[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]



 
         SECOND IN SERIES ON THE EXTRATERRITORIAL INCOME REGIME
=======================================================================



                                HEARING

                               before the

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

                               __________

                              MAY 9, 2002

                               __________

                           Serial No. 107-77

                               __________

         Printed for the use of the Committee on Ways and Means








                       U. S. GOVERNMENT PRINTING OFFICE
81-891                          WASHINGTON : 2002
___________________________________________________________________________
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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
E. CLAY SHAW, Jr., Florida           FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut        ROBERT T. MATSUI, California
AMO HOUGHTON, New York               WILLIAM J. COYNE, Pennsylvania
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM McCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM McDERMOTT, Washington
JIM RAMSTAD, Minnesota               GERALD D. KLECZKA, Wisconsin
JIM NUSSLE, Iowa                     JOHN LEWIS, Georgia
SAM JOHNSON, Texas                   RICHARD E. NEAL, Massachusetts
JENNIFER DUNN, Washington            MICHAEL R. McNULTY, New York
MAC COLLINS, Georgia                 WILLIAM J. JEFFERSON, Louisiana
ROB PORTMAN, Ohio                    JOHN S. TANNER, Tennessee
PHIL ENGLISH, Pennsylvania           XAVIER BECERRA, California
WES WATKINS, Oklahoma                KAREN L. THURMAN, Florida
J.D. HAYWORTH, Arizona               LLOYD DOGGETT, Texas
JERRY WELLER, Illinois               EARL POMEROY, North Dakota
KENNY C. HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin

                     Allison Giles, Chief of Staff
                  Janice Mays, Minority Chief Counsel

                                 ______

                Subcommittee on Select Revenue Measures

                    JIM McCRERY, Louisiana, Chairman

J.D. HAYWORTH, Arizona               MICHAEL R. McNULTY, New York
JERRY WELLER, Illinois               RICHARD E. NEAL, Massachusetts
RON LEWIS, Kentucky                  WILLIAM J. JEFFERSON, Louisiana
MARK FOLEY, Florida                  JOHN S. TANNER, Tennessee
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin


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 May 2, 2002, announcing the hearing..................     2

                               WITNESSES

Americans for Fair Taxation, T.H.E., Inc., and Godfather's Pizza, 
  Inc., Herman Cain..............................................    13
Center for Strategic Tax Reform, Ernest S. Christian.............    18
Engen, Eric M., American Enterprise Institute....................     6
Gale, William G., Brookings Institution..........................    40
Graetz, Michael J., Yale Law School..............................    24
Institute for Research on the Economics of Taxation, Stephen J. 
  Entin..........................................................    32
Jorgensen, Dale W., Harvard University...........................    54











         SECOND IN SERIES ON THE EXTRATERRITORIAL INCOME REGIME

                              ----------                              


                         THURSDAY, MAY 9, 2002

                  House of Representatives,
                       Committee on Ways and Means,
                   Subcommittee on Select Revenue Measures,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 2:05 p.m., in 
room 1100 Longworth House Office Building, Hon. Jim McCrery, 
(Chairman of the Subcommittee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                                Contact: (202) 226-5911
FOR IMMEDIATE RELEASE
May 2, 2002
No. SRM-6

        McCrery Announces Second in a Series of Hearings on the 
                     Extraterritorial Income Regime

    Congressman Jim McCrery (R-LA), Chairman, Subcommittee on Select 
Revenue Measures of the Committee on Ways and Means, today announced 
that the Subcommittee will hold its second hearing on the 
extraterritorial income (ETI) regime. The hearing will take place on 
Thursday, May 9, 2002, in the main Committee hearing room, 1100 
Longworth House Office building, beginning at 2:00 p.m.

    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Committee and for 
inclusion in the printed record of the hearing.

BACKGROUND:

    On January 14, 2002, the World Trade Organization (WTO) Appellate 
Panel issued its report finding the United States' ETI rules to be a 
prohibited export subsidy. This marks the fourth time in the past two 
and one-half years that the United States has lost this issue, twice in 
the Foreign Sales Corporation case and now twice in the ETI case. There 
is no opportunity for the United States to appeal this latest 
determination.

    On January 29, 2002, a WTO Arbitration Panel began proceedings to 
determine the amount of retaliatory trade sanctions that the European 
Union (EU) can impose against U.S. exports to the EU. The EU has 
requested $4.043 billion in sanctions. The United States has asserted 
that the proper measure of sanctions is no more than $1.1 billion. 
Originally expected on April 29, 2002, a decision by the panel is now 
expected by June 17, 2002.

    The Subcommittee held its first hearing on the issue on April 10, 
2002. The Full Committee held a hearing on February 27, 2002.

    In announcing the hearing, Chairman McCrery stated: ``Witnesses at 
our last hearing unanimously agreed that the United States cannot 
tinker with the ETI regime in a way which preserves its current 
structure and beneficiaries in a WTO-compliant manner. It is clear a 
broader approach is necessary. One approach which merits careful 
consideration is fundamental reform of our tax code. This hearing will 
give the Subcommittee an opportunity to learn more about proposals such 
as flat taxes, sales taxes, and value added taxes and whether they can 
help promote American exports.''

FOCUS OF THE HEARING:

    The focus of the hearing will be to examine whether fundamental 
reform of the current corporate tax system is a viable alternative to 
promote the competitiveness of U.S. businesses in the global 
marketplace.

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

    Please Note: Due to the change in House mail policy, any person or 
organization wishing to submit a written statement for the printed 
record of the hearing should send it electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, by the close of business, Thursday, May 23, 2002. Those 
filing written statements who wish to have their statements distributed 
to the press and interested public at the hearing should deliver their 
200 copies to the Subcommittee on Select Revenue Measures in room 1135 
Longworth House Office Building, in an open and searchable package 48 
hours before the hearing. The U.S. Capitol Police will refuse sealed-
packaged deliveries to all House Office Buildings.

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. Due to the change in House mail policy, all statements and any 
accompanying exhibits for printing must be submitted electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, in Word Perfect or MS Word format and MUST NOT exceed a 
total of 10 pages including attachments. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.

    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. Any statements must include a list of all clients, persons, or 
organizations on whose behalf the witness appears. A supplemental sheet 
must accompany each statement listing the name, company, address, 
telephone and fax numbers of each witness.

    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov/.

    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 202-226-3411 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 McCRERY. Good afternoon, everyone. If our guests 
will take their seats, we will begin the hearing.
    Welcome, everyone. This afternoon, the Subcommittee on 
Select Revenue Measures continues its examination of the issues 
surrounding World Trade Organization's (WTO's) determination 
that the Extraterritorial Income (ETI) Exclusion Act regime is 
an export subsidy inconsistent with our international trade 
obligations. As Members of this Committee know, we are fast 
approaching the June 17 date on which the WTO arbitration panel 
will determine the level of authorized sanctions which the 
European Union may impose to offset the impact of the subsidy 
provided by the ETI regime. The looming deadline makes it 
particularly important that we handle this task with both speed 
and precision.
    I was heartened by recent news reports that the European 
Union understands the difficult challenges we face in 
untangling the ETI rules and is inclined to withhold imposing 
sanctions as long as we continue to make meaningful progress 
toward a legislative solution to this issue. Despite that 
positive development, though, it would be unwise for their 
Committee or the Congress to pause in our efforts to bring the 
Tax Code into compliance with our obligations under the WTO.
    One month ago the Subcommittee held its first hearing on 
Foreign Sales Corporation (FSC) ETI. The consensus of all the 
witnesses, including former Members of this Committee who 
helped draft those laws, was that the benefits of FSC could not 
be replicated in a WTO-compliant manner. Simply put, if we are 
to avoid retaliation from Europe while continuing to help our 
exporters compete in the global marketplace, we must explore 
more far-reaching changes to the Tax Code.
    Today's hearing continues to search for answers by 
considering fundamental tax reform proposals or, as Secretary 
O'Neill was quoted as saying today in the Wall Street Journal, 
``an overhaul of the tax system.''
    Fundamental tax reform proposals are generally variations 
of a consumption tax, such as a retail sales tax, a value-added 
tax (VAT) or a flat tax. On one point, supporters of each of 
those are correct--any would be, at least in my opinion, a vast 
improvement over the current system.
    In addition to hearing from advocates of various reform 
proposals, I am hopeful this session will allow for a give-and-
take between the witnesses which we have assembled before us. 
As one of our Subcommittee Members said to me upon entering the 
room and surveying the panel, wow, we have got some smart guys 
here to testify today.
    So, as long as we have you here, I hope there is some give-
and-take among the witnesses so that will help this 
Subcommittee better understand the extent of the differences 
that you have, differences of opinion that you have, and also 
the areas of common ground which you might share.
    In particular, I will be interested to learn more about the 
contention made by some of the witnesses that the differences 
between a consumption tax and the current corporate income tax 
are more a matter of form than substance, and that only a few 
changes to the current Tax Code would be necessary to make the 
corporate tax border-adjustable.
    As my colleagues know, in prior years, this Committee has 
held several hearings to better understand this and other 
issues related to fundamental tax reform. It is my hope that 
this session will build upon those inquiries. In particular, we 
will be interested in learning what effect these proposals will 
have on efforts to promote U.S. exports within the bounds of 
our international trade obligations.
    Before introducing the panel of excellent witnesses today, 
I will yield to my friend from New York for any comments he may 
wish to make.
    [The opening statement of Chairman McCrery follows:]
Opening Statement of the Hon. Jim McCrery, a Representative in Congress 
   from the State of Louisiana, and Chairman, Subcommittee on Select 
                            Revenue Measures
    Good afternoon and welcome.
    Today, the Subcommittee on Select Revenue Measures continues its 
examination of the issues surrounding the World Trade Organization's 
determination that the Extra-Territorial Income regime is an export 
subsidy inconsistent with our international trade obligations.
    As members of this Committee know, we are fast approaching the June 
17 date on which the WTO arbitration panel will determine the level of 
authorized sanctions which the European Union may impose to offset the 
impact of the subsidy provided by the ETI regime. The looming deadline 
makes it particularly important we handle the task before us with both 
speed and precision.
    I was heartened by recent news reports that the European Union 
understands the difficult challenges we face in untangling the ETI 
rules and is inclined to withhold imposing sanctions as long as we 
continue to make meaningful progress toward a legislative solution to 
this issue.
    Despite that positive development, it would be unwise for this 
Committee or the Congress to pause in our efforts to bring the tax code 
into compliance with our obligations under the WTO.
    One month ago, the Subcommittee held its first hearing on FSC/ETI. 
The consensus of all of the witnesses, including former Members of this 
Committee who helped draft those laws, was that the benefits of FSC 
cannot be replicated in a WTO-compliant manner. Simply put, if we are 
to avoid retaliation from Europe while continuing to help our exporters 
compete in the global marketplace, we must explore more far-reaching 
changes to the tax code.
    Today's hearing continues the search for answers by considering 
fundamental tax reform proposals.
    Fundamental tax reform proposals are generally variations of a 
consumption tax, such as a retail sales tax, a value added tax, or a 
flat tax. On one point, supporters of each are correct--any would be a 
vast improvement over the current system.
    In addition to hearing from advocates of various reform proposals, 
I am hopeful this session will allow for a give-and-take between the 
witnesses which will help better define the extent of their 
disagreements and the areas of common ground.
    In particular, I will be interested to learn more about the 
contention made by some of the witnesses that the differences between a 
consumption tax and the current corporate income tax are more a matter 
of form than substance and that only a few changes to the current code 
would be necessary to make the corporate tax border adjustable.
    As my colleagues know, in prior years, this Committee has held 
several hearings to better understand this and other issues related to 
fundamental tax reform. It is my hope this session will build upon 
those inquiries. In particular, we will be interested in learning what 
effect these proposals will have on our efforts to promote U.S. exports 
within the bounds of our international trade obligations.

                               

    Mr. McNULTY. I thank the Chairman for calling this very 
important hearing. I thank him for his understanding that I may 
have to leave to go to the Floor once or twice, because I am 
involved in one of the issues in the Defense Authorization bill 
which is currently on the Floor; and in the interest of time, I 
will just make a very brief opening statement and ask unanimous 
consent that my entire statement appear in the record.
    Chairman McCRERY. Without objection.
    Mr. McNULTY. Our hearing today will focus on whether 
fundamental corporate tax reform provides a viable option for 
replacing the ETI. I look forward to receiving the testimony of 
experts on proposals for a flat tax, a national retail sales 
tax, and various European-style value-added taxes.
    I am deeply grateful to each and every one of the panel 
Members for coming here today and sharing their very valuable 
time and expertise with the Members of the Committee.
    With that, I would like to get right to the panel, Mr. 
Chairman.
    [The opening statement of Mr. McNulty follows:]
  Opening Statement of the Hon. Michael McNulty, a Representative in 
                  Congress from the State of New York
    The Select Revenue Measures Subcommittee is holding its second in a 
series of hearings on replacement of the ``Extraterritorial Income'' 
(ETI) regime which the World Trade Organization (WTO) ruled to be a 
prohibited export subsidy.
    Our hearing focus today will be on whether ``fundamental corporate 
tax reform'' provides a viable option for replacing the ETI. I look 
forward to receiving the testimony of experts on proposals for a flat 
tax, a national retail sales tax, and various European-style value-
added taxes.
    For most of us the debate over fundamental corporate tax reform is 
a very familiar one. This Committee spent many hearing sessions 
exploring the issue as part of former Chairman Archer's unsuccessful 
search for a viable legislative reform proposal to bring to the 
Congress. Many others have introduced reform plans over the past 
decade, each proposal differing in form and advantages and 
disadvantages.
    Today, we are reviewing tax reform in the context of promoting U.S. 
exports. There is no question that the Administration must respond to 
the WTO ruling in a way that does not harm the overall competitiveness 
of American businesses in the global marketplace. However, it is 
unlikely that our future response can be found in a massive overhaul of 
our current corporate tax system. Fundamental tax reform is not 
something that can be done quickly. Also, the idea of fundamental 
reform often sounds very simple. It can be, in theory. Further insight 
will show that most proposal reforms are regressive, very complex to 
administer, and often create new openings for tax sheltering activities 
and tax evasion.
    I know that all the Subcommittee Members will want to join me 
looking beyond theoretical approaches and discuss realistic 
alternatives. I want to thank Committee Chairman McCrery for scheduling 
this important hearing.

                               

    Chairman McCRERY. Thank you, Mr. McNulty. With that, we 
will certainly turn right to the panel. Our first witness today 
is Mr. Eric Engen, who is a Resident Scholar with the American 
Enterprise Institute.
    Mr. Engen, your written testimony will be included in its 
entirety in the record, but we would like for you to orally 
summarize your testimony in about 5 minutes. Thank you for 
coming, and you may begin.

    STATEMENT OF ERIC M. ENGEN, RESIDENT SCHOLAR, AMERICAN 
                      ENTERPRISE INSTITUTE

    Mr. ENGEN. Thank you, Mr. Chairman and Members of the 
Subcommittee. It is a great privilege to have the opportunity 
to appear before you today. My testimony today provides some 
broad perspectives on reforms of the corporate tax system and 
international competitiveness.
    The ETI regime exists to help offset some of the 
efficiency-distorting and anti-competitiveness features of the 
U.S. corporate income tax. The WTO's decision on the ETI 
provides an opportunity to rethink the current U.S. corporate 
income tax structure and consider whether more fundamental tax 
reform would have an even greater positive effect than the ETI 
regime on the competitiveness of U.S. businesses.
    Economic growth and a higher standard of living in the 
United States are ultimately achieved by increasing the 
productivity of U.S. workers. Increased productivity requires 
savings and investment. It is greater savings and investment 
and productivity that give businesses improved capabilities to 
produce goods and services at the relatively lower costs that 
are demanded in foreign markets.
    Businesses must contend not only with making fundamental 
economic decisions, but also with how to deal with taxes. When 
compared to our primary economic competitors, such as countries 
in the Organization of Economic Cooperation and Development 
(OECD), the United States has a relatively high corporate 
income tax rate, and unlike most of these competitors, does not 
provide relief for the double taxation of corporate income.
    The U.S. corporate income tax rate is 35 percent, while the 
average corporate rate for OECD countries is about 30 percent. 
Moreover, the United States is one of only three of OECD 
countries that does not have provisions in the Tax Code for 
some relief from the double taxation of corporate dividends. 
Coupled with individual income tax rates, the overall marginal 
tax rate on distributed corporate income in the United States 
can easily be over 60 percent.
    High marginal rates discourage savings and investment in 
corporate capital and inhibit the competitiveness of U.S. 
companies in foreign markets.
    Some options for corporate income tax reforms are as 
follows:
    First, if the ETI is repealed, then the revenue gain from 
repeal of the ETI could be used to cut other components of the 
corporate income tax, such as reducing the corporate 
alternative minimum tax (AMT). While eliminating or reducing 
the AMT would be a laudable achievement, it still is only a 
step in addressing the problem of hefty corporate burdens for 
U.S. firms relative to their competitors, which initially led 
to the creation of the ETI.
    Second, more fundamental changes that would maintain the 
basic structure of the corporate income tax system would be to 
reduce the U.S. corporate tax rate commensurate with the tax 
rates of competitors and provide relief from the double 
taxation of dividends.
    Both of these changes would increase corporate investment 
and productivity in the United States and put the taxation of 
U.S. corporations more on a par with its primary economic 
competitors, thus increasing the competitiveness of U.S.-based 
firms and reducing the pressures for an ETI regime. Reducing 
the U.S. corporate income tax rate from 35 percent to 30 
percent, for example, would remove the difference in corporate 
tax rates between the United States and other OECD countries. 
Corporate tax rates in OECD countries have decreased, on 
average, about 11 percentage points over the past 15 years from 
about 41 percent to almost 30 percent.
    In a 1992 report, the U.S. Department of the Treasury 
recommended that dividend tax relief could best be implemented 
if a shareholder was allowed to exclude from growth income the 
dividends received from a corporation, which could be 
implemented with little structural change to the Tax Code.
    Both of these tax changes would likely reduce revenue 
collected by the Federal Government even if dynamic macro 
effects were accounted for.
    Some additional revenues should be raised, or spending 
reduced, in order to be budget-neutral. A good general 
principle for revenue-neutral tax reform is often to broaden 
the base and lower the rate. This principle suggests that some 
broadening of the corporate tax base should be considered; on 
the spending side, government subsidies to corporations could 
be analyzed.
    Third, a much more substantial tax reform would be to 
completely replace the corporate income tax with a national 
sales tax, or a VAT.
    Replacing the corporate income tax with a consumption tax 
would remove a large portion of the tax distortion on capital 
formation in the United States. Moreover, the sales tax or the 
VAT could be set to be revenue-neutral. However, the incidence 
of this tax reform would almost certainly be argued by 
opponents along the lines of it is a tax cut for rich 
corporations financed by tax hikes on poor consumers, and that 
argument may very well win the debate.
    An alternative that may be more viable would be to 
fundamentally change the entire tax system. Both the corporate 
income tax and the personal income tax could be replaced with a 
flat tax or with a variant of the flat tax, the X tax, that has 
been proposed by tax economist, David Bradford, of Princeton 
University. The X tax is a two-component system comprised of a 
business tax that would replace the corporate income tax and a 
compensation tax that would replace the individual tax. 
Businesses would pay tax on--a flat rate on a base consisting 
of the receipts from sales less outlays from purchases from 
other businesses. This part is similar to a VAT and essentially 
allows complete expensing of all investment.
    In addition, business deduct all payments to workers. 
Workers pay tax on the amount received from businesses, and 
then total compensation could be taxed with progressive rates, 
if desired, including allowing an earned income tax credit 
(EITC) for low-compensation taxpayers. No other income, such as 
the interest, dividends, rent, or capital gains is included in 
the compensation tax base; thus, normal returns to capital are 
not taxed at either the business or individual level.
    Although this approach goes well beyond what to do in the 
near term regarding the ETI regime, this type of fundamental 
tax reform, in my opinion, holds the most promise for 
ultimately making U.S. businesses more competitive by putting 
them in a tax environment that promotes savings and investment 
and that ultimately leads to higher productivity.
    However, one of the potentially toughest issues in 
fundamental tax reform is the transition from the old tax 
system to the new system. In particular, there is sort of a 
``free rider'' problem that would tend to rise. Whereas, a 
majority may agree that the new tax system would be a better 
overall system, many groups would want to keep their favorite 
tax preference from the old tax system. However, if most, or 
all, of these tax preferences in the old income tax system are 
incorporated into the new consumption-based tax system, then 
many of the advantages of tax reform become diluted.
    Thank you.
    [The prepared statement of Mr. Engen follows:]
   Statement of Eric M. Engen, Resident Scholar, American Enterprise 
                               Institute
Introduction

    Mr. Chairman and members of the subcommittee, it is a great 
privilege to have the opportunity to appear before you today. My name 
is Eric Engen. I am a resident scholar at the American Enterprise 
Institute in Washington, D.C. where my research focuses on the effects 
of tax and budget policy on the economy. My testimony provides some 
perspectives on reforms of the current corporate tax system and 
international competitiveness.1
---------------------------------------------------------------------------
    \1\ I am testifying on my own behalf and not as a representative of 
AEI.
---------------------------------------------------------------------------
    My principal conclusions are as follows:

         The competitiveness of U.S. firms in a global economy 
        is influenced most significantly by the level of taxation on 
        capital, especially relative to the tax burden imposed on firms 
        in other countries. In particular, higher marginal corporate 
        tax rates in the United States and the double taxation of 
        dividends puts U.S. firms at a tax disadvantage. The ETI regime 
        exists to try to offset some of this disadvantage.

         Simply repealing the ETI regime does not do anything 
        to address the reasons for implementing the ETI in the first 
        place.

         Reducing corporate income tax rates and integrating 
        the corporate income tax with the personal income tax so that 
        dividends are not taxed twice would significantly improve the 
        economic incentives for investment and make U.S. firms more 
        competitive. However, the corporate tax base should be 
        broadened, or other revenues raise, and/or spending should be 
        reduced so that these tax changes do not have negative 
        consequences for the federal budget.

         An alternative that would go even further to reduce 
        the tax distortions on capital formation, increase investment, 
        and boost U.S. competitiveness would be to fundamentally reform 
        the income tax system by replacing the corporate income tax, 
        and possibly the personal income tax also, with a consumption 
        tax. While this type of fundamental tax reform would likely 
        have the largest payoff, it would, however, be more difficult 
        to implement.
Background

    The extraterritorial income (ETI) regime exists to help offset some 
of the efficiency-distorting and anti-competitiveness features of the 
tax system for corporate income in the United States. The WTO's 
decision to rule that the ETI is a prohibited export subsidy, along 
with earlier adverse decisions regarding the foreign sales corporations 
(FSC) regime and domestic international sales corporations (DISCs), has 
led most international tax law experts to conclude that it does not 
appear possible to comply with WTO and replicate the tax benefits of 
the ETI statute. This situation provides an opportunity to rethink the 
current U.S. corporate income tax structure and consider whether more 
fundamental tax reform would have even greater positive effects than a 
FSC-ETI-like regime on the competitiveness of U.S. businesses in the 
global economy.
The Competitiveness of U.S. companies in a Global Economy

    The global economy is expanding rapidly. It is vital to the growth 
of the U.S. economy for U.S. businesses to be internationally 
competitive. Economic growth and a higher standard of living in the 
United States are ultimately achieved by increasing the productivity of 
U.S. workers. Increased productivity requires investment, which is 
funded by saving. Investment is comprised of both physical investment--
such as purchases of plant, machinery, and equipment--and investment in 
human capital--such as education and research. It is greater savings 
and investment and productivity that gives businesses improved 
capabilities to produce goods and services, at relatively lower costs, 
that are demanded in foreign markets.
    Businesses must not only contend with making fundamental economic 
decisions concerning what investments to make, how to finance those 
investments, what workers to hire, what products and services to 
produce, where to locate production and distribution, and what markets 
to enter, but also how to deal with taxes imposed on their activities. 
Tax revenue must be raised somehow by the government, but the goal 
should be to raise revenue in a manner that imposes the fewest and 
smallest distortions on fundamental economic behavior. Taxes that 
discourage saving and investment, distort the types of investments that 
are made, and that cause resources to be wasted on tax administration, 
compliance, and avoidance activities, reduce the rate of growth of the 
economy and living standards and hinder the international 
competitiveness of businesses if these tax burdens are greater than in 
other countries.
    When compared to our primary economic competitors, such as 
countries in the OECD, the United States has a relatively high 
corporate income tax rate and, unlike most of these competitors, does 
not provide relief for the double taxation of corporate 
income.2 The U.S. corporate income tax rate is 35 percent 
while the average corporate income tax rate for OECD member countries 
is about 30 percent.3 Moreover, the United States is one of 
only three OECD member countries that does not have provisions in its 
tax code for some relief from the double layer of taxation of corporate 
dividends.4 Coupled with individual income tax rates (which, 
after last year's tax cut, currently range from 27 to 38.6 percent for 
most shareholders), the overall marginal tax rate on distributed 
corporate income can easily be over 60 percent. Even if corporate 
earnings are retained but ultimately dispersed to shareholders through 
the redemption of stocks that give rise to capital gains, which are 
typically taxed at a 20 percent rate in the personal income tax, the 
tax bite on the return from investment in corporate capital is still 
quite sizable.
---------------------------------------------------------------------------
    \2\ Dividend payments are not deductible in the corporate income 
tax and thus are included in the taxable incomes of corporations. The 
second layer of taxation arises because dividends are also included in 
the taxable income of shareholders facing the personal income tax. 
(This second layer of taxes on dividends can be avoided only if the 
shareholder is tax-exempt, such as a non-profit organization, although 
personal tax payments are delayed until withdrawal if the dividends go 
to shares held in a tax-preferred retirement or insurance arrangement, 
such as a 401(k) or other pension plan, an IRA, or variable annuity.)
    \3\ For example, the corporate income tax rate is 25 percent in 
Germany, 27 percent in Canada, 28 percent in Sweden, and 30 percent in 
the U.K. and Japan. These figures are for 2001 and are from the 
American Council for Capital Formation, ``The Role of Federal Tax 
Policy and Regulatory Reform in Promoting Economic Recovery and Long-
Term Growth'' (November 2001).
    \4\ The Netherlands and Switzerland are the other two OECD 
countries that do not have some method for reducing the double taxation 
of corporate dividends. Most OECD countries relieve some of the double 
taxation of corporate dividends through a credit, exemption, or lower 
tax rate for dividend income in the personal income tax on 
shareholders.
---------------------------------------------------------------------------
    These features of the U.S. corporate income tax come at an economic 
cost. Most importantly, high marginal tax rates discourage saving and 
investing in corporate capital. Moreover, because dividends are not tax 
deductible while interest on debt is deductible, corporations are 
encouraged to finance their activities through debt or retained 
earnings and discouraged from distributing dividends.5 These 
distortions of corporate investment and financial policy reduce 
productivity and economic growth in the United States. Moreover, higher 
taxes in the United States on the returns to corporate capital also 
inhibit the competitiveness of U.S.-based companies in foreign markets. 
As financial markets become more global, U.S. investors may tend to be 
more willing to invest in foreign-based rather than U.S.-based 
companies. Mergers may be more likely to be set up as a foreign 
acquisition of a U.S. corporation. Transactions where a foreign 
subsidiary acquires a U.S.-based parent company may become more 
frequent. The high rates of taxation on the return from corporate 
investment can tend to make the United States a relatively unbecoming 
location for the headquarters of a multinational corporation, which 
can, in turn, cause U.S. multinationals share in the global market to 
shrink and the promotion of U.S. exports to decline.
---------------------------------------------------------------------------
    \5\ In the wake of the Enron debacle, renowned financial economist 
Jeremy Siegel, a professor in the Wharton Business School at the 
University of Pennsylvania, noted that it is the corporate tax codes 
discouragement of dividend payments that helped allow the 
misinformation about the financial position of Enron to be accepted by 
its shareholders. If shareholders expected companies to pay dividends 
then companies that were in financial trouble would be more easily 
identifiable because it is would be difficult for them to pay 
dividends. (``Dividends, Not Growth, Is Wave of Future,'' The Wall 
Street Journal, 08/21/2001.)
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Some Options for Corporate Income Tax Reform
Repeal the ETI and the AMT

    Following the WTO's adverse ruling, some people have suggested that 
the Congress should simply repeal the ETI regime and be done with the 
matter. It has been argued that the revenue gain from repeal of the ETI 
would help improve the federal deficit, and that repeal of the ETI 
regime would help show that the United States supports free trade 
principles. Others have proposed that the revenue gained from repeal of 
the ETI structure could be used to cut other components of the 
corporate income tax, such as reducing or phasing-out the corporate 
alternative minimum tax (AMT). While eliminating or reducing the AMT--
especially as many businesses are currently still trying to recover 
from the recent economic slowdown--would be a laudable achievement 
within the current framework of the corporate income tax system, it 
still is only a step in addressing the problem of hefty corporate tax 
burdens for U.S. firms relative to their competitors, and does not 
fully address the competitiveness issues for U.S. companies that 
initially led to the creation of the EGI and similar regimes.
Reduce Corporate Tax Rates and Remove the Double Taxation of Dividends

    A much more fundamental change that would address the U.S. 
corporate tax burden and competitiveness directly while still 
maintaining the basic structure of the current corporate tax system 
would involve: 1) reducing the U.S. corporate tax rate commensurate 
with the corporate tax rate(s) of U.S. competitors, and 2) provide 
relief from the double taxation of dividends. Both of these changes 
would increase corporate investment and productivity in the United 
States, and put the taxation of U.S. corporations more on par with its 
primary economic competitors, thus increasing the competitiveness of 
U.S.-based firms and reducing the pressures for an ETI-like regime that 
is viewed by the WTO and other countries as a corporate subsidy and a 
hindrance to free trade.
    Reducing the U.S. corporate income tax rate from 35 percent to 30 
percent, for example, would remove all or much of the difference in 
corporate rates between the United States and other OECD countries and 
increase U.S. investment and productivity. A decrease of this magnitude 
is not unprecedented. The Tax Reform Act of 1986 reduced the U.S. 
corporate income tax rate from 46 to 34 percent. Moreover, corporate 
tax rates in OECD countries have decreased, on average, about 11 
percentage points over the past 15 years--from about 41 percent to 
almost 30 percent.6 These reductions in corporate tax rates 
in other countries have increasingly tested the competitiveness of U.S. 
companies and will likely provide ongoing temptation for companies to 
headquarter outside of the United States.
---------------------------------------------------------------------------
    \6\ These figures are from the American Council for Capital 
Formation, ``The Role of Federal Tax Policy and Regulatory Reform in 
Promoting Economic Recovery and Long-Term Growth'' (November 2001).
---------------------------------------------------------------------------
    There are several different methods in which relief could be 
provided for the double taxation of corporate dividends in the United 
States. One would provide a shareholder credit for corporate taxes 
paid. When a corporate shareholder receives a taxable dividend, the 
shareholder would be entitled to a credit against their taxes for the 
corporate taxes effectively paid on the dividend income. Most countries 
that have tax relief for double taxation of dividends use a form of the 
shareholder credit. However, the Treasury Department advised against 
this approach in a 1992 report because of the complexity of actually 
implementing the shareholder credit.7 In its report, 
Treasury recommended instead that dividend tax relief could be better 
implemented if a shareholder was allowed to exclude from gross income 
the dividends received from a corporation. I concur with Treasury's 
assessment that this dividend exclusion framework is simpler than a 
shareholder credit, and could be implemented with little structural 
change to the tax code.8
---------------------------------------------------------------------------
    \7\ Department of the Treasury, ``Integration of the Individual and 
Corporate Tax Systems: Taxing Business Income Once'' (January 1992).
    \8\ Indeed, for about a decade prior to its repeal in the Tax 
Reform Act of 1986, taxpayers were permitted a limited exclusion of 
dividends from gross income in the personal income tax.
---------------------------------------------------------------------------
    Both of these tax changes would reduce revenue collected by the 
Federal Government. Because both lowering the corporate income tax rate 
and removing the double taxation of dividends would reduce the cost of 
capital to corporations and spur investment, which in turn would tend 
to increase GDP, the official score of the lost revenues from these 
changes would likely be greater than the actual revenue reduction. 
Nevertheless, some additional revenues would have to be raised, or 
spending reduced, in order for these corporate tax changes to be budget 
neutral. A good general principle for revenue-neutral tax reform is 
often ``broaden the base and lower the rate.'' Since a corporate tax 
rate reduction is what is being proposed here, then this principle 
would suggest that some broadening of the corporate tax base should be 
considered. On the spending side, government subsidies to corporations 
should probably be considered first but other spending should also be 
put up to scrutiny. Indeed, the degree to which the corporate tax rate 
can be reduced and the degree to which dividends can be excluded would 
seem to almost certainly depend on the willingness of the Congress to 
undertake some of these more unpopular measures.
Replace the Corporate Income Tax with a Consumption-Based Tax

    A much more substantial tax reform would be to completely replace 
the corporation income tax with a consumption tax such as a national 
sales tax or a value-added tax (VAT). A sales tax would be imposed and 
collected on sales to final, or end-use, consumers, and would likely be 
similar to the broad-based sales tax levied many state governments. The 
more likely method that would be used to implement a VAT would be a 
credit-invoice VAT. In a credit-invoice VAT, the tax is applied to 
gross sales by firms and credits for previously paid taxes on gross 
purchases are allowed. While probably more difficult to implement than 
the changes to the corporate income tax suggested above, replacing the 
corporate income tax with a consumption tax would remove a large 
portion of the distortionary tax burden on capital formation in the 
United States.9 The lower cost of capital would increase 
investment, improve productivity, and enhance the competitiveness of 
U.S. firms in foreign markets. Moreover, the sales tax rate or VAT rate 
could be set such that the revenue expected to be lost from the 
corporate income tax was made up by the revenue expected to be 
generated by the consumption tax.10
---------------------------------------------------------------------------
    \9\ I am assuming in this scenario that the individual income tax 
is unchanged and capital income is still taxed at the personal level.
    \10\ An official ``static'' score of this tax change would not 
account for the increase in GDP resulting from the higher investment 
and productivity that would stem from the lower tax burden on capital. 
If a static tax score was used then the consumption tax rate might be 
set higher than what actually ends up being necessary to generate the 
same revenue. If that ends up being the case, then consumption tax rate 
could be adjusted down after an increase in revenue becomes evident.
---------------------------------------------------------------------------
    Some have argued that the distributional impacts of this type of 
tax change would be a shift in the tax burden from corporations to 
consumers. However, this argument typically only reflects the 
statutory, or legal, incidence of the corporate tax and a consumption 
tax. From an economic perspective, an important principle is that only 
individuals ultimately bear the incidence of taxes. Moreover, all 
individuals are consumers, while at the same time, most individuals 
also are workers and/or capital owners. Furthermore, the economic 
incidence of the corporate income tax is still a contested issue in the 
economics profession. Although the corporate income tax has 
traditionally been thought to ultimately be born by capital owners, 
more recent analysis has suggested that labor may bear some of the 
corporate income tax burden or even more of the tax burden than capital 
owners. Thus, the actual distributional effects of switching from the 
corporate tax to a consumption tax would be much more complicated than 
this simple argument suggests and would depend importantly on the 
initial assumptions about the incidence of the corporate income tax. 
That said, the ``political incidence'' of this type of tax reform would 
almost certainly be argued by opponents of this type of reform along 
the lines of ``it is a tax cut for rich corporations financed by tax 
hikes on poor consumers,'' and that argument may very well win the 
political debate.
    An alternative to replacing just the corporate income tax with 
sales tax or VAT--that may be more politically viable--would be to 
fundamentally change the entire income tax system. Both the corporate 
income tax and the personal income tax could be replaced with a flat 
tax or with a variant of the flat tax, which I support, that has been 
proposed by well-known tax economist David Bradford of Princeton 
University.11 Bradford's proposal, which he calls the X tax, 
is a two-component system comprised of a business tax that would 
replace the corporate income tax and a compensation tax that would 
replace the individual income tax. All businesses pay tax at a flat 
rate on a base consisting of the receipt from all sales, including 
sales from inventories and sales of existing assets, less the outlays 
for purchases from other businesses. This part is similar to a VAT and 
essentially allows complete expensing for all investment. In addition, 
businesses deduct all payments to workers. Workers pay tax on the 
amount received from businesses. Total compensation can be taxed 
progressively, if desired, with an earned income credit for low-
compensation taxpayers, and successively higher rates starting at zero 
on higher levels of compensation. To avoid income shifting, the top 
rate of the compensation tax should be the same as the business tax 
rate. No other income, such as interest, dividends, rent, and capital 
gains, is include in the compensation tax base. Thus, normal returns to 
capital are not taxed at either the business or individual level. With 
regard to distributional concerns, the tax burden on workers is 
adjusted according to their earnings.12 Within the context 
of the international economy, it would still have to be determined 
whether the X tax would be a destination-based system or an origin-
based system in its treatment of cross-border transactions--there are 
pluses and minuses associated with either treatment.
---------------------------------------------------------------------------
    \11\ David Bradford, ``Untangling the Income Tax'' (1986) and 
``Blueprints for International Tax Reform'' (2001).
    \12\ This very brief thumbnail sketch of the X tax does not 
elaborate on many of the other problems in the existing tax system that 
this type of tax reform would address.
---------------------------------------------------------------------------
    Although this approach goes well beyond what to do in the near term 
regarding the ETI regime, this type of fundamental tax reform, in my 
opinion, holds the most promise for ultimately making U.S. businesses 
more competitive by putting them in a tax environment that promotes 
saving and investment and that ultimately leads to higher productivity. 
However, a tax reform of this magnitude would not be easy to enact, 
even if it is worthwhile. One of the potentially toughest issues in 
fundamental tax reform is the transition from the old tax system to the 
new tax system. In particular, there is a sort of free-rider problem 
that would tend to arise. Whereas a majority may agree that the new tax 
system would be a better overall system, many groups would want to keep 
their favorite tax preference from the old tax system. However, if most 
or all of those tax preferences in the old income tax system are then 
incorporated into the new consumption-based tax system then many of the 
advantages of the tax reform become diluted.

