[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]



   THE U.S. TAX CODE'S IMPACT ON REVENUE PROJECTIONS AND THE FEDERAL 
                                 BUDGET

=======================================================================

                                HEARING

                               before the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

             HEARING HELD IN WASHINGTON, DC, JULY 22, 2004

                               __________

                           Serial No. 108-23

                               __________

           Printed for the use of the Committee on the Budget


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



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                        COMMITTEE ON THE BUDGET

                       JIM NUSSLE, Iowa, Chairman
CHRISTOPHER SHAYS, Connecticut,      JOHN M. SPRATT, Jr., South 
  Vice Chairman                          Carolina,
GIL GUTKNECHT, Minnesota               Ranking Minority Member
MAC THORNBERRY, Texas                JAMES P. MORAN, Virginia
JIM RYUN, Kansas                     DARLENE HOOLEY, Oregon
PAT TOOMEY, Pennsylvania             TAMMY BALDWIN, Wisconsin
DOC HASTINGS, Washington             DENNIS MOORE, Kansas
ROB PORTMAN, Ohio                    JOHN LEWIS, Georgia
EDWARD SCHROCK, Virginia             RICHARD E. NEAL, Massachusetts
HENRY E. BROWN, Jr., South Carolina  ROSA DeLAURO, Connecticut
ANDER CRENSHAW, Florida              CHET EDWARDS, Texas
ADAM PUTNAM, Florida                 ROBERT C. SCOTT, Virginia
ROGER WICKER, Mississippi            HAROLD FORD, Tennessee
KENNY HULSHOF, Missouri              LOIS CAPPS, California
THOMAS G. TANCREDO, Colorado         MIKE THOMPSON, California
DAVID VITTER, Louisiana              BRIAN BAIRD, Washington
JO BONNER, Alabama                   JIM COOPER, Tennessee
TRENT FRANKS, Arizona                RAHM EMANUEL, Illinois
SCOTT GARRETT, New Jersey            ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina   DENISE MAJETTE, Georgia
THADDEUS McCOTTER, Michigan          RON KIND, Wisconsin
MARIO DIAZ-BALART, Florida
JEB HENSARLING, Texas
GINNY BROWN-WAITE, Florida

                           Professional Staff

                       Rich Meade, Chief of Staff
       Thomas S. Kahn, Minority Staff Director and Chief Counsel


                            C O N T E N T S

                                                                   Page
Hearing held in Washington, DC, July 22, 2004....................     1
Statement of:
    Douglas Holz-Eakin, Director, Congressional Budget Office....     6
    Pamela F. Olson, partner, Skadden, Arps, Slate, Meagher & 
      Flom, LLP, Former Assistant Secretary of the Treasury for 
      Tax Policy.................................................    36
    Peter R. Merrill, Ph.D., Director, National Economic 
      Consulting Group, PriceWaterhouseCoopers LLP...............    42
    William G. Gale, Ph.D., Senior Fellow, the Brookings 
      Institution................................................    52
Prepared statement:
    Mr. Holtz-Eakin..............................................     9
    Ms. Olson....................................................    39
    Mr. Merrill..................................................    45
    Mr. Gale.....................................................    55

 
   THE U.S. TAX CODE'S IMPACT ON REVENUE PROJECTIONS AND THE FEDERAL 
                                 BUDGET

                              ----------                              


                        THURSDAY, JULY 22, 2004

                          House of Representatives,
                                   Committee on the Budget,
                                                    Washington, DC.
    The committee met, pursuant to call, at 10 a.m. in room 
210, Cannon House Office Building, Hon. Jim Nussle (chairman of 
the committee) presiding.
    Members present: Representatives Nussle, Brown, Garrett, 
Barrett, Diaz-Balart, Spratt, Moore, Scott, Capps, Thompson, 
Baird, Cooper, and Emanuel.
    Chairman Nussle. Good morning. Welcome, everybody, to 
today's Budget Committee hearing regarding the impact of our 
current Tax Code on Federal revenue projections and the Federal 
budget. We are very pleased to have back before us as our first 
witness the Congressional Budget Office Director Holtz-Eakin.
    Dr. Holtz-Eakin, thank you again for being part of our 
Budget Committee hearing. Thank you and thank your staff for 
the good work that you do. We really do appreciate all of the 
good work throughout the year that the Congressional Budget 
Office does on our behalf. We appreciate that. We want to make 
sure your folks back at CBO know that as well.
    I would also like to welcome our second panel witness Pam 
Olson who will be here, who is former Secretary of the Treasury 
for Tax Policy; Dr. Peter Merrill, who is the director of the 
National Economic Consulting Group at PriceWaterhouseCoopers; 
and William Gale, a senior fellow at the Brookings Institute.
    I will begin today with a brief overview of why the many 
problems and complexities of our current Tax Code are of 
particular concern to the Budget Committee and why we think it 
is critical to begin the discussion now. The first is, I guess, 
simply that the budget process and the Tax Code are 
inextricably linked. We collect Federal taxes to pay for 
Federal spending. The way I describe it to constituents back 
home is it is a bill. We do a lot of things out here in the 
Federal Government, and we present a bill to people for those 
services. Spending drives the process typically, so we need to 
know if we are consistently spending more than we are taking in 
and, if so, to what extent we are spending beyond our means, as 
well as what are we taking in in revenue and taxes in order to 
meet those obligations, and if the Code, the Tax Code, and the 
revenue is producing the revenue we need in order to meet those 
obligations.
    In short, receiving reliable revenue data is one of the 
most basic, essential parts of the budgeting process. So for 
this committee to put together a reasonable budget, it is 
critical that the Tax Code allow for reasonable estimates of 
revenue.
    What we have heard consistently over the years is just that 
statement: It is critical that the Tax Code allow for 
reasonable estimates of revenue. We get very frustrated, and I 
will be the first to admit that I am one of them who gets 
frustrated, with our analysts for the projections. But if they 
have an underperforming, or a nonperforming, or a very 
difficult to gauge any performance when it comes to a Tax Code, 
we are actually blaming the wrong--we are blaming the messenger 
and shooting the messenger as opposed to looking at the root 
cause.
    In all fairness, estimating revenue is notoriously 
difficult for many reasons, but it is made even more difficult 
with all the wrinkles and complexities that the Congresses have 
added over the decades. And I know Mr. Scott will want to 
mention that as well. And I would certainly be interested, as 
he would, in how many of those pages have been added since 
Republicans took control, Democrats took control. We could have 
a good conversation about that.
    The fact of the matter is over on that table is not even 
the whole story. We couldn't get the whole story here of what 
you need to know if you really want to be in complete 
compliance with the Tax Code. Just to give you an idea, there 
are stacks of 22 volumes that make up the IRS Code. That is the 
brown books, kind of in dead center over there, is the IRS Tax 
Code. Then you have 20 volumes of Treasury regulations that are 
supposed to fill in the gap, so to speak, because apparently 22 
volumes are not enough to explain everything.
    We wanted to bring in the judicial rulings of the Tax Code 
that are supposed to explain all the other stuff when taxpayers 
and the IRS actually disagree and go to court over it, but they 
fill up a whole wall at the Library of Congress. So we brought 
there a couple of volumes just to kind of identify them if you 
ever want to go over to the wall in the Library of Congress and 
look them up. We couldn't really find a truck big enough to get 
them all over here.
    On top of that, there are thousands of pieces of what you 
call administrative guidance that are issued by the IRS, with 
more coming out probably on a daily basis. These are revenue 
rulings, revenue procedures, notices, announcements, private 
letter rulings, technical advice memoranda, but, of course, we 
did not have a hearing room big enough to hold all of those.
    Suffice it to say it is very complicated. It is voluminous. 
And that is in part why we have a problem. It is this 
complexity and it is the level of fairness in transparency that 
makes this very difficult.
    I will be the first to admit, Mr. Scott, and anybody else, 
that every time we talk about simplification, unfortunately we 
add pages. And getting to the root cause of that problem, 
whether it is Republicans or Democrats, is something we do have 
to come to grips with. We are not here to blame anybody, and I 
hope that we--certainly if that is what Members want to do. I 
think what we want to do today is learn about how to do a 
better job, whether it is Congress or forecasters or whoever it 
is, do a better job of getting the information we need in order 
to make decisions. That is what today and today's hearing is 
about.
    You have heard me complain about this before. I have heard 
other Members suggest that we talk about what we can do in 
Congress to get our arms around this so that we have better 
revenue data to make our decision.
    Secondly, and probably more important, is the problems of 
the Tax Code are really not new, and it is pretty much always a 
reasonable time to talk about the problems, specific problems, 
within the Tax Code. So why is this important right now? Well, 
I think we have a window of opportunity that Mr. Spratt talks 
about all the time and other Members are quick to remind 
everybody about. There are several major factors that will be 
coming to a head over the next few years, including retirement 
of the baby boomers, expiring tax provisions, and, of course, 
the individual alternative minimum tax, or AMT.
    As circumstances have dictated, we have almost taken on the 
whole--we have also taken on a whole host of large, relatively 
new demands on our budget over the past years, such as greatly 
increasing homeland security and defense spending, and, of 
course, we are also resolved to continue our commitment to 
long-standing domestic priorities, education, health care, 
environment, veterans benefits just to name, obviously, only a 
few.
    None of these demands are going away right away or any time 
soon, and appropriately so. To add to all of this is the fact 
that we currently have a budget deficit, again not news to 
anyone, which has incurred in response to extraordinary sets of 
challenges, everything from obviously homeland security and 
national defense to economic downturn and, yes, purposefully 
reducing taxes in order to jump-start the economy, which has 
occurred finally.
    To figure out how we are going to begin to address these 
problems, we need to have some sort of reasonable guide as to 
just what our revenue potential is. We need to know not just 
how to control spending, but by how much, just how big of a 
problem that is.
    Again, I want to make it clear that the intent of this 
hearing is not to try and rewrite the Tax Code--even attempt to 
fix, for that matter, anything today--but to actually learn 
some of the problems.
    Well, if you want to fix something today, Mike, we can do 
that. I am happy to entertain fixes, too. But part of the 
problem we have got is so many Members just assume that there 
is a Tax Code, we ought to have good data about it so we can 
make our decisions. What we consistently hear from our analysts 
is it is pretty difficult to make determinations about our Tax 
Code because of its complexities.
    So there are great temptations to fix things piecemeal. We 
have tried to do that in the past. They really haven't worked. 
We have changed one part, and, however well-intentioned, it has 
had impact on other parts. It makes, obviously, the decisions 
of making the revenues and projecting revenues even more 
complicated.
    Finally, I know we are in the season, I know there is ample 
opportunity for partisan bickering, and we can do that, but I 
really did want to have an opportunity to invite some experts 
in here to learn what we can do from a more objective 
standpoint; not one particular tax cut or another or tax 
increase or another or tax provision or another, what can we 
truly do in order to make our revenue projections better 
regardless of what party is in control or what tax provision is 
being proposed.
    So I don't want to waste this opportunity, and I do want to 
give Members the opportunity to learn today.
    So with that, I turn it over to Mr. Spratt for any comments 
he would like to make. Then we will hear from Dr. Holtz-Eakin.
    Mr. Spratt. Thank you, Mr. Chairman and Dr. Holtz-Eakin. 
Thank you again for coming in. Thank you for your testimony 
this morning and the good work that CBO continually does.
    Mr. Chairman, I want to applaud you for holding this 
hearing because I think it is useful, and timely, and probably 
overdue. We have several issues, as I see it, that we should be 
pursuing this morning. The first you have already touched upon, 
and that is how do we make revenue projections more 
predictable? How do we get timely estimates of revenues that we 
can expect in the near term in order to base our budgets upon 
them?
    In this regard I think it is always a revelation to come on 
this committee or the Ways and Means Committee and find out how 
long it is before we have a handle on a break-out, breakdown of 
revenues coming in to the Internal Revenue Service, how much is 
capital gains, how much is payroll taxes, how much is income 
taxes, and to what extent are current revenues exceeding or 
lagging what we expected. Surely that ought to be something 
that all of the budget community in Washington is trying to do, 
and that is get a much, much better handle on timely revenue 
projections and break-outs.
    Secondly, with respect to reliability, I don't think we 
should too quickly exonerate ourselves. When the Office of 
Management and Budget and the Congressional Budget Office both 
present us blue sky estimates that give rise to surplus 
projections of $5.6 trillion, sometimes a credulous Congress is 
all too willing to buy into those blue sky estimates and to 
make big budget decisions based upon them.
    We warned at the time that we shouldn't bet the budget on 
these forecasts, these blue sky forecasts, and we also pointed 
to some elements in the recent past that--upon which these 
forecasts were based. For example, for 8 straight years in the 
1990s, tax revenues grew at a faster rate than taxable incomes. 
Everybody knows that can't go on forever. After 8 years it was 
about ready to peter out.
    Secondly, there was a phenomenal increase in capital gains 
taxes in the 1990s. Capital gains taxes grew over a period of 5 
years, 1995-2000, from about $40 billion to about $120 billion, 
and everyone knew that with the downturn in the stock market, 
that, too, was going to change. It was overdue when we got our 
estimates of the economy in 2001.
    That is one thing we need to keep in mind, that we bought 
into it, and we need to be wary ourselves and learn from this 
experience about betting the budget big time on revenue 
estimates and economic projections that may not obtain.
    Secondly, we are told now that the projected surplus of 
$5.6 trillion was wrong by as much as 55 to 60 percent due to 
economic factors and technical factors, and the larger of those 
two is technical factors. So the question we have to ask is are 
we refining our technical forecasting tools so that we don't 
make those mistakes again?
    Third, we should always be asking, because we haven't spent 
nearly enough time on all the ad hoc tax measures that we are 
taking up here, doing what we did in 1985 and 1986, and that is 
cleaning out the closet. We have got an enormous amount of tax 
expenditures, tax credits, tax conditions, tax preferences that 
have built up in the Code over the last 20 years. It is about 
time, past time, we went back to the Code and clean the Code 
out, had a good closet cleaning.
    In doing that we need to take care to do two things that 
most people don't understand are really sort of at opposite 
ends of each other. One is make the Code more equitable. The 
other is make it more simple and efficient. The two are not 
necessarily achieved in the same manner. They are awfully hard 
to do. But that question ought to be always before us, how do 
we make it more equitable, and how do we make it more 
efficient. Finally, as the books over there attest, how do we 
make it simple so that the average American doesn't get cynical 
about the Tax Code and say only the little guys pay taxes.
    There is one thing that we should be wary of as we start 
taking up revenues; that is, about our expectations for the 
near term. We have been told that our revenues are below 
historical levels and our budget is in deficit partly because 
of the economy, but looking at CBO's analysis of a couple 
months ago, which indicated that the contribution of the 
economic cycle--economic cycle to our current revenue shortfall 
is really pretty small, it is about $25 billion in fiscal year 
2004 and is actually expected to be negative in fiscal year 
2005; in other words, a problem right now in going forward with 
the--is not the economy, and the problem is likely to persist 
in the coming years. In terms used by CBO, revenues are down 
today and into the near-term future not because of economic 
factors, but because of technical factors. If I am wrong about 
that, I would appreciate you correcting me.
    In other words, it is probably not a revenue pot at the end 
of the rainbow that is going to resolve our problems. We will 
have to do it ourselves with tough decisions. And revenues 
based upon a pick-up in the economy are not likely to bail out 
the budget problems that we have today.
    That is a full plate to talk about today, and, Mr. 
Director, we look forward to your testimony. I appreciate your 
participation.
    Chairman Nussle. Before we begin, let me also mention for 
our benefit that Tom Kahn is going to get married here August 
1--he and his fiancee Suzy, we wish them all the very best. Now 
the date is set, and she is actually going through with it.
    We welcome you, Director Holtz-Eakin. Thank you so much for 
spending your time with us today. Pleased to receive your 
testimony.

   STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, CONGRESSIONAL 
                         BUDGET OFFICE

    Mr. Holtz-Eakin. Thank you, Mr. Chairman and Mr. Spratt, 
members of the committee. We are pleased to have a chance to be 
here today. Let me add my congratulations as well, Tom. A man 
of your advanced age getting married is quite an 
accomplishment.
    I really do want to thank the chairman and the ranking 
member for their very kind remarks about the CBO staff, who, in 
my opinion, do a simply incredible job with very little public 
recognition, and to get a little bit of that is nice. I 
appreciate it.
    Before turning to my remarks, I would also like to 
encourage the chairman if he has to choose between blaming the 
messenger and shooting the messenger, we prefer blame.
    My goal today is to talk about the challenges that the 
current Tax Code presents for budget projections, particularly 
at the CBO, but I think that in doing so, it is useful to the 
discussion in the larger context of economic policy, decision-
making, and then budgetary presentation and think about where 
the possibilities of tax reform fit in that mix.
    Stepping back, clearly the first and threshold decision 
being made by Congress is which programs to fund and at what 
scale, how much to spend on those different programs. That is 
the key economic policy decision that we discussed in testimony 
last year before this committee about the threshold costs 
presented in the Federal Government.
    From a budgetary perspective, it would be useful to have a 
clear presentation of those commitments--to know what 
commitments have been made on the part of the Congress to 
command resources from the private sector and make sure that 
those commitments are presented in a clear and transparent 
fashion to allow policymakers to undertake trade-offs in 
looking at the relative costs of different programs.
    We have worked with members of this committee for many 
years to look at some of the tougher and difficult issues in 
on- versus off-budget presentations and the presentation of 
economically equivalent, but apparently different, 
transactions--under, for example, the Credit Reform Act, which 
balanced the playing field between a direct loan and a loan 
guarantee--to make sure that the economically equivalent 
commitment of resources was reflected that way in the budget. 
And one could imagine even further discussions in that area on 
a wide variety of financial transactions or even such things as 
when a tax credit is really economically equivalent to a 
spending program on the part of Congress. Determining that 
would be a step forward in the presentation of that economic 
policy in a budgetary context.
    Step 2 in that, of course, is to finance those programs at 
the lowest possible overall social cost, which includes costs 
of administration of the Tax Code, costs by taxpayers in 
complying with the Tax Code, costs in unfairness of the Tax 
Code from the perspective of policymakers, and, most 
fundamentally, interference of the Tax Code with economic 
decisions that lead to distortions that lower the overall 
efficiency of the economy and represent economic waste.
    From that perspective it is useful to have a budgetary 
presentation that makes clear the kinds of resources that are 
being raised in the Tax Code to finance spending programs and 
the likely receipts that will come with them, and also, where 
important to Congress, who really pays for those tax resources.
    What is the state of affairs? We provided written testimony 
that focuses on three different pieces of the current Tax Code 
and the difficulties in budgetary presentation. The first is, 
looking forward over our budget window, the combination of 
sunsets, phase-ins, and then expiring provisions, and the 
difficulties that raises in budgetary projections; the second 
key aspect being the volatility of the tax base and decisions 
that have been made in the past and could be made in thinking 
about tax reform, about what would be in and not in the tax 
base; and then, finally, the differential taxation of economic 
activity across either different kinds of income or different 
kinds of activities, and also across individuals--which makes 
it more difficult to project the overall receipts that might 
come from the Tax Code as it is configured.
    Let me begin with a discussion of the sunsets, the phase-
ins, and the various expiring provisions. And a key issue here 
is what the private sector believe about the future of the Tax 
Code. If it is the case that member of the private sector 
firmly believes the Tax Code as written in current law with 
expirations, for example, of tax rates on dividends and capital 
gains in 2008, the entire sunset in 2011, then they will 
undertake to shift their economic activities, whether in real 
terms by actually doing things in different years, or at least 
in reporting terms by reporting transactions, realizing capital 
gains, and doing a variety of other things in response to that 
perception. And that will make it far more difficult to 
anticipate the likely receipts from the Tax Code.
    On the other hand, it may be the case that the private 
sector doesn't believe that at face value. That raises a very 
difficult question in doing our budget baseline projections. 
The budget law is very clear that we should take and apply on 
the spending and tax side current law as it is written. 
However, it would be desirable to have that baseline dictum 
consistent with the underlying economic forecast.
    One could imagine that the private sector believes that the 
Tax Code will evolve exactly as it is written, and, if so, we 
can construct an economic forecast based on that and then layer 
on top of it the current tax law to get the receipts that would 
likely come in. However, I think it is fair to say that is far 
from likely, that there are lots of at least pieces of the 
current sunsets and phase-ins and expiring provisions that the 
private sector doesn't believe will go as planned. If we try to 
put in the economic forecast that builds in the private 
sector's actual expectations, we will layer on top of it a 
budget law which is inconsistent with the underlying economic 
forecast.
    And to make it worse, it is really impossible to say 
exactly what the private sector expects. So we are faced with a 
dilemma in simply constructing the baselines in the current 
environment. We have chosen to imagine that the tax law will 
evolve as it is written for economic as well as budgetary 
projections and are cognizant that that leads us to make 
mistakes in a very mechanical sense that will, looking back, 
appear to be unnecessary volatility. That kind of volatility, 
broadly speaking, is a cost. It is an uncertainty to 
policymakers about what is coming in and why, and it is 
uncertainty to the private sector in thinking about what will 
the Tax Code look like.
    That is a situation that is probably not unique to the 
current environment. It is exacerbated by the variety of 
provisions at the moment. But general uncertainty about the Tax 
Code is something that the private sector has to deal with all 
the time, the prospect of change in the future. To the extent 
that the Tax Code was set in place and left alone for a while, 
revenue projections would probably improve, and private sector 
costs would be lower as well. I think that is an important 
consideration in terms of thinking about this topic.
    On the volatility of the tax base, the CBO is painfully 
aware of how volatile things can be. For example, in 2001 
capital gains receipts were $100 billion. By 2002, they had 
fallen to $57 billion. The inclusion of capital gains in the 
tax base as a result delivers some uncertainty into the revenue 
projections.
    Capital gains are a piece that has gotten particular 
attention, but there are many other aspects that are imbedded 
in the technicals, as you mentioned, which are difficult to 
project with a lot of precision, and which raise the 
uncertainty about our technical forecasts.
    Going forward, one could imagine lots of decisions made 
about the tax base for which different rates would be applied, 
and they would have different consequences for volatility. 
Some--a broad-based income tax would include capital gains, and 
that piece would contribute to volatility. Some would exclude 
capital gains. Some tax reforms might allow firms to entirely 
expense their investments in the first year. Investment is a 
notoriously volatile activity. We would have to deal with that 
in the revenue projections.
    One can imagine some pieces--the compensation of employees 
through stock options and bonuses, which would be in any flavor 
of broad-based fundamental tax return--which would remain as a 
challenging projection issue for the CBO.
    The volatility also figures into the final topic in our 
testimony, which the differential taxation across activities. 
At present, in rough terms, wage income is taxed in the 
aggregate at an effective rate of about 20 percent, whereas 
other compensation in the form of fringes at zero percent. 
Capital gains are taxed roughly at 15 percent. The return to 
investment in equipment is taxed at roughly half the rate, at 
the moment, as the return to investment in structures is. Those 
investments that take place in a C corporation are taxed at a 
rate that is probably about 10 percentage points higher than 
those investments that are done in the form of an S 
corporation. All of those features make it necessary to examine 
not just the level of taxation, but where the economic activity 
takes place in order to accurately project the receipts.
    The same is true for individuals. Accordingly to data that 
is in the CBO's publication on effective tax rates, which we 
put out for many years, in 2001 the combined effective tax rate 
from the individual and corporation income tax in the bottom 
quintile, the lowest 20 percent, was -5.3 percent. Moving 
across quintiles to the top, it rises to .7, .45, 7.9, and 19.2 
percent. So not only is it important to forecast the level of 
economic activity and the income that it generates, it is 
becoming increasingly important in the baseline to forecast who 
gets the income and the effective rate at which they will be 
taxed. This raises the challenge for CBO in providing accurate 
revenue forecasts.
    Going forward, there are two important transition issues 
that will be associated with thinking about fundamental tax 
reform. The first, and certainly the most important, will be 
the transition in the private sector and the impact on the 
economy of the adjustment costs in moving to a new tax system, 
and measuring the benefits of a new tax system net of those 
adjustment costs is a fair way to think about it. The same 
would be true in budgetary presentation: that, moving forward, 
there could be tremendous gains over time in the stability of 
the bases and the ability to project revenues accurately, but 
during the transition it is unlikely that the CBO or other 
entities interested in forecasting revenues would be able to do 
so with any great precision when we move from one Tax Code to 
another.
    The focus, I think, on the whole, however, should be on the 
private sector. It is the case that to the extent that there is 
volatility in tax receipts and that volatility is not 
symptomatic of a fundamental imbalance, the U.S. Government has 
access to credit markets unparalleled in the globe and can 
smooth that volatility at a very low cost. Picking the basic 
level of spending, picking the basic level of taxes to finance 
that spending, and deciding upon the structure of those taxes 
to meet the overall goals of efficiency and equity are really 
core issues, and the volatility around that, I think, is 
manageable from both a budgetary and economic perspective.
    That was the short version of the remarks that we 
submitted. We would be happy to elaborate to answer any 
questions you might have.
    [The prepared statement of Mr. Holtz-Eakin follows:]

