[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



 
                    HEARING ON CORPORATE TAX REFORM

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

                                HEARING

                               before the

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                              MAY 9, 2006

                               __________

                           Serial No. 109-65

                               __________

         Printed for the use of the Committee on Ways and Means




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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

E. CLAY SHAW, JR., Florida           CHARLES B. RANGEL, New York
NANCY L. JOHNSON, Connecticut        FORTNEY PETE STARK, California
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM MCCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM MCDERMOTT, Washington
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. MCNULTY, New York
PHIL ENGLISH, Pennsylvania           WILLIAM J. JEFFERSON, Louisiana
J.D. HAYWORTH, Arizona               JOHN S. TANNER, Tennessee
JERRY WELLER, Illinois               XAVIER BECERRA, California
KENNY C. HULSHOF, Missouri           LLOYD DOGGETT, Texas
RON LEWIS, Kentucky                  EARL POMEROY, North Dakota
MARK FOLEY, Florida                  STEPHANIE TUBBS JONES, Ohio
KEVIN BRADY, Texas                   MIKE THOMPSON, California
THOMAS M. REYNOLDS, New York         JOHN B. LARSON, Connecticut
PAUL RYAN, Wisconsin                 RAHM EMANUEL, Illinois
ERIC CANTOR, Virginia
JOHN LINDER, Georgia
BOB BEAUPREZ, Colorado
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana
DEVIN NUNES, California

                    Allison H. Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel

                                 ______

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                     DAVE CAMP, Michigan, Chairman

JERRY WELLER, Illinois               MICHAEL R. MCNULTY, New York
MARK FOLEY, Florida                  LLOYD DOGGETT, Texas
THOMAS M. REYNOLDS, New York         STEPHANIE TUBBS JONES, Ohio
ERIC CANTOR, Virginia                MIKE THOMPSON, California
JOHN LINDER, Georgia                 JOHN B. LARSON, Connecticut
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
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                            C O N T E N T S

                               __________

                                                                   Page

Advisory of April 19, 2006, announcing the hearing...............     2

                               WITNESSES

Desai, Mihir, Harvard Business School............................     5
Neubig, Thomas, Ernst & Young....................................    18
Pearlman, Ronald, Georgetown University Law Center...............    13
Shackelford, Douglas, University of North Carolina...............    24
Thompson Jr., Samuel, University of California, Los Angeles......    30

                                 ______

Business Roundtable, John Castellani.............................    65
PepsiCo, Inc., Matthew McKenna...................................    61
Loews Corporation, James Tisch...................................    54

                       SUBMISSIONS FOR THE RECORD

Affordable Housing Tax Credit Coalition, statement...............    83
American Forest and Paper Association, statement.................    86
Employee-Owned S Corporations of America, statement..............    89
Financial Executives International, statement....................    92
S Corporation Association, statement.............................   103


                    HEARING ON CORPORATE TAX REFORM

                              ----------                              


                          TUESDAY, MAY 9, 2006

             U.S. House of Representatives,
                       Committee on Ways and Means,
                   Subcommittee on Select Revenue Measures,
                                                    Washington, DC.

    The Subcommittee met, pursuant to notice, at 2:05 p.m., in 
room 1100, Longworth House Office Building, Hon. Dave Camp 
(Chairman of the Subcommittee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS

                SUBCOMMITTEE ON SELECT REVENUE MEASURES

                                                CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
April 19, 2006
SRM-8

                       Camp Announces Hearing on

                          Corporate Tax Reform

    Congressman Dave Camp (R-MI), Chairman, Subcommittee on Select 
Revenue Measures of the Committee on Ways and Means, today announced 
that the Subcommittee will hold a hearing on corporate tax reform. The 
hearing will take place on Tuesday, May 9, 2006, in the main Committee 
hearing room, 1100 Longworth House Office Building, beginning at 2:00 
p.m.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Subcommittee and 
for inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    A recent Congressional Budget Office (CBO) study shows that in 2003 
the United States has the third-highest statutory corporate tax rate 
among members of the Organization for Economic Co-operation and 
Development (OECD). Overall, the U.S. corporate tax system raised $278 
billion in 2005 (representing 2.3% of U.S. GDP). Despite this high tax 
rate, the amount of revenue as a percentage of GDP raised by the U.S. 
system is modest in comparison to other countries that employ lower 
corporate tax rates. In comparison to the U.S. model, corporate tax 
regimes in other OECD countries raise, on average, tax revenue equal to 
3.4% of their country's GDP.
      
    Further, it is observed that reporting requirements for income 
taxes are rapidly diverging from parallel requirements for purposes of 
financial reporting. This divergence greatly increases complexity for 
corporations. A large number of these book-tax differences can be 
attributed to specific tax-preference items which benefit narrow 
classes of taxpayer.
      
    In sum, critics argue that the U.S. corporate tax system taxes 
more, raises less revenue, and imposes significantly more complexity 
upon taxpayers than the tax code of competing countries.
      
    In announcing the hearing, Chairman Camp states, ``This hearing 
provides us with an opportunity to examine the current U.S. corporate 
tax system and the base upon which taxes are imposed. We seek to reform 
business taxation in a way which increases fairness, decreases 
complexity and improves the U.S. competitiveness on a global basis.''
      

FOCUS OF THE HEARING:

      
    The purpose of this hearing is to understand how tax-preference 
items within the corporate tax code reallocate the tax burden and 
whether these shifts are beneficial or detrimental to the U.S. economy. 
Of specific interest is to understand how the current system affects a 
company's decision of where and how to invest in technology, equipment 
and people.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
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FORMATTING REQUIREMENTS:

      
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noted above.

                                 

    Chairman CAMP. The hearing will come to order.
    Today's hearing continues our examination of tax reform 
issues. In this case, we seek to explore the role tax laws may 
play in influencing corporate investment and business 
development in the United States. The way we tax business 
activity, I think we all agree, impacts, how, in what quantity, 
and where jobs are created. We have an extremely distinguished 
group of witnesses from both the academic and business worlds 
with us today, and I am sure my colleagues join me in saying 
how much we appreciate their time.
    This hearing is simply to gather information. There is no 
predetermined or preferred outcome. Instead, we have asked our 
guests to examine certain influences business taxes provide. We 
can all agree that the Tax Code has grown more complex over the 
years, and making sure our tax system does not choke off 
economic growth requires us to explore how businesses react to 
tax law in today's economy.
    Our first panel includes distinguished academics and 
professionals from around the country, who will provide 
perspectives on subjects such as the effect of differences in 
tax and financial accounting, the importance of corporate 
rates, and incentives to expand investment. This is an 
opportunity to explore points of view on broad topics we will 
need to consider in any kind of reform program.
    Our second panel is comprised of businesspeople, who will 
give us insights on influences they see and face in making 
decisions about how and where to invest. This is a chance for 
us to ask questions about what really makes a difference when 
it comes to growth in jobs.
    This hearing is a chance to learn about what influences the 
economy. Every Member of this Subcommittee shares a desire for 
a smart tax system that will give this country a sustainable, 
robust economy. Our guests are well situated to help us in that 
quest, and with that, I turn to our Ranking Member, Mr. 
McNulty, for any remarks he may wish to make.
    Mr. MCNULTY. Thank you, Mr. Chairman. I also thank the 
panels.
    Reform of our corporate tax structure is an issue that has 
been discussed for years with little substantive progress. In 
January 2005, President Bush created the bipartisan President's 
Advisory Panel on Federal Tax Reform. On November 1, 2005, 
after 10 months of meetings and studies, the Panel issued its 
report to the Department of the Treasury for its consideration. 
I had hoped that Treasury would be our lead witness at the 
hearing today, to discuss the Department's views on the 
viability and appropriateness of the President's panel 
recommendations. Their decision not to testify today is 
disappointing.
    As we discuss corporate tax reform today, I must emphasize 
that our country continues to face record Federal deficits and 
that the national debt has ballooned to more than $8.3 billion. 
The Committee on the Budget has estimated that the deficit for 
fiscal year 2006 will be $372 billion and for fiscal year 2007 
will be $348 billion. For the sake of our children and 
grandchildren, this practice of deficit spending cannot be 
allowed to continue.
    I hope that this hearing and any future tax reform plan 
will not serve as platform for more tax cuts for corporations. 
We have an obligation to future generations to reduce the 
Federal deficit, not increase it. Finally, I want to thank 
Chairman Camp for working with me and the Democratic staff of 
the Subcommittee, on a bipartisan basis, to develop an 
excellent list of witnesses for this hearing. I look forward to 
our discussion of issues that must be considered in any future 
corporate tax reform package. Thank you, Mr. Chairman. I yield 
back the balance of my time.
    Chairman CAMP. Thank you very much, and now, we will go to 
our first panel. We have Mihir Desai, Ph.D. Associate Professor 
from Harvard Business School; Ronald Pearlman, Professor of Law 
at Georgetown University Law Center; Thomas Neubig, National 
Director of Quantitative Economics and Statistics at Ernst & 
Young; Douglas Shackelford, Professor of Taxation of 
Accounting, University of North Carolina; Samuel Thompson, Jr., 
Professor of Law and Director, Law Center, University of 
California, Los Angeles.
    Each of you will have 5 minutes to summarize your 
testimony. Your full testimony will be a part of the record. I 
want to thank you for taking the time out of your busy 
schedules to be with us today and want to welcome you to the 
Committee and look forward very much to hearing your testimony. 
Dr. Desai, why don't you begin?

 STATEMENT OF MIHIR A. DESAI, ASSOCIATE PROFESSOR OF FINANCE, 
                    HARVARD BUSINESS SCHOOL

    Dr. DESAI. Chairman Camp and Members of the Subcommittee, 
it is a pleasure to appear before you today to discuss reform 
alternatives for the corporate tax. I am an associate professor 
of finance at Harvard Business School and a faculty research 
fellow of the National Bureau of Economic Research.
    In these comments, I want to emphasize possibilities for 
corporate tax reform that do not involve fundamental tax reform 
or significant marginal tax rate reductions. While both 
fundamental tax reform and lower marginal rates are laudable 
for various, well understood reasons, I want to highlight three 
reforms to the corporate tax that are somewhat more piecemeal 
but still can yield significant economic benefits to the 
country. I believe that reforming the corporate tax as outlined 
in my comments will generate significant efficiency gains, 
would improve the competitive position of American firms in the 
worldwide markets in which they operate, and would create a 
more transparent and cost-effective reporting system for 
American firms and investors.
    Three changes to the corporate tax are discussed at length 
in my written testimony, and I briefly summarize them here. 
First, capital gains earned by corporations are currently 
penalized in an anomalous way relative to intercompany 
dividends and relative to individual capital gains. 
Effectively, the current system of corporate capital gains 
taxation creates a third layer of taxation on capital.
    While intercompany dividends are afforded relief through 
the dividends received through deductions, puzzlingly, no such 
relief exists for capital gains earned by corporations. For 
companies with large gains, this creates a significant 
disincentive to reinvest these gains in new projects, 
effectively locking up this capital. This system significantly 
influences business investment, as estimates indicate that 
American corporations hold over $800 billion in unrealized 
corporate capital gains.
    This anomalous treatment also stands in contrast to the 
approach adopted by several other countries. Unlocking these 
gains through even partial tax relief would result in 
reallocations of capital toward more productive uses that would 
generate efficiency gains that are estimated to be as high as 
$20 billion a year.
    Second, the system of taxing foreign source income, or the 
income earned by multinational firms abroad, should be 
reconsidered. Foreign operations are increasingly important to 
American firms, with more than 30 to 40 percent of corporate 
profits coming from their tightly integrated global operations. 
With the growth of markets abroad, these shares will only rise 
further.
    The annual burden of the current worldwide system of 
taxation on American firms is conservatively estimated in my 
research at $50 billion a year. The current worldwide system of 
taxation conforms neither to traditional efficiency benchmarks 
or to more recent measures grounded in modern notions of 
multinational decisionmaking. In particular, recent research 
highlights that international tax rules distort which companies 
own what assets and that these distortions matter for 
productivity and efficiency. For example, assets that should be 
owned by the most productive owner are not because of tax 
distortions associated with the country of origin of that 
owner. Something that should be owned by Wal-Mart because of 
tax considerations is instead owned by a French company, 
Carfour. An emphasis on these distortions to ownership patterns 
provides a rationale for a move toward a territorial system of 
taxation that would bring the United States closer to the 
system employed by many other countries.
    Finally, the reporting system used in corporate taxation 
should be restructured to bring reporting to tax authorities in 
line with reporting to capital markets. Currently, corporations 
must characterize their income in two distinct ways to tax 
authorities and capital markets, the so-called dual books 
system. Reconciliation of these reports is only available to 
tax authorities. Unsurprisingly, this has resulted in two 
completely different portraits of profitability.
    This dual system creates significant confusion, as it is 
impossible to infer corporate tax payments from public 
financial statements or, for that matter, to truly understand 
corporate profitability. Imagine if something that represented 
one-third of a company's costs was hidden to investors. This is 
what the current system effectively does. This system also 
creates latitude for opportunistic managers to take advantage 
of the discrepancy in a way that does not advance the interests 
of shareholders.
    At a minimum, reporting taxes paid in public financial 
statements is advisable. More ambitiously, corporations could 
simply pay taxes on income reported according to GAAP. 
Significant compliance costs currently incurred would be nearly 
eliminated. The top marginal corporate tax rate could be 
reduced significantly to 15 percent without a loss of revenue, 
and actions designed to exploit differences between these two 
different reporting systems would be eliminated.
    Significant opportunities for corporate tax reform exist by 
reconsidering the base of corporate taxation; in particular, 
the treatment of corporate capital gains and foreign source 
income, and by reconsidering the curious reporting practices 
for corporate profits. These changes, while piecemeal relative 
to fundamental tax reform, still have sizeable consequences for 
economic efficiency that will be manifest in more productive 
allocations of capital, reduced compliance costs, and 
ultimately in greater incomes for American workers.
    Thank you for this opportunity, and my written testimony 
elaborates these points with references to the underlying 
research.
    [The prepared statement of Dr. Desai follows:]

         Statement of Mihir Desai, Ph.D., Associate Professor,
           Harvard Business School, Cambridge, Massachusetts

    Chairman Camp and members of the Subcommittee, it is a pleasure to 
appear before you today to discuss reform alternatives for the 
corporate tax. I am an Associate Professor of Finance at Harvard 
Business School and a Faculty Research Fellow of the National Bureau of 
Economic Research.
    In these comments, I want to emphasize possibilities for corporate 
tax reform that do not involve fundamental tax reform or significant 
marginal tax rate reductions. While both fundamental tax reform and 
lower marginal rates are laudable for various well-understood reasons, 
I want to highlight three reforms to the corporate tax that are 
somewhat more piecemeal but still can yield significant economic 
benefits to the country. I believe that reforming the corporate tax as 
outlined below would generate significant efficiency gains, would 
improve the competitive position of American firms in the worldwide 
markets in which they operate, and would create a more transparent and 
cost-effective reporting system for American firms and investors.
    Three changes to the corporate tax are discussed at length below 
and I briefly summarize them here.
    First, capital gains earned by corporations are currently penalized 
in an anomalous way relative to intercompany dividends and relative to 
individual capital gains. Effectively, the current system of corporate 
capital gains taxation creates a third layer of taxation on capital. 
This system significantly influences business investment as estimates 
indicate that American corporations hold over $800 billion in 
unrealized corporate capital gains. This anomalous treatment also 
stands in contrast to the approach adopted by several other countries. 
Unlocking these gains through even partial tax relief would result in 
reallocations of capital toward more productive uses that would 
generate efficiency gains that are estimated to be as high as $20 
billion a year.
    Second, the worldwide system of taxing foreign source income--or 
the income earned by multinational firms abroad--should be 
reconsidered. Foreign operations are increasingly important to American 
firms with more than thirty percent of profits coming from their global 
operations. The annual burden of the current system on American firms 
is conservatively estimated in our research at $50 billion a year. The 
current system conforms neither to traditional efficiency benchmarks 
nor to more recent measures grounded in modern notions of multinational 
decision-making. In particular, recent research highlights that 
international tax rules distort which companies own what assets and 
that these distortions matter for productivity and efficiency. An 
emphasis on these distortions to ownership patterns provides a 
rationale for a move toward a territorial system of taxation that would 
bring the U.S. closer to the system employed by many other countries.
    Finally, the reporting system used in corporate taxation should be 
restructured to bring reporting to tax authorities in line with 
reporting to capital markets. Currently, corporations must characterize 
their income in two significantly different ways to tax authorities and 
capital markets. Unsurprisingly, this has resulted in two completely 
different portraits of profitability. This dual system creates 
significant confusion as it is impossible to infer corporate tax 
payments from public financial statements or to truly understand 
corporate profitability. This system also creates latitude for 
opportunistic managers to take advantage of this discrepancy in a way 
that does not advance the interests of shareholders. At a minimum, 
reporting taxes paid in public financial statements is advisable. More 
ambitiously, if corporations simply paid taxes on reported GAAP income, 
significant compliance costs would be nearly eliminated, the top 
marginal corporate tax rate could be reduced significantly to 15% 
without a loss of revenue, and actions designed to exploit differences 
between these two reporting systems would be eliminated.
    Significant opportunities for corporate tax reform exist by 
reconsidering the base of corporate taxation--in particular, the 
treatment of corporate capital gains and foreign source income--and by 
reconsidering the curious reporting practices for corporate profits. 
These changes, while piecemeal relative to fundamental tax reform, 
still have sizable consequences for economic efficiency that would be 
manifest in more productive allocations of capital, reduced compliance 
costs, and, ultimately, in greater incomes for American workers.
I. Fixing the anomalous treatment of corporate capital gains \1\
---------------------------------------------------------------------------
    \1\ See Desai and Gentry (2003) and Desai (2006) for more details.
---------------------------------------------------------------------------
    The appropriate taxation of capital income has preoccupied policy 
makers and scholars for the last half century. Within this debate, the 
taxation of capital gains has been a central topic. Surprisingly, this 
emphasis on capital gains has been limited to the role of capital gains 
at the individual level rather than at the corporate level. This 
asymmetry may have arisen due to a perception, unsupported by the 
evidence, that corporate capital gains were of a small magnitude 
relative to other sources of corporate income or relative to individual 
capital gains. In fact, reviewing the magnitude of corporate capital 
gains, the distortionary effects of corporate capital gains taxation, 
and the efficiency and revenue consequences of alternative treatments 
of corporate capital gains recommends a reconsideration of this aspect 
of the tax code.
    Corporate capital gains make up an increasingly large portion of 
corporate income, now comprising approximately 20% of corporate income 
subject to tax, and one third of the dollar amount of taxable 
individual capital gains. The late 1990s and early 2000s saw a 
significant increase in the level of unrealized corporate capital 
gains. A modest estimate of unrealized corporate capital gains exceeds 
$800 billion.
    When considered within the broader nature of capital taxation, the 
current system of taxing corporate capital gains appears anomalous. In 
particular, dividends and capital gains earned by corporations are 
treated asymmetrically, and the absence of relief for corporate capital 
gains results in a third level of taxation on capital income. 
Individual capital gains are taxed at preferential rates, in 
recognition of the importance of encouraging corporate investment and 
mitigating the impact of situations in which investors are ``locked 
into'' investments they would prefer to sell were it not for the 
associated capital gains taxes. Despite both considerations applying 
with equal or greater force to corporate investments, corporate capital 
gains are currently taxed at ordinary income rates. Many other 
countries exempt from tax corporate capital gains or tax them at 
preferential rates, further contributing to the anomalous nature of 
current U.S. tax policies.
    The corporate capital gains tax has a variety of distortionary 
effects in addition to those usually considered with respect to the 
individual capital gains tax. For example, foreign and domestic 
investors are taxed differently, thereby affecting the pattern of asset 
ownership. Additionally, corporations respond to the corporate capital 
gains tax with a variety of tax planning activities that have 
distortionary effects.
    A variety of alternatives exist to the current practice of taxing 
corporate capital gains at the same rate as ordinary income. The 
efficacy of any alternative depends on the responsiveness of corporate 
capital gains realizations to tax rates. Measured elasticities of 
corporate capital gains realizations to tax rates are higher than 
individual elasticities, giving rise to greater potential efficiency 
gains associated with reduced tax rates. The reduced ``lock-in effect'' 
associated with a reduction in the corporate capital gains tax rate to 
15% would produce annual efficiency gains of $16.7 billion a year. 
Repealing the corporate capital gains tax entirely would eliminate the 
``lock-in effect'' and thereby produce an efficiency gain of $20.4 
billion a year. In addition, these reduced corporate capital gains tax 
rates would generally reduce the tax burden on corporations, improving 
efficiency by encouraging greater corporate investment.
    While seemingly abstract, these large efficiency gains can be 
understood as a measure of economic surplus or income that is currently 
foregone because of the presence of this taxation. These improvements 
in economic efficiency correspond to increases in national income and 
corresponding increases in wages. Tax relief of various stripes has the 
potential to generate sizable efficiency gains relative to lost tax 
revenue. Several features of corporate capital gains taxes suggest that 
corporate capital gains tax relief has the potential to produce 
significant efficiency gains. The greater responsiveness of 
corporations to taxation, interactions with other financing frictions, 
and the preexisting distortions in the taxation of capital income 
suggest that alternative, less onerous treatments of corporate capital 
gains have the potential to yield greater efficiency gains, relative to 
revenue consequences, than other sources of tax relief.
II. Reconsidering the worldwide system of taxation \2\
---------------------------------------------------------------------------
    \2\ This section draws on Desai and Hines (2004) and the details of 
the efficiency calculations can be found there. Other arguments for 
reconsidering the tax treatment of foreign source income can also be 
found at Desai (2004) and the slides entitled ``Taxation and Global 
Competitiveness'' prepared for the President's Advisory Panel on 
Federal Taxation available at www.taxreformpanel.gov/meetings/docs/
desai.ppt.
---------------------------------------------------------------------------
    Markets and economies evolve continuously, making yesterday's tax 
solutions possibly much less efficient or desirable today. Time also 
brings changes in our understanding of the impact, and wisdom, of 
different tax choices, again carrying the message that what might have 
seemed to work for yesterday may not be sensible today. A rapidly 
integrating world and a wave of recent scholarship on multinational 
firms combine to suggest that the mismatch between yesterday's tax 
policy and today's reality is particularly pronounced with respect to 
international taxation.
    The rising economic importance of international transactions has 
put increasing pressure on corporate tax systems to accommodate foreign 
considerations. This accommodation has not been an easy or simple 
process. In many countries, particularly high-income countries such as 
the United States, corporate tax provisions are designed on the basis 
of domestic considerations. Subsequently, modifications intended to 
address problems and opportunities that arise due to global capital and 
goods markets are incorporated, often as afterthoughts. While such a 
method of policy development has the potential to arrive at sensible 
outcomes, doing so requires greater degrees of luck and patience than 
most would care to attribute to existing political systems.
    Several recent developments have contributed to a growing sense of 
unease over the structure of U.S. corporate taxation, particularly its 
international provisions, and have prompted calls for reform. The 
European Union successfully challenged export subsidies embedded in the 
U.S. corporate income tax, leading the World Trade Organization to 
authorize tariffs on American exports. Reported cases of corporate 
malfeasance and the aggressive use of tax shelters have drawn attention 
to the tax avoidance activities of many corporations, with particular 
attention on the role of tax havens. The difficulty of spurring 
investment through traditional channels has frustrated policymakers 
intent on reversing the large loss in manufacturing jobs in the early 
2000s. These events have each contributed to an increasing 
dissatisfaction with the structure of corporate taxation, and at the 
same time reflect the insufficiency of evaluating corporate taxes on 
the basis of strictly domestic considerations. The international tax 
provisions at the center of the trade dispute are emblematic of 
immensely complex international rules appended to a corporate tax 
system designed primarily with domestic activity in mind.
    Successful corporate tax reform requires the corporate income tax 
to be placed firmly in an international setting, which is not currently 
the case in the United States. To be sure, the U.S. corporate income 
tax includes many provisions concerning the taxation of foreign income, 
but these provisions largely reflect attempts to apply the logic of 
domestic taxation to foreign circumstances. As a consequence, the 
current U.S. corporate income tax includes foreign provisions that 
distort taxpayer behavior and impose significant burdens on 
international business activity, particularly given the greater 
mobility of international business activity. A simple framework for 
considering the burden of this tax system indicates that the current 
system imposes a burden of approximately $50 billion a year.
    Assessing the burden of the current system is useful but does not 
provide guidance on how international considerations might be better 
incorporated into a reform of corporate taxation. Incorporating 
realistic assumptions about the nature of multinational firm activity 
yields some novel analyses of what constitutes efficient systems. These 
analyses imply that efficiency requires that foreign investment income 
face no residual tax upon repatriation. From the standpoint of 
countries (such as the United States) that employ a worldwide regime 
and impose residual repatriation taxes, a reduction in the tax burden 
on foreign income would not only improve national welfare but also 
improve world welfare. Consequently, a movement to reform corporate 
taxation in the direction of exempting foreign income has a compelling 
logic. Of course, the history of taxation in the United States and 
elsewhere offers many examples of persistent differences between what 
countries do and what they should do. Nonetheless, thinking clearly 
about the burden of the current system and the appropriate efficiency 
benchmarks provides the foundation for closing the gap between old 
rules and new realities.
    In order to evaluate the wisdom of current U.S. taxation of foreign 
income it is necessary to consider appropriate welfare standards. While 
there is a timeless quality to the economic principles that form the 
basis of efficient tax policy design, the application of these 
principles to the taxation of foreign income has varied over time, and 
in particular, has undergone a significant recent change. Until 
recently, three benchmarks were commonly used to evaluate the 
efficiency of international tax systems: capital export neutrality 
(CEN), national neutrality (NN) and capital import neutrality (CIN).
    CEN is the doctrine that the return to capital should be taxed at 
the same total rate regardless of investment location, with the idea 
that adherence to CEN promotes world welfare. A system of worldwide 
taxation with unlimited foreign tax credits satisfies CEN, since then 
foreign and domestic investments are all effectively subject to the 
same (home country) tax rate, and firms that maximize after-tax returns 
under such a system thereby also maximize pretax returns. NN is the 
doctrine that foreign investment income should be subject to home 
country taxation with only a deduction for foreign taxes paid. The idea 
behind NN is that home countries promote their own welfare by 
subjecting foreign income to double taxation, thereby discouraging all 
but the most productive foreign investments, and retaining investment 
capital for use at home. Thirdly, CIN emphasizes that the return to 
capital should be taxed at the same total rate regardless of the 
residence of the investor. Pure source-based taxation is consistent 
with CIN, as long as individual income tax rates are harmonized to 
ensure that the combined tax burden on saving and investment does not 
differ among investors residing in different countries.
    These traditional welfare benchmarks suffer from a number of 
shortcomings. CIN offers little guidance for the design of a single 
country's system of taxing foreign income, since its application 
requires simultaneous consideration and coordination of corporate and 
personal taxes in all countries in the world. While CEN and NN do not 
suffer from this shortcoming, they have other worrisome features. Tax 
policies adopted by other countries matter not at all in determining 
whether a country's tax system conforms to CEN, which seems an unlikely 
feature of a benchmark that is intended to characterize policies that 
promote global efficiency. Tax policies that implement NN would subject 
foreign investment income to punishing home country taxation, thereby 
discouraging multinational business operations and, as a realistic 
matter, more likely reduce rather than advance home country welfare. As 
an empirical matter, such policies have not been adopted by any major 
capital-exporting nation. Moreover, a very common policy approach--
exempting foreign income from taxation--is incongruent with any of 
these welfare benchmarks.
    CEN, NN, and CIN rely on the intuition that FDI represents the 
transfer of net savings between countries. This characterization of FDI 
was discarded long ago by the scholarly community that studies 
multinational firms. Instead, modern scholars view FDI as arising from 
differential capabilities, and consequently differential productivity, 
among firms, and the extension of intangible assets across borders. 
This intuition squares well with empirical FDI patterns, which include 
the fact that most of the world's FDI represents investment from one 
high-income country into another, and the fact that a very high 
fraction of such investment takes the form of acquiring existing 
businesses. Consequently, most FDI represents transfers of control and 
ownership, and need not involve transfers of net savings. This emphasis 
on transfers of ownership, and the productivity differences that drive 
ownership patterns, implies that CEN, NN, and CIN do not characterize 
optimal tax systems, whereas other welfare benchmarks do. The modern 
view of FDI as arising from productivity differences among firms, with 
ownership changes taking the form of FDI, raises the possibility that 
greater outbound FDI need not be associated with reduced domestic 
investment. Indeed, it is conceivable that greater outbound FDI is 
associated with greater domestic investment, either by home country 
firms undertaking the FDI or by unrelated foreign investors. Under this 
view, in short, multinational firms are not engaged in the reallocation 
of the capital stock as much as they are engaged in the reallocation of 
ownership and control of existing capital stocks.
    This emphasis on ownership suggests that tax policies should be 
evaluated on the basis of their effects on the allocation of ownership 
of productive assets. Global efficiency is characterized by ownership 
arrangements that maximize total world output, whereas national welfare 
(taking the tax policies of other countries as given) is characterized 
by tax policies that maximize home country incomes. This perspective 
yields the welfare benchmarks of capital ownership neutrality (CON) and 
national ownership neutrality (NON), in which CON is a direct analogue 
to CEN, and NON a direct analogue to NN. CON requires that tax rules 
not distort ownership patterns, which is equivalent to ownership of an 
asset residing with the potential buyer who has the highest reservation 
price in the absence of tax differences. As a practical matter, CON is 
satisfied by conformity among tax systems, including situations in 
which all countries exempt foreign income from taxation, and situations 
in which all countries tax foreign incomes while providing complete 
foreign tax credits. The national welfare considerations that form the 
basis of NON suggest, much as is evident in practice, that countries 
should want to exempt foreign income from taxation. This policy 
prescription stems from the observation that outbound foreign 
investment need not be accompanied by reduced domestic investment in a 
world of shifting ownership patterns. As a result, countries have 
incentives to select tax rules that maximize the productivity of 
foreign and domestic investment, since doing so improves tax 
collections as well as private incomes. When both capital stocks and 
ownership claims are affected by tax rules, then NON need not 
correspond exactly to maximizing national welfare, and home countries 
might benefit from imposing modest taxes on foreign investment.
    The CON/NON framework places productivity differences among 
multinational owners, and the transfers of control induced by tax 
rules, front and center in analyzing the efficiency of taxation. The 
relevance of such a framework depends on the degree to which such 
differences matter relative to the actual transfers of net saving 
emphasized in the CEN/NN/CIN framework. That scholars who study 
multinationals have dismissed the view of FDI as transfers of net 
savings as neither satisfying theoretically nor confirmed empirically 
suggests that employing welfare frameworks that rely exclusively on 
such notions is incomplete at best. That incorporation of modern 
interpretations of FDI produces tax policies that countries actually 
use further suggests the importance of these alternative frameworks.
    The CON/NON paradigms carry direct implications for U.S. taxation 
of foreign income. The NON logic implies that the United States would 
improve its own welfare by exempting foreign income from taxation, 
rather than, as it does now, subjecting foreign income to taxation 
imposing significant burdens on American firms. In addition, should it 
be relevant to American policy, CON implies that a reduction of U.S. 
taxation of foreign income would improve world welfare by moving U.S. 
taxation more in the direction of other countries that currently 
subject foreign income to little or no taxation.
    Improving the taxation of foreign investment income requires 
abandoning the notion of international tax provisions as appendages to 
a domestic corporate tax. At first glance it is perfectly logical to 
posit that, given that the U.S. tax system requires American companies 
to remit 35 percent of their taxable incomes to the U.S. government, 
the same type of taxation should apply to foreign income. 
Unfortunately, the realities of a competitive world capital market 
suggest otherwise. U.S. taxation of foreign income impairs the 
productivity of American firms in the global marketplace, and 
interestingly, impairs the productivity of investments located in the 
United States, since it distorts ownership patterns by foreign 
investors as well as Americans.
    It would appear that the current taxation of foreign income, a 
product of many complex appendages to the domestic corporate tax, 
imposes significant burdens on U.S. firms. The simple framework 
developed above suggests that the annual burden on American firms is 
conservatively estimated at $50 billion a year. The current U.S. tax 
regime conforms neither to traditional efficiency benchmarks nor to 
more recent measures grounded in modern notions of multinational 
decision-making. Ownership based concepts of efficiency imply that 
national and world welfare would be advanced by reducing U.S. taxation 
of foreign income, thereby permitting taxpayers and the country to 
benefit from greater market-based allocation of resources to the most 
productive owners.
III. Revisiting the Dual Reporting System \3\
---------------------------------------------------------------------------
    \3\ For a more detailed discussion of the dual book system and the 
gaps between profits reported to capital markets and tax authorities, 
see Desai (2003, 2005). For a discussion of the ways in which earnings 
manipulation and tax avoidance are related, Desai and Dharmapala (2005, 
2006a, 2006b). For international evidence on these links, see Desai, 
Dyck and Zingales (2005).
---------------------------------------------------------------------------
    IRS Commissioner Mark Everson and SEC Chairman Christopher Cox have 
advanced a remarkably simple, but controversial, proposal. Discussions 
are underway to have companies publicly disclose how much they pay in 
taxes. Remarkably, the amount corporations pay in taxes is impossible 
to decipher from annual reports. Their proposal, which will likely meet 
fierce opposition from accountants, lawyers and managers, is a laudable 
first step in restoring some sanity to the way corporate profits are 
reported to tax authorities and the capital markets.
    Given that thirty-five cents of every pretax dollar is supposed to 
go the government, one would think that this figure would be easily 
deduced or that it would be clearly reported. Leading accounting 
scholars have reviewed the intricacies of tax footnotes of leading 
companies and cannot answer a simple question: how much did this 
company pay in taxes? This raises a much larger question: How did we 
end up in a world where something as important as the amount of taxes 
paid was obscured from investors?
     When the corporate tax was introduced, making reporting profits 
more credible was a central goal. Indeed, the profits reported to tax 
authorities and capital markets were essentially the same. As the 
corporate tax evolved, well-considered exceptions--such as the way 
investment was expensed--were introduced to permit fiscal policy goals. 
An investment stimulus might involve accelerating those expenses to 
make investment more attractive while accounting standards wouldn't 
permit such a treatment.
    In the last decade, the two reporting systems have developed into 
parallel universes. Large, unexplained gaps--more than $100 billion--
have developed between the profits reported to capital markets and tax 
authorities that can no longer be explained by accepted differences 
between the two reporting systems.
    In fact, we shouldn't be surprised by these developments. Imagine 
if you were allowed to represent your income to the IRS on your 1040 in 
one way and on your credit application to your mortgage lender in 
another way. You might, in a moment of weakness, account for your 
income in a particularly favorable light to your prospective lender and 
go to fewer pains to do so with the IRS. Indeed, you might take great 
liberties to portray your economic situation in two divergent ways that 
would serve your best interests. You might find yourself coming up with 
all kinds of curious rationalizations for why something is income (to 
the lender) or an expense (to the tax authorities).
    In fact, you don't have this opportunity and for good reason. Your 
lender can rest assured that the 1040 they review in deciding whether 
you are credit-worthy would not overly inflate your earnings given your 
desire to minimize taxes. Similarly, tax authorities can rely on the 
use of the 1040 for other purposes to limit the degree of income 
understatement given your need for capital. In that sense, the 
uniformity with which you are forced to characterize your economic 
situation provides a natural limit on opportunistic behavior.
    While individuals are not faced with this perplexing choice of how 
to characterize your income depending on the audience, corporations do 
find themselves in this curious situation. Dual books for accounting 
and tax purposes are standard in corporate America and, judging from 
recent analysis, are the province of much creative decision-making. 
Indeed, something as simple as interest expense on debt can be 
engineered to appear as an expense to tax authorities and a dividend to 
the capital markets.
    This confusing state of affairs has naturally drawn the attention 
of tax authorities, given the loss of tax revenues, but why is the SEC 
interested? Indeed, investors might be thought to benefit from lower 
taxes paid to the government. This simple logic doesn't account for the 
fact that managers don't always do the right thing for shareholders. If 
managers are opportunistic, then the extra latitude afforded by the 
dual reporting system can be costly to investors.
    Indeed, research shows just that--actions associated with corporate 
tax avoidance are not valued by the market unless the firms are well-
governed. And, the actors in various corporate scandals--including 
Enron and Tyco--were expert in exploiting the dual tax system to 
manufacture accounting earnings. No corporate tax shelter was ever 
undertaken that reduced book income and, often, the primary benefit of 
a corporate tax shelter is the reported income it produces.\4\
---------------------------------------------------------------------------
    \4\ For a specific discussion of Enron, Tyco and Xerox, see Desai 
(2005) and for a discussion of Dynegy, see Desai and Dharmapala (2006a, 
2006b).
---------------------------------------------------------------------------
    The proposal to publicly report taxes paid is an eminently sensible 
idea. More ambitious alternatives should also be considered. Corporate 
tax returns could be made public so shareholders could benefit from the 
additional information. More ambitiously still, we could junk the dual 
book system and simply allow corporations to pay taxes, at a lower 
rate, on the profits they report to capital markets. Such a change 
would save corporations and the governments the considerable resources 
now dedicated to compliance and allow for a lower marginal rate. Rough 
estimates, elaborated on in Desai (2005), suggest that a 15% tax on 
reported profits would generate the same revenues as the corporate tax 
does now. Such a change would embody a central lesson of economics--the 
virtues of tax with a lower rate on a more sensible base.
                                 ______
                                 
References
    Desai, Mihir A. 2003. ``The Divergence Between Book Income and Tax 
Income.'' In James Poterba, ed., Tax Policy and the Economy (17). 
Cambridge, MA: MIT Press, 169-206.
    Desai, Mihir A. 2004. ``New Foundations For Taxing Multinational 
Corporations.'' Taxes (March 2004): 41-49.
    Desai, Mihir A. 2005. ``The Degradation of Reported Corporate 
Profits.'' Journal of Economic Perspectives 19, no. 4 (Fall): 171-192.
    Desai, Mihir A. 2006. ``Taxing Corporate Capital Gains.'' Tax Notes 
110 (March): 1079-1092.
    Desai, Mihir A. and Dhammika Dharmapala. 2005. ``Corporate Tax 
Avoidance and Firm Value.'' Working Paper.
    Desai, Mihir A. and Dhammika Dharmapala. 2006a. ``Corporate Tax 
Avoidance and High Powered Incentives.'' Journal of Financial Economics 
79, no. 1 (January): 145-179.
    Desai, Mihir A. and Dhammika Dharmapala. 2006b. ``Earnings 
Manipulation and Corporate Tax Shelters.'' Working Paper.
    Desai, Mihir A., Alexander Dyck and Luigi Zingales. 2005. ``Theft 
and Taxes.'' NBER Working Paper No. 10978.
    Desai, Mihir A. and William M. Gentry. 2003. ``The Character and 
Determinants of Corporate Capital Gains.'' In James Poterba, ed., Tax 
Policy and the Economy (18). Cambridge, MA: MIT Press, 1-36.
    Desai, Mihir A. and James R. Hines, Jr. 2004. ``Old Rules and New 
Realities: Corporate Tax Policy in a Global Setting.'' National Tax 
Journal 57, no. 4 (December): 967-960.

                                 

    Chairman CAMP. Thank you very much, Dr. Desai. Mr. 
Pearlman, you have 5 minutes.

