
ECONOMIST, U.S. CHAMBER OF COMMERCE
Mr. Regalia. I will do so. My name is Martin Regalia, and I
am vice president for economic policy at the U.S. Chamber of
Commerce.
We appreciate the opportunity today to come and voice our
opinion and give you our views on the savings and investment
provisions contained in President Clinton's fiscal year 1998
budget proposal.
The Chamber believes that public policy should not only
improve our current economic environment, but also ensure our
economic prosperity in the future, and the key to this future
economic prosperity really is productivity growth.
Virtually, all economists agree that increases in
productivity growth will require savings and investment in
capital, both human capital and physical capital, and we
further believe that government policies can play an important
role in this capital formation.
To boost productivity, the Federal Government must end its
misdirection of resources and curb its appetite for borrowing.
In addition to balancing the budget, other policy prescriptions
include overhauling our regulatory and tort systems, enhancing
education, job training programs, and most importantly,
reducing the tax burden while reforming the Tax Code.
Measured against this criteria, we find the President's
fiscal year 1998 budget proposals to be a major disappointment.
Fundamental problems are left unaddressed, real spending cuts
are delayed, so-called tax cuts are offset by other tax
increases and tax triggers, and budgetary legerdemain is still
required for the budget to even come close to balancing. Long-
term economic growth appears to be a lower priority than
continuing business as usual in the Federal Government.
Focusing primarily on the tax aspects, the U.S. Chamber
believes that to increase national savings and investment,
substantive policy reforms must be made to the estate and gift
tax, to individual retirement accounts, to the capital gains
tax, and to the alternative minimum tax.
The Federal estate and gift tax system, or the death tax as
many refer to it, is a major source of our Tax Code's bias
against savings and investment. The estate tax penalizes those
who have saved and invested for their entire lives, and the
confiscatory nature of this tax clearly discourages
entrepreneurship, job creation, capital formation, and can in
extreme cases contribute to the demise of family businesses.
Ongoing businesses have no choice but to expend large
amounts of their financial and human resources on complicated
estate tax planning and tax compliance services. This is why we
believe the best approach to relieve small businesses from the
burdensome and ineffective estate tax would be to repeal it
outright. Short of that, we believe there are several ways in
which the estate tax can be reformed in order to make it less
harmful to small businessowners and their workers. These
include: Increasing the unified credit, reducing tax rates, and
exempting family owned businesses.
By virtually any measure, savings in the United States has
declined in recent decades. The ominous shortfall over such a
long period of time imperils our economic future because saving
funds the investment needed for future growth.
We believe one way to encourage higher personal savings
would be through the expansion of individual retirement
accounts. The Chamber believes that IRAs should be expanded as
broadly as possible in order to give individuals additional
incentives to save, and we believe that increasing the
deductible contribution amount, repealing the active
participant rule between spouses, permitting penalty-free
withdrawals for qualified purposes, and creating new backloaded
IRAs would all help in this regard.
A vibrant healthy economy also requires that resources be
allocated to their most efficient and productive uses, but high
tax rates on capital gains impose a barrier to the efficient
flow of capital.
Capital gains tax reform would spur investment activity,
create jobs, and expand the economy, which would benefit
individuals of all income levels.
We believe that reducing capital gains rates on individuals
and corporations, indexing the basis of capital assets for
inflation, providing capital loss treatment for sales of
principal residences, and expanding the preferential capital
gains treatment for small business stock would all work toward
increasing the amount of investment and savings in this
country.
Originally envisioned as a method to ensure that all
taxpayers pay a minimum amount of tax, the AMT has become
unfair and penalizes businesses that heavily invest in plant,
machinery, equipment, and other assets. The AMT significantly
increases the cost of capital and discourages investment in
productivity-enhancing assets by negating many of the capital
formation incentives provided under the regular tax system,
most notably accelerated depreciation. In fact, the AMT cost
recovery system is the worst among industrialized nations and
places our businesses at a competitive disadvantage
internationally.
As with the Federal estate and gift tax, the best way to
provide individuals and corporations with relief from AMT would
be to repeal it altogether. Short of that, however, the AMT
should be substantially reformed in order to reduce the harmful
effects it imposes on businesses. Such reforms include
conforming the AMT depreciation rules with the regular tax
depreciation rules, allowing taxpayers to offset their current
year AMT liabilities with their accumulated minimum tax
credits, and making the AMT system less complicated and easier
to comply with.
Our long-term economic health depends upon sound economic
and tax policies. Today, we are critically shortchanging
ourselves and, more importantly, our children as we commit too
many of our scarce resources to current consumption and away
from prudent investment. Our tax system encourages waste,
retards savings, and punishes capital formation, all to the
detriment of long-term economic growth. As we prepare for the
economic challenges of the next century, we must orient our
current fiscal policies in a way that encourage more savings,
more investment, more productivity growth, and ultimately, more
economic growth.
Thank you.
[The prepared statement follows:]
Statement of Martin A. Regalia, Ph.D. Vice President and Chief
Economist, U.S. Chamber of Commerce
The U.S. Chamber of Commerce appreciates this opportunity
to express our views on the savings and investment provisions
contained in President Clinton's Fiscal Year 1998 budget
proposal. The U.S. Chamber is the world's largest business
federation, representing an underlying membership of more than
three million businesses and organizations of every size,
sector and region. This breath of membership places the Chamber
in a unique position to speak for the business community.
Introduction
The Chamber believes that public policies should not only
improve our current economic environment but also ensure our
future prosperity. The key to a stronger economic future is
simple to define but difficult to achieve: a high rate of
economic growth. It's strong economic growth that will allow us
to maintain our position of world leadership, increase our
domestic standard of living, and meet the daunting demographic
challenges that will begin to present themselves early in the
next century.
But economic growth does not occur by accident. Just as our
farmers do not rely on good luck for bountiful harvests,
neither can we rely on chance or the momentum of the past to
propel us in the future. The seeds of tomorrow's economic
success must be planted today, and so, when evaluating economic
policies, we must ask how they would cultivate long-term
economic growth.
By definition, economic growth is simply the product of
growth in the labor force (i.e., the number of hours worked)
and growth in productivity (i.e., output per hour). With growth
in hours worked largely determined by demographics, sensible
economic policy must emphasize strong productivity growth.
This is a crucial issue because productivity growth has
been languishing for the past quarter-century or so. After
expanding at a healthy 2.7 percent rate during the 1960's, for
example, productivity growth has slowed to an anemic 1 percent
rate so far in the 1990's. With growth in hours worked hovering
a little below 1.5 percent, long-term economic growth is thus
limited to 2.5 percent--well below the average of the post-
World War II era.
While measurement problems related to productivity have
expanded with the growing share of the economy devoted to
service-producers rather than goods-producers, the decline in
economic growth over the same period confirms that we are
suffering a decline in the underlying growth rate in
productivity. The question then becomes: What can we do to
raise productivity growth?
Like the farmer who sows the seed corn and cultivates the
soil, households and businesses must also prepare for the
future. Virtually all economists agree that this is done by
saving and investing in capital--both human capital (education)
and physical capital (plant and equipment). Thus the issue of
long-term productivity growth and, in turn, economic growth
becomes one of fostering additions to, and improvements in,
capital. Consequently, the U.S. Chamber believes that today's
economic policies must be targeted toward improving economic
growth by fostering saving, investment, and capital formation.
Only through such pro-growth policies can we lay the foundation
of prosperity and security for our children into and beyond the
21st century.
To boost productivity, the federal government must end its
misdirection of resources and curb its appetite for borrowing
so that national savings and investment can be increased. This
will yield stronger productivity growth, which in turn will
propel the economy on a higher growth track. Besides balancing
the budget, other policy elements that would aid long-term
economic growth include overhauling our regulatory and tort
systems, enhancing education and job training programs,
reducing the tax burden, and reforming the tax code.
The President's Budget
Measured against this criteria, we find that the
president's FY1998 budget proposal is a major disappointment.
Unfortunately, fundamental problems are left unaddressed,
economic assumptions are too optimistic, and budgetary
legerdemain is still required for the budget to even come close
to balancing. Long-term economic growth appears to be a lower
priority than continuing business as usual in the federal
government.
We believe that the chief weaknesses of the president's
budget are:
Failure to use CBO economic assumptions--After agreeing to
use the Congressional Budget Office economic assumptions two
years ago as a common starting point, the Administration has
again reversed course and used its own Office of Management and
Budget numbers. CBO calculates that the Administration will
fall $69 billion short of eliminating the deficit in 2002.
Failure to address entitlement spending--The dramatic
growth in Social Security spending is not addressed, and the
Administration's Medicare Asolution merely shifts health care
costs instead of providing the market incentives that would
lower them. The viability of the Medicare Part A trust fund is
extended a few more years only by increasing payment
responsibility from the trust fund to the general taxpayer.
Establishment of new entitlements--The president has
proposed new, embryonic education entitlements that, like
earlier entitlements, can be expected to mushroom in cost,
expanding the federal government's presence.
Deferral of deficit reduction to the later years--The
president's budget treads water for the next four years, saving
most of the deficit reduction for the final two years of the
plan--after the president is out of office.
Not a path to continued balance in 2003 and beyond--The
president's proposal does not establish the groundwork for
maintaining a balanced budget in 2003 and beyond. The proposal
relies on one-time budgetary maneuvers that will make balancing
the budget even more difficult in later years, further
diminishing the chances of faster productivity growth.
Tax increases--Despite the Administration's talk about tax
cuts, tax increases are also an integral part of the budget.
The advertised $98 billion in tax cuts is a gross, not net,
figure. Over five years, the Clinton plan would provide at most
$22 billion in tax relief.
The tax trigger--The Administration relies on a a trigger
mechanism in the out years that would repeal many of the
proposed tax cuts and impose an across-the-board spending cut
against most programs to achieve balance by 2002. However, the
trigger may be pulled even if the budget were on target to
reach balance. According to statutory language provided by the
Treasury Department to the Joint Committee on Taxation after
the budget proposal was released, four of the president's tax-
cut provisions (education tax incentives, the child tax credit,
expanded IRAs, and brownfield provisions) would expire after
2000 regardless of how close the budget was to its target path
to balance by 2002.
Specific Tax Issues
In order to increase national savings and investment,
substantive policy reforms must be made to the estate and gift
tax, individual retirement accounts (IRAs), the capital gains
tax, and the alternative minimum tax (AMT). Each of these is
discussed below.
Estate And Gift Tax Reform
The federal estate and gift tax system--or the Death Tax,
as many refer to it--is a major source of our tax code's bias
against savings and investment. The estate tax confiscates
between 37 percent and 55 percent of a family's after-tax
savings, thereby penalizing those who have saved and invested
their entire lives. The confiscatory nature of this tax clearly
discourages entrepreneurship, job creation and capital
formation.
A growing economy depends on the ability of small
businesses to succeed. The heavy estate tax burden, coupled
with the limited amount of liquid assets available to business
owners, causes many small businesses to curtail operations,
sell income-producing assets, or, in extreme cases, liquidate.
In fact, the estate tax can be blamed for being a major
contributing factor to the demise of family businesses, which
are often not passed down from one generation to the next.
Furthermore, businesses often have no choice but to expend
large amounts of their financial and human resources on
complicated estate planning and tax compliance services--all
for a tax which generates a mere one percent of total federal
revenue. In addition, the estate tax is extremely costly for
the government to administer.
That is why we believe strongly that the best approach to
relieve small businesses from the burdensome and inefficient
estate tax would be to repeal it outright. Short of that,
however, there are several ways in which the estate tax can be
reformed in order to make it less harmful to small business
owners and their workers.
First, the unified credit--which currently provides a
credit of up to $192,800 against the estate tax--should be
increased. This credit effectively exempts up to $600,000 of a
decedent's lifetime transfers from the estate tax. At a
minimum, this credit should be indexed for inflation. If the
unified credit had been indexed since 1987 when its current
amount was phased-in, it would now effectively exempt up to
approximately $830,000 in lifetime transfers. Second, overall
estate tax rates--which effectively begin at 37 percent and
rise to a crushing 55 percent--should be significantly reduced.
Third, in order to promote prosperity for our nation's family
businesses, such businesses should be exempted from the estate
tax.
The president's budget, unfortunately, would provide
individuals or small businesses with little, or no, estate tax
relief. His proposal would merely lower the interest rate on
the deferred estate tax liabilities of certain closely held
businesses. It would not reduce the underlying estate tax
liabilities of these or any other types of businesses.
However, many proposals have been introduced in the 105th
Congress which would provide taxpayers with significant estate
tax relief. For example, The Family Heritage Preservation Act
(S. 75 and H.R. 902)--introduced by Senator Kyl (R-AZ) and
Representative Cox (R-CA), respectfully, would simply repeal
the federal estate and gift tax altogether.
The American Family Tax Relief Act (S. 2)--introduced by
the Senate Republican leadership--would effectively increase
the exemption amount from $600,000 to $1,000,000 over eight
years, exclude the first $1.5 million in value of a qualified
family-owned business interest and 50 percent of any excess
value from tax, and extend the maximum period for which federal
estate tax installments could be made from 14 to 24 years.
Other relief bills have also been introduced, including
those by Senators Lugar (R-IN), McCain (R-AZ) and Dorgan (D-ND)
and Representatives Crane (R-IL), Livingston (R-LA), Solomon
(R-NY) and Stump (R-AZ), which would either repeal the estate
tax, increase the unified credit, reduce estate tax rates, or
provide family-owned businesses with tax relief.
Expanded Individual Retirement Accounts
By virtually any measure, savings in the United States has
declined in recent decades. This ominous shortfall over such a
long period of time imperils our economic future because
savings funds the investment necessary to keep the economy
vibrant. One way to encourage higher personal savings would be
through the expansion of individual retirement accounts.
The Chamber believes that IRAs should be expanded as
broadly as possible in order to give individuals additional
incentives to save. Ways in which IRAs should be expanded
include removing the income limits on active participants in
retirement plans, increasing the deductible contribution amount
(at least for inflation), repealing the active participant rule
between spouses, permitting penalty-free withdrawals for
qualified purposes, and creating new backloaded IRAs.
Furthermore, IRAs should not be made more restrictive or
take away from other savings vehicles. For example, the IRA
contribution limits should not be coordinated with those of
salary reduction plans.
There are several ways in which IRAs can be improved and
expanded. First, the existing income limitations that apply to
those who are active participants in employer-sponsored
retirement plans should be completely removed. Individuals of
all income levels should be encouraged to save for their
futures.
Second, the active participation rule between spouses
should be repealed. Currently, one is treated as an active
participant in an employer-provided plan (and therefore subject
to the income limits for deductible IRAs) if his or her spouse
is such an active participant. This rule should be repealed not
only because it serves as a disincentive for couples to save
more for retirement, but because it can cause a serious
shortfall in savings for those who later divorce and are not
participants in a retirement plan.
Third, the deductible IRA contribution amount of $2,000
should be increased to promote additional savings. At a
minimum, the amount should be indexed for inflation. Fourth,
penalty-free withdrawals should be permissible for qualified
purposes, such as first-time home purchases, higher education,
medical expenses, long-term unemployment and start-up business
costs. Allowing for such withdrawals to be penalty-free would
give individuals greater incentive to establish and put money
into their IRAs.
Finally, creating a new vehicle for savings, such as a
backloaded IRA, would give individuals an additional option to
increase personal savings. Under a backloaded IRA,
contributions would not be deductible, but distributions
(including earnings) would not be taxable if the account is
open for a certain number of years and/or the proceeds are used
for a qualified purpose.
The president's proposed budget would gradually double the
present-law income limits on deductible IRAs, index the $2,000
contribution limit for inflation, allow penalty-free
withdrawals for special purposes (i.e., first-time home
purchases, higher education, qualified medical and long-term
unemployment expenses), and create backloaded Special IRA
accounts.
Unfortunately, his proposal would maintain the active
participant rule between spouses. Therefore, one would continue
to be considered an active participant in a retirement plan if
his or her spouse is an active participant. In addition, this
proposal would coordinate the IRA contribution limits with
those of salary reduction plans (i.e., 401(k) plans). The
effect of this provision is that the maximum amount individuals
could contribute to their salary reduction plans would be
reduced by the amount of their IRA contribution.
Several expanded IRA proposals have been introduced so far
in the 105th Congress, including The Savings and Investment
Incentive Act of 1997 (S. 197 and H.R. 446). Introduced by
Senators Roth (R-DE) and Breaux (D-LA) and Representatives
Thomas (R-CA) and Neal (D-MA) respectively, these bills would
completely phase-out the income limits for deductible IRAs over
five-years, index the $2,000 contribution limit for inflation
in $500 increments, immediately repeal the active participant
rule between spouses, allow penalty-free withdrawals for
special purposes (i.e., first-time home purchases, higher
education, qualified medical and long-term unemployment
expenses), and create backloaded IRA PLUS accounts.
Expanded IRA legislation was also included in S. 2, the
Senate Republican leadership's The American Family Tax Relief
Act. This bill would completely phase-out the income limits for
deductible IRAs over five-years, immediately repeal the active
participant rule between spouses, allow withdrawals free of
income tax and penalties for special purposes (i.e., business
start-up expenses, long-term unemployment, or higher
education), and create backloaded IRA PLUS accounts. Their
bill, however, would coordinate the IRA contribution limits
with those of salary reduction plans and would not index the
$2,000 contribution limit for inflation.
Capital Gains Tax Reform
Vibrant, healthy economies require resources to be
allocated to their most efficient, or productive, uses, but
high tax rates on capital gains impose a barrier to the
efficient flow of capital. Lower capital gains taxes would spur
investment activity, create jobs and expand the economy, which
would benefit individuals of all income levels.
Many investors and businesses are unwilling or unable to
sell their capital assets due to the high rate of tax that
would be imposed on the gain of such assets--much of which can
be due to inflation, rather that real appreciation. This
creates a locking effect of capital assets which prevents
investors and businesses from allocating their resources to
more productive capital or business ventures. Scarce capital,
therefore, remains tied up in suboptimal uses, to the detriment
of economic growth.
Bold capital gains reforms should be implemented to boost
capital formation and mobility. These reforms include reducing
capital gains rates on individuals and corporations, indexing
the bases of capital assets for inflation, providing capital
loss treatment for sales of principal residences and expanding
the preferential capital gains treatment for small business
stock.
Under the president's budget proposal, a taxpayer would
generally be able to exclude up to $250,000 ($500,000 if
married filing a joint return) of capital gain realized on the
sale or exchange of a principal residence every two years. No
other capital gains provisions were included in his package. As
a result, the president would not provide substantial capital
gains tax relief to individuals, and none to businesses.
Furthermore, only a small number of homeowners would benefit
from the president's provision since most homeowners currently
do not pay tax on their home sales due to the tax code's
rollover provisions and $125,000 exclusion for those age 55 or
older.
Several bills, however, have been introduced in the 105th
Congress which would provide broader capital gains relief. For
example, S. 2, the Senate Republican leadership's tax bill,
would permit individuals to exclude 50 percent of their net
capital gains from tax, subject corporations to a maximum
capital gains tax rate of 28 percent, permit certain taxpayers
to index certain capital assets for inflation, allow taxpayers
to treat losses on the sales of principal residences as
deductible capital losses, rather than nondeductible personal
losses, and modify rules relating to sales of certain small
business stock.
The Capital Formation Act of 1997 (S. 66)--introduced by
Senators Hatch (R-UT) and Lieberman (D-CT)--would permit
individuals to exclude 50 percent of their net capital gains
from tax, subject corporations to a maximum capital gains rate
of 25 percent and modify the rules relating to sales of certain
small business stock.
In addition, The Capital Gains Reform Act of 1997 (S. 72)--
introduced by Senator Kyl (R-AZ)--would provide individuals
with a 70 percent capital gains exclusion and corporations with
a maximum capital gains tax rate of 22 percent. Another bill,
S. 306, introduced by Senator Ford (D-KY), would reduce the
current 28 percent individual maximum capital gains tax rate
for assets held more than two years on a sliding scale down to
a 14 percent maximum rate for assets held more than eight
years.
The Chamber believes that substantive capital gains reform
is needed in order to spur business investment and productivity
growth. Short of repeal, capital gains rates should be reduced
for both individuals and corporations, capital assets should be
indexed for inflation, and losses on principal residences
should be treated as deductible capital losses.
Alternative Minimum Tax Reform
Originally envisioned as a method to ensure that all
taxpayers pay a minimum amount of taxes, the AMT had become
unfair and penalizes businesses that invest heavily in plant,
machinery, equipment and other assets. The AMT significantly
increases the cost of capital and discourages investment in
productivity-enhancing assets by negating many of the capital
formation incentives provided under the regular tax system,
most notably accelerated depreciation. In fact, the AMT cost-
recovery system is the worst among industrialized nations,
placing our businesses at a competitive disadvantage
internationally.
To make matters worse, many capital-intensive businesses
are perpetually trapped in AMT as they are unable to utilize
their suspended AMT credits. The AMT is essentially a
prepayment of tax which is substantially unrecoverable for many
taxpayers. Furthermore, the AMT is extremely complex,
burdensome and expensive to comply with. Even businesses not
subject to the AMT must go through the time and expense of AMT
calculations.
As with the federal estate and gift tax, the best way to
provide individuals and corporations with relief from the AMT
would be to repeal it altogether. Short of that, however, the
AMT should be substantially reformed in order to reduce the
harmful effects it imposes on businesses. Such reforms include
conforming the AMT depreciation rules with the regular tax
depreciation rules, allowing taxpayers to offset their current
year AMT liabilities with their accumulated minimum tax
credits, and making the AMT system less complicated and easier
to comply with.
Unfortunately, the president has not offered any AMT reform
proposals in his budget plan. However, several reform bills
have been introduced in the 105th Congress which would repeal
or reform the AMT. For example, The Corporate Tax Equity Act
(S. 73)--introduced by Senator Kyl (R-AZ)--would repeal the
corporate AMT.
In addition, Senators Nickles (R-OK) and Rockefeller (D-WV)
will soon be introducing legislation which would repeal the
depreciation adjustment for both individuals and corporations,
and allow taxpayers with accumulated minimum tax credits at
least five years old to use a portion of those credits to
offset up to 50 percent of their current year AMT liability.
The Chamber believes that the individual and corporate AMT
should be repealed in order to spur capital investment in the
business community and make our nation's businesses more
competitive in the global marketplace. To the extent repeal is
not feasible, significant reforms--such as eliminating the
depreciation adjustment and allowing taxpayers to utilize
accumulated minimum tax credits--should be implemented in order
to make the tax less harmful.
Conclusion
Our long-term economic health depends upon sound economic
and tax policies. Today we are critically shortchanging
ourselves and, more importantly, our children as we commit too
many of our scarce resources into current consumption and away
from prudent investment. Our tax system encourages waste,
retards savings, and punishes capital formation--all to the
detriment of long-term economic growth. As we prepare for the
economic challenges of the next century, we must orient our
current fiscal policies in a way that encourages more savings,
more investment, more productivity growth, and, ultimately,
more economic growth.
The president's budget fails to address these issues, and
consequently it perpetuates the present anti-growth policies
that have limited productivity for the past 25 years. The U.S.
Chamber urges Congress to pass legislation that balances the
budget, repeals or at least reforms the estate and gift tax
system, expands IRAs, reduces the tax on broad-based capital
gains, andeliminates the alternative minimum tax.
Chairman Archer. Thank you, Dr. Regalia.
Our next witness is Mark Kalish. Welcome to the Committee,
and if you will identify yourself for the record, you may begin
your testimony.
STATEMENT OF C. KENT CONINE, OWNER, CONINE RESIDENTIAL GROUP,
DALLAS, TEXAS; ON BEHALF OF NATIONAL ASSOCIATION OF HOME
BUILDERS; AS PRESENTED BY MARK KALISH, EXECUTIVE VICE
PRESIDENT, MICHAEL T. ROSE ASSOCIATES, LAUREL, MARYLAND
Mr. Kalish. Yes, Mr. Chairman. Mr. Chairman, Members of the
Committee, my name is Mark Kalish. I am executive vice
president of Michael T. Rose Associates. I was also a delegate
to the 1994 White House Conference on Small Business. Our
company is a builder developer located in Laurel, Maryland.
Although Kent Conine from Dallas, Texas, was originally
scheduled to testify this morning, he had an unexpected
emergency yesterday afternoon and asked me to take his place.
So, on behalf of the 190,000 member firms, which employ
approximately 7 million people of the National Association of
Home Builders, I want to thank you for the opportunity to
testify before the Ways and Means Committee today.
At the outset, let me state that NAHB has been a long-time
supporter of tax cuts the Committee is discussing today. Even
though we support balancing the budget, we hope, Mr. Chairman,
that you will continue your commitment to enact tax cut
legislation this year. We are particularly appreciative, Mr.
Chairman, of your longstanding support of the broad-based
capital gains relief, and we thank you for your continued
efforts over the years.
As you know, the home building industry is comprised mostly
of small business men and women. Over 50 percent of the
national members build less than 10 houses per year.
Approximately 15 percent build more than 25 houses per year,
and less than 2 percent build over 500 houses per year.
Further, about 80 percent of our members are family owned
businesses. Unlike many other industries, homebuilders are
affected by all three provisions that you have been addressing
today in these hearings. The exclusion of capital gains on the
sale of primary residence, the expansion of individual
retirement accounts, and the death tax relief, all directly
impact the ability of builders to provide affordable housing.
Mr. Chairman, the home building industry plays an
instrumental role in our Nation's economy. Housing construction
contributes jobs, taxes, and economic activity to the economy.
Each year, nearly 3 million jobs are created in the
construction of new homes. For every house that is built, 2.4
jobs are created. These jobs create $98 billion in wages and
$45 billion in Federal, State, and local taxes on those wages
and business income.
Even greater economic activity is created as the income is
generated in the construction, manufacturing, and sales jobs
that are spread throughout the rest of the local economy.
NAHB estimates that housing, including new construction,
remodeling, repairing, and maintenance, and the value provided
by existing homes account for 13 percent of the U.S. economy.
The ongoing benefit provides most American homeowners and
renters with decent, safe, affordable housing.
Affordable housing means more Americans can be homeowners,
which is an important impact on our society. We should strive
to do what is possible to provide the opportunity of home
ownership for more young families, and that, Mr. Chairman, is
the expansion of the individual retirement accounts, the IRAs,
and the penalty-free withdrawal from the IRAs for first-time
home purchases will do.
NAHB supports the expansion of tax-deferred retirement
savings and the use of IRA deposits for the downpayment on a
first home.
The proposal currently before the Committee would create a
new IRA and allow penalty-free distribution of funds from that
account and from existing IRAs for first-time home purchases.
NAHB supports this proposal and suggests modifications to
better accomplish its intended purposes.
Specifically, NAHB believes that any legislation should
also allow the tax-free withdrawal of funds in addition to
penalty-free withdrawals and provide affiliated individuals,
such as parents and grandparents, the access to the retirement
savings to help a first-time buyer.
Accumulating the downpayment for the purpose of a first-
time home is a primary barrier to home ownership for many young
households. IRAs could be a useful resource to assist in a
first-time home purchase downpayment.
In designating a successful proposal for using retirement
funds for downpayment, NAHB believes there are three important
components. One, the use must be considered as an alternative
investment, rather than a withdrawal. Eligibility must be open
to the parents and grandparents of first-time buyers, as well
as the buyers. Eligible plans must include IRAs, Keoughs,
401(k)s, other salary reduction plans, and the Federal
Government retirement system.
In the alternative, an attractive and economic proposal
would allow downpayments for first-time home buyers to be
treated as an investment for tax-deferred accounts rather than
as penalty-free withdrawals. Withdrawing the funds also
subjects the taxpayer to implicit penalties and that the
accountholder's investments in tax-deferred assets are reduced.
From the point of withdrawal on, interest of dividends on
withdrawing funds will be taxed at current marginal tax rates,
again, often higher than those anticipated during retirement.
Treating the downpayment as an alternative investment would
avoid both explicit and implicit penalties.
Mr. Chairman, NAHB encourages you to make rules for the IRA
use as flexible as possible. For example, if legislation
requires that the funds be maintained on deposit at least for 5
years prior to withdrawal, many young people would not be able
to take advantage of this legislation. First-time home buyers
are typically in their early thirties and currently have small
account balances in tax-deferred retirement accounts.
The long waiting period, coupled with the first-time
purchasers, are funds deferred and diminish the stimulative
impact of the proposal.
Mr. Chairman, now turning to the issue of capital gains
relief, NAHB remains committed to a broad-based tax cut in
capital gains rate. However, we realize that the purpose of
today's hearing is to discuss the targeted cuts contained in
President Clinton's fiscal year 1998 budget. Increasing the
capital gains exemption for home ownership would increase the
incentive to own and to own a larger house. Allowing repeated
use of the exemption after each sale would enhance housing as
an asset by removing barriers to trading before and after the
age of 55, which is the current law.
Allowing a repeal, repeated exemption will also remove
significant reporting burdens now required of homeowners. Under
current law, a typically elderly homeowner who has moved to a
retirement community must calculate capital gains liability by
going back to records of the first home purchase and following
each successive sale and purchase. The recordkeeping and effort
necessary to calculate tax liability is daunting for anybody
and all the worst for the individuals who have already paid a
lifetime of taxes.