  Prepared Statement of Douglas Holtz-Eakin, Director, Congressional 
                             Budget Office

    Mr. Chairman, Congressman Spratt, and members of the committee, I 
am grateful for the opportunity to appear before you this morning to 
discuss comprehensive tax reform. I want to begin by emphasizing that 
my remarks focus on the Federal budget, with emphasis on the problems 
that the current tax system poses and that the reform of the system 
would pose for projecting revenues. These remarks do not extend to the 
merits or drawbacks of specific proposals.
    From an economic perspective, the central role of the government is 
to provide services to the public that only it can provide (or provide 
adequately). Therefore, the threshold budgetary decisions faced by 
policymakers are about which services to provide and how much to spend 
on them. Those expenditures must be financed, and the challenge for tax 
policy is to provide adequate financing in a fair and efficient 
fashion. At present, the bulk of general tax revenues to the Federal 
Government derives from individual income taxes and corporate income 
taxes. In recent years, the combined contribution from those income 
taxes has been about 50 percent to 60 percent of Federal receipts, or 
about 8.5 percent to 12.5 percent of gross domestic product. Payroll 
taxes constitute another roughly one-third of receipts. But under 
current law, those taxes are linked to outlays for Social Security and 
Medicare. For that reason, I will ignore payroll taxes, although one 
could envision a comprehensive tax reform that encompassed them. The 
remaining sources of receipts are less than a tenth of Federal 
revenues. In light of the dominance of income taxes as a share of 
Federal receipts, discussions of tax reform are largely about reforming 
income taxes.
    Its name notwithstanding, the underlying base of the U.S. income 
tax system departs significantly from definitions of income. Indeed, a 
chief difference among many reform proposals is the question of the 
appropriate tax base. There are two useful benchmarks. One is a tax on 
comprehensive income (often referred to as a Haig-Simons income tax). 
Comprehensive income includes all labor compensation earned during the 
year (regardless of whether it is actually paid or deferred) and all 
capital income (again, regardless of whether it is realized or not). 
Comprehensive income measures the additions to an individual's 
potential to purchase consumption items. Actual purchases may fall 
short of that amount if he or she instead chooses to save part of the 
income, or purchases may exceed that amount if he or she spends out of 
past or expected future income.
    The other benchmark is a consumption tax, or consumed income tax. 
It differs from a comprehensive income tax by excluding from the tax 
base that portion of income that is saved and by subjecting to taxation 
an individual's purchases. Because comprehensive income and consumed 
income differ only as a result of individuals' saving and investment 
decisions, it is possible to implement a consumed income tax by two 
means: by excluding saving from taxation or by excluding the income 
generated from saving and investment. Both variants have been proposed.
    The current U.S. income tax system is a hybrid of those two 
benchmarks, albeit an incomplete one that excludes from taxation some 
items that would be taxed in either system. The current system relies 
principally on an income tax but embodies some elements of a 
consumption tax by excluding income saved for retirement and other 
uses. Some of the problems that arise with the tax system--both in 
terms of its effects on the economy and the difficulties it presents 
for budget projections--stem from that mixing of characteristics of 
income and consumption taxes. Many more difficulties derive from the 
ways in which the tax system departs from both concepts. For example, 
employer-provided health insurance, which is currently not taxed, would 
be taxed under either a pure consumption tax or a pure income tax, as 
would many of the expenditures that taxpayers are allowed to deduct in 
arriving at taxable income. Consequently, although some of the issues I 
discuss here might be addressed by the choice of income versus 
consumption as the tax base, many will arise in either case, because 
they are either unavoidable or the consequence of various policies that 
are independent of the choice of a base.
    I will focus on four issues. The first three are general attributes 
of the current income tax system that impede reliable revenue 
projections: sunsets and expiring provisions, the volatility of income 
sources, and differential taxation. The fourth is transition effects--a 
consideration that must be taken into account in projections when any 
major change to the system occurs. Clearly, the most important 
consideration in evaluating the merits of a tax reform is its effects 
on the economy, and not the repercussions for Federal revenue 
projections. However, knowing the effects on projections illuminates 
the real costs to the economy because the two types of effects often 
stem from the same phenomena.

                    SUNSETS AND EXPIRING PROVISIONS

    Under current law, the Tax Code contains a number of new provisions 
that take effect in phases and a number of expiring provisions. A few 
of the latter--notably the provision allowing partial expensing of 
equipment--were enacted to be temporary with a specific economic 
purpose in mind. The countercyclical effect of investment incentives 
such as partial expensing was enhanced by its temporary nature. Indeed, 
its future use as a tool to manage aggregate demand in the economy 
could be compromised by now extending it. But most of the expiring 
provisions were enacted as a step toward making them permanent or 
extending them indefinitely.
    There are essentially two groups of expiring provisions. First, 
there are the roughly 30 so-called extenders: special provisions of the 
Code that have been extended a few years at a time and are regularly 
expected to be continued (see table 1). Most, if extended, would 
diminish revenues--altogether, by about $175 billion over the 
Congressional Budget Office's (CBO's) 10-year projection period. Among 
the most significant of them is the credit for research and 
experimentation, which has been extended nine times since its enactment 
in 1981.
    Second, there are the many provisions in the Economic Growth and 
Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth 
Tax Relief Reconciliation Act of 2003 (JGTRRA). They include all of 
EGTRRA's income and estate tax provisions, which are set to expire at 
the end of 2010, and JGTRRA's reduced dividend and capital gains tax 
rates, at the end of 2008. But they also include provisions such as the 
child tax credit, the expanded standard deduction, the 10 percent and 
the 15 percent brackets, and the increased exemption under the 
alternative minimum tax, which are scheduled to be reduced in 2005 (see 
table 2). While people hold diverse views on the future of those 
provisions, it is reasonable to expect that at least some will be 
extended.
    Those scheduled changes in the Tax Code create a multitude of 
challenges for projecting receipts. In projecting baseline receipts, 
CBO is required to assume current law, a stricture that might normally 
coincide with ``current policy.'' However, at present, that requirement 
dictates that all of the legislated provisions are assumed to be phased 
in and to expire as scheduled in law, even though those required 
assumptions may differ greatly from expectations of current policy. 
Thus, even when CBO's baseline projections are accurate, the presence 
of those expirations reduces transparency about just what to expect 
concerning the future course of the government's fiscal condition.
    An even more problematic feature of the gap between current law and 
expectations of policy is that budget estimates are based on the former 
and economic activity is influenced by the latter. In projecting 
revenues, one strategy for dealing with the problem is to assume that 
the public believes that all changes to the Tax Code will occur as 
scheduled. That approach has the virtue of being consistent with the 
baseline assumption of current law. Unfortunately, it has the drawback 
of divorcing the underlying assumptions about the economy from reality.
    Assuming that the public expects the Tax Code to change as 
scheduled also complicates revenue projections. Expected changes in the 
Tax Code induce significant shifts in taxable economic activity from 
year to year. Some of that activity represents changes in behavior that 
lead to real changes in income, prices, interest rates, and other 
aspects of economic performance. Some is just reporting or accounting-
shifting bonuses into the next or previous year, for example. Those 
shifts--real or reporting--lie at the heart of the desirability of tax 
reform; the fact that households and firms alter their behavior in 
response to taxes demonstrates the importance of tax policy. But such 
shifts in measured activity resulting from the scheduled changes in the 
Tax Code make projections more sensitive to policy than they would 
otherwise be--and do so unnecessarily if, indeed, the Code ultimately 
does not actually change.
    Another way to deal with the problem of scheduled changes in the 
Tax Code in making projections is to assume that firms and individuals 
do not believe that tax provisions will change as scheduled but have 
their own view of how policy will evolve. That approach may make the 
underlying economic projections more realistic, but it renders them 
inconsistent with the rule that budget projections reflect a baseline 
under current law.
    And here again the existence of scheduled changes in the Tax Code 
complicates projections. The approach makes it necessary to discern 
what the public expects and to factor in the effects of the public's 
uncertainty. EGTRRA and JGTRRA contain many provisions that interact in 
a complicated manner, and predicting which provisions the public 
expects to lapse and which it expects to be made permanent is a 
complicated matter of judgment. Regardless of which approach is taken, 
baseline revenue projections are made less reliable by the existence of 
expirations that few people expect to occur as written in current law.
    Those difficulties for revenue projections are reflections of the 
costs to the economy introduced by expiring provisions. When households 
and firms shift the timing of their economic activity for tax purposes 
instead of market fundamentals, the efficiency of economic performance 
is impaired. Advancing or delaying the recognition of income and 
expenses uses real resources. And although it may be worth it to a 
taxpayer to incur those costs in order to save on taxes, the resources 
used are lost to society with no offsetting gain. Similarly, the 
uncertainty caused by expiring provisions for revenue projections 
mirrors the uncertainty that they introduce into all economic affairs. 
That uncertainty imposes real costs in the economy as well, as 
resources are used to avoid it and as taxpayers' choices are influenced 
by it.
    And those costs from expiring provisions are not limited to 
explicit sunsets. Even without provisions that are scheduled to be 
phased in or to expire, frequent changes in the Tax Code inflict 
analogous costs. If EGTRRA were not scheduled to expire or if it had 
not been enacted, similar uncertainty about taxes could exist. The 
public has incentives to evaluate policymakers' propensity to make 
changes to the Tax Code and to adjust its economic behavior 
accordingly. And the perception itself, even if nothing is actually 
changed, is enough to impose costs on the economy. Those costs can be 
reduced only by allowing the system some repose.
    The propensity to change the tax system is reinforced in part by 
the many exceptions and preferences already built into it. Its mixed 
attributes of income tax and consumption tax bases and the many 
exceptions and preferences that cause the system to deviate from both 
concepts mean that there is no bright line dividing new provisions that 
would be consistent with the tax system and those at odds with its 
underpinnings. One special interest claim for preferential treatment 
may seem as legitimate as any other, making changing the Tax Code 
easier and leading to further instability in it.

                      THE VOLATILITY OF TAX BASES

    Any comprehensive tax system will include some tax bases that are 
inherently more volatile than others. The current income tax embodies 
relatively stable sources of income such as regular wages and salaries, 
which yield relatively stable receipts. However, other sources of 
income swing more widely, which imparts volatility to receipts and 
makes projecting revenues more difficult. The current tax base, for 
example, includes capital gains, which are extremely volatile and 
unpredictable. Even though capital gains are taxed at substantially 
lower rates than most other income is, they nonetheless produce large 
swings in revenues. For example, as a consequence of a major adjustment 
in the stock market, receipts from gains realizations fell from $100 
billion in fiscal year 2001 to $57 billion in fiscal year 2002. Because 
stock prices are impossible to forecast, the decline in gains was not 
foreseeable. And even after the stock market's behavior became evident, 
the impending change in receipts was highly uncertain because stock 
prices do not translate directly into gains realizations.
    Capital gains are taxed under the current tax system because they 
are a form of income. However, under a comprehensive income tax, gains 
would be taxed as they accrued instead of upon realization. That change 
would not alter the fundamental difficulty of projecting fluctuations 
in the stock market, but it would eliminate the necessity of predicting 
taxpayers' decisions to realize capital gains. In contrast, neither 
variant of a consumed-income tax would tax gains; therefore, both 
presumably would avoid that source of volatility and unpredictability. 
For much the same reason, both variants of a consumed-income tax would 
tend to avoid the volatility that characterizes profits in general.
    However, volatility is not necessarily more characteristic of one 
approach to tax reform than another. Instead, the details of 
implementation matter. While consumption is less volatile than income, 
most proposed tax systems retain some volatile sources in their tax 
bases. Those that exempt saving (sales and value-added-style taxes) 
include durable consumer goods in their base, for example, which 
imparts volatility. Proposals that exclude income from capital still 
have volatility from bonuses and stock options, which are one of the 
sources of volatility under the income tax. Moreover, under some 
consumption taxes, business income is taxed net of full expensing for 
capital outlays. Because aggregate investment can be more volatile than 
business profits, the business income tax base under such a tax can be 
at least as volatile as it is under an income tax.
    In addition, volatility within a year may also be a consideration. 
Currently, most tax liabilities are paid as they accrue. Because wages 
are such a large part of income, withholding serves to match payments 
closely with the activity that generates them. Other forms of income 
should result in payments of estimated taxes through the year, but 
those liabilities can be harder to determine. Consequently, final 
settlements of liability are necessary at the time returns are filed. 
The current tax system results in ``April surprises'' that would not 
arise with some other tax systems, such as a wage tax or sales tax. 
Some consumption taxes, such as those for which the tax is collected at 
the point of sale, would reduce those surprises. Other consumption 
taxes, such as those that permit a deduction from income of 
contributions to qualified savings accounts, might be more difficult to 
pay as liabilities accrued, leading to potentially larger April 
surprises.

                         DIFFERENTIAL TAXATION

    The existing Tax Code taxes different kinds of income at different 
effective tax rates (including, in many cases, a rate of zero). For 
example, in the aggregate, the effective tax rate on wage income (from 
the individual income tax) is about 20 percent. It would be lower if 
calculated on compensation, which includes untaxed fringe benefits. Yet 
capital gains income is taxed at about 15 percent. Corporate income tax 
rates also vary, with the return on investment in equipment now taxed 
at about half the effective rate of that on structures. The combined 
corporate and individual income taxes result in tax rates of about 25 
percent to 30 percent on corporate income (which may be subject to both 
taxes), less than 20 percent on noncorporate business income (which is 
subject only to the individual income tax), and zero for the implicit 
income generated by owner-occupied housing (which is subject to 
neither).\1\
---------------------------------------------------------------------------
    \1\ Because the Tax Code is scheduled to change, those rates depend 
on which tax year is assumed.

    As a consequence of differences in effective tax rates, even an 
accurate forecast of overall income can yield an inaccurate projection 
of receipts if it is not allocated correctly among various activities 
or individuals. The variation occurs across two dimensions. First, 
there are different tax rates depending on the different kinds of 
income and consumption. Compensation in the form of wages and salaries 
is subject to taxation, while fringe benefits, which serve the same 
purpose of compensating workers for their labor, are not taxed. Profits 
accruing to C corporations--but not those of proprietorships, 
partnerships, or S corporations--are subject to the corporate income 
tax. Capital gains are subject to lower rates and sometimes no taxation 
at all. Similarly, taxpayers' patterns of expenditures generate 
different effective tax rates. For instance, expenses for mortgage 
interest, charitable contributions, or state and local taxes reduce 
Federal tax receipts. As a result, projections of receipts depend on 
projections of the components of income and expenditures, each 
introducing yet another potential source of error in receipts 
projections.
    The corresponding economic effect of that more complicated and less 
accurate budget projecting is the economic inefficiency associated with 
those differential tax rates. Firms and workers have incentives to tilt 
compensation toward untaxed fringe benefits. Capital flows toward 
lower-taxed sectors of the economy, forgoing higher gains to society 
that would accrue if invested elsewhere. Such incentives distort 
economic activity and lower overall efficiency. In addition, the 
preferences require higher rates to be applied to other forms of 
income, exacerbating the inevitable disincentives that income taxes 
cause for work effort. The effect is real and potentially substantial; 
incomes are lower than they would be without the distortions caused by 
the differential tax rates.
    The second dimension is who earns the income. Some owners of 
capital--notably tax-exempt organizations--pay no taxes, so, overall, 
income from interest and dividends yields much lower revenues than 
profits and wages do. In addition, the progressive structure of the tax 
rates means that the effective tax rate depends on whether the income 
accrues to someone of higher or lower income. Consequently, to project 
receipts, it is necessary to estimate how much income accrues to tax-
exempt entities and to forecast the income distribution among 
taxpayers.
    Again, the budgetary challenge reflects an underlying challenge 
posed by the Tax Code. In addition to minimizing interference with 
economic decisions, exhibiting fairness is another metric by which a 
Tax Code is measured--often manifesting itself in the desire to tax 
higher levels of income at higher rates. However, as the desired 
progressivity of the Tax Code increases, a premium is placed on 
accurate projections of the distribution of income. For example, the 
share of taxable income taxed in the highest marginal rate bracket 
(39.6 percent) under the personal income tax rose from 12 percent in 
1994 to 25 percent in 2000; so taxes were almost $60 billion higher in 
2000 than they would have been had the share taxed in each bracket 
remained constant (not including the effects of capital gains). While 
some forecasts may have anticipated an increasing concentration of 
incomes between those years, few would have anticipated such a large 
change.

                           TRANSITION EFFECTS

    The previous three considerations point to how the current tax 
regime makes projecting receipts more difficult. My fourth point builds 
on the fact that all projection methods rely on history to a certain 
extent. And the current system has some track record. In contrast, any 
major reform involves major uncertainties about how the new tax system 
will function and how much it will yield. As a result, following the 
introduction of any significantly reformed system, revenue projections 
would probably become less reliable in the near term.
    Again, the problems introduced for projections are reflections of 
factors at work in the real economy. The desirability of moving to a 
new Tax Code cannot be determined just by comparing what the world 
looks like now with what it would be like under a different code. The 
desirability of the reform also depends on the process of getting 
there. And the costs of the change could be significant. There are 
costs to reallocating resources to their best employment. In addition, 
some tax reform proposals, because of the effects they would have on 
prices, would create challenges for macroeconomic stabilization policy. 
Moreover, transition costs may generate perceptions of unfairness that 
lead reform proposals to incorporate relief to those most affected by 
the transition. But because such transition relief may mitigate the 
efficiency gains from reform, any tax reform proposal must be evaluated 
in light of the possible problems created by the transition from the 
old tax regime.

                               CONCLUSION

    Budget planning is aided by accurate projections of receipts, but 
the current U.S. Tax Code has several features that make accurate 
projections difficult. Of course, ultimately the issue of tax reform is 
not about what the tax system or tax reform does to analysts' ability 
to project revenues. It is about what taxes do to the economy. 
Nevertheless, some of the current challenges in making projections 
reflect the underlying costs imposed by the Tax Code.