 STATEMENT OF RONALD A. PEARLMAN, PROFESSOR OF LAW, GEORGETOWN 
                     UNIVERSITY LAW CENTER

    Mr. PEARLMAN. Thank you, Mr. Chairman, Members of the 
Subcommittee. I want to address a couple of topics briefly 
during my oral comments. The first relates to the seemingly 
age-old question of whether Congress should improve the 
business tax system through targeted tax preferences or by 
means of a reduction in the corporate tax rate. My instinct is 
that the corporate tax rate reduction most often is preferable 
to an industry-specific or activity-specific tax preference, 
or, put another way I think the legislative default should be 
to eliminate tax preferences and lower corporate tax rates.
    I think most tax preferences suffer from three 
deficiencies. First, they disregard signals the market sends to 
a business and thus distorts business decisionmaking. Second, 
tax preferences tilt the playingfield in favor of the 
beneficiaries of the preference, thereby potentially 
disadvantaging others, including entrepreneurs in emerging 
industries or new technologies in the fierce competition for 
capital. Third, enactment of a new or a continuation of an 
existing tax preference implies that the preference provides a 
sufficient quantity of the desired behavior to justify the 
resulting reduction in tax revenues.
    Unfortunately, our collective knowledge of the 
effectiveness of targeted tax preferences is not well 
developed. Except for the usual ad hoc advantages offered by 
supporters, there is not much in the way of impartial empirical 
analysis supporting the incentive effects. One thing is 
certain: a tax preference that simply rewards behavior that 
would occur anyway is a waste of money.
    I encourage the Subcommittee to use the occasion of 
corporate tax reform to question existing tax preferences. Call 
it zero-based tax reform. Continuation of existing preferences 
would not be presumed; rather, supporters would have to explain 
why the alternative of a corporate rate reduction is not in the 
best interests of U.S. tax and economic policy.
    My second topic relates to the deductibility of interest 
expense on debt incurred by business taxpayers to finance the 
purchase of capital investment. I decided to discuss this topic 
because of the relationship between interest deductibility and 
the cost recovery rules that likely will be an important part 
of corporate tax reform projects.
    A pure income tax subjects a business to tax on its net 
economic income. It would include a depreciation system that 
enables a business taxpayer to properly recover its cost in an 
asset and would allow the taxpayer to deduct interest expense 
on debt incurred to finance the purchase of the asset. On the 
other hand, a pure consumption tax exempts income from capital 
from tax. The exemption is implemented in part by allowing 
business taxpayers to fully deduct the cost of a capital 
investment when incurred, a cost recovery approach known as 
expensing.
    The effect of expensing is to exempt income generated by 
the business asset from tax on a present value basis, assuming 
a constant rate of return and constant tax rates. Because of 
this tax exemption, it is inappropriate to permit the business 
taxpayer to deduct interest expense on debt incurred to finance 
the acquisition of the expensed asset.
    The Growth and Investment Tax Plan recently proposed by the 
President's Tax Reform Panel provides for the immediate 
expensing of new business investment, but importantly, it also 
would deny the deductibility of business interest. The panel 
report, indeed, refers to the disallowance of interest as an 
essential component of the plan.
    I expect cost recovery alternatives, including forms of 
accelerated depreciation and expensing, to be prime topics in a 
corporate tax reform discussion. Permit me to be speculate: 
expensing will be seen as good and the disallowance of interest 
as bad, leading to the possible enactment of a business tax 
package that contains a tax subsidy to which the President's 
panel referred. The result will be the emergence of a variety 
of tax shelters and other tax motivated activities that will 
pose a significant threat to the U.S. tax base.
    Distortions from tax preferences and the tax arbitrage for 
a combination of interest deductibility and accelerated 
depreciation or expensing encourage business taxpayers that do 
not have sufficient income to fully utilize the resulting tax 
benefits to transfer those benefits or at least to attempt to 
transfer those benefits to other taxpayers who can use them to 
reduce their tax liabilities or to merge with other taxpayers 
that are able to use them.
    I hope that tax reform of the business tax system will lead 
us in a more productive direction. Thank you.
    [The prepared statement of Mr. Pearlman follows:]

            Statement of Ronald Pearlman, Professor of Law,
                    Georgetown University Law Center

    Mr. Chairman and Members of the Subcommittee:
    My name is Ronald A. Pearlman. I am a Professor of Law at the 
Georgetown University Law Center, where I teach courses in Federal 
income taxation.
    It is a great privilege to appear before the Subcommittee today. I 
appear on my own behalf. My comments represent my personal views and 
not necessarily those of Georgetown University or any other 
organization with whom I am associated.
    I have appeared before the Subcommittee on two prior occasions to 
address issues relating to corporate tax reform. In 1983, as a 
representative of the Treasury Department, I discussed problems with 
the carryover of corporate net operating losses and other tax 
attributes, and in 1985, I discussed factors relating to the then-
current wave of corporate mergers. Today, I would like to comment on 
two tax reform topics that, at least on the surface, appear to be quite 
different than the subjects of my prior testimony.
Business Tax Preferences
    The first topic that I wish to address involves the recurring 
question whether Congress should provide tax relief to corporate 
taxpayers, by which I mean to include all business taxpayers regardless 
of their form of organization, through targeted tax preferences or by 
means of periodic reductions in the corporate tax rate.
    My instinct, informed by 27 years of experience as a practicing tax 
lawyer advising clients in many different industries, and ranging in 
size from small closely-held businesses to large multinational 
corporations, and by 10 years of assorted tax-related government 
service, is that corporate tax rate reduction most often is preferable 
to the enactment of industry-specific or activity-specific tax 
preferences. Put another way, I think the legislative default policy 
should be to eliminate tax preferences and lower corporate tax rates.
    In May 1985, President Reagan transmitted to the Congress the 
recommendations that served as the impetus for enactment of the Tax 
Reform Act of 1986. The summary of President Reagan's proposals stated, 
``The tax system should, insofar as possible, foster economic growth by 
. . . allowing resources to be allocated efficiently on the basis of 
economic rather than tax considerations.'' In furtherance of this 
efficiency objective, the Report went onto say, ``Special subsidies or 
preferences for specific industries or sectors should be curtailed 
except where there is a clear national security interest that argues to 
the contrary.'' \1\
---------------------------------------------------------------------------
    \1\ The President's Tax Proposals to the Congress for Fairness, 
Growth, and Simplicity 5-6 (Gov't Printing Office, May 1985).
---------------------------------------------------------------------------
    Why was efficiency so important to President Reagan? I think it was 
because he understood that by altering incentives, an industry-specific 
or an activity-specific tax preference will cause business taxpayers to 
disregard market forces--or at least alter the influence of market 
competition on their decisions--thereby adversely affecting the 
allocation of resources of the particular business and of the Nation.
    Not only is a distortion in the business decision making process 
likely to impose costs on the economy, it also tilts the playing field 
in favor of one group of businesses over another. The financial 
advantage of a narrow tax preference may influence how third parties--
lenders and equity investors, for example--evaluate competing 
businesses. The tax preference thereby may create an inappropriate 
advantage in the marketplace that discourages entrepreneurs in emerging 
industries or technologies who do not enjoy a comparable tax advantage 
from successfully competing for capital, thereby stifling U.S. economic 
growth.
    While I admit to a bias in favor of President Reagan's approach to 
tax reform because of my involvement in the development of the 
Administration's proposals and my advocacy for their enactment before 
the Ways and Means Committee, I think our tax system would be much 
improved if the tax law today more fully reflected his philosophy. 
However, one does not have to accept a market efficiency analysis to 
question the appropriateness of narrow business tax preferences.
    We might tolerate the economic distortion resulting from a 
particular preference if we could be reasonably certain that it 
produces a sufficient quantity of the desired behavior over and above 
the behavior that would occur absent the existence of the preference. 
To the extent a tax preference provides a tax subsidy for behavior that 
would occur anyway, the subsidy is a waste of money that could be 
expended more productively on new or existing programs, to reduce the 
deficit, or to provide broad-based tax relief.
    Unfortunately, our collective knowledge of the effectiveness of 
targeted tax preferences is not well developed. Recently, the Director 
of Strategic Issues for the Government Accountability Office was 
reported to have bemoaned the lack of research on the true effect of 
tax incentives.\2\ Supporters of a tax preference typically point to an 
assortment of ad hoc examples of the positive impact of the preference 
and to self-serving supportive assertions by executives about the 
incentive effect. In the absence of a body of unbiased research 
regarding the effectiveness of tax preferences or a negative analysis 
by opponents of a particular preference, Members of Congress, under the 
pressure of the tax legislative process, understandably tend to accept 
supportive information as a validation of the preference's 
effectiveness.
---------------------------------------------------------------------------
    \2\ Allen Kenney & Dustin Stamper, ``Panelists Debate Role, Value 
of Tax Incentives,'' 2006 TNT 68-3 (April 10, 2006).
---------------------------------------------------------------------------
    The U.S. business tax system is replete with targeted tax 
preferences. Some are narrowly targeted, some more broadly. However, in 
every case, one class of business taxpayers is preferred over another. 
In the aggregate, the revenue effects of these preferences are 
substantial. Take for example a small group of tax credits: the credit 
for increasing research activities, popularly known as the research and 
development or ``R&D'' tax credit (Section 41 of the Internal Revenue 
Code); the low-income housing credit ( 42); the renewable electricity 
production credit ( 45); and the nonconventional source fuel credit, 
more commonly referred to as the Section 29 credit even though the 
section reference is out of date ( 45K). Assuming extension of the R&D 
credit, the combined projected revenue effect of these four credits for 
a single year (F/Y 2007) is approximately $13.7 billion, and the five-
year effect is approximately $81.6 billion.\3\
---------------------------------------------------------------------------
    \3\ These numbers are based on the revenue effects of  41, 45, 
and 45K reported in Joint Committee on Taxation, Estimates Of Federal 
Tax Expenditures For Fiscal Years 2006-2010 (JCS-2-06) (April 26, 
2006), and my rough guess of annual and five-year revenue effects based 
on the Joint Committee on Taxation's $3.2 billion estimated effect in 
2007 of a one-year extension of the R&D credit as passed by the House 
in H.R. 4297, the Tax Relief Extension Reconciliation Act of 2005 (JCX-
10-06) (February 9, 2006).
---------------------------------------------------------------------------
    Why would it not be appropriate to compare the potential economic 
effects of retaining the credits or alternatively financing a reduction 
in the corporate tax rate with the revenues generated by repeal of the 
credits? I am not so naive to assume that there is any realistic chance 
repeal will occur. Nevertheless, supporters of existing, as well as 
proposed, business tax preferences should be forced to justify why the 
alternative of a corporate rate reduction is not in the best interests 
of U.S. tax and economic policy. This Subcommittee is an ideal venue 
for carefully considering the continuing utility of these and other tax 
preferences. To those who say that $13.7 billion is not sufficient 
revenue to effect a meaningful reduction in the corporate tax rate, I 
am confident that in response to the Subcommittee's request, the Staff 
of the Joint Committee on Taxation will provide a list of additional 
repeal candidates that would finance meaningful corporate tax rate 
reduction.
    There are two occasions in the tax legislative process when 
advocates of existing tax preferences may realistically be pressured to 
justify continuation of their preferences. One arises when Congress 
needs to increase tax revenues to reduce the deficit or offset other 
tax reductions. The other is when Congress undertakes a comprehensive 
review of present law in connection with broad-based tax reform. In 
anticipation of any corporate tax reform project in the Ways and Means 
Committee, I encourage the Subcommittee to seek the assistance of the 
Joint Committee on Taxation, the Congressional Budget Office, the 
Congressional Research Service, and General Accountability Office, as 
well as academic and private sector analysts, in carefully and, might I 
suggest boldly, reevaluating the appropriateness of existing business 
tax preferences. This exercise will not, and probably should not, 
result in the repeal of all of them. However, with Member support, it 
should serve to identify those provisions that no longer can be 
justified and assist in improving the effectiveness of those provisions 
that remain in the law.
Deductibility of Business Interest
    The second topic that I wish to discuss relates to the 
deductibility of interest expense on debt incurred by business 
taxpayers to finance the purchase of capital investment, including not 
only real and tangible property (plant, machinery and equipment), but 
also intangible property, such as patents, copyrights, and know-how.
    One important reason to consider the relevance of the deductibility 
of interest expense in the context of corporate tax reform relates to 
the problems under present law that result from characterization of 
corporate investment as debt or equity. However, I am motivated to 
discuss business interest expense today for a different reason, namely, 
because of the relationship between the deductibility of interest 
expense and the tax law cost recovery rules relating to debt-financed 
investments that I assume will be an important part of any corporate 
tax reform debate.
    ``Cost recovery'' refers to mechanisms by which a business taxpayer 
is entitled to reduce or offset otherwise taxable income by its 
investment in a business asset. Depreciation is an important form of 
cost recovery, as is the right of a taxpayer to offset its 
undepreciated investment, referred to as the asset's adjusted tax 
basis, against the consideration the taxpayer receives on the sale or 
other disposition of a business asset in calculating the gain or loss 
on the disposition. Other provisions of the Internal Revenue Code that 
might not appear to be cost recovery mechanisms are best analyzed as if 
they were. In particular, certain business tax credits, such as the R&D 
credit and the low-income housing tax credit, are calculated as a 
percentage of a taxpayer's relevant expenditures and, therefore, afford 
the taxpayer an added means of recovering a portion of its investment 
in property associated with the tax-preferred activity.
    A pure, or idealized, income tax subjects a business taxpayer to 
tax on its (net) economic income. In theory, a properly designed 
depreciation system under a pure income tax, known as ``economic 
depreciation,'' would enable a business taxpayer to recover its cost in 
a business asset by properly matching periodic depreciation deductions 
with income generated by the asset during the same period. Depreciation 
deductions would be calculated based on the economic useful life of the 
asset (that is, the period over which the asset is expected to be 
productive) and the actual decline in value of the asset in each 
period.\4\ To properly calculate the taxpayer's economic income, it 
also is appropriate under a pure income tax to allow the taxpayer to 
deduct interest expense related to debt incurred to finance the 
purchase of the asset, because the interest expense is an added cost of 
earning the income generated by the asset.
---------------------------------------------------------------------------
    \4\ In the purest of pure economic depreciation systems, 
depreciation deductions also would be adjusted to account for 
inflation.
---------------------------------------------------------------------------
    Under a pure consumption tax that is calculated by reference to 
sales or other income of a business (a cash-flow consumption tax; a 
subtraction-method value-added tax, such as the so-called Flat Tax or 
the Bradford X Tax; or an invoice-credit form of value-added tax), the 
cost of capital investments would be fully recovered at the time 
incurred either through a deduction equal to 100 percent of the asset's 
cost or, in the case of an invoice-credit value added tax, by means of 
a credit for prior taxes paid.
    Unlike a pure income tax, a consumption tax exempts income from 
capital from tax. This exemption is implemented at the business level 
of a consumption tax by allowing business taxpayers to fully deduct the 
cost of a capital investment when incurred, a cost recovery mechanism 
known as ``expensing.'' The effect of expensing is to exempt the income 
generated by the business asset from tax on a present value basis, 
assuming a constant rate of return and constant tax rates. This is so 
even if it appears that income generated by the asset is taxable 
because the taxpayer makes nominal tax payments to the government over 
the productive life of the asset. This analysis is know as the 
``immediate deduction-yield exemption equivalence'' and is based on 
work postulated in 1942 by an economist named E. Cary Brown.\5\
---------------------------------------------------------------------------
    \5\ See Alvin W. Warren, Jr., ``How Much Capital Income Taxed Under 
an Income Tax is Exempt Under a Cash Flow Tax?,'' 52 Tax L. Rev. 1 
(1996).
---------------------------------------------------------------------------
    Because income from business assets is deemed to be exempt from tax 
under a consumption tax by reason of the expensing of capital 
investment, it is inappropriate to also permit the business taxpayer to 
deduct interest expense on debt incurred to finance the purchase or 
development of the expensed asset. To do so would create a negative tax 
that would provide an improper government subsidy to the taxpayer. 
Consistent with this analysis, the Growth and Investment Tax Plan 
recently proposed by the President's Tax Reform Advisory Panel would 
allow immediate expensing of all new business investment, but also 
would eliminate the deductibility of business interest. The Panel's 
Report describes the proposal to deny the deduction of business 
interest as ``an essential component'' of the Plan.\6\ ``Allowing both 
expensing of new investments and an interest deduction would result in 
a net tax subsidy to new investment. Projects that would not be 
economical in a no-tax world might become viable just because of the 
tax subsidy. This would result in economic distortions and adversely 
impact economic activity.'' \7\
---------------------------------------------------------------------------
    \6\ The President's Advisory Panel on Federal Tax Reform, Simple, 
Fair, and Pro-Growth: Proposals to Fix America's Tax System 164 (Gov't 
Printing Office, November 2005).
    \7\ President's Advisory Panel Report, p. 164.
---------------------------------------------------------------------------
    Present law is not a pure income tax but, rather, a hybrid tax 
system that has both income tax and consumption tax characteristics. I 
will be surprised if a fundamental reform of present law will result in 
a new tax law that one could describe as ``pure.'' It is for this 
reason that I chose to raise the interest expense issue in my comments 
today.
    We have seen a trend in U.S. tax policy toward liberalized cost 
recovery. Depreciation under present law is accelerated, that is, it is 
faster than economic depreciation, and in some instances, the statute 
provides for immediate expensing of capital investment, a prominent 
example being the so-called small business expensing ( 179). 
Consumption tax proponents understandably identify expensing as a key 
element of any reform of the current tax system, and I would expect 
expensing or some form of accelerated depreciation would be considered 
as part of a reform of the business tax system.
    I am concerned that in the legislative sausage factory, expensing 
will be perceived as an attractive component of a business tax package 
but the disallowance of interest expense will not, leading to the 
possible enactment of the tax subsidy to which the President's Panel 
referred. This subsidy will encourage a variety of tax shelters and 
other tax-motivated activities that will pose a very significant threat 
to the tax base.
    If we could be certain that the interest income paid by business 
taxpayers would be subject to tax in the hands of the recipients, the 
revenue effect of the continued deductibility of interest expense would 
be of less concern, even though the distortive effects to which the 
President's Panel refers would continue to be troubling. However, we 
know that a sizeable portion of interest income is exempt from U.S. tax 
because corporate debt is owned by so-called tax-indifferent parties, 
including foreign lenders that are not subject to U.S. tax. In 1989, 
the Joint Committee on Taxation reported that, based on 1987 data, 
foreign investors owned 13.3 percent of U.S. corporate bonds and an 
additional 62.2 percent were owned by insurance companies and pension 
funds, resulting in the current exemption from tax of a sizeable 
portion of the interest income received on corporate debt in their 
portfolios.\8\ I presume the percentages reported in 1989 are larger 
today.
---------------------------------------------------------------------------
    \8\ Staff of the Joint Committee on Taxation, Federal Income Tax 
Aspects of Corporate Financial Structures (JCS-1-89) (Gov't Printing 
Office, Jan. 18, 1989).
---------------------------------------------------------------------------
    The relationship between expensing and the deductibility of 
business interest expense, in my view, is a very significant issue. If 
I am correct, it will be important for the Subcommittee to analyze 
specific cost recovery proposals with this issue in mind.
    As a final point, it is worth noting that the subsidy to which the 
President's Tax Reform Panel referred exists under present law, because 
interest expense frequently is incurred in connection with debt-
financed business investments that are eligible for accelerated 
depreciation or expensing under Section 179. Thus, the tax treatment of 
business interest expense under present law also is an appropriate 
topic for examination.
Conclusion
    At the beginning of my remarks, I mentioned that I had previously 
appeared before the Subcommittee to comment on two corporate tax reform 
topics, the transferability of corporate tax attributes and corporate 
mergers and acquisitions. References to those two previous appearances 
might seem merely evidence of my nostalgia, having no relevance to my 
comments today. I do value my interactions with the Subcommittee over 
the years, but I also I think the prior appearances to which I referred 
are relevant.
    To the extent the tax law creates distortions, as do industry-
specific or activity-specific tax preferences, and to the extent the 
tax law creates discontinuities, as does the deductibility of interest 
by a business taxpayer who is entitled to recover the cost of a capital 
investment faster that economic depreciation, there exist increased 
incentives to structure transactions to enable business taxpayers that 
do not have sufficient income to fully use the tax preferences or 
interest deductions to directly or indirectly transfer those 
preferences to another taxpayer who can use them to reduce its tax 
liability or to merge with another business taxpayer that is able to 
use the tax benefit. As the Subcommittee considers corporate tax reform 
proposals, I encourage you to keep in mind the possible implications of 
these distortions and discontinuities.
    Thank you very much. I will be pleased to attempt to answer any 
questions.

                                 

    Chairman CAMP. Thank you very much, Mr. Pearlman. Dr. 
Neubig, you have 5 minutes.

      STATEMENT OF THOMAS S. NEUBIG, NATIONAL DIRECTOR OF 
      QUANTITATIVE ECONOMICS AND STATISTICS, ERNST & YOUNG

    Dr. NEUBIG. Thank you, Mr. Chairman and Members of the 
Subcommittee. I am the national director of the quantitative 
economics and statistics practice at Ernst and Young. I am the 
former director and chief economist of the U.S. Department of 
the Treasury and worked for Ron Pearlman during the 1986 tax 
reform. I am happy to be part of this academic panel, since in 
my different roles, I have been trying to teach policy makers, 
non-economists, and younger staff members.
    The breadth of the Subcommittee hearing on corporate tax 
reform is quite large, so I am going to restrict my comments to 
reasons why many corporations prefer a lower corporate marginal 
tax rate to more targeted tax reductions, specifically 
expensing of capital equipment. The President's Advisory Panel 
outlined a growth and investment tax plan for a business cash 
flow tax which included expensing, first-year, 100 percent 
writeoff of capital equipment, structures and inventory. One 
might have expected that this plan would have received a 
standing ovation from the business community, because many 
economists say it is the equivalent of a zero effective tax 
rate on new capital investment. Instead, there really has been 
silence.
    So, why this tepid response from the corporate community? 
Why this disconnect between the corporate community and what 
academic economists are saying? I think if we look at the Tax 
Council Policy Institute's Survey of Multinational 
Corporations, where they were asked to rank a range of 
alternative tax reform options, the clear favorite was lowering 
the corporate tax rate to 25 percent, compared to both 
fundamental as well as incremental tax reforms.
    I would like to highlight four reasons why many 
corporations prefer a lower corporate tax rate to the proposed 
option of expensing. First is that expensing offers only a 
timing benefit and does not reduce corporations' book effective 
tax rate. If you lower the corporate marginal tax rate, that 
would lower corporations' book effective tax rates and increase 
their reported profits for most corporations.
    Expensing accelerates corporate deductions from future 
years into the first year, providing only a timing benefit, and 
with expensing, public corporations would continue to have a 
high book effective tax rate on their current income, plus they 
would buildup large deferred book tax liabilities. In contrast, 
reducing the corporate marginal tax rate would lower book 
effective tax rates, increase their reported after-tax profits, 
and it would also reduce corporations' deferred book tax 
liabilities and assets, and that would be a very welcome 
development in a world where two-thirds of the largest 
companies report deferred tax liabilities. Ohio recently began 
phasing out its corporate income tax, and a number of companies 
immediately began reporting higher book profits as a result.
    The second reason is that corporations already expense a 
large fraction of their capital investment. A lower tax rate 
would benefit both their tangible investments and their 
intangible investments. A recent study showed that about the 
same amount of intangible investments are made as tangible 
capital investments. Intangible investments include research 
and development, copyrights, computerized databases, and brand 
equity.
    Through the deduction of wages associated with the creation 
of self-constructed intangible assets, many investments or most 
investments in intangible assets are already deducted in the 
year that the expense is incurred, and so, a lower corporate 
tax rate would help both tangible and intangible assets.
    The third reason is expensing is unlikely to occur without 
a counterbalancing loss of interest deductibility, as Ron said. 
A lower corporate marginal tax rate could occur with continued 
interest deductibility.
    The fourth reason is expensing reduces the tax wedge at 
just one margin in terms of reducing the tax rate on tangible 
capital investment. If you reduce the corporate marginal tax 
rate, you are going to be reducing the margin at which people 
make decisions in a whole host of dimensions. Currently, the 
United States has one of the highest statutory corporate tax 
rates. The Organization for Economic Cooperation and 
Development (OECD) calculates the U.S. combined Federal and 
State corporate tax rate to be over 39 percent. That compares 
to an OECD average of just 31 percent, and a number of our 
major trading partners have significantly lower corporate 
marginal tax rates.
    A lower corporate marginal tax rate would reduce the tax 
wedge for all corporate decisions, including location decisions 
between the United States and foreign investments. It would 
reduce the corporate versus non-corporate decision, debt-equity 
financing decisions, and transfer pricing planning.
    While there is a wide range of views among the corporate 
tax community, many of them would prefer to see the United 
States join other countries in lowering the U.S. corporate 
marginal income tax rate rather than moving to a business cash 
flow tax.
    [The prepared statement of Mr. Neubig follows:]

 Statement of Thomas Neubig, Ph.D., National Director of Quantitative 
                Economics and Statistics, Ernst & Young

    Mr. Chairman and Members of the Subcommittee: *
    I am the National Director of Ernst & Young LLP's Quantitative 
Economics and Statistics practice. I was previously the Director and 
Chief Economist of the U.S. Treasury Department's Office of Tax 
Analysis between 1986 and 1990.
    I appreciate the invitation to testify before the Subcommittee on 
the issue of corporate tax reform. Given the breadth of the topic of 
corporate tax reform, I will restrict my comments to the issue of 
reasons why many corporations prefer a lower corporate tax rate to more 
targeted tax reductions. My testimony is based on a recent Tax Notes 
article, entitled ``Where's the Applause? Why Most Corporations Prefer 
a Lower Tax Rate.'' **
---------------------------------------------------------------------------
    \*\ Thomas S. Neubig, Ernst & Young LLP, 1225 Connecticut Avenue, 
N.W., Washington, DC 20036. E-mail [email protected] The views 
expressed in this testimony are my own, and don't necessarily reflect 
the views of my firm or clients.
    \**\ Tom Neubig, ``Where's the Applause? Why Most Corporations 
Prefer a Lower Tax Rate,'' Tax Notes, April 24, 2006, p. 483-6.
---------------------------------------------------------------------------
    The President's Advisory Panel on Federal Tax Reform outlined a 
Growth and Investment Tax Plan for a business cash-flow tax--
essentially an expensing option that allows for a first-year 100% 
write-off of capital investment. One might have expected that this 
plan--which many economists claim would result in a zero effective tax 
rate for new capital investment--would have inspired a collective 
standing ovation from corporate finance and tax officers. Instead, the 
response has been similar to the proverbial sound of ``one hand 
clapping.''
    Why the tepid response from the corporate community? The Tax 
Council Policy Institute recently asked multinational corporations to 
rank a range of alternative tax reform options--and, according to the 
survey, the clear favorite was lowering the corporate tax rate to 25 
percent compared to other incremental or fundamental tax reforms.
    With economists and the business community differing so widely in 
their response to the Advisory Panel's expensing option, many observers 
wonder why the disconnect. Here are seven reasons why many corporations 
prefer a lower corporate tax rate to the proposed option of expensing 
capital investments.
    1) Expensing offers only a timing benefit, and doesn't reduce 
corporations' book effective tax rate. A lower corporate marginal tax 
rate would lower corporations' book effective tax rate and increase 
book net income for most corporations.
    Most economists don't think book taxes matter. Most corporate tax 
and financial officers value permanent, rather than temporary, book tax 
differences. From the perspective of the corporate officer, expensing 
accelerates tax deductions into the first year, providing only a timing 
tax difference rather than a permanent tax difference for book 
purposes.
    With expensing, public corporations would have large deferred book 
tax liabilities, yet would still have a high book effective tax rate on 
current income. While most economists believe that book corporate tax 
rates shouldn't matter (because investors should pierce the corporate 
veil), many corporate tax directors and officers do believe that book 
corporate tax rates matter to their investors--and also affect their 
own performance criteria.
    In contrast, reducing the corporate marginal tax rate would 
immediately lower corporations' book effective tax rates, thereby 
increasing their reported after-tax book profits. A lower corporate 
marginal tax rate would also immediately reduce corporations' deferred 
book tax liabilities and assets--a welcome development in an 
environment where most of the largest companies report deferred tax 
liabilities.
    A lower corporate tax rate would necessitate re-measuring existing 
deferred tax liabilities and assets, and also result in an increase or 
charge to earnings in the period the legislation is enacted. Companies 
in a net deferred tax liability position would have an increase in 
reported after-tax income from the tax benefit associated with a lower 
tax rate on their deferred tax liabilities. Of the 50 largest companies 
within the Fortune 500, 32 have a net deferred tax liability and 18 
have a net deferred tax asset. When the State of Ohio enacted 
legislation phasing down its corporate income tax rate on June 30, 
2005, a number of public corporations reported higher profits due to 
the future tax rate reductions in their second quarter financial 
results.
    2) Corporations already expense a large fraction of their capital 
investment. A lower tax rate would benefit both their tangible and 
their intangible investments--a benefit not offered by the business 
cash-flow tax.
    Undeniably, proposals for expensing would lower the economic 
effective tax rate for depreciable property, land and inventories. But, 
a recent study found that business investment in intangibles--research 
and development, copyrights, computerized databases, development of 
improved organization structures, and brand equity--is now as large as 
the spending on tangible capital. And, through the deduction for wages 
associated with the creation of the self-constructed intangible assets, 
a large portion of investments in intangible assets are already 
expensed under the current system.
    Expensing would benefit depreciable and capitalized investments, 
but would provide no incremental benefit to intangible assets that are 
currently expensed. A lower corporate marginal tax rate, on the other 
hand, would benefit income from all tangible and intangible 
investments. A lower corporate marginal tax rate would also benefit 
existing intangible investment, since the tax rate at which it expensed 
the investment would be higher than the tax rate at which the future 
income would be taxed.
    3) Expensing is unlikely to occur without a counterbalancing loss 
of interest deductibility. A lower corporate marginal tax rate could 
occur with continued interest deductibility.
    The Advisory Panel's report emphasizes the necessity of combining 
expensing with repeal of interest deductibility to prevent negative 
economic effective tax rates. ``Eliminating the business interest 
deduction for non-financial firms is an essential component of the 
Growth and Investment Tax Plan. Allowing both expensing of new 
investments and an interest deduction would result in a net tax subsidy 
to new investment. Projects that would not be economical in a no-tax 
world might become viable just because of the tax subsidy. This would 
result in economic distortions and adversely impact economic 
activity.'' (Advisory Panel, p. 164)
    As a result, the valid comparison isn't just expensing versus a 
lower corporate tax rate, it is expensing combined with loss of 
interest deductions versus a lower corporate tax rate with interest 
deductions.
    It should be noted that debt-financed capital investment is already 
calculated as having an economic effective corporate tax rate of zero 
with economic depreciation, and a negative economic effective tax rate 
with the current accelerated depreciation. ``By contrast, the average 
tax rate on debt-financed investment is negative (-15%), as deductions 
for interest, together with deductions of items such as accelerated 
depreciation, more than offset the income generated from debt-financed 
investment.'' (Advisory Panel, p. 100)
    So, expensing would really only help a small fraction of corporate 
investment: equity-financed tangible investments. Because of the loss 
of the interest deduction, debt-financed tangible and intangible 
investment would be worse off under the business cash-flow tax. For 
this reason, a lower corporate marginal tax rate on top of the current 
interest deduction and accelerated depreciation for tangible capital 
would be more advantageous for many corporations compared to expensing 
or business cash-flow tax.
    4) Corporations invest to earn above-normal returns, not just the 
``normal'' or risk-free return. While expensing reduces the tax rate on 
only the risk-free return, a lower marginal tax rate applies to the 
entire return to capital.
    Economists distinguish between four different returns to investors: 
1) a ``normal'' or risk-free return for deferring consumption, or a 
``return to waiting''; 2) an expected risk premium; 3) a return due to 
entrepreneurial skill, a unique idea, a patent or other specific 
factors; and 4) an unexpected return from good or bad luck where the 
actual return differs from the expected return. The Advisory Panel 
report (p. 150) states ``Removing the tax on the first component, the 
return to waiting, is the key to removing taxes from influencing 
savings and investment decisions.'' The Panel report stresses that both 
an income tax and a ``post-paid'' consumption tax (expensing) fall on 
the other three components, which they say has ``important implications 
for the distributional effects'' of reform.
    Academic economists argue that in competitive markets businesses 
can only earn the ``normal'' or risk-free return to capital on their 
last (marginal) dollar of investment. By this reasoning, expensing will 
provide an incentive for additional investment. However, the Growth and 
Investment Tax Plan with expensing but without an interest deduction 
would impose a tax on returns in excess of the ``normal'' or risk-free 
return arising from risk-taking, entrepreneurial effort or innovation. 
Consequently, the academic economists' zero tax rate argument only 
applies to a very small fraction of a company's total investment--just 
to that last dollar of investment, and only to the portion equivalent 
to a risk-free return. But, the reality is that companies don't invest 
just to earn a risk-free return; they expect to earn returns to justify 
their risk-taking, specialized factors and competitive positioning.
    Economic proponents of expensing like to point out that under a 
business cash flow tax profits above the risk-free return would be 
taxed. They argue that taxing ``rents'' is equivalent to a lump-sum 
tax, causing no economic distortions. Again, we are reminded that the 
economists and the corporate tax officers are two very different 
audiences.
    While most economists are focused at the ``margin'', businesses 
make investments that are large, discrete, finite, risky and also 
include substantial entrepreneurial and innovative efforts. When 
entering a market with a sizeable investment, a company looks at its 
total after-tax return. While a company might earn a risk-free return 
from the time-value of money from accelerating depreciation deductions, 
companies invest to earn a significantly higher return on their total 
investment. On the other hand, a lower corporate tax rate would reduce 
the tax on all corporate income--both the normal risk-free return 
income as well as the return to risk-taking, entrepreneurial skill and 
innovation.
    5) Many companies would not receive the full benefit of expensing 
without also being able to receive immediate refunds.
    Many companies, especially while transitioning to the business cash 
flow tax model, would not benefit from the full effect of expensing, 
because expensing would eliminate all taxable business cash flow for 
many companies. Unless the government provided immediate cash refunds, 
they would only realize a fraction of the potential benefits that 
expensing might offer. Many more companies would find themselves in a 
net operating loss (NOL) carry forward position with expensing.
    The Advisory Panel did propose that the business cash flow tax with 
expensing would also include NOL deductions with interest. And, 
economists' present value calculations would show that corporations are 
made whole with an interest adjustment to NOLs. However, corporations 
don't normally choose to invest in Treasury securities earning a risk-
free return. Deferring the tax benefits of expensing beyond the initial 
year, even with a risk-free interest rate, is not the equivalent of a 
zero economic effective tax rate when a corporation considers the 
other, more potentially rewarding, opportunities available for its 
investments or payments to shareholders.
    6) Expensing reduces the tax wedge on one margin, but a lower tax 
rate would reduce the tax wedge on all margins.
    The Advisory Panel notes that its Simplified Income Tax proposal 
for a territorial system of international taxation would put increased 
pressure on transfer pricing. (Advisory Panel, p. 242) Indeed, transfer 
pricing issues are important when marginal tax rates differ across 
countries, and currently the U.S. has one of the highest statutory 
corporate tax rates. The Organization for Economic Cooperation and 
Development (OECD) calculates the U.S. combined federal/state corporate 
tax rate to be 39.3% compared to an OECD average of 31.2 %. Other 
marginal decisions, such as debt versus equity financing, are 
influenced by the statutory marginal tax rate. Marginal and average tax 
rates also influence location decisions.
    While expensing would eliminate the differential tax treatment of 
tangible and intangible investments, a lower corporate marginal tax 
rate would reduce the tax wedge for all corporate decisions, including 
location decisions, the corporate non-corporate decision, debt equity 
financing decisions, transfer pricing, etc.
    7) Corporate tax rates could increase in the future. Expensing 
leaves large deferred tax liabilities that could be subject to 
significant future tax increases.
    The economists' assertion that expensing creates a zero effective 
tax rate on the risk-free return only holds if tax rates remain 
unchanged over the life of the investment. If tax rates increase in the 
future, then the effective tax rate would be higher. Of course, if tax 
rates were to decrease in the future, then the economists' effective 
tax rate could fall below zero.
    If tax rates increase in the future, then public corporations' 
large deferred tax liability from expensing would become even larger on 
prior investments. In addition, a higher tax rate and increased 
deferred tax liability would reduce reported book income in the year of 
the change. Academic economists might think that corporations would be 
indifferent to the possibility of future tax changes, or at least treat 
the possibility of a tax rate increase as offsetting the possibility of 
a tax rate decrease. In reality, though, many corporate officers and 
tax directors would see a much larger downside from a tax rate increase 
than benefit from a tax rate decrease. Negative surprises seem to have 
a larger adverse effect than the positive effect from positive 
surprises. In today's business environment, jobs and options can be 
lost with negative surprises; a positive surprise, on the other hand, 
might elicit a one-time bonus.
    Expensing would create large deferred tax liabilities. And, many 
theoretical economists might argue that these could later be taxed at 
higher rates without adverse economic effects since the investments had 
already been made. This is the same argument that many economists use 
for estimating the future economic benefits of moving to a consumption 
tax (either a value-added tax or business cash flow tax), since the 
shift can be financed by imposing taxes on old capital (existing 
investments). This is another reason why corporate officers are 
skeptical of expensing and also economic arguments of efficiency.
Conclusion
    Given the very different perspectives and day-to-day challenges of 
the academic economists and the business community, it is unlikely that 
the Growth and Investment Tax Plan--or any tax reform proposal that 
resembles a consumption tax--will draw raves from both audiences. And, 
while the Advisory Panel's business cash-flow tax proposal retains the 
appearance of the current corporate income tax--with expensing and a 
repeal of interest deductibility added to the mix--it is still, at its 
core, a variant of a consumption tax. Part of the explanation for the 
disconnect between academic economists and the business community is 
what might be called the ``Red Riding Hood disguise''--hiding a 
consumption tax in income tax clothing.
    Expensing capital investment would provide significant tax benefit 
to many corporations. But still, most corporations--even many of those 
who would benefit from expensing--are likely to favor lower marginal 
rates as part of any incremental tax reform. And, while expensing would 
significantly reduce the taxation of equity-financed depreciable 
property, the business cash-flow tax (with repeal of interest 
deductibility) would increase the tax burden on debt-financed tangible 
and all intangible assets. Plus, expensing would not lower book 
effective tax rates.
    Academic economists are correct when they say that expensing can 
result in a zero effective tax rate on the risk-free return to marginal 
investment. However, the underlying assumptions and limited focus of 
their analysis (marginal investment, equity-financed tangible 
investments, no financial statement effects, no principal-agent 
incentive effects) neglect the fact that businesses are seeking high 
total after-tax returns to their investments, including the return to 
risk-taking, innovation, and entrepreneurship.
    These seven reasons seem to be why many corporate tax directors and 
officers have not stood up with many economists to applaud expensing 
and the proposed business cash-flow tax. Most of the corporate tax 
community would prefer to see the U.S. join other countries in lowering 
the corporate marginal income tax rate.
    That concludes my testimony. I would be happy to answer any 
questions about my testimony.

                                 

    Chairman CAMP. Thank you very much, Dr. Neubig. Dr. 
Shackelford, you also have 5 minutes.

     STATEMENT OF DOUGLAS A. SHACKELFORD, MEADE H. WILLIS 
  DISTINGUISHED PROFESSOR OF TAXATION, KENAN-FLAGLER BUSINESS 
      SCHOOL, UNIVERSITY OF NORTH CAROLINA AT CHAPEL HILL

    Dr. SHACKELFORD. Mr. Chairman and Members of the 
Subcommittee, I appreciate the opportunity to testify. I have 
been asked to comment on suggestions that we tax the accounting 
profits that companies report to their shareholders, a practice 
known as book-tax conformity.
    I oppose conformity. I believe it would damage our capital 
markets and our tax system. I believe it disregards the 
importance of financial reporting in our economy. Let me start 
with a practical reason: conformity is not sustainable. Suppose 
we did tax book income. The accounting rules would remain the 
same, and the net income reported to shareholders would become 
the new tax base.
    Generally accepted accounting principles (GAAP), those 
guidelines that have evolved over time to guide the judgments 
underlying accounting would replace the Internal Revenue Code. 
The Financial Accounting Standards Board and other accounting 
standard setters would replace Congress as the body that 
determines the corporate tax base. In other words, conformity 
would force Congress to yield its authority to write the tax 
law. Imagine pressure on these unelected standard setters to 
set tax-advantaged accounting standards.
    Let us consider depreciation under conformity. The current 
accounting rules permit companies to depreciate equipment in a 
manner that best reflects its economic deterioration. Thus, if 
the same plant uses identical forklifts differently, management 
may depreciate them differently. On the other hand, the current 
tax law provides specific rules for the depreciation of 
equipment; for example, a percentage of the cost of the 
equipment is depreciated in the first year, regardless of the 
actual decline in the value of the equipment.
    Under conformity, judgments about the decline in the 
usefulness of the equipment would replace the certainty of 
current tax depreciation roles. Besides the impossibility of 
basing the tax system on the judgments of the taxpayer and the 
possibility that taxpayers would make tax-favorable judgments, 
suppose the economy slows, and Congress decides that more rapid 
depreciation would encourage firms to expand. What would 
Congress do? Would Congress exclude depreciation from 
conformity, or would Congress mandate that accelerated 
depreciation is the only depreciation method acceptable for 
both book and tax?
    If Congress provides the conformity exception for 
depreciation, then, soon, we are back to where we are today. In 
fact, this path brought us to where we are today. The corporate 
income tax was originally based on GAAP. Over time, Congress 
found reasons why Congress should differ from book. The 
decoupling is understandable. Book and tax reporting exists for 
different reasons. There is no reason to think that the most 
useful measure of a firm's profitability to its shareholders is 
also the most useful measure of profitability for the taxing 
authorities.
    Accounting exists because management needs to provide 
information to outside investors. Without this information, 
shareholders would be apprehensive about turning their money 
over to managers that they do not know. For example, consider 
research and development about a new drug at a pharmaceutical 
company. Insiders know the probability of success far better 
than outside investors do. Through financial reports, managers 
convey some of the knowledge to the outside investing 
community. This accounting information enables outsiders to 
better forecast the profitability of the drug, reducing their 
uncertainty about the future of the firm and increasing their 
willingness to invest in the company.
    In other words, the demand for financial reporting comes 
from the need to reduce differences in knowledge between inside 
management and outside suppliers of capital, and to provide the 
most informative financial reports requires extensive judgment 
about the current activity and future expectations of the firm.
    Conversely, the purpose of taxable income is to provide a 
verifiable measure for collecting revenue. The taxing 
authorities need information rooted in law, not in judgments. 
An important quality of the tax law is that taxable income can 
be measured the same by both the taxpayer and the government. 
As an aside, when book and tax treatment are the same, widely 
held public corporations will often care more about their 
accounting earnings than their taxable income. This is 
understandable, because investors can see the financial reports 
but not the tax returns. So, sometimes, firms choose to report 
higher earnings, even at the cost of higher taxes.
    To continue our depreciation example, when Congress 
provides accelerated depreciation for tax purposes, suppose it 
decides to maintain conformity? If so, when Congress changes 
the tax law, it will also change the reporting methods for book 
purposes. In other words, Congress will set the tax law and 
then force the book rules to conform. This option is far more 
dangerous than providing different treatment for book and tax, 
because it will erode the quality of information that managers 
can provide to external investors.
    If Congress begins to restrict the means by which managers 
can communicate to their investors, then, investors will fear 
that they do not have the information that they need to 
evaluate companies. Furthermore, legislating conformity will 
not conform taxes to the information that firms communicate to 
investors. Managers will continue to need to provide investors 
with information to attract their capital. If the financial 
reports are constrained in their ability to communicate, 
managers will find other means.
    In conclusion, conformity is naive and bad policy. I 
encourage you to reject it. I look forward to your questions.
    [The prepared statement of Dr. Shackelford follows:]

   Statement of Douglas Shackelford, Ph.D., Professor of Taxation of 
 Accounting, University of North Carolina, Chapel Hill, North Carolina