                               

    Chairman McCRERY. Thank you, Mr. Engen.
    Our next witness is Mr. Herman Cain, who has vast 
experience in the private sector as a chief executive officer 
and President of corporations; started a consulting business, 
among other things, in the private sector; and is here today as 
the spokesman for Americans for Fair Taxation, based in 
Atlanta, Georgia--or at least Mr. Cain is based in Atlanta, 
Georgia.
    Mr. CAIN. That is correct, Mr. Chairman.
    Chairman McCRERY. Thank you for coming today, Mr. Cain. 
Likewise, your full testimony will be entered in the record, 
and we would ask you to summarize it in about 5 minutes. You 
may proceed.

 STATEMENT OF HERMAN CAIN, CHAIRMAN, GODFATHER'S PIZZA, INC., 
 OMAHA, NEBRASKA; CHIEF EXECUTIVE OFFICE, T.H.E., INC., OMAHA, 
  NEBRASKA; AND MEMBER, AMERICANS FOR FAIR TAXATION, HOUSTON, 
                             TEXAS

    Mr. CAIN. Thank you, sir. Thank you very much, Mr. Chairman 
and Members of the Committee.
    Nothing would promote the competitiveness of U.S. 
businesses more than a growing national economy, and since my 
full testimony has been submitted and already incorporated into 
the record, there are three key compelling points that I would 
like to try to make with the Committee.
    First, our current Tax Code, which you have heard before, 
is an 8-million-word mess. It is beyond fundamental or any 
other kind of reform. The message that I would like to leave on 
behalf of not only Americans for Fair Taxation, but the many 
Americans that I talk with throughout my travels is that we 
should replace the current Tax Code, not try and reform it. 
That is point number one, to replace it.
    I won't belabor all of the things that are wrong with the 
current Income Tax Code, but simply leave you with a message, 
which I hope will resonate, and that is, we need to be talking 
about replacement, because that would resolve all of the border 
adjustability issues, as well as being able to unleash the full 
potential of the economic platform in this country.
    The second key point I would like to impress upon you, 
there is analogous to an old southern saying, ``Don't shoot the 
dog before the hunt is over.'' The hunt is for a replacement 
system.
    It is real easy for people to find every reason why we 
should do something. It is real easy for people to identify all 
of the reasons why a bold move, such as replacing the current 
system, is too big of a task to take on; and my point, that I 
want to impress upon you, is, let's not shoot the dog.
    If we were able to put a man on the moon, we can find 
transition rules to move us from an archaic system to a system 
that would unleash the maximum potential of this economy, and 
also release the potential for every American to pursue their 
definition of the American dream.
    When President John F. Kennedy said, We will walk on the 
moon by the end of the decade of the sixties, he didn't say 
``maybe.'' He didn't say, It's a good idea. He said, ``We 
will,'' and that determination and leadership is what caused 
the entire country to figure out the steps and the solutions 
that would get us there.
    We need that same type of resolve in order to be able to 
replace the current income tax structure with the fair tax, 
which is a national sales consumption tax.
    The third point that I would like to leave with you is 
something that is very disturbing to me personally as a citizen 
of this country. Many Americans simply do not believe that we 
will replace the system. They do not believe we can fix this 
mess. They have simply given up on Congress' ability--not all, 
but some Members' ability--to address the real solution, which 
is to install a brand-new system.
    This is about reinvigorating the belief that our Founding 
Fathers had. When I tell people that I believe that the fair 
tax, which is a national sales consumption tax, is the best way 
to go at this point in terms of eliminating all of the problems 
that you are dealing with, even with respect to the 
Subcommittee, they say they don't believe it can be done. I 
simply remind them, where would we be today if George 
Washington and our Founding Fathers didn't believe that we 
could defeat the British? We simply wouldn't be here.
    So, in summary, we must replace the current structure with 
the fair tax; number two, let us not shoot the dog before the 
hunt is over, we can work out all of the issues relative to how 
we get there; and number three, let us restore believability on 
the part of the American people.
    Thank you very much.
    [The prepared statement of Mr. Cain follows:]
  Statement of Herman Cain, Chairman, Godfather's Pizza, Inc., Omaha, 
 Nebraska; Chief Executive Officer, T.H.E., Inc., Omaha, Nebraska; and 
          Member, Americans for Fair Taxation, Houston, Texas

    Thank you Mr. Chairman and members of the committee. I am Herman 
Cain, Chairman of Godfather's Pizza, Inc., a chain of 600 small 
businesses, Chief Executive Officer of T.H.E., Inc., a leadership 
consulting company, and, I am a member of and speaking on behalf of 
Americans For Fair Taxation. I appreciate the opportunity to testify 
before your committee on ``promoting the global competitiveness of U.S. 
businesses in the global market place.''
    There are two basic issues for multinational corporations in the 
global market place. First, they are at a competitive disadvantage due 
to the imbedded costs of taxes on corporate profits, and taxes on 
payroll for domestically produced products. Secondly, the variations in 
tax law from country to country create many complex and costly 
inconsistencies. In fact, the extremely high cost of compliance may 
actually exceed the amount of taxes paid. The net result is that 
billions of dollars of foreign profits by U.S. businesses are stranded 
overseas, which cannot be economically repatriated to benefit our 
domestic economy. The solution is not more laws, more regulations, or 
even more tax treaties with more countries. The solution is a new tax 
system, which would eliminate these issues.
    The current income tax system cannot be reformed. It creates 
disadvantages for multinational businesses, domestic businesses, 
individuals, and our government. No amount of tinkering with a portion 
of the tax code is going to fix it. It is too complicated. It inflates 
the costs of U.S. goods and services to other nations. It is too unfair 
and inefficient. It discourages people from working harder to achieve 
upward economic mobility, which destroys hope and opportunity. The 
current tax system needs to be replaced. It can be replaced with The 
FairTax (H.R. 2525), which was reintroduced in the House in 2001 by 
Congressmen John Linder of Georgia, and Colin Peterson of Minnesota.
    Several commissions over the last 20 years, including the one I 
served on in 1995 (The National Commission on Economic Growth and Tax 
Reform), have all concluded that a replacement tax system should 
satisfy six principles. First, it should promote economic growth by 
reducing marginal tax rates and eliminating the tax bias against 
savings and investments. Second, it should promote fairness by having 
one tax rate and eliminating all loopholes, preferences and special 
deductions, credits and exclusions. Third, it should be simple and 
understandable. Simplicity would dramatically reduce compliance costs 
and allow people to truly comprehend their actual tax burden. Fourth, 
it should be neutral rather than allowing misguided officials to 
manipulate and micromanage our economy by favoring some at the expense 
of others. Fifth, it should be visible so it clearly conveys the true 
cost of government and so people would not be subjected to hidden 
changes in the tax law. Sixth, it should be stable rather than changing 
every year or two so people can better plan their businesses and their 
lives. Before expanding on each principle, consider the compelling 
advantages of replacing the current income tax code with The FairTax.

         Gross Domestic Product (GDP) would increase 10.5% in 
        the first year and level off in succeeding years at 
        approximately 5% annually. (Dr. Dale Jorgensen of Harvard 
        University)
         Consumer prices would decrease 20 to 30 percent by 
        eliminating the nearly 250 billion dollars in annual compliance 
        costs, and eliminating the taxes on corporate profits and labor 
        (payroll taxes), which are imbedded in what we pay for goods 
        and services. (Dr. Dale Jorgensen and other economists)
         A single national sales tax rate on all new goods and 
        services of approximately 24% (to be revenue-neutral) would 
        replace the 1.7 trillion dollars of taxes on income.
         Annual uncollected taxes of 210 billion dollars (IRS 
        estimates) would not escape The FairTax. This amount grows by 
        12 billion dollars each year.
         Taxes of 35 billion dollars on expenditures by non-
        residents would be collected.
         Taxes from the ``underground'' economy would be a 
        bonus to the federal treasury.
         Imported goods would be treated the same as 
        domestically produced goods. This means U.S. businesses would 
        be much less likely to locate their plants overseas.
         All taxpayers would have an equal voice, not just 
        people who can afford tax lobbyists and skilled tax 
        accountants.
         No taxes on the ``poor'' because basic necessities, 
        as defined by the Department of Health and Human Services, 
        would not be taxed by utilizing a rebate.
         No taxes on earnings from a second job for someone 
        who is trying to ``get ahead.''
         No taxes on education.
         More time for Government to focus on national and 
        international issues.

    These advantages of a national sales tax on consumption have been 
well researched, analyzed and documented by some of the most respected 
business people, economists, and academicians in the country. Hundreds 
of thousands of citizens are now actively supporting a change from an 
income tax to a national sales tax on consumption. We are now seeking 
the political leadership and courage to make the greatest country in 
the world even greater.
The FairTax (NST) would encourage Economic Growth

    The FairTax would significantly enhance economic performance by 
improving the incentives for work and entrepreneurial activity and by 
raising the marginal return on savings and investments. Entrepreneurs 
and small business owners would be given greater access to capital, the 
life-blood of a free economy. Investments would rise, the capital stock 
would grow, productivity would increase and the output of goods and 
services would expand. The economy would create more and better paying 
jobs for American workers and take-home pay would increase 
considerably.
    Although the magnitude of the economic growth generated by a single 
rate, neutral tax system causes lively debate among economists, 
virtually all agree that the large marginal tax rate reductions with a 
national sales tax combined with neutral taxation of savings and 
investments, would have a powerful positive effect on the economy.
    For example, Dr. Dale Jorgensen of Harvard University conducted a 
research analysis (1997), which showed that a national sales tax would 
produce a 10.5% increase in Gross Domestic Product, a 76% increase in 
real investments, and a 26% increase in exports in the first year of a 
national sales tax enactment. Those increases would level off at 5%, 
15%, and 13% respectively over the succeeding twenty-five years. 
Nothing promotes the competitiveness of U.S. businesses more than 
growth in our national economy, more dollars to grow our businesses, 
and a level playing field for selling our products and services to 
other nations.
The FairTax would be Fair, untax the ``Poor,'' and untax Education

    The FairTax would provide every household in America with a rebate 
of sales tax paid on necessities. Thus, The FairTax is progressive and 
every family is protected from tax on essential goods and services. 
Because of the planned rebate, those below the poverty line would have 
a negative effective tax rate and lower middle-income families would 
enjoy low effective tax rates.
    The responsibility of paying taxes to fund our way of life would be 
fairly distributed. It would, in fact, be much more fairly distributed 
than the income tax. Wealthy people spend more money than other 
individuals. The FairTax will tax them on their purchases and as a 
result, the wealthy pay more in taxes. If, however, they use their 
money to invest in job creating businesses, or to finance research and 
development to create new products, (all of which help improve the 
standard of living of others), those activities would not be taxed. The 
FairTax is premised on the notion that it is fairer to tax individuals 
when they consume for themselves above the essentials of life, rather 
than when they invest in others or contribute to society.
    The FairTax would in effect give a supercharged charitable 
contribution deduction because people would be able to give to their 
favorite charity free of any income tax, payroll tax or sales tax. The 
charitable deduction today allows people to make their contributions 
with pre income tax dollars, but after payroll tax dollars. For the 
three-quarters of Americans who do not itemize, most must today earn 
$155 to give $100 to their favorite charity or to their place of 
worship.1 Under The FairTax, they must earn only $100 to 
give $100, since under The FairTax what you earn is what you keep and 
charitable contributions are not taxed.
---------------------------------------------------------------------------
    \1\ $155.40 less 7.65 percent in employee Social Security ($11.89) 
and Medicare payroll taxes less 28 percent in federal income taxes 
($43.51) leaves $10,000.
---------------------------------------------------------------------------
    Education is one of the keys (along with savings and hard work) to 
an improved standard of living. That certainly was true in my case. I 
was the first person in my family to attend and graduate from college. 
It took a lot of hard work, and a lot of sacrifice by my parents. The 
FairTax is education friendly and is dramatically more supportive of 
education than current law. The FairTax embodies the principle that 
investments in people (human capital) and investments in things 
(physical capital) should be treated comparably. The current tax 
system, in stark contrast, treats educational expenditures very 
unfavorably.
    Education is the best means for the vast majority of people to 
improve their economic position. It is the most reliable means people 
have to invest in themselves and improve their earning potential. Yet 
the tax system today punishes people who invest in education, virtually 
doubling its cost. Only a national sales tax on consumption would 
remove this impediment to upward mobility. No other tax plan would do 
so.2
---------------------------------------------------------------------------
    \2\ Neither the flat tax nor the USA Tax would remedy the current 
bias against education.
---------------------------------------------------------------------------
    Today, to pay $10,000 in college or private school tuition, a 
typical middle-class American must earn $15,540 based only on federal 
income taxes and the employee payroll tax.3 The amount one 
must earn to pay the $10,000 is really more like $20,120 once employer 
and state income taxes are taken into account.4
---------------------------------------------------------------------------
    \3\ $15,540 less 7.65 percent in employee Social Security ($1,189) 
and Medicare payroll taxes less 28 percent in federal income taxes 
($4,351) leaves $10,000.
    \4\ Economists generally agree that the employer share of payroll 
taxes is borne by the employee in the form of lower wages. This figure 
assumes that employees bear the burden of the employer payroll tax and 
that they are in a seven percent state and local income tax bracket. 
$20,120 less $5,634 in income tax (28 percent), $3,079 in payroll taxes 
(15.3 percent) and $1,408 in state and local income taxes (7 percent 
leaves $10,000.
---------------------------------------------------------------------------
    The FairTax would not tax education expenditures. Education would 
be paid for with pre-tax dollars. This is the equivalent of making 
educational expenses deductible against both the income tax and payroll 
taxes today. Thus, a family would need to earn $10,000 to pay $10,000 
in tuition, making education much more affordable (not considering 
state income taxes on education). The FairTax would make education 
about half as expensive to American families compared to today.
    The FairTax would improve upward mobility but no longer punish 
work, savings, investments or education. It would better enable people 
to improve their lives. It would no longer hold people back.
The FairTax would be Simple

    The FairTax is a simple tax. Individuals who are not in business 
would have absolutely no compliance burden, nor would they be subject 
to the discretionary interpretation of the current convoluted tax code. 
As for businesses, it puts many fewer administrative burdens on 
businesses. In fact, filling out The FairTax tax return is comparable 
to filling out line one (gross revenue) of an income tax return. There 
would be no more alternative minimum tax, no more depreciation 
schedules, no more complex employee benefit rules, no more complex 
qualified account and pension rules, no more complex income sourcing 
and expense allocation rules, no more foreign tax credit, no more 
complex rules governing corporate acquisitions, divisions and other 
reorganizations, no more uniform capitalization requirements, no more 
complex tax inventory accounting rules, no more income and payroll tax 
withholding and the list goes on. Businesses would simply need to keep 
track of how much they sold to consumers.
    Compliance costs would, therefore, fall under The FairTax. Today, 
according to the Tax Foundation, we spend about $250 billion each year 
filling out forms, hiring tax lawyers, accountants, benefits 
consultants, collecting information needed only for tax purposes and 
the like. These unnecessary costs amount to about $850 for every man, 
woman and child in America. To the extent these costs are incurred by 
businesses, they must be recovered and consequently are embedded in the 
cost of everything we buy. The money we spend on unnecessary compliance 
costs is money we might as well burn for all of the good it does us. 
The Tax Foundation has estimated that compliance costs would drop by 
about 90 percent under a national sales tax.
The FairTax would be Neutral

    Under The FairTax, all consumption would be treated equally. The 
tax code punishes those who save and rewards consumption. Under The 
FairTax, no longer would the tax system be in the business of picking 
winners and losers. The tax code would be neutral in the choice between 
savings and consumption, neutral between types of savings and 
investments and neutral between types of consumption.
The FairTax would be Visible

    The FairTax is highly visible, because there would be only one tax 
rate Congress could modify on all taxpayers at the same time. Moreover, 
all citizens would be subject to any tax increases, not just a targeted 
few. It would be much harder for Congress to adopt the typical divide-
and-conquer, hide-and-disguise tax increase strategy it uses today. The 
FairTax would explicitly state the contribution to the Federal 
Government each and every time a good or service is purchased.
The FairTax would be Stable

    The FairTax would be more stable than the present system for two 
reasons. First, because it is so simple and transparent, it would not 
invite tinkering in the way that the current system with its thousands 
of pages of code and regulations does. People would resist attempts to 
make it more complex and attempts to favor special interests because 
they would understand what is going on. Second, taxing consumption is a 
more stable source of revenue than taxing income. There are fewer 
fluctuations in the consumption base than in the income base.
    A recent study showed that for the years 1959 to 1995, a national 
sales tax base was less variable than the income tax base. Why? When 
times are unusually good, people will usually save a little more. 
People tend to smooth out their consumption over their lifetime. They 
borrow when young, save in middle age and spend more than their income 
in retirement.
Impact on Businesses

    Businesses would utilize a zero corporate tax rate to create new 
jobs, grow their businesses, and be more competitive in the global 
market place. Their shareholders would not be taxed on dividends 
received from the corporation, or taxed on capital gains made on their 
investment in the business. This would stimulate business investments, 
creating more opportunities for working Americans. Compliance costs 
would be lower. Moreover, over time, most states would make their sales 
taxes conform to the federal sales tax, reducing the costs of complying 
with multiple rules in each state and political subdivisions.
    If people were willing and able to purchase more goods and services 
in a healthy economy, they would spend more money at retailers. 
Spending and shopping is no longer a luxury activity, it is a part of 
our way of life. There is nothing that hurts businesses more than a 
slow economy and nothing that helps them more than a good economy. In 
this sense, The FairTax would help all businesses.
    Currently, consumption purchases must be made with after-income-tax 
and after-payroll-tax dollars. The primary difference between a sales 
tax and an income tax is that the income tax doubles, triples or 
sometimes quadruples taxes on savings. Consumers would see their 
paychecks increase by nearly two trillion dollars. Since The FairTax is 
not a tax increase but is revenue neutral, the repeal of the income and 
payroll taxes, plus the decrease in consumer prices would provide 
consumers with the money necessary to pay for The FairTax.
    Instead of having to comply with the complexities of the income 
tax, payroll tax, and various excise taxes, there would be one sales 
tax on all goods and services. Period. Retail businesses would simply 
need to calculate on a monthly basis its total retail sales. Retailers 
would receive an administrative fee (\1/4\ of one percent) for 
collecting the sales tax.
    In summary, The FairTax would be a ``win, win, win'' for 
businesses, citizens, and government. Just consider the compelling 
nature of the advantages discussed earlier.
    I realize that there are political and public hurdles to making 
such a change to how we fund our government. In fact, many people 
simply don't believe that it can happen. They have given up on our 
government's ability to do what is in the best interest of its people 
and our Nation. To those people I ask, where would we be today if 
George Washington and the founding fathers had given up the fight to 
become an independent nation? We owe it to them, to ourselves, and most 
importantly to our children to correct a system that has gotten out of 
control.
Conclusion

    People want to be able to dream and to pursue their dreams. People 
want the liberties for which our founding fathers fought and DIED. 
People want to pay their fair share to keep this Country safe and 
great. As Dr. Benjamin E. Mays, late President Emeritus of Morehouse 
College said, ``It isn't a calamity to die with dreams unfulfilled, but 
it is a calamity to have no dreams.'' The current tax system not only 
destroys the ability of people to dream and make their dreams real, it 
causes too many people to just give up.
    We need The FairTax--a tax system more appropriate for a free 
society. The current tax code CANNOT BE REFORMED to achieve the stated 
objectives. It MUST BE REPLACED. Please use the power of the Congress 
to replace our current income tax code.
                               

    Chairman McCRERY. Thank you, Mr. Cain.
    Our next witness is an old friend who has been kind enough 
to show me through a few tax problems, tax issues, over the 
past dozen years or so, 20 years maybe. He has been around a 
while, and I have a lot of respect for his knowledge of the Tax 
Code. I don't blame him for all of it, but some of it.
    Mr. Christian, you probably should share the blame for it. 
So I will be interested to hear your comments about how we fix 
it.
    Mr. Christian is the Chief Counsel for the Center for 
Strategic Tax Reform. Ernie, it is nice to have you with us, 
and you may proceed.

  STATEMENT OF ERNEST S. CHRISTIAN, CHIEF COUNSEL, CENTER FOR 
                      STRATEGIC TAX REFORM

    Mr. CHRISTIAN. Thank you, Mr. Chairman. I assure you, I 
have repented, and I am now on the side of good.
    Chairman McCRERY. Thank you.
    Mr. CHRISTIAN. There is another old southern expression 
that I would submit to my friend, Herman Cain, and that is, 
``Let's not get the cart before the horse.''
    Everyone wants an internationally competitive tax system 
for the United States of America. We need it.
    That laudable goal is readily attainable without adopting 
some radical or experimental new tax system, I respectfully 
submit. With only two simple amendments, we can convert our 
existing corporate income tax into what, under WTO, is called 
an ``indirect tax.'' Devices such as FSC and ETI would then be 
unnecessary. In a WTO-legal way, we could then fully exclude 
U.S. export income from U.S. tax, as we ought to do as a matter 
of policy. That would provide U.S. manufacturers with the 
option of staying home while exporting American-made products 
to markets all around the world.
    Having done that, we could then take the next important 
step. We could adopt a territorial tax system that would allow 
American companies a fair opportunity to directly compete in 
those foreign markets that cannot be fully served by exports 
from America alone.
    Under WTO, a tax with a tax base equal to value added is an 
indirect tax, but value added, Mr. Chairman and Members of the 
Committee, is an accounting concept similar to net income which 
is the base of our current corporate income tax. Value added as 
a measurement device has nothing whatsoever to do with taxing 
consumers or a sales tax or any of the other kinds of things 
often associated with a VAT.
    To convert our corporate net income tax base into a 
corporate value-added tax base, we need to make the interest 
that corporations pay to their debt holders nondeductible, the 
same way that dividends paid to equity shareholders are under 
the current Tax Code already nondeductible. Not deducting 
interest is not the big deal it might appear. The corporate tax 
rate would be only 8 to 10 percent after the base is broadened 
to include full value added, which is an extension of net 
income.
    A Treasury Department study in 1992 by Glenn Hubbard, who 
is presently the Chairman of the President's Council of 
Economic Advisers, and my good friend and former Treasury 
Department colleague, Michael Graetz, sitting to my left, who 
is a distinguished professor at Yale, pointed out the negative 
impact on economic growth that results under present law from 
treating debt capital more favorably than equity capital.
    They recommended a comprehensive business income tax in 
1992, CBIT as it was called. It allowed no deduction for 
interest. It equalized the treatment of debt and equity. It is, 
in fact, the baseline from which we will proceed.
    The second amendment is to make wages nondeductible against 
the 8- to 10-percent corporate tax rate. Before you recoil in 
horror, remember that employers already pay a 7.65-percent 
employer payroll tax on wages up to $84,900 per year per 
employee, the familiar employer FICA tax, Federal Insurance 
Contributions Act. Thus, wages are already nondeductible under 
present law against a rate which is almost as high as the 8- to 
10-percent corporate rate that we are projecting in this 
proposal.
    In order to avoid double taxation in the wage area, 
employers would be allowed a credit against the corporate tax 
for the payroll tax they pay on the same wages. No messing with 
Social Security whatsoever. Thus, in reality, there would be no 
major change in the deductibility versus nondeductibility of 
wages except in the case of the highest paid employees, and 
even in their case, not very much.
    I am not suggesting, Mr. Chairman, that our friends in 
Brussels will automatically roll over and immediately accept 
without argument that America's revised corporate tax is an 
indirect tax under WTO. They won't. They will wiggle and they 
will squirm. They may even litigate, but I respectfully submit, 
Mr. Chairman, that they will have a devil of a time saying with 
any credibility that our tax, which has the same base as their 
tax, does not qualify simply because we do not engage in the 
rhetorical charade about VATs.
    The Congress, in my opinion, has a golden opportunity 
before it to act on a bipartisan basis to provide the solution 
to some longstanding problems. I hope that you and the other 
Members of Congress will take advantage of that opportunity.
    Thank you very much.
    [The prepared statement of Mr. Christian follows:]
 Statement of Ernest S. Christian, Chief Counsel, Center for Strategic 
                               Tax Reform
    Mr. Chairman and Members of the Committee. I am honored to appear 
before you today to talk about WTO-legal ways of making American 
companies and their employees more competitive in world trade.
    Some people think that the answer may be provided by the so-called 
subtraction-method value added tax. In reality, however, the 
subtraction method VAT is largely a mirage that exists primarily in the 
imaginations of some academics. The tax they so describe is, in 
substance, identical to a slightly amended version of our present 
corporate income tax that takes into account the existence of the 
employer payroll tax (the FICA tax as it is often called).
    Therefore, let us set aside the VAT syndrome and the political 
baggage that goes with it. We can then concentrate on the few changes 
in the current corporate income tax that are necessary for it to 
qualify as an ``indirect tax'' under WTO rules.
    Once we have qualified our corporate tax as an ``indirect tax'', we 
can then exclude export income from U.S. tax. Once we have excluded 
export income from tax, we can then adopt a truly territorial tax 
system that will allow U.S. companies to invest and compete directly in 
foreign markets. Devices such as FSC and ETI are unnecessary.
    There is no need to resort to some new and radical tax system. 
Indirect tax status is imminently obtainable within the framework of 
current law and within the framework of American tax traditions.
    An ``indirect tax'' under WTO rules has a base equal to value 
added. To most people, the most familiar form is the European-style VAT 
structured to resemble a sales tax, but there are other forms of taxes 
on value added that bear no resemblance whatsoever to a sales tax and 
have nothing whatsoever to do with taxing consumers.
    Value added is a concept similar to net income--as explained in the 
Appendix to my testimony.
    Only two amendments are necessary to convert our existing corporate 
tax on net income into a tax on value added. Each such amendment is 
meritorious on its own and neither is shocking.
    The first amendment is to make the interest that a corporation pays 
to its debtholders nondeductible in the same way that the dividends it 
pays to its equity shareholders are presently nondeductible. As a 
result, all the income from both debt and equity capital would be 
included in the corporation's tax base.
    After having included in the tax base the income from capital, the 
other step necessary to complete the value added base would be to 
include the income from labor. The measure of this income is the amount 
of wages paid to the corporation's employees--just as the amount of 
income from capital is the amount of interest and dividends paid by the 
corporation.
    Under the present corporate income tax, wages are, in form, 
deductible and, therefore, in form, are not included in the 
corporation's tax base, but, in reality, under current law, the 
corporation must pay a 7.65 percent FICA payroll tax on the first 
$84,900 of each employee's wages. Thus, under current law, wages up to 
$84,900 are already included in the corporate tax base--except at a 
7.65 percent tax rate instead of the 35 percent tax rate that applies 
to the rest of the corporate tax base.
    The obvious solution is to broaden the corporate income tax base by 
allowing no deductions for interest, dividends or wages--and, with that 
broad tax base, lower the corporate tax rate to the range of 8 to 12 
percent on a revenue-neutral basis. In order not to double tax the wage 
component of the new tax base, corporations would be allowed a credit 
for the employer payroll tax or corporations would be allowed to deduct 
wages up to $84,900 per employee with only the excess for highly paid 
employees being nondeductible.
    There are various ways of ``integrating'' the existing corporate 
income and payroll taxes in order to have a base equal to value added 
and, therefore, to have the same base as an indirect tax under WTO 
rules. None of these increases the tax burden on the labor component of 
GDP except in the case of the highest paid employees and, even in their 
case, not by very much.
    This is not pie-in-the-sky stuff. Its pedigree is impeccable. The 
starting point is the Comprehensive Business Income Tax (CBIT) proposal 
made in 1992 by the Treasury Department after years of 
study.1 The study was primarily authored by the Honorable R. 
Glenn Hubbard, presently Chairman of the President's Council of 
Economic Advisors, and Professor Michael J. Graetz of Yale University, 
both of whom were Deputy Assistant Secretaries of the Treasury at the 
time. The 1992 Treasury study suggested that (1) interest be made 
nondeductible like dividends and (2) that all businesses, whether or 
not incorporated, be subject to a uniform business tax which involved a 
half dozen or so amendments to the then current corporate income tax. 
The Treasury made this recommendation after concluding that allowing a 
deduction for interest, but not dividends, and taxing incorporated 
businesses differently from unincorporated businesses, had a 
significant negative effect on GDP growth.
---------------------------------------------------------------------------
    \1\ Department of the Treasury, Integratin of the Individual and 
Corporate Tax Systems--Tax Business Income Once (Washington, DC: GPO, 
1992). Because the CBIT proposal would have maintained a higher rate of 
tax--about 31 percent on corporations--it recommended that the 
nondeductibility of interest be phase in over a period of time. DBIT 
would also have excluded interest and dividends at the personal level.
---------------------------------------------------------------------------
    Other amendments that would normally be included in converting the 
corporate income tax into a more comprehensive tax with a base equal to 
value added are (1) cash accounting for inventory and (2) full first-
year expensing of capital equipment, but neither of these are 
necessary.2
---------------------------------------------------------------------------
    \2\ Some kind of border tax adjustment for imports could also be 
added--such as if a company sought to move a plant abroad and sell back 
into the United States--but that is not a necessary component and is 
outside the scope of the present inquiry.
---------------------------------------------------------------------------
    Only the two simple amendments already described are necessary to 
achieve ``indirect tax'' status and the ability to solve the FSC/ETI 
problems and much more.
    This Committee and this Congress have before them a huge bipartisan 
opportunity to serve the national interest. You can enact a few simple 
amendments that will then open the door to all kinds of opportunities 
for enhanced world trade, more and better paying manufacturing jobs in 
America, and overall higher standards of living for Americans.
    Instead of penalizing exports and, therefore, driving offshore 
American companies that would rather stay home, we can exclude exports 
from tax and make the United States of America a prime location for 
manufacturing and selling to markets around the world. The U.S. would 
be an especially desirable location if we also amended the code to 
allow full first-year expensing such as proposed by Congressman Philip 
English and Congressman Richard Neal in their recent High Productivity 
Investment Act (H.R. 2485).
    Instead of making it hard for American companies to directly 
compete in foreign markets that cannot be fully served by exports at 
the outset, we could adopt a territorial system that would give them an 
even chance. Moreover, when U.S. companies do succeed in a foreign 
market, we could stop penalizing them if they bring their money home 
for reinvestment in the American economy. (Present law gives them a tax 
break if they keep the money abroad invested in someone else's 
economy.) We could also stop favoring large companies (who can afford 
to keep the money abroad) over small companies who need to bring the 
cash home and, who, therefore, must pay the tax penalty imposed by 
current law.
    The need to cure these and many other fundamental defects in 
America's international tax rules is a long-standing bipartisan point 
of view. Moreover, it is in the joint and mutual interest of all 
companies and all employees for America to be the location of choice 
for companies--foreign and domestic--engaged in world trade.
    In the past, the barrier to action was the mistaken belief that in 
order to do so, America would have to take some drastic step such as 
repealing the income tax and replacing it with some kind of sales tax.
    Today, we know better. Only a few straightforward amendments to the 
income tax are necessary.
    The time for bipartisan action is now. The need is great. The 
opportunity is here.

