- FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL YEAR 2009

[Senate Hearing 110-735]
[From the U.S. Government Publishing Office]

S. Hrg. 110-735

Senate Hearings

Before the Committee on Appropriations

_______________________________________________________________________

Financial Services

and General Government

Appropriations

Fiscal Year
2009

110th CONGRESS, SECOND SESSION

H.R. 7323/S. 3260

COMMODITY FUTURES TRADING COMMISSION

CONSUMER PRODUCT SAFETY COMMISSION

DEPARTMENT OF THE TREASURY

DISTRICT OF COLUMBIA: COURT SERVICES AND OFFENDER SUPERVISION AGENCY

FEDERAL TRADE COMMISSION

OFFICE OF MANAGEMENT AND BUDGET

SECURITIES AND EXCHANGE COMMISSION

SELECTIVE SERVICE SYSTEM

THE JUDICIARY
Financial Services and General Government Appropriations, 2009 (H.R.
7323/S. 3260)

S. Hrg. 110-735

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

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

HEARINGS

before a

SUBCOMMITTEE OF THE

COMMITTEE ON APPROPRIATIONS UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

SECOND SESSION

H.R. 7323/S. 3260

AN ACT MAKING APPROPRIATIONS FOR FINANCIAL SERVICES AND GENERAL
GOVERNMENT FOR THE FISCAL YEAR ENDING SEPTEMBER 30, 2009, AND FOR OTHER
PURPOSES

__________

Commodity Futures Trading Commission
Consumer Product Safety Commission
Department of the Treasury
District of Columbia: Court Services and Offender Supervision Agency
Federal Trade Commission
Office of Management and Budget
Securities and Exchange Commission
Selective Service System
The Judiciary

__________

Printed for the use of the Committee on Appropriations

Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html

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__________
COMMITTEE ON APPROPRIATIONS

ROBERT C. BYRD, West Virginia, Chairman
DANIEL K. INOUYE, Hawaii THAD COCHRAN, Mississippi
PATRICK J. LEAHY, Vermont TED STEVENS, Alaska
TOM HARKIN, Iowa ARLEN SPECTER, Pennsylvania
BARBARA A. MIKULSKI, Maryland PETE V. DOMENICI, New Mexico
HERB KOHL, Wisconsin CHRISTOPHER S. BOND, Missouri
PATTY MURRAY, Washington MITCH McCONNELL, Kentucky
BYRON L. DORGAN, North Dakota RICHARD C. SHELBY, Alabama
DIANNE FEINSTEIN, California JUDD GREGG, New Hampshire
RICHARD J. DURBIN, Illinois ROBERT F. BENNETT, Utah
TIM JOHNSON, South Dakota LARRY CRAIG, Idaho
MARY L. LANDRIEU, Louisiana KAY BAILEY HUTCHISON, Texas
JACK REED, Rhode Island SAM BROWNBACK, Kansas
FRANK R. LAUTENBERG, New Jersey WAYNE ALLARD, Colorado
BEN NELSON, Nebraska LAMAR ALEXANDER, Tennessee

Charles Kieffer, Staff Director
Bruce Evans, Minority Staff Director
------

Subcommittee on Financial Services and General Government

RICHARD J. DURBIN, Illinois, Chairman
PATTY MURRAY, Washington SAM BROWNBACK, Kansas
MARY L. LANDRIEU, Louisiana CHRISTOPHER S. BOND, Missouri
FRANK R. LAUTENBERG, New Jersey RICHARD C. SHELBY, Alabama
BEN NELSON, Nebraska WAYNE ALLARD, Colorado
ROBERT C. BYRD, West Virginia (ex THAD COCHRAN, Mississippi (ex
officio) officio)

Professional Staff

Marianne Upton
Diana Gourlay Hamilton
Mary Dietrich (Minority)
Rachel Jones (Minority)

Administrative Support

Robert Rich
LaShawnda Smith (Minority)

C O N T E N T S

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Wednesday, March 5, 2008

Page
Department of the Treasury....................................... 1

Wednesday, March 12, 2008

The judiciary.................................................... 41

Wednesday, April 16, 2008

Department of the Treasury: Internal Revenue Service............. 97

Wednesday, April 30, 2008

Consumer Product Safety Commission............................... 207

Wednesday, May 7, 2008

Commodity Futures Trading Commission............................. 253
Securities and Exchange Commission............................... 349

Wednesday, May 14, 2008

Federal Trade Commission......................................... 371

Material Submitted Subsequent to the Hearings

Office of Personnel Management................................... 409
Selective Service System......................................... 413
Court Services and Offender Supervision Agency for the District
of Colum-
bia............................................................ 415

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

----------

WEDNESDAY, MARCH 5, 2008

U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 3 p.m., in room SD-138, Dirksen
Senate Office Building, Hon. Richard J. Durbin (chairman)
presiding.
Present: Senators Durbin, Brownback, and Allard.

DEPARTMENT OF THE TREASURY

STATEMENT OF HON. HENRY M. PAULSON, JR., SECRETARY OF
THE TREASURY

opening statement of senator richard j. durbin

Senator Durbin. Good afternoon, and I'm pleased to convene
a series of hearings to examine fiscal year 2009 funding
requests. Today we launch our lineup with the Department of the
Treasury.
Welcome, Secretary Henry Paulson, to the hearing room,
along with any associates who would like to join in your
testimony.
I welcome my colleagues who will join me shortly, and
others who may arrive. Although, this is a budget hearing for
the Treasury, we've scheduled a separate hearing next month to
devote particular attention to the Internal Revenue Service
(IRS), the Treasury's largest bureau. We'll defer the bulk of
our questions relating to the IRS until that hearing.
The non-IRS portion of the Department's budget constitutes
over $1.1 billion, supporting many critical activities in the
central programs we'll concentrate on today.
The Department plays a pivotal role in the global economy,
and as an ambassador for the Nation's economic and financial
institutions. In fulfilling the mission, Treasury promotes
economic prosperity, and ensures the financial security of our
Nation.
Treasury also administers the world's largest collection
system, over $2 trillion a year. In addition, Treasury supports
financial institutions in generating community development, and
leads Government efforts in the area of financial intelligence.
I'm pleased that for fiscal year 2008, we were able to
provide additional funds for the Department to address several
important needs. The funds will further support the
Department's efforts to combat terrorism, through implementing
economic sanctions, and gathering and analyzing financial
intelligence.
For fiscal year 2009, the budget request for Treasury is
$12.47 billion, an increase of $461.6 million, or 3.8 percent.
Excluding IRS, the request for the remainder is $1.11 billion.
This represents a net decrease of $7.5 million over fiscal year
2008, overall reduction of less than 1 percent. This would
appear to be a very restrained budget for the non-IRS portion
of the Department, however, the top line includes a 70 percent
decrease from fiscal year 2008 funding level for the Community
Development Financial Institutions Fund (CDFI), commonly known
as CDFI.
Holding CDFI funding at the fiscal year 2008 level, the
fiscal year 2009 President's budget reflect a $57.9 million, or
5.2 percent increase for the non-IRS portion of the Treasury
Department. I'm concerned about this proposed cut in CDFI,
which we will discuss later, because I believe that the
infusion of capital to these institutions can help many
distressed communities, and low-income individuals, who are
facing the economic downturn, with more severity than most.
I think it's clear that adequate funding for CDFI is
critically important.
For the Office of Terrorism and Financial Intelligence
(TFI), including Financial Crimes Enforcement Network, known as
FinCEN, the budget requests $153 million for fiscal year 2009,
compared to $142.6 million last year, an increase of over $10
million. I'm pleased to see Treasury continues to emphasize
strategies to counterterrorist financing and money laundering.
Beyond the Treasury Department, I also want to talk for a
few minutes with the Secretary about broader economic issues. I
know you've faced that already once today, so you've
undoubtedly been prepared for this by my colleagues in the
House.
I appreciate your insights on the current housing crisis
and the state of the economy, and we'll have a few questions
along those lines. I look forward to discussing them with you.
At this point, since Senator Brownback has not arrived, I
would like to turn the floor over to the Secretary, and Mr.
Secretary, you may proceed with your remarks.
Secretary Paulson. Thank you, Senator Durbin--there we go.
Senator Durbin. Thank you.
Secretary Paulson. That's always the most difficult part of
the hearings, turning on the microphone.
But, thank you very much for your remarks, and for your
support of the Treasury. I very much appreciate the opportunity
to discuss the Treasury Department's proposed fiscal year 2009
budget.
Our budget request reflects the Department's continued
commitment to promoting a healthy U.S. economy, fiscal
discipline, and national security. The Department has broad
responsibility in Federal cash management, tax administration,
and plays an integral role in combating terrorism, terrorist
financing, and advocating the integrity of the U.S. and global
financial systems.
Our spending priorities for the 2009 fiscal year fall into
six main categories. I'll briefly describe their priorities and
then take your questions.
Treasury has an important role to play as a steward of the
U.S. economy, and provides--and our offices provide technical
analysis, economic forecasting and policy guidance on issues
ranging from Federal financing, to domestic and global
financial systems.
Those functions are especially critical now, as the U.S.
economy--through a combination of a significant housing
correction, high energy prices, and capital market turmoil--has
slowed appreciably.
Our long-term economic fundamentals are solid, and I
believe our economy will continue to grow this year, although
not nearly as rapidly as in recent years.
In response to economic signals early this year, the
administration and Congress worked together to quickly pass, on
a bipartisan basis, the Economic Stimulus Act of 2008, and I
would like to thank this subcommittee for approving funds for
the IRS and the Financial Management Service (FMS), to
administer the stimulus check rebate program under the act, so
thank you for that.
As you know, the stimulus payments to households, and the
incentives to businesses in the act, together are estimated to
lead to the creation of 500,000 jobs by year-end. This will
provide timely and effective support for families in our
economy, and it wouldn't be possible without your leadership.
Treasury's Office of Terrorism and Financial Intelligence
(TFI) uses financial intelligence, sanctions, and regulatory
authorities, to track and combat threats to our security, and
safeguard the U.S. financial system from abuse by terrorists,
proliferators of weapons of mass destruction, and other illicit
actors.
To continue to build on our efforts to combat these
threats, we are requesting an $11 million increase for TFI,
including $5.5 million for the Financial Crimes Enforcement
Network, to ensure effective management of the Bank Secrecy
Act.
The budget request emphasizes infrastructure and technology
investments to modernize business processes and improve
efficiency throughout the Treasury Department. We will continue
to make information technology management a priority, and have
taken several significant steps to strengthen our systems and
oversight.
Treasury is committed to managing the Nation's finances
effectively, ensuring the most efficient use of taxpayer
dollars in collecting the revenue due to the Federal
Government. The IRS, of course, plays an integral role in all
of this, the budget requests a 4.3 percent increase in IRS
funding to expand IRS enforcement activities, improve
compliance, reduce the tax gap, and continue improvements in
taxpayer service.
In addition, we are asking your colleagues on the State,
Foreign Operations Subcommittee to support funding both in
multilateral development banks--noticeably, new replenishments
for the World Bank's International Development Association
(IDA), and the African Development Fund, and have forwarded a
$400 million request for the first installment of a $2 billion
clean technology fund that--with additional funding from other
donors around the world, will help finance clean energy
projects in the developing world, and make strides toward
addressing global climate change.
Overall, the budget request reflects a prudent and forward-
leaning approach to fulfilling the Treasury Department's core
responsibilities to support our economy, managing the
Government's finances, and ensuring financial system security.

PREPARED STATEMENT

I thank you for your past support and consideration of our
work, and I look forward to working with you during your
deliberations.
Thank you, and I welcome your questions.
[The statement follows:]

Prepared Statement of Henry M. Paulson, Jr.

Chairman Durbin, Senator Brownback, Members of the Committee: Thank
you for the opportunity to discuss the Treasury Department's proposed
fiscal year 2009 budget. Our budget request reflects the Department's
continued commitment to promoting a healthy U.S. economy, fiscal
discipline and national security. The Department has broad
responsibility in federal cash management, tax administration and plays
an integral role in combating terrorist financing and advocating the
integrity of the U.S. and global financial systems.
Our spending priorities for the 2009 fiscal year fall into six main
categories. I will briefly describe the priorities and then take your
questions.

U.S. ECONOMIC STEWARD

Treasury has an important role to play as steward of the U.S.
economy, and our offices provide technical analysis, economic
forecasting and policy guidance on issues ranging from federal
financing to domestic and global financial systems.
Those functions are especially critical now as the U.S. economy,
through a combination of a significant housing correction, high energy
prices and capital market turmoil has slowed appreciably. Our long term
economic fundamentals are solid, and I believe our economy will
continue to grow this year, although not as rapidly as in recent years.
In response to economic signals, early this year the Administration
and the Congress worked together to quickly pass, on a bipartisan
basis, the Economic Stimulus Act of 2008. And I would like to thank
this subcommittee for approving funds for the IRS and the FMS to
administer the stimulus check rebate program under that Act.
As you know, the stimulus payments to households and the incentives
to businesses in the Act, together, are estimated to lead to the
creation of half a million jobs by year-end. This will provide timely
and effective support for families and our economy, and it wouldn't be
possible without your leadership.

STRENGTHENING NATIONAL SECURITY

Treasury's Office of Terrorism and Financial Intelligence (TFI)
uses financial intelligence, sanctions, and regulatory authorities to
track and combat threats to our security and safeguard the U.S.
financial system from abuse by terrorists, proliferators of weapons of
mass destruction and other illicit actors.
To continue and build on our efforts to combat these threats, we
are requesting an $11 million increase for TFI, including $5.5 million
for the Financial Crimes Enforcement Network to ensure effective
management of the Bank Secrecy Act.
Efficient Management of the Treasury Department
The budget request emphasizes infrastructure and technology
investments to modernize business processes and improve efficiency
throughout the Treasury Department. We will continue to make
information technology management a priority, and have taken several
significant steps to strengthen our systems and oversight.

FISCAL DISCIPLINE

Treasury is committed to managing the nation's finances
effectively, ensuring the most efficient use of taxpayer dollars and
collecting the revenue due to the federal government.
Enforcing the Nation's Tax Laws Fairly and Efficiently
The Internal Revenue Service, of course, plays an integral role in
this. The budget requests a 4.3 percent increase in IRS funding.
As in the past three budget requests, we are proposing to increase
IRS enforcement funding as a Budget Enforcement Act program integrity
cap adjustment. IRS enforcement efforts have yielded record revenue
collections. With the requested funding, the IRS will collect an
estimated $55 billion in direct enforcement revenue in 2009.
The budget also includes a number of legislative proposals intended
to target the tax gap and improve tax compliance, with an appropriate
balance between enforcement and taxpayer service. These proposals are
estimated to generate $36 billion over the next ten years.

INTERNATIONAL PROGRAMS

We will continue to focus efforts on supporting a stable and
growing global economy, through on-going dialogue and initiatives with
developing economies throughout Asia, Latin America and Africa.
In addition we are asking your colleagues on the Foreign Operations
Subcommittee to support key objectives of the President's international
assistance agenda. This includes funding for the multilateral
development banks_notably new replenishments for the World Bank's
International Development Association (IDA) and the African Development
Fund.
Also included as a Foreign Operations priority is $400 million
request for the first installment of a $2 billion clean technology fund
that, with additional funding from the United Kingdom, Japan and other
donors, will help finance clean energy projects in the developing world
and make strides towards addressing global climate change.

CONCLUSION

Overall, the budget request reflects a prudent and forward-leaning
approach to fulfilling the Treasury Department's core responsibilities
to support our economy, managing the government's finances and ensuring
financial system security. I thank you for your past support and
consideration of our work, and look forward to working with you during
your deliberations.
Thank you and I welcome your questions.

Senator Durbin. Thanks, Mr. Secretary, and I welcome my
ranking member, Senator Brownback, of Kansas.
If you have an opening statement, I'll defer to you at this
point.
Senator Brownback. I'll just make some of those comments
during my questions, I think that would probably be the best,
prudent way.
If I could, Mr. Chairman, I'd ask if I could put my full
statement in the record, right now.
Senator Durbin. Without objection.
[The statement follows:]

Prepared Statement of Senator Sam Brownback

Good afternoon. At this first hearing of our subcommittee, I want
to thank you, Chairman Durbin, for your leadership. I look forward to
working together with you during this coming year as we make funding
decisions and provide oversight to the various agencies within this
subcommittee's jurisdiction.
Secretary Paulson, thank you for appearing before our subcommittee
today. I look forward to hearing the details of your fiscal year 2009
budget request and the key efforts that your department will be
undertaking this year. You have a crucial role in overseeing our
financial systems and in promoting our participation in the
international economy so I am interested in hearing your thoughts on
the domestic and global economic situation.
Looking at the President's budget, I am pleased that it assumes the
continuation of the President's tax cuts, which are key to preventing
recession and allowing our economy to rebound from the sub-prime
mortgage crisis. I am encouraged that the President's budget projects a
balanced budget by 2012.
Mr. Secretary, regarding the economic stimulus package, I support
the tax rebates to families and the expensing and depreciation changes
to assist businesses. But I believe that we must look down the road at
other ways to stave off recession, such as enacting incentives for U.S.
companies to bring money back to this country from abroad. This would
allow multi-national corporations to bring funds into the United States
at a reduced tax rate for a period of time. I believe that we must
continue to be proactive to keep our economy healthy. The most
effective way to do this is to lower taxes so that consumers and
businesses have more of their own money to spend and invest.
Mr. Secretary, the lion's share of your budget--approximately 90
percent--is for the Internal Revenue Service. I understand that you are
seeking additional resources to close the so-called ``tax gap.''
Certainly, we must ensure that taxes which are owed are collected.
However, I remain concerned that our tax system is overly complex,
complicated, and burdensome. Americans spend roughly $157 billion each
year in tax preparation to ensure they do not run afoul of the IRS. The
system is desperately in need of reform. One reason we have a ``tax
gap'' may be that our tax system is so complex that taxpayers cannot
figure out what they owe.
Mr. Secretary, I want to commend your Department for its efforts to
combat terrorism. Your ``Office of Terrorism and Financial
Intelligence'' is working hard to safeguard the financial system
against illicit activities and combating rogue nations, terrorist
facilitators, money launderers, drug kingpins, and other national
security threats. This is important work and I am supportive of your
efforts in this area.
I know that the Treasury Department is aggressively blocking U.S.
commercial bank transactions connected to the government of Sudan,
including those involving oil revenues. I am pleased that you are
taking these actions. Last year, we passed legislation and the
President signed into law the authority for your Department to levy
greater criminal and civil penalties for those who violate these
sanctions. I hope this new authority has acted as a strong deterrent
for bad behavior.
Mr. Secretary, I am deeply concerned that American consumers are
unwittingly purchasing products that have been manufactured with
natural resources extracted by enslaved and abused children in
countries where the profits are then used to support murdering and
raping rebels. For example, I believe that our demand for coltan--which
is an essential mineral needed for the manufacture of cell phones, TVs,
and computers--has helped to fuel the conflict in the Congo. We need to
be vigilant to ensure that American manufacturers are not supporting
the conflict in the Congo by purchasing coltan. I would like you to
work with us and perhaps the SEC to prevent American companies from
purchasing coltan that has been mined by children and whose profits are
supporting killings in the Congo. Congo's ``conflict coltan'' has
created a vast and grave humanitarian crisis where 5.4 million people
have died since 1998 directly and indirectly from the conflict and
where 1,500 people continue to die each and every day.
We cannot sit idly by while others suffer. We need to be
responsible as a nation and as consumers. We must hold our suppliers
accountable. I plan to introduce legislation to stop the exploitation
of coltan, particularly in eastern Congo. I am working with leaders of
non-governmental organizations who understand the situation as I write
this bill.
Mr. Secretary, I would like to hear what your Department is doing
to support a stable and growing global economy through initiatives with
developing economies throughout the rest of Africa and Latin America. I
would like to hear how you can help ensure that we are not complicit in
illegal activities in Congo and the rest of the world.
So Mr. Secretary, I look forward to hearing your testimony this
afternoon.
Thank you, Mr. Chairman.

HOPE NOW ALLIANCE

Senator Durbin. Mr. Secretary, the Treasury Department
reported Monday that loan modifications under Hope Now helped
45,000 borrowers in January. But that number, as I understand
it, includes all modifications of any sort, including those
that only temporarily delayed foreclosure, rather than only
counting mortgage changes that would allow families to stay in
their homes for a longer period of time.
Isn't it true that Hope Now numbers you're citing include
all mortgage changes of any sort?
Secretary Paulson. Yes sir, very much.
And let me say that with Hope Now, the objective is--and
the numbers you were citing have to do with subprime mortgage
holders who were facing resets. And a major objective there is
to help those homeowners who were facing resets they couldn't
afford, and help them stay in their homes, and modifications to
change the terms and to change, you know, the terms on a
mortgage that lets someone stay in their home, is what we're
about doing.
The other thing I would point out is that we're very
fortunate in the--to the extent that the rate cuts that the
Federal Reserve had made, made the impact of the some of the
resets much less severe. And prior to the rate cuts, some of
the initial resets were going to take the rates from 8.5
percent to 10.8 percent. After the rate cuts, they, you know,
the impact was more like 8.5 to 9 percent. So, again, we
received help there. And I certainly don't discount
modifications that mortgage servicers made to let people remain
in their homes.
Senator Durbin. Are you satisfied that the financial
institutions across America have responded voluntarily to the
administration's request, in an adequate way, to deal with the
current mortgage foreclosure crisis?
Secretary Paulson. The way I would answer that question is
I'm gratified by the progress that's been made, to date. And
again, there's been some criticism, but in terms of an
initiative that's up and going, I happen to believe it stacks
up well, relative to anything else I see out there.
So, I would start off by saying that there's been 1 million
people helped, to date, and I don't discount that at all, I
think it's significant.
Now, the objective here--and I want to put this in
perspective--that what we have is an industrywide effort in
looking at subprime mortgages, where we have servicers covering
90 percent of the market. There are varying degrees of
aggressiveness and sophistication in that group. And there are
some firms in that group that didn't even need Hope Now to be
doing the right things. And they've been out and they've been
leading, and I thank them.
There are other servicers in that group that has less
sophistication, were less prepared, we had significant
obstacles--legal obstacles, accounting obstacles--we had the
Securities and Exchange Commission (SEC) sign off on some
accounting guidance on January 8, and technological issues.
So, the way I look at it right now is, we have some
leaders, we have some followers, we have now--the followers
fully implementing the protocol, and we have them doing that
ahead of the biggest period of recess----
Senator Durbin. Let me try to narrow it down, because I
want to get to the point of understanding this. When you talked
about 1 million borrowers being helped----
Secretary Paulson. Yes.
Senator Durbin. And that you're satisfied with some
responses--I'm trying to put the response level, or the
response so far, I should say, in the context of the challenge
that we face.
Secretary Paulson. Right.
Senator Durbin. And I have heard that some 2.2 million--at
least that's a common figure--mortgage holders in America--
subprime mortgage holders--face the probability, possibility of
foreclosure.
Secretary Paulson. Right.

SUBPRIME BORROWERS

Senator Durbin. I don't know if that's an accepted figure
or an accepted estimate, but I've heard it repeatedly.
So, what do you think, what would--how would you describe,
in percentage terms----
Secretary Paulson. Right.
Senator Durbin. The number of those vulnerable homeowners
who have been helped, to date----
Secretary Paulson. Right.
Senator Durbin. By the administration's programs?
Secretary Paulson. Well, let me say--first of all, let me
deal with numbers. And if you give me a minute or two on this,
we'll go through it.
That in a average, good year, you know, if we looked at
2002 through 2005, there are 650,000 foreclosures. Last year,
estimates are there will be about 1.5 million. Some people are
projecting 2 million foreclosures this year.
Now, I think, you sir, Mr. Chairman, are right to focus on
subprime because if we look at the third quarter of last year,
we had roughly 13 percent of these 55 million mortgages are
subprime mortgage--they were----
Senator Durbin. The 55 million mortgages?
Secretary Paulson [continuing]. 55 million mortgages, 13
percent were subprime.
Senator Durbin. That's of all the mortgages, you said,
universal mortgages, 55 million?
Secretary Paulson. All the mortgages, yes. And of that
subprime universe, of that 13 percent, 50 percent of those were
where we had foreclosures. And if you even look at a smaller
sample, 6.5 percent were adjustable rate subprime mortgages,
and they had 50 percent of the foreclosures.
And we had a--and on top of that--the 18 percent, if you
take a look at sort of the--the period when there were the
worst underwriting practices, which was 2006, and these so-
called ``2-28'' mortgages, you know, teaser rate for the first
2 years, and then resets--that 18 percent of that pool
foreclosed 6 months ahead of even the first reset.
So, again, as I look as the objective--and so, I think
what's important, that we talk about what's a reasonable
objective, and to me the reasonable objective is that every
homeowner who is in a subprime mortgage and is able to afford
the initial rates--because if they can't even afford the
initial rates, I think there's a different problem we need to
deal with--every homeowner that's in a subprime mortgage and is
able to afford the initial rates, and can't afford the step-up
rate, there should be a solution that keeps them out of
foreclosure, if they are willing to talk to someone about it,
and engage to talk about solutions.
So, a major issue we continue to have--and we're making
progress--is that before Hope Now, that roughly 2 to 3 percent
of those getting letters from servicers responded. Half of
those going into foreclosure ever talked to anyone. Now the
response rate is close to 20 percent--that still means 80
percent aren't having conversations.
Now, it's very hard for the Government or anyone, to help
someone who won't try to help themselves, won't respond, won't
engage in a conversation. There's also some people out there,
where there's a different issue.
Just to step back, and the other issue that's out there,
and you hear a lot of conversation about, is the put-out
numbers, the 8.8 million homeowners that have mortgages that--
where they have zero equity or negative equity in their home.
Now, as you look at that universe, as I look at it, if you're a
mortgage holder, even if you have negative equity in your home,
if you can afford to make your mortgage payment, then I believe
you've got an obligation to make the mortgage payment and you
don't walk away--you're a speculator if you walk away because
you happen to think your home is under water and the--your
mortgage is under water. And I think most homeowners look at it
this way--I think most homeowners, 93 percent of the homeowners
are making their payment every month, you know, even if it's
difficult for them to do so--only 2 percent are in foreclosure.

SPECULATORS

So, I do believe--but there are some, some of these, and
they're doing terrible practices. Last year, even last year
after all of this, 30 percent of the mortgages that remain in
this country, there was almost no down payment or no down
payment on a mortgage. And so, there are certain people that--
sometimes they are second homes, they're speculators, they took
out a mortgage, if the home value doesn't go up, they're
walking away from that.
That's not the focus. The focus of our program is you've
got to want to stay in your home, and respond to someone, and
have the capability to do that. And I think on that--and just
to finish up, Mr. Chairman--on that, we're continuing to make a
very big effort, and I think the industry is, and we're going
to monitor that very carefully.
Senator Durbin. I've gone way over my time, and I want to
give Senator Brownback his. But I do--I do want to go back to
my question.
Secretary Paulson. Right.

LOAN WORK OUTS

Senator Durbin. You've really described the battleground,
and the universe, but I want to zero in--how many of these have
we helped? If, in fact, there are 13 percent of the 55 million
that are subprime, that calculates out to about 7 million--if
half of them are facing foreclosure, that's 3.5 million--how
many have been reached by Hope Now, and this administration's
efforts?
Secretary Paulson. I would say, to date, okay, Hope Now,
since the beginning there have been 1 million homeowners that
have engaged in some form of modification or work out, okay?
So, there have been 1 million people that have been helped.
But what we're not picking up in our numbers are the
refinancings. So, even when you--the number you cited, I looked
very carefully at that number, and there were 45,000
modifications, there were 167,000 work outs, both work outs and
modifications went up faster than foreclosure starts--which was
a positive. But we don't know the number of refinancings. And
it's been hard, and there are a lot of refinancings. And so we
will do everything we can to measure the numbers that have been
helped.
The other thing I'm really focused on is, you can't help
people that aren't going to help themselves, or reach out. The
standard I really want to set is that if there's a homeowner,
and has been able to make the reset, be able to make the
initial payment, and they said, ``I reached out and I talked to
my servicer, and I'm still put into foreclosure,'' I want to
know about that, because again, I want to follow-up. I mean,
that's, to me, another--and we're going to work to get the
numbers to help answer more and more of your question.
Senator Durbin. I have some more questions, but I want to
defer to my colleague, here.
Senator Brownback.
Senator Brownback. Thanks, Mr. Chairman.
Secretary, thanks for being here. And also, just at the
outset, I wanted to thank you for your years of expertise that
you bring into the Government. I think particularly at this
time with the economic problems we're facing, it's great to
have somebody with your background and expertise, and I
appreciate it.
Now, I'm going to yell at you, but I first want to tell you
how appreciative I am, of you being in Government with this,
because I think it does bring a stature that's needed, and it's
very helpful to have.
I want to talk about two things--the economy, and terrorist
financing. And I appreciate your describing the universe of the
home situation, I wanted to describe a philosophy and then ask
you questions on how to implement that.
I've been through a similar crisis in the past, my guess is
you've also seen a couple of things like this, and so you bring
a philosophy that's based on your experience, as well.
I went through the farm crisis of the 1980s, I was a lawyer
in an undistinguished practice in the Midwest, and then went on
to be agriculture secretary in the State. One of the things I
saw in that early 1980s farm crisis--this would have been a
Dick statement, Bigway, as well--is we took a crisis and we
made it a huge--we took a problem and we made it a crisis. And
we did that through trying to get too much done too fast.
There was land that went on the market at a cheap rate, and
then--I was representing some farmers and some banks. The
regulators came out and told the banks, ``Clean up your
loans,'' the banks went out and started suing a bunch of
farmers to get their land, so we dropped a whole bunch of land
on the market, a whole bunch of equipment, everybody's prices
fell a huge amount, and it just exacerbated the problem--we
tried to do too much, too fast, and we made it really bad. It
was bad.
So, I take that experience and I say that the thing we need
to do now, because we've got a real problem here, is we've got
to string this out, over a period of time, and not try to see
too much housing stock get on the market too fast. Because if
you get too much out there, you further plummet, and you get a
whole bunch more people that are in trouble.
So, if that's the correct philosophy, we need to meter this
out over a period of time. We've got a problem, we had excess
capital, or problems coming in, and bad loans taking place, and
sharks out there, and we've got to work our way through this.
Is the way to do that not just what the administration is
proposing, but also tax credits for purchasing housing or even
distressed housing? Or, some people are proposing changes in
the bankruptcy code, to provide for a cram-down feature on
housing? If you agree with the philosophy, I would like for you
to say which actions by Congress you think would be the
appropriate ones to prevent this problem from making an even
worse impact on the overall economy.

CAPITAL MARKETS

Secretary Paulson. Right, Senator, I assume since there's
just the two of you, I can take a little bit longer time, since
I took a lot of time on the chairman's question.
Senator Brownback. Fine.
Secretary Paulson. Because it's a very good question and I
think it deserves a thoughtful answer, and I've thought a lot
about it.
The, first of all, I've said for some time, that as we look
at this crisis, there's two focuses. First and foremost is
getting through this period with as little impact--negative
impact--as possible on the real economy, and so second, is
what's the policy response to reduce the likelihood of going
through this period again, something like this? And so we don't
want to do something up front that's going to compound the
problem in the short term, or to make it worse in the longer
term.
Now, there are a number of--even before you get to the
housing, that is why I have been, when we look at what's going
on with the capital markets turmoil right now, that I have been
so focused on having all of our financial institutions,
including the GSEs, raise capital that they need, so that they
can be active in, you know, in the market--lending, keeping up
their normal economic activities, as opposed to shrinking their
balance sheet.
Now, in looking at housing as I've looked at this, and I've
looked at a whole lot of things, first I focused on efforts
that would avoid what I would call a market failure. And the
level of adjustable rate mortgage resets that were coming is
such a wave that it wouldn't allow the private sector to react
the way they normally would react, which would be to have the
investor have time to strike a deal with each individual
mortgage holder, and work something out that was in both of
their best interest, because foreclosures are costly. And so
that's why this ASF protocol, and working the fast-track
modifications, to avoid avoidable foreclosures.
The other big effort we still have--we have a number of
things that have been done, are when you look at Fannie Mae and
Freddie Mac, that we have them today to go back far enough in
our history, we didn't, and they can play a constructive,
counter-cyclical role. And they have been, but to continue to
do so, they're going to have to raise more capital, and be very
active there.
Senator Brownback. What about tax credits and bankruptcy
reform?

BANKRUPTCY

Secretary Paulson. Oh, yeah, I would say this now, let me
get at both of those. In terms of bankruptcy reform, I've had
some very good conversations with your chairman, and he and I
have a very similar objective. We approach this differently,
and there's two reasons why I don't like the bankruptcy reform.
First, as a matter of property rights and contract, I don't
like the idea of retroactively changing contracts, and I'm
concerned with what it might do to financing availability going
forward.
But even more importantly in working through this, I am
emphasizing a program which says, if you're a homeowner, and
you want to stay in your home, and you can afford to stay in
your home--raise your hand. Call, reach out to someone. And
it's a lot quicker than slowing it down, and bogging down our
courts.
Senator Brownback. What about the tax credit ground?

TAX CREDITS

Secretary Paulson. Yeah, I think the, you know, the tax
credit, I understand the concept very well, because we're
looking at it--the overhang, and the inventory of unsold homes.
I think that what you're apt to get with that is something
that's going to prolong the issue. And so, net-net--although I
look at it as a creative idea, there have been some creative
ideas--we are much more focused right now, and let's get the
GSE reform, get the Federal Housing Administration (FHA)
modernization done, get the tax-exempt financing done, and so
we're not there on the tax credit. But, again, I understand
what people are seeking to get at with that proposal.

CONFLICT MINERALS

Senator Brownback. If I could just ask one more question in
the length of time we have. I've handed you a proposal, this is
on financing--terrorist financing, and also conflict
commodities financing, I think it's a topic you--the
administration has done a pretty good job of trying to get at--
terrorist financing.
I want to put another issue in your portfolio, and it's
conflict commodities in Africa, particularly from the Sudan and
Congo.
Secretary Paulson. Yes.
Senator Brownback. And that we really start targeting these
commodities coming out of conflicts so as to prevent further
exacerbation of the conflict.
Secretary Paulson. Yes.
Senator Brownback. Senator Durbin and I went to Congo
together, I've even got a picture of one of the coltan coming
out of Congo, financing it, now tin is being used--these are
kind of Mom and Pop mining operations.
Secretary Paulson. Yes.
Senator Brownback. This is kind of how they mine coltan
that's in your cell phone, or even tin out of Congo, this
picture is taken out of Congo. No other group--they've got a
proposal out of a draft piece of legislation saying that we
won't purchase commodities from conflict zones, where that
money is used to finance rebel groups.
I would urge you to look at it, because I think this going
to be one of the keys for us to try to stabilize Africa.
Secretary Paulson. Yes.
Senator Brownback. We need to keep the money from going to
these rebel groups, particularly like in the eastern Congo,
it's a classic place. I think it's also what we need to look at
in the Sudan.
Secretary Paulson. Yes.
Senator Brownback. There you've got a government that's
being primarily financed by oil and I think we need to be very
aggressive on this in looking at it.
And I would draw to your attention to one other thing, that
we have done, Senator Durbin and a number of others worked on
the Sudan Divestment Act that passed. I'd like to see us do a
similar one on Iran, as a way to divest and get money out of
the financing of the conflicts.
I draw that one more to your attention than for a response,
unless you give me a positive response, you don't need to
respond at all.
Secretary Paulson. How could I not be positive? Because
this is a real problem, and your leadership and the chairman's
leadership are very much appreciated on this. And I will pass
on the comments to Secretary Rice and others at the State
Department, because I think this is something that I know is an
important issue.
Senator Brownback. Thank you.
Senator Durbin. Senator Allard.
Senator Allard. Thank you, Mr. Chairman, thank you for
holding the hearing to examine the budget request for the
Treasury Department.
And it's a pleasure to be here, to be able to welcome you,
Secretary Paulson. We have an opportunity to see one another
quite frequently----
Secretary Paulson. Yes.

COSTS OF COINS

Senator Allard. And so I do appreciate the job that you're
doing and I apologize for being--not being able to be here to
hear your testimony this afternoon, we started markup on the
budget--we started debating the budget, and so, I'm on the
Budget Committee, so it's important that I at least be there
for the opening part of the Budget Committee debate.
I did want to stop by briefly to raise one issue which has
important appropriations implications, and I appreciate my
colleagues accommodating my schedule on this.
Last week on a radio program, you'd advocated for the
elimination of the penny, but added that you didn't think it
was politically doable.
Secretary Paulson. I didn't----
Senator Allard. If my information is correct.
Secretary Paulson. No, I did not advocate it. I've got no
intent, no plans to advocate it. What we're advocating, though,
very strongly, for is we have legislation that would change the
content of the----
Senator Allard. Well, that's what I'm getting at.
Secretary Paulson. The penny and the nickel.
Senator Allard. Yeah.
Secretary Paulson. Which would save the American taxpayer a
good bit of money.
Senator Allard. Okay. This was an Associated Press story.
They must have got that wrong in the story.
Secretary Paulson. Yeah, I said--what I had--we have no
intent or plans to----
Senator Allard. Well, we can still move forward with my
question.
Secretary Paulson. Right.
Senator Allard. Because I've introduced legislation, I
believe we've got bipartisan support on this, S. 1968, which
gives the flexibility to the Treasury Department to manage the
content of the coin.
Secretary Paulson. Right.
Senator Allard. Metal content. So, my question is, is--how
much do you think this could save, as far as the Treasury
Department is concerned, and how urgent do you think it is that
we get this changed, to give you the flexibility with the
changing metal market. You know, gold right now is at a
historic high, I think, and a lot of our metals are falling
right in behind that.
Secretary Paulson. Yeah, it is, you know, we're losing
money for every penny we mint and----
Senator Allard. Even a nickel, too, right?
Secretary Paulson. I don't have the number offhand--oh, the
nickel's even more. It's--I think the nickel--directionally
right, if it's, it costs 7.7 cents or something, to make a
nickel or 1.4 cents to make a penny, and I'll get you the
numbers.
[The information follows:]
Cost of Pennies and Nickels
Using current metal prices (February 2008), production costs this
year for the Mint will be more than 1.3 cents per penny and 7.7 cents
per nickel.

Secretary Paulson. But, when I looked at it over the period
of time, we're talking about hundreds of millions of dollars.
But, whatever the number is, there's no reason to be losing
money in a needless way. And so we just need to change the
metal content of those coins.

METAL CONTENT OF COINS

Senator Allard. Well, you know, and I sympathize with--
given you and the various agencies that you work with, the
flexibility to change that metal content. Because, you know,
all of these metals--they change in value from year to year,
and I don't think the action of the Congress can keep up with
it, and if we can do this in a way that saves taxpayer
dollars----
Secretary Paulson. Right.
Senator Allard [continuing]. I think we ought to do it. And
the sooner the better. And so anything you can do on that to
help us get the message out, we'd appreciate it. I do think
it's a very commonsense kind of piece of legislation, and
something that I think we need to do.
Secretary Paulson. It is. It is, very much.
Senator Allard. So, anything you can do on that, we'd
appreciate it.
And you know, I--I guess the question is, are there metals
that we would use that--we potentially could use--that we're
not using now?
Secretary Paulson. Yes.
Senator Allard. Yes.
Secretary Paulson. They are--they're composites, and
there's been a lot of work done on this.
Senator Allard. Is that right?
Secretary Paulson. And I'd be very happy to send some
people up to give you all the details on it, because there's
been a lot of good work done on this by the Mint.
Senator Allard. I would appreciate us being briefed on
that, if you would, please. And maybe other members of the
subcommittee would be interested in that.
Secretary Paulson. Go through the whole economic analysis.
Senator Allard. Okay, well, very good, well I'd like to
follow-up on that a little bit, and maybe we can all get that
information, get briefed together, or something. I don't know
if we need to have a formal hearing on it, Mr. Chairman, but if
you wanted to include it or something for the members of the
subcommittee, we could do that. But, I'm particularly
interested in it, and would like to have that information.
Thank you.
Senator Durbin. I thank the Senator from Colorado, and just
for the record the Lincoln penny was initiated 100 years ago,
on the 100th anniversary of Lincoln's birth. And the
bicentennial of that birth, next year, will result in four new
backs for the penny to show different aspects of Lincoln's
life. And the metal content is secondary to the people of
Illinois, as long as Lincoln's on the penny.
Secretary Paulson. But, we can do them both, right?
Senator Durbin. Right, no objection.
Secretary Paulson. We can do them both, and we celebrate
it.
Senator Durbin. Yes.

BANKRUPTCY

Mr. Secretary, Federal Reserve Chairman Bernanke recently
said, relative to the foreclosure crisis, ``Principal
reductions that restore some equity for the homeowner may be a
relatively more effective means of avoiding delinquencies and
foreclosure.'' And he continued, ``When the mortgage is under
water, a reduction in principal may increase the expected
payoff to the bank by reducing the risk of default and
foreclosure.''
I want to say a word about the bankruptcy provision which
you've alluded to, because Senator Brownback will get a chance
to consider that measure in a day or two in our Senate
Judiciary Committee.
Over the months since we've first initiated the concept, we
have changed it dramatically. Originally, we said that there
was no equity or justice in allowing a bankruptcy court to
modify the terms of a mortgage on a vacation condo, a farm or a
ranch, but to prohibit, by law, any modification of the terms
of a mortgage on a principal residence or a home. And so,
initially, we began with the premise, let's treat them all the
same, allow the bankruptcy court that option.
But, some have observed that that may have a negative
impact, so we have dramatically restricted the bankruptcy
reform that I am proposing. First, it's harder to get into
bankruptcy court today than it was 5 years ago. You have
chapter 13, which requires certain requirements, income
requirements and the like, before you can end up in the
bankruptcy court.
Second, we restricted this provision, this change, only to
homeowners, so no speculators need apply. You have to actually
live in the home we're talking about.
Third, we said only subprime mortgages for those homes.
Fourth, we said that any modification of the terms of the
mortgage could not reduce the principal any lower than fair
market value to protect--as best we can--the lender who, if
they're facing a distress sale, are lucky to see fair market
value.
Then we said the interest rate has to be based on the prime
rate plus a reasonable premium for risk. And, we added another
provision which, I think, is an effort to go an extra mile to
win back some support from the banking community, and it did
win the support of credit unions. If there is a modification of
the principal on a mortgage in a bankruptcy facing foreclosure,
and say a house is re-valued from $500,000 to $450,000, and
then in subsequent years, increases in value, back up over
$450,000--that delta, that change, that improvement--will go to
the lender. So, we're trying to protect the lender on the
downside fair market value and the upside, in terms of
appreciation.
What I'm troubled with is this reference by yourself and
bankers to the ``sanctity of the contract.'' I've seen some of
these contracts in our home State. There's nothing holy about
how these contracts were entered into. Many of them were
deception at its worst. People were taken advantage of. Poor
people, uneducated people, senior citizens.
And to hold these as ``holy instruments'' which now must be
respected, overlooks the obvious--when we changed the
bankruptcy code 5 years ago, we changed the impact of all of
the contracts that come in under bankruptcy. The sanctity of
the contract was never raised by the banks who wanted to change
the bankruptcy code for their advantage.
Now, when they may end up negotiating a contract of
mortgage which they've resisted negotiating, they're arguing
the sanctity, the ``holiness'' of the integrity of this
contract. And I will tell you, I can give you chapter and verse
of some that were as unholy as you can imagine.
Secretary Paulson. Can I respond to that?
Senator Durbin. Of course.
Secretary Paulson. Because there is no way you're ever
going to get me defending some of those loans. And I am
cheering on our law enforcement agencies, everyone that is
going after the fraud.
What I was talking about was taking a bankruptcy statute,
that was designed the way it was for a reason. The presumption
is the judge is going to--you're not going to be altering the
terms of a vacation home or a sailboat, or whatever. You're in
bankruptcy, the presumption is, you lose it.
Senator Durbin. Not in chapter 13.
Secretary Paulson. It's----
Senator Durbin. Not in chapter 13.
Secretary Paulson. But, I'll tell you, it's a much
different presumption when you're talking about your home. But
again, rather than--I just make two points, okay? And I'll just
make them again, and make them quickly. That, to me when you
change a bankruptcy statute and do it retroactively--I
recognize you've narrowed it, okay?--to change it
retroactively, it's something that gives me pause. And then
second, again, that when you look at bogging down the system
and dumping this in the courts when I think a simpler, more
effective way to deal with it is to have homeowners when
there's a problem, go deal with it.
And a large number of foreclosures we're seeing, from
everything I can learn, is homeowners not responding.
Senator Durbin. But, Mr. Secretary, let me tell you, you
said that earlier. ``If you can make the original payment and
can't make the reset, hold up your hand,'' you said. Well,
you've got hundreds of thousands of borrowers across America
who are in this predicament, and to say to them, ``You should
go take care of your problem.''
What I'm saying to you is, the response so far, the
voluntary response of your administration programs has reached
some, but not nearly enough to turn this crisis. The Fed--the
Chairman of the Federal Reserve, Mr. Bernanke, is basically
said what I am saying. That there comes a moment in time, that
if you want to turn this crisis, you have to deal with the
reality.
I don't want these people to go to bankruptcy court--if I
could just finish--I don't want these people to end up in
bankruptcy court. But if the lender understands that there is a
possibility of bankruptcy and modification, they are much more
likely to renegotiate the terms of the mortgage before
bankruptcy. Currently, there is no incentive.
Secretary Paulson. Listen, I very much appreciate what
you're trying to do and your motives, you appreciate mine. As
far as I know, Ben Bernanke is not advocating changing the
bankruptcy law retroactively. And again, there's a fact, and
the fact is that we're making a huge effort. There still are a
fair number of people that--a large number of people, a
disappointing number of people--aren't responding when they get
numerous letters and phone calls and they hear--and all I'm
saying is, wouldn't it be easier to--and how do you help
someone if they're not going to raise their hand and----

COUNSELING FUNDING

Senator Durbin. Then let me ask you this question, why did
the administration issue a statement saying that they would
veto the housing stimulus bill before the Senate last week, and
one of the reasons because it would have substantially
increased the number of counselors available for those facing
foreclosure. If your argument is that enough people aren't
seeking help, why did the administration say that that was one
of the specific reasons they would veto the housing stimulus
bill?
Secretary Paulson. Well, I missed that part of it, because
I will tell you that counseling is vital. And one of the things
that the administration has been advocating has been funding
for counseling, and funding a counseling partially by the
servicers at Hope Now, and the whole effort. And the 888-995-
HOPE number is to get people to call and get to counseling.
So, you know, I didn't read that part that you're referring
to, but I sure know that the--we've got a similar objective and
I appreciate the fact that you've narrowed it appreciably, and
again, I'm just giving you my----
Senator Durbin. Senator Brownback.

LOAN WORK OUTS

Senator Brownback. Thank you, and this is a good
discussion, because I remember the same discussion during the
farm crisis time period. And, a lot of these loans need to be
restructured.
Is it your belief that a number of the loans that people
want to restructure are being restructured by financial
institutions?
Secretary Paulson. I sure believe that.
Senator Brownback. Do you have any hard numbers that you've
been able to track or to look at?
Secretary Paulson. What we've got--here's some hard numbers
I've got. Some are encouraging and some are discouraging.
That, before this effort, 2 to 3 percent of the people were
responding to servicers, when they went to homeowners that were
facing resets or delinquent. Now, 20 percent are responding,
okay? So, that's a positive.
We have a hard number that since the beginning of putting
this together, that there have been 1 million homeowners who
have been helped--either, you know, through a, through a work
out of some sort.
We have hard numbers that this last--the last month, that I
was encouraged to see modifications and work outs growing
faster than foreclosure starts. But, I don't have numbers on
refinancings.
Part of the problem we have, Senator, is that--as I said
earlier, there are really--and the chairman made that point--
there were just egregious, some of the lending contracts and
some of the way people were put in these loans, and there--but
there were 18 percent of the 2006 adjustable rate subprime
mortgage holders defaulted 6 months before the first reset.
They couldn't afford the initial payment.
And so, there are, regrettably, going to be some people
that are going to return to becoming renters. But, again, I'm
going to work hard to make the Hope Now Alliance work, and work
better, we're going to work as hard as we know how to get the
data out there and to track it, and I've got to tell you, if
something isn't working the way it needs to work, then we're
open--and I'm sure open--to making modifications in the way we
approach things. We just have a----
Senator Brownback. Secretary, if I could, and I just wanted
to interject, and I appreciate you going through this--my raw
point on this would be that I really hope that the financial
institutions and the administration can make the work outs
work.
Secretary Paulson. Yes.
Senator Brownback. Because if it looks like things aren't
working or that the financial industry says, ``Look, we're just
going to dig in and start fighting on these,'' then I think the
issue comes back in front of the Congress at that point in
time.
So, I think there is a period where people can look at
this, and say, ``You know, the bank doesn't want the home
back,'' the financial institution doesn't want the home--they
want the person to stay in it.
But, a lot of times, people have gotten into something they
shouldn't have, or were talked into something that they
shouldn't have been. We are where we are today, and we all know
we've got a problem here, and I just think if we can make the
work outs work in substantial numbers across the country, then
great. I would presume, really, Senator Durbin would be very
happy with that.
If they don't, then it becomes a more difficult matter if
these numbers start jumping up. And that would be the point I
would like to make to you, on a raw basis.
Secretary Paulson. Senator, can I respond to that in one
way? Because no matter how well we make this program work,
given the excesses that were entered into, the foreclosures
will jump up. And there are a number of homeowners who were
speculators. There were a number of homeowners in hot markets
that put very little down, the first time there's some negative
equity from their home, they're going to walk away from their
obligation.
And I think the very interesting question there--to me,
it's not a difficult question, for some it's a more difficult
question, to me it isn't--that if someone is going to walk away
unless someone else pays for their losses, I don't want it to
be the Government or other taxpayers to pay for their losses.
To me, those are speculators, and that shouldn't be the focus
of our efforts.
Senator Brownback. Fair enough.
Secretary Paulson. And so, when you look at these
foreclosures, I'm focused on the same ones that Chairman Durbin
is focused on--in other words, homeowners that want to stay in
their home and are having trouble with----

REPATRIATION OF FUNDS

Senator Brownback. I want to build off of that point with
the little bit of time that I have here. It certainly strikes
me that one of the biggest things we all want to avoid is this
soft economy going on into a recession. The economy's soft,
credit's tight, and we don't want it to slide on into a
recession. I think the administration is trying to do
everything they can to stave off a recession.
One of the issues that I want to draw to your attention--
I'm sure you've looked at this--is repatriation of funds from
large corporations bringing back to the U.S. economy. Last time
we did that, that brought in $284 billion in earnings from
overseas back into the U.S. economy in a 1-year time period,
where normally we'd have about $70 billion in the same 1-year
time period. So, nearly a $200 billion infusion into the U.S.
economy. I hope the administration would look at something like
that as an infusion of cash into the economy, which we need to
have at this point in time.
Secretary Paulson. Senator, I thank you for pointing that
out. It's something we've looked at, it's something that I had
calls from a number of people I knew in the private sector
advocating very hard for that at the time we did the stimulus
package. And since we were very rigorous on the stimulus, in
terms of saying, ``Everything that went in had to be
stimulus,'' there are some things that are very good economic
policies, and, you know, I knew from a lot of experience, just
because a company brings cash back, doesn't mean they're going
to spend it, okay? And so, we focused much more on things that
were going to increase the likelihood that it'll be a real
stimulus.
But, I understand the incentives and motivations you're
talking about, and the wisdom of something like that, and I
thank you for bringing it.
Senator Brownback. Well, it strikes me that we may be
getting to a point where we want to put everything out there we
possibly can to keep the economy from going into recession. And
even if the corporations don't spend it, if it's sitting
overseas, they're for sure not going to spend it here.
Secretary Paulson. Right.
Senator Brownback. You've assured that one of taking place.
So, I think we ought to be looking at the next step on
this, just to----
Secretary Paulson. Right.
Senator Brownback [continuing]. Because things are tough
out there, and it looks like, it's going to be difficult for
the consumer to come back in the marketplace, to the degree or
level that we want. So that's going to depend upon a lot of
corporations and individuals investing, us being very
competitive with our exports--which have grown substantially.
Secretary Paulson. Yes.
Senator Brownback. Us expanding the energy industry
domestically, I just think now we're looking at some bit of
restructuring of our economy, probably a little away from the
consumer, and more towards exports, energy--and these are great
opportunities for us. I see you put some things on the energy
market, here, I hope we can do that.

ALTERNATIVE METALS FOR COINS

And just a final comment--I just hope you don't make the
penny out of plastic, or nickel out of plastic. Make it out of
some metal.
Secretary Paulson. Yeah, we're talking about composite
metals, right, we're just changing the metal content a bit.
Senator Brownback. All right, thank you. Unless it's wheat-
based plastics or something like that.
You know, maybe corn, being from Illinois, but just--don't
make it out of plastic.

COUNSELING FUNDING

Senator Durbin. We have a bipartisan position on that.
Mr. Secretary, when you get back, take a look at the
statement of administration policy issued February 26, this
year, relative to the housing stimulus bill on the floor, and
you'll see that the administration said that it would veto this
bill over the suggestion of tripling the funding for the
Neighborhood Reinvestment Corporation, which was expressly for
more counselors.
Secretary Paulson. Yeah, I just put in front of me, yeah.
You said it's because--I think the view is we've got plenty of
funding right now.
Senator Durbin. Well, I think that--I've been out, locally
in Chicago and all around our State, and I think that's
arguable. Because if we are reaching 20 percent, and still have
80 percent, some of that is because of lack of volition on the
part of the borrower, but it appears to me that there's a lot
more that needs to be done if there's truly going to be an
aggressive approach to this.
I would just like to close, and I'm going to give you a
chance to respond, because it's--what I'm about to say is
critical, and I want to hear your response to it.
When one of your senior counselors was asked yesterday
about the Treasury Department report on loan modifications
under Hope Now, 45,000 borrowers in January, the senior
mortgage banker who runs the Hope Now program said, and I
quote, ``A mortgage servicers obligation is to get the maximum
value to the investor over the life of loan. If you're going to
modify the loan and keep the borrower in the house, the bias is
to do that for a shorter, rather than a longer, period of time.
There's a reluctance to do long-term modifications.''
So, I think the 45,000 figure may be misleading. If it's
only temporarily suspending the foreclosure, it's not going to
help in terms of really trying to right this ship.
My concern from the beginning, is that I know the
administration's philosophy, that you have carried out, calls
for voluntary involvement by lending institutions. When we
suggest bringing in a bankruptcy court to try to force the hand
of some of these banks to finally renegotiate, the
administration opposes it, and says they'll veto a bill.
I have said, repeatedly, and I won't go into the graphic
detail, I don't think that the response to this housing crisis
is adequate. I think it is going to continue to get worse. And
as long as it worsens, and as long as the housing industry is
in such terrible shape across America, it's going to be hard to
see a sound economic recovery.
It isn't just the builders, and the speculators, and the
land developers, it's all the material men and skilled
craftsmen and everyone else who are, frankly, not doing much
work in my State of Illinois and around this country, waiting
for the housing market to come back. And those of us who own
homes are watching the values go down because of foreclosures.
And we're watching units of local government that will face
serious problems as assessed valuation goes down, and as
property tax revenue goes down that's used to sustain local
units of government.
If there was ever a time for someone to push away a Herbert
Hoover view of this, and say, ``We need a New Deal view of
this, that says there has to be something that's decisive, and
meaningful, and reaches the most number of people as quickly as
possible to turn this ship around,'' I think it's now. And the
longer we wait, the worse, I think, it's going to get.
And, I invite your response.
Secretary Paulson. Well, let me respond to that, and the
counseling.
I would say on counseling, I get out a fair amount, and
spend time with counselors, I'll be spending some time when I'm
out in California later this week, when I was in Chicago, I
spent time with NeighborWorks. And at least to date, when I've
talked with counseling firms, they're not impeded by a lack of
funds, okay? There's not--and so we're, because I just don't
want there to be a difference between us on that. Because this
is essential and it is, it's major.

LOAN MODIFICATIONS

Now, in terms of modifications, various firms take various
approaches to the modification. But to me, the focus I have is
having mortgage servicers make modifications that help people
stay in their home, and avoid foreclosure. And that is the
objective, it is--I think these are costly things to go
through, I don't think it's in the interest of either the
borrower or the lender, to have something not be sustainable.
All I can say to you is that on that effort, I'm going to drive
that as hard as I know how.
Now, in terms of your overall comment, where you talked
about Herbert Hoover--there's been a lot that's changed since
we went through the Depression and when the foreclosures were
50 percent and unemployment was 25 percent. We have GSEs, we
have the FHA, we have the Federal Home Loan Banks, that we're
going through a period now where 93 percent of the people in
this country, every single month, no matter how hard it is,
make their mortgage payment. Two percent--not 50 percent--are
in foreclosure.
Now, I believe when you say you think it's going to get
worse, I'm not arguing with you. I've said that I think that
those forecasters who say that this is an adjustment, a period
of adjustment, it's going to take longer to run its course--I
agree with them.
You know, when I look at the mortgages that were made in
2006, that are going to be reset over the next couple of years,
and when I look at some of the mortgages, the negative
amortization mortgages, which will be coming, now, even further
out--I recognize that this is going to take longer. And again,
I've told you where the focus is, and we're focusing very hard
on avoiding preventable foreclosures to those who want to stay
in their home, and have the capability to do that.
I appreciate you and I want to do the same thing. I'm going
to keep watching this very closely, we're going to be all over
it, and I, you know, as again, I know you've got the same
objective I do. We've got some--and you're supportive of Hope
Now, you're saying you think there should be some other things
done----
Senator Durbin. There should be more.
Secretary Paulson. And we're just----
Senator Durbin. Well, let me thank you for coming today and
testifying--we didn't talk much about your budget. But you will
get plenty of written questions on that, which we will submit
to you.
Secretary Paulson. Thank you.

ADDITIONAL COMMITTEE QUESTIONS

Senator Durbin. And we will provide those for you. And any
members who wish to make statements and allow them part of the
record, they will be included, and any questions in writing, I
ask that you try--I know you're a very busy man, but if you'd
try to respond to them in a timely fashion, we would appreciate
that very much.
[The following questions were not asked at the hearing, but
were submitted to the Department for response subsequent to the
hearing:]

Questions Submitted by Senator Richard J. Durbin

TRADE

Question. In Illinois, we continue to see losses in manufacturing
jobs that can at least in part be attributed to the forces of
globalization. The Trade and Globalization Adjustment Assistance Act of
2007 extends Trade Adjustment Assistance (TAA) to services sector
workers and workers affected by offshoring, creates a new TAA program
for rural and distressed communities, and makes training, healthcare,
and wage insurance benefits more accessible and flexible. Does the
Administration support strengthening Trade Adjustment Assistance along
these lines?
Answer. The Administration strongly supports TAA reauthorization
that includes needed reforms to help workers adversely impacted by
trade access the training and reemployment services they need to return
to work quickly.
Reauthorization provides an opportunity to redesign the TAA program
to make it more effective in enabling workers to gain the skills needed
to successfully compete in the 21st century global economy.
The Administration believes there are several flaws in the TAA
program as it is currently designed. These flaws include:
--TAA is an ``all or nothing'' program, where participants lose
access to benefits by choosing to return to work.
--Training options are limited and the process of applying for
training is lengthy and bureaucratic.
--Services cannot be provided until after the worker is laid off--
even when the layoff is announced well in advance.
--There is no requirement that One-Stop Career Centers provide
``wrap-around'' services such as career counseling, assessment
and job placement assistance to all TAA participants through
the Workforce Investment Act (WIA).
The Administration believes any reauthorization of the TAA program
should reflect the following priorities:
--Workers must have increased choice to combine employment with
training and ``earn while they learn.''
--Training options should be flexible and easy to access.
--Services should be available prior to layoff, in order to reduce
the length of time workers are unemployed.
--Integration with the Workforce Investment System should be improved
by requiring states to ensure workers have access to the full
range of services available through the One-Stop Career Centers
under WIA.
Question. It is difficult for workers to complete some courses
under the current TAA restrictions because it simply takes longer to
finish the programs than TAA allows. For example, Illinois has an acute
shortage of nurses, and yet the state is unable to find enough people
either to teach the training courses or to complete the programs. This
is a high-growth area for workers that cannot be readily outsourced.
However, our TAA rules make it nearly impossible for displaced workers
to enter the nursing profession because the program takes longer to
complete that TAA allows for training. Do you support common sense
updates to Trade Adjustment Assistance rules that would address
difficulties like this?
Answer. The Administration believes that a high priority for TAA
reauthorization is that trade-affected workers must have increased
individual choice to ``earn and learn'' by having access to
transitional benefits, such as education and training post-employment
and transitional income support (in certain cases). Benefits under the
program should include a menu of ``New Economy Worker Services'' that
allows the worker to choose the option that best fits his or her
individual needs. For example, training-related options should allow a
worker to combine either full or part-time work with education and
training. Similarly, the reauthorization would ensure greater access to
education and training by providing ``New Economy Scholarships'' to
workers that could be used over four years. Additional monies would
also be available to workers who need pre-requisites for training in a
high demand occupation. The New Economy Scholarship should be portable,
enabling certified workers to have access to tuition assistance whether
they are unemployed or return to employment. Workers should be able to
choose to attend training full or part-time and use the funds for
tuition, books, fees and required tools.

INTERNATIONAL SANCTIONS: SUDAN

Question. Does the Bush Administration intend to enforce the Sudan
Accountability and Divestment Act, which I worked very hard to pass in
conjunction with Chairman Dodd and Chairman Frank over in the House,
along with the Ranking Member of this committee, Senator Brownback?
The Treasury Department will provide to Congress the reports called
for in Section 10 of the Act. Section 6 of the Act governs the
Executive Branch concerning government contracts with companies that
conduct certain business operations in Sudan. The Treasury Department
intends to comply with that provision once the Federal Acquisition
Regulation is updated by the Federal Acquisition Regulatory Council, as
provided for in the Act.
If so, why did the Administration issue a signing statement that
left in doubt whether that would be the case? If not, why did President
Bush sign the bill?
Answer. The Department respectfully recommends that these questions
be directed to the White House.

INTERNATIONAL SANCTIONS: CUBA

Question. Do you think that the United States should view the
transfer of power from Fidel Castro to his brother Raul as an
opportunity to strengthen ties to Cuba? Or do you think our policies of
sanctions and non-communication should continue? What benefits are
derived from a stay-the-course, status-quo approach to Cuba that would
maintain the policy of isolating the Cuban government with economic
sanctions? Is any consideration being given to an approach aimed at
influencing the Cuban government through an easing of sanctions and
increased contact and engagement? If not, why not?
Answer. The United States foreign policy positions are defined by
the State Department. The Office of Foreign Assets Control (OFAC)
administers and enforces the country sanctions against Cuba, which
restrict the flow of funds to Cuba that would otherwise be used to prop
up the regime rather than benefit the Cuban people. The
Administration's policy has been designed to prevent resources from
reaching the regime, which uses its resources to control and oppress
the Cuban people. We will continue to monitor developments closely and
stand ready, if asked, to assist a genuine Cuban transition government
committed to democracy.

REDUCTION IN REQUESTED CDFI FUNDING

Question. Compared to fiscal year 2008, proposed reductions could
jeopardize $700 million in private capital for CDFIs that could
otherwise be made available to communities and individuals currently
facing credit shortages. Why are you recommending such a drastic
reduction to a program that demonstrates such a tremendous return on
the taxpayer's dollars?
Answer. The fiscal year 2009 President's budget includes over $28
million for the CDFI Fund, which will be used to expand the capacity of
financial institutions to provide credit, capital and financial
services to underserved populations and communities. Specifically, the
CDFI Fund will continue to provide grants, loans and equity investments
through the CDFI Program, allocate tax credits through the New Markets
Tax Credit Program, and support the CDFI Fund's existing grantees.
The fiscal year 2009 President's budget does not propose funding
for the Bank Enterprise Award (BEA) Program. The BEA Program provides
funds to for-profit banks based on their past activity, and has not
demonstrated that its awards increase lending and financial services in
economically distressed communities. The BEA program is in the process
of modifying the program's regulations. With these revisions in place,
any future BEA funding will encourage future community development
activities, rather than reward past activity. This change aligns BEA
Program activities with the CDFI Fund's goals and objectives.
In fiscal year 2009 the CDFI Fund will continue to serve Native
communities through the CDFI Program; however, the fiscal year 2009
President's budget does not include a separate request for Native
Initiatives.
Question. How do you reconcile this proposed reduction with the
Administration's concern with the shrinking availability of credit?
Answer. The Department of the Treasury encourages the availability
of capital and credit to all communities, including low-income, through
a broader system of financial institutions. While the CDFI Fund
provides capital and credit to financial institutions serving low-
income communities it is not the only source of funding available to
these institutions. These intuitions may also receive funds from
various federal, state, and local entities, such as the U.S. Department
of Health and Human Services, U.S. Department of Agriculture, state
economic development agencies, and local municipalities. Non-government
funding sources for these financial institutions include banks,
thrifts, credit unions, and non-regulated institutions such as loan
funds and community development venture funds.

ECONOMIC STIMULUS REBATES

Question. I understand that you anticipate that IRS will begin
sending rebate checks starting in May. When do you project that the
payments will have a noticeable positive impact on the economy?
Answer. The first economic stimulus payments will be issued by
direct deposit beginning May 2, 2008. The first paper checks will go
out beginning May 16, following the schedule outlined below.

STIMULUS PAYMENT SCHEDULE FOR TAX RETURNS RECEIVED AND PROCESSED BY
APRIL 15
------------------------------------------------------------------------

------------------------------------------------------------------------
Direct Deposit Payments

If the last two digits of your Social Your economic stimulus
Security number are: payment deposit should be
sent to your bank account
by:
00-20................................. May 2
21-75................................. May 9
76-99................................. May 16

Paper Check

If the last two digits of your Social Your check should be in the
Security number are: mail by:
00--09................................ May 16
10--18................................ May 23
19--25................................ May 30
26--38................................ June 6
39--51................................ June 13
52--63................................ June 20
64--75................................ June 27
76--87................................ July 4
88--99................................ July 11
------------------------------------------------------------------------

Based on the payment schedule, the Department projects that the
stimulus will begin to provide a meaningful boost to spending almost
immediately and that its effect on economic growth will be felt through
the rest of the year. The Department also anticipates that the
individual and business tax relief components of the package together
could lead to the creation of over half a million jobs by the end of
the year.

NEW 24/7 OPERATIONS CENTER

Question. The President's 2009 budget for the department requests
$6.2 million for a new Operations Center, which would provide 24/7
capability to monitor the global market. How will the enhanced
capabilities of the new Operations Center support Treasury's mission?
Answer. The Department of the Treasury serves the American people
and strengthens national security by managing the U.S. Government's
finances effectively, promoting economic growth and stability, and
ensuring the safety, soundness, and security of the United States and
international financial systems.
The global scope of the Department's operations requires a 24/7
response capability. The Treasury Operations Center will act as a
fusion center for the receipt, analysis, and dissemination of
information critical to the economic well being of the country. It will
have enhanced analysis capabilities necessary to monitor international
and domestic financial markets, coordinate actions with other Federal
agencies, foreign governments, and global financial markets, and manage
the Treasury's global operations on a round the clock basis. It will
have a capability to integrate open source and classified information
that currently does not exist in the Treasury organizational structure.
The speed with which financial information is processed and the fact
that decisions facing the United States are not limited to weekdays
from 9-5, dictate the creation of a 24/7 facility that will protect and
enhance the fiscal power and reach of the United States Government.
Additionally, the Treasury Operations Center will act as a
communications hub for information directly related to the financial
markets as well as to national and world events that affect the
markets. This communications hub will tie together the Treasury program
offices with their private sector counterparts, foreign financial
ministries, and other federal government entities. The Treasury
Operations Center will engage directly with international financial
market participants, foreign governments, international financial
institutions, and in multinational fora in an immediate time-sensitive
manner. Open and secure communications capabilities will be available,
as will a 24/7 executive switchboard.
Lastly, the Treasury Operations Center will function as a crisis
management center. It will be the hub for activities bringing senior
Treasury Department officials together to manage rapidly developing
issues affecting the financial community (for example, managing the
recent sub-prime mortgage situation and bolstering confidence in the
investment banking community). Current financial crises require the
Secretary to manage operations on a daily if not hourly basis, as well
as implementing policies that affect the future course of the nation's
economic health. Open and secure conference rooms will be available,
along with fully equipped private office space.

CROSS-BORDER WIRE TRANSFERS

Question. In October of 2006, Treasury's Financial Crimes
Enforcement Network released a study that found that it is technically
feasible to require financial institutions to report data on wire
transfers that cross borders. What is the status of Treasury's efforts
to implement reporting of Cross-Border Wire Transfers?
Answer. The Financial Crimes Enforcement Network (FinCEN) continues
to study regulatory proposals for the collection of Cross-Border
Electronic Transmittals of Funds. FinCEN is currently analyzing the
costs and benefits of a proposed regulation that will affect law
enforcement and regulatory agencies, and the financial industry. Upon
completion of the study, a report will be provided to the Secretary for
review and consideration.
Question. Have you conducted any analyses in order to weigh the
additional costs that data reporting on cross border wire transfers
might impose on the financial sector against the benefits of gathering
this data?
Answer. As mentioned above, FinCEN is actively engaged in a review
of the costs and benefits of a proposed regulation to collect Cross-
Border Electronic Transmittals of Funds. Data collection efforts that
contribute to the evaluation of costs and benefits include surveys, in-
person interviews, and ``use case scenarios.'' Specifically, FinCEN has
reached out to affected parties of the Bank Secrecy Act Advisory Group
(BSAAG), a statutorily created forum for discussing Bank Secrecy Act
(BSA) administration, to assess the impact on industry. FinCEN has also
coordinated with the Federal Reserve Board to survey financial
institutions that transmit funds internationally. This voluntary survey
asked institutions to identify the impact of a reporting requirement,
including the cost of reporting such information. Finally, FinCEN
conducted in-person interviews with law enforcement and regulatory
agency officials and collected ``use case scenarios,'' which are
specific examples of exactly how the agencies would use the cross
border data and its resulting benefits.

BUDGETARY IMPLICATIONS OF CUBA SANCTIONS

Question. How many fiscal year 2008 budget and staff resources
(stated in dollars and actual staff, either part-time or full-time, and
work location) are presently designated for administering the Cuba
sanctions? What proportion of total Treasury/OFAC resources do those
levels represent?
Answer. Most of OFAC's Cuba-related work is centered in its
Licensing Division and includes processing applications for travel to
Cuba to market and sell agricultural products to Cuba as provided for
by the Trade Sanctions Reform and Export Enhancement Act of 2000, as
well as applications to engage in family and religious travel and other
Cuba-related transactions. Of the 155 OFAC FTE, six FTE (approximately
$1.1 million) in Washington, DC and five FTE (approximately $.9
million) in Miami, FL are devoted full-time to the Cuba program. These
eleven FTE represent approximately seven percent of OFAC's budget. In
addition, some other individuals, including supervisors, who dedicate
time to one or more of the other 20-plus sanctions programs
administered by OFAC, work on aspects of the Cuba program as necessary.
Question. How do those levels compare to the resources that are
devoted to the other sanctions programs that OFAC implements, including
sanctions related to terrorism, weapons proliferation, and narcotics
trafficking?
Answer. The balance of OFAC's budget (approximately ninety-two
percent) is devoted to the other 20-plus sanctions programs that OFAC
implements, including those related to Iran, Sudan, terrorism, weapons
proliferation, and narcotics trafficking. However, as noted in the
response to the question above, some individuals, including
supervisors, who dedicate time to one or more of the other sanctions
programs administered by OFAC, work on certain aspects of the Cuba
program as necessary.
Within OFAC's Designations Investigations Division, there are
currently six FTE (two of which are currently vacant) devoted full-time
to administering counter-terrorism sanctions programs; eight FTE
devoted full-time to administering counter-proliferation sanctions
programs; eleven FTE devoted full-time to administering counter-
narcotics sanctions programs; and eight FTE (two of which are currently
vacant) devoted full-time to administering country/regime sanctions
programs. These figures are fluid and the resources assigned to
administer these programs can change at any time to accommodate foreign
policy interests and national security priorities. The FTE within the
other operating divisions (Licensing, Policy, Compliance, Civil
Penalties and Enforcement) are not assigned to administer and implement
specific sanctions programs; rather, these divisions assign employees
on a cross-program basis.
It should be further noted that in 2005, as part of the creation of
the Office of Terrorism and Financial Intelligence, twenty-three
analysts assigned to OFAC's terrorism sanctions program in the Foreign
Terrorist Division of OFAC were transferred to Treasury's Office of
Intelligence and Analysis (OIA) to form the nucleus of OIA's analytic
team. These analysts have continued to support OFAC's counter-terrorism
sanctions program through in-depth targeting, research, analysis, and
drafting of evidentiaries. Over time, the number of analysts assigned
to counter-terrorism work in OIA has grown to thirty-five,
strengthening and deepening Treasury's counter-terrorism sanctions
program and also allowing OIA to provide expanded analytical support to
the Treasury Department and interagency community on terrorist
financing matters.
Question. How do the fiscal year 2008 levels (resources and
staffing) compare to funds and personnel devoted to Cuba efforts in the
previous four fiscal years (fiscal years 2004 through 2007)?
Answer. In fiscal year 2008, OFAC employed new strategies on Cuba
matters in the Enforcement and Civil Penalty divisions that have
reduced and are expected to continue to reduce resources committed to
Cuba; specifically, OFAC increased its targeting of enforcement efforts
by concentrating on those facilitating illegal travel to Cuba. It is
expected that the percentage of staff time expended by the Enforcement
and Civil Penalties divisions on Cuba matters will decrease as a result
of the new strategies being deployed. Resources and staffing devoted to
Cuba will otherwise remain consistent with the previous four fiscal
years (fiscal years 2004 through 2007).
Question. Please provide the Subcommittee with a data table
detailing the resources (dollars and personnel) allocated for fiscal
year 2008 for investigating and penalizing violations of the Cuba
embargo, describing the types of activities involved, and specifying,
for comparison purposes, the amounts dedicated to each of the other 20-
plus sanctions programs that OFAC administers.
Answer. As noted above, OFAC has adopted new strategies with
respect to sanctions violations in recent years. These strategies have
resulted in a significant reduction in Cuba penalty cases. Enforcement
resources committed to Cuba are also being reduced and enforcement
efforts are being targeted in a more effective way by concentrating on
those facilitating illegal travel to Cuba. The data table below
identifies the FTE within OFAC that are devoted to administering and
implementing the Cuba program for fiscal year 2008.
As previously noted, some individuals, including supervisors, who
dedicate time to one or more of the other 20-plus sanctions programs
administered by OFAC, work on aspects of the Cuba program as necessary.
Because of the significance and demands related to the other programs
to which these individuals are assigned, OFAC does not track their time
spent on the Cuba program. For comparison purposes approximately
ninety-two percent of OFAC's budget is devoted to other sanctions
programs that OFAC implements, including sanctions related to Iran,
Sudan, terrorism, weapons proliferation, and narcotics trafficking.

FISCAL EYAR 2008
[Dollars in thousands]
----------------------------------------------------------------------------------------------------------------
Cuba All other programs Total
Divisions with FTE dedicated to a specific -----------------------------------------------------------------
program \1\ FTE Dollars FTE Dollars FTE Dollars
----------------------------------------------------------------------------------------------------------------
Licensing..................................... 11 $1,969 ......... ......... 11 $1,969
Designations Investigations:
Counterterrorism.......................... ......... ......... 6 $1,041 6 1,041
Counterproliferation...................... ......... ......... 8 1,388 8 1,388
Counternarcotics.......................... ......... ......... 11 1,909 11 1,909
Country/regime............................ ......... ......... 8 1,388 8 1,388
-----------------------------------------------------------------
Total................................... 11 1,969 33 5,726 44 7,695
----------------------------------------------------------------------------------------------------------------
\1\ As noted above, OFAC's other operating programs assign FTE on a cross-program basis rather than to a
particular sanctions program.

MANAGEMENT OF TREASURY'S IT SYSTEMS

Question. The Inspector General's 2008 Annual Plan repeats a
continuing concern with the Department's management of large capital
investments--particularly information technology (IT) investments.
While this is a challenge for any organization, the Department has had
particular problems in this area. How are you addressing these
deficiencies from a department-wide perspective? What measures and
procedures are in place to ensure the success of new systems?
Answer. Over the past year, the Department has taken a number of
significant steps to address the IT management challenges. The
Department's strategy has focused on three key elements: (1) regular
engagement of the Treasury Department and Bureau executives in the
management of IT; (2) more rigorous planning and management of IT
projects; and (3) improved IT investment review and evaluation tools,
processes and practices.
In order to better engage executives across Treasury and its
Bureaus, the Department has revitalized the Executive Investment Review
Board (E-Board), which was a key recommendation by the Government
Accountability Office's July 2007 report (GAO-07-865). The E-Board was
re-chartered in December 2007 and held its first meeting in February
2008. The E-Board is chaired by the Deputy Secretary and is comprised
of the heads of each of the Department's Bureaus. The Assistant
Secretaries for Management and Legislative Affairs, the General Counsel
and the Chief Information Officer (CIO) also participate on the E-
Board. The E-Board is tasked with ensuring the Department's IT
portfolio decisions are driven by Treasury's business requirements and
that each Bureau and the Department have in place appropriate planning,
monitoring and evaluation mechanisms. The E-Board will also identify
strategic priorities for IT use and address Department-wide IT policy
issues as they arise.
To improve the effectiveness of planning and management of IT
projects, the Treasury CIO has issued new policy and guidance regarding
requirements for project planning in order to receive CIO endorsement
for funding. The CIO, in collaboration with the Treasury Chief
Procurement Executive, has drafted a new IT acquisition policy to
strengthen the Department's IT contract management. The Department is
working with the bureaus to implement the new OMB required, Federal
Acquisition Council Project and Program Management qualifications to
ensure that the Treasury federal staff that oversee our IT projects
have the appropriate knowledge and skills required to successfully
deploy and manage Treasury IT systems. Finally, the Department
continues to strengthen its ability to defend against cyber attacks and
protect the sensitive information entrusted to the Treasury by the
public.
Another element of the Department's overall IT management strategy
is to improve the review and evaluation of Treasury IT investments.
Rigorous review at both the bureau and Department level is a
prerequisite for successful deployment and management of IT systems. In
addition, the Treasury CIO has taken action to improve the Department's
visibility into and influence on IT projects. In the fall of 2007, the
Treasury CIO made the decision to require non-major investments to
participate in a process similar to the Department's formal selection
and review processes for major investments. As a result, all IT
investments (both major and non-major) are considered during the
portfolio selection process that is integrated with the Department's
budget request. Likewise, bureaus must report quarterly for all IT
investments (both major and non-major) on cost, schedule, and
performance goals. Finally, the Treasury CIO is expanding its IT
investment evaluation process to assess not only ``completed'' projects
against planned objectives, but also those portions of IT developmental
projects that have implemented discrete operational components.
Question. The President's fiscal year 2009 budget requests $2.9
million to fund an upgrade to the IT system used for financial
reporting under the Bank Secrecy Act. In July 2006, FinCEN halted work
on BSADirect, the previous attempt to upgrade its IT systems. Treasury
spent two years of planning and $14.4 million on that failed system.
What improvements have you made to the planning and implementation
process that will avoid problems that plagued the previous failed
upgrade?
Answer. During fiscal year 2007, FinCEN made significant progress
on the full range of organizational, program management, and technical
architecture-related efforts needed to modernize the bureau's IT
systems. FinCEN identified the specific action items in its October
2006 Information Technology Plan, created in response to the BSA Direct
project termination. In fiscal year 2007, FinCEN launched an effort to
establish the organization's first enterprise business transformation
and IT modernization strategy, which serves as the roadmap for aligning
FinCEN's IT portfolio with business objectives and processes. FinCEN
also expanded its capacity for executing complex IT projects by (1)
hiring new project managers; (2) introducing management tools and
techniques through the creation of a Project Management Office; (3)
establishing a Data Management Framework to improve the management and
visibility of BSA data issues; (4) awarding a performance-based
contract for acquiring IT services; (5) and strengthening collaboration
with internal and external stakeholders. FinCEN is also fully engaged
in Treasury's revised processes in the question above.
Question. The President's fiscal year 2009 budget requests $3
million for a new debt management system. Treasury reports that the new
system will enhance the efficiency of federal borrowing, which will
save taxpayers money. How much do you estimate that the current system
is costing taxpayers? What kind of return will the taxpayers get on
this investment?
Answer. Currently, Treasury's Office of Debt Management (ODM)
spends approximately $600,000 annually to manage its $9+ trillion
liability portfolio. Given the size of the portfolio, ODM believes
there is significant opportunity cost foregone due to its current
outdated IT infrastructure and modeling capabilities which limit
sophisticated portfolio analysis.
Treasury issues $4.3 trillion of debt per year using basic Excel
spreadsheets and manual operations. The current size of Treasury's
marketable debt portfolio is $4 trillion, with an annual interest cost
of $244 billion in 2007. The additional funds to improve ODM's systems
will make a huge difference in costs. For example, if the Department
can issue just $1 billion less over a one month period due to better
portfolio analytics and sound modeling capabilities, Treasury would
save $3 million at current interest rates. Over the long term, the
Department could potentially save one one-hundredth of a percent
(.0001) on the $4 trillion marketable debt portfolio, resulting in
potential interest costs savings of over $400 million annually. We
believe this cost saving is conservative, and that additional savings
are eminently possible given better risk management systems and
operations.
More importantly, for global financial markets, a disruption in the
ability to make debt issuance decisions or the inability to function in
the event of a contingency event would precipitate severe financial
distress and cost. Since every fixed income market in the world is tied
to the Treasury market, such disruption would be significantly costly
from a financial perspective.
The proposed systems would provide: (1) a robust infrastructure on
top of the new Treasury auction system (providing 24/7 reliability,
back office servicing, and applications development), (2) a secure
contingency site with numerous business continuity options, (3) the
ability to remotely access and make debt issuance recommendations, (4)
the ability to make informed debt issuance decisions using advanced
portfolio analytics, (5) the ability to provide key interest rate data
to Congress as mandated and to financial markets as necessary without
interruption, and (6) major infrastructure upgrades (including servers
which are severely antiquated). The immediate implementation of these
systems is necessary for the national and financial security of the
United States.

COMMITTEE ON FOREIGN INVESTMENT IN THE UNITED STATES (CFIUS)--CASELOAD
MANAGEMENT

Question. The Foreign Investment and National Security Act of 2007
became law in July of 2007, increasing Congressional oversight of the
CFIUS review process. How is the Department preparing to meet the
increase in requirements under the new law?
Answer. CFIUS and Treasury have been in compliance with the
requirements of the Foreign Investment and National Security Act
(FINSA) since FINSA became effective in October 2007. To ensure that
Treasury and all CFIUS agencies comply fully with FINSA and meet the
increased Congressional oversight requirements that it presents, the
Department has made multiple changes and taken multiple steps, which
include: increases in staffing levels, increases in accountability, and
higher level cooperation between CFIUS agencies and agencies outside of
the CFIUS process.
Regarding staffing, Treasury and other CFIUS agencies have
substantially increased staffing for CFIUS-related issues. In Treasury,
we established a new Deputy Assistant Secretary position focused on
CFIUS issues and reporting to the Assistant Secretary and the Under
Secretary for International Affairs. Treasury has also hired additional
staff to handle the increased requirements, including reporting
requirements under FINSA and the increased case load. The total number
of full-time staff assigned to work on investment security issues in
Treasury has nearly tripled, rising from 5 full-time positions to 14.
On accountability, CFIUS has implemented formal processes to ensure
that CFIUS matters are fully considered at the highest levels. This
includes strong internal procedures to ensure that every case is
certified at the Assistant Secretary or Deputy Secretary level, as
appropriate, that the required post-review or post-investigation
certifications are submitted to Congress in a timely manner, and that
requested briefings are provided to Congress as required.
On coordination, Treasury (in consultation with other CFIUS
agencies) has issued internal CFIUS guidelines to ensure that the
reporting requirements under FINSA are fully satisfied in a timely
manner. CFIUS agencies meet each week to discuss and deliberate on all
cases before CFIUS, and where appropriate, outside agencies and
departments (such as the Departments of Transportation and Health and
Human Services, and NASA) are called on to bring their expertise into
the CFIUS process. Improvements have also been made in intelligence
analysis, which is now being coordinated by the Director of National
Intelligence, who is consulting with each of the key intelligence
agencies in the U.S. government. Further, the Executive Order issued by
the President on January 23, 2008, establishes executive branch rules
to ensure that CFIUS is able to meet the reporting requirements under
FINSA in an efficient and orderly manner. Treasury is coordinating with
other CFIUS agencies to submit the required annual report to Congress
by July 31, 2008.
Question. I understand that the CFIUS caseload has increased over
the last few years. Why are we seeing such a dramatic increase, and how
is Treasury adapting to respond to this increase while ensuring that
the CFIUS cases are completed in a reasonable time frame?
Answer. There are numerous reasons for the recent increase in the
CFIUS caseload, including the rate of foreign direct investment into
the United States, heightened public awareness of the CFIUS review
process following several high-profile cases in recent years, and
increased recognition among businesses that certain transactions could
raise national security considerations in the current security
environment. In addition, there have been a number of ``defensive''
filings where there is a cross-border acquisition that has little
relevance to national security.
In the last few years, Treasury has made numerous organizational
and procedural improvements to ensure that all cases continue to be
processed efficiently, with all national security considerations fully
analyzed. As noted above, Treasury established a new Deputy Assistant
Secretary position in 2006 focused on CFIUS issues. Treasury has also
hired additional staff to focus on CFIUS issues. Meanwhile, the
increased caseload requires additional resources to be dedicated to
CFIUS matters. The regulations and guidance that Treasury will be
publishing this spring will also help ensure an efficient process.
Further, CFIUS agencies have made it clear to companies and their
advisors that, where appropriate, advance pre-filing briefings and
consultations ensure that CFIUS has adequate time for reviews.

INTEGRATION OF TREASURY INTO U.S. INTELLIGENCE COMMUNITY

Question. How well is the Office of Terrorism and Financial
Intelligence being integrated in the intelligence community?
Answer. Since its creation in 2004, the Office of Intelligence and
Analysis (OIA)--Treasury's Intelligence Community (IC) component--has
become a fully-integrated member of the IC. OIA is recognized as a key
player in IC efforts to address the financial underpinnings of national
security threats and threats to international financial stability. The
Assistant Secretary for Intelligence and Analysis is a member of the
Director of National Intelligence's (DNI) Executive Committee (the IC's
``Board of Directors'') and OIA is an active participant in the various
working groups and committees guiding IC efforts against key threats,
including the National Intelligence Analysis Production Board, the
Counterterrorism Advisory Group, the IC Leadership Council, the WMD-T
Steering Group, and the Interagency Intelligence Committee on
Terrorism. The Office of the Director of National Intelligence recently
acknowledged OIA's status as a key IC figure by asking it to serve as
the National Intelligence Priorities Framework Topic Expert for
Economic Stability and Financial Networks.
OIA routinely coordinates on (and provides input to) articles
drafted for the National Terrorism Bulletin (NTB) and the President's
Daily Brief. In addition, OIA provides regular support to the Federal
Bureau of Investigations (FBI) counterterrorism investigations, and
frequently offers input to counterterrorism and counter-proliferation
analytic products drafted by the FBI, the Central Intelligence Agency
(CIA), and other IC agencies. On numerous occasions, OIA analysts have
drafted intelligence reports jointly with their counterparts at the FBI
and CIA. In order to strengthen cooperation with these agencies, OIA
has detailed officers to the FBI's Terrorist Finance Operations Section
and to the CIA. OIA also has officers forward-deployed to U.S. Central
Command, U.S. Pacific Command, U.S. European Command, and the joint
Treasury-DOD Iraq Threat Finance Cell in Baghdad. OIA is in the process
of identifying an officer to serve as Treasury's representative to the
DNI's National Intelligence Coordination Center (NIC-C). The Defense
Intelligence Agency, and the National Security Agency have assigned
officers to OIA to facilitate cooperation and information sharing.
Question. What improvements are needed to maximize the ability of
Treasury and other components of the intelligence community to exchange
critical information?
Answer. OIA's fiscal year 2009 Global Finance Initiative (GFI)
would give Treasury the resources it needs to successfully leverage its
status as a fully-integrated member of the IC. GFI would provide $2
million, including a realignment of $1 million in Department base
resources, and 10 positions to establish a capability in OIA to advance
global finance intelligence issues within the IC. Resources would be
targeted to: (a) aligning IC collection requirements on finance-related
issues more closely with policymaker needs, (b) developing and taking
advantage of new sources of information, (c) enhancing analysis on
finance-related issues in coordination with the IC, and (d) expanding
OIA's role and relationships within the IC. This initiative is aligned
with key tasks and objectives of the National Security Strategy, the
National Intelligence Strategy, the National Implementation Plan for
the War on Terror, and the Treasury Strategic Plan.
GFI would enhance the effectiveness of IC collection and analysis
on global financial networks. Addressing global financial networks
involves assessing the financial underpinnings of national security
threats, identifying our adversaries' financial vulnerabilities,
measuring the impact of targeted financial measures, and uncovering
threats to the stability of the international financial system. By
assuming a greater role in guiding financial intelligence collection
and analysis, OIA would address a growing need in the IC, and take a
large step toward meeting the expectations of Congress and Treasury
leadership when they created OIA.
Question. What organizational, technical, or other types of
barriers hamper the ability of the office to fit successfully into the
overall intelligence community, and how are those impediments being
addressed?
Answer. Since its creation in 2004, the Office of Intelligence and
Analysis (OIA)--Treasury's Intelligence Community (IC) component--has
made great strides in its efforts to integrate itself into the IC. OIA
is recognized as a key player in IC efforts to address the financial
underpinnings of national security threats and threats to international
financial stability. OIA's fiscal year 2009 Global Finance Initiative
(GFI) would give Treasury additional resources for aligning collection
requirements on finance-related issues more closely with policymaker
needs; developing and taking advantage of new sources of information;
enhancing analysis on finance-related issues in coordination with the
IC; and expanding OIA's role and relationships within the IC.
Despite these advancements, OIA faces significant challenges in
hiring highly qualified analysts. The conventional hiring process is
cumbersome and lengthy, and competition within the Intelligence
Community for qualified candidates is fierce. The Treasury Department
strongly supports section 121 of the fiscal year 2009 Intelligence
Authorization Bill, which establishes the authority to convert
positions within the intelligence component of the Treasury Department,
DHS, and other departmental intelligence components to excepted service
status, which would go a long way towards leveling the playing field.
______

Questions Submitted by Senator Sam Brownback

Question. Could you give us an update on how your ``HOPE NOW
alliance'' is working to prevent further foreclosures in the nation's
housing market?
Answer. Treasury is pleased with progress of the HOPE NOW Alliance,
a private group of lenders, servicers, non-profit counselors and trade
organizations that was initially facilitated by Treasury and HUD.
However, we recognize more work remains. As of February 29, 2008, the
industry had helped almost 1.2 million homeowners find alternatives to
foreclosure through either a loan modification or repayment plan since
July of 2007. These data do not include refinancing statistics. Of
particular significance is the fact that modifications are continuing
to rise as a proportion of work-outs. In February alone, 39,000
subprime borrowers received loan modifications. Modifications accounted
for more than 38 percent of borrower work-out plans in February, up
from just under 19 percent in July 2007. In total, the three-month rate
of change in modifications was up approximately 40 percent in February,
while the rate of change in foreclosure starts was up only 16 percent.
FHA has also aided HOPE NOW's efforts and played a vital role in
helping more current and delinquent homeowners find affordable
solutions. The recent announcement to expand FHA Secure to more
delinquent borrowers will enable FHA to refinance an additional 100,000
homeowners this year. In total, FHA Secure is estimated to refinance up
to 500,000 homeowners by the end of 2008.
Through a variety of outreach tools and operational best practices
established by HOPE NOW, Treasury believes the Alliance has laid the
groundwork for increased success in the coming months.
It is imperative that HOPE NOW continue to improve on its progress
to date, and Treasury will be sure to consistently convey that message
to the Alliance.
Question. What are your thoughts on the Durbin Bankruptcy bill that
would allow judges to re-write loan provisions? What would be the
effects on the banking system of the provisions of this bill?
Answer. While Treasury respects the efforts of Senator Durbin to
explore potential solutions for the current mortgage market downturn,
Treasury is concerned about the unintended consequences such
legislation may have on the mortgage market in going forward.
Amending the bankruptcy code in this manner would undermine
existing contracts, leading to a contraction in available and
affordable mortgage credit. This bankruptcy provision would rewrite
certain tenets of bankruptcy law in ways that would fundamentally alter
the expectations of parties to thousands of home purchases after the
fact. These provisions would also likely prolong the time it will take
the market to recover from the current downturn.
Question. I understand that the World Bank is sending U.S. taxpayer
funds to Iran through banks that we have already sanctioned as WMD
proliferators. What is the Treasury Department doing to try to stop
this from happening, since it is contrary to everything we are trying
to accomplish with our Iran policy?
Answer. The Administration shares Congressional concern with the
deceptive practices of Iranian financial institutions and the
involvement of these institutions in proliferation activities. The
Treasury Department has been a leader in singling out Iranian banks for
sanctions as a result of their illicit activities.
The Department has worked closely and diligently with the World
Bank to ensure that it is fully abreast of the evolving sanctions being
put in place by the United Nations Security Council, the inter-
governmental Financial Action Task Force (FATF), and the most recent
Treasury Department designation of Future Bank as being controlled by
Iran's Bank Melli.
The Administration has taken and will continue to take an active
role in opposing World Bank lending to Iran. The United States has
opposed every proposal for Iran since the early 1980s. However, despite
these efforts, projects have been approved by the 24-member Board and
continue to disburse funds. The Department has been assured that
disbursement of loan proceeds under these World Bank-financed projects
and the project accounts have been transferred to commercial banks
which are neither on the list of entities sanctioned pursuant to the
U.N. Security Council resolutions nor on the list of entities
sanctioned for nuclear proliferation activities by the U.S. Treasury.
When making such disbursements, the World Bank screens the list of
beneficiary entities as well as financial intermediaries against the
U.N. list maintained pursuant to the aforementioned U.N. Security
Council decisions, and the list maintained by the Treasury Department's
Office of Foreign Assets Control (OFAC).
The Treasury Department will continue to strongly oppose and vote
against any World Bank Group loan or other type of assistance to Iran
and will also ensure that the Bank continues to comply with the full
range of sanctions regimes to avoid any activity that could facilitate
Iran's nuclear or missiles programs.
Question. We have enacted legislation to allow States to divest
from Sudan. What are your thoughts on allowing States to divest from
Iran?
Answer. The Administration shares Congressional concern with the
conduct of the Iranian regime, and the Treasury Department has played a
leading role in seeking to isolate Iran financially. Such efforts
targeting Iran are most likely to succeed if they are multilateral in
nature, and much of our effort has been targeted at persuading our
allies and private sector institutions to cut back or terminate their
financial dealings with Iran. The multilateral efforts that resulted in
the recent United Nations Security Council Resolution with respect to
Iran (U.N. Security Council Resolution 1803, passed March 3, 2008) are
but one example of the cooperation we are receiving from our allies
abroad. Legislation authorizing divestment from companies that do
business in Iran risks alienating the very allies whose assistance we
need. It also limits the President's ability to conduct U.S. foreign
policy with one voice.
Question. You've asked for some increases in your budget for the
Office of Terrorism and Financial Intelligence. Can you update us on
the progress you have made in cutting off funds to terrorist
organizations and rogue nations?
Answer. The Office of Terrorism and Financial Intelligence (TFI)
has made significant progress in this area by using a combination of
financial measures, fueled by financial intelligence, in a way that
engenders the support of other governments and the private sector. TFI
has successfully drawn on a range of tools for this effort, including
executive orders issued by the President pursuant to the International
Emergency Economic Powers Act, Section 311 of the USA PATRIOT Act, and
FinCEN advisories. Combining these authorities with targeted
intelligence about illicit financing networks, TFI has used conduct-
based, intelligence-grounded, targeted financial measures to address
the threat of terrorist organizations and rogue nations in a way that
encourages support from both the private sector and larger
international community.
Executive Order (E.O.)13224 has proven to be a powerful and
flexible tool for targeting terrorist organizations, allowing the
Department to block the assets of individuals and entities controlled
by or acting on behalf of named terrorist organizations, freezing any
of the target's assets that are held by U.S. persons and preventing
U.S. persons from having any future dealings with them. To date, the
United States has designated 486 individuals and entities pursuant to
E.O. 13224, of which nearly 400 were named by Treasury. In addition, 19
individuals and entities have been designated pursuant to E.O. 12947,
which prohibits transactions with terrorists who threaten the Middle
East peace process.
Treasury has also drawn on this range of tools to influence the
conduct of rogue nations like North Korea, using targeted financial
measures and systemic controls like those previously described. In the
case of North Korea, the Department took two important actions to
address conduct ranging from WMD proliferation-related activities to
counterfeiting of U.S. currency and other illicit behavior. First, a
number of North Korean proliferation firms were targeted under E.O.
13382. That Order authorizes the Treasury and State Departments to
target key nodes of WMD and missile proliferation networks, including
their suppliers and financiers, in the same way as is done with
terrorists. A designation under this order cuts the target off from
access to the U.S. financial and commercial systems and puts the
international community on notice about a particular threat. Second,
regulatory action was taken to protect the financial system against
Banco Delta Asia (BDA). In September 2005, Treasury designated BDA as a
primary money laundering concern. At that time, Treasury issued a
proposed rule, which was subsequently finalized in March 2007,
prohibiting U.S. financial institutions from opening or maintaining
correspondent accounts for or on behalf of BDA. Treasury took this step
to protect the U.S. financial system from BDA, which exhibited systemic
failures in its application of appropriate standards and due diligence,
as well as its facilitation of unusual or deceptive financial practices
by North Korean-related clients. In addition to protecting the U.S.
financial system from the significant vulnerability that BDA
represents, the Section 311 action has spurred improvements in Macau's
regulatory environment. Following the BDA action, the Macanese
authorities took substantial steps to strengthen Macau's anti-money
laundering and counter-terrorist financing regime, notably by passing a
new law to strengthen these controls and starting the jurisdiction's
first-ever Financial Intelligence Unit (FIU). Perhaps most importantly,
the action against BDA has had a profound effect, not only in
protecting the U.S. financial system from abuse, but also in notifying
financial institutions and jurisdictions globally of an illicit finance
risk. Following these actions, responsible foreign jurisdictions and
institutions have taken steps to ensure that North Korean entities
engaged in illicit conduct are not receiving financial services.
Question. You have identified the targeting of state sponsors of
terrorism such as Iran and Syria as an immediate challenge for the
Office of Terrorism and Financial Intelligence (TFI). What can you tell
us about those activities and the progress you have made so far?
Answer. TFI has taken important steps with both Iran and Syria by
using a combination of financial measures, fueled by financial
intelligence, to target their conduct in a way that engenders the
support of other governments and the private sector.
Syria.--Targeted financial measures have proved effective in
addressing the threat Syria's problematic behavior poses to the United
States. To respond and take additional measures to address this threat
to our national security, foreign policy, and economy, President George
W. Bush issued E.O. 13460 on February 13, 2008. This measure targets
individuals and entities determined to be responsible for or who have
benefited from the public corruption of senior officials of the Syrian
regime. On February 21, 2008, the Treasury used this authority to
designate Rami Makhluf, a powerful Syrian businessman and regime
insider whom improperly benefits from and aides the public corruption
of Syrian regime officials. In addition to this use of targeted
economic sanctions against Syrian entities involved in WMD
proliferation, Treasury has taken action under Section 311 to protect
the U.S. financial system against the Commercial Bank of Syria (CBS),
which has been used by criminals and terrorists to facilitate or
promote money laundering and terrorist financing, including the
laundering of proceeds from the illicit sale of Iraqi oil and the
channeling of funds to terrorists and terrorist financiers. In March
2006, Treasury issued a final rule, pursuant to Section 311,
designating CBS as a ``primary money laundering concern'' and requiring
U.S. financial institutions to close correspondent relationships with
CBS. Consequently, prominent international financial institutions have
begun to reassess their relationships with Syria and a number of Syrian
entities.
Iran.--Due to U.S. concern about Iran's well-documented illicit
behavior, the Treasury Department maintains broad sanctions against
Iran (measures that build upon our overall and long-standing Iran
policy). U.S. commercial and financial sanctions against Iran, as
administered by OFAC, prohibit U.S. persons from engaging in a wide
variety of trade and financial transactions with Iran or the Government
of Iran, and prohibit most trade in goods and services between the
United States and Iran, and any investments by U.S. persons in Iran.
U.S. persons are also prohibited from facilitating transactions via
third-country persons that they could not engage in themselves. Against
this backdrop of long-standing sanctions against Iran, Treasury has
taken a number of actions to address the threat of Iranian
proliferation activity in recent years.
First, while under our general Iran country sanctions program,
Iranian financial institutions are prohibited from directly accessing
the U.S. financial system, they are permitted to do so indirectly
through a third-country bank for payment to another third-country bank
in transactions not involving the United States or U.S. persons. In
September 2006, OFAC cut off one of the largest Iranian state-owned
banks, Bank Saderat, from any access, including this indirect, or ``u-
turn,'' access to the U.S. financial system. This bank, which has
approximately 3,400 branch offices, is used by the Government of Iran
to transfer money to terrorist organizations. As noted below, OFAC
later designated Bank Saderat for its support for terrorist groups.
Second, OFAC is relying increasingly on the targeted financial
measures to combat Iran's pursuit of nuclear capability, development of
ballistic missiles, and its support for terrorism. With respect to
Iran, OFAC has been able to apply these measures in the context of U.N.
Security Council Resolution (UNSCR) 1737 and 1747, enabling the
Department to secure greater multilateral implementation by governments
and the private sector and use targeted financial measures against
Iranian individuals and entities in both our counterterrorism and
counterproliferation sanctions programs. Treasury took several major
actions under these programs in October 2007, building on previous
successes with designations of Iranian entities supporting
proliferation using U.S. unilateral authorities and at the United
Nations. On October 25, 2007, Treasury and State (acting in tandem)
were able to expose Iranian banks, companies, and individuals that had
been involved in proliferation and terrorism-related activities and cut
them off from the U.S. financial system. These actions included making:
--Treasury designations of two of Iran's state-owned banks (Banks
Melli and Mellat) and three individuals affiliated with Iran's
Aerospace Industries Organization (AIO) for proliferation
activities under E.O. 13382;
--Treasury designations of nine Islamic Revolutionary Guard Corps
(IRGC)-affiliated entities and five IRGC-affiliated individuals
as derivatives of the IRGC under E.O. 13382;
--The designation of the IRGC-Qods Force (IRGC-QF) under E.O. 13224
for providing material support to the Taliban and other
terrorist organizations; and
--The designation of Iran's state-owned Bank Saderat as a terrorist
financier.
Many of the U.S. designations against Iranian entities and
individuals under E.O. 13382 have been similarly designated under UNSCR
1737 and UNSCR 1747. Most recently, UNSCR 1803 added additional names
to the growing list of Iranian individuals and entities that are
subject to multilateral targeted financial sanctions. UNSCR 1803 also
includes a warning regarding Iranian financial institutions more
generally, establishing obligations for U.N. member states to exercise
vigilance over their own financial institutions activities with
financial institutions domiciled in Iran, and their branches and
subsidiaries abroad. The Resolution further names two Iranian financial
institutions that Treasury previously designated, Bank Melli and Bank
Saderat, as institutions of particular concern.
Third, in addition to these ``formal'' actions, the Treasury has
engaged in unprecedented, high-level outreach to the international
private sector, meeting with more than forty banks worldwide to discuss
the threat Iran poses to the international financial system and to
their institutions. Through this outreach, OFAC has shared information
about Iran's deceptive financial behavior and raised awareness about
the high financial and reputational risk associated with doing business
with Iran. The use of targeted measures has aided this effort by
highlighting specific threats, helping isolate these bad actors, and
preventing them from abusing the financial system. By thus partnering
with the private sector, there is an increasingly less desire to work
around sanctions. Even those institutions not formally bound to follow
U.S. law pay close attention to the targeted actions and often adjust
their business activities accordingly. Many leading financial
institutions have scaled back dramatically, refused to issue new
letters of credit to Iranian businesses, or even terminated their Iran-
related business entirely. They have done so of their own accord, many
concluding that they did not wish to be the banker for a regime that
deliberately conceals the nature of its dangerous and illicit business.
TFI has also communicated with the U.S. financial sector regarding
Iran through the issuance of advisories. In October 2007, following a
statement by the FATF on the threat posed by deficiencies in Iran's
anti-money laundering/combating the financing of terrorism regime, the
FinCEN followed suit by issuing an advisory to alert U.S. financial
institutions of similar concerns regarding Iran. In this advisory,
FinCEN advised that financial institutions should be particularly aware
that there may be an increased effort by Iranian entities to circumvent
sanctions and related financial community scrutiny through the use of
deceptive practices involving shell companies and other intermediaries
or requests that identifying information be removed from transactions.
The advisory went on to explain that such efforts may originate in Iran
or Iranian free trade zones subject to separate regulatory and
supervisory controls, including Kish Island. Such efforts may also
originate wholly outside of Iran at the request of Iranian-controlled
entities.
Question. Treasury's Office of Intelligence Analysis was
established in fiscal year 2005. Since that time, how has it
contributed to overall intelligence collection?
Answer. OIA has limited authority to collect foreign financial and
monetary information, and general foreign economic information. OIA's
primary mission is to analyze intelligence collected by other agencies
in order to support the formulation of Treasury policy and the
execution of its authorities. To support its mission, OIA leadership
firmly believes that the organization should drive intelligence
collection by providing timely and insightful analytic support to IC
members engaged in clandestine and open-source intelligence activities.
OIA analysts routinely provide their intelligence requirements to
collectors at the Central Intelligence Agency, the National Security
Agency, the Federal Bureau of Investigation, the Defense Intelligence
Agency, and other IC elements in order to help those organizations more
effectively direct their resources. OIA also provides feedback to IC
Collectors as to the timeliness, relevance, and accuracy of the
information provided by their sources. All in all, this support helps
ensure that scarce IC collection resources are focused on the hardest
targets and finance-related collection requirements are closely aligned
with policymaker needs.
In fiscal year 2008, OIA is expanding its ability to drive
collection by increasing its cadre of dedicated Requirements Officers.
OIA's fiscal year 2009 Global Finance Initiative (GFI) would provide
additional resources to ensure that each of OIA's core mission areas
receives dedicated collection requirements support.
Question. Question from the Republican Staff Director of the JEC:
Recent turmoil in financial markets is continuing, particularly the
markets for asset backed debt instruments. It's clear that in many
instances debt that received a AAA-rating was in fact not AAA grade at
all. Up until now, the credit rating agencies have relied solely on
traditional risk indicators, all of which are either borrower-focused
or collateral-focused.
It seems that both home owners and mortgage lenders alike could
benefit from an independent, objective and standardized third-party
verification step that verifies the quality and risk associated with
these loans before they are sold on the secondary market or before they
are finalized by a broker. Consumers and investors could also benefit
by having the ability to review the record of particular lenders.
Do you believe that assigning such a pre-securitization rating
based upon borrower information, adequacy of collateral and loan
quality would help to prevent future crises in the mortgage market?
Answer. On March 13th, the President's Working Group on Financial
Markets (PWG), which is chaired by the Secretary, released the
comprehensive ``Policy Statement on Market Developments.'' The PWG's
statement was intended to help to restore market liquidity, market
discipline, and investor confidence through recommendations to enhance
disclosure/transparency, due diligence/independent analysis, valuation
techniques, risk management practices, regulatory policies, and market
infrastructure. There are recommendations for all stakeholders (all
market participants and regulators) and for all links in the chain of
the securitization process (mortgage brokers, originators,
securitizers, financial institutions, credit rating agencies,
investors, and state and federal regulators).
The PWG made several recommendations to improve the quality and
disclosure of information about and analysis of mortgage loans
underlying securitized products, including:
--All states should implement strong nationwide licensing standards
for mortgage brokers;
--Federal and state regulators should strengthen and make consistent
government oversight of entities that originate and fund
mortgages and otherwise interface with customers in the
mortgage origination process;
--The Federal Reserve should issue stronger consumer protection and
disclosure rules;
--Overseers of institutional investors should require investors to
obtain from sponsors and underwriters of securitized credits
better information about the risk characteristics of such
credits, including information about the underlying asset
pools;
--Overseers should ensure that these investors develop an independent
view of the risk characteristics of the instruments in their
portfolios, rather than rely solely on credit ratings;
--The PWG will form a committee to develop best practices regarding
disclosure to investors in securitized credits;
--Credit rating agencies (CRAs) should disclose the reviews they
perform on originators of assets and should require
underwriters to represent the level and scope of due diligence
performed on the underlying assets;
--CRAs should publish sufficient information about the assumptions
underlying their credit rating methodologies, so that users of
credit ratings can understand how a particular credit rating
was determined;
--CRAs should provide the information investors need to make informed
decisions about risk, including measures of the uncertainty
associated with ratings and of potential ratings volatility;
and
--The PWG will form a group to develop recommendations for further
steps that issuers, underwriters, CRAs, and policymakers could
take to ensure the integrity and transparency of ratings, and
to foster appropriate use of ratings in risk assessment.
Question. What key ways is your Department proposing to employ to
close the ``tax gap?'' You once stated in a Finance Committee hearing
that this is not a pot of gold. How big is the gap and what will it
cost to close it?
Answer. The estimated size of the tax gap is as follows. In 2001,
the overall compliance rate was estimated at over 86 percent, after
late payments and recoveries from IRS enforcement activities. The tax
gap results from noncompliance, specifically the amount of tax that
should be paid but is not paid. After enforcement efforts and late
payments, this amount was approximately $290 billion.
The key ways in which the Treasury Department is proposing to
reduce the tax gap were set forth in a comprehensive strategy to
improve tax compliance released in September 2006. The strategy builds
upon the demonstrated experience and current efforts of the Treasury
Department and IRS to improve compliance. Four key principles guided
the development of this strategy: both unintentional taxpayer errors
and intentional taxpayer evasion should be addressed; sources of non-
compliance should be targeted with specificity; enforcement activities
should be combined with a commitment to taxpayer service; and tax
policy and compliance proposals should be sensitive to taxpayer rights
and maintain an appropriate balance between enforcement activity and
imposition of taxpayer burden. These principles underscore the Treasury
Department's and IRS' comprehensive, integrated, multi-year strategy to
improve tax compliance. Components of this strategy include: (1)
legislative proposals to reduce opportunities for evasion; (2) a multi-
year commitment to compliance research; (3) continued improvements in
information technology; (4) improvements in IRS compliance activities;
(5) enhancements of taxpayer service; (6) simplification of the tax
law; and (7) coordination between the government and its partners and
stakeholders.
More specifically, the Treasury Department's fiscal year 2009
Revenue Proposals include a number of legislative proposals intended to
improve tax compliance with minimum taxpayer burden. The fiscal year
2009 President's budget does include a number of legislative proposals
intended to improve tax compliance with minimum taxpayer imposition.
These proposals could generate $36 billion over the next ten years. The
Administration proposes to expand information reporting, improve
compliance by businesses, strengthen tax administration, and expand
penalties.
--Expand information reporting.--Compliance with the tax laws is
highest when payments are subject to information reporting to
the IRS. Specific information reporting proposals would:
require information reporting on payments to corporations;
require basis reporting on security sales; require information
reporting on merchant payment card reimbursements; require a
certified Taxpayer Identification Number (TIN) from
contractors; require increased information reporting on certain
government payments; increase information return penalties; and
improve the foreign trust reporting penalty.
--Improve compliance by businesses.--Improving compliance by
businesses of all sizes is important. Specific proposals to
improve compliance by businesses would: require electronic
filing by certain large organizations; and implement standards
clarifying when employee leasing companies can be held liable
for their clients' Federal employment taxes.
--Strengthen tax administration.--The IRS has taken a number of steps
under existing law to improve compliance. These efforts would
be enhanced by specific tax administration proposals that
would: expand IRS access to information in the National
Directory of New Hires for tax administration purposes; permit
disclosure of prison tax scams; make repeated willful failure
to file a tax return a felony; facilitate tax compliance with
local jurisdictions; extend statutes of limitations where state
tax adjustments affect federal tax liability; and improve the
investigative disclosure statute.
--Expand penalties.--Penalties play an important role in discouraging
intentional non-compliance. A specific proposal to expand
penalties would impose a penalty on failure to comply with
electronic filing requirements.
In the fiscal year 2009 President's budget, the IRS has budgeted
over $23 million to implement these proposals. The budget also includes
other items relating to the tax gap: over $286 million to reduce the
tax gap for large business, small business, and the self-employed
sector, to increase compliance of domestic taxpayers with offshore
activity, and to minimize revenue loss by increasing document matching
efforts; and over $51 million to increase support for research to
understand better the reasons for taxpayer non-compliance.
Question. If we simplified our tax code with, for example, a flat
income tax, what effect would there be on revenue receipts and revenue
collection?
Answer. Replacing the existing income tax with a flat income tax
could raise, lower, or leave unchanged tax revenue, depending on such
design features as the tax rate imposed by the flat tax. A standard
objective of tax reform efforts is to broaden the tax base and reduce
tax rates. Generally speaking, the broader the base, the lower tax
rates can be and still raise the same revenue as the current tax
system. So, for example, eliminating or minimizing special exclusions,
exemptions, deductions, and credits allows setting lower tax rates
without reducing revenue. Both a broad tax base and lower tax rates are
desirable from a policy perspective because they reduce economic
distortions caused by the tax system.
Question. Will you commit to working with us and with SEC in
preventing U.S. manufacturing companies from purchasing ``blood
minerals'' like coltan from exporters who are abusing and murdering
innocent people?
Answer. The Administration shares Congressional concern regarding
the conflict in the Democratic Republic of Congo, which has been marked
by serious violations of human rights and international law. To address
this threat to the foreign policy of the United States, the President
declared a national emergency and issued E.O. 13413 (October 27, 2006)
implementing sanctions directed at persons contributing to the
widespread violence and atrocities in the Democratic Republic of the
Congo, as called for by U.N. Security Council Resolutions 1596 of April
18, 2005, and 1649 of December 21, 2005. The E.O. blocks the assets of,
and prohibits U.S. persons from engaging in transactions and dealings
with, persons listed in the Annex to, or designated pursuant to, the
E.O. The Annex to the E.O. listed seven persons, including the
notorious international arms dealer Viktor Bout, and OFAC designated an
additional seven companies and three individuals pursuant to the E.O.
in March 2007. A number of the March 2007 designations specifically
related to exploitation of the gold sector in support of armed militia
activity. OFAC continues to investigate aggressively the operations and
holdings of rogue actors operating in the Democratic Republic of Congo.
Question. Last year, Congress passed and the President signed
legislation to give your Office of Foreign Assets Control the ability
to levy larger civil and criminal penalties for those who violate
sanctions against rogue nations. Have the stronger tools helped provide
a greater deterrent for those who would be inclined to deal with
countries on whom we have imposed sanctions?
Answer. We appreciate Congressional efforts in increasing the
maximum civil penalties available to the Office of Foreign Assets
Control and believe that the availability of such meaningful penalties
will serve as a meaningful deterrent for those who might otherwise
treat civil penalties as merely ``the cost of doing business.'' Indeed,
OFAC has conducted several outreach events specifically on this topic.
While it is still too soon to assess the full impact of the legislation
that was passed last year, we note that there has been significant
interest from the media and the general public related to these
enhanced penalties.

CONGO/COLTAN

Question. The Office of Foreign Assets Control (OFAC) administers
and enforces economic and trade sanctions, based on U.S. foreign policy
and national security goals against foreign countries, terrorists,
international narcotics traffickers, and those engaged in activities
related to the proliferation of weapons of mass destruction.
While the issue of exploited natural resources in the Democratic
Republic of Congo, or specifically the issue of coltan may not be an
engagement of proliferation of weapons of mass destruction, these
activities are some of the most brutal human rights abuses we see in
our world today (human-trafficking, child labor, sexual abuse and
rape). The product of many of these actions leads to the refined
component of a mineral which then ends up in much of our high
technology industry here--cell phones, DVD players, flat screen
televisions, etc. What are the limitations of OFAC's capabilities to
target these rogue actors in eastern Congo?
Answer. Within the framework of E.O. 13413 (October 27, 2006) and
related U.N. Security Council Resolutions, the Treasury Department has
the authority to designate rogue actors engaging in activities
contributing to the violence and atrocities taking place in the
Democratic Republic of the Congo. OFAC continues to aggressively
investigate the operations and holdings of such rogue actors (including
militia leaders and their financial enablers) operating in the
Democratic Republic of Congo. Improved access to credible and reliable
on-the-ground information pertaining to the business activities of
these rogue actors is always vital to OFAC's ability to designate
potential targets.
Question. Has OFAC looked into targeting these rogue actors before?
Answer. The Annex to the E.O. 13413 listed seven persons, including
the notorious international arms dealer Viktor Bout, and OFAC
designated an additional seven companies and three individuals pursuant
to the E.O. in March 2007. A number of the March 2007 designations
specifically related to exploitation of the gold sector in support of
armed militia activity. OFAC continues to investigate aggressively the
operations and holdings of rogue actors operating in the Democratic
Republic of Congo.
Question. What assistance might OFAC need in this procedure?
Answer. As stated above, access to on-the-ground information
pertaining to the business activities of these rogue actors is vital to
OFAC's ability to designate potential targets. OFAC is working to
enhance its access to this type of information. OFAC as a matter of
policy does not comment publicly on its techniques and sources for
gathering this type of information.
Question. In regards to the budget, what accountability measures
are in place, specifically regarding Congo, to ensure material
resources are not siphoned off by these rogue actors? If any, what is
Department of Treasury doing to implement these measures?
Answer. Pursuant to E.O.13413 (October 27, 2006), OFAC continues to
investigate aggressively the operations and holdings of rogue actors
operating in the Democratic Republic of Congo; designated individuals
and entities are deprived of access to the U.S. financial system and
any transactions involving U.S. persons.
Question. As a former board member of the Nature Conservancy, I
know that you have a great interest in natural resource conservation.
Would you support protecting parts of the Congo so that its natural
resources are not further exploited?
Answer. The Department of the Treasury strongly supporting ongoing
efforts to strengthen natural resource management in the Democratic
Republic of Congo (DRC), particularly the efforts of the World Bank to
encourage reform of the forestry and mining sectors. Some important
steps taken to date by the Congolese authorities include establishing a
moratorium on new logging titles and the promulgation of new Mining and
Forest Codes. Treasury sees these as strong building blocks for longer-
term reform and important steps toward filling the legal vacuum with
respect to the governance of the Congolese forest and mining sectors.
However, the situation in the DRC is extremely challenging and much
work remains, including developing appropriate regulatory frameworks
and strong institutions to manage these sectors. Treasury will continue
to urge the World Bank to work with the Congolese authorities on the
issue of natural resource management.
Further, the United States is a founding member and financial
supporter of the Congo Basin Forest Partnership (CBFP) which brings
together governments, the private sector, civil society and development
organizations to conserve the unique natural resources of the Congo
Basin, fight illegal logging and poaching, and improve the livelihoods
of the Basin's 100 million inhabitants. The Department of Treasury
respectfully refers you to the State Department and USAID for
additional information, as they are the lead U.S. government agencies
with regard to our involvement in the CBFP.

SUBCOMMITTEE RECESS

Secretary Paulson. We will, and I thank you very much for
the way you have supported Treasury's budget. And thank you
very much.
Senator Durbin. Thanks, Mr. Secretary. This meeting of the
Subcommittee on Financial Services and General Government will
stand recessed.
[Whereupon, at 4 p.m., Wednesday, March 5, the subcommittee
was recessed, to reconvene subject to the call of the Chair.]

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

----------

WEDNESDAY, MARCH 12, 2008

U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 4:02 p.m., in room SD-138, Dirksen
Senate Office Building, Hon. Richard J. Durbin (chairman)
presiding.
Present: Senator Durbin.