Raising the amount of home appreciation exempt from taxes
is also necessary now in order to anticipate future home
appreciation that will dilute the value of current one-time
exemption levels of $125,000.
At the current levels of house price appreciation, a
typical home buyer in 1997 will see $265,000 of appreciation in
their home-owning lifetime. Increasing the limit now will
assure those young households that they will enjoy the same tax
advantages of owning as their parents and grandparents.
Finally, Mr. Chairman, I turn my remarks to the issue of
death tax relief. Although the President's budget contains some
estate tax relief for closely held businesses, it is minimal
and needs to be significantly expanded. The President's
proposal does very little to eliminate the estate tax burden on
small business and is merely a loan program. Although complete
repeal makes the most economic sense, NAHB understands the
revenue constraints associated with the appeal. Thus, NAHB
believes the best solution would be to raise the exemption
level from $600,000 and reduce the overall estate tax rate.
NAHB looks forward with working with the Ways and Means
Committee, as well as the administration, to craft a workable
proposal that is passable. Home building is dominated by small
firms which very often are family owned and operated. The
current estate and tax laws operate to destroy family owned
businesses. Although a credit is allowed against estate and
gift tax sufficient to allow a taxpayer upon death to transfer
up to $600,000 without paying taxes, this exemption amount has
not been raised.
The forced sale of family business is disruptive to the
home-building industry and increases the cost of producing
housing. Further, building homes and developing subdivisions is
a long-term process which many times is interrupted and frozen
as part of builder's estate. Creation of affordable housing
should not be stalled or curtailed as a result of complicated
estate issues or the eventual sale of the business.
For these reasons, NAHB supports estate tax relief.
Although complete repeal of the estate tax makes the most
economic sense, NAHB also supports a reduction in the current
estate tax rate and increasing the current estate tax
exemption.
Additionally, NAHB supports legislation to preserve family
owned businesses by either repealing the estate tax in general
or eliminating it from small family owned businesses. We also
understand that Senate Majority Leader Lott, with a group of
bipartisan Senators, will be introducing an estate tax bill
that takes a step in this direction.
In conclusion, for the reasons stated above, the National
Association of Home Builders believes that the tax cut proposal
currently being considered by Congress and the administration
are important to our Nation's economy and the creation of
affordable housing.
Home building creates jobs, both directly and indirectly,
as well as fuel our economy.
Again, Mr. Chairman, NAHB thanks you for this opportunity
to present our recommendations, and we look forward to working
with you, your staff in the coming months as the budget process
and tax cut proposals move forward.
I also have a copy of our 1997 legislative tax reform
policy which I would like to give to you that has all of our
legislative issues, and we have them available for all the
Members of the Committee.
[The statement and attachment follow. The entire book,
``Building the American Dream,'' is being retained in the
Committee files.]
Statement of C. Kent Conine, Owner, Conine Residential Group, Dallas,
Texas; On Behalf of National Association of Home Builders; as Presented
by Mark Kalish, Executive Vice President, Michael T. Rose Associates,
Laurel, Maryland
Mr. Chairman, members of the committee, my name is Kent
Conine and I am a home builder from Dallas, Texas. On behalf of
the 190,000 members of the National Association of Home
Builders (NAHB), I want to thank you for the opportunity to
testify before the Ways and Means Committee today. At the
outset, let me state that NAHB has been a long supporter of the
tax cuts the Committee is discussing this morning. We are
particularly appreciative, Mr. Chairman, of your long-standing
support of broad based capital gains relief and we thank you
for your continued efforts over the years.
As you know, the home building industry is comprised mostly
of small businessmen and women. Over 50 percent of NAHB members
build less than 10 houses per year. Approximately 15 percent
build more than 25 houses per year and less than two percent
build over 500 houses per year. Further, about 80 percent of
our members are family owned businesses. Unlike many other
industries, home builders are affected by all three of the
provisions that have been addressed by this morning's hearing.
The exclusion of capital gains on the sale of a primary
residence, an expansion of Individual Retirement Accounts and a
modification to the estate tax all directly impact the ability
of builders to provide affordable housing.
Housing--Its Economic Impact
Housing construction contributes jobs, taxes, and economic
activity to the U.S. economy. Each year, nearly 3 million jobs
are created in the construction of new homes. These jobs create
$98 billion in wages and $45 billion in federal, state and
local taxes on that wage and business income. Even greater
economic activity is created as the income generated in the
construction, manufacturing, and sales jobs spread throughout
the rest of the local economy.
NAHB estimates that housing, including new construction,
remodeling, repairing and maintenance, and the value provided
by existing homes accounts for 13 percent of the U.S. economy.
The on-going benefit provides most American homeowners and
renters with decent, safe affordable housing.
Table 1. Number of Workers Needed to Construct 1,000 Houses and Total Wages by Major Industry
----------------------------------------------------------------------------------------------------------------
Single Family Mulitfamily
---------------------------------------------
Industry Groups No. of No. of
full-time Wages full-time Wages
jobs (1) (millions) jobs (1) (millions)
----------------------------------------------------------------------------------------------------------------
All Industries.................................................... 2,448 $75.5 1,030 $31.9
Construction...................................................... 1,125 34.1 428 13.0
Onsite............................................................ 957 29.0 376 11.4
Offsite........................................................... 168 5.1 52 1.6
Other industries.................................................. 1,323 41.4 602 18.9
Manufacturing..................................................... 597 20.9 279 9.8
Trade, transportation, and services............................... 675 19.3 304 8.7
Mining and Other.................................................. 51 1.2 19 0.5
----------------------------------------------------------------------------------------------------------------
(1) Full-time, year round jobs.
Source: Number of workers: NAHB estimates from Bureau of Labor Statistics surveys of labor inputs in residential
construction. Wages: NAHB estimes from Bureau of Economic Analysis data.
Table 2. Tax Revenue Generated from Constructing 1,000 Homes: 1994 U.S.
Averages
------------------------------------------------------------------------
Single Family Multifamily
Tax by Source ---------------------------------
(Millions) (Millions)
------------------------------------------------------------------------
Total................................. $37.0 $15.8
Federal Taxes......................... 26.9 11.3
Personal Income Tax................. 6.9 2.9
Corporate and Business Income Tax... 8.4 3.5
Social Security Tax................. 11.6 4.9
Employee share...................... 5.8 2.4
Employer share...................... 5.8 2.4
State & Local Taxes and Fees.......... 10.1 4.5
State & Local General Sales Taxes... 3.3 1.4
State & Local Personal Income Taxes. 1.7 0.7
State Corporate and Business Income
Taxes.............................. 2.1 0.9
Local Real Estate Taxes and Fees (1) 3.0 1.5
Property transfer tax............... 0.5 0.2
Building permits, approval and
impact fees........................ 2.5 1.3
------------------------------------------------------------------------
(1) Excludes ongoing local property taxes of $1.7 million on 1,000
single family homes and $0.9 million on 1,000 multifamily homes.
Sources: Table II-4, U.S. Department of the Treasury, Internal Revenue
Service, Statistics of Income Bulletin, Summer 1994; and U.S.
Department of Commerce; Bureau of Economic Analysis, Survey of Current
Business, July 1994 and February 1995; U.S. Advisory Commission on
Intergovernmental Relations, Significant Feautres of Fiscal
Federalism; 1993, Volume I; National Apartment Association and NAHB
estimates.
Home Ownership--It's Impact on Our Society
Homeownership truly is a fundamental part of the American
Dream. Getting a good education, working hard, practicing
thrift so that home ownership can become a reality, has been a
motivating force for millions of Americans. NAHB's surveys show
that 80 to 90 percent of all Americans want to become home
owners. Recent studies by Fannie Mae have demonstrated the goal
for home ownership is strong among all age and income groups.
Homeownership not only allows families to establish roots in
their communities, but it strengthens neighborhoods, expands
participation in civic, religious, and community activities--it
is what ties our neighborhoods together.
Financial security is another benefit of homeownership. A
home is the largest single asset of most Americans. For
millions it represents a nest egg for retirement which has
provided the elderly a strong supplement to social security.
Many point to the low rate of per capital savings in the United
States. However, if the equity in the homes of individuals were
calculated, our per capita savings rates would be dramatically
higher.
The tax base for our public schools and community services
results from homeownership. It provides a safe haven, a
sanctuary, a secure place for families to live, grow and
prosper. This environment is essential for the development and
growth of our children. How can a child study properly, develop
family values, excel and expand their goals and dreams without
the proper environment Homes are what provide that secure,
protected and nurturing environment for millions of Americans.
We should strive to do what is possible to provide the
opportunity of homeownership for more young families, and that
Mr. Chairman is what expansion of Individual Retirement
Accounts (IRAs) and the penalty free withdrawal from IRAs for
first time home purchases will do.
Expansion of Individual Retirement Accounts
NAHB supports expansion of tax-deferred retirement savings
and use of IRA deposits for down payment on a first home. The
proposal currently before the committee would create a new IRA,
and allow the penalty-free distribution of funds from that
account and from existing IRAs for first-time home purchase.
NAHB supports this proposal and suggests modifications to
better accomplish its stated purposes. Specifically, NAHB
believes that any legislation should also allow the tax free
withdrawal of funds in addition to penalty free withdrawal sand
and affiliated individuals (e.g. parents and grandparents)
should be allowed acess to retirement savings for a first-time
home buyer.
Accumulating the down payment for the purchase of a first
home is the primary barrier to home ownership for many young
households. Even with lower down payment requirements under FHA
and special affordable housing programs from Fannie Mae,
Freddie Mac, and the Federal Home Loan Bank System, first-time
homebuyers find it difficult to accumulate the cash necessary
to make the leap into homeownership. The U.S. Census bureau and
the Harvard Joint Center for Housing Studies have reported that
down payment remains a serious barrier to home ownership for
young renters.\1\ Approximately nine-out-ten young renters
cannot afford to purchase even a modest home in their area.
---------------------------------------------------------------------------
\1\ The State of the Nation's Housing 1993. Joint Center for
Housing Studies of Harvard University and Who Can Afford to Buy in
House in 1991. Current Housing Reports H121/93-3. Bureau of the Census.
---------------------------------------------------------------------------
Increasing housing costs add to the housing affordability
problem in this country. From World War II until 1980 home
ownership rates in the U.S. increased. Since that time home
ownership rates overall has declined. Particularly hard hit are
those in the prime home buying age of 25-34. The home ownership
rates of those in the age group 25-29 dropped from 43.1% to
34.4% and those in the 30-34 age group dropped from 62.2% to
53.1%. This trend is of significant concern.
Table 3. Homeownership Rates (Percent)
------------------------------------------------------------------------
Age Group 75 80 85 90 94 95
------------------------------------------------------------------------
<25..................... 20.4 21.3 17.0 15.7 14.9 15.9
25-29................... 43.1 43.3 37.4 35.2 34.1 34.4
30-34................... 62.2 61.1 53.8 51.8 50.6 53.1
35-39................... 69.0 70.9 65.3 63.0 61.2 62.1
40-44................... 73.9 74.2 71.2 69.9 68.2 68.6
45-54................... 77.0 77.6 75.4 74.9 74.9 74.8
55-64................... 77.0 79.2 79.2 79.3 79.3 79.5
65-74................... 71.8 75.2 77.8 79.3 80.4 80.9
75+..................... 67.3 67.8 69.2 72.3 73.5 74.6
All..................... 64.7 65.6 63.9 63.9 64.0 64.7
------------------------------------------------------------------------
There are many factors that contribute to the housing
affordability problem we are facing in this country. Certainly
a factor has been increasing housing costs. Higher mortgage
interest rates and general economic inflation have also been
factors. The National Association of Home Builders believes
that government over-regulation is a significant contributor to
increased land development and housing costs. The Kemp
Commission on Removing Barriers to Affordable Housing
identified numerous government regulations that add to the
problem. We strongly urge Congress to make an aggressive review
of these regulations and eliminate or change those that are
unnecessary, costly and counter productive.
NAHB urges Congress to pass legislation expanding IRAs to
create an incentive which will promote savings and encourage
homeownership. Mr. Chairman, this proposal will make it
possible for thousands of young working families to obtain the
American Dream of home ownership. In turn, the construction of
their homes will create jobs and the expansion of our economy.
Equally important the expansion of homeownership contributes to
the social/political stability of our society.
IRA Savings for a Downpayment
IRAs could be a useful resource to assist in first-time
home purchase. IRAs already have substantial deposits. Total
assets held in IRAs and Keogh plans (retirement plans for the
self-employed) reached $773 billion at the end of 1992. Another
$230 billion is invested in salary reduction plans (401(k), 457
and 403(b) tax deferred employer and employee contribution
retirement plans) and $304 billion is invested in the federal
government retirement plan for civil servants.\2\ Collectively,
these retirement plans could provide up to 1.3 trillion
dollars.
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\2\ Employee Benefit Research Institute, EBRI Notes, November 1993
and Issue Brief, December 1993.
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A number of proposals have been made to increase the
potential use of retirement accounts for first time home
purchase down payments. Proposals for use of existing front-end
accounts typically propose penalty-free withdrawals of funds
from the IRA for specified purposes. However, the tax that was
deferred when the deposit was originally made must be paid at
the time of withdrawal. Accordingly, withdrawal would be
relatively expensive, especially if the funds were deposited at
a time when the taxpayer's marginal tax rate was lower.
To this end, the Savings and Investment Incentive Act of
1997, S. 197, introduced by Senators William Roth (R-DE) and
John Breaux (D-LA) in the Senate and the House companion bill
sponsored by Representative Bill Thomas (R-CA), restores the
IRA deduction and adjusts the $2,000 deductible amount for
inflation. It would also create nondeductible tax-free IRAs
called IRA Plus accounts. Under the provisions of S. 197,
distributions may be made free of penalty if used for first-
time home purchase by the individual, their spouse, child,
grandchild or ancestor. NAHB urges the Committee to consider
these bills as it begins drafting legislation on expanded IRAs.
Mr. Chairman, NAHB encourages you to make the rules for IRA
use as flexible as possible. For example, if the legislation
requires that the funds be maintained on deposit at least 5
years prior to withdrawal, the impact on home ownership would
be minimal. First time home buyers are typically in their early
30s and currently have small account balances in tax-deferred
retirement accounts. The long waiting period coupled with the
first-time purchaser's paucity of funds defer and diminish the
stimulative impact of the proposal. Although with such a rule
there would still be an increase in the incentive to save,
resulting in greater participation, the likelihood of
generating substantial savings is small.
NAHB also suggests that the current proposal be modified to
allow home purchase withdrawals to be made from parents' and
grandparents' accounts. This modification is important because
those very individuals this proposal is targeted to assist,
young working families who are recently out of college trying
to pay off students loans, or finance a car, have precious
little left over for a retirement account.
In designing a successful proposal for using retirement
funds for down payments, there are three important components:
1) The use must be considered an alternative investment rather
than a withdrawal; 2) Eligibility must be open to parents and
grandparents of first time home buyers as well as the buyer;
and 3) Eligible plans must include IRAs, Keoghs, 401(k) and
other salary reduction plans, and the federal government
retirement system. In the alternative, an attractive and
economical proposal would allow down payments for first home
purchase to be treated as an investment for tax deferred
accounts rather than as a penalty-free withdrawal. Withdrawing
the funds also subjects the taxpayer to implicit penalties in
that the account holder's investments in tax deferred assets
are reduced. From the point of withdrawal on, interest on
withdrawn funds would be taxed at current marginal tax rates,
again often higher than those anticipated during retirement.
Treating the down payment as an alternative investment would
avoid both explicit and implicit penalties.
The ability to use tax deferred retirement accounts for a
down payment must be open to parents and grandparents because
few young people have sufficient retirement savings to be
useful. Table 1 shows participation rates by age of employee in
employer pension plans. Table 2 shows account balances by age
for salary reductions plans, chiefly 401(k) plans. Employees
between 25 and 30 years old have the lowest participation rate
in retirement plans and an average account balance of $5,185. A
10 percent down payment and associated closing costs on a
median priced existing home sold would require cash in the
amount of $13,000.\3\
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\3\ The median existing home sales price for the first half of 1993
was $106,000 and closing costs for an FHA loan are about 2.5 percent of
the mortgage amount. Hence, cash required is $10,600 for the 10 percent
down payment and $2,456 for closing costs on a 90 percent mortgage plus
the 3-percent upfront insurance premium.
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On the other hand, the parent of a potential first time
home buyer is at least 45 years old, with an average IRA
balance of approximately $16,380. Grandparent IRAs are most
likely to have sufficient balances to provide down payment
support in that workers between 60 and 64 years old have
average IRA balances of $25,011.
Under current law, IRAs are primarily alternative forms of
retirement savings when the savers' employer does not offer a
retirement account, the saver is not self-employed, or the
saver's income is under $40,000. About 20 percent of all
workers have IRAs compared to 53 percent who participate in
some employer pension plan. In order to have any sufficient
impact, the first-time home purchase provision should also
apply to other retirement accounts.
Expanding the eligible investments of a tax deferred
retirement account to include qualified first time home
purchase will have very little impact on federal tax receipts
in the near term. The transfer of funds across investment
opportunities is already a frequent occurrence and has no
federal tax implications. The ability to use retirement funds
for first time home buyer assistance may increase the
desirability of saving in this form, both for potential first
time home buyers as well as their parents and grandparents. Any
increase in tax deferred in tax deferred savings because of the
expanded options would decrease federal tax revenues over a
longer period of time as deposits increased.
Therefore, NAHB recommends that such use (by either the
buyer, parents or grandparents of the buyer) be deemed an
eligible investment of the IRA. Roughly 15 percent of potential
first-time home buyers have invested in IRAs and another 9
percent have invested in 401(k) plans.\4\ NAHB estimates that
allowing a first-time home buyer's purchase to be a qualified
investment within the plan would create 20,000 jobs and
generate 36,000 additional home purchases.
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\4\ ``Down Payment for Retirement Accounts,''Housing Economics,
March 1991.
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Capital Gains
NAHB supports reinstatement of a capital gains rate
differential for real estate and other assets and indexing
their basis for inflation. More favorable capital gains
treatment would not only encourage purchases of existing
properties, but would also encourage investment in new
construction. For example, taxation of capital gains at 50% of
ordinary income rates would eventually reduce all rents by 5%.
This represents a tax cut for the middle class and those
struggling to become middle class. Yet another example of why a
capital gains tax break is not for the wealthy.
NAHB believes that taxation of assets held for one year or
more at a lower rate than ordinary income encourages investment
and savings. However, taxation of realized gains on long-held
assets at ordinary income rates (i.e. on sale or transfer)
reduces the economic incentives to invest in the most
efficient, highest return opportunities. Removal of the
retardant effect of current law taxation would allow taxpayers
to place their capital in the most promising sectors of the
economy. More efficient capital flows would create jobs and
stimulate the economy. A capital gains tax cut would not
benefit only higher income taxpayers. Encouraging investment
through reduced taxes on the gains from that investment would
create jobs and economic activity at all levels of income.
With respect to real estate, a capital gains preference
would increase investors and owners incentives to purchase,
rehabilitate and operate rental housing. Part of the total
return to investors who own rental housing is property
appreciation. The greater the owner's after-tax income from the
appreciation portion of their return, the less income required
from rents to achieve the same earnings. Reducing capital gains
tax rates will reduce residential rents. Since much of the
appreciation in housing is due to price inflation, adjusting
the gains for inflation will reduce rents even more.
We must insist however, that any capital gains incentive
include real estate. Just as real estate serves as the engine
to lead the economic recovery, so it must be included in any
capital gains reduction in order to maximize the dynamic
economic impact of the proposal. Indeed, inclusion of real
estate effectively rebuts any argument that a capital gains tax
cut would favor only wealthy taxpayers. Mr. Chairman, I know
this has been a long standing position of yours.
Depreciation Recapture
There is a technical aspect of the capital gains issue
relating to the taxation of business and investment real estate
which could have strong negative economic impact on our
industry. If, as was considered in 1996 budget talks,
depreciation rules are altered so that only gain in excess of
depreciable real estate's original costs would qualify for a
new lower capital gains tax rate, three out of five (60
percent) of investment and business real estate sales would
effectively be excluded form a capital gains tax cut. Real
estate, therefore, would be disadvantaged vis-a-vis other
investments, such as stock, further slowing additional recovery
in the nation's still fragile real estate markets.
Depreciation deductions for real estate are intended to
reflect the inevitable costs associated with the deterioration
of a long-lived structure and its many components, such as the
roof, heating, ventilation and air conditioning units, plumbing
and electrical fixtures, etc. Sale of real estate for more than
its adjusted basis is therefore likely the result of the
combination of a number of factors--such as, inflation,
appreciation in the value of the underlying land and market
conditions.
In 1964, Congress required that a portion of the
accelerated depreciation on real property be recaptured as
ordinary income. Subsequent amendments to the tax law have
required that the entire amount of accelerated depreciation on
real property be recaptured as ordinary income. However, any
depreciation taken to the extent allowable under the straight-
line method is generally not recaptured as ordinary income, but
rather creates capital gain.
The theory behind depreciation recapture is that to the
extent depreciation allowances reflect real economic
depreciation, there is no ordinary-income tax benefit to
recapture, only a capital gain. Also, to the extent that
depreciation allowances exceed economic depreciation, there is
an ordinary-income tax benefit which should be taxed at
ordinary-income tax rates.
Changing the current depreciation recapture law for
improved real property in the manner that has been discussed by
the Treasury department would not sufficiently unlock real
estate assets and would seriously disadvantage improved real
estate to other investments. To be meaningful, a capital gains
tax cut must maintain the current depreciation recapture rules.
Capital Gains Tax on Home Sales
Roll-over and One-Time Exemption Provisions
While NAHB remains committed to a broad base cut in the
capital gains tax rate, we realize the purpose of this
morning's hearing is to discuss the targeted capital gains cut
contained in President Clinton's FY1998 budget.
Owning your own home provides a personal satisfaction such
as the ability to control your living environment and the
feeling of being an integral part of your community. Owning
also brings financial gains through appreciation, and tax
preferences. One of the tax preferences accorded owning is the
ability to postpone and partially or entirely exclude taxation
on the appreciation.
The roll-over provisions provide some relief to home owners
who wish to trade homes but otherwise may incur a tax
liability. The roll-over provisions effectively extend the tax
treatment currently accorded tax-deferred retirement accounts
to housing. If a taxpayer moves deposits in a retirement
account from one asset to another, the activity is not taxed.
Since home equity is the single largest asset for most
families, equivalent treatment would seem appropriate.
Financial and real investments not sheltered in retirement
accounts do not enjoy these tax benefits and capital gains tax
is normally due when realized. The long-run impact of the
proposal enhances housing relative to other investments. To a
home owner deciding whether to invest in housing, greater
relief from tax on gains in an owned home versus some other
asset will tilt the tax decision towards housing.
Magnitudes
There are roughly 65 million home owners currently and most
would be likely to incur a tax if they were to sell and buy a
less expensive home or decide to rent. After the typical length
of stay in one home (15 years), a typical home seller today
will have $60,000 in taxable gain if they do not qualify for
the rollover or exemption. However, few do pay capital gains
tax for one reason or another. According to 1993 IRS
statistics, 150,000 tax payers claimed a taxable gain in the
sale of a residence in 1992. About 30,000 had no tax liability,
and the remaining 110,000 taxpayers claimed an average of
$17,200 in gain. The federal government collected an estimated
$300 million on these gains.
Estimates have been made regarding the number of home
sellers who used the roll-over and the one-time exemption to
avoid tax in a particular year. The results have been that only
half of all home sellers even file the proper form. Presumably,
those that did not file were eligible for deferral and didn't
realize they still must file (or they lied to avoid paying
tax). Additionally, it is estimated that 62 percent of the
gains that are reported are not taxed because the home owner
bought or is planning to buy a more expensive home and 33
percent of the gain was subject to the one-time exclusion,
leaving 5 percent of the gain taxed. Since these ratios omit
the sales not reported, the portion of all gains that is
actually taxed is even smaller.
Effect of Change
Increasing the current capital gains exemption for home
ownership would increase the incentive to own and to own more
house. Allowing repeated use of the exemption after each sale
would enhance housing as an asset by removing barriers to
trading before and after a certain age (55 under current law).
Allowing a repeated exemption will also remove significant
reporting burdens now required of home owners. Under current
law, a typical elderly home owner who moves to a retirement
community must calculate capital gains liability by going back
to records of the first home purchased and follow each
successive sale and purchase. The record keeping and effort
necessary to calculate tax liability is daunting for anyone,
and all the worse for an individual who has already paid a
lifetime of taxes.
Increasing the amount of capital gains that is exempt from
tax will increase home ownership by removing the capital gains
reporting burden and by making the financial investment in home
owning more attractive than the financial investment in other
assets. Raising the amount of home appreciation exempt from tax
is also necessary now in order to anticipate future home
appreciation that will dilute the value of the current one-time
exemption level of $125,000. At current levels of house price
appreciation, typical home buyers in 1997 will see $265,000 of
appreciation in their homeowning lifetime. Increasing the limit
now will assure those young households that they will enjoy the
same tax advantages of home owning as their parents and
grandparents.
``Death Tax'' Relief
Home building is dominated by small firms which very often
are family owned and operated. The current estate and gift tax
laws operate to destroy family-owned businesses by imposing a
tax upon the inter-generational transfer of the business.
Moreover, the economic impact of the tax increases from year to
year because of inflation. Under present law, estate and gift
taxes of up to 55% are imposed on the value of transfers.
Although a credit is allowed against estate and gift taxes
sufficient to allow a taxpayer upon death to transfer up to
$600,000 without paying tax, this exemption amount has not been
increased since 1987.
Impact on Housing
Eighty percent of home building firms in our country are
small family-owned businesses. The current tax treatment that
we live under limits the ability for current owners to pass
these companies onto their family members. Family businesses
should be passed to heirs without tax. Death taxes force family
owners to liquidate, sell off at a fraction of market value, or
pay dearly in estate planning costs instead of growing their
business. Additionally, these taxes make parents reluctant to
help their children establish themselves in independent
business. This forced sale of the family business is disruptive
the home building industry and increases the cost of producing
housing. Further, building homes and developing subdivisions is
a long term process which many times is interrupted and frozen
as an estates of a builder. Creation of affordable housing
should not be stalled or curtailed as a result of a complicated
estate issue or the eventual sale of the business.
For these reasons, NAHB supports estate tax relief.
Although complete repeal of the estate tax makes the most
economic sense, NAHB also supports a reduction in the current
estate tax rate and increasing the current estate tax
exemption. Additionally, NAHB supports legislation to preserve
family-owned business by either repealing the estate tax in
general or eliminating it for small family-owned businesses.
Although the President's budget contains some estate tax
relief for closely held businesses, it is minimal and needs to
be significantly expanded. His budget proposes to ease the
burden of estate taxes on farms and other small businesses,
allowing their owners to defer taxes on $2.5 million of value,
up from $1 million under current law. The deferred taxes could
be paid over 14 years at a favorable interest rate. The
proposal expands the type of businesses eligible for such
treatment by making the form of business organization
irrelevant.
The President's proposal does very little to eliminate the
estate tax burden on small business and is merely a loan
program. Many other proposals on estate tax relief have also
been introduced on the Hill--ranging from complete repeal to an
approach similar to the President's. The best solution would be
to raise the exemption level from $600,000 to $1 million and
reduce the overall estate tax rate. NAHB looks forward to
working with the Ways and Means Committee as well as the
Administration to craft a workable, passable proposal.
Conclusion
For the reasons stated above, the National Association of
Home Builders believes that the tax cut proposals currently
being considered by the Congress and the Administration are
important to our nation's economy and the creation of
affordable housing. Home building creates jobs both directly
and indirectly, as well as fuel our economy.
Once again Mr. Chairman, NAHB thanks you for this
opportunity to present our recommendations. We look forward to
working more closely with you and your staff in the coming
months as the budget process and tax cut proposal move forward.
National Association of Home Builders
A. Contributions-In-Aid of Construction (CIAC)
Policy
Contributions-in-aid of construction (CIAC) must not be
taxable to utilities in the year of receipt.
Background
The 1986 Tax Reform Act (TRA) changed the tax treatment of
contributions-in-aid of construction and required utilities to
include in their gross taxable income the contributions in the
year of the receipt. The Small Business Job Protection Act of
1996 contained a provision which repealed part of the changes
made in 1986 with regard to CIAC. Specifically, the newly
enacted law restores the tax-free treatment only to CIACs made
to public utilities that provide water and sewage services.
Therefore, any payments made to a water or sewage utility after
June 12, 1996 will not be treated as gross income and thus will
not be taxable.
These grossed up CIAC (taxes paid by utilities) are passed
on to the ultimate home purchaser by the builder. Prior to
1986, Internal Revenue Code Section 118(a) allowed utilities to
exclude contributions received in-aid of construction to be
excluded from taxable income. Because of the changes in the TRA
of 1986, the buyer pays not only for the capital improvements
provided to the utility company, but also the resultant tax. In
areas affected, the price of housing has risen as much as
$1,000 to $2,000 per unit.
Solutions
Seek and support an amendment to the Tax Reform
Act of 1986 to reinstate Internal Revenue Code Section 118 (a)
for electric and gas utilities.
B. Business Taxation
Policy
Federal income tax liability for businesses should be determined by
allowing firms to deduct expenses, reserves and depreciation in the
year incurred, and by including income received in that year only.