                               __________

                         Appendix to Testimony

     A Step-By-Step Guide: How To Convert The Corporate Income Tax
      Into An Indirect Tax under WTO and Thereby Solve the FSC/ETI
                         Dilemma and Much More
Preamble: Why Do It

    FSC/ETI and/or an outright exclusion of export income would be 
legal under WTO rules if the existing corporate income tax (or an 
amended version thereof) were classified as an ``indirect'' tax. So-
called ``inversions'' and other devices by which U.S. companies flee to 
foreign locations would also be eliminated. Indeed, the United States 
of America would become the location of choice for both U.S.-owned and 
foreign-owned companies engaged in world trade.
What Is An Indirect Tax

    A tax with a base equal to value added is classified as an indirect 
tax. The most familiar form is the European-style VAT which is 
structured to resemble a sales tax, but there are other forms of taxes 
on value added that bear no resemblance whatsoever to a sales tax. 
Indeed, as will be seen later, when the existing corporate income tax 
and the existing employer payroll tax are considered together, their 
consolidated tax base is almost exactly equal to value added.
    Thus, it is not only the VAT-type sales tax that can have a value 
added base and, thereby, can gain the advantages that accrue under the 
WTO to taxes classified as ``indirect''.
    A modified version of the existing corporate income tax can also 
gain those advantages for the United States.
The Concepts of Value Added and Income Are Similar

    Like the corporate income tax, a tax on value added is imposed on 
businesses, not on individuals. Compared to the corporate income tax, 
the essential difference is in the tax base. In its most simple form 
(before adjustment for exports and imports), a business's value added 
tax base is equal to its gross income.
    Example: During the year, Black Corps. has gross income of $100X 
from the production and sale of widgets. Its value added tax base is 
$100X.
    This simple form of gross receipts tax would work just fine if all 
goods and services were produced and sold by one gigantic company, but, 
in reality, the total value of goods and services in the economy is 
added in bits and pieces by a large number of companies.
    Note: The fundamental flaw with any gross receipts tax is the 
obvious pyramiding of tax that occurs when more than one company is 
involved in producing a particular product or service. For example, if, 
in order to produce and sell $100X of widgets, Black Corps. had bought 
widget parts and components from White Corps. for $30X, the combined 
tax base of the two companies would be $130X even though only $100X of 
final product had been produced and sold.
    Therefore, in order to void pyramiding, taxes on value added as 
well as taxes on net income typically allow a business to deduct from 
its tax base the cost of the inputs (such as parts and components) that 
it purchases from some other business.

        LExample: Black Corps. paid (1) $30X for widget components, (2) 
        $10X for a widget assembly machine, (3) $1X for interest on 
        debt to finance that machine and (4) $50X for employees to 
        produce and sell the $100X of widgets it sold during the 
        taxable year. Black Corps. also paid a $9X dividend to its 
        shareholders.

        L(1) Value Added Calculation: Black Corps.'s value added tax 
        base for the year is $60X, computed as follows:

        Gross Income..........................................     $100X
        Less: Deductible Costs Paid to Another Business for 
          Components and Included in Payee's Tax Base under 
          Value Added System..................................    $(30X)
        Deductible Costs Paid to Another Business for a 
          Machine and Included in Payee's Tax Base under Value 
          Added System........................................    $(10X)
                    --------------------------------------------------------------
                    ____________________________________________________

        Value Added...........................................      $60X

        Nondeductible Costs Not Included in Payee's Tax Base 
          under a Value Added System:

        $1X of Interest

        $9X of Dividends

        $50X Salaries to Employees



        Note: In value-added parlance, Black Corps. has been allowed
         to deduct the amounts paid to other businesses because those
         amounts are included in the other business's value added tax
         base. Salaries paid to employees are not deducted because the
         employee's wages are not taxable under the value-added tax.
         Only businesses are subject to the tax on value added. In
         income tax parlance, it would be said that Black Corps. has
         been able to deduct inventory costs in the year paid (instead
         of using inventory accounting which over time tends to defer
         deductions beyond the year of payment). In income tax
         parlance, it would also be said that Black Corps. has been
         able to expense capital equipment (instead of depreciating
         its cost over a period of years), but has not been able to
         deduct wages paid to employees or interest paid to
         debtholders or dividends paid to shareholders.



        L(2) Net Income Calculation: Black Corps.'s net income tax base 
        for the year is approximately $24X, computed as follows:

        Gross Income..........................................     $100X

        Less: Approximate Amount of Deductions Allowed under 
          Inventory Accounting Rules for the $30X Paid for 
          Components that was included in the Payee's Tax Base 
          a........................................    $(20X)
        First-Year Depreciation Deduction Allowed for the $10X 
          Paid for the Machine that was included in the 
          Payee's Gross Income b...................   ($4.4X)
        Cost of Salaries Paid to Employees....................    ($50X)
        Interest Cost.........................................     ($1X)
                    --------------------------------------------------------------
                    ____________________________________________________

            Net Income........................................    $24.6X

       L  a Although in our overly simplified example where 
all purchases and sales are made in the same year, the full $30X would 
be deductible, in the typical real-life case, the business would have 
some costs that would be perpetually deferred under inventory accounting 
rules.
       L  b The depreciation calculation assumes 30% bonus 
depreciation and MACRS depreciation on 5-year property.
---------------------------------------------------------------------------
Comparison of Value Added and Net Income Calculations

    The differences between the two systems are easily discernible 
(and, as shown later, easily reconcilable).

        a. LCash vs. Inventory Accounting. In the example, the value 
        added system uses cash accounting whereas the net income 
        calculation uses inventory accounting, but this is not an 
        inherent difference: an amended corporate income tax whose base 
        was equal to value added could continue to use inventory 
        accounting. A cash system is simpler and generally better, but 
        that reform is not necessary in order to convert the corporate 
        income tax into an ``indirect tax''.

        b. LExpensing vs. Depreciation. In the example, the value added 
        system expenses capital equipment purchases, whereas the net 
        income calculation uses depreciation, but, again, this 
        difference is not immutable. Expensing is a superior rule, but 
        the corporate income tax can be converted into an ``indirect 
        tax'' without making that change. The corporate tax could 
        qualify even though it continued to use the depreciation rules 
        of current law.

    The two remaining differences relate to the deductions allowed 
under the current corporate income tax for interest paid to debtholders 
and compensation paid to employees. Because a value added base (the key 
to ``indirect tax'' status) includes the output of all capital (as well 
as the output of labor), no deductions for interest or compensation are 
allowed. Therefore, in this case, the familiar income tax deductions 
must give way to the value added rule but, as shown below, the 
deduction for interest is not an inherent characteristic of a corporate 
income tax and, insofar as concerns wages, the absence of any income 
tax deduction for compensation paid employees is not the radical change 
that might be thought. In fact, when the existing payroll tax is taken 
into account, a large portion of wages paid are, in effect, already 
nondeductible under present law.

        c. LNo Deduction for Interest Paid. A deduction for interest 
        paid is not an inherent or necessary characteristic of a 
        corporate income tax. Indeed, allowing a deduction for interest 
        (the cost of debt capital) but not for dividends (the cost of 
        equity capital) is a major distortion under present law that 
        impedes GDP growth according to a Treasury study a few years 
        ago.3 That study recommended replacing the current 
        corporate income tax with a Comprehensive Business Income Tax 
        (CBIT) that allowed no deduction for interest. (Dividends are 
        not deductible under present law.) (As will be seen later, had 
        the CBIT proposal raised its horizons only slightly higher and 
        taken into account the payroll tax that existed then (and now) 
        in another portion of the Internal Revenue Code, the 
        Comprehensive Business Income Tax would have had a base equal 
        to value added.
---------------------------------------------------------------------------
    \3\ Supra at n. 1.

        d. LNo Deduction for Wages. The idea that wages paid are fully 
        deductible under present law is largely a mirage arising from 
        the fact that the corporate income tax (where wages are 
        deductible and are not part of the tax base) is in one part of 
        the tax code and the employer payroll tax (where wages are not 
        deductible and are in the tax base) is in another part of the 
        tax code. When, however, these two taxes are viewed together, 
        it is easily seen that in substance most wages are already 
        nondeductible. In form, under present law when a business pays 
        wages it is entitled to deduct them from its corporate base, 
        but when the business turns to another page of its tax return, 
        it must add back those wages to the base of its employer 
        payroll tax and pay tax on them. The difference is, of course, 
        that the corporate rate is presently 35 percent whereas the 
        payroll tax rate is presently 7.65 percent, but under the 
        reformed corporate tax, the tax rate would be much lower--about 
        the same as the 7.65 percent employer payroll. In that case, 
        the amended ``indirect'' corporate income tax could continue to 
        allow a deduction for wages up the $84,900 cutoff point of the 
        payroll tax or could disallow a deduction for all wages, but 
        allow a credit for the payroll tax. In either case, the total 
        tax attributable to wages--whether called a corporate tax or 
---------------------------------------------------------------------------
        payroll tax would not be greatly different from present law.

    Thus, like so much else about the comparison between a value added 
base and a net income tax, the differences are much less than thought.
LObvious Conclusion: The Existing Corporate Income Tax Can Readily Be 
        Converted into an Indirect Tax

    The bottom line point is glaringly simple: Forget about VATs 
(subtraction-method or otherwise) and all other exotic tax reforms. 
Instead, convert the existing corporate income tax into an indirect tax 
by the simple expedient of disallowing the deduction for interest 
(treat same as dividends) and integrating the corporate income tax with 
the existing payroll tax by various cross credits or offset formulas 
that results in a combined labor and capital base equal to value added.
    Once indirect status is achieved, export income can be excluded 
from tax. Once export income is excluded, a correct and fair 
territorial system could be adopted. With indirect status, imports 
could also be brought into the U.S. tax base. That is, however, an 
option, not a requirement.

                               

    Chairman McCRERY. Thank you, Mr. Christian.
    Our next witness is also one who is not unfamiliar with the 
way tax laws are made, and we welcome him to our panel this 
afternoon. He is Michael Graetz, who is a Professor of Law, as 
mentioned by Mr. Christian, at a small school in the Northeast, 
Yale Law School.
    Mr. Graetz, we look forward to your testimony, and as with 
all the other witnesses, your testimony will be included in its 
entirety. Please summarize in about 5 minutes.

  STATEMENT OF MICHAEL J. GRAETZ, PROFESSOR OF LAW, YALE LAW 
                 SCHOOL, NEW HAVEN, CONNECTICUT

    Mr. GRAETZ. Thank you, Mr. Chairman.
    To promote economic growth and enhance Americans' standard 
of living, the Nation's tax system should be transparent and 
simple, should minimize economic distortions and taxpayers' 
compliance costs, and should impose the lowest rates feasible 
to fund the government's expenditures. The tax system should 
enhance productivity and should not inhibit savings. The 
Nation's tax system should also distribute its burdens 
equitably, and both the tax law and its administration should 
be regarded by the American people as fair.
    By these measures, the American tax system is badly out of 
whack. We rely too heavily on income taxes and insufficiently 
on consumption taxes. We could improve our tax system along all 
of these dimensions by replacing a substantial part of both 
individual and corporate income taxes with a consumption tax, 
and by doing so, we could have a tax system the Internal 
Revenue Service (IRS) could administer.
    To get there from here, ideologues on both sides of the 
political spectrum must compromise. Consumption tax proponents 
must abandon the fantasy that by enacting a consumption tax, we 
can completely eliminate the income tax; and income tax 
adherents must retreat from their stance that any consumption 
tax necessarily represents an attack on poor and middle-income 
taxpayers. Retaining and tinkering with the current system 
offers a poor prescription for either economic progress or tax 
justice.
    Today, Presidents and Congress use the income tax the way 
my mother used chicken soup, as a magic solution to solve all 
of the Nation's economic problems. If we have a problem in 
access to education, child care affordability, health insurance 
coverage, or financing of long-term care, to name just a few, 
the answer is a tax credit or deduction. Tax legislation during 
the nineties completed the unraveling of the 1986 Tax Reform 
Act, which had promised, but failed to deliver, a broad-based, 
low-rate, fair and simple tax.
    In 1940, Mr. Chairman, the instructions for the Form 1040 
were four pages long. Last year, the booklet was 117 pages 
long. The Form 1040 for last year had 11 schedules and 20 
additional work sheets. As the Congress has introduced new 
problems into the tax system, old problems have multiplied, and 
as these hearings suggest, probably the most important relate 
to the internationalization of the world economy.
    Clearly, we need a fundamental reexamination of U.S. income 
tax policies regarding international income, but more 
fundamental change is needed. I am a great fan of the current 
IRS Commissioner Charles Rossotti, but I remain wary when 
people talk about a customer-friendly IRS. I have often said, I 
will become a werewolf before I would be a customer of the IRS.
    To think that the IRS can become a modern financial 
services institution without an overhaul of the tax law it 
administers is to believe that you can turn a Winnebago around 
without taking it out of the garage. The fundamental problem is 
that the IRS is being asked to do too much. It cannot do all of 
the things that Congress is now asking it to do.
    The sales tax proponents are right. The majority of 
American families should not have to file tax returns or deal 
with the IRS at all. Everyone else proposing tax reform, the 
flat taxers, the income tax reformers, those who favor 
progressive consumption taxes, would fail to remove the IRS 
from the lives of average Americans.
    Flat tax advocates trumpet their claim that they would 
shorten the individual tax return to fit on a postcard, but, 
given Congress' propensity for enacting tax breaks for this or 
that, it is foolish to believe that a flat tax would stay flat 
or simple for very long. The political allure of giving 
Americans tax breaks for specific expenditures is catnip to 
both the Congress and the White House. The flat tax's treatment 
of exports and imports is properly anathema to American 
businesses.
    In contrast, since the reporting of sales taxes would be 
done by retail businesses and no individual returns would be 
required, a sales tax would offer genuine and lasting 
simplification for the American people. The rub, however, is 
that complete replacement of the income tax with a sales tax 
would provide a large tax reduction for the country's 
wealthiest people.
    Both the flat tax and the sales tax would shift the 
Nation's tax burden from high-income people to those with lower 
income. As the New York Times columnist, William Safire, has 
said, ``Most of us accept as fair this principle: The poor 
should pay nothing, the middle something, and the rich the 
highest percentage.''
    The current income tax is a horrible mess, and in thinking 
about how we should move forward to a new tax regime, I believe 
we can profitably learn from the tax policies of our past. We 
can achieve low rates and a reasonably simple tax system by 
replacing most of the income tax with a tax on consumption. In 
the process, we should return the income tax to its pre-World 
War II status, a low-rate tax on a relatively thin slice of 
higher-income Americans.
    The value-added tax is a revenue-producing mainstay in over 
120 countries on 5 continents. Sales taxes are far more 
susceptible to tax evasion than a value added tax. A VAT 
imposed at about a 12-percent rate could finance an exemption 
from income tax of families with up to $100,000 of income, and 
enacting a VAT would allow a vastly simpler income tax at about 
a 25-percent rate or less to be applied to income over 
$100,000. This shift in the composition of the Nation's taxes 
would eliminate more than 85 percent of the American people 
from the income tax rolls.
    This is a practical and workable plan. Low- and middle-
income families could be protected from any tax increase 
through payroll tax offsets. The corporate income tax could 
also be reduced to 25 percent or less, the same rate that would 
apply to the income of high-income individuals. This plan is 
designed to be both revenue-neutral to the Federal Government 
and distributionally neutral for the American people. It is a 
practical plan and I urge the Committee to consider it.
    Thank you.
    [The prepared statement of Mr. Graetz follows:]
Statement of the Michael J. Graetz, Professor of Law, Yale Law School, 
                         New Haven, Connecticut
    Mr. Chairman and Members of the Committee:
    Thank you for inviting me to testify here today on the issue of 
fundamental reform of the U.S. tax system and how it might improve the 
economic well-being of Americans.
    To promote economic growth and enhance Americans standard of 
living, the Nation's tax system should be as transparent and simple as 
practicable, should minimize economic distortions and taxpayers' 
compliance costs and should impose the lowest rates feasible to fund 
the government's expenditures. The tax system should, to the extent 
possible, enhance productivity and not inhibit national savings. The 
Nation's tax system must also distribute its burdens equitably, and 
both the tax law and its administration should be regarded by the 
American people as fair.
    By these measures, our tax system is badly out of whack. We rely 
too heavily on income taxes and insufficiently on consumption taxes. We 
could improve our tax system along all dimensions by replacing a 
substantial part of both individual and corporate income taxes with a 
consumption tax. And, by doing so, we could have a tax system that the 
IRS can readily administer.
    But to get there from here, ideologues on both sides of the 
political spectrum must compromise. Consumption tax proponents must 
abandon the fantasy that by enacting a consumption tax, we can 
completely eliminate the income tax. And income tax adherents must 
retreat from their stance that any consumption tax necessarily 
represents an attack on poor and middle-income families. Retaining--and 
tinkering with--the current income tax offers a poor prescription for 
either economic progress or tax justice.
    During the past twenty-five years the income tax has fallen into 
disrepute and disfavor, properly so. A substantial part of my book on 
the income tax endeavors to explain why this has happened, a story I 
will not repeat here, but the key facts are these: From the period 
immediately after the Second World War until 1972, the American people 
viewed the income tax as the most fair tax in the Nation.1 
Since 1980, they have consistently viewed it as the least fair. Today 
about half of the American people favor changing to a ``completely 
different'' tax system. No matter what the data show about the amount 
of income taxes being paid by high income taxpayers or about the 
relationship of corporate taxes to corporate profits, Joe Sixpack no 
longer believes he is getting a fair shake. Joe believes that wealthy 
people and large corporations have tax advisers--lawyers, accountants, 
investment bankers, magicians and alchemists--to help them arrange 
their affairs to duck the taxes they should be paying, to avoid their 
fair share of the tax burden.
---------------------------------------------------------------------------
    \1\ Michael J. Graetz, The U.S. Income Tax: What It Is, How It Got 
That Way, and Where We Go From Here, New York: W.W. Norton & Co. 
(1999).
---------------------------------------------------------------------------
    And the American people are right; substantively, the income tax is 
a mess. Taxpayers at every income level must confront extraordinary 
complexity. In 1940, the instructions to the Form 1040 were about four 
pages long. By 1976, they had expanded to 48 pages. For the tax year 
2001, the instruction booklet was 117 pages long. The Form 1040 for 
2001 had eleven schedules and twenty additional worksheets.
    Presidents and Congress now use the income tax the way my mother 
employed chicken soup: as a magic elixir to solve all the Nation's 
economic and social difficulties. If the Nation has a problem in access 
to education, child care affordability, health insurance coverage, or 
financing of long-term care, to name just a few, an income tax 
deduction or credit is the answer. Tax legislation during the 1990s 
completed the unraveling of the 1986 Tax Reform Act, which had 
promised, but failed to deliver, a broad-based, low-rate, fairer and 
simpler income tax.
    Given recent changes in the economy and technology and in how 
business is now conducted, the income tax would have become more 
complex even without its increased use as the favorite mechanism to 
address social and economic problems. While old income tax problems 
have worsened, new problems have emerged. As these hearings suggest, 
probably the most important are due to the internationalization of the 
world economy. Flows of both direct and portfolio investments into and 
out of the United States have increased dramatically in recent years. 
Foreign trade is increasingly important, as are international business 
and investment activities. Tax-favorable foreign financial centers and 
global trading have become commonplace. Individuals have also increased 
their foreign business activities. These developments, along with new 
ways of doing business, especially innovative financial instruments, 
pose striking challenges for taxation, especially income taxation. 
Elsewhere I have urged a fundamental reexamination of U.S. 
international income tax policies.2 No one can doubt the 
necessity of this task. Without it, the taxation of international 
income may completely unravel.
---------------------------------------------------------------------------
    \2\ Michael J. Graetz, The David R. Tillinghast Lecture Taxing 
International Income: Inadequate Principles, Outdated Concepts, and 
Unsatisfactory Policies, 54 Tax L. Rev. 261 (2001), reprinted at 26 
Brooklyn J. of Int. law 1357 (2001).
---------------------------------------------------------------------------
    Americans regard the income tax both as too complicated and unfair. 
Not only has this phenomenon diminished popular support for the income 
tax, it also threatens income tax compliance. Lou Harris, among others, 
has reported a growing sentiment--especially among the young--that 
there is nothing wrong with tax cheating. The January 2002 Report of 
the IRS Board of Oversight reported a similar disturbing trend.
    While I am a great fan of the current IRS commissioner Charles 
Rossotti and his efforts to reorganize the IRS, I remain wary when 
people talk about a customer-friendly IRS. I will become a werewolf 
before I change from a taxpayer into a ``customer'' of the IRS. To 
think that the IRS can become a modern financial services institution 
without a major overhaul of the tax law it administers, is to believe 
that you can turn a Winnebago around without taking it out of its 
garage.
    The fundamental problem is that the IRS is being asked to do too 
much. Having to administer the EITC, the Nation's wage subsidy for low-
income workers, has diverted IRS audit resources away from business and 
high income individual returns, leading to headlines that the Service 
is targeting the poor for audits. The IRS also administers the programs 
providing employees their health insurance and pensions, the Nation's 
largest subsidy for childcare and the many income tax provisions to 
help families finance the costs of financing higher education. The IRS 
routinely processes over 200 million individual and corporate tax 
returns and nearly 1.5 billion information documents each year. We also 
expect the IRS promptly to issue regulations implementing frequent and 
massive legislative changes, to ferret out and deter corporate tax 
shelters, to halt tax evasion and to bring the underground economy to 
the surface. The Internal Revenue Service cannot do all of these things 
well. Many it cannot do at all. We should not expect it to. A major 
simplification of the Nation's tax law is necessary. We need a 
fundamental overhaul of our Nation's tax system.
    The vast majority of American families should not have to file tax 
returns or deal with the IRS at all. In the current tax reform debate, 
only the proponents of a national sales tax seem committed to this 
result. Everyone else proposing tax reform--the flat-taxers, the income 
tax reformers, those who favor progressive consumption taxes--would 
fail to remove the IRS from the lives of average Americans.
    Flat-tax advocates trumpet their claim that they would shrink the 
individual tax return to fit on a postcard. But given Congress's 
propensity for enacting tax breaks to encourage this or that 
expenditure or activity, it is foolish to believe that a flat tax--
which would require all wage earners to file tax returns--would stay 
flat or simple for very long. The political allure of giving Americans 
tax breaks for specific expenditures or investments is catnip to both 
Congress and the White House. And the flat tax would tax the entire 
value of goods manufactured in the U.S. whether sold here or abroad, 
but would tax only the U.S. mark-up of imported goods manufactured 
abroad. The flat tax's treatment of exports and imports is anathema to 
American businesses.
    In contrast, since all reporting of sales taxes would be done by 
retail businesses and no individual returns would be required, a sales 
tax would offer a genuine and lasting simplification for American 
families. The rub, however, is that complete replacement of the income 
tax with a national sales tax would provide a large tax reduction for 
the country's wealthiest people. Neither the flat tax nor a national 
sales tax would be fair as a full replacement for the income tax. Both 
would shift the Nation's tax burden from high-income families to those 
with less income. The tax system can, and should, be fixed without such 
a shift in the Nation's tax burdens. As the New York Times columnist 
William Safire, who called the flat-tax ``Draconian,'' has said: ``Most 
of us accept as `fair' this principle: The poor should pay nothing, the 
middlers something, the rich the highest percentage.''
    The current income tax is a horrible mess. But in the course of 
radically restructuring our tax system we should not enact a massive 
tax reduction for the country's most wealthy people, those who least 
need such relief.
    In discovering how we should move forward to a new tax regime, we 
can profitably learn from the tax policies of our past. We can achieve 
low-tax rates and a reasonably simple tax system by replacing most of 
the income tax with a tax on consumption. In the process we should 
return the income tax to its pre-World War II status--a low-rate tax on 
a relatively thin slice of higher income Americans. Whittling down the 
income tax would be financed by enacting a value-added tax (VAT), a 
consumption tax commonly used throughout the world. The VAT is a 
revenue-producing mainstay in over 120 countries on five continents. A 
VAT operates much like a national sales tax, but is collected at all 
stages of production rather than just from retailers. Sales taxes are 
far more susceptible to tax evasion than a value added tax.
    A VAT imposed at about a 12 percent rate could finance an exemption 
from income tax for families with up to $100,000 of income. And 
enacting a VAT would allow a vastly simpler income tax at a rate of 25 
percent or less to be applied to income over $100,000. This shift in 
taxes would eliminate more than 85 percent of American families from 
the income tax rolls. Only about 15 million of the 125 million 
individual income tax returns would still be filed; 110 million returns 
would be eliminated. If small businesses were exempt from filing VAT 
tax returns, as they should be, only about 12-13 million VAT returns 
would be required to be filed.
    This is a practical and workable plan, which distinguishes it from 
the ideas for restructuring of the Nation's tax system which have so 
far received the most attention in the Congress. People freed from 
income taxation would pay their federal taxes when they purchase goods 
and services, as they now do with state sales taxes. They would not be 
required to file any tax returns. They would have no dealings at all 
with the Internal Revenue Service. The income tax that would remain for 
high-income taxpayers would be shrunken and simplified substantially. A 
low, flat rate of tax would be imposed on the taxable income of high-
income individuals and corporations. The marriage penalties of the 
existing income tax would be eliminated. The alternative minimum tax 
would be repealed. Most of the special income tax credits and 
allowances that now crowd the tax code and complicate tax forms would 
be repealed.
    Low and middle income families would be protected from any tax 
increase and receive amounts roughly equivalent to their current EITC 
through payroll tax offsets. Providing low-income workers tax offsets 
through the payroll tax withholding system would allow elimination of 
the tax return filing requirement for these workers without increasing 
their taxes or eliminating their wage subsidy. Moreover, payroll tax 
offsets would put money in low-income workers' pockets when their 
paychecks are earned, rather than through a lump-sum tax refund after 
year end, as the EITC now does.
    The corporate income tax rate would also be reduced to 25 percent 
or less, the same rate that would apply to the income of high-income 
individuals. The corporate income tax would be simplified substantially 
and the corporate alternative minimum tax would be repealed. By 
adopting identical tax rates (and depreciation allowances) under the 
individual and corporate income taxes, the income of small corporations 
could be taxed on a flow-through basis, thereby eliminating the 
separate corporate tax for many small businesses and taxing their 
income directly to their owners. This would also allow small business 
income to qualify for the $100,000 income tax family allowance. The 
corporate income tax would generally apply only to large publicly-held 
companies.
    With a low corporate income tax rate, international business income 
taxation might be substantially simplified by moving to a 
``territorial'' system of taxation. Under this kind of tax system, 
which is used in about half the OECD countries, the United States would 
collect tax on all business income earned in the United States, 
regardless of who owns the business, but the U.S. would not tax active 
business income earned abroad by corporations owned by Americans. In 
addition, to the extent that corporate income taxes are passed on to 
consumers in higher prices, substituting value added taxes on a 
destination basis would directly benefit American exports.
    This plan is designed to be revenue-neutral to the Federal 
Government. Nor would it result in a substantial shift in the 
distribution of the current burdens of the tax system. Thus, unlike 
proposals to replace completely the income tax with either a ``flat 
tax'' or a national sales tax, this plan does not entail a substantial 
tax cut for high income individuals or a tax increase for those below 
the top tier. And this new tax system would be considerably more 
favorable to savings than the current tax law. Most families would be 
able to save free of tax, and the tax burden on savings would be 
reduced for everyone.
    Currently the U.S. taxes consumption considerably less than our 
trading partners. (See Figures 1 and 2.) Reducing income taxes will 
make the U.S. tax system more favorable to investments by both U.S. 
residents and foreigners. Our income tax would be lower than that most 
of other nations and our taxes on consumption would be comparable to 
those imposed elsewhere. If the U.S. were to add a federal VAT of this 
rate to existing state sales taxes, the total U.S. tax rate on 
consumption would approximately equal the average VAT rates in Europe. 
(See Figure 3.) This is a realistic and feasible plan for restructuring 
the tax system of the United States.
    There are a variety of methods for imposing and collecting such a 
consumption tax. In my view, the best alternative is a so-called credit 
(or invoice) method value-added tax of the sort used predominantly 
throughout OECD nations. Experience demonstrates that such a tax works 
well. Sellers of goods and services collect taxes and receive credits 
for VAT paid on their purchases. This allows tax revenues to be 
collected regularly throughout the year from companies at all levels of 
production, rather than just from retailers, thereby easing enforcement 
of the tax. A credit-method value-added tax also permits exemptions for 
small businesses (and for specified goods or services if such 
exemptions become politically necessary). A credit-method VAT can be 
applied on a destination basis--taxing imports and exempting exports--
in full compliance with the GATT rules, a quality that only the sales 
tax can also claim with certainty.
    While I favor the credit method of collecting consumption tax, 
principally for its compliance advantages and its ability to be imposed 
on a destination basis under GATT, the particular form of consumption 
tax is not critical to the proposal I am offering here. (For example, a 
subtraction-method VAT might be used instead, but since it is imposed 
on entities rather than on transactions, it might be regarded as a 
``direct'' rather than ``indirect'' tax under the archaic GATT 
classifications, and, if so, exempting exports might be vulnerable to a 
challenge in the WTO.)
    The key points are these: The consumption tax should be collected 
only from businesses. It should exempt exports and tax imports. And the 
tax base and rate of the VAT should be structured to free the vast 
majority of Americans from any income tax liability and from any 
requirement to file tax returns. This can be done without reducing 
overall federal revenues.
    Consider what this plan would mean for the tax lives of the 
American people. This plan would eliminate about 85 percent of the 
income tax returns that currently are filed each year and would allow 
substantial simplification of the sliver of an income tax that would 
remain. The IRS should then be fully capable of administering the 
Nation's tax system, a task which it is unable to fulfill under the 
current tax law. As sales tax proponents are fond of saying, for the 
more than 150 million people from whom no income tax would be required, 
April 15 would be just another spring day.
    Revamping the Nation's tax system in this manner would also produce 
positive economic benefits. The new tax system would be friendlier to 
savings and investment than the existing tax law. Both the individual 
and corporate income taxes would be reduced to a rate of 25 percent or 
less. This would make U.S. companies more competitive and the United 
States an extremely attractive Nation for corporate investments for 
both U.S. citizens and foreigners. Restructuring the U.S. tax system 
this way should stimulate economic growth and additional jobs for 
American workers. It should produce substantial long-term benefits for 
the American economy.
    This plan merits this Committee's careful consideration.
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    Chairman McCRERY. Thank you, Mr. Graetz.
    Our next witness is Mr. Stephen J. Entin, who is President 
and Executive Director for the Institute for Research on the 
Economics of Taxation. Mr. Entin, you may proceed.