    Chairman Nussle. First let me ask unanimous consent that 
all Members be allowed 7 days to submit statements for the 
record at this point. I know there are a lot of Members that 
have an interest in this. So unless there is objection, so 
ordered.
    Let me start, Director, by asking you to take the gloves 
off. Your three comments, your three main areas, obviously tax 
bases, where--how people generate their income and the 
volatility of that income, is not something that is managed 
very often here in Washington. It is just a fact of a changing 
economy. But the other two appear to be something that is 
determined here in Washington by one entity or another. So go 
ahead and take the gloves off as far as why these problems--
sunsets, phase-ins, expiring provisions, differentiating tax, 
all of that is complication added here.
    Let's go to Mr. Scott's point and others' point that we add 
this complication ourselves, whether it is Republicans, 
Democrats, Congress, President. Take the gloves off. Where does 
this complication come from, and how does--can you give an 
example of how something that seeming--maybe seemed innocuous 
at the time, but has, as a result, made it very difficult to 
forecast accurately the resulting revenue picture from a 
provision. If you have an example on your hit parade just to 
give Members an idea of what you are talking about, that would 
be helpful.
    Mr. Holtz-Eakin. I will give you a current events example 
which is drawn from today's New York Times, in which there is a 
discussion of Microsoft paying out $32 billion in dividends. 
Those dividends, at least according to the article, ares timed 
in part due to uncertainty about the future of the tax rates 
for dividends. And as a result, the decisionmakers at Microsoft 
thought they would pay it now as opposed to face anything in 
the future which might be a higher tax rate on dividends.
    That is one tiny example of a calculation that is done 
myriad number of times in the private sector about financial 
transactions, about economic activity. And it would show up as 
receipts now that we wouldn't have gotten in our baseline 
because we didn't build in uncertainty about a new Tax Code 
next year. Our baseline said Tax Code on dividends will be the 
same until 2011.
    So there you go. That is the kind of volatility that is out 
there underneath due to uncertainty about the future of the Tax 
Code. Some of that uncertainty at the present time, in your 
words, to take the gloves off, strictly driven by policy 
decisions about the Tax Code. We have lots of expiring 
provisions, lots of sunsets, some phase-ins.
    The private sector is going to look at that and do its 
calculation about what is likely to evolve and make economic 
and financial decisions that are in its interest. We will have 
to figure out what that might be and guess what the receipts 
are.
    It is actually in all three of the areas. To the extent 
that there are differential rates across time and differential 
rates across activities, say, dividends versus capital gains, 
there will be incentives to shift the composition of the tax 
base. There is always some underlying economic activity 
determining their compostion, but if we are shifting the 
composition of the tax base toward components that are more 
volatile, capital gains, because people can realize them when 
they choose to, instead of dividends which are paid out by the 
firms, that is a result of policy as well. So there are many 
features of policy that figure into this.
    Chairman Nussle. Can you walk through the timing as well--
and I am going to ask Secretary Olson this as well. Can you 
walk through the timing from--obviously we want to know what is 
coming in right now as an example. We want to know what the 
revenue picture is right now, or, for that matter, in order to 
make a budgetary decision for next year's budget as we are 
writing it, let's say.
    When will we--so you are using projections. When will those 
projections become final reality, this is what actually did 
occur during that period of time, so that you can have a look 
back and see--what is the time frame? I have heard some people 
describe it as much as years, not days, weeks, or months. So 
could you describe the timing on that?
    Mr. Holtz-Eakin. One might like to think that in putting 
together our summer update, which will be out in a month or so, 
that we will be looking at complete 2003 data and projecting 
forward from that. That is not the case. We are building off of 
the----
    Chairman Nussle. So we don't even have last year's data.
    Mr. Holtz-Eakin. No. We are building off data from 2001 as 
our fundamental detailed facts about the individual income tax, 
for example. So the first thing we have to do is project a 
couple of years of history and then build a 10-year budget 
projection on top of that. So timely access to comprehensive 
data is something that I think anyone in this business would 
argue would be very useful. It won't be a panacea, but it would 
be a very useful----
    Chairman Nussle. But it is 3 years old.
    Mr. Holtz-Eakin. Yeah.
    Chairman Nussle. So we are just now--I mean, most Members 
do not know that we are 3 years behind getting actual data for 
what occurred even--I mean, we are not getting today's data. We 
are getting data that occurred back in 2001 as final, close-
the-books actuals of what is going on. And based on that you 
then begin to use that as a way to project what is going to 
happen in 2005 and beyond.
    Mr. Holtz-Eakin. More fairly, that is the access to 
detailed individual tax return data, so we know the 
distributions across people, for example. We do know more 
recent information on receipts that has come in the Treasury 
reports, daily Treasury statements, monthly Treasury 
statements. But those totals don't reveal some of the 
distributions that I tried to emphasize can be very important. 
For example, as firms send in their tax payments, we don't know 
the division between those tax payments which are for payroll 
taxes, Social Security, and off-budget items versus those which 
are income taxes.
    When that money comes in, it is divided based on historical 
patterns, and we try to guess that division. But simply knowing 
that division would be extremely useful in distinguishing 
between those things that are meat and potatoes, wages and 
salaries, which give you payroll taxes and other aspects of 
economic activity. So we are working with data which is 
incomplete in many ways.
    Chairman Nussle. Is that data--I am sorry, my time has 
expired. I want to finish this line, and that is has the 
timeliness improved at all over your experience or your time of 
observing this; has it closed at all in, let's say, this 3-year 
lag, or is there any effort under way that you are aware of to 
try and close that gap?
    Mr. Holtz-Eakin. I am not aware of any effort. In the past 
3 years, for example, it has been about the same system. I am 
not knowledgeable going back about what changes have been made.
    Chairman Nussle. Mr. Spratt.
    Mr. Spratt. Thank you, Mr. Chairman. Going back to my 
opening statement, as you will recall, the CBO and OMB both 
projected a surplus between 2002 and 2011 of $5.6 trillion. 
That was January, February of 2002. What is CBO's current 
estimate of how much that surplus, baseline surplus, has to be 
adjusted due to economic and technical divergences from what 
you expected due to economic and technical factors?
    Mr. Holtz-Eakin. Well, there are a variety of different 
answers. If you go back and look at what was projected for, 
say, 2004, in that period, in--say, in the year 2000 versus 
what we expect now, the difference breaks out roughly into 40 
percent economic and technical and then 60 percent legislation 
divided evenly in the tax and spending side. That composition 
differs depending whether you do it over the 10-year window or 
whether you do it for a particular year in that window. But 
broadly speaking, think of it as a 50-50 divide as economic and 
technical and then other things----
    Mr. Spratt. Fifty to 55 percent over a 10-year period?
    Mr. Holtz-Eakin. As a rough--we can get you the numbers for 
every year. It differs depending on the horizon.
    Mr. Spratt. About 60 percent of that is technical 
misestimation, and 40 percent is economic misestimation.
    Mr. Holtz-Eakin. The 40 percent reflects a combination of 
economic and technical. That dividing line--to anyone who 
doesn't do this--is far from obvious. You might think of 
capital gains realizations as an economic phenomenon, but they 
fall in the technical category. The way the math is actually 
done is this: We look at our macroeconomic forecast for overall 
GDP and then at what wages and salaries, things like that. We 
explain as much as we can with that. The residual what is left 
falls into the technical category. And so there are many 
economic phenomena in there, shifts in the income distribution, 
capital gains.
    Mr. Spratt. To the extent that the economy doesn't grow as 
you expect it, you can assign that shortfall to economic 
factors.
    Mr. Holtz-Eakin. We do.
    Mr. Spratt. The remaining shortfall is assigned to a 
residual called technical factors, and you can't really sort 
out all of the technical reasons that you are not seeing 
revenues or spending perform as you projected.
    Mr. Holtz-Eakin. We go through each year, and, doing our 
baseline updates, we try to identify the different technical 
factors, but we can never exhaustively----
    Mr. Spratt. Do you make adjustments going forward for the 
technical factors then?
    Mr. Holtz-Eakin. Yes, we do.
    Mr. Spratt. As I recall--it has been a while since I looked 
at them closely--as you go forward in time, there is a 
convergence, a reconvergence so that the estimate of the 
economy tends to return to what it was originally. In other 
words, your technical and economic adjustments in the outyears 
tending to less than those in the near term. Is that clear?
    Mr. Holtz-Eakin. On the economy, it is fairly 
straightforward. We make an attempt to forecast the business 
cycle for 18 months, 2 years; beyond that make no attempt to 
forecast business cycles. It is beyond the capability of the 
science. We estimate the average performance over that period.
    On the technical front, we review the technicals, and any 
new information that you get during the year you have to decide 
the degree to which what you have learned in the past year is 
actually informative about 10 years out. If you really believe 
there has been a fundamental change in the structure of the 
economy, then it would be appropriate to change the forecast 10 
years out. If not, then you will phase it out over the 10-year 
window. It is a difficult part of doing the projections.
    Mr. Spratt. In the year 2011, according to your current 
projections, you are not making 55 percent in the original 
projection surplus for that year, I don't believe.
    Mr. Holtz-Eakin. OK. We can check that.
    Mr. Spratt. What you are assuming is that those 
misestimations become smaller and smaller over time. I guess 
the question I am asking is can we be sure that is the case?
    Mr. Holtz-Eakin. No. But I guess I would point to a 
different piece of evidence on that, which is that we also 
display in our projections the range of uncertainty surrounding 
them. It is clear that the fan chart of likely outcomes expands 
as you go forward just due to uncertainty about the how the 
economy and technicals will evolve. We don't move our point 
estimates for something 10 years away by an enormous amount 
based on a little bit of evidence in 1 year, but we do 
acknowledge the additional information and try--in the sense of 
providing good risk management skills to the Congress--to show 
the range of possible outcomes.
    Mr. Spratt. Let me ask you specifically with respect to 
revenues, you put out a publication in May called the 
``Cyclically Adjusted and Standardized Budget Measures,'' which 
was must reading for everybody.
    Mr. Holtz-Eakin. Pleased to hear that.
    Mr. Spratt. Table A(1) in particular shows that the 
shortfall of economic performance relative to the economy's 
capacity is about $25 billion in revenues in the current fiscal 
year, 2004. But by 2005, next year, you show that the economic 
cycle will actually add revenues. So the economic factors' 
contribution to the deficit will have disappeared in the next 
fiscal year. All of it then becomes structural.
    Mr. Holtz-Eakin. That calculation is the answer to the 
following question: Suppose I could snap my fingers and make 
GDP and the economy move from its current level to the level 
that we estimate to be its potential, its capacity. If I just 
did that, I didn't change any of the technical factors, didn't 
change legislation, how much more in receipts would come in? 
The answer is about $25 billion based on our calculations.
    Mr. Spratt. One final question. Do you think that we should 
change the projecting rule by which you assume that tax cuts 
were built in, expiration dates, popular tax cuts with built-in 
sunset dates are soon to expire and not be renewed?
    Mr. Holtz-Eakin. The question, I think, is really what is 
most informative to Members. At least to my eye, the notion of 
extrapolating current laws is meant to capture what current 
policy dictates about the likely future fiscal outlook. When 
current law doesn't match a Member's view of the future, the 
future of current policy, I don't know quite how to resolve 
that.
    Our approach has been to provide a variety of alternatives 
so that members of this committee and Congress in general can 
understand what the different likely outcomes are for different 
pieces of the budget where there is some uncertainty about how 
it will actually evolve. Having good information on the future 
is the key, I think, and making sure it is transparent and 
people can evaluate the path on which we are currently headed.
    Mr. Spratt. Thank you.
    Chairman Nussle. Mr. Brown.
    Mr. Brown. Thank you, Mr. Chairman.
    Mr. Director, under the current Tax Code, we see the books 
laying over there, and I know there has been a lot of effort in 
Congress to try to simplify the process. Have you seen any of 
the plans that are there that you think might be more workable 
than the system we have now, flat tax or some other scheme?
    Mr. Holtz-Eakin. We have looked--at the CBO and in my 
career prior to coming to CBO--at many of the prototypes for 
broad-based income taxes, for a flat tax which would be a 
consumption-style tax, value-added taxes. Each of those 
prototypes would involve a different set of trade-offs along 
the issues that I discussed in terms of what is in the tax 
base, volatility, the degree to which different activities are 
taxed at different rates.
    But the common characteristics they have are that most 
prototypes have broad bases, and they have relatively low 
rates, so differential taxation is largely eliminated: Things 
in the base are taxed at the same rate. And they make a choice 
about the kind of tax base to which they aim.
    Another characteristic they all share is they are all 
prototypes, and a comparison of the current tax system to a 
prototype model is not an apples-to-apples comparison. The real 
question is, what is a real live version of any of these tax 
reforms that we might see going forward? And that is an 
important question in thinking about how it would affect our 
ability to do the projections.
    Mr. Brown. Do you plan in your tenure to try to bring a 
recommended new plan?
    Mr. Holtz-Eakin. No. The CBO will not recommend a tax 
reform, but if Members would be interested in looking through 
the implications of any of those, we would be happy to work 
with you on that.
    Mr. Brown. Thank you.
    Chairman Nussle. Mr. Moore. Oh, we will come back to Mr. 
Moore.
    Mr. Scott.
    Actually Mr. Moore was next. He is here. Mr. Moore.
    Mr. Moore. Thank you, Mr. Chairman. Good morning. I 
appreciate you being here this morning.
    What is the current deficit projected.
    Mr. Holtz-Eakin. Our current projection, published 
projection, for 2004 was $477 billion. Based on what we know 
through this point in the year, we would expect it to come in 
below that. My guess would be for it to come in south of $450 
billion somewhere.
    Mr. Moore. How does that rank in terms of relative deficits 
we have had over the years in our Nation's history?
    Mr. Holtz-Eakin. In dollar terms it is large. Relative to 
GDP it is not the largest.
    Mr. Moore. In dollar terms is it about the highest we have 
had?
    Mr. Holtz-Eakin. Yeah.
    Mr. Moore. Does that include funding for Iraq?
    Mr. Holtz-Eakin. The 2004 numbers that we put together 
include the $87 billion in appropriations for Iraq plus 
reconstruction in Iraq and Afghanistan.
    Mr. Moore. Have you heard there might be a request for 
additional or supplemental funding for Iraq?
    Mr. Holtz-Eakin. We are aware of requests and 
appropriations and/or authorizations for $25 billion.
    Mr. Moore. That is not included in the $450 billion you 
gave us, or is it?
    Mr. Holtz-Eakin. No.
    Mr. Moore. So that would put it up to $475 [billion] again 
if that turned out to be correct?
    Mr. Holtz-Eakin. If it turned into outlays in 2004, it 
would be included in that number, but it would be highly 
unlikely that that sum could be spent that quickly.
    Mr. Moore. Is there a trust fund for Social Security?
    Mr. Holtz-Eakin. There is an accounting known as the trust 
fund, but there are no real economic resources sequestered in 
any meaningful way to pay those liabilities.
    Mr. Moore. You are aware of what lawyers are required to do 
in terms of keeping a trust fund, I take it?
    Mr. Holtz-Eakin. Yes.
    Mr. Moore. The trust fund for an attorney means a trust 
fund. If somebody violates that trust by taking money out of 
that fund, they can be prosecuted and/or disbarred; is that 
correct?
    Mr. Holtz-Eakin. That is my understanding.
    Mr. Moore. That doesn't happen in Congress, does it?
    Mr. Holtz-Eakin. That is also my understanding.
    Mr. Moore. So if we go into the Social Security trust fund 
and spend that money on tax cuts or other spending matters, 
that is just the way it is. Congress has the authorities to do 
that; is that correct?
    Mr. Holtz-Eakin. The unified budget allows resources to be 
spent on all kinds of demands.
    Mr. Moore. So that is a yes?
    Mr. Holtz-Eakin. I think so.
    Mr. Moore. How are tax cuts that we enact now paid for?
    Mr. Holtz-Eakin. In the end, all budgetary resources, 
spending, tax cuts are--the underlying source of all that is 
the U.S. economy. So independently of how you do the labeling, 
that is how we pay the bills in all public and private 
settings.
    Mr. Moore. OK. But Social Security funds then are used to 
pay for tax cuts now; is that correct?
    Mr. Holtz-Eakin. There is no one-for-one linking between 
tax cuts. We know that the net budgetary outcome at the moment 
is negative.
    Mr. Moore. You said there is not a separate Social Security 
fund technically except for under an accounting procedure; is 
that correct?
    Mr. Holtz-Eakin. That is correct.
    Mr. Moore. So right now technically money that is taken for 
Social Security is used to pay, along with other money, for tax 
cuts; is that correct?
    Mr. Holtz-Eakin. I don't think you can say that in the very 
mechanical way. The payroll taxes come into the budget along 
with other resources, spending goes out, the net effect is 
negative. Linking dollars coming in to dollars going out is not 
something that can be done in a deep economic sense.
    Mr. Moore. You are aware of the term PAYGO, correct?
    Mr. Holtz-Eakin. I am.
    Mr. Moore. Is that a budget enforcement rule?
    Mr. Holtz-Eakin. Yes.
    Mr. Moore. There was PAYGO in effect--what does PAYGO 
require?
    Mr. Holtz-Eakin. PAYGO requires that when Congress 
undertakes expansions of mandatory spending or cuts in taxes, 
that they be offset in the budgetary projections in a dollar-
for-dollar fashion.
    Mr. Moore. That was the rule in effect until 2002; is that 
correct?
    Mr. Holtz-Eakin. Yeah.
    Mr. Moore. It expired at that time?
    Mr. Holtz-Eakin. Yes.
    Mr. Moore. You are aware of the new rule that requires 
PAYGO or pay-as-you-go for only spending, but not new tax cuts; 
is that correct.
    Mr. Holtz-Eakin. We don't actually have such a rule in 
place, but there have been obvious discussions in different 
parts of the Congress.
    Mr. Moore. That is what this Budget Committee is trying to 
do, at least the leadership?
    Chairman Nussle. Does the gentleman have any questions 
about revenue projections he would like to ask? He can hold a 
press conference.
    Mr. Moore. I have 48 seconds, if I might, Mr. Chairman, 
please.
    Chairman Nussle. You asked me a question, so I thought I 
would ask you a question back.
    Mr. Moore. I was just looking at you.
    Chairman Nussle. And I was just looking back.
    Mr. Moore. Thank you, Mr. Chairman, with all respect. Would 
you agree with Chairman Greenspan that it might be advisable to 
enact the PAYGO rules we had up until 2002 when they expired?
    Mr. Holtz-Eakin. My own view is that if you look at the 
evidence, the key is not the rules, the key is what the policy 
objectives of the Congress are. And once a consensus is 
developed about those objectives, then rules can be put in 
place that will support that. But in the absence of a consensus 
about fiscal policy objectives, it is unlikely that rules will 
suffice.
    Mr. Moore. I am not sure I understand that, but thank you 
very much.
    Chairman Nussle. Are there any other Members who would like 
to be recognized to ask questions about revenue projections?
    Mr. Garrett.
    Mr. Garrett. I will not be looking at you. I will be 
looking over here.
    Chairman Nussle. That is fine.
    Mr. Garrett. Thank you.
    Before I begin, let me--in your written testimony you 
didn't use this language in your testimony here, but I just 
took note of it. You are talking about the Federal Government 
here, not the other governments. In your opening line the 
second paragraph is; ``From an economic perspective the central 
role of the government is to provide services in public that 
only it can provide or provide adequately.'' That is from an 
economic perspective, obviously not from a real-life 
perspective, because we provide all sorts of services that the 
States could be providing and that business and communities 
could be providing as well, right?
    Mr. Holtz-Eakin. Yes.
    Mr. Garrett. Does that impact upon the rest of the 
testimony then?
    Mr. Holtz-Eakin. To the extent that the Federal Government 
chooses to undertake an activity, it has to be financed, and 
the commitment to spend those moneys raises the necessity of 
more receipts. You can solve that with either a broader base or 
higher rates. That figures into the kinds of feedback you get 
in the budget.
    Mr. Garrett. Mr. Spratt had an interesting comment. He said 
at the very beginning, which I think was right, that having a 
fairer Tax Code or simpler Tax Code may end up driving you in 
different directions. I mean, a fairer Tax Code might be a much 
more complicated Tax Code; is that correct?
    Mr. Holtz-Eakin. Certainly a core trade-off in tax policy 
is often presented as efficiency versus equity. That desire for 
higher tax rates on higher-resource individuals for the 
purposes of fairness leads to greater incentives for tax 
avoidance, shifting the way you do your economic transactions, 
or even evasion. The incentive would be to shift money from 
high-tax parents to their children, for example. That is the 
trade-off.
    Mr. Garrett. I am concerned about fairness for the people 
that I represent, specifically New Jersey, which is an affluent 
State, one of the most affluent States in the country, and has 
one of the worst rates of returns as far as on the other side, 
the expenditure side.
    I just learned the other day that the average income for a 
two-income couple is around $75,000-$78,000 in the United 
States, but due to cost-of-living factors in a State such as 
New Jersey, that you would have to have around $134,000 in 
order to have the same cost of living.
    Assuming that is true, or ballpark figures, the individuals 
in that first category in the average number would be paying at 
a certain Federal tax rate, whereas the individuals that, 
presumably in New Jersey, would be at the higher tax rate, at 
the $134,000, we would be paying a disparate amount of income 
tax, right?
    Mr. Holtz-Eakin. Mechanically, yeah.
    Mr. Garrett. So in order to alleviate that problem, it 
would be a more complex code, but would the fairer system be to 
have some sort of a cost-of-living index in the Federal Tax 
Code either on a regional basis or State basis or county basis 
or some other census figure basis to apply to those richer 
States so that we pay a fair amount and not pay more amount 
than any other States?
    Mr. Holtz-Eakin. You could imagine a system that attempted 
to adjust for real purchasing power in some way across 
geography or anything else, but you could also imagine the 
complications involved in what happens when people move, and a 
whole variety of other things that may make that unworkable in 
practice.
    Mr. Garrett. On the expenditure side of the equation, of 
course, a State likes ours always gets the short end of the 
stick. I always used to say 50 out of 50, but when you include 
the District of Columbia, we are actually 51 out of 51 as far 
as the return on the dollar. So isn't that exacerbated by the 
fact that we are paying at a higher level and getting back at a 
much lower level then, without having some sort of factor in 
there?
    Mr. Holtz-Eakin. Well, in the same way that moneys come in 
in one form and go out in another, coming in from one State and 
going out to that State is really a policy call. What New 
Jersey gets in terms of outlays in the programs is something 
that is controllable by policy, and I think not really driven 
by configuration of the Tax Code.
    Mr. Garrett. But the first half of the equation is figured 
by Tax Code as far as us having a higher cost of living and 
necessarily being in a higher tax level because of that; that 
is, as far as the Tax Code.
    Mr. Holtz-Eakin. Be cognizant, however, if individuals are 
savvy, and I would stipulate that there are a lot of savvy 
individuals out there, they are going to recognize when they 
choose to live in New Jersey that that is a consideration. So 
overall, there might be an impact on bidding for house prices 
and prices might be lower otherwise because residents face this 
other burden. They might have chosen to live there and be just 
as happy living in the New Jersey.
    Mr. Garrett. Yes, but the cost of prices of houses in New 
Jersey?
    Mr. Holtz-Eakin. Actually I lived in New Jersey for 10 
years. This is a fundamental conundrum in tax policy that will 
not be resolved here. Do you want to measure things on the 
basis of what comes in or comes out?
    Mr. Garrett. One last question. Your comment is if we leave 
the overall system alone, you have less as far as economic 
impact on the system and less cost to the system. You said 
complexity will add to the cost of the system, and changes to 
the system will--changes, incremental changes, will drive up 
the costs of the system.
    So if we were to make any changes along the line, as Mr. 
Spratt's opening comment saying we should start clearing out 
the closet of these things, that would add costs to the system, 
whereas if we leave it alone, we will have a flat cost overall 
as far as intermediary cost to the system as far as changes are 
concerned.
    Mr. Holtz-Eakin. Well, the real issue is how often do you 
change.
    Mr. Garrett. Yes.
    Mr. Holtz-Eakin. If you change once, hold the system stable 
in a way that has lower compliance and economic efficiency 
costs, then that net benefit could very well be positive. If 
you change every year, you are imposing an uncertainty and 
economic cost on the private sector that you should certainly 
be cognizant of.
    Mr. Garrett. Thank you.
    Chairman Nussle. Now, Mr. Scott.
    Mr. Scott. Thank you, Mr. Chairman.
    You are familiar with this chart?
    Mr. Holtz-Eakin. I think I saw it in a previous visit to 
this committee.
    Mr. Scott. You are going to be seeing it a lot. The curious 
thing about this, if we go to the next chart, is that according 
to the information we have been given, in February 2001 we 
thought this year's budget surplus would be $268 billion. A 
year later, in February 2002, we thought it would be almost 
balanced, but a little bit in deficit, $14 billion. Now, maybe 
September 11, could have done that.
    But from February 2002 to February 2003, this year's budget 
looked like it was going to be $300 billion in the hole. Now 
you are saying $400 [billion], depending on what happens with 
the extra money for Iraq--$450 [billion], or $475 [billion].
    What happened after February 2, that caused such a total 
collapse in the budget estimates, or do you disagree with these 
estimates?
    Mr. Holtz-Eakin. Well, these are all of these estimates, so 
I am not familiar with the details of them. The CBO estimates 
over the same period have a comparable profile, and as I have 
mentioned to Congressman Spratt, the difference between what 
one sees at the beginning, say, February 2001 and what the 
outlook might be today in 2004 is divided between economic and 
technical, typically something like 40 percent and then 
legislative initiatives on the interim, on both the spending 
and the tax side.
    Mr. Scott. But I think it is clear, you can't blame 
September 11, on anything that happened after February of 
February 2002.
    Let me ask you another question.
    Mr. Holtz-Eakin. It can--it is partly fractional and partly 
legislation differences on the year.
    Mr. Scott. When you consider tax cuts, do you consider 
which taxes are cut in terms of how it will effect the economy?
    Mr. Holtz-Eakin. Yes. If one cuts marginal tax rates, that 
has some economic--beneficial economic feedbacks in the 
individual and aggregate level, if it is sufficiently large. If 
one cuts something that is not a marginal tax rate, it has a 
different impact in terms of inducement to spend more in 
consumption. We try to figure that into our economic----
    Mr. Scott. But it could be better or worse.
    Mr. Holtz-Eakin. We would expect in a recession, for 
example, the impact of additional consumption is sometimes 
beneficial, that would provide support.
    Mr. Scott. Did you consider the Joint Committee on Taxation 
analysis of the 2003 tax cut that showed there would be a 
short-term spike in jobs, but long term would be worse off as a 
direct result of the 2003 tax cut--would have fewer jobs as a 
direct result of bypassing the 2003 tax cut? You are not 
familiar with that analysis?
    Mr. Holtz-Eakin. We didn't adopt that in any way. I am sure 
the staff has looked at it. I personally have not, and we try 
to include the current tax laws in all our projections going 
forward at any point.
    Mr. Scott. Could I have the next chart?
    We have kind of gone over this a little bit. As I 
understand it, you are projecting a 16.9 percent of GDP as 
revenues for next year?
    Mr. Holtz-Eakin. Sounds about right.
    Mr. Scott. Other than the previous 2 years, when is the 
last time we have had a 16.9 percent percentage of GDP in terms 
of receipts?
    Mr. Holtz-Eakin. I don't know the exact year, but the 
postwar average is a little above 18 percent, and this is below 
that.
    Mr. Scott. Fifty years?
    Mr. Holtz-Eakin. Well----
    Mr. Scott. You are projecting a good economy, too?
    Mr. Holtz-Eakin. In our most recent projections from March, 
we had a robust cyclical recovery in 2004 and 2005. And after 
that, we project sustained economic growth at something about 
2.8 percent per year.
    Mr. Scott. And so I guess you are calling that a good 
economy.
    Mr. Holtz-Eakin. We had a robust cyclical recovery in 2004, 
2005. After that we project sustained economic growth at 
something about 2.8 percent per year.
    Mr. Scott. So I guess you are calling that a good economy?
    Mr. Holtz-Eakin. 4.8 percent in 2004 and 4.2 percent in 
2005 is a robust economic recovery.
    Mr. Scott. You are only projecting a 16.9 percent GDP at a 
level that you haven't seen since 1959?
    Mr. Holtz-Eakin. I agree on your word. On the date we can 
check.
    Mr. Scott. With these lowest receipts, we haven't done much 
on lowering outlays, is that true, in terms of GDP? I am 
looking at the graph. It is right in the middle, and the 
receipts are way under the line.
    Mr. Holtz-Eakin. Depending on how the outlays are 
constructed going forward, that depends on your definition of 
discretionary, which CBO increases by inflation. I am not sure 
if that was the question.
    Mr. Scott. I think the graph speaks for itself. We have low 
income and high outgo, so that explains the first chart that we 
showed.
    I don't have any further questions. Thank you, sir.
    Chairman Nussle. Yes. If you could leave that chart up 
there, I think it says prepared by the Democratic staff, and we 
are not talking about revenue projected by the Democratic staff 
today. We are talking generally about how revenue is projected.
    Mr. Scott. Well, do you disagree with the numbers? For the 
good of the bench.
    Chairman Nussle. I was pointing that out for the good of 
the order.
    Mr. Scott. We will make it his projection if he would 
answer the question.
    Chairman Nussle. All I am suggesting, there are probably 
comments to be made on both sides, and we are not here to talk 
about revenue projections made by the Democratic staff.
    Mr. Barrett.
    Mr. Barrett. Thank you, Mr. Chairman.
    Mr. Director, thank you for coming here today. I will try 
to keep it on what the topic is today. I am from South 
Carolina, and we think things should be simple. I have only 
been in Washington a couple of years, and I guess I am not 
quite cynical enough to think that we can't do that.
    Is it possible, Mr. Director, to have a paradigm shift? I 
mean, let us talk about policy, and let's talk about politics, 
and let us, you know--the political end is, when you talk to 
people in South Carolina, when you talk to people across the 
Nation, 80, 90, 95 percent of the people say, please make it 
simpler.
    And I am talking about the tax cut, and I think that is a 