THE JUDICIARY

STATEMENT OF HON. JULIA S. GIBBONS, JUDGE, U.S. COURT
OF APPEALS, SIXTH CIRCUIT; CHAIR, BUDGET
COMMITTEE OF THE JUDICIAL CONFERENCE

OPENING STATEMENT OF SENATOR RICHARD J. DURBIN

Senator Durbin. Good afternoon. This is the second of the
subcommittee's hearings, and today we are going to focus on the
fiscal year 2009 budget for the Federal judiciary.
We will be hearing from two distinguished witnesses: Judge
Julia Gibbons--welcome--and Director James Duff. Welcome as
well. I am pleased that you are here speaking on behalf of our
Federal judiciary.
I welcome my colleagues who will come as the meeting
progresses.
In fiscal year 2008, despite the difficulty the
subcommittee faced in attempting to adequately fund all the
various agencies within our jurisdiction and remain within the
President's overall spending level, we managed to provide the
judiciary with a 4.5 percent increase overall. With the prior 3
fiscal year increases of 5 percent, all this has helped put the
courts back on track after suffering significant cuts in fiscal
year 2004.
With fiscal year 2008 funds, hirings for probation and
pretrial services are increasing back to previous levels; non-
capital panel attorney rates were increased from $94 an hour to
$100, a modest increase; courts were provided additional
funding to absorb the additional caseload expected with
increased border enforcement; court security requirements were
fully funded; and authority was clarified that the U.S.
Marshals may assume responsibility from the Federal Protective
Service (FPS) for perimeter security at several designated
courthouses.
For fiscal year 2009, you are requesting a 7.6 percent
increase overall for the judiciary above last year's levels. In
addition, within the defender services account, you are
requesting an increase in the non-capital panel attorney rate,
which would boost hourly rates from $100 to $118 and then to
$140 in fiscal year 2010. The subcommittee provided a 7.6
percent increase for defender services last year, and such
large pay increases for these attorneys this year will likely
be optimistic, given our anticipated funding constraints. It is
why I hope that we will be able to at least provide a modest
increase in the non-capital panel attorney rate.
Regarding court security, I look forward to being updated
on the progress of the pilot program undertaken with the U.S.
Marshals Service at designated courthouses. I will also be
interested to learn how the judiciary is implementing the Court
Security Improvement Act. And I will want to discuss with you
the Justice Department's inspector general's report on the U.S.
Marshals Service.
I will have questions about courthouse construction, the
impact of increased border enforcement, your workload, offender
reentry programs, General Services Administration (GSA) rent,
and more. If we cannot cover all the questions in the hearing,
we will send them to you for the record, and I am sure that you
can get them back to us in a reasonable period of time.
Senator Brownback will be unable to attend today's hearing,
but has asked that his statement be submitted for the record.
[The statement follows:]

Prepared Statement of Senator Sam Brownback

Good afternoon. I want to thank you, Chairman Durbin, for your
leadership. I look forward to working together with you during this
coming year as we make funding decisions and provide oversight for the
Federal Judiciary as well as the other agencies within this
subcommittee's jurisdiction.
I would like to thank Judge Gibbons and Mr. Duff for appearing
before our subcommittee today. I look forward to hearing the details of
your fiscal year 2009 budget request and the key efforts that the
Judiciary will be undertaking this year. The Judiciary has the critical
role of interpreting our laws and I am interested in hearing your
thoughts on the state of our Nation's courts.
Looking at the budget submission, I am pleased to see an increase
in defender services which is extremely important in light of last
night's Senate passage of the Second Chance Act. This bill reshapes the
way we look at prisoner re-entry. It is comprised of grant programs
targeted at States, local governments and non-profit, faith-based
organizations. And unlike most grant programs, in order to receive
future funding under this act, programs must show real progress in
reducing the recidivism rate of the program participants. As you all
know, the U.S. Sentencing Commission recently passed the Crack Cocaine
Sentencing Amendment, and it took effect in November. This sentence
reduction for crack cocaine offences is retroactively applicable, thus
allowing thousands of Federal offenders to seek reductions in their
sentences. I would hope that with the passage of the Second Chance Act
that we will be able to get much-needed re-entry programs to the
inmates who truly need these essential services.
I would like to mention my concerns about the overall slowdown in
Federal judge confirmations. There are currently 45 vacancies--14
circuit court vacancies and 31 district court vacancies with 27
nominees awaiting confirmation. I understand the hardship this places
on the Judiciary. There is bit of progress being made, however, because
yesterday the Judiciary Committee reported out several district court
judges for confirmation on the Senate floor and tomorrow a circuit
court judge is on the agenda for the Judiciary Committee markup. I am
hopeful that we will continue to make progress in confirming judges and
reducing the strain on the Judiciary.
Judge Gibbons and Mr. Duff, I look forward to hearing your
testimony this afternoon.
Thank you, Mr. Chairman.

Senator Durbin. I also note that the subcommittee is in
receipt of written testimony submitted by the Court of Appeals
for the Federal Circuit, the Court of International Trade,
Federal Judicial Center, and the U.S. Sentencing Commission,
all of which will be submitted for the hearing record.
Judge Gibbons, I am going to allow you to begin. I thank
you for being here today and look forward to putting your
remarks in the record. Judge Gibbons.

JUDGE GIBBONS' OPENING STATEMENT

Judge Gibbons. Thank you for the opportunity to be here.
Chairman Durbin, I appear as Chair of the Judicial
Conference Committee on the Budget, and with me today, of
course, is Jim Duff, who is the Director of the Administrative
Office of the United States Courts.
We thank you, Mr. Chairman, for attending the Judicial
Conference session yesterday and for your remarks there.

FISCAL YEAR 2008 FUNDING

Let me begin by thanking the subcommittee for making the
judiciary a funding priority in the fiscal year 2008
appropriations cycle. The courts are in good financial shape
for 2008. The funding you provided will allow us to finance
continuing operations in the courts and to address workload
needs.
We are particularly appreciative of the $25 million you
provided in emergency funding to respond to workload associated
with immigration enforcement initiatives.
We are also grateful for two provisions that were included
in the omnibus bill: the increase in the non-capital hourly
rate for panel attorneys that you have referred to and the
pilot project in our court security program.

FISCAL YEAR 2009 BUDGET REQUEST

Turning to the 2009 budget request, the judiciary is
requesting $6.7 billion, an increase of $475 million over the
2008 enacted level; 86 percent of the increase is for standard
pay and non-pay inflationary adjustments and for adjustments to
base, reflecting increases in space, information technology,
defender services, and court security programs. We are not
requesting any new staff in clerks and probation offices.
The remaining $68 million of our requested increase is
primarily for program improvements in our information
technology program and an enhancement in the defender services
program that you already referred to, increasing the hourly
rate for private panel attorneys. We are appreciative of the
increase you provided this year but believe an additional
increase is warranted.
Our budget request reflects our continuing efforts to
contain costs. We are now more than 3 years into an intensive
effort to reduce costs throughout the judiciary and our cost
containment program is producing results.
We have achieved so far the most significant savings in our
space and facilities program through an ongoing rent validation
project in which our court staff identify errors in rent for
GSA to correct and give us rent credits. GSA has been very
cooperative in this endeavor.
In the information technology area, we are consolidating
the deployment of computer servers which generate savings from
reduced maintenance and equipment replacement costs.
We are also containing personnel costs. At its September
2007 meeting, the Judicial Conference approved recommendations
from a major court compensation study that will slow the growth
in personnel costs. Containing costs is a top priority for us.

COURT SECURITY PILOT PROJECT

Let me talk briefly about the pilot project approved in the
2008 omnibus bill. During my testimony last year before you, I
discussed the judiciary's concerns regarding the expense and
quality of security provided the courts by the Federal
Protective Service. Chairman Durbin, you responded quickly to
our concerns and convened a meeting with Director Duff and the
Directors of the Marshals Service and the FPS.
As a result of your personal interest and commitment to
improve court security, the subcommittee's bill included a
provision for a pilot project permitting the Marshals Service
to assume perimeter security duties from FPS at seven
courthouses that have been selected. The Dirksen Federal
Courthouse in Chicago will be the first pilot site to move
forward. The project will begin later this year and will be in
effect for approximately 18 months. We will provide you an
evaluation of the project.

IMPACT OF INCREASED IMMIGRATION ENFORCEMENT

An issue that has received significant attention from
Congress and the administration in recent years is illegal
immigration. Despite zero tolerance immigration enforcement
initiatives like Operation Streamline, in recent years resource
constraints in the justice enforcement system on the border
have limited the number of immigration cases prosecuted. It now
appears that additional resources are making their way to the
border through the Department of Justice's emergency funding
received in 2008 and potentially through the funding requested
in the President's 2009 budget. We believe the courts' workload
will increase from this infusion of resources. Although we are
not requesting funding for new clerks or probation staff on the
border or elsewhere, we are very grateful for your provision of
$45 million over the last 2 years to address the immigration-
related workload so that we can respond in the short term to
any increased workload.
We do need additional judgeships on the Southwest border.
The Judicial Conference has requested 10 more judgeships on the
border, and we make a special plea for the subcommittee's
support of the $110 million requested for GSA in the
President's budget to fund fully a new Federal courthouse in
San Diego. This is our top space priority.

PREPARED STATEMENTS

I would ask that my statement, along with the others you
referred to, be placed in the record. And, of course, we are
available for your questions.
[The statements follow:]

Prepared Statement of Hon. Julia S. Gibbons

INTRODUCTION

Chairman Durbin, Senator Brownback, and members of the
Subcommittee, I am Judge Julia Gibbons of the Sixth Circuit Court of
Appeals. Our court sits in Cincinnati, Ohio, and my resident chambers
are in Memphis, Tennessee. As the Chair of the Judicial Conference
Committee on the Budget, I come before you to testify on the
Judiciary's appropriations requirements for fiscal year 2009. In doing
so, I will apprise you of some of the challenges facing the Federal
courts. This is my fourth appearance before an appropriations
subcommittee on behalf of the Federal Judiciary and my second
appearance before the Financial Services and General Government panel.
Appearing with me today is James C. Duff, the Director of the
Administrative Office of the United States Courts.
In addition to a discussion of our fiscal year 2009 request, my
testimony will cover several policy issues that impact the Federal
courts. I will also update you on the Judiciary's efforts to contain
costs as well as discuss several information technology innovations
that are examples of the Judiciary(s continual efforts to improve
Federal court operations.

STATEMENTS FOR THE RECORD

Mr. Chairman, in addition to my statement and Director Duff's, I
ask that the entire statements of the Federal Judicial Center, the
Sentencing Commission, the Court of Appeals for the Federal Circuit,
and the Court of International Trade be included in the hearing record.

FISCAL YEAR 2008 FUNDING

Mr. Chairman and Senator Brownback, let me begin today by thanking
you and your colleagues for making the Judiciary a funding priority in
the fiscal year 2008 appropriations cycle. The funding you provided,
combined with greater than anticipated fee carryover balances and
reduced requirements due to our cost containment initiatives, will
allow us to finance continuing operations in the courts as well as to
address workload needs. We are particularly appreciative of the $25
million you provided the Judiciary in emergency funding to respond to
workload associated with immigration enforcement initiatives being
implemented by the Department of Homeland Security and the Department
of Justice. We are fully cognizant of the difficult funding choices you
faced during conference on the omnibus bill and appreciate your
willingness to support the needs of the Judiciary. We appreciated the
opportunity to work with the Subcommittee to identify our highest
priority funding needs when your allocation was significantly reduced
during conference on a final bill.
We also are grateful for several provisions included in the omnibus
bill, which we believe will improve Federal court operations. Two that
are particularly important are the pilot project to assess the
feasibility of transferring responsibility for perimeter security at
several designated primary courthouses from the Federal Protective
Service to the United States Marshals Service and the increase in the
non-capital hourly rate paid to private panel attorneys who represent
eligible defendants under the Criminal Justice Act. I will discuss the
pilot project in more detail next and return to panel attorney rates
later in my testimony.

COURT SECURITY

Mr. Chairman, during my testimony last year I conveyed to the
Subcommittee the Judiciary's concerns regarding the expense and quality
of security provided the courts by the Federal Protective Service
(FPS). FPS provides, on a reimbursable basis, exterior perimeter
security for Federal agencies, including at courthouses and multi-
tenant court facilities. The Judiciary's FPS costs are paid from our
Court Security appropriation and fiscal year 2009 billings are
projected to be $72 million.
Last year I spoke of incidents of inoperable FPS-provided exterior
cameras at courthouses and the absence of cameras altogether at key
locations resulting in ``dead zones'' with no camera surveillance,
despite our paying FPS for the equipment. Security lapses such as these
left courthouses with serious security vulnerabilities. Fortunately, to
help ensure that the courts had adequate security, the United States
Marshals Service (USMS) assumed responsibility for repairing or
replacing FPS-provided perimeter cameras at a number of courthouses
where it was apparent that FPS did not have the resources to do so.
This resulted in the Judiciary's paying for the same services twice:
once to FPS in its security charges, and also to the USMS in the
funding we transferred to it for systems and equipment for interior and
perimeter courthouse security. The Judicial Conference had become
increasingly concerned about this issue and consequently, in March
2007, it endorsed a recommendation to expand the USMS's current mission
to include perimeter security of court facilities nationwide where the
Judiciary is the primary tenant.
Mr. Chairman, within a month after last year's hearing you convened
a meeting with the Directors of the United States Marshals Service,
Federal Protective Service, and the Administrative Office of the United
States Courts to learn more about this issue. As a result of your
personal interest and commitment to improve court security, the Senate
version of the fiscal year 2008 Financial Services and General
Government appropriations bill (H.R. 2829) included the provision
approving a pilot project permitting the USMS to assume responsibility
from FPS for perimeter security at several designated courthouses. And,
as I just mentioned, the provision was included in the final conference
agreement on the fiscal year 2008 omnibus appropriations bill thus
allowing the Judiciary and the USMS to begin implementation of the
pilot. Specifically, the pilot project involves the USMS monitoring the
exterior of the courthouses with court security officers and assuming
control of FPS monitoring equipment. The USMS, working with the
Administrative Office of the U.S. Courts, selected seven courthouses
for the pilot. I would note that the Everett McKinley Dirksen U.S.
Courthouse in Chicago will be the first pilot site to move forward. The
other six sites are: the Theodore Levin U.S. Courthouse, Detroit,
Michigan; the Sandra Day O'Connor U.S. Courthouse, Phoenix, Arizona;
the Evo A. DeConcini U.S. Courthouse, Tucson, Arizona; the Russell B.
Long Federal Building/U.S. Courthouse, Baton Rouge, Louisiana; the Old
Federal Building and Courthouse, Baton Rouge, Louisiana; and the Daniel
Patrick Moynihan U.S. Courthouse, New York, New York.
The pilot project is anticipated to begin in the fourth quarter of
fiscal year 2008 and will be in effect for approximately 18 months at
which time an evaluation of the pilot will be provided to the
Subcommittee. The annualized cost of the pilot is estimated to be $5
million, which will be offset by anticipated reductions in FPS
billings. We appreciate your concern with the security of our
courthouses, and we will provide the Subcommittee with updates as the
pilot project gets underway.
Work of the United States Marshals Service
I would like to say a few words about the vitally important work of
the United States Marshals Service. Inside the courthouse, judges,
court staff, attorneys, jurors, defendants, litigants, and the public
depend entirely on the USMS for their safety. Heightened security at
courthouses due to high-threat trials and terrorism concerns have made
the work of the USMS more difficult, and it has responded extremely
well to those challenges. For judges like myself, the USMS also ensures
our security outside of the courthouse, and it takes this charge
seriously. In September 2007, the USMS established a new Threat
Management Center that serves as the nerve center for responding to
threats against the Judiciary. The Center provides vital data to U.S.
Marshals nationwide on threats against judges and court personnel. The
USMS also has overseen the installation of nearly all of the 1,600
intrusion detection systems in the homes of Federal judges in order to
provide increased judicial security outside of courthouse facilities.
This has been a 2-year effort and includes ongoing system monitoring by
a security firm. All of us in the Federal court family are grateful to
John F. Clark, Director of the U.S. Marshals Service, his staff, and
the U.S. Marshals throughout the 94 judicial districts for their
dedication and responsiveness to the security needs of the Federal
Judiciary. The USMS operates within very tight resource levels, and we
urge Congress to fund fully the USMS's fiscal year 2009 budget request
to enable it to continue meeting its statutory mandate to protect the
Federal Judiciary.

RETROACTIVITY OF CRACK COCAINE SENTENCING AMENDMENT

Mr. Chairman, I would like to discuss an issue that has received
some attention in recent months: the changes to Federal sentencing
guidelines for crack cocaine offenses approved by the United States
Sentencing Commission. The Commission is a bipartisan, independent
agency within the Judicial Branch that was established by the
Sentencing Reform Act of 1984 to develop national sentencing policy for
the Federal courts. The Commission promulgates the sentencing
guidelines that Federal trial court judges consult when sentencing
defendants convicted of Federal crimes.
On May 1, 2007, the Commission submitted a package of amendments to
the Federal sentencing guidelines that, in the absence of congressional
action to the contrary, went into effect on November 1, 2007. Among the
amendments was one that modified the Federal sentencing guidelines for
crack cocaine offenses. The amendment reduced the base offense level,
or starting point, for crack cocaine offenses under the guidelines
downward by two offense levels. This amendment does not affect the
statutory mandatory minimum penalties for crack cocaine offenses
established by Congress. The Commission took this action to alleviate
some of the longstanding problems associated with the penalty scheme
for cocaine offenses, which requires 100 times more powder than crack
cocaine to receive the same statutory mandatory minimum penalty
commonly referred to as the (100-to-1 ratio.) As a result of the
amendment, the average sentence for crack cocaine offenders sentenced
on or after November 1, 2007 will be approximately 16 months less than
those sentenced before that date.
The Commission is authorized by statute to decide whether
amendments that reduce penalties should be given retroactive effect. In
December 2007, the Commission voted unanimously to give retroactive
effect to the amendment for crack cocaine offenses. Retroactivity of
the amendment became effective on March 3, 2008.
Pursuant to statute, once the Commission has given an amendment
retroactive effect, a defendant, the director of the Bureau of Prisons,
or a court on its own may move to have a defendant's term of
imprisonment reduced pursuant to the Commission's policy statement on
retroactivity and the limits of the amendment. The Commission estimates
that approximately 19,000 Federal offenders over a span of several
years may be eligible to seek to have their terms of imprisonment
reduced as a result of retroactivity. These individuals were sentenced
throughout the country although a large number of potentially eligible
offenders were sentenced in districts located within the Fourth Circuit
(West Virginia, Virginia, Maryland, North Carolina, and South
Carolina).
A Federal sentencing judge will make the final determination of
whether an offender is eligible for a lower sentence and how much that
sentence should be lowered. That determination will be based on many
factors, including whether the offender's reduced sentence or release
would pose a danger to public safety.
I will not discuss the merits of retroactivity since such policy
decisions are outside the Budget Committee's area of responsibility;
however, I will note that the Criminal Law Committee of the United
States Judicial Conference supported the Commission's decision on
retroactivity. The Criminal Law Committee and its staff at the
Administrative Office of the United States Courts have been working
closely with the Commission to give the courts sufficient time,
resources, and guidance to prepare for and process these cases. It is
this process that I would like to take a moment to discuss.
We anticipate there may be an initial surge of motions for
reductions in sentence filed in the Federal courts. These filings will
be handled by various district court components, including district
judges, clerks offices, probation and pretrial services offices, and
Federal defender offices. It is generally agreed that a large number of
motions for a reduction in sentence will not involve court hearings and
will be decided on written filings, so our workload associated with
processing those cases should not be unduly burdensome. The cases that
require hearings will require more court resources. At present, no
extraordinary measures have been necessary to address the increased
workload due to retroactivity, although additional resources will be
available if needed for smaller districts that may be
disproportionately impacted by the number of Federal offenders seeking
a reduction in sentence based on retroactivity.
We believe retroactivity will have the greatest impact on our
probation offices. The crack cocaine offenders who may be released
after a Federal judge grants the motion for a reduction in sentence
will require close probation supervision, drug testing, and possibly
drug and other treatment services as do other Federal offenders leaving
Federal prison. At this time, however, our fiscal year 2009 budget does
not request additional staffing or other resources associated with
retroactivity of the crack cocaine sentencing amendment. The Judiciary
believes the additional workload associated with retroactivity can be
absorbed within existing resource levels.

IMPACT OF INCREASED BORDER ENFORCEMENT

Another issue that has received significant attention from Congress
and the administration is illegal immigration, so I would like to
discuss the impact of increased border and immigration enforcement
initiatives on the work of the Federal courts. In recent years the
administration has dedicated significant resources to address the issue
of illegal immigration. The President's fiscal year 2009 budget
includes $12 billion for the Department of Homeland Security (DHS) for
border security and enforcement efforts, a 19 percent increase over
fiscal year 2008, and a more than 150 percent increase since 2001. DHS
has used the funding to increase the number of border patrol agents
significantly, particularly on the Southwest border with Mexico. Since
2001, more than 5,000 additional border patrol agents have been hired
with most of them placed along the southwest border. In fiscal year
2008, DHS received funding to hire an additional 3,000 border patrol
agents, and the President's fiscal year 2009 budget includes funding
for another 2,200 agents, bringing the total to 20,000 agents. When
fully staffed the Border Patrol will have more than doubled in size
since 2001.
The level of criminal case filings in the Federal courts in the
five judicial districts along the southwest border is high by
historical standards--19,825 filings in 2007 versus 17,184 in 2001--but
filings have not increased commensurate with the increased resources
provided to DHS for border enforcement. Despite zero tolerance border
initiatives such as Operation Streamline in which nearly everyone
apprehended for violating U.S. immigration laws is prosecuted, resource
constraints in the justice system have precluded more cases from being
prosecuted in the Federal courts. Staffing shortages in U.S. Attorney
offices, lack of detention beds needed to secure offenders awaiting
prosecution, and staffing constraints in U.S. Marshals offices have
resulted in the establishment of certain threshold levels in some
border districts that must be met before a case is prosecuted. For
example, a U.S. Attorney in one district may prosecute someone coming
into the country illegally after the tenth attempt, while a U.S.
Attorney in another district may prosecute after the fifth attempt.
To the extent the Federal courts are perceived as a factor that
limits the number of cases that can be prosecuted on the border, I
would note it is Congress that establishes the number of district
judgeships and the districts to which they are assigned, and Congress
and the Executive Branch that control the authorization, funding, and
construction of new courthouses. The district courts on the southwest
border have not received any new district judgeships since 2002 despite
Judicial Conference requests for additional judgeships in 2003 (11
judgeships), 2005 (11 judgeships), and 2007 (10 judgeships). In recent
years Congress has been responsive to the need for new courthouse space
on the southwest border, and we hope that you will support the
additional $110 million included in the President's fiscal year 2009
budget to fund fully a new Federal courthouse in San Diego, California.
The Judicial Conference designated the San Diego courthouse a judicial
space emergency in 2003, but the General Services administration has
been unable to award a contract for the project due to escalating
construction costs in Southern California.
It now appears that Congress has taken steps to address the
resource needs across the justice system on the southwest border by
providing additional resources beyond those provided to DHS. In fiscal
year 2008 the Department of Justice received $7 million in emergency
funding to hire more assistant U.S. Attorneys (AUSAs) in the five
judicial districts along the southwest border. The U.S. Marshals
Service received $15 million in emergency funding to address southwest
border workload needs including the hiring of 100 additional deputy
U.S. Marshals. The President's fiscal year 2009 budget includes $100
million for a new Southwest Border Enforcement Initiative focusing law
enforcement and prosecutorial efforts on fighting violent crime, gun
smuggling, and drug trafficking in that region. If funded, this
initiative will increase the number of AUSAs along the southwest border
by another 50 positions. The President's budget also seeks $88 million
to expand detention capacity along the southwest border. The resultant
increase in criminal filings we expect to see from this infusion of
resources will impact our district judges, clerks offices, probation
and pretrial services offices, and Federal defender offices on the
border. I would note, however, that the Judiciary's fiscal year 2009
budget submission does not request funding for new clerks or probation
office staff on the border or elsewhere. Congress provided the
Judiciary with $45.4 million over the last 2 years--$20.4 million in
fiscal year 2007 and $25 million in fiscal year 2008--to address
immigration-related workload so, from a staffing perspective, the
courts are well positioned in the short term to respond to the
increased workload that we expect will materialize. However, as I just
mentioned, we do require additional district judgeships on the
southwest border, and construction of a new Federal courthouse in San
Diego is the Judiciary's top space priority.

COST CONTAINMENT EFFORTS

The Judiciary recognizes that continuing pressures on the Federal
budget due to the conflicts in Iraq and Afghanistan, investments being
made to improve security here at home, and the goal of eliminating the
budget deficit by 2012, will necessitate austere Federal spending going
forward, particularly for non-security discretionary programs. Indeed,
the President's fiscal year 2009 budget proposes a 0.3 percent increase
in this category of spending, well below the rate of inflation. The
administration and Congress are rightfully concerned about overall
Federal spending and budget deficits, and we recognize that you face
tough choices. I want to assure the Subcommittee that the Judiciary is
doing its part to contain costs.
We are now more than 3 years into an intensive effort to reduce
costs throughout the Judiciary. As I mentioned in my testimony last
year, this cost containment effort was born out of our fiscal year 2004
experience in which a funding shortfall necessitated staff reductions
of 1,350 clerk and probation office employees, equal to 6 percent of
the courts' on-board workforce. As a result of this situation and the
prospect of continuing Federal budget pressures, the late Chief Justice
William H. Rehnquist charged the Judicial Conference's Executive
Committee with developing an integrated strategy for controlling costs.
After a rigorous 6-month review by the Judicial Conference's various
program committees, the Executive Committee prepared, and the Judicial
Conference endorsed in September 2004, a cost-containment strategy for
the Federal Judiciary. The strategy focuses on the primary cost drivers
of the Judiciary's budget--compensation costs and the rent we pay to
the General Services Administration for courthouses and leased office
space. We have had great cooperation Judiciary-wide as we have moved
forward on implementing cost containment initiatives. I will highlight
several cost containment initiatives for you.

Containing Rent Costs
The amount of rent we pay to GSA has been a matter of concern to
the Judiciary for a number of years. Since fiscal year 2004 we have
made a concerted effort to contain rent costs, with considerable
success. In fiscal year 2004, prior to the implementation of cost
containment, we projected that our GSA rent bill would be $1.2 billion
in fiscal year 2009. I am pleased to report that our current GSA rent
estimate for fiscal year 2009 is now projected to be $200 million less,
or $1 billion, 17 percent below the pre-cost containment projection.
Following are two of our rent containment initiatives that have
contributed to these reduced rent costs.
--Rent Validation Project.--In recent years we have been working
cooperatively with GSA to reduce our space rent costs through a
rent validation program that has yielded significant savings
and cost avoidances. This rent validation initiative originated
in our New York courts where staff spent months scrutinizing
GSA rent bills and found rent overcharges. The cumulative
effect of this discovery were savings and cost avoidances over
3 fiscal years totaling $30 million. The Administrative Office
expanded this effort nationwide by training all circuit
executive offices to analyze and detect errors in GSA rent
billings. Although it is quite time consuming, detailed reviews
of GSA rent billings are now a standard business practice
throughout the courts. Through this national effort, in fiscal
year 2007 we identified additional overcharges totaling $22.5
million in multi-year savings and cost avoidances, bringing
cumulative savings/cost avoidances to $52.5 million. We
anticipate receiving additional rent adjustments and credits
resulting from over $10 million in rent errors that we recently
reported to GSA. By identifying and correcting space rent
overcharges we have been able to re-direct these savings to
other Judiciary requirements, thereby reducing our request for
appropriated funds.
--Rent Caps.--To contain costs further, the Judiciary established
budget caps in selected program areas in the form of maximum
percentage increases for annual program growth. For our space
and facilities program, the Judicial Conference approved a cap
of 4.9 percent on the average annual rate of growth for GSA
rent requirements for fiscal years 2009 through 2016. By
comparison, the increase in GSA rent in our fiscal year 2005
budget request was 6.6 percent. This cap will produce a GSA
rent cost avoidance by limiting the annual amount of funding
available for space rental costs. Under this initiative,
circuit judicial councils around the country will be
responsible for managing rent costs in their circuits, which
will require the councils to prioritize space needs--and in
some instances deny requests for new space--in order to stay
within the 4.9 percent cap.

Containing Information Technology Costs
Another cost containment success has been identifying and
implementing more cost-effective approaches in deploying computer
servers around the country. Before this initiative, each court unit
maintained local servers to access Judiciary applications and
databases. New technology, along with improvements in the Judiciary's
national data communications network, has allowed the consolidation of
servers at a single location without compromising the performance
levels of existing applications. In some cases performance has actually
improved. As a result of this initiative, the Judiciary reduced by 89
the number of servers needed to run the jury management program,
producing savings of $2 million in the first year and expected savings
of $4.8 million through fiscal year 2012. In addition, servers that run
the case management system in our probation program were consolidated,
with projected savings and cost avoidances of $2.6 million through
fiscal year 2012. The Judiciary expects expanded implementation of this
initiative to result in significant information technology cost savings
or cost avoidances. A big cost saver will be the consolidation of
servers for the Judiciary's national accounting system in fiscal year
2008, which is expected to achieve savings and cost avoidances totaling
$55.4 million through fiscal year 2012.

Containing Personnel Costs
A major focus of the Judiciary's cost containment efforts involves
controlling personnel costs. At its September 2007 meeting, the
Judicial Conference approved recommendations from a major court
compensation study which will slow the growth in personnel costs
throughout the Judiciary, specifically in clerks and probation offices
and judges' chambers staff. The approved actions will reduce funding
available to the courts for annual salary step increases for employees,
limit the number of career law clerks (who are typically paid more than
term law clerks), revise salary setting policies for new law clerks,
and modernize the Federal courts' position benchmarks which govern the
classification and grading of staff nationwide. We estimate these
measures may save up to $300 million from fiscal year 2009 through
fiscal year 2017.

INNOVATION IN THE FEDERAL COURTS

While we look to contain costs wherever possible, we continue to
make investments in technologies that improve Federal court operations,
enhance public safety, and increase public access to the courts to name
just a few examples. The Judiciary is a leader in taking state-of-the-
art technology and adapting it to the courts' unique needs, and we
continually look for innovative ways to apply new technologies to our
operations. These investments are made possible through the funding we
receive from Congress, and we are grateful for Congress's continuing
support of our information technology program. Let me describe for you
several of our innovations.

Use of Global Positioning System Technology
Some of our probation and pretrial services offices are now using
Global Positioning System (GPS) technology to monitor around the clock
the location of individuals under pretrial release or post-conviction
supervision. As a condition of their sentence or supervised release, an
offender or defendant might be required to carry a GPS unit. Some GPS
tracking devices let officers send a text message or voice message
directly to the receiver worn by the offender enabling an alert to be
sent if the offender wanders into forbidden territory.
An incident that occurred in California offers an example of the
application of GPS technology. A defendant on a GPS tracking device was
ordered by a Federal judge to stay away from his ex-wife due to a prior
history of domestic violence. He was also subject to an active
restraining order. In the middle of the day, the defendant drove by his
ex-wife's place of employment. The pretrial services officer received a
text message alert and immediately contacted the defendant on the
tracking device, instructing him to come to the office. The officer
contacted the ex-wife, the court was notified, and appropriate action
was taken. In this instance, the pretrial services officer had
established exclusion zones around the wife's home and work. For
convicted sex offenders whose victims included children, these
exclusion zones can include schools, parks, and playgrounds. Many
offenders help defray the cost of monitoring on an ability-to-pay
basis. GPS monitoring can cost up to $9 per day, roughly double the
cost of less expensive electronic monitoring, but still well below the
more than $63 per day required to incarcerate an offender.

Case Management/Electronic Case Files System
The Case Management/Electronic Case Files (CM/ECF) system is an
electronic case management system that provides Federal courts with
docket management capabilities, including the option of permitting case
documents to be filed with the court over the Internet. Managing case
filings electronically is more cost efficient than the labor-and-space
intensive process of paper filings previously used. The electronic case
filing system was launched in November 1995, when a team from the
Administrative Office of the United States Courts helped the U.S.
District Court in the Northern District of Ohio cope with more than
5,000 document-intensive asbestos cases. The court faced up to 10,000
new pleadings a week, a workload that quickly became unmanageable. The
team developed a system that allowed attorneys to file and retrieve
documents and receive official notices electronically. More than 10
years and several upgrades later, the system has fundamentally changed
how the entire judicial system operates. The system is currently
operating in all of our district and bankruptcy courts and will be
operational in all of the regional courts of appeals in early 2009.
Over 30 million cases are on CM/ECF systems nationwide, and nearly
350,000 attorneys and others have filed documents over the Internet. On
average, four million new electronic documents are filed into the
system each month, and roughly half of those are filed over the
Internet by attorneys. CM/ECF is considered the world's most
comprehensive court electronic case filing system. It has been one of
the most important innovations in U.S. Federal court administration.

Public Access to Court Electronic Records
The Public Access to Court Electronic Records (PACER) system is an
electronic access service run by the Federal Judiciary that allows the
public to obtain case and docket information from Federal appellate,
district, and bankruptcy courts via the Internet. The PACER system
offers an inexpensive, fast, and comprehensive case information service
to any individual with a computer and Internet access. Users can
retrieve, among other information, a listing of parties and
participants in a case, a compilation of case-related information, such
as cause of action, nature of suit and dollar demands, judgments or
case status, and appellate court opinions. The data is displayed
directly on the user's computer screen within a few seconds. The system
is available 24 hours a day and is simple enough that little user
training is required. The PACER program has been hugely successful. In
2007 alone, over 350 million requests for information were processed by
PACER. As directed by Congress, nominal fees are charged for accessing
court records although some records are available without charge. Given
the high-volume usage of PACER, the fees collected in the aggregate are
substantial. Congress has authorized the Judiciary to utilize these
fees to run the PACER program as well as to offset some costs in our
information technology program that would otherwise have to be funded
with appropriated funds. The Judiciary's fiscal year 2009 budget
request assumes $68 million in PACER fees will be available to finance
information technology requirements in the courts' Salaries and
Expenses account, thereby reducing our need for appropriated funds.
the judiciary's workload \1\
---------------------------------------------------------------------------
\1\ Unless otherwise stated, caseload figures reflect the 12-month
period ending in June of the year cited (i.e., 2008 workload reflects
the 12-month period from July 1, 2007 to June 30, 2008).
---------------------------------------------------------------------------
I turn now to a discussion of the workload facing the courts. As
indicated in the caseload table in our fiscal year 2009 budget request,
2008 caseload projections are used to compute fiscal year 2009 staffing
needs. Our projections indicate that caseload will increase slightly in
probation (+1 percent) and pretrial services (+3 percent) and increase
substantially for bankruptcy filings (+23 percent). For 2008 we are
projecting small declines in appellate (-3 percent) and criminal (-3
percent) caseload, and a steeper decline in civil filings (-8 percent).
Let me discuss some recent trends and caseload drivers and offer some
context for these projections.

Probation and Pretrial Services \1\
Workload in our probation and pretrial services programs continues
to grow. The number of convicted offenders under the supervision of
Federal probation officers hit a record 115,930 in 2007 and is expected
to increase again in 2008 to 116,900. In addition to the increased
workload, the work of probation officers has become significantly more
challenging. In 1985, fewer than half of the offenders under
supervision had served time in prison. By 2007, the percentage had
climbed to 80 percent. As these figures indicate, probation officers no
longer deal primarily with individuals sentenced to probation in lieu
of prison. Offenders coming out of prison on supervised release have
greater financial, employment, and family problems than when they
committed their crimes. In addition, the number of offenders sentenced
in Federal court with prior criminal convictions more than doubled
between fiscal years 1996 and 2006, and the severity of the criminal
histories of persons under probation officer supervision has been
increasing as well. Offenders re-entering the community after serving
time in prison require close supervision by a probation officer to
ensure they secure appropriate housing and employment. Successful re-
entry improves the likelihood that offenders will pay fines and
restitution and become taxpaying citizens.
Recent legislation will also increase the workload of probation and
pretrial services officers. For example, we expect that the Adam Walsh
Child Protection and Safety Act of 2006 will significantly increase the
number of sex offenders coming into the Federal court system. The Adam
Walsh Act also increases the registration requirements for sex
offenders, which means probation officers must coordinate closely with
State and local authorities to ensure that law enforcement and the
public receive the required notice. Monitoring the behavior of sex
offenders is challenging and requires intense supervision on the part
of probation and pretrial services officers to protect the community.
As I discussed earlier in my testimony, the retroactive application
of the crack cocaine sentencing amendment will also have an impact on
the work of probation officers although it is difficult to predict with
certainty at this point how many current Federal prison inmates will
gain early release and enter the Federal probation system.

Bankruptcy Filings
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
(BAPCPA), implemented in October 2005, has significantly affected
workload trends in the Nation's bankruptcy courts. While filings are
still below pre-BAPCPA levels--751,056 filings in 2007 versus 1,635,725
filings in 2004--we forecast that filings will increase 23 percent in
2008 to 923,000 and top one million filings in 2009. The state of the
economy, particularly as it impacts home foreclosures and credit
availability, will be a major factor in the number of personal
bankruptcies--which constitute the majority of bankruptcy cases. It is
possible that 2008 bankruptcy filings will be above the current
projection.
The number of filings alone, however, should not be viewed as the
sole indicator of overall workload. BAPCPA created new docketing,
noticing, and hearing requirements that make addressing the petitions
far more complex and time-consuming. Our bankruptcy courts have
indicated that the actual per-case work required of the bankruptcy
courts has increased significantly under the new law, at least
partially offsetting the impact on the bankruptcy courts of lower
filings. For example, BAPCPA requires Chapter 7 filers to complete and
pass a complex ``means test'' and receive a credit counseling briefing
by an approved agency. Also, filers under Chapters 7 and 13 may not
receive a discharge of their debts unless they have completed an
approved financial management course. These and other new requirements
must be reviewed by the clerk's office, which must take further action
if the filers do not meet the requirements. BAPCPA also requires more
than 35 new motions and pleadings in various chapters of the bankruptcy
code. Each new motion requires judicial review and can result in
hearings, orders, and opinions, thus consuming more judicial resources.

Appellate Filings
After hitting an all-time high of 68,313 filings in 2006, appellate
caseload declined to 58,809 filings in 2007 and is expected to decline
by 3 percent to 57,300 filings in 2008. This decline comes on the heels
of significant workload growth from 2002 to 2006 during which filings
increased 20 percent initially due to a surge in challenges to Board of
Immigration Appeals (BIA) decisions in the appellate courts and later
due to the large number of criminal and habeas corpus petitions filed
by State and Federal prisoners from 2004 to 2006 challenging their
sentences pursuant to the Supreme Court's decisions in Blakely v.
Washington (2004), and in the consolidated cases, United States v.
Booker and United States v. Fanfan (2005). After the initial surge of
sentence-related filings associated with these decisions, we are now
seeing appellate filings for criminal and habeas corpus petitions
approach pre-Blakely and Booker/Fanfan levels.
About one-third of all BIA decisions are challenged in the Federal
appellate courts with 70 percent of those challenges occurring in the
Second and Ninth Circuits. While BIA appeals have dropped in the last
year, these cases continue to demand extensive resources since they
often turn on a credibility determination by a Department of Justice
immigration judge, thus requiring close judicial review of a factual
record by the appellate courts.

Civil Filings
Civil filings in the courts generally follow a more up and down
filing pattern. In 2005 civil filings reached a record 282,758 filings,
declined to 244,343 filings in 2006, then increased again to 272,067
filings in 2007. The increase in 2007 was due primarily to asbestos
diversity case filings in the Eastern District of Pennsylvania. The
Judiciary projects civil case filings will continue this up and down
pattern, decreasing 8 percent to 250,500 filings in 2008.

Criminal Filings
Criminal filings in the Federal courts have been trending downward
the last several years, and this trend is expected to continue through
2008. From the previous year, filings declined 2 percent in 2005, 3
percent in 2006, and a half-percent in 2007 to 67,503 filings. Filings
are projected to decline another 3 percent in 2008 to 65,800 filings.
Last year I testified that criminal filings were likely depressed
due to significant vacancies in AUSA positions nationwide and that once
vacancies were filled criminal filings would reverse course and begin
to increase. As I mentioned earlier in my testimony, it now appears
that additional resources are being provided to fill AUSA positions,
particularly in the five judicial districts along the Southwest border
with Mexico. Also, the administration is committing more resources to
the prosecution of sexual exploitation of children. In fiscal year
2008, the Department of Justice received $5 million to hire 40
additional AUSAs to prosecute these exploitation cases under the Adam
Walsh Act. I would emphasize that our criminal caseload projection for
2008 does not take into account the impact additional AUSAs will have
on criminal case filings, so we may see 2008 filings above the
projected level.

FISCAL YEAR 2009 BUDGET REQUEST

For fiscal year 2009, the Judiciary is seeking a 7.6 percent
overall increase above the fiscal year 2008 enacted appropriations. The
courts' Salaries and Expenses account, which funds clerks and probation
offices nationwide, requires a 7.4 percent increase. Fiscal year 2009
appropriations requirements for each Judiciary account are included at
Appendix A.
The goal of our fiscal year 2009 request is to maintain staffing
levels in the courts at the level Congress funded in fiscal year 2008,
as well as to obtain funding for several much needed program
enhancements. As I noted earlier in my testimony, we are not requesting
additional staff for our clerks or probation offices. We believe the
requested funding level represents the minimum amount required to meet
our constitutional and statutory responsibilities. While this may
appear high in relation to the overall budget request submitted by the
administration, I would note that the Judiciary does not have the
flexibility to eliminate or cut programs to achieve budget savings as
the Executive Branch does. The Judiciary's funding requirements
essentially reflect basic operating costs of which more than 80 percent
are for personnel and space requirements.
Eighty-six percent ($407 million) of the $475 million increase
being requested for fiscal year 2009 funds the following base
adjustments, which represent items for which little to no flexibility
exists:
--Standard pay and benefit increases for judges and staff. This does
not pay for any new judges or staff but rather covers the
annual pay adjustment and benefit increases (e.g., COLAs,
health benefits, etc.) for currently funded Judiciary
employees. The amount budgeted for the cost-of-living
adjustment is 2.9 percent for 2009.
--An anticipated increase in the number of on-board senior Article
III judges.
--The projected loss in non-appropriated sources of funding due to
the decline in carryover balances available in fiscal year 2009
versus the level available to finance the fiscal year 2008
financial plan (see discussion on the following page).
--Space rental increases, including inflationary adjustments and new
space delivery, court security costs associated with new space,
and an increase in Federal Protective Service charges for court
facilities.
--Adjustments required to support, maintain, and continue the
development of the Judiciary's information technology program
which, in recent years, has allowed the courts to ``do more
with less''--absorbing workload increases while downsizing
staff.
--Mandatory increases in contributions to the Judiciary trust funds
that finance benefit payments to retired bankruptcy,
magistrate, and Court of Federal Claims judges, and spouses and
dependent children of deceased judicial officers.
--Inflationary increases for non-salary operating costs such as
supplies, travel, and contracts.
--Costs associated with Criminal Justice Act (CJA) representations.
The Sixth Amendment to the Constitution guarantees that all
criminal defendants have the right to the effective assistance
of counsel. The CJA provides that the Federal courts shall
appoint counsel for those persons who are financially unable to
pay for their defense.
After funding these adjustments to base, the remaining $68 million
requested is for program enhancements. Of this amount:
--$33 million will provide for investments in new information
technology projects and upgrades, and courtroom technology
improvements.
--$18 million to increase the non-capital panel attorney rate from
$100 to $118 per hour. I will discuss this requested increase
in more detail in a moment.
--$8 million is requested for the Supreme Court's exterior
renovations and roof system repairs.
--$5 million is for additional staff and associated costs to address
fiscal year 2009 workload requirements (32 FTE), two additional
magistrate judges and staff (9 FTE), library renovations and
new equipment at the Court of Appeals for the Federal Circuit,
and the start-up costs for two new Federal defender
organizations.
--$4 million would provide for necessary investments in court
security, such as court security systems and equipment and new
positions at the United States Marshals Service (9 FTE).

Non-Appropriated Sources of Funding
I would like to discuss briefly the non-appropriated sources of
funding that the Judiciary uses to partially finance its operations and
how they impact our appropriations needs. In addition to appropriations
from Congress, the Judiciary collects fees from bankruptcy and civil
case filings, from the public for on-line access to court records, and
from other sources. Fees not utilized during the year they are
collected may be carried over to the next fiscal year to offset
appropriations requirements in that year. Every fee dollar collected
that is not needed to finance current year needs represents a dollar
less that the Judiciary must seek from Congress in the following year.
In formulating the Judiciary's fiscal year 2009 budget request, we
made certain assumptions regarding the level of fees and carryover that
would be available to finance fiscal year 2009 requirements. Because
the projection for carryover balances are below the level that was
available to finance fiscal year 2008 operations, the fiscal year 2009
request includes a line item requesting appropriated funds--$95 million
in the courts' Salaries and Expenses account--to replace the
anticipated decline in carryover balances. (New fee collections are
projected to be flat from fiscal year 2008 to fiscal year 2009 so there
is no restoration requested or needed for that component of our
financing.) While it is premature for me to identify a specific amount,
I am confident that we will not need the full $95 million we requested
to replace carryover balances. This is due to several factors,
including the courts' frugal spending during the continuing resolution
for the first quarter of fiscal year 2008 and fewer judge confirmations
than we anticipated. As we did this past year, we will keep the
Subcommittee apprised of changes to fee and carryforward projections
that could impact our fiscal year 2009 appropriation needs as we move
through fiscal year 2008. The Judiciary will submit the first of two
fiscal year 2009 budget re-estimates to the Subcommittee in May 2008.

INCREASE IN NON-CAPITAL PANEL ATTORNEY RATE

We believe that one program enhancement in our budget request
deserves strong consideration in order to ensure effective
representation for criminal defendants who cannot afford to retain
their own counsel. We are requesting $17.5 million to increase the non-
capital panel attorney rate to $118 per hour, effective January 2009. A
panel attorney is a private attorney who serves on a panel of attorneys
maintained by the district or appellate court and is assigned by the
court to represent financially-eligible defendants in Federal court in
accordance with the Criminal Justice Act (CJA). In the fiscal year 2008
omnibus spending bill, the Subcommittee approved an increase in the
non-capital rate paid to these panel attorneys from $94 to $100 per
hour, and provided a cost-of-living adjustment to the capital rate from
$166 to $170 per hour. These new rates took effect on January 1, 2008.
While we are very appreciative of the increase to $100 per hour for
non-capital work, we believe a more significant increase is required to
enable the courts to attract and retain enough qualified attorneys to
accept appointments and to provide them a fair rate of pay. This is
critical in order for the Judiciary to ensure that persons represented
by panel attorneys are afforded their constitutionally guaranteed right
to effective assistance of counsel.
We believe there is a direct relationship between the lack of
qualified panel attorneys available to take CJA appointments and the
significant financial difficulties panel attorneys encounter
maintaining their legal practices at the current rate. It is
predominantly solo and small-firm lawyers that take on CJA cases, and
these panel attorneys must first cover their overhead costs. With
overhead costs of approximately $64 per hour, at the $100 rate, that
leaves a net average of only $36 per hour, before taxes. We believe
that this net rate of $36 per hour, when compared to the net national
average ``market rate'' of $148 per hour for non-CJA private criminal
cases, prevents the courts from attracting sufficient numbers of
qualified attorneys to take CJA appointments because those attorneys
can obtain higher pay on non-CJA cases. Each time a panel attorney is
asked by the court to accept a non-capital CJA appointment, he or she
must consider the inherent ``opportunity'' cost associated with the
higher hourly rate he or she could otherwise earn on a non-CJA case.
The CJA authorized the Judicial Conference to implement annual
cost-of-living adjustments (COLAs) to panel attorney rates, subject to
congressional funding. If the statutory COLAs provided to Federal
employees (the base employment cost index component only) had been
provided to panel attorneys on a recurring, annual basis since 1986,
the authorized non-capital hourly rate for fiscal year 2009 would be
$136. While the Judicial Conference supports the $136 rate, it is
mindful of the constrained Federal budget environment and, therefore,
proposes attaining the authorized rate in two stages, an $18 per hour
increase in fiscal year 2009 from $100 to $118 per hour, with a second
increase to $140 per hour in fiscal year 2010 (the $140 rate includes a
$4 COLA to the fiscal year 2009 rate of $136). The Judiciary is
committed to fully restoring the non-capital panel attorney rate, in a
cost-conscious manner, by implementing the authorized rate over 2
years.
I will close on this topic by reiterating that the Judiciary
greatly appreciates the $100 non-capital rate Congress provided in
fiscal year 2008, but the concern remains that, after overhead is
considered, the rate does not provide compensation that will attract
enough qualified panel attorneys to take on the complex work involved
in Federal criminal cases. I urge the Subcommittee to provide the
funding necessary to increase the non-capital panel attorney rate to
$118 per hour in fiscal year 2009.

CONTRIBUTIONS OF THE ADMINISTRATIVE OFFICE

I would like to briefly outline the important work performed by the
Administrative Office (AO) of the United States Courts. Year in and
year out, the AO provides critical support to the courts. With only a
fraction (1.3 percent) of the resources that the courts have, the AO
does a superb job of supporting our needs.
The AO has key responsibilities for judicial administration, policy
implementation, program management, and oversight. It performs
important administrative functions, but also provides a broad range of
legal, financial, program management, and information technology
services to the courts. None of these responsibilities has gone away
and new ones are continually added, yet the AO staffing level has been
essentially frozen for 15 years. As an example, despite no new staff,
the AO has been instrumental in implementing the Judiciary's cost
containment strategy which has achieved significant savings and cost
avoidances.
In my role as Chair of the Judicial Conference Committee on the
budget, I have the opportunity to work with many staff throughout the
AO. They are dedicated, hard working, and care deeply about their role
in supporting this country's system of justice.
The fiscal year 2009 budget request for the Administrative Office
is $82 million. The AO's request represents a current services budget,
no additional staff or program increases are sought. All of the
requested increase is necessary to support current services, mainly
standard pay and general inflationary increases, as well as funding to
replace the anticipated lower level of carryover amounts with
appropriated funds in fiscal year 2009.
I urge the Subcommittee to fund fully the Administrative Office's
budget request. The increase in funding will ensure that the
Administrative Office continues to provide program leadership and
administrative support to the courts, and lead the efforts for them to
operate more efficiently. Director Duff discusses the AO's role and
budget request in more detail in his testimony.

CONTRIBUTIONS OF THE FEDERAL JUDICIAL CENTER

I also urge the Subcommittee to approve full funding for the
Federal Judicial Center's request of $25.8 million for fiscal year
2009.
The Center's director, Judge Barbara Rothstein, has laid out in
greater detail the Center's needs in her written statement. I simply
add that the Center plays a vital role in providing research and
education to the courts. The Center's research and its educational
programs are highly respected and valued for their quality and
objectivity. The Judicial Conference and its committees request and
regularly rely on research projects by the Center. The Center's
educational programs for judges and court staff are vital in preparing
new judges and court employees to do their jobs and in keeping them
current so that they can better deal with changes in the law, and in
tools--like technology--that courts rely on to do their work
efficiently.
The Center has made good use of its limited budget. It uses several
technologies to deliver information and education to more people more
quickly and inexpensively. The relatively small investment you make in
the Center each year (less than one-half of 1 percent of the
Judiciary's budget) pays big dividends in terms of the effective,
efficient fulfillment of the courts' mission.

CONCLUSION

Mr. Chairman, I hope that my testimony today provides you with some
insight into the challenges facing the Federal courts as well as what
we are doing to contain costs and become more efficient. I realize that
fiscal year 2009 is going to be another tight budget year as increased
mandatory and security-related spending will result in further
constrained domestic discretionary spending. We recognize the fiscal
constraints Congress is facing. Through our cost-containment efforts
and information technology innovations we have significantly reduced
the Judiciary's appropriations requirements without adversely impacting
the administration of justice. I know you agree that a strong,
independent Judiciary is critical to our Nation. I urge you to fund
this request fully in order to enable us to maintain the high standards
of the U.S. Judiciary.
Thank you for your continued support of the Federal Judiciary. I
would be happy to answer any questions the Subcommittee may have.

APPENDIX A.--JUDICIARY APPROPRIATIONS
[Dollars in thousands]
------------------------------------------------------------------------
Percentage
Fiscal year Fiscal year change:
2008 enacted 2009 fiscal year
Appropriation account level President's 2009 vs.
(Public Law budget (Feb. fiscal year
110-161) \1\ 4, 2008) 2008 enacted
------------------------------------------------------------------------
U.S. Supreme Court:
Salaries & Expenses....... $66,526 $69,777 +4.9
Care of Building and 12,201 18,447 +51.2
Grounds..................
-----------------------------------------
Total................... 78,727 88,224 +12.1
=========================================
U.S. Court of Appeals for the 27,072 32,357 +19.5
Federal Circuit..............
U.S. Court of International 16,632 19,622 +18.0
Trade........................
=========================================
Courts of Appeals, District
Courts & Other Judicial
Services:
Salaries & Expenses:\1\
Direct................ 4,619,262 4,963,091 +7.4
Vaccine Injury Trust 4,099 4,253 +3.8
Fund.................
-----------------------------------------
Total............... 4,623,361 4,967,344 +7.4
=========================================
Defender Services \1\. 846,101 911,408 +7.7
Fees of Jurors & 63,081 62,206 -1.4
Commissioners........
Court Security........ 410,000 439,915 +7.3
-----------------------------------------
Subtotal............ 5,942,543 6,380,873 +7.4
=========================================
Administrative Office of the 76,036 81,959 +7.8
United States Courts.........
Federal Judicial Center....... 24,187 25,759 +6.5
Judiciary Retirement Funds.... 65,400 76,140 +16.4
U.S. Sentencing Commission.... 15,477 16,257 +5.0
Direct........................ 6,241,975 6,716,938 +7.6
Vaccine Injury Trust Fund..... 4,099 4,253 +3.8
-----------------------------------------
Total................... 6,246,074 6,721,191 +7.6
------------------------------------------------------------------------
\1\ Pursuant to Public Law 110-161, fiscal year 2008 appropriations
include $25 million in emergency appropriations ($14.5 million in the
courts' Salaries and Expenses account and $10.5 million in the
Defender Services account) for workload associated with DOJ and DHS
immigration enforcement initiatives.

______

Prepared Statement of Paul R. Michel, Chief Judge, United States Court
of Appeals for the Federal Circuit

Mr. Chairman, thank you for allowing me to submit my statement
supporting the United States Court of Appeals for the Federal Circuit's
fiscal year 2009 budget request.
Our request totals $32,357,000, an increase of $5,285,000 (19.5
percent) over the fiscal year 2008 appropriation of $27,072,000. The
primary justification for such an unusual increase is the need to
accommodate seven senior judges who will expand our court's judicial
output in 2009.
Thirty percent of this requested increase ($1,575,000) is for
Congressionally and contractually mandated adjustments to base (such as
COLAs and escalation in rent and contracts). The only addition included
in the adjustment to the base appropriation is $298,000 to lease
chambers outside the courthouse for senior judges for whom there is no
space in the courthouse.
Four Federal Circuit judges are eligible to take senior status now;
three more will become eligible in fiscal year 2009; and another judge
will become eligible in fiscal year 2010. Of the three Federal Circuit
judges who will become eligible to take senior status in fiscal year
2009, at least two are expected to do so. An increase to the Court's
base of $298,000 will cover the cost of an off-site lease for these two
judges and up to three of the other four senior judges who are eligible
for senior status.
Seventy percent of the Federal Circuit's fiscal year 2009 budget
request, $3,710,000, is to fund three specific program requests.
--The first specific program request ($1,860,000) is to build out
off-site chambers for five senior judges.
--The second specific program request ($932,000) is for 12 law clerk
positions for active judges, and
--The third specific program request ($918,000) is for court
improvements and a court employee position.

PART 1

Half of the 70 percent increase for specific program requests
($1,860,000) will fund build out of leased chambers for five of the
seven judges who either are, or will be, eligible to take senior status
in fiscal year 2009. This amount is based on an estimate coordinated
with the Administrative Office of the United States Courts and on
personal experience with GSA in renovating chambers in this courthouse.
This amount will provide the leased chambers with the furniture,
furnishings and finishes consistent with the U.S. Courts Design Guide.
The amount requested is the amount needed to support judges eligible
and expected to take senior status now through fiscal year 2010 and for
whom there is no room in the existing courthouse.
As noted, two of the seven judges who will be eligible to take
senior status have indicated a desire to do so when they become
eligible for senior status in fiscal year 2009. Personal circumstances
make it likely that at least two more will also do so. It is imperative
then that the Federal Circuit acquire suitably built-out, off-site
leased chambers for the two judges who have indicated a desire to take
senior status in fiscal year 2009, two or three of the four already
eligible, and another who is likely to do so in fiscal year 2010.

PART 2

Twenty-five percent of the specific program requests ($932,000)
will fund 12 additional law clerk positions. The Court is requesting
$932,000 to cover the cost of hiring an additional law clerk for each
of the court's active judges for 6 months of fiscal year 2009. The
court's increased workload now justifies funding a fourth law clerk for
each active judge. Four law clerks are the norm at every Federal
Appeals Court in the Nation except the Federal Circuit. In our fiscal
year 2008 appropriation, Congress authorized three additional law
clerks but provided no funding. We are now requesting funding for all
12 additional law clerks: the three approved but unfunded in fiscal
year 2008, and the remaining nine, for a total of 12, or one per judge.
Patent infringement cases make up one-third or more of the Federal
Circuit docket. The number of patent infringement cases has grown by
more than 25 percent in the 15 years since the third clerk was first
provided. Patent infringement cases are critical to the Nation's
economy, and the decisions of the Federal Circuit in these cases often
have significant and sometimes dramatic economic implications for
parties whose patents are upheld and found to have been infringed,
whose patents are found not to have been infringed by other parties,
and many other economic actors. The difficulty and complexity of patent
infringement and other intellectual property cases have increased
exponentially in recent years.
Most of the patent cases now filed in the Federal Circuit Court of
Appeals are highly technical and require great insight and judgment.
The issues presented in these cases involve arcane breakthroughs on the
frontiers of science, technology, manufacturing, engineering,
mathematics and medicine. In such cases legal judgments must be made,
not only about the law itself but often on the basic underlying
technical innovation, with few if any precedents, analogies or
objective metrics to apply to help determine the outcome.
Many such cases involve a multitude of issues, no one of which can
be ignored in an effort to narrow and focus the decision-making process
as so often happens on appellate review. In patent infringement cases,
all issues must typically be left together because together they frame
the problem and the outcome. The practical effect is that one case
takes on the nature of several, whose many issues must be understood
individually and collectively before the court can integrate them into
a unifying substantive decision.
Timeliness is also an issue in many of these cases because the
speed of technological change can render a delayed decision essentially
ineffectual in a rapidly-changing economic marketplace.
In the appeal of such cases the question is not only whether the
law was correctly applied below, but also whether the science or
technology was understood correctly by the trial judge or jury. The
latter issue is especially important in the innovative appeals that
come so often before this court, where there are few if any boundaries,
signposts, or rules to guide the deciding judges. In many cases the
court is required to engage in de novo review. This means the judges
must review all elements of the decision below, in some cases retracing
the actual footwork of the trial judge, if not actually embarking on
entirely new lines of thought, logic and analysis.
In patent infringement and other intellectual property cases most
judges and their law clerks have to master an unfamiliar field of
science and draw the best conclusions they can from scarce and limited
resources. Because judges are assigned to panels randomly and not by
specific subject matter expertise, all judges and their law clerks on
the Federal Circuit are required to engage in extensive, and
fundamental scientific inquiries in every area of science and
technology. The practical effect is that each judge with his or her
Chambers staff is engaged simultaneously in varied and complicated
exercises, as opposed to deciding a series of often less complex,
single issue cases, as in other courts of appeals.
The Federal Circuit's need for additional law clerks is based on an
increased caseload in highly technical and complex appeals. Having a
fourth law clerk would ensure that the judges of the United States
Court of Appeals for the Federal Circuit can give the Nation,
practitioners and litigants and the Patent and Trademark Office timely
and thoughtful deliberation on the many challenging, critical and
complex issues that come before the Court.

PART 3

Approximately 25 percent of the specific program requests
($918,000) will fund the following:
--Cooling equipment for the network server room ($350,000);
--A new Internal Controls Analyst position ($71,000);
--Renovations to the Circuit Library ($200,000);
--Enhancements to courtroom computer technology ($255,000); and
--Furniture and equipment for the new positions requested ($42,000).
These items are important to the management and internal operation
of the United States Court of Appeals of the Federal Circuit.
Permanent Cooling Equipment.--The Court requests $350,000 to
provide permanent cooling equipment for the network server room. The
Court's server room was jerry-built out of an internal office space. It
was never properly configured, ventilated, wired or equipped. Following
several instances of dangerously high temperatures, we took temporary
steps to mitigate some of the immediate problems. These funds would
enable us to reconfigure and cool the server room properly, thereby
saving the life of expensive hardware and equipment and greatly
improving the reliability of information technology for the court's
judges and staff.
Internal Controls Analyst.--The Court is requesting $71,000 for a
new Internal Controls Analyst position which was authorized and
encouraged throughout the judiciary by the Judicial Conference. We have
already assigned existing staff additional duties to conduct internal
audits, inspections and inventories. But having a dedicated, trained
professional to perform these responsibilities would fulfill the vision
the Judicial Conference contemplates and materially improve the
stewardship of the court's property, funds, and internal procedures.
Circuit Library Renovations.--The Court is requesting $200,000 to
design and construct renovations to the Circuit Library, which has not
been renovated since the courthouse was built in 1965. These modest
renovations would improve access to and efficiency in managing the
Library collection.
Courtroom Technology Enhancements.--The Court is requesting
$255,000 to finance technological enhancements in our third courtroom,
consistent with long-standing policy of the Judicial Conference. Such
enhancements include digital sound recording equipment to enable
uploading the audio portion of oral arguments on the court's website;
laptop connectivity equipment and training to bring the courtroom into
the 21st century and allow judges and their law clerks and counsel to
use personal computers during arguments; under-floor cabling for
safety, security and easy access; and video-conferencing infrastructure
for remotely conducted oral arguments.
Furniture and Equipment.--The Court is requesting $42,000 for
furniture and equipment for the new positions described above: 12 law
clerks and an internal controls analyst.
Mr. Chairman, I would be pleased to answer any questions the
Committee may have or to meet with the Committee members or staff about
our budget request. Thank you.
______

Prepared Statement of Jane A. Restani, Chief Judge, United States Court
of International Trade

Mr. Chairman, Members of the Committee: I would like to once again
thank you for providing me the opportunity to submit this statement on
behalf of the United States Court of International Trade, which is
established under Article III of the Constitution with exclusive
nationwide jurisdiction over civil actions pertaining to matters
arising out of the administration and enforcement of the customs and
international trade laws of the United States.
The Court's budget request for fiscal year 2009 is $19,622,000.
This represents an overall increase of $2,990,000 or 18 percent over
the Court's fiscal year 2008 enacted appropriation of $16,632,000. The
primary reason for this increase in the fiscal year 2009 budget request
is a substantial increase in GSA rent charges. The total GSA rent
estimate for fiscal year 2009 is $7,527,041, which is an increase of
$2,336,000 over the fiscal year 2008 rent estimate. To put these
charges in perspective, it is important to note that these fiscal year
2009 rent charges represent 78 percent of the Court's total requested
increase and 38 percent of the Court's total requested budget. The rent
rate increase reflects a 50 percent increase in the shell rate as a
result of a new appraisal by GSA. While the shell rate is primarily
responsible for the increase in GSA rent charges, those increase
charges also include a new expenditure of $803,012 for the amortized
cost of the Court's Congressionally-approved security pavilion. The
process for the construction of this security pavilion began in fiscal
year 2002 when Congress authorized $75,000 for an architectural
analysis of the repairs and upgrades needed to ensure the health,
security and effective operation of the Court. The results of this
analysis eventually led to the construction of the security pavilion
that will be completed toward the end of fiscal year 2008.
Despite the substantial increase in rent charges, which is outside
of the Court's control, the Court continues, as it has done for the
past 13 years, to budget conservatively and request only funds that
will provide for mandatory increases in pay, benefits and other
inflationary factors, as well as funds for the essential on-going
operations and initiatives of the Court. These increases are in line
and consistent with the Court's prior average budgetary requests of 4.8
percent. I note also that these modest increases include increases in
costs paid to the Federal Protective Service for basic and building-
specific security surcharges. The security surcharges provide for the
Court's pro-rata share of installing, operating and maintaining systems
for the critical and necessary security of the Federal Complex in lower
Manhattan.
Through the use of its annual appropriation and the Judiciary
Information Technology Fund (JITF), the Court continues to promote and
implement the objectives set forth in its Long Range Plan. These
objectives promote access to the Court through the effective and
efficient delivery of services and information to litigants, the bar,
public, judges and staff. As a national court, this access is critical
in realizing the Court's mission to resolve disputes by (1) providing
cost effective, courteous and timely service, (2) providing
independent, consistent, fair and impartial interpretation and
application of the customs and international trade laws and (3)
fostering improvements in customs and international trade law and
practice and improvement in the administration of justice.
The Court continues to aggressively implement its information
technology and cyclical maintenance/replacement programs. In fiscal
year 2007, the Court: (1) purchased, configured and tested three new
replacement servers, two new file servers and one internet server; (2)
tested the new 3.1 version of the Court's customized version of the
Federal Judiciary's Case Management/Electronic Case Files (CM/ECF)
System; (3) cyclically upgraded, replaced and supported desktop
computers and printers throughout the Court; (4) upgraded the Court's
photo-copiers with new digital copiers with scanning and faxing
capabilities; (5) installed the new version of Word Perfect; (6)
supported and maintained all technical equipment and software
applications; and (7) utilized an Administrative Office contract for
professional consulting services for an evaluation of the needs of the
Court in the design and implementation of a new video conferencing
system. Additionally, in fiscal year 2007, the Court continued its
cyclical maintenance program by: (1) refurbishing the finance/property/
procurement and the technical development support sections of the
Clerk's Office; and (2) refurbishing two case file rooms and the
confidential storage room for better space utilization.
In fiscal year 2008, the Court plans to expend funds to: (1) review
and subsequently implement the consultant's recommendations, mentioned
in the above, for the purchase of a new video conferencing system; (2)
install the file and internet servers and replace the Court's voice,
fax and domain name servers; (3) replace desktop computer systems and
VPN laptops in accordance with the Judiciary's cyclical replacement
program; (4) upgrade and support existing software applications; (5)
purchase new software applications to ensure the continued operational
efficiency of the Court; and (7) support Court equipment by the
purchase of yearly maintenance agreements. The Court will also continue
to expand its developmental and educational programs for staff in the
areas of job-related skills and technology.
In fiscal year 2009, the Court will not only remain committed to
using its carryforward balances in the Judiciary Information Technology
Fund to continue its information technology initiatives and to support
the Court's short-term and long-term information technology needs, but
will also continue its commitment to its cyclical replacement and
maintenance program for equipment and furniture for the Courthouse.
This latter program not only ensures the integrity of equipment and
furnishings, but maximizes the use and functionality of the internal
space of the courthouse. Additionally, the fiscal year 2009 request
includes funds for the support and maintenance of the Court's upgraded
security systems. Lastly, the Court will continue its efforts to
address the educational needs of the bar and Court staff.
As I have continually stated in previous years, the Court remains
committed to maintaining its security systems to ensure the protection
of those who work in and visit the Courthouse. The Court is looking
forward to the completion of its security pavilion in the third quarter
of fiscal year 2008. This pavilion is expected to be fully operational
in fiscal year 2009. The Court has worked in partnership with GSA in
the design, construction and completion of this entrance pavilion and
is most gratified to see that everyone's efforts and hard work will
finally be realized.
I would like to again emphasize that the Court will continue to
conservatively manage its financial resources through sound fiscal,
procurement and personnel practices. As a matter of internal operating
principles, the Court routinely has engaged in cost containment
strategies in keeping with the overall administrative policies and
practices of the Judicial Conference. For over 5 years the Court has
only requested funds to maintain current services. The extraordinary
increase in the fiscal year 2009 projected rent charges has caused
concerns regarding the Court's ability to maintain current services
without additional funds to support the rent increase. In an effort to
lessen the projected impact of this rent increase, at the end of fiscal
year 2007 and continuing into fiscal year 2008, the Court began the
initial review process of the fiscal year 2009 rent rate. Several
meetings were held with high level regional GSA personnel responsible
for the review and implementation of the rent pricing rates.
Additionally, the Clerk of Court met with the Administrative Office. In
order to proceed with the process and at the suggestion of the
Administrative Office, the Court, in fiscal year 2008, will issue a
work order for an independent appraisal analysis. Once the new
appraisal is completed and reviewed, subsequent meetings will be held
with GSA's high level regional and national office personnel in an
effort to reduce the high rent increase.
Lastly, I would like to personally extend my deepest thanks and
appreciation to Congress for recognizing the needs of the Court by
providing, in fiscal years 2007 and 2008, adequate funding to maintain
current services. I am confident that Congress, in fiscal year 2009,
will provide the needed funds for the increase in rent costs, thereby
enabling the Court to continue to operate in a cost effective and
efficient manner.
The Court's ``General Statement and Information'' and
``Justification of Changes,'' which provide more detailed descriptions
of each line item adjustment, were submitted previously. If the
Committee requires any additional information, we will be pleased to
submit it.
______

Prepared Statement of Hon. Barbara J. Rothstein, Director, Federal
Judicial Center

I am Barbara Rothstein. I have been the Center's director since
2003, and a district judge since 1980. I am pleased to submit the
Center's 2009 budget request on behalf of the Center's Board, which the
Chief Justice chairs, and which approved this request.
First, the Center is grateful for the efforts of Congress to
provide in fiscal year 2008 not only full adjustments to its 2007 base
(for only the second time in more than a decade) but also $156,000 for
three new positions (30 percent of the $504,000 we sought in fiscal
2008 to restore 10 of the 22 Center positions vacated and frozen since
2003 because of budget shortfalls).
Our 2009 request is for $25,759,000, a $1,572,000 (or 6.5 percent)
increase over 2008. The increase includes $1,060,000 for standard
adjustments to base, $387,000 for four full-time equivalent positions
(seven positions for approximately 6 months), and $125,000 for critical
education and training programs.
Before providing more detail on this request, let me provide you
with a little background on the Center and its activities. I hope with
this description to convey to you the important contribution that the
Center makes to the effective and efficient functioning of the Federal
courts.

THE CENTER'S CONTRIBUTION TO THE COURTS

The Center's mission is to provide objective, well-grounded
empirical research and balanced, effective educational programs for the
courts.
The courts, and particularly the Judicial Conference of the United
States, as well as Congress and the public, are regular consumers of
the Center's research projects. They rely on the Center for thorough,
unbiased, well-documented research. Examples include examining the
impact of the Class Action Fairness Act of 2005 on the resources of the
Federal courts; providing information to assist judges in handling
capital cases; and developing empirically sound case weights that
accurately reflect judicial workload. Not only do projects such as
these help judges decide cases efficiently and fairly, they also help
the judiciary and Congress make better-informed decisions about
policies and procedures affecting the courts.
Center education programs are vital to judges and court staff. For
new judges, orientation programs enable them to assume their new
responsibilities quickly. Continuing education programs bring judges up
to date on topics ranging from case-management techniques to new
statutes and case law. (For example, the Center quickly responded to
the U.S. Sentencing Commission's decision to retroactively apply
changes to the sentencing guidelines on crack cocaine by providing
educational programs and other resources to help judges, probation
officers, and others deal carefully, efficiently, and fairly with the
many issues this raised.)
Court staff, who play a critical role in supporting judges and
ensuring the efficient operation of the courts, rely on the Center for
educational programs and materials that help them do their jobs better
(for example, integrating new technologies and executing cost-
containment strategies). The Center's Professional Education Institute,
which provides basic and advanced programs on leadership and management
for managers and supervisors at all levels in the courts, is a key
component of court staff training.
The Center uses a wide range of tools to deliver education. One
reality of the information age is that people can (and expect to)
receive information in many different ways. Where once the Center
relied almost exclusively on in-person programs, audiotapes, and hard-
copy publications to reach judges and court staff, we have expanded
into satellite television broadcasting, teleconferencing, and use of
the Internet and the courts' intranet, and, more recently, web-
conferencing and streaming video. All these delivery means are needed
to meet the diverse needs of a diverse population of judges, managers,
and staff.
The importance of the Center's educational programs is reflected in
their use by the courts. All Center training is voluntary; large
numbers of judges and court staff choose to participate in Center
programs and use its services because they know the Center's products
will help them do their jobs better. In 2007, over 9,000 employees of
the courts (including over 2,000 judges) attended Center programs in
person--over half did so in their own districts. Over 1,000 court staff
participated in Center video, audio, and web conferences, and thousands
of judges and court staff watched Center television programs, accessed
resources and downloaded materials from the Center's intranet site, and
used Center publications.

THE CENTER HAS MANAGED ITS APPROPRIATION RESPONSIBLY

Understanding the need for fiscal responsibility, the Center has
made careful use of its appropriation each year. As I noted earlier, we
use a wide variety of cost-effective delivery tools to provide
education and information to judges and staff efficiently. The various
delivery tools we use have enabled us to reach a larger and larger
audience for less money than we could with only one or two of these
media. But new technology also requires a highly professional staff
with diverse skills in order to take full advantage of these tools and
to identify and implement newer technologies as they emerge.
In-person programs remain a vital part of our education efforts.
Here we economize in several ways. Most in-person staff training (and
some judge education) is done by bringing faculty to the courts for
local training. Most programs to which participants must travel are
conducted in hotels in large cities where we can negotiate reasonable
rates and take advantage of competitive airfares. We conduct smaller
seminars in collaboration with several outstanding law schools,
enabling us to avoid faculty and overhead costs.
We stretch our appropriation by working closely with our sister
agencies, the Administrative Office of the U.S. Courts and the U.S.
Sentencing Commission. We regularly consult with them to avoid
duplicative efforts, and we often provide them an opportunity to convey
their information to the courts at Center-sponsored programs.

THE CENTER'S FISCAL YEAR 2009 REQUEST

Our request for 2009 is modest--standard adjustments to our 2008
base, $387,000 to enable us to fill the seven positions sought but not
funded in our fiscal year 2008 request, and $125,000 for programs that
are needed but which we cannot currently afford without cutting equally
important programs elsewhere. The seven positions will return the
Center to approximately its fiscal year 2005 staffing level, but that
level will still be more than 10 percent below the number of staff the
Center had as recently as 2003, and over 20 percent below the number of
staff employed by the Center in the early 90s. With these resources we
can continue to help the courts prepare for and meet the many
substantive, procedural, and operational challenges they face. The
additional program funds would provide expanded programming for judges
on sentencing, ethics, and case management (including the use of
information technology). These additional funds would also provide
programs for attorneys in the courts; the Center has not kept pace with
the growing educational needs of these attorneys. The requested amounts
represent a total increase of only 6.5 percent over the Center's fiscal
year 2008 level. I ask you to please find the resources to fund them in
full.
Thank you for your careful consideration of our request. I would be
pleased to respond to any questions you may have.
______

Prepared Statement of the United States Sentencing Commission

Chairman Durbin, Ranking Member Brownback, and members of the
subcommittee, the United States Sentencing Commission thanks you for
the opportunity to submit this statement in support of its
appropriations request for fiscal year 2009. The Commission's statutory
mission, as set forth in the Sentencing Reform Act of 1984, continues
to be both reaffirmed and significantly impacted by recent United
States Supreme Court decisions regarding Federal sentencing policy.
Full funding of the Commission's fiscal year 2009 request will ensure
that the Commission can continue to fulfill its statutory mission.

RESOURCES REQUESTED

The Commission is requesting $16,257,000 for fiscal year 2009,
representing a 5 percent increase over the fiscal year 2008
appropriation of $15,477,000. The Commission recognizes that it must
use its allotted resources carefully and that Congress expects the
same. The Commission accordingly has tailored its fiscal year 2009
request narrowly and is seeking a limited increase over its fiscal year
2008 appropriation to account for inflationary increases and certain
adjustments for personnel costs.

JUSTIFICATION FOR THE COMMISSION'S APPROPRIATIONS REQUEST

The statutory duties of the Commission include, but are not limited
to: (1) developing sentencing guidelines to be determined, calculated,
and considered in Federal criminal cases; (2) collecting, analyzing,
and reporting Federal sentencing statistics and trends; (3) conducting
research on sentencing issues in its capacity as the clearinghouse of
Federal sentencing data; and (4) providing training on sentencing
issues to Federal judges, probation officers, law clerks, staff
attorneys, defense attorneys, prosecutors, and others.
These statutory duties and the continuing importance of the
sentencing guidelines have repeatedly been reaffirmed by recent Supreme
Court decisions beginning with United States v. Booker.\1\ In Booker,
the Supreme Court reemphasized the Commission's continuing role with
regard to (writing Guidelines, collecting information about district
court sentencing decisions, undertaking research, and revising the
Guidelines accordingly.'' \2\ In Rita v. United States,\3\ the Supreme
Court reinforced the role of the Commission and the importance of the
guidelines in holding that a court of appeals may apply a presumption
of reasonableness to a sentence imposed within the properly calculated
sentencing guideline range. The Court noted that ([t]he Commission's
work is ongoing. The statutes and the Guidelines themselves foresee a
continuous evolution helped by the sentencing courts and courts of
appeals in that process.\4\ In Gall v. United States,\5\ the Court
reemphasized that ``([a]s a matter of administration and to secure
nationwide consistency, the Guidelines should be the starting point and
the initial benchmark'' in determining an appropriate sentence.\6\
---------------------------------------------------------------------------
\1\ 543 U.S. 220 (2005).
\2\ 543 U.S. at 264.
\3\ 127 S. Ct. 2456 (2007).
\4\ Id. at 2464.
\5\ 128 S. Ct. 586 (2007).
\6\ Id. at 596.
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While reaffirming the ongoing nature of the Commission's work,
these decisions also have had a significant impact on that work.
Consistent with Booker and its progeny, the Commission has continued
its core mission to review and revise the guidelines, taking into
account 18 U.S.C. Sec. 3553(a) and other congressional statutes and
directives and in response to information it receives from sentencing
courts, Congress, the Executive Branch, Federal defenders, and others.
The Commission also has increased its efforts to provide training on
Federal sentencing issues, including application of the guidelines, to
Federal judges, probation officers, law clerks, staff attorneys,
prosecutors, defense attorneys, and others.
Furthermore, in response to these Supreme Court cases, the
Commission has continued to refine its data collection, analysis, and
reporting efforts to provide real-time data about Federal district
court sentencing practices and trends. The Commission must continue to
disseminate sentencing information in real-time and in a thorough
manner so that Congress and others can be fully informed and advised on
sentencing policy in the wake of the Booker line of cases. In addition,
the Commission must continue to monitor appellate case law applying
these cases, requiring the Commission to further refine its appellate
court database.
Despite the impact of these cases, the Commission is not requesting
program increases for fiscal year 2009. The Commission has worked
diligently over the past several years to maximize its resources
overall and appreciates the support and funding it has received from
Congress.
Sentencing Policy Development and Guideline Promulgation
As part of its statutory duty to develop sentencing guidelines to
be determined, calculated, and considered in Federal criminal cases,
the Commission promulgated a number of guideline amendments during the
amendment cycle ending on May 1, 2007. These amendments, which absent
congressional action to the contrary became effective on November 1,
2007, related to several substantive areas of the criminal law,
including transportation, terrorism, intellectual property, and drug
offenses. As part of this work, the Commission updated its extensive
2002 report on Federal cocaine sentencing and amended the guidelines
prescribing sentences for crack cocaine offenses, keeping the guideline
penalties within the statutorily-prescribed mandatory minimum
sentences. The Commission received voluminous public comment on this
issue, including whether these changes should be applied retroactively.
It held multiple public hearings on the amendment and the issue of
retroactivity, receiving testimony from a cross-section of witnesses.
Based on this testimony and its own research, the Commission decided to
give retroactive effect to its amendment for crack cocaine offenses. It
now is working closely with the Federal criminal justice community to
ensure its efficient application.
For the amendment cycle ending May 1, 2008, the Commission is
considering several guideline amendments in response to recent
congressional action. The Commission has proposed amendments in
response to the Animal Fighting Prohibition Enforcement Act of 2007,
the Honest Leadership and Open Government Act of 2007, the Emergency
and Disaster Assistance Fraud Penalty Enhancement Act of 2007, and the
Court Security Improvement Act of 2007. The Commission also is
considering amendments in the areas of immigration offenses, drug
offenses, and criminal history. These proposed amendments respond to
input received from the criminal justice community and reflect the
Commission's ongoing work to refine the guidelines in accordance with
its statutory obligations.
Consistent with the requirements of the Sentencing Reform Act of
1984, the Commission engages in a collaborative process for sentencing
policy development and guideline promulgation. That process continues
to include significant outreach to, and input from, representatives of
the criminal justice community, as well as the review of pertinent
literature, data, and case law. For example, the Commission recently
held a public briefing session on disaster fraud offenses and the
illegal use of human growth hormone. During this briefing session, the
Commission received testimony from the Department of Justice, the
Federal Defenders Service, the Department of Housing and Urban
Development, the American Red Cross, and the Food and Drug
Administration.

Collecting, Analyzing and Reporting Sentencing Data
In fulfillment of its statutory duties related to collecting,
analyzing, and reporting Federal sentencing statistics and trends, the
Commission collects documentation from the district courts on over
70,000 Federal felony and class A misdemeanor cases annually.\7\ From
this documentation, the Commission extracts, analyzes, and reports
information on national sentencing trends and practices. As with other
aspects of the Commission's statutory mission, data collection,
analyzing, and reporting efforts continue to be impacted by the Supreme
Court's recent sentencing-related decisions.
---------------------------------------------------------------------------
\7\ See 28 U.S.C. Sec. 994(w), which requires the chief judge of
each district court, within 30 days of entry of judgment, to provide
the Commission with: (1) the charging document; (2) the written plea
agreement (if any); (3) the Presentence Report; (4) the judgment and
commitment order; and (5) the statement of reasons form.
---------------------------------------------------------------------------
Immediately after the Supreme Court's 2004 decision in Blakely v.
Washington,\8\ the Commission recognized that one of the most critical
functions it could perform was reporting timely and accurate sentencing
data. The Commission refined its data collection, analysis, and
reporting requirements to such a degree that it was able to produce
relevant information beyond that which it promulgated in its annual
reports and sourcebooks. By the time the Supreme Court issued its
Booker decision in January 2005, the Commission was able to provide
real-time data about national sentencing trends and practices.
---------------------------------------------------------------------------
\8\ 542 U.S. 296 (2004). Blakely was a precursor to the Booker
decision, which applied to a State guideline sentencing scheme. After
the Blakely decision, several Federal courts questioned whether the
Federal sentencing guideline system was still viable and Federal
sentencing practices became uncertain. The Commission's data collection
and analysis efforts assisted the criminal justice community in
evaluating the impact of Blakely, and later Booker, on the Federal
system.
---------------------------------------------------------------------------
The Commission further refined its processes throughout fiscal
years 2006 and 2007 to maximize the information it made available to
the criminal justice community. The Commission now provides detailed
quarterly national sentencing data similar to the format and types of
data produced in its year-end annual reports. In addition, the
Commission has begun to provide real-time data on the impact on Federal
sentencing practices of the Supreme Court's recent decisions in Rita,
Gall, and Kimbrough v. United States.\9\ The Commission also has
expedited publication of its year-end annual reports, which are now
released in February of each year. For fiscal year 2007, the Annual
Report and Sourcebook contained information on 72,865 Federal cases,
which represents approximately 24,000 more cases than the Commission
processed a decade ago. The information contained in these reports and
other analyses conducted by the Commission are used by, among others,
Congress, the judiciary, the Department of Justice, defense
practitioners, and academics.
---------------------------------------------------------------------------
\9\ 128 S. Ct.558 (2007).
---------------------------------------------------------------------------
Information Technology Issues Associated with Data Collection, Analysis
and Reporting
Over the past 3 fiscal years, the Commission has apprised Congress
of its development of an electronic document submission system that
enables courts to electronically submit the five statutorily required
sentencing documents directly to the Commission. This system is now
used by 91 of the 94 judicial districts, an increase from 80 districts
in fiscal year 2007 and 64 districts in fiscal year 2006. The
electronic document submission system has greatly alleviated the
Courts' need to spend judicial resources on copying, bundling, and
mailing hard copies to the Commission.
During fiscal years 2008 and 2009, the Commission intends to
continue to make technological advancements related to data collection,
analysis, and reporting. For example, working with the courts, the
Commission has begun to advance the evolution of its electronic
submission system to a web-based system with the ability to accept both
the statutorily required sentencing documents and data fields from the
courts. Specific projects include the planning, coordination, and
implementation of a pilot project for the expanded use of this web-
based system.
Increased Requests for Commission Work Product from
Congress
In addition to providing quarterly and annual data reports on
national sentencing practices, the Commission continues to experience
increased requests for particularized data analysis from Congress. The
Commission is statutorily required to assist Congress in assessing the
impact proposed criminal legislation will have on the Federal prison
population. These assessments are often complex, time-sensitive, and
require highly specialized Commission resources. The Commission also
has experienced an increase in requests for information from Congress
on issues such as drugs, gangs, fraud, immigration, and sex offenses.
The Commission increasingly is providing data to assist Congress during
oversight and legislative hearings on proposed changes to substantive
areas of the criminal law. Informational requests from the
Congressional Research Service have also increased. The Commission
anticipates that congressional requests will continue to increase
throughout fiscal year 2009 and looks forward to fulfilling them in a
timely and thorough manner.

Conducting Research
The Sentencing Reform Act of 1984 directed the Commission to
establish a research agenda as part of its role as the clearinghouse on
Federal sentencing statistics and policy and to assist the courts,
Congress, and the Executive Branch in the development, maintenance, and
coordination of sound sentencing policies. As part of this statutory
mission, the Commission issued its fourth comprehensive report on
Federal cocaine sentencing policy in May 2007. It also released an
analysis on the impact of the amendment to the guidelines for crack
cocaine offenses if it were given retroactive effect. The Commission's
research agenda in fiscal year 2008 includes reports associated with
its policy work and other projects of interest to the criminal justice
community. One of these projects is an examination of alternatives to
incarceration, which will include a 2-day symposium featuring leading
experts in the field.

Training and Outreach
The Sentencing Reform Act of 1984 also directed the Commission to
provide specialized sentencing training and guidance to the criminal
justice community. In fulfillment of this statutory duty, the
Commission provides training, technical assistance, and other
educational programs to Federal judges, probation officers, law clerks,
staff attorneys, prosecutors, and defense attorneys throughout the
year. The Commission's training and outreach efforts have expanded in
each of the past four years, particularly in response to the Supreme
Court's recent sentencing-related decisions and to the Commission's
annual promulgation of guideline amendments. In fiscal years 2007 and
2008, the Commission provided training in every Federal judicial
circuit and a majority of the districts. It also participated in
numerous symposia, conferences, and workshops. In May 2008 in Orlando,
Florida, the Commission will co-host its annual national training
program at which several hundred participants will receive Federal
sentencing guideline training. The Commission expects that the need to
provide specialized training on Federal sentencing issues will continue
to increase throughout fiscal year 2009.

SUMMARY

The Commission remains uniquely positioned to assist all three
branches of Government in ensuring sound and just Federal sentencing
policy. Located in the judicial branch and composed of Federal judges,
individuals with varied experience in the Federal criminal justice
community, and ex-officio representatives of the Executive Branch, the
Commission is an expert, bipartisan body that works collaboratively
with Congress. It therefore sits at the crossroads where all three
branches of Government intersect to determine Federal sentencing
policy.
The Commission appreciates the funding it has received from
Congress to meet its ever-increasing needs. Full funding of the
Commission's fiscal year 2009 request will ensure that the Commission
continues to fulfill its statutory mission to develop Federal
sentencing guidelines, collect, analyze and report Federal sentencing
statistics and trends, conduct research on sentencing issues, and
provide training to the criminal justice community. The Commission
respectfully asks that Congress fully support the Commission's fiscal
year 2009 appropriation request of $16,257,000 so that it can continue
its statutory role as a leader in Federal sentencing policy.

Senator Durbin. Mr. Duff, do you have a statement that you
would like to add to the record?

STATEMENT OF JAMES C. DUFF, DIRECTOR, ADMINISTRATIVE
OFFICE OF THE U.S. COURTS
Mr. Duff. Yes, Mr. Chairman. Thank you very much for
inviting us to be here today. I am very pleased to present the
budget request for the Administrative Office of the United
States Courts (AO). I will make some brief remarks and ask that
my written testimony be included in the record.
Senator Durbin. Without objection.
Mr. Duff. Thank you.
I join Judge Gibbons in thanking you for the additional
funding provided the judiciary in the 2008 appropriations bill
during such a tight funding environment. We sincerely
appreciate your recognizing the impact enhanced border
enforcement will have on the judiciary by providing emergency
appropriations to address the additional workload. This funding
will provide some staffing increases for courts whose workload
is heavily impacted by immigration and other law enforcement
initiatives.
This is my second appearance before the subcommittee. I
have now had the opportunity to work with this subcommittee and
its staff through one full appropriations cycle and have
appreciated being able to work closely with you as our
requirements changed and your allocation was reduced during
conference. I want to take particular note, Chairman Durbin, of
the good working relationship that we have with the
subcommittee and its staff. Just this week, for example, in our
executive committee meeting at the Judicial Conference, we
singled out our relationship with the subcommittee as an
example of how we should interact with Congress. It is
exemplary, and we very much appreciate the dialogue and the
subcommittee's openness and willingness to talk with us. We
hope to emulate it across the board in all of our dealings with
Congress. It is something we are proud of and very much
appreciate.

ROLE OF THE ADMINISTRATIVE OFFICE

I will talk very briefly on a couple of items here. First,
by way of background--and you may be familiar with this, but
just briefly for the record--the AO was created by Congress in
1939 to assist Federal courts in fulfilling the mission to
provide equal justice under the law. It is a unique entity in
Government. It does not operate as the headquarters for the
courts. Court operations, as you know, are decentralized,
although the AO provides administrative, legal, financial,
management, program, security, information technology, and
other support services to all the Federal courts.
The AO also provides support staff and staff counsel to the
Judicial Conference of the United States and its 25 committees
and it helps implement Judicial Conference policies, as well as
applicable Federal statutes and regulations. The AO has evolved
over the years to meet the changing needs of the judicial
branch. Service to the courts, however, will always remain our
core function and mission.

REVIEW OF THE ADMINISTRATIVE OFFICE

Last year I reported to you that I was assembling a small
advisory group of judges and court executives to assist me and
our new Deputy Director, Jill Sayenga, in a review of the
organization and mission of the AO. The ad hoc advisory group
confirmed that the AO is an organization of dedicated service-
oriented professionals, but it also identified some areas where
the AO's performance or ways of conducting business could be
improved. Teams of AO managers have been assembled to plan and
implement the recommendations.
My goal is to ensure that the AO is the best and most
efficient service organization in the Government. In supporting
the courts, the AO frequently finds itself responding to new
developments, such as the Booker and Fanfan Supreme Court
decisions, or implementing the new bankruptcy legislation. And
to do so, we work with court leaders to develop plans and
processes for the judiciary to respond to new challenges.

CURRENT ISSUES AT THE ADMINISTRATIVE OFFICE

Two developments on which we are currently responding are
the impact of enhanced immigration enforcement on the courts,
and implementation of the pilot program that you authorized
last year under which the U.S. Marshals Service assumes
responsibility from the Federal Protective Service for
perimeter security at several designated courthouses.
I will mention very briefly two other items.
Last year I spoke about the efforts to improve our working
relationship with GSA. I reported that substantial progress was
being made and that we were working on significant changes in
how GSA determines or calculates courthouse rents. Today, I am
very pleased to report that we have successfully concluded the
effort on determining how GSA calculates rent.
On February 19, I signed a memorandum of agreement, which
was cosigned by GSA's Public Buildings Service Commissioner,
that changes the way rent will be calculated for all federally
owned courthouses to be delivered in the future, and it also
applies to 32 of our existing courthouses. Both the judiciary
and GSA will benefit from knowing with certainty how much rent
the judiciary has to pay and how much rent GSA will receive.
Judiciary and GSA staff time and resources for contractor
support to conduct and validate market appraisals will no
longer be used.
Next, I would also like respectfully to request that you
consider providing assistance in solving our two major
courthouse construction problems in San Diego and Los Angeles
where market conditions and delays have increased the cost of
these projects.

FISCAL YEAR 2009 BUDGET REQUEST

And last, I would note that the fiscal year 2009
appropriations request for the Administrative Office of the
U.S. Courts is $82 million. This is an increase of $5.9
million, or 7.8 percent. Although the increase we are seeking
may appear significant, overall it represents a no-growth,
current-services budget. The requested increase is exclusively
to cover base adjustments to maintain current services. We are
requesting no program increases.

PREPARED STATEMENT

Chairman Durbin, I recognize that fiscal year 2009 will be
another difficult year for you and your colleagues as you
struggle to meet funding needs of the agencies and programs
under your review. I look forward to working with you and your
staff on meeting the needs of the Judiciary.
Senator Durbin. Thanks, Mr. Duff.
Mr. Duff. Thank you.
[The statement follows:]

Prepared Statement of James C. Duff

INTRODUCTION

Chairman Durbin, Senator Brownback, and members of the
subcommittee, I am pleased to appear before you this morning to present
the fiscal year 2009 budget request for the Administrative Office of
the United States Courts (AO) and to support the overall request for
the entire Judicial Branch.
First, I would like to join Judge Gibbons in thanking you and your
Committee for the support you provided the Judiciary in the fiscal year
2008 appropriations bill. In addition to the regular funding, we deeply
appreciate your recognizing the impact enhanced border enforcement will
have on the Judiciary by providing emergency appropriations to address
the additional workload. In the aggregate, the funding will allow the
Judiciary to provide some staffing increases in courts whose workload
is heavily impacted by immigration and other law enforcement
initiatives.
This is my second appearance before the Financial Services and
General Government subcommittee and I have now had the opportunity to
work with this subcommittee and its staff through one full
appropriations cycle. We recognize the very tight fiscal constraints in
which you operate and appreciated being able to work closely with your
staff throughout the process as our requirements changed and your
allocation was reduced. I look forward to a continued productive
relationship with your very able staff as we move through the year. I
want to answer any questions you might have, and to describe the
important needs of the Federal Judiciary.

ROLE OF THE ADMINISTRATIVE OFFICE

In July 2006, I accepted the appointment of Chief Justice Roberts
to become only the 7th Director of the Administrative Office of the
United States Courts in its 69-year history. Created by Congress in
1939 to assist the Federal courts in fulfilling their mission to
provide equal justice under law, the AO is a unique entity in
Government. Neither the Executive Branch nor the Legislative Branch has
any one comparable organization that provides the broad range of
services and functions that the AO does for the Judicial Branch.
Unlike most Executive Branch agencies in Washington, the AO does
not operate as a headquarters for the courts. The Federal court system
is decentralized, although the AO provides administrative, audit, human
resources, legal, financial, management, program, security, information
technology and other support services to all Federal courts. It
provides support and staff counsel to the policy-making body of the
Judiciary, the Judicial Conference of the United States, and its 25
committees, and it helps implement Judicial Conference policies as well
as applicable Federal statutes and regulations. The AO carries out a
comprehensive financial audit program to ensure the Judiciary expends
its resources properly. It also coordinates Judiciary-wide efforts to
improve communications, information technology, program leadership, and
administration of the courts, and is leading the effort to contain
costs throughout the Judiciary. Our administrators, auditors,
accountants, systems engineers, personnel specialists, analysts,
architects, lawyers, statisticians, and other staff provide
professional services to meet the needs of judges and staff working in
the Federal courts nationwide. The AO staff also respond to
Congressional inquiries, provide information on pending legislation,
and prepare Congressionally mandated reports.

ADMINISTRATIVE OFFICE INTERNAL REVIEW

Last year I reported to you that I was assembling a small advisory
group of judges and court executives to assist me and our Deputy
Director, Jill Sayenga, in a review of the organization and mission of
the AO. I wanted to ensure that the structure and services provided by
the AO are appropriate and cost-effective, and that they address the
changing needs of the courts. We examined our core mission of service
to the courts as defined by statute and directives from the Judicial
Conference to determine if internal adjustments were needed to improve
efficiency and responsiveness.
I am pleased to tell you the ad hoc advisory group confirmed that
the AO is an organization of dedicated, service-oriented, capable
professionals, but it did identify some areas where the AO's
performance or ways of conducting business could be improved. The group
provided practical and achievable recommendations on how to improve
both the services of the AO to, and our working relationship with, the
courts. To that end, teams of AO managers have been assembled to plan
and implement the recommendations. Among other things, we will be
reviewing internal operations, the deployment of our workforce, the
best ways to obtain court input and advice, and improvements in
communications with the courts and in working procedures. My goal is to
ensure that the AO is the best service organization in the Government.
Although the internal review was undertaken primarily to determine
how well the AO currently fulfills its responsibilities, the ad hoc
advisory group raised questions about the agency's continuing ability
to deliver critical services, as well as its capacity to adapt to our
court customers' future needs. Areas of concern include future
budgetary constraints, the anticipated retirements of highly
experienced and knowledgeable employees in senior management and
technical positions, growing numbers of staff vacancies in critical
areas, AO competitiveness in the labor market, the changing nature of
work and required competencies, and the impact of change on employee
morale.
After reviewing carefully our operations for the past year-and-a-
half, I am convinced that we require the current services level of
staff and funding we request for fiscal year 2009 to provide adequate
support to the courts. The services provided by the AO are critical to
the effective operation of our Federal courts, and I hope you will
continue to provide the resources we require.

ADMINISTRATIVE OFFICE CHALLENGES

As I indicated when I testified last year, when I became Director
in July 2006, I restricted recruitment actions for filling vacant
positions to give me time to evaluate the organization, its mission,
and priorities. Any exceptions for external recruitment were
scrutinized carefully by an executive review committee and required my
approval. I am pleased to report that, having completed this review,
the hiring freeze has been partially lifted and critical vacancies are
being filled.
In the interim, with significant additional effort on the part of
our existing staff, and at times with great difficulty, the AO
continues to perform vital human resources and financial functions,
implements the policymaking efforts of the Judicial Conference,
monitors program performance and use of resources, develops and
supports automated systems and technologies, collects and analyzes
court workload statistics, coordinates construction and management of
court facilities, defines court resource needs through caseload
forecasts and work measurement analyses, monitors the U.S. Marshals
Service's (USMS) implementation of the judicial facility security
program, provides program leadership and support for court unit
executives, develops and conducts education and training programs, and
performs cyclical court audits and other financial and system audits to
ensure integrity.
In addition to striving to perform its fundamental responsibilities
outlined above in the most efficient and effective matter, the AO must
look beyond the immediate day-to-day needs of the courts. It is our
responsibility to anticipate and plan for changes in workload,
workforce demographics, legislative mandates and other areas so that we
can serve the courts effectively in the years ahead.

PLANNING FOR THE FUTURE

The AO frequently finds itself in uncharted waters. Whether it is
responding to the Booker and Fanfan Supreme Court decisions or
implementing the Bankruptcy Abuse Prevention and Consumer Protection
Act, we are working with court leaders to develop plans and processes
for the Judiciary to respond to new challenges. I highlight three of
the initiatives on which we are currently working--responding to
enhanced immigration enforcement, preparing to implement the
retroactive application of the crack cocaine sentencing amendment, and
implementing a pilot project you authorized last year under which the
USMS assumes responsibility from the Federal Protective Service (FPS)
for perimeter security at several designated courthouses. Judge
Gibbons' testimony addresses the policy issues and impact on the
Judiciary of these three initiatives. I would like to talk about the
operational concerns and what the Administrative Office is doing to
ensure the courts are prepared to support these efforts.

Enhanced Immigration Enforcement
Increased border enforcement is a priority of this Congress and the
administration. We are grateful for your recognition that the Judiciary
is integral to this effort by providing significant resources to the
courts in 2007 and 2008 for us to respond to the resulting
apprehensions and prosecutions. In addition to having the increased
funding you provided, the Judiciary must plan and coordinate the
management of the new workload effectively, particularly as Operation
Streamline is implemented in more locations along the Southwest border.
To that end, Administrative Office staff participated in a conference
of top law enforcement officials from Southwest border districts and
continue to maintain contact with executive branch personnel to ensure
we are aware of and can respond to their priorities. Further, we have
established a task force within the AO to facilitate the Judiciary's
response to enhanced immigration enforcement and work with the
Southwest border courts.
In conversations with judges, court managers, and Federal
defenders, particularly in the Southwest border districts, but also in
districts throughout the country, we are finding that limitations
beyond funding can make it difficult for courts to respond to the
increased workload. Lack of space to hold court proceedings and to
detain those apprehended, rising caseloads of Federal defenders,
finding enough panel attorneys willing to accept these cases at the
current non-capital hourly rate of $100, locating sufficient numbers of
qualified interpreters, and hiring and retaining probation and pretrial
services officers in the difficult work environment that exists along
the Southwest border are all challenges that the AO, in coordination
with the courts, is trying to address. These are difficult problems
that will require creative and innovative solutions.
AO staff, in collaboration with court personnel, are systematically
developing an inventory of areas where we do not have all of the
resources to address the existing and potential new workload. Initially
we are focusing on the Southwest border districts, but these issues are
not necessarily limited to the Southwest border. Many districts
throughout the country are affected by enhanced immigration efforts,
resulting in increased numbers of legal and illegal alien defendants in
locations such as the Middle District of North Carolina, the Western
District of Arkansas, Nebraska, Idaho, the Northern District of
Georgia, Oregon, Colorado, and the Southern District of Iowa. This
leads, for example, to a need for more interpreters in some districts
where the availability is quite limited and the demand and supply have
not existed previously. To resolve these issues, we will have to look
beyond the traditional ways we have addressed these needs and develop
innovative, creative solutions.

Perimeter Security Pilot Program
Another new endeavor for the AO is implementation of a pilot
project whereby the USMS will assume FPS perimeter security
responsibilities in selected court facilities. As Judge Gibbons stated
in her testimony, we are very grateful that you have given us the
opportunity to pursue this project and to ensure that the Judiciary has
comprehensive and effective security in place.
We are particularly troubled by the February 8, 2008, Government
Accountability Office's (GAO) Preliminary Observations on the Federal
Protective Service's Efforts to Protect Federal Property which found
that FPS has not always maintained the security countermeasures and
equipment it was responsible for, such as perimeter cameras, which may
expose Federal facilities to a greater risk of crime or terrorist
attack. This GAO report verifies the situation that Judge Gibbons
described in testimony before this subcommittee last spring regarding
perimeter security equipment for which FPS was responsible, but which
was not maintained, fixed or replaced, despite FPS being paid by the
Judiciary for that service. Please be assured that courthouses do not
have these problems because of the security provided the Judiciary by
the USMS. It is specifically for the reasons identified in the GAO
report, however, as well as the need to have one entity responsible for
security, that we raised concerns about FPS perimeter security last
year. We are grateful that you responded by authorizing the pilot
project. The test-site courts will be provided with a consistent level
of perimeter security as is the case in the interior of courthouses,
and will allow those courts to rely on the Marshals Service as its
single provider of security services, rather than FPS.
I would point out that GAO identified funding shortfalls as a
primary cause of the FPS security deficiencies. This concerns us
because, as you know, FPS is funded fully from the fees it charges
other Government agencies for its security services. While we have
suggested on several occasions that FPS receive a direct appropriation
at a funding level Congress deems appropriate to secure Federal
buildings, this proposal has not been pursued. Consequently, under the
current funding scheme, any budgetary shortfall is borne by all Federal
agencies in the form of increased fees, thus increasing the Judiciary's
funding requirements, as well as those of the Executive Branch agencies
under your jurisdiction.
With regard to the pilot project, I assure you that AO staff are
involved in every aspect of implementation and will be monitoring the
project carefully. We have been on site at every pilot location to
assess the level of security provided by FPS and to participate in
determining the appropriate level of security to be provided by USMS.
We are cognizant of the need to control costs during this pilot and for
the future if it is determined that nationwide implementation is
appropriate.

Crack Cocaine Sentencing Retroactivity
The last new area I would like to address is implementation of the
retroactive application of the Federal sentencing guidelines amendment
for crack cocaine offenses. This effort is similar to our response to
enhanced immigration enforcement in that it involves many components of
the Judiciary as well as Executive Branch entities, as Judge Gibbons
mentioned in her testimony. The AO's role in this endeavor began in
November, when we hosted a contingency planning meeting prior to the
decision of the Sentencing Commission to apply the amendment
retroactively. We invited chief probation officers from the districts
with the largest number of crack cocaine cases to meet at the AO, and
we invited officials of the Sentencing Commission, the Department of
Justice, and the Bureau of Prisons to join us. The discussion centered
around identifying offenders in prison who may be eligible for
immediate release, and planning for the successful reentry into the
community of those qualified for release. At the planning meeting, two
chief probation officers volunteered to host large conferences in
Charlotte, North Carolina, and St. Louis, Missouri, that would gather
judges, probation officers, prosecutors, and Federal defenders from
districts with a significant number of crack cocaine cases, and provide
a forum to develop practical plans for dealing with the workload at the
district level. The 2-day conferences included presentations by the
Sentencing Commission, the Bureau of Prisons, the USMS, and also panel
discussions with judges, prosecutors, and defenders. There was
widespread agreement at the conferences that the courts involved are
capable of meeting the challenges posed by the additional workload. To
ensure that the valuable information discussed during these conferences
was available to all judges and court staff, AO staff recorded the
sessions and posted the video on the Judiciary's intranet site.
In addition to the conferences, AO staff have worked to make
implementation of the amendment easier for all of the courts. In
coordination with the Sentencing Commission and the Judicial
Conference's Committee on Criminal Law, AO staff developed a model
order that can be used by the courts when resentencing inmates. This
one-page form captures all of the information needed by the Commission
and the Bureau of Prisons, and will allow judges and court staff to
process the orders quickly. Also, databases used in the clerks offices,
probation and pretrial services offices, and Federal public defenders
offices to capture statistics and workload data related to crack
cocaine resentencings have been updated. Additionally, AO staff have
disseminated important information about Bureau of Prisons procedures
to the courts. I am pleased to report that all of these efforts were in
place prior to the March 3, 2008, effective date.

PARTNERSHIP WITH THE GENERAL SERVICES ADMINISTRATION

Last year when I testified before you I talked about my efforts to
improve our working relationship with the General Services
Administration (GSA). At that time I reported that substantial progress
was being made and that we were working on significant changes in how
GSA determines or calculates courthouse rents. Today, I am pleased to
report that we have successfully concluded that effort. On February 19,
2008, I signed a Memorandum of Agreement (MOA), co-signed by the GSA
Public Buildings Service Commissioner, that changes the way rent will
be calculated for all federally owned courthouses to be delivered in
the future. This new methodology will also be applied to a limited
number of courthouses that the Judiciary already occupies.
The conventional approach that had been used to determine rent for
most of our buildings, as well as those building occupied by other
Federal tenants of GSA space, is based on appraisals of commercial
space in the same rental market as the federally-owned building. Every
5 years a new appraisal of the market was done and rental rates paid to
GSA were adjusted accordingly. I would note that using this former
``fair market value'' method, in fiscal year 2009, the rent for the
Court of International Trade, a GSA-owned building in Manhattan that is
over 40 years old, will increase by $1.5 million or 30 percent, based
on the 5-year cyclical reappraisal done by GSA.
The MOA outlines a new process for determining rental rates based
on a return on investment (ROI) methodology. Under the MOA, the rent
will be fixed for the first 20 years of occupancy and will be set to
return to GSA approximately 7 percent per year of its capital costs;
operating costs will be adjusted annually to reflect GSA's actual
operating expenses.
We are pleased that this MOA has been signed for several reasons.
First and foremost, it ushers in a new era of collaboration and
cooperation between the Judiciary and GSA and demonstrates that by
working together, we can resolve problems in a way that is mutually
beneficial to both parties. Second, it provides the Judiciary with
certainty about the amount of rent it will pay for a 20-year time
period, rather than being subject to changes every 5 years as a result
of changing commercial market conditions. Third, the amount of rent
will be based directly on the capital resources the Judiciary consumes,
i.e., how much it costs to construct the building, rather than on
periodic assessments of market rents in nearby commercial office
buildings. Finally, with GSA agreeing to an ``open-book'' accounting of
costs, the Judiciary will not have to hire consultants and expend
considerable staff time reviewing appraisals based on subjective
opinions of market value.
I have just outlined the many benefits that the Judiciary will
enjoy under this MOA. Because this subcommittee also has jurisdiction
over the General Services Administration, I assure you that GSA will
also benefit from the provisions of the MOA. Specifically, GSA will
have a guaranteed return on investment at a set rate with no market
risk or vacancy risk. As mentioned above, under appraisal pricing,
every 5 years the rate is reset. These reappraisals result in rent
decreases as well as increases, so should market conditions be lower
than the previous appraisal, GSA would get less rent. Also, under the
MOA, the Judiciary is assuming the vacancy risk in the ROI buildings.
That is, the Judiciary will pay the same rent over the 20-year time
period even if space becomes vacant in the building. Consequently, GSA
will not lose rental income until such time that it could backfill the
space with another tenant. Finally, GSA will no longer have to respond
to challenges to the fairness and validity of the rent determination
process, which has led to criticism, tension, and unexpected reductions
in the Federal Buildings Fund when GSA refunded overcharges to the
Judiciary.

COURTHOUSE CONSTRUCTION

I next will discuss another facility-related issue--the status of
our courthouse construction needs. We appreciated your willingness to
fund new courthouse construction projects requested by the Judicial
Conference in fiscal year 2008 even though the administration did not
include them in the President's budget. We find ourselves in a similar
situation this year with the President's budget only requesting the
additional funds needed for the San Diego courthouse. Despite
reductions in the scope of the San Diego project, costs have increased
significantly over the original GSA projections because of changing
market conditions and the construction boom in California. The project
has been delayed several years and is critically needed in this
California Southwest border district because the existing courthouse is
out of space.
As you know, we have another courthouse problem in Los Angeles.
California (Central) is the largest district in the country and current
facilities are seriously inadequate. Because of market conditions and
delays, the cost of the Los Angeles project far exceeds GSA's original
estimates. Despite the sizable reductions in scope made by the court,
the cost of this project continues to grow and will only get more
expensive as time passes. The AO, the court, and GSA have been working
together to find a solution. While we recognize how costly this project
is, especially in a time of constrained resources for non-security
discretionary programs, we believe the final project design must
address long-term needs and provide an environment in which the
judicial process can function safely and effectively. We also want to
ensure that when alternatives are considered, all costs associated with
the options are included in the analysis. Consequently, we are pleased
that GAO has been asked to conduct a review of this project and trust
that it will address all aspects of the issue. We also look forward to
collaborating with GSA on the report this subcommittee asked it to
provide and trust that our views will be reflected fully. I have stated
on numerous occasions that the situation in Los Angeles is an
extraordinary problem that may ultimately warrant an extraordinary
solution.
Finally, we respectfully request that you consider the new
courthouse construction projects included on the Judicial Conference
approved Five-Year Courthouse Project Plan for fiscal years 2009-2013,
a copy of which is attached to this Statement. As I mentioned, none of
these projects is included in the President's 2009 budget request, yet
they have been on the Five Year Plan for a number of years. Most of the
projects have sites, have been or soon will be designed, and are
awaiting construction funding. Every year a project is not funded its
cost increases by about 10 percent based solely on inflation. We
appreciate your consideration of these needs.

ADMINISTRATIVE OFFICE FISCAL YEAR 2009 BUDGET REQUEST

Last I will address the fiscal year 2009 appropriations request for
the Administrative Office of the United States Courts which is
$81,959,000. This represents an increase of $5,923,000, or 7.8 percent,
over fiscal year 2008 enacted appropriations. Although the percentage
increase in appropriations we are seeking may appear significant,
overall it represents a no-growth, current services budget request. I
note this request funds 6 percent fewer staff than were funded in 1995
even though court staffing has increased almost 14 percent over the
same time period.
The AO's appropriation comprises less than 2 percent of the
Judiciary's total budget, yet the work performed by the AO is critical
to the effective operation of the U.S. Courts. In addition to the
appropriation provided by this Committee, as approved by the Judicial
Conference and the Congress, the AO receives non-appropriated funds
from sources such as fee collections and carryover balances to offset
appropriation requirements. The AO also receives reimbursements from
other Judiciary accounts for information technology development and
support services that are in direct support of the courts, the court
security programs, and defender services.
The requested increase of $5.9 million is exclusively to cover base
adjustments to maintain current services; the AO requests no program
increases. Over half of the increase is to fund the proposed fiscal
year 2009 pay adjustment and to annualize the fiscal year 2008 pay
adjustment. The balance is for inflationary adjustments and to replace
non-appropriated funds (carryover) that were used to finance the fiscal
year 2008 financial plan, but which at this time are expected to
decline in fiscal year 2009. If carryover is not replaced with direct
appropriated funds, we would be forced to reduce current on-board
staffing. This would, in turn, adversely affect our ability to carry
out the AO's statutory responsibilities and serve the courts. We will
keep you apprised of actual carryover estimates as the year progresses.
Should carryover surpass our estimates, the amount of appropriations we
are requesting could be reduced.

CONCLUSION

Chairman Durbin, Senator Brownback, members of the subcommittee, I
have shared with you only a few examples of the diverse issues we
handle and the type of services and support the Administrative Office
provides the Federal Judiciary. In addition to our service to the
courts, the AO works closely with the Congress, in particular, the
Appropriations Committee and its staff, to provide accurate and
responsive information about the Federal Judiciary. I recognize that
fiscal year 2009 will be another difficult year for you and your
colleagues as you struggle to meet the funding needs of the agencies
and programs under your purview. I urge you, however, to consider the
significant role the AO plays in supporting the courts and the mission
of the Judiciary. Our budget request is one that does not seek new
resources for additional staff or programs. I hope you will support it.
Thank you again for the opportunity to be here today. I would be
pleased to answer your questions.

Attachment

FIVE-YEAR COURTHOUSE PROJECT PLAN FOR FISCAL YEARS 2009-2013 AS APPROVED BY THE JUDICIAL CONFERENCE OF THE
UNITED STATES ON MARCH 11, 2008
[Estimated dollars in millions]
----------------------------------------------------------------------------------------------------------------
Estimated
Cost Score net annual
rent
----------------------------------------------------------------------------------------------------------------
Fiscal year 2009:
Austin, TX.......................... Add'l S&D/C.................... $114.0 82.0 $6.5
Salt Lake City, UT.................. C.............................. 168.5 67.9 11.4
Savannah GA......................... Add'l. D....................... 2.0 61.3 3.5
San Antonio, TX..................... S.............................. 18.0 61.3 9.2
Mobile, AL.......................... Add'l. S /C.................... 181.5 59.8 4.7
--------------------------------------
TOTAL............................. ............................... 484.0 ........... 35.4
======================================
Fiscal year 2010:
Nashville, TN....................... Add'l D/C...................... 164.6 67.3 7.0
Cedar Rapids, IA.................... Add'l D/C...................... 136.8 61.9 6.1
Savannah GA......................... C.............................. 52.4 61.3 3.5
San Jose, CA........................ Add'l S........................ 32.0 54.5 9.4
Greenbelt, MD....................... S&D............................ 10.5 53.8 1.6
--------------------------------------
TOTAL............................. ............................... 396.3 ........... 27.5
======================================
Fiscal year 2011:
San Antonio, TX..................... C.............................. 160.8 61.3 9.2
Charlotte, NC....................... C.............................. 106.1 58.5 7.1
Greenville, SC...................... C.............................. 66.4 58.1 4.1
Harrisburg, PA...................... C.............................. 48.1 56.8 5.4
San Jose, CA........................ D.............................. 14.4 54.5 9.4
--------------------------------------
TOTAL............................. ............................... 395.8 ........... 35.2
======================================
Fiscal year 2012:
Norfolk, VA......................... C.............................. 87.8 57.4 5.1
Anniston, AL........................ C.............................. 17.1 57.1 1.1
Toledo, OH.......................... C.............................. 91.8 54.4 5.9
Greenbelt, MD....................... C.............................. 59.0 53.8 1.6
--------------------------------------
TOTAL............................. ............................... 255.7 ........... 13.8
======================================
Fiscal year 2013: San Jose, CA.......... C.............................. 188.0 54.5 9.4
--------------------------------------
TOTAL............................. ............................... 188.0 ........... 9.4
----------------------------------------------------------------------------------------------------------------
S = Site; D = Design; C = Construction; Add'l. = Additional.
In fiscal year 2004, GSA requested only design funds for San Antonio, TX, which was planned to be built on a
federally owned site. GSA advises that a privately owned site will be needed, which, therefore, requires
funding to acquire a site.
All cost estimates subject to final verification with GSA.

FEDERAL PROTECTIVE SERVICE AND PILOT PROJECT

Senator Durbin. Let me go to some questions here, if I can.
Judge Gibbons, last year when there was testimony about the
adequacy or inadequacy of the Federal Protective Service, we
did have a meeting and discussed options, and one of those was
to extend perimeter security responsibility to the U.S.
Marshals in seven different instances of primary courthouses.
In your testimony, you indicated the pilot will begin in the
fourth quarter of 2008 and will be in effect for 18 months.
I have a couple questions for you. Why did it take so long?
Why could it not begin earlier? And second, has the performance
of the Federal Protective Service in other places--these in
particular and other places as well--improved during the past
year?
Judge Gibbons. To answer the second part of it first, we
are not aware of any improvements. In fact, you may be aware
that there was a Government Accountability Office (GAO) report
that addressed perimeter security at Federal buildings
generally, not court facilities in particular, and its findings
seemed similar to our observations, although the judiciary was
not specifically mentioned or consulted in the course of the
report.
Why did it take so long? I am not sure I can answer that
directly other than in Government, these things take a while.
What has to happen in each particular facility is an assessment
of the needs, acquisition of the necessary equipment, and the
hiring of the necessary personnel. These, of course, are court
security officers who would not be already on board, and they
must have the background checks, all the vetting that
accompanies law enforcement or security-type employees. That is
my supposition.
[The statement follows:]

While the Senate's version of the Judiciary's fiscal year
2008 appropriations bill included a provision establishing the
pilot project, the House version of the bill did not include
such a provision. The pilot project provision was included in
the final conference agreement on the omnibus appropriations
bill which was enacted into law on December 26, 2007. The
Judiciary and the U.S. Marshals Service (USMS) took preliminary
steps regarding the pilot project prior to and after the Senate
Appropriations Committee reported its bill with the provision
in July 2007, but enactment of the 2008 omnibus bill was needed
in order to take definitive steps to implement the pilot
project.
The current plan is to initiate contracting actions for
both security systems and court security officers at all sites
during fiscal year 2008. Due to contractual timelines, however,
most sites will probably not be fully transitioned and ready
for implementation until the first quarter of fiscal year 2009.
A pilot site will only be implemented when it can be
accomplished in a manner that is satisfactory to the local
court, the USMS, and the Committee on Judicial Security. The
actual implementation at each site will also need to take into
consideration the length of time necessary for the USMS to:
medically screen court security officer applicants; conduct
background investigations; provide the necessary notification
to the security companies that provide the FPS contract guards
to stop service; and to assume control of the FPS security
systems and equipment, which can vary by location.
The Moynihan Courthouse pilot was implemented in March 2008
although that site, unlike the other six sites, only involved
bringing FPS equipment under USMS control. For the six
remaining sites, in addition to bringing FPS equipment under
USMS control, each will also require the hiring of additional
court security officers which can take several months to
accomplish. Of these six sites, the Dirksen Courthouse will be
the next brought online. The USMS and the Committee on Judicial
Security will conduct formal evaluations periodically
throughout the pilot period to assess whether the program's
goals are being met and to identify areas for improvement.
Congress will be kept apprised of the program's status. The
seven sites selected for the pilot and their planned
implementation date are detailed in the table below.

------------------------------------------------------------------------
Pilot Site Planned Implementation Date
------------------------------------------------------------------------
Daniel Patrick Moynihan U.S. Implemented March 2008
Courthouse, New York, NY.
Everett McKinley Dirksen U.S. September/October 2008
Courthouse, Chicago, IL.
Sandra Day O'Connor U.S. Courthouse, October/November 2008
Phoenix, AZ.
Evo A. DeConcini U.S. Courthouse, October/November 2008
Tucson, AZ.
Russell B. Long Federal Building/U.S. October/November 2008
Courthouse, Baton Rouge, LA.
Old Federal Building and Courthouse, October/November 2008
Baton Rouge, LA
Theodore Levin U.S. Courthouse, November/December 2008
Detroit, MI.
------------------------------------------------------------------------

COURT SECURITY

Senator Durbin. Let us go to the issue of the adequacy of
the Marshals Service in gauging threat assessments against
Federal judges and courthouses. The Justice Department's
inspector general came up with a list of six recommendations to
improve the protection of the judiciary. Five I understand were
implemented. One that was not related to whether or not the
Marshals Service should be notified, in addition to local law
enforcement authority, of any alarm events at the home of a
Federal judge. This is, of course, of special interest to us in
Chicago because of the tragedy involving Judge Joan Lefkow's
family not that long ago.
Does the judiciary have an opinion about whether dual
notification of both law enforcement and the Marshals Service
is necessary when a home alarm goes off?
Judge Gibbons. I am not aware of whether we have taken a
formal position about that. Perhaps Director Duff knows. But I
am aware, at least in the district court where I formerly
served in Memphis and where I am still in the same building,
that in that particular district, the marshals are notified
because I am aware of an incident that occurred last week in a
district judge's home.
Senator Durbin. If you could find out whether any formal
position has been taken and let us know, we would appreciate
it.
Judge Gibbons. We will certainly supplement the record.
Senator Durbin. And what is the general reaction of the
judiciary to this home protection system that we have underway?
Judge Gibbons. We are very grateful for it.
Senator Durbin. Well, that is good to hear.
[The information follows:]

The Judicial Conference's Committee on Judicial Security
has discussed the recommendation in the Department of Justice
Inspector General's report concerning the response to home
intrusion detection system alarm events at judges' residences.
The Committee concluded that, in general, local law enforcement
personnel are best suited to respond to an alarm; however, the
Committee also supports appropriate coordination with the U.S.
Marshals Service of instances that warrant further
investigation.