    STATEMENT OF STEPHEN J. ENTIN, PRESIDENT, INSTITUTE FOR 
             RESEARCH ON THE ECONOMICS OF TAXATION

    Mr. ENTIN. Thank you, Mr. Chairman and Members of the 
Subcommittee. I am grateful to the Subcommittee for bring 
renewed attention to the issues of international taxation and 
competitiveness and for asking me to testify.
    The Subcommittee has asked if fundamental tax reform can 
act as a substitute for ETI in increasing U.S. exports. Such 
reforms could include a national retail sales tax, a credit 
invoice VAT, a subtraction method VAT, a business activities 
tax, a flat tax or a simple cash flow tax on individuals, which 
I hope you will add to your list.
    The simple answer to the Subcommittee's question is that 
any of the major tax reform proposals would dramatically 
increase the size of the U.S. capital stock and boost national 
income by about $4,000 to $6,000 per family. Production for 
domestic sale would certainly increase. Over time, exports 
would very probably rise and imports would very probably rise 
as well.
    Manufacturers, whether import competitors or exporters, 
would certainly benefit. The increased domestic income would be 
reflected primarily in increased wages and salaries with some 
lesser gains in domestic capital income as well.
    The precise effect on the difference between exports and 
imports over time is harder to predict. It would depend on 
whether national saving had risen by more or less than domestic 
investment in a given year.
    All of the major tax reform proposals are territorial in 
nature. Some of these territorial tax reform proposals are 
border-adjusted tax (BAT) and some are not. All of the major 
tax reform proposals eliminate the major biases in the income 
tax system against savings and investment and produce a tax 
system that is neutral between income used for consumption and 
income used for saving and investment. It is this last 
criterion, neutrality, that would lower the excess tax burden 
on U.S.-sited capital and would have the biggest impact on 
business investment, production and employment in the United 
States and on the resulting trade flows.
    The United States is no longer a low-tax country for 
business. The current tax regime's foreign tax credit is so 
limited by various divisions, by country and type of income, 
that it places U.S. businesses at a serious disadvantage to 
foreign businesses competing in foreign markets. That problem 
would be solved by a territorial tax system.
    Territorial taxation would benefit all U.S. multinational 
industries and would eliminate the U.S. tax penalties that 
pressure global countries to incorporate abroad rather than in 
the United States. It would not, however, specifically benefit 
the export operations of domestic producers and those who 
currently benefit from the ETI.
    Border adjustability is a different issue. A territorial 
tax can be border adjusted or not depending where in the 
production process it is levied. Economists generally believe 
that after an initial transition, it matters very little 
whether the tax system is of the border adjusted or nonborder 
adjusted type. What really matters is whether it treats capital 
formation and consumption neutrally and taxes them at a low 
rate.
    The income tax treats income used for savings and 
investment more harshly than income used for consumption, and 
that is the root of the problem. Income is taxed when earned. 
If used for consumption, there is generally no further Federal 
tax, except a few excises. However, income that is saved is 
subject to several additional taxes on the earnings, including 
income tax on the interest, dividends and capital gains, to the 
corporate income tax and to the estate tax.
    To correct the bias against saving, either income used for 
saving must be tax deferred and the earnings and principal 
taxed when withdrawn for consumption, or the earnings used for 
saving must be taxed up front and the earnings be left tax 
exempt.
    Fixing the added tax biases against corporate income would 
require that it not be taxed at both the individual and 
shareholder level, and there should be no estate and gift tax. 
If saving is invested directly in physical assets, the correct 
treatment is immediate expensing of the investment rather than 
depreciation. The table in my paper shows you the damage that 
depreciation is doing. Many of the industries hit by the 
shortfall of depreciation are in import competing and exporting 
sectors. Most would benefit greatly if we moved toward 
expensing; they would become more competitive.
    Recapping the rules for neutrality: If a tax is imposed at 
the individual level, saving must be tax deferred. 
Alternatively, if the saving is taxed, the returns must be left 
exempt. If the tax is imposed at the business level, investment 
must be expensed, not depreciated. All the major tax reform 
plans follow those rules.
    A retail sales tax is collected by retailers based on the 
consumption spending of individuals, which means the tax base 
is their earnings less their saving.
    Value-added taxes and the BAT are collected by businesses 
in increments through the production process, and are based on 
a business's sales less its investment expenses. This involves 
expensing, and the tax base equals national income less saving.
    An individual cash flow tax is collected from individuals 
based on their earnings less their saving. A non-corporate 
business's investment is expensed.
    In the flat tax, income from capital would be taxed at the 
business level before being distributed to the owners or 
reinvested and, as in a VAT, firms would expense their 
investment.
    Except for a few quirks, all the major reform approaches 
have the same fundamental tax base, revenues less saving, or 
revenues less investment. This is the proper definition of net 
income. These reforms should not be thought of as consumption 
taxes. They are properly defined income taxes. They all reduce 
the excess tax burden on investment.
    If I had to choose among them, it would be on the basis of 
transparency, which tax most clearly reveals to taxpayer voters 
the extent of the government's tax take. That would be the 
individual cash flow tax.
    Thank you.
    [The prepared statement of Mr. Entin follows:]
Statement of the Stephen J. Entin, President, Institute for Research on 
                       the Economics of Taxation
    Mr. Chairman and members of the subcommittee,
    My name is Stephen J. Entin, President of the Institute for 
Research on the Economics of Taxation. I am an economist with a 
background in tax analysis and international economics. I served as 
Deputy Assistant Secretary of the Treasury for Economic Policy from 
1981 to 1988, a period when significant tax changes were enacted, and 
significant shifts occurred in exchange rates, international capital 
flows, and trade balances. I am grateful to the Subcommittee for 
bringing renewed attention to these issues with these hearings, and for 
asking me to testify.
    Congress enacted the extraterritorial income exclusion (ETI) in 
response to World Trade Organization objections to the Foreign Sales 
Corporation (FSC) provision of the tax code. The WTO has since ruled 
that the ETI is also in violation of WTO rules against explicit export 
subsidies. They state that a nation may have a border-adjusted 
``indirect'' tax, such as a VAT or sales tax, or a non-border-adjusted 
``direct'' tax, such as an individual or corporate income tax, but not 
a border-adjusted ``direct'' tax. With particular regard to the ETI, 
declaring the export income to be ``foreign source'' (when it actually 
represents domestic value added) and declaring the corporate tax system 
to be ``territorial'' (but only for the selected exports, and not for 
income actually generated abroad) will not follow the usual meanings of 
the terms and will not satisfy WTO conventions. In fact, the 
distinction between a ``direct'' and an ``indirect'' tax is purely 
semantic and is economically meaningless. The difference in how the two 
types of tax treat international transactions has more to do with 
administrative convenience, bureaucratic custom and legal precedence, 
and less with real economic consequences.
Alternatives to the FSC-ETI regimes.

    Given the WTO's insistence that the ETI be abandoned, the 
subcommittee has asked if fundamental tax reform can act as a 
substitute for ETI in increasing U.S. exports. Such reforms could 
include a national retail sales tax, a credit-invoice VAT, a 
subtraction method VAT, a business activities tax, a ``flat tax'', or a 
simple cash flow tax. I have been asked to focus particularly on how 
the flat tax and a simple cash flow tax would affect the issue.
Effect of tax reform on exports.

    The simple answer to the subcommittee's question is that any of the 
major tax reform proposals would dramatically increase the size of the 
U.S. capital stock, wages, employment, and national income. (Replacing 
the corporate and personal income taxes and transfer taxes with these 
reformed systems could raise incomes by perhaps ten percent across the 
board in real terms, or about $4,000 to $6,000 per family, equivalent 
to giving each about $150,000 in current income-generating assets.) In 
the process, production for domestic sale would certainly increase. 
Over time, exports would very probably rise, and imports would very 
probably rise as well. Ending the tax bias against capital would be of 
particular benefit to the capital intensive industrial sectors of the 
economy and to commercial and residential rental real estate. 
Manufacturers, whether import competitors or exporters, would certainly 
benefit.
    The precise effect on the difference between exports and imports 
over time is harder to predict. The effect on the trade balance in any 
given year would depend on whether national saving had risen by more or 
less than domestic investment by that point. During the initial spurt 
of domestic investment and growth that would follow the elimination of 
the excess tax burden on capital, the United States would probably save 
more, and also send less of its saving abroad and attract more saving 
from foreigners. The rise in the net capital inflow (capital account 
surplus) would be accompanied by an increase in the current account 
deficit; that is, imports would rise by more than exports. Later, as 
domestic productive capacity expanded, there would be a rise in 
exports; the current account (including trade in goods and services) 
would move back toward balance or surplus. At the same time, domestic 
saving would tend to catch up with the increase in investment, and the 
capital account surplus would be further reduced by the additional 
interest and dividend payments being made to the foreign investors. 
(The balances on capital and current account are of necessity equal in 
value and opposite in sign. They always sum to zero and move by equal 
amounts in opposite directions. The net international capital flow is 
the chief determinate of the balances, not the specific tax treatment 
accorded exports and imports.)
    The ultimate increases in domestic product and income would dwarf 
the changes in the foreign accounts. The increased domestic income 
would be reflected primarily in increased wages and salaries, with some 
lesser gains in domestic capital income as well.
Incidence of the tax changes.

    The FSC and the ETI have allowed exporting businesses to save about 
$5 billion in taxes. The bulk of the total goes to a few dozen large 
companies with high export earnings. It should be noted up front that 
no general tax reduction on saving, investment, or labor, spread evenly 
across the production process, will target these exporters in precisely 
this manner. Reforming the tax treatment of foreign source income, 
which is a worthy goal, would greatly improve the competitive position 
of U.S. firms operating abroad, but these are not necessarily the same 
export-oriented businesses benefiting from the current ETI regime. Nor 
will the small sums involved in the ETI provision cover much static 
revenue reduction to aid in adopting a fundamental reform of the whole 
tax system. Therefore, eliminating excess layers of tax on capital 
formation would require spending restraint or offsetting tax increases 
to produce a static ``revenue neutral'' result. (Tax reform would be 
made much easier if the government would take account of the benefits 
to the federal budget of the additional capital formation, employment, 
and national income that the reform would induce.)
Territorial, border adjustable, and neutral: three different tax 
        attributes.

    All of the major tax reform proposals are territorial in nature, 
subjecting domestic income to tax, and excluding foreign source income 
from tax. Some of these territorial tax reform proposals are border-
adjusted (imposed on imports but not on exports) and some are not. All 
of the major tax reform proposals eliminate the major biases in the 
income tax system against saving and investment, and produce a tax 
system that is neutral between income used for consumption and income 
used for saving and investment. It is this last criterion, neutrality, 
that would have the biggest impact on business investment, production, 
and employment in the United States, and the resulting trade and 
capital flows.
    Territoriality. Territoriality and border adjustability are two 
separate concepts that are often confused. It is sometimes asserted 
that territorial taxation helps a country's trade balance. Most people 
who say that are thinking of tax systems that are border-adjusted, and 
are assuming that border-adjusted tax systems boost exports. Many 
territorial tax systems are also border-adjusted, but some territorial 
systems are not border-adjusted. When the Congress adopted the ETI, it 
was the border-adjusted element, not the territorial element, that was 
assumed to promote exports. The border adjustment aspect of the ETI 
only affects the exports eligible for the tax relief, and while it may 
encourage certain exports, it probably does not alter the total balance 
between exports and imports.
    A shift to a territorial tax would be very beneficial for 
simplicity of tax compliance and tax enforcement. It would prevent 
double taxation of foreign source income more cleanly than the current 
approach, which imposes global taxation with a credit for foreign taxes 
paid, even assuming that the current credit mechanism were applied 
uniformly. It would certainly be an improvement over the current form 
of the foreign tax credit, which is so limited by various divisions by 
country and type of income that it places U.S. multi-national 
businesses at a serious tax disadvantage to foreign businesses 
competing in foreign markets. This distorting effect of the current 
code is a serious problem that would be solved by adoption of a truly 
territorial tax system. Territorial taxation would benefit all U.S. 
multi-national industries, including financial services companies, 
natural resources companies, software and entertainment companies, and 
manufacturers with facilities abroad.
    A territorial tax would not, however, specifically benefit the 
export operations of domestic producers. It would not generally or 
broadly lower the costs of producing goods and services in the United 
States relative to costs of producing abroad. It could benefit U.S. 
exports by making U.S. firms better able to service foreign customers 
from foreign production and sales offices, and if the increased 
activity at such sites then increased orders for U.S. components and 
licensed technology. It would eliminate the U.S. tax penalties that 
pressure global companies to incorporate abroad rather than in the 
United States.
    Border-adjustability. Border-adjustability is a different issue. A 
territorial tax (or non-territorial tax for that matter) can be border-
adjusted or not, depending on where in the production process it is 
levied. Some territorial taxes are explicitly border-adjusted, imposed 
on income spent on goods and services in the United States, including 
imports, while either being rebated on, or otherwise not imposed on, 
exports. Other territorial taxes are not border-adjusted.
    A territorial VAT, business activities tax, or retail sales tax 
would normally be border-adjusted (although they could be designed 
without this feature). It would be explicitly imposed on purchases by 
residents of goods and services in the United States, whether domestic 
products or imports; the portion otherwise due on exports would be 
refunded.
    An individual cash flow or ``consumed income'' tax would be 
territorial but not border-adjusted. The income subject to the tax 
would be income earned in the United States, so the tax would be 
territorial. It would be collected from individuals on their U.S. 
source income less net saving, in effect taxing income that was going 
to be used for consumption before the taxpayers spent it. It would 
naturally fall on income spent on domestic and imported goods and 
services, and would naturally not fall on the income that foreigners 
spend on U.S. products, with no explicit border adjustment required.
    Economists generally believe that, after initial transition effects 
have dissipated, and all prices, wages, and exchange rates have 
adjusted to whichever tax regime is chosen, it matters very little 
whether the tax system is of the border-adjusted or non-border-adjusted 
type. Output and income will be roughly the same either way. What 
matters, rather, is whether domestically sited capital formation is 
taxed on a par with consumption, or more heavily than consumption, and 
at what rates capital and labor services are taxed.
    Neutrality issues: the bias against saving and investment in the 
current tax system, and steps to fix it. The income tax treats income 
used for saving and investment more harshly than income used for 
consumption. Income is taxed when earned. If it is used for 
consumption, there is generally no further federal tax (except for 
selected excise taxes on a few products). One can buy a loaf of bread 
with after-tax dollars and not be taxed again while eating it, or buy a 
television with after-tax dollars and not be taxed when watching the 
stream of programming. But buy a bond or stock with after-tax dollars 
and one faces a second layer of federal income tax on the stream of 
interest, dividends, or, if retained earnings boost the share price, on 
capital gains. This is the basic income tax bias against saving, and it 
stems from taxing both the income that is saved and the returns on the 
saving.1 If the saving is in the form of a purchase of 
corporate stock, there is also the corporate tax to be paid on the 
corporate income even before the dividend is distributed or the 
retained earnings can be reinvested, constituting a third layer of 
income tax on income saved in this form. Another layer of bias is 
imposed if the already-taxed saving is large enough to trigger estate 
and gift taxes.
---------------------------------------------------------------------------
    \1\ Consider a hypothetical 20% income tax on income used for 
either saving and consumption, and assume a 4% interest rate. Without 
the tax, one could earn $100 and consume $100 or buy a $100 bond and 
earn interest of $4 a year. With the tax, one must earn $125 to have 
$100 left after tax for consumption, a jump of 25% in the cost of 
consumption. To earn the same $4 in interest, however, one must earn 
$156.25, pay $31.25 in tax, buy a $125 bond, earn $5 in interest, pay 
$1 in tax on the interest, and have $4 left after all taxes. The cost 
of the saving has gone up 56.25% because of the taxation of the saving 
and the return.
---------------------------------------------------------------------------
    To put the tax treatment of income used for saving and investment 
on a neutral basis with income used for consumption would require 
several changes to the tax system. To correct the basic bias, either 
income used for saving must be tax-deferred, and the earnings and 
principal taxed only when withdrawn for consumption, or the income used 
for saving must be taxed up front, with no further tax on the earnings 
of the saving.2 Corporate income would not be taxed at both 
the corporate and shareholder levels; one or the layer of tax would go. 
There would be no estate and gift tax.
---------------------------------------------------------------------------
    \2\ Either allowing deferral of income saved or exempting the 
return from tax would restore the no-tax relationship between saving 
and consuming. Continuing the previous example, under deferral, one 
could earn $125, buy a $125 bond, earn $5 in interest, pay $1 in tax, 
and have $4 to consume. Under exempt returns, one could earn $125, pay 
$25 in tax, buy a $100 bond, and earn $4 tax free. In either case, the 
cost of obtaining the $4 in after-tax interest has risen 25%, the same 
as for the consumption.
---------------------------------------------------------------------------
    Fixing the basic income tax bias against saving and investment. A 
saving-deferred tax would treat all saving in the same manner as 
current law treats retirement accounts such as deductible IRAs and 
pensions. Income is a net concept, revenue less the cost of earning the 
revenue. Buying a bond or stock or adding to a bank balance is a cost 
of earning future income, and should be deductible (deferred) until it 
is recovered. Therefore, earnings less saving is the correct measure of 
income. It is also the amount of earnings one spends on consumption.
    The other approach to neutrality, a returns exempt tax, is similar 
to the tax treatment given to Roth IRAs and tax exempt state and local 
bonds. The two methods are equivalent for savers in the same tax 
bracket over the life of the saving.3 All major tax reform 
plans use one or the other method to produce a neutral outcome.
---------------------------------------------------------------------------
    \3\ Using another example, suppose that interest rates are 7.2 
percent. At that rate of interest, $1 saved would grow, with interest, 
to $2 in ten years. (Alternatively, suppose that reinvested earnings 
caused the price of a share of stock to double in ten years, and that 
the stock is sold and the capital gain is realized at that time.) 
Suppose also that the income tax rate is 20%. Under the saving-
deductible method, an individual could earn $100, save it without 
paying tax up front on the deposit or on the annual interest build-up 
(or on the stock purchase and accruing gain), and withdraw $200 ten 
years later. After paying a 20% tax on the withdrawal (or the proceeds 
of the stock sale), the saver would have $160 to spend. Under the 
returns-exempt method, an individual could earn $100, pay a 20% tax, 
and save the remaining $80. Without owing any further tax on the 
returns, he could withdraw $160 ten years later, and, here too, would 
have $160 to spend.
    Either neutral method is better than current law. Under the current 
tax system, an individual earning $100 would have to pay a 20% tax, 
save $80, and owe tax annually on the interest, reducing the 7.2% 
percent interest rate to an after-tax rate of 5.76%. With less interest 
left to build up after taxes, the saver would have only $140 to 
withdraw and spend after ten years. The $20 difference ($160-$140) 
between current law and the neutral systems (about a third of the 
interest over 10 years) is a measure of the double taxation imposed by 
current law on income that is saved. Alternatively, note that the same 
$140 balance would have been achieved by putting a neutral tax of 30% 
on the original saving (instead of the assumed 20%), leaving $70 to 
double to $140 over ten years. Clearly, ordinary income taxation 
imposes a substantially higher tax penalty on income saved than on 
income used for consumption.
---------------------------------------------------------------------------
    If the saving is invested directly in physical assets (plant, 
equipment, buildings, etc.) the correct treatment is immediate 
expensing of the investment (first year write-off), rather than 
depreciation. Depreciation, which stretches out the deduction over many 
years, results in a write-off of less than the full present value cost 
of the asset, overstating income and raising the effective tax rate.

   Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing
                                             (First-year Write-off)
----------------------------------------------------------------------------------------------------------------
                Asset lives:                               3yrs    5yrs    7yrs    10yrs   15yrs   20yrs   39yrs
----------------------------------------------------------------------------------------------------------------
Present value of first-year write-off of $1  ...........   $1.00   $1.00   $1.00   $1.00   $1.00   $1.00   $1.00
 of investment:............................
                                                         -------------------------------------------------------
Present value of current law write-off of           0%     $0.96   $0.94   $0.91   $0.88   $0.80   $0.74   $0.55
 $1 if inflation rate is:..................
                                            --------------------------------------------------------------------
                                                    3%     $0.94   $0.89   $0.85   $0.79   $0.67   $0.59   $0.37
                                            --------------------------------------------------------------------
                                                    5%     $0.92   $0.86   $0.81   $0.74   $0.60   $0.52   $0.30
----------------------------------------------------------------------------------------------------------------
Assumes a 3.5 percent real discount rate, 3-20 year assets placed in service in first quarter of the year, 39
  year assets placed in service in January.

    A dollar spent on a seven year asset gets a write-off that is only 
worth $0.91 cents in present value if inflation is zero. A dollar spent 
on a building (written-off over 39 years) gets a deduction worth just 
$0.55 cents in present value. The cost of the delay rises with 
inflation. At 5% inflation, the 7-year asset's write-off is worth only 
$0.81, and the building's write-off drops in value to $0.30. At modest 
rates of inflation, the overstatement of business income by 
depreciation can cut the rate of return on business investment in half. 
The shortfall in depreciation hits manufacturing and real estate 
particularly hard, and hits the industries with the longest lived 
assets the hardest. Many of these are import-competing or exporting 
sectors. Moving toward expensing would make these industries more 
competitive.
    Ending the corporate tax bias. Full neutrality would require ending 
the additional tax on corporate income, either by taxing capital income 
at the corporate level but not at the shareholder level, or vice versa. 
The combined federal individual and corporate tax rates on reinvested 
earnings and dividends can range as high as 48% to 60% (higher, if a 
company gets dividends from another before passing them on to the 
shareholders). The United States is no longer a low corporate tax 
country. The combined U.S. federal and state corporate tax rate 
averages 40%. This is the fourth highest combined national and local 
level corporate tax rate among the nations of the thirty member 
Organization for Economic Cooperation and Development (OECD). It is 
exceeded only in Belgium, Italy, and Japan, and is nearly 9 percentage 
points above the OECD average. Three members have corporate tax rates 
between 16 and 18 percent, seven between 24 and 29.7 percent, and 
fifteen between 24 and 29.7 percent.4 In addition, many 
nations have greater offsets to the extra layer of taxation of 
corporate income than does the United States. Some have lower tax rates 
on capital gains, lower tax rates or partial exemption for dividends, 
partial expensing of share purchases, shareholder credits for corporate 
taxes paid or partial corporate deductions for dividends or other forms 
of partial integration of corporate and individual income taxes.
---------------------------------------------------------------------------
    \4\ See CATO Institute Tax & Budget Bulletin No. 3, April, 2002, 
citing figures from KPMG, ``Corporate Tax Rate Survey,'' January 2002, 
www.us.kpmg.copm/microsite/Global--Tax/TaxFacts.
---------------------------------------------------------------------------
    Ending the estate tax bias. The transfer tax (estate and gift tax) 
must be eliminated to have a neutral tax system. Every cent saved to 
create an estate has either been taxed already when the decedent (and 
the companies she or he may have owned shares in) paid income taxes, 
or, if the saving is in a tax-deferred retirement plan, it will be 
subject to the heir's income tax. The estate tax is always an extra 
layer of tax on saving.
Systems that tax in a neutral manner.

    Recapping the rules for neutrality: If a tax is imposed at the 
individual level, saving must be tax deferred and the returns must be 
taxed. (Alternatively, if the saving is taxed, the returns must be left 
tax exempt). If the tax is imposed at the business level, investment 
must be expensed, not depreciated.
    Several specific examples of saving-consumption neutral tax systems 
have been developed, such as the cash flow tax, the Flat Tax, the USA 
tax, the VAT, the Business Activities Tax, and the national retail 
sales tax, all of which use either a saving-deferred or returns-exempt 
approach to tax neutrality. All would lead to higher levels of 
investment, productivity, and income. Whatever direction fundamental 
tax restructuring may take, it is important to remember that all these 
neutral approaches have in common this great advantage over current 
law.
    A retail sales tax is collected by retailers based on the 
consumption spending of individuals (earnings not devoted to saving). 
Value added taxes are collected by businesses in increments throughout 
the production process based on sales less investment expenses (equals 
national income less saving which again equals the amount spent on 
consumption goods and services). An individual cash-flow tax is 
collected from individuals based on their earnings less their saving 
(equals spending on consumption goods and services).
    Except for a few idiosyncrasies, all the major consumption-saving 
neutral tax reform approaches are unbiased taxes on labor and capital 
income, properly measured, either when earned or when spent. In other 
words, they have the same fundamental tax base: revenues less saving 
(or revenues less investment). This is the proper definition of net 
income. It also equals the amount spent on consumption. Consequently, 
saving-consumption neutral taxes are sometimes referred to as 
consumption taxes (if they are of the sales tax or VAT variety) or 
consumed-income taxes (if they are of the cash flow type). However, the 
point of collection of the taxes does not change their nature; they are 
all saving-consumption neutral taxes on people's income (properly 
defined), and should not viewed as taxes on consumption goods and 
services.5
---------------------------------------------------------------------------
    \5\ The nature of the neutral taxes must be clearly understood. 
Various types of sales taxes and excise taxes are often referred to as 
``consumption taxes'', rather than income taxes, because they are 
collected when products are produced or sold. A broadly-imposed 
national retail sales tax would fall on an amount of GNP that equals 
total consumption. Nonetheless, these are not taxes on the act of 
consumption or on the goods and services consumed. Goods and services 
do not pay taxes. Only people pay taxes. All taxes, in fact, are taxes 
on income. Sales and excise taxes and VATs either depress sales of the 
taxed products, reducing the incomes of the people who provide the 
labor and capital used to make them, or they reduce the purchasing 
power of that income when the workers and savers attempt to spend it. 
The two neutral consumed-income style taxes are imposed on income as it 
is earned, but properly measured, with either the amount saved and 
invested deferred or the earnings of saving excluded. Excluding from 
total income the amount that is saved and used to finance investment 
leaves an amount equal in a given time period to total consumption. 
This does not convert the tax into a ``tax on consumption'', however; 
it is merely a means of avoiding multiple taxation of income used for 
saving, and the returns on the saving will be taxed when earned, unless 
reinvested in turn. It bears repeating that all taxes are paid out of 
income by people, not by businesses, and not by goods and services.
---------------------------------------------------------------------------
    The national retail sales tax. The national retail sales tax can be 
looked at as a saving-deferred tax. It is imposed on income used to 
purchase consumption goods and services and is collected from consumers 
by businesses at the point of final sale. It falls on earnings that are 
not saved, the part of people's earnings that is spent on consumption. 
It can also be regarded as falling on national output/income less 
investment (investment, including spending on education, not being part 
of retail consumption), which also equals consumption spending. It 
falls on imports but not exports, since imports are part of the 
consumption spending of U.S. residents. There would be the usual 
problem of imposing tax on imports acquired thorough hard-to-monitor 
channels, such as items or services bought over the Internet.
    The VAT and the business activities tax. The VAT and the business 
activities tax are imposed in stages throughout the production process 
from raw materials up through processing, fabrication, distribution and 
final sales. Businesses are taxed on revenues less purchases from other 
domestic businesses, including the immediate subtraction of investment 
(expensing, not depreciation). Their tax base is national output/income 
less investment, equal to net income, which also equals earnings used 
for consumption. They fall on net income spent on imports but not 
exports.
    The cash flow tax. The cash flow tax on individuals (such as the 
``inflow-outflow'' tax designed by Dr. Norman Ture or the individual 
side of the original USA Tax introduced by former Senator Sam Nunn (D-
GA) and Pete Domenici (R-NM)) is a universal saving-deferred tax. It is 
imposed on individuals' earnings and transfers received, less net 
saving (including investment in non-corporate businesses and spending 
on education) and less transfers to others (including gifts and state 
and local taxes paid). There is no additional tax at the corporate 
level; earnings of capital are taxed at the individual level if not 
reinvested. The tax is collected at the household level before the 
taxpayers go shopping, and therefore is not explicitly border 
adjustable, even though it has virtually the same tax base as the 
retail sales tax. Unlike the sales tax, it would not require a ``use 
tax'' on goods or services purchased abroad over the internet. It is 
territorial, not including foreign source income in the tax 
base.6
---------------------------------------------------------------------------
    \6\ For simplicity, the cash flow tax would not allow a deduction 
for saving in foreign assets and would not tax foreign source interest, 
dividends, or other foreign investment income. That is, it would be a 
returns exempt tax on foreign saving by U.S. residents. This would 
eliminate the tricky enforcement problem of collecting income data from 
foreign payers and the complexity of filing for a foreign tax credit.
---------------------------------------------------------------------------
    The ``Flat Tax''. The ``Flat Tax'', as designed by Professors Hall 
and Rabushka and introduced by Representative Dick Armey (R-TX) and 
Senator Richard Shelby (R-AL) can be described as a split VAT. Unlike a 
regular VAT, wage and salary payments would be deductible by 
businesses, and the labor income would be passed on to be taxed on the 
workers' personal tax returns. As with a VAT, income from capital would 
be taxed at the business level before being distributed to the owners 
or reinvested. After subtracting labor compensation, the capital income 
would be calculated as remaining revenue less the cost of goods bought 
from other businesses, including the immediate expensing of investment. 
Thus, viewed form the business side, it is a saving-deferred tax. 
Viewed at the individual level, it allows individuals no deduction for 
saving in financial instruments but does not tax the returns at the 
individual level.7 The authors of the ``Flat Tax'' made it 
territorial but not border-adjusted. The tax on capital income is not 
rebated on exports. Most income, that of labor, is taxed on individual 
tax forms, where the tax is collected before the taxpayers spend the 
income. It therefore falls on income used to purchase domestic and 
imported goods and services without being border adjustable.
---------------------------------------------------------------------------
    \7\ The Flat Tax makes no allowance for investment in education, 
but does tax the higher incomes that result from education, and so it 
is slightly ``non-neutral'' in that regard. Also, unlike the other 
taxes, it includes income given to others in the donors' incomes 
instead of the recipients', including charitable contributions and 
transfer payments and education outlays made through state and local 
taxes. It therefore has a slightly different distribution of the tax 
base across individuals from the cash flow, VAT, BAT, and national 
retail sales tax.
---------------------------------------------------------------------------
Conclusion.

    With only minor differences, all these taxes fall on revenue less 
saving/investment, which is the correct measure of income for tax 
purposes. All will have roughly the same beneficial impact on income 
and economic activity, including exports, imports, saving, and 
investment. If I had to choose among them, it would be on the basis of 
transparency: which tax most clearly reveals to taxpayer-voters the 
extent of the government's tax take. That would be the individual cash 
flow tax, which hides none of the tax collections at the business 
level. Hiding taxes from the taxpayers disguises the cost of 
government, and encourages voters to approve more government spending 
than they would favor if they were fully aware of the tax cost.

                               

    Chairman McCRERY. Thank you, Mr. Entin.
    Our next witness is a gentleman who has been very generous 
with his time of late with some of us on the Committee on Ways 
and Means, and we look forward once again to hearing his 
testimony today. He is William G. Gale who is a Senior Fellow 
at the Brookings Institution.
    Welcome back, Mr. Gale, and please proceed with your oral 
testimony.

    STATEMENT OF WILLIAM G. GALE, SENIOR FELLOW, BROOKINGS 
                          INSTITUTION

    Mr. GALE. Thank you very much. It's a privilege to be here 
this afternoon.
    So far we have reinvented the Federal tax system about five 
times in the last 20 minutes. My head is spinning, and I study 
this stuff all day long. So I'm going to depart from what I 
planned to say a little bit and try to take a step back and 
focus on two issues.
    One is the specific international tax issues that I think 
motivated this hearing; and second is, what is the role of 
fundamental tax reform in addressing those issues? Now, that 
doesn't help us stop our heads from spinning too much because 
international taxation is notoriously complicated even for 
experts, but what I would like to do is focus on the forest 
rather than the trees here.
    There is a single kind of bright line on the international 
tax issues that has to be focused on amid all the detail and 
legal and economic discussion, and that is the principle that 
features of the Tax Code that affect the taxation of offshore 
income should not be allowed to erode the taxation of domestic 
income. If you cross that line, then you have created the 
biggest tax shelter in history. Just as when you put a hole in 
a dam, you don't just lose the water right in front of the 
hole, you lose all the water that is near it, the same thing 
would happen to tax revenues.
    So forget about all the gobbledegook and focus on this one 
issue that whatever happens on the international side should 
not be allowed to let firms reduce their domestic taxes. I 
think that's the fundamental issue on the international side.
    Having said that, let me turn to export subsidies. The 
United States subsidizes exports in a couple of ways. I think 
that the WTO rulings were and are the right ones, that is, our 
export subsidies violate the WTO regulations, but even ignoring 
the legal issues, export subsidies are not effective. They are 
not effective in improving the trade balance. They are not 
effective in that they pass on some of the subsidies to 
foreigners, who benefit from lower-priced U.S. exports. They 
are not effective in that they encourage U.S. firms to choose 
projects that have low total returns over different projects 
that have high total returns because of the differential tax 
treatment.
    Most importantly, some of our current export subsidies 
cross the bright line I mentioned, and they let U.S. firms 
reduce taxes on their domestic income on the basis of features 
of their foreign source income. That's a mistake.
    So, regardless of what the WTO said, I think it is right 
that the export incentives should be repealed. Both national 
welfare and the public fiasco would be improved. I say, may it 
rest in peace, may ETI rest in peace.
    The second international issue that has come to attention 
recently is corporate inversions. Corporate inversions occur 
when firms move their legal headquarters out of the United 
States solely for tax purposes. Although inversions are 
perfectly legal and they make perfect since sense from firms' 
perspective, they are extraordinarily bad public policy. The 
reason is that inversions allow firms not only to reduce or 
eliminate the taxes on their foreign source income, they allow 
them to reduce or eliminate taxes on their domestic income.
    So, once again, inversions cross that bright line, and that 
is a line where you sort of have to make your last stand. I 
don't know enough about the legal details to suggest exactly 
what type of laws should be written to restrict those, but I 
would argue that is a high priority for tax policy.
    My testimony goes through two reasons why moving to a 
territorial tax system is not an effective response to the 
repeal of ETI or an effective response to the increase in 
inversions. Let me just mention that moving to a territorial 
system which only taxes U.S. income in response to inversions 
is basically like saying we are going to reduce the crime rate 
by making various crimes legal; so you could reduce the crime 
rate if you make murder legal. That wouldn't reduce murder, but 
it would reduce the crime rate.
    That is the equivalent of going to a territorial system in 
order to stop inversions. It would no longer be considered an 
inversion because it would be a perfectly natural part of the 
Tax Code.
    Let me turn to fundamental tax reform. I think the issue 
here is replacing the corporate income tax with a value-added 
tax, not replacing the whole system with a value-added tax 
because it would not tax exports if we could get WTO to agree 
on that.
    The VAT obviates any potential need for export subsidies. 
It is my conjecture, though, that the political demand for 
export subsidies would not disappear. Also, it is important to 
know that moving to a VAT would not stop the inversion problem, 
and the reason is, under the value-added tax, some firms would 
see their tax payments skyrocket and the reason is because the 
VAT tax base is different from the corporate income tax base.
    The VAT does not tax profits, and so a company like General 
Motors, if we move to the flat tax, their tax liabilities would 
have gone from $110 million in the early nineties to $2.7 
billion; and that is an estimate from Hall and Rabushka, the 
creators of the flat tax. If you go to a VAT, their tax 
liability would go up even more because they couldn't deduct 
wages. So we are talking about some firms having massive 
increases in tax liabilities, some having massive reductions in 
tax liabilities. That is the way the VAT is supposed to work 
relative to the existing system, but firms that have massive 
increases would still want to invert for the same reason their 
firms want to invert now.
    I would be happy to talk more about the VAT, but my basic 
point is that neither moving to a territorial system nor 
fundamental tax reform represents an effective response to the 
ETI problem or the inversion problem. More direct measures 
would solve those problems without creating all the side issues 
that fundamental tax reform raises.
    Thank you very much.
    [The prepared statement of Mr. Gale follows:]
  Statement of William G. Gale, Senior Fellow, Brookings Institutions
    Mr. Chairman and Members of the Committee:
    Thank you for giving me the opportunity to testify at this hearing. 
The tax treatment of foreign income has become increasingly important 
in light of the WTO's decisions regarding U.S. export subsidies, and 
growing controversies regarding corporate sheltering and corporate 
inversions. These concerns have also increased interest in long-
standing debates about whether the U.S. should switch to a territorial 
tax system, and whether and how the international competitiveness of 
U.S. firms can be enhanced.
    My testimony contains two parts: a summary of principal 
conclusions, and supporting analysis.
Principal Conclusions

         The bright line: The concepts of international 
        taxation are sometimes murky and the practice of international 
        taxation can be complex and situation-specific. Despite, or 
        because, of these factors, Congress should keep one overarching 
        principle in mind in redesigning the taxation of international 
        income. That principle is that features of the tax code that 
        affect the taxation of off-shore income should not be allowed 
        to erode the taxation of domestically generated income. If this 
        ``bright line'' is crossed on an enduring basis, the 
        consequences could be very serious.