Further, businesses that are organized as limited liability companies
(LLC's) or limited partnerships should not be subject to the self-
employment tax.
Background
Some rules of the Internal Revenue Service and some tax laws do not
permit businesses to deduct business costs in the year in which they
occur. Under these circumstances, tax liabilities are determined by
amounts that may be larger than the actual resources available to the
firm. For instance, under current law a firm cannot deduct the cost of
removing an environmental hazard, but rather must capitalize the
expense over the life of the project. Requiring cost amortization
discourages acquisition, development and subsequent clean-up of
environmentally impaired real estate and discourages holding property
for sufficient time to plan and develop the property to its full
potential. Requiring amortized costs encourages land owners to sell
quickly in order to record the cost against income which further delays
careful planning and orderly development.
The current method for depreciating capital assets calculates
annual depreciation based on the original value of the asset without
regard to replacement cost. However, most capital goods, e.g.
equipment, buildings and machines, cost more to replace than their
original cost because general price inflation pushes up the cost of all
goods over time. Environmental restrictions and technological advances
make certain components of a building such as heating, ventilation and
air conditioning systems (HVAC) obsolete or unusable prior to the
applicable recovery period for residential and commercial real estate.
Major repairs or replacements of these components often have adverse
tax consequences by creating an asset with a recovery period far in
excess of its real useful life. Consequently, investors in capital
equipment and other long-lasting goods are discouraged from investing.
A neutral cost recovery system in the tax code would increase
investment in rental housing by making the tax consequences of
investing reflect the real world impacts of inflation, the economically
useful life of major components, and other factors. Under current rules
home building firms that set aside reserves against possible future
warranty claims cannot deduct the reserves from income even though the
funds are inaccessible until the warranty has expired. On the income
side prior to 1986, a taxpayer that sold property on the installment
basis was taxed as payments were received. Treating the income
otherwise requires a tax on the entire gain in the year of sale when
only a small portion of total sale proceeds may have been received in
the year of sale, resulting in a taxpayer being unable to pay the taxes
due. The 1986 Tax Reform Act prohibited the use of the installment
method for dealer sales of developed lots. As a result, landowners are
less likely to sell to builders on an installment basis and seek higher
prices to compensate for the extra tax burden. Under this change,
developers and home builders also are discouraged from building common
infrastructure before the homes are completed. Higher land costs and
fewer willing land owner partners in new home building increases the
cost of new homes and creates affordability problems for potential home
buyers.
Under current law, limited partners currently are exempt from self-
employment tax under Section 1042 of the Internal Revenue Code. The IRS
has issued proposed regulations that would subject certain limited
partners and LLC members to self-employment tax. The Taxpayer Relief
Act imposed a moratorium on the issuance of final regulations until
July 1, 998 and the conference report to the new law indicates that the
self-employment tax treatment of limited partners and LLC members
should be determined by legislation.
Solutions
1. Seek and support legislation to allow an inflation-adjusted
depreciation allowance.
2. Seek and support legislation to allow environmental cleanup
costs to be deductible by the owner in the year in which they are
incurred.
3. Obtain clear ruling from the Treasury Department to allow a
current year deduction of the costs for clean up of property that is
already contaminated when purchased.
4. Seek and support legislation to repeal the restrictive
provisions of the 1986 Tax Reform Act which require reporting income
from installment sales before it is received. H Seek and support
legislation to amend the Internal Revenue Code to define the term
``common infrastructure'' to include public use facilities.
5. Seek and support legislation to allow builders to deduct
reserves established for future warranty losses.
6. Seek and support legislation to preserve the current treatment
of limited partners and LLC members under the self-employment tax.
C. Differential Capital Gains Tax
Policy
A capital gains tax rate differential should be reinstated
for real estate.
Background
The Taxpayer Relief Act of 1997 reinstated a preferential
capital gains rate of 20 percent for capital assets held for
eighteen months. Under the new law, however, any gain
attributable to depreciation is recaptured and taxed at a 25
percent rate. Gain attributable to real estate investments
should be treated the same as gain attributable to the sale of
stocks or bonds.
Solution
1. Seek and support legislation re-establishing a lower
capital gains rate for gain attributed to recaptured
depreciation.
2. Support legislation to increase the amount of capital
gains on a primary residence that is exempt from tax and to
remove the one-time restriction on use of the exemption.
D. Estate and Gift Tax Treatment
Policy
Family businesses should be passed to heirs without tax.
Background
The recently enacted ``Taxpayer Relief Act of 1997''
increases the estate tax exemption from the current level of
$600,000 to $1 million by the year 2006. Additionally, the new
law allows an additional $300,000 exemption for qualified
family-owned businesses and farms. The phase-in of these
increases in the exemption, however, is too long and should be
immediate. Further, the exemption should be indexed for
inflation. Currently, the value of your estate over the
exemption amount can be taxed at rates as high as 55 percent.
Therefore, the overall rate of taxation should also be reduced.
Solutions
1. Seek and support legislation to phase-in more quickly
the increase in the estate tax exemption.
2. Seek and support legislation to reduce the overall
estate tax rate.
E. First-Time Home Buyer Down Payments
Policy
First-time home buyers should be able to use tax-deferred
retirement savings accounts to accumulate a down payment.
Background
Current law discourages the use of tax-deferred retirement
funds for use in purchasing a home. Distributions from tax-
deferred retirement accounts made before age 59 are subject to
an additional 10-percent tax. Borrowing from an IRA or use of
funds in an Individual Retirement Account (IRA) as security for
a loan is treated as a distribution. Allowing an eligible
first-time home buyer or an or affiliated individual (e.g.,
parent) to treat a down payment on a home as alternative
investment would increase first-time home buyers' access to
down payment funds and increase home ownership opportunities
for young families. Alternative forms of tax encouragement for
savings exempt the interest earnings and withdrawals from
taxation but do not exempt the deposit from taxation. Sometimes
referred to as ``back-end'' or the ``American Dream Savings
Accounts,'' this form of savings encouragement also increases
potential first-time home buyers' ability to save for a down
payment. A ``back end'' savings account reduces federal tax
revenue in the early years of the program less than the current
``front-end''method of favoring retirement savings.
Solutions
1. Allow retirement plans of first-time home buyers and
their family members to make equity investments in principal
residences for the first-time home buyer.
2. Seek and support legislation to increase the current
limit on deductible IRA contributions.
3. Restore the deductibility of IRA contributions for all
taxpayers.
4. Seek and support legislation to establish a ``back-end''
tax-favored savings account that would allow for tax-and
penalty-free withdrawals for a first home purchase.
Related Issue
Section VI. Issue--Down Payments
F. Home Owner Deductions
Policy
The home mortgage interest and property tax deductions must be
maintained without restriction or limitation.
Background
Deductions for mortgage interest and property tax expenses
encourage home ownership and stimulate home building which creates jobs
both directly and indirectly, fuels our economy and benefits growth at
all government levels with increased taxes and revenues. Further
restriction would decrease home ownership, depress housing values, and
reduce home construction.
Solution
Insist that Congress maintain full deductibility of home mortgage
interest and property taxes.
G. Home Office Deduction
Policy
Home office expenses should be fully deductible.
Background
Until 1993, home office expenses were fully deductible. The
Supreme Court's decision in Commissioner of Internal Revenue
Service v. Soliman substantially narrowed the availability of
the home office deduction. The ruling unfairly restricts small
businesses, especially those in the construction industry.
Disallowing the home office deduction either forces a
builder to rent or buy space away from home for the same
purpose or use the home as an office, but lose the legitimate
expense as a deduction. Either choice increases the cost of
doing business without improving the delivery of new homes to
buyers. The effect adds cost to new homes and reduces
affordability.
Solution
Seek and support legislation that allows the full deduction
of home office expenses.
H. Independent Contractor
Policy
Home building contractors should qualify as independent
contractors for tax purposes.
Background
The promise and vibrancy of the American economy generally
and the home building industry in particular lies in its make
up of millions of independent business persons. As a matter of
sound public policy, independent contractor businesses should
be fostered, and they should not be discriminated against by
Internal Revenue Code regulations. The 1996 Small Business Job
Protection Act improved the independent contractor safe harbor
relief in two respects--by injecting some clarity into the
distinction between an independent contractor and an employee,
and by putting constraints on the IRS's practice of over
aggressive auditing of small business owners using independent
contractors. These provisions take effect on September 1, 1997
but do not go far enough in clarifying independent contractor
distinctions in the home building industry.
Solution
1. Seek and support legislation to protect independent
contractor status and facilitate qualification as such.
Related Issue
Section VII., Issue--B. Health Care
I. Lobbying Tax Deduction
Policy
Lobbying expenses should be an allowable business expense
deduction.
Background
The tax code prohibits the business expense deduction for
any amounts paid in an attempt to influence federal or state
(but not local) legislation through communication with members
or employees of legislative bodies or other government
officials who may participate in the formulation of
legislation. The code also disallows a deduction for costs of
contacting certain high-ranking federal executive branch
officials in an attempt to influence their official actions or
positions. Trade associations allow their members to learn
about their industry and to participate in a complex democratic
process through professional staff and volunteer members. This
education and participation process provides a public good to
the rest of the economy by focusing issues and concerns on the
voters most affected. Taxing the dues that support this process
retards the democratic process.
Solution
1. Seek and support legislation which allows members of a
trade association to deduct lobbying expenses.
J. Low-Income Housing Tax Credit
Policy
The Low-Income Housing Tax Credit must be maintained to
encourage investment in affordable housing.
Background
The Low-Income Housing Tax Credit (LIHTC) and tax-exempt
bond financing are the primary vehicles for financing the
construction of low-income rental housing. Restrictions on
these tax incentives unnecessarily raise the cost of rental
units and subsequently reduce the number of rental units that
could be provided to low-income families. The LIHTC provides a
critical incentive for the production of affordable rental
apartments, and more than 95 percent of affordable units
produced for low-and moderate-income households involve the use
of this program.
Under the current law, states have an allocation of total
credits which can be issued and When the LIHTC was created in
1986 the annual amount of authority for the program was fixed
at $1.25/capita. This annual authority amount has not been
increased since 1986 and as a result the number of affordable
units produced annually has decreased steadily from a high of
124,500 units in 1989 to 75,000 units last year. The cost of
producing affordable housing has increased, but the amount of
authority has not.
Further, under current law states are responsible for
allocating tax credits to projects, but are restricted to two
credit rates, 9 percent and 4 percent. Allowing states to
divide their allocation of subsidy in different ways would
provide greater local flexibility and provide greater
incentives where they are needed without changing the overall
federal cost.
Solutions
1. Oppose any efforts to repeal the Low-Income Housing Tax
Credit.
2. Seek and support legislation to exempt low-income
housing tax credits from the alternative minimum tax.
3. Seek and support modification to existing law to allow
states to determine the credit rate.
4. Seek and support legislation to modify the occupancy and
income targeting requirements to enhance the use of tax-exempt
financing for low-moderate income rental projects.
5. Seek and support legislation to increase the annual
amount of authority for the LIHTC to reflect increases in
housing production costs and permit the authorized amount to be
adjusted annually for inflation.
Related Issues
Section V., Issue--B. Government Support for Affordable
Housing
Section V., Issue--D. Housing Finance Agency Programs
K. Mortgage Revenue Bond Eligibility
Policy
Certification of buyer's eligibility for the mortgage
revenue bond program should be made at the time of mortgage
application, not at the time of closing.
Background
The proceeds of mortgage revenue bonds (MRBs) are used to
finance the purchase, or qualifying rehabilitation or
improvement, of single family, owner-occupied residences.
Between the time of the original MRB application and closing
(when income is certified under the federal rules), the buyer's
family income may rise above the MRB income limit making the
buyer ineligible for MRB financing. Certification of
eligibility so late in the process unfairly harms builders who
have paid costs and met their contractual obligations in good
faith.
Solutions
1. Urge Congress to preserve the Mortgage Revenue Bond
program.
2. Seek and support legislation to modify the current rules
to provide for certification of buyers at time of mortgage
application.
L. Passive Activity Loss Rules
Policy
Private investment in rental projects should be encouraged
through the repeal of the passive activity loss tax treatment.
Background
The Tax Reform Act of 1986 discriminated against real
estate activity by enacting limitations on the deduction of
``passive'' activity losses (PAL). The impact of this rule
decreased the effective return on all investments in rental
housing--for new owners as well as existing owners. The result
has been a decrease in the value of existing properties and a
decline in investment in new rental housing. Ultimately, as the
rental inventory adjusts to the new tax rules, rents will rise
to equalize the after-tax returns on investments in rental
housing with other investment opportunities. The 1993 Budget
Act removed real estate professionals from the coverage of the
PAL rules, but imposed restrictions that allow few owners to
benefit from these changes.
Solutions
1. Seek and support legislation to repeal the passive
activity loss rules.
2. Urge the Internal Revenue Service to permit grouping
rental real estate activity with other builder-related real
estate activities.
Like Kind Exchange of Property
Policy
The current rules that allow the tax deferred exchange of
like kind property should not be changed.
Background
Under current law, section 1031 of the Internal Revenue
Code (IRC) provides for the tax deferred exchange of like kind
property. Under this section of the Code an individual may
exchange like property and defer recognition of their taxable
gain on the property until they accept cash or other payment
for the property.
The current definition of ``like kind'' allows for the
exchange of developed property for undeveloped property. There
have been legislative proposals to change the definition of
``like kind'' to ``similar use'' which would severely curtail
many beneficial real estate transactions and reinvestment in
communities struggling to improve distressed properties.
Further, changing the definition would cause taxpayer
uncertainty and create complex new administrative burdens.
Solution
Oppose any proposals to change or limit the definition of
``like kind'' for the purposes of section 1031 exchange.
M. Rehabilitation
Policy
A rehabilitation tax credit should be available for owner-
occupied historic homes.
Background
Under current law, rehabilitation of historic commercial
buildings used in a trade or business or rented are eligible
for a rehabilitation tax credit. However, owner occupants are
not eligible for the credit. Expanding the credit to owner-
occupied homes would create incentives to rehabilitate
historically significant properties and revitalize older
neighborhoods.
Solution
Seek and support an amendment to the Internal Revenue Code
to extend the historic rehabilitation tax credit to owner-
occupied residences.
Chairman Archer. Thank you, Mr. Kalish.
Our last witness in this panel, I would like personally to
have the honor to introduce, but I am going to yield to my
colleague from New York, Mr. Rangel, for the introduction.
Mr. Rangel. Bipartisanship at its height.
Let me thank the entire panel for your patience. We have
had more activity on the House floor today than we expected. I
thank the Chair for giving me the honor of introducing an old
friend, Morty Davis. Not only is he a self-made businessman and
chairman of the board of D.H. Blair Investment Banking Corp.,
but he has also spent quite a bit of time trying to reenergize
that engine that America depends on, and that is small
business. There is hardly a capital gains tax relief program
that somehow he has not managed to have his ideas incorporated
in. This Committee is privileged to have you to share those
views with us today.
Thank you for being here, Morty.
Chairman Archer. Mr. Davis, if you will identify yourself
for the record, we would be pleased to receive your testimony.
STATEMENT OF J. MORTON DAVIS, CHAIRMAN OF THE BOARD, D.H. BLAIR
INVESTMENT BANKING CORP., NEW YORK, NEW YORK
Mr. Davis. I thank you very much, Mr. Chairman. Thank you
very much, Congressman Rangel. You are both sensational guys. I
love you both, and I think you are doing fabulous jobs. You are
both great statesmen.
I am chairman of the board of D.H. Blair Investment Banking
Corp. in New York. I am also, incidently, founder, funder, and
largest stockholder of your new exciting weekly down here, The
Hill. I hope you enjoy it.
Mr. Chairman, Congressman Rangel, and Members of the
Committee, I very much appreciate the opportunity to present
testimony on the critical issue of how to promote savings and
investment.
Mr. Chairman, I am a great admirer of yours. Again, let me
repeat that. I am a great admirer of yours and particularly
your efforts to reform the present Tax Code which is biased in
favor of consumption over savings and investment.
I strongly support your campaign to remove tax barriers to
the capital formation needed to fuel economic growth and job
creation in our country.
Congressman Rangel, I am also a great admirer of your
efforts to ensure that economic growth and job creation, which
we all want, include those persons who historically have not
shared fully in the American dream.
I am testifying today in support of legislation which I
strongly believe would contribute greatly to meeting both your
objectives, specifically targeted capital gains tax relief to
new and small businesses. This legislation would build the pool
of investment capital by deferring taxes on capital gains
realized from direct investments in new and small businesses,
so long as those gains are reinvested in similar small and new
companies.
These tax-deferred rollovers would work much like the tax
treatment afforded to those who sell a home and purchase
another within a specified period of time or to those who roll
over their IRAs or 401(k) plans from one investment to another.
Mr. Chairman, you rightly have called for reform of the Tax
Code to promote investment and eliminate the prevailing bias
toward consumption. The rollover proposal would do both. The
rollover legislation would defer capital gains taxes on an
entire class of investments, so as to encourage such productive
investments, if, and only if, the initial investment and the
gain thereon is promptly reinvested in another new or small
business.
By deferring the tax on capital gains from investments in
new or small businesses, the market would be incentivized to
allocate capital to where it would do the most good. On the
other hand, if gains are not promptly reinvested in another new
or small company or, instead, used for consumption, then that
gain would immediately be taxed.
Congressman Rangel, the rollover proposal would also help
achieve your goals. The legislation would ensure that
sufficient investment capital is directed to new and small
businesses which have proven to be the most potent catalyst for
economic development and job growth in distressed urban areas.
Capital spending by small business produces jobs and lots
of them. It accounts for almost all of the new jobs. It
produces spending for capital equipment and lots of it, and far
out of proportion to the dollars invested by large companies,
and this is statistically demonstrated, capital spending by
small companies produces the most new technologies and exciting
discoveries to enhance the quality of our lives and those of
our children and our children's children. I must just add,
particularly in the new areas of biotech, where we are working
on cures for cancer and heart disease and all the things that
will enhance the quality of our lives, and particularly, in my
case, I am working especially to halt the aging process and
even reverse it so we can get even with our kids, be younger
than them, but that is the kind of exciting things we are
working on and that are so promising for the future.
As an investor, I repeatedly have observed that instead of
creating jobs with new capital, the Fortune 500 has been a net
loser of jobs, but as soon as a new or small company receives a
check, not in 1 year, not in 1 month, but the very next day, it
is out hiring new workers, purchasing new capital equipment,
and creating almost all of the new jobs and new products. This
is true capitalism and true growth enhancement.
Large companies have easy access to capital through banks,
commercial paper, and various established private and public
markets for their debt and equity securities.
Entrepreneurs and small companies, on the other hand, have
no place to go. They have to scramble around for capital and
usually often unsuccessfully.
The rollover proposal would help entrepreneurs and new and
small businesses get the capital they need. I strongly believe
that the small business capital gains rollover proposal is a
critical component of any new capital gains tax relief
legislation.
H.R. 1033, introduced last week by Congresswoman Dunn and
Congressmen Herger, Weller, Collins, Christensen, Ensign, and
others, provides for such rollovers as part of a larger package
of broad-based capital gains tax cuts. I believe that such a
comprehensive approach is the most effective means to promote
savings and investment.
Yet, I also believe the small business capital gains
rollover proposal has great merit as a freestanding bill, the
approach taken by Senator Daschle and other Senate Democrats in
S. 20.
I also wish to note the important work Congressman Matsui
had done in this area.
Finally, I very much recognize that if we are to balance
the budget, as we must, any tax proposal, no matter how worthy,
must promote maximum growth on a cost-effective basis. On that
count, the rollover is a winner.
The Joint Tax Committee has estimated the rollover
legislation introduced in the 104th Congress, which is very
similar to H.R. 1033 and S. 20, which would cost a total of
$100 million over 7 years.
Mr. Chairman, I think you will agree that in the context of
capital gains, that figure, $100 million over 7 years,
approaches de minimis.
Mr. Chairman and Congressman Rangel, I have prepared a more
detailed statement, and Members of the Committee, I have
prepared a more detailed statement which I ask for your
permission to be included in the record. I would be happy to
answer any questions you or the Committee may have, and I can't
thank you enough for inviting me to have this opportunity to
present this legislation as I see it.
Thank you very much.
[The prepared statement follows:]
Statement of J. Morton Davis, Chairman of the Board, D.H. Blair
Investment Banking Corp., New York, New York
Summary
Mr. Chairman, Congressman Rangel, and members of the
Committee, I very much appreciate the opportunity to present
testimony to the Committee on the pressing question of how we
may most effectively promote the capital formation needed to
fuel economic growth and job creation in our country. I thank
the Committee for seeking to address this problem.
The Congressional debate over capital gains taxes is no
longer focused on the question of whether there should be a
capital gains tax cut. Both the President and a great majority
of members of Congress have called for some type of capital
gains tax relief to be enacted. As a result, the question now
before Congress is how to structure a capital gains tax cut so
as to create the most new jobs, provide for the largest
increase in capital spending, and generally best stimulate
economic growth--while minimizing the loss of tax revenues to
the federal treasury.
I am testifying today in support of legislation which I
strongly believe would best meet those criteria: targeted
capital gains tax relief to small companies. Specifically, this
legislation would build the pool of investment capital
available to small businesses by deferring taxes on capital
gains realized from direct investments in small companies so
long as those gains are reinvested in similar companies. These
tax-deferred roll overs would work much like the tax treatment
afforded to those who sell a home and purchase another within
two years, or those who roll over their IRAs or 401(k) plans
from one investment to another.
Mr. Chairman, you rightly have called for reform of the tax
code to promote investment and eliminate the bias towards
consumption. The ``roll over'' proposal would do both. Other
witnesses today favor lowering capital gains rates overall, a
goal I very much support. The ``roll over'' legislation would
lower capital gains rates on an entire class of investments to
the lowest rate of all--zero. By eliminating the tax on capital
gains, the market would be allowed to allocate capital to where
it would do the most good. On the other hand, if gains were not
reinvested, but instead were used for consumption, that
consumption would be taxed immediately.
Congressman Rangel, the ``roll over'' proposal also would
help achieve your goal of ensuring that the economic growth and
job creation which we all want includes those persons who
historically have not shared fully in the American Dream.
``Roll over'' legislation now before Congress would ensure that
sufficient investment capital is directed to small businesses,
which have proven to be the most potent catalysts for economic
development and job growth in distressed urban areas.
Capital spending by small businesses produces jobs, and
lots of them. As an investor, I repeatedly have observed that
if an investment is made in a large company, that money often
is parked in an account for an indefinite period before it is
put to productive use. But when a small company receives a
check, it goes out--not in a year, not in a month, but the very
next day--and hires workers and purchases equipment. Yet larger
companies have much easier access to capital--through banks,
commercial paper, and established public markets for their debt
and equity. The ``roll over'' proposal would provide small,
entrepreneurial businesses with the capital they need.
I strongly believe that the small business capital gains
``roll over'' proposal is a critical component of any capital
gains tax relief legislation. H.R. 1033, ``The Return Capital
to the American People Act'' introduced by Congresswoman Dunn
and Congressmen Herger, Weller, Collins, Christensen, Ensign,
and others, provides for such ``roll overs'' as part of a
larger package of broad-based capital gains tax cuts. I believe
that such a comprehensive approach is the most effective means
to promote savings and investment. Yet I also believe the small
business capital gains ``roll over'' proposal has great merit
as a freestanding bill, the approach taken by Senator Daschle
and other Senate Democrats in S. 20, ``The Targeted Investment
Incentive and Economic Growth Act of 1997.''
Finally, I very much recognize that if we are to balance
the budget, as we must, any tax proposal, no matter how worthy,
must promote maximum growth on a cost-effective basis. On that
count, the ``roll over'' is a winner. The Joint Committee on
Taxation has estimated that H.R. 1785, roll over legislation
introduced in the 104th Congress which is very similar to H.R.
1033 and S. 20, would cost a total of $100 million over seven
years. Mr. Chairman, I think you will agree that, in the
context of capital gains, that figure--which does not give any
effect to taxes paid by new businesses as they become
profitable, or the taxes paid by the people employed by such
businesses--approaches de minimis.
In sum, I very much support prompt enactment of small
business capital gains ``roll over'' legislation such as that
included in H.R. 1033 or S. 20. The remainder of my testimony
seeks to address policy considerations and technical issues
relating to such legislation.
Small Business is Key to Job Creation, Economic Growth, and
Technological Innovation
In all probability we are not going to beat the newly
industrialized countries of Asia and other regions in
relatively mature industries, but we can surely improve our
competitive position and leave them decades behind in what our
pioneering and entrepreneurial spirit enables us to do best--
the development of new technologies and new products in such
emerging fields as biotechnology, telecommunications, space and
aerospace, superconductivity, laser technology, medical and
pharmaceutical products, and all of the exciting yet undreamed
of products of the 21st century and beyond.
If we look historically at our economy, it is small,
entrepreneurial businesses which have created the most new
jobs, invested the greatest percentage of their assets in new
equipment, and provided the greatest percentage of
technological breakthroughs and new products for each dollar
invested. The entrepreneurial effort, resourcefulness, and
creativity which characterize American small businesses have,
over the years, spurred the growth of our economy. Today, small
businesses are leading the way down the information
superhighway, and they are in the forefront of biotech research
that will improve the quality of life for us, our children, and
our children's children by providing cures to devastating
diseases, alleviating our most painful and life-destroying
maladies, and halting or even reversing the aging process.
Starting and promoting small businesses is an integral part
of the American Dream. One need only think of how Edison's
inventions and Henry Ford's first assembly line changed the
world forever, or, more recently, of how Ray Kroc went from
selling multimixers from the back of his station wagon to build
McDonalds, or how Bill Gates' first software program mushroomed
into Microsoft, and you begin to get an idea of the billions of
dollars of goods and services and the millions and millions of
jobs that exist today thanks to past investment in developing
companies. We as a people are amazingly good at developing new
technologies and new products--better than anyone else in the
world--and this is where we can shine competitively and truly
excel. And this is precisely the area where the roll over is
focused by providing incentives to invest in new and small
businesses.
Every day, workers are being laid off by large
corporations. In most cases, those jobs are gone forever. It's
only the new smaller companies that can create the needed new
jobs. Already, more than a third of America's workers are
employed by businesses with fewer than 100 employees, and that
percentage continues to rise, and more than 80% of all
businesses in America have fewer than 50 employees.
Simply put, new and smaller firms create the overwhelming
majority of new jobs and economic growth. Thus, any legislation
which seeks to promote economic growth must foster the growth
of small companies.
Numerous studies have concluded that small and newly
created firms play an important role not only in job creation
but in the process of technological innovation and new product
development, processes critical to future U.S. competitiveness.
A U.S. Commerce Department study pointed out that from 1982
to 1989 large United States multi-national corporations
generated a domestic employment gain of less than 1%, while the
nation's total non-agricultural payrolls rose approximately
21%. Our large corporations, which in 1982 represented
approximately 21% of the nation's employment, accounted for
less than one tenth of 1% of the job growth from 1982-1989.
These corporations' share of total employment fell from 21% to
17% during the same period. Additionally, these major
corporations contributed less than 15% of the country's total
gross national product growth from 1982 to 1989.
A 1989 study completed by the National Association of
Securities Dealers, Inc. and the Economic Research Bureau of
the State University of New York at Stony Brook, ``The Economic
Impact of IPOs on U.S. Industrial Competitiveness,'' provided
startling data as to job and technology advances provided by
companies publicly raising money for the first time. The study
covered 426 initial public offerings in 1983, 1984, and 1985
and tracked the performance of these companies through 1987.
These offerings related to companies which are typically start
up or small companies.
In short, the NASD/SUNY-Stony Brook study demonstrated
that: (a) industry employment by all public companies dropped
at an average annual rate of 6.5% while the IPO firms increased
their employment at a rate of 29.8%; (b) IPO firms grew more
than three and half times faster than industry in general,
increasing their sales at an average annual rate of 34.6%
compared with 9.4% for industry as a whole; (c) while IPO firms
could be expected to increase their invested capital faster
than industry in general, the margin of difference was more
significant than would have been expected--IPO firms grew at an
average annual rate of 51.8%, or more than seven times faster
than the industry average of 7.2%; and (d) IPO firms increased
their capital spending more than 10 times faster than industry
in general, or 62.7% versus 6.0%.
A third study, ``Tax Incentives For Investing in Emerging
Firms; A Strategy for Enhancing U.S. Competitiveness,'' by
Robert J. Shapiro of the Progressive Policy Institute concluded
that ``emerging firms create most of the new jobs in the U.S.,
generate more technological advances than other companies and
generally provide more of the innovations that are critical to
U.S. competitiveness.'' The study further stated that ``by
definition, a new company creates employment; in fact the data
[discussed in this study] show that new and young companies are
primary forces in new job creation.'' Mr. Shapiro in his study
also concluded that small corporations outpaced established
companies in their rates of expenditures, especially for
research and development and commercialization of new products
and services.
Yet another study, by the Massachusetts Institute of
Technology, reported that from 1982 to 1986 the total number of
Americans working increased by 9.3 million. Firms which were
organized during this period, however, created nearly 14.2
million jobs, and another 4.5 million new jobs were created by
companies with less than 100 employees. Thus the new jobs
created during this period by these newly organized businesses
exceeded the entire job growth during this period. The Fortune
500 companies actually decreased their total employment by
approximately 20% in the 1980s and early 1990s.