COURTHOUSE CONSTRUCTION

Senator Durbin. Now let us talk about courthouse
construction. The fiscal year 2009 budget from the President
provides funding for only one courthouse, the courthouse annex
in San Diego. In fiscal year 2005, 4 years ago, San Diego was
one of four emergency projects on the judiciary's revised 5-
year courthouse project plan. Due to increased construction
materials costs, the scope of the project was reduced, but the
project still requires $110 million as requested by the
President in fiscal year 2009 in order to be completed.
Why do emergency projects such as this not appear on the
judiciary's updated 5-year plan?
Mr. Duff. If I might answer that one, Mr. Chairman. It is
because they require additional funding that needs to be sought
by GSA. Our 5-year plan identifies the top priorities each year
for new courthouse construction funding. What happened with
regard to San Diego, as well as Los Angeles, is they
encountered difficulties hiring construction companies within
the funding that was provided to build the courthouse. The
delays in construction have caused the cost to escalate
enormously, particularly in California. And it then becomes
GSA's responsibility to seek that additional funding, and while
we fully support the additional funding for the new courthouses
in San Diego and Los Angeles, they do not go back on our 5-year
plan list. As I said, the GSA is responsible for seeking the
additional funding for those courthouses.

SENIOR JUDGES

Senator Durbin. I want to ask a question for the record on
the budgetary impact of judges seeking senior status. I
understand that when judges become eligible, they decrease
their workload by 50 percent and relocate to other office
space, freeing up their former space and staff for existing
full-time judges. The senior judge is entitled to new staff,
three law clerks and one administrative staffer. So all this
results in requiring more resources.
How many judges are currently eligible for senior status?
Judge Gibbons. I am not sure about that, and perhaps
Director Duff can answer that.
But I do want to comment on an assumption that the question
makes. Senior judges may take a 50 percent caseload. They may
take a full caseload and some do. They may take variations on
those two. Their space may become available. If they are taking
a full caseload, the space likely does not become available,
particularly if they are an appellate judge. Their need for
staff and their need for space are assessed in most circuits
according to the caseload they happen to be taking. So it is
not really just a one-profile situation. There are many, many
variations on both the caseload they take, the staff they have,
and the space they occupy.
Senator Durbin. Mr. Duff, do you know?
Mr. Duff. I do. As of December 31, 2007, there were 473
Article III senior judges, and 92 active judges were eligible
to take senior status. An additional 48 currently active judges
have senior status eligibility dates between January 1, 2008,
and December 31, 2008. Whether those 48 will choose to take
senior status, of course, remains to be seen.
Senator Durbin. But it sounds, in most instances, that
choosing senior status will require more resources.
Mr. Duff. Yes, in the sense that when a judge takes senior
status, a new judge may be appointed, and so that does require
additional resources.
Judge Gibbons. But that is really too simplistic because if
they are continuing to do work, that alleviates our need for
new judgeships which come with accompanying space and staff
needs. I believe about 17 percent of the overall work of the
Federal judiciary is performed by senior judges.
Mr. Duff. Yes. That is an important figure. Without our
senior judges, we would be overwhelmed with work.
[The information follows:]

While there are staff and space costs associated with a
judge taking senior status, it is important to emphasize that
senior judges are essentially volunteering their time in
continued service to the federal judiciary. A judge eligible
for senior status could otherwise choose to retire and leave
office at the same pay without rendering any judicial service
at all. But over 400 appellate and district court judges forego
full retirement, and instead take senior status and continue
taking cases. They are essential to the work of the federal
courts. In 2007, senior judges participated in 19 percent of
cases terminated on the merits in the appellate courts. In the
district courts, senior judges handled 18 percent of the civil
and criminal caseload. Both of these statistics are at the
highest level in a decade.
The number of senior judges working in the courts does
impact the number of new judgeships the Judicial Conference
requests from Congress. If the Judiciary were to see a sharp
dropoff in the number of senior judges working in the courts,
it would likely result in more judgeships being requested from
Congress in order to make up for the lost productivity
resulting from fewer senior judges.

COURTS OF APPEALS FOR THE FEDERAL CIRCUIT

Senator Durbin. The Federal Circuit is requesting an almost
20 percent, or $5.3 million, increase in the budget for next
fiscal year. The largest part of this, $2.5 million, appears to
be for staffing and leased office space and build-out for
senior judges.
What is the space situation at the Federal Circuit and what
is the status of judges going to senior status? Is that
included in the original number that you gave me?
Judge Gibbons. Well, actually as you know or may know, the
Federal Circuit has the statutory authority to submit its own
budget directly to Congress, and its budget does not go through
the process of approval by the Judicial Conference, nor is it
subject to the oversight of the Budget Committee. We do ask for
its submission, along with our own. But I would prefer to let
that court respond to its own budget submission.
Senator Durbin. I see. So you do not talk to those people.
Judge Gibbons. We do talk to them. I just think it
appropriate that they be their own advocates.
[The information follows:]

The United States Court of Appeals for the Federal Circuit
has requested in fiscal year 2009 an adjustment to the base
appropriation to lease chambers workspace outside the
courthouse for senior judges for whom there is no remaining
space in the courthouse.
This increase for leased space, in the amount of $298,000,
will help enable the Court to provide the workspace necessary
for up to five additional senior judges for whom there is no
remaining space in our courthouse. Four Federal Circuit judges
are eligible to take senior status now, three more will become
eligible in fiscal year 2009, and another judge will become
eligible in fiscal year 2010.
In addition, the Federal Circuit has also requested
$1,860,000 to build out leased chambers for five of the seven
judges who either are now or will be eligible to take senior
status in fiscal year 2009 (plus an eighth judge eligible and
expected to take senior status in fiscal year 2010) and for
whom there is no room in the existing courthouse. This amount
is based on an estimate coordinated with the Administrative
Office of the United States Courts and on personal experience
with GSA in renovating chambers in this courthouse. This amount
will provide the leased chambers with the furniture,
furnishings and finishes consistent with the U.S. Courts Design
Guide.
In fiscal year 2009 the Federal Circuit will have seven
judges who are or will be eligible to take senior status.
Currently, the Federal Circuit has no additional space
available in the National Courts Building for senior judge
chambers, and has no off-site leased space for senior judge
chambers. If any of the seven judges who are or will be
eligible to take senior status in fiscal year 2009 do so, there
will be no available chambers for them in the National Courts
Building or in off-site leased space once a replacement judge
is confirmed. At least two of the seven judges who will be
eligible for senior status are expected to take senior status
when they become eligible in fiscal year 2009. It is imperative
that the Federal Circuit acquire off-site leased chambers for
the two judges who have indicated a desire to take senior
status in fiscal year 2009.
By fiscal year 2010, eight of the twelve active judges on
the Federal Circuit will be eligible to take senior status. If
the Federal Circuit acquires off-site chambers for senior
judges one chambers at a time, only after the President has
been notified a judge is taking senior status, the Federal
Circuit could have senior judges occupying off-site leased
space in eight different locations around Washington, DC,
perhaps far from the courthouse. Accordingly, the Court is
working with the General Services Administration and the
Administrative Office of the U.S. Courts to identify and lease
nearby space off-site this year (fiscal year 2008) to
accommodate up to five senior judges. Five is a mid-range
number the Court believes to be reasonable in providing space
for fewer than all prospective senior judges but more than none
or one. The number will allow for changes in decision by judges
based on health or other personal issues without over-reaching
by seeking off-site space for every eligible judge who may or
may not choose to take senior status. Five will allow for
economies of scale in long-term leasing and building out
prospective chambers while reducing the risk of leaving space
unoccupied.

SUPREME COURT MODERNIZATION PROJECT

Senator Durbin. The care of the buildings and grounds
fiscal year 2009 appropriation request totals $18.4 million, an
increase of $6.2 million over the 2008 appropriation level.
Modernization of the Supreme Court construction project began
in 2004 and expected completion is the fall of this year, a
total cost of $122.3 million.
Can you tell me in the most general terms--I do not want
you to talk about security, obviously--what was achieved with
the expenditure?
Mr. Duff. Mr. Chairman, that was the Supreme Court?
Senator Durbin. Yes.
Mr. Duff. They submit their own budget request, and as I
understand it, they have a hearing tomorrow, at least over on
the House side. I am sure they will be pleased to respond
directly to the question. We can submit it to them for their
response. But their budget request is separate from the Federal
courts generally.
[The information follows:]

In 2004, the Architect of the Capitol commenced a major
project to provide the first significant renovation of the
Supreme Court building since it was constructed in 1935.
Phase I of the project--the construction of the underground
police annex, the Architect of the Capitol (AOC) shop and
parking areas--was completed in late 2005. Phase II of the
project--the interior building modernization--is ongoing and
includes updated life safety systems, windows, mechanical,
electrical, and plumbing systems. The work on one of the four
building quadrants is complete. The second quadrant is
scheduled for completion during the summer of 2008.
The contractor's projected completion date for the entire
modernization project is September 2009. The Court and the AOC
project team believe, however, that this estimate is overly
optimistic and that the project will be completed in the summer
of 2010. Although the building modernization project is more
than a year behind, the project continues to be within budget.
The fiscal year 2009 appropriation request of $18.4 million
also includes funding for two projects in addition to the
modernization project: (1) landscape expenses, including
repairs of driveways and walkways; and (2) the continuation of
roof repairs. The Architect of the Capitol expects to request
additional funds for roof repairs through fiscal year 2011.

Senator Durbin. And before anyone is critical of this 4-
year construction timetable for the Supreme Court, let me tell
you we are still anxiously awaiting the opening of the Capitol
Visitor Center which, according to the most recent report, will
be done manana.

RETROACTIVITY OF CRACK COCAINE SENTENCING AMENDMENT

I would like to ask about the retroactivity of crack
cocaine sentencing. The U.S. Sentencing Commission promulgated
sentencing guidelines that Federal trial court judges consult
when sentencing defendants. Last year, the Commission amended
Federal guidelines, reducing offenses under Federal sentencing
guidelines for crack cocaine. Furthermore, the Commission
unanimously decided to make the policy change retroactive and
the retroactivity became effective March 3 of this year.
Judge Gibbons, regarding the retroactivity of crack cocaine
sentencing, is it correct that you expect not to need
additional resources despite a surge of motions for reductions
in sentence?
Judge Gibbons. That is correct. There will be a lot of
defendants processed with requests for resentencing by the
Federal courts. And we know that obviously resources will be
required to process those. Probably the biggest resource
challenge will be for our probation officers who will have an
increase in the numbers of individuals they will be supervising
as a result of this. But we do believe that we can likely
handle it within existing resources. If you want a more
detailed explanation about why we think that to be so, I will
be happy to go into it in more detail.
Senator Durbin. I appreciate it.
Will crime victims be notified of an inmate's release, and
will they have an opportunity to provide comment to the court
prior to an inmate's release?
Judge Gibbons. I do not think that it is required in the
same way that victim notification is required in terms of an
initial sentencing. But if I am incorrect about that, we will
certainly let you know.
[The information follows:]
The Judiciary's Ability to Absorb Retroactivity Workload
While the U.S. Sentencing Commission estimates that approximately
19,000 inmates sentenced under the previous crack cocaine sentencing
guidelines may be eligible for a reduced sentence as a result of
retroactive application of the revised sentencing guidelines, it is
important to note that these 19,000 would potentially be released over
the course of 30 years. The Commission estimates that 3,804 of the
19,000 offenders would be eligible for a reduced sentence and early
release within the first year of the effective date for retroactivity
(March 3, 2008). In year two another 2,118 would be eligible, 1,967
more in year three, 1,773 more in year four and 1,353 more in year
five. The remaining offenders would be eligible in year six and after.
These filings will be handled by various district court components,
including district judges, clerks offices, probation offices, and
federal defender offices. The Judiciary believes retroactivity will
have the greatest impact on its probation offices, which will supervise
any crack cocaine offenders that may be granted early release,
including overseeing any drug testing and treatment needs that may be
imposed by a court as a condition of release.
It is generally agreed that a large number of motions for a
reduction in sentence will not involve court hearings and will be
decided on written filings, so the courts' workload associated with
processing those cases should not be unduly burdensome. The cases that
require hearings will require more court resources. At present, no
extraordinary measures have been necessary to address the increased
workload due to retroactivity, although additional resources will be
available if needed for smaller districts that may be
disproportionately impacted by the number of federal offenders seeking
a reduction in sentence based on retroactivity. Given all of these
factors, and the staggered nature of offenders becoming eligible for a
reduced sentence, the Judiciary believes it can absorb the additional
workload within existing resource levels by shifting funds as necessary
to meet workload demands, including ensuring that released offenders
receive close supervision by a probation officer.
Victim Notification of Early Release
Judges have been asked by the Bureau of Prisons (BOP) to delay for
10 days the effective date of any sentence reduction that results in an
inmate's immediate release. This delay is needed, in part, to give the
BOP adequate time to notify victims and witnesses of the offender's
release, as they are required to do per 18 U.S.C. Sec. 3771. The
Judiciary is unaware if the Department of Justice will attempt to
contact victims to seek comment prior to an inmate's release. It should
also be noted that due to the nature of these offenses, most cases will
not have an identifiable victim within the meaning of the Crime Victim
Rights Act.

WORKLOAD IN THE FEDERAL COURTS

Senator Durbin. Statistics indicate the caseload is
projected to decline in some areas, criminal, appellate, civil.
What is the impact of this on the workload in the courts?
Judge Gibbons. Well, obviously, over time our workload has
trended upward. We are expecting and projecting declines in a
number of areas. Those are projections done with statistical
models.
Obviously, there will be impacts in all areas. We are
expecting bankruptcy filings to continue to trend back upward.
What happens with the economy will be a major factor likely in
what happens with bankruptcy filings. We are expecting at least
modest increases in supervision activity by probation and
pretrial services officers. We are projecting modest declines
in criminal caseload across the country, without regard to what
may happen in border States and other areas with heavy illegal
immigration impact, and modest declines in appellate cases, and
a somewhat slightly steeper decline in civil filings. But what
happens one year is not necessarily what happens the next year.
[The information follows:]

Although the Judiciary's workload has begun to level off,
workload in the federal courts has increased considerably in
nearly all workload categories when viewed over a 10 year
perspective. As summarized in the table below, from 1997 to
2007, criminal filings increased 37 percent, the number of
criminal defendants grew 27 percent, offenders under
supervision of a federal probation officer increased 27
percent, the number of cases activated in the pretrial services
program increased 37 percent, and appellate filings grew 13
percent. Civil filings follow a more up-and-down filing pattern
from year to year and grew 3 percent overall in the last
decade. Bankruptcy filings are down nearly 566,000 filings from
the 1997 level due in large part to the sharp decline in
filings after the Bankruptcy Abuse Prevention and Consumer
Protection Act took effect in October 2005.

----------------------------------------------------------------------------------------------------------------
Percent
Workload Factor 1997 Actual 2007 Actual Change 2007 Change 2007
\1\ \1\ vs. 1997 vs. 1997
----------------------------------------------------------------------------------------------------------------
Criminal Filings........................................... 49,376 67,503 18,127 37
Criminal Defendants Filed.................................. 69,052 88,006 18,954 27
Probation: Persons Under Supervision....................... 91,423 115,930 24,507 27
Pretrial Services: Cases Activated......................... 69,959 95,955 25,996 37
Appellate Filings.......................................... 52,271 58,809 6,538 13
Civil Filings.............................................. 265,151 272,067 6,916 3
Bankruptcy Filings......................................... 1,316,999 751,056 (565,943) -43
----------------------------------------------------------------------------------------------------------------
\1\ Data reflects the 12-month period ending June of each year.

PAY FOR BANKRUPTCY CASE TRUSTEES

Senator Durbin. On the subject of bankruptcy, I am still
baffled, troubled, and find it hard to explain that a chapter 7
bankruptcy trustee receives $60--$60--for presiding in a no-
asset case. We recently proposed raising that to $120.
Do you believe the bankruptcy trustees are entitled to a
raise in compensation in no-asset cases?
Judge Gibbons. Well, I am not sure. Can we get back to you
on that? I have some information about it somewhere in this
material, but you probably do not want to sit there while I try
to locate it. And it is not coming to the top of my head
whether we have a position about that or not.
Senator Durbin. It is not a trick question.
Judge Gibbons. No, I know.
Senator Durbin. We will let you provide that later.
[The information follows:]

The Judicial Conference has no position on the amount of
compensation Congress deems appropriate for chapter 7 case
trustees. However, the Judiciary in the past has expressed its
opposition to any case trustee compensation increase that is
made at the Judiciary's expense. If the Judiciary were required
to pay the case trustees an additional $60 per case and did not
receive a specific appropriation for that purpose, it would
cost the Judiciary $30 million which could mean the loss of 375
FTEs.

Senator Durbin. Unless there is anything further you would
like to add, I want to thank you for participating in this
hearing. I appreciate all of the work you did to prepare your
testimony and to answer my questions. I think this forum has
given us some further insights into judiciary operations.

ADDITIONAL COMMITTEE QUESTIONS

The hearing record is going to remain open for a period of
1 week until Wednesday, March 19 at noon for subcommittee
members to submit statements and/or questions for the record,
which we hope you can answer in a timely fashion.
[The following questions were not asked at the hearing, but
were submitted to the judiciary for response subsequent to the
hearing:]

Questions Submitted by Senator Richard J. Durbin

COURT SECURITY--U.S. MARSHALS SERVICE

Question. Your fiscal year 2009 budget request seeks 17 new U.S.
Marshals positions (9 FTE). Why are these additional positions needed?
Are they new positions or are they replacing vacancies?
Answer. For fiscal year 2009, the U.S. Marshals Services (USMS)
requests 17 new Judiciary-funded positions (9 FTE) for a total of 64
full-time positions (56 FTE). These are new positions, not backfills.
The Judiciary currently funds 47 full-time USMS positions to administer
the Judicial Facility Security Program. This program includes the
Office of Court Security, which is responsible for the daily operations
and personnel management of the court security officer (CSO) program;
the Office of Security Contracts, which is responsible for the daily
contract responsibilities with the private contractors and the district
contracting officer's technical representatives; the Office of Security
Systems, which is responsible for all security and monitoring systems
for judicial space; and the Office of Financial Management, which is
responsible for the daily oversight responsibility on financial
matters.
A summary of the requested positions is listed below:
--The Office of Security Systems requests funding for five additional
physical security specialists and one administrative assistant/
management support specialist in order to keep up with the
workload that has resulted from expanding responsibilities and
additional oversight duties. The court security equipment
program has changed dramatically over the past few years, and
program requirements and oversight responsibilities have
increased significantly. This occurred as a result of the
growth of the court security systems program and focus on
improved security procedures, systems technologies and
maintenance. The additional personnel are required to keep pace
with these expanded duties.
--The Office of Court Security requests funding for four program
analyst positions to manage the growing workload in medical
evaluations for CSOs, and the new background investigation
requirements for CSOs mandated by Homeland Security
Presidential Directive 12.
--The Office of Security Contracts (OSC) requests funding for one
supervisory contract specialist and two contract specialists.
Over the past several years, the dollar value of contracts has
grown significantly, as has the number of procurement actions
required to support the JFSP. Staffing has not grown to match
the increase in workload. Currently, the OSC has two
supervisory contract specialists, six contract specialists, and
a chief. In light of workload increases, the current number of
contract specialists is insufficient. To provide appropriate
contract management, including an expanded audit capability,
three additional positions are required.
--The Office of Financial Management requests funding for one
additional budget analyst to address the increased workload of
the Judicial Facility Security Program. The Office of Financial
Management currently has a staff of five, consisting of a
chief, deputy chief and three budget analysts.
--Two new equal employment opportunity counselors are requested to
handle the growing number of equal employment opportunity (EEO)
complaints filed by CSOs. Previously, EEO counselors handing
CSO complaints have been funded through the USMS's Salaries and
Expenses account and represented a relatively small number of
total EEO workload. With the growth in EEO activity, this
request will ensure that the Judiciary's Court Security
appropriation properly funds the USMS's costs associated with
administrating the court security program.
--The Technical Operations Group requests funding to convert a
contractor position to a program analyst to provide the
necessary financial, administrative and contractual expertise
to support the Courthouse/CSO Radio Program. Funding for the
current contractor position will be used to partially offset
the cost of this position. Contractors are limited in the
duties that they can perform so this conversion will provide an
employee who can perform all procurement duties.

COURT SECURITY--DEPARTMENT OF JUSTICE INSPECTOR GENERAL REPORT

Question. Last September, the Justice Department's Inspector
General released a report indicating a continued problem with the
Marshals Service and their effectiveness in gauging threat assessments
against federal judges and courthouses. The IG's report said the
Marshals Service had a backlog of threat assessments and was slow in
staffing a new office designed to collect and analyze information on
potential threats.
The IG's report made six recommendations for the Marshals Service
to improve its protection of the Judiciary. In its response to the
recommendations, the Marshals Service said it would follow five of
them.
The one item that the Marshals Service disagreed with was the
recommendation to require that the Marshals Service, in addition to
local law enforcement, be notified of all alarm events at the home of a
federal judge. This is of particular interest to me because my
colleague Senator Obama and I initiated the home alarm program for
federal judges after the tragic killings of Judge Lefkow's husband and
mother inside her home.
Does the Judiciary have an opinion about whether dual
notification--of both local law enforcement and the Marshals Service--
is necessary when a home alarm goes off?
Answer. The Judicial Conference's Committee on Judicial Security
has discussed the recommendation in the Department of Justice Inspector
General's report concerning the response to home intrusion detection
system alarm events at judges' residences. The Committee concluded
that, in general, local law enforcement personnel are best suited to
respond to an alarm; however, the Committee also supports appropriate
coordination with the U.S. Marshals Service of instances that warrant
further investigation.
Question. Has the Marshals Service implemented the other five
recommendations of the IG's report relating to threat assessments?
Answer. We understand that, with the exception of one
recommendation for the USMS to develop a formal plan that defines
objectives, tasks, milestones, and resources for implementing a
protective intelligence function to identify potential threats, the
USMS has responded to the other four recommendations in the IG's report
relating to threat assessments. Specifically, the USMS has: (1)
developed a formal plan that defines objectives, tasks, milestones, and
resources for the new threat assessment process; (2) created a workload
tracking system for threat assessments; (3) modified the USMS databases
to support the new threat assessment process and protective
intelligence function to identify potential threats; and (4) issued
operational guidance for requesting and deploying Technical Operations
Group resources and Rapid Deployment Teams.
Question. In your testimony, you indicated the Marshals Service
established a new Threat Management Center last September which you
said ``serves as the nerve center for responding to threats against
judges and court personnel.''
Do you believe this new Threat Management Center has helped the
Marshals Service implement the recommendations made in the IG's report?
Answer. Yes. The Threat Management Center (TMC) that is part of the
Office of Protective Intelligence at the USMS and was opened in
September 2007 provides a 24/7 response capability for intake and
review of threats made against the Judiciary. A new threat analysis
process was initiated, and weekly and monthly reports about pending
threats against the Judiciary are now produced. A workload tracking
system for the TMC has been developed to insure a backlog of threat
assessment does not occur again. Additional staffing for the TMC in
fiscal year 2007 has also enabled the USMS to dedicate more resources
to investigating and responding to threats in a more timely manner.
Question. In its September 2007 report, the Inspector General at
the Justice Department indicates it conducted a survey of federal
judges regarding implementation of the home alarm program that Senator
Obama and I initiated. According to the IG's study, 88 percent of
federal judges said they were ``very'' or ``somewhat'' satisfied with
the home alarm program. About the same number of federal judges, 87
percent, said they were ``very'' or ``somewhat'' satisfied with the
Marshals Service performance in providing protection.
Judge Gibbons, I realize you're the chair of the Judicial
Conference's Budget Committee, not the Judicial Security Committee, but
can you give us a sense of how the Marshals Service could do a better
job with the home alarm program?
Answer. First, I would like to thank the Subcommittee for its
support of such an important program to protect judges and their
families at home. The Judiciary and the USMS worked hard to make sure
that the money Congress appropriated for this project was spent wisely,
and that every judge who wanted a home alarm system received one. We
have heard very few complaints associated with USMS's implementation of
the alarm program. I would add that the USMS has been responsive to our
needs when questions have arisen about the program.
Question. Has every federal judge who wanted a home alarm system
had one installed at this point?
Answer. To the best of our knowledge, yes. As of March 11, 2008,
1,565 judges have participated in the program and have a home alarm
system.
Question. Can you give us a sense of how the Marshals Service could
do a better job with their overall mission of providing protection to
the Judiciary?
Answer. The biggest challenge facing the USMS is securing adequate
resources to make sure their statutory mission to protect the federal
Judiciary is realized. The continued budgetary constraints on the staff
of deputy U.S. marshals (funded through the USMS's Salaries and
Expenses account, not the Judiciary's Court Security account) for
courthouse operations is troubling, especially in light of new
Executive Branch initiatives such as Operation Streamline that will
increase the volume of defendants being produced in courts along the
southwest border.
Question. In your testimony, you asked for an increase of $4
million ``for necessary investments in court security, such as court
security systems and equipment and new positions at the U.S. Marshals
Service (9 FTE).'' Please describe in more specific detail what the $4
million would go toward and why you think it's necessary above and
beyond the current allocation.
Answer. The $4 million requested for program increases will provide
funding for 17 new U.S. Marshals Service positions as explained in the
response to the question above ($1.1 million); one new contractor
position at the U.S. Marshals Service ($124,000); rent reimbursement to
the U.S. Marshals Service for Judiciary funded positions ($710,000);
reimbursement to the U.S. Marshals Service for EEO investigations
($123,000); and additional security systems and equipment ($2.0
million).
The request of $124,000 is for a contract electronics technician
position to handle the increase in troubleshooting and repair of
infrastructure and portable radio equipment than is currently possible
by the sole program manager on board. Funding is essential for the
continued success of the program with respect to the nationwide
reprogramming and encryption goals set forth in fiscal year 2007 and
beyond. Without funding, the USMS's efforts to encrypt all CSO radios
nationwide will be further delayed.
The request of $710,000 would allow the Administrative Office (AO)
of the U.S. Courts to reimburse the USMS headquarters for the space
occupied by Judiciary-funded USMS staff. The AO currently transfers
funding to the USMS to fund personnel compensation and benefits and
other costs necessary to administer the Judicial Facility Security
Program. In the past, the transfer has not included funding for
associated rent costs.
The request of $123,000 is to reimburse the USMS for contractors
hired by the USMS to investigate, process and resolve the anticipated
increase in EEO complaints filed by CSOs. This request will ensure that
the Judiciary's Court Security appropriation properly funds the USMS's
costs associated with administrating the court security program.
A $2 million increase is requested for cyclical replacement of
access control head end computers. On August 27, 2004, President Bush
signed Homeland Security Presidential Directive (HSPD)-12 for the
purpose of establishing a mandatory, government-wide standard for
security and reliable forms of identification, known as the Personal
Identity Verification (PIV) ID Card, to be issued by Executive Branch
agencies to its employees and contractor staff. This new initiative
consists of upgrading and replacing access control systems nationwide
to meet HSPD-12 compliance requirements, as well as the implementation
of a cyclical replacement program for these systems. Finally, since
this is going to be the standard ID card for the majority of government
employees and long-term contractors, Judicial Branch employees and
contractors will need the card to facilitate access to federal
facilities.

IMPLEMENTATION OF THE COURT SECURITY IMPROVEMENT ACT

Question. Less than three months ago, Congress passed and the
President signed the Court Security Improvement Act of 2007. This is
one of the most comprehensive court security bills ever passed by
Congress. One of the provisions requires the Marshals Service to
consult with the Judicial Conference on a continuing basis regarding
court security.
Has this provision been implemented yet? Has a consultation process
begun between the Marshals Service and the Judicial Conference?
Answer. Even prior to the enactment of the Court Security
Improvement Act of 2007, the relationship between the USMS and the
Judicial Conference had improved dramatically under the leadership of
the current USMS Director John Clark. In addition, in October 2005 the
Judicial Conference created a Committee on Judicial Security to focus
solely on security issues for the Judiciary and to liaison with the
USMS. Since that time, the USMS has attended the bi-annual meetings of
the Committee to discuss issues of importance to the court security
program.
An example of the consultation process that exists between the USMS
and the Judicial Conference is the recent pilot project that was
approved in the fiscal year 2008 omnibus appropriations bill for the
USMS to assume perimeter security protection from the FPS at select
primary courthouses. The judges on the Committee on Judicial Security
have consulted extensively with the USMS to craft a pilot program that
is both responsive to the Judiciary's needs and reflective of budgetary
constraints.
Question. Have other provisions of the Court Security Improvement
Act been implemented yet? Is everything going smoothly so far? If not,
what are the impediments?
Answer. Implementation of provisions that directly impact the
Judiciary in the new law appear to be going smoothly although it
remains to be seen whether the $20 million per year in appropriations
through 2011--authorized in section 103 of the Act for the USMS to hire
additional deputy marshals--will be provided. There are multiple
provisions in the Act that do not directly affect the Judiciary, so the
Judiciary has no view regarding those.

COURTHOUSE CONSTRUCTION (SAN DIEGO AND LOS ANGELES)

Question. The fiscal year 2009 President's budget provides funding
for only one courthouse--the Courthouse Annex in San Diego. In fiscal
year 2005, San Diego was one of four emergency projects on the
Judiciary's Revised Five-Year Courthouse Project Plan (fiscal years
2005-2009). Due to increased construction materials costs, the scope of
the project was reduced but the project still requires $110 million, as
requested by the President in fiscal year 2009, in order to be
completed. The Los Angeles courthouse project is in a similar
situation, requiring much more funding. What is the latest on that
project?
Answer. The courthouse problem in Los Angeles is a serious one. The
Central District of California is the largest district in the country
and current facilities are completely inadequate, primarily because of
an insufficient number of courtrooms to meet the growing needs of the
district court and significant security issues at the current location.
Market conditions and delays have created a price tag for the Los
Angeles project that far exceeds GSA's original estimates. Despite the
sizable reductions in scope already made by the court, the cost of this
project continues to grow and will only get more expensive as time goes
on. The AO, the court, and GSA have been working together to find a
solution.
While the Judiciary recognizes how costly this project is,
especially in a time of constrained resources for non-security
discretionary programs, we believe the final project design must
address long-term needs and provide an environment in which the
judicial process can function safely and effectively. The Judiciary
also wants to ensure that when alternatives are considered, all costs
associated with the options are included in the analysis. Consequently,
the Judiciary is pleased that GAO has been asked to conduct a review of
this project and trusts that it will address all aspects of the issue.
The Judiciary's understanding is that GAO will look into the reasons
for the delay, the effects of the delay, and the challenges faced in
managing this project. The Judiciary looks forward to receiving GAO's
findings.

BUDGETARY IMPACT OF JUDGES ASSUMING SENIOR STATUS

Question. My understanding of senior status is when judges become
eligible for senior status, they decrease their workload by 50 percent,
and need to relocate to other office space, freeing up the former space
and staff for an existing full-time judge. Then the senior judge is
entitled to new staff: 3 law clerks and one administrative staff. So,
all this results in requiring more resources (for which less work may
be accomplished).
Answer. Many senior judges do not reduce their workload by 50
percent. Many continue to carry a full caseload. There is no specific
workload requirement for senior judges although a senior judge must
perform ``substantial judicial work'' to employ staff and receive
``suitable quarters.'' The number of staff the senior judge receives
must relate directly to the workload he or she performs. An annual
certification process in place considers projected and actual workload
in order for a senior judge to continue having office space and staff
support.
While there are staff and space costs associated with a judge
taking senior status, it is important to emphasize that senior judges
are essentially volunteering their time in continued service to the
federal Judiciary. A judge eligible for senior status could otherwise
choose to retire and leave office at the same pay without rendering any
judicial service at all. But over 400 appellate and district court
judges forego full retirement, and instead take senior status and
continue taking cases. They are essential to the work of the federal
courts. In 2007, senior judges participated in 19 percent of cases
terminated on the merits in the appellate courts. In the district
courts, senior judges handled 18 percent of the civil and criminal
caseload. Both of these statistics are at the highest level in a
decade.
When Article III judges take senior status, they continue to
receive the salary they were earning at the time they left active
service. For a senior judge to receive the same cost of living
increases as an active Article III judge, the senior judge must perform
at least 25 percent of the work performed by ``an average judge in
active service.'' 28 U.S.C. 371(b)(1), (e)(1).
The number of senior judges working in the courts are taken into
consideration when determining the number of new judgeships the
Judicial Conference requests from Congress. If the Judiciary were to
see a sharp dropoff in the number of senior judges working in the
courts, it would likely result in more judgeships being requested from
Congress in order to make up for the lost productivity resulting from
fewer senior judges.
Question. How many judges are currently eligible for senior status?
Answer. As of December 31, 2007 there were 473 Article III senior
judges, and 92 active judges were eligible to take senior status. An
additional 48 currently active judges have senior status eligibility
dates between January 1, 2008 and December 31, 2008.
Question. Of those, how many have been eligible for more than one
year?
Answer. Of the 92 active judges that were eligible to take senior
status as of December 31, 2007, 77 had been eligible to take senior
status prior to January 1, 2007. The other 15 active judges became
eligible for senior status during 2007.
Question. So, this means that the Judiciary must continually
request funding for space and staffing for senior judges--and sometimes
you receive this funding--but you may not always need it?
Answer. The Judiciary does not assume that all judges eligible to
retire or take senior status will in fact do so. The Judiciary uses
historical patterns to estimate the number of judges that will retire
or take senior status. In formulating the fiscal year 2009 budget
request, the Judiciary estimated that 33 of the 55 judges eligible in
fiscal year 2009 will retire or take senior status. Based on the
Judiciary's projection of when judges would retire/take senior status
during the year, the Judiciary estimates that the 33 judges would
equate to 20 FTE for budget purposes. Of the 20 FTE, 18 are projected
to take senior status and continue taking cases, and two to retire and
leave the federal bench.
In the event fewer judges take senior status than the Judiciary
requested funding for, that funding is carried forward to offset the
Judiciary's appropriation requirements in the following fiscal year.
However, the Judiciary endeavors to provide the Appropriations
Subcommittees with the most accurate projection of judges expected to
take senior status. As is done each year, the Judiciary will continue
to refine its estimates of judges retiring/taking senior status and
will update the Appropriations Subcommittees--through the 2008 Spring
and Fall budget re-estimate process--on any changes to senior judge
projections that will impact the Judiciary's fiscal year 2009
appropriation requirements.

SENIOR JUDGES AT THE COURT OF APPEALS FOR THE FEDERAL CIRCUIT

Question. The Federal Circuit is requesting an almost 20 percent
(or $5.3 million) increase in its budget for fiscal year 2009. The
largest part of this increase ($2.5 million) appears to be the
staffing, and leased office space and build-out for senior judges.
[Clerk's Note.--The Court of Appeals for the Federal Circuit's
budget request does not fall under the jurisdiction of the Judicial
Conference of the United States and its Budget Committee. Accordingly,
this response was prepared by the Federal Circuit and its Chief Judge
Paul R. Michel.]
What is the space situation at the Federal Circuit and what is the
status of judges going to senior status?
Answer. Federal Circuit Judges occupy every judge's chambers
available to the Federal Circuit in the National Courts Building
complex. (The building complex houses two courts, and both courts have
assigned all available chambers space to judges.) This includes one
sub-standard chambers on the ground floor of Dolley Madison House. That
chambers has historically been used as swing space or to house visiting
judges temporarily sitting by designation, or for other special
purposes. There is no other space suitable or available to judges. The
Federal Circuit has no vacant and unassigned chambers, and none is
anticipated.
In fiscal year 2009 the Federal Circuit will have seven judges who
are or will be eligible to take senior status. Today the Federal
Circuit has no space available in the National Courts Building for even
one additional senior judge and has no off-site leased space for them,
either. If any one of the seven judges who is or will be eligible to
take senior status in fiscal year 2009 does so, there will be no
chambers available in the National Courts Building or in off-site
leased space once a replacement judge is confirmed. At least two of the
seven judges who will be eligible for senior status are expected to
take senior status when they become eligible in fiscal year 2009. The
Federal Circuit must acquire leased space off-site for the judges who
have indicated a desire to take senior status in fiscal year 2009 and
2010.
Note about staffing for a senior judge: Historically, senior judges
at the Federal Circuit work less than 50 percent of an active judge's
caseload and are therefore entitled by rule to only one law clerk.
Question. So, the Federal Circuit seeks the funding associated with
senior status, not knowing whether the judges will actually take senior
status?
Answer. As a rule, no one knows when a judge will decide to take
senior status except that judge. Timing can be highly personal, and
advance notice varies for each individual. There are strong indications
that at least one of the judges eligible to take senior status in
fiscal year 2009 plans to do so, and that at least one additional judge
will choose to take senior status in fiscal year 2010. By fiscal year
2010, eight of the twelve active judges on the Federal Circuit will be
eligible to take senior status. If the Federal Circuit acquires off-
site chambers for senior judges one chambers at a time, only after the
President has been notified that a judge is taking senior status, the
Federal Circuit could have senior judges occupying off-site leased
space in as many as eight different locations around Washington, DC,
perhaps far from the courthouse. Logistics, security, and
transportation would be challenges, and judges would feel isolated from
their colleagues. Accordingly, the Court has been working with the
General Services Administration and the Administrative Office of the
U.S. Courts to lease nearby off-site space this year (fiscal year 2008)
to accommodate up to five senior judges in the next two years. Five is
a mid-range number the Court believes to be reasonable in providing
space for prospective senior judges. The number will allow for changes
in decision by judges based on health or other personal issues without
over-reaching by seeking off-site space for every eligible judge who
may or may not choose to take senior status. Five chambers will allow
for economies of scale in long-term leasing and building out
prospective chambers while reducing the risk of leaving significant
space unoccupied.
Question. What happens if the funding is provided and the judges do
not take senior status?
Answer. The chambers will remain available until occupied by
whichever judge needs them. If Judge A does not take senior status in
fiscal year __ the chambers will remain available for Judges B, C, D,
etc. As described above, it is virtually certain that off-site chambers
will be occupied in the next two years by at least one judge and most
probably by at least two judges, although not all chambers will likely
be occupied at the outset. It is possible that housing senior judges
together in suitable space near the courthouse will induce judges to
take senior status when they wish to take it, knowing they have
appropriate space in close proximity to their colleagues. It takes time
to find suitable space, negotiate a lease through GSA, and design and
complete the build out. The Court has been at this effort for several
years and is very nearly out of time. Funds appropriated to house
senior judges will not be wasted, and space will be available even on
short notice to accommodate situations that arise with little or no
advance warning.

IMPACT OF INCREASED BORDER ENFORCEMENT

Question. Our borders, particularly the Southwest Border, have been
an area of increased enforcement in order to combat illegal immigration
over the past several years. Because that increased enforcement results
in more cases in the courts, we have provided the Judiciary with
additional resources to manage that workload. Director Duff, your
testimony indicates that this increased enforcement affects other parts
of the country, not only the Southwest Border. Please discuss this in
further detail as well as the resulting implications.
Answer. The increased emphasis by Congress and the Administration
on immigration enforcement has had the greatest impact on the five
federal district courts along the Southwest border with Mexico. Other
districts throughout the country, however, have also been impacted by
this increased enforcement. In 2002, there were 11,791 criminal cases
for violations of federal immigration laws. Of these, 7,735 cases were
in the five Southwest border district courts and 4,056 cases were in
the remaining 89 judicial districts. In 2007, there were 15,898
criminal cases for violations of federal immigration laws. Of these,
10,953 were in the Southwest border courts, and 4,945 were in the
remaining 89 judicial districts. Non-border immigration caseload in the
federal courts increased 22 percent in this five year period.
Immigration-related cases can present challenges to a court, including
the need to hire or contract for qualified interpreters to assist in
court proceedings.
Increased immigration enforcement has impacted our appellate courts
as well. Challenges to Board of Immigration Appeals (BIA) decisions in
the appellate courts totaled 1,777 cases in 2001, peaked at 12,725
cases in 2006, then declined to 9,338 cases in 2007--a more than 400
percent increase over 2001. About one-third of all BIA decisions are
challenged in the federal appellate courts with 70 percent of those
challenges occurring in the Second and Ninth Circuits. While BIA
appeals have dropped in the last year, these cases continue to demand
extensive resources since they often turn on a credibility
determination by a Department of Justice immigration judge, thus
requiring close judicial review of a factual record by the appellate
courts.
The Judiciary will utilize the additional resources provided by
Congress to respond to workload needs throughout the federal court
system and not just on the Southwest border.

JUDICIAL AUTHORITY FOR OFFENDER RE-ENTRY PROGRAMS

Question. I have supported offender reentry programs like job
training, education, drug and mental health treatment for many years,
as part of the effort to reduce criminal recidivism. Does the Judiciary
have the legislative authority it needs to increase the likelihood of
successful offender reentry into the community and positive outcomes
for post-conviction supervision?
Answer. The Judicial Conference believes it needs explicit
authority to permit the Director of the Administrative Office to
contract for non-treatment services (e.g., medical, educational,
emergency housing, and vocational training) and other re-entry
interventions for post-conviction offenders generally. At its September
2005 session, the Conference approved proposed language which was
submitted to Congress on November 14, 2005. Specifically, the proposed
legislation amends 18 U.S.C. 3672 to allow the AO Director to
contract for re-entry services, including treatment, equipment,
emergency housing, vocational training, and other re-entry
interventions. I am pleased to report this provision was included in
the Second Chance Act which was signed into law on March 30, 2008
(Public Law 110-199).
The Judicial Conference also supports legislation that would amend
18 U.S.C. 3154 to authorize the AO Director to contract for similar
services for defendants released pending trial, and to amend both 18
U.S.C. 3154 and 18 U.S.C. 3672 to authorize the Director to expend
funds for emergency services for defendants on pretrial release and
offenders on post-conviction supervision respectively. This proposed
legislation was submitted to Congress on April 16, 2007.
Expansion of the Director's authority will allow probation and
pretrial services officers to obtain contract services for all persons
under their supervision who need them. Research consistently indicates
that certain approaches yield demonstrable and measurable results in
the reduction of recidivism. With expanded authority, officers will
make greater use of practices such as cognitive-behavioral treatment,
job training, and employment placement programs that have been proven
effective in obtaining successful outcomes and making the community
safer.
The addition of authority to expend funds for emergency services
for defendants on pretrial release and offenders on post-conviction
supervision respectively would provide officers with the ability to
deal with day-to-day incidental expenses. Officers often use their own
personal money to assist offenders with small expenditures such as bus
fare to go for a job interview.
Of course, if expenditure authority is enacted, guidance and
clarification would be developed to ensure that it is used
appropriately. Some of the issues requiring clarification would include
the type of ``emergency'' services that are authorized and the spending
limit.

RENT SAVINGS

Question. Over the past few years, the Judiciary has realized
substantial savings (more than $50 million) in rent overcharges from
the General Services Administration. Judge Gibbons, your testimony
indicates that another $10 million savings is expected in fiscal year
2008. Now that you and GSA are working cooperatively in this effort, at
what point do you expect this savings to level off (or do you expect to
continue to have a savings in the tens of millions)?
The Judiciary believes it is important to continue to work with the
courts and GSA to compare the space actually occupied by the courts to
the space assignment drawings used by GSA. These drawings are used to
establish the basis for rent bills and it is therefore very important
that they are accurate. The Judiciary and GSA have recently revised the
existing approach to verifying the assignment drawings to the space
actually occupied and to adjust the rent bill in connection with errors
identified during rent validation so that rent bill adjustments for
overcharges can be performed on a more expedited basis. Although we
believe that the major rent overcharges have been identified and
corrected, savings will continue to be realized if further overcharges
are identified during our ongoing and continuous reviews of GSA rent
bills.
A second initiative underway for the Judiciary is the review of GSA
appraisals used to set rental rates to ensure their accuracy. It is
uncertain at this time whether this review will result in significant
savings for the Judiciary.

PROJECTS UNDER THE ``CARE OF THE BUILDING AND GROUNDS OF THE SUPREME
COURT''

Question. The Care of the Building and Grounds fiscal year 2009
appropriation request total $18.4 million, an increase of $6.2 million
(51.2 percent) over the fiscal year 2008 appropriation level.
Modernization of the Supreme Court construction project began in 2004
and expected completion is the fall of this year, costing a total of
$122.3 million.
[Clerk's Note.--The Supreme Court's budget request does not fall
under the jurisdiction of the Judicial Conference of the United States
and its Budget Committee. Accordingly, this response was prepared by
the Supreme Court.]
What was achieved with this expenditure of funds?
Answer. Phase I of the project--the construction of the underground
police annex, the Architect of the Capitol (AOC) shop and parking
areas--was completed in late 2005. Phase II of the project--the
interior building modernization--is ongoing and includes updated life
safety systems, windows, mechanical, electrical, and plumbing systems.
The work on one of the four building quadrants is complete. The second
quadrant is scheduled for completion during the summer of 2008.
The contractor's projected completion date for the entire
modernization project is the summer of 2010. Although the building
modernization project is more than a year behind, the project continues
to be within budget.
Question. Do you expect any further modernization needs in the
short-term future?
Answer. The Court does not foresee further modernization
requirements outside the current scope of the modernization project.
With the project two years away from completion, however, unforeseen
circumstances may arise that would require a request for additional
funding.
Question. Separate projects include the exterior property
renovation/landscaping project and the roof system project. For fiscal
year 2009, the Supreme Court is requesting $6.3 million to complete
construction to renovate the exterior landscape of the Supreme Court as
well as $2.1 million for phase 2 (of 5 phases) to repair the roof,
which is to be completed in 2011. Once the modernization, property
renovation/landscaping, and roof projects are completed, will Care of
the Buildings and Grounds of the Supreme Court go back down to a
maintenance request level or are further projects anticipated in the
near future?
Answer. When the modernization project is completed, approximately
$3 million will be needed to complete the installation of the perimeter
security plan around the Court building and grounds. Additional funding
will also be needed to complete the planned roof repairs. Although some
funding has been already provided to restore the stone sculptures of
the East and West pediments and roof perimeters of the building, it is
likely that more funding will be needed to repair and restore the
stonework in the building's four interior courtyards. At this time, no
other major projects are anticipated, and future funding requests
should be more in keeping with normal maintenance-level requirements
for the care of the building and grounds.

RETROACTIVITY OF CRACK COCAINE SENTENCING AMENDMENT

Question. The U.S. Sentencing Commission, an independent agency
within the Judiciary, promulgates the sentencing guidelines that
federal trial court judges consult when sentencing defendants convicted
of federal crimes. Last year, the Sentencing Commission amended federal
guidelines reducing offenses under federal sentencing guidelines for
crack cocaine offenses. Furthermore, the Commission unanimously decided
to make the policy change retroactive and this retroactivity became
effective on March 3, 2008.
Will crime victims be notified of an inmate's release and will they
have an opportunity to provide comment to the court prior to an
inmate's release?
Answer. Judges have been asked by the Bureau of Prisons (BOP) to
delay for 10 days the effective date of any sentence reduction that
results in an inmate's immediate release. This delay is needed, in
part, to give the BOP adequate time to notify victims and witnesses of
the offender's release, as they are required to do per 18 U.S.C.
3771. The Judiciary is unaware if the Department of Justice will
attempt to contact victims to seek comment prior to an inmate's
release. It should also be noted that because of the nature of these
offenses, most cases will not have an identifiable victim within the
meaning of the Crime Victim Rights Act.
Question. What measures are U.S. probation offices taking to
address community safety issues and to ensure a smooth transition for
inmates released into the community?
Answer. Probation officers will play a key role in recalculating
the inmate's amended guideline range and identifying any post-sentence
conduct that may impact the judge's decision. Officers will do that in
part by reviewing the inmates disciplinary records and progress reports
that are prepared by the BOP. Officers were recently provided with
refresher training for the BOP's Sentry system, which allows officers
to access information on an inmate's performance while in the BOP. If
the officer identifies a risk that cannot be addressed by the
conditions originally imposed, the probation officer may ask the court
to modify or impose additional conditions of supervised release. These
may include conditions for halfway house placement, drug or mental
health treatment, or home confinement.
Prerelease planning ordinarily begins several months before an
inmate's release, and addresses issues such as an inmate's release
residence, continuity of any treatment, and potential employment. It is
possible that some offenders will receive a sentence of time served and
not have a pre-release plan in place. In such cases, the probation
officer and BOP staff will use the 10-day period requested by the
government to develop a plan for the inmate's release. The probation
officer and BOP staff will prioritize the inmate's needs and attempt to
address as many as possible before the inmate's release. Most pressing
will be to identify an appropriate release residence. Once released,
the officer will conduct a thorough assessment and make any necessary
referrals to assist the offender in his or her reentry back to the
community.
Question. Please discuss your post-conviction supervision program.
How do you determine the services and support supervisees require and
receive, including education, job training, and treatment?
Answer. In most cases, an offender's needs have been identified
well before supervision begins, either at the pretrial or presentence
stage of the Federal criminal justice system. The presentence report
and the resulting sentencing document identify treatment, educational,
employment, and other needs that will most likely have associated
special conditions of the supervision term.
Following an offender's placement on probation or release from an
institution, the probation officer works with the offender to assess
the offender's risks, needs and strengths to prepare an individualized
comprehensive supervision plan. Not all offenders require the same
level of supervision to reach this goal. It is the officer's job to
distinguish among them and to implement supervision strategies that are
appropriately matched with the offender's risks, needs and strengths.
If substance abuse or mental health treatment conditions are
ordered, the officer will either conduct an informed assessment or
direct the person to undergo a clinical assessment performed by a
professional treatment provider. If treatment is necessary, the officer
refers the offender to a treatment program tailored to his needs.
Treatment is part of the overall supervision objectives and strategies
for the case. The officer monitors the offender's progress in treatment
and collaborates with the treatment provider to further the offender's
chances for success on supervision.
If education is identified as a need for an offender who never
completed high school, the officer may identify obtainment of a GED as
a supervision objective. If so, the officer assists the offender in
enrolling in a local educational program. The officer continually
monitors the offender's progress in this type of program, as well as in
many others, intended to enhance the offender's success on supervision
and beyond.
With respect to an unemployed or underemployed offender, federal
probation officers are now working in partnership with the Bureau of
Prisons, the Department of Labor and the National Institute of
Corrections to create a systems approach to offender reentry and
workforce development. Points of contact in each state have been
identified to bring implementation of these partnerships to the local
level. Probation and pretrial services officers have been trained as
``offender workforce development specialists'' in 36 states. Federal
probation continues to expand the initiative by training more probation
officers each year as offender employment specialists. Those trained
then develop workforce development partnerships within their states and
communities. Career fairs sponsored by Federal Probation for ex-
offenders have been held in communities in each region of the country,
and partnerships have been developed with colleges, one-stop centers,
and community and faith-based organizations to provide resources and
training for ex-offenders that provide career opportunities in
occupations identified by the President's High Growth Jobs Initiative.
This collaborative effort has reduced violations, revocations, and
recidivism rates with respect to those who have participated in the
employment initiative. Nearly 93 percent of those who start federal
supervision employed are still employed at the time their cases close,
a strong indicator that they have adapted to the community and are more
likely to be successful after completing supervision.
If, during the period of supervision, an officer identifies
educational, vocational or treatment needs for which there is no court-
ordered special condition requiring the offender participation in the
program(s), the officer will petition the court to modify the release
conditions accordingly. A court-ordered special condition allows the
officer to leverage sanctions if the offender does not comply with the
condition. In many cases, the backing of the court will induce the
offender to achieve the necessary skills and/or treatment necessary to
succeed on supervision and beyond. All of the above interventions, in
addition to individualized professional care and concern, contribute
toward the goal of increasing the likelihood of success on supervision.
Question. Do you have any data on education levels of people under
supervision and do you ensure that supervisees have opportunities to
earn a GED if needed?
Answer. If education is identified as a need for an offender who
never completed high school, the officer may identify obtainment of a
GED as a supervision objective. If so, the officer assists the offender
in enrolling in a local educational program. The officer continually
monitors the offender's progress in this type of program, as well as in
many others, intended to enhance the offender's success on supervision
and beyond.
Data on education levels of people under supervision:

PERSONS RECEIVED FOR POST-CONVICTION SUPERVISION FOR THE 12 MONTH PERIOD
ENDING 09/30/2007
------------------------------------------------------------------------
Education Level Number Percent
------------------------------------------------------------------------
No Formal Education........................... 476 1
Some Elementary............................... 1 ...........
Elementary through 8th Grade.................. 3,112 7
Some High School.............................. 12,581 27
Graduate Equivalency.......................... 7,123 15
Some Vocational School........................ 9 ...........
Vocational School Graduate.................... 441 1
High School Diploma........................... 10,312 22
Some College.................................. 8,905 19
College Graduate.............................. 2,920 6
Post Graduate................................. 643 1
-------------------------
Total................................... 46,523 100
------------------------------------------------------------------------
Modified Table E-1. Excludes pre-existing cases transferred between
districts and cases where the education level was unavailable or not
applicable.

JUDICIARY WORKLOAD

Question. The new bankruptcy legislation took effect in October
2005 and it appears that filings are still down from pre-Bankruptcy Act
levels. From your testimony, it appears that you expect a significant
increase in the number of bankruptcy filings--a 23 percent increase.
What trend do you expect in the future?
Answer. Following the implementation of the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005 (BAPCPA) in October
2005, filings plummeted, falling roughly 50 percent from 1,484,570
filings in 2006 to 751,056 filings during 2007. The Judiciary's latest
projections indicate that the number of petitions filed is expected to
rise rapidly over the next two years, growing 23 percent in 2008 and
another 13 percent in 2009. While, historically, there have been a
handful of years where double-digit percentage increases have occurred,
these 2008 and 2009 projections are still well below what would have
been projected had BAPCPA not been enacted. The number of more work-
intensive chapter 13 petitions is expected to reach pre-BAPCPA levels
much sooner than the number of chapter 7 petitions.
Question. Will the current downturn in the economy likely further
increase filings?
Answer. The Judiciary's bankruptcy filing projections assume that
economic growth will be slow--but positive--and that consumer debt will
remain high. If the economy worsens, filings would increase more
rapidly in the near term. No consensus opinion exists regarding the
degree to which a recession would affect overall filings.
Along with a slowing economy, a number of other factors indicate
that filings could continue to grow at a fast pace, namely (1) the debt
service burden is at or near record levels, (2) mortgage foreclosure
rates have been rising, and (3) adjustable rate mortgage resets have
made some monthly mortgage payments prohibitively expensive.
Passage and enactment of bankruptcy reform legislation currently
under consideration in Congress, which would strike the current
exemption of a mortgage on a debtor's principal residence, would likely
result in a surge in chapter 13 filings.
Question. In your written testimony, you discussed the impact of
the bankruptcy law passed by Congress in 2005. You wrote: ``Our
bankruptcy courts have indicated that the actual per-case work required
of the bankruptcy courts has increased significantly under the new
law.'' You also discussed the increased workload for debtors filing for
bankruptcy under Chapter 7. Do you also agree that in the aftermath of
the 2005 bankruptcy law there has also been an increased workload for
bankruptcy trustees?
Answer. Yes, the workload for bankruptcy trustees has increased in
the aftermath of the 2005 bankruptcy reform legislation. For example, a
Chapter 7 case trustee must now review results of the debtor's means
test, review extensive documentation provided by the debtor (pay stubs,
mortgage documents, etc.), and provide the court a statement if the
debtor's case is presumed to be abusive. The trustee must prosecute a
motion to dismiss a case if substantial abuse of a Chapter 7 filing is
discovered. There are also audit responsibilities for the case trustee
to ensure that the debtor's schedules of income and expenses are
accurate.
______

Questions Submitted by Senator Sam Brownback

Question. Your fiscal year 2009 budget submission does not request
resources for additional staff in clerks and probation offices. Do you
feel that you currently have the appropriate number of staff to address
your workload?
Answer. Although the courts do not currently have the appropriate
number of staff on board to address workload needs, the funding made
available by Congress in fiscal year 2007 and fiscal year 2008 will
allow the courts to narrow the gap between current staffing levels and
workload. This funding will be utilized over a three year period--
fiscal years 2007-2009--to increase staffing levels in the courts. In
addition to the staff hired in fiscal year 2007, the Judiciary
anticipates the courts will bring on another 305 FTE during fiscal
years 2008 (150 FTE) and 2009 (155 FTE).
In fiscal year 2007, Congress provided the courts with $20.4
million to address the most critical workload needs. Because full-year
funding was not made available to the courts until six months into the
fiscal year, most of these new staff will be brought on board in fiscal
year 2008. Hence, the $20.4 million was planned to be utilized during
fiscal years 2007 and 2008. The fiscal year 2008 financial plan
includes $15 million of the $20.4 million to hire 150 FTE to meet
critical workload demands.
In fiscal year 2008, Congress provided the Judiciary with $25
million in emergency appropriations to address workload stemming from
increased immigration enforcement. Of this amount, $14.5 million will
be used to hire 155 FTE in clerks and probation offices, and the
remaining $10.5 million provided for Defender Services will be used to
pay private panel attorneys handling immigration cases. With the $14.5
million, the Judiciary estimates that the courts will bring on the 155
FTE over two years: 35 FTE in fiscal year 2008 and 120 FTE in fiscal
year 2009.
Question. Please describe your current workload along the Southwest
Border. Has the Judiciary been impacted by the additional law
enforcement resources added to the border?
Answer.
Impact on the Federal Courts
The federal courts along the Southwest Border (SWB) have been
impacted by additional law enforcement resources provided to the
Department of Homeland Security (DHS) and the Department of Justice
(DOJ) for border and immigration enforcement initiatives.
Criminal filings along the SWB increased 11 percent between 2002
and 2007, and filings in those five district courts currently account
for nearly one-third of all criminal cases nationwide. The time
sensitive nature of criminal cases, created by statutory issues
involving speedy trials requirements, multiple hearings for defendants
(e.g. initial appearances, arraignments, and pleas in the early
stages), and the need for interpreter services, increase the courts'
need for adequate staffing resources.
The SWB courts have the five highest number of felony defendants
per judgeship and felony defendants along those five district courts
currently account for nearly one-third of all felony defendants
nationwide. In addition, the districts of Texas-Southern, New Mexico,
and Texas-Western have experienced compounded growth rates in criminal
caseload of 9.2 percent, 4.6 percent, and 9.1 percent, respectively, in
the number of felony defendants from 2004 to 2007.
Pretrial caseload along the SWB has increased as well. From 2002 to
2007, the five SWB districts experienced a 28 percent increase in
pretrial services cases activated compared to 8 percent growth
nationally over the same period. By June 2007, the SWB districts
accounted for 35 percent of all pretrial cases activated in the federal
system.
In the probation program, SWB districts experienced a 10 percent
increase in the number of supervision cases from 2002 to 2007.
Nationally, the growth in post-conviction cases for that period was 7
percent. The five SWB district have consistently made up 13-14 percent
of the total number of cases under post-conviction supervision in the
federal system between 2002 and 2007.
While criminal case filings in the federal courts in the five
judicial districts along the Southwest border is high by historical
standards, filings have not increased commensurate with the increased
resources provided to DHS for border enforcement. Despite zero
tolerance border initiatives such as Operation Streamline in which
nearly everyone apprehended for violating U.S. immigration laws is
prosecuted, resource constraints in the justice system have precluded
more cases from being prosecuted in the federal courts. Staffing
shortages in U.S. Attorney offices, lack of detention beds needed to
secure offenders awaiting prosecution, and staffing constraints in U.S.
Marshals offices have resulted in the establishment of certain
threshold levels in some border districts that must be met before a
case is prosecuted. For example, a U.S. Attorney in one district may
prosecute someone coming into the country illegally after the tenth
attempt, while a U.S. Attorney in another district may prosecute after
the fifth attempt.
More Resources Being Provided to the Border
The President's fiscal year 2009 budget includes $12 billion for
DHS for border security and enforcement efforts, a 19 percent increase
over fiscal year 2008, and a more than 150 percent increase since 2001.
DHS has used the funding to increase the number of border patrol agents
significantly, particularly on the Southwest border with Mexico. Since
2001, more than 5,000 additional border patrol agents have been hired
with most of them placed along the Southwest border. In fiscal year
2008, DHS received funding to hire an additional 3,000 border patrol
agents, and the President's fiscal year 2009 budget includes funding
for another 2,200 agents, bringing the total to 20,000 agents. When
fully staffed the Border Patrol will have more than doubled in size
since 2001.
In fiscal year 2008 DOJ received $7 million in emergency funding to
hire more assistant U.S. Attorneys (AUSAs) in the five judicial
districts along the Southwest border. The U.S. Marshals Service
received $15 million in emergency funding to address Southwest border
workload needs including the hiring of 100 additional deputy U.S.
Marshals. The President's fiscal year 2009 budget includes $100 million
for a new Southwest Border Enforcement Initiative focusing law
enforcement and prosecutorial efforts on fighting violent crime, gun
smuggling, and drug trafficking in that region. If funded, this
initiative will increase the number of AUSAs along the Southwest border
by another 50 positions. The President's budget also seeks $88 million
to expand detention capacity along the southwest border.
The resultant increase in criminal filings from this infusion of
resources will impact district judges, clerks offices, probation and
pretrial services offices, and federal defender offices on the border.
The Judiciary's fiscal year 2009 budget submission, however, does not
request funding for new clerks or probation or pretrial services staff
on the border or elsewhere. Congress provided the Judiciary with $45.4
million over the last two years--$20.4 million in fiscal year 2007 and
$25 million in fiscal year 2008--to address immigration-related
workload so, from a staffing perspective, the courts are well
positioned in the short term to respond to the increased workload that
is expected to materialize.
Question. What additional actions is the Judiciary taking to reduce
rent?
Answer. The fiscal year 2009 Judiciary budget request reflects
lower requirements as a result of measures incorporated since the cost-
containment strategy was initiated in fiscal year 2004. Specific
examples of planned or ongoing initiatives that are helping the
Judiciary manage costs, or will help in the future include:
establishing an annual budget cap for GSA space rental costs for fiscal
years 2009 through 2016, which limits annual growth by an average of
4.9 percent per year; revising the U.S. Courts Design Guide to lower
future rental costs of space for chambers, attorneys, and court staff;
validating GSA rent bills for each court facility and examining the GSA
appraisal methodology to ensure rent charged is comparable to
commercial rates; establishing ``asset management planning'' as the
Judiciary's new long-range facilities planning methodology that will
identify the most cost-effective strategy for meeting the court's
operational needs, while controlling and containing costs, especially
rent to GSA; and negotiating a return on investment pricing structure
with GSA for all new space acquisitions, which replaces a market
pricing approach.
Question. In particular, a GAO report identified several
opportunities for the Judiciary to reduce its space usage and therefore
its rent costs. What has the Judiciary done in response to that report?
Answer. Recommendation 1: Work with GSA to track rent and square
footage trend data on an annual basis for the following factors: (1)
rent component (shell rent, operations, tenant improvements, and other
costs) and security (paid to the Department of Homeland Security); (2)
judicial function (district, appeals, and bankruptcy); (3) rentable
square footage; and (4) geographic location (circuit and district
levels). This data will allow the Judiciary to create a better national
understanding of the effect that local space management decisions have
on rent and to identify any mistakes in GSA data.
Actions of the Judiciary:
--The Judiciary is continuing its efforts to obtain from GSA more
specific information with regard to its rent bills that will
aid the Judiciary in assigning costs to its various components.
This effort has been quite time consuming as it requires GSA to
remeasure its space and reclassify the information in GSA's
database according to its type, e.g., district court courtrooms
and chambers, clerk's office space, libraries, etc.
--The Judiciary is also continuing its national rent validation
initiative to identify mistakes in GSA data. The program has
been successful on a number of fronts. The Judiciary has
received rent credits and long-term savings (cumulative savings
over a 3-year period of over $50 million) and has benefited
from GSA's improved internal management controls on its rent-
setting practices. We anticipate receiving additional rent
adjustments and credits resulting from over $10 million in rent
errors that we recently reported to GSA. Additionally, the
Judiciary (and GSA) now has in place a program to help ensure
that accurate rent bills are sustained over the long term.
--As a follow-on to the base-line review of current rent bills, the
Judiciary has embarked on a program to: (1) ensure future rent
rates are appropriate; (2) maintain a website that will allow
court personnel to determine quickly and easily the amount and
cost of the space they occupy in federally owned facilities;
and (3) design a training curriculum to provide court personnel
with a comprehensive understanding of the rules, regulations,
and procedures that govern the assignment, classification, and
rental-rate determination for the space they occupy in
federally owned facilities.
--On February 19, 2008, the Director of the Administrative Office and
the Commissioner of GSA's Public Buildings Service signed a
Memorandum of Agreement (MOA) that changes the way rent will be
calculated for all federally owned courthouses to be delivered
in the future. The MOA outlines a new process for determining
rental rates based on a return on investment methodology. Under
the MOA, the rent will be fixed for the first 20 years of
occupancy and will be set to return to GSA approximately 7
percent per year of its capital costs; operating costs will be
adjusted annually to reflect GSA's actual operating expenses.
Both the Judiciary and GSA will benefit from knowing with
certainty how much rent the Judiciary has to pay and how much
rent GSA will receive.
Recommendation 2: Create incentives for districts/circuits to
manage space more efficiently. These incentives could take several
forms, such as a pilot project that charges rent to the circuits and/or
districts to encourage more efficient space usage.
Actions of the Judiciary:
--In September of 2007, the Judicial Conference approved creation of
the Circuit Rent Budget (CRB) program as part of the
Judiciary's overall cost containment efforts. CRB is designed
to promote greater fiscal discipline in the management of the
Judiciary's use of space by aligning, at the circuit judicial
council level, the budget responsibility for rent, with the
authority to determine space need.
--The chief purpose of CRB is to enable the Judiciary to hold space
cost growth to no more than 4.9 percent, on average, over the
next eight years. The 4.9 percent cap on rent growth was
approved by the Judicial Conference in September of 2006.
--In essence, CRB allocates rent funds to circuits to cover both
existing space assignments as well as space growth, with space
growth carefully limited through centralized approval of large
projects, and by a formulaic distribution to individual
circuits of authority to add to the rental base.
--Since its approval by the Judicial Conference in September 2007,
the CRB program has been one of the Judiciary's main priorities
in the space area. This initiative constitutes a dramatic
change in the Judiciary's management of space and rent costs
and its implementation affects virtually every work process and
system currently in place.
--Now in its pilot year, CRB is transforming the way the Judiciary
plans for and approves new space acquisitions. Numerous
initiatives are in progress to make the CRB program fully
functional and successful. Some of the initiatives include, but
are not limited to: a major communications and training plan;
and implementation and testing of updated procedures, forms,
and processes. The automated system, the Judiciary's Facilities
Asset and Construction System (JFACTS), is also being
redesigned to support the re-engineering of the Judiciary's
space and rent program.
Recommendation 3: Revise the Design Guide to: (1) establish
criteria for the number of appeals courtrooms and chambers; (2)
establish criteria for space allocated for senior district judges; and
(3) make additional improvements to space allocation standards related
to technological advancements (e.g., libraries, court reporter spaces,
staff efficiency due to technology) and decrease requirements where
appropriate.
Actions of the Judiciary:
--Over the last two years, the Judicial Conference of the United
States approved multiple reductions to the space standards set
forth in the U.S. Courts Design Guide that have reduced staff
office sizes and chambers space for senior, district,
appellate, bankruptcy and magistrate judges. In addition, the
Committee on Space and Facilities plans to consider the
criteria for the number of appeals courtrooms. Finally, the
Judicial Conference approved technical amendments including
reductions in atrium, lighting, and HVAC systems that will
result in cost savings.
--As to the impact of electronic filing on court space, the Judiciary
has reduced Design Guide requirements for some of the clerk's
office space, including intake areas and records storage,
because of the impact of the electronic case filing/case
management system and has reduced the library space by 13
percent as a result of reductions in lawbook collections.
Question. More specifically, what is the Judiciary's stance on
courtroom sharing?
Answer. The current Judicial Conference policy on courtroom sharing
is that every active district judge, magistrate judge, and bankruptcy
judge should have a courtroom. In response to an authorizing resolution
passed by the House Committee on Transportation and Infrastructure, the
Judiciary has instituted a policy of one courtroom for every two senior
judges in all pending courthouse projects. All of the Judiciary's
courtroom sharing policies for all types of judges are currently being
studied by the Judicial Conference.

SUBCOMMITTEE RECESS

Senator Durbin. The subcommittee will now stand in recess.
[Whereupon, at 4:33 p.m., Wednesday, March 12, the
subcommittee was recessed, to reconvene subject to the call of
the Chair.]

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

----------

WEDNESDAY, APRIL 16, 2008

U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 3 p.m., in room SD-192, Dirksen
Senate Office Building, Hon. Richard J. Durbin (chairman)
presiding.
Present: Senator Durbin, Brownback, and Allard.

DEPARTMENT OF THE TREASURY

Internal Revenue Service

STATEMENT OF DOUGLAS SHULMAN, COMMISSIONER
ACCOMPANIED BY:
RICHARD SPIRES, DEPUTY COMMISSIONER
LINDA STIFF, DEPUTY COMMISSIONER

OPENING STATEMENT OF SENATOR RICHARD J. DURBIN

Senator Durbin. Good afternoon. This hearing will come to
order.
I am pleased to welcome you to this session before the
Financial Services and General Government Appropriations
Subcommittee. My colleagues will be joining me a little later
on, and I will certainly welcome them.
Our focus today is on the President's fiscal year 2009
budget request for the Internal Revenue Service (IRS). It is a
perfect day, is it not, the day after tax day?
Funding for the IRS alone constitutes just over one-half of
the total amount requested by the administration for the nearly
30 agencies under this subcommittee's jurisdiction. Each year
IRS employees make hundreds of millions of contacts with
American taxpayers and businesses, and the IRS represents the
face of Government to more U.S. citizens than any other agency.
Appearing before the subcommittee is a distinguished group
of witnesses. They bring valuable expertise and public service
experiences in their lives to this hearing today, and I
appreciate it.
First, I am going to welcome Douglas Shulman, now in his
fourth week--4 weeks now, Mr. Commissioner--as the 47th
Commissioner of the Internal Revenue Service of the United
States. Thank you for embarking on this challenge.
Joining us on the second panel will be three of IRS's key
partners and watchdogs: J. Russell George, Treasury Inspector
General for Tax Administration; Paul Cherecwich, Chairman of
the IRS Oversight Board; and Nina Olson, National Taxpayer
Advocate. I appreciate their work and look forward to their
testimony.

PREPARED STATEMENT OF THE GOVERNMENT ACCOUNTABILITY OFFICE

I also want to acknowledge the helpful contributions of the
Government Accountability Office (GAO) in response to our
request for analysis. I welcome senior GAO officials: James R.
White, Director of Strategic Issues, and David Powner, Director
of Information Technology, Management Issues; and other members
of their team. Their prepared statement will be a part of the
record, and they stand ready to respond to questions.
[The statement follows:]
Prepared Statement of James R. White, Director, Strategic Issues,
Government Accountability Office

Internal Revenue Service: Assessment of the Fiscal Year 2009 Budget
Request

HIGHLIGHTS

Why GAO Did This Study
The fiscal year 2009 budget request for the Internal revenue
Service (IRS) is a road map for how IRS plans to allocate resources and
achieve ambitious goals for improving taxpayer service, increasing
research, and continuing to invest in modernized information systems.
One complicating factor in implementing IRS's plans in the immediate
future is the recent passage of the Economic Stimulus Act of 2008,
which creates additional, unanticipated workload for IRS.
GAO was asked to (1) assess how the President's budget request for
IRS allocates resources and justifies proposed initiatives; (2)
determine the status of IRS's efforts to develop and implement its
Business Systems Modernization (BSM) program; and (3) determine the
total costs of administering the economic stimulus legislation. To meet
these objectives, GAO drew upon and updated recently issued reports.
What GAO Recommends
GAO is not making new recommendations, but the statement highlights
outstanding recommendations to extend the use of return on investment
(ROI) analysis to cover major enforcement programs and improve BSM
management controls and capabilities.
What GAO Found
The President's fiscal year 2009 budget request for IRS is $11.4
billion, 4.3 percent more than last year's enacted amount. The request
proposes to maintain taxpayer service at recent levels, in part by
realizing efficiency gains from electronic filing, despite a decrease
in staffing. It also proposes a 7 percent increase in enforcement
spending, including spending for 21 legislative and nonlegislative
initiatives. The legislative proposals are projected to cost $23
million in fiscal year 2009, funding that IRS would not need if the
proposals are not enacted. Similarly, if IRS were to fall behind in its
proposed enforcement hiring efforts, it would not need all $226 million
of the associated funding. IRS justified its nonlegislative enforcement
initiatives with ROI analyses, which are useful, despite limitations,
for making resource allocation decisions. The budget request does not
provide ROI information for activities that constitute a large part of
the budget request--activities other than the proposed initiatives.
The request for BSM is over $44 million lower than the fiscal year
2008 enacted amount. IRS said this funding level will allow it to
continue its primary modernization projects, but it did not describe
how specific projects or benefits to taxpayers would be affected. IRS
has continued to make progress in implementing BSM projects and
improving modernization management controls and capabilities. However,
further improvements are needed. For example, the agency has yet to
develop long-term plans for completing BSM and consolidating and
retiring legacy systems.
IRS estimated that the costs of implementing the economic stimulus
legislation may be up to a total of $767 million--including a $202
million supplemental appropriation. In addition to the supplemental
appropriation, IRS is reallocating hundreds of collections staff to
answering taxpayer telephone calls, resulting in up to $565 million in
foregone enforcement revenue. In addition, IRS expects some
deterioration in telephone service because of the increased call
volume. For example, IRS is expecting its assistor level of service to
drop to as low as 74 percent compared to its goal of 82 percent.

THE PRESIDENT'S FISCAL YEAR 2009 REQUEST FOR IRS FULL-TIME EQUIVALENTS (FTES) COMPARED TO FISCAL YEAR 2008
ENACTED BUDGET FTES
----------------------------------------------------------------------------------------------------------------
Fiscal year Fiscal year Percentage
Appropriation 2008 enacted 2009 requested change
----------------------------------------------------------------------------------------------------------------
Enforcement..................................................... 47,349 49,792 +5.2
Taxpayer Service................................................ 31,218 30,792 -1.4
Operations Support.............................................. 12,181 11,989 -1.6
BSM............................................................. 358 333 -7.0
Health Insurance Tax Credit..................................... 17 16 -5.9
-----------------------------------------------
Total..................................................... 91,123 92,922 +2.0
----------------------------------------------------------------------------------------------------------------
Source: GAO analysis of IRS data.

Mr. Chairman and Members of the Subcommittee: We appreciate this
opportunity to comment on the President's fiscal year 2009 budget
request for the Internal Revenue Service (IRS).
Financing of the Federal Government depends largely on IRS's
ability to effectively administer the tax laws. The President has
requested $11.4 billion in program dollars to fund IRS's fiscal year
2009 operations, including $11.1 billion for service to taxpayers and
tax law enforcement, plus $223 million for the BSM program, IRS's
ongoing effort to improve the agency's business and tax processing
systems.
The fiscal year 2009 budget request is a road map for how IRS
intends to allocate resources in order to carry out ambitious plans of
improving enforcement, improving taxpayer service, increasing research,
and continuing to invest in modernized information systems. Together
with the budget request, IRS's recently published strategies spell out
its intentions for improving taxpayer service and reducing the net tax
gap--the difference between the taxes owed and eventually paid, most
recently estimated at $290 billion for tax year 2001.\1\ The budget
request and strategies aim to build on recent IRS accomplishments such
as annually bringing in more revenue through enforcement and making
progress on modernizing IRS's business and tax processing systems. One
complicating factor for carrying out IRS's ambitious plans in the
immediate future is the recent passage of the Economic Stimulus Act of
2008, which creates additional, unanticipated workload for IRS this
year.\2\ Passage of this act required IRS to act quickly to deal with
taxpayers' questions and begin issuing payments.
---------------------------------------------------------------------------
\1\ Internal Revenue Service, Reducing the Federal Tax Gap
(Washington, D.C.: Aug. 2, 2007); and Internal Revenue Service, The
2007 Taxpayer Assistance Blueprint (Washington, D.C.: 2007).
\2\ Pub. L. No. 110-185 (2008).
---------------------------------------------------------------------------
Based on your request, our objectives were to (1) assess how the
President's budget request for IRS for fiscal year 2009 allocates
resources for enforcement, service, research, and systems modernization
primarily compared to fiscal year 2008 enacted levels; (2) assess the
rationales for differences between the 2 years, including the
rationales for initiatives and the extent to which those rationales
have been justified; (3) determine the status of IRS's efforts to
develop and implement its BSM program; and (4) determine the total cost
of administering the economic stimulus program.
To meet these objectives, we drew upon and updated a recently
issued report on the budget request and IRS's 2008 tax filing season,
and for our BSM work, we relied primarily on our review of the fiscal
year 2008 BSM expenditure plan.\3\ For the first report, we compared
enacted and requested budgets for IRS; reviewed documents, including
estimates of revenues and costs from initiatives; and interviewed IRS
officials. For our BSM report, we analyzed the expenditure plan,
reviewed other documents, and interviewed IRS officials. In assessing
the cost of the economic stimulus package, we obtained performance and
production data, looking for factors that significantly affected
performance, and we interviewed IRS officials. We conducted the current
performance audit from March 2008 through April 2008 in accordance with
generally accepted government auditing standards. Those standards
require that we plan and perform the audit to obtain sufficient,
appropriate evidence to provide a reasonable basis for our findings and
conclusions based on our audit objectives. We believe that the evidence
obtained provides a reasonable basis for our findings and conclusions
based on our audit objectives. For a more detailed discussion of our
scope and methodology, see the appropriate sections in the budget and
filing season and the BSM reports.
---------------------------------------------------------------------------
\3\ GAO, Internal Revenue Service: Fiscal Year 2009 Budget Request
and Interim Performance Results of IRS's 2008 Tax Filing Season, GAO-
08-567 (Washington, D.C.: Mar. 13, 2008) and GAO, Business Systems
Modernization: Internal Revenue Service's FISCAL Year 2008 Expenditure
Plan, GAO-08-420 (Washington, D.C.: Mar. 7, 2008).
---------------------------------------------------------------------------
In summary, we make the following major points:
--The President's budget request for IRS proposes to maintain
taxpayer service at recent levels and increase enforcement.
Overall, it increases spending on IRS by 4.3 percent. Spending
on taxpayer service would increase by less than 1 percent,
which would result in reduced staffing, but the level of
taxpayer service would be maintained by realizing efficiency
gains, in part, through increases in electronic filing. The
budget proposes a 7 percent increase in enforcement spending,
including funds and staffing for various legislative and
nonlegislative initiatives. According to the proposal, the
legislative initiatives would raise about $36 billion in
revenue over 10 years. They are projected to cost $23 million
in fiscal year 2009, funding IRS would not need if none of the
legislative initiatives were enacted. Similarly, if IRS were to
fall behind in meeting its challenging hiring goals for the
nonlegislative initiatives, it would not need all $226 million
of the associated funding for fiscal year 2009.
--IRS included more information than past years on the initiatives in
the fiscal year 2009 proposed budget. Of particular note, IRS
included return on investment (ROI) information for all
nonlegislative initiatives. However, beyond those initiatives,
the budget request does not provide an analytic basis for key
resource allocation decisions. Such decisions include
allocating resources among a variety of enforcement programs
and taxpayer services. Analytic data such as ROI can be helpful
to IRS's management and the Congress for making these decisions
as well as decisions about the overall balance between taxpayer
service and enforcement. Although the budget request provides
performance measure data, it does not provide ROI for programs
or activities that constitute a large part of the budget
request--activities other than the proposed initiatives.
--The requested budget for BSM is over $44 million lower than the
fiscal year 2008 enacted amount of about $267 million and
roughly $185 million less than the amount the IRS Oversight
Board is proposing. Modernized e-File (MeF) is the project with
the largest difference between the requested budget and the
fiscal year 2008 enacted amount. IRS stated that the requested
BSM funding level will allow it to continue developing and
delivering its primary modernization projects but did not
provide details on how plans to deliver specific projects or
benefits to taxpayers would be affected. IRS continues to make
progress in implementing BSM projects and meeting cost and
schedule commitments for most deliverables, but three project
milestones recently experienced significant cost or schedule
delays.\4\ IRS has also taken steps to address our prior
recommendations; however, work remains to fully implement them,
including developing long-term plans for completing the BSM
program. Future releases of the Customer Account Data Engine
(CADE) and Account Management Services (AMS) continue to face
risks and challenges, which IRS is working to mitigate.
Finally, we recently recommended that IRS complete a plan with
specific time frames for implementing initiatives supporting
its information technology (IT) human capital strategy, and IRS
agreed.
---------------------------------------------------------------------------
\4\ Milestones represent different phases in IRS's project life
cycle.
---------------------------------------------------------------------------
--IRS estimates that the cost of implementing the economic stimulus
legislation may be up to a total of $767 million, including a
$202 million supplemental appropriation. In addition to the
supplemental appropriation, IRS is reallocating resources from
enforcement to taxpayer service by shifting hundreds of
collections staff to answering telephone calls and, as a
result, may forego up to $565 million in enforcement revenue.
IRS has experienced a deterioration of telephone access and
expects a further decline. For example, IRS's assistor level of
service--which measures a taxpayer's ability to get through and
speak to an assistor--has already declined, and IRS expects
access to continue to drop to as low as 74 percent, down from
the fiscal year 2008 goal of 82 percent.

THE FISCAL YEAR 2009 BUDGET REQUEST PROPOSES TO MAINTAIN TAXPAYER
SERVICE AT RECENT LEVELS AND INCREASE ENFORCEMENT

The President's budget request is proposing to maintain taxpayer
service levels with fewer staff by realizing efficiency gains; it also
proposes to increase enforcement by adding staff. The President's
fiscal year 2009 budget request of $11.4 billion for IRS is 4.3 percent
more than the fiscal year 2008 enacted budget and represents an
increase of less than 1 percent for taxpayer service and 7 percent for
enforcement, as shown in table 1.

TABLE 1.--THE PRESIDENT'S FISCAL YEAR 2009 REQUEST FOR IRS COMPARED TO THE FISCAL YEAR 2008 ENACTED BUDGET
[Dollars in thousands]
----------------------------------------------------------------------------------------------------------------
Fiscal year Fiscal year Percentage
Program 2008 enacted 2009 requested change
----------------------------------------------------------------------------------------------------------------
Enforcement..................................................... $6,997,226 $7,487,209 +7.0
Taxpayer Service................................................ 3,612,833 3,636,230 +0.6
BSM............................................................. 267,090 222,664 -16.6
Health Insurance Tax Credit..................................... 15,235 15,406 +1.1
-----------------------------------------------
Total..................................................... 10,892,384 11,361,509 +4.3
----------------------------------------------------------------------------------------------------------------
Note: Dollar amounts include amounts for operations support.

Source: GAO analysis of IRS data.

The budget request increases IRS-wide staff levels, measured in
full-time equivalents (FTEs), by 2 percent, with a 1.4 percent decrease
in taxpayer service FTEs and a 5.2 percent increase in enforcement
FTEs, as shown in table 2.

TABLE 2.--THE PRESIDENT'S FISCAL YEAR 2009 REQUEST FOR IRS FTES COMPARED TO FISCAL YEAR 2008 ENACTED BUDGET FTES
----------------------------------------------------------------------------------------------------------------
Fiscal year Fiscal year Percentage
Appropriation 2008 enacted 2009 requested change
----------------------------------------------------------------------------------------------------------------
Enforcement..................................................... 47,349 49,792 +5.2
Taxpayer Service................................................ 31,218 30,792 -1.4
Operations Support.............................................. 12,181 11,989 -1.6
BSM............................................................. 358 333 -7.0
Health Insurance Tax Credit..................................... 17 16 -5.9
-----------------------------------------------
Total..................................................... 91,123 92,922 +2.0
----------------------------------------------------------------------------------------------------------------
Note: The decline in taxpayer services, including operations support, reflects 91 FTEs in efficiency savings and
207 FTEs in electronic filing savings. The increase in enforcement, including operations support, includes an
additional 1,431 revenue agents and 582 revenue officers who will work on initiatives.

Source: GAO analysis of IRS data.

The President's budget proposal is consistent with longer-term
trends for IRS. Compared to actual spending in fiscal year 2006, the
proposed fiscal year 2009 budget increases taxpayer service funding by
3.7 percent, a real decrease after inflation, while increasing IRS's
enforcement funding by 10 percent.
The budget request proposes to maintain taxpayer service at recent
levels. As an example, the key taxpayer service measures shown in table
3 are projected to remain relatively stable through fiscal year 2009.

TABLE 3.--TELEPHONE SERVICE MEASURES
[In percent]
----------------------------------------------------------------------------------------------------------------
Fiscal year Fiscal year Fiscal year Fiscal year
Measure 2006 actual 2007 actual 2008 planned 2009 planned
----------------------------------------------------------------------------------------------------------------
Telephone performance--access: Assistor level of 82.0 82.1 82.0 82.0
service (percentage of taxpayers who wanted to
talk with an assistor and actually got through
and received service)..........................
Telephone performance--accuracy:
Tax law customer accuracy (percentage of 90.9 91.2 91.0 91.0
calls in which telephone assistors provided
accurate answers on tax law and took
appropriate action)........................
Accounts customer accuracy (percentage of 93.2 93.4 93.5 93.7
calls in which telephone assistors provided
accurate answers on customer accounts and
took appropriate action)...................
----------------------------------------------------------------------------------------------------------------
Source: GAO analysis of IRS data.

In order to maintain taxpayer service at recent levels despite a
decrease in real spending and staffing, IRS expects to realize
efficiency gains. For instance, IRS expects to devote 207 fewer FTEs to
the labor-intensive processing of paper returns because of expected
increases in electronic filing. These expected efficiency gains are
consistent with past trends--between 1999 and 2007, IRS reduced staff
devoted to processing paper returns by about 1,800 FTEs.
IRS's ability to maintain or improve taxpayer service beyond 2009
will likely depend on its ability to continue to improve efficiency. To
this end, in recent reports, we made recommendations to further
increase electronic filing. We recommended that IRS determine the
actions needed to require software vendors to include bar codes on
printed returns, and we suggested that the Congress mandate electronic
filing by certain paid tax preparers.\5\ IRS agreed with our bar code
recommendation and outlined the actions it would take.
---------------------------------------------------------------------------
\5\ GAO, Tax Administration: 2007 Filing Season Continues Trend of
Improvement, but Opportunities to Reduce Costs and Increase Tax
Compliance Should Be Evaluated, GAO-08-38 (Washington, D.C.: Nov. 15,
2007) and GAO, Tax Administration: Most Filing Season Services Continue
to Improve, but Opportunities Exist for Additional Savings, GAO-07-27
(Washington, D.C.: Nov. 15, 2006).
---------------------------------------------------------------------------
Some of the real spending decrease proposed for fiscal year 2009 is
because of one-time investments made in fiscal year 2008 or carryovers
in funds from fiscal year 2008. For instance, the budget request
proposes a $31 million reduction in funding for taxpayer assistance
centers and outreach. However, IRS officials told us that this
reduction includes funding used for long-term investments in fiscal
year 2008 that would not need to be duplicated in fiscal year 2009. IRS
officials also told us that a $7.7 million decrease in funding for the
Taxpayer Advocate offsets a funding increase in fiscal year 2008 that
is being used to lower the Advocate's outstanding caseload. Finally, an
$8 million reduction in the Volunteer Income Tax Assistance (VITA)
program reflects fiscal year 2008 funding that was not spent and
carried over into fiscal year 2009.\6\
---------------------------------------------------------------------------
\6\ The funding provided in fiscal year 2008 was 2-year funding.
Since IRS was ramping up the program being funded--providing matching
grants to volunteer preparer organizations--in 2008, additional funding
was not needed for 2009. Despite not asking for additional funding, IRS
is expecting to see large, but unquantified, growth in tax returns
prepared at VITA sites. According to IRS officials, IRS does not have a
separate line item showing how much it spent on VITA overall.
---------------------------------------------------------------------------
The budget request for IRS's enforcement programs includes
nonlegislative and legislative initiatives. According to the proposal,
the five nonlegislative enforcement initiatives would cost about $338
million in fiscal year 2009 and are expected to raise about $2 billion
of direct revenue annually starting in fiscal year 2011.\7\ In
addition, the budget request estimates that the enforcement initiatives
would generate at least another $6 billion annually in indirect
revenue. The indirect revenue results from improved voluntary
compliance induced by taxpayers' awareness of expanded IRS enforcement.
The budget request also proposes increases in examination coverage for
corporations with assets of $10 million or more from a planned 6.6
percent for fiscal year 2008 to 6.8 percent for fiscal year 2009. The
coverage rate would increase to 7.6 percent in fiscal year 2010 as new
enforcement staff hired in fiscal year 2009 complete training and can
audit more returns.
---------------------------------------------------------------------------
\7\ These nonlegislative initiatives involve (1) reducing the tax
gap for small businesses and the self-employed; (2) reducing it for
large businesses; (3) increasing reporting compliance related to
offshore activity; (4) through research, improving tax gap estimates,
measurement, and detection of noncompliance; and (5) expanding document
matching.
---------------------------------------------------------------------------
The budget request includes 16 legislative initiatives budgeted at
$23 million for fiscal year 2009 that it says would raise about $36
billion in revenue over 10 years; if none were enacted, IRS would not
need the $23 million. We have reported on three of the proposals. In
2006, we suggested that the Congress consider an idea for reducing
securities capital gains noncompliance.\8\ In 1991, we supported the
notion that payments to corporations be reported on information
returns.\9\ Finally, in 2007, we described ways to mitigate the
compliance costs related to these information returns and to other
information returns associated with credit and debit card payments.\10\
---------------------------------------------------------------------------
\8\ GAO, Capital Gains Tax Gap: Requiring Brokers to Report
Securities Cost Basis Would Improve Compliance if Related Challenges
Are Addressed, GAO-06-603 (Washington, D.C.: June 13, 2006).
\9\ GAO, Tax Administration: Benefits of a Corporate Document
Matching Program Exceed the Costs, GAO/GGD-91-118 (Washington, D.C.:
Sept. 27, 1991).
\10\ GAO, Tax Administration: Costs and Uses of Third-Party
Information Returns, GAO-08-266 (Washington, D.C.: Nov. 20, 2007).
---------------------------------------------------------------------------
The revenue expected from IRS's enforcement initiatives is modest
compared to the net tax gap, which was last estimated at $290 billion
for tax year 2001. As we noted in our statement to this Committee last
year, no single approach, such as IRS enforcement, is likely to fully
and effectively address noncompliance.\11\ Multiple approaches are
needed because noncompliance has multiple causes and spans different
types of taxes and taxpayers.
---------------------------------------------------------------------------
\11\ GAO, Internal Revenue Service: Assessment of the 2008 Budget
Request and an Update of 2007 Performance, GAO-07-719T (Washington,
D.C.: May 9, 2007).
---------------------------------------------------------------------------
Hiring needed staff for the nonlegislative initiatives will be
challenging for IRS's Large and Mid-Size Business (LMSB) and Small
Business/Self-Employed (SB/SE) divisions. For instance, the initiatives
call for adding 1,431 revenue agents in addition to those who must be
replaced from attrition, a high number relative to past years. IRS
divisions have previously hired large numbers of staff in a short time
because of specific budget initiatives, but officials reported that
hiring gradually over time would reduce challenges. If IRS were to fall
behind in its hiring efforts, it would not need all $226 million of the
funding for staff for fiscal year 2009 initiatives.

IRS HAS ENHANCED ITS JUSTIFICATIONS FOR INITIATIVES AND COULD BENEFIT
FROM USING ROI ANALYSES MORE BROADLY, EVEN WITH THEIR LIMITATIONS

Responding to our recommendations from last year, IRS included more
information on initiatives in the fiscal year 2009 proposed budget,
including ROI information for all nonlegislative initiatives. Last
year, we recommended that IRS have available basic descriptive, cost,
and expected performance information on all new initiatives and include
such information in future budget submissions.\12\ This year, the
budget request has sections explicitly entitled, for instance,
``Initiative Summary,'' ``Implementation Plan,'' ``Expected Benefits,''
and ``ROI.'' Four of the five nonlegislative enforcement initiatives
for fiscal year 2009 were revisions of fiscal year 2008 initiatives,
but with more total funds requested and generally more informative
justifications than for fiscal year 2008.
---------------------------------------------------------------------------
\12\ GAO-07-719T.
---------------------------------------------------------------------------
However, IRS's ROI calculations have limitations that reflect the
challenges of estimating ROIs. For example, the calculations do not
account for benefits that are harder to measure, such as improved
voluntary compliance. Another example showing ROI limitations is the
$51 million National Research Project (NRP) initiative for which IRS
estimates the ROI to be $0.40 per $1.00 invested. NRP funds research
audits in order to develop more effective enforcement programs. The ROI
calculation only includes direct revenue resulting from the research
audits, not the potential for increased revenue from improved
enforcement programs; nor does the calculation include the benefits of
the Department of the Treasury's use of NRP data to provide the basis
for legislative recommendations.
Although the budget request for IRS provides performance measure
data, it does not provide ROI analyses for programs or activities other
than the new initiatives. As we noted in our recent report, analytic
data such as ROI can be helpful to managers and the Congress when
making resource allocation decisions.\13\ ROI analyses, even with their
limitations, can help answer questions such as the following:
---------------------------------------------------------------------------
\13\ GAO-08-567.
---------------------------------------------------------------------------
--What are the implications for IRS's resource allocation of the
lower costs per taxpayer contact for some services compared to
others as shown in table 4?
--Are there extra benefits that offset the higher costs of some
services, or could costs be reduced by promoting increased
reliance on the lower-cost options?

TABLE 4.--COST OF PROVIDING TAXPAYER SERVICE IN FISCAL YEAR 2005
------------------------------------------------------------------------
Estimated cost
Service per contact
------------------------------------------------------------------------
Answering tax law questions via e-mail.................. $52.51
Providing assistance at taxpayer assistance centers..... 28.73
Answering correspondence................................ 24.97
Providing assistance by assistors via toll-free 19.46
telephones.............................................
Providing assistance through VITA sites................. 12.01
Providing assistance by automation via toll-free 0.71
telephones.............................................
Providing assistance such as downloads and searches on 0.13
IRS's Web site.........................................
------------------------------------------------------------------------
Note: IRS reported that these estimates do not fully allocate all
indirect overhead and support costs. We have reported that because of
long-standing limitations in IRS's cost accounting capability, cost
data at this detailed level have not been audited (see, for example,
GAO-07-310 and 07-247). From our perspective, it would be important to
know more about the indirect and support costs to see if they might
significantly change the cost estimates.

Source: GAO analysis of IRS data.

Similar questions can be asked about enforcement based on table 5:
--Is IRS appropriately allocating resources between field audits,
often conducted at a taxpayer's business, and correspondence
audits, which are simpler and conducted by mail? \14\
---------------------------------------------------------------------------
\14\ In fiscal year 2007 correspondence audits took, on average,
1.4 hours to conduct compared to the 30.8-hour average for field audits
done at taxpayers' locations and the 7.8-hour average for field audits
done at IRS offices.
---------------------------------------------------------------------------
--For the rows in table 5 with average recommended additional tax per
return greater for correspondence audits than for field audits,
could resources be reallocated from field audits to
correspondence audits in order to help close the tax gap?
--Are there other benefits to field audits, such as a greater impact
on voluntary compliance, that are not captured in IRS's data?

TABLE 5.--FIELD AND CORRESPONDENCE AUDITS OF SOME BUSINESS CATEGORIES OF TAXABLE INDIVIDUAL INCOME TAX RETURNS,
FISCAL YEARS 2006 AND 2007
----------------------------------------------------------------------------------------------------------------
Number of returns examined Average recommended additional
-------------------------------- tax per return
Type and size of return -------------------------------
Field Correspondence Field Correspondence
----------------------------------------------------------------------------------------------------------------
Fiscal year 2006:
Business nonfarm returns by size of total
gross receipts (TGR):
Under $25,000........................... 19,801 107,802 $3,918 $2,614
$25,000 under $100,000.................. 38,722 42,070 5,464 7,600
$100,000 or more........................ 54,716 34,515 25,787 27,863
Fiscal year 2007:
Business nonfarm returns without earned
income tax credit, by size of TGR:
Under $25,000........................... 53,092 81,237 4,836 11,048
$25,000 under $100,000.................. 31,363 31,513 6,320 11,793
$100,000 under $200,000................. 28,286 28,041 24,582 32,640
$200,000 or more........................ 11,319 1,730 15,959 7,017
Business returns with total positive income at 17,499 15,280 20,880 33,406
least $200,000 and under $1 million............
----------------------------------------------------------------------------------------------------------------
Note: This table does not include all categories of audits. For a number of those categories, field audits
produce a higher average recommended additional tax per return than do correspondence audits.

Source: GAO analysis of IRS data.

We recognize that developing ROI estimates for IRS's ongoing
programs such as examinations and taxpayer service will be a challenge.
However, because of the potential benefits of ROI analyses, we
recommended in our previous report on the fiscal year 2009 budget
request that the Commissioner of Internal Revenue extend the use of ROI
in future budget proposals to cover major enforcement programs. At that
time, IRS officials said that because of the short time frame for our
report, they did not have time to fully analyze its recommendations,
and, therefore, were unable to respond.\15\ We have agreed to meet with
IRS to further discuss the ROI recommendation.
---------------------------------------------------------------------------
\15\ GAO-08-567.
---------------------------------------------------------------------------
FURTHER PROGRESS MADE IN IMPLEMENTING BSM, BUT CHALLENGES AND RISKS
REMAIN

IRS's BSM program, initiated in 1999, involves the development and
delivery of a number of modernized tax administration, internal
management, and core infrastructure projects that are intended to
provide improved and expanded service to taxpayers as well as IRS
internal business efficiencies. Key tax administration projects include
CADE, which is intended to provide the modernized database foundation
to replace the existing Individual Master File processing system that
contains the repository of individual taxpayer information; AMS, which
is intended to enhance CADE by providing applications for IRS employees
and taxpayers to access, validate, and update accounts on demand; and
MeF, which is to provide a single standard for filing electronic tax
returns. We recently reported that while IRS has continued to make
progress in implementing BSM projects and improving modernization
management controls and capabilities, challenges and risks remain, and
further improvements are needed.\16\
---------------------------------------------------------------------------
\16\ GAO-08-420.
---------------------------------------------------------------------------
As shown in table 6, the fiscal year 2009 budget request for the
BSM program is less than the enacted fiscal year 2008 budget by over
$44 million and about $185 million less than the amount the IRS
Oversight Board is proposing. When we asked about the impact of this
reduction on its operations, IRS told us that the proposed funding
level will allow it to continue developing and delivering its primary
modernization projects but did not provide details on how plans to
deliver specific projects or benefits to taxpayers would be affected.
MeF is the project with the largest difference between the requested
budget and the fiscal year 2008 enacted amount.

TABLE 6.--BSM FUNDING DIFFERENCES, FISCAL YEAR 2008 AND 2009
[In thousands of dollars]
------------------------------------------------------------------------
Fiscal year
Project Fiscal year 2009 budget
2008 enacted request
------------------------------------------------------------------------
Customer Account Data Engine............ 58,500 58,800
Accounts Management Services............ 28,983 26,158
Modernized e-File....................... 55,802 25,000
Filing & Payment Compliance............. .............. ..............
Core Infrastructure..................... 39,150 32,000
Architecture, Integration, and 35,100 35,000
Management.............................
Management Reserve...................... 4,310 2,300
-------------------------------
Subtotal Capital Investments...... 221,845 179,258
BSM Labor............................... 44,000 42,052
-------------------------------
Subtotal Program Request.......... 265,845 221,310
Maintaining Current Levels.............. 1,245 1,354
-------------------------------
Total BSM Budget Request.......... 267,090 222,664
------------------------------------------------------------------------
Source: IRS data.

IRS has made progress in implementing BSM projects and meeting cost
and schedule commitments for most deliverables, but three project
milestones experienced significant cost or schedule delays.\17\ During
2007, IRS completed milestones of the Filing and Payment Compliance
(F&PC), a tax collection case analysis support system; MeF; CADE; and
AMS. Our analysis of reported project costs and completion dates showed
that 13 of the 14 associated project milestones that were scheduled for
completion during this time were completed within 10 percent of cost
estimates, and 11 of the 14 milestones were completed within 10 percent
of schedule estimates. However, a milestone for CADE exceeded its
planned schedule by 66 percent and experienced a 15 percent cost
increase; another milestone for the same project incurred a 153 percent
schedule delay, and a milestone for MeF experienced a 41 percent
schedule delay (see fig. 1).
---------------------------------------------------------------------------
\17\ Milestones represent different phases in IRS's project life
cycle.

IRS has taken steps to address our prior recommendations to improve
its modernization management controls and capabilities. However, work
remains to fully implement them. For example, in July 2005, we
recommended that IRS fully revisit the vision and strategy for the BSM
program and develop a new set of long-term goals, strategies, and plans
consistent with the budgetary outlook and IRS's management
capabilities.\18\ We also noted that the vision and strategy should
include time frames for consolidating and retiring legacy systems. In
response, IRS has developed a Modernization Vision and Strategy
framework and supporting 5-year Enterprise Transition Plan. However,
the agency has yet to develop long-term plans for completing BSM and
consolidating and retiring legacy systems. We also recommended in
February 2007 that IRS ensure that future BSM expenditure plans include
a quantitative measure of progress in meeting scope expectations.\19\
We further recommended that, in developing this measure, IRS consider
using earned value management since this is a proven technique required
by the Office of Management and Budget for measuring cost, schedule,
and functional performance against plans.\20\ While IRS has developed
an approach to address our recommendation, it has not yet fully
implemented it.
---------------------------------------------------------------------------
\18\ GAO, Business Systems Modernization: Internal Revenue
Service's Fiscal Year 2005 Expenditure Plan, GAO-05-774 (Washington,
D.C.: July 22, 2005).
\19\ GAO, Business Systems Modernization: Internal Revenue
Service's Fiscal Year 2007 Expenditure Plan, GAO-07-247 (Washington,
D.C.: Feb. 15, 2007).
\20\ Earned value management is a project management tool that
integrates the investment scope of work with schedule and cost elements
for investment planning and control. This method compares the value of
work accomplished during a given period with that of the work expected
in the period. Differences between accomplishments and expectations are
measured in both cost and schedule variances.
---------------------------------------------------------------------------
Future BSM project releases continue to face significant risks and
issues, which IRS is addressing. Specifically, the agency recently
identified significant risks and issues with planned system deliveries
of CADE and AMS and reported that maintaining alignment between the two
systems will be a significant challenge and source of risk for the BSM
program. IRS recognizes the potential impact of identified risks and
issues on its ability to deliver projects within cost and schedule
estimates and has developed mitigation strategies to address them.
While mitigation strategies have been developed, the risks and
challenges confronting future releases of CADE and AMS are nevertheless
significant, and we will continue to monitor them and actions to
address them.
IRS also made further progress in addressing high-priority BSM
program improvement initiatives during the past year. In September
2007, IRS completed another cycle of initiatives and initiated a new
cycle, which was scheduled to be completed at the end of March 2008.
Initiatives that were addressed in the 6-month cycle ending in
September 2007 included IT human capital, information security, and
process improvements (e.g., developing and implementing standardized
earned value management practices for major projects). IRS's program
improvement process continues to be an effective means of regularly
assessing, prioritizing, and incrementally addressing BSM issues and
challenges. However, more work remains for the agency to fully address
these issues and challenges.
Finally, we recently reported that efforts to address human capital
challenges continue, but more work remains. IRS developed an IT human
capital strategy that addresses hiring critical personnel, employee
training, leadership development, and workforce retention, and agency
officials stated that they plan to undertake a number of human capital
initiatives to support their human capital strategy, including
conducting analyses of turnover rates and continuing efforts to replace
key leaders lost to retirement. However, a specific plan with time
frames for implementing these initiatives has not been developed. We
recommended that IRS complete such a plan to help guide the agency's
efforts in addressing its IT human capital gaps and measure progress in
implementing them. IRS agreed with our recommendation and stated that
it intends to develop a plan to implement its IT human capital
strategy.

IRS ESTIMATES THE COST OF IMPLEMENTING THE ECONOMIC STIMULUS
LEGISLATION MAY BE UP TO A TOTAL OF $767 MILLION AND EXPECTS DECLINES
IN SOME TAXPAYER SERVICES

The Economic Stimulus Act of 2008 is resulting in a significant
workload increase not anticipated in the fiscal year 2008 budget. As
part of the legislation, IRS received $202 million in a supplemental
appropriation. However, because IRS could not find an alternative
according to responsible officials, it has reallocated resources from
enforcement to taxpayer service and is allowing some deterioration in
telephone service.
IRS will begin sending economic stimulus payments to more than 130
million households in early May, after the current tax filing season,
and is scheduled to be done by mid-July. These include an estimated 20
million retirees and disabled veterans, and low-wage workers who
usually are exempt from filing a tax return but will be eligible for
stimulus payments. Taxpayers required to file a tax return must do so
by April 15 in order to receive a stimulus payment by mid-July.\21\
People who are not required to file a tax return, but are doing so to
receive a stimulus payment, are required to file an IRS Form 1040A by
October 15, 2008.
---------------------------------------------------------------------------
\21\ Taxpayers who are unable to meet the April 15 filing deadline
can file a Form 4868, the automatic extension of time to file, which
gives them until October 15 to submit a 2007 tax return.
---------------------------------------------------------------------------
As part of the legislation, IRS received a supplemental
appropriation of $202 million to help fund its costs for implementing
the stimulus package. This funding will remain available until
September 30, 2009. As shown in table 7, IRS plans to spend the bulk of
the funding--$151.4 million--for Operations Support, most of it on
postage for two mass mailings and on IT support. IRS also expects to
spend $50.7 million for Taxpayer Services, including $26.2 million for
staffing and overtime for telephone assistors. IRS is expecting 2.4
million additional telephone calls in March and April with questions
for IRS assistors about the economic stimulus legislation. These calls
are in addition to the more than 14 million calls typically answered by
IRS assistors between January and mid-April.

TABLE 7.--IRS'S ESTIMATED COSTS OF IMPLEMENTING THE ECONOMIC STIMULUS LEGISLATION
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Revised
2008 goal estimate Amount
----------------------------------------------------------------------------------------------------------------
Supplemental appropriation:
Operations Support:
Postage................................................. .............. .............. $90.613
IT support.............................................. .............. .............. $43.965
Telecommunications...................................... .............. .............. $8.370
Printing................................................ .............. .............. $6.767
Communications plan..................................... .............. .............. $1.700
-----------------------------------------------
Total for Operations Support.......................... .............. .............. $151.415
Taxpayer Services: Additional staffing/overtime................. .............. .............. $50.720
-----------------------------------------------
Total supplemental funding................................ .............. .............. $202.135
===============================================
IRS estimates of foregone revenue from shifting Automated
Collection System (ACS) staff: \1\
Wage and Investment (W&I)................................... .............. .............. $191.728
Small Business/Self-Employed (SB/SE)........................ .............. .............. $373.065
-----------------------------------------------
Total foregone revenue (up to)............................ .............. .............. $564.793
-----------------------------------------------
Total (up to)............................................. .............. .............. $766.928
===============================================
Taxpayer service: Assistor level of service (percent)........... 82 ( \2\ ) ( \3\ )
----------------------------------------------------------------------------------------------------------------
\1\ Revised as of early April 2008.
\2\ As low as 74.
\3\ Reduction--Down 8 percentage points.

Source: GAO analysis of IRS and Treasury data.

To help meet the increased telephone demand, IRS is shifting about
half of its over 2,000 Automated Collection System (ACS) telephone
staff from collecting delinquent taxes to answering economic stimulus
telephone calls from March through May.\22\ To accommodate this shift,
IRS stopped sending out some ACS-generated notices, such as notices of
levy, several weeks ago.\23\ According to IRS officials, it takes about
3 to 4 weeks before this adjustment in ACS-generated notices affects
the ACS workload. IRS originally estimated that the revenue foregone by
shifting ACS staff to be up to $681 million. However, according to IRS
officials, in early April, IRS revised its foregone revenue estimate
down to $565 million, shown in table 7, largely because of lower-than-
expected demand for telephone assistance in March.\24\
---------------------------------------------------------------------------
\22\ When IRS has completed sending its initial series of notices
to tax debtors, it assigns the debts to its collections programs, such
as ACS. ACS is an automated telephone-based system designed to call tax
debtors. ACS staffers then attempt to talk with tax debtors to try to
collect outstanding tax debt. IRS estimated there are about 1,200 ACS
staff in its W&I division and about 1,100 in its SB/SE division.
\23\ IRS suspended notices sent by ACS examiners, such as final
notices before enforcement, collection due process notices, and notices
of levy.
\24\ IRS arrived at the estimates by taking a 3-year average of
dollars collected by closing ACS cases for both its W&I and SB/SE
divisions. IRS determined the projected foregone revenue by multiplying
the average dollars collected per ACS staff by the projected lost case
closures. IRS plans to minimize the use of SB/SE staff because the
revenue collected by SB/SE is greater than for W&I.
---------------------------------------------------------------------------
According to IRS officials, IRS's priority is to respond to
taxpayers' questions about the stimulus program; therefore, the
officials are monitoring call volume and adjusting the number of ACS
staff answering telephones accordingly. When call volume is low, ACS
staff work on outstanding ACS collection cases. However, IRS officials
stated that this work does not produce the same revenue as the ACS-
generated notices, particularly revenue generated from notices of levy.
When IRS adjusts the volume of ACS-generated notices, it takes several
weeks before that adjustment affects ACS workload. IRS officials do not
want to resume sending ACS-generated notices until they are sure ACS
staffers are available to handle the resulting workload.
Should the lower-than-expected call volume continue, IRS may have
an opportunity to shift the ACS staff back to their most productive
collection work. This could further reduce the revenue foregone from
using ACS staff to answer stimulus-related telephone calls. To date,
IRS has not reduced its projections for future stimulus-related call
volume. If the projections are reduced, IRS may be able to resume
sending out at least some ACS-generated notices.
According to IRS officials, IRS considered alternatives to shifting
ACS staff, including contracting out, using other IRS staff, or using
Social Security Administration or other Federal staff, but decided the
alternatives were not feasible. For example, contracting out was not
deemed feasible because of insufficient time to negotiate the contract
and conduct background checks and training.
Another cost--although not measured in dollars--is the decline in
telephone service shown in table 7. Because of the increased call
volume, IRS expects its assistor level of service to drop from 82
percent (the 2008 goal) to as low as 74 percent--the lowest level since
2002. IRS is already experiencing some declines in telephone service.
As of March 29, the level of service had dropped to 80 percent,
taxpayers were waiting a minute and a half longer than last year, and
they were hanging up 43 percent more often while waiting to speak to an
assistor. Between March 3 and March 29, IRS assistors answered over
572,000 stimulus-related calls.\25\ IRS expects call volume to increase
rapidly in upcoming weeks as taxpayers receive their stimulus notices
in the mail.
---------------------------------------------------------------------------
\25\ According to IRS officials, before March 3, taxpayers with
stimulus-related calls were transferred to an automated message, which
told taxpayers that additional information would be forthcoming. IRS
estimated that the number of these calls frequently ranged from 20,000
to 60,000 per day. IRS assistors started answering stimulus-related
questions on March 3, and IRS established its dedicated telephone line
for stimulus-related calls on March 14.
---------------------------------------------------------------------------
Because IRS is in the early stages of implementing the stimulus
legislation, IRS officials do not have much information about the
actual costs. Through March, IRS estimates that it has spent almost
$103 million, mostly for postage.

AGENCY COMMENTS

In commenting on a draft of our earlier report on the fiscal year
2009 budget request and 2008 tax filing season, IRS officials said
that, because of the short time frame for our report, they did not have
time to fully analyze our recommendation and, therefore, were unable to
respond at the time. They provided technical comments at that time and
again for this statement, and we made those changes where appropriate.
We have agreed to meet with IRS to further discuss the ROI
recommendation.
Mr. Chairman, this concludes my prepared statement. Mr. Powner and
I would be happy to respond to questions that you or other members of
the subcommittee may have at this time.

PREPARED STATEMENTS OF OMB WATCH AND COLLEEN KELLEY

Senator Durbin. In addition, written statements have been
received from OMB Watch and Colleen Kelley, President of the
National Treasury Employees Union, on behalf of the employees
of the Internal Revenue Service. Without objection, these
materials will be made a part of the permanent record.
[The statements follow:]

Prepared Statement of Colleen M. Kelley, National President, National
Treasury Employees Union

Chairman Durbin, Ranking Member Brownback, and distinguished
members of the subcommittee, I would like to thank you for allowing me
to provide comments on the administration's fiscal year 2009 budget
request for the Internal Revenue Service (IRS). As president of the
National Treasury Employees Union (NTEU), I have the honor of
representing over 150,000 Federal workers in 31 agencies, including the
men and women at the IRS.

IRS FISCAL YEAR 2009 BUDGET REQUEST

Mr. Chairman, as you know, the IRS budget forms the foundation for
what the IRS can provide to taxpayers in terms of customer service and
how the agency can best fulfill its tax enforcement mission. Without an
adequate budget, the IRS cannot expect to continue providing taxpayers
with top quality service and will be hampered in its effort to enhance
taxpayer compliance and close the tax gap.
While acknowledging that IRS employees continue to provide world
class customer service and are more efficient than ever in collecting
taxes and enforcing tax law, the administration continues to put forth
insufficient and unrealistic budget requests that fail to allow the
service to meet its customer service and enforcement challenges.
Staffing levels are dramatically below 1995 levels.
The decline in IRS personnel, particularly enforcement staff, can
be attributed to unrealistic budget requests, which since 2003, have
contemplated internally generated savings or ``efficiency savings'' to
help fund proposed increased staffing for enforcement. For fiscal year
2009, the budget request identifies ``efficiency savings'' of more than
$94 million at the cost of almost 976 FTEs. If, as sometimes has been
the case in previous years, IRS fails to realize all expected savings
then the funds available for new enforcement personnel would be further
reduced.
And although it's widely recognized that additional funding for
enforcement provides a great return on the investment, the IRS has
repeatedly told Congress that the IRS does not need any additional
funding above the President' budget request.
Employee productivity is not the issue. Despite the significant
decline in enforcement staff over the past 10 years, enforcement
revenue has increased significantly, reaching $59.2 billion in 2007, up
from $48.7 billion in 2006 and an increase of $46 billion since 2000.
The $59.2 billion in collections in 2007 represents a 5.6 to 1 return
on investment for all IRS activities. In addition, earlier this year
the IRS Data Book for 2007 was released which demonstrated that the IRS
is one of the most efficient tax collection systems in the world,
spending only 40 cents to collect $100.
Yet, between 1995 and 2007, the total number of employees has
shrunk from 114,064 to 86,638. Even more alarming is that during that
period, revenue officers and revenue agents--two groups critical to
reducing the tax gap--have shrunk by 33 and 20 percent respectively.
Revenue officers went from 8,139 to 5,468 and revenue agents fell from
16,078 to 13,026. These drastic cuts have come at a time when the IRS
workload has increased dramatically. According to IRS's own annual
reports and data, taxpayers filed 114.6 million returns in 1995. After
a steady annual climb, 11 years later, the Service saw 134.4 million
returns filed. In addition, between 1997 and 2007, the number of
individual tax returns with $100,000 in reported income, which are
generally more complex returns, increased by 103 percent.
Unfortunately, instead of recognizing that the dramatic cuts to the
IRS workforce are straining the ability of IRS employees to handle the
increasing workload, the IRS has continued to reduce its workforce.
Further exacerbating the dire staffing situation at the Service is the
aging of the IRS workforce. Approximately 4,000 of its employees are
retiring annually presenting the Service with the difficult challenge
of replacing a large portion of its workforce each year and the
institutional knowledge they take with them. These retirements of some
of the Services' most experienced personnel will only further stress
the current IRS workforce already straining under a rising workload.
Amazingly, IRS efforts to reduce the overall workforce have
targeted some of the Service's most productive employees. These include
the recent re-organization of the Estate and Gift Tax Program which
sought the elimination of 157 of the agency's 345 estate and gift tax
attorneys--almost half of the agency's estate tax lawyers--who audit
some of the wealthiest Americans. The Service pursued this drastic
course of action despite internal data showing that estate and gift
attorneys are among the most productive enforcement personnel at the
IRS, collecting $2,200 in taxes for each hour of work. It is difficult
to understand why the IRS sought the elimination of key workforce
positions in an area that could produce significant revenue to the
general treasury.
In addition, the Service continues to move forward with its plan to
close 5 of its 10 paper tax return submission facilities by 2011. The
IRS originally sought the closings of the five paper return submission
centers due to the rise in the use of electronic filing (e-filing) and
in order to comply with the IRS Restructuring and Reform Act of 1998
(RRA 98) which established a goal for the IRS to have 80 percent of
Federal tax and information returns filed electronically by 2007. But
the IRS recently reported that in 2007 just 57 percent of Federal tax
returns were filed electronically and has previously acknowledged that
it is getting harder to convert additional taxpayers to e-filing as
those that might convert most readily have already done so.
The continued slow migration of taxpayers to e-filing recently
caused the IRS Oversight Board to call on Congress to extend the 80
percent deadline to 2012 in its recent report to Congress on e-filing.
In addition, while the IRS has stated that it will achieve millions
of dollars in cost savings as a result of the paper submission
consolidation effort, an August 2007 report by the Treasury Inspector
General for Tax Administration (TIGTA) found that the agency's business
decision to consolidate sites did not even include a cost-benefit
analysis (TIGTA Report Number: 2007-40-165). Furthermore, the report
found that the IRS had not adequately updated or monitored financial
information on the personnel costs of consolidations and had included
savings not attributable to site consolidation in some of its analyses.
What is most disturbing is that while the IRS acknowledged some of the
assumptions used to determine the consolidation plan may have changed,
they refused to complete a cost-benefit analysis to determine if the
existing plan is optimal or if alternatives need to be considered.
Mr. Chairman, while overall use of e-filing may be on the rise, it
is clear that the number of taxpayers opting to use this type of return
is not increasing as rapidly as the IRS had originally projected.
Combined with the fact that the IRS consolidation strategy rests on an
incomplete business plan which did not include any type of cost-benefit
analysis, NTEU believes that the IRS should immediately postpone
further site consolidations until a comprehensive cost-benefit analysis
can be completed to ensure that the existing plan is optimal in terms
of cost savings and benefits.
It is clear that drastic reductions in some of the agency's most
productive tax law enforcement employees directly contradict the
Service's stated enforcement priority to discourage and deter non-
compliance. In addition, we believe these staffing cuts have greatly
undermined agency efforts to close the tax gap which the IRS recently
estimated at $345 billion. As Nina Olson, the National Taxpayer
Advocate noted, this amounts to a per-taxpayer ``surtax'' of some
$2,000 per year to subsidize noncompliance. And while the agency has
made small inroads and the overall compliance rate through the
voluntary compliance system remains high, much more can and should be
done. NTEU believes that in order to close the tax gap and handle a
rising workload, the IRS needs additional employees on the frontlines
of tax compliance and customer service. In addition, we believe
Congress should establish a dedicated funding stream to provide
adequate resources for those employees.

NTEU STAFFING PROPOSAL

In order to address the staffing shortage at the IRS, NTEU believes
the workforce should be gradually increased to its pre-1996 levels.
Specifically, we support a 3 percent annual net increase in staffing
(roughly 2,600 positions per year) over a 5-year period to gradually
rebuild the depleted IRS workforce to its pre-1996 levels from its
current level of 86,638. Because it takes time and careful management
to hire, train, and deploy qualified professional staff, consistent but
modest annual increases are necessary. A similar idea was proposed by
former IRS Commissioner Charles Rossotti in a 2002 report to the IRS
Oversight Board. In the report, Rossotti quantified the workload gap in
non-compliance, that is, the number of cases that should have been, but
could not be acted upon because of resource limitations. Rossotti
pointed out that in the area of known tax debts, assigning additional
employees to collection work could bring in roughly $30 for every $1
spent. The Rossotti report recognized the importance of increased IRS
staffing noting that due to the continued growth in IRS' workload
(averaging about 1.5 to 2 percent per year) and the large accumulated
increase in work that should be done but could not be, even aggressive
productivity growth could not possibly close the compliance gap.
Rossotti also recognized that for this approach to work, the budget
must provide for a net increase in staffing on a sustained yearly basis
and not take a ``one time approach.''
Adding staff to handle an increasing workload at the IRS is not a
new concept. In its 2001 budget request, IRS asked for funding for the
Staffing Tax Administration for Balance and Equity program (STABLE), an
initiative aimed at restoring IRS staffing to mid-1990s levels and
strengthening the Service's tax compliance and customer service
functions. The STABLE initiative envisioned hiring nearly 4,000 new
employees to help increase compliance and improve customer service. The
proposal sought to boost staff in Field Offices, where IRS employees
provide direct, in-person service to taxpayers, and Service Center/Call
Sites, where service is typically provided via telephone and
correspondence. Hiring requirements for the Field Offices was to be
determined based on projected workload in the office's geographic area,
and existing staff capabilities. Conversely, Service Center/Call Site
workload would be planned on a nationwide basis due to the nature of
the work, and staffing allocations based upon physical space and local
labor market conditions around the center in question.
Although such a staffing initiative would require a substantial
financial commitment, the potential for increasing revenues, enhancing
compliance and shrinking the tax gap makes it very sound budget policy.
One option for funding a new staffing initiative would be to allow the
IRS to hire personnel off-budget, or outside of the ordinary budget
process. This is not unprecedented. In fact, Congress took exactly the
same approach to funding in 1994 when Congress provided funding for the
administration's IRS Tax Compliance Initiative which sought the
addition of 5,000 compliance positions for the IRS. The initiative was
expected to generate in excess of $9 billion in new revenue over 5
years while spending only about $2 billion during the same period.
Because of the initiative's potential to dramatically increase Federal
revenue, spending for the positions was not considered in calculating
appropriations that must come within annual caps.
A second option for providing funding to hire additional IRS
personnel outside the ordinary budget process could be to allow IRS to
retain a small portion of the revenue it collects. The statute that
gives the IRS the authority to use private collection companies to
collect taxes allows 25 percent of collected revenue to be returned to
the companies as payment, thereby circumventing the appropriations
process altogether. Clearly, there is nothing magical about revenues
collected by private collection companies. If those revenues can be
dedicated directly to contract payments, there is no reason some small
portion of other revenues collected by the IRS could not be dedicated
to funding additional staff positions to strengthen enforcement.
While NTEU agrees with IRS' stated goal of enhancing tax compliance
and enforcement, we don't agree with the approach of sacrificing
taxpayer service in order to pay for additional compliance efforts.
That is why we were disappointed to see that the President's proposed
budget calls for a $31 million cut in funding for Taxpayer Assistance
Center (TACs) at a cost of 262 FTEs. NTEU believes providing quality
services to taxpayers is an important part of any overall strategy to
improve compliance and that reducing the number of employees dedicated
to assisting taxpayers meet their obligations will only hurt those
efforts. It is clear that IRS employees are continuing to provide
quality customer service to American taxpayers. 2007 year end data from
the IRS shows that IRS' customer assistance centers met the 82 percent
level of service goal, with an accuracy rate of 91 percent for tax law
questions. And while these numbers show that employees providing
taxpayer services are helping taxpayers understand and meet their tax
responsibilities, more can and should be done.
Mr. Chairman, in order to continue to make improvements in taxpayer
services while handling a growing workload and increasing collections,
it is imperative to reverse the severe cuts in IRS staffing levels and
begin providing adequate resources to meet these challenges. With the
future workload only expected to continue to rise, the IRS will be
under a great deal of pressure to improve customer service standards
while simultaneously enforcing the Nation's tax laws. NTEU strongly
believes that providing additional staffing resources would permit IRS
to meet the rising workload level, stabilize and strengthen tax
compliance and customer service programs and allow the Service to
address the tax gap in a serious and meaningful way.