         Export subsidies: I agree with the EU that U.S. tax 
        incentives for exports should be considered prohibited 
        subsidies. Even ignoring their legality, the export incentives 
        are ineffective in improving the trade balance, and inefficient 
        in that they pass subsidies on to foreigners and cause firms to 
        choose projects with lower total returns over projects with 
        higher total returns. In addition, some current export 
        subsidies cross over the ``bright line'' noted above and let 
        firms reduce taxes on their domestically generated income. Both 
        national welfare and the public fiasco would be improved if the 
        subsidies were abolished. If Congress would like to recycle the 
        revenue savings into the corporate tax system, the best use 
        would be a reduction in the corporate tax rate or the AMT.

         Corporate inversions: Inversions occur when firms 
        move their legal headquarters out of the U.S. solely for tax 
        purposes. Although they are not illegal and do make perfect 
        sense from the firm's perspective, inversions are particularly 
        troubling from a policy viewpoint. Specifically, inversions 
        allow firms not only to reduce or eliminate taxes on their 
        foreign source income, but also to reduce or eliminate taxes on 
        their domestic income. And they create these incentives without 
        requiring any sort of change in ``real'' economic activity. 
        Thus, they cross the ``bright line'' noted above. New laws 
        should strive to eliminate the tax savings from inversions.

         Territorial tax system: Although the best solutions 
        would be to repeal export subsidies and outlaw inversions, it 
        is also natural to consider more broad-based reforms to the tax 
        system. Moving to a territorial tax system is not a useful 
        substitute for export subsidies, for two reasons. First, a 
        territorial tax system reduces the taxation of foreign 
        investment by U.S. firms, which is quite different from 
        reducing the cost of exporting goods. Second, the export 
        subsidies are counterproductive in the first place and should 
        not be replaced. Nor is moving to a territorial system a 
        helpful way to deal with corporate inversions. Territorial 
        systems generally make it more difficult to defend the domestic 
        tax base from attack, since moving offshore results in a bigger 
        tax savings under a territorial system than a world-wide 
        system. That is, territorial systems enhance and legitimize 
        methods of tax avoidance and evasion that should be curtailed 
        under any sensible policy rule. Going to a territorial system 
        as a response to corporate inversions is like choosing to 
        reduce the crime rate by legalizing certain crimes. Thus, 
        although there are reasons to consider territorial tax systems, 
        substituting for export subsidies and stopping inversions are 
        not among them.

         Fundamental tax reform: Replacing the corporate 
        income tax with a value-added tax raises many important issues, 
        including the impact on economic growth, the distribution of 
        tax burdens, tax complexity and so on. Fundamental tax reform 
        obviates the need for export subsidies, but that does not mean 
        the subsidies will disappear. Replacing the corporate tax with 
        a VAT would likely worsen the trade balance, since it will 
        increase investment more than saving. Likewise, a VAT would not 
        relieve the demand for corporate inversions. Some businesses 
        would see their tax liabilities skyrocket under a VAT and thus 
        would have incentives to shift profits out of the U.S.
Analysis 1

    Recent events have drawn increasing attention to international 
aspects of the United States tax system. First, the World Trade 
Organization (WTO) has now ruled several times that traditional and 
current U.S. tax incentives for exports represent prohibited subsidies 
under WTO regulations. The implication of these rulings--that the 
United States must significantly alter the tax treatment of exports--
seems (finally) to have taken hold in the public debate. Second, 
aggressive corporate sheltering techniques in general, and so-called 
corporate inversions in particular, have shown that current tax rules 
allow firms not only to reduce or eliminate taxes on foreign source 
income, but also to reduce or eliminate taxes on domestic income as 
well. In addition, these techniques often are based on practices that 
make no sense except as tax avoidance devices. As a result, many 
observers believe these practices have gone too far and need to be 
reined in. These events have also renewed interest in long-standing 
discussions about whether the United States should switch from a world-
wide to a territorial system and how to raise the competitiveness of 
American firms. Policy makers are now considering a wide range of 
options to address all of these issues.
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    \1\ Due to time constraints in the development of this testimony, I 
do not provide references to particular publications used throughout 
the text. Rather, the sources listed at the end of the text include the 
publications that I referenced in developing these comments.
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    The remainder of this testimony is divided into five sections. 
Sections I and II provide background information. Section I summarizes 
current U.S. tax rules for international income. Section II examines 
two conceptual issues: the relationships between several different tax 
rates affecting international investment, and the determinants of the 
trade balance. Section III describes export subsidies and corporate 
inversions and discusses direct policy responses. Sections IV and V 
discuss potential indirect and broader responses to these problems, 
including switching to a territorial system and enacting fundamental 
tax reform.
I. International features of the U.S. tax system

    The United States taxes the world-wide income of its individual and 
corporate residents. Although this may sound simple in theory, in 
practice it raises a number of difficult issues.
    To avoid having the foreign source income of its residents taxed 
twice, the U.S. provides a foreign tax credit for income taxes paid to 
foreign governments. To ensure that the credit does not reduce tax on 
domestic income, the credit cannot exceed the tax liability that would 
have been due had the income been generated domestically. Firms with 
credits above that amount in a given year have ``excess'' foreign tax 
credits, which can be applied against their foreign source income for 
the previous two years or the subsequent five years. To limit the 
ability of firms to use foreign tax credits for one type of foreign 
source income to reduce taxes on a different type of foreign income, 
the foreign tax credit limitation is calculated separately for nine 
different ``baskets'' of income.
    Foreign branches of U.S. corporations are considered U.S. residents 
and therefore are subject to immediate taxation on foreign source 
income and eligible for the foreign tax credit. In contrast, controlled 
foreign corporations (CFCs, which are American-owned, separately 
incorporated foreign subsidiaries of U.S. corporations) are not 
considered U.S. residents. Their profits, therefore, are not taxable as 
long as the earnings are retained and reinvested locally in active 
lines of business. That is, U.S. income tax (and foreign tax credits) 
on such income is deferred until the income is repatriated to the U.S. 
parent.
    Deferral of taxes and credits on retained earnings is intended to 
allow foreign subsidiaries to compete on a more even basis with local 
firms. To ensure that the benefits of deferral are used only to achieve 
that goal, the law provides complex and extensive limits on the ability 
to defer income. These rules (subpart F) make deferral available only 
on active business income that is reinvested locally. Certain forms of 
income are ``deemed distributed'' and thus denied deferral. These 
include passive income broadly defined, and including portfolio 
interest and dividends.
    Because the tax treatment of domestic and foreign income differ 
under the U.S. system, firms have incentives to shift income to low-tax 
jurisdictions and deductions to high-tax jurisdictions. Income can be 
shifted via the transfer prices at which internal firm transactions are 
recorded. As a result, the U.S. imposes an extensive set of rules, that 
essentially require that transfer prices correspond to the prices that 
would have occurred in an arms-length transaction. These rules, 
however, are notoriously difficult to enforce and, in some cases, to 
interpret.
    The U.S. also imposes rules regarding the allocation of deductible 
expenses--such as research and development costs and interest 
payments--across jurisdictions. U.S. corporations may allocate only a 
portion of their expenses to domestic operations, with the rest being 
allocated against foreign income. The U.S. generally treats exports as 
taxable income and imports as deductible expenses. But, relative to the 
rules above, the U.S. subsidizes exports in two ways. First, the sales 
source rule allows taxpayers that manufacture in the U.S. and sell 
outside the U.S. to report 50 percent of the income from the sale as 
foreign income. For firms with sufficient excess foreign tax credits, 
this provision eliminates U.S. income tax on half of export sales. The 
U.S. also provides a subsidy for extra-territorial income. Taxpayers 
are allowed to exclude a portion of their income that is attributable 
to ``foreign trading gross receipts'' (FTGR) or net income from FTGR.
    A firm cannot generally benefit from both the ETI regime and the 
sales sourcing rules. Firms with excess foreign tax credits will 
generally save more through the sales sourcing rules. The ETI rules 
thus mainly benefit taxpayers that do not have excess foreign tax 
credits--that is, those who either operate in low-tax foreign countries 
or do not have foreign operations.The U.S. taxes foreigners on income 
from their active business operations in the U.S. The U.S. imposes 30 
percent withholding taxes on interest (but not portfolio interest, 
which is untaxed), royalties, and dividends that flow to foreigners, 
but frequently reduces or eliminates the withholding tax rate through 
bilateral tax treaties.
II. Two conceptual issues
A. Alternative tax rates

    The basic issues in international taxation are sometimes difficult 
to understand in part because the tax rules are so complex. There are 
at least four effective tax rates that are of interest. Consider the 
following definitions of tax rates for the U.S. and a foreign country 
(FC):


------------------------------------------------------------------------
                                       Location of
     Tax          Country of           Production/         Location of
                   residence           Operations             Sales
------------------------------------------------------------------------
T1            US                  US                    US
------------------------------------------------------------------------
T2            US                  US                    FC
------------------------------------------------------------------------
T3            US                  FC                    FC
------------------------------------------------------------------------
T4            FC                  VC                    FC
------------------------------------------------------------------------

    In words, T1 is the U.S. tax rate faced by U.S. firms on domestic 
operations that result in domestic sales; T2 is the U.S. tax rate faced 
by U.S. firms on domestic operations that result in exports; T3 is the 
total (U.S. and foreign country) tax rate paid by U.S. firms on 
operations and sales in foreign country FC; and T4 = the FC tax rate 
paid by a FC firm on operations and sales in FC. It bears emphasis that 
all of the rates refer to effective tax rates, taking into account the 
whole tax system (in terms of base, rates, exemptions, deductions, 
credits, integration of corporate and personal taxes, etc.), not just 
the statutory corporate rate. Also, I assume the taxes are all 
enforced.
    T1 and T4 are typically not equal. This occurs, for example, when 
the U.S. taxes its own domestic firms differently than other countries 
tax their own domestic firms. This is a perfectly natural and normal 
result of a system in which countries tailor their own fiscal policies. 
Relative to our industrial trading partners, U.S. domestic taxation of 
domestic firms is the same or lower than the other countries taxation 
of their own firms (Table 1 and Figure 1 offer suggestive but not 
conclusive evidence of this.) Relative to many other countries, and to 
tax havens in particular, U.S. taxation of domestic firms is higher 
than those countries' taxation of their domestic firms. In particular, 
in countries in which T4 < T1, U.S. businesses often complain that the 
U.S. tax system makes it difficult for them to compete with local firms 
in the foreign countries.
    Under this circumstance, the key issue is how should the U.S. set 
T2 and T3? If the U.S. were to tax all income at the same rate, then T1 
= T2 = T3 > T4. This would be ``fair'' from a domestic perspective--as 
the tax on U.S. firms would depend only on the income they earned--but 
it would put U.S. firms at a disadvantage relative to foreign firms in 
country x. If the U.S. were to allow all foreign income to be taxed at 
the foreign country's rate, then T1 > T2 = T3 = T4. This would ensure 
that U.S. firms could compete on an equal tax footing abroad, but would 
then bias U.S. firms away from producing for the domestic market and 
would allow foreign countries to set U.S. tax policy. If T2 does not 
equal T3, U.S. firms have incentives to move export production either 
on-shore or off-shore depending on the direction of the inequality.
    The issues addressed below can also be seen in light of these tax 
rates. Export subsidies set T2 < T1. A pure world-wide tax system sets 
T1 = T2 = T3. A pure territorial system sets T3 = T4. Inversions are 
problematic because they reduce not only T3 but also T1 and T2, and the 
reduction is not naturally bounded by T4, where T4 applies to the 
country in which the firm has real foreign operations (as opposed to 
nominal headquarters).
B. Taxes, competitiveness and the trade balance

    National income accounting provides a potent way of understanding 
the dynamics of tax policy and the trade balance. The budget constraint 
of the private sector implies that

(1)          Y = C + S + T,

    where Y is national income, C is private consumption, S is private 
saving, and T is tax payments. Likewise, national output, which equals 
national income, can be expressed as the sum of different types of 
spending:

(2)          Y = C + I + G + X - M,

    where I is investment, G is government purchases, X is exports and 
M is imports. Combining these equations yields

(3)          X - M = (S - I) + (T - G).

    Equation (3) has says that the trade surplus (X - M, deficit if 
negative) is the sum of the excess of private saving over private 
investment and of government revenues less purchases of goods and 
services. Thus, if the U.S. has a trade deficit (X < M), it must be the 
case that private saving falls below private investment and/or 
government revenues are less than government purchases
    The simple nature of equation (3) belies its importance in 
understanding the impact of tax policy on ``competitiveness'' as 
expressed by the trade balance. In particular, policies affect the 
trade balance only through their effects on private saving, private 
investment, tax revenues and government purchases. This means that tax 
adjustments at the border should have no long-term impact on the trade 
balance. Likewise, export subsidies have no effect on the trade balance 
unless they alter the right hand side variables. Fundamental tax reform 
may well alter the trade balance, but not through its effects on border 
tax adjustments. Rather, its impact on capital accumulation and labor 
supply may alter the balance between domestic saving and investment.
III. Current Issues
A. Export subsidies

    Background. The U.S. has long subsidized exports. In 1971, Congress 
allowed U.S. companies to form tax-favored export-intensive 
corporations known as domestic international sales corporations 
(DISCs). DISCs were exempt from corporate income tax and had other 
benefits. In 1976, DISCs were found to violate GATT rules prohibiting 
export subsidies. In 1984, after protracted discussions and without 
admitting guilt, the U.S. repealed the DISC rules and created foreign 
sales corporations (FSCs). With a FSC, firms who had a foreign presence 
and performed export-related activities outside the U.S. could exempt 
15-30 percent of export income from taxes. In 2000, the WTO found the 
FSC to be a prohibited subsidy. The U.S. repealed FSC and established 
the extraterritorial income (ETI) regime. ETI provides the same 
magnitude of tax benefits for exports as FSC did. The ETI provisions, 
however, also provide between a 15 percent and 30 percent tax exemption 
for a limited amount of income from foreign operations. This extension 
to foreign source income was apparently designed to incorporate 
elements of territorial taxation. However, WTO ruled that ETI was also 
a prohibited subsidy.
    The sales sourcing rule has not been challenged by the WTO. The 
reason why is not entirely clear. It may be because the sales sourcing 
rule is used by firms with excess foreign tax credits, so it is seen as 
reducing double taxation.
    In 2002, the ETI regime and the sales sourcing rules will each save 
U.S. firms about $4.8 billion. Most of these benefits go to large 
firms. In 1996, 709 firms with more than $1 billion in assets filed 26 
percent of FSC returns and received 77 percent of the benefits. These 
firms also make major campaign contributions and lobbying efforts. 
Thus, the activities that benefit from FSC and ETI regimes are a small 
portion of overall U.S. cross-border economic activity.
    Economic Effects. Although export subsidies have a long history in 
the United States, they have little economic rationale. First, although 
the subsidies may increase exports, they do not improve the trade 
balance. As noted above, the trade balance depends on the relationship 
between how much a country produces and how much it consumes. If it 
consumes more than it produces, it must be running a trade deficit. If 
export subsidies do not alter total production or consumption of U.S. 
citizens, they cannot alter the trade balance. Another way to see this 
is to note that in order to purchase more exports of American goods, 
other countries need more dollars. This drives up the demand for 
dollars and hence causes the exchange rate to appreciate. This makes 
exports from the U.S. more expensive, and imports to the U.S. less 
expensive. This rise in imports hurts U.S. industries that compete with 
imports.
    Second, tax subsidies for exports spread some of the benefits of 
the tax cut to foreigners. It is not clear why subsidizing foreign 
consumption of American goods is preferred to domestic consumption of 
American goods. Third, export subsidies will encourage firms to make 
inefficient choices--that is, to favor export projects with lower total 
return, but higher after-tax return, over domestic projects with higher 
total return but lower after-tax return.
    Finally, and most importantly, note that the sales sourcing rule 
violates of the ``bright line'' principle. The sales sourcing rule uses 
tax rules for foreign source income (in particular the foreign tax 
credit) to reduce by half taxes on exports, which are the product of 
domestic operations. In contrast, the foreign tax credit is designed 
explicitly to stop firms from cutting taxes on their domestic 
operations.
    Policy response. Given the ineffectiveness of export subsidies, 
their minor role in international economic transactions of the United 
States, their violation of the ``bright line'' principle, and the valid 
objections of the WTO, the most sensible policy would be to abolish the 
export incentives. The revenue saved could be used to reduce corporate 
tax rates, reduce the AMT, or pay down public debt.
B. Inversions

    Background. ``Inversions'' refer to a complicated set of procedures 
that allow firms not only to reduce their taxes on foreign source 
income, but to reduce taxes on domestic income as well. Here is how a 
typical inversion works. First, a domestic corporation creates a 
foreign parent in a country like Bermuda--which has no income tax and 
no tax treaty with the United States. This allows it to eliminate U.S. 
taxes on foreign source income. Second, the domestic corporation sets 
up a foreign subsidiary of the foreign parent in a third country--often 
Barbados or Luxembourg--that has a treaty with the United States and 
has lax residency requirements. To qualify as a resident of Barbados, 
for example, the company just has to meet there once a year. The reason 
the third country and its U.S. tax treaty are important for this scheme 
is that the tax treaty eliminates withholding taxes on flows of 
royalties or interest payments from the U.S. to the third country. 
Thus, once the funds are transferred to Bermuda, which does not have a 
treaty, there is no access to the funds by U.S. Government.
    With the new foreign parent in place and the existing foreign 
subsidiaries turned over to the foreign parent, the inversion works in 
two steps. First, the American company ``sends profits'' to the foreign 
subsidiary in the third country. Sending profits means the American 
company makes payments to the subsidiary that are deductible under U.S. 
tax law. Note that this reduces the American company's American taxes 
on domestic operations. These payments could include interest payments, 
royalties for use of the company logo, and so on. No taxes are withheld 
on these transactions because of tax treaties with the U.S. and the 
third country. Second, the foreign subsidiary then sends the funds to 
the foreign parent in Bermuda, which has no income tax. As a result, 
taxable American profits have been shifted to Bermuda and escape U.S. 
taxation.
    Economic analysis. Inversions have nothing to do with a lack of 
competitiveness of our tax system. Competitiveness, if it means 
anything, should refer to the effective rate of taxation on businesses. 
The effective rate of taxation depends on the statutory tax rate, 
depreciation rules, whether the corporate and personal taxes are 
integrated. The ETR does not affect the incentive for inversions. 
Rather, inversions depend only on the statutory tax rate. That is, U.S. 
firms have incentives to shift profits out of the U.S. because of the 
35 percent statutory corporate tax rate. This would be true even if 
investments were expensed, which would reduce the effective tax rate on 
capital income to below zero, since some investment is debt-financed.
    Policy Response. Inversions violate the ``bright line'' principle 
noted above. Indeed, their whole reason for existence is to violate 
that principle. That is, they exist in order to reduce U.S. taxes in 
what are in most case clearly U.S. operations. This is a dangerous 
precedent for Congress to allow and it should be eliminated as swiftly 
and completely as possible. (Note also that many of the same issues 
apply to other corporate sheltering techniques.)
IV. Territorial versus world-wide taxation

    Background. I believe the most natural and direct responses to 
export subsidies and inversions would be to repeal the first and outlaw 
the second. But it is also natural and appropriate to examine the 
extent to which broader changes in the underlying nature of the tax 
system could resolve these problems.
    As noted above, the U.S. operates its tax system on what is 
essentially a world-wide basis. No country, though, operates a pure 
territorial or world wide system. About half of OECD countries operate 
systems that are essentially territorial, while the other half operate 
systems that are basically world-wide in nature.
    In theory, the differences between a pure world-wide system and a 
pure territorial system are large. A world-wide system taxes all income 
of residents regardless of where it is earned, gives credits for 
foreign income taxes paid, and defers taxation of foreign subsidiaries 
until the funds are repatriated. As noted above, these rules lead to 
complex provisions regarding foreign tax credit limitations, anti-
deferral rules, and income and expense allocation. In contrast, a 
territorial system only taxes income earned within the country's 
borders and only allows deductions for expenses incurred within the 
borders.
    While a territorial system sounds simpler in theory, in practice it 
often turns out not to be. First, territorial systems have to define 
the income that is exempt. In practice, territorial systems tend to 
apply only to active business income. Even within that category, the 
territorial system may only exempt active business income (a) if it 
faces taxes above a certain threshold level in the host country, (b) 
from a certain type of business (e.g., e-commerce), and/or (c) from 
certain countries. Second, the treatment of non-exempt income must be 
specified. Third, the allocation of income and expenses across 
jurisdictions takes on heightened importance in a territorial system. 
For all of these reasons, territorial systems end up with complex rules 
regarding foreign tax credits, anti-deferral mechanisms, and allocation 
of income and expenses.
    Economic issues. Although the two systems are not as different in 
practice as in theory, they do have different tendencies that are worth 
noting.
    First, in a world of sophisticated and mobile transactions and 
firms, neither system is easy to operate. A territorial system is based 
on being able to define the geographic area where income is earned and 
expenses are incurred. A world-wide system is based on being able to 
define the geographic area where a corporation is resident. Both 
concepts are becoming increasingly difficult to assign and monitor and 
increasingly easy for firms to manipulate.
    Second, changing to a territorial system is not a natural or 
appropriate response to the removal of export subsidies. Export 
subsidies promote U.S. exports. Territorial systems would promote U.S. 
investment in low-tax foreign countries. These are related but quite 
different issues.
    Third, changing to a territorial system would be a curious and 
flawed response to corporate inversions (and corporate shelters more 
generally). Territorial systems make it harder to protect the domestic 
tax base. In a world-wide system, if firms go abroad, their income is 
still taxable. In a territorial system, it is not. Thus, going to a 
territorial system as a response to inversions would not make the 
underlying problem go away, it would simply ignore it by legitimizing 
and enhancing opportunities for behavior that should instead be 
prohibited or curtailed. It would be like legalizing a criminal 
activity as a way of reducing the reported crime rate.
    Finally, it should also be noted that territorial systems are not 
generally much simpler than world-wide systems, for reasons noted 
above. In addition, moving to a territorial system may generate 
difficult transition issues with respect to deferred income, deferred 
losses and accumulated tax credits in the old system. It may also 
require the renegotiation of numerous tax treaties. For all of these 
reasons, although there may be many reasons to consider a territorial 
tax system, switching to one does not seem to be a useful way to 
address the problems raised by export subsidies or inversions.
V. Fundamental tax reform
A. Background

    In recent years, increased attention has been given to fundamental 
tax reform. Usually, this refers to the idea of eliminating the 
individual income tax, corporate income tax, and estate tax (and 
sometimes payroll and excise taxes, too) and replacing them with broad-
based, low-rate taxes on consumption.
    Four main alternatives have emerged in recent years. A national 
retail sales tax (NRST) would tax all sales between businesses and 
households. A value added tax (VAT) would tax each firm on the 
difference between the sales of goods and its purchases of goods from 
other businesses. (Alternatively, firms pay VAT on their sales of goods 
and receive tax credits for the VAT that they paid on their input 
purchases.)
    The NRST and VAT are similar in economic substance. First, the 
retail price of a good represents the entire value added of that good. 
Thus, the NRST collects all tax on the value added at the final sale to 
the consumer. The VAT, in contrast, collects the same amount of tax (if 
VAT and NRST rates are the same), but collects it at each stage of 
production. Second, both are consumption taxes.The similarity in 
structure between the VAT and the NRST indicate why it is appropriate 
for European countries to rebate VAT on exports. No one would expect a 
country to charge a retail sales tax on its exports. Thus, by rebating 
the VAT payments made up to the point of exports, European countries 
are giving firms the same treatment under a VAT as they would get under 
a retail sales tax.
    A third approach to fundamental tax reform--the flat tax--is 
probably the most well known and the best conceived. Essentially, the 
flat tax is a VAT that is divided into two parts. The flat tax would 
tax non-wage valued added at the firm level and wages at the household 
level. There are some other differences (the VAT taxes pension 
contributions when made, the flat tax taxes pension contributions when 
they are consumed; the VAT is destination-based whereas the flat tax is 
origin-based), but essentially the flat tax is a two-part VAT. This 
means that the flat tax is also a consumption tax, though it may not 
appear that way to consumers or businesses.
    A fourth approach is the so-called USA (unlimited saving allowance) 
tax, which combines a personal consumption tax and a VAT on businesses. 
Since both of these taxes are consumption taxes, the overall system 
would be a consumption.
    In considering replacements for the corporate income tax, however, 
there are only two fundamental reform options: the NRST and the VAT. 
The flat tax and USA tax would not be implemented without repeal of the 
individual income tax, too. For purposes of this testimony, therefore, 
I focus on the NRST and VAT. Moreover, since all European countries 
that experimented with national retail sales taxes eventually switched 
to a VAT, I focus exclusively on switching the corporate tax to a VAT 
in this testimony.
B. Analysis: Domestic issues

    Replacing the corporate tax with a VAT raises numerous issues. The 
main result, however, should be clear. The VAT would not be a panacea 
and although it offers the potential for improvement, it provides no 
guarantees of that, and indeed it creates several other identifiable 
problems.
    Although VATs can be described simply (see above), in practice VATs 
are extremely complex. Thus, one should compare existing corporate 
taxes to VATs as they would likely be created, not as they exist on 
paper.
    Basically, the broader the tax base (i.e., the fewer the number of 
zero-rated or exempt goods), the lower the tax rate can be and (with a 
few exceptions) the simpler the tax system can be. But if the VAT is 
the only tax affecting corporations, one can expect to see pressure to 
allow corporations to deduct health insurance payments, payroll taxes 
and state and local taxes as they currently do. If these deductions 
were allowed, the required rate would jump significantly. This in turn 
would create pressure to exempt certain goods--e.g., food, health 
insurance, housing--which would raise rates further. In addition, items 
like energy subsidies and other forms of ``corporate welfare'' could be 
implemented through the VAT. Unless some mechanism were developed to 
keep such subsidies out, the VAT base would be eroded like the 
corporate base currently is and rates would be quite high.
    Even if the VAT base is kept broad (and it is not in most European 
countries), there would be a fundamental conflict in the U.S. system 
with having an individual income tax but a VAT at the corporate level. 
Essentially, income could be sheltered indefinitely via retained 
earnings in corporations. This problem does not arise in Europe because 
European countries have a corporate income tax as well as a VAT.
    Also, under a VAT, firms have incentives to report any cash inflow 
as an interest receipt and any cash outflow as a deductible expense. 
This would give firms incentives, in their transactions with 
government, non-profits, and foreigners, to relabel cash flows. Zodrow 
and McLure in a 1996 paper declared that this feature of the flat tax 
(it is also a feature of the VAT) offered unacceptable opportunities 
for abuse. Again, these issues do not arise with VATs in Europe because 
those countries have corporate income taxes (that tax interest income).
    Switching from the corporate income tax to a VAT would likely be 
regressive. The ultimate incidence of the corporate income tax is 
unclear, but most estimates suggest it is borne by capital owners. The 
VAT, in turn, would be borne by consumers. In addition, the appearance 
of changes in distributional effects might prove very important: it 
would be hard to make the political case, for example, for a tax that 
raised the cost of food and health care for low-income families in 
order to reduce the costs for a multinational corporation to invest in 
a foreign country.
    The impact on growth of a switch would likely be positive, if the 
VAT were implemented in a simple broad-based way. But if a U.S. VAT 
ends up looking like a European VAT, the net effects on growth may be 
substantially smaller. Many papers suggest that replacing the entire 
U.S. tax system with a clean, broad-based, low-rate consumption tax 
would raise the size of the economy by about 1-2 percent over the next 
10-15 years. Certainly, replacing only one small portion of that 
system--the corporate tax--with a complex VAT would have significantly 
smaller effects.
    Unlike the current corporate or individual business taxes, the VAT 
does not attempt to tax profits as commonly understood. Changing the 
entire logic and structure of business taxation will create several 
situations that will be perceived as problems by taxpayers and firms, 
even if they make perfect sense within the overall logic of the VAT. 
First, some businesses will see massive changes in their tax 
liabilities. For example, the developers of the flat tax, Hall and 
Rabushka, note that General Motors' tax liability would have risen from 
$110 million in 1993 under the current system to $2.7 billion under a 
19 percent flat tax--and the flat tax offers deductions for wages, 
which a VAT would not.
    Some businesses with large profits will pay no taxes. This will 
occur because calculations of profit (before federal taxes) include 
revenue from all sources and subtract expenses for a variety of items, 
including fringe benefits, interest payments, payroll taxes, and state 
and local income and property taxes. In the VAT, only revenues from 
sales of goods and services is included (financial income is omitted) 
and expenses on fringe benefits, interest payments and other taxes are 
not deductible. Thus, firms may be in the enviable position of 
reporting huge profits to shareholders, while paying no federal tax. 
This sort of situation makes perfect sense within the context of the 
VAT. However, in the past, precisely this situation led to the 
strengthening of the corporate and individual alternative minimum 
taxes, which are universally regarded as one of the most complex areas 
of the tax code. It is hard to see why those same pressures would not 
arise in the VAT.
    Conversely, some firms with low or negative profits may be forced 
to make very large tax payments. Again, this makes sense within the 
context of the VAT, but will not be viewed as fair by firm owners who 
wonder why they have to pay taxes in years when they lose money and who 
will push for reforms.
    Finally, converting the corporate income tax to a VAT would raise 
difficult transition with respect to unused depreciation allowances, 
interest payments on previously incurred debt, net operating loss 
carryovers, excess foreign tax credits and so on.
C. Analysis: International issues

    The VAT would be border adjustable, but this in and of itself, 
would have no effect on the trade balance. To the extent that replacing 
the corporate income tax with a VAT raised investment more than saving, 
it would make the trade balance worse.
    Because it would not exports, the VAT obviates any potential need 
for export subsidies. It is my conjecture, however, that the political 
demand for export subsidies would not disappear. Interestingly, by 
taxing imports and giving a deduction for exports, the VAT provides 
cash flow tax treatment for net foreign investment. Given that the U.S. 
is a debtor nation, its net foreign asset holdings are negative, and 
the present value of associated cash flows is therefore also negative. 
Thus, including those cash flows in the base--as the VAT does--will 
lead to a narrower tax base.
    Finally, the generally lower tax rate on a VAT would cause firms to 
set transfer prices to shift income into the U.S. But even with a 
lower-rate VAT, there would be big incentives for corporate inversions, 
especially for firms whose tax burdens rise under a VAT relative to the 
current system.