In a June 1996 article in Worth magazine, Peter Lynch
observed, ``Younger, more aggressive companies are challenging
the older companies or starting new industries from scratch.
The jobs lost when the older companies falter are made up and
then some in the younger companies that succeed.'' In support
of that conclusion, Mr. Lynch presented data which indicated
that 25 of the nation's largest companies shed a total of
360,000 jobs between 1985 and 1995, while 25 new companies,
many of which barely existed a decade ago, added over one
million jobs over the same period.
My own experience, gained over 30 years of raising equity
capital for hundreds of new and emerging small companies,
overwhelmingly supports this statistical evidence.
Even larger U.S. corporations acknowledge the crucial role
of smaller companies in forging important technological
advances. This is evident in the increasing number of instances
in which large U.S. corporations enter into joint research and
development efforts with small entrepreneurial companies or
acquire or make substantial equity investments in these
companies to gain access to their technology base. These
actions reflect a recognition that these smaller companies--
with their more dynamic, pioneering, entrepreneurial, non-
bureaucratic structure--are responsible for much of the
nation's growth and are better able to find creative solutions
to problems, which is necessary in the creation of new
technology and new products.
Tax Relief for Capital Gains Reinvested in Small Businesses Would
Create Jobs and Build the Pool of Capital Available for Productive
Investment
In assessing the various capital gains tax cut proposals
now before Congress, lawmakers should seek to determine the
best means to achieve three goals:
Create new jobs
Stimulate capital investment
Promote the development of new products and
technologies which will producer an ever-improving quality of
life for our citizenry and enable United States' businesses to
compete effectively in world markets
Targeted capital gains tax relief for small businesses in
the form of tax-deferred ``roll overs,'' such as those included
in H.R. 1033 and S. 20, would contribute mightily to achieving
each of these objectives.
Deferring taxes on capital gains which are reinvested is a
proven means of promoting savings and investment. Several tax
code provisions already provide for tax-deferred roll overs,
most notably that afforded homeowners who sell their primary
residence and purchase another within two years. The concept
would apply just as well to the reinvestment of capital gains
realized upon the sale of small business stock.
Both Republicans and Democrats have recognized the merits
of a small business capital gains ``roll over'' provision.
Generally, Democrats favor enacting the proposal in lieu of
broad-based capital gains cuts. Senate Minority Leader Daschle
has taken such an approach in S. 20. Republicans, on the other
hand, generally support the targeted small business capital
gains ``roll over'' proposal as part of a larger package of
broad-based capital gains tax relief. I believe either approach
would greatly benefit the economy.
Targeted capital gains tax relief for small businesses
effectively complements broad-based capital gains tax cuts, and
should be a part of any capital gains tax relief package which
is enacted by the 105th Congress. I wish to underscore that
passage of broad-based capital gains relief in no way
eliminates the need for a ``roll over'' provision. The two
proposals are not redundant. They differ in four principal
ways:
First, a ``roll over'' provision would defer the
entire capital gains tax on covered transactions. Thus, 100
cents of every dollar of gain would be available for
reinvestment. The most common broad-based capital gains tax cut
proposals would provide for an effective rate of between 14%
and 19.8%, thus leaving only 80-86 cents for reinvestment after
the tax is assessed.
Second, the tax deferral afforded by ``roll over''
legislation would be available only if the gain was reinvested,
while the broad-based cuts would apply even to gains which were
built up in prior years and are cashed in for purposes of
consumption. Thus, the ``roll over'' legislation is a more
effective means of addressing the tax code's general bias
against savings and investment in favor of consumption.
Third, a ``roll over'' specifically would promote
capital formation for small, entrepreneurial ventures, which
create the most jobs and have the most pressing capital
requirements.
Fourth, ``roll over'' legislation is vastly less
expensive than broad-based capital gains. As discussed below,
the Joint Committee on Taxation has estimated that ``roll
over'' legislation introduced in the 104th Congress which is
very similar to H.R. 1033 and S. 20 would cost a total of $100
million over seven years. The broad based capital gains cuts
included in the Balanced Budget Act of 1995 would cost $35
billion over the same period.
In short, the targeted ``roll over'' provisions of H.R.
1033 and S. 20 should be a key component of any legislative
effort to spur economic growth. It doesn't reward money stuffed
in a mattress or blue chip stock certificates locked in bank
vaults. It doesn't reward the substitution of equity for debt
incurred for the leveraged buy outs of large corporations, a
class of transactions which do little to encourage new
investment in equipment, research, and job formation. What it
does reward is risk taking--taking risks in the emerging growth
businesses which create new jobs and new technologies--the same
risk taking that made America great, and the same risk taking
that can make America great again.
The Joint Tax Committee has stated that Small Business Capital Gains
``Roll Over'' Legislation Would Have a Very Modest Impact on Tax
Revenues
The Joint Committee on Taxation has concluded that providing
targeted capital gains tax relief to small businesses by deferring
taxes on capital gains realized from direct investments in small
companies so long as those gains are reinvested in similar companies
would have a very modest impact on federal tax revenues relative to
other capital gains tax proposals.
Specifically, the Joint Committee estimated that H.R. 1785, a bill
introduced in the 104th Congress which is very similar to the ``roll
over'' provisions of H.R. 1033 and S. 20, would result in a tax revenue
loss to the federal treasury of a total of $100 million over seven
years. Significantly, the revenue estimate for H.R. 1785 even included
losses attributable to a provision which would eliminate, only for
investments in small businesses, the current law cap on the amount of
capital losses which could be offset against ordinary income. The
latter provision would particularly benefit middle income investors who
do not have extensive portfolios which they can manipulate to produce
capital gains to match against capital losses.
Relative to other capital gains tax proposals, the cost of the
targeted roll over proposal is de minimis. For example, the Joint
Committee scored the capital gains tax reforms passed by the 104th
Congress as part of the Balanced Budget Act of 1995 as costing over $35
billion over seven years.
Capital Gains Legislation Should Be Drafted to Facilitate, Not Impede,
Productive Investment
If capital gains tax relief is to be effective, it must facilitate,
not impede, productive investment. Specifically, the market, not the
artificial constraints of the Internal Revenue Code, must be permitted
to allocate capital to where it will do the most good. Because holding
period requirements impede the flow of capital, they must be imposed
only where they serve legitimate policy ends.
Based on my decades of experience as an investor, I believe there
are two legitimate reasons for imposing holding periods. First,
preferred investors who are granted special access to initial offerings
of securities should not be afforded any tax benefits for selling those
interests for an immediate windfall. Quite often, a security sold in an
initial public offering spikes up in value over the original offering
price within hours of hitting the market. No public policy interest is
served by encouraging sales at that point; such ``flipping'' does
nothing to promote productive investment. However, those ``spikes''
tend to last as little as a few hours, and in my experience, almost
never more than a few weeks, after which the stock value tends to
plateau. Thus, I believe a holding period of as little as three months
would address the ``flipping'' issue effectively.
The second legitimate reason for imposing a holding period
requirement is to impede disinvestment, that is, the cashing in of
capital gains which are not reinvested productively, but instead used
for purposes of consumption. To achieve that goal, holding periods of
nearly any length may be justified, although a simpler, and more
effective approach would be to impose a significant tax on consumption,
that is, capital gains which are not reinvested, and impose little tax
or, better still, defer the entire tax on those gains which are
reinvested.
The ``roll over'' provisions of H.R. 1033 and S. 20 provide that
stock in a small company must be held for a minimum of six months in
order for gains realized upon the sale of such stock to be eligible for
tax deferrals upon reinvestment. I believe such a holding period is
sound: it prevents ``flipping'' but does not impede legitimate
reinvestment. Moreover, it has strong historic precedent: from 1942
through 1988, except for a single eight year period, the Internal
Revenue Code required stock to be held for six months to be eligible
for tax treatment as long-term capital gains. (More recently, the Code
requires a one year holding period for long term capital gains.) The
robust economic growth of the first several decades of the post-war
era, growth which was characterized by the creation of vast numbers of
new businesses and GDP increases far exceeding those of recent years,
conclusively rebuts the notion that a six-month holding period renders
entrepreneurs excessively vulnerable to the vicissitudes of capital
markets.
Section 1202 of the Code, the small business capital gains
provision enacted in 1993, provides for a five-year holding period.
Five years is simply too long: I have observed that investors have
almost ignored section 1202 because they are unwilling to tie up
capital long enough to qualify for the tax benefits it confers.
Significantly, Congressman Matsui, the lead House sponsor of the
legislation which ultimately became section 1202, has introduced
legislation which would both reduce the five year holding period
requirement for gains which would qualify for a reduced tax rate and
provide for the deferral of capital gains which are realized on
investments in small companies which are ``rolled over'' into similar
investments. Yet Congressman Matsui's bill, H.R. 420, requires that
small business stock be held for three years in order to qualify for
both a reduced rate and tax-deferred roll over. As noted, it may be
appropriate to impede disinvestment by imposing a lengthy holding
period for those seeking to disinvest their gains and use those
resources for consumption. However, the tax code should not present a
barrier to reinvestment of capital gains. Thus, the three year holding
period set forth in H.R. 420 may be appropriate for the rate reduction
component, but the six month holding period set forth in H.R. 1033 and
S. 20 constitutes more sound tax policy with respect to the roll over
component.
We cannot afford to introduce impediments and disincentives to
investments in small emerging businesses. As long as the investment
serves to launch a new company or expand an existing business with the
vitally important attendant creation of new jobs, we should not require
capital to be ``locked in'' for years. Indeed, ample testimony before
the Committee correctly notes that ``capital lock'' is among the
biggest problems created by the high capital gains rates currently in
force. A number of commentators have called for the tax code to
encourage ``patient capital.'' They are correct. Yet from the
standpoint of the company in which the investment is made, equity
capital is the most patient capital of all--it is permanent capital.
And only gains on original issues of equity would be eligible for a
tax-deferred ``roll overs'' under H.R. 1033 or S. 20.
An excessive holding period--in my view, anything beyond six
months--would drastically limit the pool of potential investors to
those who can afford to tie up their funds for a long time. An
excessive holding period also would significantly lessen the incentive
by removing the possibility of a relatively prompt gain, and as a
result of such reduced incentive, necessarily would reduce the number
of persons willing to risk investing in small entrepreneurial
companies. I emphasize that it is the possibility of a quick gain that
is important. In fact, the investment will almost always be held for
more than six months. Yet holding out the possibility of an early gain,
and having taxes on those gains deferred, is what will create the real
incentive for investors to take the extra risk of funding new and small
businesses.
What we need to do is to encourage investments in small businesses
so as to achieve the positive results which derive from such
investments. Locking in capital for a predetermined period is counter
to the purpose of promoting investment in small companies. The sooner
the money is reinvested, the sooner it can go to work again. This
multiplier effect increases the pool of investment capital, and permits
it to be reinvested where it does most good.
In sum, targeted capial gains tax relief for small businesses in
the form of tax-deferred ``roll overs,'' such as those included in H.R.
1033 and S. 20, are the single most effective legislative means to help
new and small companies and to promote savings and investment in the
economy as a whole. Such legislation deserves the support of this
Committee, the Congress, the President, and all Americans, and should
be a part of any capital gains tax relief package which is enacted by
the 105th Congress.
Mr. Chairman, thank you again for the opportunity to testify today.
Chairman Archer. Mr. Davis, thank you for your testimony,
and without objection, your entire written statement will be
included in the record, as will be true for all of the witness.
Mr. Rangel, would you like to inquire?
Mr. Rangel. Thank you.
Mr. Davis, did I understand you to say that the cost of
this is de minimis?
Mr. Davis. Yes. The Tax Committee headed, I believe, by Mr.
Kies, whom I saw here earlier, after some time developed the
scoring on this, and on a static scoring, it was their advice
to us and to the Congress that the cost would be $100 million
over 7 years on a static basis. That is not considering that
many of these companies, these new and small businesses,
entrepreneurs, will be hiring employees that will be paying,
and certainly, within 7 years, in a dynamic situation, the
companies themselves will be developing and growing and paying
taxes. So it is $100 million over 7 years, yes, very correctly.
Mr. Rangel. Well, I have heard this type of optimistic
report. Certainly, it sounds more favorable when you are
dealing with small businesses because in America that is truly
where the jobs are. I will be interested in having Mr. Kies
share the result of the Joint Committee's work on this so that
I will be able to share it with other Members. Maybe the
Chairman might want to comment on that because it would seem
like those very new figures are rather low. Perhaps they are
using his new method of scoring, which is creative, but not
accepted at this time.
Let me thank all of you, but especially you, Mr. Davis.
Mr. Davis. I always appreciate your brilliance of wisdom,
and the Chairman's as well. You are two of the greatest
statesmen in the history of our country. Thank you again.
Chairman Archer. Mr. Davis, after what you have said about
both of us, I think maybe you might be preparing to run for
public office.
Mr. Davis. No, I just want to support great people like
you. You guys do a great job.
Chairman Archer. Thank you very much.
Ms. Collins, do you wish to inquire?
Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. I appreciate the
opportunity to ask a couple of quick questions here.
Mr. Davis, I appreciate the leadership you have had in
small business issues and job creation as a professional and
attracting investment.
I note with great interest and, of course, am proud to
cosponsor legislation referred to in your testimony.
I noticed toward the end of your written testimony, you
make a point regarding excessive holding periods.
Mr. Davis. The what?
Mr. Weller. The excessive holding periods.
Mr. Davis. Yes.
Mr. Weller. Requiring to hold assets for a long period of
time.
I was wondering if you can explain to me, just so I can
better understand, how you feel that by having longer holding
periods, how that would discourage investment and the creation
of small business and entrepreneur activity.
Mr. Davis. Well, something that is decidedly desirable, you
don't want to introduce any disincentives to the success of
such a program, and I think if you are familiar with the
history, Bumpers-Matsui or Matsui-Bumpers introduced a bill
several years ago that said if you held an investment for 5
years, I think you pay half the prevailing capital gains, and
if you hold it 10 years, I think you pay no capital gains tax.
That bill was such a disincentive that I think, even though
it is in effect several years, nobody has even asked for the
regulations.
If it is useful, first of all, equity capital, as
distinguished from debt capital or any other capital, equity
capital is permanent capital. You can't take it back. If I give
a company some money to put into the business, they have it
forever. I can seek to fund another buyer, but from the
company's point of view, it is permanent capital. So this idea
of having somebody hold it 2 years, 3 years, 4 years, or 5
years serves little or no purpose. I don't see any purpose, and
we do insist--we have introduced as we have refined this--to
avoid people that maybe get into issue and kick it out 2 hours
later, the free riders or flippers, as they call them on Wall
Street. We have introduced something in discussing with
Treasury. We have to hold it at least 6 months or you avoid
that kind of thing, but to the extent that somebody is
successful and selling it to somebody else, from the company's
point of view, it is permanent capital, and then he can turn
around and use that money and has to use that money within 6
months, reinvest it in another new company, otherwise he is
taxed.
It is an incentive to build a large formation of capital
for that segment of the economy that hasn't got the
availability, as big companies do, and it is important for
women, it is important for minorities. It is important for all
of us because that is this segment of this country that has
produced the largest growth over the last decade and beyond. I
hope that answers your question.
Mr. Weller. Yes, it surely does. Essentially, you are
saying that the opportunity for fairly quick gain actually
attracts more investment than new activity.
Mr. Davis. Congressman, we have an evergrowing pool, as a
guy has made a profit, and he has to reinvest the corpus, plus
the profit, again, in a new or entrepreneurial or a small
business, the ones that are creating all the jobs.
As I pointed out, the Fortune 500 have been downsizing, and
I am sure you are well aware of that. All the new jobs have
come from these small companies, and all the women are going to
new businesses at an accelerated rate. We have to make capital
available to that group, and that is where all the great new
ideas come from.
We often fund guys right out of MIT and Harvard and
Stanford, and if they didn't have access to this kind of
capital, they would never get funded.
I am sure you know friends that try to start businesses.
They run around addressing their friends, scrambling around,
and it is very, very hard to get that kind of capital.
So we have to say, in response for your taking the bigger
risk, that if you have a gain, you can reinvest that gain, and
other companies of the same nature. That helps the growth of
our country.
Mr. Weller. Thank you. Thank you, Mr. Davis.
Mr. Davis. Thank you very much.
Mr. Weller. Thank you, Mr. Chairman. That concludes my
questions.
Chairman Archer. Gentlemen, thank you very much. The
Committee will benefit from your testimony, each of you.
The Committee has no further business today. The Committee
will stand adjourned.
[Whereupon, at 4:05 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of John W. Cox, BMC Software, Inc.; on Behalf of American
Alliance for Software Exports
I am John W. Cox, Tax Director for BMC Software, Inc.
headquartered in Houston, Texas. BMC is a member of the
American Alliance for Software Exports (AASE), on whose behalf
this statement is submitted in support of H.R. 143, The
Software Export Equity Act, and the Administration's FY 1998
Budget proposal to clarify the application of Foreign Sales
Corporation (FSC) incentives to exports of software licenses.
The AASE applauds the leadership of Representatives Dunn
and Matsui in introducing H.R. 143, which clarifies that the
export of software that is accompanied by the right to
reproduce qualifies for FSC incentives. We are pleased that
similar legislation (S. 387) has been introduced in the Senate
by Senators Hatch, Nickles, Baucus and Breaux. The fact that
three-quarters of the members of the Ways and Means Committee
have co-sponsored this legislation clearly demonstrates that
this legislation has broad, bipartisan support. We commend the
Ways and Means Committee for their support of this legislation.
The AASE also applauds the Administration for recognizing
the importance of providing FSC incentives to software exports
by including, and funding, a proposal to resolve this issue in
their Fiscal 1998 Budget. The Administration's proposal,
however, is effective only for software licenses granted after
the date of enactment. Because many software licenses with
third-party distributors are multi-year agreements, relating
the effective date to licenses granted after a certain date
will force software companies to renegotiate these licenses. We
would appreciate the opportunity to work with the Committee on
drafting a more appropriate effective date.
I would like to be clear. The U.S. software industry is not
seeking any new benefit or special treatment. As I will outline
in this statement, all the industry is seeking is equal
treatment under existing law. We believe Congress always
intended for software to be included as part of the FSC
statute. We find no evidence Congress ever intended to exclude
software. To the contrary, we find strong evidence that
Congress intended to include such industries as software.
The AASE is a group of high technology companies and state,
local and national trade associations representing every region
of the country. AASE members include the Alaska Division of
Trade & Development; Alaska Hi-Tech Business Council; American
Electronics Association; Arizona Software Association;
Association of Information Technology Professionals; Austin
Software Council; Business Software Alliance; Capitol Region
Software Alliance, New York; Chicago Software Association;
Colorado Software Association; Computer Software Industry
Association, California; Computing Technology Industry
Association; Connecticut Technology Council; Council for
Entrepreneurial Development, North Carolina; Eastern Technology
Council, Pennsylvania; Electronic Industries Association;
Greater Baltimore Committee Technology Council; Independent
Computer Consultants Association; Independent Computer Services
Association of America; Indiana Software Association;
Information Industry Association; Information Technology
Association of America; Information Technology Business Center,
Pennsylvania; Information Technology Training Association;
Interactive Digital Software Association; Interactive
Multimedia Association; International Compact Disc Interactive
Systems; Maine Software Developers Association; Massachusetts
Software Council; Michigan Technology Council; Minnesota
Software Association; NASDAQ Stock Market; National Multimedia
Association of America; National Venture Capital Association;
New Hampshire High Technology Council; New Orleans Technology
Council; Niagara Software Executives, New York; North Carolina
Electronic & Information Technology Association; Northeast
Software Association, Connecticut; Northern Virginia Technology
Council; NPES, the Association for Suppliers of Printing and
Publishing Technologies; Pittsburgh High Technology Council;
Research Triangle Software Developers Roundtable, North
Carolina; Rhode Island Economic Development Corporation; Rhode
Island Software Association; San Diego Software Industry
Council; Silicon Prairie Technology Association, Missouri;
Silicon Valley Software Industry Coalition, California;
Software Association of Oregon; Software Council of Southern
California; Software Executives Group of Central & Western New
York, Software Forum, California; Software Industry Coalition,
California; Software Publishers Association; Software Valley
Corporation, West Virginia; Southeastern Software Association;
Suburban Maryland High Technology Council; Technology Council
of Central Pennsylvania; United States Council for
International Business; Utah Information Technology
Association; Virginia Department of Business Assistance;
Washington Software & Digital Media Alliance; Western
Massachusetts Software Association.
BMC is a worldwide developer and vendor of software
solutions for automating application and data management across
host-based and open system environments. As is typical of
members of AASE, exports comprise a substantial portion of
BMC's sales; more than 40 percent of BMC's over $500 million in
revenues is from exports.
High technology industries are important to the future
economic strength of the United States. In the 1980's, the high
technology industry focused on advancements in hardware. In the
past few years, however, attention has turned to software.
Software includes both the system software and applications
software that enable computers and other electronic products to
perform faster and more varied functions. Today, the United
States is a world leader in software development and employs
approximately 600,000 people in the United States in high-
skilled software development and servicing jobs, including
BMC's nearly 1,000 employees in Texas. The Commerce Department
estimates that every $1 billion of export trade is worth 19,000
domestic jobs.
Introduction
The tax code, through the FSC rules, currently provides a
tax incentive to U.S. exporters of goods developed in the
United States. AASE members are unified in their objective to
clarify that the FSC rules apply to all software exports.
Due to a narrow IRS interpretation of the FSC rules, the
export of software products that is accompanied by a right to
reproduce the software is barred from receiving this export
incentive. This interpretation unfairly discriminates against
exports of software since virtually all other U.S. produced
exports, from airplanes to toothpaste, are eligible for FSC
incentives. The IRS interpretation is particularly unfair
because master recordings of motion pictures or music for
reproduction outside the United States, which are distributed
with reproduction licenses in the same manner software is
distributed, are eligible for FSC incentives. The FSC rules
provide an important incentive for U.S. companies to produce
their products in the United States for sales overseas. Given
many of the high-skilled jobs associated with software
development, it should be equally, if not more, important to
provide FSC incentives to software as it is to provide these
incentives to airplanes, toothpaste, motion pictures, musical
recordings or any other U.S. produced exports.
In addition, the FSC rules are extremely important to
smaller businesses because the FSC incentives help reduce the
costs of entering the export market. In fact, the FSC statute
includes specific rules which make it easy for small companies
to quality for FSC incentives. Since software companies have
the opportunity to enter the export market at a very early
stage in their life cycle, it would be especially helpful if
they could utilize the FSC rules, as all other industries can.
Contributions of the U.S. Software Industry to the U.S. Economy
The U.S. software industry makes significant contributions to the U.S.
economy.
1. The U.S. software industry employs thousands of high-
skilled programmers to develop the software that is its
product. Software companies create thousands of new jobs each
year. These high-skilled jobs are the type of jobs that
Congress and the Administration have emphasized they want to
encourage through their economic policies.
2. The U.S. software industry invests heavily in research
and development to create new products for world markets. This
helps both to create new technologies and advance existing
technologies, resulting in the United States being a world
leader in the development of new technologies.
3. The U.S. software industry produces products that are in
high demand both in the United States and abroad. The demand
for U.S.-developed software outside the United States has led
to a surge in the exports of U.S. software. These exports
reduce the trade deficit of the United States and help expand
the markets for American-made goods, resulting in more U.S.
research and development and high-skilled jobs for software
programmers and others in the United States.
The U.S. software industry is currently a world leader.
However, like other U.S. exporters, FSC incentives will serve
to further enhance the industry's competitiveness. The FSC
incentives will particularly assist small and medium-sized
software companies in entering the world market, by enabling
them to reduce the cost of exporting. Moreover, all software
companies must weigh the net cost of exporting from the U.S.
against the cost of developing foreign products in foreign
jurisdictions. It is important to note that many foreign
governments have realized the many economic benefits associated
with the fast growing software industry. These foreign
governments are actively working to attract software companies
to their countries by offering substantial tax and other
financial incentives.
How the U.S. Software Industry Conducts Business
Software programmers conduct research and development
activities in the United States for the development of software
products. These software programmers are highly-skilled
employees who add significant value to the software product.
U.S. software companies license their software to customers in
both the United States and abroad.
A U.S. software company that markets its software to
foreign customers usually licenses a master copy of the
software to foreign customers, including third-party
distributors, original equipment manufacturers (OEMs) and
value-added resellers (VARs). Distributors and VARs may
translate the software into the language of the local country
and reproduce it for license to customers in that country. In
addition, software is routinely licensed through OEMs who
install the software on their hardware and sell the bundled
package of software and hardware. In other cases, software may
be licensed to VARs, who add their own software to the licensed
software and then reproduce the combined software for sale.
These are all important distribution networks for exports of
software and greatly enhance the industry's ability to export
its products efficiently and effectively. Because software
programs are constantly being updated and improved, large
physical inventories of software are impractical and very
expensive to maintain. The licensing of an updated master copy
through OEMs, VARs, and third-party distributors is the most
efficient and cost-effective method for the U.S. software
industry to export its products.
Software publishers are increasingly entering into ``site
licenses'' with some of their larger customers. A site license
is the licensing of a master copy of the software directly to
the customer. A site license enables the customer to make as
many individual copies of the master copy as required to meet
its needs. Also, in some instances, large foreign customers
prefer to do business with local companies (i.e., foreign
subsidiaries of U.S.-owned companies). In these instances, the
U.S. company will transfer the master copy to its foreign
subsidiary that will, in turn, enter into a site license with
the foreign customer.
Legislative History of the Application of the FSC Rules to
Software and Later IRS Interpretations
In 1971, Congress enacted the Domestic International Sales
Corporation (DISC) legislation to encourage the export of U.S.
produced goods in order to help U.S. companies compete in
overseas markets and so improve the nation's balance of
payments. Additionally, by encouraging the export of U.S.
produced goods, Congress hoped to keep manufacturing jobs in
the United States as well as create new jobs. In 1984, the DISC
provisions were replaced by the FSC rules. The FSC rules had
the same purpose as the DISC rules, but eliminated some of the
provisions in the DISC rules that our trading partners found
objectionable under GATT.
Under the FSC provisions, the export of certain intangibles
is ineligible for FSC incentives. Section 927(a)(2)(B).
Specifically excluded are ``patents, inventions, models,
designs, formulas, or processes, whether or not patented,
copyrights (other than films, tapes, records, or similar
reproductions, for commercial or home use), goodwill,
trademarks, trade brands, franchises, or other like property.''
This language is identical to the language contained in the
DISC statute written in 1971 (see section 993(c)(2)(13)).
Neither the statute nor the legislative history contains any
language that specifically precludes software from qualifying
for DISC or FSC incentives. The legislative history to the FSC
provisions provides no explanation of this section of the bill.
The legislative history to the DISC provides the following
explanation of this section of the bill.
Although generally, the sale or license of a copyright does
not produce qualified export receipts (since a copyright is
generally not export property), the sale or lease of a
copyrighted book, record, or other article does generally
produce qualified export receipts. House Report No. 92-533,
92nd Cong., 1st Sess. 69 (1971), 1972-1 C.B. 498, 535; Senate
Report No. 92-437, 92nd Cong., 1st Sess. 102 (1971), 1972-1
C.B. 559, 616.
Treasury regulations interpreting the DISC statute rely on
this legislative history in providing that a copyrighted
article (such as a book), if not accompanied by a right to
reproduce it, is export property. The regulations also state
that a license of a master recording tape for reproduction
outside the United States is qualified export property.
Export property does not include any patent, invention,
model, design, formula, or process, whether or not patented, or
any copyright (other than films, tapes, records, or similar
reproductions, for commercial or home use), goodwill,
trademark, trade brand, franchise, or other like property.
Although a copyright such as a copyright on a book does not
constitute export property, a copyrighted article (such as a
book) if not accompanied by a right to reproduce it is export
property if the requirements of this section are otherwise
satisfied. However, a license of a master recording tape for
reproduction outside the United States is not disqualified
under this subparagraph from being export property. Reg.
Sec. 1.993-3(f)(3).
The eligibility of software for DISC incentives was first
addressed in 1985 when the IRS National Office was requested to
provide technical advice on whether so-called ``box top'' or
``shrink-wrap'' software sold or leased outside the United
States on a mass market basis qualified for DISC benefits. In
Technical Advice Memorandum 8549003, the IRS stated:
The ``films, tapes records, or similar reproductions''
language of section 993(c)(2)(B) is not limited as to subject
matter. Since copyrighted computer software is marketed on
magnetic tapes for commercial use, such tapes seem to
specifically qualify based on the Code language. However, it is
unclear whether Congress intended this provision to apply to
other than entertainment industry tapes. Based upon the earlier
drafts of section 993(c)(2)(B), it could be argued that
Congress intended qualification for only tapes that are like
films or records, i.e., videotapes or musical tapes. See H.R.
18392, 91st Cong., 2d Sess. (1970) and H.R. 18970, 91st Cong.
2d Sess. (1970), in which the proposed version of the
parenthetical exception of finally enacted section 993(c)(2)(B)
only applied to films and tapes produced by the entertainment
industry. However, one could also argue that since the finally
enacted provision does not seem to be solely limited to the
entertainment industry, such provision should not be
interpreted in a restrictive manner. [Emphasis added]
Without concluding whether software on magnetic tape was
meant to be within the parenthetical exception to section
993(c)(2)(B), the IRS concluded that the software at issue was
eligible for DISC incentives because the provisions seemed to
include as export property finished products or inventory
items.