PRIVATE TAX COLLECTION

Mr. Chairman, as stated previously, if provided the necessary
resources, IRS employees have the expertise and knowledge to ensure
taxpayers are complying with their tax obligations. That is why NTEU
continues to strongly oppose the administration's private tax
collection program. NTEU believes this misguided proposal is a waste of
taxpayer's dollars, invites overly aggressive collection techniques,
jeopardizes the financial privacy of American taxpayers and may
ultimately serve to undermine efforts to close the tax gap.
NTEU strongly believes the collection of taxes is an inherently
governmental function that should be restricted to properly trained and
proficient IRS personnel. When supported with the tools and resources
they need to do their jobs, there is no one who is more reliable and
who can do the work of the IRS better than IRS employees.
As you know, in September 2006, the IRS began turning over
delinquent taxpayer accounts to private collection agencies (PCAs) who
are permitted to keep up to 24 percent of the money they collect. NTEU
strongly believes the collection of taxes is an inherently governmental
function that should be restricted to properly trained and proficient
IRS personnel.
NTEU believes this misguided proposal is a waste of taxpayer's
dollars, invites overly aggressive collection techniques, jeopardizes
the financial privacy of American taxpayers and may ultimately serve to
undermine efforts to close the tax gap.
According to the IRS, in fiscal year 2007, the PCAs brought in just
$32 million in gross revenue, far below original projections of up to
$65 million. After deducting commission payments to the PCAs, the true
net revenue from PCA (non-IRS) collection activity was just $20
million. Therefore, after spending $71 million in start up and ongoing
maintenance costs through the end of fiscal year 2007, the IRS private
tax collection program lost more than $50 million.
According to Nina Olson, the National Taxpayer Advocate, the dismal
performance of the private collectors is forcing the IRS to downwardly
revise its original 10-year projections for the program. For fiscal
year 2008, the IRS is now projecting gross revenues of just $23
million, despite projections as recently as last May indicating the
program would bring in up to $127 million. In addition, despite
assurances that the program would recover all start-up and maintenance
costs by April of this year, the IRS is now projecting the program will
not break even until late fiscal year 2010.
NTEU also believes that sky high commission payments to the private
contractors for work on the easiest to collect cases is unjustified and
unnecessary. Under current contracts, private collection firms are
eligible to retain 21 percent to 24 percent of what they collect. The
legislation authorizing the program actually allows PCAs to retain up
to 25 percent of amounts collected. These commission rates were never
put up for competition. Before the initial bid solicitations went out,
the IRS set commission rates at 21 to 24 percent of the revenue
collected by contractors, denying bidders an opportunity to make offers
on terms that would have resulted in the IRS getting a greater share of
the collected revenue. Consequently, one of the companies that lost its
bid for a contract filed a protest with GAO and noted in its bid
protest that ``offerors were given no credit for proposing lower fees
than the ``target' percentages recommended by the IRS.''
The problem of excessive commission rates was recently addressed by
Congress in legislation overhauling the Department of Education's
student loan program, which the IRS has consistently held up as a model
for the IRS private collection program. Amid charges that student aid
lenders have engaged in abusive and potentially illegal collection
tactics including charging excessively high collection fees, coercing
consumers into payment plans they could not afford and misrepresenting
themselves as Department of Education employees, the House and Senate
approved H.R. 2669, the ``Higher Education Access Act of 2007,'' which
lowers from 23 percent to 16 percent the amount of recovered money that
private guaranty agencies contracted by the Government can retain on
defaulted loans.
Mr. Chairman, in addition to being fiscally unsound, the idea of
allowing PCAs to collect tax debt on a commission basis also flies in
the face of the tenets of the IRS Restructuring and Reform Act of 1998
(RRA 98) which specifically prevents employees or supervisors at the
IRS from being evaluated on the amount of collections they bring in.
But now, the IRS has agreed to pay PCAs out of their tax collection
proceeds, which will clearly encourage overly aggressive tax collection
techniques, the exact dynamic the 1998 law sought to avoid.
The fear that allowing PCAs to collect tax debt on a commission
basis would lead to contractor abuse was realized when the IRS recently
confirmed that the agency had received more than five dozen taxpayer
complaints against the PCAs, including violations of the taxpayer
privacy laws under Code section 6103. At least one of those complaints
was confirmed by an IRS Complaint Panel to be a serious violation of
law. In addition, penalties totaling $10,000 have been imposed by the
IRS on the PCAs for taxpayer violations. In one instance, private
collectors made 150 calls to the elderly parents of a taxpayer after
the collection agency was notified he was no longer at that address.
And one of the three private contractors was dropped by the IRS for
dubious practices despite the Service's previous assurance that its
oversight would prevent abuse.
Mr. Chairman, NTEU is not alone in our opposition to the private
tax collection program. Opposition to the IRS tax debt collection
program has also been voiced by a growing number of major public
interest groups, tax experts, two former IRS Commissioners as well as
the National Taxpayer Advocacy Panel, whose members are appointed by
the IRS and the Treasury Department. In addition, the National Taxpayer
Advocate, an independent official within the IRS previously identified
the IRS private tax collection initiative as one of the most serious
problems facing taxpayers and recently renewed her prior call for
Congress to immediately repeal the IRS' authority to outsource tax
collection work to private debt collectors.
Opposition to the program has also been growing within Congress.
Since granting IRS the authority to use PCAs in the American Jobs
Creation Act of 2004, the House of Representatives, with bi-partisan
support, has twice passed language prohibiting the IRS from moving
forward with its private collection initiative. In addition, last
session, the House overwhelmingly approved two separate tax bills (H.R.
3056, the ``Tax Collection Responsibility Act of 2007'' & H.R. 3996,
the ``Temporary Tax Relief Act of 2007'') that contain language that
would repeal IRS' authority to use private debt collectors to pursue
tax debts.
In the Senate, stand alone legislation (S. 335) introduced by
Senator Byron Dorgan (D-ND) that would force the IRS to immediately and
permanently suspend its plan to outsource part of its tax debt
collection responsibilities to PCAs and prohibit the use of any IRS
funds for that purpose has 24 co-sponsors.
Mr. Chairman, instead of rushing to privatize tax collection
functions which jeopardizes taxpayer information, reduces potential
revenue for the Federal Government and undermines efforts to close the
tax gap, NTEU believes the IRS should increase compliance staffing
levels at the agency to ensure that the collection of taxes is
restricted to properly trained and proficient IRS personnel.
The IRS already has a significant collection infrastructure with
thousands of trained employees, including 14 Automated Collection
System (ACS) sites which allow the IRS to contact taxpayers by
telephone and collect delinquent taxes. The ACS function is a critical
Collection operation, collecting nearly $1.49 million per employee per
year. The IRS itself has analogized the use of private collectors to
the ACS, where IRS collection representatives interact with taxpayers
on the telephone. But unlike the private collectors, ACS personnel are
able to analyze financial statement information, research assets, enter
into installment agreements, make currently not collectible
determinations, and can take lien and/or levy enforcement actions. ACS
employees also receive training that is far more comprehensive and
rigorous than that of the private collectors. In addition, these
employees undergo mandatory annual training on topics such as
confidentiality and privacy of taxpayer information, ethics awareness,
taxpayer rights and computer security.
Unfortunately, inadequate staffing at ACS sites has prevented the
IRS from using its current systems to proactively contact taxpayers by
telephone to resolve delinquent accounts. The need for the IRS to
expand ACS' use of outbound calls has been recognized by IRS management
and at least two recent internal IRS study groups have recommended
making more outbound calls as a way to make the ACS operation more
effective and efficient.
Mr. Chairman, according to the IRS they will spend $7.65 million to
run the private collection program in fiscal year 2008. NTEU believes
that instead of continuing to expend valuable IRS resources on this
failed program, this $7.65 million should instead be used to fund
roughly 102 additional ACS employees that could return more than $151
million to the Treasury annually. By comparison, the IRS is now
projecting the PCAs to bring in just $23 million in gross revenue in
fiscal year 2008, far less than its original estimate of up to $127
million.
NTEU believes that increasing the number of ACS personnel would
allow the IRS to maximize its ability to proactively resolve delinquent
accounts by contacting taxpayers directly. This would also help ensure
that the high level of customer service to those taxpayers who call the
ACS seeking account resolution is preserved. The IRS has acknowledged
that ACS employees are already performing admirably noting that in
2006, ACS customer service and quality ranged between 89.5 to 99.5
percent (pg. 54--IRS response to Olson 2006 Report to Congress). These
exceptional ratings are all the more impressive when you consider ACS
employees generally work on much more complex and often contentious
cases than those being worked by the private collectors and that the
total number of cases worked by ACS employees dwarfs those worked by
the private collectors.
Mr. Chairman, NTEU understands and commends efforts to ensure that
all taxpayers pay their fair share of taxes. Without a doubt, rank and
file IRS employees are committed to achieving this goal in the most
cost-effective manner while providing a high level of customer service
to American taxpayers. But the facts make clear that the use of private
tax collection companies is not in the best interest of American
taxpayers, could potentially undermine future efforts to close the tax
gap, and should be terminated immediately.
A number of other issues important to NTEU members are often
addressed in the FSGG Appropriations bill and I would like to address
some of them here.

PAY RAISE

The Federal Employees Pay Comparability Act (FEPCA), enacted in
1990 to close the gap between Federal and private sector pay, has never
been fully implemented. As a result, there is now a 23 percent
disparity between Federal employees and their private sector
counterparts. Under the President's plan, Federal employees will fall
even further behind the private sector.
The administration's budget proposed a 2.9 percent pay raise for
Federal workers next year. This not only fails to recognize the
important role of our Nation's workforce, it is below the 3.4 percent
pay raise the President recommended for the military. The
administration's recommendation ignores the essential role of Federal
employees in protecting our Nation at the borders, in the domestic and
international movement of money, in public health, in nuclear security,
and in the collection of revenue among others. Further, it ignores the
longstanding principle of pay parity, the recognition that Federal
civil servants and their brothers and sisters in the military, work
side by side and should receive an equal level of pay increase.
Importantly, pay parity was just reaffirmed on March 13, 2008, in House
of Representatives when it passed H. Con Res. 312, the fiscal year 2009
budget resolution. I urge the subcommittee to report its bill in
keeping with this pay parity principle.
For most of the last 20 years, Government employees in civil
service and military personnel have received the same level of pay
increase. Last year, both the military and Federal civil servants
received a 3.5 percent pay raise in the final fiscal year 2008 bills.
That amounted to the annual raise in the Employment Cost Index (ECI)
plus one-half percent, the standard pay figure received in every year
of the current administration with the exception of 2007. For 2009, the
current raise in the ECI as calculated by the Department of Labor is
3.4 percent, and an extra one-half percent equals 3.9 percent. NTEU
urges the subcommittee to follow the precedent of ECI plus one-half
percent and report legislation for fiscal year 2009 providing a 3.9
percent raise to Federal employees. We will be working with the
appropriate committees to enact a military raise of the same level.
SEC Pay
NTEU represents the employees of the Securities and Exchange
Commission (SEC). We believe that the SEC must be provided with
adequate resources to ensure that its performance based pay system can
be a viable tool for employee retention and recruitment. While there
have been numerous problems with this pay system, adequate funding is
essential. From fiscal year 2002 to fiscal year 2005, the SEC budget
included a 3 percent increase over current compensation levels to fund
the performance pay system. However, for the past 2 years, the SEC's
budget has included only a 2 percent increase. This year, the President
has only requested a 1.5 percent increase. The continuing performance
pay funding crisis has hamstrung SEC managers' ability to provide
meaningful and appropriate performance based salary increases to their
employees. As budget shortfalls have shifted the system from being
fundamentally performance based, some senior managers at the SEC have
sent notices to their employees stating that they are being given lower
ratings not for performance reasons but because of budgetary
limitations. This state of affairs is having severe and negative
impacts on employee morale and retention at SEC, contrary to the stated
purpose of the performance pay system. NTEU would ask for an additional
$5 million in funding for the SEC for this purpose.

OPM PRESCRIPTION DRUG SUBSIDY

Mr. Chairman and members of the subcommittee, it is NTEU's position
that OPM should apply for the drug subsidy to which it is entitled
under the Medicare Prescription Drug, Improvement, and Modernization
Act of 2003 (Public Law 108-173). Under this law, which created the
Medicare Part D prescription drug program, the Government, as an
employer, is eligible to receive a subsidy payment made available to
all employers that provide prescription drug benefits as generous as
the Medicare program. The ``Medicare employer payment'' was designed to
encourage employers to retain such benefits.
According to GAO, if OPM had applied for the subsidy, it would have
lowered the average 2006 FEHBP premium by 2.6 percent. Some of the
individual health plans that serve a high number of retirees could have
realized a slowdown in premium growth by as much as 3.5 to 4 percent.
These savings could have been passed on to keep the enrollee portion of
the premium down. Unfortunately, estimates are that OPM has have left
more than $1 billion on the table by forgoing the subsidy. NTEU would
support legislative language require OPM to apply for the subsidy,
which would help keep FEHBP costs down for millions of Federal
employees and their families who are enrolled.

CONTRACTING OUT

Another issue pertinent to the subcommittee's jurisdiction is the
contracting out of Government positions and responsibilities. I want to
commend and thank the subcommittee for incorporating important
privatization language in its portion of the fiscal year 2008 Omnibus
Appropriations bill to help level the playing field for Federal
employees.
Unfortunately, the administration's fiscal year 2009 budget request
has called for the repeal of these important provisions. We strongly
urge Congress to oppose any efforts to repeal these important
provisions that allow Federal employees the ability to fairly compete
with the private sector.
In addition, NTEU strongly supports making Government-wide a number
of additional contracting out reforms included in the fiscal year 2008
Defense Authorization Bill which currently only apply to the Department
of Defense. These include provisions that would encourage
``insourcing'' by providing employees Government-wide the opportunity
to compete for new work or work currently performed by contractors,
allow Government employees to acquire new work by allowing agencies to
bring work in-house without going through the A-76 process, eliminate
the automatic recompetition requirement which previously only applied
to Federal employees and not contractor employees, and establishment of
a contractor inventory in every Government agency to track the cost and
performance of every service contract to help identify contract work
that could be converted to performance by Federal employees.
By making these important contracting out reforms applicable to the
entire Federal workforce, Congress can help bring fairness and
accountability to the entire competitive sourcing process. NTEU firmly
believes that Federal employees are the best value for taxpayers'
dollars and they deserve a fair and level playing field on which to
demonstrate their effectiveness and efficiency to the White House,
Congress, and the American public.

CONCLUSION

Mr. Chairman, while Federal workers, and in particular IRS
employees, continue to get mixed signals regarding their value to this
administration, they remain committed to serving the American public to
the best of their abilities. With the expected surge in Federal
retirements in the coming years, it is imperative that the Federal
Government do all it can to retain the hundreds of thousands of
talented public servants who have the knowledge and expertise to
continue contributing to the Federal workforce while at the same time
preparing to compete for the best and brightest of the young new
workers.
Therefore, NTEU believes it is imperative that the administration
reverse many of its policies that have devalued the role of Federal
employees and the work that they do including the failure to pay
competitive salaries and the constant focus on downsizing and
outsourcing. These misguided policies have reduced morale of Federal
employees Government-wide and have put the Federal Government at a
disadvantage when it comes to attracting, developing and retaining
qualified employees.
______

Prepared Statement of OMB Watch

OMB Watch would like to submit the report, ``Bridging the Tax Gap:
The Case for Increasing the IRS Budget,'' into the record for the
Committee on Appropriations Subcommittee on Financial Services and
General Government hearing on the IRS fiscal year 2009 budget on April
16, 2008.
OMB Watch supports efforts by the IRS to close the so-called ``tax
gap,'' and believes increased funding of the IRS budget is a necessary
condition to achieving this goal. The $4.6 billion appropriated to the
IRS's enforcement budget in fiscal year 2008 is less than the 1995 IRS
enforcement budget (in inflation-adjusted terms). As the enforcement
budget was cut, the IRS saw the number of tax returns filed increase 11
percent from 205 million in 1995 to 228 million in 2006 (the last year
for which such data are available).
In addition to the amount of resources available to the IRS, also
of concern are the means by which the IRS enforces tax laws. The use of
private tax collectors not only exposes taxpayer data to private firms,
but when compared to Federal tax collectors, private collectors are
extremely inefficient. Use of Federal employees for tax collection
results in a 13:1 return-on-investment (ROI) ratio ($13 collected for
each dollar spent), while private tax collectors achieve an ROI of
4.5:1. That the IRS would continue this program represents an egregious
mismanagement of tax collection resources.
OMB Watch also believes better targeting of audits and the types of
audits performed would enhance the IRS's ability to close the tax gap.
Although the overall audit rate has seen a slight increase in recent
years (a positive development, to be sure), that increase has been
largely constituted of increases in correspondence audits. Compared to
face-to-face audits, correspondence audits result in lower revenue
yields. Whereas correspondence audits of individuals earning over
$100,000 per year result in about a $32,000 increase in identified tax
liability, face-to-face audits yield, on average, about $55,000.
Additionally, the IRS has been spending too much time auditing low-
income Americans. Forty percent of all audits performed in 2006 were of
taxpayers claiming the EITC, resulting in a 2.25 percent audit rate for
EITC claimants--more than double the 1 percent rate for all taxpayers.
With an average yield of $2,895, EITC-return audits have the lowest
rate of return of any audit conducted by the IRS. That so many IRS
resources are devoted to these low-yield audits underscore the depth of
inefficient enforcement practices.
Instead of employing this punitive approach to closing the tax gap
through EITC compliance, the IRS should increase resources devoted
Taxpayer Assistance Centers (TAC) to increase EITC return accuracy.
TAC-prepared EITC returns reduce overpayments by $640-$1,300. However,
the number of TAC-prepared returns have been declining as TACs
experience staffing shortages. By increasing resources devoted to TACs,
the IRS would not only reduce the tax gap, but would expand much-needed
services to low-income taxpayers.
These important tax enforcement issues, and others, are explored in
greater detail the report we are submitting. We hope this will help
raise awareness of the importance of addressing enforcement issues at
the IRS and that the committee will use the findings of this report in
formulating IRS legislation.

January 2008.
Bridging the Tax Gap--The Case for Increasing the IRS Budget
acknowledgements

Matt Lewis, a Federal Fiscal Policy Analyst, conducted the primary
research and writing of this report, with assistance from Adam Hughes,
Director of Federal Fiscal Policy. Other OMB Watch staff provided
advice and research support. Brian Gumm, Communications Coordinator,
provided editorial support and designed the report.
OMB Watch is a nonprofit research and advocacy organization whose
core mission is increasing Government accountability and improving
citizen participation. Responsible, fair, and equitable budget and tax
policy has been an important part of our work for more than 20 years,
and we have practical experience in promoting and informing the public
on budget and tax legislation and regulations.
This report is available electronically at: http://
www.ombwatch.org/budget/irstaxgap2008.pdf.

INTRODUCTION

A significant and pernicious problem facing the Nation is the tax
gap, the difference between what is owed in taxes and what is paid.
Estimated to be over $300 billion annually, the tax gap represents an
enormous revenue loss for the Government. This lack of revenue often
causes unnecessary increases in annual deficits and the national debt,
increasing national interest payments and adding pressure to cut vital
Government services. Unfortunately, much of the gap must be made up
eventually by honest taxpayers through higher taxes and by
beneficiaries of Federal investments through service cuts.
The Internal Revenue Service (IRS) is responsible for enforcing tax
laws and collecting taxes, and therefore, it has the greatest capacity
and responsibility to reduce the tax gap. The extent to which the IRS
can influence the tax gap is mostly a product of the resources and
powers lawmakers in Congress provide the agency and how well IRS
administers those resources and powers.\1\
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\1\ Significant changes to tax laws have reduced the IRS's
influence over tax enforcement, and many proposals have been made to
increase tax compliance with authorizing legislation. For one in-depth
overview, see Max Sawicky's Bridging the Tax Gap: Addressing the Crisis
in Federal Tax Administration (Washington, DC: Economic Policy
Institute, 2005).
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Congress has given considerable lip service to doing something
about the tax gap for years but has done little to actually give the
IRS the tools to make significant progress in closing it. Despite this
fact, Congress has demanded the IRS close the tax gap without making
more resources available for the agency to do so. Thus, the IRS has
been forced to make difficult choices as to how to use the limited
resources it has been allocated. As a result, at the very least, the
tax gap remains a large problem, and most experts believe it has
probably increased in size as the IRS has largely scaled back tax law
enforcement over the last 10 years.
The IRS can reduce the size of the tax gap--progress that would
yield billions in additional revenue each year. In order to accomplish
this, Congress and the IRS will need to invest more in three areas of
the IRS budget: audits, collections, and tax preparation services for
low-income taxpayers eligible for the Earned Income Tax Credit. With
sufficient resources, the IRS should be able to implement effective and
efficient tax enforcement policies and programs that will have a real
impact on reducing the tax gap.

THE $300 BILLION PROBLEM: THE TAX GAP

IRS defines the tax gap in two ways. The gross tax gap is the total
amount of taxes that were not paid when tax returns were first filed,
while the net tax gap consists of taxes that are not paid after the IRS
takes steps to enforce tax laws. The most recent data on the gross tax
gap comes from the IRS National Research Project, which evaluated tax
returns from fiscal year 2000. It put the gross tax gap at between $312
billion and $353 billion annually, or about 16 percent of all taxes
owed. Although the percentage of the economy the tax gap represents has
not changed significantly, the absolute size of the gross tax gap has
in all likelihood grown in step with the economy.\2\ Most of the tax
gap results from taxpayers underreporting their income.
---------------------------------------------------------------------------
\2\ Internal Revenue Service, ``New IRS Study Provides Preliminary
Tax Gap Estimate,'' http://www.irs.gov/newsroom/article/
0,,id=137247,00.html (accessed October 10, 2007).
---------------------------------------------------------------------------
It is unclear, however, how much the tax gap has increased as a
percentage of the total amount of taxes owed. In the last two decades,
IRS has only measured the tax gap three times. Each time, it found the
tax gap represented between 16 and 20 percent of total revenues
owed.\3\ On the other hand, anecdotal evidence, particularly the work
of Pulitzer Prize-winning journalist David Cay Johnston, suggests the
tax gap has grown as wealthier taxpayers have responded to and
requested reductions in the IRS enforcement presence.
---------------------------------------------------------------------------
\3\ Eric Toder, ``Reducing the Tax Gap: The Illusion of Pain-Free
Deficit Reduction,'' Urban-Brookings Tax Policy Center, http://
www.taxpolicycenter.org/UploadedPDF/411496_reducing_tax_gap.pdf
(accessed October 10, 2007).
---------------------------------------------------------------------------
In any case, the IRS can influence both the net and the gross tax
gap by encouraging and requiring tax compliance. The IRS recovered
$48.7 billion of the tax gap in fiscal year 2006, which, coupled with
late payments, brought the net tax gap to between $257 billion and $298
billion.\4\ Enforcement efforts also have a strong impact on the gross
tax gap, because voluntary compliance tends to increase when
enforcement programs are more active. More enforcement increases the
fear of being audited and perhaps heightens the public sense of civic
responsibility, both of which are thought to promote voluntary
compliance. But the exact extent of the impact is subject to debate.
Some studies have found the increase in voluntary compliance is many
times greater than the money the IRS directly recovers through
enforcement programs.\5\
---------------------------------------------------------------------------
\4\ Internal Revenue Service, ``IRS Enforcement Activities Continue
To Recover,'' http://www.irs.gov/pub/newsroom/11-06_stat_charts.pdf
(accessed October 10, 2007).
\5\ Eric Toder, ``Reducing the Tax Gap: The Illusion of Pain-Free
Deficit Reduction,'' Urban-Brookings Tax Policy Center, http://
www.taxpolicycenter.org/UploadedPDF/411496_reducing_tax_gap.pdf
(accessed October 10, 2007).

IMPACT OF THE TAX GAP

The tax gap affects the public in two ways. Mainly, it reduces what
compliant taxpayers already have. Because this revenue is intended to
be collected and used by the Government, not collecting it makes
implementing Government services and investments more difficult. The
existence of the tax gap is kind of like a recurring and permanent tax
cut, in the sense it generally must be paid for by either shifting the
tax burden to others (in this case, compliant taxpayers), curtailing
Government services, or increasing debt. The IRS National Taxpayer
Advocate (NTA), for example, has testified before Congress that unpaid
taxes shift the tax burden onto compliant taxpayers. If all compliant
taxpayers were to assume an equal portion of the tax gap, it would add
$2,200 to their annual tax bills.\6\ Looked at another way, if the IRS
eliminated the tax gap, Americans could receive the same level of
services and programs while paying significantly less in taxes. The
actual impact of the tax gap on the taxes paid by each individual most
likely depends on personal circumstances and future policy decisions.
---------------------------------------------------------------------------
\6\ National Taxpayer Advocate, ``National Taxpayer Advocate's 2006
Annual Report To Congress,'' Internal Revenue Service, http://
www.irs.gov/advocate/article/0,,id=165806,00.html (accessed October 10,
2007).
---------------------------------------------------------------------------
But unlike a tax cut, the tax gap creates a patently perverse set
of winners and losers--taxpayers who do not follow the law benefit and
taxpayers who do lose out. Larger burdens also tend to fall on lower-
and middle-income taxpayers, whose compliance rates are higher than
other income levels. Higher-income taxpayers, small business owners,
and corporations are the main beneficiaries, as their compliance rates
are lower. Because of this, on the whole, the tax gap makes the tax
code less progressive than the statutory structure indicates, though by
exactly how much has not been quantified.\7\
---------------------------------------------------------------------------
\7\ Jason Furman, Lawrence H. Summers, and Jason Bordoff,
``Achieving Progressive Tax Reform in an Increasingly Global Economy,''
Brookings Institution, http://www3.brookings.edu/views/papers/furman/
200706bordoff_summers.pdf (accessed October 10, 2007).
---------------------------------------------------------------------------
Secondly, and perhaps more importantly, the tax gap reduces what
the public could have. The tax gap deprives the Government of more
revenue to finance the expansion of Government services and
investments, a reduction in the annual deficit, or payments to reduce
the national debt. If the tax gap were reduced or eliminated, the
additional revenue brought into the Government would, in most
circumstances, make the tax code much more progressive. There are
surely many different proposals about how to invest the revenue owed,
but regardless of how the $300 billion would be used, the Federal
Government is never afforded the opportunity to decide.
On a less practical, but equally important level, the tax gap also
represents the eroding integrity of the tax system and could reduce
public support for the Federal Government. Such a large amount of
unpaid taxes makes the tax system appear ineffective and unfair, since
the tax gap regressively favors wealthier people and businesses who
have the means to avoid and evade tax law. These perceptions of
unfairness in the tax system may have large-scale effects on public
policy, undermining public confidence in Government as a fiscal
manager.\8\ Compliant taxpayers may also object to tax increases on the
grounds they would be paid arbitrarily and regressively, and, as a
corollary, new Government services or investments financed by tax
increases may receive less support. Taxpayers may also view ineffective
tax enforcement as indicative of Government incompetence generally and,
therefore, oppose expansion of the Government's role. Too many citizens
may see no option but to favor tax cuts as a way to restore the
integrity of revenue collection and protect themselves from bearing
unjust burdens as compliant taxpayers.
---------------------------------------------------------------------------
\8\ Alison Kladec and Will Friedman, ``Understanding Public
Attitudes about the Federal Budget: A Report on Focus Groups,'' Public
Agenda, http://www.publicagenda.org/research/pdfs/
understanding_public_attitudes_about_the_federal_budget.pdf (accessed
October 10, 2007).
---------------------------------------------------------------------------
A PRIMARY CAUSE: LACK OF RESOURCES AT THE IRS

While it is widely established that increased resources at the IRS
could help to reduce the tax gap, IRS funding levels have not kept up
with growing demands on its budget. The total IRS budget has remained
static after adjusting for inflation since the mid-1990s. The funding
decline has been most pronounced in the enforcement account of the IRS
budget, which includes funding for tax return examinations, tax
collections, and document matching services that compare financial
records with tax returns. In fiscal year 1995, IRS had $4.43 billion in
its enforcement account. By fiscal year 2006, this budget had only
risen to $4.65 billion--less than a 5 percent increase. During the same
period:
--Inflation had eroded the value of this funding by 36 percent; \9\
---------------------------------------------------------------------------
\9\ Bureau of Labor Statistics. ``Inflation Calculator,'' U.S.
Department of Labor, http://www.bls.gov/cpi/ (accessed October 10,
2007).
---------------------------------------------------------------------------
--The size of the economy grew 42 percent; \10\
---------------------------------------------------------------------------
\10\ Bureau of Economic Analysis, ``National Economic Accounts''
U.S. Department of Commerce, http://www.bea.gov/national/index.htm#gdp
(accessed October 10, 2007).
---------------------------------------------------------------------------
--The number of tax returns the IRS processed increased 11 percent,
from 205 million to 228 million; \11\ and
---------------------------------------------------------------------------
\11\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books,''
http://www.irs.gov/taxstats/article/0,,id=102174,00.html (accessed
October 10, 2007).
---------------------------------------------------------------------------
--Hundreds of changes to the IRS's authority and tax laws gave the
agency more work.\12\
---------------------------------------------------------------------------
\12\ Charles O. Rossotti, ``Report to the IRS Oversight Board:
Assessment of the IRS and Tax System,'' http://nteuirswatch.org/
documents/numbers/Rossotti%2002%20report%20to%20oversight%20board.pdf
(accessed October 10, 2007).
---------------------------------------------------------------------------
Experts inside and outside Government have recognized the resource
problem at IRS. IRS National Taxpayer Advocate Nina Olson, who operates
independent of the IRS, believes funding shortages have become so
problematic, she has called for the creation of special rules for IRS
budget bills. Charles Rossotti, former commissioner of the IRS, told
the IRS Oversight Board in 2002 that much of the tax gap is a result of
the failure of Congress to provide enough resources for tax law
administration:

The source of this problem are two conflicting, long-term trends:
one, ever increasing demands on the tax administration system due to
rapid growth in the size and complexity of the economy; and two, a
steady decline in IRS resources due to budget constraints. The
cumulative effect of these conflicting trends over a 10-year period has
been to create a huge gap between the number of taxpayers who are not
filing, not reporting or not paying what they owe, and the IRS'
capacity to require them to comply.
The resources crunch can be seen more apparently in staffing
levels: the number of IRS employees is down sharply from 10 years ago.
Between 1995 and 2006, the total number of IRS employees shrunk 18
percent--falling from 114,000 to less than 92,000. The number of
revenue agents and officers--IRS employees who perform audits--has
decreased even faster, by 40 and 30 percent, respectively.\13\ Those
categories of employees have decreased from 8,139 to 5,665 for revenue
agents and 16,078 and 12,859 for revenue officers.\14\ Fewer staff at
the IRS has a direct impact on the auditing function at the agency.
---------------------------------------------------------------------------
\13\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\14\ Ibid.
---------------------------------------------------------------------------
There have been many experts who have called for increased funding
for the IRS, including the Treasury Inspector General for Tax
Administration,\15\ the Government Accountability Office,\16\ the IRS
Oversight Board, Max Sawicky, then of the Economic Policy
Institute,\17\ Robert McIntyre of Citizens for Tax Justice,\18\ Eric
Toder of the Urban-Brookings Tax Policy Center,\19\ and former IRS
Commissioner Donald C. Alexander.\20\
---------------------------------------------------------------------------
\15\ Treasury Inspector General for Tax Administration. ``Trends In
Compliance Activities Through Fiscal Year 2006,'' U.S. Department of
the Treasury, http://www.treas.gov/tigta/auditreports/2007reports/
200730056fr.html (accessed October 10, 2007).
\16\ Michael Brostek, ``Tax Compliance: Multiple Approaches Are
Needed To Reduce The Tax Gap,'' Government Accountability Office,
http://www.gao.gov/new.items/d07488t.pdf (accessed October 10, 2007).
\17\ Max Sawicky, ``Do-it-yourself tax cuts: The crisis in U.S. tax
enforcement'' in Bridging the Tax Gap: Addressing the Crisis in Federal
Tax Administration (Washington, DC: Economic Policy Institute, 2005).
\18\ Robert McIntyre, ``Statement of Robert S. McIntyre Before the
Senate Budget Committee, January 23, 2007,'' Senate Budget Committee,
http://budget.senate.gov/democratic/testimony/2007/
McIntyre_TaxGap012307.pdf (accessed October 10, 2007).
\19\ Eric Toder, ``Reducing the Tax Gap: The Illusion of Pain-Free
Deficit Reduction,'' Urban-Brookings Tax Policy Center, http://
www.taxpolicycenter.org/UploadedPDF/411496_reducing_tax_gap.pdf
(accessed October 10, 2007).
\20\ Max Sawicky, ``Interview: Former IRS Commissioner Donald C.
Alexander'' in Bridging the Tax Gap: Addressing the Crisis in Federal
Tax Administration (Washington, DC: Economic Policy Institute, 2005)
52.
---------------------------------------------------------------------------
IRS needs additional funding to fulfill its mission as the
guarantor of tax compliance. Where funding is needed most is in the IRS
enforcement budget, particularly for audits of high-income taxpayers
and corporations, the collection function, and services for low-income
taxpayers who receive the Earned Income Tax Credit (EITC).

INCREASES RESOURCES FOR AUDITS

One of the most disturbing trends in enforcement policy over the
last 10 years has been a sharp decline in audits, which are an
essential tool in the fight against unpaid taxes. Most of the gross tax
gap--between $250 and $260 billion--results from individuals and
businesses underreporting their income. The IRS determines who
inaccurately reported their income and how much they owe in taxes
through a variety of means. Examinations, or audits, are one way the
IRS makes this determination. In fiscal year 2006, IRS audits showed
that an additional $43.95 billion was owed on all tax returns that were
audited.\21\ The IRS performed 1.4 million audits, resulting in an
audit coverage rate of 0.8 audits per 100 tax returns, or less than 1
percent.\22\
---------------------------------------------------------------------------
\21\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\22\ Ibid.
---------------------------------------------------------------------------
In the last decade, there has been a general decline in most types
of audits. In fiscal year 1996, the audit rate for all individual
income tax returns was 1.67 percent.\23\ In fiscal year 2006, the rate
had dropped to 1 percent of all individuals, after reaching a low of
0.5 percent in 2000.\24\ The recent upswing in audits is encouraging,
but the rate is still far below earlier levels and even farther below
historic and adequate levels, according to tax administration
experts.\25\
---------------------------------------------------------------------------
\23\ Government Accountability Office, ``Tax Administration: Audit
Trends and Results for Individual Taxpayers,'' http://www.gao.gov/
archive/1996/gg96091.pdf (accessed October 16, 2007).
\24\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\25\ Sawicky, ``Interview: Former IRS Commissioner Sheldon S.
Cohen,'' 25.
---------------------------------------------------------------------------
Making things worse, the general decrease in audits has been
unequally distributed by taxpayer income with audits of higher-income
earners falling faster than the overall decrease. The decline in audits
has been the steepest among taxpayers reporting an income over
$100,000. Audits of these filers have dropped from 2.85 percent in
fiscal year 1996 to 1.3 percent in fiscal year 2006. Decreases in these
audits before 1996 were even more drastic: in fiscal year 1992, higher-
income filers were audited 5.28 percent of the time.
Furthermore, business income has been insufficiently audited.
Business income, which is reported on individual income tax returns,
has been audited at a relatively steady rate since fiscal year 1995.
Nevertheless, more audits are needed, as the IRS National Research
Project identified the underreporting of income by small businesses as
the category that contributed the most to the tax gap, accounting for
more than $109 billion in unpaid taxes annually. $68 billion of these
unpaid taxes are owed by self-proprietorships, known more commonly as
the self-employed, and another $22 billion came from partnerships, S
corporations, estates, and trusts. In order to close the tax gap, the
IRS will need the necessary resources to expand its investigation and
enforcement of tax laws related to these returns, not hold them steady.
Decline in Quality and Quantity of Corporate Audits
Individual taxpayers are not alone in experiencing a decrease in
the likelihood of being audited. Audits related to the corporate income
tax for all sizes of corporations have declined significantly. The
overall corporate audit rate has been cut in half, dropping from 2.4
percent in 1996 to 1.2 percent in 2006.\26\ What's more, new data from
the last 5 years obtained by the Transactional Records Access
Clearinghouse (TRAC) show that the quality of those audits has also
suffered.
---------------------------------------------------------------------------
\26\ Transactional Records Access Clearinghouse, ``IRS Spending
More Time on Face-to-Face Corporate Audits that Produce No Revenue,''
Syracuse University, http://trac.syr.edu/tracirs/newfindings/current/
(accessed October 16, 2007).
---------------------------------------------------------------------------
Disturbingly, the decline has been most pronounced among the
largest corporations. Audits of corporations with assets between $5 and
$10 million dropped from 14 percent in fiscal year 1995 to 3.4 percent
in fiscal year 2006--a 70 percent drop.\27\ Slightly larger
corporations--with assets of $50 million to $100 million--were audited
at a rate of 13.8 percent in fiscal year 2006, down from 21.3 percent
in fiscal year 1996--a 35 percent decline. Audits of the largest
corporations, those with assets of $250 million or more, have declined
by almost a third, from 50 percent in fiscal year 1995 to 35.2 percent
in fiscal year 2006.\28\ While companies with over $250 million in
assets are small in number--they filed only 0.2 percent of corporate
tax returns in 2002--they accounted for a staggering 90 percent of all
corporate assets and 87 percent of all corporate income during that
year.\29\ The decrease in audits among these corporate tax filers must
be reversed.
---------------------------------------------------------------------------
\27\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\28\ Transactional Records Access Clearinghouse, ``IRS Spending
More Time on Face-to-Face Corporate Audits that Produce No Revenue.''
\29\ Transactional Records Access Clearinghouse, ``Relatively Few
Corporations Have Most Income and Assets,'' Syracuse University, http:/
/trac.syr.edu/tracirs/trends/v10/corpassets.html (accessed October 17,
2007).

Audits of the largest corporations inexplicably vary by sector,
which seems to be an inefficient method of tax enforcement. In fiscal
year 2006, only 15 percent of financial services corporations were
audited, compared to 100 percent of all large manufacturing and
transportation 1corporations.\30\ Yet companies in the financial sector
make up a large part of the economy. The largest corporations in the
financial sector account for 25 percent of total receipts of large
corporations and over 62 percent of total net income--more than 2.5
times the next highest sector.\31\
---------------------------------------------------------------------------
\30\ Transactional Records Access Clearinghouse, ``Corporate Audit
Rates--Wide Disparities Found for Different Industries,'' Syracuse
University, http://trac.syr.edu/tracirs/latest/127/. (accessed October
16, 2007).
\31\ Transactional Records Access Clearinghouse, ``Net Income of
Largest Corporations,'' Syracuse University, http://trac.syr.edu/
tracirs/trends/v10/netincsecG.html (accessed October 16, 2007).
---------------------------------------------------------------------------
What's more unfortunate, however, is that the audits that have been
done for corporate filers have been increasingly unproductive,
particularly among face-to-face corporate audits--the most thorough and
intense audits the IRS conducts. The number of nonproductive auditing
hours, which is defined by the IRS as face-to-face examination hours
that produce a ``no change'' result in the amount of tax owed, has
increased for every corporate asset class over the last 5 years.\32\
The average increase in unproductive hours across all corporate asset
classes between fiscal year 2001 and fiscal year 2006 was 40 percent.
If the IRS audited a high percentage of corporations, a rise in
unproductive hours could be interpreted as a good thing, with companies
increasingly paying the taxes they owe. However, because the IRS audits
too few corporations and because the tax gap points to large amounts of
taxes not being collected, a rise in unproductive hours shows the IRS
is being inefficient in selecting which corporations it chooses to
audit--a waste of valuable enforcement resources and a missed
opportunity to collect more tax revenues.
---------------------------------------------------------------------------
\32\ Transactional Records Access Clearinghouse, ``Net Income of
Largest Corporations.''
---------------------------------------------------------------------------
The rise in unproductive auditing hours increased at faster rates
as the size of the corporation increased, especially for large
corporations (those with assets over $10 million). While all four asset
classes over $10 million saw increases in unproductive hours well above
the average of 40 percent, as the asset class grows larger, the
increases are even more pronounced. At the low end, audits of
corporations between $10 million and $50 million saw a 61 percent
increase in unproductive hours, while audits of corporations above $250
million in assets saw the largest increases, at 109 percent--more than
double the rate from 5 years earlier.\33\
---------------------------------------------------------------------------
\33\ Transactional Records Access Clearinghouse, ``IRS Corporate
Audit Hours Spent on Nonproductive Examinations Increasing,'' Syracuse
University, http://trac.syr.edu/tracirs/trends/v12/audittimechange.html
(accessed October 16, 2007).
---------------------------------------------------------------------------
Another alarming trend is the decrease in the number of hours spent
per corporate audit. In the last 5 years, every corporate asset class
except one ($10-$50 million) has seen double-digit decreases in the
average length of audits, with the average corporate audit lasting 21
fewer hours.\34\ This represents almost a 10 percent drop in the length
of corporate audits.
---------------------------------------------------------------------------
\34\ Transactional Records Access Clearinghouse, ``Change in
Average Audit Length Fiscal Year 2001 vs Fiscal Year 2006,'' Syracuse
University, http://trac.syr.edu/tracirs/trends/v12/
auditlengthchange.html (accessed October 16, 2007).
---------------------------------------------------------------------------
IRS data on corporate audits, combined with the new data obtained
by TRAC on audit length, depict disturbing trends in both the quality
and quantity of corporate audits--particularly those of the largest
corporations. Not only is the IRS performing fewer corporate audits
overall than it did 10 years ago, the ones they do perform are done too
quickly and are poorly targeted. Due to the size and complexity of the
business transactions of large corporations, those returns are likely
to produce more reporting errors, and therefore, the IRS should be
auditing more of those companies (not less) and spending more time (not
less) on each audit.
There have been a few reports that some of the changes within the
corporate auditing section (the Large and Mid-Sized Business Division)
have been forced on IRS auditors by senior level managers at the IRS.
These changes put a strong focus on completing more audits by pre-set
deadlines in order to drive up total audit numbers regardless of the
quality of the audit or of auditors' opinions about possible serious
tax violations they had not had time to investigate during audits.
David Cay Johnston reported in The New York Times on March 20, 2007,
that almost two dozen revenue agents had been pressured by their
managers to close open audits too soon--actions the auditors said could
cost the Government billions of dollars in unpaid taxes.\35\
---------------------------------------------------------------------------
\35\ David Cay Johnston, ``IRS Agents Feel Pressed To End Cases.''
New York Times, March 20, 2007. http://www.nytimes.com/2007/03/20/
business/20tax.html.
---------------------------------------------------------------------------
This phenomenon was recognized by Colleen Kelley, President of the
National Treasury Employees Union, in testimony before the House
Appropriations Committee on Financial Services and General Government.
Kelley testified the pressure put on IRS auditors was not a recent
occurrence but had been happening since 2002. Kelley believes it was
the result of a new IRS policy called Limited Focused Examination
(LIFE) and said the union had heard directly from its members that the
policy was undermining both efforts to make sure companies were paying
all the taxes they owed and employee morale at the IRS.\36\
---------------------------------------------------------------------------
\36\ Colleen Kelley, ``Statement of Colleen Kelley, National
President, National Treasury Employees Union on `Internal Revenue
Service Budget fiscal year 2008,' '' National Treasury Employees Union,
http://nteuirswatch.org/documents/numbers/CMK%20Testimony%20to%20House
%20FServices%20sub%203-29-07.pdf (accessed October 18, 2007).
---------------------------------------------------------------------------
The combination of a decrease in overall corporate audit rates, and
reports that those audits being done are closed too soon, will
encourage tax evasion behavior among corporations, which may have more
cause to believe they will not be audited, and that audits themselves
are not to be feared.

Wrong Strategy: Relying on Correspondence Audits
As far as reducing the tax gap is concerned, the type of audit
being administered is equally, if not more important than who is being
audited. There are two types of audits: a traditional face-to-face
audit, which can happen inside an IRS office or at a taxpayer's home or
business, and a correspondence audit. Traditional face-to-face audits
involve comprehensive reviews of assets and records, requiring more
time and effort for both the taxpayer and the IRS. Correspondence
audits consist of the IRS sending a letter to a non-compliant taxpayer
in which he or she is asked a few questions about his or her tax
return. Striking the right balance between these two types of audits is
essential to effective tax enforcement.
Face-to-face audits typically generate far more revenue than
correspondence audits, and ones on high-income earners in particular
produce the highest yields. In fiscal year 2006, face-to-face audits of
high-income earners generated an average of $54,934.\37\ Face-to-face
audits on individuals earning between $50,000 and $100,000, in
contrast, only averaged a $3,877 yield, yet these taxpayers were
audited almost as much (0.23 percent) as their higher-income
counterparts (0.44 percent).\38\ Even face-to-face audits on returns
with business income over $100,000 yielded less than half as much
($25,787) as audits of high-income filers.\39\ The high yields on face-
to-face audits of high-income filers show both that they are a good
investment and also that there are significantly more taxes due among
those filers.
---------------------------------------------------------------------------
\37\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\38\ Ibid.
\39\ Ibid.
---------------------------------------------------------------------------
Despite the high yields of these audits, the IRS is performing them
too rarely. IRS administered face-to-face audits for 0.44 percent of
all high-income filers in fiscal year 2006, compared to 2.9 percent in
fiscal year 1992 and 1.7 percent in fiscal year 1996.\40\ Yet the IRS
claims, and rightly so, that overall audit rates have been gradually
increasing in the last few years. These additional audits have
increased the yield on tax enforcement, from a 10-year low of $32.9
billion in fiscal year 1999 to $48.7 billion in fiscal year 2006.
---------------------------------------------------------------------------
\40\ Transactional Records Access Clearinghouse, ``IRS `Face-to-
Face' Audits of Federal Income Tax Returns Filed by Individuals,''
Syracuse University, http://trac.syr.edu/tracirs/highlights/current/
audpctcompare_ind.html (accessed October 16, 2007).

Unfortunately, the details behind the IRS data on increased audits
tell a different story. Much of the increase cited by the IRS has been
due to an emphasis on correspondence audits, not the more effective
face-to-face audits. Overall, in fiscal year 2006, 77 percent of all
audits--more than three out of four--were by correspondence.\41\ What's
more, correspondence audits--not face-to-face audits--have accounted
for 74 percent of the recent increase in audits among high-income
individuals.\42\ Face-to-face audit levels have increased only modestly
over that time.
---------------------------------------------------------------------------
\41\ Transactional Records Access Clearinghouse, ``Targeting of
Correspondence Audit Improves,'' Syracuse University, http://
trac.syr.edu/tracirs/newfindings/current (accessed October 16, 2007).
\42\ Treasury Inspector General For Tax Administration, ``Trends in
Compliance Activities Through Fiscal Year 2006,'' U.S. Treasury
Department, http://www.treas.gov/tigta/auditreports/2007reports/
200730056fr.html (accessed October 16th, 2007).
---------------------------------------------------------------------------
This trend is problematic because correspondence audits are less
effective than face-to-face audits, partly because this type of audit
can only spot problems that are evident from information submitted by
the taxpayer or from information reported by third parties (employers,
banks, and other sources). For comparison, in fiscal year 2006, face-
to-face audits on individual income tax returns for earners over
$100,000 yielded an average of $54,934, while correspondence audits
brought in $31,912.\43\ For other types of tax returns, such as large
corporations, the difference was even more dramatic. The average yield
of a face-to-face audit for large corporations in fiscal year 2006 was
$2.6 million, but correspondence audits of similarly sized companies
averaged a meager return of $285,000.\44\
---------------------------------------------------------------------------
\43\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\44\ Ibid.
---------------------------------------------------------------------------
The IRS seems to have chosen to use correspondence audits so much
mainly because administering them requires less staff time and
resources. In fiscal year 2006, correspondence audits took an average
of only 1.4 auditor hours each, drastically lower than the hundreds of
hours face-to-face audits can take.\45\ Indeed, IRS data shows even as
overall audit rates have increased in the last few years, few
additional staff have been added.
---------------------------------------------------------------------------
\45\ Transactional Records Access Clearinghouse, ``Targeting of
Correspondence Audit Improves,'' Syracuse University, http://
trac.syr.edu/tracirs/newfindings/current (accessed October 17, 2007).
---------------------------------------------------------------------------
The IRS has decided, perhaps because of limited resources, to shift
to less efficient and effective processes for auditing. If Congress and
others in Government are serious about creating a robust tax
enforcement system and closing the tax gap, additional resources are
crucial. Increased funds could be used to raise staffing levels enough
that IRS may gradually perform more high-yield face-to-face audits,
which would have a greater impact on reducing the tax gap.

EXPAND INTERNAL TAX COLLECTION

Tax law enforcement does not end once an audit has been completed.
The IRS will have to actively pursue unpaid taxes it identifies if they
are not paid voluntarily. IRS collection officers may make an agreement
with the taxpayer to pay the taxes, or issue levies, liens, or property
seizures. Agents are also charged with identifying taxpayers who do not
file a tax return and collecting the taxes owed. To do these things,
significant staffing and resources are required.
Billions are lost annually because Congress does not sufficiently
finance the IRS collection department. In 2002, former IRS Commissioner
Charles Rossotti reported to the IRS Oversight Board that an annual
investment of under $400 million in IRS collections could generate over
$11 billion each year.\46\ This additional funding could be used to
hire more full-time employees to pursue cases the IRS has not taken
action on due to insufficient personnel. Even without additional
resources, NTA Nina Olson has recently stated the IRS can tackle many
of those additional cases by implementing improvements to its current
collection regimes.
---------------------------------------------------------------------------
\46\ Charles O. Rossotti, ``Report to the IRS Oversight Board:
Assessment of the IRS and Tax System.''
---------------------------------------------------------------------------
Since Rossotti issued the 2002 report, activity in the collection
function has increased modestly. Some key measurements have been on a
steady upward trajectory, including the quantity of liens and levies
issued by IRS collection staff.\47\ However, the level of liens and
levies is still down sharply from fiscal year 1996 levels, even
excluding growth in the economy and tax returns. Some measures--such as
the quantity of seizures--have not increased at all. Indeed, a 2007
Treasury Inspector General for Tax Administration (TIGTA) report found
a robust collection function continues to be hampered by inadequate
resources, as staffing for collection activities remains 30 percent
below fiscal year 1997 levels.\48\
---------------------------------------------------------------------------
\47\ Transactional Records Access Clearinghouse, ``IRS Collection
Enforcement Trends,'' Syracuse University, http://trac.syr.edu/tracirs/
highlights/current/collenfG.html (accessed October 16, 2007).
\48\ Treasury Inspector General for Tax Administration, ``Trends In
Compliance Activities Through Fiscal Year 2006.''
---------------------------------------------------------------------------
Wrong Strategy: Private Debt Collection
In 2004, Congress enacted--and in September 2006, the IRS
implemented--a program to outsource the responsibility of collecting
small tax debts to private debt collection firms. The principle
rationale for creating the program was that its funding would not show
up in the IRS budget. Although the Government still spends resources,
using private collectors does not require additional annual
appropriations. Under the program, private collectors get to keep a
portion of the taxes they collect as payment. Therefore, given limited
budgets, the IRS would be afforded an opportunity to collect taxes it
otherwise could not.
However, the private tax collection program is wasteful and
dangerous. Private collection agencies (PCAs) yield a return-on-
investment (ROI) of 4:1, whereas--as former IRS Commissioner Mark
Everson has acknowledged--Federal employees at the IRS produce a 13:1
ROI. Even more efficient, the IRS' Automated Collection System
currently collects about $20 for every $1 spent on staffing, according
to the NTA.\49\
---------------------------------------------------------------------------
\49\ National Taxpayer Advocate Service, ``National Taxpayer
Advocate's 2007 Annual Report to Congress,'' Internal Revenue Service,
http://wwwrs.gov/advocate/article/0,,id=177301,00.html (accessed
January 9, 2008).
---------------------------------------------------------------------------
Furthermore, despite claims the program has no costs, as of May 23,
2007, the IRS had spent $71 million in appropriated funding to set it
up. If that money had instead been spent on those high-yield automated
functions, an additional $1.4 billion in revenues could have been
collected in just 1 year. Yet for all those missed opportunities, the
private collection program is expected to yield only around $1.1
billion altogether over the next 10 years.
Initial data on the program are now available for the first year of
operation, and the Washington Post has reported the PCAs averaged a
4.5:1 ROI, collecting $29 million, from which they were paid $6.34
million--far below both the IRS' ROI levels and initial revenue
projections for the program.\50\
---------------------------------------------------------------------------
\50\ Business Section ``Collectors Get $29 Million for IRS,''
Washington Post, January 9, 2008, http://www.washingtonpost.com/wp-dyn/
content/article/2008/01/08/AR2008010804439.html.
---------------------------------------------------------------------------
Regardless of the program's cost, many experts continue to worry
PCAs might violate taxpayer rights. Olson has expressed a great deal of
concern that profit-motivated companies could abuse taxpayers.
According to Olson, PCAs have the opportunity to use ``trickery,
device, and belated Fair Debt Collection Practices Act warnings to take
advantage of taxpayers,'' and yet they are not obligated to disclose
their ``operational plans'' regarding practices, letters, or scripts
they will use.\51\
---------------------------------------------------------------------------
\51\ National Taxpayer Advocate Service, ``National Taxpayer
Advocate's 2006 Annual Report to Congress,'' Internal Revenue Service,
http://www.irs.gov/advocate/article/0,,id=165806,00.html (accessed
October 16, 2007).
---------------------------------------------------------------------------
Indeed, anecdotal reports on the program's operations have borne
out many of the concerns Olson voiced regarding abusive practices. At a
May 23, 2007, hearing of the House Ways and Means Committee, Rep. John
Lewis (D-GA) presented tapes of conversations between PCA employees and
taxpayers.\52\ Due to IRS privacy protections, PCA employees did not
identify themselves, the nature of their business, or the purpose of
their calls, and haggled with taxpayers to obtain their Social Security
numbers. The taxpayers in the conversations refused to reveal their
Social Security numbers and responded angrily when PCA employees asked
repeatedly for the numbers but did not disclose the purpose of the
conversations.
---------------------------------------------------------------------------
\52\ For a transcript of the tapes, see http://
waysandmeans.house.gov/media/pdf/110/07
%2005%2023%20Debt%20Collector%20call%20transcript.pdf.
---------------------------------------------------------------------------
Olson reiterated her concerns about the ability of the program to
operate efficiently and effectively in the recently released 2007 NTA
report, stating tax collection is an inherently governmental function
that should be handled only by Government employees trained to protect
taxpayer rights. Olson argues the IRS could currently collect the
outstanding debts given to the PCAs by improving its collection
strategy and use of currently available resources, enabling the IRS to
reach ``most, if not all, of these cases [given to PCAs] at less cost
to taxpayers and less risk to taxpayer rights.'' \53\
---------------------------------------------------------------------------
\53\ National Taxpayer Advocate Service, ``National Taxpayer
Advocate's 2007 Annual Report to Congress,'' Internal Revenue Service,
http://www.irs.gov/advocate/article/0,,id=177301,00.html (accessed
January 9, 2008).
---------------------------------------------------------------------------
The sum of the evidence supports the need to shut down this program
immediately. In 2007, Ways and Means Chairman Charles Rangel (D-NY)
requested the IRS not issue any new contracts for the program, and the
House passed a bill in October 2007 to end it entirely. This would be a
wise change in IRS policy. Unfortunately, the IRS is moving forward
with soliciting bids from additional PCAs for the second part of the
program--full implementation. While Olson has pushed the IRS to include
more transparency and taxpayer safeguards in the solicitation of new
contracts, she continues to voice strong concerns and recommends
Congress end the program.
Congress needs to act immediately to end this program and instead
should make more resources available to the IRS to expand existing
internal collection efforts.

INCREASE SERVICES FOR EITC TAXPAYERS

Re-establishing a robust auditing regime at the IRS is crucial to
closing the tax gap. But focusing on enforcement at every turn,
particularly having that focus land disproportionally on low-income
taxpayers, is not the best solution. The IRS has taken an approach to
overseeing and enforcing the Earned Income Tax Credit (EITC) that
relies far too much on audits and not enough on services. This is
unfair to those taxpayers who claim the EITC, who are held to a higher
standard by the IRS than any other taxpayer group, and it fails to
address EITC over-claims caused by errors, not malfeasance.
The EITC is a refundable tax credit for low-income workers. In tax
year 2005, the EITC provided more than $41 billion to over 21 million
families and individuals.\54\ It lifts more working families out of
poverty than any other work support; in 2003, the EITC helped raise 4.4
million people, including 2.4 million children, above the poverty
line.\55\
---------------------------------------------------------------------------
\54\ Center on Budget and Policy Priorities, ``EIC Participation
for Tax Year 2005, by State,'' http://www.cbpp.org/eic2008/docs/
EIC%20participation%20prelim%20ty%202005.pdf (accessed October 17,
2007).
\55\ Robert Greenstein, ``The Earned Income Tax Credit: Boosting
Employment, Aiding the Working Poor,'' Center on Budget and Policy
Priorities, http://www.cbpp.org/7-19-05eic.htm (accessed October 17,
2007).
---------------------------------------------------------------------------
Since it is a tax credit, the IRS administers the EITC and is
responsible for maintaining its integrity. In 1999, the IRS estimated
the EITC noncompliance rate at between 27 and 32 percent, resulting in
between $8.5 to $9.9 billion annually in overpayments, or about 3
percent of the tax gap (though the NTA believes that rate is
overstated).\56\
---------------------------------------------------------------------------
\56\ Ibid.
---------------------------------------------------------------------------
Wrong Strategy: Punishing EITC Taxpayers
Mostly by congressional mandate, the IRS has taken a punitive
approach to EITC error reduction. Congress designates a portion of the
annual IRS budget specifically for EITC compliance. In fiscal year
2006, Congress allocated $167 million for EITC compliance, which the
IRS used on several initiatives that focus disproportionate enforcement
efforts on EITC taxpayers.
With this funding, Congress has instructed the IRS to heavily audit
EITC taxpayers. Under the EITC compliance initiative in fiscal year
2006, almost 517,617 audits were performed on tax returns where the
EITC was claimed. These audits constituted about 40 percent of all
audits performed on individual tax returns in fiscal year 2006.\57\ The
examination rate for EITC recipients was 2.25 percent, compared to 1
percent for all individual income tax returns, and 1.3 percent of all
individuals making over $100,000.\58\ Yet EITC audits yield only a
fraction of the total revenues recovered by IRS examinations. EITC
audits identified nearly $1.5 billion in excess payments, resulting in
a yield of only $2,895 per audit--the lowest rate of return for any
type of audit performed by the IRS.\59\
---------------------------------------------------------------------------
\57\ Internal Revenue Service, ``SOI Tax Stats--IRS Data Books.''
\58\ Ibid.
\59\ Ibid.
---------------------------------------------------------------------------
Aside from a disproportionately large number of audits, EITC
taxpayers are subject to a set of additional enforcement programs.
First, the IRS applies a unique type of examination--called
``recertification''--only to EITC taxpayers. The recertification
program requires taxpayers to ``recertify'' if they had the EITC denied
during an examination. This denial places recertification indicators on
a taxpayer's account until the taxpayer proves he or she is eligible to
receive the credit again. Once the taxpayer has provided sufficient
evidence, he or she is deemed ``recertified,'' and the taxpayer is once
again eligible for the EITC. The number of taxpayers subject to this
recertification tripled from 326,000 in September 1999 to almost 1
million by December 2003.\60\ No other tax credit, deduction, or
exemption requires such a high burden of proof.
---------------------------------------------------------------------------
\60\ Treasury Inspector General for Tax Administration, ``The
Earned Income Credit Recertification Program Continues to Experience
Problems,'' U.S. Department of Treasury, http://www.treas.gov/tigta/
auditreports/2005reports/200540039fr.html (accessed October 17, 2007).
---------------------------------------------------------------------------
The IRS has also put holds on millions of refunds to crack down on
EITC errors. Beginning in 2005, the Criminal Investigations Division of
the IRS began a program that postponed sending EITC refunds to people
suspected of fraud. The NTA's 2005 Report to Congress revealed that of
the 1.6 million taxpayers who had their refunds frozen, 75 percent were
EITC recipients.\61\ In 80 percent of the frozen refund cases brought
to the NTA last year, the IRS ended up paying full or partial refunds,
indicating a very large percentage of innocent filers had to face
hardships resulting from delayed refunds.
---------------------------------------------------------------------------
\61\ National Taxpayer Advocate Service, ``National Taxpayer
Advocate's 2005 Annual Report to Congress,'' Internal Revenue Service,
http://www.irs.gov/advocate/article/0,,id=152735,00.html (accessed
October 17, 2007).
---------------------------------------------------------------------------
Moreover, anecdotal evidence indicates the fear of punitive action
by the IRS discourages workers from claiming the EITC. Currently, one
in five workers who is eligible for the EITC does not claim it. Much of
the energy and funding the IRS devotes to EITC compliance programs
could be better spent by offering the helping hand of taxpayer services
rather than punitive enforcement.

Expanded Assistance Would Reduce Error Rates
The EITC error rate could be significantly reduced by increasing
the capacity of nonprofit or Government tax preparation services to
assist EITC-eligible taxpayers.\62\ EITC error rates do not distinguish
taxpayers who intentionally cheated on their returns from those who
simply made mistakes. EITC filings are complicated, requiring a 50-page
instruction manual, \63\ and therefore, many EITC over-claims are the
result of mistakes that could be prevented. In fact, as much as 50
percent of all tax returns with errors are thought to be unintentional
and have been linked to the complexity of EITC eligibility
requirements.\64\ These errors could be addressed principally by
simplifying tax laws and, when necessary, giving taxpayers help in
preparing what may unavoidably be a complicated application process.
---------------------------------------------------------------------------
\62\ Another effective approach is to simplify the credit. See Max
Sawicky, ``Where the Money Isn't,'' Economic Policy Institute, http://
www.epinet.org/content.cfm/issuebriefs_ib183.
\63\ See the IRS web site for the manual: http://www.irs.gov/pub/
irs-pdf/p596.pdf.
\64\ Max Sawicky, ``Where the Money Isn't,'' Economic Policy
Institute, http://www.epinet.org/content.cfm/issuebriefs_ib183
(accessed October 17, 2007).
---------------------------------------------------------------------------
Through its nationwide network of Taxpayer Assistance Centers
(TACs), the IRS makes tax return preparation services available for
low-income tax filers on a walk-in basis. Studies have found IRS-
prepared returns from these centers are substantially more accurate
than both self-prepared and commercially prepared returns.\65\ Audits
show that TAC-prepared EITC returns resulted in between $640-$1,300
less in erroneous payments than unprepared returns.\66\
---------------------------------------------------------------------------
\65\ Nina Olson, ``The IRS and the Tax Gap,'' Testimony before the
Committee on the Budget, U.S. House of Representatives, http://
www.house.gov/budget_democrats/hearings/2007/08Olsontestimony.pdf
(accessed October 16, 2007).
\66\ Ibid.
---------------------------------------------------------------------------
Yet the IRS has decided to reduce the quantity and quality of
services available at TACs. The number of tax returns TACs prepared
declined from 665,868 in fiscal year 2003 to a projected 406,612 in
fiscal year 2006.\67\ A 2006 report by TIGTA also found more than 10
percent of TACs (47 of 400) were critically understaffed.\68\ As the
sheer volume of returns processed by TACs has decreased, the range of
services they provide has also been narrowed.\69\ For example, in North
Dakota, where farming is a major industry, the TACs have been
instructed not to answer questions related to reporting farm income on
tax returns.\70\ As more evidence of the detrimental combination of
limited resources and unwise decisions at the IRS, employees at TACs
have also been reassigned to jobs unrelated to taxpayer assistance,
including being instructed to perform collection activities. This
change diverts additional resources away from services offered at
TACs.\71\
---------------------------------------------------------------------------
\67\ Nina Olson, ``Hearing on Internal Revenue Service Fiscal Year
2008 Budget Request'' Written Statement before the Subcommittee on
Financial Services and General Government Committee on Appropriations,
U.S. Senate, April 9, 2007.
\68\ Treasury Inspector General for Tax Administration, ``The Field
Assistance Office Has Taken Appropriate Actions to Plan for the 2006
Filing Season But Challenges Remain for the Taxpayer Assistance
Program.'' U.S. Department of Treasury, http://www.treas.gov/tigta/
auditreports/2006reports/200640067fr.pdf (accessed October 16, 2007).
\69\ National Taxpayer Advocate Service, ``National Taxpayer
Advocate's 2005 Annual Report to Congress,'' Internal Revenue Service.
http://www.irs.gov/advocate/article/0,,id=152735,00.html
\70\ Nina Olson, ``Hearing on Internal Revenue Service Fiscal Year
2008 Budget Request.''
\71\ National Taxpayer Advocate Service, ``National Taxpayer
Advocate's 2005 Annual Report to Congress,'' Internal Revenue Service.
http://www.irs.gov/advocate/article/0,,id=152735,00.html
---------------------------------------------------------------------------
Even more worrisome, the IRS has also been attempting to close
TACs. In 2005, the IRS announced plans to shut down 68 of the 400 TACs
nationwide. Before the IRS could carry out these plans, Congress passed
a bill prohibiting the IRS from closing the TACs until TIGTA could
evaluate the potential impact the closures would have on taxpayers. In
March 2006, TIGTA completed the report, which concluded the data
concerning TAC usage, on which the IRS based its plans for TAC
closures, was unreliable. IRS has so far delayed the closures.\72\
---------------------------------------------------------------------------
\72\ Treasury Inspector General for Tax Administration, ``The
Taxpayer Assistance Center Closure Plan Was Based on Inaccurate Data.''
U.S. Department of Treasury, http://www.treas.gov/tigta/auditreports/
2006reports/200640061fr.pdf (accessed October 16, 2006).
---------------------------------------------------------------------------
Dedicating additional resources to low-income services would have
the benefit of reducing EITC error rates, closing the tax gap, and
expanding needed services to more low-income taxpayers. At a minimum,
the IRS and Congress should dedicate sufficient resources to maintain
existing TACs. Even more funding would make the TAC network more
responsive to taxpayer needs, both by opening more centers around the
country and expanding the scope of services offered to taxpayers.

TAX ENFORCEMENT HAS TO BE A PRIORITY

The tax gap is an eminently solvable problem. If Congress were to
prioritize funding for IRS examination, collection, and tax preparation
services, it would drastically reduce the tax gap. The practical effect
of expanding these activities at the IRS would be to make the tax code
more equitable, and it would bring in additional revenue that could
responsibly finance new programs and services. If implemented in the
right way, closing the tax gap could also help to increase public
confidence in the tax system and the Federal Government.
Congress needs to enact sustained increases in the IRS budget
immediately and should make a commitment to continue to provide the IRS
with the extra resources that are so crucial to effective tax
enforcement.
This report has only highlighted a few sections of the IRS budget
that merit additional funding and reforms. However, it refrains from
specifying the dollar amounts needed to address these concerns and
recommends a thorough congressional review of the entire IRS budget. We
believe Congress, IRS administrators, and outside experts, upon whose
research and expertise this report mainly relies, should come together
to find common ground on what an appropriate funding increase would
look like, how quickly it should be implemented, and how it could be
sustained in coming years. Most experts, both inside the IRS and out,
prefer gradual increases in funding, as opposed to a sudden increase. A
sudden increase would likely overwhelm the IRS and be implemented
inefficiently and with too little oversight. Despite this
recommendation, we believe the IRS funding shortage is an urgent matter
and should be addressed as quickly as possible.
Ultimately, as with most fiscal issues, the root of the problem is
political. The case must be made that fears of an IRS run amok are, in
a way, a self-fulfilling prophecy. Attempting to curtail the powers of
the IRS through inadequate funding levels has had unintended
consequences--it has forced the IRS to institute policies and
enforcement practices detrimental to tax collection, taxpayers' rights,
and the progressivity of the tax code. So long as the IRS is
underfunded, it will be forced to enforce the tax code unfairly and
punitively. However, if the IRS is properly funded and administered
correctly, the Federal Government will have the opportunity to make
substantial progress in reducing the tax gap and to ensure the tax
system is as progressive in practice as it is in law.

STATEMENT OF SENATOR RICHARD J. DURBIN

Senator Durbin. The IRS administers the tax laws and
collects $2.4 trillion in revenue that fund over 96 percent of
Federal Government operations. With approximately 90,000
employees, the IRS is effectively the accounts receivable
department of the United States. Simply stated, the more
revenue the IRS collects, the more revenue Congress may spend
to either cut taxes, reduce the deficit, or advance important
programs. And conversely, the less that is collected, the less
revenue Congress has for these same purposes.
The IRS relies on three sources of funds it needs to
operate: appropriated funds, user fees, and reimbursables,
which are payments to the IRS which they receive from other
Federal agencies and State government for services. Nearly the
entire IRS budget, 97 percent of it, is derived from
appropriated funds.
For fiscal year 2009, the Bush administration is asking a
direct appropriation of $11.36 billion. It is an overall
increase of $469 million, or 4.3 percent, above fiscal year
2008.
In addition to the request for appropriated funds in fiscal
year 2009, the IRS also expects to realize nearly $108 million
from reimbursable programs and $177 million in user fees,
bringing total spending to $11.647 billion.
By breakdown of the nearly $11.4 billion appropriation
requested, $2.15 billion is for taxpayer services; $5.12
billion for enforcement; $3.86 billion for operations support;
$222.7 million for business system modernization; and $15.4
million for health insurance tax credit administration.
As the subcommittee evaluates the President's request, we
will take stock of the recommendations of the Oversight Board
and a lot of experts. I know the Oversight Board is tasked by
law to review and assess the annual budget request for the IRS
to make sure it supports the agency's annual and long-term
strategic plans.
Before we hear our panelists, I would like to mention just
a few of the issues we will be considering.
First, how does the proposed budget address the tax gap?
The great majority of Americans pay their fair share of taxes,
but there is still a significant tax gap. That is the
difference between what taxpayers are supposed to pay and what
they actually pay. I note that as part of its budget
submission, the IRS proposes 16 legislative reforms to recoup
$36 billion of the $290 billion net tax gap over the next 10
years.
Questions have been raised that such an approach is not
aggressive enough and amounts to a return of just slightly over
a penny on the dollar. I am anxious to hear perspectives from
our panel members.
Second, does this proposed budget achieve the proper
balance between enforcement and service? It is fundamental that
as enforcement initiatives to boost compliance are advanced,
resources for taxpayer services not be sacrificed. Taxpayer
service plays an integral role in facilitating voluntary
compliance.
Third, does the proposed budget promote critical
investments and ensure meaningful progress in information
technology enhancements? Let me just say that we know that the
IRS is facing, in addition to the regular tax return filing
season, the issuance of $100 billion in stimulus payments in
the form of rebate checks over the next few months. I
understand that as of March 28, the IRS received an estimated
1.4 million tax returns from individuals who filed them solely
to receive the rebates. I also understand the IRS has been
receiving an average of more than 63,000 calls per day above
the normal volume asking questions about the rebates.
Let me just say there are many topics of concern that we
will go into in the hearing, but in the interest of moving it
along, I am going to ask my colleague, Senator Allard from
Colorado, if he has an opening statement or a comment that he
would like to make.
Senator Allard. I do, Mr. Chairman, just brief comment, if
I might.
Senator Durbin. And when he is finished, we will proceed
with questions.

STATEMENT OF SENATOR WAYNE ALLARD

Senator Allard. Thank you, Mr. Chairman, for holding
today's hearing. I would like to thank our panelists for
joining us this afternoon.
For some time now, I have been following closely and
showing some concern on the IRS's ongoing audit process
involving the conservation easement donations in Colorado. I
understand Colorado is one of the top States in the number of
conservation efforts that it has undertaken, and it is an issue
of great importance to our State and many people in it and our
quality of life as far as our goals for open space. And I
support the IRS investigation and enforcement of legitimate
fraud in an effort to route out abuse of the conservation
easements tax credit program.
However, at times I wonder if the IRS has wrongly targeted
honest and hardworking Coloradans throughout their
investigation. I hope that they would refocus its investigation
and approach the issue in a fair and reasonable manner. There
are at least 96 audits involving donations to mainstream
conservation organizations that follow the letter and the
spirit of the law, I believe. Some of the 96 donations were
verified by legitimate conservation easements by the U.S.
Department of Agriculture and other Government agencies, I am
led to believe.
I would urge you to follow the model set by Colorado and
refocus on cases involving an appraiser or land trust who has
been disciplined or is currently under investigation by the
State. Hopefully, this approach will rightly target the actual
abuse, while releasing lawful easement donations from
multiyear, stressful, and unjustified audits.
So we will be following this particular area closely, Mr.
Chairman. My office has been contacted by a number of
organizations that work with these easements. And I would
encourage the Internal Revenue Service on their investigations
to use common sense in their approach, and I understand that
there are violations and there have been reasons why you have
had to look at some of these deals in Colorado. But on the
other hand, we hope that we do not get too broad and snare and
tie up innocent parties that perhaps did not violate the law.
So thank you very much, Mr. Chairman.
Senator Durbin. Thank you, Senator Allard.
[The statement follows:]

Prepared Statement of Senator Wayne Allard

Thank you, Mr. Chairman, for holding today's hearing. I would also
like to thank our panelists for joining us this afternoon.
For some time now I have been involved and concerned by the IRS'
ongoing audit process involving conservation easement donations in
Colorado. Colorado is a national leader in conservation, and it is an
issue of great importance to our state's economy and quality of life.
I support the IRS' investigation and enforcement of legitimate
fraud in an effort to root out abuse of the conservation easement tax
credit program. However, I feel the IRS has wrongly targeted honest and
hard working Coloradoans throughout their investigation.
I hope the IRS would refocus its investigation and approach the
issue in a fair and reasonable manner. There are at least 96 audits
involving donations to mainstream conservation organizations that
follow the letter and spirit of the law. Some of these 96 donations
were verified to be legitimate conservation easements by the U.S.
Department of Agriculture and other Government agencies.
The IRS should follow the model set by Colorado and refocus on
cases involving an appraiser or land trust who has been disciplined or
is currently under investigation by the State. This approach will
rightly target the actual abuse while releasing lawful easement donors
from multi-year, stressful, and unjustified audits.
If the IRS decides not to alter the ongoing audit process they and
the hardworking taxpayers can expect a long drawn-out battle. If they
stay on their current course, the IRS may be faced with over 200
appeals. This many appeals will take a lot of time and resources to
build a case for every easement in question. At what cost? The American
taxpayers are on the hook for this process that has been going on for
several years already and there is no end in sight.
There is a significant need for conservation easements in Colorado
and a few abuses should not end the charitable tax credit for everyone.
Thank you, Mr. Chairman.

Senator Durbin. Senator Brownback.

STATEMENT OF SENATOR SAM BROWNBACK

Senator Brownback. Thank you very much, Mr. Chairman. I
appreciate this.
Welcome, Commissioner. Glad to have you here, 4 weeks onto
the job. Yesterday, I guess, was your big day. The rest of us
were not celebrating yesterday. But delighted to have you here
and in that job and position.
I do want to make a point about yesterday, and I appreciate
the hearing, appreciate you being here on our budget. But I was
noting in my opening remarks that on the complexity of the Tax
Code, you have 800 different IRS tax forms--800. And I do not
know if any one person fills out all 800 of them. If they fill
out 100 of them or if they fill out 50, this is an unbelievably
complex Tax Code. That is your problem to enforce, but that is
our problem in the creation of it. And as I just pointed out I
think we are well overdue for tax simplification.
You are only 4 weeks into a job, but it is a 5-year
appointment, and I would hope that over the period of time that
you are Commissioner, that you really help us work on tax
simplification and that you become an advocate for it. I
mention that you note there is a part of your enforcement
problem that is involved the so-called tax gap. In your
congressional budget justification, you state that a major
contributing factor to the tax gap is that our tax system is so
complex that taxpayers cannot figure out what they owe. So a
big part of your enforcement problem is taxpayers not being
able to figure out which of the 800 forms they are supposed to
fill out. That is why I really think we have got to look at tax
simplification.
I have put forward a proposal, an optional flat tax, leave
the Code in place, but let people choose a simpler system. And
I do not expect you to put a proposal forward in the short term
while you are in, but I do hope during the time that you are
Commissioner you really help us wrestle with that problem. It
will make your job a lot simpler. I think it will be well
received across the country, that they want to see a simpler,
fairer, flatter system, and I would hope that we could learn in
your position to get a Code that is a lot easier for people to
understand and a lot easier to enforce too.
Thank you, Mr. Chairman.
[The statement follows:]

Prepared Statement of Senator Sam Brownback

Good afternoon. I want to thank you, Chairman Durbin, for your
leadership on this subcommittee. As always, I look forward to working
with you during this coming year as we make funding decisions and
provide oversight to the various agencies within this subcommittee's
jurisdiction.
Commissioner Shulman, thank you for appearing before our
subcommittee today. I understand you have only been with the IRS a few
weeks, so this is certainly a busy time for you to be taking the reins.
I'm pleased we have such a highly qualified person in the job and I
look forward to hearing the details of your fiscal year 2009 budget
request. Your budget justification says that the IRS ``represents the
face of the U.S. government to more American citizens than any other
agency.'' As surprising as it may seem in Washington, many Americans
only come into direct contact with the Federal Government on Tax Day. I
appreciate the work that you and your staff do to ensure taxpayer
compliance and to provide taxpayer assistance.
I must take this opportunity, though, to express my deep concerns
about the current tax system. Yesterday was a dark day for most
Americans as they rushed to file their tax returns. Every year,
taxpayers suffer under the burden of our complex and complicated tax
code, confused by over 800 different IRS tax forms, perplexed by
hundreds of pages of IRS instruction books, and nervous that they will
make a mistake trying to calculate how much of their money they owe the
Federal Government.
This current maze of tax regulations is so convoluted and complex
that many Americans believe it is not only incomprehensible, but
unfair. This confusion is one reason why almost two-thirds of all
taxpayers have given up on trying to figure out how to complete their
own tax returns and now spend even more of their hard-earned wages to
pay someone else to sort it all out.
I'm not blaming you for this state of affairs, Commissioner
Shulman. Lawmakers have created this labyrinthine maze and you and your
people are just working to administer it.
Looking at the President's budget request, I am pleased that it
includes a 7 percent increase for taxpayer enforcement to work toward
closing the so-called ``tax gap.'' Certainly, we must ensure that taxes
which are owed are collected. But your own congressional budget
justification states that a major contributing factor to the ``tax
gap'' is that our tax system is so complex that taxpayers cannot figure
out what they owe. I have been informed that the annual tax gap is
about $290 billion. I'm glad to see that the IRS is devoting resources
to closing this gap, but I believe that as long as we have this
convoluted and burdensome system, the gap between taxes owed and taxes
paid will remain substantial.
Again, Commissioner Shulman, this system is one that you have
inherited. I am in no way blaming you for this state of affairs. But I
have to take this opportunity to continue to push for an optional flat
Federal income tax. A flat tax would be a clear and fair way for
American families to figure out what they owe and put it on a one-page
form to the Federal Government. As long as a flat tax rate is
reasonable, it is a fairer tax than the current system because it taxes
all earned income at the same rate. Workers would not be punished for
working harder and earning more money, because each dollar that they
earn would be taxed at the same exact rate. This would be fairer,
simpler, easier to understand, and would produce more economic activity
and jobs.
Finally, I am pleased that Americans will soon be receiving
economic stimulus checks in the mail. I certainly support these tax
rebates to hard-working families. But the complexity of the tax system
was again evident when the IRS recently had to hold a ``Super
Saturday,'' opening hundreds of IRS offices to help folks file their
returns so that they could receive their economic stimulus payments. In
fact, your agency must spend over $2 billion every year just to help
people figure out how to complete their tax returns. Quite frankly,
that says it all.
So Commissioner Shulman, I thank you for your service and I look
forward to hearing your testimony this afternoon.
Thank you, Mr. Chairman.

STATEMENT OF IRS COMMISSIONER DOUGLAS SHULMAN

Senator Durbin. Thanks a lot.
Commissioner Shulman, the table is yours for a 5-minute
statement. All the rest will be put in the record. And welcome.
Mr. Shulman. Thank you, Chairman Durbin, Ranking Member
Brownback, Senator Allard. I appreciate the opportunity to
appear here before the subcommittee. As you have noted and
noticed, I am in my fourth week on the job. Let me reiterate to
this subcommittee that I look forward to working with you
during my entire tenure here to address the critical issues
related to the IRS.
I would also like to introduce the IRS's two Deputy
Commissioners, Richard Spires and Linda Stiff, who are here
with me today. They have really done an excellent job guiding
the agency through what, by any measure, are some tough times:
this filing season, the late enactment of the alternative
minimum tax (AMT) legislation, and then the stimulus package. I
am lucky to have them on the team. I also wanted to make sure
we are responsive to any questions and given that I am 4 weeks
into this, I wanted to make sure they were here with me today.
This morning I will touch quickly on the filing season and
our proposed budget, but I will also try to give you a little
sense of my approach to the job.
Yesterday we completed what looks like a successful filing
season. Electronic filers were up 10 percent as of yesterday.
The number of returns prepared by our volunteer income tax
assistance and tax counseling for the elderly centers
throughout the country were up 26 percent. The usage of our
Free File program, which allows 70 percent of all Americans to
prepare and file their returns electronically, was up 20
percent this year. And visits to IRS.gov were up 21 percent.
We also, as I mentioned, are having a successful filing
season despite some pressures, including late enactment of the
AMT and, as you mentioned, Mr. Chairman, the stimulus program
which was put on top of filing season.
Regarding the stimulus program, we have done an extensive
outreach program to make sure Americans know that all they need
to do is file a tax return in order to get a stimulus payment.
We put particular emphasis on informing Americans who normally
would not file a return, but are eligible for stimulus
payments, that they need to file a return this year. These are
people who receive Social Security, receive veterans benefits,
low income workers.
I also want to urge this subcommittee to support full
funding of the IRS's 2009 budget request. This budget will
allow us to continue a strong emphasis on taxpayer service, but
also to continue to build on our good record of enforcement
programs to target noncompliance.
During my confirmation process, I was asked by the Senate
Finance Committee whether I thought it was most important to
focus on service or to focus on enforcement. And my answer
there--and I fervently believe this--is that for the IRS to
achieve its compliance objectives, we have to continue to focus
on both service and enforcement. Said another way, I think we
need to do everything we can to make it as seamless and easy as
possible for taxpayers who want to pay the right amount of
taxes to navigate our organization, get their questions
answered, pay their taxes, and get on their way. But for anyone
who understands his or her tax obligation and is trying to
evade that obligation, we need to have aggressive enforcement
programs.
Another area of focus for me will be technology
modernization. The evolution of technology has changed the way
that every major organization, private and public, goes about
doing its work. As we adapt to this changing world, my goal is
relatively simple. It is to get the right information into the
hands of the right people at the right time, whether that is
getting information into the hands of taxpayers or our people
trying to do service or enforcement.
The other area I would mention quickly is our need to
continue to focus on leadership and workforce. The IRS, like
other Government agencies, is going to have a lot of people
retiring in the next couple of years. There is competition for
talent, and we are going to need to keep focusing on building
our next generation of leaders and developing our workforce.

PREPARED STATEMENT

So let me thank you again, Mr. Chairman, for the
opportunity to appear this morning. In my short tenure, I have
found the people at the IRS to be extremely professional,
hardworking, and dedicated to the American people every day. I
am committed to work every day to provide the level of service
that taxpayers deserve, as well as to rigorously enforce the
tax laws. We obviously need resources to execute this mission,
and I encourage this subcommittee to fully fund the
administration's 2009 proposed budget. Thank you, and I am
happy to answer questions.
Senator Durbin. Thanks, Mr. Commissioner.
[The statement follows:]

Prepared Statement of Douglas Shulman

INTRODUCTION

Chairman Durbin, Ranking Member Brownback, and members of the
subcommittee, thank you for the opportunity to appear today. This is my
third hearing as the IRS Commissioner and I look forward to working
with the Members of this subcommittee in the future as we address
issues related to the IRS.
As I settle in to my new role, it becomes clearer to me each day
what a privilege it is to be the Commissioner of the IRS. The IRS and
its employees represent the face of United States Government to more
American citizens than any other Government agency. We administer
America's tax laws and collect over 96 percent of the revenues that
fund the Federal Government each year.
My most recent experience has been as the Vice Chairman of the
Financial Industry Regulatory Authority (FINRA), formerly the NASD. In
2007, NASD consolidated with the member regulation, enforcement, and
arbitration functions of the New York Stock Exchange to form FINRA.
Based on my previous experience, I believe that leaders of large
organizations--public and private--always must be focused on ensuring
that resources are aligned with strategic priorities. It is incredibly
important that there be a balance of resources between day-to-day
execution and investments for the longer term. In my first 4 weeks, I
have been working with the senior executive team of the IRS to
understand how resource allocation decisions have been made. The
subcommittee can expect ongoing dialog and personal engagement from me
on these issues.

2008 FILING SEASON

The biggest challenge the IRS faced at the end of 2007, as it
approached the 2008 filing season, was the uncertain status of
legislation to address the situation of an additional 21 million
taxpayers who otherwise would have become subject to the alternative
minimum tax (AMT).
On October 30, 2007, Chairman Baucus, Ranking Member Grassley of
the Senate Finance Committee House and their counterparts on the House
Ways and Means Committee, sent a letter assuring the IRS that Congress
intended to enact AMT relief (the AMT patch) in a manner acceptable to
the Senate, the House of Representatives, and the President. I am told
that this letter was very helpful because it allowed the IRS to move
forward on certain planning and design aspects of implementing the AMT
relief legislation, shortening the implementation process by a number
of weeks.
However, the IRS indicated at the time that its key systems could
accommodate only one programming option without introducing excessive
risk to the filing season. As a result, the IRS was able to proceed
only so far without actual legislation being enacted. When the
President signed the AMT relief law on December 26, 2007, the IRS
immediately began the detailed reprogramming of systems to accommodate
the new law. IRS employees worked diligently to modify systems to
implement the changes in a very short time period. My thanks go out to
all of those dedicated employees who worked almost around the clock to
enable us to implement this AMT relief legislation in record time.
Given their efforts, we were able to begin the filing season on
schedule for most taxpayers. However, the processing of returns filed
by approximately 13.5 million taxpayers that included one of five forms
associated with the AMT legislation was delayed. These taxpayers had to
wait until February 11, 2008, before their returns could be processed.
The other challenge facing us this filing season is the
implementation of the economic stimulus package enacted in early
February, specifically the planning for the distribution of the
stimulus payments to eligible recipients throughout the country this
spring. To deliver the 2008 stimulus payments, we have been programming
our systems to calculate the appropriate amount for each eligible
taxpayer based on their 2007 returns so that the payments can be
distributed, through Treasury's Financial Management Service, by direct
deposit or by paper check, based on the preferences expressed on the
taxpayer's return.
We will begin immediately after the close of the filing season to
distribute those payments with the expectation that the first payments
will be sent electronically starting in the first week of May and with
the first paper checks being mailed shortly thereafter. We have
established a distribution schedule that is published on the IRS
website on a page dedicated to informing citizens about the economic
stimulus payments.
However, there are millions of individuals who may be eligible for
economic stimulus payments, but who typically do not have an income tax
filing requirement. This group includes retirees or those who have
minimal income and are thus not required to file. But in order to
receive the 2008 stimulus payment, the recipient must file a tax return
for 2007. To reach these recipients and educate them requires an
extensive outreach program that includes the mailing of information
packets and IRS coordinating with the Social Security Administration
and Department of Veterans Affairs, along with private groups such as
the AARP.
Despite the challenges presented by the late enactment of the AMT
patch and the implementation of the economic stimulus payments, I am
proud to report that thus far the filing season has gone very well.
Allow me first to give an update on some of the numbers we are looking
at as we close out the filing season.
Numbers Thus Far
We expect to process nearly 140 million individual tax returns in
2008, and we anticipate continued growth in the number of those that
are e-filed. In the 2007 filing season, almost 60 percent of all income
tax returns were e-filed. We fully expect to exceed that number this
year. As of April 5, we have received over 67 million tax returns
electronically, an increase of 10 percent compared to the number of
returns that were e-filed during the same period last year.
This increase in e-filing is being driven by people preparing their
own returns using their personal computers. The total number of self-
prepared returns that are e-filed is up by 18.2 percent compared to the
number of self-prepared returns filed during the same period a year
ago. Over 19 million returns have been e-filed by people from their
personal computers, up from just over 17 million for the same period a
year ago.
Overall, nearly 70 percent of the returns filed through April 5
have been e-filed. Encouraging e-filing is good for both the taxpayer
and for the IRS. Taxpayers who use e-file can generally have their tax
refund deposited directly into their bank account in 2 weeks or less.
That is about half the time it takes us to process a paper return. For
the IRS, the error-reject rate for e-filed returns is significantly
lower than that for paper returns.
More people are choosing to have their tax refunds deposited
directly into their bank account than ever before. As of April 5, we
have directly deposited over 53.6 million refunds, or over 71 percent
of all refunds issued this tax filing season.
People are also visiting our web site--IRS.gov--in record numbers.
We have recorded over 132 million visits to our site this year, up over
21 percent from 109 million for the same period a year ago. The
millions of taxpayers that have visited IRS.gov have benefited from
many of the services that are available through the IRS.gov web site.
The web site:
--Allows taxpayers to obtain information on the economic stimulus
package including determining the payment amount they can
expect to receive and learning when they can expect their
payment based on their Social Security Number (SSN);
--Assists taxpayers in determining whether they qualify for the
Earned Income Tax Credit (EITC);
--Assists taxpayers in determining whether they are subject to the
Alternative Minimum Tax (AMT);
--Allows more than 70 percent of taxpayers the option to prepare and
file their tax returns at no cost through the Free File
program. This includes giving a free option for those taxpayers
who normally do not file a tax return, but are required to this
year in order to receive their stimulus payment;
--Allows taxpayers who are expecting refunds to track the status via
the ``Where's My Refund?'' feature; and
--Allows taxpayers to calculate the amount of their deduction for
State and local sales taxes.
We have issued 75.1 million refunds as of April 5, for a total of
$183 billion. The average refund thus far is $2,436. In addition,
nearly 28 million taxpayers have tracked their refund on IRS.gov, up
nearly 20 percent over last year.
As of March 29, our Taxpayer Assistance Centers (TACs) are
reporting over 2.1 million taxpayers assisted. Our telephone assistors
have answered over 13 million calls, and over 17 million callers
received automated services.
Free File
Over 3.6 million people have utilized Free File as of April 5,
2008, an increase of 19.7 percent compared to the number of taxpayers
that used Free File during the same period a year ago. This year anyone
with adjusted gross income of $54,000 or less is eligible for Free
File, which includes 97 million taxpayers. The number of Free File
returns compared to the prior year has been steadily increasing, and we
expect to meet or exceed 2007 totals by the end of the filing season.
One reason for this increase is that we have committed additional
resources to promote the Free File program.
VITA/TCE Sites and Other Community Partnerships
The use of tax return preparation alternatives, such as volunteer
assistance at Volunteer Income Tax Assistance (VITA) sites and Tax
Counseling for the Elderly sites (TCEs), has steadily increased over
the years. In 2007, over 2.6 million returns were prepared by
volunteers. As of April 5, 2008, volunteer return preparation is up
over 26 percent compared to the number of volunteer-prepared returns
filed during the same period a year ago. This is reflective of
continuing growth in existing community coalitions and partnerships.
We also have made a concerted effort to expand outreach to
taxpayers, particularly those taxpayers who may be eligible for the
EITC. For example, we sponsored again this year EITC Awareness Day on
January 31, 2008, in an effort to partner with our community coalitions
and partnerships to reach as many EITC-eligible taxpayers as possible
and urge them to claim the credit. Over 125 coalitions and partners
hosted local news conferences and issued more than 100 press releases
highlighting EITC Awareness Day this year.

A COMMITMENT TO SERVICE, ENFORCEMENT AND MODERNIZATION

I understand that in fiscal year 2007, the IRS continued making
improvements in our service and enforcement programs as well as having
significant successes in our IT modernization program. A few highlights
of the IRS' fiscal year 2007 accomplishments include:
--The IRS customer assistance call centers answered 33.2 million
assistor telephone calls and 21.1 million automated calls. We
maintained an 82.1-percent level of service on the telephone
with an accuracy rate of 91.2 percent on tax law questions.
--Outreach and educational services were enhanced through
partnerships between the IRS and public organizations. Through
its 11,922 VITA and TCE sites, the IRS provided free tax
assistance to the elderly, disabled, and limited English
proficient individuals and families. Over 76,000 volunteers
filed 2.63 million returns for these individuals. Additionally,
the IRS established 6 new tax clinics in rural areas to help
low-income taxpayers meet their tax obligations.
--Enforcement revenue has risen from $33.8 billion in fiscal year
2001 to $59.2 billion, an increase of 75 percent. These numbers
do not include the deterrent effect that an increased
enforcement presence has on voluntary compliance.
--Both the levels of individual returns examined and coverage rates
have risen substantially. The IRS conducted nearly 1.4 million
examinations of individual tax returns in fiscal year 2007, an
8-percent increase over fiscal year 2006. This level of
examinations is over three-quarters more than were conducted in
fiscal year 2001, and reflects a steady and sustained increase
since that time. Similarly, the audit-coverage rate has risen
from 0.6 percent in fiscal year 2001 to 1 percent in fiscal
year 2007. This increase was achieved without a significant
increase in resources as compared to the previous fiscal year.
--The Customer Accounts Data Engine (CADE) Release 3.2 was delivered
on time (January 14, 2008) for this filing season and is doing
well in production. As, of April 11, CADE had processed 24.98
million returns, which is more than 25 percent of all
individual returns filed to date for this year. CADE also has
issued almost $38 billion in tax refunds.
--Modernized e-File (MeF) is the IRS designated e-File platform
(electronic filing system) for the future and provides e-Filing
capability for large corporations, small businesses,
partnerships, and non-profit organizations. As of April 5, MeF
has accepted 1.82 million corporate, partnership, and tax
exempt tax returns, a 45-percent increase from this same period
a year ago. MeF Release 5 went into production as planned in
January 2008 and provides the ability to file electronically
Form 1120F (tax returns for foreign corporations) and Form 990N
(so-called electronic postcard for small tax-exempt
organizations to meet their filing requirement).

THE ADMINISTRATION'S FISCAL YEAR 2009 BUDGET FUNDS TAXPAYER SERVICE AND
ENFORCEMENT

The fiscal year 2009 budget request funds activities that promote
better tax administration and compliance with the tax laws. The fiscal
year 2009 budget request for the enforcement program is $7,487,209,000,
an increase of $489,983,000, or 7 percent, over the fiscal year 2008
enacted level. The Administration proposes to include these enforcement
increases as a Budget Enforcement Act program integrity cap adjustment.
The enforcement program is funded from the Enforcement appropriation
and part of the IRS Operations Support appropriation.

Budget Request
For fiscal year 2009, the President is requesting a total of
$11,361,509,000 for IRS activities. This amount is a $469,125,000
increase, or 4.3 percent, over the fiscal year 2008 enacted level.
The overall IRS budget is broken down into the following five
appropriations:
--Taxpayer Services.--The fiscal year 2009 requested level for this
area is $2,150,000,000. This is the same as the fiscal year
2008 enacted level. The Operations Support account provides an
additional $1.5 billion to support taxpayer service activities.
--Enforcement.--The fiscal year 2009 request is $5,117,267,000. This
level is an increase of 7.1 percent from the fiscal year 2008
enacted level. As mentioned earlier, the Operations Support
budget provides an additional $2.4 billion to support
enforcement activities.
--Operations Support.--The fiscal year 2009 request is
$3,856,172,000. This level is an increase of 4.8 percent from
the fiscal year 2008 enacted level.
--Business Systems Modernization.--The fiscal year 2009 request is
$222,664,000. This level is a reduction of 16.6 percent from
the fiscal year 2008 enacted level. This appropriation funds
the planning and capital asset acquisition of information
technology to modernize the IRS business systems, including
labor and related contractual costs.
--Health Insurance Tax Credit Tax Administration.--The fiscal year
2009 request for this program is $15,406,000. This is an
increase of 1.1 percent from the fiscal year 2008 enacted
level. This appropriation funds costs to administer a
refundable tax credit for health insurance to qualified
individuals, which was enacted as part of the Trade Adjustment
Assistance Reform Act of 2002.
The justification for the requests in each of these areas is
discussed in detail below.

Adjustments from Fiscal Year 2008 Levels To Help Improve Compliance
The IRS total requested funding increase for fiscal year 2009 is
$469,125,000. This increase will go to improving compliance. These
investments fund increased front-line enforcement efforts, enhanced
research, and implementation of legislative proposals to help narrow
the tax gap. By fiscal year 2011, these investments are projected to
increase annual enforcement revenue by $2 billion. In addition, the
legislative proposals included in the fiscal year 2009 budget to
improve tax compliance are estimated to generate $36 billion over the
next ten years, if enacted.
Specific increases to improve compliance include:
--Reduce the Tax Gap for Small Business and the Self Employed
(+$168,498,000/+1,608 FTE).--This enforcement initiative will
increase enforcement efforts to improve compliance among small
business and self-employed taxpayers by: increasing audits of
high-income returns, increasing audits involving flow-through
entities, implementing voluntary tip agreements, increasing
document-matching audits, and collecting unpaid taxes from
filed and non-filed tax returns. This request will generate
$981 million in additional annual enforcement revenue once new
hires reach full potential in fiscal year 2011.
--Reduce the Tax Gap for Large Businesses (+$69,488,000/+519 FTE).--
This enforcement initiative will increase examination coverage
of large and mid-size corporations, including multi-national
businesses, foreign residents, and smaller corporations with
significant international activity. It also will enable the IRS
to use existing systems further to capture other electronic
data through scanning and imaging. The initiative will allow
the IRS to address risks arising from the rapid increase in
globalization, and the related increase in foreign business
activity and multi-national transactions where the potential
for non-compliance is significant. Funding of this request will
generate $544 million in additional annual enforcement revenue
once the new hires reach full potential in fiscal year 2011.
--Improve Tax Gap Estimates, Measurement, and Detection of Non-
Compliance (+$51,058,000/+393 FTE).--This enforcement
initiative will support and expand ongoing research studies,
including the National Research Program, of filing, payment,
and reporting compliance to provide a comprehensive picture of
the overall taxpayer compliance level. Research allows the IRS
to target better specific areas of noncompliance, improve
voluntary compliance, and allocate resources more effectively.
Improved research data will be used to refine workload
selection models, reducing audits of compliant taxpayers.
--Increase Reporting Compliance of U.S. Taxpayers with Offshore
Activity (+$13,697,000/+124 FTE).--This enforcement initiative
will address domestic taxpayer offshore activities. Abusive tax
schemes, under-reporting of flow-through income, and certain
high-income individuals are prime channels or candidates for
tax evasion. This initiative will focus on uncovering offshore
credit cards, disguised corporate ownership, and brokering
activities in order to identify individual taxpayers who are
involved in offshore arrangements that facilitate
noncompliance. Funding of this request will generate $102
million in additional annual enforcement revenue once the new
hires reach full potential in fiscal year 2011.
--Expand Document Matching (+$35,060,000/+413 FTE).--This enforcement
initiative will increase coverage within the Automated
Underreporter (AUR) program. This program matches third-party
information returns (e.g., Form W-2 and Form 1099 income
reports) against income claimed on tax returns. When potential
underreporting is discovered taxpayers are contacted to resolve
the issue. This request will produce $359 million in additional
annual enforcement revenue once the new hires reach full
potential in fiscal year 2011.
--Implement Legislative Proposals To Improve Compliance
(+$23,045,000/0 FTE).--While the IRS continues to address
compliance by improving customer service and using traditional
methods of enforcement, the fiscal year 2009 budget also
includes legislative proposals that would provide additional
enforcement tools to improve compliance. It is estimated that
these proposals, if enacted, will generate $36 billion in
revenue over 10 years (see the Treasury Blue Book, available on
the Treasury Department web site, for more information). The
proposals would expand information reporting, improve
compliance by businesses, strengthen tax administration, and
expand penalties. This enforcement initiative includes funding
for purchasing software and making modifications to the IRS IT
systems necessary to implement the proposals. The specific
legislative proposals are discussed below.

Specific Legislative Proposals
The Administration's fiscal year 2009 budget includes a number of
legislative proposals intended to improve tax compliance while
minimizing the burden on compliant taxpayers as much as possible. These
include:
--Expand information reporting.--Compliance with the tax laws is
highest when payments are subject to information reporting to
the IRS. Specific information reporting proposals would:
--Require information reporting on payments to corporations;
--Require basis reporting on security sales;
--Require information reporting on merchant card payment
reimbursements;
--Require a certified Taxpayer Identification Number (TIN) from
contractors;
--Require increased information reporting on certain Government
payments;
--Increase information return penalties; and
--Improve the foreign trust reporting penalty.
--Improve compliance by businesses.--Improving compliance by
businesses of all sizes is important. Specific proposals to
improve compliance by businesses would:
--Require electronic filing by certain large organizations; and
--Implement standards clarifying when employee leasing companies
can be held liable for their clients' Federal employment
taxes.
--Strengthen tax administration.--The IRS has taken a number of steps
under existing law to improve compliance. These efforts would
be enhanced by specific tax administration proposals that
would:
--Expand IRS access to information in the National Directory of New
Hires for tax administration purposes;
--Permit disclosure of prison tax scams;
--Make repeated willful failure to file a tax return a felony;
--Facilitate tax compliance with local jurisdictions;
--Extend statutes of limitations where State tax adjustments affect
Federal tax liability; and
--Improve the investigative disclosure statute.
--Expand penalties.--Penalties play an important role in discouraging
intentional non-compliance. A specific proposal to expand
penalties would impose a penalty on failure to comply with
electronic filing requirements.

Improve Tax Administration and Other Miscellaneous Proposals
The Administration has put forward additional proposals relating to
IRS administrative reforms. Five of these proposals are highlighted
below:
--The first proposal modifies employee infractions subject to
mandatory termination and permits a broader range of available
penalties. It strengthens taxpayer privacy while reducing
employee anxiety resulting from unduly harsh discipline or
unfounded allegations.
--The second proposal allows the IRS to terminate installment
agreements when taxpayers fail to make timely tax deposits and
file tax returns on current liabilities.
--The third proposal eliminates the requirement that the IRS Chief
Counsel provide an opinion for any accepted offer-in-compromise
of unpaid tax (including interest and penalties) equal to or
exceeding $50,000. This proposal requires that the Secretary of
the Treasury establish standards to determine when an opinion
is appropriate.
--The fourth proposal extends the IRS authority to use the proceeds
received from undercover operations through December 31, 2012.
The IRS was previously authorized to use proceeds it received
from undercover operations to offset necessary and reasonable
expenses incurred in such operations. This authority expired on
December 31, 2007.
--The fifth proposal equalizes penalty standards between tax return
preparers and taxpayers, reducing unnecessary conflicts of
interest between them. The standard applicable to tax return
preparers for undisclosed positions would be ``substantial
authority'' but for certain reportable transactions with a
significant purpose of tax avoidance, the existing standard
would persist (i.e., the preparer should have a reasonable
belief that the position, more likely than not, would be
sustained on the merits).

CONCLUSION

Thank you again, Mr. Chairman, for the opportunity to appear this
morning and update the subcommittee on the filing season and the fiscal
year 2009 proposed IRS budget. In my short tenure, I have found IRS
employees to be professional, hardworking, and dedicated.
I am committed to working hard everyday to provide taxpayers the
high level of service they deserve and to pursue enforcement actions
against those unwilling to meet their tax obligations.
We need resources to execute against our plan, and I hope this
subcommittee will support the full funding of the Administration's
fiscal year 2009 proposed budget.
I also urge this subcommittee to support the enactment of the
legislative proposals included in the budget to improve compliance.
Collectively, they will generate more $36 billion over the next 10
years if enacted.
I will be happy to respond to any questions.

CONTRACTORS

Senator Durbin. In preparation for this hearing, I am
hoping that you have read Parade magazine in last Sunday's
newspaper because my first question relates to enforcement and
an article in that Parade magazine. It was under their so-
called intelligence report entitled ``Are You Paying for
Corporate Fat Cats?'' 61 percent of U.S. corporations paid no
taxes, including 39 percent of large companies, according to
this article. They went on to describe one company in
particular, which I would like to ask you about.
It turns out that one company employs one-third of our
private contractors in Iraq. That company is Kellogg, Brown &
Root (KBR), a former subsidiary of Halliburton. The company has
54,000 people working in Iraq. Of these, over 21,000, including
10,500 Americans, are considered Cayman Island hires. What has
happened is that this company has created some subsidiaries or
offices in the Cayman Islands, and by listing these employees
paid by our Government as Cayman Island hires, they avoid
paying the Medicare and Social Security taxes that all other
American workers pay.
So here we have Federal taxpayer dollars, emergency
appropriations adding to our deficit to fund the private
contractors who are being channeled through the Cayman Islands
so that they will not have to pay taxes into the United States
for Medicare and for Social Security. I want to know if the IRS
is looking into it, and I want to know what more we can do to
try to stop this.
Mr. Shulman. Thank you for the question. Let me just state
before I start, I obviously cannot speak about any specific
taxpayers or any tax matters because of privacy laws. Let me
just react on a general level, and then we would be happy to
follow up.
We are well aware and focused on the issue of independent
contractors. Employment taxes are one of our responsibilities.
Any issue with employment taxes is very fact-specific. We have
a 20-point factor test that gets into the specific facts of a
case. It is difficult for corporations and us to work through
these issues, but we have a number of investigations ongoing in
relation to employment taxes and subcontractors, and we view
that as part of our job.
I would also mention something I have spoken about publicly
is that one of the challenges of our next 5 years is going to
be grappling with the global economy, globalization,
international tax issues. I have sat down with our team that
focuses on these areas. I am quite familiar with these issues
from my experience as a securities regulator and the global
flow of capital. So issues around cross-border trade, employees
located in multiple countries, paying the proper amount of U.S.
taxes is something that is going to get focus from me.
Senator Durbin. And I might say that it is not just KBR. A
2004 study by the Government Accountability Office found that
24 of the largest Federal contractors, contractors we pay by
our Government, use the Cayman Islands to shave their tax
bills. This bothers me that American companies doing the right
thing are being penalized and other companies are profiting
simply because they are creating these phony tax havens like
the Cayman Islands.

PRIVATE DEBT COLLECTION

Now let us talk for a minute about an issue that you have
been asked a lot about, and that is this private collection
agency for the IRS. This has been in place for a while now,
these private debt collectors. There are several of them across
the country, and they are not doing a very good job. If you
take a look at our own IRS employees collecting taxes, the
return on investment for taxpayers is 13 to 1. For the private
collectors, it is only 3 to 1. To date, after spending $71
million on startup and ongoing maintenance costs through the
end of fiscal year 2007, the IRS private tax collection program
has lost us $50 million.
Why should we continue this?
Mr. Shulman. This is an issue that I understand quite well
has a lot of attention, and there are people who support the
program and detractors from the program. I have committed to
get my arms around this. As you can imagine, there are a
variety of programs, most programs, that I still need some time
to get up to speed on, and I am going to spend time getting up
to speed on this.
What I will tell you is I know the program has been
authorized in the past by Congress. I have been told by the
people at the IRS that they are working this program to the
best of their abilities. We are very focused on the protection
of taxpayer rights and data privacy. This year the program will
do better than break even, and so there are variety of sunk
costs that have not been recovered, but it is now at a point
where it actually is bringing dollars into the Federal coffer.
So on this one, I would say I plan on looking at it closely
and studying the issue and would be happy and like to have
further conversations.
Senator Durbin. Thank you.

FORMS AND COMPLEXITY

Senator Brownback.
Senator Brownback. Thank you, Mr. Chairman.
Do you really need 800 different forms?
Mr. Shulman. As we have had a chance to discuss, clearly
the tax law is complex. Clearly, that adds burden on the
American people and makes our job difficult. I cannot speak to
all the specific forms 4 weeks into the job.
I will tell you a goal of mine is to create as much clarity
as we can within the context of the law to the American people,
make it as easy as possible, given the complexity of the law,
for the American people to comply with their tax obligation.
Senator Brownback. I hope you will look at that. That is
just mind-boggling to me.
I was just looking at the numbers that were just handed to
me. The IRS spends $2 billion on taxpayer service helping
people figure out their taxes. It is estimated that taxpayers
spend $150 billion to figure out their taxes, either hiring
third parties or in time taken away from other activities. $150
billion that people are spending to figure out their taxes.
That is amazingly high.
Do you have any sense of how that compares to other
countries in the developed world?
Mr. Shulman. I do not, Senator.
Senator Brownback. You have now got a growing set of
countries that have moved to a flat tax. I think there is
something like 16 that have gone to that system. I think it
would be an interesting question to look at, what those
countries spend in tax preparation time and money versus other
places.

STIMULUS PAYMENTS

Are you going to have any difficulty getting the economic
stimulus checks out on time?
Mr. Shulman. Since I have started the job, obviously this
is something I am very focused on. Three times a week I have
been in meetings with our staff. Everything looks like it is on
track to have direct deposit checks go out the first week in
May--start going out--and paper checks start going out shortly
thereafter. So from everything I know, being in here 4 weeks,
things look like they are on track to get the stimulus payments
out on time.
Senator Brownback. And to hit the dates?
Mr. Shulman. Hit the targets that are on our web site that
we have promised all along.
Senator Brownback. You have said that you have spent a lot
of time getting people signed up to file tax forms so they
could get their stimulus check. Did you get a number of new
registrants filing tax returns? I believe you had a special
super Saturday, March 29, to do this?
Mr. Shulman. We did something I am quite proud of, and it
was a great way to start my first Saturday on the job. I went
out to a retired veterans home and worked with our team. And we
had 700 sites around the country open that Saturday, staffed
with about one-half IRS and one-half volunteers. That day we
had over 50,000 come into that combined group of sites.
We are tracking very closely people who we think are only
filing for stimulus payments. Yesterday we just got all the
2007 returns. We are still processing paper returns. Later this
month, we are actually going to look at the number of returns,
try to figure out who we think is eligible, who has not filed
yet, and then do another round of outreach. Our plan is
actually to enlist both the administration and Members of
Congress, if we see States where it looks like a lot of people
have not availed themselves of the stimulus payments. We are
going to be doing outreach and we will try to bring you in, as
well, as partners.
Senator Brownback. I do not know if many Members of
Congress want to be very closely associated with the IRS, but
maybe if it is passing checks out, that would change it.
Do you have any idea of numbers of what you are talking
about here? I see your activities, but do you have any idea on
numbers?
Mr. Shulman. We do not. It is very hard to estimate how
many people are eligible. We are going to have a much better
sense at the end of this month, and I can assure you our team
will work on it. I have been pushing on this, and we are going
to, hopefully by the end of the month, have a real sense of how
many have come in and how many we think might still be
eligible, based on Social Security rolls and other sources, and
go out to more people.
Senator Brownback. Will you be publishing, putting those
numbers forth publicly?
Mr. Shulman. We would be happy to share them with you.
Senator Brownback. I think it would be good just because we
are all very concerned about the economy, how many people are
going to get checks, or an estimate?
Mr. Shulman. Well, I am sorry. I might have misspoken. I
was talking about the people who normally do not file who are
eligible. We do have estimates of the broad numbers. We
anticipate sending out over $100 billion in stimulus payments
this year to over 130 million taxpayers. That is the gross
number. We have not pinpointed the people who may be eligible
who otherwise would not file a tax return, which is a group
that we are very focused on providing service to.
Senator Brownback. My time is up, but that is the number I
was asking for, the number of people that you think would
qualify but are not in the system getting or are not signed up,
in your estimation who that would be? I would like to see if we
could get that number.
Mr. Shulman. Absolutely.
Senator Durbin. Senator Allard.

CONSERVATION EASEMENTS

Senator Allard. Thank you, Mr. Chairman.
I want to pursue my opening comments on the conservation
easements of Colorado. It is my understanding in mid-November,
the Internal Revenue Service began making settlement offers to
a significant number of conservation easement donors under
audit in Colorado. According to your agency, the settlements
were only offered in those cases where the sole issue between
the owner and the Internal Revenue Service was the valuation.
The offers generally fell into a bucket where the IRS stated
only 30 percent or 60 percent or 75 percent of the original
value of the charitable donation was allowed.
And the question I have is, what were the criteria that you
used to place different taxpayers into these various buckets,
and did the IRS indicate in writing to the donor how and why
you arrived at your decision, and if not, why?
Mr. Shulman. Senator, I understand this issue. I had the
opportunity to speak with your colleague from Colorado, Senator
Salazar, at length about this issue. And what I shared with him
I will share with you. I have also done some research on this,
knowing that this would be of issue to you.
My belief is that our job is to implement the tax laws in a
way that achieves the intent of the policy that Congress puts
forward, and so I share your goal that you talked about. The
goal for quality of life and open space in Colorado is what we
should be pursuing, which means we should make sure that we do
not unduly restrict people trying to do the right thing and
donate open space.
I have been briefed on this issue, and I will tell you what
I know. And I would like to come back with Steve Miller for
anything I do not know, and meet with you and continue to
pursue this.
Since last fall, there has been some good progress, and 170
offers have been made. The numbers I was given were higher than
the ones you just discussed, and so I have to dig into it more.
But I understand that, in general, these 170 offers across the
board--the general number was in the 70 percent range of the
tax deduction that people had looked for. So it was a little
higher.
Senator Allard. I just want to clarify for the record. You
determined that it was overvalued by 70 percent. Is that what
you said?
Mr. Shulman. No, that people were offered 70 percent of
their original claim. So if they claimed $100, they were----
Senator Allard. You said, well, we will give you $70.
Mr. Shulman. $70--and that is in aggregate of these
offers--is the number as I understand.
Senator Allard. Got you.
Mr. Shulman. I also know that you requested that we be
liberal in granting extensions of time for people to analyze
offers and come back, and the Service was responsive to that.
And I have been told that 20 to 25 more offers will go out
in the next several weeks.
These offers were the valuation cases. There are a number
of much more complex cases that were put behind the valuation
cases to move forward. They are very fact-intensive. We are
coordinating with the State of Colorado on all of those. So
there is some time around coordination and these will take some
more time.
Let me also tell you that the people running this program
have told me they understand the frustration that you have
around the length of time this has taken, and that they are not
happy with the pace and would like to pick up the pace. They
actually asked me for some more resources for appraisers, and
it is something that I authorized today to try to move this
backlog through. As I said, I believe we need to be thorough,
but we also need to be expeditious, so people can get on with
their business.
Regarding the exact criteria, I have talked to the team
about the program. I have not talked about any specific cases.
I am 4 weeks into the job. I would like to request, if I could,
to come back and talk with you.
What I will tell you is I believe we need to move the
backlog. I have requested and authorized to put some more
appraisers onto these cases, and I will be focused on it. I
have told your colleague Senator Salazar that as well.
Senator Allard. Well, we are interested in seeing--you
certainly have general criteria that you come to in doing your
appraisals, and we would like to look at the qualifications of
your appraiser on land values in Colorado particularly and have
a concern about where maybe the Colorado Department of Revenue
has already done a lot of the investigation, I hope you are not
duplicating what they do. Maybe you can just assume that they
have done a pretty good job and you follow with that and maybe
save some time and expedite some of these jobs. And if you feel
like you cannot, I would like to know why you feel like the
State of Colorado is not doing an adequate job, and you need to
go ahead and do that.
So I have a list of questions here, and my time is expired
here. So we would like to get those to you and then you can
review them and get back and give us some detail on where we
are on getting this process moving forward in Colorado. Thank
you.
Mr. Shulman. Thank you.
Senator Allard. Thank you, Mr. Chairman.

MISCLASSIFICATION OF WORKERS

Senator Durbin. Thanks, Senator Allard.
Commissioner Shulman, this may have been done before you
arrived, but the IRS prepared 16 legislative proposals and
several administrative proposals for closing the tax gap with
their 2009 budget submission. The one that is missing is a
pretty big one. It is the misclassification of workers. It
accounts for $148 billion in lost taxes each year. It
represents 43 percent of the gross tax gap that we face as a
country. It relates to people who call themselves independent
contractors and evade payment of taxes that they are duly owing
to the Federal and State government.
So I would like to ask you if you are familiar with this
issue, if you know of any initiatives underway, if you can
explain why it was not included as one of the proposals to
close the tax gap.
Mr. Shulman. I was not here when that tax gap proposal, the
general one, was put together, although I have studied it and I
support moving forward with those proposals. I was also asked a
lot about the tax gap during my confirmation hearing with the
Senate Finance Committee. And I have made a commitment to take
a fresh look at the tax gap and at least engage in a dialogue.
And some of the tax gap issues have political consequences, as
well as administrative consequences, which are going to be
beyond the IRS's purview, but my promise is to study it, come
to my conclusions, and at least engage in that dialogue.
I do not want to answer your question wrong. I mean, my
focus, and what I believe, is that a huge part of the tax gap
is small business, pass-through business, and self-employed.
And I have looked at that issue and am a big supporter of at
least having the dialogue around information reporting and
other issues around there. All of the studies I have done
around the tax gap show that where there is withholding, there
are the highest levels of compliance. Where there is
information reporting, so people know that someone else is
reporting information about them, there is the next highest
level, and where there is no reporting and it is just on the
honor system, there is a lower level of compliance, although a
lot of people--most Americans--want to pay their fair share,
and do pay their fair share, in taxes.
So I think that is what you are referring to. If not, I
apologize for not being responsive.
Senator Durbin. That is, and I will certainly give you time
to take a look at that. A little more time.
Senator Brownback.

STIMULUS PAYMENTS

Senator Brownback. Yes. On the next panel, one of the
testimonies will be from the National Taxpayer Advocate, Nina
Olson. I was just looking at her testimony. They were saying
that you are planning on tax rebate checks to the 130 million
taxpayers who file income tax returns, but also you must
identify and process returns from and payments to more than
20.5 million people who have no filing requirement, yet are
qualified for a tax rebate. That was just the number that has
come out of this testimony. And if that is the case, that is a
big number you are going to need to hit in pretty short order.
Mr. Shulman. Yes. That number--let me speak to that. I was
hesitant to throw that one out because that was the gross
estimate early on in the process. That does not take into
account potentially eligible people on Social Security who are
married, but who are not both eligible. So that number would be
drawn down. It does not take into account dependents or people
who are claimed as dependents on other forms. So I think that
was the early gross estimate. We are going to have a much
better sense once we get the filed numbers in.
Let me also just tell you, there are a variety of reasons--
when I was out at the retired veterans home, there are a lot of
people who are not part of the system and have not filed a
return and might not want to file a return.
Senator Brownback. They are not interested in being part of
the system. I understand that.
Mr. Shulman. Yes, to get their $300 check.
So we are very focused on doing everything the IRS can do.
I understood your comment about maybe not wanting to go out
with us and publicize this, but we are going to try to be
creative, once we see these numbers, about enlisting as many
people as we can to get the word out.
Senator Brownback. It is just that everybody is concerned
about the economy. This was a big bipartisan push by the
Congress and the administration to get this done. So we want as
broad a reach as possible, and 20 million is a large number of
people. But also I understand what you are saying about not
everybody wanting to be in the system. Still, getting all those
checks out is going to take a lot of work and you are on a
short tether to get it done in the time period you are talking
about.
Thank you, Mr. Chairman.
Senator Durbin. Thank you, Mr. Commissioner. I appreciate
it very much.
And we are now going to invite panel number 2 to be seated.
The panel includes Mr. J. Russell George, Mr. Paul Cherecwich,
and Ms. Nina Olson. They have submitted extensive written
statements, and Senator Brownback and I would appreciate it if
they would do their best to confine themselves to 5-minute
statements. Any statement that goes beyond 5 minutes, they will
be presumed guilty and subject to penalties and interest.
Mr. George, how would you like to start?