Introduction
    Mr. Chairman and distinguished members of this subcommittee, I 
appreciate the invitation to comment on corporate tax reform. My 
comments will address the interplay of financial reporting and taxation 
and proposals for conforming book and taxable income. I applaud this 
subcommittee for studying these issues. They reflect the growing 
appreciation for the impact of financial reporting on tax policy.
The Demand for Financial Reporting
    Many (investors, creditors, customers, suppliers, regulators, 
rating services and the government, among others) need financial 
information from firms. For purposes of this testimony, I will limit my 
focus to current and potential shareholders.
    Managers report financial information to shareholders to reduce the 
asymmetric information problems that otherwise would limit their 
ability to attract external capital. Asymmetric information exists when 
one party knows more than another party does. For example, in the 
equity markets, managers know more about the firm than outside 
investors know. Problems arise for managers when the external investors 
fear that the differences in information enable the managers to take 
advantage of them. The accounting information provided in financial 
reports allows managers to reduce the asymmetry and thus attract 
capital from outside investors.
    For example, consider research and development about a new drug at 
a pharmaceutical company. Insiders know the probability of success far 
better than outside investors do. Through financial reports, managers 
can convey some of their knowledge to the outside investing community. 
This accounting information enables outsiders to better forecast the 
profitability of the drug, reducing their uncertainty about the future 
of the firm and increasing their willingness to invest in the company. 
In brief, the demand for financial reporting comes from the need to 
reduce differences in knowledge between inside management and outside 
supplies of capital.
Accounting Standard Setters
    Generally Accepted Accounting Principles (GAAP) provides guidance 
about the information that firms can provide through their financial 
reports to shareholders. GAAP has evolved over decades into accounting 
conventions that provide a structure for identifying, evaluating, and 
reporting the firm's activities. The Financial Accounting Standards 
Board (FASB), with oversight from the Security and Exchange Commission 
(SEC), is the primary standard setter of GAAP. The American Institute 
of Certified Public Accountants, the Emerging Issues Task Force, and 
the SEC itself also contribute to GAAP. Each body promulgates 
statements to guide the accountants who produce the financial reports. 
Some standards mandate specific accounting treatment for a transaction. 
Other pronouncements suggest an approach or a structure for reporting 
transactions. The goal is financial reports that present relevant, 
reliable, comparable, and consistent information about the affairs of 
the company.
    At the same time, the standard setters recognize the impossibility 
of specifying the precise treatment for every transaction, and they 
rely heavily on firms to judge the appropriate approach within bounds 
for specific transactions. As a result, two firms with identical 
activities could produce different financial reports without violating 
GAAP. For example, suppose the same customers bought the same goods on 
credit from two retailers. One retailer might expect higher collections 
than the other retailer does. Consequently, the first retailer would 
report higher net income than the second retailer does--the sole 
difference being a judgment about future collections. Neither retailer 
violates GAAP. They simply disagree about future collections.
    This element of discretion enables managers to better communicate 
their expectations to investors. However, this flexibility also enables 
managers to manage their reports in a manner that reflects well on 
them. Continuing the example, the first retailer's expectations may not 
differ from the same retailer's expectations. However, the imprecision 
of financial reporting enables the first to report higher accounting 
profits. Of course, the markets are aware of this potential for 
earnings management. However, the evidence is mixed about whether 
investors can fully adjust their forecasts for earnings management. 
Nonetheless, managers behave as though they believe that investors 
cannot fully adjust for earnings management
The Demand for Tax Information
    Compared with financial reporting, the demand for tax information 
is relatively simple. The government needs each firm to report its 
taxable income in accordance with the existing tax law because self-
reporting is an efficient means of gathering the information to compute 
the tax liability. By comparison with accounting standards, the tax law 
is intentionally rigid and, to the extent possible, attempts to specify 
the appropriate treatment for every transaction.
    Whereas standard setters intend financial accounting to be a 
flexible, evolving, conceptual framework that guides accountants in 
their judgments, Congress writes the tax law to provide as much 
certainty as possible about the tax treatment of a transaction. The 
Treasury Department adds to this certainty with regulations that 
interpret the law. The courts add to this certainty when they resolve 
differences between the government and the taxpayers. Although GAAP 
itself is becoming more rules-oriented over time, it remains far less 
certain and binding than the tax law. In the starkest terms, financial 
accountants use judgments to report a firm's profitability while tax 
accountants apply the law to compute taxable income.
    Of course, since the taxpayer and the government take adversarial 
positions in the interpretation of the law, conflicts arise continually 
about the tax treatment of specific transactions. However, if tax rules 
were based on the guidelines, approaches, discretion, and judgments 
that underlie financial accounting, the differences in opinions would 
be far more extensive than we currently observe in the tax arena. In 
fact, if the tax law had the flexibility of GAAP, administration of the 
tax law would be impossible as tax cases flooded the courts. Instead, 
under the current tax system, both taxpayers and the government benefit 
from ``bright-line'' provisions in the tax law that specify the 
treatment of particular transactions as precisely as possible, reducing 
the uncertainty about the ultimate resolution of an event's tax 
treatment.
The Interplay of Financial Reporting and Tax Disclosures
    Many transactions are treated the same for financial reporting (or 
book) and tax purposes. Transactions receiving the same treatment 
create a tension between book and tax considerations. For book 
purposes, managers may wish to present the event to investors in a 
favorable light, e.g., in a manner that increases accounting earnings 
or lowers earnings volatility. For tax purposes, managers wish to 
present the event in a manner that reduces the firm's tax liability.
    For example, if a firm uses LIFO (last-in, first-out) to compute 
the costs of its inventory for tax purposes, it also must use LIFO for 
book purposes. During inflationary times, LIFO reduces both book and 
taxable income. Thus, when firms choose LIFO, they are demonstrating a 
willingness to sacrifice the profitability that they report to outside 
investors in order to lower their tax liability. Conversely, when firms 
choose other inventory costing methods, e.g., FIFO (first-in, first-
out), they are choosing to report higher earnings at the expense of 
higher taxes.
    Researchers have studied the trade-offs between book and tax 
reporting extensively.\1\ To the surprise of those who are unfamiliar 
with the importance of financial reporting, many studies find that book 
considerations dominate tax considerations. In other words, some firms 
structure their activities in a way that boosts earnings, even though 
they have to pay for the higher earnings through higher taxes. For 
example, many firms in inflationary times used FIFO. As expected, the 
companies that rely most heavily on outsiders for their capital (and 
thus face the greatest asymmetric information problems) are the ones 
that are most likely to enhance earnings at the cost of higher taxes.
---------------------------------------------------------------------------
    \1\ For a review of the literature, see Shackelford, Douglas, and 
Terry Shevlin, ``Empirical Tax Research in Accounting,'' Journal of 
Accounting and Economics 31:1-3, September 2001, 321-387.
---------------------------------------------------------------------------
    To demonstrate, suppose you are the sole shareholder, lender, and 
employee in your business. You have no need to provide information to 
outside investors. Thus, there is no tension between your financial 
reporting considerations and your tax choices. You will always report 
your affairs in a tax-minimizing manner.
    Conversely, suppose you are the CEO of a company owned by outside 
investors. The shareholders observe your financial reports, but not 
your tax return, and have access to little financial information about 
the firm, except the information that you provide them. In that case, 
the financial reports play a critical role in the firm's ability to 
raise capital.
    For example, suppose the market uses a simple price-earnings ratio 
to value stock. If a firm's price-earnings ratio is 20, then every 
dollar of (permanent) accounting earnings boosts the firm's 
capitalization by $20. Conversely, if saving one dollar of taxes does 
not increase the firm's book earnings, and thus cannot be observed by 
outside investors, then the tax savings have no effect on the stock 
price. In such an environment, it is entirely rational that a firm 
would forgo tax savings to communicate a more favorable message about 
its future profitability.
    Consequently, managers of widely held public companies are very 
concerned with the book considerations of transactions. In fact, 
managers in these types of firms often forgo tax opportunities because 
they have adverse book effects or even because they have no favorable 
impact on book earnings. On the other hand, managers may undertake a 
tax strategy that has minimal reduction in their tax liability, but 
provides a boost to earnings. In short, financial reporting 
considerations often dominate tax concerns for managers of public 
corporations with asymmetric information problems.
    The importance that corporations place on the financial reporting 
considerations of changes in tax policy can puzzle policymakers. If the 
policymakers underestimate the importance of financial reporting in 
allaying asymmetric information problems, they may be surprised when 
widely held public companies show little interest in tax reductions 
that adversely affect their financial reports. They sometimes even have 
limited interest in tax reductions that do not benefit accounting 
earnings.
    One example of the importance placed on accounting earnings 
concerns recent proposals for replacing depreciation with immediate 
expensing. Immediate expensing likely would reduce the tax bill for 
many firms and certainly would reduce taxes in the short-run. However, 
expensing would have no effect on accounting profits. The reason is 
that the timing of the deductions for tax purposes (up front with 
expensing versus over time with depreciation) is irrelevant for 
computing accounting earnings. Because expensing carries no book 
benefit, many managers of widely held public companies likely will have 
little interest in switching the tax law from depreciation to immediate 
expensing.
Book-tax Conformity
    Recently some have suggested adoption of book-tax conformity. By 
book-tax conformity, I mean taxing the accounting earnings that 
companies report to their shareholders. On the surface, conformity 
makes sense. Companies report income to their shareholders, and 
companies report income to the taxing authorities. Conformity 
simplifies the process by having companies report the same amount of 
income to both shareholders and the government. Furthermore, with 
conformity, the tendency to overstate income to shareholders would 
offset the tendency to understate income to the government, providing 
better measures for both shareholders and the government.
    Notwithstanding these claims, I believe that book-tax conformity 
would adversely affect both financial reporting and the tax system for 
at least two reasons. First, shareholders and the taxing authorities 
need different information. Second, even if Congress mandates 
conformity, it will not be sustainable. In time, the policy will revert 
to the current system. In the meantime, conformity will damage our 
capital markets.
Different Users need Different Information
    The first problem with conformity is that it ignores the different 
purposes for book and tax reporting. It assumes that the most useful 
measure of a firm's profitability for shareholders is also the most 
useful measure of profitability for the taxing authorities.
    To demonstrate that different measures are appropriate for 
different users, compare the information demands of bondholders and 
shareholders. Bondholders need information to assess the likelihood 
that the firm will be able to service its debt. For example, they may 
want to know the value of the firm under liquidation. Shareholders need 
information to assess the value of their residual claims. Thus, they 
need information that assumes that the firm is a going concern, i.e., 
not facing liquidation.
    Similarly, shareholders and the taxing authorities need different 
information. As mentioned above, shareholders need information from the 
financial reports about their residual interests. Conversely, the 
taxing authorities need verifiable information, rooted in law, rather 
than the judgments. No one would expect two financial accountants to 
reach the same book earnings for a firm because the process involves 
extensive judgment. Conversely, an important quality of tax law is that 
taxable income can be measured the same by both the taxpayer and the 
government.
Lack of Sustainability
    The second problem with conformity is that it is not sustainable. 
Suppose we did set taxable income equal to book income. The accounting 
rules would remain the same, and the net income reported to 
shareholders would be the new tax base. GAAP, those guidelines that 
have evolved over time to guide the judgments underlying accounting, 
would replace the rigid Internal Revenue Code. The seven, unelected 
members of the FASB and other accounting standard setting bodies would 
replace Congress as the body that determines the corporate tax base. In 
short, a consequence of conformity is that Congress would abrogate its 
authority to write the tax laws.
    Consider depreciation under conformity. The current accounting 
rules permit companies to depreciate equipment in a manner that best 
reflects its economic deterioration. Thus, if the same plant uses 
identical forklifts differently, management may depreciate them 
differently. On the other hand, the current tax law provides specific 
rules for the depreciation of equipment. For example, a percentage of 
the cost of the equipment is depreciated in the first year, regardless 
of the actual decline in the value of the equipment. Under conformity, 
judgments about the decline in the usefulness of the equipment would 
replace the certainty of the current tax depreciation rules.
    Besides the impossibility of basing a tax system on the judgments 
of the taxpayer, suppose the economy slows and Congress believes that 
more rapid depreciation would encourage firms to expand. What would 
Congress do? Would Congress provide an exception to conformity for 
depreciation? Would Congress mandate that accelerated depreciation is 
the only depreciation method acceptable for book and tax? Would 
Congress pressure the SEC and the FASB to change the accounting rules 
to mandate accelerated depreciation? Would Congress sit idly by, 
recognizing that it has delegated taxing authority to the accounting 
standard setters?
    First, let us reject the possibility that Congress will do nothing 
or leave responsibility of the economy to an unelected body of 
accounting standard setters. Thus, Congress has two choices. Change 
depreciation for tax purposes only or mandate that accelerated 
depreciations is required for both book and tax.
    If Congress provides a conformity exception for depreciation, then 
soon we are back to where we are today. In fact, this path brought us 
to where we are today. The corporate income tax was originally based on 
GAAP. Therefore, taxable income began closely linked to book income. 
Over time, Congress found reasons why tax should differ from book. The 
reasons include the need to provide incentives, improve efficiency, 
simplify the tax rules, provide certainty to taxpayers and the taxing 
authorities, address inequities, aid administration of the law, and 
raise revenue.
    Therefore, over time, book and tax drifted apart. The decoupling is 
understandable. The purpose of accounting earnings is to provide 
information to external investors. The purpose of taxable income is to 
provide a verifiable measure for collecting revenue. It is unreasonable 
to think that one measure of profitability can achieve both purposes. 
Naturally, changes that narrow the gap between book and tax without 
adversely affecting financial reporting or the tax system are 
desirable, but complete conformity reflects a naivety about the 
purposes of book and tax information.
    Alternatively, to continue our example, when Congress provides 
accelerated depreciation for tax purposes, suppose it decides to 
maintain conformity. If so, when Congress changes the tax law, it also 
will change the reporting methods for book purposes. In other words, 
Congress will set the tax law and force the book rules to conform.
    This option is far more dangerous than providing different 
treatment for book and tax because it will erode the quality of the 
information that managers provide to external investors. Congress has a 
long history of rarely interfering with the evolution of accounting 
standards. This has enabled accounting to change naturally with 
economic developments and ensure that managers can best communicate 
private information about their companies to external investors. The 
standards provide a delicate balance of certainty (e.g., equipment is 
depreciated and land is not) and judgment (e.g., companies decide the 
rate of depreciation). If Congress interferes with this balance, it 
will have major adverse affects on our economy.
    Financial accounting has contributed mightily to our enjoying the 
largest and most efficient capital markets in the world. Domestic and 
foreign investors pour trillions of dollars into American firms led by 
managers whom they do not know. They invest because they trust the 
accounting information that the managers communicate about their 
companies. If Congress begins to restrict the means by which managers 
can communicate to their investors, e.g., by setting book depreciation 
methods, then investors will fear that they do not have the information 
that they need to evaluate companies. Contracting costs will rise. 
Stock prices will tumble. The damage to the capital markets alone will 
far exceed any benefits to conformity.
Germany's Experience with Conformity
    Some advocates for conformity point to forms of conformity among 
our trading partners. It is true that some countries, such as Germany, 
have used conformity. However, these companies are increasingly 
abandoning conformity, providing further evidence that it would be bad 
policy for the United States.
    Germany historically mandated book-tax conformity. The reason that 
conformity could exist in Germany was that their corporations raised 
little capital from external investors and thus had little or no 
asymmetric information problems. Instead, large banks supplied the 
capital for German corporations. Through extensive stock cross-
holdings, the banks were insiders (using serving on the board of 
directors) and privy to the private knowledge of management. In other 
words, conformity could exist in a debt-centered economy, which relied 
on few external investors.
    In contrast, America has equity-centered capital markets with 
widespread external ownership. Germany is now attempting to build an 
equity-centered economy. To facilitate the transition from a debt-
centered economy to an equity-centered economy, Germany has 
discontinued conformity for consolidated financial statements, enabling 
managers to communicate more freely and thoroughly with their external 
investors. In other words, Germany is leaving conformity in an attempt 
to create the external capital markets that we already enjoy. Germany 
recognizes that book-tax conformity is inappropriate in an economy that 
relies on the equity markets to raise capital from external 
shareholders. Thus, Germany's abandonment of conformity provides enough 
further evidence that the U.S. should not adopt conformity as policy.
Unintended Consequences
    Let me close with a warning about unintended consequences. 
Corporate behavior will change with any changes to the tax law or the 
financial accounting rules. If Congress were to establish book-tax 
conformity, then firms would begin to alter their behavior in ways that 
may be unanticipated at the inception of conformity.
    For example, legislating conformity will not eliminate the need for 
information to address asymmetric information problems between insiders 
and outside investors. Thus, managers in widely held public companies 
will find other means to communicate private information to outside 
capital sources. Some firms may go private, but most will continue to 
rely on the equity markets to supply their capital. External investors 
will continue to demand information--and firms will find a way to 
supply that information--because their survival and prosperity depend 
on attracting external investors. If firms are unable to provide that 
information through their financial reports without adversely affecting 
their tax liabilities, then they will find other means of 
communication. Those other channels likely will be more costly and less 
effective than the current financial reporting system, but in the end, 
firms will find a way to communicate information to investors, which 
reduces the problems associated with asymmetric information. In short, 
managers will find a way to decouple any legislated link between 
financial reporting and taxes.
Closing Remarks
    In conclusion, I applaud these hearings and your interest in the 
coordination of financial and tax reporting. This is an important and 
often overlooked area of tax policy. Any attempts at corporate tax 
reform will require a thorough understanding of the effects of 
financial reporting on tax policy.
    As far as book-tax conformity, I strongly oppose it. It is a naive 
proposal that fails to appreciate the complex role of financial 
accounting in our economy. If we adopt conformity, we will inevitably 
abandon it (albeit after considerable damage to the economy) because 
Congress will not and should not cede its authority to set tax law. In 
the meantime, conformity will adversely affect the capital markets for 
public corporations and force managers to find alternative methods for 
addressing their inherent asymmetric information problems with external 
capital suppliers. Doubtlessly some differences between book and tax 
can be narrowed, but widespread book-tax conformity is bad tax and 
financial policy.

                                 

    Chairman CAMP. Thank you very much, Dr. Shackelford. Mr. 
Thompson.

  STATEMENT OF SAMUEL C. THOMPSON, JR., PROFESSOR OF LAW AND 
 DIRECTOR, LAW CENTER, UNIVERSITY OF CALIFORNIA, LOS ANGELES, 
                    LOS ANGELES, CALIFORNIA

    Mr. THOMPSON. Thank you, Mr. Chairman. I urge Congress to 
eliminate deferral for foreign source income, thereby rejecting 
the recommendation of the President's tax reform panel that we 
adopt a territorial system. The recent increase in oil prices 
is yet another reason for Congress to eliminate deferral. 
Finally, I will point out that dividends for higher bracket 
taxpayers are significantly undertaxed, and therefore, Congress 
should reinstate the taxation of dividends at the ordinary 
individual rates for these taxpayers.
    Codification of the economic substance doctrine (ESD) has 
been opposed by the Treasury Department, the American Bar 
Association (ABA) Tax section, the American Institute of 
Certified Public Accountants (AICPA), and the Tax Executive 
Institute (TEI). My testimony today critically examines the 
rationales given by these organizations in opposition to 
codification. The arguments against codification made by the 
former Assistant Secretary of the Treasury for Tax Policy, 
Pamela Olson, reveal four principal themes: first, codification 
would make the ESD more wooden and less flexible. Second, 
codification has the potential for creating a rule that is both 
too broad and too narrow. Third, codification would add 
complexity for the Internal Revenue Service (IRS) in its 
enforcement of the laws. Finally, codification would slow IRS 
audits.
    Although Olson uses the term wooden and rigid in a negative 
connotation, the principal argument for codification is the 
lack of woodenness or rigidity in the current state of the law, 
which gives sophisticated taxpayers too much wiggle room. 
Olson's argument that codification would lead to a rule that is 
too broad is also vigorously made by several tax organizations 
and will be discussed shortly. Olson's argument that 
codification would create a rule that is too narrow assumes 
that, currently, courts have the flexibility to prevent tax 
shelters that codification may not contemplate. However, the 
language of the statute remains sufficiently broad to allow 
flexibility in determining what constitutes an abusive, tax 
motivated transaction.
    Even a brief review of the cases attempting to interpret 
the current ESD undermines Olson's argument that codification 
would add complexity for the IRS in enforcement. Also, rather 
than slowing audits, as Olson argues, a more uniform standard 
provided by codification would enable the IRS to increase the 
speed of its audits.
    A close experience of the positions of the tax 
organizations against codification revealed the following basic 
rationales: codification would interfere with bona fide 
business transactions; two, codification would hurt small 
businesses and average taxpayers; three, these concerns have 
already been addressed by the 2004 act; and four, the 40 
percent penalty is too high.
    The ABA and the TEI argue that codification of the ESD may 
have significant ramifications for bona fide business 
transactions. It is highly unlikely that bona fide business 
transactions such as the organization of a corporation or the 
sale or reorganization of a corporation would be adversely 
affected by the ESD. The ESD would act as a speed bump for 
problematic transactions that would have virtually no impact on 
bona fide transactions.
    The AICPA argues that codification would present traps for 
small businesses in a broad cross-section of taxpayers. It is 
unlikely that ordinary business activities of small businesses 
and ordinary taxpayers will, in any way, be touched by the 
codification of ESD. These taxpayers generally cannot engage in 
the type of transactions that would raise issues under a 
codified ESD.
    All the organizations argue that the concerns with tax 
motivated transactions have already been addressed by the 2004 
act. However, the revenue estimates associated with ESD show 
that it is likely to have a much greater bite than the 2004 
act. Each of the organizations argues that the 40 percent 
penalty for nondisclosed, noneconomic substance transactions is 
too high. These organizations want to have it both ways. On the 
other hand, they oppose a 40 percent penalty that can be 
avoided by disclosure. Codification of the ESD would be good 
for business, the economy, and the tax system.
    I turn to the territorial regime proposed by the panel. The 
principal reason the panel gives for moving to a territorial 
system is competitiveness. However, there is a serious 
competitive problem in that a territorial regime would attract 
capital overseas. This would be bad for U.S. businesses. 
Congress should tax on a current basis all the income of 
foreign corporations controlled by U.S. taxpayers, which would 
produce significant tax revenues and eliminate much of the 
complexity under our current deferral system.
    Finally, my research shows that dividends for ordinary 
taxpayers, low bracket taxpayers, are indeed overtaxed, but 
dividends for high bracket taxpayers are undertaxed. I 
therefore urge Congress to reinstate the taxation of dividends 
at ordinary income rates for high income tax payers. Thank you.
    [The prepared statement of Mr. Thompson follows:]

 Statement of Samuel Thompson, Jr., Professor of Law and Director, Law 
 Center, University of California, Los Angeles, Los Angeles, California

    I. Introduction. 2
    II. Background on the ESD. 3
    III. The Basic Case for Codification of the ESD. 3
    IV. Projected Revenues from Codification of the ESD. 3
    V. Why is the Treasury against Codification of the ESD? 3
    A. The Rationale Given by Former Assistant Secretary for Tax Policy 
Olson. 3
    B. Analysis of Secretary Olson's Arguments. 3
    1. ``More Wooden'' and ``Less Flexible''. 3
    2. ``Too Broad'' and ``Too Narrow''. 3
    3. ``Complexity'' for the IRS. 3
    4. ``Slow Audits''. 3
    VI. Why are the ABA, AICPA, and TEI against Codification of the 
ESD?. 3
    A. Introduction. 3
    B. Complexity and Interference with Bona Fide Transactions. 3
    C. Hurting Small Business and Taxpayers Generally and Denying 
Flexibility. 3
    D. Concerns Have Already Been Addressed. 3
    E. Penalty too High. 3
    VII. Conclusion on the ESD. 3
    VIII. Congress Should Adopt an Imputation System Rather than a 
Territorial System as Proposed by the Tax Reform Panel 3
    A. Introduction to a Territorial Regime and the Current Deferral 
System. 3
    B. Tax Reform Panel's Reason for Moving to a Territorial Regime. 3
    C. My Proposal for an Imputation System. 3
I. Introduction
    Thank you for giving me the opportunity to share my views with you 
today. The views I express are my own, are not supported by any 
organization or client, and are motivated only by my interest in the 
U.S. tax system.
    Because of the limited time, I will focus my remarks on two issues: 
(1) codification of the economic substance doctrine (ESD), and (2) 
ending deferral for foreign source income of controlled foreign 
corporations. Most of the presentation focuses on the need for Congress 
in the ongoing fight against tax shelters to codify the ESD, currently 
reflected in Senate bill 2020, the Tax Relief Act of 2005. The current 
House bill has no similar provision. I then will provide some brief 
remarks on why I think Congress should reject the recommendation of the 
President's Tax Reform Panel that we adopt a territorial system for 
taxing foreign source income of U.S. controlled foreign corporations. I 
believe Congress should move in the opposite direction and completely 
eliminate deferral for foreign source income. The recent increase in 
oil prices is another good reason for Congress to take a careful look 
at eliminating deferral.
    My testimony today on the ESD follows themes set out in articles I 
have published urging Congress to codify the ESD,\1\ and my 
presentation on deferral is based on a published speech I gave in March 
2006 at the Penn State Forum dealing with tax reform.\2\
---------------------------------------------------------------------------
    \1\ Thompson, Despite Widespread Opposition, Congress Should Codify 
the ESD, Tax Notes 781 (February 13, 2006), and Thompson and Clary, 
Coming in from the ``Cold'': The Case for ESD Codification, Tax Notes 
1270 (May 26, 2003).
    \2\ Thompson, Federal Tax Reform and Reducing the Bush Deficit by 
$800 Billion, 110 Tax Notes 1486 (March 21, 2006).
---------------------------------------------------------------------------
II. Background on the ESD
    The Senate bill sets out a conjunctive test for determining if a 
transaction satisfies the ESD. First, the transaction must change in a 
meaningful way (apart from federal income tax consequences) the 
taxpayer's economic position. Second, the taxpayer must have a 
substantial non-tax purpose (i.e., business purpose) for entering into 
such transaction, and the transaction must be a reasonable means of 
accomplishing such purpose. This conjunctive test would act as a 
significant barrier to tax shelter activity and eliminate the different 
approaches courts have been taking when applying (or even questioning 
the validity of) the ESD under current law. In addition, the Senate 
bill would impose a 40 percent penalty on understatements attributable 
to a non-economic substance transaction, unless the transaction is 
disclosed, in which case the penalty would be 20 percent.
    Codification has been opposed by the Treasury Department, the ABA 
Tax Section, the AICPA, and the Tax Executives Institute (TEI), an 
association of in-house business tax professionals.\3\ My testimony 
today critically examines the rationales given by the Treasury and 
these tax organizations in opposition to codification. I first set out 
the basic case for codification and address the revenue estimates 
behind it.
---------------------------------------------------------------------------
    \3\ ABA Tax Section, Letter of January 4, 2006 to Congressional Tax 
Writers on Three Revenue Provisions, Including Codification of Economic 
Substance Doctrine, in Tax Relief Act of 2005 (S. 2020) as Passed by 
Senate, BNA TaxCore--Congressional Documents Correspondence(January 5, 
2006) ABA Letter]; AICPA, Comments of December 23, 2006 to 
Congressional Tax Leaders on Several Revenue Provisions, Including 
Codification of Economic Substance Doctrine, in Tax Relief Act of 2005 
(S. 2020) as Passed by Senate, BNA TaxCore--Congressional Documents 
Correspondence (January 5, 2006) AICPA Letter]; TEI, Letter of January 
10, 2006 to Chairmen of House, Senate Tax Committees Commenting on S. 
2020, Tax Relief Act of 2005, BNA TaxCore Congressional Documents 
(January 12, 2006) TEI Letter].
---------------------------------------------------------------------------
III. The Basic Case for Codification of the ESD
    Obviously there are many reasons for strong action against tax 
shelters and other non-economic tax-motivated transactions. For 
example, such transactions undermine the structure of the tax system by 
(1) allowing similarly situated taxpayers to pay different amounts of 
tax, that is, undermining horizontal equity, and (2) allowing certain 
taxpayers in higher brackets to pay less than taxpayers in lower 
brackets, that is, undermining the vertical equity inherent in our 
progressive tax system.
    From a macroeconomic perspective, non-economic, tax-driven 
transactions are a drag on the economy, because, among other things, 
time of corporate officers and their tax advisers is diverted to the 
pursuit of transactions that have little or no economic merit. Thus, it 
could be expected that codification of the ESD would have the effect of 
channeling business people and their advisers in the direction of real, 
rather than tax-motivated, transactions. Also, the self-policing nature 
of the ESD may in time allow the IRS and courts to devote less time and 
effort on these transactions.
    Certainly, codification would not end all tax shelter activity or 
tax driven transactions, but it would put a large ``speed bump'' in the 
way of non-economic transactions. The speed bump effect would help to 
level the playing field between (1) those aggressive tax advisers who 
seek financial rewards by playing close to (and in some cases over) the 
line, and (2) those more responsible advisers intent on playing within 
the rules. To be specific, codification of the ESD would reduce some of 
the competitive advantage aggressive tax planners have over their more 
responsible competitors in attracting clients. This is a real problem 
for tax advisers. Indeed, I experienced this problem first hand during 
my many years as the head of the tax department at a major Chicago law 
firm.
    If non-economic transactions are developed that are not prohibited 
by the ESD, the Treasury and Congress should stand ready to enact 
targeted legislation to shut such transactions down. This is what 
Congress did with the enactment of the passive loss provision, Section 
469, which has been very effective in shutting down many real estate 
and similar tax shelters.
    In this regard, I urge that a provision be added to the Senate bill 
requiring the Treasury to annually report to the Congress on (1) the 
effectiveness of the ESD, and (2) the need for targeted legislation 
addressing any tax shelter transactions that may not be clearly caught 
by the statute. This would keep Congress abreast of new tax shelter 
developments.

IV. Projected Revenues from Codification of the ESD
    The projected tax revenue from codification of the ESD is 
substantial, with the Staff of the Joint Committee on Taxation 
estimating that the ESD and the associated provisions would generate 
approximately $15 billion over the ten year period from fiscal year 
2006 through fiscal year 2015.\4\ The revenue from codification of the 
ESD is by far the largest single item of the many ``Revenue Offsets'' 
included in the 2005 Senate Bill.\5\ Thus, this is a big ticket item. 
Indeed, it is much larger than the revenue projected from the package 
of tax shelter provisions enacted by the Jobs Creation Act of 2004 (the 
2004 Act). The Joint Committee Staff estimated that those anti-shelter 
provisions, which related principally to disclosure and penalties, 
would raise approximately $1.5 billion over a ten year period.\6\
---------------------------------------------------------------------------
    \4\ Joint Committee on Taxation, JCX-82-05, Estimated Revenue 
Effects of the Tax Provisions Contained in S. 2020, the Tax Relief Act 
of 2005, as passed by the Senate on November 18, 2005 (November 29, 
2005).
    \5\ Id. at Section V.
    \6\ Joint Committee on Taxation, JCX-95-03, Estimated Revenue 
Effects of Chairman's Amendment to H.R. 2896 the AJCR (October 24, 
2004).
---------------------------------------------------------------------------
V. Why is the Treasury against Codification of the ESD?
A. The Rationale Given by Former Assistant Secretary for Tax Policy 
        Olson
    The Treasury has opposed codification of the ESD for many years. 
For example, in her nomination hearings in 2002 before the Senate 
Finance Committee, former Assistant Secretary of the Treasury for Tax 
Policy Pamela Olson made the following comments concerning 
codification:
    I do not think that codification of the economic substance doctrine 
will help. I do not think it will help for several reasons, but I would 
like to maybe mention a couple of them.
    One, is that the doctrine right now is a very flexible doctrine 
that is applied by the courts as needed. I think any codification of it 
even if in codifying it we say that we do not intend to override any 
other doctrines, I think it is going to make it more wooden and less 
flexible than it currently is.
    If that happens, then it has the potential for being both too broad 
and too narrow. So, that is a real danger. A more serious danger I see 
with it, is I think it adds to the complexity for the IRS in its 
enforcement of the laws and assertion of penalties in appropriate cases 
because it is yet another set of things that they need to consider, 
work through, and look at in doing an audit of a taxpayer. So I think 
that it has the potential to slow IRS audits, and anything that slows 
IRS audits is not a good thing. I think what we need at this point is 
more enforcement, and the IRS being able to complete more audits as 
rapidly as possible.\7\
---------------------------------------------------------------------------
    \7\ Nomination of Pamela F. Olson, Hearing Before the Senate 
Finance Committee (Aug. 1, 2002).
---------------------------------------------------------------------------
    Assistant Secretary Olson's opposition to ESD codification remained 
constant during her tenure as Assistant Secretary for Tax Policy, and 
her views were shared by others in Treasury.
    Olson's statement reveals four principal arguments against 
codification. First, codification would make the ESD ``more wooden'' 
and ``less flexible.'' Second, codification has the potential for 
creating a rule that is both ``too broad'' and ``too narrow.'' Third, 
codification would add ``complexity for the IRS in its enforcement of 
the laws.'' Finally, codification would ``slow IRS audits.'' The next 
section explores each of Assistant Secretary Olson's arguments and 
identifies how each is flawed.
B. Analysis of Secretary Olson's Arguments
    1. ``More Wooden'' and ``Less Flexible''
    Assistant Secretary Olson argues that codifying the ESD would 
create a rule that is ``more wooden'' and ``less flexible,'' and former 
Deputy Assistant Secretary for Tax Policy Greg Jenner has argued that 
the legislative proposals would move away from an inherently flexible 
doctrine to a ``rigid rule.'' \8\ There are two significant criticisms 
of these arguments.
---------------------------------------------------------------------------
    \8\ Sheryl Stratton, Shelter Disclosure, Doctrine Codification 
Debated, Tax Notes, Apr. 7, 2003, p. 25 (quoting the then Deputy 
Assistant Secretary for Tax Policy Greg Jenner as saying that 
codification of the ESD is ``an incredibly bad idea'' that would move 
away from an inherently flexible doctrine to a ``rigid rule.'')
---------------------------------------------------------------------------
    First, both Olson and Jenner use the terms ``wooden'' and ``rigid'' 
in a negative connotation, as if a rule is less effective because it is 
labeled as such. To the contrary, the principal argument for 
codification is the lack of ``woodenness'' or ``rigidity'' in the 
current state of the law. Look where the current ``flexible'' approach 
has left the state of the law concerning tax shelters. Courts are 
applying various standards, and it seems unlikely that the Supreme 
Court will soon clarify the law in such a way as to significantly 
curtail the use of aggressive corporate tax shelters. The current state 
of the law gives sophisticated taxpayers too much wiggle room, that is, 
too many opportunities to convince the IRS or a court that a purely 
tax-motivated transaction should be recognized. On the other hand, 
codification would give courts two guideposts for determining if a 
transaction has economic substance--the ``objective'' meaningful change 
in economic position test and the ``subjective'' business purpose test. 
The transaction would not be recognized if either test were not 
satisfied, that is, if either (1) there were no change in the 
taxpayer's economic position, or (2) the taxpayer did not have a 
meaningful nontax purpose for entering the transaction.
    Second, both Olson and Jenner have overstated the degree to which 
codification would produce a ``wooden'' rule. First, the two-prong 
test, which is central to the codification proposal, is inherently 
flexible. Both prongs are open to interpretation and will afford courts 
latitude in determining what constitutes a ``meaningful change'' or 
``nontax purpose.'' Finally, Treasury would be given significant 
rulemaking authority to clarify the provision and, therefore, would 
have substantial power to insure that the rule is applied flexibly.
2. ``Too Broad'' and ``Too Narrow''
    Assistant Secretary Olson's second argument against codification of 
the ESD is that codification would produce a rule that is both ``too 
broad'' and ``too narrow.'' Olson's argument that codification would 
lead to a rule that is ``too broad'' is based on the proposition that 
codification would result in findings that common transactions lack 
economic substance, and therefore, the desired tax consequences of 
these transactions would be denied. This argument, also vigorously made 
by several tax organizations, has several flaws, which will be 
discussed shortly.
    Assistant Secretary Olson's argument that codification would create 
a rule that is ``too narrow'' is also flawed. While the argument is not 
expressly made, presumably Olson is arguing that currently courts have 
the flexibility to prevent current and future tax shelters that the 
statute may not contemplate, and by codifying the doctrine, tax 
professionals will be able to ``plan around'' the statute, thus 
narrowing the doctrine's reach.
    Four points illustrate the flaws in this argument. First, the 
Treasury's authority to issue regulations under the provision will aid 
in the fight against such ``aggressive planning.'' Second, the language 
of the statute remains sufficiently broad (as Olson herself argues) to 
allow flexibility in determining what constitutes an abusive tax-
motivated transaction that does not result in a meaningful economic 
change or have a business purpose.
    Third, the ``too narrow'' argument assumes that codification is the 
final and only tool in the fight against abusive tax shelters. It is 
possible that clever tax planners will formulate transactions that 
skirt around the literal language of the statute. Such is the case with 
any statute. However, codification of the ESD does not foreclose future 
legislation addressing specific tax shelters, and as suggested above, 
the Treasury should provide Congress with reports on the effectiveness 
of the statute and recommendations for any needed targeted anti-shelter 
legislation.
    Finally, under proposed section 7701(o)(4), prior law continues as 
a supplement to codification. Under the language of (o)(4), other 
common law doctrines, such as the business purpose doctrine, would 
continue to operate as they did before codification. That being the 
case, it seems unlikely that codification would do anything to 
``narrow'' the ability the Service or the courts have in combating 
abusive tax shelters.
3. ``Complexity'' for the IRS
    Assistant Secretary Olson's third argument against codification of 
the ESD is that codification would add ``complexity for the IRS in 
enforcement.'' After even a brief review of the cases attempting to 
interpret and apply the current economic substance and related 
doctrines, it is hard to understand how matters could be any more 
complex for the IRS in terms of enforcement. In making enforcement 
decisions and outlining strategies, the IRS is left with a variety of 
cases that apply a multitude of standards in a seemingly ad hoc 
fashion. This leaves the IRS at a significant disadvantage when 
challenging transactions entered into by enormous global companies with 
sophisticated tax planners on their side.
    On the contrary, it would seem that codification and subsequent 
regulations would significantly decrease complexity for the IRS. 
Codification would give the IRS a much-needed tool in combating these 
abusive transactions. This tool is one of uniformity that would allow 
the IRS to apply a single standard and set of regulations in making 
decisions on enforcement, instead of basing those decisions on 
unsettled doctrines applied in disparate ways by the courts.
4. ``Slow Audits''
    Finally, Assistant Secretary Olson argues that the ESD should not 
be codified because codification would ``slow IRS audits.'' There is no 
evidence to indicate that such a slowdown would occur. On the contrary, 
a more uniform standard coupled with clear and concise Treasury 
regulations would enable the IRS to increase the speed of its audits.

VI. Why are the ABA, AICPA, and TEI against Codification of the ESD?
A. Introduction
    A close examination of the positions of the ABA, AICPA, and TEI 
against codification, reveals the following basic rationales: (1) 
codification would lead to increased complexity for taxpayers and would 
interfere with bona fide business transactions, (2) codification would 
hurt small businesses and average taxpayers and would decrease 
flexibility in the tax system, (3) there is no need for codification 
because the concerns with non-economic transactions have already been 
addressed by the 2004 Act and otherwise, and (4) the 40% penalty 
provision is too high. Each of these points is addressed in turn.
B. Complexity and Interference with Bona Fide Transactions
    Along the lines of the concerns expressed by Assistant Secretary 
Olson, the ABA Letter argues that codification of the ESD may have 
``significant ramifications for bona fide business transactions that 
are far removed from the tax shelter transactions that are the intended 
target of the legislation.'' The TEI Letter makes a similar claim:
    Indeed, codifying the economic substance doctrine would further 
complicate the system, confuse taxpayers and revenue agents, raise 
significant issues of statutory construction, impede the courts' 
ability to rely on existing precedent, and interfere with legitimate 
commercial transactions. Thus, adding a complex, subjective anti-abuse 
rule like [ESD] to the Internal Revenue Code might well be 
counterproductive and even frustrate IRS efforts to combat abusive 
transactions.
    These arguments are unconvincing; it is highly unlikely that bona 
fide business transactions, such as the organization of a corporation, 
partnership, or limited liability company, or the sale or 
reorganization of such an entity would be adversely affected by the 
ESD. Certainly, tax advisers would be more cautious in planning 
transactions that came close to the line, and this is a good thing. The 
ESD would act as a speed bump for problematic transactions but would 
have virtually no impact on standard economically motivated 
transactions.
    The current judicial ESD is difficult to understand, and courts 
take different approaches in applying the doctrine. Thus, there is a 
substantial degree of complexity and uncertainty with the current state 
of the law. Rather than increasing complexity and uncertainty, 
codification of the ESD would lead to a uniform application of the 
doctrine.
C. Hurting Small Business and Taxpayers Generally and Denying 
        Flexibility
    The AICPA Letter argues: ``In addition to introducing statutory 
complexity and traps for small businesses and a broad cross section of 
taxpayers, codifying economic substance would deprive the tax system of 
the flexibility needed to keep pace with the changing economic 
environment.'' First, it is unlikely that the ordinary business 
activities of small businesses and of ordinary taxpayers will in any 
way be touched by the codification of the ESD. Certainly, the ESD will 
act as a speed bump for any small business owner considering entering 
into a tax shelter transaction to shelter her business income or 
capital gain on the sale of the business, but that is as it should be.
    Second, small businesses and ordinary taxpayers generally cannot 
engage in the type of transactions that would raise issues under a 
codified ESD, either because the Code does not allow for such planning 
by such taxpayers, or such persons typically do not have the financial 
capacity to pay the fees of the sophisticated tax professionals who 
create and defend such transactions. Thus, without a strong mechanism 
for curtailing abusive transactions by wealthy individuals and large 
corporations, small businesses and ordinary taxpayers would be saddled 
with a greater portion of the tax burden. Consequently, by promoting 
greater horizontal and vertical equity in the tax system, codification 
of the ESD will help not hurt small businesses and ordinary taxpayers.
D. Concerns Have Already Been Addressed
    The ABA Letter argues that the concerns with tax-motivated 
transactions have already been addressed by the 2004 Act. The AICPA 
Letter makes a similar point: ``In our view, deterrence and the 
eventual eradication of abusive transactions are best accomplished 
through targeted disclosure; reasonably high non-disclosure penalties; 
clearer standards for opinion letters and reasonable cause penalty 
relief; aggressive enforcement; and continued evolution of appropriate 
solutions by an informed judiciary.'' The TEI Letter elaborates 
extensively on the point:
    Moreover, TEI has consistently urged the Congress and the Treasury 
Department to focus on and enhance disclosure-based approaches to 
address tax shelters. In response, the Treasury and IRS developed 
regulations under section 6011 requiring extensive disclosures of 
reportable transactions that might be indicative of tax shelter 
transactions; Congress, for its part, enacted sections 6662A and 6707A, 
which penalize taxpayers for tax understatements attributable to 
reportable transactions and for failing to disclose reportable 
transactions, respectively. In addition, the IRS has developed a new 
Schedule M-3 as part of the Form 1120 U.S. Corporation Income Tax 
Return (among other returns) that dramatically expands the disclosure 
and reconciliation of financial and tax accounting differences. 
Finally, the Treasury Department and IRS have issued rules to restrict 
tax-shelter promoter activities and have substantially revised the 
standards of professional conduct for practice before the IRS (the 
Circular 230 rules), including the rules governing the issuance of 
opinions on transactions. TEI believes that these actions have already 
substantially curbed tax shelter activities, especially by large 
companies.
    Thus, each of these organizations thinks that the anti-shelter 
provisions currently in place are effective. But, the revenue estimate 
associated with the ESD shows that it is likely to have a much greater 
bite than the current provisions. Thus, the assertion by these 
organizations is not consistent with the judgment of the revenue 
estimating professionals on the Staff of the Joint Committee on 
Taxation. Further, even if these organizations are correct in their 
view that the current provisions are effective, the addition of the 
ESD, as an additional speed bump, should not have an adverse effect.
E. Penalty too High
    Each of the organizations argues that the 40% penalty for non-
disclosed non-economic substance transactions is too high. For example, 
the ABA says: ``[We] believe that a 40-percent penalty is too high, is 
likely to be administered inconsistently by the IRS and may affect a 
court's decision as to whether to apply the ESD in a given case.'' And 
the TEI says: ``[W]e believe that a 40-percent penalty is too high and 
may affect the decisions of the IRS to assert the penalty or the courts 
to uphold them.''
    These organizations seem to want to have it both ways. On the one 
hand, they argue that a disclosure regime is effective, but on the 
other hand, they oppose a 40% penalty that can be avoided by 
disclosure, in which case the penalty is reduced to 20%. It seems 
eminently reasonable to impose a 40% penalty on a taxpayer who has 
entered into a non-economic transaction and decided not to disclose the 
transaction on its return.
    Further, the argument of these organizations that the courts and 
IRS will be reluctant to impose the penalty seems to acknowledge that 
the ESD provision is likely to apply only in rare cases. Indeed, 
taxpayers and their advisers will have a tendency to avoid those 
transactions that might give rise to the penalty; again, the ESD 
provision would act as an appropriate speed bump.