In a later technical advice memorandum, the IRS more
decisively reached the conclusion that the parenthetical
exception in section 993(c)(2)(B) did not seem to be limited to
the entertainment industry, and, therefore, the provision
should not be interpreted in a restrictive manner. However, in
ruling that the software, tapes in this case, which were
produced in the United States and sold or licensed outside the
United States on a mass market basis, were qualified property,
the IRS relied on the regulations under the DISC rules, which
permitted copyrighted books to qualify for DISC. (TAM 8652001).
Although it seems clear that software tapes qualify as
``tapes'' under sections 993(c)(2)(B) and 927(a)(2)(B), the
phrase ``similar reproductions'' clearly is broad enough to
include the licensing of software. This is because the
production of a master software tape, and the medium and the
manner in which it is reproduced and distributed, are very
similar to the manner in which the entertainment industry
produces and distributes its products. For example, it is
common for both films and software master tapes to be exported
to distributors who will translate the tape into the local
language and reproduce it for distribution in that country.
Additionally, today more and more music and software are
reproduced on compact disks, using almost identical equipment
and production processes. Furthermore, the direction the
technology is taking is that distribution of films, tapes,
records, videos, software and any other type of digital
information will be done electronically rather than by shipping
physical copies. Finally, the explosion of entertainment
software, which include films and music recordings, provides
strong evidence for consistent treatment. Thus, we believe the
language chosen by Congress for the parenthetical exception was
intended to be broad enough to encompass exports, like
software, that are exported in the same manner as films and
records.
Despite these IRS opinions and the broad language of the
statute, the temporary FSC regulations issued in 1987,
interpreting language identical to that interpreted by these
opinions, adopted a narrow interpretation of the parenthetical
exception that the IRS interprets as denying any FSC benefits
for the license of software if the license is accompanied by
the right to reproduce the software. (TAM 9344002).
The FSC regulations substantially parallel the DISC
regulations. However, regulation writers in 1987, now cognizant
of the existence of the U.S. software industry, decided to
specifically address software in regulations promulgated under
FSC. The regulation writers made a determination to treat mass
marketed software as a copyrighted article that is eligible for
FSC benefits. They also made a decision not to treat a license
of a software program for reproduction outside the United
States like a master recording tape, which is also eligible for
FSC incentives. In these regulations, the IRS effectively
narrowed the scope of property eligible for FSC incentives to
exclude a major portion of software exports--licenses of
software with the right to reproduce. Temporary Regulation
Sec. 1.927(a)-1T(f)(3), which defines intangible property that
is excluded from the definition of FSC export property, states:
Export property does not include any patent, invention,
model, design, formula, or process, whether or not patented, or
any copyright (other than films, tapes, records, or similar
reproductions, for commercial or home use), goodwill,
trademark, trade brand, franchise, or other like property.
Although a copyright such as a copyright on a book or computer
software does not constitute export property, a copyrighted
article (such as a book or standardized, mass marketed computer
software) if not accompanied by a right to reproduce for
external use is export property if the requirements of this
section are otherwise satisfied. Computer software referred to
in the preceding sentence may be on any medium, including, but
not limited to, magnetic tape, punched cards, disks,
semiconductor chips and circuit boards. A license of a master
recording tape for reproduction outside the United States is
not disqualified under this paragraph from being export
property. Temp. Reg. Sec. 1.927(a)-1T(f)(3). [Emphasis added]
IRS effectively narrowed the scope of property eligible for
FSC incentives to exclude a license of software with the right
to reproduce.
The narrowing of the definition of export property to
exclude software licenses that permit reproduction of the
software has no basis in the statute or legislative history to
the DISC or FSC rules, but was based on an administrative
decision by the FSC regulation writers at the IRS that software
tapes were neither ``tapes'' nor ``similar reproductions''
within the meaning of the statute. Despite the fact that the
legislative history provides no basis for limiting these terms
within section 927(a)(2)(B)'s parenthetical to the
entertainment industry, the IRS regulation writers made a
decision to do so. Not only does this ignore the way that
software is exported, it ignores the similarities between the
film, record and software industries. The future direction,
driven by technology, is that all digital information, whether
it be music, video, or software, will be distributed in the
same way. No logical distinction has ever been made between
these different products.
AASE strongly believes that Congress' statute, specifically
allowing for ``similar reproductions'' to qualify for DISC and
FSC treatment, recognized the need for the legislation to
address developing industries and new means of doing business
like software. We do not believe that Congress in enacting the
FSC rules intended to deny incentives to the software industry.
Indeed, the Administration recognizes that software licenses
should be provided FSC incentives, as they have included a
legislative proposal to address this issue in their FY 1998
Budget. AASE strongly supports the Administration's legislative
proposal to provide FSC incentives to software licenses.
Summary
The software industry is an important contributor to the
economy of the United States today and will continue to be in
the future. The software industry creates many new high-skilled
jobs in the United States, helps the United States to maintain
its position as a world leader in the high technology field and
is a large and growing source of U.S. exports, the revenue from
which reduces the U.S. trade deficit. The failure to permit
exports of software to qualify for FSC incentives is
counterproductive to the continued growth of this industry. In
addition, there is no tax policy reason for denying exports of
software the same FSC incentives that are available to
virtually all other U.S. exporters.
We are on the brink of an explosion in the global use of
information technology. The United States is well-situated to
turn that economic reality into immense growth and job
opportunities for the United States. In times of tight budgets
and tough choices, we are not looking for handouts or special
treatment. We are looking for a clarification in existing law,
so that the U.S. software industry can continue to do what it
does best, create and market high-value, job creating products
across the globe. AASE strongly supports the Administration's
budget proposal to provide a legislative solution to this
problem, and urges Congress to enact H.R. 143, the Software
Export Equity Act, which would clarify that the definition of
FSC export property includes the license of software to
distributors and customers with the right to reproduce.
Statement of American Bankers Association
The American Bankers Association (ABA) is pleased to have
an opportunity to submit this statement for the record on
certain of the savings and investment provisions of the
Administration's fiscal year 1998 budget proposal.
The ABA brings together all elements of the banking
community to best represent the interests of this rapidly
changing industry. Its membership--which includes community,
regional, and money center banks and holding companies, as well
as savings associations, trust companies, savings banks and
thrifts--makes ABA the largest banking trade association in the
country.
The Administration's 1998 revenue plan contains several
significant proposals of interest to banking institutions
which, with modification, would provide much needed tax relief,
as set out more fully below.
Individual Retirement Accounts
The Administration's proposal to expand the availability of
individual retirement accounts (IRAs) is of particular interest
to ABA. The banking industry fully supports efforts to
revitalize IRAs, and we are particularly pleased that the
concept of tax-advantaged retirement savings has garnered long-
standing bi-partisan support. In this regard, we note that ABA
fully supports the expanded IRA proposed by Representatives
William Thomas (R-CA) and Richard Neal (D-MA) in H.R. 446. That
legislation would provide a model IRA vehicle designed to
address the nation's need to increase retirement savings.
By way of background, the personal savings rate in this
country has trended down over the past several decades. During
the 1970s, individuals saved 7.8 percent of their disposable
income; in the 1980s, the personal savings rate declined to 6.5
percent; for the first half of the 1990s, individuals saved
only 4.7 percent of their disposable income. This declining
trend means that individuals will be less prepared to meet the
variety of financial needs they are likely to encounter during
their lives--including buying a home, paying for college,
covering medical emergencies and providing an adequate
retirement income. Since savings and investment are critical
ingredients in economic growth, a declining savings rate also
has negative implications for the future of our economy and for
our ability to create new jobs.
The primary appeal of the IRA concept to individuals is
based upon the tax advantage associated therewith. That tax
advantage is often viewed as a supplement to savings, making
the IRA an appealing product for an individual's long-term
savings growth. Individuals concerned about the availability of
retirement funds can appropriately complement social security
and other retirement savings vehicles with IRAs. Once an IRA
has been established, the tax penalties that accompany early
withdrawals provide further encouragement to save for the long-
term.
The challenge, then, is to develop a viable IRA product
with sufficient appeal to attract a wide range of individuals
to participate. We believe that, to be successful, an IRA must
meet three criteria:
first, it must be simple enough to be easily
understood by consumers;
second, eligibility criteria must be sufficiently
inclusive to permit broad participation; and
third, it must be flexible enough to be responsive
to the financial needs of today's consumers.
If such criteria are met, we believe that individuals will
view the new and improved IRAs as valuable tools for long-term
savings, and the product will be far more successful than the
IRA vehicle that is currently available.
Simplicity
One problem that has diminished the effectiveness of the
current version of the IRA for bank customers is its
complexity. Particularly, the rules for determining eligibility
for today's IRAs are simply too difficult to understand.
Millions of consumers have been so confused about the tests,
eligibility determinations, and income limitations, that even
when they are eligible, many individuals do not participate in
IRAs. The problem has been exacerbated by the changes, and by
constant discussions of changes, in IRAs. We recommend that any
new proposal be simple to understand in its terms and
conditions.
Eligibility
In 1981, almost all working Americans were eligible for IRA
coverage, and IRAs became immensely successful. However, after
the 1986 tax reform act, the eligibility rules were changed
dramatically--individuals covered by private pension plans were
no longer eligible and the income limits established ($25,000
for individuals and $40,000 for couples) significantly reduced
eligibility. Participation declined dramatically and
contributions have continued to shrink every year since 1986--
40 percent of the eligible taxpayers are not currently using
IRAs.
Inflation also contributed to the decline in the
effectiveness of IRAs. Many of those in the low to middle
income bracket who remained eligible after the 1986 tax act
have gradually been forced out of eligibility simply because of
inflation-based pay increases. In the near future, inflation
will continue to shrink the base of those eligible to invest
unless some type of indexing is permitted under the statute.
For a tax-favored savings incentive to be effective in
generating new savings, the pool of those eligible to
participate in the plan should be as wide as possible. The
Administration's plan would, inter alia, raise and index the
income limitations on deductible IRAs. The proposal represents
an important first step in resolving the eligibility problem of
the currently available IRA vehicle. It could be further
improved by eliminating income phaseout limits altogether,
which would allow a much greater number of individuals and
households to participate in the expanded IRA vehicle.
Flexibility
If there is any single reason why people have been
reluctant to establish IRAs, it is probably the lack of
flexibility. Individuals are understandably concerned about
sinking their money into a totally illiquid account from which
funds can not be retrieved without significant penalties--
except by crossing the retirement age threshold. For a savings
incentive to work, people need to have a certain comfort level
that their savings can be accessed for emergencies and for
certain other important expenditures.
We also believe that a plan should be flexible in offering
a range of options to the customer. The current savings
proposals differentiate between whether the IRA is ``front-
loaded'' or ``back-loaded.'' With a front-loaded IRA, the
taxpayer may take a tax deduction for the amount of the
contribution. Alternatively, with a back-loaded IRA, there is
no tax deduction for the contribution; instead, all earnings
and contributions from the investment can be withdrawn tax-free
for qualifying expenditures, as well as at retirement age. A
tax-favored savings plan should be flexible enough to offer
both options to customers, since the decision as to which plan
would be preferred may differ among individuals. An IRA plan
should also protect the contribution limits from erosion by the
effects of inflation so that contribution limits will not need
to be adjusted by law in the near future.
Economic Benefits of an Expanded IRA
A properly designed retirement savings instrument will
result in higher usage by individuals and more long-term
savings. One of the most important long-term issues for this
country is inadequate savings. Savings promote capital
formation, which is essential for job creation, opportunity and
economic growth.
The Administration's proposal represents an important first
step in resolving the eligibility problem of the current IRA
vehicle. It could be further improved by eliminating income
phaseout limits altogether, which would allow a greater number
of individuals and households to participate in the expanded
IRA vehicle.
Capital Gains
We would like to commend Representatives Philip English (R-
PA) and Robert Matsui (D-CA) for introduction of the
``Enterprise Formation Act of 1997,'' (H.R. 420). We would also
like to commend Representative Jennifer Dunn (R-WA) for
introducing H.R. 1033, the ``Return Capital to the American
People (ReCAP) Act.'' The bills would provide much needed
improvements to existing small business stock investment tax
incentives. The ReCAP Act would also provide a broad-based
capital gains tax cut and index the basis of capital assets for
inflation.
ABA is pleased that the subject of capital gains rate
reduction has garnered bi-partisan support. We fully support
the enactment of tax legislation that incorporates targeted
investment incentives for small business along with a broad-
based capital gains cut.
Broad-Based Capital Gains
The current tax regime essentially discourages investment
in the most efficient, highest return opportunities. A broad-
based capital gains rate cut would reduce the cost of capital
and encourage the use of equity financing, rather than debt,
for business activities. It would benefit a wide variety of
income groups and economic sectors, including retirees, middle
income families, large and small investors, businesses,
farmers, and entrepreneurs. According to the 1996 Congressional
Budget Office report, in 1989, thirty-one percent of families
with incomes under $20,000 owned capital assets, not including
their personal residences. For families with incomes between
$20,000 and $50,000, the figure was fifty-four percent. Also,
according to the Investment Company Institute, approximately
sixty-percent of households earning $50,000 or less own mutual
fund investments.
Capital gains tax relief is necessary in order to increase
capital formation, stimulate saving and investment, raise
domestic wages, and to boost domestic economic growth.
Accordingly, a broad-based tax cut would impact virtually every
sector of the American economy.
Venture Capital
Under the present law, venture capital investment of
corporations is effectively taxed at three levels: (1) the
earnings of the recipient of the capital are subject to the
regular corporate income tax, (2) the gains earned by the
venture capital subsidiary are subject to the corporate income
tax, and (3) distributions to individual stockholders of the
investing corporation or the bank holding company parent are
once again taxed. Reducing the capital gains tax rate is
expected to ``unlock'' capital assets, lower interest rates and
spur the economy, resulting in raising federal revenues. It
would also encourage venture capital investments by financial
institutions by lowering the excessively high cost of capital.
The banking industry is actively involved in the venture
capital business and is a vital source of venture capital
funding. Banks represent a stable source of venture capital
that has provided a cushion during periods when other sources
of capital have contracted. By obtaining funds from the parent
holding company, banks provide consistent, long-term support
for the venture firms. Bank venture capital subsidiaries are
also less subject to the fluctuations of the availability of
venture capital funds and may also diversify their portfolios
across industries and geographic regions to reduce risk.
Many of the larger U.S. commercial banks have non-bank
venture capital subsidiaries which obtain funding from a parent
bank holding company. In recent years, commercial banks have
provided between 6 and 13 percent of all new venture capital
invested each year and have more than $5 billion invested in
venture capital.
Generally, investment in the stock of young entrepreneurial
firms is among the most productive of investments. According to
the Small Business Administration, a new job is created for
every $17,000 of venture capital invested. These high risk,
innovative and usually highly technical enterprises often must
rely on investor purchase of stock to finance their operations.
Most venture companies have little or no operating history and
virtually no sales. A very large percentage of them produce
losses or fail. However, successful venture businesses are
among the fastest growing domestic companies. A reduction in
the rate of capital gains tax on corporate venture capital
investments is not only appropriate but sorely needed to
stimulate continued job growth and development. We urge you to
include a broad-based capital gains tax cut in the budget
bill's tax package along with targeted venture capital
investment incentives.
Estate tax relief for small business
Under the current law, a unified credit of $192,800 is
provided against the estate and gift tax, which effectively
exempts the first $600,000 in taxable transfers from tax. If
the estate tax is imposed, it is due within nine months of a
decedent's death. Internal Revenue Code section 6166 provides
that an executor generally may elect to pay the Federal estate
tax attributable to an interest in a closely held business in
installments over, at most, a 14-year period. If the election
is made, the estate pays only interest for the first four
years, followed by up to 10 annual installments of principal
and interest. A special 4-percent interest rate applies to the
amount of deferred estate tax attributable to the first
$1,000,000 in value of the closely-held business. A special
estate tax lien applies to property on which the tax is
deferred during the installment payment period. Interest paid
on the deferred estate tax is allowed as a deduction against
either the estate tax or the estate's income tax.
Financial institutions routinely serve as corporate
fiduciaries for trust administration or as personal
representatives for estate administration. According to the
Federal Financial Institutions Examination Council's 1995
report, entitled, ``Trust Assets of Financial Institutions,''
approximately 2,700 financial institutions are currently
engaged in trust activities which include estate
administration. Said institutions hold approximately $21
billion in estate assets in either a discretionary or non-
discretionary capacity, representing approximately 49 million
estate administration accounts.
Banks, through their trust departments, provide a variety
of personal fiduciary services, such as settling an estate
following the death of a client. Settling an estate may involve
a series of actions from the admission of a will to probate
court to the final distribution of assets to the estate
beneficiaries. By way of example, in an estate settlement, the
bank would serve as either executor or administrator of the
estate. As personal representative, the bank's responsibilities
would include providing legally required notice to heirs,
beneficiaries, and interested persons; collecting and
appraising assets; drawing up a budget for payment of estate
obligations and, if necessary, selling assets to meet
outstanding debts; safekeeping assets; making tax elections;
settling all tax obligations (income taxes and state and
federal estate taxes); assessing claims filed against the
estate; making a final accounting to the probate court; and
finally, distributing any remaining assets to the
beneficiaries.
The Need for Estate Tax Relief
The present law often causes family businesses to be sold ,
at the worst possible time, in order to pay estate tax. More
than 70% of family businesses and farms do not survive through
the second generation, and 87% do not survive through the third
generation. Indeed, the White House Conference on Small
Business Commission called for repeal of the estate tax because
it was considered one of the paramount threats to family-owned
inherited businesses and a disincentive to growth.
We agree with the Conference's Report. We also believe that
the Internal Revenue Code--particularly with respect to estate
and gift taxation--has become overly complex. Taxpayers expend
significant resources on compliance activities. Similarly,
banking institutions expend significant resources on training
trust department employees in estate planning and
administration. Thus, estate tax simplification would benefit
customers as well as banking institutions. Of course, any
change should not sacrifice simplicity in exchange for vitally
needed estate tax relief.
We note that the estate tax has also had an inordinate
impact on farmers. In this connection, we would respectfully
call to your attention the February 25, 1997 testimony of Keith
Collins, Chief Economist, Department of Agriculture before the
House Committee on Agriculture. In that testimony Mr. Collins
pointed out that over 75 percent of a farm's assets (such as
real estate) can not be easily liquidated to pay the estate tax
without disruption of the farm as a going business. A quick or
``distress'' sale to raise cash would probably result in sale
of the farm at a lower than market rate, with harmful results
to the taxpayer and any lenders involved.
Recommended Solutions
The ABA supports the legislative proposals to increase the
unified credit amount. This much needed modification would both
simplify the Code and reduce the estate tax for small business
owners and farmers. The credit amount, set in 1981, is not
indexed for inflation and has not been increased. Indexed for
inflation, the $600,000 value exemption would be $830,000 in
1997 dollars. Today, taxpayers may easily exceed $600,000 in
value by simply owning a home, a modest investment portfolio,
life insurance (the face amount of the policy is subject to
estate tax), and retirement benefits. A family business will
greatly increase the odds of exceeding the tax-free limit.
Further, the relief provided by Code section 6166 may, as a
practical matter, be unavailable to many taxpayers. By
subjecting the business property to a tax lien, credit
availability may be limited and the day-to-day operations may
be impeded. Further difficulties may arise if the value of the
property or business declines during the installment period. In
the event of a bankruptcy, the estate tax would remain due,
with the bank-fiduciary required to continue payment
irrespective of the absence of cash from the estate. Moreover,
the fees due to the bank for such services would not be paid.
Also, the installment method involves complex rules and
prevents a quick and simple closing of the estate.
The Administration's proposal would make several
modifications to Code section 6166: increasing the amount of
value for eligible business from $1,000,000 to $2,500,000;
providing that interest paid on the deferred estate tax would
not be deductible; reducing the 4 percent rate to 2 percent;
and subjecting the deferred estate tax on any value of a
closely held business in excess of $2,500,000 to interest at a
special rate. It would also authorize the Secretary of the
Treasury to accept security arrangements in lieu of the special
estate lien. The Administration's proposal would do much to
remedy the problems faced by small businesses owners and
farmers; but it would not simplify the estate tax laws. It
would still necessitate extensive estate planning and add
complexity to the administration of estates.
We note that Senate Finance Committee Chairman William Roth
(R-DE) has introduced the ``American Family Tax Relief Act,''
S.2, which would increase the unified estate and gift tax
credit over an eight-year period beginning in 1997 from an
effective exemption of $600,000 to an effective exemption of
$1,000,000. The bill would provide special estate tax treatment
for ``qualified family-owned business interests'' if such
interests comprise more than 50 percent of a decedent's estate.
It would exclude the first $1,500,000 in value of qualified
family-owned business interest from the decedent's estate and
would also exclude 50 percent of the remaining value of
qualified family-owned business interests. The bill would also
extend the Code section 6166 installment period from 14 years
to a maximum of 24 years, with the estate paying only interest
for the first four years, followed by up to 20 installments of
principal and interest. There would be no interest on the
amount of deferred estate tax attributable to the first
$1,000,000 in value of the closely held business.
Although we believe that the estate tax relief provisions
of S. 2 may be a step in the right direction, we are concerned
that compliance with the qualified family-owned business rules
would require adherence to an overly complex set of rules,
which, due to their long-term application, may prove to be more
problematic than the current installment rules. Additionally,
the American Family Tax Relief Act is unclear with respect to
the treatment of qualified family-owned businesses held within
trusts.
Accordingly, we would urge you to include provisions
pertaining to ``death tax'' relief in the form of raising the
unified credit amount in the fiscal year 1998 budget.
Conclusion
We appreciate having this opportunity to present our views
on these issues. We look forward to working with you in the
further development of solutions to our above-mentioned
concerns.
Statement of David Rhodes, President, School of Visual Arts, New York,
New York; Chair, Federal Advocacy Committee, Association of Proprietary
Colleges
I am David Rhodes, President of the School of Visual Arts
in New York City and Chairman of the Association of Proprietary
Colleges' (APC) Committee on Federal Advocacy. On behalf of
APC, I want to thank Chairman Archer and Members of the House
Committee on Ways and Means for holding these hearings and
permitting our Association to submit testimony regarding the
Savings and Investment Provisions in the Administration's
Fiscal Year 1998 Budget Proposal.
We commend both the Administration and numerous Members of
Congress for recognizing that the education of our population
should be a federal priority and for proposing many new and
creative ideas to assist parents and students with obtaining
the education, training and retraining they will need to lead
productive lives and become active knowledgeable citizens in
our rapidly-changing world.
The Association of Proprietary Colleges is a group of 31
degree-granting colleges located in the State of New York. Most
of our members' colleges offer associate degree programs. My
own institution, the School of Visual Arts, confers
baccalaureate degrees and master of fine arts degrees. Many of
our members' colleges are small family-owned businesses, some
of which have been in existence for more than 100 years. Even
our youngest member was established more than 20 years ago. The
average placement rate for our students exceeds 90 percent. Our
graduation rates exceed those of other educational sectors in
the State.
In order to remain competitive, we must and do maintain a
close working relationship with the marketplace, expose our
students to the latest technology, and equip our graduates with
the advanced conceptual skills required for entry into the
business world. Because we receive no public subsidies to
attract, retain and graduate students in a world which changes
as rapidly as ours does, we have developed structures and
mechanisms which allow for unusual flexibility in tailoring
curricular and support services to better educate our students
for a society whose pace of change is increasing. We are
mindful that our times call for multiple careers, for we know
that the average student today can anticipate eight different
jobs in a lifetime.
New York State recognizes and separately regulates two
kinds of postsecondary institutions: non-degree granting trade,
technical or business schools and degree granting institutions
of higher education. For the State of New York, the type and
level of the program offered by an institution are paramount.
Corporate structure is not a factor in the State regulatory
apparatus. Proprietary colleges are institutions of higher
education whose programs are evaluated using the same
regulations and staff as all other institutions of higher
education. Trade schools, whether for-profit, not-for-profit,
or public are governed by a separate set of regulations that
are administered by a different staff. Only institutions of
higher education, for example, may grant credit-hours while
postsecondary trade, technical and business schools must use a
contact-hour format to measure the length of their programs.
Although New York State has been regulating education for
more than 200 years, and has therefore been able to take the
time to refine its practices with unusual precision, the
difference between postsecondary nondegree training and higher
education at the associate, baccalaureate or postbaccalaureate
level is clear throughout the country. Since the regulation of
education is a state and local matter, it seems to us that
those states which have permitted qualified proprietary
institutions to become institutions of higher education should
not have their considered judgments preempted at the federal
level.
Unfortunately, the Department of Education categorizes
institutions by their corporate structure and not by the
quality or level of education their students receive. Within
the Higher Education Act, there are basically two definitions
of ``institutions of higher education.'' Section 1201(a) of the
Higher Education Act of 1965 defines only public and nonprofit
institutions as those ``institutions of higher education''
eligible for institutional aid. Approximately 2,500
institutions nationwide are included in this definition.
Section 481 of the same Act defines ``institutions of
higher education'' that are eligible participants in student
financial aid programs. This is a much broader definition and
includes diverse institutions providing a wide range of
programs: public, nonprofit, for-profit, short-term programs,
foreign medical schools, foreign graduate medical schools, etc.
We estimate that approximately 6,000 institutions are included
under this definition.
Concerns
Our primary concern is that our students receive the same benefits
from the federal government as students who attend private and
nonprofit institutions. Since proprietary colleges meet the same state
standards as public and nonprofit institutions, we believe our students
should receive equal treatment.
Many of the new proposals, particularly those favoring expanded
uses of Individual Retirement Accounts (IRAs) to encourage parents to
save for college, cite Section 135(c)(3) of the Internal Revenue Code
of 1986 in defining ``institution of higher education.'' This
definition, in turn, refers to Section 1201(a) of the Higher Education
Act of 1965, as amended through 1988. Students attending our two-year,
and (as in my own case) four-year degree-granting proprietary
institutions would not be permitted to pay tuition from money their
parents were encouraged to set aside in an IRA.
In addition, the 1201(a) definition will present some enormous
administrative burdens. Program quality and reputation are the
significant determining factors in choosing an institution of higher
education for most families, not corporate structure. The only way to
ensure compliance with the section 1201(a) definition would be through
an Internal Revenue Service audit years after the funds have been
spent. We find it difficult to believe that you would sanction such
intrusions by the Federal Government into these most intimate family
decisions.
Solutions
We urge the Committee on Ways and Means to revise the tax code to
make higher education more affordable for parents and students.
Students attending those proprietary institutions which have been
authorized by their appropriate state regulating agency to confer
degrees should have the same right as students attending other public
and nonprofit institutions. The Committee should define ``institution
of higher education'' as it is defined under Section 481 of the Higher
Education Act of 1965.
Although we have not seen the final Hope Scholarship proposal
submitted by the Administration, we support the concept behind this
initiative to extend study for two additional years beyond high school.
However, if the proposed Hope Scholarship is offset dollar-for-dollar
by a student's Pell Grant, state financial aid, and/or with private
scholarship aid, we fail to see how access to higher education is
enhanced by this proposal. This is particularly true in states, such as
New York, that maintain extensive financial aid programs. Therefore, we
would urge the members of the Ways and Means Committee to permit needy
students to receive the full benefits of Pell Grants, state financial
assistance, and private scholarships in addition to the Hope
Scholarship.
I appreciate the opportunity to submit written testimony on behalf
of the Association of Proprietary Colleges. If I or the Association can
provide additional information, please contact us.
Statement of the Independent Bankers Association of America
Mr. Chairman, Members of the Committee: The Independent
Bankers Association of America (IBAA) appreciates the
opportunity to submit its views on the Clinton Administration's
tax proposals to the House Ways & Means Committee, which under
the Constitution is the starting point for tax legislation.
IBAA represents more than 5,500 locally-owned community
banks nationwide, and is the only trade association that
exclusively represents the interests of such independent banks.
Our median bank holds about $50 million in assets, has about 25
employees and two branches. The core business of these banks is
financing small businesses, farms, ranches, and local
consumers.
Our Association wishes to commend this Committee, for
getting under way a hearing that will explore the vital areas
of savings, investment, and family business continuity, and the
Administration for submitting proposals in each of these areas.
These initiatives, by President Clinton and Members of Congress
offer possible avenues to common ground, which could promote
enactment of critical and long-delayed tax relief that would
benefit the U.S. economy as a whole over the long term.
Proposals for Increasing Retirement Savings Are Aligned
IBAA agrees with the Treasury Department's warning, earlier
this month that the U. S. personal savings rate--critical for
the retirement security of an aging American population is
disturbingly low, having declined from 7.7 percent over the
1960-86 period to 4.9 percent in 1996 (Statement of Deputy
Secretary of the Treasury Lawrence Summers before the Senate
Finance Committee, March 6, page 2).
We also recall the conclusion of Federal Reserve Chairman
Alan Greenspan before this Committee in 1991, that increasing
individual savings and national investment are the highest
economic priorities. IBAA so testified before this committee on
January 31, 1995, in favor of enhancing tax-favored savings
products. Since then, bipartisan efforts have succeeded in
enacting the Spousal IRA provision in 1996. However, Secretary
Summers confirmed that the U.S. savings rate remains
significantly below the average of industrialized countries
with which the U.S. competes.