universal theme, and I think that is what we are talking about 
here today, something that we can make simple, something that 
we can have data accurately and quickly, rather than 3 years 
later.
    You have got to tell us if there is a plan, or is it 
possible to have a plan? I have seen the plans. Is it possible 
to have a plan, a consumption plan or a flat tax plan, that can 
accomplish what we want to do?
    I am not talking about the politics. Take the politics out 
of it. Is it possible to have a policy that we can have that 
can move this country forward, that can be simple, that people 
can sit down and figure out their taxes by themselves without 
having H&R Block come in and all of these other things--I mean, 
it is beyond my comprehension that we can't, whether it is a 
paradigm shift, whether we do it in stages or whatever. 
Enlighten me just a minute.
    Mr. Holtz-Eakin. From the perspective of the economics, 
certainly many of the broad-based income or consumption tax 
plans that have been proposed would be much simpler to 
understand. They would have beneficial economic effects in 
reducing economic inefficiencies. Whether they would be simpler 
to comply with, everyone suspects the answer is yes. But for a 
person who has life a W-2 that with his or her wages, salary 
and income and who does not have a very complicated financial 
life, probably not much would change, quite frankly.
    And, you know, the real issue is how to move including the 
politics from the current system to that when in the deeper 
sense it is desirable public policy. But from a economics 
perspective, it is hard to imagine not seeing the potential for 
gains from a more efficient Tax Code.
    Mr. Barrett. Let us say we wave the magic wand and we went 
to a consumption tax. Do you think it would be possible to do a 
total shift within 1 year, or would it be something that would 
probably have to be phased in, Mr. Director?
    Mr. Holtz-Eakin. There are many different flavors of 
consumption taxes. You could go to an extreme where you did a 
national retail sales tax, where you taxed all consumption 
purchases at the individual level. That is a very big change in 
the administration, the compliance, the collection, and one 
would be hard pressed to imagine this happening quickly.
    There are other flavors of consumption tax that could be 
administered in a fashion that is much closer to our two-part 
taxation of income at the individual and at the corporate 
levels. That kind of transition one could imagine occuring much 
more quickly. It really would depend on the way one went about 
doing that. Not all the consumption tax plans are the same in 
that respect.
    Mr. Barrett. The chairman made reference earlier if we 
brought all the regulation, litigation, all the paperwork that 
was required, it would probably fill up this room. I have seen 
so many estimates of the costs of implementing these 
regulations. Tell me your estimate, what CBO has said the cost 
of making sure that people comply with it, with the Tax Code, 
is.
    Mr. Holtz-Eakin. We don't have an estimate, to be honest. 
There are widely varying estimates that are in the literature. 
Quite frankly, the next panel is better equipped to answer 
that. We would be happy to look at it for you if you like.
    Mr. Barrett. Would a shift like that, if we could make it 
simpler, would it be easier for you to bring projections to us 
so we could make intelligent decisions or better decisions, I 
will say, on how we spend our money and what we spend it on?
    Mr. Holtz-Eakin. First, on the outlay side, how you make a 
decision of how you spend your money is how you present the 
alternative program. So that is an ongoing issue.
    Mr. Barrett. Sure.
    Mr. Holtz-Eakin. On the receipt side, it will depend on the 
transition where, quite frankly, it is likely we do worse. In 
the new world transition in the private sector, we are trying 
to guess and respond to how people reported, and then to the 
extent that the Tax Code settled down. And I think an important 
issue is why the Tax Code is complicated now; what are the 
incentives to make it complicated? Well, there are sometimes 
pay-offs to have taxes complicated, so it is desirable. But 
making it settle down would make our job easier. So there is a 
trade-off.
    Mr. Barrett. Thank you, Mr. Chairman.
    Chairman Nussle. I thank the gentleman.
    Mr. Baird.
    Mr. Baird. I thank the chairman for holding this meeting.
    Mr. Holtz-Eakin, we always appreciate your frank and 
informative conversation with us. I mean that sincerely. I 
share the chairman's astonishment at this issue which came up 
at the end of a hearing about a year ago.
    When you get money, it is almost as if it is giant sacks, 
and you don't know how much should go to Social Security, how 
much to Medicare, how much came in from corporate taxes. We 
have broad numbers, but no specifics; is that accurate?
    Mr. Holtz-Eakin. When income and payroll tax withholdings 
comes into the Treasury, the receipts are lumped together. In 
some cases companies do report voluntarily, but there is no 
requirement that the money come in labeled for the tax--in 
particular Social Security versus other--for which it is sent 
in. So we don't really know on an ongoing basis.
    Mr. Baird. What puzzles me about this is when I calculate 
my taxes, I have got to sort out how much I owe in Social 
Security. A business does as well, if I have to calculate my 
quarterly estimates. Why is it that that is not tracked 
electronically or physically in some fashion?
    Mr. Holtz-Eakin. I actually do not know.
    Mr. Baird. Mr. Chairman, I would hope and offer to work 
with you on this that we could really to find a way with you. 
Maybe the Ways and Means Committee will get less excited about 
jurisdictional issues, but it is just common sense.
    It seems to me if you were to tell the American people 
this, if you ran your own budget or business budget, you just 
wouldn't run your business or home that way. If we run our 
company or home that way, it is not surprising that you folks 
give us 3-year-old numbers and we see more dramatic shifts of 
$40 [billion], $50 [billion], sometimes $60 billion a year.
    You know, when you are doing your estimates, one of the 
things I am puzzled about, you hear statements about dynamic 
scoring of taxes. Do you ever dynamically explore expenses?
    Mr. Holtz-Eakin. We do not incorporate macroeconomic 
feedback into our cost estimates on the outlay side. We do, and 
I think it is a fair statement to say that the joint committee 
does, on the tax side look at individual-level behavior and the 
incentives that would be in an outlay bill for whoever might be 
affected to change their behavior. So it is not that our cost 
estimates are static in the sort of naive sense that you assume 
the world is fixed, but there are certain feedbacks that we do 
not explicitly incorporate, and they are largely macroeconomic.
    Mr. Baird. OK. So for example, if you were to say what are 
the net long-term benefits from expenditures on education or 
expenditures on transportation, that is not allocated?
    Mr. Holtz-Eakin. We leave the future cost of GDP explicitly 
unchanged in doing estimates. So it is explicitly off the 
table.
    Mr. Baird. OK. Following our discussion a year ago, someone 
explained to me that many corporations have separate earnings 
reports. In other words, they report one set of earnings for 
the purpose of taxation, and a separate set for their 
stockholders. Is that accurate, and how--does it make sense, 
and how does it affect your work?
    Mr. Holtz-Eakin. There are different financial reporting 
versus tax reporting. Our focus is on the tax side.
    There are a few instances where we have tried to look at 
the financial reporting to bring extra information. Stock 
options, for example, stand out. In looking at the late 1990s 
and then the most recent couple of years, the large run-up in 
bonuses and options and then the drop-off in those kinds of 
things do affect receipts.
    Supplementary information out of the financial reporting is 
something we have tried to get our hands on in order to better 
understand the future of the tax receipts. It is a challenge.
    Mr. Baird. I raise that issue because it seems to be 
congruent of our discussion today of the complexities in the 
Tax Code to some extent and also with how we predict revenues.
    I don't have any further questions.
    I guess I would just, Mr. Chairman, appreciate it if we 
could work on this issue.
    Chairman Nussle. Yes, and it may take--and we may want to 
talk to Ms. Olson, who is probably as versed in this as anyone, 
and someone I have spoken to about this before, as well as the 
Ways and Means Committee. My understanding is this May take a 
legislative fix or adjustment, in addition to the fact that we 
shouldn't be complicating the Code.
    But so this is something that I am very happy to work on. 
You are right. It may have some extrajurisdictional 
complications, but, hey, you and I have done that before.
    Mr. Baird. Mr. Chairman, I applaud you for that leadership.
    Chairman Nussle. So we can add to that pile any time we 
want.
    You have nothing further then.
    OK. Let us see, who is next on my list?
    Mr. Emanuel.
    Mr. Emanuel. Thank you, Mr. Chairman, for holding the 
hearing.
    There was a recent report, I think it was picked up by a 
number of--both the Wall Street Journal and New York Times. 
There is some $311 billion, on a low estimate--I met with the 
IRS commissioner, he said that was a low estimate--
underreported and not collected in tax returns, mainly high-end 
individuals that companies just don't--either hide money, don't 
file, don't return, don't pay. And the complexity, I mean, for 
all of us who struggled on dealing with the issue of a balanced 
budget, the complexity has led to a situation, in fact, where, 
in fact, what is owed to the government is not being paid.
    There is some earned income tax credit earned. In terms of 
the complexity there leads, I think, to what we call--some 
would use the term fraud. I would not use the term fraud. It is 
the complexity to let people, A, not filing who do deserve it, 
and, B, those who file wrong because of the complexity, 
notintentionally, but that is the end result. But the $311 
billion would get us more than halfway toward eliminating the 
deficit, the annual Federal deficit.
    Since 1994, we have added about 10,000 pages to the Code 
and made about 3,500 changes. So in the last 10 years you can 
think about 350 changes a year in the Code and added about--if 
my math works correctly--about 1,000 pages' worth of changes to 
the Code.
    So when we hold that up as a symbol of the complexity, we 
are part and parcel--what happens is, as you know, about every 
20 years we try to simplify it, and then we try to make social 
changes with it, adding the idea of a deduction for higher 
education or health care, et cetera, and try to achieve some 
policy changes that we don't do through government spending, 
which adds credit, then complexity, and we just go backwards.
    I am open to the idea of tax reform, I have opened my own 
proposal about taking the earned income tax credit, the per 
child, dependent care, collapsed down to a single credit, have 
it down to 12 questions and eliminate well over 200 pages of 
the Code. But the truth is that simplicity costs money, and you 
can't do it on the cheap.
    One of the questions I have here is, A, how do we do a 
better job of dealing with that $311 billion that goes 
underreported or not paid and is hidden and using the Tax Code 
against the fairness that is expected in the tax system?
    I will start there, and then I have a follow-up question.
    Mr. Holtz-Eakin. Well, I think the good news is that the 
tax policy community in general, the research community and 
practitioners all believe the U.S. Tax Code is the best in the 
world. The bad news is it relies heavily on voluntary 
compliance. And in the face of incentives to not comply or 
inability to comply, or reasons we just don't understand, we 
will see underperformance of the Tax Code relative to 
expectations--and also there are very hard to measure issue of 
people's faith in the Tax Code and their willingness to comply. 
That has emerged in recent years, I think, as the theme about 
concerns over the U.S. Tax Code.
    The first step, of course, is to make sure if you are going 
to rely on voluntary compliance, that it is understandable and 
that there are incentives to comply; and the second step is to 
enforce proper auditing and collection mechanisms. I have no 
particular expertise in that latter category.
    Mr. Emanuel. Let me ask you another question, what you said 
about complexity to the sales tax, but you could also bring 
simplification to the tax definitions that would lead to an 
easier process.
    Have you ever looked at the notion of a hybrid, that is X 
tax for X income, and basically a flat income tax for anything 
above a certain number, and then eliminate definitions so you 
get away from loopholes, phase-in, phase-out, and that you 
basically stop differentiating types of income? Because one of 
the problems is, if you look at the Tax Code especially over 
the last 3 years, we have made the burden harder on work and 
less on worth and less on capital investment.
    I think that is fundamentally wrong, because when somebody 
gets an investment income versus what they get for salary, they 
don't make a distinction. Yet we are the Tax Code, and yet that 
is a reflection of our values.
    So rather than say one is hard and the other one is easier, 
coming together with a hybrid that has a national sales tax, 
but an income tax, a flat number for all income regardless of 
type from that point forward.
    Have you looked at a hybrid like that?
    Mr. Holtz-Eakin. I haven't seen that. I have seen plans 
that are a combination of value-added taxes, which, at least in 
concept, are just a multistage sales tax. It is a collection of 
the same base in different stages, following income tax. There 
are a variety of themes and variations that are out there in 
the literature.
    Mr. Emanuel. I will send you a copy of what has been out 
there just as food for thought as a way to go, maybe something 
to look at as we talk about simplification. I think it is a 
case for simplification would add the revenue and also add to 
the point where others don't feel they are cheating the system 
while they carry a bigger burden.
    Thank you, Mr. Chairman, for this hearing.
    Chairman Nussle. Just to follow up on that, does the 
complication itself make it difficult for enforcement? I mean, 
it is probably just as obvious that it is difficult to pay the 
tax because of the complication; it is also difficult to 
enforce the Tax Code because of complication as well?
    Mr. Holtz-Eakin. Certainly. With respect to sales taxes, 
labeling something a sales tax does not necessarily make it 
simpler. The States' experience in trying to administer their 
sales tax, I think, is very illustrative. There are the same 
kinds of complexities and difficulties, particularly if one 
does not choose to make it comprehensive and tries to carve out 
typical classes of sales, like medical necessities, and the 
dividing line between necessity and purchase becomes harder. 
Complexity will depend not so much on the label, but on the 
form the tax takes, whether it is a sales tax or another type.
    Mr. Emanuel. That will then also apply--if you don't mind, 
Mr. Chairman?
    Chairman Nussle. No.
    Mr. Emanuel. If you apply it on income, to somehow having 
definitions of income, therefore, would actually help you lower 
the rate as long as it was universally applied?
    Mr. Holtz-Eakin. Yes. There is no question, whether income 
or consumption tax. One of the first things that one teaches in 
tax policy is that we have a constitutional amendment that made 
taxing income possible, but it doesn't define taxable income.
    Mr. Emanuel. Thank you, Mr. Chairman.
    Chairman Nussle. Mrs. Capps.
    Mrs. Capps. Thank you, Mr. Chairman, for calling this 
hearing.
    The 2 years I have been on the Budget Committee, we have 
been struggling with or dealing with a budget deficit that has 
been exploding during this current leadership. Given that our 
children and grandchildren will be paying for it, we all want 
to focus on what we can do to bring it under control, assuring 
that we have the most accurate estimates of revenues as part of 
that picture.
    As my colleague Mr. Baird has pointed out, it is tough to 
know how to get something when you are driving blindfolded and 
don't have the data in front of you.
    Thank you very much to all of our witnesses for your 
testimony, but especially Mr. Holtz-Eakin.
    Last night I was reading a paragraph from your testimony 
that I would like to quote from, because I believe--and you 
have said it this morning, it reflects the priorities we have 
in mind when constructing the budget. This is what you say: 
``The central role of the government is to provide service to 
the public that only it can provide or provide adequately. 
Therefore, the threshold budgetary decisions faced by 
policymakers about which services to provide and how much to 
spend on them. These expenditures must be financed, and the 
challenge is for tax policy is to provide adequate financing in 
a fair and efficient fashion.''
    I think you have laid out a process, which is good. First, 
figure out what our government needs to do; second, figure out 
how much it will cost; and third, figure out how to pay for it. 
But unfortunately we now find ourselves in the position with 
our current leadership that we have first figured out what kind 
of tax cuts to push. We then have a deficit that we have to 
face, and then we come to the body and say the deficit is 
forcing cuts, and we get down to programs like military housing 
and others that we have really wrestled with here and made, I 
believe, the wrong--because of the wrong kind of priorities--
the wrong kind of decision.
    I want to focus now and ask you a question, finally, on two 
of the provisions we use in budgeting, which make it difficult, 
I think, to assess revenues. Over the past 3 years the Congress 
and President have tried to shoehorn the maximum amounts of tax 
cuts into what budget limits we have had by using phase-ins and 
sunset provisions. The result has been a measured cost that was 
only a small fraction of what the Treasury would lose if those 
tax cuts were put out in full effect and continued 
indefinitely. The proponents of these tax cuts, of course, have 
every intention that the cuts become permanent even while 
writing the provisions that make the law expire.
    My question will be what will be the additional as yet 
unmeasured cost if all of the 2001-03 tax cuts become 
permanent?
    Mr. Holtz-Eakin. I don't remember the exact number, but I 
am sure that in our March report or January report we showed 
the implications for the 10-year budget window for extending 
all of the tax cuts. It is on the order of 2 percent of GDP out 
in 2014 or a little bit above. We could certainly get you the 
number.
    Mrs. Capps. Alright. I appreciate that.
    Then I guess my second question is--because we are about 
budgeting in this committee--what do those sunset and phase-in 
provisions do to the evolving revenues, which is the heart of 
what you are about?
    Mr. Holtz-Eakin. As I mentioned in my opening remarks, it 
really has presented us with some great difficulties in 
understanding the future path of, first, the economy--what does 
the private sector believe about the future of tax policy? And 
then, conditional on that, what is the best way to present the 
budgetary implications: following current law, which might not 
be consistent with the economy, or projecting the economy in a 
way that is not consistent with what the private sector expects 
and put the law on top? It has been a tough call.
    Mrs. Capps. Again, as my colleagues have said, you wouldn't 
be able to run a business this way. One could say, if one is 
cynical, it is an attempt to cloud and make fuzzy as to what 
our budget situation is, because certain things are being 
phased in over time, and other things are being sunsetted out.
    In actuality it is a gimmick, and you are faced with having 
to try to make some sense out of it. I think it is really hard 
for us to understand. I think it is even harder for our 
constituents to get a handle on it.
    Would you mind, for one final question in the few seconds 
that I have, to tie this feature of our budgeting process to 
what difference it would make if we did really apply, as my 
previous questioner asked you about the pay-as-you-go method, 
to both taxes and spending revenues? If this were applied to 
taxes, what would it do to the phase-in and phase-out qualities 
that we now have there?
    Mr. Holtz-Eakin. From the perspective of CBO, that is not 
really the central issue. What we are trying to do in our 
baseline projections is give you a neutral benchmark against 
which you can measure policy changes, to take the current law 
and do our best to extract implications, thus allowing you to 
measure impact on a bill-by-bill basis. PAYGO would apply in 
that bill-by-bill basis--on any decisions you might make, PAYGO 
would apply to that, to that bill-by-bill decisionmaking and 
those things that the Congress chose to do or chose not to do. 
It is hard for me to speculate how that would play out.
    Mrs. Capps. I think we make your job tougher than it should 
be.
    I yield back the balance of my time.
    Chairman Nussle. Thank you, gentlelady.
    Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman.
    The next panel will have Ms. Olson on the roster. I think 
she has perhaps given this committee two of the most important 
sentences to testimony that I have seen in my tenure on the 
committee. I would like to read those aloud.
    It refers to tax loopholes. Of course, a loophole is what 
somebody else gets, but if you get it yourself, it is an 
element of essential tax fairness. She says, ``In recent years 
the Internal Revenue Code has been amended repeatedly with 
provisions intended to encourage, reward or reduce the costs of 
certain activities through exclusions, deductions, exemptions, 
special rates and credits. While the goals of some of the 
provisions may be admirable, they represent uncapped, 
unverified and, in a large measure, unverifiable direct 
spending programs.''
    That is a powerful statement to me, because it basically 
means that these tax expenditures or tax loopholes make it 
almost impossible for someone like you to estimate. So that 
means, to me, that the worst direct spending program is still 
probably preferable to the best indirect spending program, 
because at least you can measure and verify the direct spending 
program.
    But these indirect spending programs through the Tax Code 
amount to a blank check, because if they are uncapped, 
unverified and unverifiable, we have lost complete control, and 
almost every day in this body we are tempted by some group or 
another to give them a tax break. To our friends on the Ways 
and Means Committee, those will seem like real deals.
    I know that President Reagan and others had a thing that 
``there was no such thing as a tax expenditure, it was all your 
own money anyway,'' and some of my friends on the other side 
may perhaps believe this. But for Ms. Olson to say this, and I 
believe she was a political appointee of the Bush 
administration, the George W. Bush administration, to me, she 
is speaking the truth.
    This spending is uncapped, unverified and unverifiable. 
That is perhaps the most damning statement I have ever heard, 
and yet this Congress and previous Congresses engaged in these 
programs wholesale.
    So, what am I missing here? Do you have a secret mechanism 
for verifying these unverifiable spending programs, the number 
of which we could barely count if we had an encyclopedia? In 
fact, most of the documents that are listed over there are full 
of these very loopholes. So we don't even have a clue about how 
much revenue we are missing or how much of a subsidy we are 
offering to these individual beneficiaries.
    If these are, in fact, as Ms. Olson is about to testify, 
uncapped, unverified and unverifiable, what am I missing?
    Mr. Holtz-Eakin. I will leave Ms. Olson to defend her 
alliteration. I think the issue is an important one. As I said, 
just at the conceptual level, presenting a budget where you can 
make trade-offs and see all programs for their resource cost is 
important, and the degree to which things are treated 
differently on one side or the other is not helpful, at our 
end, when one does these targeted sorts of tax policies. That 
falls into that very difficult category of technicals. It is a 
composition of activity in the economy not captured by just 
whether--we have got full employment GDP. When we are wrong, we 
have technical restimates, and we see that all the time.
    Mr. Cooper. Dr. Olson--in your little time remaining, I 
think what--you are mistaken here. I am talking about what Ms. 
Olson seems to be claiming are the biggest loopholes in 
American history. These are uncapped spending programs, 
unverified and unverifiable. How on Earth do the advocates of 
these loopholes know what they are costing? How can you make a 
cost/benefit analysis if you have no idea of the cost?
    You know, this is uncharted water, it seems like, if Ms. 
Olson is correct, and she was a top trusted official in this 
administration. This is to say one of the most damning 
statements I have ever heard, and she has been brave enough to 
put it in plain English. She is, I assume, on the other side of 
the aisle. This is an amazing thing. These loopholes you are 
describing are so big you could drive a truck through them.
    There is barely enough law left to hold all the loopholes 
together if her claim is verified, uncapped, that these 
programs are unverified and unverifiable. You are making some 
nice, technical-sounding statements, but if her claims are 
correct, you cannot do your job with thousands of these in the 
budget, in the Tax Code.
    Mr. Holtz-Eakin. Again, to look at the details, I am 
looking at the cost in a budget sense. In the sense of 
introducing such a tax loophole that would be a job that the 
Joint Committee on Taxation would have to do, and that is a 
highly professional group. They will do the best they can under 
these circumstances.
    Mr. Cooper. Which is no good. Which is no good.
    Mr. Holtz-Eakin. Your characterization.
    Mr. Cooper. Well, Ms. Olson's.
    Mr. Holtz-Eakin. Ms. Olson's.
    At the CBO we don't have to do that. We have to take that 
law when it is in place and project what will be collected. We 
do not have to calculate how much of the loss is varifiable 
behavior. What we have to do may be hard, but not as hard as 
that particular problem. These are very difficult projections 
in the revenue projections.
    Mr. Cooper. Say you had a special mortgage tax break for 
blue houses, you got a double mortgage deduction. Wouldn't you 
get--you would have a lot more blue houses?
    Mr. Holtz-Eakin. Absolutely.
    Mr. Cooper. People would suddenly like that color. Then in 
order for you to do your job, you would have to count the 
number of blue houses and new blue houses in America in order 
to estimate the revenue you could anticipate. Who is out there 
doing that counting? No one.
    These are uncapped, unverified and unverifiable spending 
programs through the Ways and Means Committee, not the 
Appropriations Committee, which is a much more accountable 
body. So this to me is an outrage. But my time is up.
    Chairman Nussle. Reserving the right to object on the 
question of whether the Appropriations Committee is more 
accountable than Ways and Means. Yes, we won't go there.
    Mr. Cooper. Seriously, Mr. Chairman.
    Chairman Nussle. You don't have to make up an example about 
blue houses. There is the earned income tax credit that 
probably may be the mother of all good examples.
    Mr. Diaz-Balart.
    Mr. Diaz-Balart. Thank you, Mr. Chairman.
    I have the highest respect particularly for colleagues in 
this committee, but I think all of us, including me, we kind of 
get confused by our own minutiae. The government tends to do 
that a lot. I have just heard, for example, tax cuts are a 
gimmick. In other words, the government taking less money from 
the American people is a gimmick.
    We all know government taking less money from hard-working 
Americans is government taking less money from hard-working 
Americans; by the way, doesn't stimulate the economy. I think 
there is a consensus on that.
    But also, now, I am rather kind of concerned about this 
unverifiable amount of money that I guess we have in tax cuts, 
I guess, if all we are concerned about is government, and then 
we should probably just take every single penny that Americans 
earn, and then we could definitely verify how much money there 
is. But ultimately, again, we have to remember that the people 
in small business and hard-working Americans are not here to 
serve governments. Government is here to supposedly serve the 
people.
    So the fact that--and I know it wasn't many members of this 
committee that actually made that original quote, but the fact 
that this thing about unverifiable, again, that we can't 
verify, and it is unverifiable, and it is unverified, it would 
seem to me that if that is the--heck, let us just take 
everybody's money, 100 percent of it, because if we are 
concerned about--if the only thing we are concerned about is 
how much the government can figure out how much we are or are 
not taking, and that is what we are concerned about, man, we 
are getting the wrong role rule here. The role should be to 
take every penny.
    The bottom line is, the reason I mention that, I think we 
sometimes get confused in our own minutiae, and the bottom line 
is tax cuts are taking money from the American people. Tax cuts 
in the complicated Tax Code is again taking less money from 
American people, and I agree that is not spending it. When you 
take less money from the American people, that is not spending; 
the government isn't spending anything, but we are taking less 
of their money.
    And I do have a question. You know, one of the things that 
is interesting is that the alternative minimum tax that was 
enacted in the 1970s has obviously been expanded periodically, 
has never been indexed, as far as I know, to inflation. As a 
result my understanding and projections indicate a massive 
growth of the number of taxpayers paying the AMT in the future, 
which would make sense. Does that AMT complicate revenue 
projections? And also it would seem that predicting what the 
taxpayers will have to pay, how much AMT, would be difficult. 
Is that correct; is that accurate?
    Mr. Holtz-Eakin. The AMT is another part of our challenge, 
for revenue projections. We have the AMT rising to nearly 30 
million taxpayers in our baseline. Again, we look at the 
composition of their income, look at the composition of their 
deductions, and then look to see whether it will be on the AMT 
based on nominal incomes, because the AMT is not indexed.
    Mr. Diaz-Balart. Mr. Chairman, we have seen again--looks 
like from 2001--the errors in the CBO projections that resulted 
more from economic factors, assumptions and technicals than 
from actual legislation, and that is what my understanding is. 
Is there anything we can do regarding our tax system to reduce 
those economic and technical forecasting errors, or is that 
something that is beyond our control?
    Mr. Holtz-Eakin. I think that the underlying economic 
uncertainty, the fact that there are business cycles over that 
period--it is a particularly difficult period because of a 
turning point which is very hard to forecast. But, in general, 
that part won't go away.
    Technicals depend in many ways on these policy issues where 
you have incentives to shift the composition of your activity, 
or that the Tax Code explicitly favors one activity over 
another. Having those simplified might help somewhat, along 
with better data. Simply having more information to both permit 
the analysis of past technical errors and also timely 
projection of the likely future of tax receipts--those are all 
things that would help.
    We have worked very hard at CBO to try to understand this 
better. We had a conference last year. We brought in experts on 
literally the year-by-year technicals and examined what the 
nature of the construction of those were--top down, bottom up, 
the use of supplementary information from States, a wide 
variety of issues. Nothing stood out as a silver bullet. I 
mean, this is just a hard area.
    Chairman Nussle. I thank you.
    Director, thank you very much for your testimony today. As 
we move forward, I think you can tell from a bipartisan 
smattering of questions and comments that we are interested in 
getting better data. If CBO has any recommendations regarding 
giving data, whether that is access to better information from 
whether its Treasury or Joint Tax, whatever it may be, we want 
to make sure that the Congress has the best information in 
order to make decisions. It may not be day old or week old or 
even monthly, but 3 years is difficult. And as we have heard 
today, I think Members are interested in doing what we can, 
even if it required internal or legislative changes that we can 
make in order to get better information. So we appreciate that.
    If you have recommendations, we would be very interested in 
receiving them as we move forward.
    Mr. Holtz-Eakin. Thank you, Mr. Chairman.
    Chairman Nussle. I thank you.
    Now we will invite the second panel to come forward. We 
have three distinguished panelists, the Honorable Pam Olson, 
Dr. Peter Merrill and Dr. William Gale, and we will take a 
brief 2-minute recess while we are changing the names and 
inviting our guests to come forward.
    [Recess.]
    Chairman Nussle. Our second panel, we are pleased to have 
at the panel table. We are pleased, I am pleased, to invite Pam 
Olson, often quoted. We appreciate you being here, we 
appreciate your service.
    As a member of the Ways and Means Committee, I have to say, 
I was always very appreciative of your testimony before our 
committee as Under Secretary. We miss you, but we are certainly 
glad to have you here today to be able to present us with your 
ideas regarding revenues projections. So you may proceed as you 
see fit.