                              Sources Used

    Altshuler, Rosanne and Harry Grubert. ``Where Will They Go If We Go 
Territorial? Dividend Exemption and the Location Decisions of U.S. 
Multinational Corporations. National Tax Journal 44 No. 4 (December 
2001): 787-810.
    Auerbach, Alan J. ``Flat Taxes: Some Economic Considerations.'' 
Testimony before the U.S. Senate Committee on Finance. Washington, DC: 
April 1995.
    Auerbach, Alan J. ``Tax Reform, Capital Allocation, Efficiency, and 
Growth.'' In Economic Effects of Fundamental Tax Reform, edited by 
Henry J. Aaron and William G. Gale, 29-82. Washington, DC: Brookings 
Institution, 1996.
    Avi-Yonah, Reuven S. ``Comment on Grubert and Newlon, `The 
International Implications of Consumption Tax Proposals.''' National 
Tax Journal 49 No. 2 (June 1996): 259-65.
    Brewer, Ken. ``Treason? Or Survival of the Fittest? Dealing With 
Corporate Expatriation.'' Tax Notes 95 No. 4 (April 22, 2002): 603.
    Brumbaugh, David L. ``Export Tax Benefits and the WTO: Foreign 
Sales Corporations and the Extraterritorial Replacement Provisions.'' 
Congressional Research Service Report for Congress. RS20746. January 
24, 2002.
    Brumbaugh, David L. ``The Foreign Sales Corporation (FSC) Tax 
Benefit for Exporting: WTO Issues and an Economic Analysis.'' 
Congressional Research Service Report for Congress. RL30684. December 
11, 2000.
    Brookings Institution and International Tax Policy Forum. 
``Notebook of the Conference on Territorial Income Taxation.'' April 
30, 2001.
    Desai, Mihir A., C. Fritz Foley, and James R. Hines, Jr. 
``Repatriation Taxes and Dividend Distortions.'' National Tax Journal 
44 No. 4 (December 2001): 829-852.
    Elmendorf, Douglas W. and N. Gregory Mankiw. ``Government Debt.'' 
NBER working paper no. 6470. March 1998.
    Gomi, Yuji and Cym H. Lowell. ``Deferral: Platform for 
International Tax Policy in the 21st Century?'' Tax Notes 95 No. 4 
(April 22, 2002): 611.
    Graetz, Michael J. and Paul W. Oosterhuis. ``Structuring an 
Exemption System for Foreign Income of U.S. Corporations. National Tax 
Journal 44 No. 4 (December 2001): 771-786.
    Grubert, Harry. ``Enacting Dividend Exemption and Tax Revenue.'' 
National Tax Journal 44 No. 4 (December 2001): 811-828.
    Grubert, Harry and T. Scott Newlon. ``The International 
Implications of Consumption Tax Proposals.'' National Tax Journal 48 
No. 4 (December 1995): 619-47.
    Grubert, Harry and T. Scott Newlon. ``Reply to Avi-Yonah.'' 
National Tax Journal 49 No. 2 (June 1996): 267-71.
    Hines, James R. Jr. ``Fundamental Tax Reform in an International 
Setting.'' In Economic Effects of Fundamental Tax Reform, edited by 
Henry J. Aaron and William G. Gale, 465-502. Washington, DC: Brookings 
Institution, 1996.
    Hufbauer, Gary. ``The Case of Mutating Incentives: How Will the 
FSC/ETI Drama End?'' Tax Notes 95 No. 5 (April 29, 2002a): 791-793.
    Hufbauer, Gary. ``The FSC Case: Background and Implications.'' 
Institute for International Economics Working Paper. February 27, 
2002b.
    Joint Committee on Taxation. ``Background and History of the Trade 
Dispute Relating to the Prior-Law Foreign Sales Corporation Provisions 
and the Present-Law Exclusion for Extraterritorial Income and a 
Description of These Rules.'' JCX-10-02. February 25, 2002a.
    Joint Committee on Taxation. ``Background Materials on Business Tax 
Issues Prepared for the House Committee on Ways and Means Tax Policy 
Discussion Series.'' JCX-23-02. April 4, 2002b.
    Johnston, David Cay. ``Tax Treaties with Small Nations Turn Into a 
New Shield for Profits.'' New York Times. April 16, 2002.
    Krugman, Paul and Martin Feldstein. ``International Trade Effects 
of Value Added Taxation.'' NBER Working Paper 313. Cambridge, MA: 
National Bureau of Economic Research, 1989.
    McIntyre, Michael J. Testimony before the U.S. House of 
Representatives Committee on Ways and Means, Subcommittee on Select 
Revenue Measures. Washington, DC: April 10, 2002.
    Shay, Stephen E. Testimony before the U.S. House of Representatives 
Committee on Ways and Means. Washington, DC: February 27, 2002.
    Sheppard, Lee A. ``Preventing Corporate Inversions, Part 2.'' Tax 
Notes. May 6, 2002.
    Sullivan, Martin A. ``20 Talking Points on U.S. Export Tax 
Incentives.'' Tax Notes 95 No. 5 (April 29, 2002): 660-64.

                                                     Table 1
                                        Corporate Taxes in OECD Countries
----------------------------------------------------------------------------------------------------------------
                                                                                               Top        Top
                                                                                             Marginal   Marginal
                                                                Corporate      Corporate     Federal     Total
                           Country                             Income Tax/    Income Tax/   Corporate  Corporate
                                                                GDP, 1999      Total Tax,     Income     Income
                                                                                  1999      Tax Rate,  Tax Rate,
                                                                                               1998       1998
----------------------------------------------------------------------------------------------------------------
United States                                                       2.4            8.3         35.0       39.5
Australia                                                           4.9           15.9         36.0       36.0
Austria                                                             1.8            4.1         34.0       34.0
Belgium                                                             3.6            7.9         40.2       40.2
Canada                                                              3.7            9.8         29.1       46.1
Czech Republic                                                      3.8            9.5         35.0       35.0
Denmark                                                             3.0            5.0         34.0       34.0
Finland                                                             4.2            9.1         28.0       28.0
France                                                              2.9            6.4         41.6       41.7
Germany                                                             1.8            4.8         47.5       58.2
Hungary                                                             3.2            8.7         18.0       19.1
Iceland                                                             2.3            5.9         30.0       30.0
Ireland                                                             1.5            4.2         32.0       32.0
Italy                                                               3.9           12.1         37.0       37.0
Japan                                                               3.3            7.7         33.5       50.0
Korea                                                               3.4           12.9         28.0       31.2
Luxembourg                                                          2.1            8.9         31.2       39.6
Mexico                                                              7.3           17.6         34.0       34.0
Netherlands                                                         4.2           10.1         35.0       35.0
New Zealand                                                         4.0           11.1         33.0       33.0
Norway                                                              3.2            7.6         28.0       28.0
Poland                                                              2.6            7.4         36.0       36.0
Portugal                                                            4.0           11.7         34.0       37.4
Slovak Republic                                                     2.8            8.0
Spain                                                               2.8            8.0         35.8       35.8
Sweden                                                              3.2            6.0         28.0       28.0
Switzerland                                                         2.5            7.2          7.8       33.2
Turkey                                                              2.4            7.6         44.0       44.0
United Kingdom                                                      3.8           10.4         31.0       31.0
EU 15                                                               3.5            8.7
OECD America                                                        3.1            9.1
OECD Europe                                                         3.2            8.2
OECD Pacific                                                        3.6           12.2
OECD Total                                                          3.3            8.8
----------------------------------------------------------------------------------------------------------------
Sources: Organization for Economic Co-operation and Development. Revenue Statistics 1965-2000. OECD, 2001., and
  Slemrod, Joel and Jon Bakija. Taxing Ourselves: A Citizen's Guide to the Great Debate Over Tax Reform. 2nd
  edition. Cambridge, MA: The MIT Press, 2000. Table A.2.

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    Chairman McCRERY. Thank you, Mr. Gale.
    Our final witness on the panel today is a respected 
Professor of Economics at another small school in the 
Northeast, Harvard.
    Mr. Jorgensen, welcome today. We appreciate your taking 
time out to join us, and we look forward to hearing your oral 
testimony. You may proceed, sir. Thank you.

 STATEMENT OF DALE W. JORGENSEN, FREDERIC EATON ABBE PROFESSOR 
   OF ECONOMICS, HARVARD UNIVERSITY, CAMBRIDGE, MASSACHUSETTS

    Mr. JORGENSEN. Thank you, Mr. Chairman, distinguished 
Members of the Committee. It is a very great privilege to 
participate in these hearings.
    I think that you have heard from the other witnesses about 
the serious deficiencies in our existing tax system. What I 
would argue is that this is the time for reform, and the 
argument is going to be based on the fact that the U.S. economy 
is emerging from a recession at the moment. Maybe we have 
already emerged.
    Investment is still seriously depressed, especially in the 
corporate sector. Therefore, it is very appropriate for these 
hearings to focus on the corporations' income tax, as you did 
in the call for the hearings that are taking place now. 
Therefore, I am going to propose to focus on tax reform that 
would have the effect of stimulating investment and thereby 
accelerating the rate of economic growth to the higher 
potential that is now evident from our productivity statistics 
issued only last Monday.
    I want to make three points. I want to talk in a little bit 
more detail about the potential economic impact of tax reform. 
I think it is very important to try to quantify that, to 
appreciate the scope of what is under discussion here.
    Second, I would like to outline a tax reform proposal that 
focuses on investment and making investment more effective, as 
well as providing more for more investment.
    Then, finally, I would like to refer to the issue of 
transition rules and simplification, which is also very much on 
everybody's mind.
    What I would like to propose is, in fact, that every dollar 
of investment should be earning precisely the same rate return 
before any taxes are levied. That ought to be the fundamental 
principle, because that is the only way that it is going to be 
possible to generate the kind of economic growth of which our 
economy is capable.
    The second step in fundamental tax reform is to reduce 
marginal rates, the rates on the last dollar of income earned, 
in order to provide the maximum incentives for American 
workers. My written statement outlines an approach to tax 
reform that would achieve these two objectives, and it would 
consist of two parts: a capital income tax rate that equalized 
before-tax rates of return, and a proportional earnings tax 
that minimizes the marginal tax rate on earned income.
    What kind of effect would this have on our economic growth? 
Well, for that purpose, I would like to propose a very simple 
yardstick, and that is the impact on consumer welfare measured 
in dollars. The reforms I have suggested would have a massive 
welfare impact amounting to $4.9 trillion. By comparison, U.S. 
national wealth in the year of the comparison was only $25.4 
trillion. So the welfare impact amounts to 19 cents on our 
National wealth, or 19 cents for every dollar of assets that we 
hold as a Nation.
    How much would the impact be for the kind of value-added 
tax that has been described by other witnesses? The answer is 
about 40 percent as much. I estimate that would be $2.06 
trillion, about 40 percent of the $4.9 trillion that is 
potential.
    In short, the opportunity we face for stimulating 
investment and bringing our economic growth up to full 
potential is staggering, and to take advantage of this historic 
opportunity, I think what we have to do is to reform our 
taxation of property-type income so as to equalize the burdens. 
We have to reform our taxation of earned income in order to 
minimize the marginal rates.
    The kind of reform that I have discussed in my written 
statement, which I hope you have before you, would produce a 
rate on earned income of only 10.9 percent. For property-type 
income, the rate would turn out to be something like 30.8 
percent, far below the combination of individual and corporate 
taxation which are now faced by corporate investors. So, the 
system that I am proposing is one that introduces differential 
taxation of property-type income and earned income.
    This is something that has a great history in U.S. tax law, 
and precisely this kind of differential taxation existed 
between 1962 and 1983, for two decades. So, there is a long 
tradition here to draw on. The definitions of income in the Tax 
Code would remain unchanged, and the rate structure on 
property-type income would remain unchanged.
    So, this method is based on the idea of reintroducing 
investment tax credits that would be specific to specific forms 
of legal organizations. In particular, corporations would 
receive tax credits of 3.9 cents on the dollar for new 
investments in equipment and 18.9 cents on the dollar for new 
investments in structures. Noncorporate businesses would be 
given a tax credit of 0.5 cent on equipment and 8 cents per 
dollar on structures. The effect of that is essentially to 
eliminate, that is to say, abolish the distinction between 
corporate and noncorporate income so far as the tax structure 
is concerned.
    This would be financed by means of a system of taxation on 
new investments by the household sector in housing and in 
equipment, and the rates would be set in such a way as to 
achieve a revenue-neutral system altogether.
    So far as transition rules are concerned, there aren't any. 
This doesn't require any transition rules. It is a very 
straightforward system, and there is nothing inconsistent 
between what I have proposed and any program of tax 
simplification like the three volume proposal which has been 
made by the Joint Committee on Taxation.
    So, to sum up, the system that I propose is a fundamental 
reform that deals with the issue that you identified in calling 
for these hearings, namely, the deficiencies of our current 
corporate tax system. It is a system that would promote 
investment, especially in the corporate sector, and it would 
enhance the competitiveness of American businesses in the 
global marketplace. This would be a forceful and effective 
response to the World Trade Organization and will meet the 
needs of American businesses and consumers in our 21st-century 
economy.
    Thank you.
    [The prepared statement of Mr. Jorgensen follows:]
   Statement of Dale W. Jorgensen, Frederic Eaton Abbe Professor of 
        Economics, Harvard University, Cambridge, Massachusetts

                      EFFICIENT TAXATION OF INCOME

                A NEW APPROACH TO FUNDAMENTAL TAX REFORM

                                Summary

    1. Fundamental tax reform through the EFFICIENT TAXATION OF INCOME 
consists of two parts, an Efficient Capital Income Tax and a 
Proportional Labor Income Tax. Adjusted Gross Income for individuals 
and Corporate Income would be defined as in the existing tax code. The 
Proportional Labor Tax would tax labor income at a flat rate of 10.9%. 
The Efficient Capital Tax would tax capital income at an effective rate 
of 30.8%.
    2. Since the definition of income would be unchanged and the rate 
structure for capital income would be preserved, the Efficient Capital 
Tax would introduce a system of Investment Tax Credits to equalize 
before-tax rates of return on all business assets. The average tax 
credits for the business sector would be:

        Corporate business: 3.9% on equipment, 18.9% on structures.
        Non-corporate business: 0.5% on equipment, 8.1% on structures.

    To equalize before-tax rates of return on assets in the business 
and household sectors, new taxes on investments by households would be 
collected by car dealers, real estate developers, and other providers 
of investment goods to households at the rates:

        7.2% on equipment, 32.5% on structures.

    Tax credits for businesses and taxes on household investments would 
apply only to new assets and would not apply to existing assets.
    3. The welfare gains from this tax reform would be $4.90 trillion; 
by comparison GDP was $8.11 trillion and National Wealth was $25.38 
trillion in 1997, the base year for our welfare comparison. The welfare 
gains would amount to 19.3% of our national wealth or 19.3 cents for 
every dollar of wealth.

    Source: Dale W. Jorgensen and Kun-Young Yun, LIFTING THE BURDEN: 
Tax Reform, the Cost of Capital and U.S. Economic Growth, Cambridge, 
MA: The MIT Press, 2001.

                      EFFICIENT TAXATION OF INCOME

                       Frequently Asked Questions

    Question 1: Is this a good time to introduce EFFICIENT TAXATION OF 
INCOME?

    Answer: The U.S. economy is just emerging from recession and 
investment is depressed, relative to the boom period in the 1990's. 
Instituting investment tax credits, like those under EFFICIENT TAXATION 
OF INCOME, would stimulate investment, especially in the corporate 
sector.

    Question 2: What about the long-run effects?

    Answer: These are measured by the welfare gains. The welfare impact 
of $4.90 trillion is the answer to the question: How much additional 
wealth would be required to purchase the added consumption of goods and 
leisure made possible by tax reform? The welfare gains reflect more 
investment and faster economic growth.

    Question 3. Is EFFICIENT TAXATION OF INCOME a tax on income or a 
tax on consumption?

    Answer: As the name suggests, EFFICIENT TAXATION OF INCOME is a tax 
on income rather than consumption. Income would be defined in exactly 
the same way as in the existing tax code.

    Question 4: What about transition rules?

    Answer: Since the definition of income would be unchanged, no 
transition rules would be required. EFFICIENT TAXATION OF INCOME could 
be enacted today and implemented tomorrow. All existing tax exemptions 
and deductions on capital income would be unaffected. This would 
include depreciation and interest deductions by businesses as well as 
mortgage interest and property tax deductions by existing homeowners.

    Question 5: What about tax simplification?

    Answer: The system of tax credits for businesses and taxes on 
household investments could be adjusted to preserve equality of before-
tax rates of return on all assets whenever the tax code is altered. In 
short, there is no conflict between EFFICIENT TAXATION OF INCOME and 
simplification of the tax code.

    Question 6. How would the tax rates under EFFICIENT TAXATION OF 
INCOME compare with rates under consumption taxes? The tax rates under 
EFFICIENT TAXATION OF INCOME would be

        labor income tax                                           10.9%
        effective capital income tax rate                          30.8%

    Key tax rates for some of the popular consumption tax proposals 
are:

        Hall-Rabushka Flat Tax
        flat tax rate                                              27.6%
        average labor tax rate                                     15.3%

    Progressive National Retail Sales Tax (No Deductions; Exemptions 
like the Flat Tax)

        marginal sales tax rate                                    40.1%
        average sales tax rate                                     29.6%

    Proportional National Retail Sales Tax (No Deductions, No 
Exemptions).

        sales tax rate                                             28.5%

    Question 7. How do the welfare gains from EFFICIENT TAXATION OF 
INCOME compare with gains from consumption taxes?

    Answer: EFFICIENT TAXATION OF INCOME would have a larger impact 
than a Proportional National Retail Sales Tax and twice the impact of 
the popular Flat Tax proposal. Here are the numbers:

        EFFICIENT TAXATION OF INCOME                      $4.90 trillion
        Hall-Rabushka Flat Tax                            $2.06 trillion
        Progressive National Retail Sales Tax             $3.32 trillion
        Proportional National Retail Sales Tax            $4.69 trillion

    Question 8: Does EFFICIENT TAXATION OF INCOME sacrifice 
progressivity?

    Answer: Progressivity would result from differences between 
taxation of capital income and taxation of labor income, not from 
exemptions like those in the Flat Tax or a progressive rate structure 
like the current income tax.

    Question 9: Why not introduce exemptions and/or a progressive rate 
structure?

    Answer: The welfare gains would depend critically on lowering the 
marginal rates on both capital and labor income; these are the rates on 
the ``last dollar'' of income. Exemptions and progressive tax rates 
would increase the marginal rates and reduce the welfare gains.

    Question 10: How would EFFICIENT TAXATION OF INCOME be affected by 
introducing exemptions like those in the Flat Tax?

    Answer: The capital income tax rate would be unaffected, but the 
marginal labor income tax rate, the rate on the last dollar of income, 
would rise from 10.8% to 26.0%. As a consequence, the welfare gains 
would be sharply reduced to $2.02 trillion.

    Question 11: What would happen to Social Security and Medicare 
contributions under EFFICIENT TAXATION OF INCOME?

    Answer: These would be unchanged.

    Question 12: What about contributions to private pension funds 
through 401(k)'s and similar provisions of the existing tax code?

    Answer: These would also be unchanged.

    Question 13: What would happen to property values for home owners?

    Answer: Existing home owners would be deemed to have paid taxes on 
their property at the time they originally purchased it. They would be 
exempt from all future taxes on this property, including capital gains 
taxes when they eventually sell it. Property values would be protected 
by the reduction in future capital gains taxes and the taxes on new 
housing, so that home owners would share in the welfare gains from 
EFFICIENT TAXATION OF INCOME.

    Question 14: How does this affect people thinking of becoming home 
owners?

    Answer: By definition, these people are renters, not home owners, 
and they
    would be made better off. They would find home ownership slightly 
more expensive and rental housing somewhat less expensive. In short, 
they would also share in the welfare gains from EFFICIENT TAXATION OF 
INCOME.

    Question 15: What would happen to stock market values for corporate 
shareholders?

    Answer: Since the new investment tax credits would reduce the cost 
of acquiring new assets after taxes, the value of existing assets would 
fall. However, this would be offset by an increase in the rate of 
return on these assets, so that stock market values would be largely 
unaffected.

    Question 16: How would EFFICIENT TAXATION OF INCOME impact states 
and localities?

    Answer: Most states use the same tax bases as federal corporate and 
individual income taxes. Since the tax bases would not change, state 
and local income taxes could be left unchanged. More likely, states and 
localities would follow the Federal Government in adopting EFFICIENT 
TAXATION OF INCOME. The tax rates given above assume that they would, 
so that these rates include federal, state, and local taxes.

    Question 17: What about state sales and property taxes?

    Answer: These would not be affected. Also, deductions of these 
taxes at the federal level would be preserved.

    Question 18: What would happen to tax revenues?

    Answer: EFFICIENT TAXATION OF INCOME is revenue-neutral, so that 
tax revenues at federal, state, and local levels would be unchanged.

    Source: Dale W. Jorgensen and Kun-Young Yun, LIFTING THE BURDEN: 
Tax Reform, the Cost of Capital and U.S. Economic Growth, Cambridge, 
MA: The MIT Press, 2001

                               