In this context, we feel the renewal of the President's
four-part proposal to double the income eligibility for
deductible contributions, create a ``back-loaded, nondeductible
IRA as an alternative, index eligibility and contribution
levels and broaden withdrawal privileges under certain
circumstances, is very constructive. Broadening IRA's has a
respectable lineage for both Democrats and Republicans--before
it was a Lott-Roth bill, it was Roth-Breaux bill, and, before
that, a Bentsen-Roth bill.
We believe opening the most attractive type of Individual
Retirement Account investment to a larger population would be a
powerful incentive to both prospective savers and the
institutions holding, administering (and marketing) these
funds.
For example, financial statistics reflect that three-
fourths of all U.S. banks hold IRA or other retirement
accounts. So, the banking system, among other service
providers, is ready, willing and able to expand retirement
account services to the public. Banks believe they have
something special to offer, in that bank-IRAs are insured
against loss up to $100,000.
Before IRAs were cut back in 1986, they were attracting
approximately $38 billion of retirement savings. In the past
few years, the annual total has hovered around $10 billion. So,
there appears to be a potential for sizable increases in IRA
savings. It is encouraging that President Clinton's proposals
and the Congressional proposals of Representatives Thomas and
Neal (H.R. 446) in the House and of Senators Lott-Roth-Breaux
(Title IV of S. 2 and S. 197) in the Senate are similar in
outlook and direction. Great benefits to the economy would
result if these proposals were blended and enacted.
Capital Gains Proposal Advances the Discussion
In the capital gain area, the Clinton Administration, which
advanced a proposal favoring small business and venture capital
in 1993 (that became law), has taken another worthwhile
initiative with its proposal to exempt $500,000 of value in the
sale of a residence.
We believe the homeowner exemption is based upon at least
three principles: (1) the value of a residence accumulates over
a long period, (2) it is often a family's primary asset, and
(3) it seems unfair to most Americans to tax a family on a
nest-egg of a reasonable amount.
What seems most promising to us is that these principles
also apply to family farms and small businesses. One problem in
cross-applying this limitation directly was discussed at the
Senate Agriculture hearings of February 26, by IBAA witness
John Dean. Most farmers live modestly, and would not be able to
take full advantage of a residence exemption at that level.
However, if such a concept can be applied generally to the
build-up of farm and small business assets, there appears to be
a significant opportunity to make progress in the closely
related areas of capital gains and estate taxes, the
interaction of which does much to determine whether farms and
small businesses to pass from one generation to another.
Estate Tax Problem Is Raised
In the estate tax area, the Administration's deferral-of-
payment proposal recognizes that there is a problem, but not
what the problem really is. A fraction of U.S. businesses (30
percent) are passed down to a second generation and only 13
percent make it to a third generation, according to the SBA,
despite the American Dream of family business succession.
Federal estate taxes, that rise steeply to 55 percent and were
last adjusted by 1981 legislation, are a prime cause of this
attrition.
This impact of estate tax is basically unfair to family and
small commercial and agricultural enterprises. Importantly, the
income tax exemption is adjusted for inflation, but the estate
tax exemption is not. Also, as federal estate taxes are
structured, the most enterprising elements of our population
are frequently taking a triple-hit. First, all business income
is taxed as it is earned. Second, business assets are subject
to tax again at death, at a very high rate. Third, many farm
and business estate must sell part of the enterprise to pay
these taxes, often at distressed prices because they are
``forced sales.'' Other heirs must mortgage their farms or
businesses to the hilt for 20 or more years to literally buy
them back from the federal government.
The maximum estate tax rate was scheduled to fall from 55
percent to 50 percent after 1993, but the reduction was
postponed to raise more revenue. Some argue that estate tax
reductions should not take place until the budget is balanced.
Our customers can't wait indefinitely; half of U.S. farmers are
age 57 or older.
Common Budget Context
At the beginning of this year, there seemed to be an
agreement in concept between the Executive and Legislative
Branches that the budget should be balanced within the next
five years in a way that would accommodate tax reductions
decided to be most in the public interest.
Effective reform of estate tax, as well as savings and
investment enhancements, would strengthen the common foundation
of the American economy. These are the kind of tax reductions
that should be compatible with efforts to balance the budget,
because all are long-term projects. Estate tax relief,
especially, can be phased in over a considerable length of
time, as was done between 1981 and 1986.
Moreover, there appears to be a realistic possibility that
these tax measures will encourage increased investment, that
will, in turn, boost federal and state tax revenues. If
improvements in these three areas are reported from the Ways
and Means Committee, there will be an opportunity, under the
new rules, to obtain a dynamic revenue estimate to provide a
concrete test of this proposition.
Estate Tax Structure Is a Particular Problem
However, to freeze the estate tax structure for the
indeterminate future would compound the problems for farm and
business owners, and be, literally, counterproductive not only
for these entrepreneurs, but for their communities across the
country, and for our national economy.
The problems created by federal and state death taxes are a
very serious and legitimate set of problems for the American
small business community that need to be addressed. Our bankers
have a world of first-hand experience with the adverse impact
of federal estate on small and family firms. This experience
impels us to strongly favor structural reform of federal estate
taxes ``to make possible orderly succession of ownership in key
community-based businesses (including) financial institutions
(and) agriculture `` (IBAA Resolution, 1996).
We also support further reduction of capital gain taxes,
but in ways that promote long-term investment in community
businesses. To fulfil these objectives, we believe that capital
gain tax reductions should be done in tandem with estate tax
reduction and achievement of a balanced budget over the near
term.
IBAA believes these two areas of taxation on tightly
linked. The relative levels of capital gains and estate taxes
powerfully influence the decisions of small businesses and
farmers about whether to sell out or to keep their enterprises
in the family.
The current maximum federal rates are 28 percent for
capital gains and 55 percent for estate taxes. So, there can be
as much as a 2:1 financial advantage in selling a business
property. If the maximum capital gains tax is reduced, say to
20 percent, the differential might, in some cases, approach
almost 3:1 unless some comparable adjustments are made in
federal estate taxes.
The Role of Family Farms and Businesses
For more than 200 years in this country, entrepreneurs have
been able to start farms and businesses and pass them along
from one generation to another. These enterprises put down
roots in their communities. Their owners come to know and care
about their employees, their customers, their schools, churches
and hospitals. They and family members volunteer at local
charities and are a significant part of the cement of American
life. Family stewardship of the land and other productive
assets has worked well in this country.
Because of the fixed threshold of federal estate taxes, and
the steeply graduated rates above that threshold, there is a
real threat that federal estate taxes will destroy the system
of existing family farms, businesses, and banks by taxing it
out of existence. Giving substance to this threat is the fact
that, since federal estate taxes were last adjusted
legislatively in 1981, revenues from this tax have increased
150 percent, from $6.389 billion in 1980 to an estimated
$15.924 billion in 1996.
This increase vastly out paced inflation, and is an
indication that estate taxes are a growing source of revenues
for the range of federal expenditures.
Limited Value of a Deferral Provision
When a farm or small business owner dies, typically federal
estate taxes are due, within 9 months. IBAA believes that the
estate tax installment payment privilege, under section 6166,
is of very limited value, because the Internal Revenue Service
acquires a ``special lien'' on the farm or business until the
tax is fully paid. Conventional lenders are wary of extending
credit to a business where the federal government is a senior
creditor.
For this reason, section 6166 is little used now, and
extending it to somewhat larger estates, as the Treasury
Department recommends, would be almost entirely symbolic.
The Future of Many Communities in Peril
No wonder that, in most cases, farm acreage or business
assets must be sold off to pay the taxes, or the heirs must
take out a mortgage, payable over 20 or more years.
The U.S. Department of Agriculture has estimated that
500,000 farmers over the age of 57 will retire in the next 10-
20 years. That total could represent as much as one-quarter of
U.S. family farms. How many of these farms and small businesses
are going to make it over the next estate tax hurdle?
Two types of commercial businesses predominate in this
country--local, family businesses and chain stores (e.g. Wal-
Mart, K-Mart, Sears). The former pay estate taxes; the latter
do not. So, across the economy, taxes discourage family
ownership, pushing enterprises toward larger units that often
are transferred to absentee owners who have few ties to the
communities in which they operate.
Full interstate banking takes effect in the U.S. on June 1,
1997. Banks across the country must develop strategic plans
that include whether they wish to continue as independents or
whether they will seek to sell their franchise to another
financial institution. Federal and state death taxes occupy a
very significant role in this decision.
Today, community banks with less than $100 million in
assets--typical IBAA banks--make more small business loans than
any other size category of bank. Studies show that these
financial institutions (which hold about 10 of U.S. deposits)
make almost 30 percent of small business loans of less than
$100,000. Often, a community bank is the only financial
institution in a small town or rural area.
Banks as small as 8 employees and $15 million in assets
have experienced estate tax problems. Should current IBAA
owners plan to increase their investment, to better serve their
customers, and incur greater estate tax risks, or should they
plan to sell out? If owners are replaced with less experienced
branch managers, business and farm loan applications may be
sent to distant cities for evaluation by specialists who are
probably not well acquainted with either the owners or their
communities.
Estate Tax Structure Should Be Modified
IBAA urges, in the strongest terms, that the current grim
reaping machine of the federal estate tax be thoroughly
reexamined, for both economic and social reasons.
These taxes discourage investment where we need investment
to remain world-competitive. They separate our most
enterprising people from the enterprises their families have
built, where our nation needs to preserve traditional family
enterprise.
An extensive study by the Heritage Foundation in
Washington, D.C. concluded as follows: ``the economic cost of
the estate tax is many times greater than the revenue it
produces, and its reach into American households extends far
beyond those few who pay it . . . The hardest hit by the tax
are small businesspeople who work hard to pass on an enterprise
of value to their children. And its bias against saving and
wealth generation is the antithesis of the American Dream.''
(August 21, 1996, pages 3, 29).
Fortunately, estate tax problems are increasingly being
recognized. For example, in Iowa, Governor Branstad, on
February 17, signed into law a bill that abolishes the state
inheritance tax for lineal descendants. The combined vote of
the Iowa House and Senate was 137-9.
Senate Majority and Minority Bills Excellent Departure Points
Now that there is recognition, there should be action. On
the federal level, IBAA supports the increase in the filing
threshold from current $600,000 as a desirable first step. But,
this will not help many family businesses and farms. We believe
it is important to note that, in IBAA's view, increasing the
Unified Credit alone is not a cost-effective way of assuring
the transfer of farms and businesses from one generation to
another. It is more expensive because it applies to all assets,
rather than just productive assets. Because of this, it is
difficult, especially in the present budget climate to increase
the Unified Credit enough to help production farms and modest
sized community businesses.
To get the job done, recognition needs to be given to the
family and small business character of these assets, and the
fact that they build up over a lifetime of effort, and the
continuous risk of the market. The Senate Leadership bills,
authored by Majority Leader Lott and Finance Committee Chairman
Roth (S. 2), and by Minority Leader Daschle (S. 20), are
excellent points of departure for crafting appropriate
legislation.
Administration Proposal Offers Common Ground
As noted above, President Clinton proposal a homeowners'
exemption for the first $500,000 of value in a residence may
provide an avenue toward common ground. Since the same
principles apply to a farm and a small business. We therefore
hope, as Senator Lott has indicated, that there can be a
convergence of interest that can lead to bipartisan legislation
that will really work to permit the transfer of family assets,
while guarding against abuse.
Importance of Enacting Legislation That Is Effective
It is thus vital that the 105th Congress get estate tax
reform right, because if the 1997-98 legislation falls short,
there will be many more horror stories from farm and small
business families before Congress comes around to this issue
again. And, in the meantime, the character of American life may
be changed permanently for the worse.
We hope that a bridge can be built between the President's
proposals and the House and Senate Leadership proposals, so
that legislation bringing about both a balanced budget and
needed tax reductions, can be enacted sooner rather than later.
Thank you again for this opportunity to express our views.
IBAA would be pleased to work with this Committee and the
Congress to improve these areas of the tax laws, so they can
truly promote the economic well-being of small independent
enterprises, their communities and the national economy.
Statement of the Investment Company Institute
A. Introduction
The Investment Company Institute (``Institute''),\1\ the
national association of the American investment company
industry, appreciates this opportunity to present its views on
the Administration's proposal to expand IRAs. We commend the
Committee for holding hearings on a topic so vital to our
economy and the retirement security of millions of Americans.
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\1\ The Institute's membership includes 6,266 open-end investment
companies (``mutual funds'') with assets of about $3.627 trillion,
approximately 95% of total industry assets, and over 59 million
individual shareholders.
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The U.S. mutual fund industry serves the needs of American
households saving for their retirement and other long-term
financial goals. By permitting millions of individuals to pool
their savings in a diversified fund that is professionally
managed, mutual funds provide an important financial management
role for middle-income families. An estimated 37 million
households, representing 37 percent of all U.S. households,
owned mutual funds in 1996.\2\ Mutual funds serve as the
investment medium for retirement programs, including IRAs and
employer defined contribution plans (the largest type being
401(k) plans). As of December 31, 1995, mutual funds held over
$1 trillion in retirement plan assets, about 19 percent of the
retirement market's total assets of $5.21 trillion. The
remaining 81 percent is managed by such institutions as
corporations, pension firms, insurance companies, banks and
brokerage firms Of the retirement plan assets held by mutual
funds, about half are IRA investments.\3\
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\2\ See Brian Reid, ``Mutual Fund Developments in 1996,''
Perspective, Vol. 3, No. 1 (Investment Company Institute March 1997).
\3\ 1996 Mutual Fund Fact Book, Investment Company Institute.
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The Institute has a long history of supporting legislative
efforts to enhance individual retirement saving. For instance,
we supported the establishment of the universal deductible IRA,
as well as legislation creating the SEP, SARSEP and SIMPLE
IRAs. We strongly opposed the 1986 Tax Act's restrictions on
IRA eligibility. Moreover, we continue to support efforts, such
as the AdAs and legislation introduced by Congressmen Thomas
and Neal, H.R. 446, that would substantially expand IRA
eligibility and simplify the tax rules associated with IRAs.
Such legislation is both necessary and appropriate, because--
First, Americans are not preparing adequately for
retirement and need more opportunities to do so;
Second, simple, universally-available IRAs will
work to increase retirement saving; and
Third, such IRAs will generate new additional
saving that would not be made absent such legislation.
B. America Is Not Preparing Adequately for Retirement
Stanford University Professor Douglas Bernheim found that
members of the Baby Boom generation are saving at only about
one-third the rate they need to maintain their pre-retirement
living standards in retirement.\4\ Along that same vein, an
Institute study of the ``baby boom'' generation similarly found
that more than 6 out of every 10 ``boomers'' state that they
are not saving for retirement even though more than half
expressed concern about the inability to meet their financial
needs after retirement.\5\
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\4\ Bernheim, B. Douglas, ``The Merrill Lunch Baby Boom Retirement
Index'' (July 14, 1994).
\5\ ``The Baby Boom Generation, A Financial Portrait,'' Investment
Company Institute (Spring 1991).
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USA Today, on March 26, 1997, reported that 78% of retirees
wish they had financially planned better for retirement; 42% of
retirees wished they have saved more in retirement plans, while
37% wished they had opened IRAs or contributed to employer
salary reduction plans.
C. A Simple, Universal IRA Effectively Increases Personal Retirement
Saving
Our long time national experience with the IRA teaches that
saving incentives work best if the rules are simple and
consistent. In order for the IRA to be useful to Americans, it
must be universally accessible, easy for the average American
to understand, and easy to administer.
When Congress introduced universal deductions for IRAs in
1982, Americans took advantage of the opportunity. IRA
contributions rose from less than $4 billion in 1980 to
approximately $38 billion in both 1985 and 1986. At the IRA's
peak in 1986, about 29% of all families with a head of
household under age 65 had IRA accounts. Contrary to what IRA
critics said at the time, these IRA contributions were not
mainly ``wealthy'' families using IRAs as ``tax shelters.'' In
1986, 75% of all IRA contributions were from families with
annual incomes less than $50,000.\6\ Moreover, the median
income of those making IRA contributions (expressed in 1984
dollars) dropped by 24 percent, i.e., from over $41,000 in 1982
to below $29,000 in 1986.\7\ The program was, indeed, effective
and was being used by middle-class Americans and encouraging
them to save for retirement.
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\6\ Venti, Steven F., ``Promoting Savings for Retirement
Security,'' Testimony prepared for the Senate Finance Subcommittee on
Deficits, Debt Management and Long-Term Growth (December 7, 1994).
\7\ Hubbard, R. Glenn ands Incentives: A Review of the Evidence''
(January 19, 1995).
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When Congress restricted the deductibility of IRA
contributions in the Tax Reform Act of 1986, the level of IRA
contributions fell sharply and has never recovered. In 1986,
IRA contributions totaled $38 billion; they were $15 billion in
1987, but only $8.4 billion by 1995.\8\ While it is true that
as a result of the 1986 restrictions, many families are no
longer able to deduct their IRA contributions, they still may
take advantage of the tax deferral for earnings on non-
deductible IRA contributions. This incentive, however, has
proved extremely complicated and insufficient to induce
continued participation in the IRA program. The 1986 changes
introduced a level of complexity in an otherwise simple program
that proved overwhelmingly oppressive to its success as a
savings incentive program. Even among families not affected by
the 1986 Act and who retained eligibility for fully deductible
IRA contributions, IRA participation declined on average by 40%
between 1986 and 1987, despite the fact that the change in law
did not affect them.\9\
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\8\ Internal Revenue Service, Statistics of Income.
\9\ Venti, supra at note 7.
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The lessons of the past are clear. First, deductibility
matters to people. Although non-deductible IRAs are available
to all working Americans, without the deductibility feature,
there are insufficient incentives to save. A front-end tax
incentive gives households an immediate incentive to save. It
is our view that this immediate incentive is a powerful
alternative to the usual preference for current consumption of
income.\10\
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\10\ Hubbard and Skinner, supra at note 8.
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Second, confusing rules undermine even the powerful
incentive of deductibility. When the tax rules are not simple,
individuals are confused as to their eligibility. The post-1986
IRA with multiple limits, set offs, exceptions, exclusions and
other technicalities cannot be understood by most Americans.
American Century Investments recently surveyed 534 ``savers''
with respect to the rules governing eligibility, contribution
levels and tax deductibility have left a majority of retirement
investors confused.''\11\ It is no wonder: today, IRS
Publication 590, which deals solely with taxpayer use of IRAs,
contains 70 (seventy) pages of explanations, examples, and
worksheets on the subject. Simply put, individuals stop
investing and financial institutions cease marketing activity
when the product cannot be readily understood and easily
explained.\12\
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\11\ American Century Investments asked survey participants, who
were self-described ``savers,'' ten general questions regarding IRAs.
One-half of them did not understand the current income limitation rules
or the interplay of other retirement vehicles with IRA eligibility.
``American Century Discovers IRA Confusion,'' Investor Business Daily
(March 17, 1997). Similarly, even expansive changes in IRA eligibility
rules, when approached in piecemeal fashion, require a threshold public
education effort and often generate confusion. See, e.g., Crenshaw,
Albert B., ``A Taxing Set of New Rules Covers IRA Contributions,'' The
Washington Post (March 16, 1997) (describing 1996 legislation enabling
non-working spouses to contribute $2,000 to an IRA beginning in tax
year 1997).
\12\ For this reason, the Institute opposes the addition of any
offset of IRA contributions against those of a 401(k) plan. Such a rule
would add unnecessary complication to the IRA, confuse the public,
place additional burdens on 401(k) plan sponsors, and create
disincentives to save.
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Experience clearly demonstrates that Americans respond
enthusiastically to appropriately designed tax incentives aimed
at increasing retirement savings. For example, last year
Congress enacted legislation creating the SIMPLE, a simplified
retirement plan for small businesses that (because of the
administrative burden) could not offer a pension program for
their workers. The Institute's members report immediate, strong
employer interest in the SIMPLE. One member in particular
reports that it has sold over 1,000 SIMPLE-IRA plans to small
employers since the program's inception on January 1, 1997. The
reasons for such a high response rate are clear. First, the
SIMPLE offers significant tax incentives. Second, the program's
rules are indeed ``simple,'' easy to understand and easy to
communicate. Prior to 1986, the universal IRA had similar
success and for precisely these same reasons.
D. IRAs Create New Retirement Saving
A great deal of research has been done on the effectiveness
of IRAs as incentives for increased personal saving. Many
studies have focused on whether the IRA tax incentive produces
new saving or merely reshuffles existing saving from taxable to
tax-favored accounts. Put differently, the issue is whether
IRAs serve merely as a windfall to higher income taxpayers.
In study after study of this issue, economists have
concluded that a substantial portion of IRA contributions in
fact constitute new saving that otherwise would not have
occurred. For example, extensive analyses of IRA contributors
essors Steven Venti of Dartmouth and David Wise of Harvard.
They estimate that 66% of the increase in IRA contributions
come from current consumption, 31% from the tax subsidy and
only 3% from reshuffled assets (emphasis added).\13\ Similar
conclusions--that a substantial majority of IRA contributions
represent new savings--has been reached in separate papers by
Professor Hubbard of Columbia, Professor Skinner of the
University of Virginia and Professor Thaler of University of
Chicago.\14\ The IRA has resulted in additional saving in both
tax-favored IRA accounts and non-tax-favored accounts. This is
the kind of long-term saving that is essential to capital
formation and economic growth.
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\13\ Venti, Steven F. and Wise, David A. ``The Evidence on IRAs,''
38 Tax Notes 411 (January 1988).
\14\ Skinner, Jonathan, ``Individual Retirement Accounts: A Review
of the Evidence,'' 54 Tax Notes 201 (January 1992); Hubbard, R. Glenn
and Skinner, Jonathan, ``The Effectiveness of Savings Incentives: A
Review of the Evidence'' (January 19, 1995); and Thaler, Richard H.,
``Self-Control, Psychology, and Savings Policy, `` Testimony before the
Senate Finance Subcommittee on Deficits, Debt Management, and Long-Term
Growth'' (December 7, 1994).
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E. Conclusion
Today's targeted individual retirement vehicles help
millions of Americans secure their future retirement through
long-term investment. By simplifying the IRA eligibility rules,
making deductible IRAs available to as many Americans as
possible and expanding IRA options, Congress can empower
millions more Americans to save for their own long-term
financial security.
Our recommendation: make the IRA available as broadly as
possible; keep it simple; make it permanent.
Thedford, Nebraska
The Honorable Mr. A.L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington D.C. 20515
Dear Sirs,
My name is Craig Miles, son of Sam and Charlotte Miles, of Thedford
Nebraska. We own and operate a beef cattle ranch in the Sandhills of
north central Nebraska.
Unlike some other ranchers in other regions or states that have
extra resources, such as oil or mining for a diversified income,
Sandhills ranchers survivability normally rest upon the beef industry.
With this in mind, you can understand how important the beef industry
is to us and our livelihood.
Although Estate taxes may be a key issue for some folks, it is not
one for us, as my folks have unselfishly thought about the continuation
of the business on down to the next generation and have taken the
necessary steps to see that this is fulfilled. So at this time, I would
like to explain to you why Capital Gains Tax is such a critical issue
for us.
My father is physically ready to retire but feels like he can't
afford to do so. He's 66 years old and has worked hard to all these
years building the ranch's land base and cow herd. Operating expenses
as well as property and other taxes have continued to rise dramatically
while cattle prices are at an all time low in years. Thus, my father
had to put most of his equity back into the ranch. In recent years he
has tried to put something away for his retirement but it was too late
to have enough liquid assets for this. What he would like to do is
liquidate part of the cow herd in order to fund his retirement, but
after paying the capital gains tax there wouldn't be enough in reserve
for this. In short he wants out but can't get there. What I would like
to see is a break in capital gains for retirement age agricultural
people if not the elimination of it.
Sincerely,
Craig Miles
Statement by National Apartment Association and National Multi Housing
Council
We greatly appreciate the opportunity to speak in strong
support of efforts by the committee to encourage savings and
investment in America through changes in our Federal Tax Code
and proposals to enact a broad-based reduction in capital gains
taxes.
A reduction in capital gains taxes beyond those proposed
for the sale of a personal residence, should be enacted only if
the reduction is truly broad-based. Of particular concern is
discussion in certain quarters that real estate should only
receive the new lower capital gains tax rate on gain above
original purchase price. Such a change in tax law would go
against current tax policy that correctly recognizes real
estate as a long-term wasting asset that should not be subject
to depreciation recapture rules. As we will expain below, there
are no sound tax policy reasons for changing the real estate
depreciation recapture rules. Additionally, removing the
benefit of lower capital gains taxes from commercial and
residential real estate will result in fewer new jobs created
and could seriously impact real estate investment and values;
not unlike what happened to real estate in the post-1986
period.
The National Multi Housing Council (NMHC) and the National
Apartment Association (NAA) represent the majority of the
nation's firms participating in the multifamily rental housing
industry. Our combined memberships are engaged in all aspects
of the development and operation of apartments, including
ownership, construction, finance, and management. The National
Multi Housing Council represents the apartment industry's
largest and most prominent firms. NMHC members are the
principal officers of these organizations. The National
Apartment Association is the largest nat of state and local
associations of apartment industry professionals including
developers, owners, investors and property managers. NAA is
comprised of 150 affiliates and represents more than 25,000
professionals who own and/or manage more than 3.3 million
apartments.
Job creation, an expanded economy, and the efficient flow
of capital are often stated as the principal reasons for
lowering the rate of capital gains taxation. To achieve these
goals, it is necessary to provide a broad-based reduction in
the tax. Using Department of Commerce data, it has been
estimated by the National Association of Realtors that 27 new
jobs are created for every $1 million spent in upgrades to
commercial and residential buildings. At present, many needed
upgrades are not occurring because of the ``lock-in'' effect
caused by the lack of flow of capital to various real estate
properties where existing investors are unable to sell to new
investors because of the high rate of the capital gains tax.
A recent study by the firm of Price Waterhouse LLP shows
that a majority of real estate will remain locked-in if
previously taken depreciation must be recaptured at the current
capital gains rate of 28 percent. This study analyzed the price
that an owner received for selling a building after 1994 with
the price the owner had earlier paid to acquire the building at
some time after 1985. The Price Waterhouse data shows, ``60
percent of multifamily buildings sold for less than the owners
had paid for them earlier, and the median decline was 30
percent.'' Obviously a change in tax law that would place real
estate at a disadvantage versus other investments would
significantly reduce any hoped for benefits of job creation
from the reduction of capital gains taxes.
Tax policy arguments are equally compelling for not
subjecting previously taken real estate depreciation to any tax
rate that is inconsistent with the capital gains tax rate. On
March 11, 1997, the E&Y Kenneth Leventhal Real Estate Group of
Ernst & Young LLP prepared a Tax Policy Memorandum and
Executive Summary on the Tax Policy Arguments for Full Capital
Gains Tax Relief for Real Estate. The significant points of
this memorandum are summarized as follows:
Executive Summary
Tax Policy Arguments For Full Capital Gains Tax Relief for Real Estate
Background
During last year's budget negotiations and presidential
campaign, options were explored to change current tax policy
regarding recapture of depreciation on sales of real estate as
part of a broad-based capital gains tax relief proposal. Under
current law, all gain on the sale of investment real estate is
taxed as capital gain unless accelerated depreciation is taken;
only the excess of accelerated over straight-line depreciation
(``excess depreciation'') is ``recaptured'' and taxed at
ordinary income rates. Some recent broad-based capital gains
tax relief proposals would lower the capital gains tax rate on
sales of real estate only for sales price in excess of original
cost. The tax rate on the gain attributable to previously
deducted straight-line depreciation would not be reduced, and
the gain attributable to current law excess depreciation would
remain subject to tax at full ordinary income rates.
Conclusions
We have conclusions concerning broad-based capital gains
tax relief proposals that do not offer full capital gains tax
relief for sales of real estate:
1. These proposals ignore the fact that real estate is a
long-lived wasting asset, and a sale of depreciable real estate
is a sale of only what remains of the original asset, not of
that which has wasted away. Any gain from a sale of the
remaining asset--to the extent not created by excess
depreciation deductions--is of a nature properly subject to
full capital gain treatment.
2. The current tax policy of taxing only excess
depreciation at ordinary rates, and taxing gains due to
inflation and other economic factors at full capital gain
rates, is the only tax policy that maintains horizontal equity
in taxation among competing capital investments. Any effort to
provide broad-based capital gains tax relief should as a matter
of tax policy fully include the elements of capital gain
inherent in sales of depreciable real estate--gains due to
inflation and other economic factors--in order to maintain
horizontal equity among competing forms of capital investment.
3. It would be inappropriate to change the definition of
excess depreciation in a manner that would take away incentives
previously offered by Congress to owners of ACRS real property.
However, should Congress decide to change the computation of
excess depreciation for these assets, it should do so only for
depreciation deductions taken after enactment of an amending
statute, as Congress has done every time it has changed the
recapture rules in the past.
4. The combination of indexing with any broad-based capital
gains relief proposal that changes current depreciation
recapture tax policy highlights the inequities of denying full
capital gain tax relief to sales of real estate. Considering
that real estate would have its economic gains in excess of
inflation taxed at 28% to the extent of previous straight-line
depreciation taken, real estate would be at a serious and
obvious disadvantage compared to other investments. Basis
indexing combined with capital gains tax relief would not
correct the inequity that changes in depreciation recapture tax
policy would cause.