VII. Conclusion on the ESD
    Codification of the ESD will not bring business to a halt; rather, 
through its speed bump effect, codification will tend to deter business 
people from pursuing transactions that have no economic substance. This 
will be good for business, the economy, and the tax system.
    One final point! Codification of the ESD should be a non-partisan 
issue, and there is bipartisan support for the provision in the Senate. 
Although the principal opponents to codification in the House are 
Republicans, it should be remembered that in the 1980s strong action 
was taken against tax straddle and real estate tax shelters by the 
Reagan Administration, which led the successful legislative effort to 
shut those shelters down. Now is the time for the Republicans and 
Democrats in the House to come together with their colleagues in the 
Senate and enact the ESD.

VIII. Congress Should Adopt an Imputation System Rather than a 
        Territorial System as Proposed by the Tax Reform Panel
A. Introduction to a Territorial Regime and the Current Deferral System
    I turn now to the question of whether Congress should replace our 
current deferral system for taxing foreign source income with the 
``territorial'' or ``exemption'' system proposed by the President's Tax 
Reform Panel.
    Under a territorial system, U.S. corporations would be exempt from 
paying Federal income taxes on business income they earned in foreign 
countries. For example, assume that a corporation headquartered in 
State College, Pennsylvania, let's call it State Oil Corp, sets up a 
subsidiary corporation in China, let's call it China Oil Sub. State Oil 
Corp would not be taxed on the income earned by China Oil Sub either at 
the time the income was earned or at the time the income was brought 
back (that is, repatriated) to the U.S. in the form of dividends paid 
by China Oil Sub to State Oil Corporation.
    Under our current deferral system, State Oil Corp is not taxed at 
the time China Oil Sub earns the income but is taxed at the time China 
Oil Sub pays dividends to State Oil Corp, and at that time State Oil 
Corp receives, within limits, a foreign tax credit against its U.S. tax 
liability for China taxes paid by China Oil Sub.
    To summarize, under our current deferral system, the business 
income of China Oil Sub gets taxed when the income comes home, with a 
credit for taxes paid to China; under the proposed territorial system, 
the business income of China Oil Sub is completely free of U.S. tax 
even when it comes home.
B. Tax Reform Panel's Reason for Moving to a Territorial Regime
    The principal reason the President's Tax Reform Panel gives for 
moving to a territorial system is ``competitiveness.'' In other words, 
a territorial system is designed to make U.S. firms competitive with 
other firms doing business in China by subjecting the U.S. firm to the 
tax rate that applies to other companies doing business in China.
    Although a territorial regime addresses this aspect of 
competitiveness, it also creates another competitiveness issue, that 
is, it creates an unlevel playing field between business conducted in 
the U.S., for example in State College, and business conducted in 
China. The President's Tax Reform Panel does not address this 
competitiveness problem.
    To illustrate, assume that the corporate tax rate in China is 15%, 
which is 20 percentage points lower than the 35% U.S. corporate tax 
rate. Assume that State Oil Corp is faced with the following investment 
decision: (1) invest $50 million in oil exploration and refining in 
State College, which is expected to produce $10 million in annual 
taxable income, or (2) invest $50 million in oil exploration and 
refining in China, which is also expected to produce $10 million in 
annual taxable income. Thus, the pre-tax return of both investments is 
$10 million. Other things being equal, with a territorial system, what 
investment decision would State Oil Corp make?
    The answer is clear: State Oil Corp will invest in China because 
although the pre-tax returns of the two investments are the same, the 
after-tax return with the China investment is $8.5 million, that is, 
$10 million less the $1.5 million China tax, while the after tax return 
for the State College investment is only $6.5 million, that is $10 
million minus the $3.5 million U.S. tax.
    Thus, in purporting to solve a potential competitiveness problem 
for U.S. companies doing business in foreign countries, a territorial 
system would create a very real competitiveness problem for the people 
of State College in that it would give U.S. corporations an incentive 
to invest capital in foreign markets with lower tax rates, rather than 
investing that capital here at home. Also, such an incentive would only 
exacerbate the problem of the job outsourcing.
    There are many other problems with a territorial system. For 
example, there is an enhanced incentive for companies to deflect what 
would otherwise be high taxed U.S. income into low taxed foreign subs 
through the use of related party transfer pricing that is not arm's 
length pricing, as Section 482 of the Code requires. Also, in the case 
of businesses where costs of operating in foreign markets are less than 
in the U.S., there is a basic financial incentive (in addition to the 
tax incentive inherent in a territorial system) for foreign as opposed 
to U.S. investment. For example, suppose China Oil Sub can produce and 
refine oil for the China market more cheaply than it can in the U.S. 
Assuming the ultimate price to consumers is the same in China and the 
U.S., China Oil Sub will have greater profits on its China sales than 
on comparable U.S. sales, and this is an additional incentive for 
investing in China rather than the U.S.
C. My Proposal for an Imputation System
    My bottom line is that Congress should not adopt a territorial 
regime. In thinking about this issue for many years, I have come to the 
conclusion that Congress should tax on a current basis all the income 
of foreign corporations controlled by U.S. taxpayers. Thus, under this 
system, which has been proposed by, among others, Stephen Shay, the 
International Tax Counsel in the first Bush Administration,\9\ State 
Oil Corp would be taxed currently on the income earned by China Oil 
Sub; in other words, the income of China Oil Sub would be imputed to 
State Oil Corp as the income is earned. Also, State Oil Corp would 
within limits receive a foreign tax credit for the China tax paid by 
China Oil Sub.
---------------------------------------------------------------------------
    \9\ See e.g., Peroni, Flemming, and Shay, Getting Serious about 
Curtailing Deferral of U.S. Tax on Foreign Source Income, 52 SMU L. 
Rev. 55 (1999). See also Flemming and Peroni, Exploring the Contours of 
a Proposed U.S. Exemption (Territorial) Tax System, 109 Tax Notes 1557 
(December 19, 2005) (analyzing the territorial proposal of the Tax 
Reform Report and a similar proposal by the Joint Committee on 
Taxation; concluding that we should move to an imputation system).
---------------------------------------------------------------------------
    Therefore, under the above example, State Oil Corp would be taxed 
in the U.S. on the $10 million of income earned by China Oil Sub, which 
would produce a tentative U.S. tax of $3.5 million. However, State Oil 
Corp would receive a credit of $1.5 million against this tax for the 
China taxes paid by China Oil Sub, producing a final U.S. tax liability 
of $2.0 million. Thus, the total of the U.S. and China taxes would be 
$3.5 million. Under this system, the after tax return from investing in 
the U.S. and China is the same; in other words, the playing field is 
level.
    Leveling the field in this way would also produce significant tax 
revenues. For example, the Office of Management and Budget estimates 
that the tax cost of our current deferral system is $69 billion over 
the period 2007 through 2011. This type of imputation system would also 
eliminate much of the complexity with our current deferral system and 
significantly reduce the ability of firms to engage in abusive transfer 
pricing schemes.
    Let me make one final point. I am not suggesting that we penalize 
investments by China Oil Sub. I am only proposing that the China 
profits of China Oil Sub be taxed at the same rate as U.S. profits.

                                 

    Chairman CAMP. Thank you very much, Mr. Thompson. I want to 
thank the entire panel. Now, we will go into a question period, 
and each Member will have 5 minutes to ask questions. I will 
begin. Dr. Desai, I believe you testified that we have seen 
increased global operations, and many businesses are receiving 
more of their income from their global operations. What, then, 
are the tax trends in other countries. We are not alone in 
terms of dealing with these issues. What do you see as the 
trends around the world?
    Dr. DESAI. I would highlight two things that are apparent. 
First, we have seen declining marginal rates around the world 
so, the idea that people have in their heads that the United 
States is relatively competitive on tax rates is no longer 
true; It was true 20 years ago, but now is no longer true. 
Second, I think we see, and just to flesh that out a little 
bit, Tom mentioned some numbers, but the OECD averages are now 
well below U.S. numbers, and major competitors, both developed 
countries and developing countries have significantly lower 
marginal rates.
    Second, we see our comparable countries employing tax 
regimes for their foreign income which are territorial, and as 
a consequence, American firms that are using this worldwide 
system can be placed at a significant disadvantage relative to 
those foreign firms that are living in an international tax 
regime which is far more friendly.
    Then, finally, just on this point of how we as American 
companies or how American companies compete with those firms, I 
think it is important to note that when firms grow abroad, that 
is good for the United States. Research shows that firms that 
grow abroad grow domestically, and it makes sense; which is to 
say this is not a zero sum game. If it is not a zero sum game, 
if we make American firms more competitive abroad, they are 
going to do more activities in the United States as well. So, 
we should not view this as a zero sum game where, you know, if 
some investment goes abroad, somehow it is lost. In fact, the 
exact opposite is true.
    Chairman CAMP. Thank you. Mr. Pearlman and Dr. Neubig, if 
you could just comment: not all businesses are C Corporations. 
Tell me how you feel expensing and accelerated depreciation, 
how do passthrough entities like partnerships and Subchapter S 
companies, how important are those items to them in your 
opinion?
    Mr. PEARLMAN. I think the tax cost recovery system is 
important to every business. Indeed, in this context, as I 
noted in my written statement, I think you cannot just think 
about corporations. This is really a business tax system issue. 
Therefore, the sole proprietor, the business being operated in 
partnership form, the corporate enterprise, whether it is in a 
passthrough form like a Subchapter S corporation or a regular C 
Corporation, all are affected by the cost recovery system. 
Therefore, I think you have to think about all of those forms 
as you think about changes to any aspect of the cost recovery 
system.
    Chairman CAMP. Dr. Neubig?
    Dr. NEUBIG. I would agree with Ron Pearlman, that 
accelerated depreciation is important for all businesses. 
Although it is a timing difference, there are positive 
reductions in the cost of capital. The question is, for 
corporations and for noncorporations, if you have a choice, an 
explicit choice, between accelerated depreciation or expensing 
and a lower rate, what would work best, and for many 
noncorporations, they are also earning a lot of income from 
their hard work, their entrepreneurial efforts, their risk-
taking in addition to from their equipment and their property.
    Chairman CAMP. Thank you. For Mr. Pearlman and Dr. 
Shackelford, we heard from the panel a recommendation that we 
should look at the corporate rates. If those were reduced, what 
effect would that have on taxpayers with deferred liabilities, 
those that are heavily in debt, if you could both just take a 
chance to answer that? Dr. Shackelford, if you want to begin.
    Dr. SHACKELFORD. Let me make sure I understood your 
question. You asked about deferred tax liability?
    Chairman CAMP. Yes, and how would a change in the rate 
affect those companies or businesses with deferred tax 
liabilities or those that are heavily in debt?
    Dr. SHACKELFORD. Deferred tax liabilities are taxes that 
you have to pay in the future. Since the rate would be lower in 
the future, this would create current income to companies on 
their books. Obviously, companies would be pleased by that.
    Conversely, if you had deferred tax assets, in other words, 
you have deductions coming in the future; those deductions just 
became smaller. So, for companies in that situation, and there 
are a lot of companies with very large tax assets, 
surprisingly, reducing the tax rate from their perspective will 
not be good.
    I am not sure that that has a direct implication to 
leverage, except that the stronger your balance sheet, the more 
easily you can raise capital.
    Chairman CAMP. All right; thank you. Mr. Pearlman?
    Mr. PEARLMAN. Mr. Chairman, the only thing I would add to 
that is actually a more general comment. Dr. Shackelford is the 
world's expert on this topic, so I do not think I can add very 
much. More generally, I think the book effects, the financial 
accounting effects of tax law changes are obviously critically 
important to businesses, particularly to public companies, and 
I think at least as tax professionals, we tend to deemphasize 
or not pay attention to those, and obviously, in the tax policy 
process, it is critically important to at least be aware of 
what those effects will be.
    Chairman CAMP. All right; thank you very much. Now, Mr. 
McNulty may inquire.
    Mr. MCNULTY. Thank you, Mr. Chairman. Since our time is so 
limited, I am going to harken back to what I said in my opening 
statement. I come from New York. We had a Governor years ago, 
Al Smith, who used to say let us look at the record. I have 
been here since the eighties, and I note that in the nineties, 
we had the longest sustained period of economic growth in the 
history of the country. We also had the only four budget 
surpluses in the last generation.
    Then, in the year 2001, we started on this era of 
multitrillion dollar tax cuts. We have since had the largest 
budget deficit in the history of the country, and the national 
debt is now exceeding $8.3 trillion. Now, people that are my 
age are going to get through the rest of their life okay. I 
have got four children and five grandchildren, and I think more 
and more each day about what we are leaving them. Frankly, I do 
not like the picture right now.
    I guess I would like to ask each of you to comment briefly 
on, not the reasons for what has happened in the last few 
years, but based upon the recommendations that you have just 
made, how do you see your recommendations ameliorating that 
situation, if, indeed, you think they would? Yes.
    Dr. DESAI. Congressman, I share your concern about both 
large deficits, both for future generations, with the value of 
the dollar, for a variety of reasons. As it relates to 
recommendations I put forward, the key concern is that we 
continue to grow as an economy, and unlocking these corporate 
capital gains so they can be reinvested productively, as 
opposed to being held on in the way they are now, would 
stimulate new investment domestically.
    Second, making our firms more competitive and allowing them 
to compete against other corporations that have different tax 
regimes that they face again I think would help the economic 
growth picture here.
    Finally, on book tax conformity, which I advocate, and Doug 
disagrees with, there is the potential for a much simpler 
system which has much lower compliance costs and effectively 
could be revenue neutral.
    So, I think those are savings, and I think those allow us 
to grow further. There is an interesting question you raise 
about how we think about financing ourselves going forward. In 
my proposals today, I have emphasized and really focused on the 
growth effects of these proposals, which I believe are 
substantial and would help us ultimately grow out of these 
deficits.
    Mr. MCNULTY. Thank you.
    Mr. PEARLMAN. Mr. McNulty, as it relates to the topics I 
discussed today, I think the primary focus is my concern, 
frankly, that tax reform is viewed just another opportunity to 
reduce taxes, either on individuals or businesses or both. What 
I was simply trying to convey in my comments is that tax reform 
can be an opportunity to improve the efficiency of the tax 
system, but it has to be under a very severe discipline.
    The thing that I think was the hallmark of the 1986 effort, 
with which I was somewhat involved, was that it was done on a 
strict revenue neutrality basis that forced a recognition that 
there would be, as best people could determine, no revenue 
loss. Absent that, tax reform could just contribute to the 
serious economic condition of the country, and I am worried 
about that, and that is what prompted a lot of what I tried to 
address today.
    Mr. MCNULTY. Thank you.
    Dr. NEUBIG. I think I have worked too long with Ron and 
have shared the experience of the 1986 tax act. There clearly 
is improvement for meaningful reform in the corporate tax area 
that will improve our economy, increase the personal incomes of 
our kids and grandkids, and in many ways, we have to make hard 
decisions between choices such as narrowing the base versus 
lowering the rate, and whether or not Congress can choose what 
will be best for the economy on an industry by industry basis 
or trying to reduce rates for all industries is something you 
should be deciding.
    Dr. SHACKELFORD. I think my comments with regard to 
conformity have really very little to do with what you are 
asking. My comments raise the concern that as you move forward 
in considering corporate tax reform, you take into 
consideration that the financial reporting system is closely 
linked, and in improving the tax system, we want to be careful 
not to harm our capital markets.
    Mr. THOMPSON. If Congress were to follow my suggestions on 
dividends, the deficit would be $109 billion less over the next 
10 years. With respect to the imputation system I have 
suggested, revenues would go up significantly, and a bias in 
favor of foreign investment vis-a-vis U.S. investment would be 
eliminated. The enactment of ESD would generate significant 
revenues, according to the JCT revenue estimates.
    Mr. MCNULTY. I thank you all, and thank you, Mr. Chairman.
    Chairman CAMP. Thank you. Mr. Linder may inquire.
    Mr. LINDER. Mr. Thompson, do you think the taxing on 
various assets is a zero sum game? Are people going to have the 
same dividends paid out if you tax them higher as they do 
today?
    Mr. THOMPSON. I think the evidence is ambiguous as to 
whether the reduction in the rate of taxation on dividends has 
generated an increase in dividend payouts. There are some basic 
disputes among the economists----
    Mr. LINDER. Do you think Microsoft would have finally paid 
dividends even if we did not change the taxes?
    Mr. THOMPSON. Pardon me?
    Mr. LINDER. Do you think Microsoft would have made the 
decision to pay dividends even if we did not have a tax----
    Mr. THOMPSON. I do not know about Microsoft as a company. I 
am simply talking about it on an aggregate basis. I think the 
evidence is in dispute as to whether it has generated. Even if 
it has generated, that does not necessarily mean that it is 
better for the economy, because where are those dividends going 
to go? Are they necessarily going to be plowed back into other 
companies or plowed back into other investment? Is it more 
efficient to have dividends than to have retained earnings? I 
think that----
    Mr. LINDER. I got your idea. Dr. Shackelford, how much do 
we spend in corporate America on compliance costs?
    Dr. SHACKELFORD. I do not have a figure. I am sure it is 
extraordinarily high.
    Mr. LINDER. What percentage of all income taxes are paid by 
corporations or businesses?
    Dr. SHACKELFORD. I do not have that percentage in front of 
me either.
    Mr. LINDER. Ten or 11 percent.
    Dr. SHACKELFORD. It is not a particularly large number in 
corporate taxes. It is difficult to make that statement, 
because S corps and other things would flow through to 
individual tax returns. So, if you look at the tax return data, 
that becomes a hard question to answer.
    Mr. LINDER. Is it fair--the Tax Foundation says that we 
spent $265 billion last year filling out IRS paperwork. Is that 
a fair number?
    Dr. SHACKELFORD. I cannot verify that, but as I said, I am 
sure it is a large number.
    Mr. LINDER. Is it also fair to assume that we also spend 
almost that much or at least half that much calculating the tax 
implications of a business decision?
    Dr. SHACKELFORD. Again, I do not have that number, but that 
number also is high.
    Mr. LINDER. Mr. Pearlman, if corporate America is paying 
about 10 percent of the income tax burden, and they used to pay 
about a third, who is actually paying those taxes?
    Mr. PEARLMAN. Well, that is a question that is probably 
unanswerable. The economic literature suggests that the 
corporate tax is borne by wage earners, by investors, and by 
consumers. In what proportions? You talk to three economists, 
they will give you different answers.
    Mr. LINDER. Have you ever started a business?
    Mr. PEARLMAN. I am sorry?
    Mr. LINDER. Have you ever started your own corporation?
    Mr. PEARLMAN. I have never started my own corporation. I 
have started lots of corporations but never my own.
    Mr. LINDER. I have started six in which I was the only 
shareholder. You put as much money as you can into it, and then 
you go to the bank and borrow. Guess who paid my taxes when I 
made profits? My customers, my clients, my patients. I could 
not go back to my pocket again.
    Mr. PEARLMAN. As I said, the economic literature suggests 
that corporate taxes are borne by all of them: some in the form 
of adjustments to wages; some in the form of prices to 
consumers; some are borne by shareholders, and I do not think 
there is any definitive response that anyone can give to your 
question.
    Mr. LINDER. Well, if you start that company, and you are 
the only shareholders, you know you cannot go back to that 
pocket again. It comes from your customers. If we are spending 
as much to comply with the Code and calculate the tax 
implications of a business decision as we are submitting to the 
government, is it reasonable to assume that if we eliminated 
all business taxes entirely, we might have more revenues to the 
Federal Government?
    Mr. PEARLMAN. I do not know the answer to that question. 
Clearly, I mean, clearly, you are correct, Mr. Linder, that the 
financial cost of tax compliance is very high in this country, 
and presumably, tax reform could contribute to a meaningful 
reduction in that cost. Would that be good for the tax system 
or the economy? I am confident it would be.
    Mr. LINDER. If we are spending $300 billion to $400 billion 
a year to comply with the Code and submit $1.5 trillion in 
income taxes, that is not just inefficient; that is stupid. 
Thank you, Mr. Chairman.
    Chairman CAMP. Thank you. Mr. Doggett may inquire.
    Mr. DOGGETT. Mr. Chairman, thank you. I genuinely 
appreciate you having this hearing, and my remarks about what I 
consider to be the scandalous role of the Committee on Ways and 
Means in its failure to address corporate tax abuses are in no 
way directed at you as the new Subcommittee Chairman on a 
personal level, but I do think----
    Chairman CAMP. Well, I certainly appreciate that.
    [Laughter.]
    Mr. DOGGETT. --it is very important to put this in proper 
perspective, and I do not think it has been put in proper 
perspective.
    I do agree with you fully that all Members of the Committee 
want a tax system that does not choke off economic growth, but 
when you look at the ongoing abuses that this Committee has 
disregarded through the years, it really is enough to make you 
choke. Citizens for Tax Justice did a study of corporate income 
taxes in the Bush years that was published in 2004 and found 
that about a third of the 275 major companies they surveyed 
paid nothing or less in Federal income taxes in at least 1 year 
from 2001 to 2004. There were 28 companies that enjoyed a 
Federal income tax rate of zero or negative for the entire 
period, 2001 to 2003.
    I think that it is not realistic to compare statutory rates 
with the OECD. The main thing we have in common with the 
Europeans is Swiss cheese, and we have a Swiss cheese corporate 
Tax Code, except that it is mostly hole and not very much 
cheese. This hearing in a way is the nearest thing that the 
Committee on Ways and Means has done to continue any hearing or 
investigation of corporate tax abuse since Chairman Archer 
reluctantly convened this Committee in this room on November 
10, 1999, and in the intervening half a dozen years. During 
that period, the proportion of the national tax burden that is 
borne by corporations has steadily declined, and the use of 
abusive tax dodging techniques has cost Americans billions and 
billions in revenue.
    On that day, November 10, 1999, the discussion focused on 
recommendations of the Joint Committee on Taxation and on 
legislation that I had introduced to close at least a few of 
the most abusive corporate tax shelters. Since then, the U.S. 
Senate, even when it had a Republican majority, has on at least 
three occasions overwhelmingly approved legislation to address 
this matter of abusive corporate tax shelters.
    The issue continues even to this moment, as Chairman 
Grassley has attempted, even in the tax reconciliation 
conference Committee, to address the problem of corporate tax 
avoidance. Senator Levin brought in the tax returns from Enron. 
This Committee was even afraid to look under a rock to see what 
was under there with the kinds of abuses that led not only to 
the defrauding of shareholders but to the conduct that was to 
the great detriment of the U.S. Treasury.
    Throughout this period, the House Committee on Ways and 
Means has been the obstacle. It has been the major enabler of 
corporate tax shelters. It simply would not have been possible 
for KPMG, other major accounting firms, investment banks, and 
assorted law firms to rip off the U.S. Treasury without this 
Committee blocking reform.
    What was the kind of conduct that this Committee was 
permitting to continue? Well, one of those who testified as a 
former KPMG employee over in the Senate described having 
personally witnessed in his large accounting firm tax shelter 
promoters openly proclaiming their disregard as the law by 
making statements to clients such as, ``it is like stealing 
candy from a baby;'' ``you will never pay taxes again;'' ``our 
clients do not pay income taxes.'' Paying tax is optional--kind 
of the Leona Helmsley approach to corporate taxes.
    So, as we look at how to restructure our corporate tax 
system, the first thing we need to look at is how to shut down 
some of the abuses. There may well be more commonality than my 
comments indicate in that to the extent that we simplify the 
system, the opportunities for corporate tax abuse will be 
reduced.
    Let me ask you, Professor Thompson, the comparison to the 
OECD, if you actually compare instead of the statutory rate, 
the amount versus gross domestic product (GDP) of U.S. domestic 
tax revenues with the amount of corporate tax revenues versus 
GDP in those other countries, how do we come out comparing? Do 
we look like we are the most negative toward corporations or 
overdemanding to them in what they provide, or are we behind 
the European countries in that regard?
    Chairman CAMP. Mr. Thompson, the Gentleman's time has 
expired, but we would like to hear your answer.
    Mr. DOGGETT. Thank you.
    Mr. THOMPSON. Thank you, sir. It so happens, Congressman, 
that I had an opportunity to look at that very question. The 
Tax Foundation came out with this report that follows the 
Professor's statement here about statutory rates, and the 
statutory rate in the United States is 39.4 percent, according 
to the OECD; for example, the statutory rate in the U.K. is now 
30 percent. As of 2000, the year 2000, note the difference in 
the percentage of GDP produced by those two statutory rates.
    In the United States, the 39.4 percent statutory rate came 
out to 2.5 percent of U.S. GDP. The 30 percent statutory rate 
in the United Kingdom (U.K.) comes out to 3.7 percent of U.K. 
GDP, and the average percentage of corporate tax to GDP is 3.6 
percent among OECD countries, which indicates that our 
corporate tax system is full of holes. We have a high statutory 
rate and a very low effective rate. Other countries have lower 
statutory rates and higher effective rates.
    Chairman CAMP. Thank you very much. Ms. Hart may inquire.
    Ms. HART. Thank you, Mr. Chairman. I have too many 
questions, so I am going to pick one.
    I had a forum with about eight different corporate 
financial people on Friday to get an opportunity to hear from 
them and their everyday lives and the decisions they make 
basically as a result of the Tax Code, not necessarily because 
they are the best decisions for the business but because they 
are the best decisions for the business because of the Tax 
Code, which I think we all agree is really strange and 
undesirable.
    One thing I left the meeting with, one point, and I believe 
Professor Pearlman made it, is just the idea of getting rid of 
the different unique little exemptions and other special 
provisions and just having an effective across the board lower 
rate. If Congress actually did decide to broaden the corporate 
base and then reduce rates, I would like to hear first from Mr. 
Pearlman and then anybody who we have time for, what effect you 
think that might have on taxpayers and the deferred tax 
liabilities and other decisions that they have made and the 
suggestion of timeframe that it would take, actually, to change 
the system that drastically.
    Mr. PEARLMAN. Well, Ms. Hart, I will try to be very brief 
so that others have a chance to comment. I think overall, it 
would be an extraordinarily positive thing to do. Very 
candidly, however, it is going to differ depending on 
taxpayers. Taxpayers who currently enjoy the benefits of very 
targeted tax preferences are not going to be happy. Taxpayers 
who have higher effective tax rates are going to be delighted.
    I think the financial accounting impacts in the aggregate 
should be positive, although again, I would leave it to 
Professor Shackelford to react authoritatively to that. It is a 
difficult process; I lived through that during the 1986 act, 
and it is a difficult process. If one were to make a judgment 
that it were desirable to reduce the marginal tax rate, as I 
believe it would be, and you are willing to take on the burden 
of getting there, that is, identifying the losers that are 
necessary to do that, I think ultimately, that would be good 
for this country, both from a tax policy and an economic policy 
standpoint.
    Ms. HART. Thanks. I guess, Dr. Shackelford, since you have 
been called upon.
    Dr. SHACKELFORD. I wholeheartedly agree with a broader base 
and lower rates. One thing that it would cost you is, if you 
move the corporate rates, you also need to move the individual 
rates. If you move the corporate base, you need to move the 
individual base. An example of this is the opportunity between 
having a C corporation and an S corporation. You do not want a 
situation where, basically, individuals can either game the 
system by being a corporation and getting a more favorable tax 
system or remaining as an individual for tax purposes and 
gaining a more favorable situation.
    So, I fully endorse broader base, lower rates, but I would 
say it needs to be further than just corporate reform.
    Ms. HART. Okay; thank you for that. Anybody else care to 
comment? Yes, I would run from that one screaming, too. The one 
thing you all did not give me, and I will see if I can get it, 
is a timeframe to get there. Should it be, you know, here is 
the law now, and in 10 years, this is going to be the new law, 
or how do we get there?
    Mr. PEARLMAN. Well, to some extent, frankly, it depends on 
how you get there. My assumption has always been that 
reasonable transition from the existing law to a desired future 
goal makes a lot of sense, and while there are academics who 
disagree with that and say you should just go cold turkey, 
change the law, let people just suffer with the change, I think 
that is not realistic either from a business perspective or in 
a realistic political world.
    How long depends on what the changes are. For example, if 
you made massive changes to the depreciation system, 
presumably, you would do that over a longer period of time. If 
you merely cut out a couple of very targeted, narrow tax 
shelters, perhaps you could do that more quickly.
    Ms. HART. The more things we offer from 1 year to the next, 
the harder it gets.
    Mr. PEARLMAN. Exactly.
    Ms. HART. It obviously makes delay a problem.
    Mr. Thompson.
    Mr. THOMPSON. Let me say, I am a Democrat, but I have the 
utmost admiration for Ron Pearlman and what he and others did 
in the Reagan Treasury Department in 1986, and I think that if 
we could start, if we could go back to the 1986 code right now, 
we would have one hell of an improvement over what we have.
    Ms. HART. Okay; that gets us at least 20 years back--by the 
way, I was in law school in 1986, learned all the tax law, and 
then, it was all different, which was really helpful. I think 
that is the only question I have for now, because I see my time 
has gone. I yield back, Mr. Chairman.
    Chairman CAMP. Thank you very much. Ms. Tubbs Jones may 
inquire.
    Ms. TUBBS JONES. Thank you, Mr. Chairman. Good afternoon, 
gentlemen. Thank you for appearing here today. I want to start 
with, if I can read this, Dr. Neubig, seeing how you decided to 
talk about my State having recently--I am from Ohio, by the 
way; there are a lot of things going on in Ohio, like a loss of 
160,000 jobs, and so forth, but I want to focus in on where you 
said when the State of Ohio enacted legislation phasing down 
its corporate tax rate on June 30, 2005, a number of public 
corporations reported higher profits due to the future tax rate 
reductions and their second quarter financial results. Have you 
followed that since June of 2005, sir?
    Dr. NEUBIG. Well, I guess this goes to the question that 
Congressman Hart also asked in terms of the timing of the 
transition, that the Ohio Legislature and the Governor signed a 
5-year phasedown of the corporate franchise or income tax, 
completely eliminating the corporate income tax 5 years out, 
and the way the accounting works--and again, I would defer to 
Professor Shackelford, is that when you have deferred tax 
liabilities, oftentimes, those deferred liabilities are going 
to be going out, 5, 10, even 20 years.
    To the extent that there are lower rates, because, as taxes 
might have been paid 10 years from now, they are currently 
measured at, in the case of Ohio, it might have been 5 percent, 
but now, it will be at zero; they were able to report higher 
book profits. So, there is almost an immediate effect in terms 
of some of the book changes.
    Ms. TUBBS JONES. If I understand the discussion about a 
book change and a real change, what impact--was there a real 
change for growth of business in Ohio as a result of this tax 
change?
    Dr. NEUBIG. Well, I certainly think the Ohio Legislature 
thought that was true. The Ohio Business Roundtable was 
supportive of the----
    Ms. TUBBS JONES. I did not ask you that question, sir. I 
asked you was there a real change.
    Dr. NEUBIG. My colleague, Bob Cline, has done analysis of 
it. I mean, it has only been in effect for 9 months. It is 
being phased in over----
    Ms. TUBBS JONES. Sir, I do not have but 5 minutes. Either 
it did, or it did not. Was there an improvement?
    Dr. NEUBIG. Well, we certainly believe it will have a 
positive effect on Ohio's economy; absolutely.
    Ms. TUBBS JONES. So, do you think if individuals had the 
ability to defer their taxes over 5 or 10 years, they would 
have an opportunity to improve upon their economic situations?
    Dr. NEUBIG. Well, I think marginal tax rates matter. High 
marginal tax rates discourage activity, and if we can have 
broader bases with lower marginal tax rates, I think that is 
positive for State economies and also the U.S. economy.
    Ms. TUBBS JONES. Let me go to the Democrat. Mr. Thompson, 
tell me, are you familiar with the change in Ohio tax laws with 
regard to corporations?
    Mr. THOMPSON. I do not know anything about State taxes.
    Ms. TUBBS JONES. Got you. Got you. Got you. Let me ask you 
something else, then. It was a great answer. From what I am 
hearing, as I recall some of the things you said, Mr. Thompson, 
there could be improvements in the income for the United States 
if there were some changes in the corporate tax structure. That 
is a good summary of what you said.
    Mr. THOMPSON. Yes.
    Ms. TUBBS JONES. Can you give us some specific examples of 
changes that you would suggest would assist us in improving the 
income of the United States or the deficit? Maybe that is a 
better question to ask.
    Mr. THOMPSON. Well, as I said, I think that this idea that 
dividends are undertaxed is just flat out false for high 
bracket taxpayers. I think that the case--I think the 
conservative Republicans ought to be strongly supportive of 
moving to tax dividends of high bracket taxpayers at regular 
marginal rates that would eliminate a huge subsidy that those 
taxpayers are receiving and would give you some revenue to 
begin to focus on the idea of bringing down corporate rates.
    If you have a tax system that is just full of loopholes, 
you are going to be bound to have these high statutory rates to 
make up for the deficits that arise from the loopholes. So, the 
dividend problem is a major problem.
    Ms. TUBBS JONES. The argument that is made for reducing the 
capital gains and dividends is that hundreds and millions of 
Americans depend on their dividends for their retirement and 
the like. Are you able to compare, in the work that you have 
done, how much income comes from dividends for these poorer 
people who live on their dividends as opposed to the reduced 
rate for the high income folks?
    Chairman CAMP. Mr. Thompson, the time has expired, but 
please complete your answer.
    Ms. TUBBS JONES. Thank you, Mr. Chairman.
    Mr. THOMPSON. Clearly, high bracket taxpayers get most of 
the benefit from the dividend cut. I believe that if you move 
back to taxing dividends at the regular, ordinary rate, there 
ought to be some targeted relief for low bracket taxpayers.
    Ms. TUBBS JONES. Thank you, Mr. Chairman.
    Chairman CAMP. Thank you. Mr. Chocola may inquire.
    Mr. CHOCOLA. Thank you, Mr. Chairman. Thank you all for 
being here. Obviously, we are here to talk about potential tax 
reform, and a lofty goal or a reasonable goal for any tax 
reform is to increase our competitiveness, U.S. companies, and 
our standard of living as a country. So, with that in mind, 
just to review some of the economic data that we have had 
recently: we have had 18 straight quarters of economic growth; 
unemployment is at a historic low of 4.7 percent. We have had 
5.3 million new jobs since August of '03 created in this 
country. After-tax personal income has grown about 4.1 percent 
in the last 12 month. The Dow Jones is at historic highs. Tax 
receipts grew by 15 percent in 2005, one of the largest 
increases, I think, in over 20 years. Capital gains receipts 
alone grew by over 50 percent from 2003 to 2005. The deficit, 
the annual deficit last year, was reduced by about $100 
billion, and receipts in the first quarter of '06 are up 10 
percent, and the deficit is down about $11 billion.
    What lessons do you think we learned in the tax bill that 
we passed in 2003, which is right, after I was elected in 2002? 
Are there any lessons that we can learn from that? Do you think 
the dividends rate, the cap gains rate, 179 expensing, had 
anything to do with that growth?
    Dr. DESAI. I am going to take a shot at that. I think that 
experience illustrates two things: first, it illustrates that 
reduced marginal rates on capital gains and dividends have the 
potential to impact the cost of capital and increase 
investment.
    Mr. CHOCOLA. So, reduced rates could actually lead to 
increased tax receipts?
    Dr. DESAI. Increased investment, and then, following down 
the chain, ultimately to higher wage levels and to higher tax 
receipts.
    I think it also illustrates the fact that we came out of a 
recession at that simultaneous time. What is very hard to 
disentangle is what those relative two effects are: what is the 
natural bounceback, and what is the effect of those tax 
changes? The economic studies on that subject suggest that, A, 
it improved dividend payouts for sure; and B, there is 
competing evidence on whether or not it actually influenced 
investment, in large part, because it is hard to tell the 
timing of the tax act versus just a natural bounceback.
    Mr. CHOCOLA. Anybody else? Mr. Thompson?
    Mr. THOMPSON. Congressman, it is attractive to say we 
reduced the capital gains rate; we reduced the dividend rate, 
and the economy has been doing well, and therefore, the economy 
has been doing well for those reasons, but think back to 1993. 
In 1993, we increased taxes, and yet, there was a significant 
period of growth, and indeed, a period of growth that far 
eclipsed the period of growth that we have seen recently, so 
that is it fair to say that all of the 1993 and thereafter 
growth was attributable to the tax increase? I think some 
people believe that it probably was.
    I do not think that we can say that a significant portion 
of the current growth that we have seen is attributable to the 
tax break for capital gains and dividends. Also, I think that 
by extending the dividend rate, the current dividend rate and 
the current capital gains rate is going to have a significant 
adverse budgetary effect going into the future. There may have 
been a decrease in the budget recently, but if there is a 
continuation of the cuts for dividends and capital gains, it 
will be a significant adverse budgetary effect.
    Mr. CHOCOLA. Well, I am certainly not a history professor 
or an economist, but one of the things that I have learned is 
that when you have lower marginal rates, be they individual or 
corporate rates, it seems to me that history has proven that 
tax receipts actually increase because of economic growth, with 
the Kennedy tax cuts, the Reagan tax cuts, and now, the tax 
cuts that we have enacted over the last few years. You said 
that you would raise dividend rates on high income earners. How 
do you define high income earners?
    Mr. THOMPSON. My research shows that if you move back to 
taxing dividends as ordinary income, taxpayers in the 28 
percent bracket and lower would be overtaxed on dividends, and 
you ought to have some kind of relief for those taxpayers. But 
taxpayers in the 33 percent and higher tax brackets would not 
be overtaxed on dividends, and they should be subject to 
taxation at regular rates.
    Mr. CHOCOLA. What about, and I should probably know this, 
but how are mutual funds taxed? If I am a teacher, and I am 
part of a pension plan that has investments, that pays 
dividends, how are those mutual funds taxed, and how is the 
individual teacher in the pension plan taxed?
    Mr. THOMPSON. Well, the mutual fund is not subject to 
taxation, and the dividends that are distributed to the 
retirement plan are exempt from taxation. The teacher is exempt 
from taxation until he or she retires, in which case, the 
distributions from the pension plan would be taxable to the 
teacher.
    Mr. CHOCOLA. Okay; thank you. Thank you, Mr. Chairman.
    Mr. FOLEY. [Presiding.] The time of the gentleman has 
expired. The gentleman from California may inquire.
    Mr. THOMPSON OF CALIFORNIA. Thank you, Mr. Chairman. I 
thank all of you for being here today. I just want to go back 
to something that two of my colleagues mentioned. Mr. McNulty 
talked about the size of the problem, particularly the debt and 
the deficit. Mr. Thompson, I appreciate your proposal that 
would save $109 billion over 10 years, and just for the record, 
though, it is important to note that the debt is $8.3 trillion, 
so we would have to do about 81 times those savings in order to 
have an effect on that, and we learned here in this very 
hearing by the Comptroller that by 2041, the Federal Government 
is going to take in enough revenue to pay the interest on the 
national debt. As a matter of fact, just in the little bit of 
time that we have been here today, the interest payments have 
been about $21 million, so this is a pretty substantial 
problem.
    Then, we see that competing interest, because later, Mr. 
Thompson, you mentioned that we could then use those savings to 
bring down the corporate rate, so those savings did not even go 
down to pay the debt of the $400 billion deficit. They are 
already in the hunt for how to spend those.
    The other issue was abuse that Mr. Doggett talked about, 
and being that this is a hearing to get ideas on how to fix the 
tax structure, do any of you have ideas on how we can go after 
this abuse issue, and what sort of changes in the law could we 
put in place to close those abuse loopholes?
    Dr. DESAI. I would go back to my third proposal, which is 
to link book and tax income more carefully. As Congressman 
Doggett alluded to, we are living in this world where we have 
two completely different notions of income: what people report 
to capital markets and what they report to tax authorities. So, 
that gives them license to do a lot of different things, and 
they take advantage of that. So, that is the world that we are 
living in today.
    If we lived in a system where marginal rates were lower, 
where income was defined according to the principles that have 
been developed by accountants, that would be much more 
preferable to a system where income was defined according to 
transitory legislative needs or tinkering, legislative 
tinkering; no disrespect intended. So, in that sense, I think 
conformity would allow for that kind of shelter abuse to stop. 
In fact, we know that corporate tax shelters are never 
undertaken to reduce book income, and in fact, they are often 
undertaken to produce book income. So, eliminating that 
distinction between the two, I think, could actually help a lot 
of the corporate tax abuse that we see.
    Mr. THOMPSON OF CALIFORNIA. Thank you. Any other ideas on 
how to stop the abuses? Yes, sir.
    Dr. SHACKELFORD. I would recommend increasing funding for 
the IRS.
    Mr. THOMPSON OF CALIFORNIA. Create----
    Dr. SHACKELFORD. Increased funding for the IRS. Some years 
ago, corporations were audited in a much higher proportion than 
they are now. I think that reductions in funding contributed to 
some of the things in recent years that occurred.
    Mr. THOMPSON OF CALIFORNIA. So, better enforcement.
    Dr. SHACKELFORD. Yes.
    Mr. THOMPSON OF CALIFORNIA. Any other ideas? Mr. Neubig, 
you mentioned the issue of capital expensing, and could you 
talk a little bit about how this helps to influence purchasing 
choices? It seems to me that that is one way to stimulate the 
economy, one way to generate more business here at home. Is 
that what happens? I was not certain on your testimony whether 
you were critical of that or----
    Dr. NEUBIG. I am not being critical of having depreciation 
rules that are set by Congress in terms of achieving the 
optimal investment incentives, but there are tradeoffs, and 
depreciation is a large part of the corporate and total 
business income tax base. To the extent that there is a 
deficit, to the extent that you were doing revenue neutral tax 
reform, there are choices that have to be made in terms of do 
you want to have accelerated or more accelerated depreciation 
versus the alternative of having a lower rate for corporations 
or for individuals?
    When people do their cost of capital calculations, it is 
not only the treatment of depreciation, but it is also the tax 
rate that goes into those calculations. So, both of them, both 
lower rates and accelerated depreciation, can have favorable 
effects in terms of the investment decisions. There are an 
awful lot of other margins that are important that businesses 
are making besides just making investments in equipment and 
property. They are making decisions in terms of where they are 
going to be doing business in the world; they are going to be 
making decisions about their debt-equity choice, whether or not 
they are going to choose to operate in corporate form versus 
noncorporate form. They are making decisions about transfer 
pricing. All of those other decisions are affected by the 
statutory tax rate.
    So, that is why I think I would agree with Ron that there 
might be a presumption of having lower rates over more targeted 
changes. Again, those should be evaluated. The Treasury 
Department has established this dynamic analysis group. It 
would be very useful if they looked at individual provisions in 
terms of the dynamic analysis.
    Mr. THOMPSON OF CALIFORNIA. Thank you.
    Mr. FOLEY. The time of the gentleman has expired. The 
gentleman from Connecticut, Mr. Larson.
    Mr. LARSON. Thank you, Mr. Chairman. I thank all the 
panelists for their expert testimony. I want to join with the 
sentiments expressed by Mr. McNulty in terms of our 
disappointment that the Treasury Department is not here, 
because I do think that these are important and timely issues 
to be taken up, and I also regret that we have not heard from 
the President's commission as well.
    I further want to commend a colleague of ours, Mr. Linder, 
both in terms of his robust questioning, and I realize that 
this is not about consumptive taxation, and while not an 
endorsement, I think that he has written an intriguing book and 
raises some very important issues along with other Members like 
Chaka Fattah, who is also exploring many avenues as it relates 
to our Tax Code and all the more disappointing that the 
Treasury Department is not here and that we do not have a 
chance to look at that stuff, but again, I thank Chairman Camp 
for this.
    I was told when I first came on this Committee that it 
would be instructive if I read Showdown at Gucci Gulch. I had 
the opportunity to do so, and it allowed me to trace the 
history, the very storied history of this Committee including 
proposals that were put forward by Senator Bradley and then 
Representative Gephardt and then ultimately from 1982, when 
they first introduced it, to passage in 1986 with Dan 
Rostenkowski working almost--well, I cannot say quite hand in 
glove with President Reagan but nonetheless, an interesting 
read and it raised a lot of questions.
    My questions are twofold to the panelists: number one, how 
would you categorize the influence of K Street or undue 
influence of K Street, and then, philosophically, as experts in 
the field of our Tax Code, are we at odds in terms of corporate 
interests versus citizen interests? We used to say that what is 
good for GM is good to the country. Can we say that today? Or 
is that in this era of globalization, with continued 
outsourcing and people fearing for loss of their pensions and 
health benefits that corporate interests, with their own set of 
fiduciary responsibilities to the shareholder, run counter to 
the interests of citizens and their work force? Start with Mr. 
Thompson and move--or whoever else would like to join in.
    Mr. THOMPSON. Let me pass.
    Mr. LARSON. All right.
    Dr. DESAI. I will not comment on the K Street part of the 
question. On the philosophical part of the question, I am happy 
to comment, which is that I do not think globalization has 
outmoded that logic. I think people have come to that 
conclusion wrongly. I think it is the case that if we make our 
firms competitive, and they go abroad, the evidence is they 
grow domestically.
    So, it is very easy to think this is zero sum, but there is 
no reason to think markets are zero sum. If firms are able to 
do something, one part of their production process more 
efficiently somewhere else----
    Mr. LARSON. Well, that is good in theory, but can you give 
me an example?
    Dr. DESAI. I will give you----
    Mr. LARSON. I look right in my hometown, at Augie and 
Ray's, when I go there and talk to the people, and they say 
that they are out of work, and they see their jobs outsourced 
overseas, and they do not see anything in return for them. Some 
companies are farsighted, like United Technologies; they 
provide educational training. Thomas Friedman has written 
extensively about a trampoline. Where is the trampoline? Where 
do they spring to the next job after their job has been 
outsourced? Can you give me any concrete examples?
    Dr. DESAI. I think that is a fair point. It is certainly 
the case that education and training programs are critical for 
workers who are displaced. I was speaking to, in some sense, 
the aggregate evidence, which is that firms that grow abroad 
grow domestically in other ways, and that, there are plenty of 
examples, and there is empirical evidence on. I share your 
sentiments though, that education and training programs for 
those workers who are displaced are critical.
    Mr. LARSON. Mr. Thompson?
    Mr. THOMPSON. Yes, I think again--I do not think that we 
want to have a system that penalizes our companies from going 
overseas, but I also do not think that we should have a system 
that gives them a tax benefit for going overseas. It is clear 
that a territorial system would give U.S. companies a tax 
benefit, a tax saving for going overseas.
    As the President's Panel points out, our current deferral 
system is a quasi-self help territorial system. So, if the 
territorial system has this defect, our current deferral system 
has this defect, and the only way that I can see to solve it, 
that is, to eliminate the incentive to move overseas, tax 
incentive, is to move to a straight-out imputation system, to 
put investment, whether it is in the United States or in China, 
on the same tax footing.
    Mr. LARSON. Interesting.
    Mr. FOLEY. The time of the Gentleman has expired. On behalf 
of the Committee, we thank Dr. Desai, Mr. Pearlman, Dr. Neubig, 
Dr. Shackelford, and Mr. Thompson for your appearance before 
the Committee today. We will now call our second panel and ask 
them to take their place at the table. Our next panel includes 
James Tisch, President and CEO (chief executive officer) of 
Loews Corporation, headquartered in New York; Matthew McKenna, 
Senior Vice President of Finance at PepsiCo, Inc., also from 
New York; and John Castellani, President of the Business 
Roundtable.
    Let me thank the gentlemen for appearing today before the 
panel. I will reserve the time for Chairman Camp upon his 
return so he may ask questions under his own time allocation. I 
will first turn to Ranking Member McNulty.
    Mr. MCNULTY. Thank you, Mr. Chairman. I think all of you 
were in the room when I made my opening statement, so I am 
going to stick with that theme. I recounted that during the 
nineties, under the tax structure which existed at the time. We 
had the longest sustained period of economic growth in the 
history of the country. We had four budget surpluses, the only 
ones in the last generation, and since 2001, things have gone 
in the other direction. We have had the largest budget deficit 
in the history of the country, a national debt of $8.3 trillion 
and growing, and I just want to emphasize that that is a great 
concern to me and I think to all Americans now, and I hope that 
when we get to the question and answer period that we can 
discuss that a little bit among the other items that will be 
brought forward.
    I thank you all for being here, and I want to assure John 
that Union and RPI (Rensselaer Polytechnic Institute) are doing 
just great back in the 21st District of New York.
    Chairman CAMP. [Presiding.] All right; thank you. Just a 
moment, please. All right; again, welcome. Sorry I had to step 
out, but when the Chairman calls, you show up, so I want to 
thank you for coming today and for testifying. I look forward 
to hearing what you have to say. I have looked at the submitted 
statements. Your full statements will be included in the 
record. You each have 5 minutes, and so, why do we not begin 
with Mr. Tisch? Welcome.