    Chairman McCRERY. Thank you. Mr. Jorgensen.
    We thank all of you on the panel for providing us with some 
excellent testimony and some excellent ideas for us to think 
about.
    Now we have the privilege of asking you a few questions 
regarding your testimony and anything else that the panel of 
Members wishes to inquire about. I would tell the Members of 
the Subcommittee that if the panel is amenable to staying 
around, I will allow a second round of questions if anybody 
wants to stick around for a second round, because this subject 
matter, as anybody who might be watching on TV has figured out 
by now, is fairly complex; and if they weren't convinced before 
Mr. Jorgensen's testimony, they certainly are now. Mr. 
Jorgensen, if you could hang around for about another 6 months, 
we could get some excellent feedback from your testimony.
    Mr. Gale, I can't help but go back to your analogy about 
crimes and reducing the crime rate. Some might retort that if 
the crime were reading any writings of Thomas Paine or reading 
any writings of Ivy League professors, it might be a good thing 
to abolish that crime and reduce the crime rate. So keep that 
in mind.
    We are going to have a hearing in June that will 
specifically include the subject of corporate inversions, so we 
hope to further explore that issue at that hearing. It is a 
very important issue for us to learn more about and to explore, 
and we intend to do that in the June hearing, but I appreciate 
your remarks today about that.
    Mr. Entin, let me start with you, but I want others to 
comment on this. I have heard in other for a--some of you 
comment on this. Generally, the economists and the tax experts 
that have spoken to Members of the Committee on Ways and Means 
and in other settings have agreed that border adjustability is 
not necessarily an advantage, it is not an advantage or a 
disadvantage in terms of the competitiveness of our domestic 
corporations.
    Do you agree with that, Mr. Entin?
    Mr. ENTIN. I do agree with that. Sometimes people do a 
partial analysis; they take the first step and then they don't 
allow other things to adjust.
    When adjustments are made, border adjustment washes out. 
The neutral taxes that you see in fundamental tax reform 
proposals are collected at various points in the production 
process. Labor and capital come together and produce a product, 
and the business sells it. The proceeds are paid out to the 
labor and the capital, and the labor and the capital go off and 
buy the goods.
    A sales tax is imposed at the point of sale, at retail. 
Products that are sold to exporters don't go through the 
retail. Thus, they are not taxed. Sold to the domestic person, 
they are. Imports are taxed when the family takes its income 
and goes to the retailer and spends it.
    In the cash flow tax that I described, individuals take 
their income, subtract their saving and pay tax on what is 
left; then they go to the store. Whether they buy an import or 
an export, there is no tax there. It was collected before they 
left the house.
    If you tax the same tax base before they leave the house or 
after they get to the store, it is the same tax base. One 
appears to be border adjustable. One is sort of implicitly 
border adjustable. There is no difference.
    That would be true also for the VAT, which is collected 
within the firms as their products go up through the production 
process, or in the sort of Roth-style flat tax approach. All 
these things wash out.
    What the tax reforms do for exporters, I think, is twofold. 
They take away the extra layer of tax on corporations, many of 
whom are large exporters and many of whom are import 
competitors. For corporations and for the small businessman, 
they also move from depreciation to expensing. These steps 
lower the cost of capital.
    In the United States, we hit manufacturers harder than the 
service sectors because manufacturers use more capital. The 
manufacturers with the longest-lived capital get hit the 
hardest because depreciation shortchanges longer lived assets 
the most; and if there is inflation, it is even worse. So by 
fixing that element of it, you happen to benefit many of the 
sectors that have suffered over the years, sectors that have 
experienced a shift of our resources into other sectors. You 
are undoing this effect of the bad tax system on manufacturers, 
and they will grow. There will be some more exports, perhaps, 
but there will also perhaps be some more imports.
    The difference between exports and imports may not be 
affected very much, but the sectors that you worry about the 
most and which are complaining the most about import 
competition are really complaining about the fact that our tax 
system is hitting them over the head with a two-by-four. Fix 
that and they won't worry so much about whether their 
competitors are down the street or over the ocean.
    Chairman McCRERY. Does anyone on the panel think that 
border adjustability is important for competitiveness?
    Mr. GRAETZ. Mr. Chairman----
    Chairman McCRERY. Go ahead, Mr. Graetz, and then I will 
call on Ernie.
    Mr. GRAETZ. I think that it is important. The economic 
analysis suggests that it doesn't matter whether you apply a 
consumption-type tax on an origin basis or whether you apply it 
on a destination basis with border adjustments. The argument is 
that foreign currency relationships will change to equalize 
things over time.
    The first point I would make is, this is an ``over time'' 
story, and the question of how much time is required is not 
clear.
    The second point I would make is, if you take an origin-
based tax like the flat tax, it taxes imports only on their 
U.S. markup, whereas a domestic business is taxed on its full 
value added, if you will. American business properly is going 
to say that system is creating an unfair advantage for imports.
    We went through this many times with energy-type taxes. You 
may remember proposals for energy taxes that were not border 
adjustable, and the American manufacturers insisted that this 
put them at a tremendous competitive disadvantage.
    I think it is extremely important that you have a tax that 
does have border adjustments in order to achieve a level 
playing field quality, and in order not to a rely on the 
currency adjustments that the economists assure us will take 
place to protect American businesses. So, it is fundamental 
issue, and it is not a subsidy.
    Border adjustments are not a subsidy for U.S. exports. They 
just put imports and exports in the same place in terms of what 
the American consumer pays for them, but I think, in terms of 
practicality, there is all the difference in the world.
    Chairman McCRERY. Mr. Christian.
    Mr. CHRISTIAN. Well, what Mike says is by and large 
correct. I would further point out that this ``over time'' 
theoretical adjustment of exchange rates that he has referred 
to might be an extremely long period of time. Given that 
transactions in goods are only a very small portion of the 
transactions in the current account, they are almost too small 
to have the effect that economists predict in theory.
    The point really is that what we should stop, as a 
practical real-life matter, penalizing manufacturing in the 
United States and exporting it to a foreign market. Companies 
should have the option of staying at home and selling into a 
foreign market. At the present time we provide an incentive to 
manufacture abroad and sell abroad. At the present time--if you 
do succeed in a foreign market, we penalize you if you bring 
the money home for reinvestment in the United States of 
America, whereas, if you can keep it abroad, if you are a large 
enough company to do so, and reinvest it in someone else's 
economy, you can defer U.S. tax indefinitely.
    Applying little theoretical catechisms to little pieces of 
the puzzle is wrong. We have to look at the practical picture 
of what is occurring with respect to U.S. exports. 
Manufacturing in the United States is in a decline and has been 
in a decline for a very long period of time.
    Mr. CHRISTIAN. It is almost not an issue worth debating. It 
is like arguing about the last war and the tactics that were 
employed by generals in the last war. We are in a different 
situation now.
    Chairman McCRERY. Mr. Cain.
    Mr. CAIN. I would just like to add that if we were able to 
develop the perfect border adjustability formula under the 
current system, the revenue impact that we are talking about 
would be minuscule compared to the upside if we put an economic 
boon in the U.S. economy by changing the entire system. That is 
one of the points that I wanted to make, because if we go to a 
national consumption tax, imports and exports get treated the 
same. The U.S. businesses would applaud that. They know how to 
compete if there is a level playing field. This is why we are 
proposing to look at replacing the system such that the 
temptation to build plants overseas would be gone. There would 
be an even greater temptation to build plants at home by 
eliminating that.
    Chairman McCRERY. Before I go to Mr. Neal, Mr. Engen, on a 
variation of this question, and if you want to comment on that 
question you may, but is it your opinion that U.S. companies 
and taxpayers are paying a portion of other country's social 
welfare costs when value-added taxes are imposed on U.S. 
exports at the border of those other countries?
    Mr. ENGEN. I think it depends on what transactions you are 
looking at specifically. I mean, I think there is a possibility 
with the way some of the border adjustments work that with some 
of the payments, those are going into the tax revenues of other 
countries, and thus of funding whatever they choose to spend on 
it. I don't necessarily believe that is an obvious conclusion.
    The one thing to comment on from before is, I think I would 
agree with Mr. Cain to my left, that one of the most important 
things here is not necessarily the border adjustment, that in 
the end, that is a relatively small issue, although there are 
some practical issues in this. In that sense, Mr. Graetz's 
points that, you know, in the near term and for practical 
purposes, there are some various issues with the X tax that I 
was talking about, which is a variant of the flat tax. It can 
matter in some small ways whether you choose an origin base or 
a destination base how you do the border adjustments.
    I think the main issue is the point brought up is that if 
we reduce the tax distortion on capital, it is going to make 
the U.S. economy a much more friendly place for businesses to 
invest, and it takes away a lot of these other pressures, a lot 
of the concerns about border adjustment and import--export 
subsidies.
    Chairman McCRERY. Thank you. Mr. Neal.
    Mr. NEAL. Thank you, Mr. Chairman. Thank you for holding 
this hearing, and I think these get-togethers are most helpful. 
Indeed, Chairman Thomas' decision to hold the sessions with the 
Congressional Research Service also I think have been very, 
very helpful.
    I want to also publicly thank you for agreeing to hold a 
hearing in early June on the whole issue of corporate 
inversions.
    Stanley Works voted this morning to leave the United States 
and to reincorporate in Bermuda. That is going to set off a 
fire storm on both sides of the aisle. A very prominent 
Republican said to me before the last vote, ``You are 
absolutely right; if this gets to the Floor, I am with you.''
    I would like to ask first of all, Mr. Gale, and then come 
back to Mr. Graetz for a second, sometimes it is very hard for 
all of us to understand what is meant by international 
competitiveness. Does it mean that tax reductions that are good 
for some multinational corporations are good for America as a 
whole?
    Mr. GALE. Economists usually like to squirm at the popular 
definition of competitiveness, which is often defined in terms 
of the trade balance. Then we get into these arguments about 
whether border adjusting improves the trade balance, and 
economists generally think in the long term the answer is no, 
on the short term generally, I think the answer is no too, but 
there is room for discussion there, I guess.
    Different people define competitiveness in different ways. 
There is an issue, if it is defined in terms of the trade 
balance, then border adjustability is just not a big issue. If 
it is defined in terms of the underlying productivity of 
American firms, then you have something you can sort of grab on 
to and talk about how different policies affect productivity. 
That is a little less of a swishy concept than competitiveness 
as it usually is applied in the public sector.
    Mr. NEAL. Okay. Mr. Graetz, regarding companies that are 
avoiding U.S. tax by reincorporating with a Bermuda mailbox, 
would rules to stop this hurt U.S. international 
competitiveness or speed harmful foreign takeovers of U.S. 
businesses?
    Mr. GRAETZ. Mr. Neal, I don't believe so. I believe the 
corporate inversion problem does need to be stopped because I 
think that--actually, this is one of the places I can actually 
agree with Bill Gale, which I like to do if I can--one of the 
things that is going on in these inversions is an effort to 
eliminate U.S. tax on U.S. source income. This is not a story 
that is limited to competitiveness in foreign markets. When 
some corporations can find it possible and easy to avoid U.S. 
tax, and others do not, I see no reason to think that this is 
good for America. Nor do I think it is good for America to have 
our tax base depend on a mailbox in Bermuda and a meeting in 
Barbados. I think now you need both. That is Stanley Works' 
plan, as I understand it; you have to have a mailbox in Bermuda 
and you have to meet once a year in Barbados, not that is such 
a hardship for the companies. I think it is an important 
problem, and I think it needs prompt attention by the Congress.
    Mr. NEAL. Thank you. I want to ask another question if I 
could, then feel free to expound upon it. Mr. Cain, do you 
think that we are going to change the Tax Code? You said the 
American people don't believe we are going to change the Tax 
Code. Do you think we are going to?
    Mr. CAIN. Do I think?
    Mr. NEAL. That Congress is going to change substantially 
the Tax Code? Do you think we are going to a consumption tax or 
flat tax?
    Mr. CAIN. I believe so, because even if we were to pass 
regulations, or if Congress were to pass regulations to address 
the issue that you are talking about, it would simply create 
more complexity, more costs. So we really aren't solving the 
problem. I firmly believe that the American people have a 
desire to see some bold action on this thing. So I think that 
there are a lot of people who believe that it can be done, but 
doing it to stop that type of thing would just make it more 
complex.
    If I may add one other thing, let me give you the 
definition of competitiveness that I know most businessmen 
share, whether it is in the domestic or international. It is a 
level playing field with the absence of disadvantages and 
disincentives to do business. That is all American businesses 
want, whether that is domestic or in the international arena.
    Mr. NEAL. I would just close if I could. Back in 1995, the 
Majority Leader here talked extensively and expansively about 
changes in the Tax Code. He said, in this Committee, we were 
going to, I think, pull the Tax Code up by its roots. He said, 
we were going to drive a stake into its heart. We were moving 
in the direction of a consumption tax 1 day and a flat tax the 
next day. One thing I am curious about, Mr. Cain, is whether 
you think it is going to happen, because I haven't seen a lot 
of evidence around here that it is going to happen.
    Mr. CAIN. Mr. Neal, I believe it can happen, but more 
importantly, I believe it must happen. I am familiar with those 
hearings and those statements because you may recall, I was on 
the Tax Commission in 1994-1995, but that is part of the 
problem. We have debated this for a long time, but due to lack 
of follow-through and leadership, nothing has been done yet.
    Mr. NEAL. Thank you very much, Mr. Cain.
    Chairman McCRERY. Thank you, Mr. Neal. Mr. Weller?
    Mr. WELLER. Thank you, Mr. Chairman. I commend you for this 
series of hearings which are very informative as we look at 
ways of creating economic growth and making or giving the 
opportunity for American companies to be competitive on the 
global stage. I recognize we are limited on time, we have a 
vote here to go to, so I am going to cut to the point here. 
Over the last several years, it has become very clear that our 
Tax Code hampers economic growth in the way we depreciate 
assets or how we recover the cost of assets in our economy. The 
office computer we carry on the books for 5 years, it has 
depreciated over 5 years, but on average, business replaces it 
every 14 months. It just doesn't make sense under our current 
Tax Code.
    My colleague, Mr. English, and I know, Mr. Neal and others, 
we have all been advocating ideas out of the expense and 
Technology Reform Act, which will allow you to fully expense 
computers and telecommunications equipment, wireless, medical 
technology, security equipment, surveillance equipment, and 
biometrics and other equipment, that has a very short real 
life.
    Mr. Christian, you in particular have been one who has been 
very involved and engaged on this issue in cost recovery and 
depreciation reform. With the Chairman's leadership, we were 
successful in beginning that process in the economic stimulus 
plan that the President signed with a 30-percent expensing, or 
some call bonus depreciation or accelerated depreciation 
component That is temporary, and we have introduced legislation 
to make it permanent as the bottom line as we look at 
depreciation reform. Mr. Christian, I would like to hear from 
you and others on the panel just what your thoughts are about 
how expensing in particular how you feel that would impact 
capital formation, how it would impact economic growth, and 
also our international competitiveness.
    Mr. CHRISTIAN. Mr. Weller, thank you. You and Mr. Neal and 
Mr. English and others you have taken the leadership role, 
which has already benefited America. The 30-percent expensing 
was done in a bipartisan way. I have come here today to propose 
a bipartisan solution to an international problem involving 
exports. If you adopted the solution we are talking about and 
in the same bill went to 100-percent expensing, you would 
essentially have a neutral tax system for exports from the 
United States, you would have credited a neutral tax system for 
capital recovery.
    Moving quickly then to the issue of inversions and the 
international situation which is becoming intense. People are 
fleeing. Foreign companies are not coming here to make this 
their headquarters. If we did in one bill what you and Mr. Neal 
and others under the Chairman's leadership have been trying to 
do for several years by enacting 100-percent expensing, and if 
we made the changes to exclude export income from U.S. income 
tax.
    The United States would be the most desirable place in the 
world for all business, whether American-owned business or 
foreign-owned business, to conduct world trade throughout the 
world. Companies that have fled America would want to come 
home. Those who are thinking about fleeing it would not do so.
    There are various kinds of inversions and there are various 
things about inversions such as earning stripping, that are not 
good. Mr. Graetz has pointed that out. Those are not small 
issues, but they are, in a way, tangential issues to what is 
the larger problem of the cost of capital in the United States 
and how we treat our exports relative to how other countries 
treat theirs.
    I commend you, Mr. Neal, and others for the progress you 
have already made on expensing.
    Mr. WELLER. Thank you, Mr. Christian. I realize I have run 
out of time here. I would comment that one thing I would hope 
that our Subcommittee would look at is how our competitors 
overseas treat assets when it comes to cost recovery. I have 
seen information which would suggest that particularly our 
competition in Asia and Korea and some other countries 
overseas, that their tax treatment of assets is much more 
favorable than ours giving their companies a greater advantage 
when it comes to economic growth.
    Thank you, Mr. Chairman.
    Chairman McCRERY. Thank you Mr. Weller. Gentlemen, we have 
a vote on the House Floor. I am going to recess the 
Subcommittee for just a few minutes just long enough for us to 
run over vote and come right back. So the Committee will stand 
in recess.
    [Recess.]
    Chairman McCRERY. The Committee will come to order. I 
appreciate our panel of witnesses being patient with our duty 
to vote, and we don't expect another vote for a while. So, we 
should have sufficient time to finish the questioning. Now I 
would like to turn to another distinguished Member of the 
Subcommittee, Mr. Ryan from Wisconsin.
    Mr. RYAN. Thank you, Mr. Chairman. Before I ask a couple 
quick questions, I thought that just for the record there might 
be some clarifications. It's been said a couple of times that 
the flat tax is not a consumption tax. That is just not the 
case. The flat tax is a consumption tax. I just want to make 
that clear for the record. Also it is a progressive tax. It is 
a tax because of generous exemptions means that it is 
effectively a progressive tax. So I just wanted to kind of 
clear that.
    I wanted to nail down this issue of those of you who are 
for destination principle taxation versus origin principle 
taxation, different from an economic standpoint, from a 
competitiveness standpoint on having a territorial origin tax 
system versus the destination principle system. I would like to 
continue that road. I saw a couple heads shaking when Mr. 
Graetz, and I think Mr. Christian, were talking about it.
    Steve, let me go to you. I think your head was shaking the 
most. When we talked about that, and it is the idea that over 
time, the differences made up and that exchange rates play into 
it, I would like to see if we can just focus on that discussion 
right now.
    Mr. ENTIN. This is so much easier with a blackboard and 
maybe about 16 weeks. About the timeframe; orders for goods and 
services change over time, and there is usually a prolonged 
period waiting for payment. Back in the old days we used to 
think that exchange rate changes took a long time to work.
    The bond market, the stock market, and particularly the 
foreign exchange market which have gotten so much bigger since 
the thirties and forties. All of these adjust instantly, unless 
it is a weekend, and even then there is after-hours trading.
    If I were to go from a system where we have no border 
adjustability and then simply impose one, initially I would be 
saying, ``Look, there is a 10-percent drop in the price of 
exports, a 10-percent tax on imports.'' But within a matter of 
a blink of an eye, the exchange rate could go bang, and jump up 
10 percent, and the drop in the price of the exports would be 
undone and the cost of the imports would be driven right back 
down to where they were a nanosecond ago. That is what we are 
taught in school.
    More to the point, assume that we are at full employment 
and the Europeans are at full employment (or what passes for it 
given their huge tax load--it looks like their unemployment 
rate is very high, but nobody can afford to hire them so they 
are stuck). We have low unemployment, or did until a few weeks 
ago. If we are at full employment and someone comes along and 
says, ``I am going to do something that boosts your exports,'' 
that is fine, but what happens next? Instead of selling my 
product down the street, I am selling it to the guy in Canada. 
I am still getting paid so I am still going shopping. The guy 
down the street is still getting paid, and he is still going 
shopping. If the product I was putting into the domestic market 
has gone overseas and we all are still going shopping, and we 
still want to buy just as much stuff, then we are going to have 
to buy something to fill in the hole left by the exports, and 
it is going to be an import.
    Exports and imports go up at the same time. So, you are 
going to get the same trade balance, which is governed by 
whether capital is flowing in or not, but, in fact, the 
exchange rates adjust and you generally don't get such a big 
swing in either exports or imports. That is why economists say 
the adjustment happens quickly and there is not much effect on 
the pattern of production.
    If you want to fix the sectors that are hurting from 
imports, look and see if our tax system is doing anything 
particularly brutal to those sectors.
    Mr. RYAN. That is the discussion on manufacturing we have 
been having.
    Mr. ENTIN. That is the sector you can help less with 
depreciation reform, moving to expensing, and perhaps by 
eliminating or reducing the added layer of corporate taxes, at 
which point the rest of the concerns about competitiveness 
pretty much fall into line. I am not saying you shouldn't have 
a border adjustable tax. It you are going to do a VAT, it's 
naturally border adjustable. Any retail sales tax is naturally 
border adjustable, although it is sort of implicit in the way 
you collect it. If you do a cash flow tax where you collect it 
before people leave the house, as in the personal side of the 
old Nunn-Domenici bill, it is not explicitly border adjustable, 
but people pay the tax and then when they go shopping, it falls 
equally on what they buy, whether it is domestic or imported. 
It is implicit. All of these things are. Don't fuss over it so 
much. Just get rid of the excess tax layers on capital, and 
make to border adjusted or not, whichever way it naturally 
turns out to be in the reform you choose, and it is going to 
take care of it itself.
    Mr. RYAN. Mr. Graetz, you are going to answer that, I know, 
but let me ask you a quick question on top of that because I 
see the time going. Your proposal, which I just sketched out, 
you said a 12-percent VAT plus a 25-percent income tax rate on 
individuals over $100,000 and a corporate rate. I guess it 
depends on the rate, or if you folded into the tax rate, isn't 
that effectively a higher tax burden on Subchapter S 
corporations or the corporate structure? You went through the 
plan so fast I didn't--you said it was also not only revenue-
neutral, but distribution-neutral? I have never seen anybody 
accomplish that before when they are proposing tax reform, but 
could you enlighten me on that as well?
    Mr. GRAETZ. I can. I am happy to supplement it for the 
record, or in other conversations with you, but, yes, the basic 
plan is to substitute a 12-percent VAT, I think, 12 percent is 
about right, it may be 13 percent. I may be off a little bit on 
the number. I am not sure that the 25-percent income tax rate 
doesn't come down. Those numbers can be adjusted. But the basic 
point is that for people with under $100,000 of income, you are 
collecting only a consumption tax and no income tax. That plan 
can be made distributionally neutral as long as you take care 
of the low income and moderate income people. The plan is also 
revenue-neutral because what you are doing is you are using the 
VAT to fund the exemption of $100,000. That benefits Subchapter 
S corporations, because they will have a $100,000 exemption on 
their first $100,000 of income and pay only a 25- or 20-percent 
rate on their income over that.
    The value-added tax is like a retail sales tax. I do think 
people have gotten confused in thinking about the value-added 
tax, even when Bill Gale was talking about the burden on 
American companies. The difference between a value-added tax 
and retail sales tax is only in the way it is collected. The 
VAT is collected at all stages of consumption. So, if you want 
to think about it as a sales tax instead of value-added tax, 
that is fine with me. The only advantage of a value added tax, 
as far as I am concerned, is that you are collecting it at 
different stages of production. So, if somebody gets cash at 
the retail level they don't rip off the whole tax base, they 
just rip off a little share of the tax base.
    So, the VAT is more protected against evasion, but if you 
want to think about it as a sales tax, I have a 12-percent 
sales tax, and I have an exemption of $100,000 for Subchapter S 
businesses. They are much better off than they are under the 
current system. It is a much lower tax on capital and small 
businesses than the current system would be.
    Mr. RYAN. Origin versus destination.
    Mr. GRAETZ. Destination. What I can't imagine, what I 
cannot imagine in the political context is how you are going to 
be able to say to General Motors that your tax base is 
everything you do in the United States, your manufacturing and 
the markup, but for imported automobiles, it is just the dealer 
markup.
    That is the way the flat tax works, and can you tell them--
which, you know, all the economists agree, and I don't disagree 
with the economists--tell them ``Well, exchange rates are going 
to adjust instantaneously and take care of you.'' Is that going 
to be your solution? I just don't think it is politically 
feasible ---it is a political point as much as anything.
    I believe that it comes back to what Mr. Cain said about a 
level playing field. The American businesses that now talk 
about competitiveness are going to talk about competitiveness 
in much higher octaves if you tax only dealer markup on 
imported goods and tax the full value added of products 
produced in the United States, whether they are consumed here 
or whether they are consumed abroad.
    Mr. RYAN. I see my time is well over. So, I would love to 
talk to you about that more. Maybe another time.
    Chairman McCRERY. Mr. English.
    Mr. ENGLISH. Thank you, Mr. Chairman, and thank you for the 
opportunity to sit today as part of the Subcommittee. To my 
untrained mind much of the debate over whether border 
adjustability makes a difference, particularly the argument 
that border adjustability does not have a substantial impact on 
imports and exports, has a little bit of the flavor of Xeno's 
Paradox. The motion because you are going in a straight line 
you are always in motion, that Achilles will never catch the 
tortoise.
    I have to believe that there is some distortion involved in 
imports and exports by having a tax burden placed on exports, 
that is a result of the cost of doing business in this country 
and no comparable tax burden placed on imports. I have to 
believe that has--that makes a difference somewhere. I am 
struck by something Mr. Entin said that maybe we should be 
looking at specifically, certain sectors or certain kinds of 
product lines that might--where it might be having some kind of 
an impact.
    Mr. Christian, if I could pick you out, since do you 
believe that border adjustability matters at some level, could 
you give your view on whether there are certain sections of the 
economy, manufacturing to be specific, where with a mature 
industry, a capital intensive industry, relatively low profit 
margins, that border adjustability could have a significant 
impact on decisions?
    Mr. CHRISTIAN. I don't think there is any question about 
it, Mr. English. On the outbound side, on the export side, we 
are making it extraordinarily difficult for manufacturing to 
exist in the United States. There is this constant pressure to 
move. I am talking about eliminating that pressure to move. Let 
people remain in the United States and let companies that have 
fled come back, let foreigners who wish to come here, trade 
around the world without paying U.S. income tax on their 
foreign source income. That is an enormous boon to employment, 
to business growth, and to economic growth in the United 
States.
    The attenuated counter argument that some people make about 
exchange rates is 10 or 15 years old as I said earlier, like 
generals fighting the last war. It is not really the issue 
today. It is not really the issue, I believe, before the 
Congress of the United States. It is not really a practical 
debate. The practical debate is what we can do to eliminate the 
impediments, the hobbles, if you will, that we have placed on 
American companies and their ability and their employees' 
ability to participate in this global economy.
    On the in-bound side, the import side, if you will permit 
me, the Chairman, Mr. McCrery, earlier asked a question about 
the Europeans who impose an import tax when we sell into their 
country. Mr. McCrery asked whether by doing so, they were, in 
effect, forcing us to pay their social welfare costs. My answer 
to that is yes, there is no question about that.
    The so-called origin and destination principle that the VAT 
advocates like to talk about is actually operating in reverse. 
The origin of an automobile exported from the United States is 
the United States. Its destination is Europe. Europe imposes a 
tax relative to that automobile. The burden of that tax falls 
back on its origin in the United States. It falls back on the 
labor and capital in the United States that produced it.
    We, in turn, could make a kind of a border adjustment for 
imports into the United States. There are various ways of doing 
this. One is to simply redefine what the cost of goods sold is 
under section 61 definition of gross income as Professor Graetz 
was referring to in another context earlier. If we had a border 
adjustment, we would bring foreign labor and capital into the 
tax base of the United States, not just the distribution markup 
that Professor Graetz was referring to, but the entire output 
of labor and capital that is reflected in that commodity, 
product, or other transaction.
    That would be a neutral kind of system that would work 
greatly to the advantage of the U.S. economy. On the in-bound 
side, we would want to have some kind of exception for goods on 
a ``short supply'' list that are not subject to a competitive 
international market. As long as there is a competitive market 
on goods, the burden of the import adjustment would fall on 
foreign labor and companies.
    I don't want to get into it in great detail today because I 
don't have time, I suppose, but the implicit in this idea of 
being able to bring foreign labor and capital into the U.S. tax 
base, much more than we did under section 482 today, is the 
potential for an enormous shift in the tax burden.
    There is the potential for a shift of about $100 billion 
off of U.S. labor and capital and on to foreign labor and 
capital. That might be the subject of another hearing. I assure 
you that is not some pie-in-the-sky idea that I just scribbled 
down on the back of a yellow pad on the way up here in the car. 
It is a very important thought that has been given a great deal 
of analysis and effort over a number of years.
    Mr. ENGLISH. I thank you. My time has expired. I want to 
thank you, Mr. Entin and the entire panel for providing some 
intellectual heft to this discussion. Thank you, Mr. Chairman 
for allowing me to inquire.
    Chairman McCRERY. Thank you, Mr. English. Mr. Foley.
    Mr. FOLEY. Thank you, Mr. Chairman. Just very quickly, Mr. 
Christian, you mentioned about the taxation issue relative to 
corporations, and there have been a flight of companies leaving 
to go to Bermuda for instance. Could you elaborate again on 
your response to that?
    Mr. CHRISTIAN. Yes, sir, Mr. Foley. There are two or three 
kinds of situations, and I am not an expert on all the details. 
Some of them are what are called earnings stripping 
transactions where you are using devices, shall we say, to 
strip out of your U.S. company its U.S. income from activities 
in the United States. You need to do something about that.
    I would hate to see you create another destructive Rube 
Goldberg kind of thing like subpart F. You need to be very 
careful in addressing the flight of American companies abroad. 
We are forcing them to do it, really. We ought to deal with the 
fundamentals here at home and eliminate some needless tax 
aberrations, if you will, which cause people to want to go 
abroad. I think we can do that by the kind of proposals that I 
have sketched out today.
    Mr. FOLEY. I missed some of your testimony. That is why I 
was asking specifically. You are talking about not taxing 
income that is derived from overseas or----
    Mr. CHRISTIAN. Yes, sir. I am talking about not taxing 
income which is derived from trading with foreigners. Today we 
have a strange sort of definition in the Tax Code. We define as 
foreign source income, income that is derived from selling 
something to a foreigner only when the activity that produces 
that income has occurred abroad. When the activity that 
produces income occurs in the United States, we define the 
income as U.S. source income even though the sale is to a 
foreigner. I am simply saying if we are talking about foreign 
trade income, income derived from selling to a foreign 
purchaser, whether by export or by going there directly, all of 
that income ought to be foreign source income and exempt from 
U.S. tax. It is a very fundamental and long-talked about 
proposition. There is nothing new or shocking about it.
    Mr. FOLEY. I know Florida in the eighties had a rather 
memorable experience with trying to tax--it was called at that 
time a unitary tax that was brought forward by first Senator 
Bob Graham and then actually applied by Governor Bob Martinez, 
one Democrat and one Republican. Ultimately we lost a lot of 
corporations because they said if you were in Florida doing 
business abroad, you would pay worldwide taxes to Florida for 
that income. It chased out some giants. We lost IBM. They were 
ultimately downsizing, but they ultimately left completely 
virtually the State of Florida and a lot of other corporations. 
Do you see that as an impediment to corporate strength of 
America the continuation of those taxes?
    Mr. CHRISTIAN. Yes sir. I remember the unitary problem 
quite well. I spent many years working on it. We used to think 
in this country that we had a closed economy. Yes, various 
States had to worry about companies fleeing if they had such a 
bad tax system that companies wanted to get out, but we always 
thought that America had a closed economy here. Well, we don't 
anymore.
    Professor Harberger and others have concluded that we 
really don't and that capital is highly mobile. Capital is the 
engine that makes it work, that makes the jobs, provides the 
tools for American workers. It is highly mobile today, and it 
can flee.
    So, why should we create in the United States a hostile tax 
environment for our own companies and a hostile tax environment 
for companies who are foreign? I don't think it has escaped the 
attention of this Committee that before inversion was the 
problem of the day there was the earlier problem when foreign 
companies were acquiring U.S. companies wholesale and sort of 
moving their headquarters abroad. People often wondered why the 
foreign companies that acquired U.S. companies didn't move 
their own headquarters here when they were virtually equal in 
size. Well, I can tell you the reason they don't do that. It is 
because of the U.S. tax system.
    Mr. FOLEY. Probably. DaimlerChrysler is an example. Deutsch 
Bank buying certain corporations. There are a lot of examples 
that should be quite frightening, and should be to American 
enterprise, because it is virtually suggesting they are not 
welcome here, and you might as well assemble your corporate 
entities overseas. Bermuda is, right now, an attractive target, 
and I think that Chairman Johnson is very mindful of that from 
Connecticut.
    We have some exposure and experience in Florida. Tyco 
bought a company that was headquartered there and but now has 
moved a lot of their operations, which was ADT and now Tyco 
what have you. It is troubling because you lose jobs, you lose 
prestige of having the corporate presence. You lose real estate 
sales for communities that are dependent, on those large 
corporate transfers that are, at least when they leave, they 
flee and take a lot of good business with them. Does anybody 
else, quickly, I know the Chairman has been very kind.
    Mr. CAIN. If I may add, you are absolutely right because 
there have been a large number of American companies that have 
been bought by foreign companies because they have certain 
advantages which basically addresses your point relative to 
some of the things that we have seen happen. So, I would 
underscore that just by looking at the companies that have been 
bought out here now, they are foreign-controlled rather than 
U.S.-controlled. I would like to point out that if some rules 
were passed, just to try and discourage companies being able to 
locate in other countries, we would simply be making the 
problem worse. We really wouldn't be fixing the problem, 
because then in the long run, we would have to come back and 
try to put in another stop gap.
    Mr. ENTIN. Mr. Foley, 10 to 30 years ago when our tax rates 
were relatively low compared to Europe, it was American firms 
buying European firms. Now their tax rates are lower than ours, 
and it is their firms buying ours. We need to fix our tax rate.
    Mr. FOLEY. Just the other day, Miller Beer announced they 
may be selling to a foreign source. There are a lot of 
companies that have long been the flagships of American 
industries, and all of a sudden, you keep reading in the trade 
papers the acquisition of another American brand by--and maybe 
that is global competitiveness. It seems there is an impediment 
to them remaining even aggressively buying on the other side of 
the waters. I would rather our companies be buying them.
    Mr. CAIN. It is the tax on the income and the labor that is 
causing that. You would see a flip-flop if American companies 
didn't have that penalty on their corporate profits and that 
penalty on labor. More U.S. companies could buy more foreign 
companies.
    Mr. FOLEY. I wish Mr. Crane was here. He would applaud 
this, because he has long advocated the abolition of corporate 
income taxes since it is double taxation. Thank you, Mr. 
Chairman for your indulgence.
    Chairman McCRERY. Thank you, Mr. Foley. All good questions. 
I saw Mr. Entin nodding as Mr. Cain was making his point that 
if we went to a consumption tax, and I assume you would say do 
away with the corporate income tax all together, that would 
solve the problem of American companies being bought by foreign 
companies. Did you mean to nod?
    Mr. ENTIN. Yes.
    Chairman McCRERY. Why is that? Why would--also I think in 
your testimony, Mr. Entin, you said that if we were to go to a 
consumption tax, that the U.S. national income would rise as a 
result of that. Would you get into both of those questions a 
little bit?
    Mr. ENTIN. I am tempted next time to write shorter 
testimony. The current broad based income tax raises its 
revenue with heavier taxes on income that is saved and invested 
than on income used for consumption, because capital is very 
sensitive to taxation, and because capital has to shrink a 
great deal to drive its returns up by enough to pay the higher 
tax, the current tax system shrinks the capital stock a great 
deal. That reduces productivity, which reduces wages and 
employment. If we had a tax that was less punitive on capital 
and brought the tax on income that is saved down to match the 
tax on income that is used for consumption, we would have a 
much larger capital stock, higher productivity and much higher 
wages. That is the connection, because capital so sensitive to 
tax and because it is being mistreated under current law.
    The major tax reform plans are often called consumption 
taxes. Mr. Christian makes a point a lot, and it is a very good 
one: we really shouldn't think of the consumed income tax or 
the VAT or the national retail sales tax as consumption taxes. 
Goods and services don't pay taxes. People pay taxes. If you 
remember that income is a net concept, revenue minus the cost 
of earning the revenue, then you can start thinking of saving 
as a cost of earning interest. You have to buy the bond to earn 
the interest. You have to buy the stock to earn the dividend. 
You have to buy the machine to earn the return.
    The correct tax treatment, then, is to look at net income, 
which is revenue minus the saving, or revenue minus is the 
expense investment. We should be giving all saving the 
treatment we give the regular deductible IRA, individual 
retirement account, or a Roth-style treatment, which is the 
same thing in present value. We should be expensing plant 
equipment, not depreciating it. Income is really that net 
concept. Then we see that the things we are calling consumed 
income taxes are really income taxes where income is correctly 
viewed as net income, and saving is recognized as a cost of 
earning income. Don't think of them as goods and services 
taxes. These are income taxes where income is properly defined, 
and if you went to a properly defined income tax, you would 
have a much higher capital stock and a much higher level of 
output and income.
    Chairman McCRERY. I believe in your testimony you also 
concluded that going to a consumption tax would make U.S. 
businesses more competitive; is that right?
    Mr. ENTIN. It would make all businesses more productive. Of 
course, if we were more productive and sold more goods abroad, 
we would earn more foreign exchange and buy more imports, too, 
but we would certainly be a more productive economy. So, the 
competition is not really between the U.S. firm and the foreign 
firm, or the United States and a foreign government, it is 
between from the bad current tax system that is shooting us in 
the foot and a good alternative tax system that wouldn't shoot 
us in the foot.
    Chairman McCRERY. Is our goal to raise our National income? 
Does that trump everything else, or are there considerations of 
job creation and the type of jobs that we have?
    Mr. ENTIN. In shooting ourselves in the foot, we are 
shooting ourselves in the manufacturing foot twice and the 
other foot once. We would have higher income and a bigger 
manufacturing sector. So if you fix this, you happen to be also 
helping the manufacturing sector which is suffering from under 
depreciation.
    Chairman McCRERY. So, if we go to a consumption tax, we not 
only raise our national income, but we increase the number of 
manufacturing jobs in this country?
    Mr. ENTIN. Probably.
    Mr. CAIN. Yes, sir. If I could comment on it, it starts 
with supercharging the economy at a growth rate much higher 
than we anticipate at the present time with the current tax 
system. So, if the gross domestic product (GDP) is growing at 5 
percent instead of a paltry 1 percent or 1\1/2\ percent--and 
Mr. Jorgensen has actually done some research on that--consumer 
prices go down to help offset the fact that you have a national 
consumption tax.
    One other point I wanted to make very quickly is that in 
the United States--if we change to a consumption tax, they 
would be forced to reexamine their tax structures, which would 
create a ripple effect around the world because of all the new 
companies that are going to want to come here. This is because 
of the--increased competitiveness of businesses operating here. 
So, fixing the real problem has far-reaching impacts not only 
relevant to the issues of border adjustability and relative to 
some of the other issues you are dealing with, but also in 
terms of keeping this country as the leader economically with 
respect to building on its economic platform.
    Mr. GALE. Could I add a comment there? You asked about the 
effects of consumption taxes on national income or on economic 
growth. There is a range of estimates. The most well-known 
academically refereed estimates are by Alan, Averbach, and a 
team of coauthors in an article that came out in the American 
Economic Review a couple of years ago. That paper suggests 
that, using a very sophisticated model, that after 15 years if 
you introduced a realistic flat tax--that is, one that had 
transition relief--the economy would be about 1.5 percent 
larger than it otherwise would be. That is after 15 years. That 
is for a well-designed flat tax that did not have, for example, 
deductions for health insurance, deductions for State and local 
taxes, firm deductions for payroll taxes. It had no EITC, no 
child credit, no education credit, and so forth. If you think 
that for political reasons those things would creep back into a 
flat tax, the growth effect would go to zero really fast.
    So, the results that everyone is talking about, about how 
going to a consumption tax would raise national income, that is 
true if we go to a pure or very broad-based consumption tax. If 
we go to a consumption tax that looks like European consumption 
taxes, for example--and there is no reason to think that we are 
going to be purer about this than the Europeans will be--if we 
go to a consumption tax like theirs, there is no reason to 
think that there is going to be very big growth effects at all.
    The one thing we do know is that we will redistribute tax 
burdens, and normally we think of some--at least along some 
dimensions of tradeoffs between equity and efficiency. So, you 
should not think that moving to a consumption tax basically 
solves the growth equation or is an unambiguously positive 
growth effect. It is quite possible, and I would venture it is 