Tax Policy Arguments For Full Capital Gains Tax Relief for Real Estate
I. Introduction
In the past year, there has been some discussion as well as
some actual legislative proposals to change current tax policy
regarding recapture of depreciation on sales of real estate as
part of a broad-based capital gains tax relief proposal. These
proposed changes to current tax policy seem largely the result
of unsound tax policy arguments designed primarily to lower the
cost of a capital gains tax bill. These kinds of broad-based
capital gains tax relief proposals would lower the capital
gains tax rate on sales of real estate only for sales price in
excess of the tax rate on the gain equal to previously deducted
straight-line depreciation would not be reduced, and the gain
attributable to current law excess depreciation would remain
subject to tax at full ordinary income rates.
This paper examines the current tax policy applicable to
sales of real estate--taxing only excess depreciation at
ordinary rates, and taxing gains due to inflation and other
economic factors at full capital gain rates--and demonstrates
that these tax policy considerations mandate retention of full
capital gain treatment for gains from the sale of real estate
(in excess of current law IRC Sec. 1250 recapture) in the
context of a broad-based capital gains tax relief proposal in
order to preserve horizontal equity in taxation among competing
capital investments. This paper also examines basis indexing,
and demonstrates that combining basis indexing with a broad-
based capital gains tax relief bill that does not provide full
capital gains tax relief for real estate would not solve this
fundamental issue of horizontal equity, but would in fact
highlight it.
II. Depreciation--Real Estate as a Wasting Asset
IRC Sec. 167 allows taxpayers as a depreciation deduction
an allowance for ``exhaustion, wear and tear (including a
reasonable allowance for obsolescence) of property used in the
trade or business.'' Real estate is properly included in those
assets subject to the allowance for depreciation due to its
wasting nature.\1\
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\1\ See Even Realty Co. v Comm., 1 BTA 355 (1925).
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The allowance for depreciation is one of the oldest
standing tax provisions, first appearing in the Corporation Tax
Act of 1909.\2\ The purpose of the statute is to create a fund
to restore the property to the extent of the investment of the
taxpayer at the end of its useful life.\3\ The Supreme Court
has stated that ``the theory underlying this allowance for
depreciation is that by using up the plant, a gradual sale is
made of it. The depreciation charged is the measure of the cost
of the part which has been sold. When the plant is disposed of
after years of use, the thing then sold is not the whole thing
originally acquired.'' \4\ Because of the difficulty of
attributing to each article sold or to the sales in a taxable
year an exact sum representing the proportion of basic value of
machinery, buildings, patents, etc., entering into such sale,
the statutes have consistently provided for a reasonable
allowance.\5\ Accordingly, it has never been necessary to
conduct an exhaustive engineering study to determine just how
much a building has wasted during the year in order to claim a
deduction for depreciation.
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\2\ 1909 Act, Sec 38.
\3\ Detroit Edison Co. v. Comm., 131 F2d 619 (CA6 1942), affd 319
US 98, 87 L Ed 1286, 63 S Ct 902 (1963).
\4\ United States v. Ludey, 274 U.S. 295 (1927).
\5\ Even Realty Co. v, Comm., supra, page 359.
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It is instructive to consider the fundamental distinction
between the taxation of depreciation and appreciation with
respect to a given asset. This important distinction was
eloquently discussed in the Even Realty case: There is no
reason why wear and tear, purely intrinsic matters, need be
tied up to appreciation resulting from extrinsic causes. The
two can go on simultaneously and no provision of law requires
the one to be offset against the other.
The above discussion summarizes the tax policy behind the
allowance for depreciation. This allowance is meant to
approximate the degree to which a depreciable asset has wasted
away over time. The deduction for depreciation for real estate
is properly allowed against ordinary income because it is
incurred in producing ordinary income. The courts have
recognized that a sale of a depreciable asset is a sale of only
what remains of the original asset purchased or constructed,
not of that which has wasted away. This remaining asset may be
subject to economic factors which increase or decrease its
value, but that does not in any way suggest the asset did not
physically deteriorate. Such increases or decreases in value of
the remaining asset are of a nature normally subject to capital
gain treatment. Current tax policy properly recognizes that
real estate has an operational aspect (the production of
ordinary income) and a capital aspect (the eventual sale of the
remaining asset), and taxes each aspect accordingly: the
operational aspect is taxed at ordinary rates and the capital
aspect is taxed at capital gain rates.
It is this deduction against ordinary income and the
corresponding basis adjustment to the remaining capital asset
which gives rise to the potential for converting ordinary
income into capital gain when depreciation deductions are
excessive. The depreciation recapture rules were enacted to
address the concept of excess depreciation.
III. Components of Taxable Gain on the Sale of Depreciated Real Estate
A. In General
When depreciated real estate is sold at a price in excess
of its adjusted tax basis, the gain can be broken down into
three distinct components:
Gains caused solely by excess depreciation,
Inflationary gains, and
Gains due to other economic factors.
The first component, gains created solely by excess
depreciation, is properly taxable at ordinary income rates. The
second two elements, gains due to inflation and other economic
factors, are properly taxable at full capital gain rates, not
just for real estate but for all capital investments. This has
been the tax policy embodied in IRC Sec. 1250 for the past 32
years, and remains the only viable tax policy today for sales
of depreciable real estate that puts real estate on a parity
with competing investment vehicles.
B. Excess Depreciation
Currently, IRC Sec. 1250 defines ``additional
depreciation'' for sales of real estate, which is subject to
tax at ordinary rates. In general, ``additional depreciation''
subject to recapture under IRC Sec. 1250 is equal to the
lesser of a) the excess of depreciation taken over straight
line or b) the gain on sale. Excess depreciation is a concept
unique to depreciable assets as compared with other forms of
capital investment. Arguably, various depreciation methods
afforded taxpayers over time have allowed for depreciation in
excess of ``actual'' wear and tear, and to the extent this is
the case, tax policy should not allow capital gain treatment of
gain resulting solely from excess depreciation. IRC Sec. 1250
is merely a correction to the measurement of the operational
aspect of real estate from a tax policy standpoint.
The potential for excess depreciation does not exist with
respect to nondepreciable capital investments, but there is the
potential for ``under amortization'' of market discount (as
opposed to original issue discount) on a bond that gives rise
to ordinary income ``recapture'' to the extent this under
amortization is realized at sale or maturity.\6\ Both recapture
provisions--the excess depreciation recapture provision
applicable to depreciable real estate, and the accrued market
discount re to discount bonds--can be said to properly prevent
the conversion of ordinary income into capital gains, thereby
preserving parity in taxation among competing investments.
---------------------------------------------------------------------------
\6\ See IRC Sec. 1276 through 1278.
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1. IRC Sec. 1245--The Revenue Act of 1962
The historical debate surrounding the enactment of IRC
Sec. 1245 highlights the distinctions between the various
elements of gain from the sale of real estate, and shows that
this code section is the product of careful deliberation and
thoughtful public testimony. First proposed in 1961, IRC Sec.
1245 originally included real estate along with personal
property as an asset subject to full depreciation recapture
upon sale.\7\
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\7\ President's Tax Message, April 20, 1961, page 40.
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However, testimony before the Ways and Means Committee
demonstrated that IRC Sec. 1245 as originally proposed would
inappropriately tax major components of gains on the sale of
real estate. For instance, it was pointed out that ``the forces
of inflation and market action inevitably result in prices
which are usually in excess of [adjusted] basis,'' \8\ and
``gains due to factors such as these are generally taxed at
capital gains rates.'' \9\ In other testimony, it was pointed
out that under IRC Sec. 1245 as originally proposed,
---------------------------------------------------------------------------
\8\ Statement of Alan J.B. Aronshon, Esq.--1961 Testimony before
Ways and Means on the President's Recommendations on Tax Revision at
page 1167.
\9\ Id at 1169.
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``the ordinary income on sale [of real estate] would not be
limited to depreciation in excess of that which the taxpayer
should have deducted. That could be the case if it's applied
only when the taxpayer had used an unrealistically short life
expectancy, or some form of artificial ``accelerated''
depreciation. Instead, it would apply even if the taxpayer had
used straight line depreciation over a conservative life
expectancy.
It would therefore apply even though the property has
actually depreciated as much as the taxpayer has deducted, and
the additional value was attributable to inflation, to change
in location, to increased costs of replacement, or to any of
the other factors which traditionally create capital gain on
property.''\10\
---------------------------------------------------------------------------
\10\ Statement of Mark H. Johnson, Representing the Commerce &
Industry Association of New York--1961 Testimony before Ways and Means
on the President's Recommendations on Tax Revision at page 1242.
---------------------------------------------------------------------------
``In common with every investor, a builder hopes that his
property will increase in value. Such increase may result from
negotiation of favorable leases, from economies in management,
from adjacent construction or other improvement in the
neighborhood, or from a variety of other factors. Such increase
in value may also, as we have all learned, represent merely a
counteraction against further inflation.''
Leslie Mills, Chairman of the AICPA's Committee on Federal
Taxation in 1961, offered similar testimony about the basic
relationship between depreciation and gains on sales of real
estate:
``Statutory depreciation, and depreciation in the
accounting sense, is not a measure of decline in the value of
property, but is a technique for prorating the original cost of
property having a useful life extending over a period of years.
Changes in market value of depreciable property are not
pertinent factors in determining annual depreciation allowances
since the asset is not bought for resale, but for use in the
taxpayer's business.
In the case of particular properties, specific
circumstances such as opportunities for greater usefulness of
the property, changes in economic circumstances,s in markets,
and so forth, may result in increases in fair market value of
the properties. Such gains realized by taxpayers are correctly
classified as capital gains since they are not caused by
miscalculation of prior depreciation deductions.
In a great many cases, particularly concerning depreciable
properties with long useful lives, the increase in value is
basically attributable to a decline in the purchasing power of
the dollar. We believe that any element of gain which can be
attributed to this ``inflationary'' effect is true capital gain
and, consistent with the general philosophy expressed elsewhere
in our tax laws, this portion of the gain should not be treated
as ordinary income.'' \12\
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\12\ Statement of Leslie Mills, Chairman, Committee on Federal
Taxation, AICPA,--1961 Testimony before Ways and Means on the
President's Recommendations on Tax Revision at page 1098.
---------------------------------------------------------------------------
Richard Swesnik, Chairman of the Subcommittee of Federal
Taxation of the National Association of Real Estate Boards in
1961, offered the following testimony distinguishing the
portion of the asset used up versus the portion of the asset
sold:
``Depreciation represents the actual wearing out of the
asset It is true that in any one year the rate of actual wear
and tear of the property may vary somewhat from the straight
line or other rate now permitted by law for computing
depreciation. This variation does not justify either the
assumption that the asset is not in fact being subjected to
wear and tear, or the assumption that the entire amount of the
depreciation is an improper deduction which should be
recaptured as ordinary income when the property is sold. The
property is in fact being used up, and depreciation at some
consistent rate should be allowed, even though the remaining
property (that is, the property remaining after wear and tear)
may be subject to economic factors which vary from year to
year, and which may increase or decrease the value of the
remaining asset. Gain from the sale of the remaining asset is
attributable to these economic factors, and is of the same
nature as other gains now subject to capital gains treatment.''
\13\
---------------------------------------------------------------------------
\13\ Statement of Richard Swesnik, Chairman of the Subcommittee of
Federal Taxation of the national Association of Real Estate Boards,--
1961 Testimony before Ways and Means on the President's Recommendations
on Tax Revision at page 1058.
---------------------------------------------------------------------------
Testimony was also presented on administrative expediency
and the complexity of separating out gain attributable to non-
depreciable land and gain attributable to the depreciable
building:
``This committee will recall that, for the period between
1938 and 1942, the tax law experimented with the rule that gain
or loss on depreciable property be treated as ordinary income
or loss. This committee stated, in introducing the Revenue Act
of 1942:
The present law not only results in unfairness to the
taxpayer but also in considerable administrative difficulty.
For example, if an apartment house is sold, under the present
law, it is necessary to separate the land from the building for
income tax purposes. This is because the gain allocable to the
building is subject to the normal and surtax rates, while the
gain allocable to the land is subject to the capital gains
rate. *** It is very difficult to allocate the capital gain or
loss between the land and the buildings. Accordingly, your
committee has changed the rule of existing law, so that both
the building, or similar real estate improvements, are treated
as capital assets (77th Cong., 2d sess., H. Rept. No. 2333
(1942) 52).
That comment is surely as appropriate today as it was [55]
years ago. The present proposal would require the
reintroduction of precisely the complication which this
committee so sensibly eliminated a long time ago.'' \14\
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\14\ Statement of Mark H.Johnson, supra, at 1244.
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As a result of this and other testimony, depreciable real
property was exempted from full recapture under IRC Sec. 1245.
In doing so, the House of Representatives in its report on the
Revenue Act of 1962 said ``your committee decided not to apply
this treatment to buildings or structural components of
buildings at this time because testimony before your committee
indicated that this treatment presents problems where there is
an appreciable rise in the value of real property attributable
to a rise in the general price level over a long period.'' \15\
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\15\ House of Representatives Report No. 1447, at page 471.
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2. IRC Sec. 1250--The Revenue Act of 1964 and Amending Acts
Through 1981
After it was decided to exempt depreciable real estate from
full ordinary income recapture in 1962, and apparently in
response to the 1961 debate, President Kennedy proposed in 1963
to restrict depreciation methods on real estate to the straight
line method, and to recapture depreciation on the sale of real
estate in full for property held less than 6 years, on a
sliding scale between years 6 and 14, and not at all for
property held more than 14 years.\16\ Congress did not enact
the President's exact proposal, but did in 1964 enact the first
recapture provision affecting real estate--IRC Sec. 1250.
---------------------------------------------------------------------------
\16\ Summary of the President's 1963 Tax Message at page 67.
---------------------------------------------------------------------------
In doing so, Congress explicitly recognized that not all
depreciation should be subject to ordinary income recapture as
a matter of tax policy. Congress said that in 1962, they ``did
not include real property in the recapture provision applicable
to depreciable personal property because [they] recognized the
problem in doing so where there is an appreciable rise in the
value of real property attributable to a rise in the general
price level over a long period of time. The bill this year
[1964] takes this into account. It makes sure that the ordinary
income treatment is applied upon the sale of the asset only to
what may truly be called excess depreciation deductions. It
does this first by providing that in no event is there to be a
recapture of depreciation as ordinary income where the property
is sold at a gain except to the extent the depreciation
deductions taken exceed the deduction which would have been
allowable had the taxpayer limited his deductions to those
available under the straight line method of depreciation.
Secondly, a provision has been added which in any event tapers
off the proportion of any gain which will be treated as
ordinary income so that it disappears gradually over a 10-year
holding period for the real estate. As a result, under the
bill, no ordinary income will be realized on the sale of real
estate held for more than 10 years.'' \17\
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\17\ Senate Report No. 830 on the Revenue Act of 1964, at page 636.
---------------------------------------------------------------------------
In 1969, Congress repealed the 10 y for post 1969
depreciation except for low income housing, and lengthened it
to 18 years and 4 months from 10 years for new residential
housing. In 1976, Congress repealed the burn off of recapture
for new residential housing. These and other subsequent
amendments were merely adjustments to what Congress felt were
accurate measurements of excess depreciation properly subject
to ordinary income recapture, but they were not repudiations of
the basic tax policy embodied in the original enactment of IRC
Sec. Sec. 1245 and 1250.
3. The 1981 Economic and Recovery Tax Act
In 1981, Congress enacted a major overhaul of the
depreciation and recapture rules. The purpose behind these
changes were stated to be as follows:
``The Congress concluded that prior law rules for
determining depreciation allowances and the investment tax
credit needed to be replaced because they did not provide the
investment stimulus that was felt to be essential for economic
expansion The real value of depreciation deductions allowed
under prior rules has declined for several years due to
successively higher rates of inflation. Reductions in the real
value of depreciation deductions diminish the profitability of
investment and discourage businesses from replacing old
equipment and structures with more modern assets that reflect
recent technology. The Congress agreed with numerous witnesses
who testified that a substantial restructuring of depreciation
deductions and the investment tax credit would be an effective
way of stimulating capital formation, increasing productivity,
and improving the nation's competitiveness in international
trade. The Congress, therefore, concluded that a new capital
cost recovery system was required which provides for the more
rapid acceleration of cost recovery deductions and maintains or
increases the investment tax credit.'' \18\
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\18\ General Explanation of the Economic Recovery Tax Act of 1981,
Prepared by the Staff of the Joint Committee on Taxation, 67-86 (12/29/
81), page 75.
---------------------------------------------------------------------------
The more generous depreciation deductions granted in 1981
were not accompanied by a tightening of the recapture rules
(except for non-residential real property depreciated using the
accelerated rates, which was subjected to the Sec. 1245
recapture rules), presumably because as stated above in the
committee report the purpose of the 1981 Act was to stimulate
the economy. Subjecting this new accelerated depreciation to
increased ordinary income recapture would have been
counterproductive.
It can be argued that real property depreciated under the
rules in effect between 1981 and 1986 have generated excess
depreciation in an economic sense, and this excess depreciation
should be subject to recapture. However, it was the express
intention of Congress that in order to stimulate the economy,
Congress would not require recapture of excess depreciation
caused by the shortened recovery periods, if any. Sound tax
policy dictates that once an inducement is offered through the
tax code to influence investment decisions, those inducements
should remain in place through the life of the investment.
Congress should now honor the tax incentives that were offered
to these investors to get them to risk their capital at a time
when the country was in bad economic straits, and not take them
away when times are better, in a large part, due to the
investments they made at that time. It should also be noted
that every time the recapture rules have been changed in the
past, the changes only applied to depreciation deductions taken
after the amending statute. The recapture rules have never been
changed with respect to deductions already taken.
4. The Tax Reform Act of 1986 Through the Present
In 1986, Congress passed the Modified Accelerated Cost
Recovery System (MACRS). By virtue of mandating use of the
straight-line method of depreciation for real estate placed in
service after 1986, there is effectively no depreciation
recapture with respect to post-1986 real estate. The
lengthening of recovery periods to 27.5 years for residential
real estate, and 31.5 years for non-residential real estate
(later increased to 39 years in 1993) has arguably eliminated
excess depreciation with respect to these assets from an
economic standpoint.
5. Comparison of IRC Sec. 1250 with Personal Property
Recapture Rules
Excess depreciation for personal property is computed
differently than for real estate, because personal property has
a much shorter useful life, has no non-depreciable component
susceptible to inflationary gains (land), and has no provision
for salvage value. Accordingly, most (but not necessarily all)
of the gain from a sale of personal property is properly
considered excess depreciation from a tax policy standpoint,
taxable at ordinary rates to the extent of previous
depreciation taken.
C. Inflationary Gain
Any broad-based capital gain tax relief proposal that
changes the current tax policy for depreciation recapture on
sales of real estate would to a significant degree withhold
capital gain tax relief for gains solely attributable to
inflation. No comparable provision would exist with respect to
the inflationary gains of other forms of investments. Such a
proposal would place real estate investment at a competitive
disadvantage with other forms of investment to the extent it
excludes inflationary gains from full capital gain tax relief.
This type of broad-based capital gain tax relief proposal
would exclude a real estate investor's inflationary gains from
capital gain tax relief at a time where there is a debate
whether to tax these gains at all. On January 26, 1994, current
Ways and Means Chairman Bill Archer of Texas introduced the
Capital Formation and Jobs Creation Act, which would have
indexed the basis of assets for inflation. In introducing this
bill, he stated:
``my bill would end the current practice of taxing
individuals and corporations on gains due to inflation.
Currently, taxpayers must pay capital gains taxes on the
difference between an asset's sales price and its basis--the
asset's original purchase price, adjusted for depreciation and
other items--even though much if not all of that increase in
value may be due to inflation. The bill would increase the
basis of capital assets to account for inflation occurring
after 1994. Taxpayers would be taxed only on the real--not
inflationary--gain.'' [emphasis added] \19\
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\19\ Congressional Record entry 7 of 100, January 26, 1994, page
E35.
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At a time when there is a legitimate debate as to the
propriety of taxing illusory inflationary gains from a tax
policy standpoint, it makes absolutely no sense to subject the
inflationary gains of only one class of investment, real
estate, to discriminatory tax rates.
D. Gain due to Economic Factors Other Than Inflation
The element of gain from the sale of real estate which is
arguably the most difficult to measure of the threeconomic
factors other than inflation--offers the strongest argument for
retention of current tax policy regarding depreciation
recapture in the context of a broad-based capital gains relief
proposal. This paper has demonstrated through careful analysis
of pertinent authorities that depreciation relates to the
operational aspect of real estate, and that the sale of
depreciated real estate--the capital aspect of real estate--is
a sale of ``not the whole thing originally acquired.'' \20\ As
to the remaining real estate asset sold, this paper has talked
about the concept of excess depreciation and Congress's
attempts over the last 36 years to properly measure this
amount, along with the concept of inflationary gain and the
ease at which this amount can be measured. Assuming that after
36 years Congress has a pretty good idea of what constitutes
excess depreciation, and assuming that the CPI is an accurate
measure of relative purchasing power over time, any taxable
gain in excess of these first two elements of gain must be an
accurate measure of the increase in value of the remaining
physical property and land due to other economic factors, as
measured by the free market. The only method of taxation of
this element of gain that preserves horizontal equity in the
taxation of income among competing capital investment vehicles
is taxation at full capital gains rates.
---------------------------------------------------------------------------
\20\ See United States v. Ludey, supra.
---------------------------------------------------------------------------
Economic factors which commonly add to the value of
depreciated real estate include the following:
Negotiation of favorable leases
Scarcity of comparable development sites
Adjacent development / improvement of the
neighborhood
Improvement of market demographics
Increased replacement costs
Economies in management
Infrastructure improvements
These and other economic factors which typically increase
the value of the remaining asset can be categorized into two
broad categories: favorable market trends and strong
management. The values of other forms of capital investment are
subject to these same market forces, yet the resulting
increments in value are taxed at full capital gains rates. It
would be unfair and discriminatory to enact a broad-based
capital gains tax relief proposal that would tax the gains of
real estate due to these types of economic factors any
differently than other forms of capital investment, yet some
recent proposals would do just that.
IV. Basis Indexing in Combination With Depreciation Recapture
One of the broad-based capital gain tax relief proposals
introduced last year would have indexed the basis of capital
assets for inflation, starting with assets purchased in 2001.
This proposal would have reduced capital gains taxes to a top
rate of 14%, but would have exempted real estate to the extent
of depreciation previously taken not already recaptured under
IRC Sec. 1250.
The combination of these two provisions, once fully phased
in, would have had the effect of:
Taxing excess depreciation at full ordinary
rates,
Not taxing inflationary gains at all, and
Taxing gains due to other economic factors at a
discriminatory 28% rate to the extent of depreciation not
already recaptured, and at a 14% rate thereafter.
The combination of basis indexing with broad-based capital
gains tax relief highlights the inequities of denying full
capital gains tax relief to sales of real estate. Considering
that other have all of their economic appreciation taxed at the
reduced capital gain rate, real estate would be at a serious
and obvious disadvantage compared to other investments. Basis
indexing would not correct the inequity that a change in
depreciation recapture tax policy would cause.
V. Conclusion
Sound tax policy dictates that similarly situated taxpayers
be treated the same under the tax code. Real estate must
compete with other forms of investment for scarce capital, and
should not, as a matter of tax policy, be discriminated against
by the tax code unless there is a public policy reason to
discourage such investment. No such public policy argument has
been advanced by those who would change current tax policy
regarding depreciation recapture on sales of real estate as
part of a broad-based capital gain relief proposal. Rather, the
rationale behind such a policy change seems to be to lower the
cost of a broad-based capital gains relief proposal, at the
expense of real estate and sound tax policy. Any effort to
provide broad-based capital gains tax relief should as a matter
of tax policy fully include the elements of capital gain
inherent in sales of depreciable real estate -gains due to
inflation and other economic factors -in order to maintain
horizontal equity among competing forms of capital
investment.''
Concluding Statement
The economic evidence noted by Price Waterhouse LLP and the
strong reasons for retaining present tax policy as advanced by
Ernst & Young LLP give clear and compelling arguments for
including real estate fully in any broad-based capital gains
tax reduction legislation. A fair capital gains tax cut, that
neither discriminates against real estate nor against existing
investments in favor of new investments, would unlock real
estate capital and bring in new investment for job creation.
Through the redeployment of existing capital, real estate
assets will more likely be recapitalized and reengineered for a
very dynamic and fast-changing marketplace.
Present federal tax law recognizes the key difference
between rapidly wasting assets like fork-lift trucks and
stamping machines, and longer-lived assets such as an apartment
building. In the one case, there is little, if any, value left
when a piece of machinery is sold. In the case of real estate,
the remaining value is primarily due to an increase in land
value, the extrinsic value of the property, and the long-term
rate of inflation. Thus previously taken building depreciation
should not be ``recaptured'' at ordinary income rates or at 28
percent if the capital gains tax rate is reduced below 28
percent; the capital gains tax rate should be applied to the
full gain above adjusted basis.
Three reasons are usually given by those who favor changing
the recapturication No. 1: ``We need the $7-10 billion this
would raise in order to help fund the reduction in capital
gains tax rates.'' Justification No. 2: ``Since real estate now
pays a 28 percent capital gains tax rate, its taxes would not
be going up. They have not lost anything. No harm, no foul.''
Justification No. 3: ``Real estate has an unfair advantage
versus investment in machinery and equipment.''
Let's take the argument that more money is needed to help
pay for the capital gains tax cut and juxtapose this with the
argument that there is ``no harm, no foul.'' Anything that
brings in $10 billion must have some economic bite. If changing
the depreciation recapture rules for real estate brings in this
much, it will all but negate any benefit of a capital gains tax
reduction; the Price Waterhouse study shows this to be true.
Real estate overall has not appreciated considerably in value
and thus would remain ``locked-in'' by a capital gains tax cut
that includes full real estate depreciation recapture at 28
percent or higher.
Looking forward, a change in the recapture rules would
place real estate investment at a significant disadvantage
compared to other investments. So there indeed is a ``foul''
caused by changing the rules. Finally, the so-called double
standard argument that compares machinery to buildings is
inappropriate. The fact is there is not a tax policy fairness
problem to begin with, since these are two fundamentally
different assets. Real estate is a long-lived wasting asset.
Any gain upon sale does not result from having taken
depreciation in prior years.
Most real estate is held for longer periods of time, has
not appreciated significantly in value, and is still held
primarily by individual investors. The vast majority of
investors and properties would not receive any benefit from a
capital gains tax cut that has a depreciation recapture
provision.
A broad-based reduction in capital gains taxes would
clearly benefit investors and free up dollars for new
investment. However, the use of the term ``broad-based'' should
be discontinued if the proposal also includes a change in the
depreciation recapture rules that would tax previously taken
depreciation at a non-capital gains tax rate. That type of
legislation is truly not broad-based and might cause
significant harm to future real estate values. For tax policy
reasons and sound economic reasons, a broad-based cut in the
capital gains tax that does not change the recapture rules
should be the proposal that our lawmakers pursue.
Statement of Patrick Brennan, Vice President, Pericom Semiconductor
Corp., San Jose, California; on Behalf of the R&D Credit Coalition
Mr. Chairman and members of the Committee, my name is
Patrick Brennan, and I am the Vice President of Pericom
Semiconductor Corporation of San Jose, California. I thank you
for the opportunity to submit this statement on behalf of the
R&D Credit Coalition on the importance of making permanent the
research and experimentation tax credit (commonly referred to
as the ``R&D'' credit), as recently modified by the Small
Business Job Protection Act of 1996. The R&D Credit Coalition
is a broad-based coalition of eighteen trade associations and
approximately 600 small, medium and large companies, all united
in seeking the permanent extension of the R&D credit. The
members of the R&D Credit Coalition represent many of the most
dynamic and fastest growing companies in the nation and include
the entire spectrum of R&D intensive industries: aerospace,
biotechnology, chemicals, electronics, information technology,
manufacturing, pharmaceuticals and software. (I have attached
to this statement a letter from the members of the R&D Credit
Coalition to President Clinton concerning including the R&D
credit in the Administration's FY 1998 Budget.)
Pericom Semiconductor Corporation, founded in 1990, is a
privately owned semiconductor company located in San Jose,
California. The company designs, develops and markets high
performance digital and mixed signal integrated circuits for
the personal computer, workstation, peripherals and networking
markets. Pericom's expertise in design and system technologies
has created over 200 products and the company delivers large
quantities of vital components to major customers worldwide.
Rapid new product development is essential to success in our
industry. Pericom's advanced design and engineering expertise
and continued commitment to research and development provides
users with innovative products which offer immediate measurable
benefits. The company has grown to over 125 employees and
spends approximately 15% of each revenue dollar on research and
development of new products. The company is an ISO registered
facility and is recognized for the quality of its products.