STATEMENT OF J. RUSSELL GEORGE, TREASURY INSPECTOR
GENERAL FOR TAX ADMINISTRATION, DEPARTMENT
OF THE TREASURY
Mr. George. Thank you, Chairman Durbin, Ranking Member
Brownback. I appreciate the opportunity to testify on the
Internal Revenue Service's fiscal year 2009 budget.
As you heard from the Commissioner, the IRS's proposed
fiscal year budget requests approximately $11 billion in direct
appropriations. This amount is approximately a 4.3 percent
increase over its fiscal year 2008 budget. The 2009 budget
request seeks an increase of $337 million for enforcement.
Meanwhile, funding for taxpayer services remains virtually the
same as the 2008 appropriation. Funding for the business
systems modernization project is reduced by more than 16
percent.
The previous Commissioner of Internal Revenue frequently
stated that taxpayer service plus enforcement equals
compliance. The budget request provides a 7 percent increase
for the IRS's enforcement activities. As you are well aware and
noted earlier, our Nation has a tax gap estimated to be grossly
about $345 billion per year. A vital component of the effort to
reduce the amount requires the IRS to take steps to ensure that
everyone who owes Federal taxes pays their debt.
The fiscal year 2009 budget request seeks nearly $361
million in program increases for IRS enforcement initiatives.
This amount accounts for 77 percent of the agency's overall
funding increase. Part of the enforcement initiative funding
would allow the Service to hire just over 3,000 new enforcement
and operation support employees. The IRS estimates that these
new employees will help generate more than $2 billion in
additional annual enforcement revenue by fiscal year 2011.
In addition to hiring new employees, IRS enforcement
initiatives will focus on enhancing activities targeted at
improving compliance. The budget request supports this by
proposing funding to reduce the tax gap for large and small
businesses, as well as the self-employed, increase compliance
of domestic taxpayers with offshore activity, and minimize
revenue loss by increasing document matching efforts.
The initiatives also include increased support for research
to better understand the reasons for taxpayer noncompliance and
implementation of legislative proposals to improve compliance.
It is noteworthy that the 2009 budget request does not seek
additional funding for any taxpayer service initiatives above
the 2008 funding levels. This was of concern to the Treasury
Inspector General for Tax Administration (TIGTA). As you know,
at the request of this subcommittee and Congress as a whole,
the IRS has expended considerable resources to develop the
taxpayer assistance blueprint. Many of the blueprint's
initiatives would provide IRS customers with services similar
to those that they are accustomed to receiving from private
financial organizations such as online access to their
accounts.
The IRS must continue to determine the kinds of assistance
taxpayers want and need to ensure that the blueprint strategy
is effectively implemented to meet those demands. However, most
of these initiatives were not funded in 2008 and would remain
unfunded in fiscal year 2009.
A key component of any success the IRS would hope to
achieve in providing better service, as well as increased
enforcement, is its business systems modernization effort. The
modernization program has been a long-term challenge for the
IRS. The 2009 budget request cuts funding for projects that are
at the heart of the IRS's efforts to replace its antiquated
computer systems. The program is in its 10th year and has paid
out approximately $2.5 billion for contractor services. In
addition, the IRS has spent $265 million through fiscal year
2007 in internal IRS costs and plans to spend an additional
$223 million on a program in fiscal year 2008.
According to the IRS's original plan, the modernization
program should have been past the halfway point this year.
Although the IRS has made advances in the effort, it has not
progressed as anticipated. While the IRS has improved its
project management and contract oversight, the program remains
behind schedule, over budget, and is not delivering what was
promised.
For example, the IRS originally planned to complete the
replacement of its individual master file with the customer
accounts data engine in 2005. The current estimated completion
date for this replacement is the year 2012.
In January 2005, the Government Accountability Office
designated business systems modernization as a high-risk area.
One reason for that designation is that the IRS's new systems
need to include adequate audit trails to capture improper
intrusions and unauthorized transactions.
Consistent with recommendations made by TIGTA in the past,
the IRS has narrowed its efforts and is focused on three of its
most important projects: the customer accounts data engine, the
accounts management services, and the modernized e-file
program. At this time, TIGTA does not know what impact the cuts
on the modernization budget may have on these programs. The IRS
declined to provide TIGTA with that information.
The final issue I will discuss--I beg your indulgence, Mr.
Chairman--is the impending retirement wave. Thirty percent of
the IRS's current employees will be eligible to retire within
the next 2 years, while nearly 40 percent of its executives are
currently eligible to retire. GAO has designated human capital
as a high-risk Government-wide concern. TIGTA has also
designated the strategic management of human capital as one of
the IRS's major management challenges. The loss of
institutional knowledge places several of the IRS's critical
projects at great risk, including the multiyear, multi-billion
dollar effort to modernize its technology and related business
processes.
It is vital that the IRS effectively implement the human
capital strategies listed in its fiscal year 2009 budget
request. Not only will the IRS need to place significant focus
on recruiting, it will need to ensure that the new employees
reach their full potential. At the same time, the IRS will need
to retain its more experienced employees and capture the
knowledge of those who leave the IRS.
Mr. Chairman, Ranking Member Brownback, thank you for your
indulgence. I hope my discussion will help you in your
deliberations.
Senator Durbin. Thank you, Mr. George.
[The statement follows:]

Prepared Statement of the Honorable J. Russell George

Chairman Durbin, Ranking Member Brownback, and Members of the
subcommittee, thank you for the opportunity to testify today. My
comments will focus on the Internal Revenue Service's (IRS) fiscal year
2009 budget and, at your request, the Treasury Inspector General for
Tax Administration's (TIGTA) fiscal year 2009 budget request. I will
also briefly comment on the status of the 2008 Filing Season.
The IRS administers America's tax laws and collects approximately
95 percent of the revenues that fund the Federal Government. The IRS
has four major components: the Wage and Investment Division, the Small
Business/Self-Employed Division, the Large and Mid-Size Business
Division and the Tax Exempt and Government Entities Division. Together,
these divisions are largely responsible for collecting more than $2
trillion in tax revenues each year. At a time when our Nation is at
war, it is imperative to identify the resources required to support the
IRS's role as steward of the country's tax administration system.
The IRS must continue to address management and operational issues,
including modernization of its computer systems, addressing the tax
gap, protecting taxpayer rights, and ensuring the security of its
resources. To that end, the IRS has requested $11.4 billion to fund the
agency's operations for fiscal year 2009. This is a 4.3 percent
increase over the 2008 enacted budget. The IRS's fiscal year 2009
budget request for systems modernization is $40 million less than the
fiscal year 2008 enacted amount. The IRS does not specify which
programs will absorb these costs, only that the requested amount will
allow continued progress on key modernization projects. However,
millions of taxpayers entrust the IRS with sensitive financial and
personal data stored and processed by its computer systems. The IRS
faces enormous challenges in securing this vast amount of personally
identifiable information, including ensuring that all systems have
sufficient controls to prevent and detect intrusions and improper
accesses.
The budget request includes a 7 percent increase for enforcement
and less than a 1 percent increase for taxpayer service. In 2007 the
IRS finalized strategies to reduce the tax gap and improve customer
service.\1\ The IRS is in the preliminary stages of both strategies.
Determining what role taxpayer service plays in increasing voluntary
compliance and reducing the tax gap will continue to be a challenge in
the near future. The IRS must strive to enforce the tax laws fairly and
efficiently while balancing service and enforcement to promote
voluntary compliance and reduce taxpayer burden.
---------------------------------------------------------------------------
\1\ Reducing the Federal Tax Gap: A Report on Improving Voluntary
Compliance (Washington, D.C.: Aug. 2, 2007); The 2007 Taxpayer
Assistance Blueprint Phase 2 (Washington, D.C.: 2007).
---------------------------------------------------------------------------
overview of the irs's fiscal year 2009 budget request
The proposed fiscal year 2009 IRS budget requests approximately
$11.4 billion in direct appropriations, $107.9 million from
reimbursable programs, and $177.7 million from user fees. The direct
appropriation is approximately a $469.1 million increase (4.3 percent)
over the fiscal year 2008 enacted level of $10.9 billion.
In fiscal year 2008, the IRS requested a budget of approximately
$11.1 billion, an increase of $498 million (4.7 percent) over its
fiscal year 2007 spending authority. The amount enacted by Congress for
fiscal year 2008 was $203 million (1.8 percent) less than the budget
request. Congress also made substantial changes in budget priorities in
fiscal year 2008 by increasing the Taxpayer Services appropriation by
$46.9 million above the IRS's request while cutting the
Administration's Enforcement and Operations Support appropriation
requests by a total of $235 million. The budget request also included a
net increase in the overall size of the IRS of nearly 1,800 Full-Time
Equivalent \2\ employees.
---------------------------------------------------------------------------
\2\ A Full-Time Equivalent is a measure of labor hours. One Full-
Time Equivalent is equal to 8 hours multiplied by the number of
compensable days in a particular fiscal year.
---------------------------------------------------------------------------
The fiscal year 2009 IRS budget request includes appropriations for
five IRS budget accounts (categories): Enforcement, Operations Support,
Taxpayer Services, Business Systems Modernization, and the Health
Insurance Tax Credit Administration (see Figure 1).

Within these appropriation accounts, the IRS seeks to increase
funding for Enforcement, Operations Support, and the Health Insurance
Tax Credit Administration while decreasing funding for Business Systems
Modernization (Modernization). The budget request seeks an Enforcement
Appropriation of $5.12 billion, an increase of $337 million (7.1
percent) over the current fiscal year 2008 appropriation of $4.78
billion. The funding for Taxpayer Services remains the same as the
fiscal year 2008 enacted level.
The Modernization program is a complex effort to modernize IRS
technology and related business processes. It involves integrating
thousands of hardware and software components while replacing outdated
technology and maintaining the current tax system.
The Modernization program is in its 10th year and has received
approximately $2.5 billion for contractor services. Additionally, the
IRS had spent $265 million through fiscal year 2007 for internal IRS
costs, and plans to spend an additional $223 million on the program in
fiscal year 2008. According to the IRS's original plan, the
Modernization program should be past the halfway point in Calendar Year
2008. However, the IRS has not completed as many Modernization projects
as planned because it has received less funding than initially
anticipated and has had difficulties in managing the scope and
complexity of the work. For example, the Customer Account Data Engine
(CADE) is the foundation of the Modernization program. The IRS
originally planned to complete replacement of its Individual Master
File with the CADE in 2005.\3\ The current estimated completion date
for this replacement is 2012.
---------------------------------------------------------------------------
\3\ The Individual Master File is the IRS database that stores
individual taxpayer account information.
---------------------------------------------------------------------------
Although the IRS has made advances in its Modernization effort, it
has not progressed as anticipated. TIGTA has reported that inconsistent
compliance with project development controls has contributed to delays
in project deliveries, increased development costs, and reduced
capabilities.\4\ Since fiscal year 2002, TIGTA's Modernization program
annual assessments have cited the following four specific challenges
the IRS needs to overcome to deliver a successful modernization effort:
---------------------------------------------------------------------------
\4\ Annual Assessment of the Business Systems Modernization Program
(Reference Number 2007-20-121, dated August 24, 2007).
---------------------------------------------------------------------------
--Implement planned improvements in key management processes and
commit necessary resources to enable success;
--Manage the increasing complexity and risks of the Modernization
program;
--Maintain the continuity and strategic direction with experienced
leadership; and
--Ensure that contractor performance and accountability are
effectively managed.
Accordingly, because solutions to the IRS's serious and intractable
financial management problems largely depend upon the success of its
Modernization efforts, in January 2005 the financial management risk
was combined with the Modernization risk into the Business Systems
Modernization high-risk area.\5\ Modernization remains a high risk for
the IRS. One reason is that all of its new systems need to include
adequate audit trails.
---------------------------------------------------------------------------
\5\ In January 2005, the Government Accountability Office (GAO)
combined its two previous high-risk areas, IRS Business Systems
Modernization and IRS Financial Management, into one Business Systems
Modernization high-risk area. See U.S. Government Accountability
Office, GAO-05-207, High Risk Series: An Update (2005).
---------------------------------------------------------------------------
For fiscal year 2008, the IRS requested funding of approximately
$222.7 million for Modernization, a cut of 16.6 percent ($44.4 million
from the $267.1 million enacted). This cut is expected to eliminate at
least 25 employees. However, the fiscal year 2008 enacted amount was an
increase of $54.4 million (25.6 percent) from the $212.7 million
enacted for fiscal year 2007.
The fiscal year 2009 budget request does not specify which programs
will absorb the cuts, although it states that the requested amount will
allow continued progress on key modernization projects, including the
CADE, Accounts Management Services (AMS), and Modernized e-File (MeF).
However, the Government Accountability Office (GAO) recently issued a
report that included proposed spending by major project.\6\ Figure 2
shows the funding proposed for major Modernization projects in fiscal
year 2009 compared to the amounts enacted for fiscal year 2008:
---------------------------------------------------------------------------
\6\ Internal Revenue Service: Fiscal Year 2009 Budget Request and
Interim Performance Results of IRS's 2008 Tax Filing Season, (GAO 08-
567, dated March 2008).

FIGURE 2.--BUSINESS SYSTEMS MODERNIZATION PROJECTS IN FISCAL YEAR 2009 IRS BUDGET REQUEST
[In millions of dollars]
----------------------------------------------------------------------------------------------------------------
Fiscal year Change from
Project Fiscal year 2009 budget fiscal year
2008 enacted request 2008 enacted
----------------------------------------------------------------------------------------------------------------
Customer Account Data Engine................................... 58.5 58.8 0.3
Accounts Management Services................................... 29.0 26.2 (2.8)
Modernized e-File.............................................. 55.8 25.0 (30.8)
Core Infrastructure............................................ 39.2 32.0 (7.2)
Architecture, Integration, and Management...................... 35.1 35.0 (0.1)
Management Reserve............................................. 4.3 2.3 (2.0)
------------------------------------------------
Subtotal Capital Investments............................. 221.9 179.3 (42.6)
Business Systems Modernization Labor........................... 44.0 42.0 (2.0)
------------------------------------------------
Subtotal Program Request................................. 265.9 221.3 (44.6)
Maintaining Current Levels..................................... 1.2 1.4 0.2
------------------------------------------------
Total Business Systems Modernization Budget.............. 267.1 222.7 (44.4)
----------------------------------------------------------------------------------------------------------------
Source: TIGTA analysis of GAO Report, Internal Revenue Service: Fiscal Year 2009 Budget Request and Interim
Performance Results of IRS's 2008 Tax Filing Season (GAO 08-567, dated March 2008).

TIGTA requested information from the IRS on the impact of the
proposed funding on the projects above, which the IRS declined to
provide. The IRS also declined to provide this information to GAO for
its report.
Customer Account Data Engine
The IRS states that the CADE is the lynchpin modernization project
to replace the antiquated master file. The master file currently
requires 2 weeks to update taxpayer tax accounts. The CADE consists of
current and planned databases and is designed to post information to
taxpayers' accounts daily rather than weekly, which will facilitate
faster refunds to taxpayers and provide IRS employees with more up-to-
date and accurate account information.
The latest release of the CADE, Release 3.0, was originally
developed to deliver 17 new functions and capabilities. The IRS divided
Release 3.0 into two sub-releases. CADE Release 3.1 contained four
major functions and was deployed between August and October 2007. CADE
Release 3.2 included seven major functions and was delivered in
February 2008. The major functions delivered include the capability of
processing tax returns with a disaster area designator; processing tax
returns claiming the Earned Income Tax Credit, Credit for Child and
Dependent Care, and requests for Split Refunds; providing address
change service requests; and validating tax balances. The remaining six
functions will be determined for delivery in future releases of the
CADE. These additional capabilities were expected to significantly
increase the volume of returns posting to the CADE from the
approximately 11.2 million returns posted during Calendar Year 2007. As
of March 28, 2008, about 21.1 million tax returns had been posted to
the CADE.
In 2009, the IRS plans to continue the development of the CADE in
stages, and its fiscal year 2009 budget request includes $58.8 million
for the project. TIGTA's review of CADE Release 2.1 found that tax
return information was accepted and generally posted accurately to CADE
accounts during the 2007 Filing Season.\7\ However, several programming
problems were affecting the accurate posting of Itemized Deductions,
Adjusted Gross Income, and Taxable Income amounts. TIGTA reported this
issue to the IRS, and it promptly corrected the programming. TIGTA is
currently reviewing the accuracy of the expanded capabilities offered
by the most current release of the CADE.\8\
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\7\ The Customer Account Data Engine Release 2.1 Generally Posted
Tax Return Information Accurately (Reference Number 2007-40-131, dated
August 10, 2007).
\8\ Customer Account Data Engine Release 3, (Audit Number 2008-20-
009).
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Accounts Management Services Project
The IRS is continuing to modernize its databases to provide
immediate access to account data, enable real-time transaction
processing, and ensure daily account settlement to improve customer
service and business results. The Accounts Management Services (AMS)
project, initiated in May 2006, was chartered to address these needs.
The project objective is to provide an integrated approach to view,
access, update, and manage taxpayer accounts. This is accomplished by
providing IRS employees with the tools to access information quickly
and accurately in response to complex customer inquiries and to update
taxpayer accounts on demand. The fiscal year 2009 budget request
includes $26.2 million for the AMS project.
In March 2008, TIGTA determined that the AMS project team
successfully implemented project management processes and activities,
which included project justification, contract management, risk
management, configuration management, performance management, and
transition management.\9\ The AMS project team successfully planned
work schedules, identified and addressed potential risks to project
development, and coordinated with appropriate staff to implement
initial release capabilities. Although the AMS project team is on
schedule to make the proposed processing capabilities available, its
implementation is dependent on the IRS's Modernization and Information
Technology Services organization's abilities to integrate these project
capabilities into taxpayer account processing.
---------------------------------------------------------------------------
\9\ The Account Management Services Project Is Meeting Its
Development Goals (Reference Number 2008-20-053, dated March 3, 2008).
---------------------------------------------------------------------------
The IRS, however, does not collect all transactions and audit logs
on its modernized systems, including CADE and AMS. Without audit logs,
the IRS cannot conduct proper intrusion investigations and hold
individuals accountable for unauthorized transactions and disclosures.

Modernized e-File
The MeF project provides a standard filing structure for all types
of IRS tax returns and can meet performance and capacity needs with
enhanced and up-to-date technologies, therefore providing greater
appeal to external customers and stakeholders. The MeF project's goal
is to replace the IRS's current tax return filing technology with a
modernized, Internet-based electronic filing platform.
In fiscal year 2009, the IRS will continue development of Release
7, which was initiated in fiscal year 2008. Release 7 will roll out an
additional 90 supporting schedules and forms that will expand the reach
of MeF to 99 percent of the e-File population, or approximately 93.7
million filers. The IRS's fiscal year 2009 budget request includes $25
million for the MeF project.
Previous TIGTA audits of the MeF project found that the IRS's plans
for processing additional tax forms using the MeF system were
uncertain, including plans to schedule development of the U.S.
Individual Income Tax Return (Form 1040) family. In addition, the IRS
can improve its management of requirements development and testing
activities to assure that the requirements expected and approved for
deployment are the requirements that are actually deployed.\10\
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\10\ The Modernized e-File Project Can Improve the Management of
Expected Capabilities and Associated Costs (Reference Number 2007-20-
005, dated December 27, 2006); The Modernized e-File Project Can
Improve Its Management of Requirements (Reference No. 2007-20-099,
dated July 9, 2007).
---------------------------------------------------------------------------
Furthermore, TIGTA continues to be concerned that the IRS is
developing its modernized systems and bringing them online without
adequately contemplating the security implications.

Human Capital
The IRS, like many organizations, is concerned about an impending
retirement wave, or brain drain. According to the IRS, 30 percent of
its current employees will be eligible to retire by 2010 and nearly 40
percent of its executives are currently eligible to retire. The GAO has
designated human capital as a ``high risk'' Government-wide concern and
recently reported that ample opportunities exist for agencies to
improve. TIGTA has also designated the strategic management of human
capital as one of the IRS's major management challenges.
Due to the potential loss of institutional knowledge, the IRS has
several critical projects underway, such as a 5-year strategic plan for
enhancing the services it provides to taxpayers and a complex,
multiyear, multibillion dollar effort to modernize its technology and
related business processes. The IRS is also battling a tax gap,\11\ as
well as implementing and adjusting to changes in its managerial and
executive pay structure.
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\11\ The IRS defines the gross tax gap as the difference between
the estimated amount taxpayers owe and the amount they voluntarily and
timely pay for a tax year.
---------------------------------------------------------------------------
It is critical that the IRS effectively implement the human capital
strategies listed in the IRS's fiscal year 2009 budget request. While
acting to replace those employees lost through retirement and other
attrition, the fiscal year 2009 budget request seeks more than 3,000
additional Full-Time Equivalents. The IRS states that additional
employees will lead to increased revenue of more than $2 billion by the
time new employees reach their full potential in fiscal year 2011. Not
only will the IRS need to place a significant focus on recruiting, it
will need to ensure that new employees reach their full potential. At
this same time, the IRS will need to retain its more experienced
employees and capture the knowledge of those who leave the IRS.
If the IRS is not able to effectively accomplish the human capital
strategies:
--There might not be a sufficient number of qualified employees to
adequately administer the tax code. In addition, fewer
qualified employees may be on the front-line to assist
taxpayers.
--The tax gap could increase if high-performing, well-trained
taxpayer service and enforcement personnel cannot be hired and
retained.
--The IRS might not be able to replace its leadership cadre and
ensure that significant projects remain on track.
--The aging workforce could retire before its vast knowledge of tax
administration is transferred to younger workers.
TIGTA has an ongoing Human Capital audit strategy reviewing these
areas and will continue to monitor the IRS's efforts to strategically
plan and monitor human capital resources to ensure having the right
resources in the right place at the right time to achieve its mission
and goals.

SECURITY OF THE INTERNAL REVENUE SERVICE

Privacy and security are growing concerns in nearly every
organization, both private and public. As technology advances, the
IRS's ability to protect sensitive information must advance to meet new
threats. In addition to the IRS's commitment to protect sensitive
taxpayer data and personally identifiable information, a robust
security program also requires adequate financial and human capital
resources.
Each year, millions of taxpayers entrust the IRS with their
sensitive financial and personal data that are stored in and processed
by IRS computer systems. The risk that this sensitive data could be
compromised and computer operations disrupted continues to increase.
Both internal factors, such as the increased connectivity of computer
systems and greater use of portable laptop computers, and external
factors, such as the volatile threat environment related to increased
phishing scams and hacker activity, contribute to these risks.
Network Security
Because the IRS sends sensitive taxpayer and administrative
information across its networks, routers and switches on the networks
must have sufficient security controls to deter and detect unauthorized
use. In March 2008, TIGTA reported that access controls for IRS routers
were not adequate and reviews to monitor security configuration changes
were not conducted to identify inappropriate use.\12\ Of 374 accounts
for employees and contractors to access routers and switches in
performing system administration duties, 141 (38 percent) did not have
proper authorization to access the routers. Of particular concern, 27
employees and contractors had accessed the routers and switches to
change security configurations.
---------------------------------------------------------------------------
\12\ Inadequate Security Controls Over Routers and Switches
Jeopardize Sensitive Taxpayer Information (Reference Number 2008-20-
071, March 26, 2008).
---------------------------------------------------------------------------
To authenticate users, the IRS relies on a security application
that requires users to enter an account name and password. Users
circumvented this control by setting up unauthorized accounts that
appeared to be shared-user accounts. Any person who knew the password
to these accounts could have changed configurations without
accountability and with little chance of detection. For this reason,
the IRS requires that shared accounts be used only on a limited basis
and that they be subjected to special authorization controls. However,
during fiscal year 2007, 4.4 million (over 84 percent) of the 5.2
million accesses to the routers were made by the 34 user accounts.
Audit trail reviews necessary to detect security events were also not
being conducted. The IRS agreed with TIGTA's findings and is taking
corrective actions to address the recommendations made to correct these
weaknesses.

Database Security
The IRS stores its taxpayer, financial, and other data in more than
2,100 databases. TIGTA reported in fiscal year 2008 that high-risk
weaknesses continue to exist and sufficient corrective actions have not
been taken.\13\ TIGTA scanned IRS networks and determined that 11
percent of the approximately 1,900 databases scanned had one or more
installation accounts with a default or blank password. A total of 369
installation accounts had default or blank passwords, including 26
containing powerful database administrator privileges.
---------------------------------------------------------------------------
\13\ Internal Revenue Service Databases Continue to Be Susceptible
to Penetration Attacks (Report Reference Number 2008-20-029, dated
December 14, 2007).
---------------------------------------------------------------------------
Databases found with default or blank passwords during the scans
included those that contained personally identifiable tax information.
Malicious users can exploit accounts with default or blank passwords to
steal taxpayer identities and carry out fraud schemes.
TIGTA made several recommendations, including ensuring that
security training is provided to employees with key security
responsibilities and improving the process for identifying and
correcting accounts with blank or default passwords by expanding the
scanning criteria. IRS management agreed with all of the
recommendations in the report and plans to take appropriate corrective
actions.

IMPROVE TAXPAYER SERVICE

Since the late 1990s, the IRS has increased its delivery of quality
customer service to taxpayers. The first goal in the IRS's current
strategic plan is to improve taxpayer service. However, since the late
1990s, the IRS has allocated more resources to its collection,
examination, and criminal investigation functions and fewer resources
to taxpayer service functions. See Figure 3 for a comparison of funding
for taxpayer service and enforcement since fiscal year 2006.

As a result of this resource shift and other factors, in July 2005,
Congress requested that the IRS develop a 5-year plan, including an
outline of which services the IRS should provide and how it will
improve services for taxpayers. The IRS developed the plan, the
Taxpayer Assistance Blueprint, in two phases.
The IRS is already facing challenges with its Blueprint. For the
Phase I report, the conclusions and strategic improvement themes were
valid; however, not all information was accurate or consistent.\14\
Given the importance of this plan as the IRS moves forward,
inaccuracies and inconsistencies will put the plan at risk of
improperly aligning service content, delivery, and resources with
taxpayer and partner expectations. In fiscal year 2007, the IRS issued
its Taxpayer Assistance Blueprint Phase 2 report that details the
research and analyses efforts of the IRS and outlines the Blueprint
Strategic Plan for taxpayer services. The Phase 2 report contains
information from over 100 data sources and represents the first large-
scale effort to attempt to collect data specific to Taxpayer Assistance
Center customers. In February 2008, TIGTA reported that the data in the
Phase 2 report was for the most part accurate.\15\
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\14\ The Strategic Improvement Themes in the Taxpayer Assistance
Blueprint Phase I Report Appear to Be Sound; However, There Were Some
Inaccurate Data in the Report (Reference Number 2007-40-078, dated
March 18, 2007).
\15\ The Taxpayer Assistance Blueprint Phase 2 Was Generally
Reliable, but Oversight of the Survey Design Needs Improvement
(Reference Number 2008-40-059, dated February 5, 2008).
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A second review of the Phase 2 report focused on the Taxpayer
Assistance Center \16\ Geographic Footprint--the IRS's step-by-step
process for future decisions regarding Taxpayer Assistance Center
locations--and found that inaccurate and incomplete management
information continues to delay its implementation.\17\ The IRS has yet
to determine the optimum locations for the Taxpayer Assistance Centers
and which taxpayers they most effectively serve. Additionally, of the
41 criteria used for the Taxpayer Assistance Center Geographic
Blueprint, 19 (46 percent) contained inaccurate or incomplete data.
Without accurate and complete data, the IRS cannot measure the
effectiveness of the Taxpayer Assistance Center Program or determine
where to best offer its face-to-face services.
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\16\ Taxpayer Assistance Centers are walk-in sites where taxpayers
can receive answers to account and tax law questions, as well as
assistance in preparing their tax returns.
\17\ Inaccurate and Incomplete Data Has Adversely Affected the
Implementation of the Taxpayer Assistance Center Geographic Footprint
(Audit # 200740042), Draft issued March 20, 2008.
---------------------------------------------------------------------------
The IRS is also still unable to measure how closing Taxpayer
Assistance Centers might affect taxpayers and compliance. The IRS does
not have the means to capture all interactions between a Taxpayer
Assistance Center employee and a taxpayer to determine why the taxpayer
visited the Taxpayer Assistance Center, what service he or she
received, and, most importantly, the effect the service or action had
on the taxpayer's future compliance.
The President' fiscal year 2009 budget request for the Taxpayer
Service Program is $2.15 billion. The fiscal year 2009 funding for the
direct appropriation maintains the fiscal year 2008 enacted level. The
Operations Support budget provides an additional $1.5 billion to
support taxpayer services.
--Fiscal year 2009 program decreases include funds provided in the
fiscal year 2008 enacted. Specifically, $31 million is being
used for long-term investments that would not be duplicated in
2009, and $8 million from the Community Volunteer Income Tax
Assistance (VITA) Matching Grant Program that was provided in
fiscal year 2008 and is still available through fiscal year
2009.
--Fiscal year 2009 increases include an additional 426 Full-Time
Equivalents and $14.8 million to fully fund postal costs.
The budget request does not include funding to support any taxpayer
service initiatives that increase its 2009 request over the 2008
enacted amount. The IRS has expended considerable resources to develop
the Blueprint and many of its initiatives would provide its customers
with the same services currently available to them from private
financial organizations. Most of the Blueprint initiatives have not
been funded. The IRS must continue to find out what assistance
taxpayers want and need, and ensure that the Blueprint Strategy Plan is
effectively implemented.
The IRS is implementing a new matching grant program for the
Community VITA Grant Program with $8 million in fiscal year 2008
funding. The IRS's Volunteer Program, including the VITA and the Tax
Counseling for the Elderly Programs,\18\ plays an increasingly
important role in the IRS's efforts to improve taxpayer service and
facilitate participation in the tax system. TIGTA recently reviewed the
Tax Counseling for the Elderly Program and found that it has not been
effectively administered. The IRS does not have effective controls or
monitoring processes to ensure that funds are appropriately spent, and
management information is not sufficient to provide adequate oversight
for the program. The IRS is using TIGTA's audit results to develop the
VITA grant program.\19\
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\18\ The Tax Counseling for the Elderly Program is a grant program
that provides free tax help to people age 60 and older using grants
appropriated. The Tax Counseling for the Elderly Program appropriation
was $3.95 million for each of fiscal years 2005 through 2007 and $3
million in fiscal year 2008.
\19\ Oversight and Administration of the Tax Counseling for the
Elderly Program Need Improvement.
---------------------------------------------------------------------------
ENHANCE ENFORCEMENT OF TAX LAWS

A compelling challenge confronting the IRS is tax compliance. Tax
compliance initiatives include the administration of tax regulations,
collection of the correct amount of tax for businesses and individuals,
and oversight of tax-exempt and Government entities. Late in fiscal
year 2007, the Department of the Treasury and the IRS issued a report
on improving voluntary compliance.\20\ The report outlines steps that
the IRS plans to take to increase voluntary compliance and reduce the
tax gap.
---------------------------------------------------------------------------
\20\ Internal Revenue Service, U.S. Department of the Treasury,
Reducing the Federal Tax Gap: A Report on Improving Voluntary
Compliance (2007).
---------------------------------------------------------------------------
The fiscal year 2009 IRS budget request seeks nearly $361 million
in program increases for IRS enforcement initiatives, which account for
77 percent of the agency's overall funding increase of $469 million.
Part of the enforcement initiative funding is intended to hire 3,057
new IRS Enforcement and Operations Support employees who are expected
to help generate over $2 billion \21\ in additional annual enforcement
revenue, once the new hires reach full potential in fiscal year 2011.
The $361 million increase is split between three appropriation
accounts: Enforcement ($261 million), Operations Support ($97 million),
and Taxpayer Services (nearly $3 million). Many of the same or similar
enforcement proposals described in the fiscal year 2009 budget request
were included in the fiscal year 2008 IRS budget request but not funded
by Congress in the final appropriations bill, the Consolidated
Appropriation Act of 2008.\22\ The programs included in the enforcement
initiatives in the fiscal year 2009 IRS budget request are shown in
Figure 4:
---------------------------------------------------------------------------
\21\ Amount does not include annual $3.6 billion expected from
legislative proposals.
\22\ Consolidated Appropriation Act of 2008, Public Law 110-161.

FIGURE 4.--ENFORCEMENT INITIATIVE PROGRAMS IN FISCAL YEAR 2009 IRS BUDGET REQUEST
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Staffing
Expected increase (full- Included in fiscal year
Program Cost revenue fiscal time 2008 IRS budget request
year 2011 equivalents)
----------------------------------------------------------------------------------------------------------------
Reduce the tax gap for small business/ $168.5 $981 1,608 Yes
self-employed taxpayers.
Reduce the tax gap for large businesses 69.5 544 519 Yes
Improve tax gap estimates, measurement 51.1 16 393 Yes
and detection of non-compliance.
Increase reporting compliance of U.S. 13.7 102 124 No
taxpayers with offshore activity.
Expand document matching............... 35.1 359 413 Yes
Implement legislative proposals to 23.0 3,600 .............. Yes
improve compliance.
------------------------------------------------------------------------
Totals........................... 360.9 5,602 3,057 .......................
----------------------------------------------------------------------------------------------------------------
Source: TIGTA analysis of fiscal year 2008 and fiscal year 2009 IRS Budget Requests.

ADDRESSING THE TAX GAP

Tax compliance initiatives include administering tax regulations,
collecting the correct amount of tax for businesses and individuals,
and overseeing tax-exempt and Government entities for compliance.
Increasing voluntary compliance and reducing the tax gap are currently
the focus of many IRS initiatives. Nevertheless, the IRS is facing
significant challenges in obtaining more complete and timely data, and
developing the methods necessary for interpreting the data. The IRS
must continue to seek accurate measures for the various components of
the tax gap and the effectiveness of the actions taken to reduce it.
Broader strategies and better research are needed to determine what
actions are most effective in addressing non-compliance.
Unreported Self-Employment Taxes Contribute to the Tax Gap
According to the GAO, outlays from the main trust funds of the
Social Security and Medicare programs are projected to exceed revenues
in the next decade. As the tax collector for these programs, the IRS
must ensure that self-employed taxpayers meet their tax
responsibilities by assessing and collecting the proper amount of self-
employment taxes. Self-employment tax is estimated to make up about $39
billion (72 percent) of underreported employment taxes, or 11 percent
of the total gross tax gap, making it one of the largest components of
the tax gap.
TIGTA's fiscal year 2007 review of the self-employment tax found
that IRS procedures were inconsistent for identifying Form 1040
reporting income on line 21 that is potentially subject to the self-
employment tax.\23\ Also, there was a significant problem with
assigning an audit code to tax returns with potentially unreported
self-employment taxes.
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\23\ Identification of Unreported Self-Employment Taxes Can Be
Improved (Reference Number 2008-30-001, dated October 11, 2007).
---------------------------------------------------------------------------
TIGTA recommended that the IRS: (1) improve processing of those tax
returns with potential self-employment tax liabilities and provide
additional training to tax examiners; (2) strengthen reviews of tax
returns for potential unpaid self-employment taxes; and (3) reconsider
the decision to cancel TIGTA's previous recommendation to immediately
work significant unreported self-employment tax cases with refunds
available and no response or an inadequate response to any letter
issued by the IRS.
IRS management agreed with the first two recommendations and
disagreed with the third. The IRS planned to explore the possibility of
expanding existing returns processing training material issued in
January 2008. However, IRS management stated that the parameters could
not be accurately identified to ensure that the IRS would not be
withholding the refunds of taxpayers who were not subject to self-
employment taxes. Based on the findings of this and previous audits,
TIGTA maintained that it was feasible for the IRS to begin examining
the tax returns of taxpayers who appear to owe a significant amount of
self-employment tax, have an available refund, and have not responded
to contact letters from the IRS.

Schedule C Hobby Losses Contribute to the Tax Gap
About 1.5 million taxpayers, many with significant income from
other sources, filed Form 1040 Schedules C (Profit or Loss From
Business) showing no profits, only losses, over four Tax Years 2002-
2005; 73 percent were assisted by tax practitioners. By claiming these
losses to reduce their taxable incomes, about 1.2 million of the 1.5
million taxpayers potentially avoided paying $2.8 billion in taxes in
Tax Year 2005. Changes are needed to prevent taxpayers from continually
deducting losses in potential not-for-profit activities to reduce their
tax liabilities.
The ``hobby loss'' provision and related regulations do not
establish specific criteria for the IRS to use in determining whether a
Schedule C loss is a legitimate business expense without conducting a
full examination of an individual's books and records.\24\ The purpose
of the hobby loss provision was to limit the ability of wealthy
individuals with multiple sources of income to apply losses incurred in
``side-line'' diversions to reduce their overall tax liabilities. TIGTA
reported in September 2007 that 332,615 high-income taxpayers received
the greatest benefit by potentially avoiding approximately $1.9 billion
in taxes for tax year 2005.\25\
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\24\ Internal Revenue Code Section 183 (Activities not engaged in
for profit); related Treasury Regulation Section 1.183-1.
\25\ Significant Challenges Exist in Determining Whether Taxpayers
With Schedule C Losses Are Engaged in Tax Abuse (Reference Number 2007-
30-173, dated September 7, 2007).
---------------------------------------------------------------------------
The law does not require a taxpayer to have a reasonable
expectation of profit; rather, the taxpayer needs only the
``objective'' of making a profit. Internal Revenue Code (I.R.C.) 183
makes it difficult for the IRS to efficiently administer tax law that
ensures taxpayers are not deducting not-for-profit losses to reduce
their taxes on other incomes year after year.
TIGTA recommended that the IRS provide a copy of the report to the
Department of the Treasury, Office of Tax Policy, to consider
legislative changes to I.R.C. 183. The proposal should include
establishing a clearly defined standard or bright-line rule for
determining whether an activity is a business or a not-for-profit
activity. Due to the large number of these tax returns being prepared
by tax practitioners, TIGTA also recommended that the IRS continue
coordinating with practitioner organizations to encourage compliance
with existing provisions.
In their response to the report, IRS officials stated that they
agreed with the recommendations and planned to take appropriate
corrective actions. The IRS plans to coordinate with the Office of
Legislative Affairs to forward a copy of the final report to the
Department of the Treasury, Office of Tax Policy, and to include key
messages and talking points about I.R.C. 183 tax obligations as a
fiscal year 2008 outreach initiative directed to practitioner
organizations.

LEGISLATIVE PROPOSALS

The fiscal year 2009 IRS budget request includes 16 legislative
proposals--13 submitted in prior budget requests--that are expected to
generate $36 billion in additional tax over 10 years as a result of
improving tax compliance and administration. Of the 13 proposals in
prior budget requests, 12 await some form of congressional action. Many
of these proposals also represent a significant part of the IRS
strategy to improve tax compliance and reduce the tax gap described in
the IRS's August 2, 2007, report, Reducing the Federal Tax Gap: A
Report on Improving Voluntary Compliance.

2008 FILING SEASON

The 2008 Filing Season appears to be progressing without major
problems. As of March 29, 2008, the IRS reported that it had received
approximately 86.8 million tax returns. Of those, approximately 62.2
million were filed electronically (e-filed) (an increase of 9.3 percent
from this time in 2007), and approximately 24.6 million were filed on
paper (an increase of 4.8 percent from this time in 2007).
Additionally, nearly 69.8 million refunds totaling approximately $172
billion had been issued. Of these, 50.8 million (73 percent of all
refunds) were directly deposited to taxpayer bank accounts, an increase
of 7.3 percent compared to 2007.
Use of the IRS's free online filing program had been declining in
prior years. However, based on the current volume, it appears that
taxpayers are increasingly taking advantage of this option, as the
number has increased by 17.4 percent from 2007. Additionally, the
number of taxpayers who e-file from their home computers increased by
17.3 percent this filing season.
So far this filing season, over 2 million tax returns have been
prepared by volunteers, an increase of 22 percent over the 2007 Filing
Season. TIGTA's accuracy rate at the Volunteer Program sites has
improved from 56 percent last year to 67 percent this year. The IRS is
reporting a 76 percent accuracy rate. Volunteers are doing a better job
using the tools and information available when preparing tax returns.
As of March 29, 2008, use of IRS.gov is up over 19 percent, with
almost 122 million visits to the Web site. Nearly 26 million taxpayers
went to IRS.gov to obtain their refund information via the ``Where's My
Refund?'' option, a 19.7 percent increase over the same time period
last year.
Additionally, calls to the toll-free assistance lines are up from
the 2007 Filing Season and the Level of Service \26\ is lower,
primarily because taxpayers are calling about the stimulus payments.
The IRS had planned to provide an 82 percent Level of Service for
fiscal year 2008, but has projected that the Level of Service could be
as low as 74 percent. For the 2008 Filing Season (as of March 29,
2008), the IRS had already answered about 112 percent of the planned
10.9 million assistor-answered calls. Its 80 percent Level of Service
is 4.5 points lower than the actual 2007 Filing Season Level of Service
of 84.5 percent. Additionally, the IRS had planned to answer 14.8
million automated calls but has answered 16.1 million automated calls.
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\26\ The Level of Service is the primary measure of service to
taxpayers. It is the relative success rate of taxpayers who call for
services on the IRS toll-free telephone lines.
---------------------------------------------------------------------------
economic stimulus act of 2008 \27\
---------------------------------------------------------------------------
\27\ Economic Stimulus Act of 2008, Pub. L. No. 110-185 (2008).
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In keeping with the intent of the Economic Stimulus Act of 2008,
the IRS expects to issue more than $100 billion in stimulus payments
(often referred to as rebates) and is trying to ensure that everyone
who is entitled to a rebate knows what to do to receive it. The IRS
sent Economic Stimulus Payment Notices (Notice 1377) to more than 130
million taxpayers who filed a Tax Year 2006 income tax return.
Beginning in May, an additional notice will be mailed to those
taxpayers eligible for the payments to explain the payment amount and
how it was calculated. The IRS believes it will receive significantly
fewer calls to its toll-free telephone information line as a result of
issuing the advance notices.
As of March 28, 2008, the IRS had received an estimated 1.4 million
tax returns from individuals who filed them solely to receive the
rebates. Because these are tax returns that would generally not be
filed, the normal IRS refund controls are not designed for this
situation. The IRS is evaluating alternatives to identify any of these
tax returns that are fraudulent so it can prevent any associated
fraudulent stimulus payments. TIGTA is currently evaluating the
controls over the processing of these tax returns and monitoring their
volume and effect on the 2008 filing season.
Since the Economic Stimulus Act of 2008 was enacted, the IRS has
been receiving an average of more than 63,000 calls per day above
normal volume to its toll-free telephone lines related to the upcoming
rebates. The IRS is using over 1,000 Automated Collection System \28\
telephone assistors to take rebate telephone calls during their regular
tours of duty and has also trained more than 500 tax examiners and
assistors who normally work taxpayer correspondence and paper casework
to answer general rebate calls.
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\28\ The Automated Collection System is an integral part of the IRS
process for collecting unpaid taxes and securing unfiled tax returns
from both individual and business taxpayers. When taxpayers do not
comply with the IRS's computer-generated notices, Automated Collection
System tax examiners attempt to contact them by telephone to secure
payments or unfiled returns. The Automated Collection System is the
computer system that assigns these cases to the individual tax
examiners.
---------------------------------------------------------------------------
The IRS stopped the issuance of Automated Collection System
enforcement tools (systemic notices and letters were stopped on
February 22 and systemic levies were stopped on February 29). However,
issuance of regular delinquency notices on accounts not yet assigned to
the Automated Collection System has not been stopped, and the IRS
expects to reserve 40 percent to 50 percent of the available Automated
Collection System staff to answer calls from taxpayers who respond to
these notices. The IRS plans to restart the notices when telephone
demand decreases. The IRS reports that the foregone revenue associated
with these actions could be as high as $666 million.

TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION FISCAL YEAR 2009
BUDGET REQUEST

TIGTA was created by Congress to provide independent oversight of
the IRS. TIGTA's audits and investigations protect and promote the fair
administration of the Nation's tax system. Responsibilities include
ensuring that the IRS is accountable for more than $2 trillion in tax
revenue received each year. Audit recommendations aim to improve IRS's
systems and operations while maintaining fair and equitable treatment
of taxpayers. Investigations are focused on IRS employee misconduct and
infrastructure security, as well as external attempts to corrupt
Federal tax administration.
TIGTA's Office of Audit (OA) conducts audits that advise Congress,
the Secretary of the Treasury, and IRS management of high-risk issues,
problems, and deficiencies related to the administration of IRS
programs and operations. Audits not only focus on the economy and
efficiency of IRS functions but also ensure that taxpayers' rights are
protected and the taxpaying public is adequately served. Overall, as of
March 31, 2008, audit reports potentially produced financial
accomplishments of $172.5 million, and potentially impacted
approximately 1,217,000 taxpayer accounts in areas such as taxpayer
burden, rights, and entitlements. OA develops an annual audit plan that
communicates oversight priorities to Congress, the Department of the
Treasury, and the IRS. Emphasis is placed on mandatory coverage imposed
by the IRS Restructuring and Reform Act of 1998 \29\ and other
statutory authorities, as well as issues impacting computer security,
taxpayer rights and privacy, and financial-related audits. OA's work
focuses on the IRS's major management challenges, the progress in
achieving its strategic goals, the elimination of the IRS's systemic
weaknesses, and the IRS's response to the President's Management Agenda
initiatives.
---------------------------------------------------------------------------
\29\ Pub. L. No. 105-206, 112 Stat. 685 (codified as amended in
scattered sections of 2 U.S.C., 5 U.S.C. app., 16 U.S.C., 19 U.S.C., 22
U.S.C., 23 U.S.C., 26 U.S.C., 31 U.S.C., 38 U.S.C., and 49 U.S.C.).
---------------------------------------------------------------------------
TIGTA's Office of Investigations (OI) conducts investigations that
protect the integrity of IRS employees, contractors, and other tax
professionals; provides for infrastructure security; and protects from
external attempts to threaten or corrupt the administration of Federal
tax laws.
TIGTA's OI investigates employee misconduct involving unauthorized
access (UNAX) of confidential taxpayer records, theft, false
statements, financial fraud, taxpayer abuses, and extortion.
OI assists in maintaining IRS employee and infrastructure security
by investigating incidents of threats or assaults made against IRS
employees, facilities, and data infrastructure. As mentioned
previously, the IRS's fiscal year 2009 budget request seeks a 7.1
percent increase in its enforcement appropriation. This continued focus
on enforcement has resulted in OI receiving higher levels of reported
assaults and threats against IRS personnel. Additionally, the IRS's
increasing reliance on electronic processes has resulted in an
increased need for OI to investigate and respond to cyber attacks.
TIGTA also investigates allegations involving external attempts to
corrupt tax administration, such as bribes offered by taxpayers to
compromise IRS employees, the use of fraudulent IRS documentation to
commit crimes, taxpayer abuse and misconduct by tax practitioners,
impersonation of IRS employees, and the corruption of IRS programs
through procurement fraud.
TIGTA faces major human capital challenges in delivering and
adapting its oversight activities to the increasingly complex and high-
risk issues associated with IRS operations. Some of these issues
include detection and investigation of fraud and electronic crime,
procurement activities, taxpayer privacy, and an increasing number of
requests for IRS program reviews from Congress and other IRS
stakeholders. While adapting to this changing environment,
approximately 37 percent of TIGTA employees are eligible for retirement
by fiscal year 2011.
Additionally, in order to accomplish its mission, TIGTA employees
need to possess the appropriate skills. As the IRS continues to
modernize and operate in an automated environment, it is essential that
TIGTA auditors and investigators are appropriately trained to operate
in this environment.
To help address these challenges, TIGTA has initiated or is
initiating the following actions in fiscal year 2008:
--Created the Office of Inspections and Evaluations whose mission is
to provide TIGTA with additional flexibility, capacity and
capability to provide value-added products and services to
improve tax administration and promote good Government. This
function was created and staffed by a realignment of existing
resources.
--Implementing a bureau-wide electronic learning management system
containing a skills assessment program that identifies the
critical skills needed for each of TIGTA's major occupations
and provides a means to assess resident skill levels. Based on
the results, TIGTA will develop a strategic recruitment program
to fill critical vacancies with the skills necessary to carry
out its increasingly complex oversight activities and align
future hiring in critical geographic areas.
--Building its first Senior Executive Service Candidate Development
Program. The objective of the program is to promote a greater
understanding of the mission and culture of the Federal
Government and to train outstanding leaders and prepare them
for the Senior Executive Service.
Mr. Chairman, as you requested, I will discuss TIGTA's 2009 budget
needs. From fiscal year 2001 to fiscal year 2007, TIGTA's labor
expenses have grown 20 percent from $88 million to $106.3 million,
despite a substantial reduction in Full-Time Equivalents (a decrease of
16 percent from 938 to 792). Labor costs currently account for 80
percent of TIGTA's annual budget. As the number of TIGTA employees
covered under the more expensive Federal Employees Retirement System
increases, labor costs will continue to rise, reducing the funds
available to TIGTA for non-labor spending.
Since fiscal year 2001, TIGTA has only been able to meet its
financial obligations through Full-Time Equivalent losses and
implementation of cost-cutting initiatives in non-labor expense
categories. From fiscal year 2001 to fiscal year 2007, non-labor
spending (such as training, travel, equipment, etc.) fell 9 percent
from $19.5 million to $17.7 million. These costs currently consume 13
percent of TIGTA's annual budget.
The fiscal year 2009 President's budget request for TIGTA will be
used to continue to provide critical audit and investigative services,
ensuring the integrity of tax administration on behalf of the Nation's
taxpayers. While there are a number of critical areas in which TIGTA
will provide oversight, highlights of TIGTA's investigative and audit
priorities include:
--Adapting to the IRS's continually evolving operations and
mitigating intensified risks associated with modernization;
--Addressing the tax gap and enforcement efforts;
--Responding to threats and attacks against IRS employees, property,
and sensitive information;
--Improving the integrity of IRS operations by detecting and
deterring fraud, waste, abuse or misconduct by IRS employees;
--Conducting comprehensive audits, inspections, and evaluations that
include recommendations for cost savings and enhancing the
IRS's service to taxpayers; and
--Informing Congress and the Secretary of the Treasury of problems
and progress made to resolve identified issues.
The total resources needed in fiscal year 2009 to support TIGTA's
mission are $146,636,000, including $145,736,000 from direct
appropriations and approximately $900,000 from reimbursable agreements.
This is a $5.2 million (3.7 percent) increase over the fiscal year 2008
spending authority compared with the IRS's 4.3 percent increase.
I hope my discussion of the continuing challenges that face the IRS
and TIGTA will assist you as you consider the fiscal year 2009 budget.
Mr. Chairman and Members of the subcommittee, thank you for the
opportunity to share my views.

Senator Durbin. You should have filed for an extension 1
minute and 6 seconds ago.
Willie Nelson will be your hearing officer.
On behalf of the IRS Oversight Board, Paul Cherecwich.

STATEMENT OF PAUL CHERECWICH, JR., CHAIRMAN, INTERNAL
REVENUE SERVICE OVERSIGHT BOARD
Mr. Cherecwich. Chairman Durbin, Ranking Member Brownback,
and members of the subcommittee staff who are here, thank you
very much. My name is Paul Cherecwich. I am chair of the IRS
Oversight Board.
One of our most important responsibilities is to ensure the
IRS budget and related performance expectations support the IRS
strategic plans. I would like to take this time to summarize
the Board's recommendations for the IRS fiscal year 2009
budget.
If I had one word to characterize the difference between
the Board's recommendations and the President's request, it
would be ``direction.'' I have taken the liberty of making a
chart of one of the key figures in my written statement because
I think that best illustrates the difference in the direction
the Board is recommending.
This chart shows the four major line items in the IRS
budget. The Board wants to spend more for service and
information technology (IT) modernization. The President would
spend less. It would appear that the Board and the President
have similar recommendations for enforcement, but when you get
inside the numbers, there are real differences in balance. And
the Board would spend about $100 million more for
infrastructure, but the President's budget would keep the
infrastructure budget at its present underfunded state.
Let us start at the top with funding for taxpayer service.
To put it simply, the Board wants the IRS to do more service,
not less, especially service that helps taxpayers better
understand their obligations and service targeted at
underserved taxpayers. Most of the additional money for service
that Congress added to the IRS budget last year would be
eliminated by the President's budget. The Board believes the
taxpayer assistance blueprint needs to be funded, and I have
personally visited volunteers in tax assistance (VITA) sites in
Utah, Georgia, and Kansas and can tell you that VITA is
delivering important services to underserved taxpayers.
With respect to enforcement, it may seem that the Board and
the President are making identical recommendations, for the
funding is so close, about $360 million. And reality is my
written statement shows the Board's recommended enforcement
programs are spread more broadly and not focused exclusively in
a few areas. As discussed in my statement, the Board has also
questioned the ability of the IRS to absorb the requested
staffing in its small business, self-employed, and large
business divisions.
With respect to infrastructure, that is something that
tends to be forgotten, but it is really quite important. The
Board believes more funding for security is important in an age
where the IRS is under increasing pressure to protect its
databases from assault and keep taxpayer records private. I
note that just the last week my colleague, Mr. George, issued a
report chastising the IRS for their lack of security. The IRS
does put a high priority on maintaining taxpayer privacy, but
more should be done.
People are also an important part of the IRS infrastructure
and more attention must be paid to having an aging workforce
effectively pass along their skills and special expertise to
the next wave of leaders and employees.
Now, the biggest difference in dollars between the Board
and the President's budget is in business systems modernization
(BSM). We have a $185 million difference between the Board's
recommendation and the President's recommendation. By the way,
this is the appropriations line. Technology modernization will
result in major benefits to taxpayers and the Government. The
Board believes the BSM to be the highest priority because of
its ability to contribute to reducing the tax gap in the long
term. We simply have to make progress faster. TIGTA and GAO
have recently been reporting positively on the business systems
modernization program. This is not the time to go backward in
funding.
Among other things, erratic funding makes program
management more difficult and creates staffing issues for both
the IRS and the contractors. When projects are cut back, you
always lose the talented people you most want to keep.
Few taxpayers would use a financial institution that
updated its accounts weekly. Yet, we accept that for the IRS.
This has to change.
Modernized systems are required for electronic filing and
financial controls. The failure of funding to upgrade the
integrated financial system is going to prevent the IRS from
managing its own accounts better.
Now that I have summarized the Board's recommendations on
the four major accounts, let me make a point on the entire IRS
budget. There is a television program on the Discovery channel
called ``Myth Busters'' whose avowed mission is to separate
truth from fiction, and I want to bust a myth about the IRS.
The myth is that taxpayers who are also voters will be unhappy
if too much money is appropriated for the IRS. The Board has
tested that myth in our taxpayer attitude surveys and found it
was wrong. My written statement provides the details.

PREPARED STATEMENT

In conclusion, the Congress must choose whether it wants to
pursue short-term growth in enforcement activity over a more
balanced path that stresses the benefits of long-term
investments in technology infrastructure, service, and
research.
Thank you for the opportunity to present the board's views.
Senator Durbin. Thanks.
[The statement follows:]

Prepared Statement of Paul Cherecwich, Jr.

Chairman Durbin, Ranking Member Brownback, and members of the
Subcommittee, thank you for this opportunity to present the Oversight
Board's views on the administration's fiscal year 2009 IRS budget
request. My name is Paul Cherecwich and I serve as Chairman of the IRS
Oversight Board. My testimony explains the Board's recommendations for
the IRS fiscal year 2009 budget and why the Board believes this level
of funding is needed to meet the needs of the country and of taxpayers.
Created as part of the IRS Restructuring and Reform Act of 1998
(RRA 98), the Oversight Board's responsibilities include overseeing the
IRS in its administration, management, conduct, direction and
supervision of the execution and application of the internal revenue
laws. The Board is also responsible for ensuring that the IRS'
organization and operations allow the agency to carry out its mission.
To this end, the Board was given specific responsibilities for
reviewing and approving annual budgets and strategic plans.
In fulfilling its responsibilities, the Board must ensure that the
IRS' budget and the related performance expectations contained in the
performance budget support the annual and long range plans of the IRS,
support the IRS mission, are consistent with the IRS goals, objectives
and strategies and ensure the proper alignment of IRS strategies and
plans. In addition to my statement today, the Board developed a formal
report in which it explains why it has recommended this budget for the
IRS. I request that my statement and the report be entered into the
committee record.

FISCAL YEAR 2009 IRS BUDGET RECOMMENDATIONS

One of the IRS Oversight Board's most important statutory
responsibilities is to ensure that the IRS' budget request supports the
agency's annual and long-term strategic plans. A budget request is more
than a mechanism for appropriating funding; it's also a plan and a
commitment. Not only does a proposed budget request funding, it also
describes the activities the IRS will perform, how those activities
align with the long-range strategic plan, and identifies measures to
evaluate the expected results. A performance budget, properly used,
enhances the ability of the IRS to meet its short-term performance
targets and three strategic plan goals: (1) improve customer service;
(2) enhance enforcement of the tax law; and (3) modernize the IRS
through its people, processes and technology.
Achieving these three strategic goals will enable the IRS to
address the most serious problem facing tax administration today--
reducing the tax gap, the difference between what taxpayers should be
paying and what they actually pay in a timely manner. The size of the
tax gap is significant, with the IRS' most recent estimates placing it
at approximately $290 billion (net) annually, based on 2001 tax
returns. The imperative for closing the tax gap has never been greater.
An annual net tax gap of $290 billion averages to about $2,200 per
individual tax return, an enormous burden for the average taxpayer, and
one that should not be tolerated by honest taxpayers. It is far too
large to be dismissed lightly--it imposes a large burden on all
taxpayers and undermines respect for tax administration.
The IRS Oversight Board recommends an IRS fiscal year 2009 budget
of $11.737 billion, an increase of $845 million over the enacted fiscal
year 2008 amount of $10.892 billion, as summarized in Tables A-1 and A-
2 in Appendix A.
The recommended budget takes a long-term view of IRS needs. Despite
the severity of the tax gap, the Board believes such a view is both
warranted and needed. In submitting its fiscal year 2009 budget
recommendations to the Treasury Department in June 2007, the Board
identified increased funding for Business Systems Modernization (BSM),
security, infrastructure, and research as high priorities. These
initiatives offer the best opportunity to reduce the tax gap in the
long term.
By following this approach, the Board's recommended budget
maintains balance at its core: enforcement, taxpayer service, business
systems modernization, and employee development must be adequately
funded for the IRS to succeed in all parts of its mission and to ensure
the long-term health of our tax administration system.
The Board's recommended IRS budget compares to the President's
request of $11.361 billion, an increase of $469 million over the fiscal
year 2008 enacted appropriation. Although the two budgets are within
3.3 percent, they take different approaches to funding priority program
initiatives at the margin. The Board recommends a total of $644 million
in program initiatives, spread among four areas: enforcement, taxpayer
service, infrastructure and IT, and BSM. The President's budget
requests a nearly identical amount of funding for enforcement
initiatives as the Board, but cuts taxpayer service and BSM funds, and
includes no program initiatives for infrastructure and IT. Figure 1
shows the differences in graphic form.

Although both budgets have as a core objective the reduction of the
tax gap, the Board recommends funding initiatives across the full range
of IRS functions and taxpayer segments. In contrast, the President's
budget has as its central focus a short-term effort to build up IRS
revenue-producing enforcement staffing at a time when the IRS is hard-
pressed to replace the high number of experienced employees who are
retiring. Increased staffing is important, but the Oversight Board
believes the IRS cannot ``audit its way out of the tax gap,'' and
should avoid the temptation to close the tax gap with large staffing
increases in revenue-producing functions that cannot be absorbed
effectively. The Board believes its recommended budget avoids this
problem by focusing on ways to make the IRS more efficient in the long
term, and putting more resources into technology, infrastructure, and
service as well as enforcement.
Because reducing the tax gap is of critical importance, the Board
has identified a subset of its recommended initiatives as having the
highest priority. These initiatives are generally infrastructure and
research intensive and will have the greatest effect on reducing the
tax gap in the long term, and are identified in Table 1.

TABLE 1.--IRS OVERSIGHT BOARD HIGHEST PRIORITY INITIATIVES
[Dollars in millions]
------------------------------------------------------------------------
Amount
------------------------------------------------------------------------
Technology/Infrastructure:
Fund Business Systems Modernization in Line with Current $141.0
Strategy.................................................
Enhance IT Security....................................... $16.7
Enhance Contingency Planning and Disaster Recovery........ $8.7
Implement Security Auditing............................... $6.8
Preserve quality IT workforce in applications development. $36.8
Build alternate power supply for computing center......... $11.0
---------
Subtotal, Technology/Infrastructure..................... $221.2
=========
Enforcement: Improve tax gap estimates, measurement, and $11.1
detection of non-compliance..................................
Taxpayer Service: Research Taxpayer Burden, Complexity, and $10.0
Compliance...................................................
---------
Total Highest Priority Initiatives...................... $2.3
------------------------------------------------------------------------

None of these initiatives, except the enforcement initiative for
improving tax gap estimates, are funded in the President's budget.
Moreover, as shown in Figure 1, the BSM program and taxpayer service
programs undergo reductions of $45 million and $47 million,
respectively. The Board recommends that the appropriated IRS fiscal
year 2009 budget closely follow the priorities and balance reflected in
this statement.
The following sections discuss the Board's budget recommendations
in the context of each of the IRS' strategic goals.
Strategic Goal 1--Improve Taxpayer Service
IRS customer service has made consistent gains since fiscal year
2002. For example, Toll-Free Tax Law Accuracy and Accounts Accuracy are
at 91 percent and 93 percent respectively in fiscal year 2007, as
compared to 84.4 percent and 90 percent 5 years ago. Of particular
note, overall customer satisfaction with IRS Toll-Free Service has held
steady at 94 percent for four consecutive years. Such stability is most
welcome and a good indicator that best practices have taken root.
As a result, a more pressing challenge is to deliver more extensive
electronic self-assistance tools and to perform research that
identifies innovative ways to expand taxpayer education and outreach to
all taxpayer segments, especially those who are now under served.
To a large degree, many of the IRS' customer service activities are
designed to respond to taxpayer inquiries. Examples include toll-free
telephone service and Taxpayer Assistance Centers. Overall, the IRS has
done a good job fielding and answering questions, whether via toll-free
telephone, the Internet, or in person at Taxpayer Assistance Centers.
The IRS expends considerably fewer resources on education and
outreach services. A broader approach to customer service would entail
giving taxpayers access to self-service applications so they could
``pull'' specific information on accounts or tax law, and ``pushing''
answers, information and updates to taxpayers, practitioners and other
affected parties as the need for such information became apparent.
Lastly, the IRS must seize opportunities to provide innovative
outreach, education and community partnerships. For example, given
limited resources and elimination of programs such as TeleFile, the IRS
must also work to broaden and strengthen partnerships, such as
Volunteers in Tax Assistance (VITA).
To take service to the next level, the IRS must better understand
the taxpayers they serve. The IRS must conduct more insightful
research, and develop services better tailored to the specific needs of
particular taxpayer segments. By better understanding taxpayers, the
IRS can focus both its service and enforcement efforts to increase
compliance through targeted pre-filing, filing, and post-filing
efforts. The IRS must find out what kind of information and assistance
taxpayers need and the most effective ways of delivering that
information to them.
In the last 2 years, the IRS has put considerable effort into
developing the Taxpayer Assistance Blueprint (TAB), which establishes a
5-year plan for delivering service to taxpayers. This vision entails a
much broader use of electronic interactions between taxpayers,
practitioners and the IRS, such as account management and the ability
to resolve taxpayer issues securely over the Internet. The TAB
describes an IRS that is an ``interactive and fully integrated, online
tax administration Agency'' with the capability ``for any exchange or
transaction that occurs face-to-face, over the phone, or in writing to
be completed electronically.'' These types of services are much along
the lines of what customers of large financial institutions already
experience today but are still for the most part unavailable to
taxpayers.
The Oversight Board disagrees with the President's program
reductions for taxpayer service and recommends that the following three
initiatives be funded for a total of $26.3 million:
--Maintain Processing of Critical Pension Plan Returns ($6.3
million);
--Research Taxpayer Burden, Complexity, and Compliance ($10 million);
and
--Expand Volunteer Income Tax Assistance and Low Income Tax Clinics
($10 million).
The first initiative supports customer service by providing funds
to maintain processing of essential pension plan return information
while transitioning to a new mandated electronic filing system
``EFAST2'' in 2010. It also enables processing of residual returns that
are IRS-only forms and not part of the mandated EFAST2 system (Form
5500EZ and Schedule SSA filings).
The second initiative provides funding to enhance understanding of
the interaction between taxpayer burden, tax law complexity, and
taxpayer compliance. This research will help improve understanding of
these inter-relationships, in keeping with strategies put forth in the
Taxpayer Assistance Blueprint (TAB) and the Department of the Treasury
report, A Comprehensive Strategy for Reducing the Tax Gap.
The third initiative provides funding to improve service to two
taxpayer segments with special needs: the growing number of elderly and
the ethnically diverse. These taxpayer segments face unique challenges
in meeting their tax obligations because of limited access to or
inability to use all of the channels offered for service delivery.
Additional resources will enhance the IRS's volunteer return
preparation and other services provided by the Volunteer Income Tax
Assistance (VITA) and the Low Income Tax Clinic programs with emphasis
on both targeted taxpayer segments. Such services help created a more
fair and just tax system.

Strategic Goal 2--Enhance Enforcement of the Tax Law
Increases in IRS enforcement activity intended to produce gains in
direct revenue collection must be balanced with a broad view of the tax
gap. The Board recognizes that increased enforcement activity over the
past five years has produced noticeable results--enforcement revenue
has increased from $34.1 billion in fiscal year 2002 to $59.2 billion
in fiscal year 2007, a gain of nearly 74 percent. The IRS estimates
that it can produce more than a four-to-one return on every dollar
invested in additional enforcement resources, a fact that the Board
believes warrants the appropriation of additional enforcement funding.
However, while the Board applauds the increases in enforcement
activity and revenue, it also recognizes that the IRS cannot ``audit
its way out'' of the tax gap. There is wide belief, as evidenced by the
Board's recommendations for reducing the tax gap and the Treasury
Department's tax gap strategy, A Comprehensive Strategy for Reducing
the Tax Gap, that an integrated set of comprehensive actions is needed.
Even a large infusion of resources for more enforcement personnel--
something highly unlikely--would not eliminate the tax gap. There are
many reasons for taxpayer non-compliance. Only a balanced program that
promotes voluntary compliance across a broad continuum of taxpayers,
from education and service for those who want to comply, to enforcement
and even criminal prosecutions for those who refuse to comply, can be
effective.
Table 2 compares the Board's and President's enforcement
initiatives. Although very close in dollars, the President's
initiatives place more emphasis on enforcement resources that can be
shown to produce revenue in the short term. The Board takes a broader
view of enforcement, and recommends program increases in such areas as
expanded collection of proper taxes from recipients of Federal
payments, investigation of tax-related criminal activity, Bank Secrecy
Act compliance, tax exempt organization examination, more published
guidance for Tax Exempt taxpayers, additional litigation staff, and tax
preparer monitoring.
Additional enforcement resources produce a positive return on
investment and result in short-term benefits, so the benefits of
increased enforcement are apparent. However, increases in enforcement
resources must also be balanced with more systemic long-range actions
that improve voluntary compliance, and priorities must be considered as
budget resources are limited. The Oversight Board considers technology
modernization and research a higher priority than additional
enforcement resources, in recognition of the long-term impact that
technology modernization and research have on the IRS' ability to work
more efficiently to reduce the tax gap and to be better able to focus
both its service and enforcement resources optimally.

TABLE 2.--COMPARISON OF ENFORCEMENT INITIATIVES FOR BOARD'S AND PRESIDENT'S BUDGETS
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Oversight board's budget enforcement President's budget enforcement
initiatives Amount initiatives Amount
----------------------------------------------------------------------------------------------------------------
Reduce the Tax Gap for Small Business/Self- $120.7 Reduce the Tax Gap for Small Business/ $168.50
Employed. Self-Employed.
Increase Reporting Compliance of Domestic 16.4 Improve Reporting Compliance of U.S. 13.70
Taxpayers with Offshore Activity. Taxpayers with Offshore Activity.
Reduce the Tax Gap for Large Businesses.... 52.0 Reduce the Tax Gap for Large Business.... 69.49
Expand Federal Payment Levy Program........ 17.3 ......................................... ...........
Reduce Tax Fraud........................... 72.2 ......................................... ...........
Enhance Financial Investigations of 24.0 ......................................... ...........
Narcotics Trafficking Organizations.
Enhance BSA Compliance Program............. 3.4 ......................................... ...........
Address Complexity through Up-Front 8.9 ......................................... ...........
Guidance, Education, and Correction.
Expand Examination of Tax Exempt 28.6 ......................................... ...........
Organizations.
Increase Tax Court Litigation.............. 5.8 ......................................... ...........
Implement New Procedural Tax Court 3.4 ......................................... ...........
Requirements.
Improve Tax Gap Estimates, Measurement, and 11.1 ......................................... 51.06
Detection of Non-Compliance.
Increase Monitoring of Preparers........... 2.5 ......................................... ...........
........... Expand Document Matching................. 35.06
........... Implement Legislative Proposals to 23.05
Improve Compliance.
--------------------------------------------------------------------
Total Enforcement.................... 366.3 ......................................... 360.85
----------------------------------------------------------------------------------------------------------------

Another factor that must be considered is the degree to which
additional staffing can be absorbed into various IRS organizational
units. Figure 2 depicts the distribution of new hires in major IRS
organizations under the President's and Board's budgets. The Board
believes its budget strikes a more balanced posture across all IRS
organizational units and expands enforcement resources for a range of
activities that are important elements of IRS enforcement, although
they do not generate revenue directly, such as examination of tax
exempt organization reporting, regulation of pension plans, and
criminal investigation of tax fraud and abusive tax shelters. These
activities are all part of a balanced, enforcement program that has as
a goal the promotion of voluntary compliance among all taxpayer
segments.
To better understand the impact of both budgets on the Small
Business/Self-Employed (SB/SE) and Large and Mid-Sized Business (LMSB)
organizations, the Board examined hiring requirements during fiscal
year 2009 for both divisions. Table 3 shows the number of Mission
Critical Occupation (MCO) employees projected to be on-rolls as of
September 30, 2008, as well as the hiring requirements contained in
both budgets. The Board has used a rule of thumb that 15 percent new
hires is a reasonable limit on the amount of new employees that can be
effectively accommodated into an organization in a year. It had
concerns with the hiring implications of its own budget on SB/SE, but
thought this risk could be mitigated. The President's budget would
increase the percentage of new hires in SB/SE to over 23 percent of its
employees in fiscal year 2009, and over 16 percent for LMSB.

TABLE 3.--SB/SE AND LMSB HIRING REQUIREMENTS IN THE BOARD'S AND PRESIDENT'S FISCAL YEAR 2009 BUDGETS
----------------------------------------------------------------------------------------------------------------
Operating Unit Mission Critical Occupations
---------------------------------------------------
Oversight board budget President's budget
---------------------------------------------------
SB/SE LMSB SB/SE LMSB
----------------------------------------------------------------------------------------------------------------
Projected on rolls as of 9/30/2008.......................... 19,394 5,126 19,394 5,126
---------------------------------------------------
Projected Attrition Hires in fiscal year 2009............... 2,612 403 2,612 403
Projected New Hires in fiscal year 2009 to Meet Budget 1,177 273 1,918 433
Request....................................................
---------------------------------------------------
Total Attrition Hires and New Hires................... 3,789 676 4,530 836
---------------------------------------------------
Percent of Hires to total MCO population.................... 19.5 13.2 23.4 16.3
----------------------------------------------------------------------------------------------------------------

As in fiscal year 2006 through fiscal year 2008, the administration
proposes to include its requested enforcement increases as a Budget
Enforcement Act program integrity cap adjustment. The Oversight Board's
recommended enforcement initiatives would also qualify for such
treatment, should Congress decide to make such an adjustment.

Strategic Goal 3--Modernize the IRS Through its People, Processes and
Technology
The most effective strategy for reducing the tax gap in the long
term is to provide the IRS with modern technology that enables it to
operate at a high performance level. The Board has no doubts that a
high performing organization with high service, quality, and
satisfaction levels also minimizes taxpayer burden. Under such
conditions, service and enforcement activities are prompt, efficient,
and correct.
The Board has identified program initiatives for IT and
infrastructure activities that are funded under the BSM and Operations
Support accounts. These initiatives will further modernize the IRS core
IT systems used for tax administration, upgrade its infrastructure, and
improve its security posture.

BUSINESS SYSTEMS MODERNIZATION PROGRAM INITIATIVE

Tax administration is a knowledge-intensive activity and the IRS
depends heavily on information technology (IT) to leverage the
knowledge and perform its mission. The IRS has made slow but steady
progress in replacing its antiquated IT systems. The most noticeable
improvements to taxpayers have been increased use of electronic
products and services to interact with the IRS. However, the IRS'
performance is still hampered by archaic IT systems used for central
record-keeping that update taxpayer account information on a weekly
instead of a daily basis.
The Board has long advocated that the BSM program be funded at a
higher level so progress could be made more quickly. Admittedly the
program experienced a series of cost and schedule overruns during its
first several years, and the result has been to slow down the funding
stream to levels that dictate only modest progress can be made in
modernizing the core IRS master files and account management systems.
Because of its long-term effect on reducing the tax gap, the Board
considers increasing BSM funding so that the pace of IT modernization
can be increased as having the highest priority.
Figure 3 compares the BSM budget recommended by the Oversight
Board, the amount requested by the President, and the BSM funding
appropriated by Congress for fiscal years 2003 to 2008. BSM funding
needs to be restored to the levels realized in fiscal year 2003 and
fiscal year 2004 to make progress faster.

Table 4 shows the Board's and President's budgets for the BSM
program in fiscal year 2009. Had the Board's funding recommendations
been followed, the IRS would be closer to the day when it could update
its central records on a daily basis.

TABLE 4.--APPLICATION OF FISCAL YEAR 2009 BSM FUNDING TO PROJECTS IN THE IRS OVERSIGHT BOARD'S AND PRESIDENT'S
BUDGETS
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Oversight board President
-----------------------------------------
Fiscal Increase Increase
Project activities year Fiscal over Fiscal over
2008 year fiscal year fiscal
2009 year 2008 2009 year 2008
----------------------------------------------------------------------------------------------------------------
Customer Account Data Engine................................ 58.5 80.0 21.5 58.8 0.3
Accounts Management Services................................ 29.0 47.4 18.4 26.2 (2.8)
Modernized e-File........................................... 55.8 36.1 (19.7) 25.0 (30.8)
Common Services Project..................................... ........ 16.0 16.0 ........ .........
Integrated Financial System................................. ........ 73.0 73.0 ........ .........
Core Infrastructure; Architecture Integration & Management; 78.6 98.1 19.5 69.3 (9.3)
and Management Reserve.....................................
---------------------------------------------------
Subtotal Capital Investments.......................... 221.8 350.6 128.8 179.3 (42.6)
BSM Labor................................................... 45.2 56.7 11.5 43.4 (1.8)
===================================================
BSM Program Total..................................... 267.1 407.3 140.2 222.7 (44.4)
----------------------------------------------------------------------------------------------------------------
Note: BSM program excludes $1.2 million of corporate costs in Operations Support.

The Board believes that when implemented, modernized IT systems
will literally save taxpayers billions of dollars in burden reduction
and make the IRS much more efficient. For example, replacement of the
Individual Master File by the Customer Account Data Engine (CADE) will
allow the IRS to update the tax accounts for individuals on a daily
basis, instead of its current weekly update process. The Oversight
Board expects that a rapid refund from the IRS of 3 to 5 days will
reduce the number of Refund Anticipation Loans (RALs). The National
Consumer Law Center and Consumer Federation of American estimate that
approximately 12 million American taxpayers spent an unnecessary $1.6
billion on RALs in 2004 (the latest year for which data is available)
to obtain their refund monies faster by 2 weeks. Moreover, daily
updating of account records will give IRS employees and taxpayers
access to the most current taxpayer account data, eliminating the
problems associated with having various data bases with less than
current status. The Oversight Board expects that daily posting of
account information will improve the IRS' analysis capability and
greatly reduce the burdens associated with the account resolution
process.
The Modernized e-File system not only makes it easier for taxpayers
to file tax returns with the IRS, it reduces the human resources needed
to receive and process tax returns and eliminates the error-prone
transcription process. For corporate filers, it helps the LMSB division
improve currency and cycle time in working large corporate tax cases.
When implemented for individual tax returns, it will make the
electronic filing process even simpler than it is today with the
current legacy electronic filing system.
The Integrated Financial System (IFS) will provide necessary
improvements to the system the IRS uses to manage its financial
resources, clearly a must for any agency, especially one that is
responsible for managing taxpayers' accounts as well as its own
appropriated resources. The IFS upgrade is needed to ensure that the
IRS remains in compliance with Federal accounting and other financial
management requirements. The additional funding for the IFS initiative
will enable the IRS to add procurement and asset management modules to
the existing IFS application and integrate related business processes
with core accounting and financial management operations. The funding
will also provide for the subsequent transfer of IFS to a Shared
Service Center and thereby maintain its longer term viability.
The Board believes that funding for the BSM program should be
accelerated, not slowed down. Failure to fund the IRS BSM program at
higher levels, in the view of the Board, is a case of being penny-wise
and pound foolish.

INFORMATION TECHNOLOGY/INFRASTRUCTURE PROGRAM INITIATIVES

The IRS must be held to the highest standards for security and data
integrity while increasing its engagement in the electronic world in
which most taxpayers already live. Meeting this dual challenge of high
security and a high degree of electronic interaction with taxpayers
demands that the IRS have a modern information systems and
infrastructure.
The Board recommends six program initiatives for a total of $103
million that will improve the IRS' operations by allowing it to make
critical improvements to its technology and personnel infrastructure.
By comparison, the President's budget contains no initiatives for IRS
infrastructure.
Three of the initiatives, totaling $32.2 million, enhance the IRS'
security posture as the way the IRS does business continues to evolve
and security threats seem to increase on a daily basis. Data security
has taken on an expanded meaning in a post-9/11 world. Terrorists from
around the globe are actively working to exploit weaknesses in
Government IT security systems with the intent of producing both great
physical and economic harm. Disrupting IRS returns processing and
stealing sensitive information could wreak havoc on the economy and
financial markets. The IRS cannot be complacent with respect to
security, and the Board recommends the following security initiatives:
--Enhance IT Security ($16.7 million);
--Enhance Contingency Planning and Disaster Recovery ($8.7 million);
and
--Implement Security Auditing ($6.8 million).
The first initiative enables the IRS to further implement key IT
security and privacy safeguards to assure the integrity of sensitive
taxpayer and employee data and supporting infrastructure processes.
Protecting taxpayer data is paramount. The second initiative is to
enhance the IRS enterprise-wide contingency planning and disaster
recovery capabilities to support critical business systems. Any
unavailability of critical IRS business systems poses an unacceptably
high risk to the Nation's security. The third initiative, Security
Auditing, will allow the IRS to more effectively monitor key networks
and systems to identify any unauthorized activities.
The remaining three initiatives, for a total of $71.3 million,
allow the IRS to improve other elements of its infrastructure. They
are:
--Redesign Form 990 for Tax Exempt Organizations ($23.5 million);
--Preserve Quality IT Workforce in Applications Development ($36.8
million); and
--Build Alternate Power Supply for the Computing Centers ($11
million).
The first initiative, the only one that is not considered high
priority, is recommended because it brings new efficiencies to tax
filing for a segment of taxpayers who are frequently ignored because
their tax returns do not produce revenue--tax exempt organizations. The
Form 990 tax return is difficult to complete for tax exempt
organizations to complete and for reviewers to comprehend. Worse, it
fails to provide the IRS with sufficient information to detect and
analyze compliance trends in the sector and target enforcement actions
as needed.
The second initiative will give the IRS better tools to retain its
IT workforce by mitigating intellectual and experiential loss through a
series of supporting strategies such as workforce re-tooling,
succession planning, and retention. The third initiative provides
alternate power supply for three of the IRS's computing centers.
Currently there is but a single power supply facility at each of the
computing centers. An alternate power supply capability at each of the
three computing centers would ensure the continuous operation of, and
continuous access to, tax processing systems at the computing centers
during unplanned emergencies and planned power supply tests, and avoid
the revenue loss and overtime expense associated with the current
process that requires total shut down periods.

INVESTING IN IRS IS A GOOD BUSINESS DECISION SUPPORTED BY THE PUBLIC

In spite of recommendations made by the IRS Oversight Board, the
IRS has not been funded at the most effective levels to achieve its
strategic objectives. Figure 4 illustrates funding recommendations made
by the Board since its inception, the President's budget request during
this same time frame, and the funding appropriated by Congress. One of
the principal reasons for this so-called ``resource gap'' is the budget
process which treats the IRS the same as it does all other
discretionary spending requests. It does not credit the IRS with
bringing in 95 percent of all the revenue to fund the Federal
Government, nor does it recognize the previously discussed four-to-one
return on every dollar invested in tax enforcement.
The Oversight Board has urged previously Congress to view funding
of the IRS as an investment.\1\ Other members of the tax administration
community, such as the National Taxpayer Advocate and the National
Treasury Employees Union, have made similar recommendations.\2\
---------------------------------------------------------------------------
\1\ IRS Oversight Board reports, Fiscal Year 2006 IRS Budget
Recommendations/Special Report, Fiscal Year 2007 IRS Budget
Recommendations/Special Report, and Fiscal Year 2008 IRS Budget
Recommendations/Special Report.
\2\ NTA, 2006 Report to Congress, Section 2, p. 445, and Statement
of Colleen M. Kelley, President, National Treasury Employees Union,
Testimony Before the House Committee on Ways and Means, May 23, 2007.

There are a number of approaches that Congress could take to
achieve this result, such as funding the IRS outside of budget caps,
and the Board believes that the implementation of such a change is best
left for Congress to decide. The Board would be remiss, however, if it
didn't point out providing additional funds to the IRS has been
consistently supported by nearly two out of three members of the
public. In its annual Taxpayer Attitude Survey, the Board has asked
taxpayers whether they support additional funding for the IRS. The
results for 2005 through 2007 are shown in Table 5.

TABLE 5.--RESULTS OF TAXPAYER ATTITUDE SURVEY ON IRS FUNDING
----------------------------------------------------------------------------------------------------------------
Percent completely agree Percent mostly agree
Survey question 11 -----------------------------------------------------------
2007 2006 2005 2007 2006 2005
----------------------------------------------------------------------------------------------------------------
The IRS should receive extra funding to enforce tax 24 24 20 40 39 43
laws and ensure taxpayers pay what they owe........
The IRS should receive extra funding so it can 21 24 22 42 42 44
assist more taxpayers over the phone and in person.
----------------------------------------------------------------------------------------------------------------

The Board believes such strong support indicates the public
understands the need for effective tax administration and realizes
that, ultimately, it pays for itself.

CONCLUSION

Approving a budget is not just about money; it's also about
choices. The Board believes its budget recommendations, if implemented,
will put the IRS on an effective long-term path to achieving the IRS
strategic goals, improving voluntary compliance, and reducing the tax
gap.
Although the Board's recommended budget is $375 million more than
the President's request, there are some important decisions that must
be made with respect to priorities and balance. The Congress must not
only decide the amounts to be appropriated, but must also choose
whether it wants to pursue short-term growth in enforcement activity
over a more balanced path that stresses the benefits of long-term
investments in technology, infrastructure, service, and research.

Appendix A.--IRS Oversight Board Recommended IRS Fiscal Year 2009
Budget

TABLE A-1.--IRS OVERSIGHT BOARD'S RECOMMENDED FISCAL YEAR 2009 IRS
BUDGET BY PROGRAM INITIATIVE
[In millions of dollars]
------------------------------------------------------------------------
Amount
------------------------------------------------------------------------
Fiscal Year 2008 Enacted Appropriation................. 10,892.38
Base Adjustments................................... 262.62
Savings/Reinvestments.............................. (61.65)
----------------
Fiscal Year 2008 Base Budget..................... 11,093.35
================
INITIATIVES

Enforcement:
Reduce the Tax Gap for Small Business/Self-Employed 120.7
Increase Reporting Compliance of Domestic Taxpayers 16.4
with Offshore Activity............................
Reduce the Tax Gap for Large Businesses............ 52.0
Expand Federal Payment Levy Program................ 17.3
Reduce Tax Fraud................................... 72.2
Enhance Financial Investigations of Narcotics 24.0
Trafficking Organizations.........................
Enhance BSA Compliance Program..................... 3.4
Address Complexity through Up-Front Guidance, 8.9
Education, and Correction Opportunities...........
Expand Examination of Tax Exempt Organizations..... 28.6
Increase Tax Court Litigation...................... 5.8
Implement New Procedural Tax Court Requirements.... 3.4
Improve Tax Gap Estimates, Measurement, and 11.1
Detection of Non-Compliance.......................
Increase Monitoring of Preparers................... 2.5
----------------
Total Enforcement................................ 366.3
================
Taxpayer Services:
Maintain Processing of Critical Pension Plan 6.3
Returns...........................................
Research Taxpayer Burden, Complexity, and 10.0
Compliance........................................
Expand Volunteer Income Tax Assistance and Low 10.0
Income Tax Clinics................................
----------------
Total Service.................................... 26.3
================
Infrastructure/IT:
Enhance IT Security................................ 16.7
Enhance Contingency Planning and Disaster Recovery. 8.7
Implement Security Auditing........................ 6.8
Redesign Form 990 for Tax Exempt Organizations..... 23.5
Preserve Quality IT Workforce in Applications 36.8
Development.......................................
Build Alternate Power Supply for the Computing 11.0
Centers...........................................
----------------
Infrastructure/IT Initiatives Subtotal........... 103.5
================
Business Systems Modernization (BSM)................... 142.4
HITCA.................................................. 5.50
================
Total Initiatives................................ 644.00
================
Fiscal Year 2009 Budget Request........................ 11,737.35
Fiscal Year 2009 Request Increase over Fiscal Year 2008 844.97
Base..................................................
Fiscal Year 2009 President's Request for IRS........... 11,361.51
Increase Over President's Budget Request............... 375.8
------------------------------------------------------------------------

TABLE A-2.--IRS OVERSIGHT BOARD'S RECOMMENDED FISCAL YEAR 2009 IRS BUDGET BY APPROPRIATION ACCOUNT
[In millions of dollars]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Taxpayer Ops
services Enforcement support BSM HITCA Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
Fiscal Year 2008 Enacted Appropriation..................................... 2,150.0 4,780.0 3,680.1 267.1 15.2 10,892.4
Base Adjustments....................................................... 54.7 125.0 81.2 1.4 0.3 262.6
Savings/Reinvestments.................................................. (10.5) (48.8) (2.2) .......... (0.2) (61.6)
----------------------------------------------------------------------------
Fiscal Year 2009 Base Budget......................................... 2,194.2 4,856.2 3,759.0 268.4 15.4 11,093.4
============================================================================
INITIATIVES

Enforcement:
Reduce the Tax Gap for Small Business/Self-Employed.................... 2.9 94.0 23.8 .......... ........... 120.7
Increase Reporting Compliance of Domestic Taxpayers with Offshore ........... 13.8 2.6 .......... ........... 16.4
Activity..............................................................
Reduce the Tax Gap for Large Businesses................................ ........... 44.0 8.0 .......... ........... 52.0
Expand Federal Payment Levy Program.................................... 0.4 16.5 0.4 .......... ........... 17.3
Reduce Tax Fraud....................................................... ........... 55.8 16.4 .......... ........... 72.2
Enhance Financial Investigations of Narcotics Trafficking Organizations ........... 21.0 3.0 .......... ........... 24.0
Enhance BSA Compliance Program......................................... ........... 2.8 0.6 .......... ........... 3.5
Address Complexity through Up-Front Guidance, Education, and Correction 1.1 6.5 1.3 .......... ........... 8.9
Opportunities.........................................................
Expand Examination of Tax Exempt Organizations......................... 0.2 23.3 5.1 .......... ........... 28.6
Increase Tax Court Litigation.......................................... ........... 5.0 0.8 .......... ........... 115.8
Implement New Procedural Tax Court Requirements........................ ........... 2.8 0.5 .......... ........... 3.4
Improve Tax Gap Estimates, Measurement, and Detection of Non-Compliance ........... 7.6 3.5 .......... ........... 11.1
Increase Monitoring of Preparers....................................... ........... 2.2 0.4 .......... ........... 2.5
----------------------------------------------------------------------------
Total Enforcement.................................................... 4.7 295.2 66.5 .......... ........... 366.3
============================================================================
Taxpayer Services:
Maintain Processing of Critical Pension Plan Returns................... 6.0 ........... 0.2 .......... ........... 6.3
Research Taxpayer Burden, Complexity, and Compliance................... ........... ........... 10.0 .......... ........... 10.0
Expand VITA and Low Income Tax Clinics................................. 9.8 ........... 0.2 .......... ........... 10.0
----------------------------------------------------------------------------
Total Service........................................................ 15.8 ........... 10.5 .......... ........... 26.3
============================================================================
Infrastructure/IT:
Enhance IT Security.................................................... ........... ........... 16.7 .......... ........... 16.7
Enhance Contingency Planning and Disaster Recovery..................... ........... ........... 8.7 .......... ........... 8.7
Implement Security Auditing............................................ ........... ........... 6.9 .......... ........... 6.9
Redesign Form 990 for Tax Exempt Organizations......................... ........... ........... 23.5 .......... ........... 23.5
Preserve Quality IT Workforce.......................................... ........... ........... 36.8 .......... ........... 36.8
Build Alternate Power Supply for the Comp Centers...................... ........... ........... 11.0 .......... ........... 11.0
----------------------------------------------------------------------------
Infrastructure/IT Initiatives Subtotal............................... ........... ........... 103.5 .......... ........... 103.5
============================================================================
Business Systems Modernization (BSM)....................................... ........... ........... 1.2 141.2 ........... 142.4
HITCA...................................................................... ........... ........... ........... .......... 5.5 5.5
----------------------------------------------------------------------------
Total Initiatives.................................................... 20.5 295.2 181.6 141.2 5.5 644.0
============================================================================
Fiscal Year 2009 Budget Recommendation..................................... 2,214.7 5,151.4 3,940.6 409.7 20.9 11,737.4
Fiscal Year 2009 Recommendation over Fiscal Year 2008 Enacted.............. 64.7 371.4 260.6 142.6 5.7 845.0
Fiscal Year 2009 President's Request for IRS............................... 2,150.0 5,117.3 3,856.2 222.7 15.4 11,361.5
Increase Over President's Budget Request................................... 64.7 34.2 84.5 187.0 5.5 375.9
--------------------------------------------------------------------------------------------------------------------------------------------------------

Senator Durbin. Taxpayer Advocate, Nina Olson.
STATEMENT OF NINA E. OLSON, NATIONAL TAXPAYER ADVOCATE,
INTERNAL REVENUE SERVICE
Ms. Olson. Chairman Durbin, Ranking Member Brownback, and
members of the subcommittee, thank you for inviting me to
testify on the proposed budget of the IRS for fiscal year 2009.
As an initial matter, I want to acknowledge that the IRS is
doing an excellent job with most of its core services as
illustrated by its ability to pull off the recent filing season
despite the late AMT patch and the need to apply its limited
resources to providing stimulus payments. There are always
tasks the IRS could perform better and I will address some of
those today, but I think it is important to take a moment to
reflect on the vast responsibilities the IRS must meet to
collect the revenue our Government requires to function and to
acknowledge how much the IRS does very well.
Now, I would like to emphasize five points.
First, in my 2006 annual report to Congress, I recommended
that Congress provide the IRS with after-inflation budget
increases of about 2 to 3 percent a year for the foreseeable
future. Assuming the funds are wisely spent, I believe that
each additional dollar appropriated for the IRS will generate
substantially more than $1 in increased Federal revenue.
Providing adequate funding for the IRS, which is in reality the
accounts receivable department of the Federal Government, is a
wise financial investment.
Second, one of the most critical choices facing tax
administration is how to allocate resources between taxpayer
services and tax law enforcement. While I believe that both
categories would benefit from additional funding, I am
concerned that the IRS has been emphasizing enforcement at the
expense of taxpayer services. Over the 5-year period, fiscal
year 2004 through fiscal year 2008, GAO concluded that funding
for enforcement has increased substantially while funding for
taxpayer services has been reduced. The budget proposal for
fiscal year 2009 would continue this trend.
Moreover, while the taxpayer services appropriation is
currently $2.2 billion, more than 70 percent of those funds are
used for filing and account services, mostly the processing of
tax returns. Return processing is not pure taxpayer service but
also constitutes the first step in screening returns for audit.
The budget subcategory titled ``pre-filing taxpayer assistance
and education'' is what most people think of as core taxpayer
service, and significantly, only 6 percent--6 percent--of the
IRS budget, or $645 million, is currently devoted to this area.
The budget proposal would reduce this $645 million taxpayer
service amount by about $28 million, a reduction of 4.35
percent in nominal terms and a larger reduction after taking
into account inflation.
There are no reliable data that show that more enforcement
is more effective than more taxpayer service in increasing
compliance. I believe the IRS can produce a positive return on
investment from more funding in both areas, but given limited
resources, I think it is misguided to continue to ramp up
enforcement at the expense of providing core taxpayer services.
Third, research plays a vital role in helping the IRS make
the major strategic and operational decisions needed to
effectively administer the tax system. Just as research and
development (R&D) is critical to a technology company as it
seeks to improve the products and services it provides to
customers, tax administration-related research is critical to
the IRS as it seeks to meet taxpayer service needs and improve
tax compliance in a cost effective manner. For that reason, I
have consistently advocated for a more robust IRS research
capability.
The Taxpayer Advocate Service has initiated or worked with
the IRS to conduct taxpayer-centric research on several
enforcement and service issues. Some of these projects have
been undertaken in response to appropriations directives and
they are detailed in my written statement.
In my annual reports to Congress and in prior testimony, I
have expressed serious concerns about many aspects of the
private debt collection initiative. I now add to these concerns
the issue of foregone revenue. Very simply, the PDC initiative
will cost the Government more than $81 million in foregone
revenue this year, and the cost is likely to reach nearly $500
million over the next 6 years. Moreover, 46 percent of the
fully paid liabilities included in PDC gross revenue have been
collected through offsets or direct payments made by the
taxpayer after receiving a letter from the IRS informing the
taxpayer that his or her account would be placed with a private
collection agency (PCA), but before the PCA made contact with
the taxpayers. These fully paid liabilities are a direct result
of IRS action, not action taken by the PCA. Although the
purpose of the private debt collection (PDC) program is
obviously to raise revenue, the PDC program has lost revenue in
absolute terms and will continue to cost the Government
significant foregone revenue each year.
I will make my fifth point in my written statement so I am
not penalized.
Senator Durbin. Thank you very much, Ms. Olson.
[The statement follows:]

Prepared Statement of Nina E. Olson

Mr. Chairman, Ranking Member Brownback, and distinguished Members
of the Subcommittee: Thank you for inviting me to submit this written
statement regarding the proposed budget of the Internal Revenue Service
(IRS) for fiscal year 2009. I will address the overall level of funding
I believe the IRS should receive, the allocation of that funding
between enforcement and taxpayer service, and a number of important tax
administration issues in which this Committee has expressed an
interest. I approach these issues from my perspective as the National
Taxpayer Advocate, the voice for taxpayers and taxpayer rights inside
the IRS.\1\
---------------------------------------------------------------------------
\1\ The views expressed herein are solely those of the National
Taxpayer Advocate. The National Taxpayer Advocate is appointed by the
Secretary of the Treasury and reports to the Commissioner of Internal
Revenue. However, the National Taxpayer Advocate presents an
independent taxpayer perspective that does not necessarily reflect the
position of the IRS, the Treasury Department, or the Office of
Management and Budget. Congressional testimony requested from the
National Taxpayer Advocate is not submitted to the IRS, the Treasury
Department, or the Office of Management and Budget for prior approval.
However, we have provided courtesy copies of this statement to both the
IRS and the Treasury Department in advance of this hearing.
---------------------------------------------------------------------------
As a threshold matter, I want to acknowledge that the IRS is doing
an excellent job with most of its core services, and it is seriously
attempting to improve its operations in other areas. This filing season
alone demonstrates that when the IRS devotes its full attention to a
task, it performs it extraordinarily well. As I noted in my 2007 Annual
Report, late-year tax-law changes impact both taxpayers and the IRS,
and the uncertainty surrounding such changes increases the risk that
problems will arise with basic service delivery and return
processing.\2\ These challenges increase when the IRS must devote
substantial resources during the filing season to a major new
initiative, such as preparing to issue the recently authorized economic
stimulus payments. To deliver these payments, the IRS not only must
process payments to the over 130 million taxpayers who currently file
income tax returns, but it also must identify and process returns from
and payments to more than 20.5 million persons who have no filing
requirement.\3\ All of these exigencies divert the IRS from other
important work, yet the fact that the IRS has managed to turn on a dime
and deliver this filing season without significant glitches is a
testament to the extraordinary people who work at the IRS.
---------------------------------------------------------------------------
\2\ See National Taxpayer Advocate 2007 Annual Report to Congress
3-12 (Most Serious Problem: The Impact of Late-Year Tax-Law Changes on
Taxpayers).
\3\ Approximately 20.5 million persons received Social Security or
Veterans benefits and are therefore likely to qualify for stimulus
payments but did not file tax returns in 2006. IRS News Release,
Special Economic Stimulus Payment Packages Go to Social Security,
Veterans Recipients, IRS-2008-37 (Mar. 10, 2008). There is also an
unknown number of low income taxpayers who ordinarily would not have a
filing requirement but will have to file this year to receive stimulus
payments.
---------------------------------------------------------------------------
There are always tasks the IRS could perform better--and I will
address some of them below--but I think it is important to take a
moment to reflect on the vast responsibilities the IRS must meet to
collect the revenue our Government requires to function and to
acknowledge how much the IRS does very well.

To Increase Federal Revenue, Congress Should Provide Increases in IRS
Personnel Funding at a Rate of About Two Percent to Three
Percent a Year Above Inflation
In my 2006 Annual Report to Congress, I recommended that Congress
provide the IRS with after-inflation increases of about 2 percent to 3
percent a year for the foreseeable future. Assuming the funds are
wisely spent, I said that I believe increasing the IRS budget at this
rate is an excellent financial investment. I continue to believe this
is the case.
Most Federal expenditure programs are just that--expenditure
programs. The funds are intended to be spent on worthwhile programs,
but the expenditures generally do not directly generate more Federal
revenue.
The IRS is different. The IRS is effectively the Accounts
Receivable Department of the Federal Government, and it collects about
96 percent of all Federal revenue.\4\ On a budget of about $10.6
billion,\5\ the IRS collected about $2.24 trillion in fiscal year
2006.\6\ In other words, every $1 spent on the IRS produced about $210
in Federal revenue.\7\
---------------------------------------------------------------------------
\4\ Government Accountability Office, GAO-07-136, Financial Audit:
IRS's Fiscal Years 2006 and 2005 Financial Statements 84 (Nov. 2006).
\5\ Department of the Treasury, Fiscal Year 2007 Budget in Brief at
59.
\6\ Government Accountability Office, GAO-07-136, Financial Audit:
IRS's Fiscal Years 2006 and 2005 Financial Statements at 95 (Nov.
2006). The IRS actually collected $2.51 trillion on a gross basis in
fiscal year 2006, but issued $277 billion in tax refunds.
\7\ When collecting tax from the vast majority of taxpayers who
file returns and pay all or substantially all of the tax they owe
voluntarily, the cost the IRS incurs per taxpayer is very low. As the
IRS attempts to collect tax from noncompliant taxpayers through broader
outreach efforts or through examination and collection actions, the
cost per taxpayer rises substantially. Therefore, the marginal ROI the
IRS achieves as it attempts to collect unpaid taxes is likely to be
considerably lower than the average ROI of 210:1 that the IRS achieves
on taxes paid voluntarily. But if the IRS were given more resources,
most data indicate that the IRS could generate a substantially positive
marginal ROI.
---------------------------------------------------------------------------
If the Federal Government were a private company, its management
clearly would fund the Accounts Receivable Department at whatever level
it believed would maximize the company's bottom line. Since the IRS is
not a private company, maximizing the bottom line is not--in and of
itself--an appropriate goal. But the public sector analogue should be
to maximize tax compliance, especially voluntary compliance, with due
regard for protecting taxpayer rights and minimizing taxpayer burden.
Studies show that if the IRS were given more resources, it could
collect substantially more revenue.
In his final report to the IRS Oversight Board in 2002, former
Commissioner Charles Rossotti presented a discussion titled ``Winning
the Battle but Losing the War'' that detailed the consequences of the
lack of adequate funding for the IRS. He identified 11 specific areas
in which the IRS lacked resources to do its job, including taxpayer
service, collection of known tax debts, identification and collection
of tax from non-filers, identification and collection of tax from
underreported income, and noncompliance in the tax-exempt sector.
Commissioner Rossotti provided estimates of the revenue cost in
each of the 11 areas based on IRS research data. In the aggregate, the
data indicated that the IRS lacked the resources to handle cases worth
about $29.9 billion each year. It placed the additional funding the
agency would have needed to handle those cases at about $2.2
billion.\8\
---------------------------------------------------------------------------
\8\ Commissioner Charles O. Rossotti, Report to the IRS Oversight
Board: Assessment of the IRS and the Tax System 16 (Sept. 2002).
---------------------------------------------------------------------------
Significantly, this estimate reflected only the potential direct
revenue gains. Economists have estimated that the indirect effects of
an examination on voluntary compliance provide further revenue gains.
While the indirect revenue effects cannot be precisely quantified, two
of the more prominent studies in the area suggest the indirect revenue
gains are between 6 and 12 times the amount of a proposed
adjustment.\9\
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\9\ Alan H. Plumley, Pub. 1916, The Determinants of Individual
Income Tax Compliance: Estimating The Impacts of Tax Policy,
Enforcement, and IRS Responsiveness 35-36 (Oct. 1996); Jeffrey A.
Dubin, Michael J. Graetz & Louis L. Wilde, The Effect of Audit Rates on
the Federal Individual Income Tax, 1977-1986, 43 Nat. Tax J. 395, 396,
405 (1990).
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I want to emphasize that the existing modeling in this area is not
especially accurate, and estimates of both the direct and indirect
effects of IRS programs vary considerably. As I will discuss below, the
IRS needs to develop better modeling to produce more accurate return-
on-investment estimates. But I also want to emphasize that almost all
studies show that, within reasonable limits, each additional dollar
appropriated to the IRS should generate substantially more than an
additional dollar in Federal revenue, assuming the funding is wisely
spent.

The IRS Currently Spends Only Six Percent of Its Budget on Taxpayer
Assistance and Education; a More Equitable Balance Between
Taxpayer Services and Enforcement Should Be Achieved
One of the most critical choices facing tax administration is how
to allocate resources between taxpayer services and tax-law
enforcement. While I believe that both categories would benefit from
additional funding--and I do not believe the categories should be
viewed as mutually exclusive--I am concerned that the IRS has been
emphasizing enforcement at the expense of taxpayer service.
After the administration issued its fiscal year 2008 budget
proposal last year, the GAO analyzed recent IRS funding trends. Over
the 5-year period fiscal year 2004 through fiscal year 2008, it
concluded that funding for enforcement has increased substantially
while funding for taxpayer services has been reduced. Based on the
administration's proposal for fiscal year 2008, it pointed out that
funding over the fiscal year 2004 through fiscal year 2008 period would
increase by 19.4 percent for enforcement while funding for taxpayer
services would decline by 3.8 percent.\10\ The final appropriations
bill for fiscal year 2008 made a modest adjustment to the
administration's proposal, providing about $46.9 million more for
taxpayer service and $145 million less for enforcement.\11\
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\10\ Government Accountability Office, GAO-07-673, Internal Revenue
Service: Interim Results of the 2007 Tax Filing Season and the Fiscal
Year 2008 Budget Request 27 (April 2007). These numbers are apparently
not adjusted for inflation. GAO reported that overall IRS funding would
increase, on an inflation-adjusted basis, by a mere 0.5 percent from
fiscal year 2004 to fiscal year 2008 under the Administration's
proposal. Id. at 26.
\11\ Compare Department of the Treasury, Fiscal Year 2009 Budget in
Brief at 53 with Department of the Treasury, Fiscal Year 2008 Budget in
Brief at 55.
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However, the proposal for fiscal year 2009 would continue the trend
of spending relatively more on enforcement. The pending budget proposal
would increase enforcement spending by $490 million (7 percent), while
increasing spending for taxpayer services by only $23 million (0.6
percent).\12\ Thus, after inflation, the proposal would reduce taxpayer
services spending still further.
---------------------------------------------------------------------------
\12\ Department of the Treasury, Fiscal Year 2009 Budget in Brief
at 54. These dollar amounts reflect the allocation of the Operations
Support budget to the Taxpayer Services and Enforcement categories.
---------------------------------------------------------------------------
Moreover, the budget categories of ``Taxpayer Services'' and
``Enforcement'' are misleading. Of the $2.2 billion in the ``Taxpayer
Services'' category, only $645 million, or 6 percent of the IRS budget,
is currently allocated for ``Pre-filing Taxpayer Assistance and
Education.'' \13\ A significant majority of funds under the ``Taxpayer
Services'' category is allocated for ``Filing and Account Services,''
which largely covers the processing of tax returns. Returns processing
is hardly a pure service activity. While it does enable the IRS to
issue tax refunds, it is an internal processing function that also
constitutes the first step in screening returns for audit. In any
event, it is far removed from the type of taxpayer service that informs
taxpayers about their tax obligations and assists them in complying
with the laws. The budget proposal would reduce funding for taxpayer
assistance and education from $645 million to $617 million--a reduction
of 4.34 percent in nominal terms and a larger reduction after taking
into account inflation.\14\
---------------------------------------------------------------------------
\13\ Id. at 53.
\14\ Department of the Treasury, Fiscal Year 2009 Budget in Brief
at 53.
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I am deeply concerned about this long-term shift in the balance
between taxpayer services and enforcement and the fact that only 6
percent of the IRS budget is devoted to pre-filing taxpayer assistance
and education, which I view as core taxpayer service. There is no
reliable data showing that more enforcement is more effective than more
taxpayer service in increasing compliance. I believe the IRS can
produce a positive return on investment from more funding in both
areas. But given limited resources, I think it is misguided to continue
to ramp up enforcement at the expense of taxpayer service.
The concerns I am expressing about the relative shift in emphasis
from taxpayer service to enforcement do not reflect simply the
misgivings of a zealous taxpayer advocate. My concerns are shared by
former IRS Commissioner Rossotti. In a memoir about his experience
running the IRS from 1997 to 2002, Mr. Rossotti wrote:

Some critics argue that the IRS should solve its budget problem by
reallocating resources from customer support to enforcement. In the
IRS, customer support means answering letters, phone calls, and visits
from taxpayers who are trying to pay the taxes they owe. Apart from the
justifiable outrage it causes among honest taxpayers, I have never
understood why anyone would think it is good business to fail to answer
a phone call from someone who owed you money.\15\
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\15\ Charles O. Rossotti, Many Unhappy Returns: One Man's Quest to
Turn Around the Most Unpopular Organization in America 285 (2005).

At his confirmation hearing, Commissioner Shulman said that he
believes the choice between service and enforcement is a ``false
choice'' because the IRS must do both well.\16\ I agree completely. But
the IRS needs adequate funding in both areas to do the job.
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\16\ Hearing Before the S. Comm. on Finance, 110th Cong. (2008)
(Jan. 29, 2008) (statement of Douglas H. Shulman).
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The IRS Has Improved Its Research in Recent Years, But Significant
Improvements Are Still Needed
Research plays a vital role in helping the IRS make the major
strategic and operational decisions needed to effectively administer
the tax system. Just as R&D is critical to a technology company as it
seeks to improve the products and services it provides to customers,
tax administration-related research is critical to the IRS as it seeks
to meet taxpayer service needs and improve tax compliance in a cost-
effective manner. For that reason, I have consistently advocated for a
more robust IRS research capability.
The IRS has more information available today than it did 5 years
ago, particularly in the area of taxpayer service because of ongoing
work in connection with the Taxpayer Assistance Blueprint. However, the
IRS should continue to expand its available knowledge and should make
research an integral part of its next strategic plan. In particular,
the IRS should make it a priority to improve the accuracy of its return
on investment (ROI) estimates for various categories of work,
particularly taxpayer service and the indirect effect of enforcement
actions. Improved methods should also be developed to verify,
retrospectively, the marginal ROI that the IRS has achieved for major
categories of its work. Such information would be extremely helpful in
guiding future resource-allocation decisions.
Because of the value I place on research, TAS has initiated or
worked with the IRS to conduct taxpayer-centric research on enforcement
and service issues. Some of these projects have been undertaken in
response to Appropriations directives. For example, TAS Research is
currently working with the central IRS research function and the
research functions in the IRS's Wage & Investment and Small Business/
Self-Employed Divisions to develop and implement a 5-year research plan
to enhance taxpayer service in support of the Taxpayer Assistance
Blueprint initiative. TAS Research is collaborating with the IRS
research community to develop a 5-year research plan directly
supporting enterprise-wide strategic goals. TAS Research is working
with the central IRS research function to identify and quantify the
numerous factors that impact taxpayer compliance behavior. TAS Research
is working with the Office of Electronic Tax Administration and
Refundable Credits to study alternatives for increasing electronic
filing, and will work with the IRS's National Research Program to
conduct research into the causes of noncompliance (whether advertent or
inadvertent).
In addition, TAS Research is involved in a number of other
initiatives addressing significant tax administration issues, such as:
--A collaborative effort with the research function in the Wage &
Investment Division to explore development of a filter for the
Federal Payment Levy Program to protect low income taxpayers
from systemic levies;
--A collaborative effort with the Office of Program Evaluation and
Risk Analysis (OPERA) to explore new applications of ``agent-
based modeling,'' a technology that simulates taxpayer behavior
in social networks, to tax administration issues;\17\
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\17\ National Taxpayer Advocate 2007 Annual Report to Congress,
vol. 2 (Research Study: Simulating EITC Filing Behaviors: Validating
Agent Based Simulation for IRS Analyses: The 2004 Hartford Case Study).
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--A collaborative effort with the IRS research community to explore
ways to positively influence the impact practitioners and
preparers have on taxpayer compliance; and
--Ongoing research by an independent contractor into the impact
preparers have on taxpayer compliance.\18\
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\18\ National Taxpayer Advocate 2007 Annual Report to Congress,
vol. 2 (Research Study: Study of the Role of Preparers in Relation to
Taxpayer Compliance with Internal Revenue Laws).
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In Volume 2 of the 2007 National Taxpayer Advocate's Annual Report
to Congress, I published a comprehensive literature review of the
cognitive and normative factors that influence taxpayer compliance
behavior.\19\ In another section of the report, I adopt the central
recommendation of the study--that the IRS should establish a cognitive
learning and applied research laboratory to explore how taxpayer
values, social norms, and cognitive processes influence taxpayers'
compliance.\20\
---------------------------------------------------------------------------
\19\ National Taxpayer Advocate 2007 Annual Report to Congress,
vol. 2 (Research Study: Normative and Cognitive Aspects of Tax
Compliance: Literature Review and Recommendations for the IRS Regarding
Individual Taxpayers).
\20\ See National Taxpayer Advocate 2007 Annual Report to Congress
158 (Most Serious Problem: Taxpayer Service and Behavioral Research).
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Toward that end, TAS Research is proposing a survey conducted as a
component of the National Research Program (NRP), in which an
independent firm surveys taxpayers who were subjects of NRP audits and
explores the causes of any detected noncompliance and the factors
influencing taxpayer compliance behavior. This information, combined
with the compliance data from the NRP audits themselves and the
observations of IRS auditors about the reasons for the detected
noncompliance, should provide a rich resource for future studies and
initiatives, and should improve the IRS's ability to improve taxpayer
compliance.\21\
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\21\ For an example of how one might conduct such a study and an
interesting analysis of some of the attitudinal and knowledge factors
that might impact taxpayer compliance in a self-assessment tax system,
see Ern Chen Loo, Margaret McKerchar, & Ann Hansford, An International
Comparative Analysis of Self-Assessment: What Lessons are there for Tax
Administrators?, 20 Australian Tax Forum 667 (2005).
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I cite these studies as important examples of research studies that
I hope and expect will improve the IRS's ability to serve taxpayers and
collect revenue. However, these studies are merely a starting point. If
the IRS has better information, it can make more informed resource
allocation decisions. Absent clear information, the IRS unavoidably
bases its resource allocation decisions on intuition and bases its best
guesses on incomplete data, and that is obviously not an ideal way to
make decisions.

The IRS Is Paying More Attention to Taxpayer Services, But Significant
Challenges Remain
In 2006, Congress directed the IRS to prepare a Taxpayer Assistance
Blueprint (TAB), which was released last April.\22\ The TAB was
intended to serve as a strategic plan for taxpayer service and lead to
the development of taxpayer-centric, research-based models to help the
IRS make decisions about taxpayer service and the delivery of face-to-
face service. Because of the TAB and my own office's research, we know
more than ever about taxpayers' needs and preferences, and their
willingness to try new methods of service delivery.\23\
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\22\ H. Rep. No. 109-307, at 209 (2005). The Senate Committee
Report provides further detail on the content of the 5-year plan,
directing the IRS to: ``. . . undertake a comprehensive review of its
current portfolio of taxpayer services and develop a 5-year plan that
outlines the services it should provide to improve services for
taxpayers. This plan should detail how it [IRS] plans to meet the
service needs on a geographic basis (by State and major metropolitan
area), including any proposals to realign existing resources to improve
taxpayer access to services, and address how the plan will improve
taxpayer service based on reliable data on taxpayer service needs. As
part of this review, the Committee strongly urges the IRS to use
innovative approaches to taxpayer services, such as virtual technology
and mobile units. The IRS also should expand efforts to partner with
State and local governments and private entities to improve taxpayer
services. S. Rep. No. 109-109, at 134 (2005).
\23\ See National Taxpayer Advocate 2006 Report to Congress, vol. 2
(Research Study: Study of Taxpayer Needs, Preferences, and Willingness
to Use IRS Services).
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Over the last 2 years, the IRS has begun to reverse its trend in
recent years of limiting the types of services and methods of delivery.
I applaud the IRS for creating a Services Committee--the counterpart to
the Enforcement Committee--thereby enabling the entire IRS senior
leadership to consider and coordinate taxpayer service initiatives. The
IRS currently is undertaking many initiatives to assist taxpayers in
claiming economic stimulus payments, including keeping the IRS's walk-
in sites--known as Taxpayer Assistance Centers, or TACs--open on more
Saturdays during the filing season. I am also pleased that IRS
management has indicated a willingness to consider reinstating Problem
Solving Days and taking a geographic approach to determining which
topics to designate as ``out-of-scope'' (e.g., the IRS should not treat
farm-related questions as ``out-of-scope'' in TACs located in areas
where there is a significant amount of farming activity). The IRS has
also recently relaxed its stringent rules that generally prevented
taxpayers from obtaining copies of their tax return transcripts at the
TACs.\24\
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\24\ Previously the IRS required taxpayers to obtain transcripts of
their accounts through the toll-free service, which would mail a
transcript within seven to ten days. Taxpayers could only obtain
transcripts at TACs in ``emergency'' situations. It was TAS's
experience that the TACs almost never acknowledged an emergency
situation. In fact, since that policy was in place, TAS transcript
cases have increased sharply. The IRS's more flexible transcript policy
should result in fewer TAS cases in this area.
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It remains to be seen, however, whether the IRS will dedicate the
resources--both in terms of personnel, dollars, and priorities--
necessary to make the TAB a reality. I discuss a few of my concerns
below.

Sustained Funding for Taxpayer Services Is Crucial to
Meeting Taxpayer Needs

Any reduction in the IRS's taxpayer service budget presents a
significant challenge to implementation of the TAB. In fact, taxpayer
service funding should be increased so that, while the IRS continues to
deliver its traditional services, programs developed by the TAB team
are not just piloted but are instead fully implemented. For example,
this filing season the IRS is piloting an approach in the TACs called
``Facilitated Self Assistance.'' Under this model, taxpayers who come
to certain TACs for assistance may carry out designated service tasks
on IRS.gov or the IRS phone system with the help of a live IRS
assistor. Preliminary feedback from the 15 TACs offering Facilitated
Self-Assistance has been positive. Without sufficient funding, however,
the IRS will be unable to expand the pilot testing, let alone fully
implement the program, no matter how successful it might be. If the
financial support for taxpayer service is not sufficient, the TAB
process will have been for naught--having produced many interesting
ideas and important research that simply cannot be implemented or
applied.
Internet Services Are Important, But They Cannot Be the
Only Game in Town

Insufficient funding increases the temptation for the IRS to put
all its eggs in one basket when it comes to taxpayer service--namely,
self-assisted Internet services. The Internet may be adequate for
taxpayers who are comfortable handling financial transactions online,
but the TAB's research studies showed that a certain percentage of
taxpayers, and particular types of tax issues, require personal
interaction--by telephone, face-to-face, or both.
For example, we now know that nearly 25 percent of taxpayers do not
have Internet access.\25\ Additionally, more than 25 percent of
taxpayers stated that they are unwilling to use the IRS website for any
service activities in the future.\26\ Among taxpayers who used IRS
services between mid-2004 and mid-2006, about 45 percent of those who
called the IRS and more than 75 percent of those who visited the IRS
stated they would not use the IRS website. When probed further as to
why they would not use the website, more than half gave a reason that
suggests they could not use the website due to lack of computer
equipment, Internet access or computer savvy.\27\ Approximately 75
percent of taxpayers stated they do not feel comfortable sharing
personal information via the Internet.\28\ Approximately 12 percent of
taxpayers have some type of disability, \29\ and about 6 percent of
taxpayers speak a language other than English at home.\30\
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\25\ W&I Research, Opinion Survey of Taxpayer Resources and
Services, 2006--Question 7--22.5 percent-24.6 percent.
\26\ W&I Research, Opinion Survey of Taxpayer Resources and
Services, 2006--Question 8--25.3 percent-27.4 percent.
\27\ IRS Oversight Board, 2006 Service Channels Survey, Questions
17, 19 & 20: About 50 percent (42.5 percent-57.5 percent) of taxpayers
who called or visited the IRS are unwilling to use IRS.gov (i.e., 37.2
percent-52.7 percent of those who called and 60.5 percent-92.7 percent
of those who visited the IRS stated they would not use the IRS Internet
site). More than 23 percent of taxpayers called or visited the IRS
between mid-2004 and mid-2006, which translates to roughly 32 million
taxpayers (based on a filing population of slightly less than 135
million). About half of taxpayers who use IRS phone or TAC services,
approximately 16 million taxpayers, are unable or unwilling to use the
Internet. IRS, 2006 Filing Season Statistics, Cumulative Through 10/27/
06, Individual Income Tax Returns total receipts = 134,919,000.
\28\ IRS Oversight Board, 2006 Service Channels Survey, Question
11: 70.2 percent-76.2 percent do not feel comfortable sharing personal
information over the Internet. Reasons include privacy concerns (33.4
percent-40.8 percent) and Internet security issues (41.9 percent-49.6
percent).
\29\ W&I Research, Opinion Survey of Taxpayer Resources and
Services, 2006, Question 19: 87.2 percent-88.7 percent of taxpayers do
not have a disability.
\30\ W&I Research, Opinion Survey of Taxpayer Resources and
Services, 2006, Question 20: 5.4 percent-6.8 percent of taxpayers speak
a language other than English.
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The IRS has an obligation to provide services through methods that
will assist all taxpayers. The IRS must therefore maintain and improve
its telephone and face-to-face services for as long as there is a
segment of the population that needs it--which, given the complexity of
the tax law and IRS procedures, will be as far into the future as I can
see.