  STATEMENT OF JAMES S. TISCH, PRESIDENT AND CHIEF EXECUTIVE 
                   OFFICER, LOEWS CORPORATION

    Mr. TISCH. Thank you, Chairman Camp, Ranking Member 
McNulty, and distinguished Members of the Subcommittee on 
Select Revenue Measures, my name is Jim Tisch, and I am the 
President and CEO of Loews Corporation.
    Loews, with a market capitalization in excess of $20 
billion, is one of the largest diversified financial companies 
in the United States. We either own or are a minority 
shareholder in six separate and unique businesses, including 
commercial property and casualty insurance, tobacco, offshore 
drilling services, interstate natural gas pipelines, hotels, 
and watches.
    My fellow panelists will address the impact of our high 
rates on our competitive taxes. My testimony, however, is from 
a domestic perspective. The issue of reducing the cost of 
capital for U.S. corporations, specifically the high rate of 
tax on long-term capital gains, has been absent from the debate 
on tax reform thusfar.
    I believe that a significant reduction in the current 35 
percent tax rate on long-term capital gains would enhance the 
competitiveness of U.S. corporations by enabling them to 
redeploy capital more efficiently. More freedom of capital 
redeployment would improve international competitiveness, would 
enhance economic growth and job creation, increase shareholder 
value, and possibly result in greater revenue for the U.S. 
Treasury.
    We are presenting a proposal that has historical precedent. 
In fact, from 1942 to 1986, for 44 years, there existed lower 
rates on U.S. capital gains as a means to stimulate investment 
in the United States and to attract foreign investment to the 
United States. As I said, the current 35-percent rate on 
corporate capital gains is one of the highest rates in the 
world.
    The 35 percent corporate capital gains tax rate has 
resulted in a lock-in effect of corporate investment capital. 
Corporate taxpayers oftentimes do not sell appreciated assets, 
because the tax cost severely reduces the after-tax proceeds 
for reinvestment from that asset sale. Faced with the prospect 
of a large tax wedge in the form of a 35 percent toll charge 
for redeploying capital, companies either do not sell or are 
tempted to borrow on their appreciated assets instead of 
selling them.
    Our current corporate capital gains tax reflects a policy 
of imposing triple taxation on U.S. corporate investment. 
First, when the regular corporate tax is imposed on income 
generated by the investment; a second time when the capital 
gains taxes are imposed, when the investment is sold, and the 
proceeds are redeployed to other uses; and a third time when 
dividends are paid to shareholders.
    A decision to reduce the corporate long-term capital gains 
tax rate will foster greater economic productivity in U.S. 
corporations. Companies will be able to convert from one form 
of capital to another more productive form, since the 
prohibitively harsh and stifling tax consequences will have 
been removed. Additionally, the transfer of capital assets from 
stale to newer, more dynamic hands will result in greater 
economic growth and job creation, as the asset's worth is 
maximized by the new holder.
    I am currently soliciting the support of like-minded 
executives and their companies to form a Committee, which we 
have named America Gains. Once this coalition is in place, our 
goal will be to educate policy makers, business leaders, and 
interested media about this issue, with the objective of 
bringing corporate long-term capital gains tax reform to the 
forefront of the tax reform debate.
    Mr. Chairman, I again applaud you for your interest and for 
having this hearing today, and I hope that you will use our 
coalition as a resource as you and the Committee develop 
Federal tax reform legislation.
    Thank you.
    [The prepared statement of Mr. Tisch follows:]

    Statement of James Tisch, President and Chief Executive Officer,
                 Loews Corporation, New York, New York

    Chairman Camp, Ranking Member McNulty, and distinguished members of 
the Subcommittee on Select Revenue Measures, my name is Jim Tisch and I 
serve as the President and CEO of Loews Corporation. Loews is one of 
the largest diversified financial companies in the United States and we 
either own or are a majority shareholder in six separate and unique 
businesses, including commercial property & casualty insurance, 
tobacco, offshore oil drilling services, natural gas interstate 
pipeline transmission, hotels, and watches. I thank you for the 
opportunity to present my views regarding the excessively high rate of 
tax on U.S. corporate capital investment.
    The 35-percent corporate capital gains tax rate needs to be 
reduced. Reducing the rate of corporate capital gains tax will foster 
greater economic productivity of U.S. corporations by enabling them to 
convert one form of capital to a more productive form, without 
incurring unduly harsh tax consequences
    We presently have the highest rate of tax on corporate capital 
investment in the history of the United States, with the exception of 
two years during World War II. This historically high rate is creating 
economic distortions both at home and abroad. The 35-percent capital 
gains rate induces a ``lock-in'' effect under which corporate taxpayers 
often times do not sell appreciated assets because the tax cost 
severely reduces the after-tax reinvestment proceeds from that asset's 
sale. This ``lock-in'' effect impedes corporate investment within the 
United States and carries grave implications for the future of 
America's domestic growth and employment prosperity.
    It is important to note what a capital gain represents in the 
corporate context. It represents the proceeds, after-tax, that are 
retained by a company for future investment in a new business venture 
or for pay-out as a dividend to its shareholders. These proceeds are 
derived from the long-term investment of capital in assets that create 
jobs and taxable income.
    Corporate investment in assets that produce capital gains occur in 
many ways, but three are most prominent: (1) controlling ownership 
interests in active business entities, (2) equity investments in 
business entities, and (3) acquisition of the corporation's own plant, 
equipment or intellectual property.
    In asking the Committee to consider reducing the rate of tax on 
corporate capital investment, we want to emphasize that we are not 
asking Congress to do something it has never done before. For 44 years, 
from 1942 to 1986, Congress imposed lower rates of tax on U.S. capital 
investment as a means to stimulate investments in the United States, 
and to attract foreign investment in the United States. We would like 
to see the current 35-percent rated reduced to match the individual 
capital gains rate or to its historically lower rates.
    It is important to point out that neither integration of the 
individual and corporate tax regimes or the 15-percent individual 
capital gains and dividends tax rate will solve this problem. None of 
the recommendations of the President's Advisory Panel on Federal Tax 
Reform correct this problem. Only a reduction of the rates imposed on 
corporate capital gains will ``unlock'' the ``lock-in'' effect.
    I will now turn to a more detailed explanation of our position, 
beginning with a detailed history of the corporate capital gains tax 
rate.
History of the Corporate Capital Gains Tax Rate
    The current corporate capital gains rate is 35-percent. With the 
exception of the years 1940 and 1941, the current 35-percent rate 
surpasses any capital gains rates imposed on corporations in the 
history of the Internal Revenue Code.
    The Revenue Act of 1942 adopted the first capital gains preference 
for corporate taxpayers in the form of a 25-percent maximum rate. 
Against the backdrop of World War II, the 1942 Act also increased the 
combined corporate normal and surtax rates from 31-percent to 40-
percent. The 1942 Act's 25-percent corporate capital gains tax rate 
changed very little between the years 1942 to 1986.
    The maximum rate on a corporation's net capital gains was increased 
to 26-percent for a very short time in the early 1950's, but by 1954, 
the rate was returned to its historical 25-percent rate.
    It was increased to 30% in 1969, but was again reduced in 1978 to 
28-percent. The corporate capital gains tax rate remained at 28-percent 
until 1986.
    The Tax Reform Act of 1986 effectively eliminated the 28-percent 
rate for corporate capital gains by subjecting capital gains to the 
same rate of tax as ordinary income. It set the rate for both capital 
and ordinary corporate income at 34-percent.
    The Tax Reform Act of 1986 also eliminated lower capital gains tax 
rates for individuals. As enacted in 1986, the capital gains tax rate 
for individuals and corporations would not exceed 28% and 34%, 
respectively. The 1986 elimination of the capital gains preference for 
individuals and corporations appears to have been part of an overall 
simplification measure. There is no evidence that Congress intended to 
disfavor capital gains generally, or corporate capital gains in 
particular.
    After 1986, Congress enacted several measures to reduce capital 
gains taxes, but those measures only affected individuals, not 
corporations.
    The Omnibus Budget Reconciliation Act of 1990 increased the maximum 
individual ordinary income tax rate to 33-percent, but left the 
individual capital gains rate at 28-percent. This rate differential 
between individual ordinary and capital gains rates was not the result 
of a new choice to prefer individual capital gains over corporate 
capital gains, but rather, reflected a decision not to increase the 
rate of tax on capital gains above the rates enacted in the Tax Reform 
Act of 1986.
    In the Omnibus Budget Reconciliation Act of 1993, the maximum 
corporate ordinary tax rate was increased from 34-percent to 35-
percent, and the corporate capital gains tax also was increased from 
34-percent to 35-percent.
    As a result of the 1993 tax increase, which was the largest tax 
increase in the history of the United States, U.S. corporations are now 
subjected to the highest capital gains rate since World War II.
    The House passed the Contract with America Tax Relief Act of 1995, 
which sought to reverse the 1993 tax increases on capital gains. That 
bill contained a maximum 25-percent corporate capital gains tax rate.
    Congress later passed the Balanced Budget Reconciliation Act of 
1995, which reduced the maximum corporate capital gains tax rate to 28-
percent. President Clinton vetoed that bill.
    The Taxpayer Relief Act of 1997 enacted the first capital gain tax 
reduction after the Tax Reform Act of 1986. The Taxpayer Relief Act of 
1997 reduced the maximum rate on individual net capital gains to 20-
percent. The House Report for that bill, in its ``Reasons for Change,'' 
stated that reduced taxation of capital gains promotes economic growth 
for four principal reasons:

      Reduced capital gains taxes would increase the return to 
individual savings and cause an increase in savings by individuals, 
which in turn, would help increase business investment in equipment and 
research.
      Reduced capital gains taxes would reward risk taking and 
the pursuit of new technologies.
      Reduced capital gains taxes would encourage investors to 
dispose of assets and allow the proceeds to flow to the segments of the 
economy where they would be most productive, thus offsetting the 
``lock-in'' effect that high taxes on capital income have on the 
willingness of the owner to divest.
      Such an ``unlocking'' effect would increase government 
revenue in the short and long run; both due to current reduced taxes 
collected on sales and to improved economic activity resulting from the 
freer flow of capital.

    The most recent Congressional action on capital gains occurred in 
2003, with the passage of the Jobs and Growth Tax Relief Reconciliation 
Act of 2003. This bill reduced the individual capital gains tax rate 
from 20-percent to 15-percent. This reduction expires in the year 2008, 
when the individual capital gains rate will revert back to 20-percent. 
Because the Jobs and Growth Tax Relief Reconciliation Act of 2003 was 
primarily a bill for individuals and small businesses, there was no 
consideration of reducing the corporate capital gains tax rate in that 
bill.
The Economic Rationale for Reducing Capital Gains Tax Rates Are Even 
        More Compelling for a Corporation
    Our current corporate capital gains tax reflects a policy of 
imposing triple taxation on U.S. corporate investment: first when 
regular corporate tax is imposed on income generated by the investment, 
a second time when dividends are paid to corporate shareholders, and a 
third time when the capital gains taxes are imposed when the investment 
is sold and the proceeds are redeployed to other uses.
    As I noted earlier, the 35-percent corporate capital gains tax rate 
has resulted in a ``lock-in'' of corporate investment capital, under 
which corporate taxpayers often times do not sell appreciated assets 
because the tax cost severely reduces the after-tax proceeds for 
reinvestment from that asset's sale. Companies should be allowed to 
convert one form of capital investment to a more productive form, 
without incurring a 35-percent ``toll charge'' for doing so. Congress 
referred to this ``lock-in'' effect in 1997 and 2003,\1\ so the term we 
use in this testimony is not unknown to Washington's tax policymakers.
---------------------------------------------------------------------------
    \1\ H.R. Rep. No. 108-93, 108\th\ Cong., 1\st\ Sess. III.A. The 
lock-in effect is further exacerbated by Code provisions that are 
hostile to redeployment of capital asset investment. For example, under 
section 1245 certain gains on sale of depreciable property used in a 
trade or business are ``recaptured'' as ordinary income. Similarly, 
restrictions on capital losses increase the tax cost of capital 
redeployment. Section 1212 of the Code provides that corporate capital 
losses can be carried back 3 years and forward 5 years. The ability of 
a corporation filing consolidated returns to deduct a loss on the stock 
of a group member is heavily restricted by various consolidated return 
regulations, including Regs.  1.1502-19(c) and -35T, and  1.337(d)-2.
---------------------------------------------------------------------------
    Mihir Desai, an associate professor with the Harvard Business 
School, confirms this ``lock-in'' effect in an article published in the 
March 7, 2006 edition of Tax Analysts. I would note at the outset that 
Professor Desai was not retained by the America Gains coalition to 
produce that article.
    Professor Desai states that it is surprising that the emphasis on 
capital gains has been limited to the individual level, rather than the 
corporate level. He states that greater efficiency gains can be 
achieved by reducing corporate capital gains rates as compared to 
individual capital gains rates, because corporations are more sensitive 
to tax rates in their decision-making. Professors Desai and Gentry 
published a study in 2003 which confirmed that a high rate of corporate 
capital gains rate does influence the decisions of firms to dispose of 
assets and realize the capital gains and losses.\2\
---------------------------------------------------------------------------
    \2\ Desai and Gentry, The Character and Determinants of Corporate 
Capital Gains, NBER Working Paper No. 10153, p. 26 (Dec. 2003). The 
Working Paper supports many other points submitted in this testimony, 
including: if reallocation of assets among firms raises their 
productivity, then corporate capital gains realizations can have a 
positive effect on productivity that individual capital gains 
realizations do not have; the logic of the corporate dividends received 
deductions also supports some tax relief for corporate capital gains; 
the ``lock-in'' effect can result in social costs from a mismatch of 
assets with a more productive owner; the ``lock-in'' effect also can 
prevent the corporate owner of an asset from redeploying its value to a 
more productive use.
---------------------------------------------------------------------------
    Professor Desai notes that many policymakers assume capital gains 
are a minor piece of overall corporate income, but in fact, quite the 
opposite is true. He estimates that capital gains constitute, on 
average, around 20% of the taxable income reported by U.S. 
corporations, and during the last 5 years of available information they 
averaged $128 billion a year. That amount, however, is greatly reduced 
by the lock-in effect.
    Professor Desai conservatively estimates that nearly $800 billion 
of corporate capital gains remain unrealized and untaxed because of the 
lock-in effect. This $800 billion amount is approximately one-third of 
the value of realized and taxable individual capital gains. The $800 
billion amount, however, is based on the historical asset values shown 
in a company's financial statements for minority interests in 
investments. Professor Desai and I suspect that unrealized corporate 
capital gains greatly exceed $800 billion.
    I ask the distinguished members of this Committee to consider the 
stimulus to both the U.S. economy and the Federal Treasuries if even 
$800 billion of corporate capital is freed up for reinvestment, 
redeployment, and made available for Federal tax collection. I must 
tell you that at the current historically high 35% rate, those 
corporate capital gains will not be realized as taxable income by the 
Federal government. The current 35% rate is impeding U.S. capital 
deployment, which in turn, impedes U.S. collection of corporate capital 
gains taxes.
    The economic consequences of the lock-in effect are particularly 
undesirable because the impetus for a sale of assets by a corporation 
is often a desire to convert those assets to other uses that would be 
more economically productive for the corporation, consequently creating 
more jobs and economic growth. Another owner, in turn, who has made a 
significant investment in the asset, would certainly be incentivized to 
put the divested assets to their highest and best use, better managing 
them and creating yet more jobs and economic growth.
    Faced with the prospect of a large ``tax wedge'' in the form of a 
35-percent ``toll charge'' for redeploying capital, corporate 
managements either refrain from selling or are tempted to borrow on 
existing appreciated assets instead of selling them, thus increasing 
the corporation's debt burden and reducing its economic stability and 
flexibility. The cost of losing 35-percent of an asset's appreciated 
value often exceeds the cost and risk of incurring additional debt. As 
a consequence, these unsold, newly leveraged assets are not likely to 
realize their greatest economic value.
    The impact of the capital gains tax on the international 
competitiveness of U.S. companies is equally troubling. Several 
European countries have, in certain circumstances, substantially 
reduced corporate capital gains rates or eliminated them altogether.
    Professor Desai notes that Hong Kong, Singapore, New Zealand, and 
several other countries do not tax capital gains at all. For example, 
starting next year France will exempt 95% of qualifying capital gains 
from taxation. Professor Desai's study also shows that Germany, Greece, 
the Philippines, Austria, Luxembourg, the Netherlands, Sweden, 
Switzerland, Mexico, Canada, Israel, Zimbabwe, South African, and even 
Pakistan have some form of corporate capital gains tax relief, but not 
the United States.
    Not only does the United States impose the highest rate on 
corporate investment in its history, but we also prohibit corporations 
from claiming losses to the extent they have no capital gains to offset 
those losses, and those losses may expire unused. Current law allows 
capital losses to only offset capital gains. Those losses may be 
carried back three years to offset net capital gains in those years, or 
carried forward to offset net capital gains in the next five years. If 
the losses are not used within that framework, they simply disappear 
from the tax return, as if they never actually happened. The tax 
deduction for the losses is denied, even though the taxpayer suffered a 
real economic loss. This is a great disincentive to risk-taking in the 
United States.
    Professor Desai identified several countries, such as Japan, the 
U.K, Germany, Belgium, Egypt, Netherlands, and Spain that provide 
capital gains relief for certain classes of capital gains that are 
subsequently reinvested. I would encourage the Committee to consider 
reinvestment of the cash proceeds as a factor in its deliberations for 
addressing corporate capital gains relief in the context of overall tax 
reform.
    As you can see, other major economies generally tend to subject 
corporations to materially lower effective long-term capital gains 
rates, permitting--if not encouraging--corporations in these countries 
to redeploy capital to a more productive use. The international 
competitiveness of U.S. businesses will be enhanced if the capital 
gains lock-in effect is reduced.
    As I said earlier, we are not asking Congress to take an action 
that is without historical precedent. The 1986 Tax Code eliminated the 
reduced rate for corporate capital gains in order to raise sufficient 
funds to make the 1986 tax reforms revenue neutral. From 1942 to 1986, 
however, corporate capital gains had always been given a preferential 
rate.
    The rationale Congress relied on for reducing individual capital 
gains rates in 1997 and again in 2003 is equally applicable to reducing 
the rate for corporations, namely, eliminating the lock-in effect 
promotes long-term economic growth and job creation, and better 
encourages work effort, savings and investment, which also happens to 
be President Bush's third criterion for tax reform.
    Historically, support for reducing the individual capital gains tax 
rate rests in part on the theory that lower rates make individuals more 
willing to invest in capital assets in general and in stocks in 
particular. This theory is widely accepted by economists and 
policymakers. This theory, however, is even more compelling in the 
corporate context because of the greater magnitude of corporate capital 
investment activity and the more direct relationship between corporate 
capital spending and economic productivity.
    Corporations raise huge amounts of capital from both stock issuance 
and debt sources, and redeploy it into business and investment 
ventures. In terms of new investment, corporations raise far more 
capital from borrowing than from new equity investment. This is 
evidenced by the fact that debt, rather than equity from public stock 
offerings, is a far more significant source of investment capital for 
corporations.
    For example, in 2004 the ratio of global debt to stock underwriting 
was 10 to 1.\3\ This means that for every dollar invested by 
individuals and others in new stock issuances, another 10 dollars was 
created by the corporation's own borrowing. When this new capital is 
used for new investment in productive assets, the result is a more 
immediate economic up-tick and increase in federal tax revenues than 
from individual investments in stocks.
---------------------------------------------------------------------------
    \3\ Diya Gullapalli, Underwriting Volume Rises to a Record, Wall 
St. J., Jan. 3, 2005, at R17.
---------------------------------------------------------------------------
    Therefore, the magnitude of the benefits from reducing the 
corporate capital gains rate could dwarf the economic investment 
stimulus created by reducing the individual capital gains tax. If there 
is ever a circumstance in which reducing capital gains tax will yield 
an immediate up-tick in investment reallocation and federal tax 
revenues, it is in the corporate arena.\4\
---------------------------------------------------------------------------
    \4\ Stimulating corporate investment through reducing the corporate 
capital gains tax can also buoy the economy as a whole. The recession 
during the 2001 to 2003 timeframe was caused largely by a lack of 
business-to-business investment, rather than a downturn in consumer 
spending and investment.
---------------------------------------------------------------------------
Unique Aspects of Corporate Tax Policy Compel Capital Gains Relief
    A feature of corporate income taxation that distinguishes it from 
individual taxation is that corporate assets are indirectly owned by 
the corporation's shareholders. This can result in the so-called 
``double taxation'' of corporate income: once to the corporation and 
again to the shareholder, either when the shareholder receives a 
dividend or when the shareholder sells stock in the corporation. Such 
double taxation applies to the corporation's sale of capital assets 
followed by a distribution of the sale proceeds (net of tax) to 
shareholders.
    Under current law, it is not uncommon for corporate capital gains 
to be subject to triple taxation. As I mentioned earlier, corporate 
earnings are taxed a third time when the corporate capital gains tax is 
imposed. One common corporate investment provides an extreme example of 
a need for a policy change. In the situation where one corporation owns 
stock in a second corporation, the income from a disposition of that 
stock can result in triple taxation of the of the second corporation's 
income: once to the second corporation; once on the capital gain of the 
``owner'' corporation when it sells its second corporation stock; and 
once to the individual shareholder of the ``owner'' corporation.
    Because of the pervasive levels of double and triple taxation 
within a corporation, a lower corporate capital gains rate serves to 
mitigate, but not eliminate, the damaging effects of multiple taxation 
of the same income. What is even more troubling, however, is that much 
of the double and triple taxed income may not represent economic income 
at all. Corporate capital gains often represent an inflationary 
increase in asset value, which does not represent an economic 
enhancement of the corporation's financial condition.
    Long before the benefits to the economy of reduced taxes on capital 
income achieved a high profile, the Code's capital gains preference 
served as a rough tool to ameliorate the taxation of gains that reflect 
inflation. An ideal income tax base would not tax inflationary gains, 
but the theoretical remedy of indexing basis has generally been judged 
too difficult to attempt, and so reduced tax rates on capital gains is 
a rough attempt at justice.\5\ Policymakers should never overlook the 
dubious nature of capital gain ``income'' and the extent to which 
capital gains are attributable to inflation. In this respect, they 
represent no increase in the corporation's spending power and, hence, 
should not be viewed as income. Historically, the dubious nature of 
capital gain income has justified a lower capital gains rate.
---------------------------------------------------------------------------
    \5\ See U.S. Treasury Tax Policy Staff, Blueprints for Basic Tax 
Reform, p. 42 (Tax Analysts, 2d ed.).
---------------------------------------------------------------------------
Corporate Capital Gains Relief Is Not Provided by Corporate-Shareholder 
        Integration or the 15-Percent Individual Dividends & Capital 
        Gains Rate
    I would add one final point. Some commentary has suggested that 
integration of the corporate and individual tax systems would eliminate 
the investment reallocation problems created by the current 35-percent 
corporate capital gains rate. We respectfully disagree. Corporations 
base their investment decisions and rate-of-return calculations on the 
effect to the corporation itself, not on whether a shareholder pays the 
current 15-percent tax on dividends or whether, under an integrated 
system, the shareholder would pay no tax on a dividend. The variety of 
shareholder tax rates and their possible tax-indifferent status (such 
as mutual funds and pension plans) make it impossible for a corporation 
to consider shareholder tax effects in its own investment decisions. 
What they do consider, however, is that one of the highest capital 
gains tax rate in the history of the United States creates a tax wedge 
that forces them to keep investment capital locked in place and borrow 
to the hilt to finance the future of their company, thereby depriving 
the economy of the highest and best use of those leveraged assets. This 
cannot, under anyone's measure, be considered sound tax policy.
    Proposals to integrate the corporate and individual income taxes 
will not address the major reasons for corporate capital gains relief. 
Integration generally means eliminating or reducing the possibility 
that corporate income will be taxed a second time when it is 
distributed to the shareholders of the corporation as a dividend. The 
15-percent rate for dividend income enacted in the Jobs and Growth Tax 
Relief Reconciliation Act of 2003 is a mitigating step toward 
integration. However, so long as the corporate capital gains tax is 
imposed, some level of the lock-in effect will continue. The question 
is what level of rate reduction is necessary to remove taxes as a 
material investment consideration. As noted above, corporations base 
their investment decisions and rate-of-return calculations on the 
effect to the corporation itself, not on whether a shareholder pays the 
current 15-percent tax on dividends or whether, under an integrated 
system, the shareholder would pay no tax on a dividend. What they do 
consider, however, is that the highest corporate capital gains rate in 
the history of the United States will appropriate 35-percent of their 
asset values if they redeploy assets to potentially more productive 
investments, forcing them to lock that investment in place.

                                 

    Chairman CAMP. Thank you very much, Mr. Tisch. Mr. McKenna, 
you have 5 minutes.

   STATEMENT OF MATTHEW M. MCKENNA, SENIOR VICE PRESIDENT OF 
                     FINANCE, PEPSICO, INC.

    Mr. MCKENNA. Thank you, Chairman Camp, and thank you, 
Ranking Member McNulty and Members of the Committee. My name is 
Matthew McKenna. I am senior vice president of finance at 
PepsiCo, and it is an honor to be before you today.
    I think as you may know, PepsiCo is a leading global food 
and beverage company with annual revenues of over $32 billion. 
We currently have 17 brands, each of which are in excess of $1 
billion in revenue, the brands, which include not just the 
Pepsi branded beverages but Quaker Foods, Tropicana, Frito Lay, 
and Gatorade.
    The United States is PepsiCo's largest single market. 
PepsiCo and its affiliates do business in every State of the 
Union and employ more than 60,000 people in the United States. 
Over the past decade, PepsiCo has expanded its market presence 
in the United States and continues to invest in the United 
States, with investments in new facilities such as the rapid 
expansion of our Gatorade facilities in Virginia, Oklahoma, 
West Virginia, and Florida.
    I would like to talk today about two changes to the U.S. 
tax system that would provide tremendous economic benefit. The 
first is fairly straightforward: a reduction in the corporate 
tax rate. The second is more complex but equally important, and 
that is reform of the U.S. international tax rules. These 
changes, both the domestic and the international, would enhance 
the competitiveness of U.S. business and contribute to the 
continued growth of the U.S. economy through increased capital 
investment and increased U.S. jobs.
    As referenced in the earlier panel, in the eighties, the 
United States led the international trend to lower corporate 
tax rates. The United States is now well behind the curve of 
other countries. The United States has one of the highest 
corporate tax rates among the OECD countries, and this fact 
alone, I think, would be a cause for reexamining the direction 
that we are going.
    I urge you not to ignore the evidence from our trading 
partners and our competitors, and believe me, we are in 
competition with these countries, and in terms of tax rates, we 
are losing that competition.
    A brief word about the choice between reducing tax rates or 
increasing credits and other tax preferences to provide 
incentives for specific actions. Speaking for PepsiCo, I feel 
that too often, tax preferences reward behavior that is already 
taking place, that too often, the loudest voices for such 
preferences are the companies that are already heavily engaged 
in those activities.
    PepsiCo is in favor of rate reduction. Allow us to decide 
how to reinvest our earnings to maximize returns to the 
business and to our shareholders and make those decisions based 
upon productivity, profitability, and growth, rather than 
pursuing preferences and obstacles in the Tax Code. I also want 
to touch today on an equally important topic, the modernization 
of the U.S. international tax rules.
    In addition to our activities in the United States, we do 
business in over 200 countries around the world. Our 
international business is exploding right now. In 2005, our 
international operations grew by over 20 percent, to the point 
where they now exceed more than a third of our overall revenue 
and almost half of our growth. Our international success, our 
international businesses, are built upon local businesses 
serving local customers in their country. Given the cost of 
transportation for potato chips and beverages, we need to 
establish local brands, local manufacturing facilities, and 
typically, our businesses are sourced in each country for that 
country's market.
    Today, as has been referenced already a number of times, 
the U.S. operates under a worldwide system of taxation. The 
current U.S. worldwide tax system incents U.S. companies to 
redeploy their foreign earnings overseas rather than bring 
those profits back home. These incentives to redeploy overseas 
and the reaction by U.S. companies were demonstrated, I think, 
very categorically last year in the reaction to companies in 
response to the American Jobs Creation Act of 2004 (P.L. 108-
357).
    The U.S. tax system differs significantly from many of our 
overseas trading partners. As referenced already, there are a 
number of cases where we are at a competitive disadvantage to 
our international trading partners. Many times, our expansion 
overseas is by way of acquisition. We are competing for those 
acquisitions against our international competitors. Because of 
the competing tax regimes, our international competitors can 
afford to pay more for those investments than we can.
    I urge you to consider that from a competitive point of 
view that hurts PepsiCo and hurts the American corporations. 
Thank you for the opportunity to testify today, and I look 
forward to answering your questions as well.
    [The prepared statement of Mr. McKenna follows:]

    Statement of Matthew McKenna, Senior Vice President of Finance, 
                   PepsiCo, Inc., New York, New York

Profile of PepsiCo
    PepsiCo is a leading global food and beverage company with annual 
revenues of over $32 billion. We manufacture, market and sell a variety 
of food products and carbonated and non-carbonated beverages. Some of 
PepsiCo's well known brands include Pepsi branded beverages, Quaker 
Foods, Tropicana, Frito-Lay and Gatorade.
    The United States is PepsiCo's single largest market. PepsiCo and 
its affiliates do business in all 50 states and the District of 
Colombia and employ more than 60,000 people within the United States. 
Over the past decade, PepsiCo has seen increased profits and a major 
expansion of its market presence in the U.S. and worldwide through 
acquisitions and product development. I am proud that PepsiCo continues 
to build plants in the U.S., like the new Gatorade facilities PepsiCo 
is in the process of building, to serve our growing market. PepsiCo 
also operates in over 200 countries. During 2005, our operations 
outside the United States had growth of 21% and that growth continued 
in the first quarter of 2006. International operations now represent 
35% of total revenue and constitute 46% of PepsiCo's overall growth. 
Our international success has been built upon local businesses, serving 
local customers. The cost of transporting our snacks and beverages, 
combined with the need to establish local brands, typically requires 
local sourcing in each country. PepsiCo continues ambitious 
international expansion and is investing hundreds of millions of 
dollars in plants and equipment in both developed and developing 
markets around the world.
The United States Needs a Competitive Tax System
    Today's economy is truly global and is becoming more so every day. 
In this environment, the United States cannot afford to have a tax 
system that forces U.S.-based businesses to face foreign competitors 
with one hand tied behind their backs. Unfortunately, given the state 
of the U.S. tax laws, that is exactly how PepsiCo is forced to compete.
    There are two areas where PepsiCo believes changes to the U.S. tax 
system would provide tremendous economic benefit. The first is simple 
and straightforward: a reduction in the corporate tax rate. The second 
is more complex, but is critically important: reform of the U.S. 
international tax rules. These changes would help enhance the 
competitiveness of U.S. businesses and contribute to the continued 
growth of the U.S. economy through increased capital investment and 
increased U.S. jobs.

I. Reduction in Corporate Tax Rate
    Lower corporate tax rate fosters competitiveness, investment and 
growth: In the 1980s, the U.S. led the worldwide trend toward lower 
corporate tax rates. Today, however, the U.S. has one of the highest 
overall corporate income tax rates (35% federal; 39.3% combined federal 
and state) among all countries in the Organisation for Economic Co-
Operation and Development (OECD). In contrast, the OECD trend has been 
to reduce corporate rates. Ireland, for example, reduced its rate by 
approximately 48%, down to 12.5%, and now has the lowest corporate tax 
rate of all OECD nations. This favorable rate has fostered foreign 
direct investment in Ireland and bolstered that country's economy. The 
average OECD rate is approximately 29.2% (combined central and sub-
central tax rates), which is ten percentage points lower than the U.S. 
rate.
    While the U.S. is clearly a leader in the global economy today, it 
must change in order to stay a leader. For U.S. companies to continue 
to be competitive with companies that reside in other large 
industrialized nations, and to foster foreign direct investment in the 
U.S., the corporate federal income tax rate should be reduced. A lower 
corporate tax rate would allow businesses to operate in a more 
efficient manner, enhance certainty for business planning purposes and 
ensure that strategic decisions are driven by productivity, 
profitability and growth concerns as opposed to the preferences and 
obstacles of the tax code.
    Expensing versus lower corporate tax rate: The President's Advisory 
Panel on Federal Tax Reform proposed an option that would provide 
immediate expensing for capital assets as a means of encouraging 
economic investment. Capital investment clearly is important to the 
growth and expansion of U.S. businesses. Over the past three years, 
PepsiCo has expended $5.7 billion on acquisitions and other investments 
in the U.S. and around the world. At the same time, PepsiCo has 
returned $12 billion to its shareholders through dividends and share 
repurchases. However, if I were given a choice between increased 
expensing and a reduction in the corporate tax rate, my preference 
would be a lower tax rate.
    Increased expensing provides only a timing benefit. In contrast, a 
lower corporate tax rate provides a permanent benefit. Increased 
expensing does not affect a company's book tax rate or net income for 
financial statement purposes. Most importantly, a lower corporate tax 
rate allows businesses to choose how best to deploy their earnings--
whether to invest in tangible assets or intangible assets and whether 
to return funds to shareholders so that they may invest those funds. 
These decisions should be driven by the market and business plans--not 
based on accounting timing and methods.
    Credits and other tax preferences versus lower corporate tax rate: 
The current U.S. tax code provides a variety of incentives to 
businesses through credits and other preferences, and PepsiCo benefits 
from many of these credits and preferences. Nevertheless, if I were 
asked to choose between increased credits and other preferences or a 
lower corporate tax rate, again I would choose the lower tax rate. As 
noted above, a reduction in the corporate tax rate would allow 
businesses to determine for themselves how best to deploy their 
earnings in order to maximize returns to the business and to the 
shareholders.