 STATEMENTS OF PAMELA F. OLSON, PARTNER, SKADDEN, ARPS, SLATE, 
MEAGHER & FLOM, LLP, FORMER ASSISTANT SECRETARY OF THE TREASURY 
  FOR TAX POLICY; PETER R. MERRILL, PH.D., DIRECTOR, NATIONAL 
  ECONOMIC CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP; AND 
     WILLIAM G. GALE, Ph.D., SENIOR FELLOW, THE BROOKINGS 
                          INSTITUTION

                  STATEMENT OF PAMELA F. OLSON

    Ms. Olson. Thank you, Mr. Chairman, for that warm welcome, 
a welcome maybe a little warmer than I would have liked. Mr. 
Chairman, Mr. Spratt and members of the committee, I do 
appreciate the opportunity to be here to discuss the tax 
system, particularly on the budget side.
    The ideal tax system would raise the revenue to fund the 
operations of the government with the least adverse impact on 
the economy. It would be neutral, transparent, stable and 
certain. Our tax system falls short of the ideal system in 
several respects, and it is those shortcomings my testimony 
addresses. Before turning to that topic, however, it would be 
useful to focus for a moment on the budgetary impact of the 
increasing tendency to spend through the Tax Code. We have 
already heard a little bit about that in this hearing.
    I guess I won't reread the two sentences that have already 
been read into the record, but let me explain what I meant by 
uncapped, unverified and unverifiable. Expenses or amounts that 
we spend through the Tax Code are uncapped because any taxpayer 
satisfying the applicable requirements may claim the resulting 
tax deduction or outlay. While targeting the benefits of the 
provisions to particular classes of taxpayers may hold down the 
budgetary impact, it does so at the expense of simplicity, a 
point that is worthy of further discussion.
    The multiplication of these provisions prompted a waggish 
Treasury Department economist a few years back to design the 
``tax credit for the taxpayer who didn't get a tax credit'' in 
an effort to stave off the development of further credits.
    These spending programs are unverified because taxpayers 
need not establish to the Internal Revenue Service their 
eligibility for the tax reduction or outlay before claiming it 
on their tax return. They are largely unverifiable because 
neither the Treasury Department nor the Congress has been able 
to devise mechanisms that would permit the Internal Revenue 
Service to efficiently and effectively determine taxpayers' 
eligibility for the special provisions. There is, of course, an 
IRS audit program, but as we have heard an awful lot in the 
press lately, we don't begin to cover the number of taxpayers 
that we perhaps ought to be covering. Certainly we will never 
get to the point where we cover them all, at least not so long 
as we insist on adding complications to the Code that can't be 
readily verified by information provided by a third party, for 
example.
    This inability to verify presents another serious issue for 
the Congress. We cannot assess the efficacy of the expenditures 
in achieving our desired goals.
    As the late former Treasury Secretary William Simon 
observed, the United States should have a tax system which 
looks like someone designed it on purpose. No tax system ever 
devised has included so many things unrelated to tax 
collection. While one or two exceptions might be reasonable, 
the weight of all the exceptions puts at risk the basic goals 
of the tax system.
    Spending through the Tax Code presents particular 
challenges to our ability to make accurate budgetary 
projections. It also affects economic growth and, this is 
really important, deprives the tax system of the neutrality, 
transparency and certainty that would make for a better system.
    With respect to minimizing the impact of the tax system on 
the economy by, removing resources from the private sector, the 
tax system slows the growth of the private sector of the 
economy. If we want to minimize the effect on the economy, we 
should have a system that minimizes its impact on decisions to 
work, save and invest. We can best foster economic growth with 
low rates, a broad base--that is, few exceptions, equally 
applied--eliminating barriers to deploying and redeploying 
capital and labor and a stable system.
    The amounts that we spend through the Tax Code have 
considerably narrowed the tax base in recent years, 
particularly since we did a house cleaning back in 1986. The 
myriad sunsets of current law are the opposite of the stability 
that allows taxpayers to plan their affairs.
    It is important to have a system that is as uncomplicated 
as possible, a standard that the current Tax Code fails 
miserably. Resources spent complying with the tax laws, which 
the Internal Revenue Service estimates for individuals alone--
this is the issue that was raised earlier--totaled between $70 
[billion] and $95 billion annually. These are resources that 
are unavailable for more productive investments and endeavors 
and are a drag on the economy.
    Turning now to the other principles that should guide us in 
designing our tax system. First, neutrality. The tax system 
should apply on a neutral basis, that is, without 
discriminatory treatment. Investment decisions made on a basis 
other than maximizing pretax returns reduce national income to 
the detriment of all. The best rules are rules that apply 
equally without regard to industry, activity, type of entity, 
or form of investment. The Internal Revenue Code fails the 
neutrality principle on multiple scores.
    Second, transparency. Transparency in the tax system has 
been described as certainty about what the rules are, how they 
will be applied, and that they will be applied fairly. 
Transparency matters because it gives taxpayers confidence in 
the system. A system that is too complex loses its transparency 
because of the difficulty of administering and complying with 
it. That, in turn, will erode confidence in the system and 
voluntary compliance.
    The U.S. tax system is nothing short of opaque; that is, 
the opposite of the transparent system we should be seeking. It 
is impossible for any one person to understand all of the Tax 
Code's provisions, and the Internal Revenue Service cannot 
assure compliance or consistent application.
    It is my view that the growing complexity of the system has 
reduced compliance because many taxpayers simply throw up their 
hands in despair. Perhaps even more important is that 
complexity creates shadows, concealing those inclined to avoid 
their responsibilities. In short, the opacity of the current 
system is a danger to our self-assessment system.
    Third, certainty. Decisionmaking is difficult. This 
committee is certainly aware of that. Decisions involve 
expectations about the future, but the future is uncertain. The 
greater the uncertainties, the greater the risk. The greater 
the risk, the greater the premium required by the decision 
maker. We can reduce decision makers' risk premiums by giving 
them greater certainty about the future. At a minimum, we 
should not add to the risk premium attached by the decision 
maker with provisions that go in and out of the Tax Code like 
yoyos. A system that is stable will reduce the risk premium and 
result in more productive decisions.
    There are particulars I want to draw to the committee's 
attention. The first relates to the efficacy of spending 
through the Tax Code.
    Simply stated, the Tax Code is not a good delivery vehicle 
for many of the programs we have added over the years. In order 
to deliver the benefits intended by the various spending 
provisions added to the Tax Code, a taxpayer must be aware of 
the benefits and capable of claiming them, and the Internal 
Revenue Service must be capable of administering them. The 
complexity of the Tax Code, coupled with the educational level 
of many of the individuals to whom benefits are targeted, makes 
the Tax Code a poor delivery mechanism for many intended 
benefits. The fact that eligibility is determined after 
benefits are claimed adds an unhealthy uncertainty about 
whether an outlay will have to be repaid or whether additional 
taxes might be due at some point down the road.
    Benefits delivered through the Tax Code are sometimes 
highly particularized, requiring the Internal Revenue Service 
to make determinations about eligibility that it is without the 
expertise to make. Consider, for example, the expertise 
required to administer provisions in the tax laws relating to 
the environment, conservation, or energy production. The 
resources required to administer such provisions appropriately 
are significant and detract from the Internal Revenue Service 
carrying out its primary tax collection function.
    The second relates to projecting corporate receipts. Over 
time corporate receipts have proved difficult to project and a 
volatile source of revenue. Receipts' trending down in an 
economic downturn is desirable because of the countercyclical 
effect, but it may be advisable to consider whether there is a 
base that would produce more predictable revenues than our 
current income tax base does.
    I was interested to hear the question about the difference 
between financial statement reporting and the amountes reported 
on tax returns. As the years have passed, we have increased the 
number of disparities between book income and taxable income. 
And taxpayers do have to follow the tax laws when preparing 
their returns. Removing the disparities between financial 
statement incomes and taxable incomes might reduce some of the 
volatility that we see. It might also have the effect of making 
it easier for corporate tax receipts to be projected. On the 
other hand, an entirely different base might be considered, 
such as a business activities tax.
    Finally, our current savings rate is abysmal. It seems 
clear that the complexity of the savings provisions in the Tax 
Code prevents many taxpayers from taking advantage of those 
opportunities. Some complexity stems from the best of 
intentions: the desire to provide as many options as possible. 
As behavioral economists have demonstrated, however, having too 
many options can actually reduce the take up rate. Taxpayers 
spend too much time trying to understand their options under 
the tax rules. It would be better if they put that time into 
making wise investment decisions. If we want people to get off 
the spending couch and into the savings gym, we need to make it 
easier for them to do so.
    Although our tax system is sometimes said to be a hybrid of 
income and consumption taxes, it favors spending over saving 
except to the extent that taxpayers can avail themselves of the 
complicated and illiquid savings provisions in the tax law. In 
other words, under our tax law today, virtue carries a cost 
rather than a reward. Although current budget shortfalls 
dominate many discussions, the long-term shortfalls stemming 
from unchecked Medicare and Social Security spending is a far 
more serious problem. The problem can be eased by increasing 
our savings rate. That means creating a Tax Code that 
encourages, not penalizes, those who save.
    I would be happy to answer the committee's questions.
    [The prepared statement of Ms. Olson follows:]

 Prepared Statement of Pamala F. Olson, Partner, Skadden, Arps, Slate, 
Meagher & Flom, LLP, Former Assistant Secretary of the Treasury for Tax 
                                 Policy

    Chairman Nussle, Ranking Member Spratt, and distinguished members 
of the Committee, I appreciate the opportunity to appear this morning 
to discuss current problems facing our tax system. I am here today at 
the request of the Committee. I am currently a partner in the law firm, 
Skadden, Arps, Slate, Meagher & Flom, LLP, but I am not appearing on 
behalf of any client or other organization, and the views I offer are 
solely my own.

                            I. INTRODUCTION

    The ideal tax system would raise the revenues to fund the 
operations of the government with the least adverse impact on the 
economy--that is, it would be neutral, transparent, stable, and 
certain. Our tax system falls short of the ideal system in several 
respects, and it is those shortcomings my testimony addresses. Before 
turning to that topic, however, it would be useful to focus for a 
moment on the budgetary impact of the increasing tendency to ``spend'' 
through the Tax Code.\1\
---------------------------------------------------------------------------
    \1\ The Treasury Department and the Joint Committee on Taxation 
each prepare an annual tax expenditure analysis, which is far broader 
in concept than the issues described below. The Treasury Department has 
devoted considerable effort in recent years to revising its tax 
expenditure analysis, some of which is described in the President's two 
most recent Budgets, to address inconsistencies and limitations of the 
analysis.
---------------------------------------------------------------------------

                     II. SPENDING THROUGH THE CODE
 
   In recent years, the Internal Revenue Code has been amended 
repeatedly with provisions intended to encourage, reward, or reduce the 
cost of certain favored activities through exclusions, deductions, 
exemptions, special rates, and credits.\2\ While the goals of some of 
the provisions may be admirable, they represent uncapped, unverified, 
and, in large measure, unverifiable indirect spending programs. They 
are uncapped because any taxpayer satisfying the applicable 
requirements may claim the resulting tax reduction or outlay. While 
targeting the benefits of the provisions to particular classes of 
taxpayers may hold down the budgetary impact, it does so at the expense 
of simplicity, a point worthy of further discussion.
---------------------------------------------------------------------------
    \2\ What appeared to be an effort a few years back to ``put a tax 
credit in every pot'' led a Treasury Department economist to design the 
``tax credit for the taxpayer who didn't get a credit'' in an effort to 
stave off further proposals.
---------------------------------------------------------------------------
    They are unverified because taxpayers need not establish to the 
Internal Revenue Service their eligibility for the tax reduction or 
outlay before claiming it on their tax returns. They are largely 
unverifiable because neither the Treasury Department nor the Congress 
has been able to devise mechanisms that would permit the Internal 
Revenue Service efficiently and effectively to determine taxpayers' 
eligibility for many of the special provisions.
    The inability to verify presents another serious issue: We cannot 
assess the efficacy of the expenditures in achieving the desired goals.
    As the late former Treasury Secretary William Simon observed, ``The 
United States should have a tax system which looks like someone 
designed it on purpose.'' No tax system ever devised has included so 
many things unrelated to tax collection. While one or two exceptions 
might be reasonable, the weight of all the exceptions puts at risk the 
basic goals of the tax system.
    Spending through the Tax Code presents particular challenges to our 
ability to make accurate budgetary projections. It also affects 
economic growth and deprives the tax system of the neutrality, 
transparency, and certainty that would make for a better system, points 
to which I will now turn.