The IRS Should Expand and Improve the Services Provided by
Taxpayer Assistance Centers

For several years I have highlighted problems with the IRS's
delivery of face-to-face taxpayer services in the TACs.\31\ In my 2007
Annual Report to Congress, I identified several problems that limit the
usefulness of the TACs, including the insufficient number and staffing
of TACs and the significant conditions for obtaining return preparation
assistance that have the effect of deterring taxpayers from seeking
service.
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\31\ See National Taxpayer Advocate 2007 Annual Report to Congress
162-182 (Most Serious Problem: Service at Taxpayer Assistance Centers),
see also National Taxpayer Advocate 2006 Annual Report to Congress xi-
xiv (Taxpayer Assistance Blueprint: The National Taxpayer Advocate's
Perspective); National Taxpayer Advocate 2005 Annual Report to Congress
2-24 (Most Serious Problem: Trends in Taxpayer Service); National
Taxpayer Advocate 2004 Annual Report to Congress 8-66 (Most Serious
Problem: Customer Service in a Complex and Changing Tax Environment).
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The Location and Number of TACs May Not Be Adequate

In 2001, the IRS committed to opening 118 new TACs in the following
seven to 8 years.\32\ Unfortunately, none of these new TACs was opened,
and the IRS even initiated an unsuccessful effort to close 68 TACs.\33\
The TAB concluded that TAC offices were adequately serving only 60
percent of the United States population.\34\ In order to make better
decisions about the location, number, and staffing of TACs, the IRS
developed a decision tool about TAC operations. However, that tool only
includes the present TAC locations. It is not clear whether the IRS
will use this program to consider adding TAC locations, even though TAB
research demonstrates that TAC coverage across the United States is
insufficient. Thus, we recommend that the IRS conduct additional
research of population segments to determine the volume, scope, and
type of services that taxpayers require by geographical location, and
utilize its TAC decision tool to identify the most appropriate number
and placement of TACs.
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\32\ National Taxpayer Advocate 2001 Annual Report to Congress 49.
\33\ IRS News Release, IRS to Create Efficiencies with Taxpayer
Assistance Centers, IR-2005-63 (June 27, 2005).
\34\ Internal Revenue Service, Taxpayer Assistance Blueprint: Phase
2, at 116 (Apr. 17, 2007).
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TAC Staffing and the Availability of Services Are
Inadequate To Meet Taxpayer Needs

Only 55 percent of TACs are open for 36 to 40 hours per week, and
during the last 3 years, the IRS reduced TAC staffing by 9 percent,
leaving most TAC offices with staffing shortages.\35\ Although the IRS
is now hiring seasonal workers to ease the staffing crunch, I believe
the IRS should make a firm commitment to providing TACs with the level
of staffing necessary to meet taxpayer needs.
---------------------------------------------------------------------------
\35\ Information obtained from IRS Wage & Investment Division
(Field Assistance function) (September 2007).
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The IRS Should Meet its Fundamental Tax Administration
Responsibility To Provide Tax Return Preparation
Assistance for Low Income Taxpayers

I am concerned that the IRS imposes too many barriers and
limitations on tax preparation. I am pleased that the IRS heeded our
earlier criticism and has changed its position on requiring taxpayers
to visit a TAC twice in order to obtain return preparation services--
once to make the appointment and once to have the return prepared.
However, the IRS continues to downplay its own role in tax preparation.
To my mind, tax preparation is a core service for the tax
administrator. The tax administrator cannot look to the nonprofit
sector alone to meet the needs of the millions of low income taxpayers,
including many elderly taxpayers, who cannot afford to pay a return
preparer. Yet the IRS continues to straddle the line--it prepares
enough returns to allow it to claim it is providing the service but
makes it very difficult in some cases for taxpayers to obtain
assistance. For example, the IRS has declared returns involving
cancellation of debt income ``out of scope'' both for the TACs and for
volunteer preparation sites, \36\ even though those subjects are highly
likely to impact the very taxpayers who are eligible for TAC services
(whether because of credit card debt forgiveness or home foreclosures).
Thus, these low income taxpayers have no alternative but to pay for
return preparation, something they generally cannot afford to do.
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\36\ IRS Small Business/Self-Employed Division, Response to TAS
Information Request (Oct. 30, 2007).
---------------------------------------------------------------------------
It is not just individual taxpayers who suffer from this
restriction on preparation services in the TACs. Today, organizations
exempt from tax under IRC 501(c)(3) are generally required to file an
e-postcard annually if their gross receipts are normally $25,000 or
less, providing the IRS with basic contact information and informing
the IRS whether the organization is still a going concern.\37\ Failure
to file for 3 consecutive years will result in automatic revocation of
the organization's exempt status.\38\
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\37\ IRC 6033(i); IRC 6033(a)(3)(B); Announcement 82-88, 1982-
25 I.R.B. 23.
\38\ IRC 6033(j).
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Approximately half of exempt organizations have all-volunteer
staffs and another third have fewer than 10 employees.\39\ These
smaller nonprofits frequently lack professional tax guidance and rely
on their volunteers to deal with the IRS.\40\ Yet the TACs have agreed
to assist exempt organizations with filing the e-postcard on the
condition that the IRS not publicize the availability of this
assistance. Thus, the only way a small exempt organization will know
whether the IRS will help it is if it happens to visit a TAC on its own
initiative. This ``we will provide you service but we won't tell you
about it'' approach falls well short of the level of service the public
has a right to expect from its Government.
---------------------------------------------------------------------------
\39\ IRS, TE/GE Fiscal Year 2005 Strategic Assessment 3 (Feb. 2,
2005).
\40\ Id.
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The IRS Should Explore Alternative Methods of Delivering
Face-to-Face Services

In 2003, the IRS committed to providing alternative methods of
service to taxpayers.\41\ Among the ideas proposed were alternative
locations to brick-and-mortar TACs and mobile units specifically
tailored to the needs of the communities they serve.\42\ I support
these ideas, and I strongly encourage the IRS to pursue them and to
explore other service methods as well. For example, the IRS should
partner with State tax agencies, or other service-oriented Government
agencies such as the Social Security Administration, to provide one-
stop shopping for taxpayers. Additionally, the IRS could co-locate with
other agencies, both State and Federal, to offer services targeting a
specific taxpaying population (e.g., co-locate with Departments of
Motor Vehicles to offer excise fuel tax assistance to truck drivers).
---------------------------------------------------------------------------
\41\ National Taxpayer Advocate 2003 Annual Report to Congress 149.
\42\ Id.
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I commend the IRS's recent coordination of ``Super Saturday'' to
assist taxpayers in filing economic stimulus payment returns. The IRS
should replicate that approach in similar efforts targeted at other
groups of taxpayers. The IRS previously sponsored ``Problem Solving
Days,'' where taxpayers could receive assistance on any tax issue and
potentially have their problems resolved with one contact. The IRS
should bring back Problem Solving Days using Super Saturday as a model
and aggressively market the effort to taxpayers. Other initiatives
could include National Filing Days, which I recommended in my 2007
Annual Report to Congress, where taxpayers who are currently not in
compliance with their tax obligations could come to the IRS and be
brought into compliance.\43\
---------------------------------------------------------------------------
\43\ National Taxpayer Advocate 2007 Annual Report to Congress 257.
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The IRS Should Expand Outreach and Education in the Exempt
Organization Sector

If the IRS is to increase compliance by exempt organizations (EOs),
more resources must be devoted to outreach to, and education of, these
organizations. I commend the Tax Exempt and Government Entities (TE/GE)
Division's Customer Education and Outreach (CE&O) office for its
existing efforts to address the needs of EOs. CE&O has done much with
few resources, but it cannot adequately carry out its mission without
better funding. TE/GE allocated only approximately $1.2 million or 1.4
percent of its $85.4 million fiscal year 2007 EO budget to education
and outreach.\44\ The number of EO education and outreach full-time
equivalents (FTEs) has stagnated at approximately 12 for the last three
fiscal years \45\ while the number of EOs has grown by more than 70,000
per year.\46\ Twelve FTEs are simply not enough to carry on the
important work of EO education and outreach, regardless of how cost-
effective and innovative the IRS's outreach methods may be.
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\44\ Information received from Tax Exempt/Government Entities
Division (Nov. 7, 2007).
\45\ Information received from Tax Exempt/Government Entities
Division (Nov. 6, 2007); IRS, Tax Exempt and Government Entities
Business Performance Review 21 (May 9, 2007).
\46\ Remarks of Steven T. Miller, Commissioner, IRS Tax Exempt and
Government Entities Division, before the Philanthropy Roundtable (Dec.
10, 2007).
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TE/GE has leveraged its limited EO education and outreach resources
through increased use of electronic means. Electronic education and
outreach is an excellent tool that should be used in conjunction with,
but not supplant, face-to-face and non-electronic outreach. For
example, the Charities and Non-Profits page of the IRS website contains
many useful materials, but the IRS needs to proactively distribute hard
copies of those materials through partners and outreach sessions rather
than wait for EOs to find and view them online. Moreover, the IRS must
obtain better data on EOs' access to the Internet, how EOs use the
Internet, and EOs' willingness and ability to change how they use the
Internet before investing further in electronic education and outreach.
IRS Daily Delinquency Penalty (DDP) abatement rates reveal that
there is great potential to reduce noncompliance with more education
and outreach. The IRS may assess a DDP when an EO files an information
return with missing or incorrect information \47\ but will abate the
DDP if the penalized organization later supplies the missing
information or corrects the error and shows reasonable cause for the
mistake.\48\ Between 2000 and 2005, the IRS abated almost 62 percent of
all assessed DDPs and nearly 68 percent of all assessed DDP dollars
(nearly $857 million).\49\ A study conducted by the IRS in 2003 found
that most assessed DDPs were attributable to organizations' failure to
include Schedules A and B with their returns.\50\
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\47\ IRC 6652(c)(1)(A).
\48\ IRC 6652(c)(4).
\49\ IRS Enforcement Revenue Information System (ERIS) and
Statistics of Income (SOI) for EO Returns, 2000-2005 DDP assessments
and abatements. See also National Taxpayer Advocate 2006 Annual Report
to Congress 491 (Legislative Recommendation: Increase the Exempt
Organization Information Return Filing Threshold).
\50\ Ogden Form 990 Study, Attachment to Memorandum for Director,
Exempt Organization SE:T:EO, EO Correspondence Review and Timeframes
(Oct. 2003).
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The annual cycle of DDP assessment and abatement is not good for
anyone. EOs that receive DDP assessments due to curable errors must use
their resources to get the IRS to abate the penalty. Alternatively,
they may simply pay the penalties to avoid dealing with the IRS but are
likely to be penalized again if they do not work with the IRS to find
out why the penalties were assessed. The DDP assessment/abatement cycle
also wastes IRS resources. When more than 60 percent of all assessed
DDP penalties are abated, IRS employees are spending significant time
determining whether the mistakes that gave rise to the assessments were
attributable to reasonable cause.

To Reduce the Tax Gap, the IRS Should Place More Emphasis
on Combating Noncompliance in the Cash Economy
As you know, the gross ``tax gap''--the amount of tax that is not
voluntarily and timely reported and paid--stood at an estimated $345
billion in 2001 and remains a serious problem.\51\ As a result,
households that comply with their tax obligations effectively pay a
``surtax'' averaging about $2,680 per year to subsidize noncompliance
by others.\52\ Where taxable payments are reported to the IRS by third
parties, taxpayers generally report well over 90 percent of their
income.\53\ By contrast, where taxable payments are not reported to the
IRS by third parties, reporting compliance drops below 50 percent.\54\
Therefore, it should come as no surprise that underreported income from
the ``cash economy''--which, for tax administration purposes, we define
as taxable income from legal activities that is not subject to
information reporting or withholding--is probably the single largest
component of the tax gap, likely accounting for over $100 billion per
year.\55\
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\51\ The gross tax gap is the amount of tax that is imposed by law
for a given tax year, but not voluntarily and timely paid. The net tax
gap is the portion of the gross tax gap that remains uncollected after
taking into account late payments and IRS enforcement actions for a
given tax year. The 2004 IRS National Research Program study estimated
the 2001 gross tax gap at $345 billion and the net tax gap at $290
billion. IRS, Tax Gap Map for Year 2001 (Feb. 2007), available at
http://www.irs.gov/pub/irs-utl/tax_gap_update_070212.pdf. These figures
do not include unpaid tax on income from illegal activities.
\52\ If we divide the estimated 2001 net tax gap of $290 billion by
the estimated 108,209,000 U.S. households in 2001, we see that each
household was effectively assessed an average ``surtax'' of about
$2,680 to subsidize noncompliance. See U.S. Census Bureau, Population
Division (data as of Mar. 2001).
\53\ See IRS News Release, IRS Updates Tax Gap Estimates, IR-2006-
28 (Feb. 14, 2006) (accompanying charts), available at http://
www.irs.gov/newsroom/article/0,,id=154496,00.html.
\54\ Id.
\55\ Id. Underreporting makes up about 83 percent of the tax gap
($285 billion of the $345 billion gap). Underreporting of business
income by individuals--from sole proprietors, rents and royalties, and
pass-through entities--accounted for about $109 billion. Associated
underreporting of self-employment taxes by unincorporated businesses
accounts for another $39 billion. Id.
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Noncompliance in the cash economy merits special attention because
the IRS's traditional enforcement tools such as document matching and
audits are less effective when there is no third-party reporting, and
also because it is growing. According to one study, the percentage of
all income subject to third-party information reporting fell from 91.3
percent in 1980 to 81.6 percent in 2000.\56\ The IRS's filing
projections suggest that the cash economy and the amount of unreported
income may continue to grow.\57\
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\56\ Kim Bloomquist, Trends as Changes in Variance: The Case of Tax
Noncompliance, presented at the 2003 IRS Research Conference (June
2003) (citing growth in capital gains, partnership, and small business
income).
\57\ The IRS expects the number of individual returns from small
business or self-employed taxpayers to grow by about 33 percent between
2006 and 2014, while the number of individual returns from other
taxpayers is expected to decline by about 2 percent over the same
period. IRS Office of Research, Research, Analysis and Statistics,
Document 6292, Fiscal Year Return Projections for the United States,
2007-2014 (Sept. 2007), available at http://www.irs.gov/pub/irs-soi/
d6292.pdf.
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The IRS Should Establish a Cash Economy Program Office To
Increase the Effectiveness of its Efforts

In my 2007 Annual Report to Congress, I proposed a comprehensive
strategy to address the cash economy portion of the tax gap that
consisted of 15 administrative recommendations and seven legislative
recommendations.\58\ As a threshold matter, I believe the IRS should
establish a Cash Economy Program Office. The office would have
responsibility for coordinating efforts to improve compliance in the
cash economy. At present, there is no single unit or executive within
the IRS with responsibility for ensuring that enforcement, research,
and educational activities aimed at the cash economy are implemented in
a coordinated fashion. The IRS uses a coordinated approach to address
certain other issues--an example being the EITC Program Office--and I
believe a program office would help the IRS address the cash economy as
well. Such an office would bring accountability to the effort because
it could measure its success based on the impact of IRS initiatives on
compliance by cash economy participants.\59\ Absent a strategic,
coordinated approach, the IRS is less likely to make progress in
reducing noncompliance in the cash economy.
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\58\ See National Taxpayer Advocate 2007 Annual Report to Congress
35-65 (Most Serious Problem: The Cash Economy), 490-502 (Legislative
Recommendation: Measures to Address Noncompliance in the Cash Economy),
and vol. 2, at 1-43 (Research Study: A Comprehensive Strategy for
Addressing the Cash Economy).
\59\ The Treasury Inspector General for Tax Administration and the
Government Accountability Office both generally agree that measures
that promote accountability would help the IRS reduce the tax gap. See,
e.g., Government Accountability Office, GAO-06-208T, Multiple
Strategies, Better Compliance Data, and Long-Term Goals Are Needed to
Improve Taxpayer Compliance (Oct. 26, 2005); Written Statement of
Russell George, Treasury Inspector General for Tax Administration,
Hearing Before the Senate Committee on Appropriations Subcommittee on
Transportation, Treasury, the Judiciary, Housing and Urban Development,
and Related Agencies on the Internal Revenue Service's Fiscal Year 2006
Budget Request (Apr. 7, 2005).
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The IRS Should Research the Most Effective Use of Its Audit
Resources

In addressing the cash economy, the IRS should also leverage its
limited audit resources by investing in research to identify the most
effective uses of these resources after taking into account the direct
and indirect effects of IRS activities on tax revenue. In addition to
the direct revenue that audits generate from the taxpayer for the
period(s) under audit, as discussed above, economists estimate the
indirect effects or ``ripple effects'' of an audit on voluntary
compliance by other taxpayers or by the same taxpayer in future periods
provide even greater revenue gains.\60\ The IRS needs more and better
research on how best to use limited audit resources to improve
compliance in the cash economy. For example:
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\60\ See, e.g., Alan H. Plumley, Pub. 1916, The Determinants of
Individual Income Tax Compliance: Estimating The Impacts of Tax Policy,
Enforcement, and IRS Responsiveness 35-36 (Oct. 1996).
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--Should the IRS use more correspondence examinations or face-to-face
examinations in cash economy industries? Does the answer depend
on the industry?
--To achieve the greatest impact, should audits be clustered either
geographically or within industries, so as to generate maximum
publicity and possibly change local or industry norms, or
should audits be more spread out in a dispersed pattern of
``touches''?
--Do audits have an even greater ``ripple'' effect on compliance when
coupled with outreach and education targeted at unaudited
members of the same community?
My other recommendations fall into four broad categories: (1)
making compliance easier, (2) increasing income visibility and the
productivity of audits, (3) increasing the focus on preparers, and (4)
identifying areas where additional research is needed to help the IRS
understand how it can efficiently improve voluntary compliance.\61\
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\61\ See National Taxpayer Advocate 2007 Annual Report to Congress
35-65 (Most Serious Problem: The Cash Economy), 490-502 (Legislative
Recommendation: Measures to Address Noncompliance in the Cash Economy),
and vol. 2, at 1-43 (Research Study: A Comprehensive Strategy for
Addressing the Cash Economy).
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The Private Debt Collection Initiative Will Cost the Federal Government
at Least $81 Million in Foregone Revenue Annually and Should Be
Terminated
In my Annual Reports to Congress and in prior testimony, I have
expressed serious concerns about many aspects of the private debt
collection (PDC) initiative, including the potential for violations of
taxpayer rights, the fact that private collection agency (PCA)
procedures are less transparent to the public--and to congressional
oversight--than IRS procedures, and the evidence that the so-called
``simple'' cases on which the program was initially promoted do not
exist in significant numbers.\62\
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\62\ See National Taxpayer Advocate 2007 Annual Report to Congress
411-431 (Status Update: Private Debt Collection); National Taxpayer
Advocate 2006 Annual Report to Congress 34-61 (Most Serious Problem:
True Costs and Benefits of Private Debt Collection) and 458-462
(Legislative Recommendation: Repeal Private Debt Collection
Provisions); IRS Private Debt Collection: Hearing Before the H. Comm.
on Ways and Means, 110th Cong. (May 23, 2007) (statement of Nina E.
Olson, National Taxpayer Advocate).
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I now add to these concerns the issue of foregone revenue. Very
simply, the PDC initiative will cost the Government more than $81
million in foregone revenue this year, and the cost is likely to reach
nearly a half billion dollars over the next 6 years. I explain below
how I arrive at this conclusion.
The IRS projects that it will use $7.65 million in appropriated
funds in fiscal year 2008 to administer the PDC program, and it
anticipates relatively steady costs in future years.\63\ At the same
time, the IRS estimates that the program will generate gross revenue
averaging about $23 million this year and next, \64\ and it is unlikely
that gross revenue will increase in future years unless the nature of
the program changes significantly. By these calculations and after
subtracting the direct costs of the program ($7.65 million) and
commissions payable to the PCAs (about $4.60 million), the program can
be expected to yield annual net revenue of about $11 million. Thus, an
annual IRS expenditure of $7.65 million will produce annual net revenue
of about $11 million, which translates to about a 1.45:1 net return on
investment (ROI).\65\
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\63\ E-mail from Director, PDC Program Office, to TAS Attorney
Advisor (Feb. 29, 2008).
\64\ Id.
\65\ As discussed in the text below, the data I have cited actually
overstate the likely ROI because the IRS's cost estimates are not
comprehensive (e.g., they do not include the time that Taxpayer
Advocate Service case advocates spend assisting taxpayers who request
our help with PDC cases or the time senior IRS executives must devote
to studying, monitoring, and answering continual questions about the
program) and the IRS's revenue estimates include funds that the IRS
collects on the basis of its initial letter--before the PCAs make any
contact with the taxpayers.
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If the PDC program did not exist and the IRS instead allocated
$7.65 million in appropriated funds to its Automated Collection System
(ACS) function, the ROI would be substantially higher. IRS data shows
that the average ROI for the ACS program is about 20:1, which means an
expenditure of $7.65 million would generate annual revenue of $153
million.\66\ In testimony before the House Ways and Means Committee
last May, Acting Commissioner Kevin Brown placed the ACS ROI somewhat
lower, at about 13:1.\67\ Even accepting the lower figure, a 13:1 ROI
on an expenditure of $7.65 million would produce gross revenue of
$99.45 million and net revenue (after subtracting the $7.65 million
expenditure) of $91.8 million.
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\66\ We have computed the full cost of an average ACS employee at
slightly less than $75,000 (assuming GS-8, step 5). The current average
amount collected by an ACS employee per year is about $1.53 million.
That volume of collection translates to a return-on investment on the
average ACS employee of about 20:1.
\67\ IRS Private Debt Collection: Hearing Before the H. Comm. on
Ways and Means, 110th Cong. (May 23, 2007) (testimony of Kevin M.
Brown, Acting Commissioner of Internal Revenue).
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Thus, the IRS's expenditure of $7.65 million in appropriated funds
is generating about $11 million in net revenue when applied to the PDC
program but should generate at least $91.8 million if applied to its
ACS collection function. In other words, the opportunity cost of
spending $7.65 million of appropriated funds on the PDC program each
year is $81 million, and possibly much more.
Since the purpose of private debt collection is to raise revenue,
the fact that it is costing the Government $81 million or more each
year destroys whatever thin rationale might remain for its existence.

The $7.65 Million Cost Estimate for the PDC Program Fails
to Capture Significant Costs
In addition to consuming $7.65 million in annual operating costs,
the PDC program required $70 million in start-up costs. The IRS
previously estimated that it would recoup these ``sunk'' costs in
fiscal year 2008 but now acknowledges that fiscal year 2010 is the
earliest point at which the initiative is likely to ``break even.''
\68\ Moreover, as of September 2007, the IRS had 54 employees (and this
total does not include Modernization & Information Technology Services
(MITS) infrastructure or TAS case working employees) working on the
initiative and overseeing 62 employees from the PCAs.\69\
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\68\ The 2008 Filing Season: Hearing Before the H. Comm. on Ways
and Means, 110th Cong. (Mar. 13, 2008) (testimony of Linda E. Stiff,
Acting Commissioner of Internal Revenue).
\69\ IRS Response to Information Request on PDC Initiative (Sept.
2007).
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The annual expenditure of $7.65 million is significant for an
initiative that is failing in most respects. Additionally, we have
learned that the $7.65 million cost estimate provided by the IRS does
not include numerous expenses. The $7.65 million cost estimate includes
PDC-related costs incurred by the IRS referral unit and most IRS
headquarters staff as well as costs incurred by MITS for support and by
TAS to cover the cost of one employee assigned to work with the PDC
Project Office. However, the $7.65 million cost estimate does not
include the PDC-related costs incurred by the IRS Office of Chief
Counsel, which is periodically consulted for legal advice; the IRS
Office of Legislative Affairs, which has spent considerable time
presenting the program to Members and Committees of the Congress and
responding to inquiries; by TAS for working with more than 1,500
taxpayers who have sought our assistance on PCA-related cases; or by
other IRS functions that have helped to support the program.\70\ We
have been unable to obtain a complete estimate of the costs of the
program.
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\70\ IRS Response to TAS Request for Information (April 10, 2008).
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The IRS's Own Collection Actions Account for a Significant
Portion of the PDC Program's Full-Paid Accounts
Almost half--specifically, 46 percent--of the fully paid
liabilities included in PDC gross revenue has been collected through
offsets or direct payments made by the taxpayer after receiving a
letter from the IRS informing the taxpayer that his or her account
would be placed with a PCA but before the PCA made contact with the
taxpayer.\71\ These fully paid liabilities are a direct result of IRS
action--not action taken by a PCA.
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\71\ The 46 percent of fully paid liabilities includes payments
received by the IRS through the following means: (a) dollars received
by the government 10 calendar days or less after the IRS transferred
the account to the contractor; (b) unidentified payments (i.e.,
payments that cannot be matched and posted to a debtor's account within
the contractor's inventory of accounts); (c) dollars collected in
excess of an individual's balance, resulting in overpayment by the
debtor; (d) dollars received on any account 11 calendar days or more
after the account was returned to the IRS except as specifically
described by contract; and (e) dollars received through Federal, State
or local administrative, tax refund, salary, Treasury offset, Federal
Levy payment or other type of offset or other administrative action
which results in the reduction or elimination of the debt in a manner
beyond the scope of the contractor's performance. IRS, Request for
Quotation, Request No. TIRNO-05-Q-00187, at 22 ( A.4.1). The National
Taxpayer Advocate's 2006 Annual Report to Congress reported that, while
the IRS would not send accounts to private collectors that were already
subject to levy under the Federal Payment Levy Program (FPLP), the IRS
would not recall accounts already assigned to a PCA if the account
becomes subject to an FPLP levy after assignment. National Taxpayer
Advocate 2006 Annual Report to Congress 43. When the IRS first
described its vision of the PDC program to Congress, the IRS maintained
that cases under enforcement action were not the types of cases that
would be referred to private collectors. Private Debt Collection:
Hearing Before the Subcomm. on Oversight of the House Comm. on Ways and
Means, 108th Cong. (May 13, 2003) (testimony of Commissioner Mark W.
Everson). As a consequence of the IRS's decision to leave FPLP cases
with private collectors, private collectors are contacting taxpayers
whose Social Security payments are already under active FPLP levies and
are demanding full payment of the tax liability.
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Moreover, more than half of the payments received by the PDC
initiative are fully paid liabilities.\72\ In many of these cases, the
IRS had taken no action on the accounts after its standard ``notice
stream'' had run its course. However, these data seem to indicate that
if the IRS were to spend 41 cents on a letter to taxpayers sometime
after the end of the standard notice stream to say, in effect, ``Hello,
we're back,'' the IRS could obtain a meaningful return.
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\72\ IRS, Filing Payment Compliance Advisory Council (April. 14,
2008) at 3.
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The Inventory of ``Easy'' Cases for PCAs To Work Has
Largely Dried Up

The PDC initiative has taken several steps to address the lower
than expected revenue, which are deviations from the original intent of
the initiative.\73\ Because the number of ``easy'' cases was also
smaller than expected, the IRS began to include older inventory which
is more difficult to resolve.\74\ The IRS is still searching for other
types of cases to hand over to the PCAs, many of which are complex,
require discretion, and are already being worked by the IRS's own
collection function. For example, the IRS is studying the feasibility
of assigning cases in which the taxpayer has not agreed to the entire
outstanding tax liability.\75\ The IRS is also considering placing with
the PCAs cases that ACS is currently working, and it is studying 1,500
modules to identify cases that it can move from actual IRS ACS
inventory to the PCAs.\76\ Thus, the IRS is now proposing to give the
PCAs the types of cases that the IRS itself is already working and
could continue to work at a greater rate in the future. Placing these
types of cases with the PCAs is precisely the opposite of the premise
on which the program was sold--namely, giving PCAs only the easy cases
the IRS itself otherwise would not work.\77\
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\73\ Former Commissioner Mark Everson testified: ``Private
collectors will work the easy cases, thereby ensuring that they will
not engage in `inherently governmental' activities and that the IRS
will be able to focus on more complex work.'' Private Debt Collection:
Hearing Before the Subcomm. on Oversight of the H. Comm. on Ways and
Means, 108th Cong. (May 13, 2003) (statement of Commissioner Mark W.
Everson). I also testified to that point: ``The IRS has stated that it
will only send to PCAs those cases that meet the following criteria:
(1) the taxpayer has either agreed to the tax debt and/or has made
three or more payments toward that debt; and (2) the taxpayer appears
to have the ability to pay this debt in full immediately or within 36
months. It is vital to the success of this proposal that only those
cases that fit these parameters are selected and referred to the
PCAs.'' IRS Use of Private Debt Collection Agencies by the IRS: Hearing
Before the Subcomm. on Oversight of the H. Comm. Ways and Means, 108th
Cong. (May 13, 2003) (statement of Nina E. Olson, National Taxpayer
Advocate).
\74\ The IRS had to remove 15,500 cases from the initial inventory
of 42,800 cases that would possibly have been assigned to private
collectors. These cases were removed because the taxpayer had previous
shelved delinquencies. IRS, Filing & Payment Compliance Advisory
Council Presentation 9 (July 31, 2006).
\75\ IRS, Filing and Payment Compliance Advisory Council (Jan. 14,
2008) at 7.
\76\ IRS, Filing and Payment Compliance Advisory Council (Feb. 11,
2008) at 10.
\77\ Private Debt Collection: Hearing Before the Subcomm. on
Oversight of the H. Comm. on Ways and Means, 108th Cong. (May 13, 2003)
(testimony of Commissioner Mark W. Everson).
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The IRS Has Left Cases in the Control of PCAs for Much
Longer Than It Originally Intended

The IRS's concern about the PDC initiative's low revenue might have
influenced the IRS decision to extend the timeframe for which
unresolved cases from the initial stage of the PDC program (known as
Release 1.1) will remain with the PCAs.\78\ Initially, the IRS planned
to recall taxpayer accounts after 12 months.\79\ However, the IRS
extended the recall to 18 months and now has extended it until the
collection curve on these cases declines, but it is not clear how
significant the decline must be for the recall to begin.\80\ Nor is it
clear how frequently the PCAs attempt to collect on these cases or
whether the taxpayers would be better off if their cases were sent back
to the IRS.
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\78\IRS, Filing and Payment Compliance Advisory Council (Mar. 10,
2008) at 12.
\79\IRS, Request for Quotation, Request No. TIRNO-05-Q-00187, at 22
( A.4.5). Taxpayer accounts will be automatically recalled after 12
months unless the account condition warrants continued work efforts by
the Contractor assigned the case. Conditions that would warrant an
extension of the placement period may include acceptable payment within
60 calendar days prior to recall date or approval from the Contracting
Officer's Technical Representative (COTR). The IRS can request the
return of a case at any time upon notice to the PCA.
\80\ IRS, Filing and Payment Compliance Advisory Council (Mar. 10,
2008) at 12.
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To Evaluate the Cost Effectiveness of the PDC Program, an
``Apples-to-Apples'' Comparison Between IRS
Employees and PCA Employees Is Needed

As I have recommended in my reports to Congress, to determine the
true efficiency and effectiveness of PCAs to the IRS collection
function, I believe the IRS should design and implement a true apples-
to-apples comparison of IRS and PCA collection.\81\ The version of the
IRS fiscal year 2008 funding bill reported by this Committee last year
directed the IRS to conduct a test to make such a comparison.\82\
Although this mandate was not contained in the final funding
legislation, the IRS has taken steps toward implementing an apples-to-
apples test. In January of 2008, the IRS created a team, which included
TAS, to design such a test. The test would use IRS employees with
similar skill sets as the PCA employees and limit IRS enforcement
powers so their authority to take action on a case would mirror that of
the PCAs, thereby creating an apples-to-apples comparison. In addition,
it would create an entry-level bridge position for IRS employees who
would like to obtain collection experience. These employees could work
these easy cases that only require a phone call or could help locate
taxpayers. This would be an opportunity for the IRS to train new
collection employees and address the IRS's challenge to fill behind an
aging workforce. Now that the test has been designed, it is time to put
it into action so the IRS can honestly evaluate who can do this work
better.
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\81\ See National Taxpayer Advocate 2007 Annual Report to Congress
416-418, and National Taxpayer Advocate 2006 Annual Report to Congress
34-61.
\82\ Financial Services and General Government Appropriations Act,
2008, H.R. 2829, 110th Cong. 113 (as reported by S. Comm. on
Appropriations, July 13, 2007).
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The IRS Should Reassess Its Approach to e-filing to Ensure That the
Needs of All Taxpayers Are Addressed and that All Taxpayers May
Prepare Their Returns and File Directly with the IRS Without
Charge
While the IRS has made impressive progress in increasing the rate
of electronic filing, it is still far from reaching the congressionally
mandated goal of 80 percent.\83\ During the 2007 filing season, almost
57 percent of all individual returns were filed electronically.\84\ As
the tax administrator, the IRS has the authority to determine the
policies and criteria that entities must meet to participate in the e-
file program. In important respects, however, it appears that the IRS
has historically relinquished control of the electronic filing program
to private industry and faces difficulty in re-asserting ownership of
the program. Considering the significant benefits e-filing affords to
both the IRS and taxpayers, we are pleased that the IRS is currently
evaluating its role in the e-file program in order to increase the rate
of e-file and to properly align its policies and procedures to meet the
best interests of taxpayers and the agency itself. We encourage the IRS
to consult with the Office of the Taxpayer Advocate on this important
matter, and we look forward to lending support in any manner possible.
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\83\ The IRS Restructuring and Reform Act of 1998 directed the IRS
to set a goal of having 80 percent of all returns filed electronically
by 2007. See Internal Revenue Service Restructuring and Reform Act,
Pub. L. No. 105-206, 2001(a)(2), 112 Stat. 685 (1998). The 80 percent
e-filing goal was not achieved by 2007. However, we believe Congress
should reiterate its commitment to requiring the IRS increase the e-
filing rate as quickly as possible.
\84\ IRS News Release, IRS E-File Opens for 2008 Filing Season for
Most Taxpayers, IR-2008-5 (Jan. 10, 2008).
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The IRS has an incentive to increase the rate of electronic filing
to the highest level possible. Electronic filing of tax returns brings
benefits to both taxpayers and the IRS.\85\ From a taxpayer
perspective, e-filing improves accuracy by eliminating the risk of IRS
transcription errors, pre-screens returns to ensure that certain common
errors are fixed before returns are accepted, and speeds the delivery
of refunds. From an IRS perspective, e-filing eliminates the need for
data transcribers to input return data manually (which permits the IRS
to shift resources to other areas), allows the IRS to capture return
data electronically, and enables the IRS to process and review returns
more quickly.\86\
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\85\ See S. Rep. No. 105-174, at 39-40 (1998).
\86\ See IRS Fact Sheet, 2008 IRS E-File, FS-2008-4 (Jan. 2008).
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Nearly one-third of all individual returns processed by the IRS
through October 2007--or 43 million returns--were prepared using
software yet mailed rather than submitted electronically.\87\ These
taxpayers could have e-filed their returns once they were prepared
using computer software, but for some reason, the taxpayers chose to
file paper returns. If the IRS successfully converts a significant
portion of these taxpayers to electronic filing, it would approach, and
perhaps surpass, the 80 percent e-filing goal.
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\87\ IRS Tax Year 2006 Taxpayer Usage Study (through Oct. 26,
2007).
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I have advocated for years for the IRS to place a basic, fill-in
template on its website to permit taxpayers to self-prepare their tax
returns and file directly with the IRS for free.\88\ There is no reason
why taxpayers should be required to pay transaction fees to file their
returns electronically. A free template and direct filing portal would
address some taxpayers' cost and security concerns and would result in
a greater number of e-filed tax returns. For those taxpayers who are
comfortable preparing their returns without assistance, the Government
should provide the means for them to do so without charge. For those
taxpayers who do not find a basic template sufficient and would prefer
to avail themselves of the additional benefits of a sophisticated
software program, they would remain free to purchase one.
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\88\ See, e.g., National Taxpayer Advocate 2004 Annual Report to
Congress 471-477. We have proposed that the IRS create an electronic
tax return that is analogous to the paper environment, but that also
incorporates the benefits of electronic technology. Specifically, the
return should be fill-in, with math checking and number-transfer
capability. The fill-in return should link to line-by-line IRS
instructions for each form, and where the IRS instructions reference a
publication, there should be active links to specific sections of the
forms. Where the instructions or publications have worksheets embedded
in them, these worksheets should be fill-in, with math-checking and
number-transfer capability. These capabilities are important, since
they will substantially reduce the number of ``math error'' notices the
IRS must issue each year.
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During a visit to the Australian Taxation Office (ATO) last month,
I had the opportunity to learn first-hand about Australia's e-file
program. The ATO built e-tax, a direct filing program, completely in-
house and officially launched the program in 1999. The resulting e-file
(e-tax) rates are impressive.\89\ For the 2005-2006 tax period,
approximately 49 percent of all individuals who self-prepared filed
their returns through e-tax, while only 7.5 percent of U.S. taxpayers
who self-prepared their returns used Free File for tax year 2006 (and
only 2.9 percent of all individual income tax returns filed in tax year
2006 were prepared using Free File).\90\ Further, only tax agents (the
Australian equivalent to tax return preparers) use commercial software
to prepare and file returns.\91\ It is our understanding that the IRS
is currently evaluating the Australian taxation system. We hope the IRS
can apply lessons learned from Australia's experience to our own e-file
program, especially with regard to ATO's direct filing program, e-tax.
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\89\ Unlike Free File, e-tax is available to taxpayers at all
income levels. For information on e-tax, see http://www.ato.gov.au/
corporate/content.asp?doc=/content/83847.htm&pc=001/001/001/
005&mnu=&mfp=&st=&cy=1 (last visited April 7, 2008).
\90\ Australian Taxation Office, Taxation Statistics 2005-06,
available at http://www.ato.gov.au/content/downloads/
00117625_2006CH2PER.pdf (last visited April 7, 2008); E-Gov, IRS Free
File Performance Measures--Summary View, available at http://
www.whitehouse.gov/omb/egov/c-7-3-irs.html (last visited April 7,
2008). Specifically, 1,521,780 individual self-preparers filed through
Australia's e-tax program in tax year 2005/2006 out of a total of
3,132,230 self-preparers. The remaining 8,378,729 individual taxpayers
used tax agents (return preparers). In the United States, 3.9 million
individual taxpayers self-prepared for tax year 2006 on Free File out
of 49 million total self-preparers. Approximately 135 million U.S.
individual returns were filed for tax year 2006. IRS Document 6149,
Calendar Year Return Projections by State, CY 2007-2014 (Rev. 12.2007),
Table 1.
\91\ Tax agents are regulated by the statutorily created Tax Agent
Boards located in every state. For more information on the relationship
between tax agents and tax administration in Australia, see http://
www.ato.gov.au/corporate/content.asp?doc=/content/66215.htm (last
visited March 27, 2008).
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Recent, highly publicized phishing schemes confirm the need for the
IRS to develop a free fill-in template and direct filing portal. During
the 2007 filing season, for example, an Internet tax scam lured
taxpayers into entering confidential tax return information on sites
masquerading as Free File sites, and these taxpayers became victims of
identity theft.\92\ It is understandable that some potential Free File
users fall victim to scams, especially when taxpayers wishing to
prepare their returns pursuant to an IRS sanctioned program visit the
official IRS website only to be directed to one of 19 potentially
unfamiliar commercial websites. All taxpayers should have the option to
prepare and file their Federal income tax returns on the IRS's own
website.\93\ Although Free File is accessible through the official IRS
website, not all taxpayers are eligible to use the program.
Approximately 30 percent of individual taxpayers--which amounts to more
than 40 million taxpayers--are ineligible for IRS Free File.\94\
Moreover, the IRS exerts little control over the content of each Free
File program. As a consequence, each of the programs has its own
eligibility requirements, capabilities and limitations, and the
complexity is confusing to taxpayers.
---------------------------------------------------------------------------
\92\ See IRS News Release, Late Tax Scam Discovered; Free File
Users Reminded to Use IRS.gov, IR-2007-87 (April 13, 2007). The IRS is
also aware of several phishing schemes during the 2008 filing season.
See IRS News Release, IRS Warns of New E-Mail and Telephone Scams Using
the IRS Name; Advance Payment Scams Starting, IR-2008-11 (Jan. 30,
2008).
\93\ Congress contemplated the IRS developing a basic electronic
template in the IRS Restructuring and Reform Act of 1998, Pub. L. No.
105-206, 112 Stat. 685 (1998). The RRA 98 conference report states that
``the conferees also intend that the IRS should continue to offer and
improve its Telefile program and make available a comparable program on
the Internet.'' H.R. Rep. No. 105-599, at 235 (1998) (Conf. Rep.).
\94\ Taxpayers must have adjusted gross income of $54,000 or less
to be eligible. See IRS Fact Sheet, 2008 IRS E-File, FS-2008-4 (Jan.
2008); Free Online Electronic Tax Filing Agreement Amendment (2005),
available at http://www.irs.gov/pub/irs-efile/free_file_agreement.pdf
(last visited on April 7, 2008). Ironically, some members of the Free
File Alliance provided free services to 100 percent of taxpayers under
the initial term of the Free File Agreement and wanted to continue to
do so, but the Treasury Department agreed with the Free File Alliance
to place a cap on the number of taxpayers who would qualify for free
tax preparation and filing services. As a consequence, Free File
members are now restricted in the number of taxpayers to whom they may
offer their services.
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Despite the IRS's best efforts, some paper filers will refuse to
convert to e-file. For those cases, the IRS should develop 2-D bar code
technology, which would provide taxpayers and the IRS with many of the
same benefits as electronic filing.\95\ It is my understanding that the
IRS has already incorporated this technology into other functions.
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\95\ To utilize 2-D bar code technology, a taxpayer or preparer
uses software to complete the return. Once printed, the return has a
horizontal and vertical bar code containing tax return information. The
IRS scans the return, captures the data, decodes it, and processes the
return as if it had been sent electronically.
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Pursuant to an Appropriations directive, the IRS Office of
Electronic Tax Administration and Refundable Credits (ETA) is
developing a comprehensive strategic plan to meet the 80 percent e-file
goal.\96\ ETA has commissioned MITRE to conduct the Advancing E-File
Study, and we are pleased that the study will determine or review the
following items:
---------------------------------------------------------------------------
\96\ Staff of H. Comm. on Appropriations, 110th Cong., H.R. 2764,
Consolidated Appropriations Act, 2008, Pub. L. 110-161, Explanatory
Statement at 871 (Comm. Print 2007); Staff of H. Comm. on
Appropriations, 110th Cong., Financial Services and Government
Appropriations Bill, 2008, at 28 (Comm. Print July 2007). Although the
deadline for submission of the study was March 1, 2008, the IRS Office
of Electronic Tax Administration and Refundable Credits has faced
considerable challenges during the current filing season, and it is
planning to complete the study later this year.
---------------------------------------------------------------------------
--The characteristics of paper and e-filers as well as potential
barriers to e-file;
--The current third-party model of tax administration and current
trends in State and foreign governments; and
--Potential strategies to increase the rate of e-file or any other
means to receive return information electronically. This will
entail a review of direct filing with the IRS, 2-D bar coding,
and Telefile.\97\
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\97\ Information Provided by Electronic Tax Administration (Jan.
30, 2008); Diane Freda, IRS to Study Direct Filing Portal, 2-D Bar
Coding to Boost E-Filing, BNA Daily Tax Report (Jan. 29, 2008); MITRE
IRS FFRDC, Center for Enterprise Modernization, IRS Advancing E-File
Study: Draft Overview of Findings to Date (Jan. 31, 2008) (on file with
the Office of the Taxpayer Advocate).
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I believe this study represents an important first step in the
Government's fulfilling its core responsibility to taxpayers in a
secure and straightforward fashion, without competing with the private
sector. The Appropriations directive states that this strategic plan
should be developed in consultation with me and other stakeholders, and
I look forward to continuing to work with the IRS on this study.
Finally, I believe that the IRS should take a more proactive role
in the electronic filing arena by setting the policies and standards
for participation in the IRS e-file program. Such policies and
procedures should align with the needs of both taxpayers and tax
administration. All high quality return preparation and filing products
should have equal access to the market, reflect the latest tax law
changes, and be compatible with filing season peaks in demand as well
as IRS's computer and processing needs. Moreover, all programs should
meet IRS established minimum standards for data and identity security,
and these standards should apply to both for-profit and free tax
preparation offerings.\98\ Unless the IRS takes corrective action, the
IRS remains in a reactive position at the whim of private industry and
is forced to devote scarce resources to address the downstream
consequences of potentially avoidable problems. We are encouraged that
the IRS is currently evaluating its role in the e-file program as part
of the Advancing E-File Study and look forward to lending support to
the study as well as to receiving periodic briefings of research
findings as the study progresses.
---------------------------------------------------------------------------
\98\ At the time of this writing, it is not clear how many of the
programs listed on the IRS e-file partner webpage would meet IRS-
developed data or identity security specifications.
---------------------------------------------------------------------------
Taxpayer Advocate Service Case Receipts Have Risen by 47 Percent Since
Fiscal Year 2004 While the Number of Case Advocates Available
To Work Taxpayer Cases Has Declined by 13 Percent
I will close with a brief report on my own organization, the
Taxpayer Advocate Service (TAS), and its role in identifying and
mitigating the downstream consequences of IRS actions and programs, and
improving taxpayers' attitudes toward the tax system. Since I became
the National Taxpayer Advocate in 2001, I am pleased to say that TAS
has grown up as an organization and substantially improved its ability
to assist taxpayers. In fiscal year 2001, our quality measures showed a
performance level of 71.6 percent. In fiscal year 2007, TAS's talented
and dedicated employees managed to achieve a quality rating of 90.5
percent. The performance of TAS employees since fiscal year 2004 has
been particularly commendable--TAS case receipts rose an overwhelming
47 percent from fiscal year 2004 to fiscal year 2007,\99\ while the
number of case advocates available to work those cases declined by 13
percent over the same period. Yet we have managed to handle this
increased workload while maintaining consistent case quality over these
3 years.
---------------------------------------------------------------------------
\99\ In fiscal year 2007, TAS received a total of 247,839 cases. In
fiscal year 2004, TAS received a total of 168,856 cases.
---------------------------------------------------------------------------
The increase in TAS cases is not surprising. The IRS has
substantially increased the number of its compliance actions in recent
years,\100\ and about 65 percent of TAS's cases are classified as
``compliance'' related.\101\ Increasing the number of compliance cases
inevitably produces a corresponding increase in TAS cases. Thus, the
greater IRS emphasis on enforcement has resulted in a greater need for
TAS services. Economic downturns also contribute to increases in TAS
inventory, as taxpayers who lose their jobs and become unable to pay
their tax bills get into trouble with the IRS and seek assistance.\102\
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\100\ On the Examination side, the number of individual return
closures increased by 37 percent and the number of business return
closures increased by 102 percent from fiscal year 2004 to fiscal year
2007. On the Collection side, the number of levies increased by 85
percent, the number of liens increased by 28 percent, and the number of
seizures increased by 54 percent over the same period. See Internal
Revenue Service, fiscal year 2007 Enforcement and Services Results
(Jan. 17, 2008) (accompanying fiscal year 2007 Enforcement and Services
Tables), available at http://www.irs.gov/pub/irs-news/
irs_enforcement_and_service_tables_fy_2007.pdf.
\101\ In fiscal year 2007, TAS classified 160,131 case receipts as
compliance-related and 87,708 as service-related, for a total of
247,839 case receipts.
\102\ TAS received 86,261 economic burden case receipts in fiscal
year 2007 compared with 34,653 in fiscal year 2004--a 149 percent
increase.
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TAS is able to assist most taxpayers who seek our help. Overall,
TAS was able to obtain full relief for the taxpayer in 69 percent of
the cases we closed in fiscal year 2007 and partial relief in an
additional 4 percent of our cases.
TAS Customer Satisfaction surveys provide some evidence that the
quality and nature of taxpayer service has an impact on taxpayer
attitudes toward the tax system. When a taxpayer brings an eligible
case to TAS, he is assigned a case advocate who works with him
throughout the pendency of the case. Taxpayers have a toll-free number
direct to that case advocate, and each TAS office has a toll-free fax
number. TAS employees are required to spot and address all related
issues and to educate the taxpayer about how to avoid the problem from
occurring again, if possible. This level and quality of service drives
TAS's high taxpayer satisfaction scores, as evidenced by the results
for the last 2 years. In fiscal year 2006 and fiscal year 2007, the
percentage score for overall satisfaction of the taxpayers who came to
TAS was 85 percent and 83 percent, respectively. Equally important, 50
percent of taxpayers stated that they felt better about the IRS as a
whole after coming to TAS. Even among taxpayers who did not obtain the
result they sought, an impressive 34 percent reported that they had a
more positive opinion of the IRS because of their experience with
TAS.\103\
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\103\ For fiscal year 2006, the Gallup Organization collected the
customer satisfaction data for the Taxpayer Advocate Service. In fiscal
year 2007, TAS began using a new vendor, Macro International, to
conduct its surveys.
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However, I am concerned that with the increasing volume,
complexity, and urgency of TAS's caseload, the cycle time for our cases
has begun to increase. Closed case cycle time was 71.1 days in fiscal
year 2004 but has risen to 80.6 days in fiscal year 2008.\104\ These
results are hardly surprising. If you increase the workload of a
customer service organization by 47 percent and reduce the number of
employees available to assist customers by 13 percent, you are
essentially increasing the average workload of each employee by nearly
70 percent. And because TAS generally assists taxpayers only where they
face an imminent economic burden because of an IRS collection action or
where normal IRS procedures have failed, TAS does not have much
flexibility to turn away cases. Indeed, TAS expects to receive more
than 250,000 cases in fiscal year 2008, and our case inventory
continues to rise. If the balance between TAS staffing and the number
of cases we handle does not improve, I am concerned that TAS is in
jeopardy of becoming part of the IRS problem rather than the advocate
for the solution, as Congress intended.
---------------------------------------------------------------------------
\104\ Fiscal Year 2008 data reflects case closures from October 1,
2007 through March 31, 2008 (six months).
---------------------------------------------------------------------------
Lastly, I provide a brief report on the Low Income Taxpayer Clinic
(LITC) program, which is administered by my office. For fiscal year
2008, the IRS's Taxpayer Services appropriation included $9 million for
LITC grants. This appropriation represented an increase of $1 million
compared with the 2007 grant cycle.\105\ The LITC program currently
funds 154 clinics in all 50 States, the District of Columbia, Puerto
Rico, and Guam, thus meeting my goal of having at least one LITC in
each State. The increased appropriation allows us to provide funding
for new clinics as well as to provide increased funding for existing
clinics that have expanded or plan to expand their services to
underserved areas and populations. This additional funding also has
enabled the LITC Program to work toward its goal of funding at least
one controversy and at least one English as a Second Language (ESL)
clinic in every State. The LITC Program Office, in conjunction with TAS
Research, has identified locations where there are significant
populations of low income and ESL taxpayers who are not currently
served by a clinic. Recently, we announced a supplemental grant period
to solicit qualified organizations willing to address the needs of
these identified areas.\106\
---------------------------------------------------------------------------
\105\ Although appropriations are made on a fiscal-year basis,
grants for the LITC program are awarded on a calendar-year basis (which
we refer to as the ``grant cycle'').
\106\ Low Income Taxpayer Clinic Grant Program; Availability of
2008 Supplemental Grant Application Period, 73 Fed. Reg. 15,841-42
(Mar. 25, 2008).
---------------------------------------------------------------------------
Conclusion
Compared to the IRS of 10 years ago, the IRS of today is a more
responsive and effective organization. On the customer service side,
the IRS Restructuring and Reform Act of 1998 and the IRS response have
brought about fairly dramatic improvements, and the Taxpayer Assistance
Blueprint, created in response to an Appropriations directive, provides
a useful roadmap to maintain and improve the delivery of taxpayer
services. On the enforcement side, the IRS has been ramping up its
enforcement of the tax laws, particularly with regard to corporate tax
shelters and high-income individuals, and the results have generally
been positive.
But the IRS can, and should, do better. To increase voluntary
compliance, the IRS should incorporate an ongoing taxpayer-centric
assessment of taxpayer service needs into its strategic plans. It
should consider whether it can meet taxpayer service needs adequately
when it devotes only 6 percent of its budget to taxpayer assistance and
education. It should conduct research (including applied research) into
the causes of noncompliance and apply the resulting knowledge to IRS
enforcement strategies, including those pertaining to the cash economy.
Finally, the IRS must have sufficient resources to move forward with
its technological improvements, which are critical to its ability to
improve both its Taxpayer Services and Enforcement functions.

PRIVATE DEBT COLLECTION

Senator Durbin. What a loser this private debt collection
is. I mean, it just seems like we are stuck on this. Not to say
anything negative about our colleagues, but my guess is that it
is just a nice, little business with a bunch of employees in
several places in America that the Senator and Congressmen want
to keep open, but it sounds like it is a bad deal. This is
privatization that is costing us more than if we used the
public employee. Is that your conclusion?
Ms. Olson. Well, I think that it originated in a concern
that there was a pool of taxpayers that the IRS was not
currently touching and that we were not going to get additional
appropriations to hire employees to touch those taxpayers. And
what has turned out is that, first, that pool of cases, the
ones that are easy to work, do not exist. We are running out of
those cases and we are reaching into cases that the IRS is
actually scheduled to work, and we are stretching the bounds of
what PCAs can do efficiently.
The second thing we have found is what I highlighted in my
testimony, that a lot of these cases, if the IRS sent a
letter--we get a return that a lot of these cases have just
been sitting there----
Senator Durbin. You said 46 percent.
Ms. Olson. For a 41-cent stamp, we would get the taxpayer
going, oh, they are back on the scene. We need to respond to
them instead of our other creditors.
Senator Durbin. Of course, if the private debt collector
gets in, they get what? Twenty-five cents on $1?
Ms. Olson. Well, up to 25 cents on $1? Yes, correct.
Senator Durbin. So that seems like a loser.
Mr. George, about this brain drain, do you know what the
IRS is doing to use student loan forgiveness to either recruit
or retain talented people?
Mr. George. Actually I do not, Mr. Chairman. Allow us to
get back to you on that.
Senator Durbin. Would you?
Mr. George. But if I may, though, could I briefly address
the private debt collection issue?
Senator Durbin. Sure.
Mr. George. Because TIGTA recently conducted an audit and
there are a couple of facts that I would like to share with
this subcommittee for your appreciation.
As of February 23 of this year, the total cases assigned to
the private debt collection agencies are approximately 98,000
with the dollars assigned of just under $900 million. The
actual payments received as a result of this program are $46.19
million. Out of this, the commissions paid to the private debt
collectors has been just over $7 million. The number of
accounts paid. Again, out of approximately 98,000, the total
number of accounts fully paid is just over 12,000. The number
of accounts entering into installment agreements is just over
5,000, and the number of accounts referred to, as we call them,
taxpayer account services is just over 1,300.
We really do not know whether or not a simple letter would
achieve these results. We have not done the research to give
you a definitive answer in that regard. But Senator Brownback
may recall that when he was on the Government Reform
Subcommittee, chaired by Congressman Stephen Horn, over 10
years ago, we worked on this very issue. Back then the program,
the pilot that was established, was an abject failure. No one
would disagree with that point. Here we just simply do not know
whether the startup costs are those that the private sector
would simply assume are a part of doing business as the startup
costs.
So the bottom line is I am saying I want to make sure that
this tax gap is addressed somehow and if turning to a project
such as a private debt collection would help address it----
Senator Durbin. It sounds objective and valid, but it is
not working. How long have we been trying this now?
Ms. Olson. The program started in September 2006, and in
fact, the way it is structured is any payments that come in the
first 10 days in response to the first letter the IRS sends to
the taxpayer saying, hello, we are back, we are going to send
your case out to the private debt collectors if you do not
respond to us, are non-commissionable payments. And we do have
those numbers. In 2007, out of the $32 million--is that how
much we collected? And $31 million in 2007. About $5 million
came in the first 10 days.
So you can see it is about 19 percent of the collections
were in response to the IRS letter, and I maintain that if we
sent a letter saying, hello, we are back and we could levy on
your bank account, on your pay stub, all the things that we
could do, we would get a response.
Senator Durbin. I am going to go over time here.
Senator Brownback. I will not tax you.
Senator Durbin. Thanks. No penalties, no interest.

BUSINESS SYSTEMS MODERNIZATION

Mr. Cherecwich, my experience has been that the Federal
Government is not very darned good when it comes to business
modernization systems. And I have some personal experience
since 9/11 trying to get the FBI to have an updated computer
system. I cannot tell you how much money we have wasted in that
effort and still are not where we ought to be.
There are similar efforts that have been made in trying to
verify visas coming in and out of this country. For more than
10 years, we have failed to come up with what appears to be a
pretty simple task.
So what kind of confidence do you have if more money is
funneled into the IRS for business modernization systems and
technology that it is going to be well spent?
Mr. Cherecwich. A couple of responses to that, Senator.
Typically with high-tech projects, you have a little bit of
risk going into them, and delays and failure to meet schedules
are to be expected. Any business that tries to install a
massive computer system like we are talking about, a massive
information system, will expect to have hiccups along the road.
What happens in business when you get a hiccup along the road
is not that you cut the funding because they are bad boys. You
turn around and you provide the support in the manner in which
you feel that they can deal with that.
Now, how do I feel comfortable that they can deal with
that? The IRS in the last few years has developed something
they call a modernization and visions strategy for their
computer systems, their information structures. And this
modernization and visions strategy is a tool in which projects
can be prioritized and the appropriate management assigned to
make them work. It is an overall program that gives me a great
deal of comfort that the IRS is on a proper path to properly
manage this.
Where we will run into difficulty is this ramped-down stuff
where we start losing all the skilled people. We need to have
good, steady, level funding and keep moving forward.
Senator Durbin. I am going to ask my ranking member a favor
here. I have to take a phone call, and if he would be kind
enough to ask questions and recess the subcommittee meeting. I
want to personally thank the panel and others who have been
here today to help us.
Senator Brownback.
Senator Brownback [presiding]. Thank you very much.
All those in favor of a flat tax?
I have got to wait until he gets out of the room.

TAX SIMPLIFICATION

I want to look at tax complexity. You guys are very
familiar with this Code. I think the difficulties of
enforcement are interesting.
I presume all of you would agree with me that if Congress
provided a simpler Code, that there would be more compliance
with the tax system.
Mr. Cherecwich. It is hard to argue with that one.
Mr. George. I agree, Senator Brownback.
Senator Brownback. Have you studied or looked at other
countries that have simplified codes--other industrialized
countries that have a similar system and know of compliance
rates? Nina?
Ms. Olson. Well, I think that some of them are--although
the IRS might not like this heard--comparable to us. Some of
them have divided their tax systems between a modest income tax
and then a value-added tax or a goods and services tax.
I think that some of the directions talking about a return-
free system, some of the systems like Sweden where they have so
much information on their individuals, that they have a very
high compliance rate, but they know more about their citizens--
--
Senator Brownback. Yes. Well, our folks do not really go
for that.
Ms. Olson [continuing]. Than United States people would
want.
Senator Brownback. But are there other industrialized
countries that have simplified systems that are not thoroughly
penetrated into a person's personal information?
Ms. Olson. I was just in Australia this past month for a
tax conference, and they have a system that has income tax, has
a pay as you earn essentially system, so that many people just
like the United Kingdom do not have to file taxes because the
taxes are paid by the employer and you pay what you pay each
paycheck and you do not do a return reconciling. You only file
a return when you have sole proprietorship income or capital
gains, you know, transactions that the tax system would not
know about. And then the rest of the tax is made up by either a
goods and services or a value-added tax, which is paid along
the way and is invisible to the individual taxpayer at least.
Senator Brownback. What would you like to see us do to
simplify the system?
Obviously, up here in Congress we use the Tax Code to try
to manipulate the economy, to try to stimulate the economy, to
try to get people to do certain things. And each attempt adds a
layer of complexity, and we are all guilty of it. Every
lobbyist in town is hired by somebody to do something in this
Tax Code, and they are very good. So you have got an incredibly
complex Tax Code.
But what would you like to see us do? What should we do on
tax simplification?
Ms. Olson. Well, let me hedge my comments by saying I do
not do tax policy. I look at this from the taxpayer's
perspective in terms of being asked to comply with the laws and
the difficulty there. And so I will not go into whether it
needs to be a flat tax or what kind of tax. But whatever tax
system we have it has to be intuitive to the basic taxpayer and
not impose arcane rules like the alternative minimum tax that
confuses people.
I think that the President's reform panel made some really
interesting proposals, and I would like to see some of them
revisited.
I think that, as well, we do need to look around the world
and see what other industrial nations are doing and what the
differences are with their population and our population. We
have to keep the taxpayer's perspective in mind and say what is
it that taxpayers can handle so that we do not set them up for
problems.
Senator Brownback. I have studied some on the flat tax
systems in different countries, and the countries I have gone
to are generally second world countries. But they substantially
lowered their rate. They simplified their system. They
increased Government revenue substantially in those places and
they increased compliance. Currently, with high rates and
complexity, a lot of people just said, I am out of here. I am
going to figure a way around you guys, and did. But if it got
down to a rate that was fairly simple, a lot more people will
say, well, rather than trying to skip around this, I will pay
it. That is that intuitive piece, I think, of what you are
saying.
Ms. Olson. Yes. Well, and I think also that goes to
something else we have been recommending which is that IRS do
more research into the reasons that taxpayers do not comply
because once you learn that, you can incorporate that into not
only just how do you do your outreach and your education and
your enforcement initiatives, but also into your system design.
If you know what causes taxpayers to not comply, whether it is
attitude or the sheer complexity of the laws, they get
confused, that informs how your system should look.
Senator Brownback. Do we know the answer to that, Mr.
George?
Mr. George. Well, I have to, at the outset, say, Senator
Brownback that, as Nina indicated, tax policy is not my
bailiwick and actually under directives within the Department,
I am not in a position to advocate a particular policy.
That stated, there is no question that if there were a
simplified tax system, more people would easily or more readily
comply with their requirements. For example, I note that if the
legislation that is before Congress helping to determine the
cost basis of stocks were enacted, that would most definitely,
I think, help in terms of the overall compliance with people
acknowledging what they paid and what they owe after stock
transactions. I actually had an opportunity to raise this issue
with Jim Cramer of CNBC and he readily acknowledged that that
would be a very helpful device and that it would not be too
burdensome on the financial industry.
Senator Brownback. It would seem like all you guys could
help us quite a bit if, as we are proposing tax changes, which
happen every year in the Congress, you had some sort of
complexity index or rating of what this is going to do on
making the Tax Code more complex. Our focus is the policy
initiative we are trying to hit with the money we have. That is
the whole game. We want to go green and we have got this pool
of money. So how do we get this policy into that amount of
money? But we never really look at the complexity issue of what
it is going to do to the complexity of the code and its impact.
It would be a helpful exercise actually, particularly
because I think right now what people are most fed up with is
the complexity of the Code. I would like to see the rates
lower. I think most people would like to see the rates lower.
But what really drives them nuts is how complex this thing is.
Mr. Cherecwich. Senator, our Board conducts an annual
attitude survey among taxpayers, which I referred to earlier.
Among the findings of that survey is most Americans think it is
inappropriate to try to cheat on their taxes. They think it is
appropriate to pay the taxes as required.
Given the complexity of the Tax Code, we feel that it is
very important to balance the combination of services with
enforcement. We have a tax gap and we cannot audit our way out
of the tax gap. We have to have this balance with services and
enforcement. And that is the reason why our recommended budget
for fiscal year 2009 has that balance in recognition of the
complexity that you talk about.
Senator Brownback. I think you also note in there if it was
not as complex, you would not have quite as big a tax gap. That
is a feature of it as well. That is our role here in Congress,
and I think we need to do a lot better on that.
Thank you all very much for being here.

ADDITIONAL COMMITTEE QUESTIONS

The record will remain open for a period of 1 week for
people to be able to submit additional questions or for
panelists to submit statements into the record.
[The following questions were not asked at the hearing, but
were submitted to the Department for response subsequent to the
hearing:]

Questions Submitted by Senator Mary L. Landrieu

Question. Last year, I sent a letter to Acting Commissioner Stiff,
suggesting several ways to alleviate some of the financial burdens on
individuals who are being taxed on these grants. In Commissioner
Stiff's December 27, 2007 letter to me, she responded that all but one
of my suggestions required a legislative fix. The one suggestion she
did not address--providing families more time to pay back any tax
attributable to their grant--would have provided short term relief and
would have allowed us more time to craft a legislative solution to the
problem.
Why didn't Commissioner Stiff address this solution?
Answer. I understand that then-Acting Commissioner Stiff intended
the response to indicate the mitigation you requested, extending the
time to pay back tax attributable to a Road Home grant, requires
legislative action. We apologize for not being clearer in this regard.
Question. Could the IRS have allowed for an extension of time?
Answer. No, there is no legal basis to extend the time period for
affected taxpayers to pay the tax due. Legislation would be required in
order to provide additional time to pay the tax due in this case,
either by extending the payment date or providing for a payment of tax
over a number of years.
Question. What was the basis for concluding that the IRS could not
provide additional time for hurricane victims to pay back any tax
attributable to a Road Home grant?
Answer. The IRS does not have the discretion applicable to provide
taxpayers with an extension of time to pay taxes due.
Question. Are there other administrative steps that the IRS can
implement to mitigate the effects of its decision to tax Road Home
grants?
Answer. Because, as discussed above, our administrative flexibility
is limited under the law, the IRS has focused on providing information
to keep taxpayers well-informed on this issue. Representatives from the
IRS met with tax professionals and others to provide tax assistance on
Road Home grant issues (among other tax issues relating to the
hurricane). The IRS continues to keep an open dialogue with local tax
professionals to identify and address emerging filing issues, including
issues involving Louisiana Recovery Authority (LRA) Grants and the
effect of the taxpayer reporting a casualty loss in a prior tax year.
The IRS website has a page dedicated to providing information on
disaster relief, which includes detailed responses to frequently asked
questions for hurricane victims concerning the tax implications of Road
Home grants, including the tax-benefit rule.
______

Questions Submitted by Senator Wayne Allard

Question. Can you please provide me with an accurate and detailed
account outlining where the IRS audit process involving conservation
easements currently stands in Colorado?
Answer. The status of the audit process is as follows:
--We have issued 183 private offer letters. These private letter
offers are similar to settlement proposals. The letters address
over 400 tax years and over 103 easements. They concern over
$38,900,000 in claimed easement donation value.
--Of the 183 offer letters, 64 (35 percent) have been accepted, 91
(50 percent) have been rejected, and 28 (15 percent) are
pending.
--We expect to send a small number of additional offer letters within
the next several weeks.
--Audits are continuing for 316 taxpayers, 489 tax years, and 159
easements.
--Audits have concluded for 356 taxpayers, 667 tax years, and 168
easements.
Question. Does the IRS have any intention of refocusing its
investigation off of legitimate easements and focus solely on those who
have been targeted by the state?
Answer. The IRS strives to avoid focusing its investigations on
legitimate easements. Our efforts have focused on two approaches.
First, we attempted to resolve through our settlement offer program
those cases in which the sole issue was valuation of the easement.
Although this approach resolved many cases, we will need to do further
work with respect to those taxpayers who declined to accept the
settlement offer. Second, we have been investigating some of the
organizations that have been targeted by the state of Colorado as
promoters of questionable or abusive easements. We intend to pursue our
work with respect to these cases as we complete our work on
conservation easements in Colorado and elsewhere across the United
States.
Question. In mid-November, the IRS began making settlement offers
to a significant number of conservation easement donors under audit in
Colorado. According to the IRS, the settlements were only offered in
those cases where the sole issue between the donor and the IRS is
valuation.
The offers generally fell into a ``bucket'' where the IRS stated
only 30 percent, 60 percent, or 75 percent of the original value of the
charitable donation was allowed.
What were the criteria the IRS used to place different taxpayers
into these various ``buckets''? Did the IRS indicate in writing to the
donor how or why the IRS arrived at their decision? If not, why?
Answer. The IRS established the three separate categories after
reviewing factors that affected the strength of the taxpayers'
appraisals and other substantiation of the deductions claimed, with the
highest allowance percentage being provided to those taxpayers the IRS
believed had the strongest cases, taking into account the hazards of
litigation. A 30 percent allowance offer was made to those taxpayers
that had subdivided their properties into small parcels, such as 35
acre parcels, in connection with making a contribution of an easement.
The primary difference between the 60 percent and 75 percent
categories was the extent of the taxpayer's appraisal process; 75
percent was offered to those identified as having undergone an
appraisal process that was identical or similar to Colorado's ``Great
Outdoors Colorado'' (GOCO) process; and 60 percent was offered to all
other taxpayers. GOCO is a state program intended to encourage
conservation and preservation, including through conservation
easements.
We attached as Appendix A a copy of the standard form of letter
that was sent to the taxpayers, as well as one of its attachments--a
letter from the state of Colorado concerning the resolution of state
income tax liability. The standard letter invites taxpayers to contact
the IRS with any questions they may have. Many taxpayers who received
this letter have done so, and have discussed their offers and the
reasons for them with Revenue Agents and Engineers.
Question. Since the IRS investigations began into the 2003
easements how much money has the IRS recuperated and how much taxpayer
money has been spent on the blanket audit of conservation easements in
Colorado?
Answer. Our information systems do not track costs in this fashion.
To date in Colorado we have assessed $6.9 million in tax, penalties,
and interest in these cases.
We respectfully note that decisions on administering the tax laws
generally are not guided exclusively by a cost-benefit approach as
contemplated by the question. Other considerations, including
requirements of the tax law, the deterrent effect on taxpayers, and the
interests of justice, must be taken into account.
Question. Wouldn't the IRS be more successful in recuperating tax
dollars if it investigated the same fraud the state uncovered rather
than auditing good easements that have been shown to meet rigorous
state and national standards?
Answer. The IRS commenced this examination program because of
problems reported and discovered in conservation easement donations
generally, but initially focused on Colorado after the State of
Colorado expressed its concerns regarding valuation and other issues
involving donations made in Colorado. The State initiated its actions
after our work elsewhere had begun. We have and will continue to work
collaboratively with the State of Colorado and will focus on what we
believe are the more egregious cases.
Question. How much money does the IRS expect to spend defending its
settlement offers in court? Do you find this to be a good way of using
taxpayer's dollars?
Answer. No reliable estimate of such costs is possible until we
know better the number of cases involved. However, as we choose how to
audit and resolve cases, we always take into account limited resources
and long-term strategies. We experience such choices in virtually every
examination initiative.
Question. Does the IRS have appraisers or other professionals that
are experts in conservation easements? If not, why?
Answer. Yes, the IRS does have a number of appraisers and other
specialists who are experts in valuing various forms of property, and
who have valued conservation easements for federal income tax purposes.
Question. Has the IRS used the experts in conservation easement
valuation or tax law that have offered their expertise? If not, why?
Answer. Yes, and we will be using more. The IRS is currently
working to hire additional experts to work Colorado cases, including
cases involving potentially abusive promotions of easements.
Question. The longer these cases remain pending, the more impact
they can have on land conservation in Colorado. When does the IRS
expect to conclude their investigation?
Answer. The IRS understands the need to be expeditious in
attempting to resolve these cases. The IRS has already completed
examination work in Colorado easement cases involving 168 easements.
Cases involving 159 easements remain open at this time. The IRS
continues to work toward completing its examinations involving Colorado
easements, and we recently dedicated additional resources to complete
them as quickly as possible. Although the IRS expects to conclude many
of its examinations of the existing open Colorado conservation easement
cases by December 2008, we expect that the balance of the examinations
work will not be completed until as late as June 2009. This timeframe
does not include the time required for cases to work their way through
the Appeals and litigation processes.

APPENDIX A

Internal Revenue Service
(IRS Address)
Date:

(Taxpayer name)
(Address )

Department of the Treasury

Refer Reply to:
Group:
Person to Contact:

Employee Identification Number:
Contact Telephone Number:

Dear (Taxpayers name):
This letter is to inform you that Appeals has considered the
federal tax implications of a group of returns reflecting charitable
contributions of conservation easements in the state of Colorado.
Because your conservation easement is within that group, the Internal
Revenue Service proposes to resolve the issue(s) related to the
conservation easement contribution claimed on your federal income tax
return for XXXX(tax year) under Delegation Order 4-25, as described
below. This proposed offer must be accepted within 30 days of the date
of this letter.
This resolution reflects Appeals' assessment of the hazards of
litigation. Appeals has concluded the settlement proposed in this
letter is an equitable resolution of the issue(s). Absent atypical
facts and circumstances, you (investor or investor partner) should not
expect a resolution of the tax issue on terms that are more favorable
than the terms offered in this letter. If you do not accept this offer,
the resolution of your case in Appeals will be based on the merits of
the issues presented and may in fact be less favorable than the terms
of this letter.
If you accept this offer, the Service will resolve your
conservation easement on the following terms. For purposes of this
settlement:
1. The government will treat the easement you donated during the
year 20xx as a qualified conservation easement contribution.
2. The allowed amount of the conservation easement contribution
is based upon the amount of the value of the easement
originally claimed and the hazards of litigation. Please see
the attached Form 4549A.
3. If you sold or transferred the Colorado state tax credit
resulting from the donation of the conservation easement, the
amount you received in exchange for the sale or transfer will
be subject to tax as ordinary income. Please see the attached
Form 4549A.
4. If the settlement results in an adjustment for a period(s)
other than the period(s) listed in the first paragraph of this
letter, you will file amended returns reflecting the settlement
and furnish copies of same to the person named above.
5. You are liable for interest as provided by law.
You are not eligible for this settlement offer if the conservation
easement in question involves:
1. An appraisal that determines the highest and best use for the
property is the extraction of natural resources where such
resources have not been shown to exist or to be economically
feasible to extract.
2. A quid pro quo arrangement.
3. Property which was purchased or sold within 18 months of the
contribution of the conservation easement.
4. A contribution made to a donee organization that either does
not qualify under section 501(c) (3) of the Internal Revenue
Code or is under active consideration for termination of its
exempt status.
5. An appraisal from a participant or individual who was involved
in the promotion or marketing of conservation easements or
under investigation for inflated valuations.
6. Conservation land easement on property outside the state of
Colorado.
7. The legal issue of whether the contribution is a qualified
conservation contribution under section 170(h) of the Internal
Revenue Code.
In addition, you are not eligible for this settlement offer if you
are:
A. A party to a court proceeding (individual or as a partner in a
TEFRA partnership) in which the determination of the tax
treatment of the conservation easement is at issue.
B. A partner, owner, promoter, or advisor in the business of
developing real estate.
C. A promoter, partner of a promoter, or employee of a promoter
of a conservation easement transaction.
D. A person under criminal tax investigation. This includes a
person under related criminal tax investigation by the Service
or the Department of Justice, or a person who has been notified
before the date of execution of the Form 906, closing
agreement, that the Service or the Department of Justice
intends to commence a tax related criminal investigation of
that person.
If any of the above exclusions applies, you are not eligible for
this settlement offer.
If you are eligible for this settlement offer and wish to resolve
your Colorado conservation easement issue on the terms set forth above,
you must sign and return the enclosed Forms 870-AD (triplicate original
signatures) and Forms 906 (triplicate original signatures) to the
person whose name is listed above within 30 days of the date of this
letter.
You must thereafter cooperate with the Service to resolve your case
expeditiously. In addition if the Service requests additional
information, or documents necessary to effect this settlement, you must
provide those documents within 20 calendar days of the request. The
Service will grant an extension of the 20 day period only in
exceptional circumstances and at its discretion.
The settlement is not binding until both you and the Service sign a
specific matters closing agreement (Form 906) and Form 870-AD resolving
the issues for all taxable years affected by this transaction in
accordance with the above terms. When the Service signs the specific
matters closing agreement, the one-year period of limitations on
assessment will begin under section 6229(f) of the Internal Revenue
Code for investor partners.
Full payment of the liabilities under this offer is expected by the
date the closing agreement and Form 870-AD are returned to the Service.
If you are unable to make full payment, you must submit complete
financial statements (Form 433-A or Form 433-B, as appropriate) and
return them to the person whose name is listed above.
If you choose not to accept this proposed settlement or you are not
eligible for this settlement, development of the issue will continue.
If the issue is still in dispute at completion of the examination, you
may request an Appeals conference.
This settlement is solely a settlement of civil tax matters. No
statement contained herein shall be deemed to be an admission by the
Service. Nothing herein shall preclude the Service from asserting a
position on the merits that is different from this settlement in
contexts other than those concerning the civil tax liability of the
taxpayer-parties whose cases are settled under this offer.
If you choose to have a representative you must authorize such
representation by completing a Form 2848, Power of Attorney and
Declaration of Representative. You can obtain this form from a local
IRS office, through our website at www.irs.gov or by calling 1-800-829-
3676.
Also, enclosed is a letter from the state of Colorado which
provides instructions on resolving your state income tax liability
involving this issue provided that you resolve your federal tax matter
at this time.
If you have any questions, please contact the person whose name and
telephone number appear at the top of this letter.
Sincerely,
Name of Person Issuing Letter
Title of Person Issuing Letter
Enclosures:
Form 906
Form 870-AD
Form 4549A
Form 433-A
Form 433-B
State of Colorado letter

State of Colorado,
Taxpayer Service Division,
Department of Revenue,
Denver, Colorado 80261, November 1, 2007.

COLORADO DEPARTMENT OF REVENUE SETTLEMENT OFFER

Taxpayers who participate in the Internal Revenue Service's
conservation easement donation settlement offer will also be eligible
for a settlement offer from the Colorado Department of Revenue
according to the terms set forth below. The IRS will advise the
Colorado Department of Revenue of the identity of taxpayers who qualify
for their offer as allowed through our information sharing agreement.
In order to accept the Colorado offer, the taxpayer must file an
amended return for all affected tax years within 30 days of the
acceptance and execution of the IRS' settlement offer. The amended
return(s) will include:
--Adjustments to federal taxable income matching the federal
settlement adjustments;
--Adjustment to Colorado's federal charitable contribution deduction
addback to the extent applicable to the federal settlement
adjustments;
--Repayment by the easement donor of 50 percent of the gross
conservation easement tax credit that would have been
disallowed under the federal settlement adjustments. The donor
may pay this amount rather than having the transferees
assessed.
Questions regarding this offer should be referred to Richard
Giardini at the Colorado Department of Revenue at 303-866-3900.
Richard Giardini,
Colorado Department of Revenue, Taxpayer Service Division.

SUBCOMMITTEE RECESS

Senator Brownback. The hearing is recessed.
[Whereupon, at 4:13 p.m., Wednesday, April 16, the
subcommittee was recessed, to reconvene subject to the call of
the Chair.]

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

----------

WEDNESDAY, APRIL 30, 2008

U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 3:02 p.m., in room SD-192, Dirksen
Senate Office Building, Hon. Richard J. Durbin (chairman)
presiding.
Present: Senators Durbin and Brownback.

CONSUMER PRODUCT SAFETY COMMISSION

STATEMENTS OF:
NANCY A. NORD, ACTING CHAIRMAN
THOMAS H. MOORE, COMMISSIONER

OPENING STATEMENT OF SENATOR RICHARD J. DURBIN

Senator Durbin. Good afternoon. I am pleased to welcome you
to this hearing today before the Financial Services and General
Government Appropriations Subcommittee.
Today we will discuss the President's fiscal year 2009
budget request for the Consumer Product Safety Commission
(CSPC). Testifying before us will be Acting Chairman Nancy Nord
and Commissioner Thomas Moore.

THEN AND NOW

Last year, thanks to investigative reporting by the Chicago
Tribune, which won a Pulitzer Prize for its work, I became
concerned about toy safety issues. With the spotlight shining
on some deadly toys, America became much more aware of the
dangers of toys on store shelves, often ones coming from China.
At this time last year, we were reviewing the budget of an
agency that had been neglected and underfunded for years. We
acted together on a bipartisan basis last year to boost funding
from a level of $63 million to $80 million, a dramatic increase
by today's budget standards. The House and Senate both passed
reauthorization bills to improve CPSC's abilities to protect
the public.
So now, with the 28 percent increase in funding last year
and an expected final reauthorization that will, if the Senate
prevails, give the CPSC new tools, we will be able to prevent
dangerous products from reaching stores, ensure faster recalls,
and allow families access to information on existing safety
complaints. I think the Consumer Product Safety Commission has
the potential to become an exemplary watchdog agency.
The Commission has gone from a high of 978 full-time
employees in 1980 to a low of 380 employees in January of this
year. Now that it is turning around, because CPSC has the
funding we provided to replace the key staff it has lost over
the years, I hope the Commission will swiftly hire all the
needed technical experts and investigators to get the agency
back to better fulfill its mission.
We discussed last year in detail the dilapidated laboratory
that CPSC uses to test toys. I understand that Bob, one of the
toy testers, has since retired. Bob became a very famous figure
in America, as we talked about his workbench and his testing
laboratory.
But soon CPSC will move to a new and improved testing
laboratory. We provided funding last year to enable that
timetable to be accelerated, and with funds requested in fiscal
year 2009, the Commission will be able to move into the space a
year earlier than expected.

FISCAL YEAR 2009 PRESIDENT'S BUDGET

While good things are being done with funding provided last
year, unfortunately, the President did not join in the cheer.
The President froze funding for this agency for the next fiscal
year at the $80 million level. So while the agency is hiring
new staff, the fiscal year 2009 budget proposal by the
President would just maintain the staff and not continue to
build the professional staff that is needed to protect
consumers across America. I do not agree with the President.
There has been a dramatic upsurge in imports into the United
States, a dramatic increase in products that have to be
reviewed by this Commission to make sure that American families
are safe.

MISINFORMED APPROACHES TO CONSUMER PROTECTION

At this point, I hope that we can move forward. I hope that
we can understand that some of the challenges are very obvious.
A CPSC engineer was asked to design a new study of the
mechanics and stability of all-terrain vehicles (ATVs). He
proposed a cursory review of the latest ATV's on a budget of
about $40,000. He was turned down because it cost too much, he
was told. How can $40,000 be too much to study a vehicle that
literally is responsible for the deaths of hundreds of people
and sends hundreds of thousands to emergency rooms each year?
It is clearly a case of penny-wise and pound-foolish.
In 2001, CPSC issued an administrative complaint, a first
step in litigation leading to a recall, against Daisy
Manufacturing Company about their Powerline Airguns. Airgun's
BBs were getting stuck in the gun, so children thought the guns
were empty and began aiming and shooting at each other. Due to
the high velocity BBs, this resulted in deaths and serious
injuries among kids. Daisy alleged there was a misuse of the
product and an education campaign would solve the problem.
The Commission alleged a defect, which caused the BB to
lodge in the gun so that an administrative complaint was
issued, but it was then dismissed by the CPSC in 2003 under a
new administration. One of the factors leading to the
settlement action was that Daisy Company could have gone out of
business if there had been a recall.
Mr. Moore, at the time, your statement took issue with that
settlement action, and I quote. ``The bottom line is that we
are not the business protection agency. We are the Consumer
Product Safety Commission. Our responsibility is to protect the
public from dangerous consumer products. If we lose sight of
that, we will get entangled in endless discussions of company
finances while consumers are being put at risk of death or
serious injury.''
These are clearly issues and many others that we will have
to consider, and we will talk about them as we get into this
hearing. But at this point, let me turn to my ranking member,
Senator Brownback of Kansas.

STATEMENT OF SENATOR SAM BROWNBACK

Senator Brownback. Thank you, Mr. Chairman.
The hearing we did last year on the Consumer Product Safety
Commission was an excellent hearing. I thought it was a ground-
breaking hearing, and I am pleased to see progress is being
made.
I would like to thank Acting Chairman Nord and Commissioner
Moore. I will begin by commending you for the steps you have
taken to improve the agency and the work and the safety of
imported consumer products since our September 12, 2007
hearing. I understand that you used the additional resources we
appropriated to improve your import surveillance activities,
modernize your product testing, and hire additional product
safety inspectors. It is unfortunate that such advances were
not made until after all the toy recalls, bad press, and
congressional hearings.
We discussed the issue of imported products from China at
great length in our earlier hearing, so I will be briefer on
that today. But clearly, China is our biggest regulatory
challenge since 70 percent of all defective products are coming
from that country--70 percent. We must continue to focus our
efforts on stopping dangerous and even lethal products from
reaching American consumers. This is where the problem is and
this is where our focus, I believe, should be. It is hoeing
where the weeds are.
I am glad to hear the continuing dialogue with the Chinese
and the enhanced ways your agency is communicating with them,
but I am concerned that dialogue just is not enough. The
memorandum of understanding (MOU) that you have signed with the
Chinese must be honored and you must verify--verify--that the
Chinese are holding up their end of the bargain. I would
recommend that you hold annual, rather than biennial, product
safety summits with the Chinese. I still believe that we cannot
merely trust China to do what is right.
Certainly regarding product safety, they have given us
every reason not to trust them. In fact, just yesterday a Food
and Drug Administration (FDA) official testified before a House
subcommittee that FDA's working hypothesis is that the
contamination of heparin was intentional. Although FDA has not
proven this yet, it speaks volumes about the grave concerns we
must have about all products coming from China.
I hope that during today's hearing you will be able to
identify specific ways you intend to hold China accountable.
Again, this is where the problem is and this is where our focus
should be. It is a totalitarian system. It does not have a free
press. It has graft and corruption that operate within the
political system. I think by looking at the exterior factors
you would expect a series of problems to probably arise.
So Ms. Nord and Mr. Moore, I thank you for your commitment
to protect America's consumers. I look forward to hearing your
detailed testimony and what we can do to particularly address
the issue of the products that we are seeing coming in from
China.
Thank you, Mr. Chairman.
Senator Durbin. Thanks, Senator Brownback.
I now invite testimony from Chairman Nord and Commissioner
Moore. Please proceed.
Ms. Nord. Thank you, Mr. Chairman, Senator Brownback.
A lot has happened at the CPSC since the last time I
appeared before you, thanks in large measure to the leadership
of this subcommittee and to you personally, Chairman Durbin and
Senator Brownback.
The CPSC received a nearly 28 percent increase in our
fiscal year 2008 appropriation, and I can report to you that we
are putting these new funds to very good use this year and are
building a foundation for further growth in 2009.
The consumer product landscape is changing with
globalization and a surge in imported products, more
technologically complex products, and a dramatic increase in
Internet sales. As this landscape changes, so must we.
This afternoon I want to highlight changes we are making
with the increase in our 2008 funding and discuss our 2009
budget proposals which are built on this foundation.
The first change is staffing. We started fiscal year 2008
anticipating a staffing level for the year of around 400.
Instead, for the first time in many years, the CPSC will end
the fiscal year with more people on staff than at the beginning
of the year. Our ambitious goal is to begin fiscal year 2009,
this October, with the full complement of staff requested for
the entire year, an increase of over 50 people since this past
January.
While we are staffing up throughout the agency, we are
making a special effort to increase our compliance and field
staff who are part of CPSC's new Import Surveillance Division,
which is a centerpiece of our new import safety initiative. For
the first time we will have a team of permanent full-time
personnel at selected key ports, supported by a team of
technicians, scientists, and lawyers at headquarters, with full
access to Customs' technology that will give our team real-time
information on consumer product shipments bound for the United
States. When a suspect shipment warrants inspection, we will be
using the newly acquired XRF technology to screen for violative
products.
The second change is in our laboratory. Our lab team tests
products sent from our field staff to identify defects and
violations, and they provide the scientific backbone to support
our rulemakings such as the one we are pushing forward now on
upholstered furniture. With more field inspectors and
compliance officers, the work of the lab will grow
significantly. As you know very well, the laboratory is housed
in a substandard facility. The fiscal year 2008 funding you
provided allowed us to begin the modernization a year earlier
than we had anticipated, and our fiscal year 2009 budget
request allows us to plan to move into a new modern laboratory
by the end of 2009. It is anticipated that the new facility
will increase our efficiency by accommodating not only our lab
staff, but also other technical and scientific staff who work
closely with them.
The third change concerns our data management and
information technology (IT). The CPSC receives an enormous
amount of information, close to half a million individual
product incident reports each year. And I have here a couple of
samples of a 1-day's run of data of product reports from two
different databases. Processing, investigating, and responding
to this information is an enormously complex undertaking. Yet
it is in this data that we find the clues that point to
possible emerging hazards.
Unfortunately, due to the age and limitations of our IT
infrastructure, this data is entered in numerous systems that
are not integrated with each other. These two databases which
have consumer complaints and product incident reports are not
integrated. They do not talk to each other. Thus, we have to
rely on the keen eyes and the institutional memories of our
experienced staff to pick up trends and patterns, an inadequate
approach as the agency grows and as our more seasoned staff
retires.
Our IT improvement plan will connect these data systems to
allow staff to more effectively identify patterns and flag
hazards as they emerge. The recently launched early warning
system, which initially is focusing on nursery products in the
sleep environment, is a pilot program for this data integration
project.
Our fiscal year 2009 budget request proposes to build a
more comprehensive plan on the foundation provided by the early
warning system. We will keep the subcommittee informed of the
progress of this work since we do anticipate that additional
funding will be needed in fiscal year 2010 to bring the new
system online.
Before concluding, I would like to reference two
legislative developments that will impact our funding needs.
First, Congress passed the Virginia Graeme Baker Pool and
Spa Safety Act after our budget plans were finalized this past
December. That law directs us to undertake a number of new
enforcement and education requirements and to administer a new
grant program. We anticipate returning with an amendment to our
budget request for additional funds.

PREPARED STATEMENT

We also anticipate that the CPSC reauthorization bill will
be finalized soon. In addition to giving us needed new
authorities, it appears that the final bill will include many
new mandates for the agency, including as many as 40 new
rulemaking requirements. When it is enacted, we undoubtedly
will need additional resources above our 2009 budget proposal.
In this regard, I look forward to continuing to work with the
members and staff to make sure that we have those resources
that we need to continue to serve our most important
stakeholder, the American consumer.
Thank you.
Senator Durbin. Thank you, Chairman Nord.
[The statement follows:]

Prepared Statement of the Honorable Nancy A. Nord

Thank you for this opportunity to present to you the appropriation
request for the U.S. Consumer Product Safety Commission (CPSC) for
fiscal year 2009. As the Committee members know, the CPSC is a small,
independent and bipartisan agency created by Congress. Our mission is
to protect the public from unreasonable risks of injury and death
associated with more than 15,000 types of consumer products.
Last December, the appropriations committees significantly
increased CPSC's fiscal year 2008 budget by over 27 percent above the
previous year. I want to begin my testimony by thanking the Committee,
and specifically the Chairman, for your strong support of our agency
and our safety mission. The funds that you have provided are helping us
lay the necessary groundwork for the agency's expanded initiatives that
are presented in the agency's fiscal year 2009 budget request.

FISCAL YEAR 2009 BUDGET REQUEST

For fiscal year 2009, the CPSC is requesting $80 million to carry
out our various safety missions for America's families. While the
agency's final appropriation for fiscal year 2008 was also $80 million,
there are significant expenditures in 2008 that do not recur in 2009.
Therefore, an additional $11,800,000 is available in the agency's 2009
budget request compared to the 2008 funding level. With these fiscal
year 2008 and 2009 funds, the CPSC will be able to complete the
modernization of our testing laboratory, begin to overhaul our
information technology (IT) infrastructure, and hire more staff.
The facilities, staff and IT systems provided by this funding will
combine to create the foundation we need to begin to build the agency's
newest safety programs, including the Early Warning System that I
initiated last year to enhance our ability to identify emerging hazards
and the Import Safety Initiative that will allow the agency, for the
first time in its history, to have a full-time presence at the Nation's
ports. These expenditures for laboratory facilities, workspace and IT
infrastructure are critical capital investments that must be made now
to accommodate current and expected future growth of the agency,
especially in tandem with our projected staff increase.

MEETING THE CHALLENGE OF IMPORTED PRODUCTS

Since the CPSC's inception in 1973, the agency's work has
contributed substantially to the decline in the rate of deaths and
injuries related to hazardous consumer products. Today, the American
home environment has never been safer. However, the international
marketplace is dynamic, and there is always more work to be done and
new challenges to be met.
Perhaps the greatest of these is the import safety challenge. Most
of the consumer products that we use today are no longer manufactured
in the United States. For example, over 85 percent of toys and 59
percent of electrical products are manufactured in other countries,
notably in China. The number of products imported into the United
States showed a 200 percent increase from 1997 to 2006.
The Commission has taken aggressive steps to meet this challenge,
including ongoing dialogue and initiatives with the Chinese Government;
working with the private sector, including Chinese manufacturers
directly; and increased surveillance and enforcement activities at the
borders and within the marketplace.
To provide a comprehensive and coordinated effort to ensure greater
import compliance with recognized American safety standards, the
Commission in 2004 created the Office of International Programs.
Through this Office we have established a formal relationship between
the CPSC and the General Administration of Quality Supervision,
Inspection and Quarantine (AQSIQ), our counterpart agency in China.
Formal working groups and action plans with the Chinese Government were
set up to focus on key product areas, and they continue to make
progress on their immediate goals of developing strategies to address
safety problems and to respond quickly to urgent product safety issues.
Last autumn, the CPSC sponsored the U.S.-Sino Product Safety Summit
where significant agreements were signed with AQSIQ to strengthen these
working groups. China has pledged to increase pre-export inspections,
improve compliance with mandatory and consensus standards, and crack
down on repeat violators of U.S. safety standards. While we recognize
that China is a huge country with thousands of manufacturing facilities
and that implementation of these agreements cannot be accomplished
overnight, we have begun to see positive results. The CPSC will
continue to work with the Chinese to assure that they fully implement
their commitments.
The initial steps that the CPSC has taken to assure the safety of
imported goods are an important beginning to our goal of maximizing
Chinese industry compliance with U.S. product safety requirements. In
this regard, it is essential to convey to them a full understanding of
U.S. regulatory requirements. Summaries of provisions of nearly 300
U.S. mandatory and consensus consumer product safety standards are now
available in Chinese. We are posting timely information briefs on our
website in Chinese, and our plans include links to full Chinese texts
and audio-visual products. The agency is also participating in
industry-specific safety seminars and retail and vendor training
seminars on-site in China.

BUILDING A NEW IMPORT SURVEILLANCE DIVISION

The CPSC is hiring new staff in the areas of hazard identification
and reduction, as well as in compliance and field operations. CPSC's
number of actual FTEs at the start of calendar year 2008 was under 390;
our aggressive goal is to increase that number to 439 by October 1,
2008--a 13 percent increase with more than 50 new employees.
Additionally, increased staff training and performance initiatives will
enhance retention of CPSC's experienced and skilled employees.
These personnel will enable the agency to expand its monitoring,
inspection and testing of products, and especially children's products,
as part of our Import Safety Initiative. Our new Import Surveillance
Division is designed to be the front line of defense working to prevent
dangerous toys and other hazardous products from entering the country
and reaching American consumers.
These employees will be specialists trained specifically in import
surveillance procedures and will work closely with other Government
agencies and with CPSC's compliance officers, technical staff,
attorneys, and laboratory personnel. CPSC's new port investigators will
track cargo and, with Customs' officials, stop and inspect suspect
shipments. High impact ports will be targeted and new measures of
import compliance will be established to better assess progress.

MODERNIZING CPSC'S TESTING LABORATORY

When our import surveillance and compliance officers find suspect
products, those products are sent to our laboratory to determine if
they violate standards or are defective. Therefore, our laboratory is
an integral and critical part of our operation. As you know, and as
your staff has witnessed first-hand, CPSC's testing laboratory needs to
be modernized to create efficiencies and to better support CPSC's
product safety work, including the new work generated by the Import
Safety Initiative. As presently configured, the laboratory space is
inefficient to say the least, though our staff there do an incredible
job with the tools that they have at hand.
Our new funding has allowed the agency in 2008 to begin to
implement plans that not only address the needs of the laboratory but
also anticipate critical and immediate workspace issues for a growing
staff. The Commission has been able to move forward with site selection
and will make a substantial payment to the General Services
Administration of $8 million in fiscal year 2008 so that we can move
into the new laboratory a year earlier than otherwise expected. An
additional payment of $6 million is requested in CPSC's fiscal year
2009 budget proposal to complete the laboratory project.
By accelerating our laboratory modernization plan, we will provide
not only a modern facility for our engineers and scientists to conduct
their testing and investigations but also office space for an
additional 70 employees to be relocated from CPSC's headquarters
office. These employees will be those who work closely with the
laboratory staff. This action will allow further efficiencies and
improvements in office space at our headquarters site.

IMPROVING CPSC'S IT INFRASTRUCTURE

Per the Committee's interest, the agency is also spending new
funding on important improvements to our information technology (IT)
infrastructure. The need for increased funding for IT has been a
constant in CPSC's budget proposals over the years. Our IT systems have
not been fully modernized since 1993 when the agency last relocated its
headquarters. As directed by the Committee, CPSC's 2009 budget request
includes a report on our information technology modernization
requirements.
Achieving the agency mission is dependent on our IT systems because
our work requires electronic accessibility of information to maintain
productivity. The increased emphasis on import safety demands greater
reliance than ever before on integrating CPSC databases and accessing
other agencies' databases, such as those of U.S. Customs and Border
Protection, in a seamless fashion.
With new funding in fiscal year 2008, the CPSC has permanently
established a long-sought capital fund to replace aging and outdated IT
equipment on a systematic basis and a fund to support development of
more advanced electronic applications. Additionally, a one-time
expenditure of $2.3 million is allowing the agency to replace its
resource management information system which is so outmoded that vendor
support is being withdrawn.
Funding in fiscal year 2009 will continue this modernization effort
and include the development of our IT improvement plan to convert our
current data systems from a client-server environment to a web-based
environment; full integration of the Document Management System;
updating current, outdated database platforms to one, mainstream
platform; and converting current, disparate data systems to one data
system.
These IT improvements are essential to the agency's Import Safety
Initiative. Improved electronic data exchanges with Customs' databases
in the future will enhance the Government's capabilities to identify,
track and stop hazardous products from entering the United States. Our
IT plan will also include a new system that can track historical
changes of addresses and names for foreign companies which will provide
for more rapid identification of hazardous imported products. The new
system will also integrate several third party sources of information
that will yield improved monitoring. Finally, it will potentially give
us, for the first time, an effective tool to flag and guard against
foreign suppliers who repeatedly ignore our product safety
requirements.

ESTABLISHING A NEW EARLY WARNING SYSTEM

The new IT improvements will also support our new Early Warning
System (EWS) which I initiated last year to enhance our current hazard
identification systems. The goal of the EWS is to systematically
identify and respond to children's product safety hazards starting with
cribs, bassinets and playpens. This initiative is important because it
is designed to address emerging hazards more quickly and effectively.
Through an enhanced identification system, the agency will be able to
detect product hazard patterns more promptly as they emerge.

ONGOING CPSC ACTIVITIES

While I have discussed CPSC's new systems, programs and
infrastructure at length, it is also important to recognize the
critical ongoing work of the agency in standards setting, domestic
enforcement and public education.
Though the Commission was without a quorum for the better part of
2007, I am pleased to report that the agency was able to make progress
on a number of fronts. As a result of last year's staff work, the
Commission was able to vote earlier this year, before the quorum again
expired, on a final rule to update our clothing textile flammability
standard and on a notice of proposed rulemaking on upholstered
furniture flammability.

Reducing Carbon Monoxide Poisonings
Additionally, the Commission completed a great amount of work to
reduce carbon monoxide (CO) poisonings.
First, the Commission issued a mandatory rule last year for a new
danger label for portable generators to warn consumers about CO
poisoning and to encourage safe use. The regulation became effective on
May 14, 2007, for all portable generators manufactured or imported
after that date.
Second, the Commission issued an advance notice of proposed
rulemaking in December 2006 to initiate a multi-faceted proceeding that
includes as its goal reducing consumer exposure to CO through technical
means and performance standards that will enable and encourage proper
generator placement outdoors.
Third, the CPSC awarded a contract to develop a prototype generator
engine with reduced CO in the exhaust.
Fourth, CPSC staff has an interagency agreement with the National
Institute of Standards and Technology (NIST) to conduct physical
testing and indoor air quality modeling of in-home CO infiltration in
various styles of homes when a generator is used in various locations.
Finally, CPSC staff conducted a proof-of-concept demonstration of a
remote CO sensing automatic shut-off device, as well as an interlock
concept in which a CO sensor was located in the generator. The results
of these investigations will help determine practical and effective
performance requirements for portable generators and provide the basis
for subsequent rulemaking activity.
Implementing a New Mattress Flammability Standard
In 2007, the CPSC's new mattress flammability standard became
effective. The staff estimates that the new standard, when fully
effective, will prevent as many as 270 deaths and 1,330 injuries
annually.
In implementing the new standard, CPSC staff has sponsored and
participated in education seminars for manufacturers and retailers.
Staff has also developed a dedicated mattress information webpage and
prepared and distributed several reference documents and informational
brochures.
In addition to the progress the agency has made on these
rulemakings, the CPSC is continuing its work in the voluntary standards
process by providing expert advice, technical assistance, and
information based on data analyses of how deaths and injuries occurred.
Staff is currently supporting the development or revision of over sixty
voluntary standards, including those to reduce fires related to
candles, batteries, appliances and other electrical products.
Enforcement and Compliance Efforts
CPSC's Office of Compliance completed 473 cooperative recalls in
2007 involving approximately 100 million product units. While those 473
recalls in 2007 were heavily publicized in the media, they were only
marginally above the 467 cooperative recalls that were completed in
2006, and in fact, they involved fewer than the 120 million product
units in 2006. The increased media attention on the CPSC in 2007 did,
however, have the salutary effect of raising both public awareness of
the agency's safety mission and its effectiveness in removing products
from the marketplace that violate mandatory standards or present a
substantial risk of injury to the public.
To assist industry in recalling products and complying with our
regulations easily and quickly, the agency relies on Fast Track product
recalls to streamline the process for firms that are willing and
prepared to recall their products promptly. Because every defective
product presents a risk of injury or death, removing hazardous products
from the marketplace faster can prevent more injuries and save more
lives. Recalls under the Fast Track program are conducted without the
need for a time-consuming hazard analysis and, over 90 percent of the
time, are implemented within 20 days of a firm's report to the CPSC.
For non-Fast Track corrective actions, we also established new
efficiency goals to complete key actions within a specified time
period.

Educating the Public
CPSC's Office of Public Affairs is very active in educating the
public and informing consumers of recalls and emerging hazards. In
2007, that Office issued more than 350 press releases on product
recalls and safety information and completed more than 20 safety
campaigns on such topics as all-terrain vehicles; mattress safety;
stove, television and furniture tipovers; portable generator dangers;
and outdoor and indoor drowning prevention. American consumers viewed
safety information announced by the CPSC more than a half billion times
through television interviews, video news releases, free publications,
and the Neighborhood Safety Network.
I am especially proud of that Office's work on outreach to the
Spanish-speaking community. In 2007, we translated the Neighborhood
Safety Network Toolkit into Spanish, as well as several safety
publications and three times the number of press releases as in the
previous year. The CPSC coordinated a Lead Poisoning Prevention Web
site in cooperation with other Federal agencies and the National
Council of La Raza.
Before concluding, I should note that the House and the Senate have
passed different versions of reauthorization legislation for the CPSC.
CPSC's fiscal year 2009 budget request does not include funding
increases in the event that Congress finalizes this legislation and the
President signs it. Since it is clear that the final legislation would
impose substantial new regulatory, enforcement and other mandates on
the CPSC, we will, of course, be in further contact with the
appropriations Committees in that regard at the appropriate time.
The CPSC is an agency that is undergoing change, like no other
agency of Government, with significant budget increases, comprehensive
reauthorization, and national attention unlike ever before in its
history. As we make the transitions that accompany this change, I look
forward to continuing to work closely with the Committee. Our common
goal is to assure the safety of the products that American families
bring into their homes, schools and recreation areas. I am honored to
serve the American public as Acting Chairman of the Consumer Product
Safety Commission at this time of great challenge and great
opportunity, and I look forward to answering your questions.
Thank you.

Senator Durbin. Commissioner Moore.

SUMMARY STATEMENT OF THOMAS H. MOORE

Mr. Moore. Mr. Chairman, Mr. Ranking Member, thank you for
providing me with this opportunity to present testimony before
you today on the U.S. Consumer Product Safety Commission's
fiscal year 2009 appropriations request.
For our current fiscal year 2008, Congress, led by this
subcommittee, took up the cause of the American consumer by
focusing on, and addressing, the serious deficiencies at the
Commission resulting from our most recent years of shrinking
resources. Our agency was appropriated $80 million, a $16.75
million increase over the administration's request.
For fiscal year 2009, the President's funding request for
the agency is $80 million, which is equal to the level of
funding provided by Congress for fiscal year 2008. With this
amount of funding, we propose to hire up to a level of 444
full-time employees. Additionally, we propose to continue our
efforts to acquire a modern, state-of-the-art laboratory
facility and to acquire additional office space, which we will
need to accommodate some of our new hires.
The fiscal year 2009 request on its face is a request for
level funding from 2008. However, there are a number of one-
time expenses occurring in 2008 that are not anticipated in
2009. Not having those expenses in 2009 provides the Commission
with $5.8 million to direct toward activities which would give
indications of growth as opposed to stagnation or movement in
the negative direction.
Most important to me is our now present ability to rebuild
our staff. CPSC is a staff-intensive organization, as I have
said previously. At the heart of CPSC's operation is its staff,
without question our greatest and most important asset.
In addition to Congress' focus on Commission appropriation
issues, both Chambers, the House and the Senate, have passed
reauthorization legislation. Both bills provide significant
increases in our authorization levels for future years at the
Commission. The bills would require the Commission to undertake
a number of activities that I am not taking into consideration
as I present this statement. I cannot say at this time what
resources we would need to fully implement any new
requirements. When a final package is agreed upon and signed
into law, we certainly intend to communicate with this
subcommittee with respect to any future requirements and their
effect on Commission resources.
Also, last December, the President signed into law the Pool
and Spa Safety Act. For fiscal year 2009, the act authorizes $7
million for the Commission to carry out its requirements. Our
staff has done an estimate of the cost of carrying out the
requirements of the act and has advised the Commission that for
fiscal year 2009, we would need an additional--an additional--
$7.887 million. The President's request of $80 million does not
include this funding and Congress would have to include
additional funds above the President's request for the
Commission to carry out the act's requirements.
Mr. Chairman, I want to thank this subcommittee for your
recognition of the importance of our agency with respect to
product safety for American consumers. The sale of unsafe
consumer products remains a major national problem. Because of
your attention and assistance, we are now on the way back to
firm footing in preventing unsafe, potentially harmful consumer
products from causing deaths and injuries to American
consumers. The continued support of this subcommittee is
essential to a successful fulfillment of our mission.

PREPARED STATEMENT

I thank you again, and I am now available to respond to
questions that you may have. Thank you.
Senator Durbin. Thank you, Mr. Commissioner.
[The statement follows:]

Prepared Statement of Thomas H. Moore

Mr. Chairman, Ranking Member, and members of the subcommittee,
thank you for providing me with this opportunity to present testimony
before you today on the U.S. Consumer Product Safety Commission's
(CPSC) fiscal year 2009 appropriations request.
In summary, for fiscal year 2009, the President's funding request
for the agency is $80,000,000 which is equal to the level of funding
provided by Congress for fiscal year 2008. With this level of funding,
we propose to hire up to 444 Full Time Equivalents (FTEs) from our
budget submission level of approximately 380 FTEs. Additionally, we
propose to continue our efforts to acquire a modern laboratory facility
and to acquire additional office space, which we will need to
accommodate some of our new hires.
However, it must be noted that the fiscal year 2009 funding request
does not take into consideration the cost of implementing the
requirements of the ``Virginia Graeme Baker Pool and Spa Safety Act''
nor does the 2009 funding request address the cost of implementing
possible requirements of any final passage of a conference agreement on
the ``Consumer Product Safety Commission Reform Act'' as passed by the
Senate and the ``Consumer Product Safety Modernization Act'' as passed
by the House.
On December 19, 2007, the President signed into law the Virginia
Graeme Baker Pool and Spa Safety Act which is aimed at reducing the 260
pool and spa drownings each year involving children younger than 5 and
reducing suction entrapment deaths and injuries. The act addresses pool
and spa safety issues by specifying requirements that would make pools
and spas safer. The act also authorizes the Commission to establish an
incentive-based grant program for States, subject to the availability
of appropriations. Additionally, the act requires the Commission to
``establish and carry out an education program to inform the public of
methods to prevent drowning and entrapment in swimming pools and
spas.''
For fiscal year 2009, the act authorizes $7 million for the
Commission to carry out these requirements. Our staff has done an
estimate of the cost of carrying out the requirements of the act and
advised the Commission that, for fiscal year 2009, we would need an
additional $7.887 million--which would provide for start-up cost,
contract cost, the cost of an additional 6 FTEs, and other costs
associated with implementing the requirements of the act. As I have
indicated, the President's request of $80 million does not include
funding for these activities and Congress would have to include
additional funds, above the President's request, for the Commission to
carry out these requirements.

IMPACT OF FISCAL YEAR 2008 FUNDING

In order to fully understand our fiscal year 2009 request, we must
first look at what is transpiring for us in fiscal year 2008. In fiscal
year 2008, the administration's budget contemplated funding the
Commission at $63,250,000 which would have resulted in an all-time low
funded staffing level of 401 FTEs; a decrease of 19 FTEs from the
fiscal year 2007 funded level. As I indicated in my written statement
to this subcommittee last year, such a funding level would have had a
devastating effect on the agency's ability to maintain the broad range
of skilled staff we need to address the full scope of the 15,000 types
of consumer products under our jurisdiction. Congress, led by this
subcommittee, took up the cause of the American consumer by focusing
on, and addressing, the serious deficiencies at the Commission
resulting from our most recent years of shrinking resources by
appropriating $80 million, a $16.75 million increase over the
administration's request.
With the additional resources, the Commission has been able to
start the process of reversing the effects of the Commission's downward
spiral in staffing. The Commission is now able to begin filling
critical vacancies, moving our staff level in the positive direction
toward 420 FTEs. We have also started a process to reacquire
headquarters office space that we forfeited in order to reduce our
operating cost.
Part of our staffing increase has been directed to an import safety
initiative through the creation of a new Import Surveillance Division
in the Office of Compliance and Field Operations. For the first time,
CPSC will have permanent, full-time product safety investigators at key
ports of entry throughout the United States. Initially, we have
identified up to 10 ports where we will assign personnel.
We are also implementing an Early Warning System (EWS) initiative
which is designed to identify emerging product safety hazard patterns
more quickly and effectively in children's products such as cribs,
bassinets and play yards (playpens). Fiscal year 2008 funding will
allow staff to continue to develop and implement processes and
procedures to evaluate and characterize hazard scenarios and failure
modes which should alert the Commission staff that a product hazard may
exist and quick action to address it must ensue.
The additional resources for fiscal year 2008 will also allow the
Commission to move in the direction of expediting the acquisition of a
new state-of-the-art laboratory facility and equipment. We will commit
$8 million of fiscal year 2008 funding toward this effort. The
Commission is taking the approach of acquiring a new facility as
opposed to modernizing the present laboratory site based on current
projections by CPSC staff, GSA, and OMB that acquiring a new facility
would be a more cost effective, more expeditious, and more efficient
process for the Commission than rehabilitating the present laboratory
site.
Our laboratory situation is well known to most people who have
focused on the problems presented by the Commission's limited resource
allocations in recent budgets. We have been trying, through various
avenues, to remodel or rebuild our existing facility for many years. We
now appear to be getting closer to the reality of a new testing
laboratory. The process with GSA has been frustrating, with their
stated deadlines to us slipping again and again. Last year when GSA
gave us the preliminary estimate of how much they were going to raise
the rent at the current laboratory facility (with no improvements) it
seemed the last straw. (They have since backed off substantially from
the threatened initial rent increase.)
Finally, after much discussion, GSA was willing to start the
process of looking at what other facilities might be available to see
if the option of moving the lab was more cost effective than rebuilding
the present one. Perhaps, by the end of this fiscal year we will have a
much better handle on that option, but given the fits and starts of
this process I am not as confident as I would like to be about the
outcome. The cost estimates we are operating on are numbers from OMB
and GSA, based on the assumption that we will indeed find appropriate
new space for all of our current and future testing needs as well as
office space for perhaps as many as 70 of our other employees. I am
hopeful that at the end of this process we will have a clear picture of
the efficiency and cost effectiveness of moving in this direction. For
now, I must simply go on what information staff is presenting to me on
this issue and I have consented to fully exploring this option.
We are also able, for the first time, to establish in our base
funding, a capital fund to replace aging and outdated Information
Technology (IT) equipment and we are able to dedicate funds to further
the process of developing more advanced electronic applications for our
IT system. These advanced electronic applications will be essential to
the Commission's Import Safety and EWS initiatives as well as an
important element in converting our current, disparate database systems
to a one-stop data acquisition system. Moreover, we are able to replace
our outmoded resource management information system, for which vendor
support was withdrawn due to the age of the system. Not included in
this budget are resources to integrate and modernize our various
database systems into one larger searchable format, an improvement to
our data analysis capabilities that we have wanted for a long time. If
Congress requires the agency to create additional publicly accessible
databases--a move I strongly support--being able to do that in the
context of improving our overall data capabilities would be especially
helpful.
The fiscal year 2008 increase will additionally provide for other
important product safety related activities such as a modest increase
in our contract funds for our rulemaking, research, and project
support. And, because we need to be able to compete with other
governmental agencies and the private sector for qualified candidates
to fill our vacancies, the budget increases funds for our staff
training and staff performance incentives.
Most important to me in our fiscal year 2008 increase is our now
present ability to begin rebuilding our staff. CPSC has been under a
glaring spotlight for the last year. While it is not always a
comfortable position for the agency to be in, for me, it has been
welcomed and much needed attention. It brought to light, especially for
Congress, the woeful state of the agency's resources, from its
declining staffing levels to its aging and inadequate laboratory
facilities. For too many years the agency had been forced to put a
brave face on its situation by claiming it could do more with less.
When we stopped getting enough resources to meet our basic needs that
claim began to ring hollow and the agency was left without the
necessary tools to properly police the consumer product marketplace.
Now, not only has Congress shown a willingness to give us the
resources we so desperately need, but it has also positioned itself to
increase our authorities and responsibilities. I am very thankful for
Congress' efforts on our behalf. I do hope, however, that any final
authorization bill that Congress passes gives the Commission the
necessary time it will need to rebuild to meet our current
responsibilities. Once we reach that point, then we can give full
concentration to tackling the many new responsibilities that are
projected to be part of a final reauthorization package.
Our fiscal year 2009 budget assumes that we will have 444 staff on
board for the beginning of fiscal year 2009. This requires us to add
nearly 65 new employees, a 17 percent increase over our budget
submission level. That will bring us almost back to our fiscal year
2005 staffing level of 446 FTEs. When I first came to the agency in
1995, we had final FTE authority of 487 FTEs and averaged 474 FTEs on
board for the year. So we still will need to hire another 30 people in
fiscal year 2010 just to get us back up to our 1995 staffing level, a
staffing level at which we handled that year's existing
responsibilities fairly comfortably.
Over time we hope to be able to hire and train capable replacements
for those that have left, but the experience that we have lost due to
their departure will take years to recover. I am very optimistic that
now, with the change in attitude about the Commission's importance that
has manifested itself in our increased funding levels, we will be able
to reverse the negative perceptions about the Commission and move in a
positive direction on our staffing issues and, therefore, on product
safety.
cpsc's safety work can continue in fiscal year 2009
By most measures, CPSC provides both tremendous service and
tremendous value to the American people and we are very proud of our
staff's accomplishments. Our agency is the major factor in the
substantial decline in the rate of deaths and injuries related to
consumer products since 1974. During that time, through our standards
work, compliance efforts, industry partnerships, and consumer
information, there has been a 43 percent reduction in residential fire
deaths, a 74 percent reduction in consumer product-related
electrocutions, a 41 percent reduction in consumer product-related
carbon monoxide deaths, an 83 percent reduction in poisoning deaths of
children younger than 5 years of age, an 88 percent reduction in baby
walker injuries and an 84 percent reduction in crib-related deaths.
The fiscal year 2009 request, on its face, is a request for level
funding from fiscal year 2008. What we really have, however, amounts to
a $5.8 million increase. Assuming the projections on the lab are
accurate, we will spend $2 million less on the lab in 2009 and we have
another $3.8 million in other non-recurring, one-time costs that we are
funding in 2008 that we don't fund in 2009 for a total of $5.8 million
in additional funds for 2009.
Of that, $2.457 million will go to maintaining the costs of the 420
employees we anticipate having on board in fiscal year 2008, along with
increases in other fixed costs such as rent. Another $3.218 million
will go to hiring 24 new employees to supplement and to provide support
for the Import Safety Initiative. We have also targeted $125,000 for
travel for the U.S.-Sino Product Safety Summit. While I note that both
the pending reauthorization bills anticipate the Commission receiving
additional funding for the modernization of our testing and research
laboratory, our budget requests for both fiscal year 2008 and fiscal
year 2009 are constructed to utilize a large portion of the funding
increases provided by Congress for the laboratory modernization,
certainly a greatly needed improvement. The rest of the increases begin
the crucial staff rebuilding and the acquisition of additional office
space to accommodate the additional staff. Those concentrations leaves
us little for anything else.
Now, there are certainly many questions remaining unanswered at
this time concerning reauthorization legislation requirements. I know
that there are many questions about what should be included as part of
our request for our fiscal year 2009 budget. At this particular moment,
it is extremely difficult to determine what additional staff and funds
we will need to meet the new responsibilities that Congress may give
us. We have made no attempt to do that in the fiscal year 2009 budget
request as that would have been premature. The Acting Chairman's office
in a response to a question presented by House appropriators had staff
prepare estimates as to what those resources might be (some of those
estimates are already going through second revisions), but we are all
flying somewhat blindly until we have a final bill with definite
requirements and timelines for Commission action. I hope that the
deadlines in the final bill will take into account the time needed to
hire and train new employees, to find them adequate office space and to
integrate them and their skills into our existing workforce. The
Commission hasn't had to hire at this pace since it was first
established back in the 1970s.
We at the Commission strongly feel that many, many deaths and
injuries have been prevented as a result of the heightened attention
given to safety issues by manufacturers and consumers due to CPSC's
leadership. However, we are very mindful that the product safety
landscape is ever evolving because of more technologically complex
products as well as an ever growing emphasis on imports. Last year's
heightened activities with respect to imported toys, in particular,
clearly illustrate the benefits of a strong CPSC Federal presence in
today's consumer product marketplace and therefore provide substantial
justification for present and future funding to keep our safety
programs intact.

CONCLUSION

As I have indicated, Congress is poised to come to agreement on a
final reauthorization package. Both bills under consideration provide
significant increases in our authorization levels for future years at
the Commission. The authorization levels reflect my own views on how
growth should be contemplated for the Commission, and I am hoping that
future appropriations will be in line with the House and Senate final
agreed upon authorization levels.
As I have previously discussed, the bills would also require the
Commission to undertake a number of activities that I am not taking
into consideration as I present this statement. The final legislative
package will most certainly contain some significant new regulatory,
enforcement and other mandates that could have some effect on what
resources we would need to fully implement all of the requirements.
When a final determination is made, we certainly intend to communicate
with this subcommittee with respect to future requirements and their
effect on Commission resources.
Mr. Chairman, I want to thank this subcommittee for your
recognition of the importance of our agency with respect to product
safety for American consumers. The sale of unsafe consumer products
remains a major national problem. Because of your attention and
assistance, we are now on the way back to firm footing in preventing
unsafe, potentially harmful consumer products from causing deaths and
injuries to American consumers. The continued support of this
subcommittee is essential to a successful fulfillment of our mission.

STAFFING LEVELS

Senator Durbin. Chairman Nord, if I recall, it was in
December when it was clear that we were sending you this pretty
substantial increase in your appropriation to $80 million, and
I was asking the staff here what kind of staffing levels you
had last year at this time. We think it was around 400 million
FTE's. Pardon me. 400 FTE's.
Ms. Nord. You have been dealing with other agencies way too
long.
Senator Durbin. I am not sure there is any agency with 400
million. But 400 FTE's.
Now, historically we have talked about where this agency
has been. 980 is the high watermark and now apparently at 380,
the low watermark. So the question I have is that in the 4-or
5-month period of time that we have sent you the new resources
to staff up, it appears you are staffing down. It appears you
are losing ground. Some 5 percent of your employees have left
and not been replaced, instead of an additional 10 percent
being hired. So can you give us an indication of why the trend
line is moving in the wrong direction?
Ms. Nord. Well, we see attrition on a regular basis. You
generally see one or two every month leave, and those people
have to be replaced to keep you even. But since January, we
have brought on 21 new hires. We have got 12 offers out right
now. We have got well over 30, almost 40 new positions that are
in the mix for being put out for advertisement. So we are
working really very, very aggressively to get up to that goal
of starting the fiscal year with 444 FTE's.
Senator Durbin. So are the 21 that you have hired included
in the 380 number?
Ms. Nord. If they are on board, they would be included in
our current staffing.
Senator Durbin. What is your current staffing? What number?
Ms. Nord. It is approximately 385 to 390. I will have to
give you the precise number.
Senator Durbin. Well, I do not want you to go out and pick
the first person off the street, and I am sure you would not
want to.
Ms. Nord. No.
Senator Durbin. But we sure want to make certain that you
understand the sense of urgency. I will tell you why, and I
think you know it better than I do.
The biggest scandal last year involved toys. We know that
the design for toys for this coming holiday season in
December--those were all agreed on last year, and they are
currently under manufacture and currently being shipped to the
United States. So the new dolls, the new games, whatever they
happen to be are on their way. Clearly, we have to be ready to
make sure that the American families do not go through the same
thing next holiday season that they did the last one.
Ms. Nord. I do understand your sense of urgency and I share
that, Senator.
The thing that I would like to point out is that the type
of people we are seeking to hire are statisticians, scientists,
toxicologists, human factors, engineers. These people are
essential to our operations, but they are also in demand in
other Government agencies who are also now trying to staff up,
as well as in the private sector. So this is something we are
committed to doing. We are working full out right now to get
ourselves up to the 444. That is our goal and we are working
very hard to reach it.
Senator Durbin. We are going to keep in touch with you to
monitor your progress----
Ms. Nord. Good.
Senator Durbin [continuing]. And hope that you can reach
the 444 with competent individuals as quickly as possible.