II. Modernize U.S. International Tax Rules
    International competitiveness benefits the U.S. economy: With over 
95% of the world's population living outside the United States, reform 
of the U.S. international tax rules is needed in order to protect and 
enhance the global competitiveness of U.S.-based businesses. It is 
important to understand that foreign activity of U.S. businesses--and 
continued success of PepsiCo's international investments--complements 
our U.S. activity; it is not a substitute for it. Our foreign 
investment contributes to the U.S. economy and to U.S. employment. The 
global success of U.S. businesses provides real benefits in terms of 
economic growth and jobs in the United States. The United States must 
ensure that policies are in place to allow U.S. businesses to make the 
most of the tremendous opportunities that globalization and 
technological advances provide.
    U.S. worldwide tax system creates the wrong incentives:Today, the 
U.S. operates under a ``worldwide'' tax system in which U.S. resident 
companies are taxed on their worldwide income--regardless of where it 
is earned. The current system attempts to mitigate the potential for 
double taxation arising from overlapping source-country taxing 
jurisdictions. It does so by providing for a foreign tax credit for 
taxes paid on income that is also subject to tax in the U.S. In 
practice, U.S. companies are generally not taxed on business income 
earned by foreign subsidiaries until that income is repatriated to the 
U.S. as dividends.
    The current U.S. worldwide tax system incents U.S. companies not 
only to redeploy foreign earnings abroad rather than in the U.S., but 
also to keep any excess or idle foreign cash that may not even be 
needed for foreign investment overseas rather than returning it to the 
U.S. These incentives and the resulting (and expected) reaction by U.S. 
companies are demonstrated by U.S. companies' response to the temporary 
reduced rate of taxation on repatriated dividends under the provisions 
of the American Jobs Creation Act (AJCA). To date, about $290 billion 
in AJCA repatriations have been announced by companies and as a result 
the U.S. Treasury has reportedly collected an additional $17 billion in 
taxes in a very short period of time. This capital, which had been held 
offshore, is now available and has freed up cash in the U.S. for the 
support of jobs, acquisition of capital assets, payment of dividends to 
U.S. shareholders, pay-down of debt, strengthening of U.S. pension 
plans and other important uses that will help to strengthen and 
stimulate U.S. companies and the U.S. economy as a whole.
    In addition, the complexity associated with the current tax system 
causes U.S. companies to engage in a greater degree of tax--distorted 
business planning, versus companies that are not subject to a complex 
worldwide system. For example, companies can put great efforts into 
repatriating foreign earnings periodically in ways that do not trigger 
additional U.S. tax. These incentives and behaviors distort the 
business and investment decisions of U.S. companies and ultimately are 
detrimental to the U.S. economy as a whole.
    Finally, in addition to being overly complex and disincenting U.S. 
companies to act in a manner that supports the U.S. economy, the 
current tax system also puts U.S. companies at a competitive 
disadvantage, versus their foreign competition. Under the current 
system, when foreign earnings are repatriated and U.S. tax is paid, 
U.S. companies are generally taxed at the higher of the source country 
or U.S. tax rate. In contrast, under a territorial system many U.S. 
companies' competitors are taxed only at the source country rate, even 
if it is lower than their tax rate at home. Combined with the high rate 
of tax in the U.S., as discussed above, this puts U.S. companies at a 
significant competitive disadvantage.
    U.S. should consider a territorial tax system: The U.S. tax system 
differs significantly from the tax systems of many of our trading 
partners. Two-thirds of the OECD countries operate territorial tax 
systems. To create an efficient method of taxation that will enhance 
the competitiveness of U.S. multinationals and strengthen the U.S. 
economy in today's global marketplace, we should examine the various 
territorial systems used by so many of the world's developed economies. 
Under a purely territorial system, a country taxes only income derived 
within its borders, regardless of the residence of the taxpayer. Many 
countries tax resident corporations on a predominantly territorial 
basis by exempting dividends received from foreign subsidiaries from 
residence country tax--commonly referred to as a ``participation 
exemption'' system.
    We believe that a territorial system would allow U.S. 
multinationals to invest overseas in order to grow their businesses. At 
the same time, it would remove the barrier or disincentive to 
repatriate earnings to the U.S. for investment here at home.
    Of course, the extent to which a territorial tax system would 
enhance competitiveness depends upon the specific details of the 
system. The key design issues with respect to a territorial tax system 
include (1) what income is exempt from tax, (2) how expenses are 
treated, and (3) what rules apply to tax passive-type income. More work 
is needed to develop a territorial tax approach for the United States 
that would accomplish the objectives of reducing the complexity of the 
current U.S. international tax system, enhancing the competitiveness of 
U.S.-based companies operating in the global marketplace, and 
eliminating the disincentive to bringing profits home to the United 
States.
    Some may argue that a territorial system that exempts active 
foreign income from U.S. tax is an invitation for U.S. businesses to 
invest overseas. In fact, foreign investment is necessary in order for 
U.S. companies to maintain their competitiveness in today's global 
economy. It is a plain and simple fact that in order for U.S. companies 
to remain healthy, and even viable, they must compete with their 
foreign competitors and invest in the growing and emerging markets 
around the world. Without tapping into that opportunity for growth, one 
can only imagine what would happen to the value of U.S. multinationals 
or what the stock market impact might be of the failure of U.S. 
multinationals to grow in these markets. Adverse impacts to employment 
in the U.S. and to the U.S. economy in general would no doubt follow if 
U.S. companies could not compete effectively in the global economy.
    Lastly, some would argue that exempting active foreign income from 
U.S. taxation is an invitation for U.S. companies to off-shore their 
U.S. business operations. However, the global economy is a reality in 
connection with operating in and supplying not only foreign, but U.S. 
markets as well. Foreign competitors are locating operations in 
advantageous jurisdictions around the world in order to supply and 
compete in both foreign and domestic markets. The tax laws cannot be 
used to make U.S. companies more competitive and at the same time to 
stop U.S. companies from investing in operations overseas to supply 
foreign or U.S. markets. However, what the U.S. tax system can do and 
should do is to allow U.S. companies to be competitive with their 
overseas competition and at the same time incent U.S. companies to 
employ as many people as possible in the U.S. to support those growing 
business operations around the world.

                             *  *  *  *  *

    In conclusion, a tax system that allows U.S. companies to be 
competitive on a worldwide basis, provides an incentive to maintain and 
increase jobs in the U.S. to support those businesses and allows for 
the repatriation of significant foreign profits to the U.S. is a win-
win situation for the competitiveness of U.S. business and ultimately 
for the U.S. economy as a whole. Similarly, a lower domestic corporate 
tax rate would allow businesses to operate in a more efficient manner, 
enhance certainty for business planning purposes and ensure that 
strategic decisions are driven by productivity, profitability and 
growth concerns as opposed to the preferences and obstacles of the tax 
code. Congress has an opportunity to develop a system to sustain our 
competitiveness and growth for the generations to come. We look forward 
to working with you on this critical initiative.

                                 

    Chairman CAMP. Thank you, Mr. McKenna. Mr. Castellani, you 
have 5 minutes.
    Mr. CASTELLANI. Thank you.
    Chairman CAMP. If you could turn on your microphone. Thank 
you.

            STATEMENT OF JOHN CASTELLANI, PRESIDENT,

                      BUSINESS ROUNDTABLE

    Mr. CASTELLANI. Thank you, Mr. Chairman, Ranking Member 
McNulty, Members of the Panel. The Business Roundtable is an 
association of CEOs of leading U.S. corporations with over $4.5 
trillion in annual revenues and a work force of more than 10 
million employees. Roundtable member companies comprise nearly 
one-third of the total value of the U.S. stock market and 
account for nearly one-third of all corporate income taxes paid 
to the Federal Government.
    The Roundtable is committed to advocating public policies 
that ensure rigorous economic growth. Through economic growth, 
American workers can attain even higher living standards 
generation after generation, and it is this key objective, 
maximizing the sustainable long-term growth of the U.S. 
economy, that we bring to the consideration of tax policy and 
tax reform.
    Now, whether we like it or not, tax policy ultimately 
affects business decisions and the ability to earn a profitable 
rate of return. In today's global business environment, U.S. 
tax policy can create an obstacle to the pursuit of global 
business strategies to the detriment of our domestic economy.
    While taxes are not the only factor affecting our ability 
to compete globally, they do have a significant impact. We know 
we will never live in a world where no taxes are necessary, but 
the key to an appropriate tax policy is to collect the 
necessary revenue to fund government while minimizing the 
adverse impact that taxation can have on economic activity and 
the economic wellbeing of our society.
    In this context, we believe that there is an urgent need to 
reform U.S. tax rules as they apply to both domestic and 
international commerce in order to improve the competitiveness 
of the United States. As U.S. companies seek to expand 
internationally, they often find that the U.S. tax system poses 
a serious impediment to their plans. Despite important reforms 
to the tax system over the years, the U.S. tax system today 
still reflects an economy of a different era, a time when 
international activity was far less important, and the United 
States faced far less international competition.
    In 1970, U.S. multinational firms were dominant globally 
and accounted for over 50 percent of the world's cross-border 
investment flow. In contrast, in the three most recent years 
for which data is available, 2002 to 2004, the share of the 
world's cross-border investment made by U.S. firms averaged 
less than 25 percent.
    Now, in my written testimony, I give several examples of 
problems faced by U.S.-based companies as they attempt to 
compete globally, but let me draw on one those to illustrate 
the impediments faced by U.S. companies. This major U.S. 
company has successfully pursued a global business strategy 
which has resulted in significant job expansion at home, with 
high-wage, high-quality jobs and U.S. employment of more than 
200,000 workers. While it competes for business around the 
world, it finds that its major foreign rival has an effective 
tax rate that is some 15 percentage points below its own rate 
of approximately 38 percent. This tax advantage has permitted 
this rival to reinvest $2 billion globally over the past 6 
years and thereby gain footholds around the world. One 
naturally wonders, what would this U.S. company have been able 
to achieve if it were able to compete on a level playingfield?
    This example and more like it point to the need for 
substantive reform of the tax rules. U.S. businesses face 
strong competition around the world, and there can be no 
presumption that we can overcome the tax disadvantage in this 
competition. The two most significant areas in which our Tax 
Code must be reformed are, first, the statutory corporate tax 
rate, and second, our international tax rules.
    In 1986, after the United States reduced its top income tax 
rate from 46 to 34 percent, as you have heard today, most of 
the other industrial countries followed suit. Thirty-five 
percent, our corporate rate, is no longer low. The U.S. Federal 
and the combined Federal and State corporate tax rates are 
approximately 10 percentage points above the corresponding OECD 
average rates.
    Overwhelmingly, our members find that the international 
trend is for lower taxes on corporations, and if U.S. 
corporations are to remain competitive with foreign 
headquartered firms, they cannot be subject to high corporate 
tax rates that are 10 percent or more higher than what their 
competitors face.
    Second, our U.S. tax rules are at variance with 
international norms. U.S. tax rules deviate significantly from 
those of our trading partners, and they are a detriment to our 
U.S. firms. The American Jobs Creation Act of 2004 has provided 
some important and positive steps to address the 
competitiveness of U.S.-based multinationals; however, 
complexities and barriers remain that continue to handicap U.S. 
competitiveness.
    Even relative to other countries that have not adopted a 
territorial tax system, that is, countries that still follow a 
worldwide tax system, U.S. international tax rules often serve 
to impose a higher tax burden. In particular, no other country 
limits deferral as rigorously as the United States.
    With growing world economic integration, the shortcomings 
of U.S. international tax policy will be increasingly 
magnified. The playingfield is already unlevel, and every year, 
we risk falling further behind. Eighty percent of the world's 
purchasing power and 95 percent of the world's population lie 
outside the United States. Success or failure for U.S. 
companies in their quest to compete in foreign markets as well 
as at home will affect domestic jobs and the growth of our 
economy. For U.S. companies to compete successfully and bolster 
U.S. growth, we need a tax system that does not handicap us. 
Thank you.
    [The prepared statement of Mr. Castellani follows:]

      Statement of John Castellani, President, Business Roundtable

Introduction
    Business Roundtable (``the Roundtable'') is an association of chief 
executive officers of leading U.S. corporations with over $4.5 trillion 
in annual revenues and a workforce of more than 10 million employees. 
Roundtable member companies comprise nearly one-third of the total 
value of the U.S. stock market and account for nearly one-third of all 
corporate income taxes paid to the federal government. Roundtable 
companies undertake nearly one-half of the total private R&D spending 
in the United States.
    The Roundtable is committed to advocating public policies that 
ensure vigorous economic growth. Through economic growth, American 
workers can attain ever higher living standards, generation after 
generation. It is this key objective--maximizing the sustainable, long-
term growth of the U.S. economy--that we bring to consideration of tax 
policy and tax reform.
Global Competitiveness and Tax Reform
    Whether we like it or not, tax policy ultimately affects business 
decisions and the ability to earn a profitable rate of return. In 
today's global business environment, U.S. tax policy can create an 
obstacle to the pursuit of global business strategies, to the detriment 
of our domestic economy. While taxes are not the only factor affecting 
the ability of U.S. companies to compete globally, they have a 
significant impact.
    We will never live in a world where no taxes are necessary. The 
basic purpose of the tax system is to fund the many essential services 
and activities of our government and business taxes will always be an 
important source of revenue to fund this need. Corporations share a 
responsibility to pay tax to support these essential government 
services. The key to an appropriate tax policy is to collect the 
necessary revenue to fund government while minimizing the adverse 
impact that taxation can have on economic activity and the economic 
well-being of our society.
    In this context, as recognized by the President's Advisory Panel on 
Federal Tax Reform, there is an urgent need to reform U.S. tax rules as 
they apply both to domestic and international commerce--in order to 
improve the competitiveness of U.S. businesses and to improve the 
outlook for our economic growth. Achieving and sustaining economic 
growth requires that U.S. companies be competitive both at home and in 
the expanding markets of the world. In the globally competitive 
environment we face, this requires--at a minimum--a tax system that 
does not impede the ability of U.S. companies to compete on equal terms 
with their foreign-based competitors.
    The world is rapidly becoming more integrated. Reductions in the 
cost of communication and transportation and falling trade and 
investment barriers have opened the door to competition on a truly 
global scale. Nearly 80 percent of the world's purchasing power rests 
in markets outside of the United States. China alone represents a 
market two-thirds the size of the U.S. market and it is expanding at an 
annual rate of 10 percent. American corporations and American workers 
stand to benefit from the economic growth and higher living standards 
made possible by these new and expanding markets.
    U.S. firms are increasingly adopting global investment and 
marketing strategies. Over the past 40 years, exports by U.S. 
corporations have doubled as a share of the size of the total economy 
and the share of worldwide profits of U.S. corporations attributable to 
foreign earnings has nearly tripled.
    As U.S. companies seek to expand internationally, they often find 
that the U.S. tax system poses a serious impediment to their plans. 
Despite important reforms to the tax system over the years, 
particularly the 2004 American Jobs Creation Act, the U.S. tax system 
today still reflects an economy of a different era--a time when 
international activity was far less important and the United States 
faced far less competition.
    In 1970, U.S. multinational firms were dominant globally, 
accounting for over 50 percent of the world's cross-border investment 
flows. In contrast, in the three most recent years for which data are 
available (2002-2004), the share of the world's cross-border investment 
made by U.S. firms averaged less than 25 percent.
    Let me give you some real-life examples of the problems faced by 
U.S.-based companies as they attempt to compete globally against 
foreign-based companies:

      One U.S. company has successfully pursued a global 
business strategy, resulting in significant job expansion at home, with 
high-wage, high-quality jobs. At the same time, it finds that its major 
foreign rival has an effective tax rate some 15 percentage points below 
its own rate of approximately 38 percent. This tax advantage has 
permitted its foreign rival to reinvest some $2 billion globally over 
the past six years and gain footholds around the world. One naturally 
wonders what the U.S. company would be able to achieve if it were 
permitted to operate on a level playing field.
      Another U.S. company had accrued foreign earnings abroad 
but faced a significant tax disincentive to repatriating these funds to 
the United States until a special one-year temporary provision was 
enacted in 2004. This company took advantage of that provision by 
bringing back the maximum it was permitted--more than $500 million--to 
expand domestic operations. The additional funds resulted in an 
improvement in the firm's credit rating, which brought about the 
opportunity to finance additional U.S. investments, and additional tax 
dollars to the U.S. Treasury. As the one-year provision has expired, 
this U.S. company and others like it will again be subject to a tax 
penalty for bringing home foreign earnings.
      Another U.S. company pays taxes to a foreign jurisdiction 
from its operations at a 15 percent tax rate, but due to U.S. subpart F 
rules, it pays an additional 20 percent on this income to the U.S. with 
no deferral. Its foreign-based competitors, however, pay tax at only 
the local country rate of 15 percent. This puts the U.S. company at a 
severe competitive disadvantage relative to its direct competitors.

    These examples, and many more like them, point to the need for 
substantive reform of U.S. tax rules. U.S. businesses face strong 
competition around the world, and there can be no presumption that the 
U.S. business can overcome its tax disadvantage in this competition. 
Dominance of U.S. corporations in foreign markets is no longer assured. 
Of the world's largest global corporations (valued by foreign assets), 
just four of the twenty largest non-financial corporations and only 
three of the twenty largest financial corporations are headquartered in 
the United States.
    Many countries have responded to the increasing importance of 
cross-border investment by removing tax obstacles to international 
commerce. The U.S. tax system has not kept pace with this need to 
adjust to new international realities.
Corporate Tax Rates
    In 1986, after the United States reduced its top corporate income 
tax rate from 46 percent to 34 percent, most other major industrial 
countries followed suit. Today, at 35 percent the U.S. federal 
corporate income tax rate is no longer low; indeed it is now tied for 
highest among the thirty countries of the Organization for Economic 
Cooperation and Development (OECD), and is 8.6 percentage points above 
the OECD average tax rate of 26.4 percent. Including state and local 
corporate income tax rates, the U.S. rate is second highest in the OECD 
after Japan and is 10.4 percentage points above the OECD average of 
28.9 percent. The U.S. rate is also 11 to 14 percentage points higher 
than the average national and combined national and local corporate tax 
rates of the twenty-five countries of the European Union (see Table 1). 
Researchers using other measures, such as effective tax rates, have 
found generally similar patterns: high U.S. rates, with our major 
competitors having lower rates that have declined over the past decade.
    Overwhelmingly, the international trend is for lower taxes on 
corporations. If U.S. corporations are to remain competitive with 
foreign-headquartered firms, they cannot be subject to corporate tax 
rates that are ten percentage points or more higher than those of their 
competitors.

                                 Table 1
  Central Government and Central and Local Government Tax Rates, OECD,
                                  2005

                                                   Central and Local Top
        Country              Central Top Rate              Rate

Japan                    30.0                     39.5
United States            35.0                     39.3
Germany                  26.4                     38.9
Canada                   22.1                     36.1
Spain                    35.0                     35.0
Belgium                  34.0                     34.0
France                   33.8                     33.8
Italy                    33.0                     33.0
New Zealand              33.0                     33.0
Greece                   32.0                     32.0
Netherlands              31.5                     31.5
Luxembourg               22.9                     30.4
Australia                30.0                     30.0
Denmark                  30.0                     30.0
Mexico                   30.0                     30.0
Turkey                   30.0                     30.0
United Kingdom           30.0                     30.0
Sweden                   28.0                     28.0
Norway                   23.8                     28.0
Korea, Republic of       25.0                     27.5
Poland                   19.0                     27.5
Czech Republic           26.0                     26.0
Finland                  26.0                     26.0
Austria                  25.0                     25.0
Portugal                 25.0                     25.0
Switzerland              8.5                      21.3
Slovak Republic          19.0                     19.0
Iceland                  18.0                     18.0
Hungary                  16.0                     16.0
Ireland                  12.5                     12.5

OECD average             26.4                     28.9
European Union average   24.2                     25.3

Source: OECD and PricewaterhouseCoopers

    And as we watch our foreign competitors continue to reduce their 
taxes, there is one other key data point that stands out: in these 
other countries, the share of government revenue represented by 
corporate taxes remains largely unchanged. That is, the government's 
ability to fund other priorities has not been diminished as the 
corporate tax rate has fallen. This point has dramatic implications for 
evaluating how economic competitiveness and economic growth can be 
improved without reducing overall government tax collections.
U.S. International Tax Rules at Variance with International Norms
    U.S. tax rules also deviate significantly in other ways from those 
of many of our trading partners to the detriment of U.S. firms. The 
American Jobs Creation Act of 2004 has provided some important positive 
steps to address the competitiveness of U.S.-based multinationals and 
the U.S. economy, including numerous changes to address the complexity 
of the foreign tax credit rules. However, complexities and barriers 
remain that continue to handicap U.S. companies in the global 
marketplace.
    U.S. multinationals in many cases must pay U.S. tax in addition to 
foreign tax on income earned abroad. By contrast, competitors 
headquartered in countries with territorial tax systems generally do 
not pay home-country tax on business income earned abroad. The 
President's Advisory Panel on Federal Tax Reform, in recommending an 
option moving in the direction of the territorial tax systems employed 
by some of our major trading partners, noted that territorial systems 
are used by twenty-one of the thirty OECD countries. An appropriately 
structured territorial tax system that allows U.S. companies to compete 
globally on level terms is worthy of consideration. The variations of 
territorial systems employed by our major trading partners, as well as 
other possible variations, should be examined to determine the 
particular features of a territorial tax system that would serve to 
enhance the competitiveness of U.S. multinational companies in the 
global marketplace.
    Even relative to other countries that have not adopted a 
territorial tax system, that is, countries following a ``worldwide'' 
system of taxation, U.S. international tax rules often serve to impose 
a higher tax burden. In general, U.S. multinational companies are not 
subject to U.S. tax on the operating earnings of their foreign 
subsidiaries until those earnings are actually paid to the U.S. parent 
as a dividend. This ability to defer tax until a dividend has been paid 
to the U.S. parent permits earnings to be reinvested by the foreign 
subsidiary without reduction for U.S. taxes. An important exception to 
this general rule of deferral is subpart F of the Internal Revenue 
Code, which taxes U.S. multinational companies on certain active 
business income earned by their foreign subsidiaries, even though no 
dividend has been paid to the U.S. parent. No other country limits 
deferral as rigorously as the United States. In the absence of 
deferral, a U.S. company has only 65 percent of its foreign source 
earnings to reinvest (with up to 35 percent going to U.S. tax) while a 
foreign competitor can reinvest up to 100 percent, depending on the 
foreign rate of tax. There is urgent need to modernize these rules, 
including making permanent the treatment of financial services income 
as active income not subject to the subpart F restriction.
    With growing world economic integration, the shortcomings of U.S. 
international tax policy will increasingly be magnified. The playing 
field is already un-level and every year we risk falling further 
behind.
Double Taxation of Domestic Income
    All of the major trading partners of the United States relieve or 
eliminate the double taxation of corporate income, which occurs when 
corporate profits (but not the profits of any other type of business) 
are taxed at both the corporate and shareholder levels.
    Double taxation increases the cost of capital for U.S. companies 
compared to foreign competitors whose countries have eliminated or 
reduced this handicap. Partial relief from double taxation was enacted 
in 2003 in the form of a reduced individual tax rate on corporate 
dividends received by shareholders. This partial relief is set to 
expire after 2008 unless extended, as House-passed legislation 
provides, or made permanent, as requested by the President.
    Permanent relief from double taxation would provide significant 
economic benefits to the U.S. economy. Since enacting the temporary 
dividends investment incentives in 2003, economic growth is up, more 
than 5 million new jobs have been added, business investment has been 
very strong, and companies have rapidly expanded their dividend 
payments. As noted in a recent study by the Federal Reserve Bank of 
Boston, the dividends investment incentives expand investment by 
corporations and lead to higher paying jobs for American workers.
A Tax Code for the 21st Century
    The broad brush of reform must reach into other areas, as well. To 
enhance economic growth, U.S. policy must encourage increased savings 
by individuals, including long-term savings which can in turn be used 
as a source for long-term investment capital for businesses. Capital 
investments in plant and equipment can be fostered through depreciation 
allowances that properly reflect the more rapid obsolescence of capital 
goods in today's modern economy. We must also recognize the need for 
promoting investment in research and development. When we name research 
and development, the Roundtable speaks not only of the critically 
important tax credits for finding and perfecting new products and 
technologies--credits which should be extended and strengthened as 
swiftly as possible along the lines of legislation passed by both the 
House and the Senate--but also of the need to develop our human capital 
by improving math and science education so that our citizens, too, 
improve their global competitiveness.
    The Roundtable is ever mindful of the U.S. federal budget and 
deficit concerns. We consistently and enthusiastically advocate 
responsible budgetary policy. At the present time, with economic 
activity appearing to have fully recovered from a previous slowdown in 
the economy, it is imperative to focus on deficit reduction.
    In light of the need to maintain fiscal discipline to promote long-
term economic growth, we support an approach to tax reform in a revenue 
neutral manner--that is, formulation of tax proposals that neither 
increase overall tax collections nor reduce overall taxes and cause 
deficits to expand. However, revenue neutrality must not be reached by 
increasing business taxes to pay for individual tax reductions. In 
today's competitive international business environment, tax increases 
on business have a doubly negative impact. By increasing our cost to 
finance new investment, business taxes reduce the ability of U.S. 
businesses to grow and expand at home and they cause U.S. businesses to 
lose sales to our foreign competitors who are unhindered by U.S. tax 
rules.
Conclusion
    Current U.S. tax policy is handicapping our economic prowess at a 
time when it needs to be unleashed. Expanding demand for consumer 
products and capital equipment around the world creates extraordinary 
potential growth opportunities for U.S. companies. With 95 percent of 
the world's population and 80 percent of the world's purchasing power 
residing outside of the United States, success or failure of U.S. 
companies in their quest to compete in foreign markets, as well as at 
home, will have a significant impact on domestic jobs and the growth of 
our economy. For U.S. companies to compete successfully and bolster 
U.S. growth, we need a tax system that doesn't handicap us from the 
starting line.
    The number one priority of Business Roundtable to enhance the 
competitiveness of U.S. companies is a significant reduction in the 
corporate tax rate. If U.S. companies are to remain competitive in 
world markets, they cannot be subjected to tax rates more than ten 
percentage points above those of their foreign-based competitors.
    Second, our international tax rules must be modernized to permit 
U.S. multinational companies to operate on a global scale through 
global operations. We encourage Congress to examine features of other 
territorial tax systems, as well as other reforms, that can serve to 
promote the competitiveness of U.S. companies with international 
operations rather than penalize them as our present tax system often 
does.
    As the importance of international commerce will only become more 
pronounced each decade, the longer we wait in undertaking these 
reforms, the greater is the loss to our economy.
    Long-term economic growth will also require that we take a 
disciplined approach toward deficit reduction. As projections from all 
governmental authorities show, any realistic attempt to hold down long-
run deficits requires that spending on entitlement programs be kept in 
check. Spending on the three major entitlement programs of Social 
Security, Medicare, and Medicaid will, if left unchanged, absorb an 
unsustainable share of economic resources and overwhelm the federal 
budget. We welcome the opportunity to explore ideas and proposals that 
will slow the rate of growth of these programs while continuing to 
provide increasingly higher living standards for all Americans.
    The Roundtable greatly appreciates the work this Committee and its 
Members are undertaking by addressing this weighty and complex subject. 
But as complicated as the subject may be, the underlying truth is a 
simple one: American companies are at a competitive disadvantage in the 
global marketplace and tax reform that allows our companies to be more 
competitive is a critical step towards reinvigorating America's 
business edge abroad and economic growth at home.
    I appreciate this opportunity to share with you our concerns. On 
behalf of Business Roundtable, we look forward to continuing to work 
with the Congress as it explores ways to modernize our tax system to 
reflect the realities of today's globally competitive environment and 
undertake reforms to augment future economic growth. I thank you for 
your time and attention and I welcome your questions.

                                 

    Chairman CAMP. Thank you very much. Thank you all for your 
testimony. Mr. Castellani, first of all, I would like to 
mention that many witnesses today have raised the international 
competitiveness concerns about our tax system, and we will be 
holding a hearing in June on the international tax issues, but 
I did want to ask a question about, as a rule of thumb, do you 
find that a country's rates, the rate a country imposes on a 
tax base, is that more important than specific incentives in 
terms of business investment? I realize this is in your role 
working with the senior management of many prominent companies 
throughout the country and world.
    Mr. CASTELLANI. Yes; in general, our experience and our 
members' experience is that it is the rates that have the 
greatest long-term impact on investment decisions. A lot of 
specific incentives can be transitory. They can disappear. 
Ultimately, they create artificial behavior, but when we look 
across all of our member companies and the countries in which 
we compete and the companies with which we compete around the 
world, it is the rates that affect those business decisions the 
most significantly.
    Chairman CAMP. All right; thank you. Mr. Tisch, thank you 
for your comments regarding long-term capital gains. I do have 
a question: do you see much value in pursuing the book versus 
tax conformity reporting requirements?
    Mr. TISCH. The first I have really heard of that was during 
the prior panel, and the conclusion that I quickly drew, that 
is my preliminary conclusion, is that it sounds good when you 
say it fast but that when you dig deeper and deeper into it, I 
dare say I do not think Congress wants the Financial Accounting 
Standards Board (FASB) determining what tax policy is for the 
United States, and I do not think that would be particularly 
good for the United States either.
    Chairman CAMP. Do you, in your role as a CEO, see 
compliance--not really concerns but cost issues with complying 
with both systems, or is that not a concern for your--in your 
experience?
    Mr. TISCH. It is very, very expensive to comply both with 
FASB and the U.S. Securities and Exchange Commission (SEC) 
rules with respect to GAAP accounting, and it is also very 
expensive to comply with IRS rules. But this year, our company 
will earn between $1.5 billion and $2 billion. So, the costs, 
while large, in the tens of millions of dollars, will 
nonetheless be manageable within the context of our company.
    Chairman CAMP. Thank you. Mr. McKenna, you said that the 
rates are generally favored over expensing. Does that lead to 
the same result?
    Mr. MCKENNA. Perhaps in the short-term, it leads to the 
same result in terms of producing a tax savings. But if the 
long-term plan is to influence behavior, and that is the point 
I was trying to make, that the tax preferences and tax credits 
in the case of PepsiCo really don't influence our behavior. 
They reward activities that we would otherwise already be 
doing.
    That may sound counterproductive, and I do not mean to be 
glib about that, but comparing a long-term tax rate benefit 
with a more targeted tax preference, PepsiCo and our 
shareholders would benefit much more, assuming the dollars are 
equal, would enjoy much more the benefits of a long-term rate 
reduction.
    Chairman CAMP. Thank you. Again, thank you all for your 
testimony. Mr. McNulty may inquire.
    Mr. MCNULTY. I also thank all of you for taking the time to 
be here today, and based upon my earlier comments about our 
huge budget deficits and the staggering national debt and the 
impact that that will have on future generations, my question 
is, do you believe that the proposals which you are making here 
today will have the impact of reducing budget deficits in the 
future, hopefully moving us toward balanced budgets and then 
eventually the ability to start paying down the national debt 
rather than increasing it every year, and if so, how? I would 
just like to get a brief comment from each of you on that.
    Mr. TISCH. Congressman, I think that the reduction in the 
rate for long-term corporate capital gains will actually raise 
revenues for the Treasury. The reason for that is that there is 
an enormous backlog of gains that have not been taken by 
companies because the tax rate is so high. A reduction in the 
rate will do several things: number one, it will get companies 
to sell capital assets that they otherwise have been holding, 
and so, it would generate revenue for the Treasury.
    Number two, it will lead to increased economic activity, 
because the assets that companies are holding that they want to 
sell but for the tax rate are probably not being maximized by 
those companies, and the sale of those assets to other 
companies that want to own that asset and want to maximize the 
value of that asset will result in increased job creation and 
will result in increased national income and revenue for the 
Treasury.
    Mr. MCNULTY. Has that been the history in the past, when we 
have made cuts in the capital gains rate?
    Mr. TISCH. We do not know, because the tax rate for 
corporate capital gains has been so high for so long. It is 35 
percent now. Let me take you through a very simple example. We 
are in the hotel business. Suppose a long time ago, we bought a 
hotel for $20 million, and suppose, today, it is worth about 
$100 million, because it has income of about $5 million a year.
    As a corporate CEO, here is what would go through my mind 
in determining whether to continue owning the hotel or whether 
to sell it. I would look at how much I would get; $100 million; 
sounds like a lot of money, and it sounds, on a pretax basis, 
like I am selling it at a pretty good yield, at 5 percent. 
However, I would have $80 million of gain on that transaction. 
At the 35-percent rate, that means I would pay $28 million in 
taxes.
    So, when the dust has settled on the transaction, I am 
going to have $72 million, meaning that my yield is really 7 
percent. My reinvestment yield is 7 percent. I have to be able 
to get 7 percent just to break even with the 5 percent that I 
was earning before the transaction. So, what we are seeing is 
that the reinvestment rate has gone up 40 percent.
    Now, suppose instead we had a 15 percent capital gains rate 
for corporations similar to what we have for individuals. 
There, I would sell the asset, because there would not be such 
an enormous tax wedge, and the Treasury would get $12 million, 
which is 15 percent of the $80 million gain, as opposed to 
getting zero dollars, which is what it is currently getting, 
because I am unwilling to sell the asset. Not only that; once I 
have sold the asset, it is going to go to hands that are going 
to exploit that asset more, exploit in the good sense. I am 
going to get cash that I can then use to reinvest in yet other 
assets that I want to own more than that hotel that I sold. So, 
everybody wins. There is economic activity; there is job 
creation; and there is dramatically more revenue to the 
Treasury.
    Mr. MCNULTY. Thank you. Mr. McKenna?
    Mr. MCKENNA. Mr. McNulty, my comments domestically were 
focused more on the competitiveness of U.S. corporations and 
the efficiency of how the tax laws are administered and goes 
more toward targeting lower tax rates as opposed to targeted 
tax benefits. Internationally, the additional point I made goes 
to the competitiveness of U.S. companies competing abroad, 
which is that our competition is taxed at lower rates, and that 
has all the obvious business pressures for U.S. companies 
trying to compete against those companies in those locales.
    Mr. MCNULTY. How concerned are you about the budget 
deficits and the national debt that we have right now?
    Mr. MCKENNA. It is a significant concern; obviously, a 
significant concern.
    Mr. MCNULTY. Mr. Castellani?
    Mr. CASTELLANI. If I might address that, there are two 
aspects of the economy that your question gets to, and both are 
very important.
    One is to have the economy growing at its maximum 
efficiency. In fact, most of our members believe that this 
economy, particularly with our productivity improvements and 
the tremendous productivity of American workers could probably 
grow at a noninflationary rate, at a much higher rate than we 
are seeing now, which is a pretty robust rate. Every percentage 
of GDP growth increase produces more than $620 billion over a 
five-year period in additional tax revenues, so that is one 
part of the equation.
    But the other part has been and remains a concern for the 
members of the Business Roundtable, and that is over the long-
term, we need to reduce our deficit. That part of our equation 
is reducing our spending. The very substantial portion of the 
Federal outlays that are in entitlement programs will grow to 
be nearly half of the budget, and Social Security and Medicare 
and Medicaid present a very significant problem for the economy 
as a whole and our worldwide competitiveness if we do not 
address them.
    So, our view has been keep the economy going as well as it 
can grow efficiently without causing inflation and producing 
income but at the same time begin to modernize our systems and 
our entitlement systems to reflect not only the demographic 
reality but also our ability and our need to compete 
internationally.
    Mr. MCNULTY. Thank you all very much, and I thank Mr. 
Chairman for letting me go over my time a little bit.
    Chairman CAMP. Thank you. It was helpful to hear from the 
whole panel. Mr. Foley may inquire.
    Mr. FOLEY. Thank you, and Mr. Tisch, I was intrigued by 
your analogy of the buildup of value and what a corporation 
does with that asset, but would it not be fair to say that a 
corporation would maybe find a way to maybe swap out that asset 
or trade stock with another corporation or like-kind exchange? 
Does the Tax Code not provide mechanisms by which you can defer 
viability?
    Mr. TISCH. There is some of that, but the rules are very 
difficult, and you have to jump through hoops to comply. It is 
easier in real estate than it is anywhere else, but even in 
real estate, you only have 6 months to make the reinvestment. 
So, you have to tee up not one transaction but two transactions 
simultaneously, and that is oftentimes very difficult to do.
    With respect to other capital assets, it is very, very 
difficult to do, and generally, it does not give you, at the 
end of the day, cash that you can use to spend to buy something 
else. So, we have found, not wanting to tie ourselves up in to 
all kinds of knots, that instead, we just do not do 
transactions.
    Mr. FOLEY. I guess that was my point, because there are 
ways to do it. You could leverage the building and add debt, 
pull out cash tax-free in the real estate sense, maybe not from 
the operating side, but the fact remains that if we had a 
preferable rate of 15 percent, most would prefer to transact, 
pay the tax, and move on; is that correct?
    Mr. TISCH. That is right, and I think Professor Desai 
estimated that there are $800 billion of gains locked up in 
companies. My guess is that his number is very, very low.
    Mr. FOLEY. See, and that is something I wish we would all 
focus on. When we talk about rates, we get caught up in what is 
it going to cost the Treasury. My example of how companies 
operate, individuals, if I have a liability on a sale of 
assets, I am going to find a way to exchange it out and move 
forward to the--at some point, there is a day of reckoning, but 
I am going to make complicated transactions in order to 
minimize taxation.
    I will keep a lot of people busy, accountants and lawyers, 
to make sure that I have complied with the law, but in essence, 
I have delayed the day of reckoning, starved the government 
moneys that it could have earned on the day of a closing. So, 
the simplicity by which you are advocating under the John F. 
Kennedy model of lower taxes, greater revenue, truly is an 
example that we witness after we reduce capital gains from 27 
to 15 percent.
    Mr. TISCH. If it is good for individuals, the question is 
why is it not good for corporations? My strong belief is that 
it would increase revenues to the Treasury.
    Mr. FOLEY. Mr. McKenna, could you describe something 
PepsiCo may do that would avoid a domestic operation in favor 
of an international one, based on the tax climate?
    Mr. MCKENNA. It is difficult, Mr. Foley. Most of our 
businesses must be fairly established in each local country. We 
could perhaps choose to source the United State from Mexico or 
Canada, where transportation costs are not that significant. We 
could choose to perhaps locate a factory in one country or 
another based upon the tax laws, but in most cases, because our 
businesses are so local, our operations have to be located in 
that country. PepsiCo's tax planning with respect to growing 
our international markets, is much more a question of looking 
at local laws as opposed to the impact today of U.S. laws, with 
one exception, and that is the U.S. law that taxes those 
profits when they come home. That taxation is a major hurdle 
that we have to put into our investment models.
    Mr. FOLEY. Did you bring back moneys when we reduced the 
level for repatriation?
    Mr. MCKENNA. Yes, we did. We brought back the maximum 
amount we were permitted under the law.
    Mr. FOLEY. Do you recall the number?
    Mr. MCKENNA. Over $7 billion.
    Mr. FOLEY. So, $7 billion of PepsiCo's money that was 
worldwide, held offshore, was brought back based on a more 
efficient tax model.
    Mr. MCKENNA. That is right.
    Mr. FOLEY. Final thought, and I do not expect an answer, 
but in the effort to reduce taxes for corporations, one of the 
things that we are hit with politically is the fact, and we 
open the paper and see huge compensation packages, $200 
million; $400 million as a walkaway; something to keep in the 
back of our minds as we are working together to make a better 
business climate. The fallout of some of those makes it very 
difficult for us to say let us reduce rates, even though we can 
enthusiastically make the case that when do reduce rates, as in 
the case of Pepsi, Apple, IBM, I can go through a litany, 
brought home hundreds of billions of dollars that are now 
domestically deployed that not have been, so I think those are 
things that we all have to work on together. Thank you.
    Chairman CAMP. Thank you. The gentleman's time has expired. 
Mr. Doggett may inquire.
    Mr. DOGGETT. Thank you, Mr. Chairman. If I understand 
correctly, all three of you agree that you would like to see a 
lower corporate tax rate, and you would be willing to yield 
some tax preferences and some tax credits in order to get one.
    Mr. MCKENNA. Speaking for myself, the answer is yes, yes, 
sir.
    Mr. CASTELLANI. When the very diverse membership of the 
Business Roundtable, and as you know, they represent every 
sector in the economy, look at how the Tax Code can be made 
most effective and enhance competitiveness, the two answers 
that are almost universal are lower the rate and reform our 
international tax system.
    Mr. DOGGETT. Same for you, Mr. Tisch?
    Mr. TISCH. No.
    Mr. DOGGETT. Well, that argument has some appeal to me, 
even though we come from a different perspective. I would like 
to know what we are getting in order to lower the tax rate. 
Just beginning with you, Mr. McKenna, which tax credits or 
preferences that PepsiCo regularly uses would you recommend 
that we repeal in order to lower corporate tax rates?
    Mr. MCKENNA. I can perhaps answer the question in a little 
bit different fashion.
    Mr. DOGGETT. Could you answer that question first? Are 
there any that you can identify that PepsiCo regularly uses in 
the way of tax credits or tax subsidies or preferences of any 
kind that you would recommend we repeal in order to get to a 
lower corporate tax rate?
    Mr. MCKENNA. Yes; we would be willing, on our books alone, 
to trade some of the depreciation benefits that are available 
today in exchange for a lower tax rate.
    Mr. DOGGETT. All right; and you, Mr. Tisch?
    Mr. TISCH. I did not say that I was in favor of lower 
corporate rates. I think that the goal of the CEO is to 
maximize the income of the company.
    Mr. DOGGETT. Certainly.
    Mr. TISCH. We have to generate pre-tax earnings, as much 
pre-tax earnings as possible. Then, we pay our taxes; and then, 
we have net income, which is what the shareholder looks at. My 
job is not going to be different if the rate is 35 percent or 
30 percent.
    Mr. DOGGETT. Okay.
    Mr. TISCH. However, my behavior will change if you lower 
the corporate capital gains tax rate. I will make dramatically 
different investment decisions as a result of that.
    Mr. DOGGETT. With regard to your position on the 
territorial tax system that you would recommend, do I 
understand that each of you also favor a territorial system in 
which taxes would be limited to profits generated here in the 
United States, and if PepsiCo has operations in India or 
Nigeria or Italy that you would pay your taxes there, but you 
would not pay taxes here in the United States on those profits?
    Mr. MCKENNA. That is right. When they came home, they would 
not be taxed a second time. That is right.
    Mr. DOGGETT. That is something that you support also, Mr. 
Tisch?
    Mr. TISCH. I have not given it a dramatic amount of 
thought, but on first thought, yes.
    Mr. DOGGETT. That is what I believe what your paper 
advocates.
    Mr. CASTELLANI. Yes.
    Mr. DOGGETT. You call it a territorial system, but what it 
really is is no tax in America on any profits earned outside of 
America, is it not?
    Mr. MCKENNA. Yes, or an exemption system, that is right.
    Mr. DOGGETT. It is an exemption for all earnings. So, like, 
Exxon-Mobil, on everything that it earns outside the 
Continental United States, it would pay no tax whatsoever ever 
on those earnings.
    Mr. MCKENNA. The exact ramifications of a territorial 
system are not quickly decided upon, and I think from a policy 
perspective, a great deal of study is necessary before deciding 
exactly what is taxed and what is not taxed----
    Mr. DOGGETT. We can agree on that. Since my time is running 
out, let me just ask you once more about your company. During 
the time you have been there, has PepsiCo ever paid an 
effective tax rate of 35 percent on its total corporate 
earnings?
    Mr. MCKENNA. Our current effective tax rate is not 35 
percent.
    Mr. DOGGETT. You would fire your whole tax department if 
they paid 35 percent effective tax rate, would you not? No 
corporation around here of the size of your corporation pays a 
35 percent effective tax rate, does it?
    Mr. MCKENNA. Probably not very many, but I cannot speak 
to----
    Mr. DOGGETT. No, sir. The ones that are losing, they are 
losing shareholders, perhaps, but there are so many ways to 
avoid the 35 percent effective tax rate that no one pays it. 
Thank you very much, Mr. Chairman.
    Chairman CAMP. Mr. Tisch, did you want to make a comment? 
You had your hand up.
    Mr. TISCH. Yes; the question as to whether you are paying 
an effective 35 percent tax rate, I understand what the 
numerator is. The numerator is cash that you pay to the 
government. The thing I do not completely understand is what 
the denominator is. If, in fact, the denominator is what you 
call GAAP net income, then, in fact, no, companies do not pay a 
35 percent effective rate. If the denominator instead is the 
bottom line that comes out on the tax form, our taxable net 
income, then, obviously, yes, all companies pay that 35 percent 
net rate.
    Chairman CAMP. All right; thank you. Just briefly, Mr. 
McKenna, we did have a repatriation provision in the JOBS Act 
of 2004. Did that affect Pepsi in any way?
    Mr. MCKENNA. Yes, it did.
    Chairman CAMP. I realize we are going to have a hearing on 
the international provisions later, but I just wanted----
    Mr. MCKENNA. Yes, it did. PepsiCo did take advantage of the 
ability to bring back accumulated profits overseas, profits 
that we hesitated to bring back because of the tax consequences 
until that law was passed.
    Chairman CAMP. All right; thank you. Mr. Linder may 
inquire.
    Mr. LINDER. Mr. McKenna, how much do you still have 
offshore?
    Mr. MCKENNA. In terms of earnings, sir, or cash?
    Mr. LINDER. Cash.
    Mr. MCKENNA. I think at this point, on a net basis, 
probably a deficit of cash offshore. I cannot say exactly.
    Mr. LINDER. Do you have any idea how much is offshore in 
offshore financial centers in dollar-denominated deposits?
    Mr. MCKENNA. No, I could not tell you that off the top of 
my head.
    Mr. LINDER. Would $10 trillion surprise you?
    Mr. MCKENNA. Pardon me?
    Mr. LINDER. Would $10 trillion surprise you?
    Mr. MCKENNA. From a cumulated point of view, it would not 
surprise me, sir, but I do not know.
    Mr. LINDER. How much do you spend every year on your tax 
department?
    Mr. MCKENNA. Several million dollars a year.
    Mr. LINDER. How much do you spend in total compliance costs 
in addition to that?
    Mr. MCKENNA. Again, an additional several millions of 
dollars a year.
    Mr. LINDER. How much money do you think you put into 
calculating the tax implications of a business decision?
    Mr. MCKENNA. That is an important consideration of every 
decision we make.
    Mr. LINDER. Mr. Tisch, same thing for you?
    Mr. TISCH. We spend about $20 million a year on 
accountants. We spend----
    Mr. LINDER. Inside accountants or outside accountants?
    Mr. TISCH. Outside accountants. We probably spend another 
$20 million of internal people just putting together financial 
statements, and then, we probably spend another, oh, I would 
say $10 million or $15 million across all of our companies 
complying with Tax Codes.
    Mr. LINDER. On top of that, what do you spend, do you 
think, calculating the tax implications of a business decision?
    Mr. TISCH. It is difficult to say, because that just goes 
part and parcel with----
    Mr. LINDER. Every decision.
    Mr. TISCH. Every decision.
    Mr. LINDER. Yes; if we had no tax on capital or labor and 
taxed only personal consumption, how much of the offshore 
business would be onshore? Mr. McKenna? You mentioned 
transportation costs, and people doing business in Detroit 
would probably like to be in Detroit if it were not for the tax 
implications.
    Mr. MCKENNA. By transportation costs, I meant moving from 
the factory to the customer to the warehouse. Our operating 
businesses probably would not be impacted at all in the sense 
that our operating businesses are, more often than not, local 
businesses in each country, in France or Germany or India, 
wherever it might be. Those markets need to be sourced from 
local production.
    Mr. LINDER. Is it not true that Daimler-Chrysler really 
wanted to be Chrysler-Daimler, and they really wanted to be in 
New York except for the crushing tax on capital in this 
country?
    Mr. MCKENNA. I cannot speak for them; I am sorry.
    Mr. LINDER. Mr. Castellani, have you, through your 
organization, ever taken the time through your companies to try 
to calculate how much we spend complying with a code that 
brings in roughly $1.5 trillion a year?
    Mr. CASTELLANI. We have not, but as you know, others have. 
The figure is rather astounding. I do not recall it, but I am 
sure you do; we have not calculated it. We have relied on 
others to do that, because we only have one portion of the 
economy that we look at.
    Mr. LINDER. Mr. McKenna, who pays your business taxes? Do 
you think it comes out of your shareholders pockets, your 
employees' pockets, or your consumers?
    Mr. MCKENNA. I think as a corporate expense, it ultimately 
comes out of the returns that shareholders receive.
    Mr. LINDER. You do not think your consumers are paying 
anything to that?
    Mr. MCKENNA. It certainly impacts the pricing of our 
products, absolutely.
    Mr. LINDER. Have you ever done an estimate of how much the 
tax component is in your price system?
    Mr. MCKENNA. We have not approached it from that angle, no. 
We have not approached it from a revenue perspective, no.
    Mr. LINDER. We have a study from Dale Jorgenson and 
Harvard, 1997, I think it was, that suggests that on average, 
20 percent of the producer price system represents the embedded 
cost to the IRS, from leather goods at 15 percent to government 
services at 26 percent. Would that surprise you?
    Mr. MCKENNA. No, I am sure it is significant.
    Mr. LINDER. Does that make us less than competitive in a 
global economy?
    Mr. MCKENNA. Certainly, the way the U.S. tax laws impact 
international tax laws impact our competitors.
    Mr. LINDER. Thank you all. Thank you, Mr. Chairman.
    Chairman CAMP. Thank you.
    Ms. Tubbs Jones may inquire.
    Ms. TUBBS JONES. Thank you, Mr. Chairman. I am sitting here 
laughing, because I am confident that many of the provisions of 
the Tax Code were put in place as a result of the lobbying the 
business community, even though we are all complaining we would 
like to get rid of all of these tax benefits and have a code 
that did not give you such blues in terms of preparation. You 
all will agree with that, that if we went back and looked at 
the tax history or the hearings with regard to this Committee 
that you were lobbying awful hard for an R&D tax credit or 
whatever other credit. Will you not agree with me, Mr. 
Castellani, just to be nice, so I can keep going with my line 
of questioning?
    [Laughter.]
    Mr. CASTELLANI. Well, ma'am, it has been very difficult----
    Ms. TUBBS JONES. Short answer?
    Mr. CASTELLANI. The answer is yes, because it has not been 
as simple as you have described, because no one is offering the 
very difficult task of a broad-based reform of the Tax Code.
    Ms. TUBBS JONES. I did not ask about a broad-based reform, 
Mr. Castellani. I am saying if you went back and looked at the 
Congressional hearings, there were lobbyists on behalf of 
business saying give me this tax credit. I need this to do 
this, that or the other. Mr. McKenna----
    Mr. MCKENNA. Absolutely.
    Ms. TUBBS JONES. --you would agree that that is there 
somewhere, right?
    Mr. MCKENNA. Yes, it is. It is certainly there somewhere.
    Ms. TUBBS JONES. Mr. Tisch, you would agree with me, would 
you not?
    Mr. TISCH. I would agree in terms of business in general. I 
can tell you this is my first time here, and my company rarely 
if ever lobbies for tax relief.
    Ms. TUBBS JONES. Individually, you do not, but the Business 
Roundtable through Mr. Castellani, and you agree with a lot of 
the things that Mr. Castellani proposes.
    Let me leave that alone and go on to something else. Can 
you tell me, Mr. McKenna, what did PepsiCo do with the money 
that they got back under the change and repatriation of 
dollars, the money you were able to bring back into the 
country? Did you give it to your shareholders? What happened 
with it?
    Mr. MCKENNA. Well, it contributed to our continuing 
investment in the United States. I can tell you that in 2006, 
we are reinvesting approximately $1 billion into capital 
projects in the United States.
    Ms. TUBBS JONES. So, how many more jobs did we get as a 
result of repatriation?
    Mr. MCKENNA. I cannot identify the specific number, but the 
Gatorade factories and the Tropicana facilities around the 
country all will demand new, additional jobs.
    Ms. TUBBS JONES. So, you are suggesting to me that by 
allowing you to bring money back to the United States that you 
paid no tax on previously that we then increase the revenue to 
the United States of America by having more jobs, and so forth. 
I am not asking you that question. I have one for you.
    Mr. McKenna.
    Mr. MCKENNA. Yes, I think it took away the disincentive to 
investing that money back into the United States.
    Ms. TUBBS JONES. So, what exact benefit did you receive 
through repatriation? No tax on----
    Mr. MCKENNA. There was a small tax paid. It was not quite 
tax free. There was a small tax but a significant reduction in 
tax.
    Ms. TUBBS JONES. Mr. Castellani, if I said to you okay, I 
will give you your capital gains and dividend tax relief that 
you are asking for, what would you be willing to give up?
    Mr. CASTELLANI. Well, ma'am, the capital gains and dividend 
relief that we had been asking for is in fact in the Code now. 
What we have seen as a result----
    Ms. TUBBS JONES. I know it is in the Code now, sir, but 
there is a whole debate about whether it should be extended. 
So, my question to you is what would you be willing to give up 
if I said it was extended ad infinitum?
    Mr. CASTELLANI. What I would not be willing to give up and 
what our members----
    Ms. TUBBS JONES. No, my question is what would you give up?
    Mr. CASTELLANI. --is our ability to be competitive, ma'am.
    Ms. TUBBS JONES. What are you willing to give up? See, you 
are playing words with me. Mr. Castellani.
    Mr. CASTELLANI. We do not view this as a zero sum game.
    Ms. TUBBS JONES. You know what? That is the dilemma that we 
are in, because I am trying to have a real conversation with 
you. You have already said to me that the problem that we have 
in the United States of America are entitlement programs and 
the fact that Medicare and Medicaid and Social Security are 
going bankrupt. The reality is, Mr. Castellani, you do not 
believe that American workers should not have Medicare, 
Medicaid, or Social Security, or do you?
    Mr. CASTELLANI. Oh, absolutely; we agree that it is very 
important that they have them and that those systems both 
reflect the needs of people who use them as well as reflect the 
new demography that we have in our country, quite frankly. One 
of the issues that we have been arguing for for a long time has 
been Social Security reform, and one of the problems we have 
had with the debate----
    Ms. TUBBS JONES. Private accounts?
    Mr. CASTELLANI. No, ma'am, we said the option for personal 
savings should be there.
    Ms. TUBBS JONES. Do you know what, Mr. Castellani? I am 
trying to give you assistance in getting what you want. What I 
am suggesting to you is that there is enough money made in 
America that workers should not have to give up Social 
Security, Medicare, or Medicaid, and until we are able to talk 
honestly, Democrats and Republicans, see, I want business to do 
well in my country, because it provides jobs. But I do not want 
them to do well at the behest of the workers who are starving, 
making $5.15 an hour right now.
    I am out of time. It is nice to talk with you. I look 
forward to further conversations, but the reality is there has 
got to be a give and take on both sides.
    Chairman CAMP. All right; thank you. Mr. Chocola may 
inquire.
    Mr. CHOCOLA. Thank you, Mr. Chairman. Thank you all for 
being here today. Before being elected, I was CEO of a 
publicly-traded company, much smaller than the companies you 
all represent. I just spoke with our CFO that is still there, 
and he said, you know, all we want to do is be competitive. I 
bring that out just because I think when we talk about these 
issues a lot of times, people think we are only talking about 
PepsiCo or Loews or members of the Business Roundtable.
    We are talking about thousands and thousands of small 
companies for every one of the big companies that are dealing 
with these issues. So, no one is immune no matter what size 
your company is, if you are trying to compete in a global 
marketplace to try to be more competitive.
    Let me just ask you from the territorial tax system 
questions, those who criticize it say it will create a flight 
of capital to some foreign land, is there anything preventing 
U.S. shareholders from making the decision not to invest in 
your companies but to invest in a foreign company that is more 
competitive because they have a territorial tax system?
    Mr. TISCH. I would say, in fact, that the current system is 
chasing money out of this country. One of the industries we are 
in is the offshore drilling industry, and a few years ago, a 
number of offshore drilling contractors, our competitors, moved 
their operations offshore, incorporated in the Cayman Islands 
and in other places, and in essence, decamped from the United 
States and now no longer have the issue of worrying about 
bringing back foreign earnings to the United States.
    So, I think that doing something to level the playingfield 
so that our domestic company could compete with those foreign 
companies would be greatly appreciated.
    Mr. CHOCOLA. So, you think by making U.S. companies more 
competitive, more people would invest in U.S. companies; is it 
simple as that?
    Mr. TISCH. Absolutely.
    Mr. CHOCOLA. On the flip side, if we had, in effect, a 
territorial system in place, what would that do, Mr. McKenna, 
to PepsiCo's market share worldwide?
    Mr. MCKENNA. It would--in each individual market outside 
the United States, it would allow us to increase our returns 
and invest more money in those markets and give us greater 
market share and greater return to our shareholders.
    Mr. CHOCOLA. How about access to capital?
    Mr. MCKENNA. PepsiCo does not have the particular need for 
access to capital at this point. We are able to fund most of 
our capital from internally generated cash at this point.
    Mr. CHOCOLA. Nice position to be in. Just finally, in the 
previous panel, we heard that people who received dividend 
income are undertaxed. Do you agree with that, and what do you 
think would happen if we would raise the dividend tax rate or 
lower it to even zero? Mr. Castellani?
    Mr. CASTELLANI. I am not sure of the Professor's definition 
of undertaxed or overtaxed. What I can say, because we are very 
strong advocates of eliminating the double taxation of 
dividends, the income, as you know well, that companies 
received that is paid out in dividends is already taxed at the 
company level. What we have seen as a result of the lowering of 
the dividend tax has been a substantial increase in dividends 
paid out by companies. In fact, I stopped counting when it got 
in the 500s and 600s of companies that announced it.
    A very large proportion of that dividend income goes first 
to individuals; secondly, a disproportionate share goes to 
elderly individuals older than 60. The next thing that we saw 
is that it had both a very positive impact not only on wealth 
in the country but also on share price. To the extent that 
people who were nearing retirement or were retired or saving 
for a home or education saw the value of their savings that 
were in equities and shares go up, they felt better about the 
economy. They were better able to handle those needs. They 
participated more in the economy. So, of all of those things 
that were done in 2003, I think this probably had the most 
significant impact in terms of economic activity, increasing 
corporate payouts, and improving the valuation of savings.
    Mr. TISCH. Let me chime in. I do not know what is the right 
rate, but what I do strongly believe is that if the individual 
gains rate is increased, or the current 15-percent rate is 
allowed to lapse, and we go to a higher rate, what you will see 
is enormous selling by individuals as the date, the expiration 
of that 15-percent rate comes along, and you will see markets 
take a very significant header as a result. It will probably 
take a long time to recover from that type of tax-induced 
selling.
    Mr. CHOCOLA. Just real quick, Mr. Chairman: I do not think, 
Mr. Tisch, you have advocated this, but talk about fewer tax 
preferences, lower corporate rate. Has anybody built a model on 
what the appropriate rate would be?
    Mr. MCKENNA. I have not. I cannot speak to that. I do not 
know.
    Mr. CHOCOLA. All right; thank you.
    Chairman CAMP. Thank you. I want to thank our distinguished 
panel of witnesses, and I want to thank the Members for their 
attendance at this hearing, and the Select Revenue Measures 
hearing on corporate tax reform is hereby adjourned.
    [Whereupon, at 4:25 p.m., the Subcommittee adjourned.]
    [Submissions for the record follow:]