     III. MINIMIZING THE TAX SYSTEM'S ADVERSE IMPACT ON THE ECONOMY

    By removing resources from the private sector, the tax system slows 
the growth of the private sector of the economy. Minimizing the effect 
on the economy requires a system that minimizes its impact on decisions 
to work, save, and invest.
    We can best foster economic growth with low rates, a broad tax base 
(i.e., few exceptions equally applied), eliminating barriers to 
deploying and redeploying capital and labor, and a stable system. The 
amounts spent through the Tax Code (discussed previously) have narrowed 
the tax base. The myriad sunsets of current law are the opposite of the 
stability that allows taxpayers to plan their affairs.
    It is important to have a system that is as uncomplicated as 
possible, a standard the current Tax Code fails miserably. Resources 
spent complying with the tax laws, which the Internal Revenue Service 
estimates for individuals alone total between $70 billion and $95 
billion annually, are resources unavailable for more productive 
endeavors and are a drag on the economy.
    The Tax Code's adverse effect on economic growth deserves 
Congressional attention.

                             IV. NEUTRALITY

    The tax system should apply on a neutral basis, that is, without 
discriminatory treatment. Investment decisions made on a basis other 
than maximizing pre-tax returns reduce national income to the detriment 
of all. Consequently, we should avoid rules that discriminate, thus 
biasing investment decisions. The best rules are rules that apply 
equally, without regard to industry, activity, type of entity, or form 
of investment. The Internal Revenue Code fails the neutrality principle 
on multiple scores.

                            V. TRANSPARENCY

    Transparency in a tax system has been described as certainty about 
what the rules are, how they will be applied, and that they will be 
applied fairly.\3\ Transparency matters because it gives taxpayers 
confidence in the system. A system that is too complex loses 
transparency because of the difficulty of administering and complying 
with it. That, in turn, will erode confidence in the system and 
voluntary compliance. It goes without saying that reduced compliance 
means higher tax rates for compliant taxpayers.
---------------------------------------------------------------------------
    \3\ A transparent system is the opposite of one in which the 
taxpayer negotiates his tax liability.
---------------------------------------------------------------------------
    The U.S. tax system is nothing short of opaque, that is, the 
opposite of the transparent system we should be seeking. It is 
impossible for any one person to understand all of the Tax Code's 
provisions, and the Internal Revenue Service cannot assure compliance 
or consistent application. Using income for our tax base ensures some 
complexity because income is inherently difficult to measure. However, 
we have exacerbated the problem with special rules that increase the 
disparities between taxable income and conventional determinations of 
income, such as financial statement income.
    Although reliable information on compliance levels is hard to come 
by, it is my view that the growing complexity of the system has reduced 
compliance because many taxpayers simply throw up their hands in 
despair. The multitude of special provisions leaves taxpayers uncertain 
whether they have correctly claimed the allowable tax benefits, 
worrying they have missed some hidden provision, and wondering whether 
they paid more than their fair share. Perhaps even more important is 
that complexity creates shadows concealing those inclined to avoid 
their responsibilities.
    In short, the opacity of the current system is a danger to our 
self-assessment system. Although the decline of the tax system on 
account of complexity has been predicted for decades, I believe that we 
are at a critical juncture. If we do not begin soon with significant 
steps to simplify the tax laws, I believe the system may collapse of 
its own weight.

                             VI. CERTAINTY

    Decision-making can be difficult. Decisions involve expectations 
about the future but the future is uncertain. The greater the 
uncertainties are, the greater the risk is. The greater the risk is, 
the greater the premium required by the decision-maker. We can reduce 
decision-makers' risk premiums by giving them greater certainty about 
the future. At a minimum, we should not add to the risk premium 
attached by the decision-maker with provisions that go in and out of 
the Tax Code like yoyos. A system that is stable will reduce the risk 
premium and result in more productive decisions. I would urge you to go 
to work now to create a tax system that is not subject to annual 
revision.

                            VII. PARTICULARS

    I want to note for the Committee three particular budget issues.
    The first relates to the efficacy of spending through the Tax Code. 
In order to deliver the benefits intended by the various spending 
provisions added to the Tax Code, the taxpayer must be aware of the 
benefits and capable of claiming them, and the Internal Revenue Service 
must be capable of administering them. The complexity of the Tax Code 
coupled with the educational level of many of the individuals to whom 
benefits are targeted makes the Tax Code a poor delivery mechanism for 
many intended benefits. The fact that eligibility is determined after 
the benefits are claimed adds an unhealthy uncertainty about whether an 
outlay will have to be repaid or additional taxes will be due at some 
point down the road.
    Benefits delivered through the Tax Code are oftentimes highly 
particularized, requiring the Internal Revenue Service to make 
determinations about eligibility that it is without the expertise to 
make. Consider, for example, the expertise required to administer 
provisions in the tax laws relating to the environment, conservation, 
or energy. The resources required to administer such provisions 
appropriately are significant and detract from the Internal Revenue 
Service carrying out its primary tax collection function.
    The second issue relates to projecting corporate receipts. The fact 
that corporate receipts have declined as a percentage of all receipts 
has received considerable attention of late. The decline may be traced 
to a number of factors:
     The growth of pass-through entities such as partnerships 
that has shrunk the corporate sector's share of gross receipts.
     Expensing of stock options.
     Increased use of indebtedness as a more tax efficient 
capital structure.
     A decline in corporate profitability.
    Over time, however, corporate receipts have proved difficult to 
project and a volatile source of revenue. Receipts' trending down with 
an economic downturn is desirable because of the countercyclical 
effect, but it may be advisable to consider whether there is a base 
that would produce more predictable results than our current corporate 
income tax base does. Removing disparities between financial statement 
and taxable income might reduce some volatility. An entirely different 
base, such as business activities, might be considered as well.
    Finally, our current savings rate is abysmal. It seems clear that 
the complexity of the savings provisions in the Tax Code prevents many 
taxpayers from taking advantage of those opportunities. Some complexity 
stems from the best of intentions: the desire to provide as many 
options as possible. As behavioral economists have demonstrated, 
however, having too may options can actually reduce the take up 
rate.\4\ Taxpayers spend too much time trying to understand their 
options under the tax rules. It would be better if they put that time 
into making wise investment decisions. If we want people to get off the 
spending couch and into the savings gym, we need to make it easier for 
them to do so.
---------------------------------------------------------------------------
    \4\ In an upscale grocery store experiment, researchers set up a 
jam-tasting booth, first with six jars of jam from which shoppers could 
choose, and then with 24 jars of jam. When the shoppers had only six 
jars from which to choose, 40 percent tasted and 30 percent made a 
purchase. When the number was increased to 24, the percentage tasting 
increased to 60 percent, but the number buying dropped to 3 percent. 
More choices are not always better.
---------------------------------------------------------------------------
    Although our tax system is sometimes said to be a hybrid of income 
and consumption taxes, it favors spending over saving except to the 
extent taxpayers can avail themselves of the complicated and illiquid 
savings provisions in the tax law. Over time, for example, two families 
who are identical except that one saves diligently will bear different 
tax burdens. The family that saves will see its income tax burden 
increase relative to the burden of the taxpayer who spent. In other 
words, virtue carries a cost, not a reward. Although current budget 
shortfalls dominate many discussions, the long-term shortfall stemming 
from unchecked Social Security and Medicare spending is a far more 
serious problem. The problem can be eased by increasing our savings 
rate. That means creating a Tax Code that encourages, not penalizes, 
those who save.
    Thank you for inviting me to testify today. I would be happy to 
answer any questions.

    Chairman Nussle. I thank you for your testimony, and the 
warm welcome was meant--I can tell just again by your testimony 
today versus when you maybe had your hands tied speaking a 
little bit just for the administration, it is even better. So I 
appreciate it.
    Dr. Merrill, welcome to the committee, and we are very 
pleased to receive your testimony. Just so everyone knows, your 
full testimony will be made part of the record, and you may 
proceed as you see fit.

                 STATEMENT OF PETER R. MERRILL

    Mr. Merrill. Thank you, Mr. Chairman, Mr. Spratt and 
members of the committee. I am Peter Merrill, director of the 
National Economic Consulting Group of PriceWaterhouseCoopers. I 
am testifying today on my own behalf and not as a 
representative of any organization. The focus of my testimony 
is on the competitiveness of the U.S. tax system, how it 
compares with the tax systems of other major industrial 
countries.
    In the global economy, tax policy is one of the ways that 
the United States competes for investment at home and for the 
success of U.S.-owned companies abroad. The United States is a 
relatively low-tax country, according to OECD statistics. 
Federal, State and local combined was lowest among the OECD 
countries in 2001.
    The favorable tax burden reflects the smaller role that the 
government plays in the United States economy. Government 
expenditures relative to GDP also were fourth lowest among the 
OECD countries. According to the 2001 OECD statistics, the U.S. 
Government's public debt as a share of GDP was less than the 
OECD average by about 12 percentage points. However, based on 
CBO projections, the U.S. public debt-to-GDP ratio will exceed 
the current OECD average within the next 10 years if all the 
expiring income tax relief projections in the Code are 
extended.
    While the United States is a relatively low-tax country, it 
relies more heavily on taxes on income and profits, both as a 
share of total taxation and as a share of GDP, than the average 
OECD country. Combining all levels of government, income and 
profits taxes accounted for about half of U.S. revenues in 2001 
compared to 36 percent for the average OECD country. At the 
Federal level the government is even more reliant on income and 
profit taxes as there is no broad-based Federal consumption tax 
as there is in every other OECD country.
    The top Federal U.S. tax rate on individual income is now 
30 percent, less than the OECD average of 37.6 percent. 
However, unlike most of the OECD countries, U.S. residents 
typically are subject to income tax on State or local levels of 
government. Unless it is extended, the top individual Federal 
income tax rate will increase from 35 to 39.6 in 2011, to put 
the top Federal individual income tax rate at 2 percentage 
points above the current average for OECD countries.
    Immediately following the Tax Reform Act of 1986, which 
lowered the U.S. income tax rate from 46 to 34 percent, the 
U.S. corporate rate was quite attractive. This is no longer 
true. The U.S. corporate income tax rate increased to 35 
percent in 1991, while the average OECD country's corporate 
rate fell to 29.3 percent in 2003. In other words, the average 
OECD country's average tax rate is 5.4 percent percentages 
points less than the U.S. rate. If you look at the 25 members 
of the newly expanded European Union, the average corporate tax 
rate is about 27 percent, 8 percentage points less than the 
U.S. corporate rate. The U.S. is tied with Spain and Greece for 
third highest corporate income tax rate among OECD countries. 
High corporate income tax rates discourage businesses from 
operating in regular corporate form.
    While the 2003 Tax Act reduced the shareholder level tax on 
corporate tax dividends, this relief is scheduled to sunset 
after 2008. If it does sunset, the U.S. will join Switzerland 
as the only OECD country without double taxation relief, and 
the top rate on income tax on dividends, combining Federal and 
individual-level taxation, would increase from about 45 percent 
today to 60 percent after 2010.
    Payroll taxes provide, of course, a primary source of 
funding to the U.S. for the Social Security, Medicare, and 
unemployment systems. The social insurance and payroll taxes 
represent about one-fourth of revenues in the United States, 
which is actually quite similar to other OECD countries.
    Like many other advanced industrial economies, the future 
obligations of the U.S. social insurance system exceed the 
dedicated revenue streams. In 2003, the GAO estimated that 
future liabilities for the U.S. Social Security and Medicare 
systems would exceed future revenues for these programs by 
about $21 trillion in present value, and that didn't include 
the Medicare prescription drug expansion that was done this 
year. That unfunded liability is about 71,000 for every U.S. 
citizen. So it is obviously a significant long-term challenge.
    Looking at multinationals, the United States imposes higher 
taxes on U.S.-based multinationals than competitor countries 
impose on their multinationals. As a result, U.S. 
multinationals will lose global market share.
    A decline in global market share of U.S. multinationals 
will obviously affect domestic workers--I will not go into all 
of the written testimony on this--but competitiveness of U.S. 
multinationals abroad is directly related to employment at 
home.
    Aside from the relatively high U.S. corporate income tax 
rate, there are a number of other features of the U.S. system 
of taxing foreign-source income that depart from international 
norms. Over half of the OECD countries have dividend exemption, 
or so-called territorial tax systems, under which the parent 
company generally is not subject to tax on the income earned by 
its foreign subsidiaries.
    The U.S. foreign tax credit, which is intended to limit or 
prevent double taxation, has a number of defects that increase 
the complexity and prevent double tax relief.
    Moving to complexity, the burden of the tax system includes 
both taxes paid and compliance costs. The Tax Foundation has 
estimated that the cost of complying with the Federal income 
tax raises the total tax burden by about 20 percent, that is, 
194 billion in 2002. There are lower estimates of this as well; 
they vary on how you value the time that people spend filling 
out returns.
    Just by comparison to a 20 percent compliance cost, typical 
estimates of the cost of complying with consumption taxes are 
on the order of 3 to 4 percent of revenue.
    One source of complexity that has been mentioned here 
several times earlier today is the alternative minimum tax 
which requires calculation of tax liability under two different 
systems. In principle, dual calculation is required whether or 
not you actually owe the AMT. The individual AMT is becoming 
far more pervasive because the dollar amount of the AMT 
exemption was not indexed in 1986 and the regular tax rates, 
but not the AMT rate, were reduced in 2001, as Doug Holtz-Eakin 
told you earlier, CBO estimates that by 2010 there will be 29 
million households that face AMT one way or another.
    Fixing the AMT is a very serious budget challenge. CBO has 
estimated it would cost about 400 billion to index the AMT 
exemption to 2004 levels over the next 10 years.
    Another source of complexity that has been mentioned before 
is Tax Code instability. The frequency of change in the Tax 
Code imposes costs, as Doug Holtz-Eakin mentioned, it affects 
taxpayer behaviors in ways that are very difficult to predict. 
According to the Tax Foundation, from 1995-2000, the Tax Code 
increased by 182 pages, which is about half the pages of the 
entire 1954 code. At this rate, the Code will increase from 
about 1,700 pages in 2000 to about 2,600 pages in 2010, and who 
knows where it will end.
    Tax Code instability is also due to the adoption of tax 
provisions on a temporary basis to comply with budgetary 
scoring rules, and that is an example of how rules that were 
designed to promote fiscal responsibility have the unfortunate 
side effect of creating instability in the tax system.
    In summary, U.S. residents currently pay a smaller share of 
GDP in total taxes than do residents of most other OECD 
countries. However, the present U.S. tax structure does not 
generate sufficient revenue to meet projected Federal spending 
in the long run.
    Closing the fiscal gap by raising income and profit taxes 
would cause the U.S. tax system to depart even further from 
international norms, as the U.S. already relies more heavily on 
income and profit taxes, as I said, both as a percent of GDP 
and percent of total taxes, than the typical OECD country.
    The cost of complying with the Federal income tax system, 
which is roughly 20 percent of income taxes raised, is much 
higher than the cost of complying with consumption taxes by 
most estimates. Obviously, the AMT is a very important issue in 
the future as a source of complexity for taxpayers.
    Finally, the U.S. international rules, the rules that tax 
the income of our multinationals are very much out of step with 
competitor countries. They are very complex, and they impose 
very high compliance costs relative to revenue raised.
    Thank you.
    Chairman Nussle. Thank you.
    [The prepared statement of Mr. Merrill follows:]

  Prepared Statement of Peter R. Merrill, Director, National Economic 
              Consulting Group, PriceWaterhouseCoopers LLP

                            I. INTRODUCTION

    I am Peter Merrill, Principal and Director of the National Economic 
Consulting group at PriceWaterhouseCoopers LLP. I am testifying today 
on my own behalf and not as a representative of any organization.
    The focus of my testimony is on the competitiveness of the U.S. tax 
system, which I assess through a comparison of the structure of the 
U.S. tax system with that of the 30 member countries of the 
Organization for Economic Cooperation and Development (OECD). In a 
global economy, differences in tax systems can affect international 
capital flows-to the benefit or detriment of a country's workers and 
investors.
    In some instances, U.S. rules regarding the taxation of both 
domestic and foreign income are out of step with the tax systems used 
by other major industrial countries.

              II. TAX COMPETITIVENESS IN A GLOBAL ECONOMY

    Much of the U.S. tax system was developed when the United States 
dominated the global economy. This is no longer the case. In the 1960s, 
the U.S. economy represented 40 percent of global GDP and U.S. 
multinationals accounted for 50 percent of cross-border investment. In 
2003, the U.S. economy represented 30 percent of global GDP and U.S. 
multinationals accounted for less than 22 percent of cross border 
investment (see Exhibit 1).
    The U.S. economy is also far more open to trade and investment than 
was the case just a few decades ago. Merchandise trade (imports plus 
exports) has increased from less than 7 percent of GDP in the 1960s to 
18.6 percent over the last 4 years. From 1980 to 2002, the stock of 
U.S. direct investment abroad increased (in nominal dollars) from $390 
billion to $1.84 trillion (370 percent), while foreign direct 
investment in the United States increased from $130 billion to $1.50 
trillion (1,080 percent). The growth in the stock of cross-border 
portfolio investment is even more staggering. From 1980-2002, private 
investment in foreign securities increased from $62 billion to $1.8 
trillion (2,855 percent), while foreign private investment in U.S. 
securities increased from $90 billon to $3.2 trillion (3,500 percent) 
(see Exhibit 1).
    As a result of the growing importance of international capital 
flows, U.S. tax policy is no longer insulated from global market 
forces. Increasingly, one of the considerations in the design of a 
country's tax system must be how it compares with that of its major 
trading partners. And, there is little doubt that governments react to 
changes in the tax systems of their trading partners. For example, the 
reduction in the U.S. corporate income tax rate from 46 percent to 34 
percent under the 1986 Tax Reform Act precipitated similar reductions 
in many other OECD countries. Another example is the spread of the 
value-added tax systems from the European Union to over 120 countries 
worldwide.
    Competitiveness is one of a number of criteria by which to judge 
the U.S. tax system--other traditional criteria include fairness, 
simplicity, efficiency, and revenue adequacy. The focus of this 
testimony is on how the U.S. tax system compares with that of other 
major industrial countries.

            III. INTERNATIONAL COMPARISON OF TAX STRUCTURES

A. Aggregate Revenues and Expenditures
    The United States is a relatively low tax country. According to 
OECD statistics, as of 2001, the total tax burden in the United 
States--federal, State, and local combined--was 28.9 percent of GDP, 
fourth lowest among the 30 OECD countries (see Exhibit 2). The 
favorable tax burden reflects the smaller role that government plays in 
the U.S. economy, where government expenditures relative to GDP were 
fourth lowest among the OECD countries. The publicly financed share of 
expenditures on health and post-secondary education generally is higher 
outside the United States and correspondingly greater government 
revenues are required to finance these outlays.
    In January of this year, the Congressional Budget Office estimated 
that Federal Government revenues would fall short of Federal Government 
expenditures by 3.0 percent of GDP in fiscal year 2005, but that the 
Federal Government deficit would be eliminated by 2014. This forecast, 
however, assumes that all of the temporary provisions in EGTRRA and 
JGTRRA expire as scheduled and excludes the Medicare prescription drug 
benefit enacted earlier this year.

B. Aggregate Debt
    According to 2001 OECD statistics, outstanding marketable debt of 
the United State government was less than the average OECD country by 
12.7 percent of GDP.\1\ In January of 2004, CBO projected that by 2009, 
Federal debt held by the public would increase by 7.6 percentage points 
of GDP relative to the 2001 level. This forecast assumes that all 
expiring provisions expire as scheduled and excludes the new Medicare 
prescription drug benefit.

C. Composition of Revenues
    While the United States is a relatively low tax country, it relies 
more heavily on taxes on income and profits-both as a share of total 
taxation and as a share of GDP--than the average OECD country. 
Combining all levels of government, income and profits taxes accounted 
for about 48 percent of U.S. revenues in 2001 as compared to 36 percent 
for the average OECD country (see Exhibit 3). Income and profits taxes 
collected at all levels of government amounted to 14.1 percent of GDP 
in the United States in 2001 as compared to 13.4 percent for the 
average OECD country (see Exhibit 4).
    The Federal Government is even more heavily reliant on income and 
profits taxes as there is no broad base consumption tax, like the 
retail sales tax used in 45 states and the District of Columbia. 
Indeed, the United States is the only OECD member country that does not 
have a national value-added or goods and services tax.
    From a trade perspective, heavy reliance on income taxes relative 
to consumption taxes may be viewed as disadvantageous because World 
Trade Organization (WTO) rules only permit border tax adjustments 
(i.e., exemption of exports and taxation of imports) on indirect taxes. 
Absent border adjustments, taxes may distort the composition if not the 
volume of trade.\2\ An important reason to avoid over-reliance on 
income and profits taxes is that they discourage savings and 
investment, and thus suppress long-run economic growth.

D. Personal Income Tax
    The average OECD central government imposed a top personal income 
tax rate of 37.6 percent in 2003 (see Exhibit 5). In the United States, 
the top Federal tax rate on ordinary income is 35 percent, less than 
the OECD average. However, unlike most of the OECD countries, 
individuals in the United States typically are subject to income tax by 
both Federal and state levels of government.
    Unless the sunset in the 2001 Act is removed, the top Federal 
individual income tax rate will increase to 39.6 percent in 2011. This 
would put the United States 2 percentage points above the current 
average for OECD countries.
    High marginal income tax rates discourage savings and work effort-
particularly of secondary workers-and encourage tax avoidance and 
evasion. Moreover, countries with high personal income taxes are 
unattractive places to locate facilities with high-paying jobs such as 
corporate headquarters and research facilities.

E. Corporate Income tax
    Immediately following the Tax Reform Act of 1986, which lowered the 
U.S. corporate income tax rate from 46 to 34 percent, the U.S. rate was 
relatively attractive. This is no longer true today. The U.S. corporate 
income tax rate increased to 35 percent in 1991, while the average OECD 
country's corporate rate fell to 29.3 percent in 2003-5.7 percentage 
points less than the U.S. rate. The average corporate rate for the 25 
members of the newly expanded European Union is just 26.3, 8.4 
percentage points less than the U.S. rate (see Exhibit 6). The United 
States is tied with Spain and Greece for third highest corporate income 
tax rate among the 30 OECD countries. Unlike most OECD countries, the 
United States imposes corporate income taxes at the state and, in some 
cases, local levels of government. Taking into account multi-level 
corporate income taxes, the disparity between the U.S. rate and the 
OECD average is likely greater.
    Despite relatively high rates, the U.S. corporate income tax raises 
relatively little revenue. In 2001, U.S. corporate income tax receipts 
amounted to just 1.9 percent of GDP compared to the OECD average of 3.5 
percent of GDP). U.S. corporate income tax receipts were suppressed in 
2001 by the recession, the fall in the stock market, the terrorist 
attack of September 11, and the temporary adoption of bonus 
depreciation and extended loss carrybacks.
    High corporate income tax rates are economically unattractive for a 
number of reasons. First, high corporate income tax rates make the 
United States a relatively unattractive location for corporate 
investment. In a global economy, countries with high corporate income 
tax rates may suffer a declining share of worldwide investment and 
reduced employment opportunities for local workers. Second, high 
corporate income tax rates encourage the shifting of income abroad. 
Within the limits of existing rules, companies have an incentive to 
establish inter-company prices and corporate financial structures that 
locate income away from high-tax jurisdictions. Third, the incentive to 
engage in tax planning increases the higher the tax rate, which reduces 
the corporate revenue yield and diverts valuable resources away from 
more economically productive activities.