NEW IMPORT SAFETY INITIATIVE

Let me ask you about the import safety initiative, which
will allow you to put permanent, full-time product safety
investigators at key ports. How many ports will be part of this
initiative and how many investigators will be placed at these
ports?
Ms. Nord. We are going to be putting people at 10 different
ports. Our overall division is going to be approximately, I
believe, 12 people, and I would prefer to give your staff
privately the locations of those ports, if I could.
Senator Durbin. May I ask, if you are talking about one
person or slightly more than one person per port, what kind of
workload will that person face?
Ms. Nord. Well, they will certainly face a very heavy
workload, but the thing that needs to be remembered here is,
first, we have to start someplace.
And second, we do anticipate that this is a program that
will grow based on our experiences this year.
Third, these people are not out there standing alone. They
are supported by technical staff back at headquarters and also,
very, very importantly, they are going to be working hand in
glove with their colleagues from Customs. And that relationship
between CPSC and Customs has grown wonderfully well over this
past year, and I am very encouraged by the support that we are
getting.
Senator Durbin. Are you considering any new technology in
these ports for the detection of lead or other dangerous
substances?
Ms. Nord. Yes. Because of the increased funding that we
were able to receive from you, we have now acquired what is
known as XRF technology. This is important because it allows us
to screen for potential violations. What we had to do before is
if the inspector's eye saw something that they thought was
suspicious, that product had to be sent back to Washington for
testing, and that was a process that took a great deal of time.
So this allows us to screen it right there quickly. We can then
separate out the things that pass from the things that need a
further look.

WILL THERE BE A CPSC PRESENCE IN CHINA?

Senator Durbin. My last question. Do you expect to place
any staff in China?
Ms. Nord. If I have my way, we will.
Senator Durbin. You are the Acting Chairman.
Ms. Nord. Yes. We have been having conversations with the
Beijing Embassy and with the State Department about having a
foreign service national assigned to us over there. If we are
to send CPSC staff there and put them there, that is a big
undertaking for our agency. I believe it requires a vote of the
Commission, and at this point, you know, we do not have a
quorum. But I think that would be a good thing to do. So I will
certainly be voting for it.
Senator Durbin. I am going to turn this over to Senator
Brownback. I have to step out while he questions, but I will be
returning.
Senator Brownback. Thank you, Mr. Chairman.
Are you conducting any surprise inspections in China now?
Ms. Nord. We do not do inspections per se in China as, for
example, the FDA does. What we are doing is all our recall
notices go directly to our counterpart agency in China, and
they investigate them. We are now getting very detailed reports
back from them as to their findings. We have monthly video
conferences where we go over each of the recalls and what their
investigations found.
Senator Brownback. What about doing surprise inspections in
China? You were talking about putting personnel or somebody at
the Embassy there. What about doing surprise inspections?
Ms. Nord. It is clear actually that under our statute we
only regulate American product sellers. So we would not have
the legal authority to go into a Chinese-owned plant with an
American inspector and do an inspection. What will happen is
that the Chinese Government does that, and if we have people in
China, then they could certainly participate in those
inspections, but they would have to be done by the Chinese
since they would be inspecting Chinese factories.
Senator Brownback. Therein lies the rub, if you will,
because we are getting so much from China and we are having so
many problems and their system is so different from ours. That
is the problem. You could kind of say, well, okay, China has a
free press and so they are going to kind of track these issues
or get some light on them. Well, they do not. If they had an
open political system where you would have different political
parties batting this around, well, okay, maybe that would be
something that would produce it. They do not. It is well known
the corruption and graft that is taking place at local levels
in China. The national level of the Chinese Government is
trying to get some competitiveness at a local level because of
primarily dealing with graft and corruption that they are
trying to get out of the system but is there.
So I do not know how we depend upon the Chinese Government
to assure that we get a decent product without us being there
and in on surprise inspections.
Ms. Nord. We cannot look to the Chinese Government to
enforce American safety laws, and we do not intend to. But what
we can do is put in place a number of different kinds of
processes that will push toward an ultimate result of safer
products, and that is what we were trying to do with the
agreements that we signed last September that created a
framework for this ongoing activity. That is what we are trying
to do with our monthly meetings with the Chinese. That is what
we are trying to do with the training sessions that go on in
China.
But having said all that, it is very, very important that
we also understand that we have got to be looking at layers of
protection. We can do all that with China, but we have got to
make sure that we are vigilant at the ports, that we have got
police on the beat, that is to say, that we recall products
when we find violations, and that we put penalties in place.
But one of the things that I think is important for you to
know, Senator, is that, first of all, the number of toy recalls
and lead paint violations is going way down. And also it is
important and I think very good news that we have not yet seen
any products manufactured after the point of our agreements
that have been recalled for lead paint violations.
Senator Brownback. If I could before my time is up, have
the total number of consumer product recalls on imported items
from China increased or decreased since September 2007, and not
just the lead-based products?
Ms. Nord. I am sorry. I did not have that statistic. The
number of recalls that we have done in fiscal year 2008 is
going up, but those are products that were already in the
marketplace. They are not new products that have entered the
marketplace since September. So they are things from 2005,
2006, that kind of thing.
Senator Brownback. Just to conclude on this, when you catch
it, the horse is already out of the barn. It is in the consumer
marketplace here and that is where we catch it when we ought to
be backing up a lot earlier on this. I do not have confidence
that, with whatever kind of cooperation we get from the Chinese
Government, that they are going to catch this. And at the point
at which we catch it, it has already entered the consumer
marketplace.
Ms. Nord. That is why the layers of protection is such an
important concept. Obviously, consumers are better off if the
product is manufactured safely in the first place, and that is
what we have to be shooting for.
Senator Brownback. Thank you.
Thank you, Mr. Chairman.

CPSC REAUTHORIZATION

Senator Durbin. Chairman Nord, when the Consumer Product
Safety Commission Reform Act was pending, Commissioner Moore
and you sent letters to Chairman Inouye about it, and you have
alluded to it in your testimony today. Now, of course, this
bill, having passed the Senate, is subject to conference with
the House in terms of its outcome.
I just want to make sure that I understand what you have
said today. If this bill as passed in the Senate was enacted
into law, would this give you more tools and more authority to
do your job?
Ms. Nord. It would certainly give us more tools and more
authority.
Senator Durbin. Is there any way that you think provisions
of this bill would make your job more difficult?
Ms. Nord. There are a number of new mandates in the
legislation and they have very, very short time deadlines on
them. So we will either have to come back to you with a plan
for staffing up, to the extent we can, or reallocating existing
resources, taking things off existing projects and putting them
on what is there.
Senator Durbin. Can you give me any examples of those
mandates as you are sitting there?
Ms. Nord. Oh, gosh. The bill set out a whole schedule for
doing rulemakings on children's products, durable infant
products.
Senator Durbin. Like tracking labels for children's
products?
Ms. Nord. Well, no, doing rulemakings on putting in place
rules dealing with durable children's products.
Senator Durbin. Such as a comprehensive ban on lead?
Ms. Nord. Well, that certainly is there as well, but I was
speaking of something else.
Senator Durbin. I am trying to get down to what you are
speaking of. I am not trying to misstate you.
Ms. Nord. The bill tells us on a schedule we are to
finalize two rulemakings every year on durable children's
products. It also, as you point out, has the ban on lead, and
we are working very hard with the authorizers' staff to----
Senator Durbin. I hope you do not disagree with that
mandate.
Ms. Nord. Oh, of course, not.

CONSUMER COMPLAINT DATABASE

Senator Durbin. What about the online product safety
database enhancing public access to product safety information?
Does that exist today?
Ms. Nord. No, it does not.
Senator Durbin. Do you know what it would take to put that
database in operation? Have you considered that?
Ms. Nord. Yes. I have asked our information technology
people to give us some estimates, and they have advised me that
to do what is described in the Senate bill as it passed would
take approximately $20 million in startup costs and about $2.5
million to $3.5 million annual maintenance cost.
If I may expand, the database is a very good example of why
we really need to get a better handle overall on our
information technology needs. Unfortunately, because the agency
has been short funded, we have put together databases on an as-
needed basis. They are stovepiped. They do not communicate with
each other, and for our staff to have the tools it really needs
to do its work, we have got to modernize our IT resources.

SENATE CPSC REAUTHORIZATION BILL AND COST ESTIMATES

Senator Durbin. I would like to ask you, if you would, to
take a look at the bill that passed the Senate.
Ms. Nord. Yes.
Senator Durbin. And if you would give us your best estimate
from your staff of where you consider to be the most expensive
and the most challenging elements of that bill, I would like to
know because I want to get this bill passed. We have been
working hard to get the conference committee to go to work on
it, and I want to be thinking in terms of next year's
appropriation as to what will be needed. For example, this
database requirement here. If people can come up with a
reasonable estimate of what that might cost, I want to be
thinking ahead about what that might require in the next
appropriation bill.
I believe in this bill. I introduced an earlier bill which
was very similar to it. Senator Pryor improved on it and did a
great job leading it through the floor on a bipartisan basis.
But I want to think ahead to what these new challenges might be
and what their costs might be. It certainly is not going to be
served with a remake of the $80 million fiscal year
appropriation for this year. It is going to take more.
Ms. Nord. We will need an amendment, and I will be happy to
do that.
Senator Durbin. If you would, please, I would appreciate
that very much.

MOST IMPORTANT ELEMENTS OF CPSC REAUTHORIZATION BILL

Commissioner Moore, your letter in reference to this bill
was much more supportive in terms of the tools that it would
give to your Commission. As you reflect on that, were there any
specifics that you had in mind that you think could really make
a difference in the way you do your job?
Mr. Moore. Certainly given the increase in the number of
products coming in through our ports, the ability to expand our
study and our interest in products as we meet them at the
ports, at the docks, I think is very important. To the extent
that we can turn products around if they are violative--they do
not meet standards--I think the more effective we can be in
controlling product safety problems.
Senator Durbin. Mr. Moore, I think we all understand what
happened last year. It was a troubling time for many American
families. There were questions raised about toys in particular
but other products as well. And a lot of people came up to me
in my State and to other Senators and said, what is safe? What
is it safe to buy? And I could not tell them. I really did not
know the answer to that question. I could not make a
recommendation of what to do.

ARE WE BETTER OFF NOW?

Do you feel that there is anything happening at the
Commission today which gives you confidence that the next
holiday season will be any different or any better?
Mr. Moore. Well, I think one of the most risky elements of
products out there most recently has been lead in children's
toys, and I think there has been enough publicity and enough
vocal concerns raised about that, that I think the public is
very much aware. Also manufacturers are very much aware. And, I
think to the extent that we can eliminate that particular
problem, that is a major consideration.
Senator Durbin. It is.
Chairman Nord, let me ask you the same question. Can you
tell me with any degree of certainty that the next holiday
season, that families can have more peace of mind in the toys
and products that they are purchasing, that we will have done a
better job or that the process will be any safer?
Ms. Nord. Last Christmas, the toys, because of what
happened, were the most tested and examined in the history of
our country. We need to build on that. I think that the toy
industry safety initiative is a really interesting proposal
because, to Senator Brownback's concern, it really does force
an examination of the Chinese factories. I think that if I
could have one thing only from the authorization bill--this is
something I asked for last summer--it is to have certification
authority. That would do so much to help us. It would drive
testing. It would give us another tool for imports. That simple
thing.

CERTIFICATION AUTHORITY

Senator Durbin. Certifying laboratories?
Ms. Nord. No. Certify that toys meet all relevant
standards.
Senator Durbin. Where would the certification take place?
Ms. Nord. The importer and the product seller would have to
get it certified.
Senator Durbin. Where?
Ms. Nord. If it was manufactured in China, they would have
to have it tested there.
Senator Durbin. So there would be laboratories doing this
work.
Ms. Nord. Absolutely.
Senator Durbin. That we would certify.
Ms. Nord. Absolutely.
Senator Durbin. And that would, obviously, mean that some
CPSC employees would have to be traveling to these
laboratories.
Ms. Nord. Well, we would certainly be traveling to these
laboratories, but I think we would be setting up a structure
that would make sure that the quality control is in place, but
that all flows from that simple certification requirement.
Senator Durbin. Is there any effort underway now, even
absent this new reform bill, to establish these laboratories in
China, not Government laboratories, but private laboratories,
the names of which we might recognize?
Ms. Nord. There are many ongoing efforts. I think the
community has anticipated that the bill will pass, and that
sets out a very full third party, independent testing and
certification requirement. And so they are gearing up for that
now.
Senator Durbin. And are you involved at all in that current
undertaking?
Ms. Nord. Yes.
Senator Durbin. What does the CPSC do?
Ms. Nord. Well, our staff is working very closely with the
other Government players who have experience doing this in
other areas. I mean, we have an ongoing relationship with all
the testing and certification accreditation bodies. You know
them as well as I, UL, ANSI, ASTM, and there are many others
that have a role to play here, and we work daily with them.

ENDING REMARKS

Senator Durbin. I do not have any further questions. I want
to thank Commissioner Moore and Chairman Nord for being here
today.
We are looking forward to receiving your best estimate of
what impact the new reform bill might have on your agency. I
encourage you as quickly as possible in a professional way to
try to get staffed up to make sure that we have the technical
staff and investigators, both here in the United States and
overseas. If there is any need of this subcommittee or Congress
to be involved to help you locate your people in other places,
I hope you will turn to us because I hope I made it clear that
I do not want to live through what we did last year, and I am
sure you do not either.
Ms. Nord. You can be assured of that, Senator.
Senator Durbin. We learned from that experience, and we owe
it to the American people, all of us in Congress and in the
executive branch, to do a better job.

ADDITIONAL COMMITTEE QUESTIONS

So the record will be open if my colleagues have questions
that they might submit for your consideration. We have made a
couple of requests of you here, and I thank you for joining us
today.
[The following questions were not asked at the hearing, but
were submitted to the Commission for response subsequent to the
hearing:]

Questions Submitted to Nancy A. Nord
Questions Submitted to Senator Richard J. Durbin

NEW IMPORT SAFETY INITIATIVE

Question. How will this initiative change your stated goal for
fiscal year 2008 for Import Surveillance, which was for staff to
conduct port-of-entry surveillance for 1 product for which fire safety
standards are in effect?
With the funding increase from fiscal year 2008 and knowing of the
limited goals listed in your fiscal year 2008 budget justification,
will any of your fiscal year 2009 stated goals for import safety and
interaction with China be able to be accelerated into this year?
I know you are using XRF technology. Are there other functional
technologies being considered for inspection?
Answer. The 2008 stated goal for one port-of-entry surveillance for
fire safety contemplated a focus on compliance with CPSC's new mattress
flammability standard. That important initiative is underway. While the
stated goals in the Consumer Product Safety Commission's (CPSC)
Performance Budget and Operating Plan cannot be changed without a vote
of the Commission (and the Commission currently lacks a quorum), the
CPSC has been able to use the additional funds provided for fiscal year
2008 to strengthen its import surveillance activities. A substantial
portion of the new funds have been used to create the new Import
Surveillance Division within the Office of Compliance. This new
division includes, for the first time in CPSC history, personnel who
work at the ports-of-entry on a full-time basis. The new division
already has a staff of 11 employees, most of whom are new to the agency
(although all have had significant prior experience in import safety).
This increased presence at the ports is yielding a larger number of
import samples to be evaluated for conformity with mandatory safety
standards.
CPSC staff is currently using our new XRF technology at the ports,
and it has proven to be a very efficient and effective screening system
in identifying products that may contain lead or be coated with lead
paint. CPSC staff is exploring whether there are other functional
technologies that could be used for inspection at the ports.

UPDATE ON U.S.-CHINA AGREEMENT

Question. Last year, you announced an agreement between the United
States and China on lead paint and consumer product safety.
Can you give me an update on any progress? Do you believe that
you'll soon be signing a specific follow up agreement to the framework
agreement you announced last year?
What do you see as the tangible benefits of finishing a formal
agreement?
Have you observed improvements in China's capacity and willingness
to perform compliance and enforcement activities regarding product
safety?
What outreach has been conducted as a result of the U.S.-China
agreement?
Do you expect any such agreements with other countries?
Answer. The work plans that the CPSC agreed to at the U.S.-Sino
Consumer Product Safety Summit held in September 2007 were outcomes of
our Memorandum of Understanding (MOU) with the Peoples' Republic of
China (PRC) which established the framework for cooperation and
outreach. The work plans called for cooperative work in four product
categories: toys, lighters, electrical products, and fireworks.
Technical experts are now working on exchanges of standards
information, training for product testing, and sharing information on
best practices in those four product categories.
Since September, CPSC staff has met eight times, either in person
or via video conference, with staff of China's General Administration
for Quality Supervision, Inspection and Quarantine (AQSIQ) to review
recalls and safety issues.
The CPSC has begun a Chinese language service on our web site,
where Chinese suppliers and government officials can get updated
compliance information in Chinese. We are translating many product
safety requirements and posting them on the web site, as well as
providing summary descriptions in Chinese that link to full texts in
English.
Regarding Chinese cooperation, first it should be stressed that the
CPSC does not rely on the Chinese government to enforce U.S.
requirements. The CPSC enforces our requirements with American
importers. That said, the PRC offered to use its export quality control
system to target Chinese-made products that would be recalled if they
entered the United States. The CPSC singled out lead paint on toys as a
problem and the Chinese agreed to take that on.
--The PRC says it has inspected thousands of factories and revoked
hundreds of export licenses for lead paint violations. As we
send them case reports, they now send us the results of their
investigations, and their reports frequently cite specific
remedial action that they have required the Chinese factory to
take.
--The Chinese government has stated that no export permit is granted
for a painted toy unless the paint on the toy came from an
approved lead-free suppliers list.
--The PRC has sponsored numerous high-profile standards and
compliance seminars aimed at getting the product safety message
to Chinese manufacturers. The CPSC participated in one of these
in November.
--CPSC staff has noticed that the Chinese government shows an
increased interest in promoting industry best practices for
compliance assurance, compared to simply increasing its factory
inspections.
Nothing the Chinese government promises and no amount of export
control inspection can take the place of major systemic changes in
Chinese manufacturing. CPSC staff is working with Chinese suppliers to
hasten that change, but it is the U.S. importer that must ensure its
product complies with U.S. laws.
At CPSC's invitation, product safety officials from the European
Union will join us in China during September for a joint outreach
program directed to consumer product exporters. The Chinese government
has enthusiastically endorsed this project and has agreed to facilitate
access to the appropriate audiences for the compliance outreach
seminars.
Because we have found the formal work plan to be an effective
mechanism for articulating priorities and specific outcomes, CPSC staff
will focus on revising the work plan to capture new priorities rather
than creating new formal agreements. New work plan priorities will be
the subject of discussions with the Chinese over the coming months.
These will be formalized during the U.S.-Sino Safety Summit now being
planned for 2009.
With regard to other nations, CPSC staff is negotiating a work plan
under a new 2008 MOU with Vietnam which is designed to maximize success
in priority product areas, with textiles as a strong candidate for a
product area. The CPSC will do a training outreach in Vietnam this
year, as well as a joint training outreach in China with the European
Union.

NEW IMPROVEMENTS IN IT

Question. You plan to spend a significant amount of the fiscal year
2008 funding we provided ($4.3 million) on information technology
enhancements.
What are the improvements you are making and what practical results
will be achieved?
How will these upgrades improve the quality of injury and hazard
data received by CPSC and the targeting of inspection and compliance
activities?
Answer. With the additional funding provided in fiscal year 2008,
the CPSC has established both a long-sought permanent capital fund to
be used to replace aging and outdated equipment on a systematic basis
as well as a second fund to support development of more advanced
electronic applications. Additionally, a one-time expenditure of $2.3
million is allowing the agency to replace its resource management
information system which is so outdated that vendor support is being
withdrawn.
These IT improvements are essential to the agency's new Import
Safety Initiative and Early Warning System Initiative (EWS). These
improvements lay the foundation for improved electronic data exchanges
with Customs and Border Patrol's databases and enhance our capabilities
to identify, track and stop hazardous products from entering the United
States. Development and implementation of our EWS will enhance our
current hazard identification systems. The goal of the EWS is to
systematically identify and respond to hazards, quickly and
effectively. Through an enhanced identification system, the agency will
be better able to quickly detect and initiate action on emerging
product-associated hazards.

STATUS OF CPSC LABORATORY

Question. I was pleased to have been helpful in discussions with
the General Services Administration about securing a proper laboratory
for testing, investigations, and other staffing purposes. I'm glad with
the funding we provided, that CPSC will be able to move staff to the
laboratory a year earlier than expected.
What is the latest on the laboratory move and expected timetable?
What are the most significant improvements in performance you'll be
able to demonstrate as a result of moving to the new laboratory?
Answer. The General Services Administration (GSA) is currently
working with those who made offers in the Best and Final Offer stage of
the process. GSA has estimated a July/August completion of this stage
of the project. We expect a lease award to be made in early fiscal year
2009, with the occupancy date dependent on build-out requirements.
The new facility will improve the efficiency of CPSC's technical
and testing operations by allowing the CPSC to consolidate technical
staff currently located at our headquarters in Bethesda and at our
laboratory in Gaithersburg, Maryland, in one location and to expand
testing and evaluation capacity in support of our Import Surveillance
Initiative. The new laboratory will allow for a more efficient use of
space through the proper integration of offices and laboratories and is
expected to reduce the time currently required to set-up and conduct
various tests. The new laboratory will be designed to be more flexible
and will permit CPSC staff to adapt the layout to future changes in
operational requirements.
Plans also include the design and construction of a Human Factors
laboratory within the new facility. This laboratory will provide the
CPSC with the capability to perform studies of children's and adults'
interaction with various consumer products such as toys.

WHAT ELSE WILL CPSC STUDY THIS YEAR?

Question. Yesterday, I cosponsored legislation to ban bisphenol A
(BPA), a chemical found in plastics, from all products made for infants
and children up to age 7. I understand that in 2002, the CPSC studied
rattles, teething rings, and pacifiers and found BPA in 5 of 13 plastic
samples.
Given the growing evidence from new studies that have linked the
chemical to cancer, diabetes, behavioral disorders and productive
problems, do you now plan to study BPA further, particularly with
regard to toys and other items children may put into their mouths?
With the increased resources that you now have, what other issues
do you expect to begin to focus on and study?
Nanotechnology?
Answer. Bisphenol A (BPA) is a chemical used in the manufacture of
polycarbonate plastics and epoxy resins. The greatest potential for
human exposure to BPA is from food contact items. The recent in-depth
peer review conducted by the National Toxicology Program (NTP) Center
for the Evaluation of Risk to Human Reproduction (CERHR) stated that
diet accounts for the vast majority, 99 percent, of human exposure. If
BPA migrates out of a food contact surface into food, it is considered
an unintentional food additive and would be under the jurisdiction and
expertise of the Food and Drug Administration (FDA).
Polycarbonate is used in consumer products where there is a need
for a very hard, clear, unbreakable and sturdy plastic. Polycarbonate
is used in helmets, pacifier shields, protective gear such as goggles
and shin guards, as well as other products, that fall under the
jurisdiction of the CPSC.
Polycarbonate is used in some pacifier shields (that prevent the
nipple from being swallowed) so that when a child falls, the shield
does not shatter, breaking into small parts and exposing the child to a
possible choking or laceration injury. Any potential exposure from this
product would result from mouthing the shield. In 2000 and 2001, CPSC
staff conducted a behavioral observation study on mouthing related to
the agency's investigation of exposure to diisononyl phthalates; the
results of this study are instructive with regard to BPA. In the
behavioral observation study, trained observers monitored the behavior
of 169 children between the ages of 3 and 36 months. The study found
that the daily mouthing times of children's toys and related products
were much lower than expected. Based on these findings, the potential
exposure from the pacifier shield would be negligible. As with adults,
the preponderant exposure route for children would be through food.
There would be no exposure to BPA expected from compact disks,
electronics, helmets, goggles, other protective gear, and related
consumer products. It should be noted that polycarbonate plays a very
important role in its use in helmets and other protective gear,
preventing children from receiving serious head injuries, eye injuries
or other bodily injuries while engaging in sports and play.
With respect to nanotechnology, CPSC staff is actively
participating in a number of interagency initiatives or initiatives by
other groups addressing the production, use, and potential health
effects and safety of nanomaterials. These groups include: Nanoscale
Science, Engineering and Technology (NSET) subcommittee of the National
Science and Technology Council (NSTC) and its working groups such as
the Nanotechnology Environmental and Health Implications (NEHI);
American National Standards Institute (ANSI); International Life
Sciences Institute (ILSI); National Toxicology Program (NTP); ASTM
International (ASTM); and International Council on Nanotechnology
(ICON).
Participation in these groups and activities fosters communication
between CPSC staff and the staff of various federal agencies and other
groups. CPSC staff learns about health effects data and the best
available practices for the regulation of nanomaterials. These
interactions also promote responsible research and development of
nanomaterials that can be used in consumer products.
A contractor for the CPSC has completed a literature review of
nanomaterials that may be used as flame-retardant (FR) chemicals. The
report focuses on the physico-chemical properties of the FR chemicals
and also reviews potential exposure and health effects of these
compounds.
CPSC staff has met with staff at NIST, EPA, FDA, and NIOSH to
identify areas of mutual interest and collaboration. For example, CPSC
staff has signed a memorandum of understanding (MOU) with NIST to
review nano-flame retardants in various products. CPSC staff is also
developing an interagency agreement (IAG) with the National Institute
for Occupational Safety and Health (NIOSH) to conduct laboratory
investigations of emissions of nanomaterials from selected consumer
products.
The increased resources for the CPSC are primarily devoted to three
purposes in fiscal year 2008: new laboratory facilities, information
technology modernization and additional field staff. However, CPSC
staff will continue chemical-related activities focusing on lead in
consumer products; nanotechnology; strong sensitizers; ozone-generating
air cleaners; the use of flame retardant chemicals in upholstered
furniture and mattresses; implementation of the Globally Harmonized
System (GHS) for Classification and Labeling; and participation in
interagency and international workgroups and committees. Additionally,
the staff has begun to investigate phthalate substitutes.
In 2009 all of these current activities are expected to continue.
In addition, the staff plans to begin new projects looking at potential
health effects on issues that may include the use of aerosol products
(such as leather waterproofing sprays) and the presence of stabilizers
in plastics.
Question. Is CPSC Collecting Data on Fire-Related Injuries and
Deaths?
Your fiscal year 2008 budget justification indicates that you began
an evaluation of a new system for collecting data on fire-related
injuries and deaths but that additional data collection and
investigation for this new system was being suspended pending a review,
resulting in temporary cost savings.
Where does this effort stand today? Have you resumed collection and
analysis of fire death data and will you continue to collect and
evaluate fire injury data?
Answer. Two preliminary studies, one on fire fatalities and the
other on fire injuries, have been completed. The preliminary study
results are currently undergoing agency review, evaluation and
clearance procedures; further work is pending completion of those
procedures. The CPSC continues to utilize data provided by the U.S.
Fire Administration's National Fire Incident Reporting System and the
National Fire Protection Association's Survey of Fire Departments to
generate fire loss estimates (fires, death, injuries, and property loss
damage) for products within CPSC's jurisdiction.

DATA ANALYSIS--NEW EARLY WARNING SYSTEM PILOT PROGRAM

Question. I understand that with the additional funds provided last
year, you will implement a pilot program; an early warning system that
will facilitate rapid identification of and action on emerging product-
associated hazards.
How will this program work and what products will you focus on?
Answer. The goal of the Early Warning System (EWS) is to enhance
CPSC's current hazard identification systems by decreasing the time
required to identify and initiate action on emerging product-associated
hazards, and increasing accountability for decisions.
In November 2007, CPSC staff initiated an EWS pilot program that
targets products found in the sleeping environments of children--cribs,
bassinets, and play yards (play pens). The agency's current focus is on
mechanical and structural hazards that have the potential to entrap or
otherwise fatally injure a child.
A multidisciplinary team of subject matter experts meets weekly to
evaluate and characterize the hazard scenarios and failure modes of
product-associated incidents received during the previous week. An
electronic database has been developed to capture these hazard
scenarios, failure modes, and the investigative status.
The automated system that is being developed will include the
ability to: consolidate incident information from CPSC's many databases
into one incident record, associate records that have like incident
scenarios, identify hazard patterns and trends, apply a set of decision
rules based on specific hazard characteristics and frequency of
occurrence, and assign decision rule-based outcomes.
The next stage in the development of our EWS, currently underway,
is proof of concept. Concepts that are developed to automate the
program requirements identified in the pilot program will be tested to
ensure that system outputs meet the needs of system users and satisfy
the project objective.

WHY ARE CPSC GOALS FOR CUSTOMER SATISFACTION DECREASING?

Question. Your fiscal year 2009 budget justification lists annual
goals for customer satisfaction. Categories include, but are not
limited to: responding to voicemail messages by the next business day;
processing incident reports within 8 working hours; and mailing
incident information for verification to consumers within 2 business
days. In almost every category listed, your goals for 2008 and 2009 are
lower than your actual rates for years 2004 through 2007.
Why is that?
Answer. The staff of the National Injury Information Clearinghouse
(NIIC) was reduced over the last several years from six full time
technical information specialists to the current staff level of three
full time technical information specialists. As the agency continues to
hire more staff as a result of increased appropriations, the number of
staff resources devoted to the NIIC will increase, and pending the
restoration of a quorum, the Commission will be reassessing these
performance goals when developing the agency's fiscal year 2009
operating plan.

ALL-TERRAIN VEHICLES

Question. I understand that you've collected reports on fatal
crashes.
Have you recorded that information in your database so it can be
studied?
Have you performed any tests on ATVs to see whether the companies
are abiding by agreements on lateral (side) stability?
ATVs used to be mostly three-wheeled vehicles. Moving to more
stable, four-wheel models was an improvement, but a side effect was to
shift the safety debate to rider behavior and away from ATV design.
Have you challenged manufacturers on the design of four-wheel ATVs
or done any meaningful stability testing of four-wheel ATVs in the past
decade?
Are most of these ATVs coming from China?
Now that you are hiring more staff, will this be an area of focus?
Answer. CPSC staff collects information on fatalities associated
with the use of all-terrain vehicles (ATVs) and records that
information in a CPSC ATV database (ATVD) so that the information can
be retrieved, reviewed, and analyzed. The ATVD is available to the
public on request. The fatality data are gathered from a variety of
sources, including news clips; reports submitted to CPSC staff from
medical examiners and coroners; consumer reports received via telephone
or the Internet; and death certificates received from state and city
vital registries.
ATV fatalities generally are assigned for in-depth investigation by
CPSC Field Operations staff, who attempt to gather any available
information about the:
--incident (date, location, number of deceased persons, a description
of the circumstances surrounding the incident and how the
incident occurred, number of riders on the ATV when the
incident occurred);
--decedent (date of death, age, gender, helmet use, cause of death);
--driver (age, gender, height, weight, alcohol use at time of
incident, drug use at time of incident, how the driver learned
to operate an ATV);
--ATV (type, manufacturer, brand, model, and engine size);
--environment (type of terrain being traveled at the time of the
incident, type of road being traveled at the time of the
incident); and
--hazard pattern (e.g., did the ATV overturn? Did the ATV land on the
victim?).
CPSC staff uses these fatality data in preparing its annual report
of ATV-related deaths and injuries, in special studies requested by the
Commission, in support of education initiatives by CPSC's Office of
Public Affairs, and in support of voluntary standard and rulemaking
activities.
In August and September 2007, Office of Compliance staff requested
lateral stability values for all current ATV models from all of the
firms with Letters of Understanding (LOUs) with the CPSC. All reported
lateral stability values met the requirements that were agreed to when
the consent decrees were in effect.
Currently, CPSC Engineering Sciences (ES) staff is examining the
current generation of ATVs to become familiar with the static and
dynamic testing of ATVs using the latest available technologies. As a
part of this effort, ES staff recently tested nine youth ATVs at the
U.S. Army Automotive Test Center in Aberdeen, Maryland. This testing
consisted of gathering baseline measurements of the vehicles' static
stability and preliminary measurements of the vehicles' dynamic
performance. In addition, CPSC staff has been developing the capability
to perform dynamic testing of ATVs, has been consulting with vehicle
dynamic experts at Aberdeen, plans to test adult ATVs in fiscal years
2008 and 2009, and has been developing a robotic steering system to
test ATV stability under a variety of operational conditions, some of
which would be too dangerous to perform with a test operator.
In the time since the consent decrees, vehicle technology has
evolved in terms of brake systems, suspension systems, and engine
horsepower. CPSC staff believes that the exploration of a lateral
stability requirement for ATVs, while potentially very useful, is an
exceedingly complex task. This is because ATVs are rider-interactive
vehicles used in many types of off-road terrains. The effort to address
lateral stability issues requires extensive test and evaluation with
the cooperation of CPSC staff, industry and other private sector
entities.
With regard to ATVs imported from China, a recently-released trade
press report indicates that for 2007 about 42 percent of the ATVs sold
in the United States were from ``nontraditional'' companies. Nearly all
of these units were from Chinese companies. A report, with a chart
showing Chinese ATVs as a proportion of the ``nontraditional'' ATVs
sold in the United States for the years 1997 through 2007, can be found
at: http://www.dealernews.com/dealernews/article/
articleDetail.jsp?id=512838&searchString=nontraditi.
CPSC staff intends to continue its ATV rulemaking and other
activities in 2008 and 2009, as directed by the Commission. Other
activities include continued testing of ATVs with the goal of better
understanding vehicle stability; information and education activities
(see ATVsafety.gov); completion of the next annual report of ATV-
related deaths and injuries; and conducting focus groups to address the
issue of maximum speed for youth ATVs.

NEW POOL AND SPA SAFETY ACT

Question. Your budget justification indicates that this year, you
will begin an education program associated with the Pool and Spa Safety
Act, enacted last year.
What specific activities will you undertake?
Answer. On May 21, 2008, the CPSC launched its 2008 media and
education campaign on pool safety and drowning prevention by hosting a
pre-Memorial Day Weekend news conference. CPSC's news conference and
news release focused on new death and injury data, building layers of
protection in and around the pool and spa, the importance of constant
supervision, and the requirements for public pool and spa owners/
operators under the new federal law.
The news conference, the issuance of a video news release, and
proactive communication with the media, resulted in: a segment on ``The
Today Show'', a news reader on ``Good Morning America'', citation of
our data on ``CBS Evening News'' reader, an ABCNews.com story on a CPSC
employee who lost her son in a pool drowning, and stories on ``CBS
Radio'', ``CNN Radio'', ``Telemundo'', Washingtonpost.com, the
Associated Press wire, and in Parenting Magazine. Current data
collected by the CPSC shows more than 25 million TV viewers and radio
listeners were reached.
In addition, the CPSC is working with two respected companies in
the Washington, DC area to disseminate nationally and locally, our TV
and Radio Public Service Announcement (PSA) on pool safety, which is
entitled ``Quickly and Quietly.''
The CPSC, in partnership with Safe Kids USA and the American Red
Cross, also produced a safety poster on drowning prevention that was
specifically designed for our 5,300 Neighborhood Safety Network
members, who provide safety information to disadvantaged families.
The agency continues to provide consumers, pool owners, pool
operators and others with free copies of our ``Guidelines for
Entrapment Hazards: Making Pools and Spas Safer'' and ``Safety Barrier
Guidelines for Home Pools'' publications.
During the summertime, the CPSC will work closely with Safe Kids
USA to respond to news reports of child drownings and will provide
critically important safety information and PSAs to media in the
affected community.
The CPSC is working hard to educate families on pool and spa safety
this year and, pending the availability of appropriations, is preparing
to carry out a significantly expanded information and education
campaign in fiscal year 2009. This effort, combined with our commitment
to effectively implement the new Pool and Spa Safety Act, is aimed at
reducing the tragic number of child drownings which occur each year.

YO-YO WATER BALL

Question. In 2003, CPSC announced the results of an investigation
into the ``Yo-Yo Water Ball'', a plastic toy with a stretchy cord, for
which CPSC had received 186 reports of incidents in which the toy's
cord wrapped around a child's neck. CPSC determined that there was a
low but potential risk of strangulation and that the toy did not meet
the standards for a recall. I understand that as of mid-December 2007,
CPSC has received more than 400 injury reports related to this toy. And
the State of New Jersey has now banned the sale of Yo-Yo Water Balls.
Is CPSC considering taking any action with regard to this dangerous
product?
Answer. The CPSC has not received 400 injury reports related to
this toy. Incident reports provided to the CPSC do not necessarily
involve an injury. For example, many of the incident reports regarding
yo-yo water balls were concerns about odors, leaking or possible
flammability. The majority of these reports were received before the
CPSC issued a public advisory on the product on September 24, 2003.
Since that time, incident reports have dropped precipitously. In
calendar year 2006 the CPSC received 10 incident reports, four of which
were complaints about the product's odor.
When CPSC's professional staff investigated this product in 2003,
they decided not to recommend that the Commission ban yo-yo water
balls. Staff did not believe that the product met the banning
requirements under section 15 of the Federal Hazardous Substances Act.
Subsequently, the CPSC worked with ASTM International in their
development of a voluntary safety standard for yo-yo water balls. That
standard was published in the March 2007 version of ASTM F963.

CPSC QUORUM

Question. CPSC's quorum expired in early February. The CPSC
Reauthorization, in conference negotiations right now, and which may be
completed in May, would temporarily permit two members of the
Commission, if they are not affiliated with the same political party,
to constitute a quorum for the transaction of business.
What rulemakings and other items requiring a vote of the Commission
do you foresee this year?
What items are pending right now and ready for a vote?
Answer. The Commission's official Regulatory Agenda sets forth the
status of all CPSC rulemakings currently underway. A copy of the
current Regulatory Agenda is attached. If a CPSC reauthorization bill
is enacted into law that reflects the language currently being
considered by the Senate/House conference committee, the Regulatory
Agenda will have to be very substantially revised to reflect
redeployment of Commission personnel resources to address new statutory
mandates. In that case, during the remainder of calendar year 2008, the
Commission may take official action on project changes to the fiscal
year 2008 and 2009 Operating Plans and the CPSC fiscal year 2009 budget
submission.

AGENCY RULE LIST--SPRING 2008--CONSUMER PRODUCT SAFETY COMMISSION
--------------------------------------------------------------------------------------------------------------------------------------------------------
Agency Agenda Stage of Rulemaking Title RIN
--------------------------------------------------------------------------------------------------------------------------------------------------------
CPSC................................ Proposed Rule Stage........ Flammability Standard for Upholstered Furniture.................. 3041-AB35
CPSC................................ Proposed Rule Stage........ Possible Revocation or Amendment of Standard for the Flammability 3041-AC27
of Mattresses and Mattress Pads (Cigarette Ignition).
CPSC................................ Proposed Rule Stage........ All-Terrain Vehicles............................................. 3041-AC28
CPSC................................ Long-Term Actions.......... Amendment of Safety Regulations for Cribs........................ 3041-AB67
CPSC................................ Long-Term Actions.......... Portable Bed Rails............................................... 3041-AB91
CPSC................................ Long-Term Actions.......... Safety Standard for Baby Bath Seats.............................. 3041-AC03
CPSC................................ Long-Term Actions.......... Petition CP 03-1/HP 03-1 Requesting a Standard for Bunk Bed 3041-AC10
Corner Posts.
CPSC................................ Long-Term Actions.......... Petition CP 04-1/HP 04-1 Requesting Mandatory Fire Safety 3041-AC22
Standards for Candles and Candle Accessories.
CPSC................................ Long-Term Actions.......... Mandatory Safety Standard for Cigarette Lighters................. 3041-AC25
CPSC................................ Long-Term Actions.......... Proposed Standard To Address Open-Flame Ignition of Bedclothes... 3041-AC26
CPSC................................ Long-Term Actions.......... Regulatory Options for Infant Pillows............................ 3041-AC30
CPSC................................ Long-Term Actions.......... Regulatory Options for Table Saws................................ 3041-AC31
CPSC................................ Long-Term Actions.......... Fireworks Devices................................................ 3041-AC35
CPSC................................ Long-Term Actions.......... Portable Generators.............................................. 3041-AC36
CPSC................................ Long-Term Actions.......... Civil Penalty Factors............................................ 3041-AC40
CPSC................................ Long-Term Actions.......... Regulatory Options for Lead Toy Jewelry.......................... 3041-AC41
CPSC................................ Completed Actions.......... Amendment of the Standard for the Flammability of Clothing Tex- 3041-AB68
tiles.
--------------------------------------------------------------------------------------------------------------------------------------------------------

VIEW RULE

CPSC RIN: 3041-AB35 Publication ID: Spring 2008
Title: Flammability Standard for Upholstered Furniture
Abstract: On October 23, 2003, the Commission issued an ANPRM to
expand the scope of the ongoing upholstered furniture flammability
proceeding to include both cigarette and small open flame-ignited
fires. The staff developed a draft standard addressing both cigarette
and small open flame ignition, and held public meetings in 2004 and
2005 to present and discuss the draft. In January, 2006, the staff sent
a briefing package containing a revised draft standard and describing
regulatory options to the Commission and provided follow-up status
reports on various technical research efforts in November 2006 and
December 2006. The staff forwarded another options package to the
Commission in November 2007. The Commission voted to propose a rule
based on the 2007 draft standard. The Commission's proposed standard
would not require FR chemicals in fabrics or fillings.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Economically Significant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Proposed Rule Stage
Major: Yes
Unfunded Mandates: No
CFR Citation: 16 CFR 1640 (To search for a specific CFR, visit the
Code of Federal Regulations.)
Legal Authority: 15 USC 1193, Flammable Fabrics Act; 5 USC 801
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
ANPRM............................. 06/15/1994....... 59 FR 30735
Commission Hearing May 5 & 6, 1998 03/17/1998....... 63 FR 13017
on Possible Toxicity of Flame
Retardant Chemi- cals.
Meeting Notice.................... 03/20/2002....... 67 FR 12916
Notice of September 24 Public 08/27/2003....... 68 FR 51564
Meeting.
ANPRM............................. 10/23/2003....... 68 FR 60629
ANPRM Comment Period End.......... 12/22/2003....... .................
Staff Held Public Meeting......... 10/28/2004....... .................
Staff Held Public Meeting......... 05/18/2005....... .................
Staff Sends Status Report to 01/31/2006....... .................
Commission.
Staff Sends Status Report to 11/03/2006....... .................
Commission.
Staff Sends Status Report to 12/28/2006....... .................
Commission.
Staff Sends Options Package to 12/22/2007....... .................
Commission.
Commission Votes to Direct Staff 12/27/2007....... .................
to Prepare Draft NPRM.
Staff Sends Draft NPRM to 01/22/2008....... .................
Commission.
Commission Decision to Publish 02/01/2008....... .................
NPRM.
NPRM.............................. 03/04/2008....... 73 FR 11702
NPRM Comment Period Ends.......... 05/19/2008....... .................
------------------------------------------------------------------------

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: Yes
RIN Data Printed in the FR: No
Agency Contact: Dale R. Ray, Project Manager, Consumer Product
Safety Commission, Directorate for Economic Analysis, 4330 East-West
Highway, Bethesda, MD 20814-4408. Phone: 301 504-7704. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC27 Publication ID: Spring 2008
Title: Possible Revocation or Amendment of Standard for the
Flammability of Mattresses and Mattress Pads (Cigarette Ignition)
Abstract: The Commission published an advance notice of proposed
rulemaking (ANPRM) in the Federal Register on June 23, 2005, requesting
comments on a rulemaking proceeding that could result in revoking or
amending its existing flammability standard that includes a test for
cigarette ignition of mattresses and mattress pads (16 CFR part 1632).
On January 13, 2005, the Commission issued a proposed flammability
standard for mattresses and mattress and foundation sets that
prescribes an open flame ignition test. Some commenters to that
rulemaking stated that they believe that once the new mattress standard
is in effect the cigarette ignition test currently required in 16 CFR
1632 will not be necessary and conducting both tests will be burdensome
for industry. The Commission issued this ANPRM to begin consideration
of whether the existing mattress standard should be revoked or amended.
The staff is analyzing the public comments. A research project
examining the criteria for self-sustained smoldering began in late
2006.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Proposed Rule Stage
Major: Undetermined
Unfunded Mandates: Undetermined
CFR Citation: 16 CFR 1632 (To search for a specific CFR, visit the
Code of Federal Regulations.)
Legal Authority: 15 USC 1193, Flammable Fabrics Act
Legal Deadline: None

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Patricia K. Adair, Project Manager, Consumer
Product Safety Commission, Directorate for Engineering Sciences, 4330
East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7536. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC28 Publication ID: Spring 2008
Title: All-Terrain Vehicles
Abstract: On October 14, 2005, the Commission published an advance
notice of proposed rulemaking (ANPRM) concerning all terrain vehicles
(ATVs). Issuance of the ANPRM initiated a rulemaking proceeding under
the Consumer Product Safety Act (CPSA) and the Federal Hazardous
Substances Act (FHSA). After reviewing the regulatory alternatives and
the comments submitted in response to the ANPRM, the staff developed a
May 31, 2006, briefing package recommending that the Commission issue a
notice of proposed rulemaking (NPRM) that would formally ban three-
wheeled ATVs and mandate performance, training, labeling, and
information requirements for four-wheeled ATVs. Other non-regulatory
activities also were recommended, including the launch of an ATV safety
Web site and a two-phase information and education effort. A Commission
briefing was held on June 15, 2006. On July 12, 2006, the Commission
voted 3-0 to approve publication of the draft NPRM with changes in the
Federal Register. The NPRM was published on August 10, 2006, with a
comment closing date of October 24, 2006. Seven ATV manufacturers and
distributors requested a 60-day extension of the comment period. The
Commission granted their request, and the comment closing date was
extended to December 26, 2006. Staff is conducting research as directed
by the Commission in its vote on July 12, 2006. On February 13, 2008,
staff sent a report to the Commissioners summarizing the status of the
staff's research activities.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Proposed Rule Stage
Major: Undetermined
Unfunded Mandates: Undetermined
CFR Citation: 16 CFR 1307; 16 CFR 1410; 16 CFR 1500; 16 CFR 1515
(To search for a specific CFR, visit the Code of Federal Regulations.)
Legal Authority: Consumer Product Safety Act; 15 USC 1261; Federal
Hazardous Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff sends draft ANPRM to 09/15/2005....... .................
Commission.
Commission Decision............... 10/05/2005....... .................
ANPRM............................. 10/14/2005....... 70 FR 60031
ANPRM Comment Period Closes....... 12/13/2005....... .................
Staff Sends Briefing Package to 05/31/2006....... .................
Commission.
Commission Decision............... 07/12/2006....... .................
NPRM.............................. 08/10/2006....... 71 FR 45903
NPRM Comment Period Extended...... 10/20/2006....... 71 FR 61923
NPRM Comment Period Closes........ 10/24/2006....... .................
NPRM Comment Period Closes........ 12/26/2006....... .................
Staff Sends Status Report to 02/13/2008....... .................
Commissioners.
Staff Send Second Status Report to 06/00/2008....... .................
Commission.
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Elizabeth W. Leland, Project Manager, Consumer
Product Safety Commission, Directorate for Economic Analysis, 4330
East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7706. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AB67 Publication ID: Spring 2008
Title: Amendment of Safety Regulations for Cribs
Abstract: On December 16, 1996, the Commission published an advance
notice of proposed rulemaking (ANPRM) to begin a proceeding that could
result in amendment of the safety regulations for full-size and non-
full-size cribs, 16 CFR parts 1508 and 1509. Among the regulatory
alternatives under consideration is amendment of the regulations to add
tests to assure that slats will not disengage from the side panels of
cribs. The Commission began this proceeding after considering
information about incidents in which crib slats disengaged from the
side panels of cribs, creating a risk that children may become
entrapped between the remaining slats or fall out of the crib. At the
urging of CPSC staff, in April 1999, the voluntary standard for cribs
designated, ``Specification for Full Size Baby Cribs (ASTM F1169-99),''
and published by ASTM International was revised to include performance
requirements for crib slats. CPSC staff is currently assessing the
adequacy of and conformance with the voluntary standard. Following this
assessment, the staff will prepare a briefing package for Commission
consideration as to whether to continue the rulemaking.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: 16 CFR 1508 to 1509 (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 5 USC 553, Administrative Procedure Act; 15 USC
1261, Federal Hazardous Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff Recommended Revisions to 09/30/1996....... .................
Voluntary Standard.
ANPRM............................. 12/16/1996....... 61 FR 65996
ANPRM Comment Period End.......... 02/14/1997....... .................
Revisions to Voluntary Standard 04/10/1999....... .................
Approved.
Voluntary Certification Program 03/01/2000....... .................
Begins.
Staff Began Monitoring Adequacy of 03/27/2001....... .................
and Conformance with Revised
Voluntary Standard.
Staff Completes Monitoring ( \1\ ).......... .................
Adequacy and Conformance.
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Patricia L. Hackett, Project Manager, Consumer
Product Safety Commission, Directorate for Engineering Sciences, 4330
East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7577. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AB91 Publication ID: Spring 2008
Title: Portable Bed Rails
Abstract: The Commission is considering whether certain portable
bed rails present an unreasonable risk of injury that should be
regulated. A portable bed rail is a device intended to be installed on
an adult bed to prevent a child from falling out of the bed. Such bed
rails may be constructed in a manner that allows children to become
entrapped between the portable bed rail and the bed. This entrapment
can result in serious injury or death. In October 2000, the Commission
issued an advance notice of proposed rulemaking (ANPRM) addressing this
issue. The ASTM International standard for bed rails has since been
revised and staff is evaluating the adequacy of, and conformance to,
the revised standard. Following this evaluation, the Commission staff
will prepare a briefing package for Commission consideration as to
whether to continue the rulemaking.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 15 USC 1261, Federal Hazardous Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff Sent Briefing Package to 06/28/2000....... .................
Commission.
Commission Decision............... 09/21/2000....... .................
ANPRM............................. 10/03/2000....... 65 FR 58968
ANPRM Comment Period End.......... 12/04/2000....... .................
Staff Sent Briefing Package to 10/01/2001....... .................
Commission.
Commission Decision............... 10/30/2001....... .................
Staff Begins Evaluating 10/01/2005....... .................
Conformance to Voluntary Standard.
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Patricia L. Hackett, Project Manager, Consumer
Product Safety Commission, Directorate for Engineering Sciences, 4330
East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7577. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC03 Publication ID: Spring 2008
Title: Safety Standard for Baby Bath Seats
Abstract: An advance notice of proposed rulemaking (ANPRM),
published in the Federal Register on August 1, 2001, requested comments
on a rulemaking proceeding that could result in a mandatory rule
addressing baby bath seats. These are consumer products used to hold an
infant in a bathtub while the child is being bathed. The staff briefed
the Commission on July 28, 2003, and the Commission received oral
comments from the public on the same date. The staff evaluated the
comments received at the hearing and sent a briefing package to the
Commission. In October of 2003, the Commission voted to direct the
staff to prepare a notice of proposed rulemaking (NPRM) for the
Commission's consideration. On December 29, 2003, the NPRM was
published in the Federal Register. The comment period closed on March
15, 2004. Since the NPRM, staff worked with ASTM International to
revise the voluntary standard for bath seats (ASTM F1967). The standard
was revised in 2004 and again in 2007. Staff is currently evaluating
the adequacy of the revised standard. Following this evaluation, staff
will prepare a briefing package for Commission consideration as to
whether to continue the rulemaking.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: Undetermined
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 15 USC 1261, Federal Hazardous Substances Act
Legal Deadline: None

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: None
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Related RINs: Related to 3041-AB93
Agency Contact: Patricia L. Hackett, Project Manager, Consumer
Product Safety Commission, Directorate for Engineering Sciences, 4330
East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7577. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC10 Publication ID: Spring 2008
Title: Petition CP 03-1/HP 03-1 Requesting a Standard for Bunk Bed
Corner Posts
Abstract: A petition from the Danny Foundation requests that the
Commission establish a standard to address an alleged hazard of
strangulation posed by bunk bed corner posts. The petitioner asserts
that due to the height of bunk beds, corner posts on bunk beds pose a
substantial risk to children when the children's clothing, bedding, or
other items become caught on the corner posts. On November 8, 2002, the
Commission published a notice in the Federal Register to solicit
comments on the petition from all interested persons. The comment
period closed on January 7, 2003. On April 13, 2004, the staff sent a
briefing package to the Commission on this issue. On July 30, 2004, the
Commission voted to defer action on the petition while the staff
continues to work with the ASTM International bunk bed subcommittee on
this issue. A revised voluntary standard for bunk beds was published in
October 2004 that incorporates warning language about hangings
associated with bunk beds and attaching items to the bed. CPSC staff
worked with the subcommittee to develop requirements to address
strangulation hazards with vertical protrusions. A revised standard was
approved on July 15, 2007. Staff is currently evaluating the adequacy
of the revised standard.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 5 USC 553(e), Administrative Procedure Act; 15 USC
1262(j), Federal Hazardous Substances Act; 15 USC 2058(i), Consumer
Product Safety Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Petition Docketed................. 10/23/2002....... .................
Notice............................ 11/08/2002....... 67 FR 68107
Comment Period End................ 01/07/2003....... .................
Staff Sends Briefing Package to 04/13/2004....... .................
Commission.
Commission Votes To Defer Action.. 07/30/2004....... .................
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
Staff Begins Evaluating ( \1\ ).......... .................
Conformance to Voluntary Standard.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: None
Federalism: No
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Susan Bathalon, Project Manager, Consumer Product
Safety Commission, Directorate for Engineering Sciences, 4330 East-West
Highway, Bethesda, MD 20814-4408. Phone: 301 504-7566. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC22 Publication ID: Spring 2008
Title: Petition CP 04-1/HP 04-1 Requesting Mandatory Fire Safety
Standards for Candles and Candle Accessories
Abstract: The National Association of State Fire Marshals requests
that the Commission issue mandatory safety standards for candles and
candle accessories such as candleholders. The request was docketed as a
petition for rulemaking on March 10, 2004. A notice requesting comment
on the petition was published in the Federal Register on April 6, 2004.
The comment period closed on June 7, 2004. On July 10, 2006, CPSC staff
sent a briefing package to the Commission for consideration and
recommended that the Commission defer action on the petition. On July
19, 2006, the Commission voted 3-0 to defer the petition and directed
the staff to provide updates on the progress of voluntary standards
activities. Staff provided a status report to the Commissioners on June
6, 2007.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: Undetermined
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 5 USC 553(e), Administrative Procedure Act; 15 USC
2051, Consumer Product Safety Act; 15 USC 1261, Federal Hazardous
Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Petition Docketed................. 03/10/2004....... .................
Notice............................ 04/06/2004....... 69 FR 18059
Comment Period End................ 06/07/2004....... .................
Staff Sends Briefing Package to 07/10/2006....... .................
Commission.
Commission Votes to Defer Action.. 07/19/2006....... .................
Staff Sends Update on Progress of 06/06/2007....... .................
Voluntary Standards Activities to
Commissioners.
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: None
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact:, Allyson Tenney, Project Manager, Consumer Product
Safety Commission, Directorate for Engineering Sciences, 4330 East-West
Highway, Bethesda, MD 20814-4408. Phone: 301 504-7567. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC25 Publication ID: Spring 2008
Title: Mandatory Safety Standard for Cigarette Lighters
Abstract: In November 2001, a petition from the Lighter
Association, Inc. requested that the Commission issue a rule to adopt
an ASTM International voluntary safety standard for cigarette lighters.
In November 2004, the Commission voted to grant the petition and
initiate a rulemaking proceeding. An advance notice of proposed
rulemaking (ANPRM) was published in April 2005 and the comment period
closed on June 10, 2005. Staff completed monitoring conformance of
lighters with the voluntary standard, and sent a status report to the
Commission for consideration in October 2006. On January 23, 2008,
staff provided a review of applicable law, decision factors, and
pertinent information to assist the Commission in considering whether
to formally rely upon the voluntary standard for cigarette lighters.
The Commission did not agree on this approach.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 5 USC 553(e); Administrative Procedure Act; 15 USC
2051; Consumer Product Safety Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff Sent Draft ANPRM to 03/25/2005....... .................
Commission.
Commission Decision............... 03/31/2005....... .................
ANPRM............................. 04/11/2005....... 70 FR 18339
ANPRM Comment Period End.......... 06/10/2005....... .................
Staff Begins Monitoring of 10/01/2005....... .................
Conformance with Voluntary
Standard.
Staff Completes Monitoring of 05/15/2006....... .................
Conformance with Voluntary
Standard.
Staff Sent Status Report to 10/10/2006....... .................
Commission.
Staff Sent Briefing Package to 01/23/2008....... .................
Commission.
Commission Decision............... 02/01/2008....... .................
Next Action Undetermined.......... ( \1\ ).......... .................
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Rohit Khanna, Project Manager, Consumer Product
Safety Commission, Directorate for Engineering Sciences, 4330 East-West
Highway, Bethesda, MD 20814-4408. Phone: 301 504-7546. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC26 Publication ID: Spring 2008
Title: Proposed Standard To Address Open-Flame Ignition of
Bedclothes
Abstract: On January 13, 2005, the Commission published an advance
notice of proposed rulemaking (ANPRM) to begin a proceeding for
development of a flammability standard to address risks of death,
injury, and property damage from fires associated with open-flame
ignition of bedclothes. Bedclothes are a major contributor to mattress
ignition. Commission staff reviewed research indicating that mattresses
and bedclothes operate together as a system in fires involving
mattresses. Research has suggested that improved flammability
performance of some bedclothes can reduce the fire hazard. The
Commission staff will review public comments received on the ANPRM and
consider how information derived from implementation of the new open
flame mattress standard impacts bedclothes flammability. Staff will
prepare a decision package for Commission consideration.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Economically Significant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: 16 CFR 1634 (To search for a specific CFR, visit the
Code of Federal Regulations.)
Legal Authority: 15 USC 1193; Flammable Fabrics Act; 5 USC 801
Legal Deadline: None

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Allyson Tenney, Project Manager, Consumer Product
Safety Commission, Directorate for Engineering Sciences, 4330 East-West
Highway, Bethesda, MD 20814-4408. Phone: 301 504-7567. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC30 Publication ID: Spring 2008
Title: Regulatory Options for Infant Pillows
Abstract: On July 13, 2006, the Commission voted 3-0 to grant a
petition requesting that the Commission amend the ban on infant pillows
under 16 CFR 1500.18(a)(16)(i). The staff prepared a draft advance
notice of proposed rulemaking (ANPRM) concerning infant pillows to
initiate a rulemaking proceeding under the Federal Hazardous Substances
Act (FHSA) to identify the product and the risk of injury associated
with infant pillows, summarize regulatory alternatives, and invite
comments from the public. On September 27, 2006, the Commission issued
the ANPRM. Staff reviewed public comments and prepared an options
briefing package for Commission consideration. On February 1, 2008, the
Commission voted 2-0 to exempt certain nursing pillows from the ban on
infant pillows and to terminate rulemaking.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: 16 CFR 1500.18(a)(16)(i)
Legal Authority: 5 USC 553, Administrative Procedure Act; 15 USC
1261, Federal Hazardous Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff sends Draft ANPRM to 09/07/2006....... .................
Commission.
Commission Decision............... 09/14/2006....... .................
ANPRM............................. 09/27/2006....... 71 FR 56418
ANPRM Comment Period Ends......... 11/27/2006....... .................
Staff Sends Briefing Package to 01/24/2008....... .................
Commission.
Commission Decision............... 02/01/2008....... .................
Staff Drafts FR Notice............ ( \1\ ).......... .................
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Suad Wanna-Nakamura, Ph.D., Project Manager,
Consumer Product Safety Commission, Directorate for Health Sciences,
4330 East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7252.
Email: [email protected].

VIEW RULE

CPSC RIN: 3041-AC31 Publication ID: Spring 2008
Title: Regulatory Options for Table Saws
Abstract: On July 11, 2006, the Commission voted 2-1 to grant a
petition requesting that the Commission issue a rule prescribing
performance standards for a system to reduce or prevent injuries from
contacting the blade of a table saw. The Commission also directed the
staff to prepare an advance notice of proposed rulemaking (ANPRM)
initiating a rulemaking proceeding under the Consumer Product Safety
Act (CPSA) to identify the product and the risk of injury associated
with table saw blade contact injuries, summarize regulatory
alternatives, and invite comments from the public. A draft advance
notice of proposed rulemaking will be prepared for Commission
consideration.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 5 USC 553(e), Administrative Procedure Act; 15 USC
2051, Consumer Product Safety Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff Sends ANPRM to Commission... ( \1\ ).......... .................
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Caroleene Paul, Project Manager, Consumer Product
Safety Commission, Directorate for Engineering Sciences, 4330 East-West
Highway, Bethesda, MD 20814-4408. Phone: 301 504-7540. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC35 Publication ID: Spring 2008
Title: Fireworks Devices
Abstract: The staff prepared a draft advance notice of proposed
rulemaking (ANPRM) concerning fireworks devices requesting comments on
whether there is a need for the agency to update and strengthen its
regulation of fireworks devices and sent it to the Commission for
consideration on June 26, 2006. On June 30, 2006, the Commission voted
3-0 to issue an advance notice of proposed rulemaking. The ANPRM was
issued on July 12, 2006. The comment period on the ANPRM closed on
September 11, 2006. Commission staff is evaluating comments received.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: Undetermined
CFR Citation: 16 CFR 1500; 16 CFR 1507 (To search for a specific
CFR, visit the Code of Federal Regulations.)
Legal Authority: 15 USC 1261, Federal Hazardous Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff sends draft ANPRM to 06/26/2006....... .................
Commission.
Commission Decision............... 06/30/2006....... .................
ANPRM............................. 07/12/2006....... 71 FR 39249
Comment Period Closes............. 09/11/2006....... .................
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact:, James Joholske, Compliance Officer, Office of
Compliance, Consumer Product Safety Commission, 4330 East-West Highway,
Bethesda, MD 20814. Phone: 301 504-7527. Email: [email protected].

VIEW RULE

CPSC RIN: 3041-AC36 Publication ID: Spring 2008
Title: Portable Generators
Abstract: On December 5, 2006, the Commission voted 2-0 to issue an
advance notice of proposed rulemaking (ANPRM) under the Consumer
Product Safety Act (CPSA) concerning portable generators. The ANPRM
discusses regulatory options that could reduce portable generator-
related deaths and injuries, particularly those related to carbon
monoxide poisoning. The ANPRM was published in the Federal Register on
December 12, 2006. Staff reviewed public comments and is conducting
technical activities. Staff awarded a contract to develop a prototype
generator engine with reduced CO in the exhaust and entered into an
interagency agreement (IAG) with the National Institute of Standards
and Technology (NIST) to model the buildup and concentration of CO in
various locations. NIST will also verify the efficacy of the prototype
generator in reducing CO. In addition, staff conducted a proof-of-
concept demonstration of a remote CO sensing automatic shutoff device
for a portable generator, as well as an interlock concept in which a CO
sensor was located on the generator.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: Undetermined
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 15 USC 2051, Consumer Product Safety Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff Sends ANPRM to Commission... 06/29/2006....... .................
Staff Sends Supplemental Material 10/12/2006....... .................
to Commission.
Commission Decision............... 10/26/2006....... .................
Staff Briefs Commission........... 10/26/2006....... .................
Staff Sends Draft ANPRM to 11/21/2006....... .................
Commission.
ANPRM Published................... 12/12/2006....... 71 FR 74472
Comment Period Ends............... 02/12/2007....... .................
Staff Sends NPRM Briefing Package ( \1\ ).......... .................
to Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact: Janet L. Buyer, Project Manager, Consumer Product
Safety Commission, Directorate for Engineering Sciences, 4330 East-West
Highway, Bethesda, MD 20814. Phone: 301 504-0508. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC40 Publication ID: Spring 2008
Title: Civil Penalty Factors
Abstract: Section 20(b) and (c) of the Consumer Product Safety Act,
15 USC 2069(b) and (c), require certain factors to be considered in
assessing and compromising civil penalties. The Commission proposed a
new interpretive rule that identifies and explains related factors that
may be considered by the Commission and staff in evaluating the
appropriateness and amount of a civil penalty. On July 12, 2006, the
Commission solicited comments on a proposed new interpretive rule. The
comment period closed on August 11, 2006. CPSC staff will prepare a
briefing package for Commission consideration concerning the content of
a possible final interpretive rule.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: 16 CFR 1119 (To search for a specific CFR, visit the
Code of Federal Regulations.)
Legal Authority: 15 USC 2069(b) and (c), Consumer Product Safety
Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Notice of Proposed Interpretive 07/12/2006....... 71 FR 39248
Rule.
Comment Period End................ 08/12/2006....... .................
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: Undetermined
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact:, John Gibson Mullan,, Assistant Executive Director,
Compliance and Field Operations, Consumer Product Safety Commission,
4330 East-West Highway, Bethesda, MD 20814. Phone: 301 504-7626. Email:
[email protected].

VIEW RULE

CPSC RIN: 3041-AC41 Publication ID: Spring 2008
Title: Regulatory Options for Lead Toy Jewelry
Abstract: On December 11, 2006, the Commission voted 2-0 to grant a
petition requesting a ban on toy jewelry containing more than 0.06
percent lead by weight. On December 27, 2006, the Commission approved
an advance notice of proposed rulemaking (ANPRM), which was published
in the Federal Register on January 9, 2007. The public comment period
ended March 12, 2007. CPSC staff is reviewing public comments and will
prepare a briefing package for Commission consideration as to whether
to continue with rulemaking.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Long-Term Actions
Major: Undetermined
Unfunded Mandates: No
CFR Citation: Not Yet Determined (To search for a specific CFR,
visit the Code of Federal Regulations.)
Legal Authority: 5 USC 553, Administrative Procedure Act; 15 USC
1261, Federal Hazardous Substances Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Commission Decision on Draft ANPRM 12/27/2006....... .................
FR Notice.
ANPRM Published................... 01/09/2007....... 72 FR 920
Comment Period Ends............... 03/12/2007....... .................
Staff Sends Briefing Package to ( \1\ ).......... .................
Commission.
------------------------------------------------------------------------
\1\ To Be Determined.

Regulatory Flexibility Analysis Required: Undetermined
Government Levels Affected: None
Federalism: Undetermined
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact:, Kristina Hatlelid, Ph.D., Project Manager,
Consumer Product Safety Commission, Directorate for Health Sciences,
4330 East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7254.
Email: [email protected].

VIEW RULE

CPSC RIN: 3041-AB68 Publication ID: Spring 2008
Title: Amendment of the Standard for the Flammability of Clothing
Textiles
Abstract: The Standard for the Flammability of Clothing Textiles
prohibits the manufacture, importation, or sale of clothing and fabrics
and related materials intended for use in clothing, which are
dangerously flammable because of rapid and intense burning. The
standard prescribes the apparatus, procedure, and criteria to be used
for testing to determine compliance with that standard. The standard
was made mandatory by the Flammable Fabrics Act of 1953 (Pub. L. 83-88,
67 Stat. 111; June 30, 1953). Some of the equipment and procedures
specified by the standard, particularly those for laundering and
cleaning of test specimens, have become obsolete, unavailable, or
unrepresentative of current practices. The staff prepared a briefing
package describing modifications of the standard that may be needed to
assure that the test in the standard is conducted with equipment and
procedures representative of conditions to which garments currently are
exposed. After consideration of the briefing package, the Commission
decided to begin a proceeding for amendment of the standard. An advance
notice of proposed rulemaking (ANPRM) was published in the Federal
Register on September 12, 2002. The staff reviewed public comments and
proposed amendments for Commission consideration. On January 12, 2007,
the Commission voted to publish a notice of proposed rulemaking (NPRM)
in the Federal Register. The comment period closed on May 14, 2007. The
staff evaluated the comments and prepared a final rule briefing package
for Commission consideration. On February 1, 2008, the Commission voted
to approve the final rule amending the standard for the Flammability of
Clothing Textiles.
Agency: Consumer Product Safety Commission (CPSC)
Priority: Substantive, Nonsignificant
RIN Status: Previously published in the Unified Agenda
Agenda Stage of Rulemaking: Completed Actions
Major: No
Unfunded Mandates: No
CFR Citation: 16 CFR 1610 (To search for a specific CFR, visit the
Code of Federal Regulations.)
Legal Authority: 15 USC 1191, Flammable Fabrics Act
Legal Deadline: None

TIMETABLE
------------------------------------------------------------------------
Action Date FR Cite
------------------------------------------------------------------------
Staff Sent Briefing Package to 06/11/2002....... .................
Commission.
Commission Decision............... 08/28/2002....... .................
ANPRM............................. 09/12/2002....... 67 FR 57770
ANPRM Comment Period End.......... 11/12/2002....... .................
Staff Sends Briefing Package to 11/30/2006....... .................
Commission.
Commission Decision............... 12/08/2006....... .................
Draft NPRM to Commission.......... 01/10/2007....... .................
Commission Decision on Draft NPRM. 01/12/2007....... .................
NPRM.............................. 02/27/2007....... 72 FR 8843
NPRM Comment Period End........... 05/14/2007....... .................
Staff Sends Briefing Package to 12/27/2007....... .................
Commission.
Staff Sends Draft FR Notice with 01/22/2008....... .................
Draft Final Rule to Commission.
Commission Decision............... 02/01/2008....... .................
Final Action...................... 03/25/2008....... 73 FR 15636
------------------------------------------------------------------------

Regulatory Flexibility Analysis Required: No
Government Levels Affected: None
Federalism: No
Included in the Regulatory Plan: No
RIN Data Printed in the FR: No
Agency Contact:, Patricia K. Adair, Project Manager, Consumer
Product Safety Commission, Directorate for Engineering Sciences, 4330
East-West Highway, Bethesda, MD 20814-4408. Phone: 301 504-7536. Email:
[email protected].
why does it take so long for cpsc to publish a final rule?
Question. For seven regulations that CPSC has worked on for the
past 4 years--some of which date back to the 1990s--the average length
of time from initiation of a regulation to a final rule has been almost
6 years, which is a long time to wait when the public has the potential
of being injured or killed by a product. Your own statute states that,
with certain exceptions, a rule shall be issued within one year of
publication of an advance notice of proposed rulemaking.
How can the length of time between initiation of a rule and
finalization of it be accelerated?
Answer. Under its statutes, to issue a final rule, the Commission
must prepare thorough responses to substantive public comments (which
can lead to the need to conduct complex research and testing) and
develop a record to support its findings concerning ``unreasonable
risk,'' costs and benefits, the basis for why the rule is the ``least
burdensome alternative,'' and the inadequacy of any voluntary standards
addressing the risk. The findings must be sufficiently robust to
withstand judicial challenge, generally against a ``substantial
evidence'' review standard.
Additionally, in rulemakings under the Consumer Product Safety Act
or the Federal Hazardous Substances Act that address chronic risks of
cancer, birth defects or genetic mutations, the Commission is required
to appoint a panel of scientific experts from a list of nominees
provided by the National Academy of Sciences, allow the panel to
deliberate, and receive the panel's expert opinion concerning the
potential harm to human health that could result from exposure to the
substance, before the rulemaking may commence with an Advance Notice of
Proposed Rulemaking (ANPR). Also, of course, loss of quorum can
materially impact rulemaking schedules.
In addition to the requirements of the Commission's statutes noted
above, there are numerous other federal government-wide statutory
requirements and treaty obligations that impose constraints on the
rulemaking process and the rate at which it can be accomplished,
including the Regulatory Flexibility Act, the Paperwork Reduction Act,
the Small Business Regulatory Enforcement Fairness Act, the National
Environmental Policy Act, and public comment period duration
requirements under the North American Free Trade Agreement, among
others.
All of these statutorily mandated complexities and checks and
balances on the Commission's rulemaking authorities and procedures of
necessity constrain the rate at which the deliberative process leading
to a final rule can be accomplished.
Last year, I submitted a proposal to Congress to make optional the
statutory requirement to commence all standard or ban rulemakings with
an ANPR, and I am hopeful that this reform will be included in CPSC's
reauthorization when it is passed.
A March 2008 report by Public Citizen criticized the CPSC for not
completing work on the seven rules that are referred to in your
question. The report is grossly misleading, and information on a few of
the examples cited by the Public Citizen report follow:
The upholstered furniture rulemaking activity has been
exceptionally complex, with many diverse stake holders providing input
into the process. Upholstered furniture components include such varied
materials as cover fabrics, loose fillings, barriers, wood, plastic and
resilient foams. Each reacts differently to open flame and smoldering
ignitions. The components interact with each other during a fire
depending on the materials involved and the construction and geometry
of the product. In some cases, potential solutions that would mitigate
open flame ignitions may not address, or could even reduce, the
effectiveness of measures addressing smoldering ignitions and vice-
versa. Solving these complex fire science problems has been critical to
developing an effective standard that complies with the agency's
governing statutes. Nonetheless, the CPSC has proposed a new
flammability standard for residential upholstered furniture and
published it in the Federal Register on March 4, 2008, for public
comment. Finalization of this very important rulemaking is one of my,
and the Commission's, highest priorities.
The rulemaking on bedclothes (e.g., quilts, blankets, bedspreads)
flammability is closely related to the Commission's recently issued
rule on open flame ignition of mattresses, a rule that when fully
effective is estimated to prevent over 200 deaths each year. As we
enforce the new rule that became effective on July 1, 2007, we gain
important information that is relevant to bedclothes flammability.
Before proceeding with the development of testing methodology and
performance requirements related to bedclothes, CPSC staff will need to
evaluate this critical data. It should also be noted that, like
upholstered furniture, the fabrics and contents of bedclothes vary
enormously in the market, and so development of a single flammability
standard would be a very difficult and complex undertaking.
The amendments to the Clothing Textile Standard are technical
clarification and work was delayed so that CPSC's flammability experts
could concentrate on the important mattress flammability standard
(referred to above). This work is now complete and a final rule was
published on March 25, 2008.
After the CPSC initiated a rulemaking activity on baby bath seats,
the voluntary standard was revised so that it was essentially the same
as the mandatory requirements proposed by the CPSC. As noted above, the
Commission is prohibited from issuing a mandatory rule if there is a
voluntary standard in place that adequately addresses the hazard and
there is likely to be substantial compliance with that standard. In
that regard, staff is monitoring and evaluating the adequacy of the
revised standard and will prepare a formal briefing package for
Commission consideration as to whether to continue rulemaking. In the
interim, CPSC staff participation in the development of revisions to
the voluntary standard has been ongoing and significant.

ILLINOIS--LEAD IN KEYCHAINS

Question. It has come to my attention that Illinois Attorney
General Lisa Madigan has contacted you about the sale of some keychains
in the State of Illinois that far exceeded lead standards through
independent testing. One of these keychains resulted in the injury of a
9-month old baby from Decatur, Illinois. Part of the Attorney General's
letter raised concerns about CPSC's response to this report of
independent testing.
Will you provide me with your response to this injury report?
Have you responded to the Attorney General's letter?
Answer. The keychains were first brought to CPSC's attention by a
professor of chemistry whose class conducted testing of these keychains
along with a number of children's jewelry items. There are no standards
for lead content of keychains, and at that time, CPSC staff focused on
the jewelry items, which are subject to a specific enforcement policy,
and obtained recalls as appropriate. Like the CPSC, the State of
Illinois also considered the keychains a product for adults, but it
became aware of lead exposure caused by one of the keychains given to
an infant by its mother. As soon as CPSC staff learned of this
exposure, a recall quickly ensued.
______

Questions Submitted by Senator Sam Brownback

Question. Since our toy safety hearing last September, what
specific ways have Chinese manufacturing plants changed their
operations to ensure toy safety?
What specifically has the Chinese government done to ensure that
toys and other consumer products manufactured for export are meeting
safety standards?
How would you characterize your agency's relationship with the
Chinese government? Has China been willing to work with you?
Answer. During the past year of CPSC outreach to Chinese
manufacturers and Chinese government export inspectors, we have
detected a shift of attitudes toward adoption of modern, end-to-end
best practices to ensure compliance with safety standards. This shift
can be seen in toy industry publications, in seminars for manufacturers
hosted by the Chinese government, and in recall case reports to the
CPSC from the Chinese regulator.
The work plans that were agreed to at the U.S.-Sino Consumer
Product Safety Summit held in September 2007 were outcomes of our
Memorandum of Understanding (MOU), which established the framework for
cooperation. The work plans called for cooperative work in four product
categories: toys, lighters, electrical products, and fireworks.
Technical experts are now working on exchanges of standards
information, training for product testing, and sharing information and
best practices in those four product categories.
Since September, CPSC staff has met eight times, either in person
or via video conference, with staff of China's General Administration
for Quality Supervision, Inspection and Quarantine (AQSIQ) to review
recalls and safety issues.
The CPSC has begun a Chinese language service on our web site,
where Chinese suppliers and government officials can get the latest
information in Chinese (we are translating requirements and posting
them) and descriptions in Chinese that link to the full texts of
English language requirements.
At CPSC's invitation, product safety officials from the European
Union will join us in China during September for a joint outreach
program to consumer product exporters. The Chinese government has
enthusiastically endorsed this project and has agreed to facilitate
access to the appropriate audiences for the compliance outreach
seminars.
Regarding Chinese compliance cooperation, first it should be
stressed that the CPSC does not rely on the Chinese government to
enforce U.S. requirements. The CPSC enforces our requirements with
American importers. That said, the Peoples' Republic of China (PRC)
offered to use its export quality control system to target Chinese-made
products that would be recalled if they entered the United States. We
singled out lead paint on toys as a problem and they agreed to take
that on.
--The Chinese government investigates recall causes at the factory
and mandates specific changes, such as a change of supplier or
more frequent testing. It reports those case-specific outcomes
to CPSC. The PRC says it has inspected thousands of factories
and revoked hundreds of export licenses for product safety
violations.
--The PRC has sponsored numerous high-profile standards and
compliance seminars aimed at getting the product safety message
to Chinese manufacturers. The CPSC participated in one of these
in November.
However, nothing the Chinese government promises and no amount of
export control inspection can take the place of major systemic changes
in Chinese manufacturing. We are working with Chinese suppliers to
hasten that change, but it is the U.S. importer that must ensure that
its product complies with our laws.
Question. We cannot merely trust the Chinese. What specifically is
your agency doing to verify that the Chinese are adhering to the MOU
that we have entered into with them? Have the Chinese resisted your
efforts to verify their agreements with us?
Answer. CPSC officials are in China frequently meeting with Chinese
industry representatives and government officials to witness their
implementation of the policies and practices that we have been
encouraging. During the past year, CPSC staff participated in training
seminars in China for thousands of Chinese suppliers and we have
visited several factories. We also work closely with State Department
officials in China, who also visit factories and report on product
safety issues. We have not experienced resistance to any of our
requests for access or cooperation. Notably, when the CPSC requested an
immediate visit to the factory producing the recalled toy ``Aqua
Dots,'' we were provided access to the property (which was not
sanitized for us) within 24 hours, as well as an opportunity to speak
to the toy designer.
Question. Have the number of consumer product recalls of imported
items increased or decreased since September 2007?
Have the number of consumer product recalls of imported items from
China increased or decreased since September 2007?
Answer. As a result of heightened industry awareness and aggressive
enforcement activities by the CPSC, the number of consumer product
recalls of imported items has increased since September 2007, relative
to earlier years, and specifically, the number of consumer product
recalls of imported items from China has increased since that time. It
should be noted that the recalled products from China in this time
frame were manufactured and exported to the United States before the
U.S.-Sino Consumer Product Safety Summit in September 2007.
Question. Frankly, I worry that the Chinese are unwilling or unable
to implement productive changes in their manufacturing processes. How
are we to be assured that safety standards will be met and that
inspectors will monitor production facilities?
Answer. Regarding Chinese cooperation, it must be stressed that the
CPSC does not rely on the Chinese government to enforce U.S.
requirements. The CPSC enforces our requirements with American
companies that import consumer products. This is the essential purpose
of CPSC's new Import Safety Initiative. We have already seen that
recalls by the CPSC provide a significant economic incentive to promote
change in China.
As noted at the hearing, I would welcome funding for a CPSC
Regional Product Safety Officer, supported by a Foreign Service
National (FSN), to be stationed at the U.S. Embassy in Beijing to cover
Asia and to help us coordinate with Chinese authorities--as a first
step in a CPSC overseas presence. Since we are beginning to work with
Vietnam and other countries in the region, there would be extended
benefits to such a presence.
Question. Ms. Nord, I would like to commend you for your new
surveillance initiatives and your plan to hire employees to staff your
new Import Surveillance Division. Do you think this increased presence
is enough to stem the tide of defective imports flowing into the
country? In your estimation what more should be done by the CPSC to
help protect American consumers?
Answer. The new CPSC presence at U.S. ports-of-entry is an
important advance in our efforts to reduce the number of defective
products entering the country. However, because of the sheer volume of
consumer products imported into the nation annually, port inspection
activity alone is not sufficient. That is the reason that the CPSC has
implemented a multi-pronged approach to meet this challenge. In
addition to increased dialogue and initiatives with China and other
nations to encourage systemic change in their manufacturing processes,
the CPSC is working with the private sector and reaching out to foreign
manufacturers to establish product safety systems as an integral part
of their manufacturing process. Additionally, I have requested a number
of new enforcement tools, some of which are included in the CPSC Reform
Act that is currently awaiting final action by a Senate/House
conference committee. For example, I proposed that it be unlawful to
fail to furnish a certificate of compliance with a mandatory standard
under any statute administered by the CPSC or to issue a false
certificate of compliance. As I mentioned at the hearing, this would be
an extremely effective enforcement tool for the CPSC, and although this
provision was not in the Senate-passed bill, I am hopeful that the
final legislation will include it.
Question. With the increased surveillance at the nation's high
impact ports, do you expect there to be any ``port shopping'' of
shipping vessels unloading at the docks with a lower federal presence?
If so, how do you plan to tackle this problem?
Answer. It is probably inevitable that some unscrupulous importers
will try to find ways to bypass CPSC's fulltime presence at certain
ports. It is important to recognize, however, that CPSC's field staff
can visit any of the 300 U.S. ports-of-entry and sample products at
those locations on an as-needed basis. In addition, the CPSC is now a
participating agency in the International Trade Data System (ITDS)
Automated Commercial Environment (ACE), which will give us much better
information with which to target imports.
Question. Commissioner Nord, Wichita and El Dorado happen to be
hubs of the largest latex balloon manufacturing operation in America,
and I'm very proud that we continue to have this kind of domestic
manufacturing presence in Kansas and in the United States.
I understand that the Balloon industry, Pioneer Balloon in
particular, voluntarily put cautionary statements on their packaging as
early as 1992. They also worked closely and cooperatively with the CPSC
to develop standardized cautionary statements for all balloon packages
that were implemented in 1994. These efforts have been effective, with
fatal incidents associated with balloons dropping dramatically.
As you may know, there is a provision in the CPSC reauthorization
legislation that deals with extending the mandate for cautionary
statements on a class of products, including balloons, from the labels
of those products to advertising, including Internet and Catalog
advertising, for these products. These efforts appear to be intended to
ensure that consumers who would see the cautionary statement in a brick
and mortar store would also be aware of the hazard if they were to buy
balloons online.
While the Balloon Industry wants to safeguard consumers as much as
they can, they want to make sure they can continue to do business
without a huge chilling effect on commerce or on their business-to-
business practices. To that end:
By your understanding of the bill, would the provision affect
business to business advertising, in catalogues or the Internet?
Because balloons are generally sold from manufacturers to distributors
and retailers, I want to be sure that this provision would not be
misconstrued to affect business-to-business advertising or catalogs
that balloon companies send to their distributors that never make it
into the hands of consumers?
Answer. As written, section 11 of S. 2663 does not make a
distinction between business-to-business advertisements and business-
to-consumer advertisements. Rather, it requires an appropriate
cautionary statement in any advertisement on the internet or in a
catalogue or other distributed material ``that provides a direct means
of purchase.'' The provision does not specify who is making the
purchase.
Question. While conferees still have work to do on a final bill, if
the provision were to become law, would the CPSC work cooperatively
with the Balloon Industry in a way that befits previous cooperation so
that we can be sure that only consumers who buy online or from a
catalog are affected, and that business to business practices can
continue as they exist today?
Answer. The CPSC works cooperatively with affected industries to
assure that they understand their requirements under the law as it is
written by Congress.
______

Questions Submitted to Thomas H. Moore
Questions Submitted by Senator Sam Brownback

Question. Numerous states have either passed or are considering
passing their own product safety laws. In some cases, the states would
be imposing standards, for lead content for example, which are
considerably more restrictive than the contemplated federal standards.
How does S. 2663 guard against states creating what would in effect
become a patchwork of different material content standards across the
country?
Answer. It is unclear the extent to which either S. 2663 or the
express preemption provisions of the Federal Hazardous Substances Act
would sufficiently address this problem. Regardless of the language
used in the final version of the federal statute, in all likelihood
these issues will ultimately be resolved in the courts by resort to
judicial principles concerning preemption.
Question. While S. 2663 defines ``children's product'' to mean
products designed or intended for use by consumers aged seven or
younger, certain state statutes have a higher age threshold. How does
S. 2663 avoid a situation in which products destined for very young
children are subject to the federal standard while products intended
for older children face more restrictive material content standards
imposed by the states?
Answer. S. 2663 contains no provision which would avoid such a
situation.
Question. How does S. 2663 guard against states passing their own
children's product safety laws which encompass specific products, such
as jewelry, or a broader array of materials than does the federal law,
thus, effectively creating special restrictions for products or
materials which Congress did not feel compelled to regulate?
Answer. S.2663 contains no provision which would avoid such a
situation.
Question. In the State of Washington, a new product safety law will
go into effect in July of 2009. Senate bill 2663 will probably not
become effective until after that time; likely the end of 2009. Thus,
retailers may face a situation in which they are forced to comply with
a very restrictive state standard for several months before the new
federal standards take effect. How can S. 2663 be modified to avoid
this problem?
Answer. This situation is essentially impossible to prevent in the
absence of enactment of a federal law addressing the same scope of
products and very clearly stating Congressional intent to preempt the
Washington law prior to the effective date of the Washington law.

SUBCOMMITTEE RECESS

Senator Durbin. The meeting of the subcommittee will stand
recessed.
[Whereupon, at 3:46 p.m., Wednesday, April 30, the
subcommittee was recessed, to reconvene subject to the call of
the Chair.]

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

----------

WEDNESDAY, MAY 7, 2008

COMMODITY FUTURES TRADING COMMISSION

STATEMENT OF HON. WALTER L. LUKKEN, ACTING CHAIRMAN

OPENING STATEMENT OF SENATOR RICHARD J. DURBIN

Senator Durbin. I call to order this meeting of the Senate
Appropriations Committee Subcommittee on Financial Services and
General Government. The hearing this afternoon will consider
funding requests for two Federal regulatory agencies that are
part of the jurisdiction of our subcommittee. My colleagues
will be joining me a little bit later.
I am pleased to welcome Acting Chairman Walter Lukken of
the Commodity Futures Trading Commission (CFTC), and I am told
that CFTC Commissioners Mike Dunn--please indicate, Mike, where
you are. Mike, good to see you again. Bart Chilton; is Bart
here? Bart, thank you for joining us. Jill Sommers, present.
Jill, thank you for attending. I also understand that Chairman
Chris Cox of the Securities and Exchange Commission, if he's
not here--he's enroute.
I'm going to waive the reading of my opening statement in
the interest of having more time to ask questions, and ask
consent that it be put in the record. Without Senator
Brownback's objection, it will be. So, Senator, if you would
like to make any kind of an opening statement, you're welcome
to.
Senator Brownback. Before I start, Senator Shelby has
submitted a statement that he would like to be included in the
record.
[The statements follow:]

Prepared Statement of Senator Richard J. Durbin

Good afternoon. I am pleased to welcome you to this hearing to
consider the funding requests of two Federal regulatory agencies within
the jurisdiction of the Appropriations Subcommittee on Financial
Services and General Government.
I welcome my colleagues who have joined me on the dais today and
others who may arrive.
I am pleased to welcome Acting Chairman Walter Lukken of the
Commodity Futures Trading Commission (CFTC). I also note that CFTC
Commissioners Mike Dunn, Bart Chilton, and Jill Sommers are present.
Thank you for attending and for your service.
I welcome Chairman Chris Cox of the Securities and Exchange
Commission (SEC), and members of his staff. Thank you all for being
here.
The CFTC and the SEC enjoy unique histories, hold specialized and
independent responsibilities, and take different approaches to markets
that serve differing purposes. Yet the CFTC and the SEC both occupy
pivotal positions at the forefront of stimulating and sustaining
economic growth and prosperity in our country. Through their vigilance,
the United States is better equipped to compete in today's evolving
global marketplace.
As the subcommittee prepares to make difficult funding decisions
for the next fiscal year, I look forward to hearing from our witnesses
about the particular challenges their respective agencies face in
today's tumultuous economic environment. I welcome input on how we can
best address those needs.
Before hearing from our panelists, I'd like briefly outline the
missions of these agencies and their budget proposals:
First, the CFTC: It is charged with protecting the public and
market users from manipulation, fraud, and abusive practices. It is
also responsible for promoting open, competitive, and financially sound
markets for commodity futures. The CFTC regulates the activities of
nearly 70,000 registrants--from sales people to trading advisors to
floor traders.
The CFTC helps ensure that the futures markets are equipped to
better perform their vital function in the U.S. economy--providing a
mechanism for price discovery and a means of offsetting price risks.
The CFTC's oversight and enforcement mission becomes tangible when
you consider that futures prices impact what we pay for the basic
necessities of our daily lives: Our food, clothing, shelter, fuel in
our vehicles, and heat in our homes.
We have witnessed a remarkable transformation in the nature and
type of products listed by exchanges since the CFTC was established in
1976. Thirty-two years ago, the vast majority of futures trading
occurred in the agricultural sector--cattle, grains and crops, and the
proverbial pork bellies.
Today, novel and highly complex financial contracts are emerging,
based on such things as foreign currencies, interest rates, Treasury
bonds, weather, real estate and economic derivatives, and stock market
indices. These now surpass agricultural contracts in trading volume.
And the ever-expanding complexities pose ever-demanding challenges as
new futures products emerge.
For the CFTC, the President's budget requests funding of $130
million, representing an increase of $18.7 million--a 17 percent hike--
over the fiscal year 2008 enacted level of nearly $111.3 million.
Of the $18.7 million in increased funding for next year, $3.2
million is slated for increased compensation and benefit costs for a
staff of 465; $13.6 million will be devoted to increased operating
costs for information technology modernization, lease of office space,
and other services; and $1.9 million will support the salary and
expenses of 10 additional full-time staff.
Currently, with the $111.3 million provided for fiscal year 2008 (a
14 percent increase over the $98 million in fiscal year 2007), CFTC is
beginning an intensive hiring process to boost staffing from 447 up to
465 and is making some initial investments to upgrade its information
technology to keep pace with the rapidly-evolving technology-driven
futures markets.
In the past decade, trading volume has increased more than ten-
fold--reaching well over 3 billion trades in 2007, and actively traded
contracts have quintupled--from 258 in 1997 to 1,540 in 2007. CFTC
oversees $4.2 trillion of daily trades. But despite this phenomenal
surge in activity, staffing levels have not kept pace, and in fact,
have dropped 21 percent. As I pledged last year, I am committed to
addressing this resource deficiency.
I also understand that various components of the CFTC
reauthorization, included as part of the farm bill, would impose new
responsibilities for the CFTC. Among these elements are regulation of
energy derivatives markets and increased penalty authorities for market
manipulation violations, which may require additional resources not
contemplated in the fiscal year 2009 request.
I look forward to hearing more about CFTC's budgetary needs today,
and the opportunity to discuss with Chairman Lukken a variety of
issues, including the oversight and regulatory challenges and
opportunities presented by rising commodity prices, particularly for
agricultural items and oil.
Turning to the SEC, its three-prong mission is to protect
investors; maintain fair, orderly, and efficient markets; and
facilitate capital formation.
The SEC is responsible for overseeing more than 12,000 publicly
traded companies, over 10,000 investment advisers that manage more than
$38 trillion in assets, nearly 1,000 fund complexes, 6,000 broker
dealers with 172,000 branches, and close to $44 trillion worth of
trading conducted each year on America's stock and option exchanges.
The strength of the American economy and our financial markets
depends on investors' confidence in the financial disclosures and
statements released by publicly traded companies. Investors expect the
SEC to be the vigilant ``cop on the beat.'' This subcommittee wants to
make certain that the SEC has the necessary resources to effectively
fulfill its obligatory singular mission: protecting shareholders.
Crucial to the SEC's effectiveness is its enforcement authority.
Each year the SEC brings hundreds of civil enforcement actions for
violations of the securities laws. Typical infractions include insider
trading, accounting fraud, and providing false or misleading
information. Serious, thoughtful questions have been raised about
whether the proposed enforcement budget is adequate to keep pace with
the growing demands.
The SEC's budget request for fiscal year 2009 totals $913 million,
a slight $7 million (0.8 percent) increase over the agency's fiscal
year 2008 enacted level of $906 million. Part of the $913 million will
be provided through $42 million of prior year balances, resulting in an
appropriated level of $871 million. These funds are offset by
registration and transaction fees. The fiscal year 2009 budget would
fund 3,409 permanent staff, a reduction of 94 staff (a 2.7 percent cut)
below the SEC's fiscal year 2008 level.
What is troubling about the paltry increase is that it is
insufficient to sustain the agency's salary needs at SEC's authorized
personnel level and will actually require cutting nearly 100 staff.
This reduction of personnel comes at a time when developments and
trends in the market call for more, not less, vigilance to protect
investors. Resources devoted to enforcement are declining in both
dollar terms and proportionality.
I am concerned this bare-bones budget will hinder the SEC's ability
to accomplish its mission. I look forward to exploring this topic more
fully with Chairman Cox. In addition, I also plan to delve into other
issues including the recent SEC-CFTC Memorandum of Understanding, Sudan
divestment disclosure, SEC's role with subprime mortgage markets,
expediting Fair Fund disbursements to investor-victims, plans for
greater oversight of credit rating agencies, and how availability of
interactive data is simplifying investor understanding and access to
corporate filings and financial information.
I look forward to hearing from our witnesses about the resources
they require to keep pace with change and achieve success in a 21st
century world, while responsibly managing taxpayer dollars.
______

Prepared Statement of Senator Richard C. Shelby

Chairman Cox, in your testimony today you state your support for
providing dedicating funding for the SEC's Consolidated Supervised
Entities (CSE) program. However, this program has never been explicitly
authorized by Congress. Rather, it was created by the SEC. Unlike the
Fed's regulation of bank holding companies and the OTS's regulation of
thrift holding companies, the SEC's regulation of investment bank
holding companies under the CSE program is not authorized by statute.
The CSE program is entirely the SEC's creation.
Normally, Congress is responsible for making policy, while the SEC
implements that policy. In this case, however, the SEC decided that the
CSE program was needed and then took it upon itself to create the
program. Before the SEC now decides that a CSE program needs dedicated
funding, I believe the SEC needs to take a step back and let Congress
decide how investment banks should be regulated.

STATEMENT OF SENATOR SAM BROWNBACK

Senator Brownback. I appreciate your way and means of doing
this, and I'm going to do similarly because I've got a lot of
questions.
I would like to, though, point out two things very quickly
if I could. First, welcome, Chairman Lukken. I appreciate you
being here. And Securities and Exchange Commission (SEC)
Chairman Cox is on his way.
We put these in the record last week at the Joint Economic
Committee on ending stocks of wheat and rice. I think it's
important to get some factual basis out there. We are at a 27-
year low on ending stocks of wheat, I believe. We had a
terrible crop last year in the Midwest. You guys don't grow any
wheat, but we do, and we didn't grow much last year. And then
they didn't in Australia and a number of other places. A
similar thing happened on the rice markets as well.
But you can look at other markets that didn't have much of
a problem, and yet you've seen this huge rise in prices. I want
you particularly to address some of that if you would, because
it strikes me that we do have people taking resources and
putting them into commodities which drives up some commodities,
not based on the fundamentals. There are crop movements that
are based on the fundamentals; there are some that are not
based on it.
I really hope we can look at that particular issue and the
potential manipulation of the market by large hedge funds or
index funds, of taking money that they would normally put in
other places, maybe even put it in commercial real estate, but
with the declining value of the dollar shifting into the
commodity markets, and then driving up those market prices
above what the fundamental would support. I want to ask you
what you anticipate doing to try to address that issue.
Mr. Chairman, thanks for the hearing.
Senator Durbin. Thanks.
Chairman Lukken, your opening statement. We'll put whatever
you like officially in the record and invite you now to give us
a few minutes of the introduction to your statement.

SUMMARY STATEMENT OF WALTER L. LUKKEN

Mr. Lukken. Thank you, Mr. Chairman and other Senators of
the subcommittee. I am pleased to be here to testify on behalf
of the Commodity Futures Trading Commission. The CFTC is the
agency charged with overseeing and regulating the U.S.
commodity futures and options markets. These markets play a
critical role in the U.S. economy by providing important risk
management tools for market participants. The futures markets
also serve to discover prices that accurately reflect supply,
demand, and other economic factors.
These are extraordinary times for our markets, with
commodity futures prices at unprecedented levels. In the last 3
months the agricultural staples of wheat, corn, soybeans, rice,
and oats have hit all-time highs. We've also witnessed record
prices in crude oil, gasoline, and other related energy
products. Broadly speaking, the falling dollar, strong demand
from the emerging world economies, global political unrest,
detrimental weather, and ethanol mandates have driven up
commodity futures prices across the board.
On top of these trends, the emergence of the subprime
crisis last summer led investors to increasingly seek portfolio
exposure in commodity futures. As the Federal regulator of
these products, the CFTC is closely monitoring these growing
markets to ensure they are working properly for farmers,
investors, and consumers.
To date, CFTC staff analysis indicates that the current
higher futures prices generally are not a result of
manipulative forces. That said, we continue to probe,
investigate, and gather information from the entire marketplace
and welcome outside analysis and perspectives so that we can
ensure that we have an accurate and full view.
For example, the agency convened an industry agricultural
forum 2 weeks ago to have a full public airing of views as to
the driving forces in these markets. The comment period for
that event ends today and we hope to announce in the near
future agency initiatives to address the concerns we heard at
that forum.
The CFTC also recently announced the creation of an energy
markets advisory committee and scheduled its first meeting for
June 10 to review the functioning of the energy markets.
Despite this tumultuous time in our markets, the agency
continues to make advancements on important policy initiatives.
Last fall, the Commission delivered an extensive report to
Congress recommending additional authorities for the agency in
overseeing exempt energy trading. Through bipartisan efforts,
these recommendations became a part of the CFTC reauthorization
bill, which is contained in the farm bill conference report.
The enactment of that legislation will improve our oversight of
the energy markets with the addition of new authorities at the
agency. The President's fiscal year 2009 budget does not take
into account these new powers.
The U.S. futures and options markets of today bear little
resemblance to the industry of 1976, the Commission's first
year of operation, in terms of complexity, globalization,
volume, and economic importance. Yet, staff resources and
operating funds over time have not kept pace.
Figure 1 on the monitor shows the growth in trading volume
on the U.S. futures exchanges from 1996 to present. Trading
volume has increased sixfold during the last decade, while at
the same time Commission staffing levels have fallen to 447
full-time employees. That's 50 fewer staff today than the
agency had 30 years ago.
Figure 2 lists many of the different components of the
futures industry. As you can see from the chart, the growth of
these categories from 1976 to present is stunning. For
instance, total contract volume has increased more than 8,000
percent in 30 years, compared to CFTC's staffing and overhead
expenses, which have decreased 12 percent and 5 percent
respectively.
On behalf of the entire Commission, I would like to express
my appreciation for the support provided to the CFTC in the
fiscal year 2008 budget. The $111 million appropriated by
Congress for the current calendar year is already being put to
good use to address critical needs in two major areas:
personnel and technology. That focus will continue with the
fiscal year 2009 budget.
The Commission employs highly trained individuals who work
within three program divisions: market oversight; clearing and
intermediary oversight; and enforcement. The Division of Market
Oversight ensures that the markets are operating efficiently
and free from manipulation and fraud. The Commission's staff
economists utilize the Commission's Large Trader Reporting
System and one of the Commission's main technology systems, the
Integrated Surveillance System (ISS), to detect and deter
market manipulation. As you can see in figure 3, the current
atmosphere of rising futures prices across a wide range of
products makes these anti-manipulation efforts ever the more
important.
The Division of Clearing and Intermediary Oversight ensures
the financial integrity of the futures industry as a whole. The
amount of funds handled by clearinghouses has increased
significantly of late. During this time, all exchanges have
experienced record settlements, including one day in January
2008 in which the Chicago Mercantile Exchange cleared and
settled more than $12 billion worth of transactions in 1 day,
nearly six times its normal load. Despite these spikes in cash
flow, the clearing system has worked well.
When a manipulation or fraud occurs in the futures markets,
it is the job of the Enforcement Division to prosecute the
offenders. Since the collapse of Enron, CFTC has brought 39
cases involving energy markets and charged 64 entities or
persons with manipulation, attempted manipulation, and false
reporting. The collective civil monetary penalties levied in
these energy market enforcement cases has exceeded $444
million.
Unfortunately, these programs have felt the effects of
turnover at the agency. The Commission lost 58 experienced
employees in fiscal year 2006, 49 in 2007, and 15 in 2008.
Replenishing these losses is critical if this agency is to
continue to meet its responsibilities in overseeing the futures
markets.
The fiscal year 2009 President's budget request, as seen in
figure 5, is an appropriation of $130 million and 475 full-time
staff, an increase of approximately $18.7 million and 10 staff
over the fiscal year 2008 appropriation. Key changes in the
fiscal year 2009 budget are: $3.2 million to provide increased
compensation and benefits for current employees; $1.9 million
to provide for salary and expenses of 10 additional full-time
employees. This increase, although modest, will allow us to
build on current key hiring efforts. And $13.6 million to
provide for increased operating costs for technology
modernization, office space, and all other services.
In fiscal year 2009, the requested increased funding will
continue to target technology upgrades and staffing increases.
It would permit the Commission to improve existing critical
technology systems, such as the ISS and E-Law systems. The
funds requested would also permit the development of the new
Trade Surveillance System, or TSS. Soon, with these
investments, we will have the capability to more quickly
monitor and analyze traders' intraday trading activity.
In conclusion, I am very proud of the agency and our highly
skilled staff. Every day they carry out the agency's mission of
protecting the public and market users from manipulation,
fraud, and abusive practices. If the futures markets fail to
work properly, all Americans are impacted. Accordingly, it is
critical that the CFTC have sufficient resources to hire and
maintain skilled talent as well as to provide a steady stream
of technology investment commensurate with the agency's
expanding and evolving global mission.

PREPARED STATEMENT

Thank you for this opportunity to appear today and I
welcome any questions.
[The statement follows:]

Prepared Statement of Walter L. Lukken
Thank you, Mr. Chairman and members of the subcommittee. I am
pleased to be here to testify before you on behalf of the Commodity
Futures Trading Commission.

BACKGROUND AND CURRENT MARKET EVENTS

The CFTC is the agency charged with overseeing and regulating the
U.S. commodity futures and options markets. These markets play a
critical role in the U.S. economy by providing risk management tools
that producers, distributors, and commercial users of commodities use
to protect themselves from unpredictable price changes. The futures
markets also play a price discovery role as participants in related
cash and over-the-counter markets look to futures markets to discover
prices that accurately reflect information on supply, demand, and other
factors.
As you are well aware, these are extraordinary times for our
markets with commodity futures prices at unprecedented levels. In the
last 3 months, the agricultural staples of wheat, corn, soybeans, rice,
and oats have hit all-time highs. We have also witnessed record prices
in crude oil, gasoline and other related energy products. Both macro-
economic factors as well as micro fundamentals for specific markets are
at play in these prices. Broadly speaking, the falling dollar, strong
demand from the emerging world economies, Mideast political unrest,
detrimental weather and ethanol mandates have driven up commodity
futures prices across-the-board.
On top of these trends, the emergence of the sub-prime crisis last
summer led investors to increasingly seek portfolio exposure in
commodity futures. As the Federal regulator of these products, the CFTC
is monitoring these growing markets to ensure they are working properly
for farmers, investors, and consumers. To date, CFTC staff analysis
indicates that the current higher futures prices are generally not a
result of manipulative forces. That said, we continue to gather
information from the entire marketplace--and welcome outside analysis
and perspectives--so that we can ensure that we have an accurate and
full view.
For example, the agency recently convened an agriculture forum 2
weeks ago in which we brought together a diverse group of market
participants to have a full airing of views and opinions as to the
driving forces in these markets. The comment period for that event ends
today and we hope to announce in the near future agency initiatives to
address the concerns we heard at the forum. The CFTC also recently
announced the creation of an Energy Markets Advisory Committee and
named the public members of the Committee just last week. Our first
meeting is scheduled for June 10th to look at issues related to the
energy markets and the CFTC's role in these markets under the Commodity
Exchange Act. I am confident that these public forums will benefit our
ability to make informed decisions as we strive to improve our
oversight of these important markets.
Despite this tumultuous time in our markets, the agency continues
to make advancements on several important policy initiatives. Last
September, the Commission held a public hearing on the regulation of
exempt markets, resulting in an extensive Report to Congress
recommending additional authorities for the agency in overseeing this
type of trading. Through bipartisan efforts, these recommendations
became a part of the CFTC's reauthorization legislation, which is
contained in the Farm Bill conference report now being debated. The
enactment of that legislation will mean increased responsibilities for
the agency--and accordingly, will mean a need for additional CFTC staff
to carry out the new authorities. The President's fiscal year 2009
budget for the $130 million funding level does not take into account
the new authorities included in the Farm Bill. The legislation would
also raise penalties for market manipulation violations and close a
legal loophole that has developed due to adverse court decisions that
are hindering the CFTC's efforts to combat retail off-exchange foreign
currency fraud.
The CFTC has also worked to strengthen its relationship with the
Securities and Exchange Commission (SEC) over the last year, given our
shared responsibilities over certain products that affect the
regulatory interests of both agencies. In March, our respective
agencies entered into a memorandum of understanding (MOU) that will
help the agencies share information as well as coordinate our review of
novel derivative products that have attributes of both securities and
futures. Two Chicago exchanges, the Chicago Board Options Exchange and
OneChicago, are the first beneficiaries of this new framework as both
seek to list for trading derivative products based on gold ETF
products.
Last year was busy on the enforcement front as well with the agency
assessing record penalties against those seeking to manipulate the
markets and defraud the public, culminating in the CFTC and Department
of Justice reaching a record settlement against British Petroleum for
manipulating the propane market. I am confident that the CFTC's
dedicated staff will continue this productive effort in the coming
year.

EVOLUTION OF THE MARKETS

Congress created the CFTC in 1974 as an independent agency. The
CFTC's primary mission under our governing statute, the Commodity
Exchange Act, is to ensure that the commodity futures and options
markets operate in an open and competitive manner, free of price
distortions. In December 2000, Congress reauthorized the Commission
with passage of the Commodity Futures Modernization Act of 2000 (CFMA).
This landmark legislation established a flexible, principles-based
regulatory regime. Today, the CFTC is the only U.S. principles-based
financial regulator. This flexible approach has allowed the regulated
futures industry to flourish. The same flexibility also allows alert
and responsive oversight by the CFTC to fulfill the agency's mission.
The U.S. futures and options markets of today bear little
resemblance to the industry of 1976 in terms of complexity,
globalization, volume, and economic importance--and these differences
will continue in fiscal year 2009. Yet, staff resources and operating
funds over time have not kept pace.
For example, Figure 1 shows the growth in trading volume on U.S.
futures exchanges from 1996 to present. Trading volume has increased
six-fold during the last decade, while at the same time, Commission
staffing levels have fallen to 447 full-time employees. That's 50 fewer
staff today than the agency had 30 years ago in 1976--the Commission's
first year of operation.

Figure 1.--Growth in Volume of Futures & Option Contracts Traded &
FTEs.

Figure 2 lists the many different components of the futures
industry, including the number of contracts traded, the volume of
trading, the number of futures industry participants, the number of
exchanges and other trading facilities, and the overall notional value
of these markets.

----------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
Indicator 1976 2007 Percent change
----------------------------------------------------------------------------------------------------------------
CFTC Staff...................................................... 497 437 -12
Overhead Expenses as a Percentage of Budget..................... 34 29 -5
Total Contract Volume........................................... 37M 3.085B +8,238
Types of Contracts Traded....................................... 66 1,365 +1,968
Commodity Trading Advisors...................................... 447 2,601 +482
Commodity Pool Operators........................................ 544 1,416 +160
Floor Brokers................................................... 2,591 8,038 +210
Associated Persons (Sales Persons).............................. 25,579 53,844 +110
CFTC--Regulated Exchanges....................................... 10 12 +20
CFTC--Registered Clearing Organizations......................... .............. 11 ( \1\ )
Exempt Boards of Trade.......................................... .............. 9 ( \1\ )
Exempt Commercial Markets....................................... .............. 20 ( \1\ )
Notional Value of Contracts Traded (Per Day).................... $4B \2\ $4.78T 119,400
Customer Funds in FCM Accounts.................................. $577M $155B 26,763
----------------------------------------------------------------------------------------------------------------
\1\ Not available.
\2\ Estimate.

----------------------------------------------------------------

Figure 2.--Indicators of Industry Growth.

As you can see from the chart, the growth in these categories from
1976 to present is stunning--with percentage increases in the triple,
quadruple, and quintuple digits. For instance, total contract volume
has increased more than 8,000 percent in 30 years. Contrast that with
the CFTC staffing and overhead expenses over time, which have decreased
-12 percent and -5 percent, respectively. Looking at the growth in all
sectors, it's clear that CFTC is doing a lot more with a lot less.

FISCAL YEAR 2008 BUDGET

On behalf of the entire Commission, I would like to express my
appreciation for the support provided to the CFTC in the fiscal year
2008 budget. The $111 million appropriated by Congress for the current
calendar year was the first substantial increase for the Commission in
recent years and is already being put to good use. It is important to
explain how the CFTC is using the fiscal year 2008 funding to address
critical needs in two major areas--experienced professionals and a
modern technology infrastructure--because the fiscal year 2009 funding
will build on that foundation.
Additional Staff Hires
The Commission is implementing an intensive hiring program for the
first time since October 2005. This program seeks to fill the loss of
experienced, long-time Commission employees, as well as address new
skill sets required by the rapidly evolving industry we regulate. The
Commission employs highly-trained, expert staff who works within three
major program divisions--Market Oversight, Clearing and Intermediary
Oversight, and Enforcement. These divisions are complemented and
supported by the Offices of the Executive Director, General Counsel,
Chief Economist, International Affairs, and External Affairs.
The Division of Market Oversight ensures that the markets are
operating efficiently and without manipulation and fraud. One of the
keys to Market Oversight is market surveillance. The Commission's staff
economists utilize the Commission's large trader reporting system and
one of the Commission's main technology systems, the Integrated
Surveillance System (ISS), to detect and deter market manipulation and
disruption. As you can see in Figure 3, the current atmosphere of
rising futures prices across a wide range of products makes these anti-
manipulation efforts all the more important.

Figure 3.--Recent Commodity Price Changes by Percent Change.

The Division of Clearing and Intermediary Oversight ensures the
financial integrity of the futures industry as a whole. Futures and
options trading on U.S. contract markets increased by approximately 27
percent in 2007 over the prior year and remains at consistently high
levels. Not only has the volume of trading increased and the futures
prices of some commodities increased to record levels, the amount of
funds handled by the clearing houses has increased as well. In this
regard, all exchanges have experienced record settlements during this
time period, including one day in January 2008 in which the Chicago
Mercantile Exchange cleared and settled more than $12 billion of
transactions--nearly six times its normal load. Despite these spikes in
cash flow, the clearing system has worked extraordinarily well.
Nevertheless, with the rising need for risk management by businesses
and the rising importance of futures markets to the Nation's economy,
the Commission's financial integrity programs must be continually
strengthened. A key component of the Commission's financial integrity
program is the required segregation of all customer funds from those
funds of Futures Commission Merchants (FCM). As shown in Figure 4, the
level of required segregated customer funds has more than doubled since
the end of 2000.

Figure 4.--Segregated Funds Required.

When a manipulation or fraud occurs in the marketplace, it is the
job of the Enforcement Division to gather information, build a case and
prosecute the offenders. In the foreign currency or FOREX markets, the
CFTC has filed 98 cases involving 374 entities or persons with more
than $562 million in civil monetary penalties levied and more than $453
million in restitution awarded. Since the collapse of Enron, CFTC has
brought 39 cases involving energy markets and charged 64 entities or
persons with manipulation, attempted manipulation, and/or false price
reporting. The collective civil monetary penalties levied in these
energy market enforcement actions exceed $444 million.
As our financial markets become more complex, global, and
interwoven, the Commission is increasingly called upon to co-ordinate
and co-operate with other agencies domestically and world wide.
Internationally, these activities involve the Commission's
participation in multilateral bodies, such as the International
Organization of Securities Commissions (IOSCO), as we strive to raise
global regulatory standards. This is complemented with specific
bilateral information sharing arrangements with other nations as we try
to coordinate our enforcement and oversight efforts. Domestically, the
Commission staff works with several Federal and State agencies,
including USDA, FERC, and DOJ, to harmonize our mutual regulatory
efforts. The Commission recently signed an MOU with the SEC to further
co-ordinate our efforts, given the additional convergence of the
futures and equities markets. In addition, our agency has an
information sharing MOU with FERC to enhance cooperation in the
policing of the energy markets.
All of these important responsibilities and priorities require
qualified personnel in their execution. Unfortunately, recent turnover
at the agency has been significant. Throughout the agency and its
divisions, the Commission lost 58 experienced employees in fiscal year
2006, 49 in fiscal year 2007 and 15 to date in fiscal year 2008. The
Commission currently has 447 full-time employees onboard and with the
recent increased funding, we are actively recruiting toward a target of
465 FTEs for fiscal year 2008. Such personnel additions are critical if
this agency is to continue to meet its responsibilities in overseeing
the futures markets.

Technology Investments
The other focus of the fiscal year 2008 budget allocation is
technology. The CFTC primarily uses technology in the surveillance of
the markets and the monitoring of the financial integrity of the
clearing organizations and firms. The Commission's fiscal year 2008
appropriation enables the agency to undertake a long-delayed
modernization of capital investments in Information Technology (IT)
software and hardware, such as computers, servers, routers, switches
and other critical communications components. The modernization of our
surveillance systems will pay off with enhanced transparency and
detection tools for the oversight of our markets.
The CFTC receives and analyzes millions of data points everyday
that come in from the exchanges and firms, which allow us to monitor
the marketplace. Once aggregate position levels are determined, CFTC
staff not only monitors daily positions of all large traders, but also
has the ability to analyze the minute-by-minute trades of these market
participants, including hedge funds and other speculators, during times
when there is a heightened risk of manipulation. To do this job, the
CFTC's market surveillance staff uses its ISS system to organize and
group the information into meaningful categories.
With the exponential growth of these global electronic markets, the
CFTC must continue to devote significant portions of its budget to
technology in order to stay on top of this sector. This year the agency
will increase its technology budget by almost 37 percent with the hope
of almost doubling the overall technology budget by fiscal year 2009.
These resources will be primarily used to enhance the agency's
surveillance tools--making these programs faster, more functional and
better able to detect wrongful activities across markets and
jurisdictional borders.
Clearly, technology and personnel investments are keys to the
agency's success and the fiscal year 2009 budget builds on the
foundation that has been enhanced this year. I am grateful for the
administration's and appropriators' recognition of the need for
increased funding for our agency in these two key areas.

FISCAL YEAR 2009 BUDGET

The fiscal year 2009 President's budget request, as seen in Figure
5, is for an appropriation of $130 million and 475 full-time staff, an
increase of approximately $18.7 million and 10 staff over the fiscal
year 2008 appropriation.

Figure 5.--Fiscal Year 2009 Budget Request Provides for an Increase of
$18.7 Million and Additional 10 FTEs.

Compared to the fiscal year 2008 appropriation, key changes in the
fiscal year 2009 budget are:
--$3.2 million to provide for increased compensation and benefit
costs for a staff of 465 full-time employees;
--$1.9 million to provide for salary and expenses of 10 additional
full-time employees. This portion of the budget also includes
$200,000 to establish a student loan program that is designed
to help with retention and recruitment of young, qualified
professionals. The agency has not had the resources in previous
years to be able to support this program and we're pleased to
have this program planned for in our budget.
--$13.6 million to provide for increased operating costs for
information technology modernization, lease of office space,
and all other services.
This funding increase provides the Commission with the financial
wherewithal to build on the fiscal year 2008 investments by continuing
to hire additional staff and make critical investments in technology.
Additional Staff Hires
For fiscal year 2009 the Commission is requesting ten additional
positions. This increase--although modest compared to industry growth--
will allow us to build on the hiring we are undertaking as a result of
the fiscal year 2008 appropriation. The ten positions requested for
fiscal year 2009 are spread throughout the Commission because our needs
cut across all of our responsibilities. For example, in the Division of
Market Oversight, we will allocate an additional surveillance economist
to focus principally on the complex issues and changing practices in
the energy cash and derivatives market. In the Division of Clearing and
Intermediary Oversight, we will allocate two additional staff to
enhance the expanding financial and risk surveillance functions. In the
Enforcement program, two additional staff will focus mainly on
allegations of manipulation, trade practice violations, and false
reporting, but the additional staff will also enhance our ability to
address a wide range of violations of Federal commodities law. One
additional staff is planned for the Office of the Chief Economist to
conduct market research and analysis commensurate with the growth in
new types of exchanges, new trading execution methods, and the role of
speculators in our markets. For the Office of Proceedings, we are
requesting one addition position to fill the long vacant directorship.
For the Office of General Counsel, we are seeking one additional
position to replace a loss in expertise among senior staff in areas
such as bankruptcy and anti-trust law. Finally, in the Office of
Information Technology, we are requesting two additional positions to
enhance in-house expertise to assist the major program Divisions in
monitoring, auditing, and investigating increasingly sophisticated
technologically driven markets.

Technology Investments
In fiscal year 2009, additional funding would permit the Commission
to upgrade telecommunications systems and to expand and improve
existing critical systems, such as the Integrated Surveillance System
and eLaw. Also in fiscal year 2009, funds requested would permit
continued development of the new Trade Surveillance System (TSS), which
will be used for trade practice surveillance on all exchanges,
including new and emerging electronic exchanges. TSS will use state-of-
the-art, commercially available software to enhance both intra-exchange
and inter-exchange trade practice surveillance. We can now obtain and
analyze the trading activity of our large traders in a mere fraction of
the time it used to take--minutes instead of days. Soon, with these
investments, we will have the capability to monitor and analyze even
more quickly and efficiently a trader's intraday trading activity.
The Commission's ability to fulfill its mission depends on the
collection, analysis, communication and presentation of information in
forms useful to Commission employees, the regulated industry, other
Federal, State, and international agencies, the Congress, and the
American public. The resources allocated in fiscal year 2008 and fiscal
year 2009 to Information Technology will permit a secure modern
information technology infrastructure and the development of a Document
Management System to modernize, centralize and automate the management
of the Commission's information resources. These comprehensive
enhancements will enable the Commission to serve these stakeholders
effectively.
The fiscal year 2009 budget, if approved, will largely enable
completion of the CFTC's technology modernization initiative--barring
unforeseen industry developments or new statutory requirements. The
Commission is making a concerted effort to use commercial best
practices in developing and maintaining its IT systems and ensuring
that our IT staff is focused on increasing efficiency and controlling
costs.
All of the technology improvements have one commonality; they help
increase the availability of one of our most critical resources--time.
That is, technology allows our growing staff to become more productive
by spending additional time on qualitative analysis rather than
quantitative processing and compilation.

CONCLUSION

I am very proud of the agency and our highly-skilled staff.
Everyday, they carry out the agency's mission of protecting the public
and market users from manipulation, fraud, and abusive practices and
promoting open, competitive and financially sound markets. If the
futures markets fail to work properly, all Americans are impacted.
When looking at the increased volume of activity across all areas
of the CFTC mission and the scope of the industry changes, the
resulting increase in specialized workload is demonstrable.
Accordingly, it is critical that the CFTC have sufficient resources to
hire and maintain skilled talent, as well as provide a steady stream of
technology investment commensurate with the agency's expanding and
evolving global mission.
Thank you for the opportunity to appear before you today on behalf
of the CFTC. I would be happy to answer any questions you may have.

ADEQUATE STAFFING TO MEET VOLUME INCREASES

Senator Durbin. Chairman Lukken, your graphs tell the story
about a dramatic increase in trading that you are responsible
to oversee. As I understand it, if you're able to replace
employees that have left, the President's new budget request
will give you an additional 10 employees over the 465 that
you're targeting. I can't imagine that gets close to matching
the volume increase that this agency faces in terms of the
markets that you supervise. Does it?
Mr. Lukken. Well, our fighting weight as an agency
historically has been in the mid-500s, and we're trying to
build up over a series, a period of years, to get to those
levels, and we're hopeful to reach that. I think the 10 that
we've requested in 2009 is the minimum we need to ensure our
responsibilities at the agency. The technology is very
important in ensuring that we're productive in those 10
individuals.
So we're looking over a long-term horizon to make sure that
we get to where we need to be, but we think 10 is a good start
in that venture.