I want to commend Representatives Nancy Johnson and Bob
Matusi, and the original cosponsors of H.R. 947, and Senators
Hatch and Baucus, and the original cosponsors of S. 405, for
introducing legislation to permanently extend the R&D credit,
as enacted last year in the Small Business Job Protection Act
of 1996. Senators Gramm and Hutchinson are also to be commended
for introducing legislation (S. 355) to permanently extend the
R&D credit. I also want to commend President Clinton for
including, and funding, an extension of the R&D tax credit, as
enacted in the Small Business Job Protection Act, in the
Administration's FY 1998 Budget.
I hope the Congress will take swift action to permanently
extend the R&D credit by enacting the provisions of H.R. 947--
S. 405 before the credit expires once again on May 31, 1997.
I. R&D Credit Legislative History
The R&D credit was enacted in 1981 to provide an incentive
for companies to increase their U.S. R&D activities. As
originally passed, the R&D credit was to expire at the end of
1985. Recognizing the importance and effectiveness of the
provision, Congress decided to extend it. In fact, since 1981
the credit has been extended seven times. In addition, the
credit's focus has been sharpened by limiting both qualifying
activities and eligible expenditures, and altering its
computational mechanics. The credit has been the focus of
significant legislative activity and has undergone refinement
many times since its inception.
In 1986, the credit lapsed, but was retroactively extended
and the rate cut from 25 percent to 20 percent. In 1988, the
credit was extended for one year. However, the credit's
effectiveness was further reduced by decreasing the deduction
for R&D expenditures by 50% of the credit. In 1989, Congress
extended the credit for another year and made changes that were
intended to increase the incentive effect for established as
well as start-up companies. In the 1990 Budget Reconciliation
Act, the credit was extended again for 15 months through the
end of 1991. The credit was again extended through June 30,
1992, by the Tax Extension Act of 1991. In OBRA 1993, the
credit was retroactively extended through June 30, 1995.
In 1996, as part of the Small Business Job Protection Act
of 1996, the credit was extended for eleven months, through May
31, 1997, but was not extended to provide continuity over the
period July 1, 1995 to June 30, 1996. This one-year period,
July 1, 1995 to June 30, 1996, was the first gap in the
credit's availability since its enactment in 1981. In 1996, the
elective Alternative Incremental Research Credit (``AIRC'') was
added to the credit, expanding the availability of the credit
to R&D intensive industries which could not qualify for the
credit under the regular criteria. The AIRC adds flexibility to
the credit to address changes in business models and R&D
spending patterns which are a normal part of a company's life
cycle.
According to the Tax Reform Act of 1986, the R&D credit was
originally limited to a five-year term in order ``to enable the
Congress to evaluate the operation of the credit.'' While it is
understandable that the Congress in 1981 would want to adopt
this new credit on a trial basis, the credit has long since
proven over the sixteen years of its existence to be an
excellent investment of government resources to provide an
effective incentive for companies to increase their U.S.-based
R&D.
The historical pattern of temporarily extending the credit,
combined with the first gap in the credit's availability, has
reduced the incentive effect of the credit. The U.S. research
community needs a stable, consistent R&D policy in order to
optimize its contribution to the nation's economic growth and
sustain the basis for ongoing technology competitiveness in the
global arena.
II. Why Do We Need a R&D Credit?
A. Credit offsets the tendency for under investment in R&D
The single biggest factor behind productivity growth is
innovation. As stated by the Office of Technology Assessment in
1995: ``Much of the growth in national productivity ultimately
derives from research and development conducted in private
industry.'' Sixty-six to eighty percent of productivity growth
since the Great Depression is attributable to innovation. In an
industrialized society R&D is the primary means by which
technological innovation is generated.
Companies cannot capture fully the rewards of their
innovations because they cannot control the indirect benefits
of their technology on the economy. As a result, the rate of
return to society from innovation is twice that which accrues
to the individual company. This situation is aggravated by the
high risk associated with R&D expenditures. As many as eighty
percent of such projects are believed to be economic failures.
Therefore, economists and technicians who have studied the
issue are nearly unanimous that the government should intervene
to bolster R&D. A 1994 study, Extending the R&D Credit: The
Importance of Permanence (November 1994), conducted by the
Policy Economics Group of KPMG Peat Marwick, concluded that
``...[A] tax credit for research and experimentation was
enacted with the goal of offsetting the tendency to under
invest in industrial research. The R&D tax credit has been an
effective-and cost-effective tool for stimulating private R&D
activity.'' Stimulating private sector R&D is particularly
critical in light of the decline in government funded R&D over
the years. Direct government R&D funding has declined from 57%
to 36% of total R&D spending in the U.S. from 1970 to 1994.
Over this same period, the private sector has become the
dominant source of R&D funding, increasing from 40% to 60%.
B. The credit helps U.S. business remain competitive in a world
marketplace
The R&D credit has played a significant role in placing
American businesses ahead of their international competition in
developing and marketing new products. It has assisted in the
development of new and innovative products; providing
technological advancement, more and better U.S. jobs, and
increased domestic productivity and economic growth. This is
increasingly true in our knowledge and information-driven world
marketplace.
Research and development must meet the pace of competition.
In many instances, the life cycle of new products is
continually shrinking. As a result, the pressure of getting new
products to market is intense. Without robust R&D incentives
encouraging these efforts, the ability to compete in world
markets is diminished.
Continued private sector R&D is critical to the
technological innovation and productivity advances that will
maintain U.S. leadership in the world marketplace. Since 1981,
when the credit was first adopted, there have been dramatic
gains in R&D spending. Unfortunately, our nation's private
sector investment in R&D (as a percentage of GDP) lags far
below many of our major foreign competitors. For example, U.S.
firms spend (as a percentage of GDP) only one-third as much as
their German counterparts on R&D, and only about two-thirds as
much as Japanese firms. This trend must not be allowed to
continue if our nation is to remain competitive in the world
marketplace.
Moreover, we can no longer assume that American companies
will automatically choose to site their R&D functions in the
United States. Foreign governments are competing intensely for
U.S. research investments by offering substantial tax and other
financial incentives. An OECD survey of sixteen member
countries found that thirteen offer R&D tax incentives. Of the
sixteen OECD nations surveyed, twelve provide a R&D tax credit
or allow a deduction for more than 100% of R&D expenses. Six
OECD nations provide accelerated depreciation for R&D capital.
According to the OECD survey, the U.S. R&D tax credit as a
percentage of industry-funded R&D was third lowest among nine
countries analyzed. Even without these tax incentives, the cost
of performing R&D in many foreign jurisdictions is lower than
the cost to perform equivalent R&D in the U.S. In light of this
international trend, Congress and the Administration must make
a strong and permanent commitment to attracting and retaining
R&D investment in the United States. The best way to do that is
to permanently extend the R&D credit.
C. The credit provides a targeted incentive for additional R&D
investment, increasing the amount of capital available for
innovative and risky ventures.
The R&D credit reduces the cost of capital for businesses
that increase their R&D spending, thus increasing capital
available for risky research ventures.
Products resulting from R&D must be evaluated for their
financial viability. Market factors are providing increasing
incentives for controlling the costs of business, including
R&D. Based on the cost of R&D, the threshold for acceptable
risk either rises or falls. By reducing the costs of R&D, you
make it possible to increase R&D efforts. In most situations,
the greater the scope of R&D activities, or risk, the greater
the potential for return to investors, employees and society at
large.
The R&D credit is a vital tool to keep U.S. industry
competitive because it frees-up capital to invest in leading
edge technology and innovation. It makes available additional
financial resources to companies seeking to accelerate research
efforts. It lowers the economic risk to companies seeking to
initiate new research, which will potentially lead to enhanced
productivity and overall economic growth.
D. Private industrial R&D spending is very responsive to the
R&D credit, making the credit a cost effective tool to
encourage economic growth
Economic studies of the credit, including the KPMG Peat
Marwick 1994 study referenced above, and B. Hall, ``R&D Tax
Policy in the 1980s: Success or Failure?'' Tax Policy and the
Economy (1993), have found that a one-dollar reduction in the
after-tax price of R&D stimulates approximately one dollar of
additional private R&D spending in the short-run, and about two
dollars of additional R&D in the long run. That in turn,
implies long-run growth in GDP. In addition, the KPMG Peat
Marwick study concluded, ``The credit has been a public policy
success... The best available evidence now indicates that the
increase in R&D due to the tax credit equal or exceed the
credit's revenue costs.''
E. Research and Development is About Jobs and People
Investment in R&D is ultimately an investment in people,
their education, their jobs, their economic security, and their
standard of living. Dollars spent on R&D are primarily spent on
salaries for engineers, researchers and technicians.
When taken to market as new products, incentives that
support R&D translate to salaries of employees in
manufacturing, administration and sales. Of exceptional
importance to Pericom Semiconductor Corporation and the other
members of the R&D Credit Coalition, R&D success also means
salaries to the people in our distribution channels who bring
our products to our customers as well as service providers and
developers of complementary products. And, our customers
ultimately drive the entire process by the value they put on
the benefit to them of advances in technology. Benefits that
often translate into improving their ability to compete. By
making other industries more competitive, research within one
industry contributes to preserving and creating jobs across the
entire economy.
My experience has been that more than 75 percent of
expenses qualifying for the R&D credit go to salaries for
researchers and technicians, providing high-skilled, high-wage
jobs to U.S. workers. Investment in R&D, in people working to
develop new ideas, is one of the most effective strategies for
U.S. economic growth and competitive vitality.
F. The R&D credit is a market driven incentive
The R&D credit is a meaningful, market-driven tool to
encourage private sector investment in research and development
expenditures. Any taxpayer that increases their R&D spending
and meets the technical requirements provided in the law can
qualify for the incentive. Instead of relying on government-
directed and controlled R&D spending, businesses of all sizes,
and in all industries, can best determine what types of
products and technology to invest in so that they can ensure
their competitiveness in the world marketplace.
III. The R&D Credit Should Be Made Permanent To Have Optimum Incentive
Effect
Research projects cannot be turned off and on like a light
switch. If corporate managers are going to take the benefits of
the R&D credit into account in planning future research
projects, they need to know that the credit will be available
to their companies for the years in which the research is to be
performed. Research projects have long horizons and long
gestation periods. Furthermore, firms generally face longer
lags in adjusting their R&D investments compared, for example,
to adjusting their investments in physical capital.
In order to increase their R&D efforts, businesses must
search for, hire, and train scientists, engineers and support
staff. They must often invest in new physical plant and
equipment. There is little doubt that a portion of the
incentive effect of the credit has been lost over the past
seventeen years as a result of the constant uncertainty over
the continued availability of the credit.
If the credit is to provide an effective incentive for
increased R&D activity, the practice of periodically extending
the credit for short periods, and allowing it to lapse, must be
eliminated, and the credit must be made permanent. Only then
will the full potential of its incentive effect be felt across
all the sectors of our economy.
IV. Conclusion
Making the existing R&D credit permanent best serves the
country's long term economic interests as it will eliminate the
uncertainty over the credit's future and allow R&D performing
businesses to make important long-term business decisions
regarding research spending and investment. Private sector R&D
stimulates investment in innovative products and processes that
greatly contribute to overall economic growth, increased
productivity, new and better U.S. jobs, and higher standards of
living in the United States. Moreover, by creating an
environment favorable to private sector R&D investment, jobs
will remain in the United States. Investment in R&D is an
investment in people. A permanent R&D credit is essential for
the United States economy in order for its industries to
compete globally, as international competitors have chosen to
offer direct financial subsidies and reduced capital cost
incentives to ``key'' industries. The R&D Credit Coalition
strongly supports the permanent extension of the R&D credit and
urges Congress to enact the provisions of H.R. 947--S. 405
before the credit expires on May 31, 1997.
Attachment: Letter from members of R&D Credit Coalition to
President Clinton
December 18, 1996
The Honorable William Jefferson Clinton
President of the United States
The White House
Washington, D.C. 20500
Dear Mr. President:
We urge you to include a permanent extension of the Research and
Experimentation tax credit (commonly referred to as the R&D Credit), as
recently enacted in the Small Business Job Protection Act, including
the elective alternative incremental research credit, in your Fiscal
Year 1998 Budget. As you know, the R&D Credit was allowed to lapse for
the first time since its inception and is set to expire again in only a
few short months; it is now more critical than ever that your
Administration demonstrate its continuing commitment to the R&D Credit
by including, and funding, a permanent extension in your FY 98 Budget.
The R&D Credit enjoys broad, bipartisan support and provides a
critical, effective and proven incentive for companies to maintain and
increase their investment in U.S. based research and development. The
continued encouragement of private sector R&D is particularly important
in light of the substantial tax and other financial incentives offered
by many of our major foreign trade competitors and the budgetary
pressures to reduce Federal Government investment in basic and applied
research. Moreover, targeted primarily at salaries and wages paid to
employees engaged in U.S.-based R&D activities, the credit supports the
creation of valuable new, high-skilled jobs for American workers.
For these reasons, we strongly urge you to make an investment in
the future economic growth of our country by funding a permanent
extension of the R&D Credit in your FY 98 Budget.
We thank you for your consideration of our strong interest in a
permanent R&D Credit and look forward to working with you toward this
goal.
Sincerely,
(Attached Signatories)
cc: Honorable Robert E. Rubin
Honorable Franklin D. Raines
Honorable Erskine Bowles
Aerospace Industries Association of America, Inc.
American Automobile Manufacturers Association
American Electronics Association
Biotechnology Industry Organization
Business Software Alliance
Chemical Manufacturers Association
Computing Technology Industry Association
Electronic Industries Association
Information Technology Association of America
Information Technology Industry Council
National Association of Manufacturers
Pharmaceutical Research & Manufacturers of America
Semiconductor Equipment and Materials International
Software Publishers Association
Telecommunications Industry Association
U.S. Chamber of Commerce
US Telephone Association
Utah Information Technologies Association
3Com Corporation
3M Company
3M Health Information Systems
Abbott Laboratories, Inc.
Absolute Time Corporation
Academedia Multimedia Solutions
AccelGraphics
Accel Technologies, Inc.
Access The West
AccSys Technology, Inc.
Accurel Systems International Corporation
ACT Teleconferencing
Active Power
Action Instruments, Inc.
Adastra Systems Corporation
Adobe Systems, Inc.
Advanced Energy Industries, Inc.
Advanced Micro Devices, Inc.
Advance Technology, Inc.
Advent Systems, Inc.
AG Associates
Air Products and Chemicals, Inc.
Airtouch Cellular
Alcatel NA Cable Systems, Inc.
Alex Systems
Allen Communication
Alliance Semiconductor Corporation
Allied Signal
Alpnet, Inc.
America-Net
American Computer Hardware Corporation
American Home Products Corporation
American Telecorp, Inc.
Ameritech Library Services
Amgen, Inc.
AMP
Analogic, Inc.
Ancestry, Inc.
Angle Technologies, Inc.
Apple Computer, Inc.
Applied Computer Techniques, Inc.
Applied Materials
Arcanvs, Inc.
Arcom Architectural Computer Services
Artnet
Asante' Technologies, Inc.
Ashton, Harker, Bingham, Inc.
Associates & Blair
Associated Components Technology, Inc.
Astra USA, Inc.,
AT&T
AT&T Wireless Services
Atmel Corporation
Attachmate Corporation
Autocon, Inc.
Autodesk, Inc.
Autosimulations, Inc.
Auto-Soft Corporation
Autosplice, Inc.
Avid Technology, Inc.
Axiom Technologies, L. C.
Aztek Engineering, Inc.
Banyan Systems, Inc.
Bay Networks, Inc.
Bell Atlantic
Bell & Howell Lightspeed
Berger & Co.
Best Consulting
BFGoodrich Company
BI Incorporated
Bison Group
BMC Software, Inc.
Boehringer Ingelheim Pharmaceuticals, Inc.
Bolder Technologies Corporation
Bolt Beranek & Newman
Bonneville International Corporation
Borland International
Boston Technology, Inc
Bristol-Myers Squibb Company
Broderbund Software, Inc.
Burton Group
Bybee Printed Circuit Design
C-COR Electronics Inc.
Caldera, Inc.
Calex
California Healthcare Institute
California Instruments Corporation
Calimetrics, Inc.,
Call Business Systems, Inc.
Call Dynamics
Callware Technologies
Cambric Graphics, Inc.
Cambridge Technology Partners, Inc.
Candescent Technologies Corporation
Capsoft Development Corporation
Carco Electronics
Carlisle Wilkins, L.C.
Cartwright Communications
Caseware Technology, Inc.
Catapult Communications
CASCADE Communications Corp.
CDI Information Services, Inc.
Centre Technologies
Centric Engineering Systems, Inc.
Century Software
Certified Management Software, Inc.
Charles Industries, Ltd.
CHI Squared Software, Inc.
Chrysler Corporation
Circuit Technology Corp.
Cirque Corporation
Cirris Systems Corporation
Cisco Systems, Inc.
Citizens Telecom
Citrix Systems, Inc.
Claris Corporation
Clark Development Company, Inc.
Codar Technology, Inc.
Cognex Corporation
Coherent Technologies,
Coleman's
Companion Corporation
COMPAQ Computer Corporation
Compass Data Systems, Inc.
Computer Consultants Corporation
Computer Management Systems, Inc.
Computer Sciences Corporation
Computer Task Group, Inc.
Comspec Corporation
Connecting Point Computer Center
Connective Solutions, LLC
Consultnet
Copley Controls
Corel, Inc.
Correct Knowledge
Cray Research, Inc.
Create-A-Check, Inc.
Creative Computer Solutions, Inc.
Creative Insight, Inc.
Creative Media
Crystal Canyon Interactive
Cyberamerica
CyberSym Technologies
Cygnus Solutions
Darbick Instructional Software Systems
Data Systems International
Dataflow Services
Datamatic, Inc.
Dataware Technology
Datum Inc.
Dayna Communications, Inc.
Decision Systems Technologies, Inc.
Desktop Visual Products
Digital Equipment Corporation
Digital Radio Communications Corp.
Digitran Systems, Inc.
Digivision
Dimensions/Computer Advisors, Inc.
Dionex Corporation
Directell, Inc.
DOCU Prep, Inc.
Document Control Systems
DS Technologies, Inc.
Duplication Group
Dupont Merck Pharmaceutical Company
DVT Corporation
E. I. Dupont Nemours and Company, Inc.
Eastman Kodak Company
Eckersley Associates DP+R
Edge Semiconductor Incorporated
EDS
EFI Electronics Corporation
Electro Scientific Industries, Inc.
Electronic Cottage
Electronic Decontamination Specialists
Electronic Expressway Connections
Elpac Electronics, Inc.
Embedded Performance, Inc.
EMC Corporation
Engineering Geometry Systems, Inc.
Equis International
Ernest & Young LLP
ESCO Electronics Corporation
Eskay Corporation
Evans & Sutherland Computer Corporation
Expersoft
Eyring Corporation
Fiber Optic Technologies, Inc.
Fibernet
FileNet Corporation
Fisher Berkeley Corporation
Floppy Copy, Inc.
Folio Corporation
Ford
Four Corners Technology, Inc.
Franklin Estimating Systems
Frequency Products
FTP Software, Inc.
Future Active Industrial Electronics
Galapagos Software, Inc.
GECAP
Genentech, Inc.
General Dynamics Corporation
General Motors Corporation
Genetics Institute
GENZYME CORPORATION
Geometrics, Inc.
GLASPAC--Total Solutions
Glaxo Wellcome, Inc.
Global Ergonomic Technologies, Inc.
Gold Systems, Inc.
GSE Erudite Software
H. Rel Laboratories, Inc.
Hall-Mark Computer
Harding & Harris Behavioral Research
Harris Corporation
Harry Sello and Associates
Headway Research, Inc.
HEC Software, Inc.
Hemasure, Inc.
HNC Software, Inc.
Hoffman-LaRoche
Home Financial Network, Inc.
Honn Enterprises
Horix Manufacturing Company
Hurricane Electronics Lab., Inc
Hutchinson Telephone Company
HY-Tech Business Services
IBM Corporation
IC One
ICIS, Inc.
I-EIGHTY
IES, Inc.
Individual, Inc.
Industry West Electronics
Indyme Electronics, Inc.
Infobusiness, Inc.
Infonational, LLC
Information Builders, Inc.
Information Enabling Technologies (IET)
Information Plus Corporation
Information Technologies
Infosphere
Innerworks
Inno Cal
Innovative Telecom
Innovax Concepts Corporation
Innovus Multimedia, Inc.
Insight Software Solutions, Inc.
Inso Corporation
INSTRON Corporation
INTA
Intel Corporation
Intelli Media, Inc.
Intelliquest Technologies, Inc.
Intellitrends
Interactive Services
Interated Systems, Inc.
Interconnect West
Interim Technology
Interlake Software Solutions
Interlynx Technology Corporation
Internet Magic, Inc.
Intuit Inc.
InVINCIBLE Enterprises
I-O Corporation
IOMEGA Corporation
IPM/Management 2000, LC
I*SIM Corporation
ITC Companies
ITPARTNERS, Inc.
J. R. Firestack & Assciates
Jason Associates Corporation
JH Associates
Johnson & Johnson
Kaiser Electroprecision
KAMP--Data
KCE
Keane, Inc.
Kenex Systems, Inc.
Kenter Information Systems, Inc.
Keylabs, Inc.
Kiva
Kofax Image Products
Komag Inc.
KV Communications, Inc.
Laser Mail
Laser Supply of Utah, Inc.
Laser Systems
Latin Connection, Inc.
Lexmark International, Inc.
Liconix
Lifeline Systems, Inc.
Eli Lilly and Company
Lockheed Martin Tactical Communication Systems
Logic Works, Inc.
Logical Services Incorporated
Loronix Information Systems, Inc.
Lucent Technologies, Inc.
McAfee Associates
McData Corporation
McDonnell Douglas
Macromedia
Majesco Software, Inc.,
Mark Communications
Marketing Ally Teleservices
Marshall Contractors
Maxon America, Inc.
MCI Communications
MCI Telecommunications Corporation
Meeting Ware International, Inc.
Megg Associates, Inc.
Mentor Graphics Corporation
Merck & Company, Inc.
Metastorm, Inc.
Metcam, Inc.
Metronerles Corporation
Micro Automation Enterprise
Micro Choice, Inc.
MicroHelp, Inc.
MicroSim Corporation
Microsoft Corporation
Microsurge, Inc.
Microsystems Software
MIS LABS
Mitel Semiconductor, Inc.
MKS Instruments, Inc.
Monsanto-Searle Company
Motorola
Mountain View Software Corp.
Multiling International, Inc.
Napersoft, Inc.
National Applied Computer Technologies, Inc.
National Semiconductor Corporation
National Software Testing Laboratories
Net Dynamics, Inc.
Nets, Inc.
Netscape Communications, Inc.
NetSoft
Network Centre
Network Computer Systems
Network Information Research Corp.
Network Integration, Inc.
Network Publishing, Inc.
Network Technical Services
New Client Software, Inc.
Newbridge Networks Inc.
Newport Corporation
Northridge Systems, LLC
Northrop Grumman
Northern Telecom Inc.
Novell, Inc.
NYNEX
OEC Medical Systems, Inc.
Omnidata International, Inc.
One-Off CD Shops--Division of Software Duplicators
ONYX Graphics, Corp.
Open Highways, LLC
Optek Technology, Inc.
Optical Data Systems, Inc.
Optionomics Corporation
Oracle Corporation
Organogenesis, Inc.
Ortho-Graphics, Inc.
Oryx Technology Corporation
Outsource Engineering and Manufacturing
Outsource Solutions
Outsource Technologies
Ovid Technologies, Inc.
Oxford & Associates
Pacific Telesis Group
Palomar Systems, Inc.
Paragraph International
Parametric Technology
ParcPlace-Digitalk, Inc.
Park City Group
Pasteur Merieux Connaught
PC Software Systems, LLC
PCD, Inc.
Pembroke's, Inc.
Pen Interconnect, Inc.
Pericom Semiconductor Corporation
Pfizer
Pharmacology Data Management Corporation
Pharmacia & Upjohn
Philips Electronics
Phoenix Fiberlink, Inc.
Phonex Corporation
Pivotpoint, Inc.
Planet Software
Pleiades Software Dev., Inc.
Polatomic, Inc.
PowerQuest Corporation
Power Stream Technology, Inc.
POWERTEX INC.
Pragmatic Data Quest
Precision Assembly, Inc.
Precision Cable Corporation
Premier Laser Systems
Primavera Systems, Inc.
Prime Technological Services, Inc.
Printronix, Inc.
Process Software Corporation
Procopy
Prodigy, Inc.
Programart Corporation
Progressive Solutions, Inc.
Project Software & Development, Inc.
Promodel Corporation
Protel
Prototype & Plastic Mold Co. Inc.
Procter & Gamble Company
Pulizzi Engineering, Inc.
Qlogic Corporation
QLP Laminates
QSI Corporation
Quality Education Data
Quantum Leap
Questar Infocomm, Inc.
R. R. Donnelley & Sons Company
Racore Computer Products, Inc.
Rainbow Technologies, Inc.
RAM Software Systems, Inc.
Rapid, LLC
Raptor Systems, Inc.
Rascom, Inc.
Raster Graphics, Inc.
Raytheon Company
Red Rock Technologies
Redcon, Inc.
Relationship Software, LLC
Reliability Incorporated
Rhyse Development, Inc.
Rockwell International Corp.
Rocky Mountain Hardware Company
Rohm & Haas Company
Router Ware
Saffire Corporation
Salt Lake Cellular
Saville Systems, Inc.
SBC Communications
SBE, Inc.
Schering-Plough Corporation
SCHOTT Corporation
Science Applications International Corp. (SAIC)
Scientific-Atlanta, Inc.
Scientific Technologies, Inc.
Scitex America, Inc.
Scopus Technology, Inc.
Seer Technologies, Inc.
Semiloa Semiconductors
Sepracor, Inc.
Sequent Computer Systems, Inc.
Sequoia Group, Inc.
ShareData Inc
Shelby Industries, Inc.
Silicon Graphics
Silicon Valley Group, Inc.,
Siemens Corporation
Siemens Rolm Communications, Inc.
Sierra Semiconductor
Simates, Inc.
SIMCO Electronics
Singletrac Entertainment Technologies, Inc.
Skipstone, Inc.
SkyHook Technologies, Inc.
Smart Communications
Smartdial/Information Access Technology, Inc.
Smarttalk, Inc.
Smartware Systems, Inc.
SmithKline Beechman Corporation
Softset International, Inc.
Software Forum
Software Development Corp.
Software Magic
Software Publishing Corporation
Software Studios
Solid Design & Analysis, Inc.
Source Services
Spatial Technology Inc.
Spiricon, Inc.
Sprint
SRC Computers, Inc.
Stac, Inc.
Sterling Wentworth Corporation
Storage Technology Corporation
Strata, Inc.
Stratedge Corporation
Strategic Marketing
Stream International, Inc.
Streamlined Information Systems
Stuart & Co.,
Subscriber Computing, Inc.
Summit Consulting Group
Summit Technology, Inc.
Sun Microsystems, Inc.
Sun Remarketing, Inc.
Surfware, Inc.
Sybase, Inc.
Symantec Corporation
Synergy, Inc.
Systems West Computer Resources, Inc.
Tandem Computers Incorporated
Target Software, Inc.
TCG--Teleport Communications Group
TCI Caglevision Of Utah, Inc.
Teal Electronics Corporation
Technology Advancement Corporation
Technology Sales, Inc.
Tecknowledgez, Inc.
Tekana Corporation
Tel0ecom Strategies, Inc.
Telect, Inc.
Telesensory Corporation
Telesync, Inc.
Tels Corporation
Teltrust, Inc.
Teltrust, Com
Tenth Planet
Teradyne, Inc.
T.H.E., LLC
The Automatic Answer
The Directorate, Inc.
THE LEARNING COMPANY
The VALIS Group, Inc.
The Video Call Company
Theoretics, Inc.
Thiokol Corporation
Thunderbird Technologies, Inc.
Tomax Technologies, Inc.
TRW Inc.
Tranquility Systems
Transoft International, Inc.
Traveling Software
Trebor International
TSI International
U'S West Communications
United Technologies Corporation
Union Carbide Corporation
Unisys Corporation
Unitrode Corporation
Usability Center
Utah Education Network
Utah Scientific, Inc.
Value Added Software, Inc.
Varian Associates
Venture Advisory Group
Venture Engineering Corporation
Verite' Multimedia
Versant Object Technology
Vertex Pharmaceuticals Incorporated
VideoServer, Inc.
Viewpoint Datalabs
Viewsoft, Inc.
Vinca Corporation
Visicon, Inc.
Visio Corporation
Vitrex Corporation
Voicestream Wireless
Voiceteck Corporation
VZ Corporation
Wall Data, Inc.
Warever Corporation
Warner-Lambert
Watkins-Johnson Company
Western Digital Corporation
Western Midrange Corporation
Western Telematic, Inc.
Westin Technology Center
Wicat Systems, Inc.
Wiltel Technology Ventures, Inc.
Wind River Systems
Winward Telecommunications
Wydah Corporation
Xerox Corporation
XILINX, Inc.
Z Microsystems, Inc.
Zebra Technologies VTI, Inc.
ZZ Soft
ZZ Software Systems, Ltd.
Any inquiries concerning this letter may be directed to Donna
Siss Gleason, Director, Government Relations, Electronic
Industries Association (703) 907-7587.
Addendum
The listed company names below were received after the
letter was sent out to the President.
New Image Industries, Inc.
Odetics
Jones & Askew
Racom Systems, Inc.