          Statement of Affordable Housing Tax Credit Coalition

The Low Income Housing Tax Credit and Corporate Tax Redorm
Comments of the Affordable Housing Tax Credit Coalition
    The Low Income Housing Tax Credit (the ``Housing Credit'') provides 
an excellent example of how the corporate tax code affects a company's 
decision to utilize capital. The Housing Credit program is the most 
significant Federal resource for the production of affordable rental 
housing for America's low-income families. It is tested, efficient, 
transparent, and governed not only by the IRS and state agencies, but 
also the investing institutions themselves. The program, which has 
created more than 1.7 million units of affordable rental housing since 
its inception in 1986, stimulates economic development in general 
through housing production and creates safe, affordable, attractive 
housing. The program brings private capital investments to communities, 
and primes the market for other activities, including home ownership 
and retail facilities. Tax incentives have proven to be the most 
efficient way to create affordable housing, and the Housing Credit 
program is one of the areas in which use of the Internal Revenue Code 
to meet social goals is vital and has no viable alternatives.
Affordable Housing Tax Credit Coalition
    The Affordable Housing Tax Credit Coalition is a group of 
developers, investors, lenders, nonprofit groups, public agencies, and 
others concerned with the low-income housing tax credit. The Coalition 
is a nonprofit corporation chartered under the laws of the District of 
Columbia and governed by an elected Board of Directors.
    On an ongoing basis, the Coalition represents tax credit 
participants before Congress in seeking needed legislative changes to 
the program, and represents the interests of the tax credit community 
before groups that effectively have regulatory control over the 
program, including the Treasury, IRS, FASB, and the National Council of 
State Housing Agencies. AHTCC undertakes a public information campaign 
to make widely known the success of the tax credit program to house 
low-income Americans.
Background of the Housing Credit Program
    Originally signed into law as part of the Tax Reform Act of 1986, 
the Housing Credit is responsible for the production of up to 50 
percent of all multifamily housing starts in any given year, and 
virtually all affordable rental housing in the United States since that 
time--more than 1.7 million units since enactment. It is estimated that 
200,000 affordable units are converted to some other use (such as 
market rate rental housing, condominium conversion, or demolition) each 
year. The Housing Credit accounts for construction of 130,000 new units 
each year. Thus, the nation continues to lose ground with its supply, 
even with the success of the Housing Credit.
    Congress understood from the beginning that private capital could 
only be attracted to affordable housing if there were tax benefits to 
replace the cash flow typically paid to real estate investors. The 
program is a model of effective use of public resources, leveraging 
taxpayer dollars with private capital, creating well-aligned public-
private partnerships, and relying on states for administration and 
local priority setting. Together these factors assure that any new 
housing developed meets local community needs and is developed and 
maintained in accordance with strict compliance rules.
    In 1993 Congress decided to make the Housing Credit a permanent 
program. Its longevity is testimony to the fact that the program has 
operated as intended. The program enjoys widespread bipartisan 
congressional support. In 2000, legislation to increase the amount of 
Housing Credits was co-sponsored by 85 percent of the Congress, with 
almost equal numbers of Republicans and Democrats. In addition, in 
2005, in response to the affordable housing crisis created by 
Hurricanes Katrina and Rita, Congress authorized a significant increase 
in Housing Credits available in the Gulf Opportunity Zone.
How the Housing Credit Works
    The program provides tax incentives, in the form of credits against 
federal income tax, in exchange for investment in newly constructed or 
substantially rehabilitated affordable rental housing. For periods of 
30 years or more, this housing must serve low to moderate income 
tenants, who pay restricted rents and who earn a maximum of 60 percent 
of area median income (although average incomes in these properties are 
often far lower). Credits are allocated to the States based upon their 
respective population. The States determine their own housing 
priorities, within broad federal guidelines, and then choose which 
proposed developments will receive Housing Credits.
    Developers, many of which are non-profit organizations, must 
compete for Housing Credit allocations under a highly transparent 
selection process. The Housing Credit is capped, which helps ensure 
that only a rational and reasonable amount of housing is built. But in 
most States, demand for Housing Credits far exceeds the supply, even 
with the increase authorized in 2000.
    Housing Credit developments are located in urban, suburban and 
rural areas. A majority of the properties serve families, but a 
substantial number serve also elderly, disabled and special needs 
populations.
    Once the Housing Credits are awarded to a housing developer, 
investors provide equity capital to finance a substantial portion of 
the costs of constructing or rehabilitating the housing. This equity 
capital reduces the need for mortgage financing and decreases debt 
service payments, thereby lowering operating costs and allowing owners 
to rent to low-income persons who pay rents they can afford.
    Approximately 98 percent of this equity capital is raised from 
corporations, including banks, financial institutions, insurance 
companies, and Government Sponsored Enterprises. Many banks invest in 
Housing Credits as a mechanism to fulfill their Community Reinvestment 
Act requirements. Investors have invested nearly fifty billion dollars 
since 1986.
    Due to the passive loss limitations and alternative minimum tax 
limits, individual investors supply very little capital toward this 
program. Furthermore, raising capital from individual investors is far 
less efficient because individuals cannot be expected to make 
commitments at the levels which corporations invest, which are 
typically in the tens of millions of dollars. Thus, the existence of 
the tax credit does not create undue complications for the individual 
taxpayers; the Housing Credit is instead primarily utilized by 
institutional investors.
    It is important to note that the prices which corporations are 
willing to pay for Housing Credits have risen dramatically over the 
past ten years, which translates into more equity available to build 
affordable housing. Prices began to rise after the Congress made the 
Housing Credit program a permanent part of the Code in 1993 because 
investors became confident that the program would exist for the long 
term. Indeed, prices have risen by approximately 50 percent in the past 
ten years, meaning that each tax credit dollar brings in more private 
capital, increasing the program's efficiency.
    Housing Credits are earned over a 10-year period, although they are 
subject to recapture for 15 years if various program rules are 
violated. Accordingly, corporations are highly motivated to make sure 
that the Housing Credits are received and not lost to recapture. Many 
corporations engage firms with special expertise in this area, often 
referred to as Housing Credit syndicators, to help them in structuring 
and monitoring the properties. This very intense oversight and the 
effective administration conducted by States are the principal reasons 
that the program has operated in accordance with government 
requirements--and even exceeded expectations--throughout its history. 
The threat of the severe penalty of tax credit recapture--a penalty 
only available through the tax code--serves to keep the program 
operating as Congress intended.
Why Use Tax Incentives?
    Affordable housing development simply cannot be financed without 
the private capital attracted by the credit. HUD subsidies and other 
programs do not provide sufficient resources to encourage the 
development of affordable housing. For example, housing vouchers would 
not provide upfront assistance to build housing developments, nor would 
they address issues of rehabilitating old housing. Prior to the 
enactment of the Housing Credit there was insufficient production of 
affordable rental housing. Furthermore, the States do not have the 
resources to provide something on the scale of the Housing Credit.
Other Positive Results from the Housing Credit
    The Housing Credit is also a driver in the revitalization of lower 
income communities. Through the Housing Credit, private capital is used 
to reverse the cycle of decline. The Housing Credit has turned around 
neighborhoods and stabilized the urban core while these regions are 
growing at the periphery. The Housing Credit also contributes to 
recapitalization of existing housing and can be used to address special 
needs housing, such as housing for the elderly, formerly homeless, and 
special needs populations.
    The Housing Credit also brings jobs to an area. The program is 
responsible for an estimated 167,000 jobs each year associated with the 
creation of housing financed through the Housing Credit.
The Tax Code is the Best Way to Meet the Nation's Affordable Housing 
        Needs
    A housing production program like this cannot be set up anywhere 
other than the tax code because the potential tax benefit (or loss 
thereof) and threat of tax credit recapture is not available in any 
spending program. There is no effective real estate collateral that can 
act as a penalty. The Housing Credit program provides for loss of tax 
benefits and tax credit recapture in cases where there is evidence of 
non-compliance with program rules. The threat of loss of tax benefits 
and recapture has acted as a powerful compliance mechanism that 
spending programs simply cannot replicate.
Conclusion
    The effect of the Low Income Housing Tax Credit on corporate 
investment decision-making demonstrates the necessity of the such a 
targeted corporate tax preference. Without the credit to spur 
investment and construction, our nation's supply of qualify affordable 
housing would be drastically reduced.

                                 

           Statement of American Forest and Paper Association

Introduction
    The American Forest & Paper Association (AF&PA) is the national 
trade association for the forest products industry. We represent more 
than 200 companies and related associations that engage in the 
ownership and management of timberlands for the production of timber 
and the manufacturing of pulp, paper, paperboard and wood products. 
America's forest and paper industry ranges from large landowners, to 
state-of-the-art paper mills, to small, family-owned sawmills, and to 
some 10 million individual woodlot owners. The U.S. forest products 
industry is vital to the nation's economy. We employ approximately 1.3 
million people, we own millions of acres of forestland, and we rank 
among the top ten manufacturing employers in 42 states with an 
estimated payroll of $50 billion. Sales of the forest products industry 
top $230 billion annually in the U.S. and export markets. We are the 
world's largest producer of forest products.
    The forest products industry manages timberland and produces timber 
and wood fiber for use in its two main product segments: pulp & paper 
and finished wood. Many firms in the industry are integrated growers 
and manufacturers. Others specialize in growing and selling timber, 
while others specialize in manufacturing. The forest products industry 
has faced heightened foreign competition during recent years as an 
increasing number of other countries with low-cost labor, abundant wood 
fiber reserves, and more favorable corporate tax systems become 
increasingly active in world markets. In fact, the United States' 
overall trade balance in forest products has deteriorated from a small 
surplus during the early 1990s to a $21 billion trade deficit last 
year. The increase in the industry's trade deficit accelerated in the 
late 1990s in part because of the dollar's strength between 1997 and 
2002 but principally due to the emergence of competition from overseas.
    The increasing effectiveness of this foreign competition has 
serious negative consequences on our industry's major product segments. 
The paper segment of the industry, which produces communications papers 
(used for newspapers, office correspondence, magazines, books, and 
catalogs), packaging products (bags and boxes and cartons), and tissue 
paper, saw U.S. production of paper and paperboard peak at 97 million 
tons in 1999, but since then U.S. production has declined some 6 
percent to 91 million tons. During that same period, imports of 
foreign-produced paper and paperboard increased 10.5 percent to 20.4 
million tons.
    In some paper grades, such as the coated papers used in magazines, 
corporate annual reports, and advertising materials, the import surge 
has been particularly dramatic. For these paper grades, the import 
market share increased from about 15 percent in 1995 to 27 percent in 
2005. Most of the increase in imports came from South Korea, China, and 
Western Europe, particularly Finland.
    The packaging segment of the paper industry suffers from the 
general decline in domestic manufacturing, which brings with it a 
corresponding decline in demand for domestic packaging, because 
packaging occurs where the products are made.
    The pressures of foreign competition have contributed to severe 
consequences for the U.S. paper industry. Paper mill employment has 
declined by 37 percent since early 1997. Industry capacity to produce 
paper has been contracting since 2001 and the paper industry has earned 
a return on capital of only 3.2 percent in the 2000-2005 period, which 
is not nearly sufficient to encourage re-investment to maintain 
capacity and to maintain employment.
    In contrast to the paper segment, demand for wood products (lumber, 
plywood, other panels) has been strong during recent years owing to 
robust home construction. However, foreign suppliers have captured much 
of the increase in demand. U.S. imports of wood products (measured in 
dollars) overall increased 49 percent since 1999, and the share of U.S. 
softwood lumber consumption met by foreign suppliers rose from 35 
percent in 1999 to 39 percent in 2005. These gains for imports were 
mainly attributable to South America and Europe, regions that have not 
been traditional suppliers of the U.S. market. Canada's share of the 
U.S. softwood lumber market has remained stable during recent years at 
approximately 34 percent. While imports from foreign sources increase, 
U.S. exports have stagnated, further straining our once-dominant 
domestic industry.
    Like paper packaging, the wood segment of the industry suffers from 
declining U.S. manufacturing of finished goods, with this production 
being won by foreign manufacturers. This is especially the case with 
hardwood products as more and more wood furniture is being made in 
China and other developing countries. While it is true that the United 
States exports some wood products to China for use in making furniture, 
the exodus of the domestic wood furniture business is a net drain from 
the United States.
    The real-world impact of these trends is that some 350 paper and 
wood mills have closed since 1997 and more than 150,000 industry jobs 
have been lost. The indirect effects of these losses are even more 
severe as many mill towns lose their core businesses and entire 
communities face uncertain futures.
    The truth is that these losses could have been prevented. The U.S. 
forest products industry is losing market share to those countries and 
regions that have moved aggressively to capitalize not only on supplies 
of material and labor, but also to enact corporate tax laws that enable 
their companies to better compete on a global scale. The U.S. forest 
products industry faces significant hurdles from our outdated tax 
system. Absent reform in U.S. tax policy to improve the ability of U.S. 
companies to compete effectively, the trends of job loss and reduced 
production will continue to the detriment of our industry, job growth 
in the United States, and the American economy in general.
The Urgent Need for Corporate Tax Reform
    It is critical that the U.S. tax system provide the forest products 
industry an opportunity to compete on a level playing field. Currently, 
U.S. tax policy does not provide this opportunity; on the contrary, 
relative to many other countries, the domestic forest products industry 
is disadvantaged by U.S. tax policy.
    Even with the improvements made by the American Jobs Creation Act 
of 2004, U.S. tax rules consistently raise disadvantages for U.S. 
corporate forest product investments relative to the tax rules of most 
of the industry's major competing nations. An April 2005 report by 
PricewaterhouseCoopers on behalf of the American Forest & Paper 
Association found that U.S. income taxes are the second highest of the 
major competing nations for the industry--with U.S. effective tax rates 
exceeding the median of the competing nations by a whopping 17 
percentage points for paper and 16 percentage points for wood or, 
stated another way, U.S. effective tax rates are 50 percent or more 
higher than the median effective rates for the competing nations.\1\ 
The overall result of these high taxes is that U.S. companies cannot 
profitably undertake certain investments that foreign competitors can 
undertake because U.S. investors would be left with an insufficient 
return after paying tax whereas foreign investors would enjoy an ample 
net return. U.S. companies compete against foreign companies in capital 
and product markets both at home and abroad and the overwhelming U.S. 
tax disadvantage ultimately limits the degree to which U.S. companies 
may successfully challenge foreign competitors.
---------------------------------------------------------------------------
    \1\ The report, Taxes in Competing Nations: Their Effects on 
Investments in Paper Manufacturing and Timber Production (April 2005), 
and a companion policy paper providing reform options, Reducing Tax 
Disincentives for Corporate Investments in Paper Manufacturing and 
Timber Production (April 2005), are included in this submission. The 
effective tax rate considers taxes paid on corporate earnings at both 
the corporate and individual levels.
---------------------------------------------------------------------------
    Significant reform of the U.S. tax system is necessary in order for 
the U.S. forest products industry to compete in the global marketplace. 
A key feature of any tax reform must be to significantly reduce U.S. 
corporate income tax rates so that the U.S. forest products industry 
does not continue to face effective tax rates as much as 50 percent 
higher than the median of the major competing nations. Important 
additional reforms include an exclusion for timber gains, improved cost 
recovery for business investment, repeal of the corporate alternative 
minimum tax (AMT), and modernization and simplification of U.S. 
international tax rules. We will briefly examine each in turn.
Lower Rates
    While the United States was once a leader in moving to a 
competitive tax rate structure, this is no longer the case. At 35 
percent, the U.S. statutory corporate tax rate is among the highest in 
the world. Even taking into consideration the fully-phased in value of 
the domestic manufacturing deduction enacted in the American Jobs 
Creation Act of 2004, U.S. taxes on the forest products industry remain 
considerably higher than in competing nations. The 
PricewaterhouseCoopers study examined reform options that would be 
necessary to bring the effective tax rate on the forest products 
industry into a competitive range, which we define to be the median of 
the industry's competitors. The effective tax rate accounts for taxes 
paid on corporate earnings at both the corporate and individual levels. 
The study found that for the corporate paper manufacturing segment of 
the industry, all statutory tax rates--both corporate and individual--
would need to be cut by 40 percent. That is, the top corporate and 
individual tax rate would drop from 35 percent to 21 percent and the 
individual tax rate on capital gains and dividends would drop from 15 
percent to 9 percent. For corporate timber production, a more than 40 
percent reduction in these rates would be needed to move into the 
competitive range.
    The United States stands out among our trading partners in not 
providing permanent relief from double taxation of domestic income at 
both the corporate and personal levels. The temporarily reduced 
individual tax rates on dividend and capital gains income enacted in 
2003 should be made permanent.
Timber Exclusion
    Timber growing is a unique activity when compared to other economic 
activities. It takes between 20 and 70 years to grow timber to be ready 
for harvest. This extraordinarily long investment period requires a 
strong commitment from investors. Timber is subject to risks of nature 
throughout the growing cycle, including fire, storms, insects, and 
disease. Acts of nature are not insurable, thus greatly adding to the 
risk and unpredictable nature of timber investments.
    As a result of these special characteristics of timber and timber 
growing, timber gain has been eligible for long-term gain tax treatment 
for over 60 years. Under current law, timber gain of individuals is 
taxable at the maximum 15 percent long-term gain rate rather than the 
maximum 35 percent tax rate applying to ordinary income. However, due 
to various phase-outs, some individual timber gain can be taxed at 
significantly higher rates. In addition, the individual AMT can cause 
effective tax rates on long-term gains to rise as high as 22 percent. 
Since 1987, timber gain of corporations has been taxable at the regular 
corporate income tax rate, which currently is 35 percent.
    The Timber Tax Act, H.R. 3883, and companion legislation in the 
Senate (S. 1791) would exclude 60 percent of qualified timber gain from 
the sale or exchange of timber held for more than one year, resulting 
in a maximum timber gain tax rate of 14 percent for both individuals 
and corporations.\2\
---------------------------------------------------------------------------
    \2\ These bills are currently sponsored and co-sponsored by 139 
members in the House and 30 members in the Senate.
---------------------------------------------------------------------------
    The PricewaterhouseCoopers study found that, compared to the major 
competing countries of the forest products industry, the United States 
has the second highest tax rate applying to corporate income from the 
sale and cutting of timber. Passage of the Timber Tax Act would 
implement a needed update to the tax rules for timber, improve the 
ability of the U.S. forest products industry to compete against 
international competition, and represent a significant step towards 
larger tax reform.
Investment Recovery
    More advantageous rules could be implemented for recovering the 
costs of business investment, including expensing for business assets. 
The U.S. tax system could be reformed to allow expensing for all 
equipment and structures, or a combination of partial expensing and 
accelerated depreciation. The PricewaterhouseCoopers study found that a 
system of expensing could lower the effective tax rate in the paper 
manufacturing industry to the median of the industry's foreign 
competitors. A system of partial expensing, while beneficial, would be 
insufficient to bring the paper manufacturing effective tax rate into 
the competitive range without further reforms, such as rate reduction. 
For corporate timber production, full expensing of reforestation 
expenditures, while also beneficial, would be insufficient to bring the 
effective tax rate into the competitive range without additional 
reforms.
Corporate AMT
    The corporate alternative minimum tax, an additional tax burden 
placed on corporations that mandates even slower depreciation 
allowances, should be repealed. A 2001 study by the staff of the Joint 
Committee on Taxation recommended repeal of the corporate AMT. As noted 
in the PricewaterhouseCoopers study, even in the absence of the AMT, 
the rules of the U.S. tax system serve to disadvantage the industry 
relative to its competitors. The AMT provides yet a further hurdle on 
top of an already heavily burdened industry.
    Companies with AMT credits should be permitted to utilize these 
credits in a timely manner. Freeing up these credits, which represent 
prepayment of tax liability, will provide funds to finance new 
investment, expand employment, fund pension plan contributions and 
employee and retiree health benefits, and undertake other worthwhile 
business investments to improve competitiveness.
International Reforms
    Despite recent reforms to U.S. international tax rules, they remain 
in urgent need of reform. U.S. companies operate under tax rules that 
are far more complex and disadvantageous in the taxation of foreign 
income than those of our trading partners. The United States should 
consider reforming its international tax rules so U.S. multinational 
corporations can compete effectively. Items to consider include a 
review of the use of worldwide income as a starting point in 
determining taxable income, revision of tax laws to encourage 
repatriation of earnings to the United States, and overall 
simplification of international tax laws.
Transition
    Any significant reform should consider the need for phase-ins, 
delayed effective dates, or transition relief to provide companies an 
opportunity to deduct unrecovered costs and receive the benefit of 
other tax attributes, such as loss carryforwards and tax credits, 
currently being carried forward. In the absence of a coordinated 
transition to a new tax system, certain business activities may be 
double taxed due to timing differences between the old and new tax 
systems.
Conclusion
    We appreciate the opportunity to provide the Subcommittee with our 
concerns and thoughts on the need to reform the corporate tax system. 
The U.S. forest products industry is at the heart of a vibrant economy 
that has produced the highest living standards in the world. However, 
the industry faces global competition and challenges on a level 
previously unseen. One of the most serious challenges to its future 
viability is that the current U.S. corporate income tax system 
functions as a major obstacle in global competition. Tax reform is 
urgently needed to level the playing field. At home, that means a more 
abundant supply of the materials that build the American dream and a 
more stable and fruitful way of life for the communities that thrive in 
the forest products industry. We would welcome the opportunity to 
discuss these issues with you in more detail.

                                 

         Statement of Employee-Owned S Corporations of America

    As the Ways and Means Committee continues its work to examine the 
many issues inherent in reforming the Internal Revenue Code, the 
Employee-Owned S Corporations of America (``ESCA''), on behalf of 
member companies and their employee-owners, appreciates the opportunity 
to share our unique concerns and views on this issue.
    ESCA is the leading voice of the employee-owned S corporation 
community, serving to protect and promote employee ownership of private 
Subchapter S businesses for workers across the nation. ESCA was formed 
in 1999, and in its short history represents more than 45,000 employee-
owners. Member companies operate in virtually every state in the 
nation, engaging in a broad spectrum of business activities that range 
from heavy manufacturing to hospitality. All sizes of companies are 
represented (from large firms with 7,000 employee-owners to small 
operations with as few as 50 employee-owners). ESCA companies are a 
hallmark of American entrepreneurship, providing jobs and a key 
retirement savings opportunity for tens of thousands of American 
workers.
    As the Committee is well aware, employee-owned S corporations have 
been in existence since 1998. They are pass-through entities owned in 
part or fully by an employee stock ownership plan (``ESOP''). As such, 
these entities offer their employees a ``piece of the rock'' as a 
retirement savings opportunity. In this sense, S corporation ESOPs are 
much more than standard retirement savings plans; hundreds of thousands 
of employees who own a stake in their employers through ESOPs are 
amassing impressive nest eggs--often hundreds of thousands of dollars 
or more--that enable them to retire from line jobs with dignity and 
free from the need for federal support.
I. President's Advisory Panel on Federal Tax Reform
    While S corporations are a tremendous benefit to employee-owners of 
these companies, they are also uniquely structured entities that are 
vulnerable to changes in the tax code and in pension laws. Indeed, the 
unique structure of employee-owned S corporations raises questions 
about how they might be treated under the new retirement security 
paradigm recommended by the President's Advisory Panel on Federal Tax 
Reform (the ``Panel''). Given this, ESCA and its members are concerned, 
first, with the Panel's proposal to apply a blanket, entity-level tax 
on S corporations and all other non-C corporations (except sole 
proprietorships). Without an exemption for employee-owned S 
corporations similar to the exemption the Panel envisions for regulated 
investment companies (``RICs'') and real estate investment trusts 
(``REITs''), an entity-level tax on an ESOP's share of S corporation 
income would eliminate the ability of the company's employee-owners to 
build up meaningful retirement savings.
    Another concern of ESCA's members is that the Panel's employer-
based ``Save at Work'' proposal does not address ESOPs. The omission of 
ESOPs in the Panel's proposal to streamline several current defined 
contribution plans into one ``Save at Work'' retirement plan suggests 
that ESOPs might be affected by this sweeping change. While we do not 
believe that the Panel intended to eliminate ESOPs, we do believe that 
any tax reform proposal put forward by the Congress should confirm the 
important function that S corporation ESOPs in particular have in 
helping the employee-owners of these companies amass substantial 
retirement income through their ownership stake in these companies.
A. Entity-Level Tax
    Under the Panel's Simplified Income Tax Plan (``SITP''), all large 
businesses--those with more than $10.5 million in receipts--would be 
taxed at the entity level, paying a 31.5 percent rate. The Panel's 
report recognizes the importance of making certain exceptions to this 
rule, and exempts RICs and REITs from the entity-level tax. Under the 
Panel's Growth and Investment Tax Plan (``GITP''), businesses other 
than sole proprietorships would pay a corporate rate of 30 percent at 
the entity level, although it is unclear whether a tax-exempt 
shareholder's share of business income would be taxed.
    If Congress does ultimately support an entity-level tax system 
similar to the SITP or GITP, it is critical that employee-owned S 
corporations be allowed to retain their current pass-through attributes 
and not be subjected to the entity-level tax with respect to the ESOP's 
share of S corporation income. Congress quite specifically designed the 
S corporation ESOP structure to ensure only one level of taxation, and 
adding another tax at the entity level would clearly go against 
Congress' intent, while undermining the retirement savings attributes 
of the S corporation ESOP to employee-owners of these companies.
    The pass-through structure is especially important for employee-
owned S corporations because it allows these companies to rapidly grow 
retirement wealth in the ESOP for their employees. An entity-level tax 
would, for many employee-owned companies, reduce the amount of funds 
available for retirement savings in the ESOP.
    Moreover, a tax paid at the entity-level by these companies is 
equivalent in substance to the qualified retirement plan (the ESOP as 
the owner) paying income taxes. This result runs counter to long-
standing tax policy, whereby participants (employee shareholders in the 
case of employee-owned S corporations) in qualified plans are not taxed 
until income is received upon retirement.
B. Clarity Needed for ESOPs
    A second concern raised by the Panel is that it did not address the 
role of ESOPs in the context of its proposed new tax treatment of 
defined contribution plans. The Panel's SITP and GITP call for the 
consolidation of the following employer-sponsored defined contribution 
plans into the ``Save at Work'' plan: 401(k), ?SIMPLE 401(k),' Thrift, 
403(b), governmental 457(b), ?SARSEP,' and SIMPLE IRA. ESOPs are left 
out of the analysis. Although ESOPs are not explicitly singled out for 
consolidation in the Panel's report, some in the business community 
have expressed fears that the Panel envisions that all defined 
contribution plans, including ESOPs, should be consolidated into its 
``Save at Work'' plan.
    ESOPs are, as this Committee is aware, a key economic asset to 
thousands of companies and their employees. Employee-owned S 
corporations are an increasingly utilized business structure found 
across the nation and in every state, and with their proliferation has 
come an important increase in the retirement savings of the ESOP 
participants in these companies. Fuelled by the work and commitment of 
their employee-owners, these companies provide jobs for workers across 
the economic and industrial spectrum, including manufacturing, 
construction, health care, trucking and tourism. Indeed, a recent study 
by the National Center for Employee Ownership that surveyed nearly 
2,000 employee-owners from S corporation ESOP companies around that 
nation found that:

      Have account balances three to five times higher than the 
U.S. average for 401(k) plans--with large numbers of these ESOP 
participants amassing $75,000 to $100,000 in their accounts;
      Have even higher account balances--five to seven times 
the average for 401(k) plans--when measured among employee-owners 
nearing retirement age; and
      Quit at a rate of half the national average, and are 
fired or laid off two-thirds less frequently than workers in other 
kinds of companies.

    ESCA believes that Members of Congress recognized the tremendous 
promise of S corporation ESOPs when legislators first created these 
structures, and we note that employee-owned S corporations have long 
enjoyed broad bipartisan support on Capitol Hill. Indeed just five 
years ago, Congress reaffirmed its support for employee-owned S 
corporations during consideration of the Economic Growth and Tax Relief 
Reconciliation Act (P.L. 107-16). In 2001, the Ways and Means Committee 
said that it ``continues to believe that S corporations should be able 
to encourage employee ownership through an ESOP.'' \1\
---------------------------------------------------------------------------
    \1\ H.R. Rep. No. 107-51, part 1, at 100 (2001).
---------------------------------------------------------------------------
    With this in mind, and given the pervasiveness of ESOPs and the 
major role they play in providing a secure source of retirement income 
for retirees, we respectfully urge that any tax reform proposal 
supported or put forward by the Congress recognize and affirm the 
continued existence of ESOPs, and S corporation ESOPs more 
specifically.
    ESCA appreciates the Committee's consideration of the concerns and 
interests of our members. We would welcome the opportunity to discuss 
these issues further with Committee members and staff in the weeks and 
months ahead.