                  DOUBLE TAXATION OF CORPORATE INCOME

    In a tax system where corporate income is taxed a second time when 
paid as dividends to shareholders, high corporate income tax rates 
discourage businesses from operating in regular corporate form. While 
the 2003 Act reduced the shareholder level tax on corporate dividends, 
this relief is scheduled to sunset after 2008. If dividend relief is 
allowed to sunset, the United States would join Switzerland as the only 
OECD countries without double taxation relief and the top rate of 
income tax on dividends-combining Federal and individual level 
taxation-would increase from 44.75 percent today to over 60 percent 
after 2010 (see Exhibits 7 and 8).

F. Payroll Taxes
    Payroll taxes provide the primary source of funding for the Social 
Security, Medicare, and Federal and state unemployment insurance 
systems. Social insurance and payroll taxes represent about one-fourth 
of government revenues in the United States, similar to the average for 
all OECD countries. While the expenditures from social insurance 
programs are progressive, the payroll tax is regressive. However, the 
regressivity of the Federal payroll tax is mitigated by the earned 
income tax credit, which is a refundable income tax credit targeted at 
low-income workers. In addition, the portion of the Federal payroll tax 
dedicated to hospital insurance (imposed at 1.45 percent rate on 
employees and employers) is not subject to the wage cap that applies to 
the balance of Social Security taxes (imposed at a 6.2 percent on 
employers and employees).

       FUTURE REVENUES AND OUTLAYS OF THE SOCIAL INSURANCE SYSTEM

    Like many other advanced industrial economies, the projected 
increase in the obligations of the U.S. social insurance system are far 
greater than the revenue stream that will be generated by existing 
funding sources. In 2003, the General Accounting Office estimated that 
future liabilities for the Social Security and Medicare systems would 
exceed future revenues for these program by $20.7 trillion in present 
value, not including the new Medicare prescription drug benefit enacted 
earlier this year (see Exhibit 9).\3\ This unfunded liability amounts 
to over $71,000 for every U.S. citizen.

G. Consumption and Excise Taxes
    The United States is one of the few countries that does not have a 
national level value-added or goods and services tax. The main form of 
consumption tax is the retail sales tax which is imposed by 45 states 
and the District of Columbia as well as approximately 7400 local 
jurisdictions. The retail sales tax system has a number of 
disadvantages as compared to the VAT. In particular, the retail sales 
tax excludes most services and, unlike the VAT, cannot be fully 
recovered by business purchasers, with the result that the tax can 
cascade through the production/distribution chain.

       IV. TAXATION OF INCOME FROM U.S. DIRECT INVESTMENT ABROAD

A. Do the Foreign Operations of U.S. MNCs Hurt the Domestic Economy?
    If taxes make the United States an unattractive location to 
headquarter a multinational corporation, then U.S. multinationals will 
lose global market share. This loss in global market share can happen 
in a variety of ways. First, U.S. individual and institutional 
investors can choose to invest in foreign rather than U.S. 
headquartered companies. Second, in a cross-border merger, the 
transaction may be structured as a foreign acquisition of a U.S. 
company rather than the reverse. By choosing to be headquartered 
abroad, the merged entity can invest outside the United States without 
being subject to the complex and onerous U.S. rules that apply to the 
foreign source income of U.S.-headquartered companies.\4\ Third, and 
most starkly, a number of U.S. companies have structured transactions 
in which their U.S. parents are acquired by their own foreign 
subsidiaries. Such ``inversion'' transactions, like foreign 
acquisitions of U.S. companies, allow new foreign investments to be 
structured as subsidiaries of a foreign parent corporation and thus not 
subject to U.S. rules relating to the taxation of foreign source 
income. Fourth, new ventures can be incorporated at inception as 
foreign corporations.
    A decline in the market share of U.S. multinationals would 
adversely affect domestic workers. U.S. multinationals play an 
important role in promoting U.S. exports and creating high-wage jobs. 
According to the U.S. Commerce Department, in 2001, U.S. multinationals 
were directly responsible, through their domestic and foreign 
affiliates, for $425 billion of U.S. merchandise exports-almost 60 
percent of all merchandise exports. The role of multinationals in 
promoting exports is corroborated by an OECD study which found that 
each dollar of outward foreign direct investment is associated with 
$2.00 of additional exports.\5\ Dartmouth professor Mathew Slaughter 
has found that over the 10-year period 1991-2001, jobs added by U.S. 
multinationals abroad were matched almost two for one by U.S. jobs 
added in their parent operations.6 Moreover, Slaughter finds that U.S. 
multinationals increased their domestic employment at a faster pace 
than U.S. companies without foreign affiliates-evidence that the 
foreign operations of U.S. multinationals increase domestic job growth. 
As noted by David Riker and Lael Brainard:
    ``Specialization in complementary stages of production implies that 
affiliate employees in industrialized countries need not fear the 
multinationals' search for ever-cheaper assembly sites; rather, they 
benefit from an increase in employment in developing country 
affiliates.''\7\
    U.S.-based multinationals account for 20 percent of domestic 
employment, and locate 77 percent of their global production and 80 
percent of the global capital spending at home.\8\ In addition, 
multinational companies pay their domestic workers more than comparable 
U.S. companies without international operations.\9\
B. Comparison of U.S. and Foreign Country Rules for Taxing 
        Multinational Income
    Compared to major competitor countries, the United States is a 
relatively unattractive jurisdiction in which to locate the 
headquarters of a multinational company. Quantitative evidence of this 
comes from a study published by the European Commission in 2001 which 
found that, on average, U.S. multinationals bear a higher effective tax 
rate-ranging from three to 5 percentage points--when investing into the 
European Union than do multinationals headquartered in the EU (see 
Exhibit 10).
    Aside from the relatively high U.S. corporate income tax rate, 
there are a number of features of the U.S. system of taxing foreign 
source income that depart from international norms.
    Worldwide tax system. Over half of the OECD countries have dividend 
exemption (``territorial'') tax systems under which a parent company 
generally is not subject to tax on the active income earned by a 
foreign subsidiary (see Exhibit 11). By contrast, the United States 
generally taxes income earned through a foreign corporation when 
repatriated.\10\ Moreover, the United States is the only OECD country 
that does not exempt the foreign earned income of its citizens who 
reside abroad, making it more expensive for U.S. multinationals to send 
employees on international assignments.\11\
    Foreign tax credit limitations. The U.S. foreign tax credit, which 
is intended to prevent double taxation of foreign source income, has a 
number of deficiencies that increase complexity and prevent full double 
tax relief, including:\12\
     Over allocation of U.S. interest expense against foreign 
source income due to failure to take into account foreign debt. This 
reduces the foreign tax credit limitation and can cause income that has 
been subject to foreign tax at a rate of 35 percent or more to be 
subject to additional U.S. tax;
     Asymmetric loss recapture rules that have the effect of 
restoring U.S. but not foreign income, thereby reducing the foreign tax 
credit limitation;
     The limitation on foreign tax credits to 90 percent of 
alternative minimum tax liability;
     The limited carryover period for foreign tax credits (two 
years back and 5 years forward); and
     The complexity associated with the numerous separate 
foreign tax credit limitations and the ``high-tax kick out'' rules that 
move certain income out of the passive basket.
    U.S. anti-deferral rules. Another difference from the multinational 
tax rules of other countries is the unusually broad scope the U.S. 
anti-deferral rules under subpart F. While most countries tax passive 
income earned by controlled foreign subsidiaries, the United States is 
unusual in taxing a wide range of unrepatriated active income as a 
deemed dividend to the U.S. parent, including:\13\
     Foreign base company sales income;
     Foreign base company services income;
     Foreign base company shipping income; and
     Active financial services income (a temporary exclusion of 
this income from Subpart F will expire for taxable years beginning 
after 2006).
    Moreover, the U.S. anti-deferral system is extraordinarily complex, 
with multiple and overlapping rules including separate regimes for: 
controlled foreign corporations (CFCs), passive foreign investment 
companies (PFICs), foreign personal holding companies (FPHCs), foreign 
investment companies (FICs), and Personal Holding Companies (PHCs).\14\
    The net effect of these differences between U.S. tax rules and 
international norms, is that U.S. multinationals frequently pay a 
greater share of income in foreign and U.S. tax than do competing 
multinationals headquartered outside of the United States.
C. Recent Legislative Proposals
    The ETI replacement bills adopted earlier this year by the House 
and Senate contain international tax reform provisions that would 
address many of the aspects of U.S. tax law that depart from 
international norms in ways that adversely affect the competitiveness 
of U.S. multinationals.
    Foreign tax credit.-Both bills alleviate the double taxation of 
foreign source income through measures addressing interest allocation, 
recharacterization of domestic losses, and removing the 90-percent 
limitation in the AMT. The House bill also reduces the number of 
separate foreign tax credit limitation categories, while the Senate 
bill extends the carryforward period for foreign tax credits to 20 
years, consistent with net operating losses.
    Anti-deferral rules. Both bills reduce the taxation of active 
foreign income that is reinvested abroad by ``looking through'' 
payments between related CFCs to determine their character and by 
excluding certain active foreign shipping and aircraft income from 
Subpart F. Both bills also simplify compliance with Subpart F by 
repealing the FPHC and FIC rules and the PHC rules applicable to 
foreign corporations. In addition, the Senate bill simplifies 
compliance by increasing the de minimis exemption from Subpart F.

                             V. COMPLEXITY

    The burden of the tax system includes not only the amount that 
taxpayers are obliged to remit to the government but also the time and 
money cost of compliance, including researching and monitoring changes 
in tax laws and regulations, collecting information required for return 
preparation, preparing and filing the return, record retention, and 
responding to audits. Compliance costs were estimated by the Tax 
Foundation to increase the burden of the Federal income tax by 20.4 
percent, or $194 billion in 2002.\15\ By comparison, estimates of the 
compliance costs imposed by the retail sale taxes typically are on the 
order of 3-4 percent of revenues.\16\
    Some of the complexity of the income tax system is inherent in 
measuring taxable income in a technologically advanced and globally 
integrated economy. There are few remedies for this inherent complexity 
short of adopting an alternative basis of taxation, such as 
consumption.

  PROLIFERATION OF SPECIAL PURPOSE DEDUCTIONS, CREDITS, AND EXEMPTIONS

    One important source of complexity is a policy choice-the use of 
special purpose deductions, credits, and exemptions in the Code to 
encourage certain types of economic activities or to redistribute 
income to specific groups of taxpayers judged needy of assistance. Many 
of the policy objectives underlying these special purpose deductions, 
credits and exemptions could be achieved through Federal spending 
programs, subject to the Congressional authorization and appropriations 
process, and administered by Federal agencies other than the IRS.

                        ALTERNATIVE MINIMUM TAX

    Redesigned in 1986, the alternative minimum tax (AMT) for 
individuals and corporations operates like a parallel tax system. 
Taxpayers compute tax liability twice: under the regular system and 
under the AMT system, with its own separate tax base and rates. AMT 
liability is equal to the excess, if any, of tax liability under the 
AMT system over the regular system. Certain AMT payments may be carried 
forward and used to offset regular tax in future years to the extent in 
excess of liability determined under the alternative system.
    On its face, the AMT system is inherently complex as it requires 
calculation of tax liability under two different systems. It imposes 
compliance burdens on all taxpayers-whether or not AMT is owed-because, 
in principle, they must calculate hypothetical liability under the 
alternative system to determine whether AMT is due and whether the use 
of tax credits under the regular tax system is constrained by the AMT.
    Worse still, for individuals, the AMT is becoming far more 
pervasive because (1) the dollar amount of the AMT exemption was not 
indexed in 1986, and (2) the regular tax rates but not the AMT rates 
were reduced in 2001 and 2003. As a result, CBO estimates that the 
number of returns affected by the AMT will increase from 3 million in 
2004 to 29 million in 2010.\17\
    Fixing the AMT is a serious budgetary challenge. The Congressional 
Budget Office has estimated that indexing the AMT exemption amount at 
2004 levels would cost $376 billion over the next 10 years.\18\

                          TAX CODE INSTABILITY

    Another source of compliance burden is the frequency of changes in 
the tax Code. According to the Tax Foundation, from 1995 to 2000, the 
tax Code increased by 182 pages, about half the pages of the entire 
1954 Code. At this rate, the Code will increase from 1670 pages in 2000 
to about 2600 pages in 2010.
    Tax Code instability also is due to the adoption of tax provisions 
on a temporary basis to comply with budgetary scoring rules. These 
sunsets create uncertainty and impose real costs on taxpayers. The most 
absurd example is the scheduled repeal of the estate and gift tax in 
2010 and re-enactment in 2011. This is an example of how rules designed 
to promote fiscal responsibility have had the side effect of creating 
tax structure instability.

                         FOREIGN SOURCE INCOME

    As noted in the administration's fiscal year 2003 budget, one of 
most complex aspects of corporate taxation is the treatment of foreign 
source income. A survey of Fortune 500 companies found that 43.7 
percent of U.S. income tax compliance costs were attributable to 
foreign source income even though foreign operations represented only 
26-30 percent of worldwide employment, assets and sales.\19\ These high 
compliance costs are a hidden form of taxation that discourages small 
U.S. companies from operating abroad and makes it more difficult for 
larger companies to compete successfully with foreign multinationals.

                              VI. SUMMARY

    This testimony supports the following conclusions:
     U.S. residents currently pay a smaller share of GDP in 
total taxes than do residents of most other OECD countries.
     However, the present U.S. tax structure does not generate 
sufficient revenue to meet projected Federal spending in the long run.
     Closing the fiscal gap by raising income and profit taxes 
would cause the U.S. tax system to depart even further from 
international norms, as the United States already relies much more 
heavily on income and profit taxes-both as a percent of GDP and as a 
percent of total taxes-than the average OECD country.
     The U.S. corporate income tax rate is tied with Greece and 
Spain as third highest among the OECD countries.
     If the 2001 and 2003 Act sunsets are not reversed, the top 
central government individual income tax rate in the United States will 
by 2011 jump to 2 percentage points above the current average for OECD 
countries.
     According to the Tax Foundation, the cost of complying 
with the Federal income tax system increases the U.S. tax burden by 20 
percent. This is much higher than estimates of the cost of complying 
with VAT and retail sales tax systems.
     A particularly worrying source of tax complexity is the 
estimated increase in the number of individual returns affected by the 
AMT from 3 million in 2004 to 29 million in 2010.
     The U.S. international tax rules are out of step with 
competitor countries. The U.S. system of taxing worldwide income is 
extremely complex and imposes high compliance costs relative to revenue 
raised.

                                ENDNOTES

    \1\ OECD, OECD in Figures: Statistics on the Member Countries, 
2003.
    \2\ A theoretical framework is set forth in, Martin Feldstein and 
Paul Krugman, ``International Trade Effects of Value Added Taxation'' 
(with Paul Krugman) in Taxation in the Global Economy, Assaf Razin and 
Joel B. Slemrod, (eds.), the University of Chicago Press, 1990. 
Consistent with the standard theoretical model, empirical research 
finds there is no export or trade advantage for countries with greater 
reliance on value-added taxes. In fact, Hines and Desai find a negative 
relationship which the authors attribute to two implementation features 
of VAT systems: VATs tend to be imposed at higher rates on traded than 
non-traded goods and exporters often receive incomplete VAT rebates 
See, James R. Hines, Jr. and Mihir A. Desai, ``Value Added Taxes and 
International Trade: The Evidence,'' (November 2002) presented at 
December 2002 Brookings/ITPF conference on Tax Systems and 
International Trade (www.itpf.org/presearch--itpindex.htm).
    \3\ U.S. General Accounting Office, Financial Statement of the 
United States Government, 2003.
    \4\ Note that, absent restructuring, the existing foreign 
operations of a U.S. company acquired by a foreign company remain 
subject to U.S. tax rules.
    \5\ OECD, Open Markets Matter: The Benefits of Trade and Investment 
Liberalization, p. 50 (1998).
    \6\ Mathew J. Slaughter, ``Globalization and Employment by U.S. 
Multinationals: A Framework and Facts,'' Daily Tax Report, March 26, 
2004, section J, pp. 1-7.
    \7\ David Riker and Lael Brainard, U.S. Multinationals and 
Competition from Low Wage Countries, National Bureau of Economic 
Research Working Paper no. 5959 (1997) p. 19.
    \8\ Laura D'Andrea Tyson, ``Why The Trade Deficit May Not Loom So 
Large,'' Business Week, June 7, 2004
    \9\ Doms and Jensen find that U.S. plants of companies without 
foreign operations pay production workers 10-15 percent less and 
nonproduction workers 5-7 percent less than comparable plants of U.S. 
multinational companies, controlling for industry, size of company, and 
state where the plant is located. See, Mark Doms and Bradford Jensen, 
Comparing Wages, Skills, and Productivity between Domestic and Foreign-
Owned Manufacturing Establishments in the United States, mimeo. 
(October 1996).
    \10\ I am unaware of any OECD country that requires formula 
apportionment of domestic interest expense to exempt foreign dividends 
with the result that this portion of domestic interest expense is 
nondeductible. Grubert and Mutti find that adoption of a dividend 
exemption system with formula apportionment of domestic interest 
expense would actually increase the U.S. tax burden attributable to 
foreign source income. See, H. Grubert and J. Mutti, Taxing 
International Business Income: Dividend Exemption versus the Current 
System, American Enterprise Institute, 2001.
    \11\ See, Price Waterhouse, ``Economic Analysis of the Foreign 
Earned Income Exclusion,'' 1995.
    \12\ See, National Foreign Trade Council, U.S. International Tax 
Policy for the 21st Century, vol. 1, Part II, 2001
    \13\ Ibid., vol. 1, Part I.
    \14\ See, Carl A. Dubert and Peter R. Merrill, Taxation of U.S. 
Corporations Doing Business Abroad: U.S. Rules and Competitiveness 
Issues (Second Edition), FEI Research Foundation, 2001.
    \15\ Scott Moody, ``The Cost of Tax Compliance,'' Tax Foundation, 
February 2002. Using a different methodology, Prof. Joel Slemrod 
estimated the private sector collection cost of the U.S. income tax 
system at $125 billion in 2004. See, Joel Slemrod, ``Written Testimony 
submitted to the Committee on Ways and Means, Subcommittee on 
Oversight, Hearing on Tax Simplification,'' June 15, 2004.
    \16\ Tax Administrator News, 1993.
    \17\ CBO, The Budget and Economic Outlook, Fiscal Years 2005 to 
2014, January 2004, p. 81.
    \18\ Ibid. pp. 5-7.
    \19\ Marsha Blumenthal and Joel Slemrod, ``The Compliance Costs of 
Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy 
Implications, International Tax and Public Finance, vol. 2, no. 1, 37-
54 (1995).

    Chairman Nussle. Dr. Gale, welcome back to the committee. 
We are pleased to receive your testimony. As I said, your full 
written testimony will be made part of the record, and you may 
summarize.

                  STATEMENT OF WILLIAM G. GALE

    Mr. Gale. Thank you, Mr. Chairman and members of the 
committee, for inviting me to testify. It is always an honor to 
appear here. I want to start by highlighting the fact that on 
behalf of policy wonks and budget analysts everywhere, I 
applaud the committee's efforts to focus on the important role 
of uncertainty in shaping budget outcomes and policies.
    My testimony will be both capped and verifiable.
    Chairman Nussle. Just pay-as-you-go, too, will you?
    Mr. Gale. I would like to address four topics. The first 
is, how good are the growth assumptions and baseline 
projections made by the CBO.
    I think it is fair to say that CBO does a very good job of 
forecasting future economic activity and its relation to 
revenues and spending. It is a fact that the projections are 
often wrong, sometimes by sizable amounts. It is also a fact 
that it is very hard to understand when the economy changes 
directions. But my understanding is that CBO does as well or 
better than anyone else who tries to define the economic 
future. So in this case, CBO is not the cause of the 
uncertainty; they are just the messenger.
    Doug Holtz-Eakin gave you the choice of shooting or blaming 
the messenger. I would suggest we not even blame the messenger. 
My sense is that CBO is doing a very good job on this score.
    The second question is, if it is not CBO, what is it that 
is causing the baseline budget projections to be so uncertain? 
And here I think the dominant form of uncertainty is 
uncertainty about the future of the economy. Future GDP is 
difficult to predict precisely, and small differences in the 
future GDP turn into big differences in budget deficits.
    So, for example, CBO in January predicted a real growth 
rate of 3 percent over the next decade. That is a perfectly 
reasonable estimate, but it is also an uncertain estimate. And 
if the growth rate is off by three-tenths of a percentage 
point, the difference in the budget deficit is about $700 
billion over the next decade. So relatively minor changes in 
the growth rate of GDP make big differences in the projected 
budget deficit.
    Given the size of the economy, uncertainty about other 
economic factors is also important. In the 1990s, the shifting 
distribution of income, the enormous capital gains in the stock 
market and changes in inflation and interest rates had a 
significant effect on budget outcomes. Usually, however, these 
impacts are not as large. The late 1990s and the early part of 
this decade were unusual in that respect.
    The third factor is the actual structure of tax policy. I 
don't have access to the detailed models that CBO does, but my 
sense is, given the size of the economy, given the structure--
in terms of interest rates, inflation rates, the level of the 
stock market--the actual structure of tax policy doesn't 
contribute that much additional uncertainty to the budget 
forecast.
    For example, it would be wonderful if we taxed different 
activities at the same rate and we reduced the disparity across 
activities in the indifferential taxation. But even if we did, 
we would still face enormous amounts of budget uncertainty; 
that would not solve the problem. So I think we are stuck with 
uncertainty and have to deal with it.
    The second issue dealt with uncertainty in the baseline. A 
third issue is, even if we got the baseline right, the baseline 
is becoming an increasingly useless measure of realistic actual 
budget outcomes. That is, even if you know exactly what the 
baseline is, you still have no idea these days what a realistic 
policy is going to turn out to be. And this relates to concerns 
that both of the other witnesses mentioned.
    I want to highlight three issues in particular. One is the 
enormous increase in the use of expiring tax provisions and 
sunsets in the Tax Code. So we know how the baseline treats 
them. What we don't know is what is a good, realistic way to 
think about them.
    The second issue is the existence of specific unsustainable 
policies. And here the AMT is a perfect example. Nobody 
believes that we are going to end up with 30 million people on 
the AMT by 2010 and almost 40 million people by 2014, but that 
is what is built into the budget forecast. And so it increases 
uncertainty between the baseline and what the actual budget 
outcome will be.
    The third issue, which is even harder to address, is the 
existence of an overall unsustainable fiscal policy; that is, 
everyone who looks at the current trajectory of spending and 
taxes says, This can't go on. But that is what the baseline has 
in the current-law trajectory.
    So all three of those factors mean that even if we got the 
baseline exactly right, the baseline is increasingly becoming 
less useful as a measure of budget outcomes.
    The last issue is, what do we do about uncertainty? There 
are really two issues here: How do we reduce it and how do we 
deal with whatever uncertainty is left?
    Reducing uncertainty is pretty straightforward--in theory, 
at least. It is easy for me to say and tell you how to reduce 
it, but it will involve some pretty difficult choices. The way 
to reduce it is to undo the features of the Tax Code that 
create uncertainty, so, for example, a budget-conscious fix to 
the AMT problem, some fix to the unsustainability of fiscal 
policy generally, and in particular, these issues will all come 
to a head in thinking about whether to make the tax cuts 
permanent.
    At first glance, you might think that making the tax cuts 
permanent would reduce uncertainty because it tells people that 
there is a commitment to lower tax rates for the long term. 
But, remember, one of the issues that generates uncertainty is 
the existence of an unsustainable fiscal policy. And if you cut 
taxes you make the fiscal gap, the unsustainability of fiscal 
policy, even worse.
    And so that not only raises uncertainty about how and when 
the fiscal gap will be closed, but at some point it can raise 
uncertainty about whether the fiscal gap will ever be closed. 
And at that point it is not an issue of the economy creating 
uncertainty in the budget; it is an issue of the budget 
creating uncertainty in the economy. That is a completely 
gratuitous uncertainty that is particularly damaging to the 
economy.
    Besides fixing the specific policies that lead to 
uncertainty in the Tax Code, there are a number of other things 
policy-makers could do to reduce the impact of uncertainty. One 
is simply to give realistic budget projections more weight in 
the policy process than they currently have relative to the 
baseline.
    In 2001, for example, it was mentioned we had a baseline 
surplus of $5.6 trillion; realistic budget surpluses puts it 
between $1 trillion and $1.7 trillion over the decade, which 
obviously is quite different from 5.6 trillion.
    A second issue is to distinguish between projections that 
are more certain than those that are less certain. If you know 
how many 50-year-olds there are now, you can make a pretty good 
guess how many 70-year-olds there will be in 20 years. However, 
if you know the size of the economy now, you don't have a clue 
as to how much it is going to grow in the next 20 years. So 
certain things like demographics, at least over the medium 
term, are uncertain, but are relatively certain compared to 
things variation in economic growth.
    So, for example, the long-term fiscal crisis that the 
Nation faces is subject to an enormous amount of uncertainty, 
yet almost everyone that looks at the reasonable magnitudes of 
uncertainty decides that we still have a fiscal crisis even 
after adjusting for that.
    The third issue I would suggest is to think about how 
families respond to uncertainty. Families face pervasive 
uncertainty about jobs, about future income, future spending 
needs, future health needs; and typically they respond to that 
by trying to establish a reserve fund. That might be very 
difficult given the way the Federal budget is set up to 
literally establish a reserve fund, but one thing Congress 
could do is not allocate every available dollar to tax cuts and 
spending increases and try to establish and hold on to a budget 
surplus on an ongoing basis. That would also help with the 
national saving issue that Pam Olson mentioned.
    My last point is just that I want to end where I started, 
which I think it is very important that the Budget Committee 
does consider uncertainty. And I applaud your efforts in that 
regard. There is a danger though. Because of uncertainty things 
could end up a lot better than they are, they could end up a 
lot worse than they are.
    The danger is that people use uncertainty as a method of 
procrastinating or avoiding dealing with the serious issues. I 
think it is fair to say that almost everyone who has looked at 
the fiscal situation facing the country thinks that we can't 
just grow out of it, it won't just go away on its own. But as 
soon as one invokes uncertainty there is the conceptual 
possibility that it could.
    So let me just close by saying, focusing on uncertainty is 
very important, but it would be unfortunate if that appropriate 
focus led to the inappropriate willingness to procrastinate and 
avoid facing the real fiscal problems.
    Thank you.
    [The prepared statement of Mr. Gale follows:]