probable, that if we designed the consumption tax, it would be 
pockmarked, so full of holes that the rate would have to be so 
high that the growth effect would be zero or negative.
    Chairman McCRERY. Mr. Jorgensen, did you have a comment on 
that?
    Mr. JORGENSEN. Yes. I wanted to make a point again that I 
suggested in my earlier testimony. I think that if you think in 
terms of the potential impact of tax reform, the consumption 
tax achieves about 40 percent of that potential, and that is 
essentially with the most optimistic assumptions. I am 
overlooking all of the issues that Bill Gale just raised.
    Another issue is why don't we have a consumption tax? As 
you remember, Chairman Archer held hearings for many years 
which many of us participated in. There is lots and lots of 
testimony about all the plans that have been discussed here 
about a consumption tax. The reason is because the tax rates 
are staggering.
    For example, if you have a progressive national retail 
sales tax--this is what Archer originally was interested in--
the marginal tax rate, the tax that you would have to collect 
on every dollar at the retail level--just imagine this--is 40 
cents. That is what we are talking about. So, it is not a very 
practical idea. I think that is what led to the neglect of 
consumption tax reform when this issue was very thoroughly 
discussed by the Committee on Ways and Means in the middle 
nineties.
    I think you have really put your finger on the issue here. 
The issue here is not how to benefit the corporations which 
have been up to this point benefiting from the export subsidies 
that have now been struck down by the World Trade Organization, 
the issue here is how to enhance the productivity of the U.S. 
economy. We have an extremely productive economy. Since 1995 
our economy has been growing at more than 4 percent a year. If 
you look at the way that productivity is behaving in the 
current recession, it is running at about 1.1 percent above 
what it has in previous recessions throughout the whole postwar 
period. We are in a new economy. What do we need to do to deal 
with the issues of a new economy? We need to focus on 
investment and how to stimulate investment, and that, it seems 
to me, is where the attention should be directed rather than 
toward a consumption tax.
    Chairman McCRERY. Yes, Mr. Entin.
    Mr. ENTIN. The Joint Committee on Taxation had a panel 
about 4 years ago, and they are going to revive this for some 
future work, which looked an a number of models and how they 
would model going to fundamental tax reform. The models showed 
great differences in the amount of growth that you would get 
out of tax reform, according to whether the models assumed that 
there was a free flow of capital and goods, including 
manufactured goods and investment goods, across borders, or 
whether the economy was closed to such flows. In the closed 
economy models, which relied entirely on increasing U.S. saving 
to fund the additional capital and assumed very low rates of 
elasticity of domestic saving, it took forever to get to the 
higher growth levels, and those models showed very small growth 
numbers. The open economies showed growth in the 6- to 15-
percent range, and I took a 10-percent estimate in my paper.
    Since the opening of the capital markets in the last two 
decades, we really cannot look at closed models as being 
realistic. I once debated someone from a major econometric 
modeling company who was worried about the effect that the flat 
tax would have on mortgage interest and have values. I said, 
``We are going to get a lot of growth.'' He said, ``You will 
never get enough saving to fund it.'' He said that foreigners 
are already lending us $100 billion a year--this was way back 
in the eighties--and we cannot expect them to go to $200 
billion a year. I said, ``You know those capital flow figures 
that you just quoted? Those are net figures.'' At the time, 
there were about $300 billion of investment going out and about 
$400 billion coming in to the United States each year. It was 
$700 billion to play with, not $100 billion, and all we had to 
do was stop lending abroad. He turned beet red. He remembered 
after I said it that the net capital inflow number was, in 
fact, a net figure.
    When we lowered the inflation rate in the early eighties 
and prospectively enacted some accelerated depreciation which 
was later repealed, businesses started thinking that it was a 
good idea to invest in the United States instead of in Brazil 
and Argentina and all around the world. Between 1982 and 1984, 
the United States lending abroad from the banking system fell 
by over 85 percent, from about $120 billion annually to less 
than $20 billion. There was very little increase in the inflow 
from Europe. Essentially it was our own savings staying home. 
As for physical capital investment, if you run into problems in 
the machine tool industry and they can only ramp up output 25 
percent, you can buy more machine tools from Europe, and you 
can add very quickly to the domestic capital stock. You can get 
the growth quickly, and it can be a big change. Always use an 
open model, because the world is open.
    Mr. GALE. Can I respond to that, just one more comment? If 
you have an open economy model, as Steve mentioned, you will 
definitely get more GDP growth; that is, gross domestic 
product. You will get more capital coming in if you move to a 
reform like that. What you won't necessarily get more of is 
more national income, more gross national product (GNP), and if 
you want to look at the future welfare of Americans, you need 
to look at the national income numbers. Money that comes in has 
to be paid back. So it increases our GDP, but it is essentially 
a mortgage against the GDP. So once we pay that back, we are 
not anywhere near as better off as the GDP figures themselves 
would suggest, and when you want to look at the future welfare 
of American citizens, you want to focus mainly on GNP or 
national income rather than on national product.
    Mr. ENTIN. If I borrow $100 to put a machine in my shop, 
and I have had to borrow it from a foreigner, then the interest 
is going to go to the foreigner. If I borrow it from my 
brother-in-law, the interest is going to my brother-in-law. 
Either way, I get to work with that machine and my employees 
get to work with that machine and 75 percent of the economy is 
wages. So our workers get to benefit from the machine, 
regardless of who paid for it and who gets the interest or the 
dividend.
    Mr. CAIN. Mr. Chairman, if I can just add one comment.
    Chairman McCRERY. I think I agree with Mr. Entin. It is not 
that I disagree with Mr. Gale. It just seems to me--and I am 
not an economist, thank goodness, but it just seems to me that, 
Mr. Gale, your argument is up here floating around in the 
ether, when Mr. Entin's is right on the ground in terms of jobs 
and job creation.
    Mr. GALE. Oh, I agree that his is on the ground. The issue 
is that if you--in Steve's example, when you pay your brother-
in-law back, that dollar is still in the economy. Okay. When 
you pay the foreigner, it is out. It is gone. So there is a 
distinction between how much we produce--how much is produced 
in the United States. That is GDP, and that would go up 
substantially, as Steve mentioned. How much of that is ours.
    Chairman McCRERY. But isn't that----
    Mr. GALE. That is national income.
    Chairman McCRERY. If GDP goes up, isn't that good?
    Mr. GALE. Of course. Other things equal, yes. My point is 
that GNP, national income, is the measure of economic welfare. 
The wealth of Americans depends on the national income, not on 
national product. This is Econ 1 stuff, but there is a 
difference between producing in the United States and having 
the proceeds of that output go to Americans, and that is the 
fundamental issue here.
    Chairman McCRERY. I appreciate your treating us like we are 
in Econ 101, because we are not economists, and we need to 
learn. So, I do appreciate your taking the time to try to 
explain, but surely you are not saying that there is no 
relationship between GDP growth and GNP growth or national 
income?
    Mr. GALE. No, I don't think I said that. I said that GDP 
growth that is financed by capital inflows has to be paid back 
via capital outflows in the future, and sort of the question is 
are you--if you----
    Chairman McCRERY. Let me just interject, but if that 
capital inflow continues and so we continue to create jobs and 
increase productivity, what difference does it make if for a 
temporary period of time it goes back overseas? If it is----
    Mr. GALE. If we can create a system where we have continual 
capital inflows, then you have solved all of our problems. 
Normally people have to pay back their capital inflows, and 
that is the nature of borrowing is you have to pay it back, but 
I agree, if we----
    Chairman McCRERY. You are paying back the capital and the 
interest. I mean, as long as they are willing to continue to 
finance growth here in the United States, that is a good thing, 
I think.
    Mr. GALE. That is a good thing, except that then we also 
have to pay it back. I am just saying we don't get the entire 
proceeds of capital borrowed from abroad.
    Chairman McCRERY. I agree, we don't get the entire 
proceeds, but in a global economy, it just seems to me that we 
can no longer think or expect to be self-contained and to have 
just a circular flow of capital here in the United States.
    Mr. GALE. No one is suggesting that. All I am suggesting is 
that when we talk about big output effects or potentially big 
output effects of tax reform, that does not necessarily 
translate into big national income effects. That is the only 
point I was trying to make.
    Mr. CAIN. Mr. Chairman, I am not an economist either. Let 
me give an example that I can relate to as a businessman. The 
advantage of having a very vibrant gross domestic product, as 
you have pointed out, is that it would create more jobs. 
Unemployment would go down. We would be able to employ those 
people that want to be employed, and so forth, but one of the 
things that it would allow people to do by taking the tax off 
of income and putting it on consumption is that it would not 
penalize people's sweat equity. I am looking at it more from a 
standpoint that if someone chooses to work a little harder or 
extra, they won't be penalized when they are trying to increase 
their individual income. So from that perspective, that is the 
importance of having a very vibrant GDP. Quite frankly, I don't 
worry as much about national income as the ability of 
individuals to increase their own income with their own sweat 
equity.
    Chairman McCRERY. Mr. Engen.
    Mr. ENGEN. If I could just wade in carefully. As an 
economist on a couple of things here, one, I was on the Joint 
Committee on Taxation modeling group that was brought up here, 
and one of the things that I want to point out was in that 
looking at the number of different models that--looking at the 
effects of flat taxes, all of them were positive in terms of 
their growth effects. There was a range, but they were all 
positive. Some were at a lower end, and some were unbelievably 
high.
    That said, the point that Bill brought up in that, well, if 
you do enough in terms of adding in other components, you can 
erode the growth effects back to zero or close to zero is true, 
and that was the final point I made in my testimony. 
Essentially what you are doing is you are then--you are saying 
we are going to switch to, say, a flat tax or another type of 
consumption tax, but then you are building in all of the 
features of the income tax that we are having problems now. So 
that is a key feature.
    I mean, Bill's point is one that should be definitely 
heeded, that an important part of getting the positive growth 
effects from a flat tax, just for example, is that you cannot 
let all of these other exceptions come in as people want to 
keep their favorite tax preference from the old system and put 
it in the new system.
    The second thing is that just it is the case that if we 
have the increased capital financed by domestic saving, then 
yes, all of the proceeds from that output, both that go to 
labor and that go to capital, stay in the United States. If 
that capital does come from outside of the United States, yeah, 
you do have to make payments back on that, but in all 
likelihood, the labor that foreign investment in the United 
States is hiring is U.S. labor, and that is still kept in the 
States.
    So there is--there can be a discrepancy on that, and, yes, 
it is more beneficial if U.S. capital formation is financed by 
U.S. saving--or it can be, but there is still a return to 
labor.
    Chairman McCRERY. One more comment, and then I would like 
to----
    Mr. JORGENSEN. I just want to make a comment about 
transition rules. I think that Bill has made a very important 
point that Eric is agreeing with. Let us think of what these 
transition rules amount to. Are you saying that after you 
change to a consumption tax, you are going to take away all of 
the depreciation allowances you promised all of those investors 
who have in good faith bought equipment and built factories and 
commercial buildings and so on, with the expectation they are 
going to be able to make deductions? I don't think so. Are you 
going to say that every corporation that has issued a bond is 
not going to be able to deduct the interest payments that it 
was contemplating when it issued that security? I don't think 
so, and if you simply go down the list--I have just mentioned 
the two most prominent examples. These are not airy-fairy 
examples. This is something that is the heart and soul of tax 
policy. You are going to end up, as Bill said, undermining most 
of the benefits that are associated with the switchover.
    So you might say, should we give up, do we have to abandon 
the effort? Should we just say, well, we have had these 
hearings; can't do it. I mean, it is just impossible.
    Chairman McCRERY. That is what we have done so far.
    Mr. JORGENSEN. The answer is that we start from the income 
tax. That is the key idea. Forget about the idea of a 
consumption tax. It just isn't going to happen. An income tax 
that focuses on investment is feasible. It is something that 
doesn't require any transition rules. Why? Because it leaves 
all of the provisions of the income tax in place, and I am 
referring to the depreciation provisions, the tax deductibility 
of interest and all of the things that fill 110 volumes of the 
Internal Revenue Code.
    Now, how do we fix this? What we do is simply take a step 
that will make sure that every asset in the economy earns the 
same rate of return before taxes. In order to do that, all we 
need to do is to change the method by which we carry out our 
capital cost recovery. In the system that prevailed before 
January 1, 1987, when the investment tax credit was abolished, 
we had a two-pronged approach to that. We had capital 
consumption allowances and we had the investment tax credit. My 
proposal is to simply reinstitute the investment tax credit, 
but in a way that would achieve the goal.
    What is the goal again? The goal is trying to equalize the 
rate of return before taxes on all assets, and that doesn't 
require any transition rules. It starts with new assets. It 
doesn't affect any existing assets. All existing assets would 
be treated in exactly the same way, and existing liabilities. 
If you take a bond, for example, tax deductibility of bond 
interest would continue. Capital consumption on allowances on 
all of the existing assets would continue, but this would 
superimpose on it a system of tax credits that would eliminate 
the corporate tax. If you don't call that a tax reform, I don't 
know what it is.
    Mr. GRAETZ. Mr. Chairman, can I make one point?
    Chairman McCRERY. Sure.
    Mr. GRAETZ. This transition problem, I think, is a very 
important problem----
    Chairman McCRERY. Yeah, and I was going to get into that.
    Mr. GRAETZ. When people are talking about an entire 
replacement of the system we now have with some form of 
consumption tax, among the reasons to try and do the kind of 
hybrid approach that I have been pushing here, is that you get 
the advantage of low rates. You shift the burden to consumption 
substantially, but you are retaining a corporate tax at a 20- 
or 25-percent rate, which makes the United States very 
attractive, both as a headquarters and as a source of 
investment. You have taken away some of the advantage of those 
depreciation and interest deductions, they were going to get 
against the 35-percent rate. Now they are only going to get 
those deductions against a 20-percent rate, but nobody can 
complain about that, because you have kept the tax in place, 
and you have lowered the rate. This is not the kind of 
transition relief Congress has ever felt necessary to give, in 
effect to say, you have really got to get the benefit of your 
depreciation against a higher rate when we are lowering 
corporate rates. We don't do that.
    So, my plan gets some of the advantages of Dale's ideas, 
but it is not the kind of radical change that either the 
proponents of going fully to a consumption tax are arguing for 
or the proponents of going to a full investment relief for new 
capital are arguing for. My plan really is a compromise. I just 
want to emphasize that fact. It avoids many of the problems, 
including the transition problems of the total restructuring of 
the system of the sort this Committee has been talking about so 
far. I really urge you to start thinking about this in a 
broader way, and not to think that you are going to replace the 
entire income tax with a sales tax. If you replace it for 85 
percent of Americans and they don't have to file tax returns, 
that would be a major improvement in the lives of the American 
people. And it would whittle the IRS down to a size that would 
enable it to do what it might be able to do. So, this plan is a 
major step in the direction that people have been advocating, 
but it doesn't cause the kind of problems that have been 
discussed so far here today.
    Chairman McCRERY. Well, let me try to pose some problems 
with your approach. Your approach--I think you have just stated 
clearly the advantage to your approach, which is that you avoid 
a lot of the transition problems associated with a complete 
overhaul to a sales tax or VAT or anything else, and those 
problems are substantial, in my view. There are a number of 
conservatives who would say to you, my goodness, you are going 
to create another tax--you are not going to do away with any 
tax. You are going to keep an income tax. You are going to keep 
all of the State sales taxes and everything, and then you are 
going to add a new tax, a VAT or, you know, some kind of 
consumption tax on top of that. My goodness, the Congress would 
have all kinds of opportunities to increase taxes on the 
American people. They could do a little bit here, a little bit 
there, and tweak it here and there, and you just really 
increase the opportunity for more of our National income to go 
to the Federal Government in the form of revenues. Isn't that a 
legitimate concern?
    Mr. GRAETZ. Well, I think it is always appropriate to be 
concerned about Congress increasing taxes and how they might do 
that.
    Chairman McCRERY. But haven't you increased their 
opportunity----
    Mr. GRAETZ. I don't think this proposal increases the 
opportunities in the following sense, Mr. Chairman. I cannot 
imagine a Congressman standing up on the Floor of either the 
House or the Senate and suggesting that you lower the $100,000 
exemption from the income tax. It took the Second World War for 
the income tax that we had from the beginning of the century 
until the Second World War to become a tax on the masses, and 
it would take that kind of catastrophe to bring that 85 percent 
of Americans back in. So that is the first point. The second--
--
    Chairman McCRERY. That underscoring the flip side danger, 
which is that you have such a small amount of the American 
public paying income taxes, that it is much easier for a 
politician to say, why do I care about that 15 percent? It is 
the other 85 percent that is going to elect me. I can increase 
the taxes, which is my only pool of income tax revenues. I can 
just easily--politically easily increase their taxes.
    Mr. GRAETZ. Let me make two comments about that. One is, it 
is easy under the current system.
    Chairman McCRERY. It is getting easier, I know.
    Mr. GRAETZ. It is easy under the current system. That is 
exactly what Bill Clinton did in 1993. He said, let's take the 
top rate, which was 31 percent, and let's move it up to 40 
percent and not bother with anybody below that level. If you 
have a majority in the Congress, that can be done.
    The answer to that, I think is--and this is a reform that 
the House voted, and appropriately so in my view, is to put in 
a super majority rule that says that you cannot raise rates, 
you cannot raise tax rates as part of this plan without having 
a 60 percent vote in both the House and the Senate. That 
would----
    Chairman McCRERY. That would overcome a lot of objections, 
but I am not sure we can----
    Mr. GRAETZ. I think that the problem is, Mr. Chairman, that 
when you think, well, we are going to raise those rates--
remember the goal here. The rate we are talking about is a much 
lower tax rate than we now face. That is, we would have lowered 
the rate on marginal investments, on marginal income, on all of 
these people by dividing the tax base up so that we are not 
relying entirely on an income tax to finance our government. No 
other country does that.
    If you look at the chart at the end of my testimony and you 
look at how the U.S. taxes consumption compared to how 
everybody else in the industrial world does, we have given up 
an important tool. We have given up the consumption tax tool. 
The advantage to us is that we have lower taxes compared to GDP 
than our trading partners. We have said we are not going to 
have lower tax rates. We can let other countries have lower tax 
rates, because we have given up the tool of a tax on 
consumption which could ease the burden on capital and 
production in the United States. I think that in terms of long-
run health of the economy and long-run marginal tax rates, this 
program would be lower. I am just as conservative as you are on 
the thought that--let's not make this an occasion for bringing 
more money into Washington. I understand that objection and I 
sympathize with it entirely, but I don't think that is a good 
reason, frankly, to give up the tool of taxing consumption in a 
greater way and easing the burden of taxes on production and 
investment.
    Chairman McCRERY. Mr. Engen, do you agree with that? Would 
you like to see us create a consumption tax and keep the income 
tax?
    Mr. ENGEN. I have sort of struggled over this particular 
issue, and indeed it was one of the things I mulled over quite 
a bit as I was writing my testimony for this. On the one hand--
I guess I am going to be an economist here; do the one-hand, 
two-hand thing. I do have sympathy with I think the point of 
view that you are bringing up. When I look at countries that do 
have this extra tax lever to the greater degree, they are ones 
in Europe, and they have an overall tax burden on the economy 
as a whole that is higher.
    On the other hand, I think that the type of proposal that 
Mr. Graetz is putting forth is a nice medium ground, in between 
some of the various proposals that are out there, and as long 
as you could implement these restrictions on raising taxes in 
the future, then it would be okay. I guess I am not quite as 
convinced that you could implement those, but of course, I am 
an economist and not a politician, so I have less of a view on 
that. I think it is a reasonable concern.
    Chairman McCRERY. Thanks for clearing that up. I don't mean 
to belittle what you just said. You are right. Mr. Graetz 
certainly, I think, has a proposal that is worth looking at, 
and it may be the only--well, not the only, but it may be one 
of a very few realistic proposals that we could possibly enact. 
It does scare me and a lot of others, I think, as well as you, 
that we are creating another opportunity for tax increases.
    Mr. Gale.
    Mr. GALE. Thanks. Just real quickly, I have read literally 
every word of Mike's book and wrote a 35-page review of it for 
a legal journal, which was a huge mistake. I want to say two 
things. One is, it is one of the few serious large-scale 
proposals out there. The flat tax X tax is another, and 
something like broad-based income tax reform is the third. So, 
I think it is a very serious proposal. I don't want to sound 
like a broken record here, but the thing to remember is that 
the rates that were quoted depend on having a very broad base. 
Mike is right that, pre-World War II, we had an income tax that 
was only on high-income people. On the other hand, we have had 
a mortgage interest deduction since 1913. We have had a State 
and local tax deduction since sometime in the teens, I think in 
1913. We have had a charitable deduction since the teens. We 
have had a health insurance adjustment since way back before 
1920. So when you start adding those in, they take out big 
chunks of the income of people that have income above $75,000 
or $100,000, and the rates have to go up.
    Similarly with the VAT. If you exempt things the way the 
European countries have exempted in a VAT, the rates go way up. 
So, I congratulate Mike on putting forward a doable, cohesive, 
coherent proposal, but I just want to caution that all of these 
rate estimates depend on how broad the base is. As soon as we 
start introducing these subsidies, the rates go through the 
ceiling.
    Chairman McCRERY. You have made that point several times, 
and it has sunk in, even into this country lawyer.
    Mr. GRAETZ. One point with which I certainly agree. The VAT 
base needs to be very broad in order to get the kind of rate I 
am talking about, but I think it is realistically broad. I have 
looked at this deal pretty carefully. The income tax on people 
above the $100,000 floor does not eliminate the deduction for 
charitable contributions or home mortgage interest, as one 
might believe. You can still, based on information I have, get 
to the right rates, but this is an important question as to 
whether the rates are realistic or not. I would only hope that 
we would be sitting in this room.
    Chairman McCRERY. Trying to set the rate.
    Mr. GRAETZ. Trying to set the rate and making sure the 
rates are low enough.
    Chairman McCRERY. Right. Mr. Entin, do you want to jump in 
on this?
    Mr. ENTIN. I think I am of the view--my boss who was a tax 
expert in town for many years, Norman Ture, kept drumming into 
my head that taxes needed to be transparent and visible to the 
electorate, otherwise people would think someone else was 
paying them. They would vote for people who were promising more 
government than they would vote for if they knew that they were 
paying it. So, I favor broadly based taxes without a lot of 
people dropped off the rolls, and I don't particularly care for 
taxes hidden at the business level, when in fact it is the 
workers and the consumers and the shareholders who are paying 
the taxes. I do worry that we would get a runaway tax situation 
if we left too many people off the income tax.
    The other thing I worry about are those distribution tables 
which will guide you in picking one plan over another simply 
because the initial incidence at the time is imposed will look 
better or worse. Not one of your burden tables is correct. Not 
one of them is close to being correct. When you put taxes, for 
example, on upper-income doctors or impose huge malpractice 
premiums on them, what do you think happens to the quantity of 
those doctors? People retire early. They don't enter the 
profession. The number of doctors shrinks. They don't employ as 
many nurses or other workers in the offices. They don't produce 
as much health care for the people, and the providers who 
remain can charge a higher price so that they can pay their 
malpractice insurance and their higher income taxes. It is the 
consumers who end up paying the higher premiums and taxes 
through their insurance company.
    The same thing is true for income taxes. A lot of people 
who have been pushed into the upper brackets go to their 
corporations and say, ``If you want my skills, you are going to 
have to pay my tax bill.'' Then it shows up in the price of the 
product.
    Taxes never stay where you think you are putting them. The 
payroll tax partly falls on capital, because it shrinks the 
labor supply. Capital taxes partially fall on the work force 
because it shrinks the capital stock. Upper income taxes fall 
on lower income people. Lower income taxes to some extent fall 
on the upper-income people. Please don't let those silly burden 
tables take you away from a good tax plan and push you toward a 
bad one.
    Chairman McCRERY. Easier said than done.
    Let me try to conclude, getting not back to, because all of 
this has a relation to the subject of the hearing--or the 
series of hearings, which is the ETI, and what do we do about 
losing the ETI, which I think everyone that has talked to the 
Committee has said you are going to lose the ETI eventually. 
You are going to have to do something with it, or the Europeans 
will retaliate. They have shown some forbearance. They think 
that we are, in good faith, searching for a solution to the 
problem, and so they are not retaliating now, and no indication 
that they will in the next couple of months or so. Eventually 
we are going to have to find a replacement or a substitute, 
something, or we are going to have to decide--and this is the 
question I want to put to you--we are going to have to decide 
that the economic value to the country is not sufficient to 
justify risking a trade relationship, and instead of trying to 
replicate or trying to take care of those specific companies, 
that group of companies that were benefited by the ETI, we take 
that income, and we spread it throughout corporate America, or 
whatever, in the form of lower rates or more expensing.
    So I suppose--I would want to ask you to give me your 
thoughts on that generally and mix into that more on the 
subject of today's hearing. Even though we all agree our 
current tax system is convoluted and complex and burdensome in 
terms of the compliance costs, all those bad things, still in 
all, don't we have as a Nation generally have a tax burden that 
is competitive, so to speak, if not advantageous in terms of 
our trading partners around the world? I mean, if you look at 
the total tax burden in any European country, it is probably 
going to be higher than the total tax burden here in the United 
States.
    So what should this Committee do in terms of trying to fix 
ETI in the context of our entire tax burden here? Ernie?
    Mr. CHRISTIAN. Mr. Chairman, I think that the ETI is gone, 
it is lost. I think we should move on beyond that. I think that 
I would, of course, stick with the suggestion I made about the 
easy way to fix it; and that is, adjust our base a little bit 
in the corporate tax and exclude exports.
    We need to be practical about what can happen and what 
can't happen. I have concentrated here today on something I 
think is a very practical, doable solution to the problem that 
you identify. I have probably worked for 20 years on various 
different fundamental tax reform proposals. I suspect I have 
perhaps spent as many hours on that as anybody at this table. I 
have concluded that fundamental tax reform, as such, is simply 
too big, is too hard. It is a symphony with too many notes to 
be played in this body.
    We need to concentrate on the things that are good 
components of fundamental tax reform, that we can do and that 
solve real problems. One of the impediments to that is trying 
to do too much, and another one is simply terminology. We here 
today use the word ``consumption tax'' to refer to two 
different things and in two different ways. Realistically, the 
only consumption tax being talked about is Mr. Cain's retail 
sales tax and Mike Graetz's particular version of the European 
credit invoice VAT, which is a sales tax. That is a tax on 
consumers.
    Economists, including many here today, have on the other 
hand been referring to--as a ``consumption tax''--an income tax 
amended in only one respect. That is, it expenses capital 
equipment. So, I would hope that rather than becoming embroiled 
in this morass of calling an income tax with expensing a 
consumption tax, and confusing ourselves and everybody else, we 
would talk about our income tax with all its warts and about 
how we can fix it on the international side, on the investment 
side, and in other ways that represent longstanding, familiar 
amendments that can be enacted into law. We cannot tear the 
whole thing out by its roots, as the former Chairman used to 
say, and start over and rebuild it on some other grounds, like 
a sales tax or something like that. It is basically in my 
opinion contrary to the American tradition and ethic of 
taxation at the Federal level.
    So, we need to operate in that tradition, that ethic, and I 
think by deftly doing it, we can find our way through this 
process and end up with the components, the economic 
components, that are actually the substance of all of the tax 
reform proposals that everybody has been talking about for 
years: not double-taxing investment, not double-taxing personal 
saving, a genuinely workable, competitive, international tax 
system with an expert exclusion, and, if we wish, bringing 
foreigners into the U.S. tax base by means of an import 
adjustment or a cost-of-goods-sold adjustment.
    When stated in those ways, those are imminently doable 
things for the most part. It doesn't scare anybody. It is not 
too hard, and we can do it. When we got to the last page and 
turned it over, we would have accomplished the economic 
substance involved in all of the tax reform proposals, 
including the four or five I have drafted over the years, and 
Professor Graetz's and others, is my answer.
    Mr. GRAETZ. Mr. Chairman, I do want to point out that--and 
I am a person who was involved in the creation, along with Glen 
Hubbard and others, of the Comprehensive Business Income Tax 
(CBIT) bit proposal that is the basis for Ernie Christian's 
testimony--I believe that the CBIT tax, which is a single 
business tax without a deduction for interest or dividends, and 
no taxation of interest or dividends at the individual level, 
is a better tax system than the one we now have and would be a 
great improvement.
    On the other hand, I also want to say, having managed to 
get that proposal out the door of the Treasury Department after 
a lot of conversations with a lot of people, that denying the 
corporate interest deduction is not a small step as it has just 
been painted. It is really quite a large step.
    So, I think the question of what is realistic and what is 
not realistic in this environment is one that the Congress is 
going to have to come to grips with. Ultimately I believe, with 
the help of the President of the United States--I think that 
the one lesson of the 1986 act that was well learned is that 
when a President of the United States makes a tax change of 
some major sort a key issue--fundamental reform can happen. And 
in the absence of that kind of Presidential leadership, it is 
not likely to happen. The 1986 act, whatever you think about 
it, would never have been passed if Ronald Reagan hadn't come 
to the Congress the way he did in 1995 and 1986 and made it a 
key issue.
    I have been around tax legislation with Ernie for 30 years, 
and we have been around different tables doing this sort of 
thing for a long time. I remain much more optimistic than he 
does about what Congress can do. I am actually with Herman Cain 
in his optimism. I think that the tax system that we have and 
that we are relying on, that this income tax and tinkering with 
depreciation and tinkering with investment tax credits in order 
to try and make us more competitive, is a road to disaster. I 
think it has proved to be a dead end. We can go on for another 
5 or 10 years continuing to prove it to be a dead end.
    It wouldn't shock me if this kind of change doesn't happen 
overnight, but I think that the optimism that Mr. Cain has 
suggested is the right way to think about this. I do think we 
have to be realistic about what we can do. I don't believe we 
can take a system that we have relied for the 20th century as 
heavily--not entirely until the Second World War, because we 
had tariffs as our consumption tax--but as heavily as we have 
relied on the income tax, and say we are going to throw that 
tax away and that we are now going to go to a consumption tax 
system all in one step. I just don't see it happening, and I 
don't see it happening largely because of the distributional 
question. I think I have been in print more critical of 
distribution tables than anyone at this table. I have called 
them paint-by-numbers tax law making and all sorts of other 
ugly names. The truth of the matter is that there are serious 
questions about what happens to the distribution of the tax 
burden and who we shift it to by moving completely from an 
income tax to a consumption tax. We would shift the tax burden 
down the income scale in ways that I think are going to be 
ultimately unacceptable if we replace the income tax in full, 
and that is why I think looking for some middle ground is 
important.
    I do not think it is worth this Committee's time and effort 
to jeopardize our trade relationships by looking for some new 
export subsidy. I was at the Treasury Department, I guess Ernie 
was, too, when we did the DISC, Domestic International Sales 
Corp. Then we did the FSC, and then we did the ETI, and each 
time the WTO has said no-go. I believe that if you think 
seriously about consumption taxes, it is very important to 
think about ones that will get through the WTO, because we have 
committed ourselves to this international trade relationship, 
and I think properly so. I think it is not clear that a 
subtraction method value-added tax will get through WTO if 
challenged. Japan currently has such a tax. It has not been 
challenged. Their economy has been in very bad shape and nobody 
wants to challenge them. If the United States went to such a 
tax, I am not at all sure it wouldn't be challenged. Whether it 
would succeed or not, I don't know. It should succeed.
    The indirect/direct distinction--the distinction between 
taxing transactions as Mr. Cain's tax and mine do, or taxing 
entities as Mr. Christian's and Mr. Entin's and others do--is 
not a substantive distinction. The WTO has an indirect/direct 
distinction that it may well stick to, no matter how archaic, 
particularly if it gives it a lever vis-a-vis the United States 
on trade issues, which is what has happened in the recent round 
here.
    I would give up on the ETI. I think the question is where 
can the revenue best be spent, and that is the question that 
this Committee ought to turn to and address. There are lots of 
possibilities, but I would hope that we would move in 
directions that keep this fundamental tax reform issue on the 
agenda as you have tried to do in these hearings.
    Chairman McCRERY. We will go to Bill and then Mr. 
Jorgensen.
    Mr. JORGENSEN. All right. Thanks. This has been a very fun 
and illuminating hearing. I just want to say a couple of 
things. One is, as I mentioned earlier, I think we should let 
ETI die a peaceful death. I would consider the revenues gained 
sort of money that could be used anywhere you want to. Cut the 
corporate tax rate. You know, pay down the public debt. 
Whatever. I don't see any obligation to put it back into an 
export subsidy, and I want to emphasize from a macro economics 
viewpoint, they don't do any good, although they may benefit 
the bottom lines of several major corporations.
    On the broader picture, there are a number of well-
conceived tax reforms that would be unambiguous improvements 
over our existing system. I mentioned the--Mike's proposal, a 
flat tax, slash, X tax proposal or broad-based income reform. 
The problem with all of those and the things that I worry about 
is they only exist on paper, and in order to get them to exist 
in the real world, they have to go through the political 
process. They have to be inured against attack by aggressive 
tax attorneys and accountants and tax planners, and they have 
to transition from the existing system.
    So, there are basically two problems. One is, how do you 
get to any of these systems? That is the transition problem. 
Second is, how do you stay there? I think basically you have to 
repeal politics, repeal the politics of tax policy in order to 
stay there. I don't know how you do that, because the 
complications that exist in our income tax, you know, weren't 
there at the beginning, but they grew in; not because anyone 
wanted to make it more complicated, but because it was a 
natural response of the political system.
    So, I am not at all opposed at the principle level to 
broad-based tax reform, but I don't know how we get there, and 
I am worried that if we do that and then the political process 
takes over, we end up with a situation where we have done a 
huge amount of work to change the entire tax system. The one 
thing we know, we would do is redistribute tax burdens away 
from the wealthiest households, and we would probably end up 
with a system that probably isn't a whole lot better than what 
we have. I don't think it is worth taking the leap in order to 
do that unless we have some assurances.
    I hear this man on the Moon comment all the time that Mr. 
Cain raised. That is, if we could put a man on the Moon, why 
can't we do this? It is a darn good question, and the answer 
is, putting a man on the Moon is a technological problem that 
could be solved with everyone working together. Tax policy is 
not a problem where everyone works for the same goals. People 
have diametrically opposite goals, and half of the Congress 
feels like they have made their day when they have subverted 
the will of the other half. In a situation like that, you can't 
make unambiguous progress. So, I am very concerned about what 
you might call the political economy of tax reform, although I 
think if you put several economists and lawyers in the room and 
let us design a system that would be set forever, we could come 
up with pretty close to the same system.
    Mr. JORGENSEN. Could I chime in at this point?
    Chairman McCRERY. Yes sir.
    Mr. JORGENSEN. I just wanted to agree with the general 
sentiment around the table that ETI is gone, and I don't think 
it should be greatly limited. I am glad you are having hearings 
about this and so on, but it is something that has disappeared 
and is probably better forgotten.
    In terms of the issue that you have raised in these 
hearings, though, about where do we go from here, I think Bill 
has put it very well, and that is that basically you can try to 
retread the footsteps of predecessors who have focused on so-
called fundamental tax reform--I am thinking in terms of 
these--the value-added tax or the flat tax or a national retail 
sales tax. We have already done that several times, and it 
always leads to the same conclusion, which Bill, I think has 
summarized for us very adequately.
    So, I think that what I would recommend is the following 
and that is that we try to amend the existing income tax 
system. I think that is the direction for reform. It can be 
done in such a way that we would achieve the objectives that 
you and your colleagues have emphasized repeatedly in your 
questions.
    What you are really concerned about, it seems to me, is to 
deal with the inequity in our tax system that arises from the 
differential treatment of corporate-source income. Corporate-
source income, whether it is derived domestically or abroad, is 
double tax. That is what we have heard over and over again from 
this panel and which you raise this question over and over 
again in your questions. How do you deal with that? You have a 
system of taxation in which effectively you treat corporate-
source income symmetrically with other kinds of income. Now, 
you might say, wouldn't it be better to have a hybrid system? 
That is what Michael Graetz has been raising throughout these 
hearings. I am going to tell you, and I think everybody here 
would agree with that, our current system is a hybrid system. 
What do I mean by that? Pension funds are consumption taxes. 
The way that we think about a 401(k), for example, is that we 
exempt the investment and we charge tax on the consumption when 
the benefits are finally paid during retirement. That is a 
growing part of our tax structure. The way that taxation of 
owner-occupied housing is structured under our system, it is 
effectively a consumption tax. So we have a hybrid system. The 
issue is how can we use this existing hybrid system in order to 
achieve the goals that you have identified? Namely, to deal 
with the problems in the corporate sector. That is the issue 
which I think you can address using the scheme that I have 
placed before you.
    Mr. CAIN. Mr. Chairman--and I will be brief.
    Chairman McCRERY. Thank you, Mr. Jorgensen. Mr. Cain.
    Mr. CAIN. I have much more confidence in Congress' ability 
to make a bold move and get through the political barriers that 
will be needed to solve the long-term problem. Some suggestions 
have been made for the short-term issue that you deal with 
relative to the WTO, and I respect those suggestions, but the 
success of American businesses, the success of this country, 
starts with believing that you can do something. As long as we 
continue to believe that we can't change it in a big way and 
that our elected representatives will never take the big steps 
to change it dramatically, we have defeated ourselves. We will 
continue to have hearings and debates over who gets to get a 
cookie out of the cookie jar this time, driven only by more and 
more complexity and more and more debate.
    So, I would encourage you, Mr. Chairman, and your 
colleagues, to begin to believe that, yes, we can make dramatic 
changes to the Tax Code.
    Chairman McCRERY. Thank you, Mr. Cain.
    Mr. Engen, do you want to have some last shots here, or 
have you had enough?
    Mr. ENGEN. I guess the one thing I would add is that it 
would seem to me if--Bill's point is a good one. We have gotten 
to the point where we are with the Tax Code now because of the 
system we have and all of us that operate within it. It doesn't 
necessarily seem to me that we should then be more optimistic 
that we are necessarily going to change the current system, 
say, an income tax in a more beneficial way, than we should be 
more optimistic that we could change to a system, say, like the 
X tax or Mr. Graetz's tax.
    You know, my view is it would seem like the probability of 
going in any of those different directions--they are somewhat 
simpler--that there is no reason to believe that it would be 
easier to amend the income tax in a way that is more 
beneficial. So in that sense, I would say that is where the 
focus should be, even though in any direction it is going to be 
difficult, that those steps are well worth being taken.
    I would like to say, yeah, I think the ETI should go. Those 
foreign subsidies I think don't have a place. There are some 
small things that can be done with the revenue from that, but 
the type of fundamental changes we are talking about here, 
whether it is broad-based income tax reform, whether it is an X 
tax, whether it is Mr. Graetz's hybrid, that is going to take a 
lot more effort for sure, but it is well worth it.
    Chairman McCRERY. Mr. Entin.
    Mr. ENTIN. If you can do a fundamental reform, that would 
be wonderful. Many things fit together better if you are 
changing everything in a consistent manner than if you are 
trying to do it reform piecemeal. If you can't do a major 
reform, and you have only a few billion dollars, Ernie 
Christian suggested a gradual move toward expensing at the 
business level or a lower-corporate rate, and to improve 
gradually the tax treatment of saving. Go far enough down that 
road and you will get to reform eventually. I will second his 
remarks on that.
    Chairman McCRERY. Thank you. I want to thank all of you for 
staying with us for 3 hours this afternoon. This is, as Mr. 
Gale said, a very interesting subject. To sum all this, it was 
illuminating in some respects, so I do appreciate the expertise 
that you bring with you, and your enthusiasm, Mr. Cain. We in 
Congress, sometimes I think, do get somewhat jaded and lose 
sight of the goals we had when we came here. So maybe after the 
elections, if the President does what Secretary O'Neill said 
yesterday he was going to do, which is promote fundamental tax 
reform, an overhaul of the tax system, maybe we can be 
rejuvenated here at the legislative level and move forward.
    So, we will certainly consider your thoughts and ideas, and 
I am sure talk with all of you again before we proceed with 
such an undertaking. Thank you very much, and the hearing is 
adjourned.
    [Whereupon, at 5:00 p.m., the hearing was adjourned.]

                                
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