              ESCA EMPLOYEE-OWNED S CORPORATIONS OF AMERICA
                       ESCA MEMBER COMPANIES 2006

         Member Company                    Headquarters Location

Acadian Ambulance                 Louisiana
Agron, Inc.                       California
Albert C. Kobayashi               Hawaii
Alion Science and Technology      Virginia
Amerequip, Inc.                   Wisconsin
Amsted Industries                 Illinois
Antioch Company                   Ohio
Appleton                          Wisconsin
Appleton Marine                   Wisconsin
Austin Industries, Inc.           Texas
BCC Capital Partners              California
Bimba Manufacturing               Illinois
Columbia Financial Advisors       Oregon
Community Bancshares, Inc.        Missouri
Crowe Chizek & Co.                Ohio
Deloitte                          Illinois
The Dexter Company                Iowa
DuCharme, McMillen & Associates   Illinois
Duff & Phelps, LLC                Illinois
ESOP Services                     Virginia
First Bankers Trust Services      Illinois
Ferrell Companies, Inc.           Kansas
Floturn, Inc.                     Ohio
Freeman Companies                 Texas
Garney Companies, Inc.            Missouri
The George P. Johnson Company     Michigan
GreatBanc Trust                   Illinois
Greenheck Fan Corporation         Virginia
Herff-Jones, Inc.                 Indiana
Hisco                             Texas
Holborn Corporation               New York
Houlihan, Lokey, Howard and       Illinois
 Zukin
Inland Truck Parts Company        Kansas
Katten Muchin Rosenman LLP        Illinois
Keller Structures                 Wisconsin
Krieg DeVault Alexander           Indiana
Lake Welding Supply Company,      Michigan
 Inc.
LaSalle Bank, N.A.                Illinois
Lifetouch, Inc.                   Minnesota
McDermott, Will and Emery         Illinois
Messer Construction Company       Ohio
Molin Concrete Products           Minnesota
Moretrench American Corporation   New Jersey
Morgan Lewis and Bockius          Illinois
Muehlstein & Co., Inc.            Connecticut
Nathan Alterman Electric Co.,     Texas
 Inc.
The Parksite Group                Illinois
Pavement Recycling Systems, Inc.  California
PERCS USA Inc.                    Florida
Performance Contracting Group,    Kansas
 Inc
Phelps County Bank                Missouri
Pridgeon & Clay, Inc.             Michigan
The Principal Financial Group     Wisconsin
Richard Goettle, Inc.             Ohio
Round Table Pizza, Inc.           California
RSM McGladrey                     Iowa
Schreiber Foods, Inc.             Wisconsin
Scitor Corporation                California
Scot Forge Company                Illinois
Segerdahl Corporation             Illinois
Social & Scientific Systems       Maryland
Sonalysts, Inc.                   Connecticut
Spee Dee Delivery Service, Inc.   Minnesota
State Street Bank                 Massachusetts
Stout Risius Ross, Inc.           Illinois
The Scooter Store                 Texas
Sundt                             Arizona
Thirdpage Services                Virginia
Thoits Insurance                  California
Thybar Construction               Illinois
Vector Health Sytems, Inc.        Rhode Island
Vermeer Equipment of Texas Inc    Texas
Volkert & Associates              Alabama
Walman Optical Company            Minnesota
Williams Brothers Construction    Texas
Woodfold Inc.                     Oregon



                                 

 Statement of Financial Executives International Committee on Taxation 
                   and Committee on Private Companies

IMPACT OF INTERNATIONAL TAX REFORM ON U.S. COMPETITIVENESS
I. INTRODUCTION
    Financial Executives International (``FEI'') is a professional 
association representing the interests of 15,000 CFO's, treasurers, 
controllers, and other senior financial executives from over 8,000 
major companies throughout the United States and Canada. FEI represents 
both the providers and users of financial information. Furthermore, FEI 
acts on behalf of the business community to advocate policies which 
will rationalize corporate operations, improve global competitiveness, 
and promote long-term business stability.
    This testimony addresses the relationship between U.S. tax policy 
and international competitiveness. In many instances, current rules 
regarding the taxation of both domestic and foreign income create 
barriers that harm the competitiveness of U.S. companies. These rules 
also are excessively burdensome for both taxpayers and the Internal 
Revenue Service. This testimony represents the views of FEI's Committee 
on Taxation and the Policy Subcommittee of the Committee on Private 
Companies.

II. U.S. MULTINATIONALS AND THE U.S. ECONOMY
    In a global market, the competitiveness of a country depends on the 
ability of its enterprises to produce goods and services that are 
successful both at home and in foreign markets. Today, almost 80 
percent of world income and purchasing power lies outside of U.S. 
borders. Opportunities for U.S. companies to grow their businesses 
increasingly lie overseas. For the largest American companies included 
in the S&P 500, sales by foreign subsidiaries have increased from 25 
percent of total corporate sales in 1985 to a remarkable 39 percent in 
2005.\1\
---------------------------------------------------------------------------
    \1\1985 figure from: The Business Roundtable, ``Taxing U.S. 
Corporations in the Global Marketplace'' April 1993. 2005 figure from 
calculations based on data from S&P's Compustat database.
---------------------------------------------------------------------------
A. U.S. Investment abroad and Exports
    It is a common perception that investment abroad by U.S. 
multinationals comes at the expense of the domestic economy. This is an 
incorrect view. The primary motivation for U.S. multinationals to 
operate abroad is to compete better in foreign markets, not domestic 
markets. According to the Commerce Department, less than 11 percent of 
sales by U.S.-controlled foreign corporations were made to U.S. 
customers.\2\
---------------------------------------------------------------------------
    \2\ U.S. Department of Commerce, ``U.S. Direct Investment Abroad: 
Operations of U.S. Parent Companies and Their Foreign Affiliates, 
Preliminary 2003 Estimates,'' (2003).
---------------------------------------------------------------------------
    Investment abroad is required to provide services that cannot be 
exported, to obtain access to natural resources, and to provide goods 
that are costly to export due to transportation costs, tariffs, and 
local content requirements. Foreign investment allows U.S. 
multinationals to compete more effectively around the world, ultimately 
increasing employment and wages of U.S. workers.
    While 44 percent of U.S. multinational parent companies are in the 
services sector, 61 percent of all foreign affiliates are in this 
sector, which includes distribution, marketing, and product support 
services.\3\ Without these sales and services subsidiaries, it would be 
impossible to sustain current export volumes.
---------------------------------------------------------------------------
    \3\ Ibid.
---------------------------------------------------------------------------
    According to the U.S. Commerce Department, in 2003, U.S. 
multinationals were directly responsible, through their domestic and 
foreign affiliates, for $412 billion of U.S. exports, or 57 percent of 
all U.S. exports.\4\
---------------------------------------------------------------------------
    \4\ U.S. Department of Commerce, ``U.S. Multinational Companies: 
Operations in 2003,'' Survey of Current Business, July 2005.
---------------------------------------------------------------------------
    A study by the Organization for Economic Cooperation and 
Development (OECD) found that each dollar of outward foreign direct 
investment is associated with $2.00 of additional exports.\5\
---------------------------------------------------------------------------
    \5\ OECD, Open Markets Matter: The Benefits of Trade and Investment 
Liberalization, p. 50 (1998).
---------------------------------------------------------------------------
B. U.S. Employment
    Foreign investment by U.S. multinationals generates sales in 
foreign markets that generally could not be achieved by producing goods 
entirely at home and exporting them.
    A number of studies find that U.S. investment abroad generates 
additional employment at home through an increase in the domestic 
operations of U.S. multinationals. As noted by Professors 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.'' \6\
---------------------------------------------------------------------------
    \6\ 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.
---------------------------------------------------------------------------
    Moreover, workers at domestic plants owned by U.S. multinational 
companies earn higher wages than workers at domestic plants owned by 
companies without foreign operations, controlling for industry, size of 
company, and state where the plant is located.\7\
---------------------------------------------------------------------------
    \7\ Mark Doms and Bradford Jensen, Comparing Wages, Skills, and 
Productivity between Domestic and Foreign-Owned Manufacturing 
Establishments in the United States, mimeo. (October 1996).
---------------------------------------------------------------------------
C. U.S. Research and Development
    Foreign direct investment allows U.S. companies to take advantage 
of their scientific expertise, increasing their return on firm-specific 
assets, including patents, skills, and technologies. Professor Robert 
Lipsey notes that the ability to make use of these firm-specific assets 
through foreign direct investment provides an incentive to increase 
investment in activities that generate this know-how, such as research 
and development.\8\
---------------------------------------------------------------------------
    \8\ Robert Lipsey, ``Outward Direct Investment and the U.S. 
Economy,'' in The Effects of Taxation on Multinational Corporations, p. 
30 (1995).
---------------------------------------------------------------------------
    Among U.S. multinationals, total research and development in 2003 
amounted to $161 billion, of which $140 billion (86 percent) was 
performed in the United States.\9\ Such research and development allows 
the United States to maintain its competitive advantage in business and 
be unrivaled as the world leader in scientific and technological know-
how.
---------------------------------------------------------------------------
    \9\ U.S. Department of Commerce, ``U.S. Multinational Companies: 
Operations in 2003,'' Survey of Current Business (July 2005).
---------------------------------------------------------------------------
D. Summary
    Recent analysis of data on U.S. multinational firms collected by 
the U.S. Bureau of Economic analysis finds that the domestic and 
foreign operations of U.S. multinationals are complements rather than 
substitutes. Professors Desai, Foley and Hines find that:
    ``. . . 10% greater foreign capital investment is associated with 
2.2% greater domestic investment, and that 10% greater foreign employee 
compensation is associated with 4.0% greater domestic employee 
compensation. Changes in foreign and domestic sales, assets, and 
numbers of employees are likewise positively associated; the evidence 
also indicates that greater foreign investment is associated with 
additional domestic exports and R&D spending. The data do not support 
the popular notion that greater foreign activity crowds out domestic 
activity by the same firms, instead suggesting the reverse.'' \10\
---------------------------------------------------------------------------
    \10\ Mihir A. Desai, C. Fritz Foley, and James R. Hines, Jr., 
``Foreign Direct Investment and Domestic Economic Activity,'' National 
Bureau of Economic Research Working Paper No. 11717, October 2005.
---------------------------------------------------------------------------
    In summary, U.S. multinationals provide significant contributions 
to the U.S. economy through:

      Sales of U.S. goods and services abroad;
      Domestic employment at above average wages; and
      Critical domestic investments in equipment, technology, 
and research and development.

    Thus, the United States has an important interest in ensuring that 
its tax rules do not hinder the competitiveness of U.S. multinationals.

III. DOMESTIC TAX COMPETITIVENESS
A. Corporate Income Tax Rate
    With the reduction in the U.S. corporate income tax rate from 46 to 
34 percent, as a result of the Tax Reform Act of 1986, it is commonly 
thought that the United States is a low-tax jurisdiction for 
corporations. While true immediately after the 1986 Act, it is no 
longer true today. The United States increased the corporate income tax 
rate to 35 percent in 1991. Meanwhile, the average central government 
corporate tax rate in OECD member states has fallen since 1986 to 26.2 
percent in 2005--8.8 percentage points less than the U.S. rate (see 
Exhibit 1a). This disparity in corporate tax rates would be even larger 
if corporate income taxes imposed by subnational levels of government 
were taken into account.
    Moreover, the high rate can produce an impediment to future 
investments in the U.S. For example, under an analysis of the costs of 
a high tech semiconductor manufacturing facility located in the U.S. 
compared with potential non-U.S. locations (especially in Asia), the 
U.S. corporate income tax rate is the largest contributing factor to 
the ten-year costs of constructing, equipping and operating such a 
factory in the U.S. being a billion dollars more than if located 
outside the U.S. A reduced U.S. corporate income tax rate would help 
alleviate what is effectively an anti-competitive cost penalty on 
future U.S. investments. Such a multi-billion dollar facility would 
employ over a thousand high-wage employees, utilize state-of-the art t 
technology and equipment, attract many other businesses to supply and 
maintain the facility, and significantly contribute to local, state, 
and national economic prosperity.
    Privately-owned companies also support an overall reduction in the 
tax rate, as well as the repeal of the estate tax. These companies 
labor under high tax rates which drain critical business funds that 
could be used to expand their businesses and/or to create new jobs. The 
``death tax'' is particularly onerous, since it forces many business 
owners to liquidate their concerns upon the death of a key member of 
the enterprise. The owners of private companies typically have the vast 
majority of their wealth tied up in the business but that wealth is not 
liquid. The value of that wealth is also not known, either by the 
preparer of the estate return or the IRS. Too often the result is a 
forced sale and the loss of jobs and good ``corporate citizens'' in the 
community.
B. Double Taxation of Corporate Dividends
    Prior to 2003, the United States was one of only three OECD member 
countries that did not provide some form of relief from the double 
taxation of corporate dividends (see Exhibit 3).\11\ Most OECD 
countries relieve double taxation of corporate dividends at the 
shareholder level through some form of credit, exemption, or special 
tax rate for dividend income. Starting in 2003, dividends accruing to 
shareholders in the top individual income tax bracket (35.0 percent) 
are taxed at a lower rate (15.0 percent). The combination of corporate 
and individual income tax is over 44 percent of distributed corporate 
income (see Exhibit 3). The combined income tax rate on distributed 
corporate income is even higher if state and local taxes on corporate 
and individual income are taken into account. Furthermore, the special 
(lower) rate on dividends is set to expire at the end of 2008 unless 
extended or made permanent. If the 15 percent rate is not extended, the 
combined corporate and individual income tax rate on dividends will 
increase to 57.75 percent starting in 2009.
---------------------------------------------------------------------------
    \11\ Prior to 2001 there were three countries which did not provide 
some form of relief for the double taxation of corporate dividends. 
However, starting in 2001, the Netherlands exempted investment income 
from taxes with minor exceptions.
---------------------------------------------------------------------------
C. Reliance on Income and Profit Taxation
    While the total tax burden as a percent of Gross Domestic Product 
(GDP) is relatively light in the United States compared to other OECD 
countries, reliance on income taxes to fund spending at all levels of 
government is unusually high. In 2003, the United States relied on 
income and profits taxes for almost half of all revenues (43.3 percent) 
while the average OECD country raised slightly over one-third of 
revenues (34.4 percent) from this source (see Exhibit 4). The U.S. data 
include sales taxes imposed by state and local governments; the federal 
government is even more heavily reliant on income and profits taxes as 
there is no broad-based consumption tax at the federal level. Indeed, 
the United States is the only one of the 30 OECD member countries that 
does not have a national value-added tax.
D. Conclusion
    When compared to other OECD and EU member countries, the United 
States relies relatively heavily on income taxes to fund government 
operations, has a comparatively high corporate income tax rate, and is 
unusual in not providing a permanent mechanism for relieving the double 
taxation of corporate income.
    From a trade standpoint, heavy reliance on income taxes relative to 
consumption taxes may be viewed as disadvantageous because the WTO 
Agreement on Subsidies and Countervailing Measures permits border tax 
adjustments for indirect taxes such as consumption taxes, but prohibits 
such adjustments for income and profits taxes. However, from the 
standpoint of U.S. economic growth, the main reason to avoid over-
reliance on income and profit taxes is that they discourage savings and 
investment, which are closely linked to growth in national income.

IV. INTERNATIONAL TAX COMPETITIVENESS
A. Rising Level of International Competition
    In 1962, when the controlled foreign corporation rules in Subpart F 
were adopted, U.S. multinationals overwhelmingly dominated global 
markets. In this environment, the consequences of adopting tax rules 
that were out-of-step with other countries were of less concern to many 
policymakers.
    Today, the increasing integration of the world economies has 
magnified the impact of U.S. tax rules on the international 
competitiveness of U.S. multinationals. Foreign markets represent an 
increasing fraction of the growth opportunities for U.S. businesses. At 
the same time, competition from multinationals headquartered outside of 
the United States is becoming greater.\12\

    \12\ See, National Foreign Trade Council, International Tax Policy 
for the 21\st\ Century, vol. 1, 2001, pp 95-96.

      Of the world's largest multinationals (measured by 
foreign assets), just four of the 20 largest non-financial 
multinational firms and only three of the 20 largest financial 
multinational firms are headquartered in the United States.\13\
---------------------------------------------------------------------------
    \13\UNCTAD, ``Largest Transnational Corporations'' available on-
line at: http://www.unctad.org/Templates/
Page.asp?intItemID=2443⟨=1.
---------------------------------------------------------------------------
      U.S. multinational companies' share of global cross-
border investment declined from 53 percent in 1970 to 31 percent in 
2004.\14\
---------------------------------------------------------------------------
    \14\ UNCTAD, World Investment Directory On-Line.
---------------------------------------------------------------------------
      The 25,000 foreign affiliates of U.S. multinationals 
compete with about 690,000 foreign affiliates of foreign 
multinationals.\15\

    \15\ U.S. Bureau of Economic Analysis ``U.S. Direct Investment 
Abroad: Operations of U.S. Parent Companies and Their Foreign 
Affiliates, Preliminary 2003 Estimates'' and UNCTAD, ``World Investment 
Report, 2004.''

    If U.S. rules for taxing foreign source income are more burdensome 
than those of other countries, U.S. multinationals will be less 
successful in global markets, with adverse consequences for exports and 
employment at home.
B. International Comparison of Rules for Taxing Multinational Companies
    A study published by the European Commission in 2001 found that, on 
average, U.S. multinational companies bear a higher effective tax rate 
when investing into the European Union than do EU multinationals. The 
additional tax burden borne by U.S. multinationals ranges from 3 to 5 
percentage points depending on the type of finance used (see Exhibit 
5).
    In addition to the relatively high U.S. corporate income tax rate, 
there are a number of other reasons why the United States has become a 
relatively unattractive jurisdiction in which to locate the 
headquarters of a multinational corporation.
    First, 70 percent of the OECD countries have a dividend exemption 
(``territorial'') tax system under which a parent company generally is 
not subject to tax on the active income earned by a foreign subsidiary 
(see Exhibit 6). By contrast, the United States taxes income earned 
through a foreign corporation when repatriated (or when earned, if 
subject to U.S. anti-deferral rules).
    A second difference from the multinational tax rules of other 
countries is the unusually broad scope of 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: \16\

    \16\ Ibid., vol. 1, Part I.

      Foreign base company sales income;
      Foreign base company services income; and
      Active financial services income (an exclusion of this 
income from Subpart F is scheduled to expire at the end of 2006).

    The net effect of these tax differences is that a U.S. 
multinational frequently pays a greater share of its income in foreign 
and U.S. tax than does a competing multinational company headquartered 
outside of the United States.
C. Complexity
    The U.S. rules for taxing foreign-source income are among the most 
complex in the Internal Revenue Code. 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.\17\ These data show that U.S. tax compliance costs related to 
foreign-source income are grossly disproportionate. 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. 
The Treasury Department's tax simplification project, described in the 
Administration's FY 2003 Budget, also identifies the international tax 
rules as an area singled out by taxpayers as one of the biggest sources 
of compliance burden.\18\
---------------------------------------------------------------------------
    \17\ 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).
    \18\ Office of Management and Budget, Budget of the United States 
Government, Fiscal Year 2002, Analytical Perspectives, p. 79
---------------------------------------------------------------------------
D. Risks of a Non-Competitive tax regime for MNCs
    If the United States is an unattractive location--from a tax 
standpoint--to headquarter a multinational corporation, then U.S. 
multinationals will lose global market share. This 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. 
This allows U.S. shareholders to invest in multinational companies 
whose foreign operations generally are outside the scope of U.S. tax 
rules. 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.\19\ Third, an increasing number of new 
business ventures are being incorporated at inception as foreign rather 
than U.S. corporations.
---------------------------------------------------------------------------
    \19\ Where business reasons dictate the form of a transaction, 
there generally is no cause for concern. The concern we are raising is 
that non-competitive U.S. tax rules may be influencing the form of 
transactions.
---------------------------------------------------------------------------
    While some have suggested that reducing the U.S. tax burden on 
foreign-source income could lead to a movement of manufacturing 
operations out of the United States (``runaway plants''), a 
noncompetitive U.S. tax system will lead to a migration of corporate 
headquarters outside the United States.\20\ A decline in the global 
market share of U.S. multinationals may adversely affect the U.S. 
economy because, as noted above, U.S. multinationals play a vital role 
in promoting U.S. exports and creating high-wage jobs.
---------------------------------------------------------------------------
    \20\ To block corporate ``inversions,'' Congress adopted measures 
in 2004 that impose heavy tax penalties on companies that re-
incorporate outside of the United States (by merging the U.S. parent 
into a foreign affiliate).
---------------------------------------------------------------------------
E. Conclusion
    While, the American Jobs Creation Act of 2004 made considerable 
progress in streamlining the foreign tax credit system, significant 
opportunities to increase the competitiveness and reduce the complexity 
of the current worldwide tax system remain.
V. DIRECTIONS FOR TAX REFORM
    Based on the preceding analysis, FEI offers the following 
recommendations for Congressional consideration of domestic and 
international income tax reform.
A. Domestic Tax Reform
    From the perspective of economic growth and competitiveness, one of 
the most important priorities for reform of business taxation is a 
reduction in the corporate income tax rate. The combined federal, state 
and local corporate income tax rate in the United States is now over 10 
percentage points higher than the average for the 30 OECD countries and 
14 percentage points higher than the average of the 25 EU countries.
    A lower corporate income tax rate would encourage investment in the 
United States by both U.S. and foreign companies, reduce the use of 
sophisticated tax planning strategies intended to reduce taxable income 
in the United States, and would lower the current barrier to 
repatriating income from foreign subsidiaries (because U.S. tax on 
repatriated earnings is limited to the excess of the U.S. tax rate over 
the foreign rate). Moreover, economic analysis of data from 72 
countries indicates that higher corporate taxes lead to lower wages: 
``A 1 percent increase in corporate tax rates is associated with nearly 
a 1 percent drop in wage rates.'' \21\ Thus, a reduction in the U.S. 
corporate tax rate would be expected to lift wages of U.S. workers.
---------------------------------------------------------------------------
    \21\ Kevin Hassett and Aparna Mathur, ``Tax and Wages,'' American 
Enterprise Institute, March 6, 2006.
---------------------------------------------------------------------------
    A second priority for business tax reform is to impose equal 
taxation on investment regardless of the legal form of the 
organization. Under present law, businesses organized as sole 
proprietorships, partnerships, and S corporations, are subject to a 
single level of federal income tax at the individual owner level 
regardless of size, while regular C corporations are subject to federal 
income tax both at the corporate and individual shareholder levels. 
Eliminating the double taxation of corporate income would remove the 
incentive under present law for companies to select non-corporate forms 
of organization (which generally restrict liquidity and public trading) 
for tax reasons. The current single level of taxation for S-
corporations has proven itself as an effective tax structure for 
encouraging investment and driving US employment growth.
    A third priority for business tax reform is to impose equal 
taxation on investment regardless of industry. If all business income 
is subject to equal taxation, tax considerations will not distort the 
allocation of investment away from its most productive uses.
B. International Tax Reform
    A key choice in international tax reform is whether to continue to 
use the worldwide system of taxation or to move to a dividend exemption 
(territorial) tax system. This paper first identifies opportunities for 
reform of the current system and then discusses adoption of a 
territorial tax system.
1. Incremental Reform of Worldwide Income Tax System
    The American Jobs Creation Act did relatively little to reform the 
U.S. anti-deferral rules. Thus, one of the priorities for international 
tax reform is to enhance the competitiveness of U.S. multinationals by 
limiting the amount of active business income subject to subpart F, 
including:

      Enactment of the look-through rules that were included in 
the House--and Senate-passed versions of the American Jobs Creation Act 
of 2004, and in the House-passed version of the pending tax 
reconciliation bill.\22\ This provision would classify inter-CFC 
payments of interest, dividends, and royalties as foreign personal 
holding company income based on the underlying character of the income 
out of which the payment is made. The provision allows U.S. MNCs to 
redeploy funds among their foreign affiliates without triggering U.S. 
tax.
---------------------------------------------------------------------------
    \22\ H.R. 4520 as passed by the House (sec. 311) and the Senate 
(sec. 222) in 2004. H.R. 4297 as passed by the House (sec. 202) on 
December 8, 2005.
---------------------------------------------------------------------------
      Repeal of the foreign base company sales and services 
income rules which, among other things, increase the tax burden on 
foreign affiliates established for the purpose of promoting exports of 
U.S. goods and services. Few other OECD countries have comparable 
rules--indeed the United States originally enacted the predecessor of 
the Foreign Sales Corporation (``FSC'') rules in order to allow U.S. 
exports to compete on a more equal footing with exports of European 
countries that exempt income earned by foreign sales corporations. The 
original policy rationale for these rules was thrown into doubt by the 
Treasury Department's December 2000 policy study on Subpart F, which 
concluded that the economic efficiency effects of the base company 
rules were ``ambiguous.'' \23\
---------------------------------------------------------------------------
    \23\ U.S. Department of the Treasury, Office of Tax Policy, The 
Deferral of Income Earned through U.S. Controlled Corporations: A 
Policy Study (December 2000) p. 47.
---------------------------------------------------------------------------
      Permanently extend the active financial services income 
exception to subpart F that is scheduled to expire at the end of 2006.

    While, the American Jobs Creation Act of 2004 made considerable 
progress in streamlining the foreign tax credit system, some additional 
simplification should be considered, including:

      Use of financial statement or foreign taxable income 
rather than U.S. earnings and profits (``E&P'') for purposes of 
calculating the indirect foreign tax credit limitation. Under present 
law, each of the foreign affiliates of a U.S. multinational is required 
to re-compute its taxable income under U.S. rules, with certain 
adjustments required to translate taxable income into E&P. U.S. 
multinationals currently must train accounting staff in each of their 
foreign affiliates on U.S. E&P measurement and collect this information 
on an annual basis. Other countries generally do not impose a similarly 
burdensome tax requirement on multinational companies.
      Reduction of double taxation by curtailing the amount of 
domestic expense that is required to be allocated and apportioned to 
foreign source income for purposes of the U.S. foreign tax credit 
limitation. As a result of these expense allocations, U.S. 
multinationals in some cases are unable to credit foreign income taxes 
even though the foreign tax rate is not higher than the U.S. rate 
(because other countries do not allow a deduction for allocated 
expenses.) The U.S. rules regarding allocation and apportionment of 
domestic R&D expense are of particular concern as they can have the 
unintended effect of encouraging U.S. companies to undertake research 
activities in laboratories outside of the United States.\24\
---------------------------------------------------------------------------
    \24\ See, James R. Hines, Jr., ``On the Sensitivity of R&D to 
Delicate Tax Changes: The Behavior of U.S. Multinationals in the 1980s, 
in: Alberto Giovannini, R. Glenn Hubbard, and Joel Slemrod, eds. 
Studies in International Taxation (Chicago: University of Chicago 
Press, 1993), 149-187.
---------------------------------------------------------------------------
2. Adoption of a Territorial Tax System
    In a November 2005 report, the President's Advisory Panel on 
Federal Tax Reform (the ``Panel'') recommended two tax reform options 
for the Treasury Department's consideration.\25\ One option, the 
Simplified Income Tax (``SIT'') plan, would adopt a so-called 
territorial income tax system with an exemption for active foreign 
source business income. This plan is similar, but not identical to a 
proposal described in a January 2005 report of the Joint Committee on 
Taxation (``JCT'') staff, which was estimated to increase federal 
government revenues by $54.8 billion over the FY 2005-2014 period.\26\
---------------------------------------------------------------------------
    \25\ President's Advisory Panel on Federal Tax Reform, Simple, 
Fair, and Pro-Growth: Proposals to Fix America's Tax System, Report of 
the President's Advisory Panel on Federal Tax Reform, November 2005.
    \26\ Joint Committee on Taxation, Options to Improve Tax Compliance 
and Reform Tax Expenditures, JCS 02-05, January 27, 2005 (hereinafter 
``JCT Options Pamphlet'').
---------------------------------------------------------------------------
    The effects of a territorial tax system in the United States would 
depend critically on the details of the system. The JCT and Advisory 
Panel proposals each diverge in some significant respects from 
international norms to the detriment of U.S. multinationals, 
specifically:

      The proposals retain the overly broad U.S. anti-deferral 
regime, subjecting to immediate U.S. tax certain types of active 
foreign business income (whether or not repatriated).
      The proposals disallow deduction of certain domestic 
expenses to the extent allocable or apportionable to exempt foreign 
income (although the Panel's proposal disallows fewer deductions than 
the JCT's proposal).
      The Panel's proposal would impose higher U.S. shareholder 
taxation on dividends paid by U.S. companies with foreign-source income 
than purely domestic companies.

    If Congress were to adopt a territorial tax system, FEI recommends 
that:

      The present law deduction for domestic expenses should 
not be disallowed. Disallowance of domestic expenses would put U.S. 
multinationals at a competitive disadvantage relative to foreign 
multinationals and, for some companies, would result in a huge tax 
increase. Disallowance of domestic R&D expenses would have the 
additional and undesirable effect of discouraging the location of 
research activities in U.S. laboratories.
      All foreign-source income should be exempt other than 
income subject to anti-deferral rules. If, instead, some foreign income 
is exempt and other foreign income is taxable as under present law 
(i.e., dividends are taxable with a credit for foreign income taxes), 
the result will be a tax system with greater compliance burdens.
      Appropriate transition rules should be provided. 
Fundamental changes in tax policy generally are accompanied by 
transition rules. One important transition issue would be the treatment 
of carryforwards of foreign tax credits. Elimination of these credits 
would prevent relief from double taxation of certain foreign income 
previously subject to U.S. tax and would likely be recorded as a 
reduction in deferred tax assets, reducing the taxpayer's reported 
equity and net income.

    Finally, FEI notes that this type of fundamental change in U.S. tax 
law would require the re-negotiation of U.S. tax treaties that 
currently contemplate alleviation of double taxation through a foreign 
tax credit mechanism rather than an exemption mechanism. That re-
negotiation process likely will take a significant period of time.

Table 1. Top Statutory Corporate Tax Rates in OECD Countries, 2005
    [Ranked by combined central and local government tax rate]

    [GRAPHIC] [TIFF OMITTED] T0445A.001
    
     Source: OECD and PricewaterhouseCoopers

   Exhibit 2--Taxation of Corporate Dividends in OECD Countries, 2005

                    Method of relieving double taxation of corporate
                                       dividends
  No relief
 from double      Shareholder
 taxation of   level Imputation     Tax        Special
  corporate     system (partial    credit   personal tax     Corporate
  dividends      or complete)      method       rate           level


Sweden\5\      Australia*        Canada     Austria
Switzerland    Mexico*           Ireland    Belgium
               New Zealand*      Rep. of    Czech
                                  Korea*     Republic
               Norway                       Denmark
               Spain                        Finland\1\
               United Kingdom               France\2\
                                            Germany\2\
                                            Greece\3\
                                            Hungary
                                            Iceland
                                            Italy
                                            Japan*
                                            Luxembourg\2
                                             \
                                            Netherlands
                                            Poland
                                            Portugal\4\
                                            Slovak
                                             Republic\3\
                                            Turkey\2\
                                            United
                                             States

\1\ Beginning January 1, 2005 the old imputation system has been
  replaced with a classical double taxation system but with a 43%
  dividend exemption.
\2\ Dividends taxed at normal rates but with a 50% dividend exemption.
\3\ Dividends are not subject to tax in the hands of the shareholder.
\4\ Individuals must include 50% of gross domestic dividends in taxable
  income. In general, domestic dividends are also subject to a 15%
  withholding tax, but that tax is credited against the individual's
  final tax liability.
\5\ Dividends are paid out of after-tax profits and are generally
  taxable at the individual level. However, a limited exemption applies
  for dividends from small or medium-sized companies.
Source: International Bureau of Fiscal Documentation, ``European Tax
  Handbook 2005, except where noted.
* Information for 2004 from PricewaterhouseCoopers, Individual Taxes
  2004-2005: Worldwide Summaries.


Exhibit 3A. Combined U.S. Individual and Corporate Statutory Tax Rate in
     2005: Corporate Income Distributed as a Dividend to Individual
                       Shareholder in Top Bracket
Corporate income                              $100.00
  Less corporate income tax at 35% (federal)  $ 35.00
Net income                                    $ 65.00
Dividend assuming 100% distribution           $ 65.00
  Less individual income tax at 15.0%         $  9.75
 (federal)
Net income after federal and individual       $ 55.25
 income tax
Combined corporate and individual income tax     44.75%
 rate




 Table 3B. Combined U.S. Individual and Corporate Statutory Tax Rate in
     2009: Corporate Income Distributed as a Dividend to Individual
                       Shareholder in Top Bracket
Corporate income                              $100.00
  Less corporate income tax at 35% (federal)  $ 35.00
Net income                                    $ 65.00
Dividend assuming 100% distribution           $ 65.00
  Less individual income tax at 35.0%         $ 22.75
 (federal)
Net income after federal and individual       $ 42.25
 income tax
Combined corporate and individual income tax     57.75%
 rate




              Exhibit 4. Income and Profits Taxation, 2003
               Percent of Total Taxation in OECD Countries

                Rank                       Country           Percent

 1                                    Denmark           59.9%
 2                                    New Zealand       59.6%
 3                                    Australia         55.2%
 4                                    Canada            46.0%
 5                                    Iceland           44.3%
 6                                    Norway            43.3%
 6                                    United States     43.3%
 8                                    Switzerland       42.9%
 9                                    Ireland           39.3%
10                                    Belgium           39.0%
11                                    Finland           38.7%
12                                    United Kingdom    36.5%
13                                    Luxembourg        36.3%
13                                    Sweden            36.3%
15                                    Italy             30.9%
16                                    Japan             30.6%
17                                    Austria           29.7%
18                                    Spain             28.2%
19                                    Korea             28.0%
20                                    Germany           27.4%
21                                    Mexico            26.5%
22                                    Netherlands       25.5%
23                                    Czech Republic    25.3%
24                                    Hungary           24.8%
25                                    Portugal          24.5%
26                                    Turkey            23.7%
27                                    Greece            23.3%
28                                    France            23.2%
29                                    Slovak Republic   22.3%
30                                    Poland            18.2%
Unweighted
averages
                                      OECD              34.4%
                                      EU                31.7%

Source: OECD, Revenue Statistics, 1965-2004 (2005)



      Exhibit 5--Effective Average Tax Rate for Investment into EU
------------------------------------------------------------------------
                                     Financing of foreign subsidiary
                                ----------------------------------------
 Investment from MNC based in:    Retained      New
                                  earnings    equity    Debt    Average
------------------------------------------------------------------------
EU                               30.1%       30.4%     30.2%   30.2%
------------------------------------------------------------------------
US                               33.2%       35.7%     34.7%   34.5%
------------------------------------------------------------------------
 Source: Commission of the European Communities, ``Towards an Internal
  Market without Obstacles,'' Com(2001)582, Brussels, October 23, 2001.



 Exhibit 6--Taxation of Foreign Subsidiary Dividends in OECD Countries,
                                  2005
    Dividend exemption (``territorial'') system Worldwide tax system

                                               (with credit or deduction
     (by statute or treaty or for listed           for foreign taxes)
                  countries)

 1. Australia*                                  1. Czech Republic\2\
 2. Austria                                     2. Ireland
 3. Belgium\1\                                  3. Japan
 4. Canada*                                     4. Rep. of Korea
 5. Denmark                                     5. Mexico
 6. Finland\3\                                  6. New Zealand
 7. France                                      7. Poland
 8. Germany                                     8. United Kingdom
 9. Greece                                      9. United States
10. Hungary                                    .........................
11. Iceland                                    .........................
12. Italy\5\                                   .........................
13. Luxembourg                                 .........................
14. Netherlands                                .........................
15. Norway\6\                                  .........................
16. Portugal\7\                                .........................
17. Slovak Republic\8\                         .........................
18. Spain                                      .........................
19. Sweden                                     .........................
20. Switzerland                                .........................
21. Turkey                                     .........................

 Source: President's Advisory Panel on Federal Tax Reform, Simple, Fair
  and Pro-Growth: Proposals to Fix America's Tax System,2005, p. 243.


                                 

                 Statement of S Corporation Association

    As the Ways and Means Committee examines the many issues inherent 
in reforming the Internal Revenue Code, the S Corporation Association 
(``S-CORP'') appreciates this opportunity to share our views on behalf 
of our member companies and the 3.2 million S corporation owners 
nationwide.
    S-CORP is the only organization in the Nation's Capitol exclusively 
devoted to protecting America's S corporation community. Our mission is 
to defend America's small and family-owned S corporation businesses 
from excessive taxes and government mandates, while also working to 
ensure that America's most popular corporate structure remains 
competitive with other business structures in the Twenty-First Century.
    Before Congress created S corporations, entrepreneurs had two basic 
choices when starting a business. They could form a regular ``C 
corporation,'' enjoy liability protection, but shoulder federal taxes 
both at the corporate and individual level. Or they could form a 
partnership, enjoy a single layer of taxation at the individual level, 
but sacrifice the umbrella of liability protection.
    In 1958, Congress enacted Subchapter S of the Internal Revenue Code 
to combine a single layer of tax (at the individual level) with 
corporate liability protection. Creation of the ``S corporation'' was a 
huge step forward in encouraging small and family business creation in 
the United States. Nearly a half century later, S corporations are the 
most popular corporate structure in America. Small businesses are the 
cornerstone of the American economy, and S corporations are the 
cornerstone of America's small business community.
    S-CORP encourages the Committee to keep in mind the unique history 
and structure of S corporations, and the dramatic improvement the 
development of subchapter S represented in the history of taxing small 
and closely held enterprises, as it reviews plans to reform the tax 
code.
Advisory Panel Recommendations
    The President's Tax Reform Panel has put forward two alternative 
plans for consideration by the Administration and Congress--the 
Simplified Income Tax Plan and the Growth and Investment Tax Plan.
    For S corporations, SITP divides the business community into two 
groups, those with more than $10 million in annual revenues, and those 
with less. Those with less than $10 million in annual revenues would be 
allowed to retain their current structure (S corporation, LLC, etc) 
with certain changes, many of them beneficial.
    S corporations with more than $10 million in revenues, on the other 
hand, would need to convert to the new corporate structure with the 
following main features: a lower 31.5-percent top tax rate imposed at 
the business level, a 100 percent dividend exclusion for domestic 
corporations on their domestic earnings, and a 75 percent exclusion for 
capital gains realized from the sale of the corporate stock.
    The GITP similarly divides businesses into two groups, those with a 
single shareholder (sole proprietorships) and those with two or more 
shareholders. S corporations and others with multiple shareholders 
would, under the GITP, be subject to a new corporate structure and tax. 
Under the new structure, companies that are currently S corporations 
would be taxed at the corporate level at a top rate of 30 percent, and 
dividends from the new corporation would be taxed an additional 15 
percent. Capital investments could be expensed and interest received 
would be tax free.
    While there are too many moving pieces to definitively state that 
either plan would result in a better or worse approach to taxing S 
corporations, America's Subchapter S businesses are extremely troubled 
by any proposal to impose a new tax at the entity level or elsewhere on 
their businesses. The point of creating the S corporation fifty years 
ago was elimination of double taxation. In many ways, the Panel's 
report reflects a retreat from that premise.
    And while one could read between the lines of the report and 
discern an unwritten objective of trading a single layer of tax at the 
shareholder level with a single layer of tax at the corporation level, 
several details within the Panel's report fail to live up to that 
theme.
    For example, the GITP plan explicitly recreates two layers of 
taxation for all businesses with two or more shareholders. In some 
cases, this double layer results in a higher level of federal tax than 
the current tax code--an S corporation shareholder in the top tax 
bracket pays a 35 percent tax, while that same taxpayer under the new 
structure would pay a tax of 41 percent. In a similar fashion, the SITP 
would increase capital gains taxation on smaller businesses that choose 
to remain S corporations while imposing on them a higher top marginal 
tax rate than would be paid by businesses which elect the new corporate 
structure.
    Finally, we note that S-CORP and its member S corporations are 
cognizant of the inherent risks involved in the legislative process. A 
plan that begins its legislative life by trading a single layer of tax 
for two layers of taxation, even at reasonably low levels, could easily 
become a conference report that imposes two layers of tax at much 
higher levels. S-CORP encourages Congress to remain committed to a 
single layer of tax as the starting point for tax reform.
The Comprehensive Business Income Tax
    The President's tax reform effort now moves to its second stage, 
with the Department of Treasury considering the Tax Reform Panel's 
report before making its own recommendations to the President. With 
that in mind, S-CORP would like to comment on the concept of a 
Comprehensive Business Income Tax.
    As evidenced by the testimony heard by the Advisory Panel and its 
subsequent report, Panel members were heavily influenced by a 1992 
Treasury report outlining the economic benefits of a comprehensive 
business tax. That report sought to create a single, unified business 
tax structure that taxed business income once while eliminating many of 
the biases in the current code.
    Treasury found CBIT would produce significant welfare gains to the 
economy by improving the allocation of investment between the corporate 
and non-corporate world, eliminating the bias towards debt and against 
equity financing, and improving the tax treatment of dividend payments 
to corporate shareholders.
    As noted above, S-CORP strongly supports reform efforts that pursue 
the goal of taxing business income once. We also note that most of the 
economy efficiency gains of CBIT come not from the uniform business 
structure it would establish, but rather from the elimination of the 
bias in the tax code. In other words, most of the economic benefits of 
CBIT can be realized without eliminating those business structures that 
already enjoy a single layer of federal tax.
Build on Subchapter S
    For the S corporation community, tax reform represents both an 
opportunity and a risk. Tax reform is an opportunity for Congress to 
continue what it started back in 1958 when it first created the S 
corporation--a continued improvement in the tax treatment of America's 
businesses, one that fosters growth, innovation, jobs and investment.
    On the other hand, tax reform represents the risk that Congress may 
turn away from this basic premise, and--in the name of simplification--
impose new taxes where none now exist. Moreover, it represents a risk 
that Congress will choose to eliminate S corporations, LLCs, and other 
pass-through businesses without noting the cost to those businesses and 
the economy of transitioning from one business structure to another.
    S-CORP appreciates the opportunity to bring these issues and 
concerns before the Committee. We look forward to working with you in 
the weeks and months ahead as you continue your consideration of 
federal tax reform.

                                  
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