  Prepared Statement of William G. Gale, Senior Fellow, the Brookings 
                     Institution, Tax Policy Center

    Arjay and Frances Fearing Miller Chair, Economic Studies Program, 
and Co-Director, Tax Policy Center. The views presented are my own and 
should not be taken to represent the views of the Brookings Institution 
or the Tax Policy Center.
    Chairman Nussle, Ranking Member Spratt, and members of the 
committee: Thank you for inviting me to testify today. It is always an 
honor to appear before this committee. I applaud the committee's 
efforts to focus on the important role of uncertainty in shaping budget 
outcomes and policies. I'd like to address four questions.
    The first question is how good are the growth assumptions and 
baseline projections made by the Congressional Budget Office? I think 
it is fair to say that the CBO does a very good job of forecasting 
future economic activity and its relation to revenues and spending. The 
CBO's projections are often wrong, sometimes by sizable amounts. It is 
particularly difficult to predict and understand turning points. But my 
impression is that CBO does as well as, or better than, anyone else who 
tries to divine the economic future.
    The second question is what causes the baseline projections to be 
so uncertain? The primary source of uncertainty in the baseline 
projection is uncertainty regarding the overall size of the economy in 
the future. Not only is future GDP difficult to predict precisely, but 
small differences in assumed growth rates can generate large changes in 
budget outcomes.
    For example, in January, CBO predicted a real growth rate averaging 
3.0 percent per year over the next decade. This is a reasonable 
estimate, but everyone would agree there is substantial uncertainty 
surrounding the exact figure. If the annual rate of economic growth 
turns out to be just three-tenths of a percentage point larger or 
smaller than CBO projects, the difference in the deficit will be about 
$700 billion over the next 10 years (CBO, Economic and Budget Outlook 
for Fiscal Years 2005-14, January 2004, Appendix B).
    Compared to the size of the economy, uncertainty about other 
economic factors is usually significantly less important in generating 
budget projections. Such factors include the rate of inflation, the 
level of interest rates, and the level of the stock market. While it is 
true that changes in capital gains have significantly influenced 
revenues over the past several years, it has required enormous, 
atypical changes in capital gains to have that effect, and the effects 
have been far smaller than those due to changes in the size of the 
economy. Typical changes in inflation, interest rates, and the stock 
market generate modest changes in budget projections.
    Given the size of the economy, and given the other economic 
factors--like capital gains, inflation, and interest rates--the actual 
structure of tax policy plays a very small role in generating 
uncertainty in the baseline projections. To be more specific, the 
current tax system taxes different people and different forms of income 
at different rates. Even if we taxed everyone at the same rate on all 
activities, the great majority of uncertainty would still be present in 
budget projections.
    A third issue is that the baseline projection is becoming an 
increasingly misleading measure of realistic budget outcomes. This 
increases everyone's uncertainty regarding what the actual budget 
outcome will be, given the baseline. This trend is due to several 
factors, most notably: (i) the enormous increase in the use of expiring 
tax provisions and sunsets in the Tax Code; (ii) the presence of 
specific unsustainable policies, like the built-in growth of 
alternative minimum tax, which no one believes will be allowed to 
persist; and (iii) the presence of an overall unsustainable fiscal 
policy stance, such as we now face. When policy-makers enact laws that 
are fiscally unsustainable or that are designed in a blatant manner to 
skirt budget rules, the effect is to increase uncertainty about the 
course of future Federal policy. This likely has negative effects on 
the economy.
    The fourth issue is what to do about uncertainty in the budget 
projections. There are two policy questions: how to reduce uncertainty 
and how to respond to whatever uncertainty is left in the system.
    If the main source of uncertainty is the economy itself, then 
policy-makers will always face a significant amount of uncertainty. But 
policy-makers can still reduce uncertainty in several ways. The best 
way to reduce uncertainty is avoid creating fiscally unsustainable 
policies. A second way is to avoid creating artificial sunsets.
    These issues will come to a head in dealing with whether to make 
the 2001 and 2003 tax cuts permanent. At first glance, one might think 
that making the tax cuts permanent would reduce uncertainty since it 
indicated a long-term Congressional commitment to lower tax rates. 
Making the tax cuts permanent, however, will substantially increase the 
severity of the fiscal gap between revenues and spending and hence it 
will serve to increase uncertainty about how and when the overall 
fiscal gap will be closed. In fact, making the tax cuts permanent in 
light of the current fiscal situation is sufficiently irresponsible 
that it may lead to investors wondering not just how and when the 
fiscal gap will be closed, but whether it will ever be closed. That is, 
several knowledgeable observers, most notably Treasury Secretary Robert 
Rubin, have raised the concerns that ever-increasing Federal debt 
projected for the medium- and long-term could seriously disrupt 
financial markets and the broader economy.
    In contrast to extending the tax cuts, letting them expire would 
reduce uncertainty about the tax system as well as reduce uncertainty 
about the overall fiscal gap. Likewise, establishing a budget-conscious 
solution to the AMT problem would go a long way toward reducing 
uncertainty about future tax rates and reduce uncertainty regarding 
whether, how, and when the fiscal gap will be closed.
    Policy-makers should also shape policies explicitly in light of the 
fact that uncertainty is present. First, I think that realistic budget 
projections should be given more weight in the policy process than they 
currently are. The baseline is useful for understanding the effects of 
legislation, but is extremely misleading as a guide to what likely 
budget outcome are going to be. The reason why is that the baseline is 
constructed according to certain fixed rules for projecting spending 
and revenues that do not reflect likely or plausible outcomes. If 
policy-makers paid more attention to alternative, realistic forecasts 
of likely budget outcomes rather than the baseline, they would not be 
so surprised by many of the changes in the budget projections.
    Second, policy makers should distinguish between projections that 
are more certain and those that are less uncertain. Population growth, 
for example, is relatively certain in the medium term. If you know how 
many 50 year olds are alive today, chances are you can make a pretty 
good guess at how many 70 year olds will be alive in 20 years. On the 
other hand, if you know the size of the economy today, that may provide 
very little guidance for estimating the change in the size of the 
economy over the next 20 years. Along similar lines, almost every study 
finds that the nation faces a substantial long-term fiscal shortfall, 
even though there is substantial uncertainty about many economic 
factors over the long-term. Simply put, population aging and health 
care technologies will create budgeting problems under almost any 
scenario.
    Third, Congress should consider ways to adopt budget rules that not 
only limit both tax cuts and spending increases but also do so in a way 
that does not let every available dollar be allocated as soon as it 
appears. Families face substantial economic uncertainty about future 
wages, health, asset returns, and so on. They often manage that 
uncertainty by trying to keep a financial reserve. A literal financial 
reserve might be hard to establish at the Federal level, but budget 
rules that limited the extent to which policy- makers could create 
future tax cuts and spending increases would be a step in the right 
direction.
    My last point is that perhaps the biggest danger in acknowledging 
the importance of uncertainty is that it will allow policy makers to 
shrug off any potential fiscal problems with the insight that the 
problems might go away on their own. Current, plausible budget 
projections suggest significant medium-term deficits and very sizable 
long-term deficits. But the presence of uncertainty suggests that these 
problems could conceivably go away on their own. This observation might 
tempt politicians to delay seeking solutions, hoping to avoid the 
daunting economic and political risks associated with large-scale tax 
increases and spending cuts. Indeed, in the last few years, the 
majority of legislators have chosen not only to ignore the long-term 
fiscal problems but to make them substantially worse by enacting and 
advocating significant tax cuts and spending increases. But it is 
extremely unlikely that the current fiscal problem will resolve itself 
without policy actions, and delays in addressing the issue will only 
make the eventual solutions more extreme and painful. It would be a 
travesty if the explicit recognition of uncertainty in the policy 
process led policy-makers to choose to avoid dealing with the serious 
fiscal problems the country faces.

    Chairman Nussle. Mr. Baird.
    Mr. Baird. I thank the chairman for bringing together this 
outstanding group of panelists. I also in sincerity want to 
commend the chairman. As I heard some of the testimony, it 
would suggest to me that some of the ways we have gone about 
passing some of the tax cuts in the last couple of years have 
actually enhanced the complexity and the uncertainty in the Tax 
Code and thereby distorted the decision-making process and 
certainly the predictability process. The use of expiring tax 
cuts as a way to say that the deficit and fiscal implications 
will be smaller than they might actually be creates not only a 
false impression, but a difficult thing in predicting and some 
strange impacts in terms of budget deficits, et cetera.
    One of the questions I would have, and I will direct this 
perhaps initially to Ms. Olson, it seems to me, to sort of an 
average commonsense kind of person, that most folks would say, 
look, people who make income by taking their lives and their 
time and working their guts out, it is reasonable to say that 
maybe they should face a different level of taxation or 
different kinds of taxation on that income than somebody who, 
let's say, was given a million and the million generates a lot 
of income for them while they go play in the surf or something.
    Are you suggesting that we should treat the income from the 
million dollars given to someone as the same as the income for 
somebody who has to work every day of their life and leave 
their family and go risk their lives and time?
    Ms. Olson. Well, I guess I am not sure that I would use the 
Tax Code to try to achieve a social objective, if what we are 
trying to do is to say--essentially what we are doing is 
redistributing the tax burden on the basis of somebody being 
born with wealth versus somebody not being born with wealth and 
having to work for a living as I do. But----
    Mr. Baird. And 99 percent of my constituents do.
    Ms. Olson. I think 99 percent of the people I know do as 
well. But one of the things that the Tax Code does--let's set 
aside somebody who was born with $1 million and instead 
consider somebody who, because they have chosen not to spend 
everything they earned but----
    Mr. Baird. I would agree with that distinction.
    Ms. Olson [continuing].--accumulated a nice nest egg. What 
happens under our tax system over time is that that person who 
is deferring spending, delaying gratification, which I think we 
would all say is a virtue, is going to end up carrying a larger 
share of the tax burden in this country. I am not sure that is 
the right message for us to be sending people. It seems to me 
it is a bad civics lesson.
    So then if you go back and you try to figure out how would 
you make it different, do you really want to have something 
that goes back and asks whether somebody was born with money or 
had to work to get it? That is a kind of intrusiveness on the 
part of the government that I find somewhat troublesome.
    Mr. Baird. I think government by nature has to be somewhat 
intrusive. It is an illusion to believe we are not. The absence 
of policy is in fact an influence on behavior whether or not we 
like it.
    Don't most Americans pay more in payroll taxes now than in 
income taxes? Isn't it somewhere around 80 percent pay more in 
payroll tax than income tax?
    Mr. Gale. That is basically right. Some of those numbers, 
it depends on whether you attribute the employer portion to 
worker or not. But most studies suggest that the employer 
portion is borne by workers in lower after-tax wages, so it is 
reasonable to do that.
    Mr. Merrill. I believe about 30 percent of households do 
not pay income tax on that basis.
    Mr. Baird. So for a significant number of people, we have a 
de facto hybrid system and a flat tax. In a sense, you have a 
flat tax on the base level of your wages and an income tax on 
something on top of that. If you live in a State with sales 
tax, you have a sales tax in addition to that. Is that more or 
less accurate?
    Mr. Gale. It is more or less accurate. It is very difficult 
to characterize the existing system in simple terms because the 
system itself is so complicated. There is some question as to 
whether it is appropriate to call what we have an income tax 
because so many forms of saving are actually exempted.
    Mr. Baird. It would seem that one of the questions we would 
face in this body--we could sit around and maybe in a few weeks 
or months come up with a better system, and then some--there 
would be a little tap on the door by a lobbyist who would say, 
but you know, we could make it better.
    Chairman Nussle. Little tap on the door?
    Mr. Baird. There would be 4,000 of them tapping, Mr. 
Chairman. And it sort of becomes whose--the one point that I 
would close with is, you would be insane, literally, to defend 
the current Tax Code, not only just as a politician but just as 
a normal rational human being, say that is really the best way 
to do things, the best of all possible worlds. And yet we seem 
unable to resolve it. We use it on both sides, frankly, for 
partisan--we will attack you, you attack us, and somewhere that 
tapping of the lobbyist may have something to say about why we 
don't change that in more constructive ways. I thank the Chair 
very much.
    Chairman Nussle. We have a series of votes. What I would 
like to do is have Mr. Cooper--I will make a couple comments or 
questions, then we will dismiss the panel. Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman.
    If I were to propose to my colleagues that someone give me 
an unlimited number of blank checks that I would hand out 
pretty much as I would like, I would pretty much be laughed out 
of this body. But when I read in Ms. Olson's testimony that tax 
expenditures are uncapped, unverified, and unverifiable, that 
sounds like an unlimited number of blank checks. So suddenly an 
aura of respectability is given to an otherwise ridiculous 
program just because it goes through the Ways and Means 
Committee and is a tax break. Those sorts of ridiculous 
programs get covered with the speech material that we heard 
some of our colleagues mention a little earlier.
    And when my colleague from Washington mentions the 4,000 
knocks on the door that we get from various tax loophole 
lobbyists, they are essentially, every one of them, asking us 
for an uncapped, unverified, and unverifiable bunch of blank 
checks.
    So, Mr. Chairman, I know that you serve on the Ways and 
Means Committee, it sounds like we might need to curtail the 
jurisdiction.
    Chairman Nussle. Oh, I would be happy if you want to do a 
little bet here. I will bet you there are a lot more Members of 
this Congress that sign on to those as cosponsors than just the 
Ways and Means Committee members. I bet I could check your 
record on that, too. I wouldn't just blame the appropriators or 
the Ways and Means Committee.
    Mr. Cooper. I am not saying blame anyone here. I think we 
need to try to cure it for all Americans. Before we can get to 
the important issues, Mr. Merrill and Mr. Gale, issues, macro 
issues and international issues, we have to solve the problem 
of how these tax breaks get inserted into the Code every day, 
every week, every year. It is now so chock full of them, we 
need to worry about curtailing the process.
    So I wanted to ask any of the witnesses if you know, you 
gave us a great figure, Mr. Merrill did, perhaps about 20 
percent of the cost of the Tax Code trying to figure it out or 
implement it, the taxpayer nightmare that we all face. Is there 
any good data on how much is spent on K Street and other parts 
of Washington, DC, trying to lobby Congress for these uncapped, 
unverified, and unverifiable tax breaks?
    Because if you just think of it as an economic proposition, 
it must be so worthwhile for various interests around the 
country to pay folks to hang out in Gucci Gulch to get these 
uncapped, unverified, and unverifiable benefits, that it is 
essentially a good investment on their part to try to lobby us 
to get these unlimited number of blank checks.
    But who is keeping data on, for example, how much money 
Skadden Arps makes or Merrill Lynch or PriceWaterhouseCoopers 
or all the other firms that are involved in this activity? How 
are we getting a handle on that expenditure and the results 
that are procured from these lobbying expenditures? Does 
anybody have any data on that?
    Ms. Olson. I don't have any data on that, but my guess is 
you capture a lot of it in the lobbying reports that are 
required to be filed.
    Mr. Cooper. We know how much they spend to try and 
influence us, but we don't know the benefits that are resulting 
for their clients.
    Ms. Olson. That is right. We don't. We can only make 
estimates of it. I only want to say one thing on the 
unverifiable. There was a qualifier there, which was largely 
unverifiable. And to the extent that you are talking about the 
folks who have enough money to actually come and knock on your 
door regularly, those folks are all part of the IRS's 
continuous examination program. So they are not likely to be 
able to get away with something without it at least being 
verified. That doesn't mean that there is a cap on it, however.
    Mr. Gale. There have been a series of papers in a journal 
called Tax Notes the last year or so that goes through what 
different firms spend on lobbying, and tries to link that 
recent legislation. The author of the articles is named Marty 
Sullivan. I could track those down if you are interested.
    I also want to mention a couple of things. If you talk to 
analysts who are not on the lobbyists' payroll, you will find 
nearly universal consensus among economists that broadening the 
base and cleaning out the loopholes is a good idea. And I put 
that on the table.
    Second, the way these programs work, uncapped, unverified 
et cetera, it is essentially the way entitlement spending 
works. You set up the rules and then if you are eligible you 
qualify. The difference is that entitlement spending is for 
broad-based, wide swaths of the population. It is consistent 
with consensus, domestic policy goals, and it is out in the 
open; it is a spending program, whereas these subsidies are 
hidden deep, deep in the recesses of the Tax Code.
    Mr. Cooper. I would agree. Entitlement programs are 
uncapped, but there is usually a verifiable measure such as, 
for example, turning age 65 that enables you to be a 
beneficiary. So these are verified and verifiable programs.
    Chairman Nussle. Ms. Olson, what would you say is the 
largest tax provision that is unverified, largely unverifiable?
    Ms. Olson. Well, a lot of the--there are a lot of 
provisions on the individual side that are largely 
unverifiable. For example, the earned income tax credit. And 
there are a lot of difficulties with the earned income tax 
credit that make it an ineffective program, like, for example 
that it cannot function on an advance basis. If you really want 
to increase somebody's income on a constant basis, which would 
be our goal with the credit, generally speaking, we cannot do 
it. The reason is most taxpayers do not opt to claim the 
advanced earned income tax credit because they are concerned 
that their income is going to go too high and they will end up 
having to repay it at the end of the year, so they prefer to 
wait and make the claim on their tax return.
    Were you to ask for the same kind of a benefit from the 
government through some other program, you would have walked 
into an office in advance and had your eligibility for it 
verified before you would actually get the check. That is not 
the way the earned income tax credit functions. It is an outlay 
on the basis of what you reported on your return. It is only if 
the IRS has some reason to suspect the accuracy of the return 
that they actually will freeze the money, not pay it out, and 
do a verification beforehand. But doing that has been very 
controversial.
    So that is one example. There are a number of provisions 
affecting business taxpayers as well, probably not of that 
magnitude, but where it is very difficult for the IRS because 
it doesn't get third-party records or some other way of 
verifying the item in the filing of the return.
    Chairman Nussle. We have only 4 minutes left. Part of the 
reason why I wanted to have the opportunity of this hearing is 
to have you walk us through for members part of the reason why 
it take 3 years for information to get to us in a verifiable 
form and a final form. I don't know if it is possible for you 
to do that for the record, just to kind of give us an idea of 
how that might work. I don't think we have time to do it right 
now on the record because we have a vote with 3 minutes left. 
But I know I would be interested in that as well as any 
recommendations you would have for myself, Mr. Baird, or other 
members who are interested, and possible legislative ideas in 
order to do that. Because I understand some of the great ideas 
you were talking about, about how Congress complicates the 
Code. It is kind of like the gentleman was just saying: Don't 
be shocked, there are politics in Washington, there is lobbying 
in Washington, just like there is gambling in Vegas. I don't 
think we are going to get rid of that anytime soon.
    Are there things we can do in the process of projecting 
that can help in this regard? And my understanding is that 
there may be. And I guess, finally, I would just observe that I 
don't believe I have ever had a tap on my door from a lobbyist 
with regard to EITC. Probably a few other ones have tapped for 
other reasons, but for the largest one I don't think I ever had 
that tap. So I think there are probably a lot of areas that we 
can work on here. So those would be the requests I would have.
    I appreciate the three panelists for participating in 
today's hearing as well as from members who asked, I think, 
some great questions regarding how we can get our arms around 
this. And if there is nothing more to come before the 
committee, we will stand adjourned.
    [Whereupon, at 12:35 p.m., the committee was adjourned.]


                                  
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