SPECULATION IMPACT ON ENERGY FUTURES

Senator Durbin. So let me try to be more specific in the
next question about another issue. As I understand your
testimony and your agency's responsibility, you look for
illegal conduct, market manipulation, evidence of corruption,
and obviously do your best to keep transparency and
credibility, integrity in the marketplace, and that is an
important part of your role.
But you've also initiated several discussions that relate
to the overall market and the role it has in our economy as it
relates to specific commodities. Now being more specific, when
it comes to energy contracts, that's one that's in the news.
And there are a lot of people, including some of my colleagues
that I respect very much, who think that the speculation and
trading in energy futures has driven up the price of oil, for
example. One of my colleagues today said he thought that of the
$120 a barrel, maybe $30 of it or more was attributable just to
speculators driving up the price of the commodity.
There's also a question about margin requirements when it
comes to these energy futures.
Let me throw in the third element, of course: global
competition. In London, ICE is selling many of these same
contracts or contracts similar to them.
That's as soft a pitch as I could throw you on this, but
I'd like your feedback on the speculation on this issue.
Mr. Lukken. Well, certainly we closely follow the market
participants and track what speculators may be doing in our
markets. As I mentioned, we receive every day the trade
positions of all traders in our markets above a certain
threshold. That ensures that we can see what sort of
controlling positions they may have as traders on a given
market.
Our economists also closely follow fundamentals of those
markets to ensure that those types of traders aren't using
their positions in order to manipulate or cause some sort of
illegal behavior in our markets. So we closely follow that.
Like I said, every day we're looking at who the large traders
might be and whether they're either themselves or colluding
with others to try to manipulate the markets.
Senator Durbin. Do you think that that's happening now? Do
you think that the observation that $20 or $30 on a barrel of
oil can be attributed to speculation is a valid observation?
Mr. Lukken. Well, I think as far as illegal behavior, where
an individual or a set of individuals are trying to manipulate
the market, I can say with a high degree of confidence that we
are not seeing that. With regard to speculation, we also have
controls in place for speculators. Each month as the contract
is about to expire, they have to get down to certain positions
in agricultural markets and other, energy contracts so that
there's a less chance that they may be able to manipulate the
markets, and those controls are currently in place.
So between seeing the transparency of the reporting that we
receive, plus the controls, the position limits we have in
place, we have a high degree of confidence that people are not
manipulating the markets.

MARGIN REQUIREMENTS

Senator Durbin. And what are the margin requirements on
these energy contracts?
Mr. Lukken. The margin requirements--as you know, in the
futures industry, margin is set based on a risk modeling that
the exchanges perform, and this is meant to cover a 1-day price
move, so that the losers can pay the winners every day, and the
markets mark to market at least twice a day. This wrings the
risk, credit default risk, out of the marketplace, so that
losses can't accumulate over a period of days. So every day
everybody starts afresh.
So this has worked very well to----
Senator Durbin. Is there a margin requirement?
Mr. Lukken. For?
Senator Durbin. Energy futures.
Mr. Lukken. Yes, there is. There is to cover a potential 1-
day price move. Again, this is based on statistical, historical
and statistical evidence of what that might be.
Senator Durbin. How does that compare with other
commodities, the actual margin requirement?
Mr. Lukken. It's based on volatility. I'll have to ask our
staff whether we can get you figures on percentages. But oil, I
think, is sort of middle of the pack as far as volatility
compared to some of the other commodities. But we can give you
specific numbers.
Senator Durbin. The last question--I'm sorry to go over a
minute, but I didn't get my entire opening statement, so I can
have an extra minute here. So if we passed a law calling on you
to substantially increase the margin requirements on energy
futures, particularly as they relate to crude oil, what impact
would that have in your estimation on migration to another
marketplace, like ICE in London, as an alternative market to
pursue the same type of future?
Mr. Lukken. I think there would be migration off exchanges.
It would be a tax on a type of trader. These traders--I know
that there's a lot of people who have disparaging remarks about
speculators, but they do provide liquidity for a lot of these
markets and have for years, and that's necessary to make sure
that the commercial participants in the markets, the producers,
the farmers, and everybody, has a buyer for every seller and a
seller for every buyer.
Senator Durbin. What percentage of those who trade, for
example, in these energy commodities actually take possession?
Mr. Lukken. Very few. Very few actually ever deliver. The
vast majority of the contracts never deliver the physical
commodity. The futures markets are not a marketing tool for
product. It is a risk management tool and people utilize it as
a risk management tool. There has to be delivery as part of the
mechanism to ensure that the cash price and the futures price
eventually converge, but the truth is that most people get out
of these contracts way before delivery ever occurs.
Senator Durbin. Senator Brownback.
Senator Brownback. Thank you, Mr. Chairman.

MONITORING MARKET FUNDAMENTALS

Years ago when I was a farm broadcaster, I thought I was
really smart on these markets, so I speculated a little bit,
lost my shirt. My dad would not listen to anything I ever said
again from that point. He farms and he said: All right, we're
just going to keep it in the bin now; I'm not listening to you
any more.
So I know those things move on you. I was long in the wheat
futures when the Soviets invaded Afghanistan, if anybody
remembers that period, and we lock-limited down the markets for
3 days. I'll never forget it. It was quite an experience for a
young man.
You mentioned, though, earlier, Chairman, that your
economists track the fundamentals and what the market should
be. What should the price of oil be now, according to what your
economists are saying?
Mr. Lukken. Well, we make sure that the markets are
reflecting as best they can and they are functioning
efficiently and performing. We can't predict what prices may
be. That's the function of a free market.
Senator Brownback. Do you do a range? Do you do a range and
say, on these fundamentals, this supply, this demand, there is
a range that this price should in normal circumstances trade
in? Do you do any historical view of that?
Mr. Lukken. We do not.
Senator Brownback. There's been a number of articles out
lately thinking that these markets are being driven heavily.
Mr. Lukken. We do closely follow what the Department of
Energy and the U.S. Department of Agriculture, the numbers that
they're putting out, looking at a holistic approach to make
sure the fundamentals are supporting the general prices that
are being put out by the markets. And if we see----
Senator Brownback. Well then, answer that question: Do the
fundamentals support the general prices being put out by this
oil market?
Mr. Lukken. I think, based on supply and demand that we're
seeing--and a lot of people in the markets agree--that yes, the
fundamentals do support largely what the prices are at today.
Senator Brownback. So you disagree with what the chairman
said, that there's as much as $30 in these markets that's based
on speculation?
Mr. Lukken. Well, I have not seen that study, so we'd have
to look at that. But we have not seen that speculators again
are driving--are a major factor in setting these prices.
Senator Brownback. You're familiar, and I'll enter into the
record, there's a Barron's article that cites that they believe
that they are.
[The information follows:]

[From Barron's, Monday, March 31, 2008]

Commodities: Who's Behind the Boom?
(By Gene Epstein)

China, as everyone knows, is a big force in the extraordinary boom
in commodities. Its voracious appetite for everything from corn and
wheat to copper and oil has helped push up U.S. commodities prices by
some 50 percent over the past 12 months.
But China is by no means the whole story. Speculators--including
small investors--are also playing a huge role. Thanks to the
proliferation of mutual funds and exchange-traded funds tied to
commodities indexes, speculative buying has gone way beyond anything
the domestic commodities markets have ever seen. By one estimate, index
funds right now account for 40 percent of all bullish bets on
commodities. The speculative juices are even more plentiful--nearly 60
percent of bullish positions--if you count the bets placed by
traditional commodity ``pools.''
Here's the problem: The speculators' bullishness may be way
overdone, in the process lifting prices far above fair value. If the
speculators were to follow the commercial players--the farmers, the
food processors, the energy producers and others who trade daily in the
physical commodities--they'd be heading for the exits. For right now,
the commercial players are betting on price declines more heavily than
ever before, says independent analyst Steve Briese.
For example, in the 17 commodities that make up the Continuous
Commodity Index, net short positions by the commercials have been
running more than 30 percent higher than their previous net-short
record, in March 2004.
Briese, author of the recent book The Commitments of Traders Bible
and editor of the Website CommitmentsOfTraders.org, was one of the
first to recognize that information on the bets made by the commercials
could provide rare insights into how the ``smart money'' views the
price outlook. These days, the data suggest, the smart money clearly
believes that the market's exuberance has turned irrational.
Indeed, the great commodities bubble started springing its first
leaks two weeks ago: Oil, gold and other major commodities posted their
steepest weekly drop in half a century. Though prices have since
firmed, they could eventually drop 30 percent as speculators retreat.
The only real question is when.
It's not easy to size up the influence of the index funds. But
based on their known cash commitments in certain commodities, and the
commodity indexes their prospectuses say they track, it is possible to
estimate the size of their commitments in all commodities they buy.
Using this method, analyst Briese (pronounced ``breezy'') estimates
that the index funds hold about $211 billion worth of bets on the buy
side in U.S. markets.
Applying a similar method, but with slightly different assumptions
for indexes tracked, Bianco Research analyst Greg Blaha puts that
figure at $194 billion. Either figure is enough to turn the index funds
into the behemoths of the commodity pits, where total bullish positions
now stand at $568 billion.
Commodities index funds, which arrived on the scene in the late
1990s, have come into their own in the past several years. The biggest
index fund, Pimco Real Return (ticker: PRTNX), has seen its assets
swell to $14.3 billion from $8 million since its inception in January
1997.
Index funds offer investors an easy, inexpensive way to gain
exposure to a segment of the commodities markets or a broad-based
basket of commodities. Result: The funds have drawn many private
investors who have never ventured into futures, along with pension
funds and other institutional players looking to diversify. But for all
the virtues that the funds hold as a way of spreading bets across
commodity markets, they take only long, or bullish, positions, avoiding
short-selling. In other words, they trade on the naive and potentially
fatal assumption that commodities have the same tendency as stocks to
rise over the long run.
That this large, bullishly oriented group of funds is flourishing
is partly a result of a regulatory anomaly. In recognition of the fact
that the commodity markets are too small to absorb an excess of
speculative dollars, the Commodity Futures Trading Commission, in
conjunction with exchanges, imposes position limits on speculators. But
the agency has effectively exempted the index funds from position
limits.
The dislocations caused by allowing so much money into markets that
have limited liquidity is now causing alarm in the trading pits. That,
in turn, is prompting the CFTC to call for an industry gathering April
22 at its Washington headquarters ``to hear firsthand from participants
to ensure that the exchanges are functioning properly.'' On this and
related issues, CFTC Acting Chairman Walter Lukken declined to comment
to Barron's.

Unless regulators clamp down, the index funds could become an even
bigger force in the markets. In the midst of the recent sell-off,
commodity bull Jim Rogers made that very point in an interview with
Bloomberg News. Referring to the ``over 70,000 mutual funds in the
world'' compared with the ``fewer than 50'' that now invest in
commodities, he held out the prospect of a speculative bubble that
could last for years.
In Rogers' view, the bull market is in the ``fourth inning'' of a
``nine-inning baseball game.'' To which commodity bear Steve Briese
counter-quips, ``Maybe, but can't the game be called for a year or two,
on account of rain?''
In the organized commodity markets, trading is in futures and
options, which are essentially two-way bets on the outlook for prices.
For every buyer (a ``long'') of a future or options contract betting on
a price rise, there is a seller (a ``short''), taking the other side of
the contract by betting on a price decline. Since speculators and
commercials as a group can be either short or long, the charts (see the
last page) track the net position--longs minus shorts--held by either
group. Courtesy of Briese, the charts track net long or short positions
in dollars, based on the dollar value of the commodity each futures or
options contract covers.
The speculators, now so bullish, are mainly the index funds. To see
how their influence on the market has become outsized, just look at how
they operate. Nearly $9 out of every $10 of index-fund money is not
traded directly on the commodity exchanges, but instead goes through
dealers that belong to the International Swaps and Derivatives
Association (ISDA). These swaps dealers lay off their speculative risk
on the organized commodity markets, while effectively serving as market
makers for the index funds. By using the ISDA as a conduit, the index
funds get an exemption from position limits that are normally imposed
on any other speculator, including the $1 in every $10 of index-fund
money that does not go through the swaps dealers.
The purpose of position limits on speculators, which date back to
1936, is clearly stated in the rules: It's to protect these relatively
small markets from price distortions. An exemption is offered only to
``bona fide hedgers'' (not to be confused with ``hedge funds''), who
take offsetting positions in the physical commodity.
The basic argument put forward by the CFTC for exempting swaps
dealers is that they, too, are offsetting other positions--those taken
with the index funds.
Position limits on speculators, in some commodities specified by
CFTC rules and in others by the exchanges, are generally quite liberal.
For example, the position limit on wheat traded on the Chicago Board of
Trade is set at 6,500 contracts. At an approximate value of $60,000
worth of wheat per contract, a speculator could command as much as $390
million of wheat and still not exceed the limit.
But at least one index fund that does trade the organized commodity
markets directly and must therefore abide by the rules--PowerShares DB
Multi-Sector Commodity Trust (DBA)--recently informed investors that it
was bumping up against position limits and therefore would change its
strategy.
No such information is available from individual swaps dealers. But
based on CFTC data on their total position in a commodity like wheat,
together with the fact that only four dealers account for 70 percent of
all the trading from the ISDA, it is quite clear that if the exemption
were ever rescinded, the dealers' trading in these markets would no
longer be viable.
Speculators also use the older commodity pools, whose position is
likewise tracked on the charts. The pools, open to sophisticated
investors, are flexible enough to sell short as well as buy long and
are subject to position limits. But since they are generally trend-
followers, they will almost always go long in bull markets. Through
most of the recent period, then, the pools have been adding to the
price distortions caused by the index funds. Add the pools' bets to
those of the index funds, and speculative money forms 58 percent of all
bullish positions.
To get a further idea of the impact of these speculative bets,
Barron's asked Briese to measure them against production in the
underlying markets. He calculates that in soybeans, the index funds
have effectively bought 36.6 percent of the domestic 2007 crop, and
that if you add the commodity pools, the figure climbs to 59.1 percent.
In wheat, the figures are even higher--62.3 percent for the index funds
alone, and the figure jumps to a whopping 83.6 percent if you add the
pools. Betting against them as never before are the commercials, who
deal in the physical commodity.
The CFTC provides these figures on index trading for only 10
commodities. Why are such major commodities as crude oil, gold, and
copper excluded? The agency's rationale, which even certain insiders
question, is that it would be hard to get reliable information on these
other commodities from the swaps dealers.
What might finally trigger the bursting of the commodities bubble?
One possible trigger was cited in a Barron's interview with Carl
Weinberg of High Frequency Economics, published last week. Weinberg
anticipated a break ``some time this year'' in industrial commodities,
including crude oil, copper and natural gas once there is news of
``even the slightest slowdown in the Chinese economy,'' the country
whose insatiable demand, together with that of India, has been a
rallying cry of the bullish speculators. When industrial commodities
prove vulnerable, speculative money could start fleeing agricultural
commodities, also.
Societe Generale analyst Albert Edwards goes much further. Based on
his view that the ``Commodity bubble is nonsense on stilts,'' Edwards
holds the ``very strong conviction that before the end of this year,
commodity prices . . . will be unraveling.'' He believes the triggering
events will be the ``unfolding U.S. consumer recession'' and likelihood
of ``negative CPI [consumer price index] inflation rates.''
A sudden turnaround in the dollar could be another trigger, notes
Briese. By making dollar-denominated commodities ever cheaper in terms
of other currencies, the collapsing dollar has been a legitimate
bullish factor. ``But the buck won't go down forever,'' Briese argues.
``The same cycles that coincided with the dollar's major bottom in 1992
are due to make a low later this year. A rebounding dollar would pinch
demand for dollar-denominated commodities.''
Alternatively, to borrow a quip from the late humorist Art
Buchwald--who once explained that his candidate lost the election owing
to ``not enough votes''--the bubble could burst from not enough buying.
Brokerage houses have been advising their clients to allocate part of
their portfolios to commodities, compared with allocations of zero
several years ago. Even a shift of five percentage points would have
been more than enough to account for the dollars that have fueled the
``nonsense on stilts.''
But what if the U.S. economy proves more resilient than currently
thought, doesn't fall into recession, and instead starts growing again?
The resulting rally in the stock market could send the allocation share
back to zero and the bubble could burst, not with a bang, but with a
whimper.
The CFTC could also prick the bubble by enforcing its own rules. If
the agency were to rescind the exemption on position limits given to
the index funds (say, on a phased basis, so that the funds could make
an orderly retreat), prices would probably fall back to reflect their
true supply-demand fundamentals.
Briese's analysis of commercial hedger positions leads him to
believe that commodities in general were fully valued in terms of the
fundamentals as of early September 2007. Based on the 24-commodity S&P
Goldman Sachs Commodity Index, that would mean about a 30 percent
collapse from present levels. But, he adds, ``Given the tendency for
prices to overshoot, commodity values could be cut in half before they
stabilize.''
Maybe it's time to start listening to the smart money.

LIMITATIONS ON OPEN POSITIONS

Senator Brownback. I would ask you as well: You have
limitations on what one individual can control as far as the
number of open positions in a commodity; is that correct?
Mr. Lukken. That is correct.
Senator Brownback. Does that same limitation apply to a
hedge fund?
Mr. Lukken. It does.
Senator Brownback. To an index fund? To a hedge fund?
Mr. Lukken. Well, a hedge fund is in our terms somebody who
is a speculative trader. An index fund is somebody like Goldman
Sachs or AIG, which is a fund that brings in passive long-only
investments into our markets. We typically call speculators
those that are buying and selling over a short-term horizon.
These are long-term investments in which pension funds such as
CALPERS or retirement funds and endowment funds come into our
markets in a buy and hold type strategy.
Senator Brownback. And there is no limitation on the amount
of open positions they can maintain?
Mr. Lukken. They receive an exemption from us for those
position limits.
Senator Brownback. Now, in one article that I read--only
long position?
Mr. Lukken. Only long.
Senator Brownback. But in one of the articles I read, that
they were holding as much as 40 percent of some of the near-
term long positions in these index funds.
Mr. Lukken. Well, they normally never get into the spot
month. They roll before the spot month occurs. So they again
are seeking long-term exposure.
But in our analysis--and this is something that was
discussed quite a bit at the agricultural forum we held 2 weeks
ago--we've seen evidence where the largest percentage of index
fund trading is in live cattle right now, about 45 percent of
the market, and yet live cattle is down 6 percent, 8 percent on
the year. So we have not seen high levels of correlation. In
fact, Minneapolis wheat contract has no index fund trading----

INDEX FUNDS IN OIL MARKETS

Senator Brownback. What about oil?
Mr. Lukken. Unfortunately, because of the way that index
funds enter into the oil markets, we're not able to pull out
that data separately. But it's something we're looking into
trying to drill down to find out how the index funds enter into
those markets.
Senator Brownback. It sure seems like that's one you really
ought to be, as you say, no pun intended, drilling down into.
Mr. Lukken. Well, it's something we want to look into
further, how we can do it. It's a resource question because
many of these index funds do a variety of types of trading.
They don't separate the two, and so for us to try to find out
that type of data, it would be very resource-intensive. But
it's something we're interested in finding out.
Senator Brownback. Why wouldn't you want to limit the
number of open positions, open long positions, that an index
fund could maintain? I mean, it seems to me, and maybe I'm
looking at this too simply, but that people are parking money
in these areas, which is fine, but you're taking a bunch of
product off the market then and you're letting one entity
control it, which you would not let an individual do. But an
individual runs this fund and so you've got an individual
sitting on top of a big hedge fund that's controlling a lot of
positions.
Mr. Lukken. Yes.
Senator Brownback. I think back to when somebody was trying
to capture the silver market two or three decades ago. It seems
like you could get very much in the same spot, just only now
the name's an index fund rather than an individual, but it's
still a person that controls it.
Mr. Lukken. Our markets are risk management markets.
Financial institutions who are selling these products to
pension funds and others have a risk. They have risks that
they're trying to offlay in the futures markets. They are
exposed to a long or short position when they do sell these
products. Our markets try to help them to offset that risk.
That's why I think there's been some discussion of whether
we should call them a hedger, such that a producer or a grain
elevator is a hedger. But they are hedging some type of
financial risk, and it's been the position of the Commission
for 20-plus years to allow them to have that type of an
exemption.
But I think this is something that came out in this ag
forum and something that we're closely looking at to make sure
that we're categorizing them correctly.
I would point out that, even though they are not subject to
these position limits, we still see all the positions. We see
who they are. The transparency is complete for us. So we're
able, if we think they have a position that's going to
manipulate the markets, we as regulators can see that. They
just don't have hard limits as they do maybe with the position
limits. But we certainly can see and exercise judgment on
whether they're trying to control the marketplace.
Senator Brownback. It seems to me that you could see where
this could happen, where they could drive the market up just by
having a big quantity of open positions on long positions. I
mean, it just seems, on its face, something that really we
ought to be deeply concerned about. I hope you do look at the
amount of positions you let them hold, long positions in those
months.
Mr. Chairman, thank you for being generous with my time.
Senator Durbin. Senator Allard.
Senator Allard. Thank you, Mr. Chairman. I do have a
statement I'd like to put in the record, with unanimous consent
to do that.
Senator Durbin. Without objection.
[The statement follows:]

Prepared Statement of Senator Wayne Allard

I would like to thank Chairman Durbin and Ranking Member Brownback
for holding this hearing to examine the fiscal year 2009 budget
requests of the Commodities Futures Trading Commission (CFTC) and the
Securities and Exchange Commission (SEC). I appreciate the opportunity
to more closely examine the regulation of our securities and futures
markets.
American capital markets are predicated on openness and fairness,
and that fairness is only assured though careful, prudent, consistent
regulation. The SEC and CFTC are at the heart of the effort to protect
market participants and investors and to ensure market integrity.
The financial markets have seen a great deal of growth and
evolution during recent years. Regulation is becoming all the more
challenging as the agencies must not only adapt to changing times, but
try to anticipate future trends. The SEC and CFTC budget requests for
fiscal year 2009 are an important part of helping the agencies meet
those challenges.
I place a strong emphasis on outcomes, particularly in the area of
budgeting. Budgets are not, or at least should not, be simply a sign of
how much we like a particular program. Rather, it should be tied to
need and the results that are being achieved with past funding.
I am concerned that neither budget before us today strikes the
right balance. The CFTC is requesting a very large funding increase,
yet according to the PART assessment is demonstrating no results. By
contrast, the SEC, at least in some of its programs, has been shown to
be effective. We have also heard repeated testimony in the authorizing
committee about the need for a stronger SEC presence, yet, this budget
actually proposes reduced staffing levels.
I will be eager to hear from the chairmen to see how they square
their budget requests with the facts on the table.
Thank you, Mr. Chairman.

Senator Allard. Just for the record of this subcommittee, I
think if we were ever to look at a place where there is some
market control it would be the OPEC countries. Obviously, we're
not going to be able to control them, but you know, they
produce oil, I'm told, in Iran for $15 to $17 a barrel. In
Saudi Arabia they produce it out of the ground for $1 to $3 a
barrel. We're paying $115 a barrel.
I think that has more to do with the OPEC cartel and what
they're doing, their markup. I think that's where the real
problem is. So I just wanted to make that point for the record.

PROGRAM ASSESSMENT RATING

One thing that you're doing that does concern me in a big
way, and that is that I don't see you having a satisfactory
score on the PART program. If you refer to the PART program,
you understand which program I'm referring to? Well, you need
to know about it. The PART program is where the administration
measures objectives and results.
You are scored as not making any effort--your score on that
is that you haven't done anything to measure results and
outcomes. Many of the agencies have. The SEC, which we'll be
hearing from, has a good PART score. You have ``no results
demonstrated.''
Why is that?
Mr. Lukken. I have to admit, Senator, this is something--I
just got handed a note. This is dealing with the enforcement
program?
Senator Allard. Well, it's ``CFTC.'' That's the way it's
listed, I think, on the PART program. How is it listed?
Mr. Lukken. ``CFTC?''
Senator Allard. It's listed as ``CFTC'' in general, a line
item, ``CFTC.''
Your evaluation comes from the Office of Management and
Budget (OMB). As a policymaker, we look at that to see whether
the taxpayer dollars or the fees that you're collecting are
being put into an efficient and effective program. If we look
at yours, where ``no results demonstrated,'' what is this? I
mean, it's the CFTC; they're supposed to be a good business.
They're not even practicing good business. Most good-managed
businesses use management by objectives. That's what we're
talking about.
I see from ``no results demonstrated,'' which tells me
you're not even bothering to set goals and objectives and
trying to reach those. Those are measurable goals and
objectives.
If you go onto the Internet on expectmore.gov, enforcement
of commodity futures and options, your rating is ``not
performing, results not demonstrated; the program lacks
performance measures that illustrate whether the program meets
its overall objectives. The program demonstrates through the
existing performance measures that it brings substantive cases
in a timely manner. The program is well-designed to meet its
objectives and examine the use''--those are the three
classifications.
You're classified as ``results not demonstrated.'' So a
question I have is, why aren't you doing this?
Mr. Lukken. Well, that's something I'll commit to you to
look further into. I just got handed a note that we rated 80
out of 100. But this is something----
Senator Allard. Well, it's not showing up on
expectmore.gov.
Mr. Lukken. It's my understanding that we did score, and on
the enforcement program I know there was something we were
trying to get a line item in the budget on so we can try to
find measurable outcomes for the enforcement program. It's
something I know we want to look into, but I commit to you
today that this is something we'll try to improve on.
Senator Allard. I've pulled into the second page. It's
commodity futures trading--it's ``Enforcement of commodity
futures and options markets,'' and that's where the ``results
not demonstrated'' is. That's the way it comes up on the
report.
Mr. Lukken. Well, we'll make this a priority.
Senator Allard. You know, I think it's important. You know,
if you can't demonstrate results and effectiveness, maybe you
ought to be combined with the SEC, where they know how to do
that. I served on the Agriculture Committee and I know you
don't want to hear that suggestion. But I've tried to say
something that catches your attention.
Mr. Lukken. I understand.
Senator Allard. I think things need to change there and
it's something that I watch very closely. Whenever you show
up--you've never had an opportunity to show up before me, but
whenever you show up before me you can always expect me to have
looked at your PART score to see what you're doing, because
it's something I think that's quite helpful as policymakers for
us to review.
I served on the Agriculture Committee. I've been pretty
impressed actually with your programs, and I understand why you
have speculators there and how important they are. I understand
that most of your dealings that you have on commodities futures
and trading are, they're hedging. They're buying and selling in
a timely way so that they reduce their risk. And I think you
serve a good and valuable function in that way and you help our
markets a lot.
You want to increase your fees. Have you looked at how a
fee increase might impact your global marketing?
Mr. Lukken. A fee increase has been suggested by OMB to try
to help us with raising money. This is not something, a
position that the Commission has taken, whether it's in support
or not in support of a fee. I think we believe, and different
Commissioners can talk about this, their own personal view,
that this is something that Congress and OMB should have a
discussion about, how to raise the money.
From my point of view, I'm here to describe how we spend
the money, the types of programs we need to ensure illegal
activity is not occurring on the marketplace.
Senator Allard. You're the only regulatory agency that
doesn't collect a fee.
Mr. Lukken. That's my understanding, we're the only agency
that does not have a fee.
Senator Allard. And I think your input is important. I
wouldn't just leave it up to the OMB and Congress, because we
don't understand the world markets. You're out there dealing in
the world markets. You're dealing with other exchanges
throughout the world and you understand, I think, the impact,
how the impact would be on your customers and whether you
continue to do business in a competitive way. So I hope you
don't back away on that.
Thank you, Mr. Chairman.
Senator Durbin. Senator Allard, I'm going to pass down this
performance and accountability report. I had not seen it
before, but the staff shared it with me. And we'll let you take
a look at it. It may address some of your earlier questions,
and see if it does.
Senator Allard. We just pulled this off the Internet before
I came here to the subcommittee meeting. So maybe it's not
updated there.
Senator Durbin. Okay. Thank you.
Senator Allard. It's probably the same as what we've got in
here.

IMPACT OF BIOFUELS MANDATE ON PRICE INCREASES

Senator Durbin. Chairman Lukken, last month you had a
roundtable at CFTC to talk about changes in the marketplace.
I'm glad you did it. In your opening remarks you said: ``During
the last year the price of rice has increased 118 percent,
wheat 95 percent, soybeans 88 percent, corn 66 percent, cotton
and oats by 47 percent. These price levels, combined with
record energy costs, have put a strain on consumers as well as
many producers and commercial participants that utilize the
futures market to manage risk and discover prices.''
Now, the big question we're facing is the impact of the
biofuels mandate on this phenomenon. I wonder if you could tell
me whether or not you considered that element and have an
opinion as to whether this biofuels mandate can be linked to
any of these price increases?
Mr. Lukken. I think the economists that follow those
markets very closely, our agricultural markets, believe ethanol
is a factor that is affecting the price of not only corn, but
other commodities around that may substitute acreage from corn.
So this is something that we closely--I can't comment on the
mandate itself, but certainly when nearly one-third of corn
production is going now for biofuels, that's going to have an
impact on corn, on wheat, on soybeans and others that may be
involved or be interrelated to the price of corn.
Senator Durbin. Have you considered--I'm told that there's
still more American corn exported than converted to ethanol.
Have you considered why that element is still there if in fact
we have a short domestic market in corn?
Mr. Lukken. I'm not sure if that's something we've studied
intensively or not. But it's something we can get back to you
on later.
Senator Durbin. Would you, please.
Mr. Lukken. Yes.
[The information follows:]

CFTC-SEC COORDINATION

Senator Durbin. The last question I have relates to the
next panel and that is the memorandum of understanding (MOU)
that I understand that you and SEC Chairman Cox have worked on.
Could you comment on that and how you are trying to coordinate
the activities of your two agencies?
Mr. Lukken. I think both Chairman Cox and I recognize how
our agencies have to collaborate more as our markets become
more intertwined. So this was the fruits of that labor, to sign
an MOU that allows for information-sharing and for us to
discuss the possibility of allowing novel derivative products
to get to market quickly.
So we've taken it out for a test ride. There's a couple of
Chicago exchanges, in fact, that have submitted products to us
that we are--that are out for comment, on ETF gold products. We
hope that those are finalized in the coming months. But we also
hope to tackle other big issues, such as portfolio margining.
To allow more efficient use of margin between the two
marketplaces I think would be enormously helpful, and allowing
more product choices to consumers.
Senator Durbin. Have you run into any conflicts with the
SEC trying to figure out where a new product coming to market
should be regulated?
Mr. Lukken. Well, certainly we have differing missions.
Theirs is capital formation. They have insider trading
provisions that they have to think about. Ours are risk
management markets. So we come at this from different angles.
Certainly we have to discuss our mandates and make sure that we
can align those mandates properly.
Certainly we have differences of opinion, but we try to
work through them, and understanding that collaboration is the
way forward for both of our agencies.
Senator Durbin. Thank you.
Senator Brownback.
Senator Brownback. Thank you.

LONG CONTRACTS HELD BY INDEX FUNDS

What percentage of open long contracts are held by index
funds? Do you have that number?
Mr. Lukken. I think it's about 30 percent across, 30
percent across the agricultural sector.
Senator Brownback. Do you know about it in other sectors as
well?
Mr. Lukken. Again, we only break this out for agricultural
products at the moment. We're looking into whether we can do
that, given resources, for energy complex.
Senator Brownback. I really want to urge you to do that in
the energy complex. But it's 30 percent of the positions across
agriculture. Does that vary substantially based on what it is
in--corn or wheat or beef?
Mr. Lukken. We do have a graph that we can give to your
staff, but it ranges anywhere from about 45 percent in live
cattle, which again I mentioned actually was in negative
territory this year, down to around 15 percent in other
commodities.
But they typically are somewhere in the range of 25 to 30
percent in the agricultural commodities.
Senator Brownback. And what were they several years ago, if
you'd know? Do you know any of those historic numbers?
Mr. Lukken. I think when we started tracking this they were
about 27 percent, 27 to 28 percent. So they've grown slightly
over the last couple years, but not significantly. We haven't
seen a huge uptick in growth since we started tracking this in
the agricultural area.

ETHANOL IMPACT ON GAS PRICES

Senator Brownback. You've noted that you think the price of
corn is being impacted by ethanol, and certainly the ethanol
consumption of corn would have an impact on corn prices. I
don't know if you've tracked the impact of ethanol on gasoline
prices. Do you track that at all?
Mr. Lukken. I'm not sure this is something--no, I don't
think so.
Senator Brownback. Just for the record, I would put this
out, and I've got a couple of charts and articles, Mr.
Chairman, I would like to put in the record.
Senator Durbin. Without objection.
[The information follows:]

______

[From The Wall Street Journal, Mar. 24, 2008]

As Biofuels Catch on, Next Task is to Deal With Environmental, Economic
Impact
(By Patrick Barta)

The world's economy is acquiring a new energy addiction: biofuels.
Crop-based fuels such as ethanol and biodiesel are quietly becoming
a crucial component of the global energy supply, despite growing
concerns about their impact on the environment and world food prices.
Biofuels production is rising rapidly, while other fuel sources are
failing to keep pace with demand. As a result, biofuels are making up a
larger portion of the world's energy-supply gap than many analysts
expected. That means the debate over biofuels probably will shift from
whether they are good or bad to the more difficult question of how to
make sure their production keeps growing--without wreaking economic and
environmental havoc.
Global production of biofuels is rising annually by the equivalent
of about 300,000 barrels of oil a day. That goes a long way toward
meeting the growing demand for oil, which last year rose by about
900,000 barrels a day.
Without biofuels, which can be refined to produce fuels much like
the ones made from petroleum, oil prices would be even higher. Merrill
Lynch commodity strategist Francisco Blanch says that oil and gasoline
prices would be about 15 percent higher if biofuel producers weren't
increasing their output. That would put oil at more than $115 a barrel,
instead of the current price of around $102. U.S. gasoline prices would
have surged to more than $3.70 a gallon, compared with an average of a
little more than $3.25 today.
Biofuels are playing ``a critical role'' in satisfying world
demand, says Fatih Birol, chief economist of the Paris-based
International Energy Agency. Without them, ``it would be much more
difficult to balance global oil markets,'' he said.
The implications are huge. After an initial burst of enthusiasm in
2005 and 2006, environmentalists and some economists now blame biofuels
for a host of global problems. These include a sharp jump in the price
of corn and other biofuel crops, which has triggered a rise in global
inflation and protests in poor nations.
Many environmentalists now believe biofuels contribute
substantially to greenhouse gases--those responsible for global
warming--instead of reducing them, as was previously believed, in part
because farmers clear forest land to grow biofuel crops. Scientists say
deforestation causes a large, quick release of carbon into the
atmosphere when existing plant life is destroyed.
International agencies, including the Food and Agriculture
Organization of the United Nations, have called on governments to deal
with problems caused by biofuels, and some countries have started to
rethink their support for the fuels. But cutting back on them won't be
easy. Just as developing nations continue to gobble up coal, despite
the high environmental cost, Western consumers seem to want whatever it
takes to ensure enough fuel for their cars.
As global energy consumption grows, ``there will be pressure to
continue relying on these sources regardless'' of their negative
impacts, says Jeff Brown, a Singapore-based economist at consulting
firm FACTS Global Energy Group. ``The only other choice is higher [oil]
prices.''
It's possible newer biofuels will be developed that pose fewer
problems. In India and Africa, farmers are expanding production of
jatropha, an inedible shrub that is grown on marginal land and requires
relatively little water. There also is rising interest in miscanthus, a
perennial grass grown in Britain and elsewhere that can be used to
generate energy without driving up the cost of crops needed for human
consumption.
Still, most farmers prefer to grow biofuel crops they are familiar
with, such as corn. And most ``second-generation'' biofuels are coming
on more slowly than many experts had hoped, meaning it might be several
years, if ever, before they are viable on a large scale.
It is also possible that ``first-generation'' biofuels like palm
oil-derived biodiesel will run into constraints that would make it
difficult to boost their production. The cost of raw materials like
palm oil has shot up over the past year, cutting into profits for
biofuel producers and forcing some to idle refineries or cancel new
ones. It is also unclear whether there is enough land or water left to
keep boosting biofuels' production at their current rate of increase.
But a slowdown in biofuel production would only tighten world
energy markets--and further highlight the world's dependence on the
fuels, especially as producers of traditional crude oil struggle to
crank up their supply.

Earlier this month, Exxon Mobil Corp. said it planned to boost
capital spending by several billion dollars in 2008 to roughly $25
billion, and yet production levels will likely stay about the same this
year. Mr. Blanch at Merrill Lynch says he expects new oil from
producers outside the Organization of Petroleum Exporting Countries to
taper off to as little as 300,000 barrels a day by 2011--about the
equivalent of today's annual increase in biofuels production.
Production from OPEC is tougher to forecast, in part because of the
unpredictable political forces that shape the group's decisions. Last
year, however, the cartel's output, including that of new members
Angola and Ecuador, declined by about 400,000 barrels a day, according
to the IEA. OPEC has lately decided to hold production at its current
levels despite oil prices in excess of $100 a barrel.
All of that can only mean one thing: With so many challenges ahead
for increasing oil supplies, the world will have to get used to relying
on biofuels--or find yet another alternative, at a time when there
aren't many.
______

The Relative Impact of Corn and Energy Prices in the Grocery Aisle
(John M. Urbanchuk, Director, LECG LLC, June 14, 2007)

Retail food prices measured by the Consumer Price Index (CPI) for
food have begun to accelerate and are beginning to approach rates of
increase last seen in mid-2004. Critics of renewable fuels are blaming
the recent increases on high prices for corn caused by increasing
ethanol production. They fail to point out that corn prices are only
one of many factors that determine the CPI for food, and in fact,
directly affect a small share of retail food prices. Increases in
energy prices for example exert a greater impact on food prices than
does the price of corn. A 33 percent increase in crude oil prices--
which translates into a $1.00 per gallon increase in the price of
conventional regular gasoline--results in a 0.6 percent to 0.9 percent
increase in the CPI for food while an equivalent increase in corn
prices ($1.00 per bushel) would cause the CPI for food to increase only
0.3 percent.
The purpose of this study is to examine and compare the impact on
consumer food prices resulting from increases in petroleum and corn
prices.
Background
The ethanol and corn industries are under attack by a wide range of
critics for causing everything from sharply higher food prices for
American consumers to shortages of and high prices for Mexican
tortillas and even potentially higher tequila prices. Expansion of the
ethanol industry to meet clean air standards and reduce dependence on
imported petroleum has boosted demand for corn, the primary feedstock
for U.S. ethanol. This increased demand has caused corn prices to rise
to their highest levels since the drought of 1995. Critics contend that
the recent increase in retail food prices measured by the CPI for food
is the direct result of higher corn prices caused by ethanol demand and
that an even larger increase in food prices is in store for American
consumers.
The actual record on the relationship between ethanol, corn, and
retail food prices is less clear. Over the past 5 years, ethanol
production has more than doubled, increasing from 2.14 billion gallons
in 2002 to 4.86 billion gallons in 2006. Over this same period, the
demand for corn to produce ethanol has grown from 996 million bushels
to 2.2 billion bushels. Over most of this period, cash market corn
prices were relatively stable. From January 2002 through September
2006, corn prices averaged $2.18 per bushel. However, between September
2006 and May 2007, corn prices jumped 61 percent to $3.56 per bushel in
May 2007.
During this same period, the CPI for food averaged a year-over-year
increase of 2.4 percent. In fact, the inflation rate for food declined
from a 5-year peak of 4.1 percent in May 2004 to a 2.5 percent year-
over-year rate in September 2006. However, since September 2006 the CPI
for food has accelerated to a year-over-year rate of 3.7 percent in
April 2007, an increase of 1.2 percent. During this same period, cash
market corn prices increased $1.15 per bushel. While it is tempting to
blame the entire increase in food price inflation over the past 8
months on higher corn prices, most of the increase in food prices was
the result of foods not impacted by corn such as fish, fruits and
vegetables, sugar and sweeteners, and food away from home. Meat,
poultry, eggs, and dairy products--the foods where corn is a major
input and are most affected by rising corn prices--accounted for about
0.2 percent of the 1.2 percent acceleration in food price inflation
between September 2006 and April 2007. Rising energy prices had a more
significant impact on food prices than did corn.
Year-over-year increases in the CPI for all items, CPI for food and
selected components are shown in Table 1.

TABLE 1.--CPI URBAN WORKERS
[Percent change, year-over-year]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Cereals and Meat,
All items All food bakery poultry, Beef and Pork Poultry Eggs Dairy
products fish veal
--------------------------------------------------------------------------------------------------------------------------------------------------------
2002............................... 1.6 1.8 2.2 0.5 0.1 -0.4 1.3 1.3 0.6
2003............................... 2.3 2.2 2.4 4.0 9.0 1.9 1.3 13.8 -0.1
2004............................... 2.7 3.4 1.6 7.4 11.5 5.6 7.5 6.2 7.3
2005............................... 3.4 2.4 1.5 2.4 2.6 2.0 2.0 -13.7 1.2
2006............................... 3.2 2.4 1.8 0.8 0.8 -0.2 -1.8 4.9 -0.5
--------------------------------------------------------------------------------------------------------------------
January 2007....................... 2.1 2.4 2.7 1.7 0.2 1.4 0.2 11.8 -0.1
February 2007...................... 2.4 3.1 4.1 1.7 1.4 0.5 1.0 29.1 0.2
March 2007......................... 2.8 3.3 3.6 2.8 2.3 2.2 2.1 20.8 1.5
April 2007......................... 2.6 3.7 4.5 3.7 4.7 0.7 4.6 18.6 2.5
--------------------------------------------------------------------------------------------------------------------------------------------------------

Annual average and recent monthly average market prices for corn,
soybean meal, Distiller's grains, and regular gasoline are shown in
Table 2. The shift in corn prices that occurred in late 2006 is clearly
evident and has been mirrored by soybean meal and Distiller's grains.
During this same period energy price also accelerated rapidly. For
example, the national average price of conventional regular gasoline
increased 89 cents per gallon (39 percent) between October 2006 and May
2007.

TABLE 2.--MARKET PRICES FOR FEED AND GASOLINE
----------------------------------------------------------------------------------------------------------------
Corn No. 2
Yellow SBM High Regular
Calendar year central Pro decatur DDG L'burg gasoline
Illinois ($/ ($/cwt) ($/cwt) ($/gallon)
bushel)
----------------------------------------------------------------------------------------------------------------
2002........................................................ $2.17 $167.36 $81.55 $1.38
2003........................................................ 2.29 200.00 91.66 1.60
2004........................................................ 2.39 237.01 105.18 1.89
2005........................................................ 1.90 188.08 75.71 2.31
2006........................................................ 2.41 175.85 89.01 2.62
---------------------------------------------------
January 2007................................................ 3.66 190.56 118.00 2.29
February 2007............................................... 3.90 208.81 129.00 2.32
March 2007.................................................. 3.76 205.26 130.88 2.61
April 2007.................................................. 3.36 ........... ........... 2.89
May 2007.................................................... 3.56 ........... ........... 3.19
----------------------------------------------------------------------------------------------------------------

Livestock and poultry producers are beginning to respond to higher
feed costs by slowing the growth in animal numbers and market prices
are reflecting these changes. However, corn prices are only one of
several factors that impact livestock and meat production.
--Heavy cow and calf slaughter and early placement of feeder cattle
in feedlots have combined with poor fall and winter pasture
conditions and higher grain prices to set the stage for slower
growth in cattle numbers through early 2008. This will in turn
slow growth in beef production in 2008 and support higher beef
prices.
--Growth in hog inventories are expected to be constrained by higher
feed costs. However, this will be offset by growth in domestic
demand supported by a stronger consumer economy and increases
in exports as China turns to the U.S. to offset sharply reduced
domestic pork production.
--Higher feed costs will dampen broiler producer's zest to sharply
expand production. However, producers will respond to higher
prices for red meat and growth in real disposable income that
will support demand growth. This will moderate any potential
sharp increases in broiler prices in 2008.
Recent data for beef, pork, and broiler production and market
prices are summarized in Table 3.

TABLE 3.--SELECTED LIVESTOCK, POULTRY PRODUCTION, AND PRICES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Beef and Broiler
Cattle on veal Steer price Pork Barrows and Hog and pig Broiler price 12-
feed production Omaha production gilts inventory production city
(thousands (millions direct ($/ (millions national (thousands (millions average ($/
of head) of pounds) cwt) of pounds) base of head) of pounds) cwt)
--------------------------------------------------------------------------------------------------------------------------------------------------------
2002............................................ 9,910 27,090 $67.04 19,664 $34.91 59,722 32,240 $55.52
2003............................................ 9,124 26,238 84.69 19,945 39.45 59,554 32,749 62.00
2004............................................ 11,253 24,547 84.75 20,511 52.48 60,444 34,063 74.10
2005............................................ 11,299 24,682 87.28 20,685 50.01 60,975 35,365 70.80
2006............................................ 11,726 26,071 85.41 20,999 47.28 61,449 35,752 64.30
-------------------------------------------------------------------------------------------------------
January 2007.................................... 11,974 2,178 86.75 1,898 44.04 62,149 3,015 70.43
February 2007................................... 11,726 1,965 88.68 1,636 48.60 ........... 2,656 75.89
March 2007...................................... 11,599 2,131 96.39 1,861 46.00 ........... 2,903 78.66
April 2007...................................... 11,644 2,027 98.04 1,711 48.43 ........... 2,905 78.63
May 2007........................................ ........... 2,279 95.90 1,759 54.00 ........... 3,259 80.50
--------------------------------------------------------------------------------------------------------------------------------------------------------

Analysis
Retail food prices are not likely to accelerate significantly in
2008 and beyond, even as ethanol production continues to expand. In
fact, consumers will be more severely affected by rising gasoline and
energy prices than by increases in corn prices.
Increasing petroleum prices have about twice the impact on consumer
food prices as equivalent increases in corn prices. A 33 percent
increase in crude oil prices--the equivalent of $1.00 per gallon over
current levels of retail gasoline prices--would increase retail food
prices measured by the CPI for food by 0.6 to 0.9 percent. An
equivalent increase in corn prices--about $1.00 per bushel over current
levels--would increase consumer food prices only 0.3 percent.
The reason for the larger impact on food prices from petroleum and
energy prices stems from the relative importance of energy in food
production, packaging, and distribution compared to that of a single
ingredient. While petroleum and energy prices affect virtually all
aspects of agricultural raw material transportation, processing, and
distribution of all finished consumer food products, corn prices affect
only a segment of consumer foods--livestock, poultry, and dairy. Corn
is an important feed ingredient for livestock and poultry producers and
changes in corn prices can have significant impacts on profitability
and production. However, meat, poultry, fish, eggs, and dairy products
account for only one-fifth of the CPI for food which, in turn, is only
15 percent of the overall CPI.
Crude oil and refined petroleum prices have increased sharply over
the past several years and have put considerable pressure on consumers.
Energy plays a significant role in the production of raw agricultural
commodities, transportation and processing, and distribution of
finished consumer food products. Several studies have looked at the
impact of increased energy prices on food prices.
--Reed, Hanson, Elitzak and Schluter utilized three different model
structures to examine the impact of a doubling of crude oil
prices on the CPI for food.\1\ They conclude that the short run
impact of a doubling (e.g., 100 percent increase) in crude oil
prices would cause a 1.82 percent rise in average food prices
in the short run and 0.27 percent in the long run.
---------------------------------------------------------------------------
\1\ A.J. Reed, Kenneth Hanson, Howard Elitzak, and Gerald Schluter.
``Changing Consumer Food Prices: A User's Guide to ERS Analyses''. USDA
Economic Research Service. Technical Bulletin 1862. June 1997.
---------------------------------------------------------------------------
--A more recent analysis published by Chinkook Lee examined the
impact of energy price increases as an intermediate input for
food processing and concluded that a 10 percent increase in
energy prices results in a 0.2709 percent increase in the
purchase (consumer) price of food and kindred products
prices.\2\
---------------------------------------------------------------------------
\2\ Lee, Chinkook. ``The Impact of Intermediate Input Price Changes
on Food Prices: An Analysis of ``From-the-Ground-Up'' Effects.''
Journal of Agribusiness 20, 1 (Spring 2002).
---------------------------------------------------------------------------
As pointed out, earlier corn prices also have increased
significantly over the past year as the markets have recognized the
impact of increasing ethanol production on corn demand. The price of
No. 2 Yellow corn at Central Illinois averaged $3.56 per bushel in May
2007, nearly 60 percent higher than year ago levels. The USDA and many
private sector forecasters project ethanol production to exceed 15
billion gallons by 2017, utilizing more than 4 billion bushels of corn
and maintaining corn prices well above $3.00 per bushel for most of the
decade.
We evaluated the impact of an increase in petroleum prices on
consumer prices food prices by applying the impact elasticities
summarized above to an assumed 33 percent increase in crude oil (the
equivalent of a $1.00 increase in retail gasoline prices from current
levels). To determine the impact of an increase in corn prices on
livestock, poultry, dairy and consumer food prices we imposed a 33
percent increase in corn prices (about $1.00 per bushel from current
levels) on the current LECG agricultural sector baseline forecast over
the 5-year period 2007 through 2012. This is consistent with the
increase in corn prices that has occurred over the past year.
The analyses by Reed and Lee indicate that a 33 percent increase in
oil/energy prices would increase retail food prices by 0.6 percent and
0.9 percent. Reed indicates that a 100 percent increase in crude oil
prices results in a short-term increase of 1.82 percent in consumer
food prices while Lee reports that a 10 percent increase in energy
prices provides a 0.2709 percent increase in retail food prices.
Restating these on an equivalent 33 percent basis (1.82 percent times
.33 and 0.2709 times 3.3) provides the 0.6 to 0.9 percent range.
As shown in Table 4, the equivalent 33 percent increase in corn
prices over the 5-year period is expected to reduce beef, pork, and
broiler production by 2.6 percent between 2008 and 2012 and increase
prices by 2.4 percent. Combined with higher turkey, egg, and dairy
prices, the CPI for food is projected to increase an additional 0.3
percent. This result is consistent with the 0.2 percent contribution to
food price inflation between September 2006 and April 2007 from meat,
poultry, fish, and dairy and the $1.15 per bushel increase in cash
market corn prices.

TABLE 4.--IMPACT OF A $1.00 CORN PRICE INCREASE ON LIVESTOCK, POULTRY, AND CONSUMER FOOD PRICES
[Average 2008-2012]
----------------------------------------------------------------------------------------------------------------
Percentage
Baseline Scenario change
----------------------------------------------------------------------------------------------------------------
Corn Price, Average Farm ($/bu)................................. $3.10 $4.10 33.0
Beef and Veal Production (millions of pounds)................... 25,778 25,749 -0.1
Pork Production (millions of pounds)............................ 21,057 20,696 -1.7
Broiler Production (millions of pounds)......................... 35,530 33,740 -5.0
Steer Price, Omaha Direct ($/cwt)............................... $98.41 $98.59 0.2
Barrows and Gilts, Market ($/cwt)............................... $49.95 $50.99 2.1
Broilers, 12-City Average (cents/lb)............................ $77.90 $82.09 5.4
CPI, Food (percent)............................................. 2.3 2.6 0.3
CPI, Food at Home (percent)..................................... 1.9 2.2 0.3
CPI, Meats, Poultry, Eggs (percent)............................. 1.4 2.1 0.7
----------------------------------------------------------------------------------------------------------------

Conclusion
The days of cheap corn are more likely than not over. Livestock and
poultry producers who enjoyed low and relatively stable corn (and other
feed) prices over most of the past decade are now faced with the
challenge of adjusting to an environment of higher feed prices. The new
reality is that corn prices are likely to remain nearer to the $3.00
per bushel than the $2.00 per bushel mark for an extended period. The
good news is that prices may be more stable as corn production expands
to meet ethanol requirements and new ethanol feedstocks and
technologies emerge. Livestock and poultry producers also will have an
incentive to increase use of the ethanol coproduct Distiller's grains
in order to control feed costs. This medium protein feed component can
be used in place of corn in a substantial portion of the feed ration.
As ethanol production expands, so will production of Distiller's grains
and thus putting downward pressure on prices.
Corn and energy prices both affect consumer food prices. However,
since increases in corn prices are limited to a relatively small
portion of the overall CPI for food, an increase in corn prices
resulting from higher ethanol demand or a supply disruption such as a
major drought is expected to have about half the impact of the same
percentage increase in petroleum and energy prices.

APPENDIX TABLE 1.--CPI ALL URBAN WORKERS
[Percent change from previous year]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Cereals and
All items All food bakery Beef Pork Poultry Eggs Dairy Fruits and Fats, oils
products products vegetables
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
January 2004.................................................. 1.9 3.5 2.1 20.4 5.4 5.5 30.5 3.6 2.3 3.1
February 2004................................................. 1.7 3.3 1.3 16.1 3.6 4.1 31.2 2.9 2.9 2.3
March 2004.................................................... 1.7 3.2 1.3 12.8 5.5 6.1 33.2 2.9 2.9 5.5
April 2004.................................................... 2.3 3.4 1.8 13.2 4.8 5.9 26.4 4.9 3.2 6.5
May 2004...................................................... 3.1 4.1 1.5 15.9 6.6 9.5 19.0 12.4 2.4 7.5
June 2004..................................................... 3.3 3.7 1.5 16.0 6.3 8.9 10.1 15.2 -0.3 9.5
July 2004..................................................... 3.0 4.0 1.3 15.4 7.0 9.5 6.3 14.0 -0.9 10.0
August 2004................................................... 2.7 3.5 1.3 14.2 7.4 10.5 -1.0 10.4 -0.4 7.6
September 2004................................................ 2.5 3.3 1.4 12.2 6.2 9.8 -9.6 6.6 0.7 8.1
October 2004.................................................. 3.2 3.4 1.9 7.4 5.3 8.3 -12.4 6.0 6.1 6.6
November 2004................................................. 3.5 3.2 2.1 0.6 5.2 6.3 -21.1 5.7 9.1 6.7
December 2004................................................. 3.3 2.7 1.7 -0.9 4.7 5.1 -19.9 4.1 7.9 6.2
---------------------------------------------------------------------------------------------------------------------------------
January 2005.................................................. 3.0 2.9 1.8 1.5 5.5 5.3 -23.0 6.3 4.5 6.0
February 2005................................................. 3.0 2.6 2.0 3.5 6.3 4.5 -21.5 5.6 2.2 4.3
March 2005.................................................... 3.1 2.5 1.8 6.0 4.5 4.0 -27.0 5.5 1.6 0.5
April 2005.................................................... 3.5 3.1 1.8 5.3 7.0 3.4 -25.9 4.7 5.2 1.9
May 2005...................................................... 2.8 2.4 1.7 5.0 2.8 1.2 -18.6 -1.4 5.6 -0.9
June 2005..................................................... 2.5 2.2 1.3 3.3 1.8 1.3 -17.3 -4.1 5.2 -4.0
July 2005..................................................... 3.2 2.1 1.1 0.8 0.1 0.5 -11.9 -3.2 7.0 -2.7
August 2005................................................... 3.6 2.2 1.4 0.8 -0.7 0.1 -12.2 -1.1 5.6 -1.2
September 2005................................................ 4.7 2.5 0.9 0.5 -1.0 1.3 1.4 0.1 6.5 -0.6
October 2005.................................................. 4.3 2.2 1.2 1.4 -0.8 -0.2 -0.6 0.3 2.4 -0.9
November 2005................................................. 3.5 2.2 1.1 1.2 -0.2 2.3 5.3 1.4 -0.8 -1.0
December 2005................................................. 3.4 2.3 1.0 2.2 -0.1 0.3 1.4 1.7 0.6 -1.3
---------------------------------------------------------------------------------------------------------------------------------
January 2006.................................................. 4.0 2.6 1.4 2.8 -1.7 -1.3 8.3 0.2 6.4 -0.3
February 2006................................................. 3.6 2.8 0.9 1.3 -1.7 -0.3 -3.1 0.9 7.9 0.6
March 2006.................................................... 3.4 2.6 1.2 1.2 -1.0 -1.6 5.5 0.9 6.3 0.9
April 2006.................................................... 3.5 1.8 0.9 0.7 -1.9 -2.0 8.7 -0.5 2.7 -2.6
May 2006...................................................... 4.2 1.9 1.0 -1.7 -0.8 -2.0 2.4 -1.3 1.3 0.5
June 2006..................................................... 4.3 2.2 1.6 -1.9 -1.0 -1.4 8.9 -0.8 4.0 1.7
July 2006..................................................... 4.1 2.2 2.5 -0.5 0.2 -2.7 0.5 -0.4 3.7 -0.2
August 2006................................................... 3.8 2.4 2.1 1.4 1.1 -1.7 6.0 -1.6 5.3 -0.1
September 2006................................................ 2.1 2.5 2.5 1.6 1.3 -2.6 -0.8 -1.0 7.2 -0.9
October 2006.................................................. 1.3 2.6 2.5 2.0 1.6 -1.9 1.5 -0.3 6.5 0.3
November 2006................................................. 2.0 2.3 2.6 2.4 0.1 -3.1 6.6 -1.6 4.2 1.1
December 2006................................................. 2.5 2.1 3.1 0.5 0.7 -0.7 14.1 -1.2 1.9 0.9
---------------------------------------------------------------------------------------------------------------------------------
January 2007.................................................. 2.1 2.4 2.7 0.2 1.4 0.2 11.8 -0.1 1.7 0.2
February 2007................................................. 2.4 3.1 4.1 1.4 0.5 1.0 29.1 0.2 6.0 0.8
March 2007.................................................... 2.8 3.3 3.6 2.3 2.2 2.1 20.8 1.5 6.2 1.4
April 2007.................................................... 2.6 3.7 4.5 4.7 0.7 4.6 18.6 2.5 6.2 2.9
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

______

The Impact of Ethanol Production on U.S. and Regional Gasoline Prices
and on the Profitability of the U.S. Oil Refinery Industry

ABSTRACT

Using pooled regional time-series data and panel data estimation,
we quantify the impact of monthly ethanol production on monthly retail
regular gasoline prices. This analysis suggests that the growth in
ethanol production has caused retail gasoline prices to be $0.29 to
$0.40 per gallon lower than would otherwise have been the case. The
analysis shows that the negative impact of ethanol on gasoline prices
varies considerably across regions. The Midwest region has the biggest
impact, at $0.39/gallon, while the Rocky Mountain region had the
smallest impact, at $0.17/gallon. The results also indicate that
ethanol production has significantly reduced the profit margin of the
oil refinery industry. The results are robust with respect to
alternative model specifications.
Keywords: crack spread, crude oil prices, ethanol, gasoline prices.

Introduction
Fuel ethanol production in the United States increased from 1.63
billion gallons in 2000 to 7.22 billion gallons in 2007 (RFA). In
comparison, the United States consumed approximately 146 billion
gallons of petroleum in 2007 (EIA). The purpose of this paper is to
estimate the impact of this increase in ethanol supply on the U.S.
gasoline market.
Ethanol is blended with gasoline to improve octane and performance
in about 50 percent of the Nation's gasoline supply. Typically, a
gallon of ethanol blend will have 10 percent ethanol and 90 percent
gasoline. This gallon of ethanol blend will contain approximately 97
percent of the energy of a gallon of gasoline (Tokgoz et al. 2007) and
will use approximately one-tenth as much fuel energy to produce as it
contains (Wang et al. 2007). Therefore, ethanol has essentially added
to U.S. gasoline supplies by utilizing solar energy to grow the crop,
coupled with energy from natural gas and coal to manufacture the farm
equipment and fertilizer used in crop production.
In order to identify the separate impact of ethanol on gasoline
prices, we need to separate the impact of ethanol from the other forces
driving gasoline prices. We do so by examining the price of gasoline
relative to the price of crude oil. We also estimate the impact of
ethanol on the profits made by refiners. Both estimates are calculated
for the United States as a whole and for each of five regions within
the United States. The motivation for conducting the regional analysis
is that if ethanol is affecting gasoline prices, then we hypothesize
that this impact will be largest in the Midwest where regional ethanol
production and utilization is at its maximum.
The paper proceeds as follows. First, background information
regarding previous work, relative gasoline prices, and the use of the
crack spread as a measure of industry profitability are introduced. We
then describe the five regional ``Petroleum Administration for Defense
Districts'' (PADDs) that are the basis for the analysis. Next, we
present a detailed description of and motivation for the explanatory
variables. We also provide a description of and motivation for the
three estimation methods that are used. The last section summarizes the
results.

Previous Work
Quantitative analysis of the effect of ethanol on gasoline prices
and on the profitability of the refinery industry has been largely
neglected in the literature. Eidman (2005) points out that ethanol
largely acts as a fuel extender. He also shows that there has been a
strong positive correlation between ethanol and gasoline prices.
Employing an international ethanol model consisting of behavioral
equations for production, consumption, and trade, Tokgoz and Elobeid
(2007) analyze the price linkage between ethanol and gasoline markets.
They conclude that ethanol is mainly used as an additive to gasoline
and that the complementary effect of ethanol dominates the substitution
effect on gasoline prices. Szklo, Schaeffer, and Delgado (2007)
conclude that by replacing methyl tertiary butyl ether (MTBE), which is
a traditional additive used as an oxygenate to raise the octane number,
ethanol blending will not reduce gasoline use until flexible fuel
vehicles become widely available. Vedenov et al. (2006) apply a
continuous-time option pricing method to calculate the decision
threshold of switching to ethanol. Their empirical analysis suggests
that blending ethanol into gasoline would generate lower gasoline price
volatility and that switching from conventional gasoline to an ethanol
blend is an economically sound decision.
The ``3:2:1 crack spread'' is used as one of the significant
indicators of refinery profitability. It is a term used in the oil
industry and futures trading as a proxy for the profitability of
refineries. Although there is some qualitative description of its
determinants, formal quantitative analysis is limited in the
literature. Asche, Gjolberg, and Volker (2003) examine the price
relationships among crude oil and refined products. They find that the
crude oil price is weakly exogenous and that the spread is constant
among some of the prices. Girma and Paulson (1998) examine the crack
spread of daily futures prices of crude oil and heating oil. Girma and
Paulson (1999) investigate the long-run relationship among crude oil,
gasoline, and heating oil futures prices and find the prices are co-
integrated. They also find a stationary relation between crude oil and
its end products.
In the literature on mergers in the refinery industry, several
studies rely on analysis of the price margin, which is defined as
wholesale prices of gasoline less crude oil prices. The Government
Accounting Office (GAO 2004) models the price margin as a function of
the crude oil price, inventory ratio, utilization rate, and dummy
variables representing a merger and acquisition event. Geweke (2003)
provides a comprehensive survey on this subject.
The degree of market concentration has been long recognized and
analyzed in the literature seeking to explain price changes and
adjustment in the wholesale gasoline market. Focusing on Gulf Coast,
Los Angeles, and New York whole spot gasoline markets, Oladunjoye
(2007) investigates the effects of market structure on the pattern of
price adjustment and finds that market concentration has a significant
asymmetric effect on gasoline price changes responding to crude price
shocks. The GAO (2004) concludes that mergers and increased market
concentration generally led to higher wholesale gasoline prices in the
United States from the mid-1990s through 2000. Examining wholesale
price responses in 188 gasoline markets in the United States,
Borenstein and Shepard (2002) find that refinery firms with market
power generally choose a different adjustment rate and adjust prices
more slowly than do competitive firms.

Background
The 3:2:1 crack spread is defined as

where PG, PH, and PO are the prices of regular gasoline, no. 2 heating
oil, and crude oil, respectively.
The 3:2:1 crack spread has been institutionalized over the years as
a way to measure the refinery margin. The use of the 3:2:1 crack spread
is justified by the fact that among all finished products converted
from crude oil in the refinery process, gasoline and distillate fuel
oil are the two primary product classes. The relative proportion of
these two products is approximately two barrels of gasoline to one
barrel of distillate fuel. Together, gasoline and distillate fuel
comprise about 80 percent of the refinery yield. The average refinery
yield of finished motor gasoline is about 46 percent and has been
stable over the 1993-2007 sample period (DOE).
The West Texas Intermediate (WTI) crude oil price, which is priced
at Cushing, Oklahoma, is chosen to represent the crude oil price in
this study. The reason is that WTI-Cushing is one of the most widely
traded and price-transparent crude oils in the U.S. crude oil market.
We use the Petroleum Administration for Defense Districts (PADDs)
to define refinery product markets. This market definition was formed
during World War II for the purpose of administering oil allocation.
The PADDs are still used by the Department of Transportation (DOT) and
Energy Information Administration (EIA) for statistical and reporting
purposes. The five regions are East Coast (PADD I), Midwest (PADD II),
Gulf Coast (PADD III), Rocky Mountain (PADD IV), and West Coast (PADD
V). These five geographically distinct regions are also very different
in terms of their economic conditions, oil and petroleum
characteristics, oil-related pipeline infrastructure, and local product
supply and demand conditions.
Because of its high population density, the East Coast PADD I has
the highest demand for refined products in the country, but it has very
limited refinery capacity. Its regional demand is largely satisfied by
the Gulf Coast and by foreign imports. The Midwest PADD II is distinct
in its coexistence of a highly industrialized section and a rural
agricultural section. It also leads the Nation in ethanol production,
mainly because of its leading role in corn production, the primary
feedstock for ethanol production. For example, Iowa had 30 ethanol
plants in operation by the end of 2007 and produces nearly 2.1 billion
gallons of ethanol annually. Much of the crude oil used in the Midwest
is piped in from the Gulf Coast and Canada. One place worth mentioning
in this region is Cushing, Oklahoma, which is the major crude oil
transportation hub for the Midwest.
The Gulf Coast region, including Texas, Louisiana, New Mexico,
Arkansas, Alabama, and Mississippi, produces over 50 percent of the
Nation's crude oil and 47 percent of its final refined products. This
region also serves as a national hub for crude oil and is the center of
the pipeline system. The Rocky Mountain region, or PADD IV, has the
smallest and fastest-growing oil market in the United States, with only
3 percent of national petroleum product consumption. The West Coast
region, PADD V, is the largest oil-producing and consuming region. This
region's oil supply is independent of
other regions since it is geographically separated by the Rocky
Mountains. In addition, the refinery market of this region is highly
concentrated.

Data
The gasoline price relative to that of crude oil is used as a
dependent variable to measure ethanol's possible substitution effect on
the gasoline price, while the 3:2:1 crack spread is employed as a
dependant variable to quantify the effect of ethanol on the refinery
profit margin. Figure 1 presents the relative gasoline to crude oil
price over the 1995-2007 period. Figure 2 is for the 3:2:1 crack spread
deflated by Producer Price Index (PPI) for crude energy material for
five PADD regions over the same sample period. The PPI data are
obtained from the U.S. Bureau of Labor Statistics.

The relative gasoline price is similar to crack spread in the sense
that both are measurements of profitability of the refinery industry.
The difference is that relative gasoline prices only account for the
contribution of gasoline to the profit margin. It is employed in this
study to quantify the substitution effect of ethanol production on
gasoline prices. Relative gasoline prices and the refinery profit
margin are mainly determined by similar explanatory variables. The
explanatory variables included in this study are market demand and
supply conditions, refinery capacity and utilization rate, market
concentration and structure, unexpected supply disruptions, gasoline
imports, seasonality, and ethanol production. Each of these chosen
variables and its relationship with the relative gasoline price and
refinery profitability is discussed in greater detail in this section.
Crude and Product Market Conditions
The gasoline price and refinery profitability are affected by the
supply and demand balances of the crude market and product market. When
the crude oil market has ample stocks, refinery profit should increase
because of lower crude oil prices. Alternatively, when there are large
stocks of gasoline and other refinery products, refinery profits should
fall because of lower product prices. A tight product market will
generate upward pressure on product prices even when there is an ample
supply of crude oil. That is, product prices are bid up by more than
any underlying cost increases. This upward movement relative to crude
oil prices will be seen as an increase in the relative price and crack
spread. We use monthly crude oil inventory and gasoline inventory data
collected by the EIA to represent the conditions in these two markets.
The gasoline stock and crude oil stock data for the East Coast region
from 1995 to 2007 are shown in Figures 3 and 4, respectively.

Refinery Capacity and Capacity Utilization Rate
Refinery capacity is a critical factor influencing the
profitability of the refinery industry. Figure 5 presents the operable
crude oil distillation capacity in the five PADD regions from 1995 to
2007. In this figure, refinery capacity is represented by monthly data
of atmospheric crude oil distillation units (barrels per calendar day).
Total refinery capacity increased by 13 percent over the past 12 years,
with PADD III, the Gulf Coast, having the highest growth of 19 percent.
The lowest increase in capacity occurred in the Midwest, with a 4
percent growth over the same period.

The monthly percent refinery capacity utilization rates for 1995 to
2007 for PADDs II, III, and V are shown in Figure 6. Here, refinery
capacity utilization is based on gross input to atmospheric crude oil
distillation units divided by the refinery operable distillation
capacity. The average rate over five regions is 92 percent, which means
that capacity utilization has increased significantly and refineries
are running at high rates of utilization. Refinery capacity and its
utilization rate are variables that will affect gasoline price and
refinery profits via higher prices for products and possible increases
in marginal costs.

Market Concentration
Mergers and acquisitions among refinery firms may potentially
further reduce the competition in the refinery market, thus possibly
leading to a higher refinery margin. To measure the level of market
concentration, the Herfindahl-Hirschman Index (HHI) is commonly applied
in the literature. The HHI of a market is calculated by summing the
squares of the percentage market shares held by the respective firms as

where Sit is the market share of a specific firm in the corresponding
production market with total firms of Nt at year t. A market with an
HHI less than 1,000 is considered to be a competitive market; 1,000-
1,800 to be a moderately concentrated market, and greater than 1,800 to
be a highly concentrated market.
We constructed an HHI for the five PADD regions over the period
1995 to 2007, and we present this information in Figure 7. The HHI for
the refinery market in PADD I increased from 1,558 to 2,335 from 1995
to 2007 and changed from a moderately concentrated to a highly
concentrated market using Department of Justice definitions. Since much
of this region's refinery product supply is from other regions, the
impact of this increased concentration may be small. The refinery
market in PADD II, the Midwest, suggests that this is a competitive
market, although its HHI increased to 960 in 2007. Similar to the
Midwest region, PADD III, the Gulf Coast, also has a competitive
refinery market as of the end of 2007. The HHI for PADD IV, the Rocky
Mountain region, decreased from 1,025 to 930, which suggests that its
refinery market became less concentrated than before. The HHI for the
PADD V, the West Coast region, increased from 914 to 1,155, and this
refinery market changed its definition to a moderately concentrated
market by 2007.

Unexpected Supply Disruptions
On August 29, 2005, Hurricane Katrina hit the U.S. Gulf Coast at
New Orleans. On September 24, 2005, Hurricane Rita hit at the border
between Texas and Louisiana. Both were category four storms when they
did significant damage to the refineries' facilities and pipeline in
the Gulf Coast region. Refinery operations were reduced by 1.8 million
barrel/day in September and October 2005. Retail gasoline prices jumped
by $0.50 to over $3.00 per gallon on a national average basis after
Hurricane Rita. Prices were distinctly higher than before. In order to
control for the effect of this event on the gasoline and refinery
profit margin, we include dummy variables for September and October in
2005, when the disruptions were most severe.
Gasoline Imports
A significant share of total gasoline demand in the United States
is met by imports. The net import share of total gasoline consumption
in 2007 is 14 percent. Figure 8 presents U.S. finished motor gasoline
imports from all countries over the period 1995 to 2007. Imports
reached their highest level in October 2005, the month after Hurricanes
Katrina and Rita. Major sources of gasoline imports include Canada,
Europe, and the Virgin Islands. A structural surplus in gasoline
production in Europe means that gasoline production costs are lower
when derived from foreign sources than they would be if the United
States built and operated additional refinery capacity domestically.
Growth in imports is expected to be tempered because of the increased
use of domestically produced ethanol. Also, with increases in imported
gasoline, refinery profitability is expected to be negatively affected.

Ethanol Production
Figure 9 presents the monthly ethanol production over the 1995-2007
period. There are 68 ethanol plants under construction or expanding.
Iowa leads the Nation with about 2 billion gallons of ethanol
production capacity. Our hypothesis is that this additional production
has had a negative impact on gasoline prices and on the margins of
crude oil refiners.

Seasonality
The gasoline market is highly seasonal due to stronger demand in
spring and summer. Gasoline price tends to gradually rise before and
after summer. Demand for distillate fuel including heating oil and
diesel fuel typically peaks in winter and thus has a counter-cyclical
price pattern from gasoline. We include a set of monthly dummies to
account for the seasonal pattern.
Estimation Method
The regression model is specified as follows:

where pit it is the price of gasoline divided by the price of crude oil
or the 3:2:1 crack spread of region i at month t, and Xit is the K-
dimensional vector of explanatory variables described earlier.
There are several options for estimating equation (1), including
pooled OLS regression and panel data models. The pooled OLS regression
simply pools together data series for all PADD regions and applies the
ordinary least squares method. The OLS estimates of the standard errors
may be highly inaccurate if the data exhibits heteroskedasticity and/or
cross-sectional and serial correlation. The panel data models increase
precision of estimates and allow us to control for an unobservable
individual region's heterogeneity and temporal effects without
aggregation bias.
The Hausman test for misspecification (Greene 2003, p. 301) is
employed to help us select from two principal types of panel data
models: the fixed effect model and the random effect model. Under the
null hypothesis, the random effects estimator is consistent and
efficient, while under the alternative, it is inconsistent. The random
effect model is chosen if we fail to reject the null hypothesis. In the
case of relative gasoline price (3:2:1 crack spread), the x\2\ test
statistic was calculated at 26.92 (48.99) and significant at the 5
percent (1 percent) significance level. This suggests that the fixed
effect estimator is consistent and asymptotically efficient in both
cases.
Different specification tests are applied on the data set to better
specify the panel data model. Applying the Wooldridge test for
autocorrelation in panel data for the relative gasoline price (or crack
spread) (Wooldridge 2002, p. 282), we get an F-test statistic of 917
(1,708), which is highly significant, and the null hypothesis of no
first-order autocorrelation is rejected. Tests developed by Pesaran
(2004) and Frees (1995) of cross-sectional independence are applied and
both null hypotheses are rejected; this confirms the existence of
cross-sectional correlation across regions.
Based on these diagnostic results, we used a fixed effect panel
data model with correction for first-order serial correlation. We also
estimated a feasible generalized least squares (FGLS) model with
generalized error structure to allow for the presence of AR(1)
autocorrelation within panels, as well as for heteroskedasticity and
cross-sectional correlation across panels. By using three alternative
model specifications we hope to provide information on the robustness
of the results.
The fixed effect model is specified as

where ai represents the individual regional effect. The fixed effect
model is typically estimated by the least squares dummy variable (LSDV)
method (Greene 2003, p. 287).
The FGLS estimation method takes into account heteroskedasticity,
and cross-sectional and serial correlation. The error terms can be
written as

An FGLS panel data model is also called the Parks-Kmenta method
(Kmenta 1986). This method consists of the following steps. Estimate
equation (1) by regular OLS. Then use the estimation residuals to
estimate assumed error AR(1) serial correlation coefficient r. Use this
coefficient to transform the model to eliminate error serial
correlation. Substitute V for V using estimated r and s\2\ then obtain
the FGLS estimator of b as

Analysis of Estimation Results
Using the relative gasoline price as the dependent variable, we get
estimation results for the pooled OLS regression, a fixed effect panel
data model, and a panel FGLS method; these are shown in Table 1. The
corresponding estimation results for 3:2:1 crack spread are shown in
Table 2.
In the case of the relative gasoline price, three estimation
methods generate similar results. The only difference is that standard
errors of coefficient estimates get bigger after taking into account
cross-sectional and temporal autocorrelation, which in turn lead to a
comparatively lower significance level for corresponding variables.
Crude oil and gasoline inventories, refinery capacity, short-run supply
disruption, and dummy variables for some summer months all
significantly influence the relative gasoline price. Ethanol production
has a considerably negative impact on the gasoline price, which is
highly significant at the 1 percent level in all three estimation
results. This indicates that over the sample period, ethanol has a
significant substitution effect on gasoline. Evaluating at the sample
mean, we find that the gasoline price is lowered by 39.50 cents,
28.70 cents, and 34.10 cents per gallon because of the substitution
effect of ethanol.
For the 3:2:1 crack spread, the estimation results of the fixed
effect and panel FGLS models are quite different from that of the
pooled OLS regression. In addition, the pooled OLS regression model
generates highly significant estimates for all explanatory variables
except the dummy variables for January, February, and November. As
previously mentioned, ignoring cross-sectional and serial correlation
as well as individual heterogeneity typically leads to highly
inaccurate standard error estimation; i.e., the significance estimation
results are not reliable. Hence, we focus on the fixed effect and panel
FGLS estimation results.
From these two sets of estimates, all the explanatory variables
have intuitively correct signs. First, the profitability represented by
the 3:2:1 crack spread presents a strong seasonal pattern. This is
reflected by the fact that the dummy variables for months in the second
and third quarters are all significant at the 1 percent significance
level in the panel FGLS model and at the 5 percent level in the fixed
effect model. Second, crude oil and refinery product market conditions,
refinery capacity, ethanol production, and unexpected supply disruption
significantly affect profit margins. For all five PADD regions,
unexpected supply disruption, measured by dummies for Hurricanes
Katrina and Rita, considerably increased profits in the months right
after the occurrence. Gasoline imports and the HHI are found not to
have statistically significant effects on crack spread nationally.
Finally, we find that ethanol production generates negative pressure on
crack spread over the sample period. For the fixed effect and panel
FGLS models, the marginal effect of ethanol production on the crack
spread is estimated to be -0.000073 and -0.000077, respectively.

Regional Analysis
Pooling cross-sectional and time-series information provides more
accurate estimation results. However, it is instructive to analyze the
time-series data of each region individually. Each PADD region has
unique supply and demand conditions of crude oil and refinery products,
different market structures, and different ethanol production and
usage. The effects of explanatory variables may differ considerably
because of region-specific factors.
We apply regular OLS regression on individual region's monthly data
series over the period 1995 to 2007. The estimation results for the
relative gasoline price and 3:2:1 crack spread are summarized in Tables
3 and 4, respectively.
From the estimation results for the relative gasoline price,
ethanol production has a significant negative effect on gasoline prices
in all regions. And the magnitude of the effect varies with PADD
regions, ranging from -0.000041 to -0.000095. As expected, in PADD II,
the Midwest region, ethanol production has the largest impact on the
gasoline price with a coefficient of -0.000095. The substitution effect
is highly significant and reduces the gasoline price by 39.5 cents on
average over the sample period. The West Coast and East Coast
experience similar negative ethanol impacts with estimates of
-0.000056, which means that the corresponding gasoline price is lowered
by 23.3 cents. The Gulf Coast region, PADD III, has a slightly higher
coefficient estimate of -0.000059, or, equivalently, a 24.6 cents
reduction in gasoline prices. The Rocky Mountain region, or PADD IV,
experienced the smallest downward gasoline price change, at 17.1 cents,
probably because of its comparatively low total gasoline consumption.
These results tell us what would have happened had we removed the
entire ethanol industry at the mean of the data set, and they are not
marginal effects of removing one unit of ethanol capacity in each
region.
From the estimation results of the profit margin for individual
regions, effects of some explanatory variables differ considerably
across regions. In PADD regions III and V, the HHI has a significant
positive effect on refinery profit. This result suggests that higher
market concentration in these two regional markets results in refinery
profits. We did not find this pattern in our panel data model.
Similarly, gasoline imports have a significant negative effect on the
profit margin in both East Coast and Midwest regions, possibly because
these two regions are more heavily dependent on imported refinery
products to meet their regional demand. Ethanol production has a
significant negative effect on the refiner's profit margin in all five
PADD regions.

Conclusions
We employ pooled OLS regression, a fixed effect panel data model,
and a panel FGLS estimation method to quantify the possible impact of
ethanol on regular gasoline in the United States as a whole and in five
regions of the United States. The models control for gasoline imports,
refinery capacity, capacity utilization rate, hurricanes, market
concentration in the refinery industry, stocks, and seasonality.
Estimation results show that over the period 1995 to 2007, ethanol
production had a significant negative effect of $0.29 to $0.40 per
gallon on retail gasoline prices. The results suggest that this
reduction in gasoline prices came at the expense of refiners' profits.
These results are statistically significant across a range of model
specifications and across all regions.
Results for individual U.S. regions indicate that the largest
impact of ethanol on gasoline is found in the Midwest region where
gasoline prices were reduced by 39.5 cents per gallon. The Gulf Coast
region is found to have experienced a 24.6 cents reduction in the
retail gasoline price, while for the West Coast and East Coast, the
average price drop is about 23.3 cents. The smallest impact, a
17.1 cents reduction, is found in the Rocky Mountain region, mainly
because of its comparatively low gasoline consumption.
These reductions in retail gasoline prices are surprisingly large,
especially when one considers that they are calculated at their mean
values over the sample period. The availability of ethanol essentially
increased the ``capacity'' of the U.S. refinery industry and in so
doing prevented some of the dramatic price increases often associated
with an industry operating at close to capacity. Because these results
are based on capacity, it would be wrong to extrapolate the results to
today's markets. Had we not had ethanol, it seems likely that the crude
oil refining industry would be slightly larger today than it actually
is, and in the absence of this additional crude oil refining capacity
the impact of eliminating ethanol would be extreme. In addition, the
impact of the first billion gallons of ethanol on this capacity
constraint would intuitively be greater than the billions of gallons
that came later. We did try a quadratic term to pick up this effect,
and it was not significant.

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Szklo, A., R. Schaeffer, and F. Delgado. ``Can One Say Ethanol Is a
Real Threat to Gasoline?'' Energy Policy, 2007: 35, 5411-5421.
Tokgoz, S., and A. Elobeid. ``Understanding the Underlying
Fundamentals of Ethanol Markets Linkage between Energy and
Agriculture.'' Paper presented at the American Agricultural Economics
Association annual meeting, Portland, OR, 29 July-1 August, 2007.
Tokgoz, S., A. Elobeid, J.F. Fabiosa, D.J. Hayes, B.A. Babcock, T-
H. Yu, F. Dong, C.E. Hart, and J.C. Beghin. ``Emerging Biofuels:
Outlook of Effects on U.S. Grain, Oilseeds, and Livestock Markets.''
Staff Report 07-SR 101, Center for Agricultural and Rural Development,
Iowa State University, 2007.
Vedenov, D.V., J.A. Duffield, and M.E. Wetzstein. ``Entry of
Alternative Fuels in a Volatile U.S. Gasoline Market.'' Journal of
Agricultural and Resource Economics, 2006: 1-13.
Wang, M., M. Wu, and H. Huo. 2007. ``Life-Cycle Energy and
Greenhouse Gas Emission Impacts of Different Corn Ethanol Plant
Types.'' Environmental Research Letters 2 (April-June) Article 024001,
available at http://www.iop.org/EJ/abstract/1748-9326/2/2/024001/
(accessed January 2008).
Wooldridge, J. Econometric Analysis of Cross Section and Panel
Data. Cambridge, MA: MIT Press, 2002.

TABLE 1.--REGRESSION RESULTS FOR POOLED OLS, THE FIXED EFFECT MODEL, AND THE PANEL FGLS METHOD ON RELATIVE GASOLINE PRICES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Pooled OLS Regression Fixed effect model with AR(1) Panel FGLS method
Variable -----------------------------------------------------------------------------------------------------
Estimate Standard error Estimate Standard error Estimate Standard error
--------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock......................................... \1\ 3.88e-6 8.42e-7 \2\ 1.97e-6 9.28e-7 \1\ 5.71e-7 2.19e-7
Gasoline stock.................................... \1\ -5.03e-6 1.11e-6 \1\ 0.000010 2.70e-6 \2\ 1.03e-6 5.24e-7
Refinery capacity................................. \1\ -0.000099 0.000029 \2\ -0.00038 0.00019 \3\ -0.00040 8.94e-6
Utilization rate.................................. -0.0019 0.0028 0.00095 0.0015 0.00048 0.00041
Ethanol production................................ \1\ -0.000095 3.96e-6 \1\ -0.000069 0.000012 \1\ -0.000082 0.000012
Supply disruption................................. \1\ 0.32 0.11 \1\ 0.20 0.055 \2\ 0.20 0.099
Gasoline import................................... \1\ -0.000037 3.89e-6 \1\ 7.37e-6 2.75e-6 6.22e-6 4.78e-6
HHI............................................... \1\ 0.00028 0.000062 -0.00019 0.00019 -0.000037 0.000025
January........................................... -0.030 0.054 \2\ -0.047 0.022 0.015 0.035
February.......................................... -0.083 0.054 \2\ -0.058 0.028 0.00061 0.046
March............................................. 0.013 0.055 -0.0079 0.031 0.031 0.053
April............................................. \2\ 0.12 0.055 0.055 0.035 0.069 0.058
May............................................... \1\ 0.19 0.056 \2\ 0.089 0.036 \3\ 0.099 0.060
June.............................................. \1\ 0.17 0.055 \1\ 0.10 0.037 \3\ 0.10 0.060
July.............................................. \2\ 0.11 0.055 0.046 0.036 0.020 0.059
August............................................ 0.046 0.055 0.029 0.034 -0.0084 0.056
September......................................... -0.0077 0.054 -0.012 0.031 -0.060 0.052
October........................................... -0.014 0.054 -0.014 0.026 -0.069 0.046
November.......................................... -0.032 0.053 -0.0063 0.019 -0.05 0.034
Constant.......................................... \1\ 3.12 0.29 \1\ 3.20 0.076 \1\ 2.46 0.12
R \2\............................................. 0.6014 ............... r = 0.87 ............... ............... ...............
Adjusted R \2\.................................... 0.5914 ............... F test 9.42 ............... ...............
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.

TABLE 2.--REGRESSION RESULTS FOR THE POOLED OLS, THE FIXED EFFECT MODEL, AND THE PANEL FGLS METHOD ON THE 3:2:1 CRACK SPREAD
--------------------------------------------------------------------------------------------------------------------------------------------------------
Pooled OLS Regression Fixed effect model with AR(1) Panel FGLS method
Variable -----------------------------------------------------------------------------------------------------
Estimate Standard error Estimate Standard error Estimate Standard error
--------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock......................................... \1\ 4.61e-6 9.53e-7 \1\ 7.27e-7 3.19e-7 1.7e-6 1.18e-6
Gasoline stock.................................... \1\ -4.56e-6 1.26e-6 1.13e-6 7.55e-7 \1\ 0.000011 3.48e-6
Refinery capacity................................. \1\ -0.000015 0.000032 \1\ -0.000063 0.000012 \3\ -0.00039 0.00022
Utilization rate.................................. \1\ -0.015 0.00032 -0.000066 0.00073 -0.00087 0.0019
Ethanol production................................ \1\ -0.000091 4.49e-6 \1\ -0.000073 0.000011 \1\ -0.000077 0.000014
Supply disruption................................. \1\ 0.32 0.12 \3\ 0.23 0.13 \3\ 0.13 0.071
Gasoline import................................... \1\ -0.000062 4.41e-6 -3.3e-6 6.0e-6 5.19e-6 3.53e-6
HHI............................................... \1\ 0.00026 0.000069 -0.000027 0.000036 0.000079 0.00024
January........................................... -0.058 0.06 0.00099 0.046 \1\ -0.075 0.028
February.......................................... -0.075 0.06 0.022 0.059 -0.036 0.036
March............................................. \2\ 0.13 0.062 \2\ 0.14 0.067 \2\ 0.095 0.039
April............................................. \1\ 0.30 0.063 \1\ 0.22 0.072 \1\ 0.18 0.044
May............................................... \1\ 0.39 0.063 \1\ 0.23 0.07 \1\ 0.19 0.046
June.............................................. \1\ 0.36 0.063 \1\ 0.24 0.074 \1\ 0.20 0.046
July.............................................. \1\ 0.31 0.062 \2\ 0.17 0.073 \1\ 0.15 0.045
August............................................ \1\ 0.28 0.062 \2\ 0.16 0.07 \1\ 0.18 0.043
September......................................... \1\ 0.23 0.061 \3\ 0.12 0.066 \1\ 0.18 0.039
October........................................... \1\ 0.19 0.061 \3\ 0.099 0.059 \1\ 0.18 0.034
November.......................................... 0.0022 0.060 -0.03 0.044 0.02 0.025
Constant.......................................... \1\ 4.04 0.33 \1\ 2.06 0.13 \1\ 2.53 0.10
R \2\............................................. 0.6196 ............... r = 0.87 ............... ............... ...............
Adjusted R \2\.................................... 0.6101 ............... F test 3.98 ............... ...............
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.

TABLE 3.--RESULTS FOR OLS REGRESSION ON RELATIVE GASOLINE PRICE WITH INDIVIDUAL PADD REGIONAL DATA
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
PADD I PADD II PADD III PADD IV PADD V
---------------------------------------------------------------------------------------------------------------------------------
Variable Standard Standard Standard Standard Standard
Estimate error Estimate error Estimate error Estimate error Estimate error
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock..................................................... \3\ .000025 .000015 \1\ .000012 2.11e-6 \1\ 3.89e-6 9.38e-7 -7.88e-6 .000018 2.84e-6 5.62e-6
Gasoline stock................................................ \1\ .000031 6.48e-6 .000011 8.16e-6 \1\ .000024 7.36e-6 \1\ .00015 .000055 .000029 .000019
Refinery capacity............................................. 0.0048 0.00032 .00054 .00047 -.00012 .00021 \1\ -.0062 .0023 \1\ -.0032 .00074
Utilization rate.............................................. 0.0051 0.0046 -.012 .0073 \3\ .010 .0056 -.010 .0086 .0037 .011
Ethanol production............................................ \1\ -.00005 .000014 \1\ -.00009 8.45e-6 \1\ -.00005 .000014 \1\ -.00004 .000020 \1\ -.00005 .000015
6 5 9 1 6
Supply disruption............................................. \2\ .47 .20 .19 .19 \1\ .54 .20 .23 .26 -.069 .29
Gasoline import............................................... \1\ -.00004 7.58e-6 -.000012 9.59e-6 -5.07e-6 8.18e-6 -.000013 .000014 -9.37e-6 .000014
4
HHI........................................................... \3\ -.00029 0.00017 -.00029 .00037 .00037 -.0030 .00051 .00053 \1\ .0019 .00046
January....................................................... -.10 .097 -.047 .10 -.0057 .0084 -.14 .13 -.067 .15
February...................................................... -.11 .098 -.11 .10 -.024 .088 -.17 .13 -.0060 .15
March......................................................... .0079 .099 -.12 .11 -.006 .079 -.063 .12 .12 .14
April......................................................... .060 .10 -.013 .10 -.0044 .080 .15 .13 .22 .14
May........................................................... .023 .11 .11 .11 .019 .080 \3\ .26 .13 .22 .14
June.......................................................... .000052 .10 .17 .11 .0097 .078 \2\ .35 .14 .22 .14
July.......................................................... .018 .10 .065 .10 -.0013 .078 \2\ .33 .15 .16 .14
August........................................................ .072 .10 .093 .10 .017 .079 \2\ .32 .15 .11 .15
September..................................................... -.037 .10 .053 .098 -.047 .076 .23 .14 .074 .14
October....................................................... .035 .10 -.012 .099 -.056 .077 .18 .13 .096 .14
November...................................................... -.029 .097 -.025 .096 -.052 .075 .09 .12 .046 .14
Constant...................................................... \1\ 0.17 .67 .31 1.79 .048 1.20 \1\ 5.56 1.49 \1\ 8.87 2.79
R \2\......................................................... .7109 ........... .7119 ........... .8229 ........... .6610 ........... .6415 ...........
Adjusted R \2\................................................ .6705 ........... .6717 ........... .7981 ........... .6136 ........... .5915 ...........
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.

TABLE 4.--RESULTS FOR OLS REGRESSION ON 3:2:1 CRACK SPREAD WITH INDIVIDUAL PADD REGIONAL DATA
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
PADD I PADD II PADD III PADD IV PADD V
---------------------------------------------------------------------------------------------------------------------------------
Variable Standard Standard Standard Standard Standard
Estimate error Estimate error Estimate error Estimate error Estimate error
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock..................................................... .000012 .000018 .000014 2.3e-6 \1\ 4.9e-6 1.0e-6 .000017 .000019 \3\ .000012 6.2e-6
Gasoline stock................................................ \1\ .000038 7.8e-6 \3\ .000015 8.7e-6 \1\ .000029 7.9e-6 \1\ .000023 .000058 .000025 .000021
Refinery capacity............................................. -0.000079 0.000038 -.00017 .00050 -.00028 .00023 \1\ -.012 .0025 \1\ -.0029 .000082
Utilization rate.............................................. \2\ -.01 .0055 \1\ -.031 .0078 \3\ -.012 .0063 -.013 .0091 -.0065 .012
Ethanol production............................................ \1\ -.00005 .000017 \1\ -.00009 9.e-6 \2\ -.00003 .000016 -4.2e-6 .000021 \1\ -.00004 .000016
1 9 7
Supply disruption............................................. \2\ .59 .24 .23 .21 .10 .21 .079 .27 -.24 .32
Gasoline import............................................... \1\ -.00006 9.1e-6 \1\ -.00002 .00001 \2\ -.00001 8.8e-6 -.000023 .000015 -.000019 .000016
5 9 9
HHI........................................................... -.00033 .24 -.00042 .00039 \1\ -.0023 .000078 .00033 .00056 \1\ .0016 .00050
January....................................................... -.098 .12 -.053 .11 -.13 .090 -.19 .13 -.11 .16
February...................................................... -.023 .12 -.098 .11 -.12 .10 -.17 .14 -.025 .16
March......................................................... .16 .12 -.069 .11 .05 .085 .044 .14 .22 .16
April......................................................... \3\ .22 .12 .16 .11 .14 .086 \2\ .34 .14 \2\ .41 .16
May........................................................... .17 .13 \1\ .33 .12 \3\ .16 .086 \1\ .46 .14 \2\ .36 .16
June.......................................................... .11 .12 \1\ .41 .11 \3\ .15 .084 \1\ .59 .15 \2\ .36 .16
July.......................................................... .16 .13 \2\ .28 .11 \3\ .15 .084 \1\ .62 .16 \2\ .36 .16
August........................................................ \2\ .25 .12 \1\ .37 .11 \2\ .21 .085 \1\ .68 .16 \2\ .38 .16
September..................................................... .14 .12 \1\ .32 .10 \3\ .14 .081 \1\ .63 .15 \2\ .40 .16
October....................................................... .20 .12 \3\ .18 .10 .065 .083 \1\ .53 .14 \2\ .34 .16
November...................................................... .01 .12 .017 .10 -.053 .081 .21 .13 .068 .15
Constant...................................................... \1\ 2.10 .81 \1\ 3.76 1.91 \1\ 3.52 1.29 \1\ 7.22 1.58 \1\ 8.04 3.07
R \2\......................................................... .7017 ........... .7419 ........... .8299 ........... .7216 ........... .6592 ...........
Adjusted R \2\................................................ .6600 ........... .7058 ........... .8061 ........... .6827 ........... .6116 ...........
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.

______

November 2007.
Analysis of Potential Causes of Consumer Food Price Inflation

PREPARED FOR: THE RENEWABLE FUELS FOUNDATION
PREPARED BY: INFORMA ECONOMICS, AN AGRA INFORMA COMPANY

I. EXECUTIVE SUMMARY
A. Introduction
Since fall 2006, public debate has intensified over the extent to
which the expansion of the ethanol industry has resulted in higher
agricultural commodity prices and, more importantly, whether and to
what extent there has been an impact on consumer food prices. To date,
this debate has been fueled mainly by anecdotal information. Given that
this issue has bearing on major policy decisions with respect to
agriculture and renewable energy, it is imperative that an objective,
fact-based assessment be available to public policymakers. The
Renewable Fuels Foundation (RFF) commissioned Informa Economics, Inc.
(Informa) to conduct such an assessment, and the results are contained
in this report.
B. Key findings
The ``farm value'' of commodity raw materials used in foods
accounts for 19 percent of total U.S. food costs, a proportion that has
declined significantly from 37 percent in 1973. For food products where
corn is only one of several farm-produced inputs, the proportion of the
total product cost attributable to the cost of corn is even less than
19 percent. The remaining portion of total retail food costs is known
as the marketing bill. The marketing bill includes the costs of labor,
packaging, transportation, energy, profits, advertising, depreciation,
rent, interest, repairs, business taxes, and other costs not
attributable to basic agricultural commodities. The marketing bill has
a higher correlation with the consumer price index (CPI) for food than
does corn, although there is a notable long-term upward trend to both
the marketing bill and the food CPI. Within the overall marketing bill,
the costs of energy and transportation have increased considerably over
the last several years, with crude oil prices surging from just under
$60 per barrel in fall 2006 to nearly $100 per barrel in November 2007,
the same period during which corn prices have increased.
An analysis was performed to quantify the historical price
relationships between corn prices and livestock, poultry, egg, and milk
prices, and the results showed weak correlations. With these low
correlations, it is statistically unsupported to suggest that high and/
or rising corn prices are the causative reason behind high and rising
retail meat, egg, and milk product prices. Moreover, the upward trend
in cattle, hog, and poultry prices began in the late 1990s, well before
the corn price began to increase significantly. Notably, dairy and egg
prices have been driven higher mainly by strong export demand.
More generally, there has historically been very little
relationship between corn prices and consumer food prices. Statistical
relationships are weak even when corn price data are lagged to allow
time for them to work their way through the food supply chain. The corn
price would be considered a statistically insignificant variable in
determining what drives the food CPI.
To provide context to an analysis of consumer food prices, it is
useful to consider the role of food expenditures in the average
American's budget. The proportion of the average American's disposable
income that is spent on food has declined steadily over the last half-
century, from 21 percent of disposable income in 1950 to below 10
percent in 2006. Additionally, the share of total food expenditures
accounted for by at-home food consumption has been declining relative
to away-from-home consumption. In 1950, 83 percent of total food
expenditures were for at-home consumption, but by 2006 this share had
declined to 58 percent.
Consumer food prices have been increasing at a relatively steady
pace over the last two decades. The annual increase in the food CPI has
averaged 2.96 percent since 1985, with food price inflation peaking at
5.84 percent in 1989 and falling to 1.2 percent in 1992. Since 1992,
the rate of increase in the food CPI has averaged a slightly lower 2.57
percent. By comparison, the annualized growth rate during the first
three-quarters of 2007 has been 3.40 percent. While growth rates in the
CPI sub-index for food consumed away from home have been slowly
trending upward since about 1994, the CPI for food consumed at home is
significantly more volatile and is currently growing more rapidly than
away-from-home food prices.
The United States harvested a record corn crop of 11.8 billion
bushels in 2004, but production fell to 11.1 billion bushels in 2005
and dropped further to 10.5 billion bushels in 2006. Over the same time
period, encompassing crop-marketing years 2004-2005 through 2006-2007,
the usage of corn in ethanol production expanded to 2.1 billion bushels
from 1.3 billion bushels. Yet, the ethanol industry was not the only
source of additional demand for corn. U.S. corn exports, which were 1.8
billion bushels in 2004-2005, rose to 2.1 billion bushels in both 2005-
2006 and 2006-2007--a level that was at the top of the range
experienced over the previous decade. Thus, the combination of a
reduction in supply and an increase in demand from both the ethanol
industry and the export market led to corn prices moving higher
starting in fall 2006.
Sub-indices of the food CPI are reported for the major food product
categories. It was investigated whether the price of corn has a greater
influence on these sub-indices than the overall food CPI. However,
similar to the case with the overall food CPI, the relationship with
the product sub-indices is generally weak.
Given the weak correlation between corn prices and consumer food
prices, it can be hypothesized that a considerable proportion of the
impact of corn price changes is absorbed by participants in the value
chains for meats, poultry, and other corn-based food products. This
does not necessarily mean that margins within the value chain are low
or negative, but rather that they are lower than they would be in the
absence of higher corn prices.
In summary, the statistical evidence does not support a conclusion
that the growth in the ethanol industry is driving consumer food prices
higher. This is demonstrated by the fact that the R-squared statistic
between nearby corn futures prices on the Chicago Board of Trade (CBOT)
and the food CPI is only 0.04, which means that only 4 percent of the
change in the food CPI is ``explained'' by fluctuations in nearby corn
futures prices. Even when the corn price is lagged to allow for the
effects to work their way through the food supply chain, the
statistical results do not improve. It can be concluded that no single
factor is the driver of consumer food prices over time--or the
moderately higher-than-average inflation during the first three
quarters of 2007--but rather there is a complex and interrelated set of
factors that contribute to food prices.

II. INTRODUCTION

Since fall 2006, public debate has intensified over the extent to
which the expansion of the ethanol industry has resulted in higher
agricultural commodity prices and, more importantly, whether and to
what extent there has been an impact on consumer food prices. To date,
this debate has been fueled mainly by anecdotal information. Given that
this issue has bearing on major policy decisions with respect to
agriculture and renewable energy, it is imperative that an objective,
fact-based assessment be available to public policymakers. The RFF
commissioned Informa to conduct such an assessment, and the results are
contained in this report.
As a result of the confluence of several factors that are explained
in Section VIII of this report, corn prices received by farmers
increased to an average of $3.03 per bushel during the crop-marketing
year that began in September 2006 and ended in August 2007, which was a
substantial increase from the $2.09 per bushel that farmers received in
August 2006, just before the start of the 2006-2007 crop year.
Similarly, it was considerably higher than the $2.00 per bushel average
experienced during the 2005-2006 crop year. However, other costs
incurred in the production and distribution of food products were
moving higher as well.
The price of crude oil (West Texas Intermediate) hovered just below
$60 per barrel in fall 2006, then increased to the $60-$70 per barrel
range in the spring and early summer of 2007 and further to the $70-$80
per barrel range in the late summer and early fall of 2007; in November
2007, the price surged to near $100 per barrel. Additionally,
transportation costs have been surging in recent years, propelled
higher partly by increasing fuel prices and partly by capacity
tightness relative to strengthening demand for transportation services.
As will be shown in this report, no single factor is the driver of
consumer food prices over time--or the moderately higher-than-average
inflation during the first three quarters of 2007--but rather there is
a complex and interrelated set of factors that contribute to food price
inflation. In addition to the analysis contained in this report,
Appendix A provides background on media coverage of the ``food versus
fuel'' debate and on other studies that have looked into whether
ethanol industry growth and changes in corn prices are contributing to
food price inflation.

II. CONSUMER FOOD PRICES

Consumer food prices have been increasing at a relatively steady
pace over the last two decades. Specifically, the annual increase in
the food CPI has averaged 2.96 percent since 1985, with food price
inflation peaking at 5.84 percent in 1989 and falling to 1.2 percent in
1992 (see Figure 1). Since 1992, the rate of increase in the food CPI
has averaged a slightly lower 2.57 percent. In comparison, the
annualized growth rate during the first three-quarters of 2007
(January-September) has been 3.40 percent--a rate of growth that was
matched only one other time in the last 15 years (in 2004).

The ``core CPI,'' which excludes food and energy prices, is viewed
as a more accurate reflection of underlying inflationary pressures in
the general economy than the overall CPI (at least in the short term),
since the core CPI excludes food and energy prices, which tend to be
significantly more volatile from month-to-month than other sectors of
the economy. Over the 1985-2007 time period, the average annual
inflation rate of the core CPI has been 3.09 percent, which is very
close to the 2.96 percent average food CPI growth rate (see Figure 2).
Whether inflation in the core CPI or the food CPI is higher varies
almost from year to year.

If only the period since 1992 is considered, core CPI inflation has
on average been 0.17 percent below food CPI inflation. Essentially,
this again indicates food CPI inflation has been similar to the core
inflation rate over the long run. During this time period, the greatest
differential between the two CPI inflation rates was in 2004, when food
CPI inflation was higher than core CPI inflation by 1.69 percent.
Similarly, from January to September 2007, the food CPI inflation rate
has been running 1.32 percent above the core CPI inflation rate.
Not only is the overall CPI composed of major expenditure
categories such as food and energy, but the food CPI is composed of two
main sub-indices: food consumed at home and food consumed away from
home. While growth rates in the away-from-home food CPI have been
slowly trending upward since about 1994, the at-home food CPI is
significantly more volatile and is currently growing more rapidly than
away-from-home food prices (see Figure 3). However, both are currently
growing at rates exceeding the core CPI.

Importantly, the USDA's Economic Research Service (ERS) and the
Bureau of Labor Statistics (BLS) have noted that the at-home food CPI
statistic likely overestimates actual inflation in prices consumers pay
for food. This is due in part to the impact of emerging ``big-box
stores'' (e.g., Wal-Mart and Costco) on the food at-home CPI. Data from
previous studies have shown that food prices from these ``big-box
stores'' are, on average, 7 percent to 8 percent lower than those found
in large supermarket chains. The problem is that such stores might not
be fully represented in the sample of stores surveyed for price data.
Furthermore, when a ``big-box store'' acquires a store that is included
in the surveyed group, the BLS has an aligning procedure which assumes
that quality-adjusted prices at these stores are equal to the prices at
the large supermarket chains. In essence, this procedure equates the
prices of these alternative food retailers. A study by Hausman and
Leibtag \1\ concluded that this phenomenon confers an upward bias of
0.32 percent to 0.42 percent in the at-home food CPI.
---------------------------------------------------------------------------
\1\ Hausman, J. and E. Leibtag. 2004. ``CPI Bias from Supercenters:
Does the BLS Know that Wal-Mart Exists?'' NBER Working Paper #20712
(Aug). National Bureau of Economic Research, Cambridge, MA.
---------------------------------------------------------------------------
The at-home food CPI is further categorized into additional sub-
indices, broken down into product categories with increasing levels of
specificity. An evaluation of relevant first-level product categories
further demonstrates which categories are largely responsible for
changes in the overall food CPI. Among products that have a direct or
indirect linkage to corn as an input, egg prices have recently been
exhibiting the strongest inflation, while other livestock, dairy, and
poultry markets exhibit similar, but much milder, trends (see Figure
4). In contrast, the CPI for cereals and bakery products has avoided
the large, volatile swings that have occurred in the egg market. In
general, the more value added in the manufacture of the product, the
more consolidated the market, and the more price elastic the demand
(i.e., costs cannot be passed along to consumers without lowering
demand), the less volatile end-product prices will be.

iv. perspective on consumer food expenditures
In providing context to the food-versus-fuel debate, in addition to
examining how the CPI has changed over time it is also useful to
consider the role of food expenditures in the average American's
budget. To start with, the proportion of the average American's
disposable income that is spent on food has declined steadily over the
last half-century. In 1950, approximately 21 percent of disposable
income was spent on food; by 2006, the share had broken below 10
percent (see Figure 5).

Interestingly, the proportion of disposable income spent on food
away from home has remained relatively stable over time. Away-from-home
food consumption has remained in the range of 4.0 percent to 4.3
percent of total disposable income since 1976. Given the increase in
consumers' disposable income over time, this means that in nominal
terms the total amount spent on food away-from-home has increased
substantially. In fact, per capita away-from-home food expenditures
have increased 44 percent between 2000 and 2006, increasing from an
average $971 to $1,402.
Another trend within food expenditures is that the share accounted
for by at-home food consumption has been declining relative to away-
from-home consumption. Again, this is the share of food expenditures,
whereas the previous paragraph addressed the share of disposable
income. In 1950, 83 percent of total food expenditures were for at-home
food consumption (see Figure 6). By 2006, this share had declined to 58
percent, and according to the USDA, it is predicted to fall to 51
percent by 2016.

Increases in food prices in 2007 have been showing up more in the
at-home food CPI than the away-from-home food CPI, which is to be
expected since at-home food prices historically have been more volatile
than away-from-home food prices (refer back to Figure 3). However,
given that the at-home food category has been a declining component of
total food expenditures, and that food expenditures have accounted for
a declining proportion of consumer incomes, the effect of any increase
in at-home food prices on the average American's financial condition
will be considerably muted relative to what it would have been in the
past.
In the Center for Agricultural and Rural Development (CARD) study
referenced in the appendix to this study, long-run general food prices
were predicted to increase by as much as 1.8 percent above the ``no
ethanol'' scenario. This was the most extreme scenario of the reviewed
research publications, as the USDA forecasts long-run food price
inflation equal to or less than the general inflation rate, the AFBF
found no short- or long-term relationship, and the consulting firm AES
only reported inflationary increases for individual products. However,
even though the inflation rates estimated by AES were only examined for
individual products, for most product categories the rates were less
than those estimated by the CARD study. Therefore, it can be said that
this average retail food price inflation estimation of 1.8 percent
above the ``no ethanol'' control is the highest inflation rate
estimation of those referenced.
What would the scenario of 1.8 percent higher food price inflation
mean for consumers? In 2006, the average disposable income was $32,114,
with 9.9 percent of this being spent on food. This would mean that a
1.8 percent increase in the price food would increase the total annual
food expenditures of an average household by about $57 a year. With 58
percent of this being spent on at-home food expenditures, this means
that the average American household can be expected to spend an extra
$34 a year on their groceries.
However, to understand the net impact on consumers' financial
condition, changes in expenditures on not only food but also fuel would
have to be considered. Specifically, if more abundant supplies of
ethanol were to result in a measurable reduction in retail fuel prices,
this would have to be compared to any food price increase in
determining the net impact to consumers. The effect of ethanol on
retail fuel prices is not addressed in this study.

V. RELATIONSHIP BETWEEN CORN PRICES AND OTHER AGRICULTURAL COMMODITIES
PRICES

This section analyzes the relationships among the prices of corn,
other commodities and consumer food prices. It examines whether there
is a sufficient relationship between corn prices and other commodity
and food prices to substantiate whether an increase in corn prices--
regardless of the reason for the increase in corn prices--would cause
an increase in the prices consumers pay for food.
A. Historical relationships among corn and other commodity prices
1. Grain and oilseed prices
Grain and oilseed prices have always been highly volatile. In
Figure 7, historical monthly nearby futures averages are shown for
corn, soybeans, and wheat, the three major row crops grown in the
United States.\2\ Until recently, domestic demand for these commodities
generally grew at a relatively steady rate, while changes in supply
(usually due to weather) have been the main determinants of price
volatility.
---------------------------------------------------------------------------
\2\ ``Nearby'' futures refer to the futures contract closest to
expiration. For example, March futures would serve as the nearby corn
contract during January and February of any given year, since contracts
are not traded with delivery during those months.

While these three commodities have only limited substitutability
for each other, conditions in one market can influence the prices in
another--often caused by the common denominator of weather. Recent
increases in corn prices are no exception. While a record corn crop is
being harvested in the fall of 2007, there is concern that increased
demand will bring soybean supplies down to low levels by the end of the
crop year, and weather problems in Australia and other wheat-growing
nations have caused wheat prices to reach record levels. As a result,
corn prices have not been able to fall as would have been expected
given the size of the crop. This section provides a brief overview of
the complex historical relationships among these three markets.
The Corn Price.--Over the historical time period extending from
January 1985 to August 2007, the average nearby corn futures price has
averaged $2.46/bu. Weather had a substantial impact on corn futures
prices in the 1988-1989 crop year, when poor crops resulted in high
prices. (The crop year for corn begins in September, when harvest gears
up on a large scale, and ends in August of the following calendar
year.) In 1995-1996 record high corn prices were reached when a drop in
production coincided with very strong export demand, resulting in
record corn futures prices as high as $5.00/bu.
Following record corn production in the 2004-2005 crop year of 11.8
billion bushels and another crop over 11 billion bushels in 2005-2006,
corn futures prices declined to $2.23/bu in the 2005-2006 crop year.
However, driven by a significant decrease in corn acreage harvested in
2006, corn production fell to 10.5 billion bushels, while corn usage in
ethanol production increased and exports rebounded strongly to the top
end of the range experienced during the prior decade; as a result,
nearby corn futures in 2006-2007 increased to an average $3.56/bu, with
spring prices approaching the $4.50/bu range.
A fundamental driver of the price of corn is the level of
inventories at the end of the crop-marketing year. Ending stocks are
viewed by the industry as the ``cushion'' or ``buffer'' stocks
available to incorporate increases in demand or reductions in supply in
the following crop year. The larger the level of ending stocks, the
more comfortable the market will be with a given level of demand. In
particular, the ratio of year-end stocks to total consumption during
the year is a key price determinant. Corn prices tend to weaken when
supplies are plentiful relative to usage, whereas they strengthen when
stocks are drawn down compared to demand. The level of stocks is market
driven, as the U.S. Government no longer carries large stocks as part
of its corn support programs.
Price Relationships Among Corn, Wheat, and Soybeans.--As was shown
above in Figure 7, a general price relationship exists among these
three crops. In 1995, the early frost that affected corn production
also led to spikes in soybean and wheat prices. Just as the corn price
increases were compounded by strong export demand, the wheat price
increase was also compounded by other factors. These included low
stocks that year and world supply issues, as production and export
subsidies in the United States and EU were curtailed under the Uruguay
Round of the General Agreement on Tariffs and Trade (now called the
World Trade Organization, WTO).
However, a weather problem for one crop does not necessarily always
mean a supply problem for the other. A prime example of this is the
drought of 2003, which affected the soybean crop but left the other two
crops relatively unscathed. While weather plays a key role in
explaining the relationship between these three commodities, it is not
the only factor. Each market has its own set of supply and demand
factors that can either exacerbate the problems in another market or
help to mitigate potential price increases.
Higher corn prices can influence wheat prices, but typically the
reverse has not been true. This is because as corn prices move higher,
wheat prices will be pulled higher to keep wheat from being used as a
feed. However, the record wheat prices of 2007 are very much a result
of supply-side issues. U.S. wheat supplies were reduced by adverse
weather, including a spring freeze and unseasonably heavy rainfall
around harvest. To add to the global supply problems, Australia's wheat
production has fallen significantly due to drought. Eastern Europe,
Ukraine, and to some extent Canada--all of which are large-scale wheat
producers--have also been having supply issues.
In general, the demand bases for wheat and corn are quite different
since the crops' end-product uses are generally different, with corn
mainly used as a feed grain and wheat mainly used as a food grain.
Usually, the global wheat supply has a modest impact on corn exports,
although for countries where wheat and barley are the primary feed
grains, a weather problem can necessitate increased usage of other feed
grains, including imported corn. Although there can be some linkage
between the wheat and corn markets in such a case, corn futures prices
are remaining at high levels in fall 2007 in order for corn to
``compete'' against high-priced soybeans for acres to be planted in
spring 2008; this competition is mainly with soybeans as opposed to
wheat, since wheat is typically grown in areas that are not necessarily
best suited for corn.
This competition between corn and soybean acres has affected the
price relationship between these two commodities over the last couple
of years. In the spring of 2006, futures prices provided a net revenue
premium to grow soybeans compared to corn, and soybean acres expanded
at the expense of corn. In 2007, the reverse was true, and corn acreage
increased substantially. After the 2007 crop was made, the market
realized that the pace of usage would bring soybean inventories to low
levels at the end of the 2007-2008 crop year, and if a larger soybean
crop were not realized next year, the inventory situation would become
particularly acute by the end of the 2008-2009 crop year. This has led
to inflation in the corn price over what it would have been had it not
had to compete with soybean acreage.
While part of the increase in soybean prices can be attributed to
the shift of some soybean acres to corn in 2007, it can be argued that
the price of soybeans would not have gone quite so high had it not been
for the price of crude oil (petroleum), which has driven soybean oil
prices higher due to the growth of the biodiesel industry.
2. Livestock, poultry, egg, and milk prices
Figure 8 provides a visual indication that there is not a strong
correlation between corn prices and livestock or poultry prices. It is
also evident that the upward trend in cattle, hog, and poultry prices
began in the late 1990s, well before the corn price began to increase
significantly in 2005-2006.

Cattle prices have been on an upswing since the mid-to-late 1990s,
resulting from declining cattle supplies and increasing demand. Cattle
inventories declined from 103.5 million head in 1996 (January 1
inventories) to just under 95 million head by 2004, and there has been
only a modest 2-million-head rebound since then. In conjunction with
declining cattle inventories was an increase in beef demand that became
evident in the late 1990s. Consumer preferences began to take a
detectable turn; the previously held belief that beef was a health
detriment began to moderate as consumers adopted diets that placed more
emphasis on protein and less on carbohydrates. These shifts in supply
and demand have been the main driving forces behind the increasing
cattle prices, which have been rising at an average annual growth rate
of about 3.6 percent since 1998. Previous (1985-1998) cattle price
increases averaged just less than 1 percent.
In contrast to the strong growth in cattle prices, the growth in
hog and poultry prices has been more moderate, although there have
still been increases. Similar to cattle prices, an upward trend in hog
prices can be detected beginning near the turn of the millennium. In
recent years, annual productivity gains have continued at trend levels,
even as industry structure has matured. The breeding herd has held
relatively steady, at or slightly above 6 million head since 2000, with
minor deviations from year to year. From the demand side, pork demand
at the wholesale level has remained stagnant in the United States,
while export demand has increased dramatically. In general, there
appears to be very little relation between corn prices and hog prices,
with the possible exception being in the 1996-1997 crop year when hog
prices spiked following the large corn price spike in 1995-1996. While
most of this increase is attributed to constrained supplies of pork
that year, the large increase in corn prices the previous year
(exceeding the recent corn price spike in 2006-2007) may have partially
motivated these supply reductions.
Poultry prices remained relatively flat across the 1985-1986 to
1999-2000 time period, averaging $54.50/cwt. Since then, poultry prices
have been trending upward at an average annual growth rate of 4 percent
(averaging $67.86/cwt). Such price increases can be largely explained
by increasing per capita poultry consumption. Further demand increases
have been seen following the Avian Influenza found within Asia and
Europe in 2003. Such demand increases, along with tight supplies,
resulted in the record-high prices recorded during the 2003-2004 crop
year. Then in 2005-2006, prices dropped back down as exports backed off
as a result of the record prices.
Egg prices, on the other hand, have been relatively more responsive
to corn prices. There are several reasons for this tighter
relationship. First, while the egg industry supply chain is not as
concentrated as the broiler industry, it is still relatively integrated
and consolidated. These larger, integrated operations are able to make
supply decisions and respond more quickly to changing input prices than
small, independent laying operations. Second, demand for eggs is
relatively inelastic, as they are a cheaper source of protein than
meats or other livestock products and are used in a range of processed
food products. This enables price changes to be passed on to consumers
without affecting overall consumption severely.
Egg values have been extremely high in 2007. With production
margins extremely poor during 2005 and into 2006, producers cut their
laying flocks considerably. Consequently, egg production has fallen.
The total number of eggs produced up to this point in 2007 is about 1.5
percent fewer than the number of eggs produced during the same time
period in 2006.
Along with a diminished U.S. egg supply, export trade of both eggs
and egg products has risen strongly during 2007 (see Table 1). There
has been a significant increase in exports of both shell eggs and egg
products during the first 9 months of 2007 compared to recent years.
Even though exports of shell eggs still account for less than 2 percent
of all U.S. egg production, the increase in exports combined with
diminished egg production was enough to skim necessary supplies from an
already tight domestic market for eggs and has been a contributing
factor to higher egg prices in 2007.
Similarly, inelastic demand for milk leads to a moderately tighter
relationship between corn and milk prices than with other livestock and
poultry prices (see Figure 9). That being said, recent milk price
increases have been driven primarily by substantial increases in world
dairy product demand and tight world supplies that resulted from major
droughts in leading milk-producing countries, such as Australia (see
Figure 10).

TABLE 1.--U.S. EXPORTS OF SHELL EGGS AND EGG PRODUCTS, JANUARY-SEPTEMBER, 2003-2007
----------------------------------------------------------------------------------------------------------------
All egg
products,
Year Table eggs Shell eggs liquid
(1,000 dozen) (1,000 dozen) equivalent
(1,000 lbs)
----------------------------------------------------------------------------------------------------------------
2003 (January-September)........................................ 33,523 68,816 70,603
2004 (January-September)........................................ 36,123 73,157 61,195
2005 (January-September)........................................ 47,216 82,250 110,308
2006 (January-September)........................................ 37,838 75,478 114,536
2007 (January-September)........................................ 62,170 107,057 125,603
----------------------------------------------------------------------------------------------------------------
Note: Since only January-September data are available for 2007, data for the same time periods in previous years
are shown for purposes of comparison.

Correlation analysis
An analysis was performed to quantify the historical price
relationships between corn prices and livestock, poultry, egg, and milk
prices, and the results showed rather weak correlations. With these low
correlations, it is statistically unsupported to suggest that high and/
or rising corn prices are the causative reason behind high and rising
retail meat, egg, and milk product prices.
Quarterly average nearby corn futures prices were analyzed relative
to quarterly average nearby cattle and nearby hog prices and quarterly
cash price averages for broilers, milk, and eggs (January 1985-
September 2007). Direct quarter to quarter correlations were calculated
as were lagged correlations for one, two, three, and four quarters to
identify if there was a lagged impact from corn prices on meat, egg,
and milk prices. The results are presented below.
Cattle and beef
In the cattle-and-beef sector, the correlation coefficients were
weak over short periods of time and even negative over longer periods
of time, which indicates that there is no discernible strong
relationship between corn prices and cattle prices (see Table 2). Based
on this analysis, it can be concluded that high corn costs do not
automatically result in higher cattle prices, either in the short term
or over a 12-16 month period. The higher costs of producing beef result
in a negative impact on cattle feeders' margins, and this ultimately
would have a negative impact on feeder cattle prices (i.e., the prices
paid animals entering feedlots). Irrespective of the price of corn, the
price of fed cattle and beef might be higher or lower, with such prices
determined by the supply/demand conditions in the beef market.

TABLE 2.--CORN/CATTLE PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
Correlation
------------------------------------------------------------------------
Current................................................. +0.18
One quarter lag......................................... +0.15
Two quarter lag......................................... +0.06
Three quarter lag....................................... -0.06
Four quarter lag........................................ -0.21
------------------------------------------------------------------------

The cattle and beef industry has a rather complex supply chain, as
numerous independent entities participate in the production of cattle
as they progress from the core cow-calf production operation through
backgrounding activities and then on through commercial cattle-feeding
activities. In the production process for grain-fed beef, it can take
anywhere from 16 to 24 months for an animal to move from birth to
slaughter. Multiple buy/sell transactions occur in this process, as
young calves are typically sold to operations that put these animals on
forage programs and then eventually sell the animals to feedlot
operations that feed out the animals to slaughter weights. The
complexity of this process has a tendency of disrupting the supply
response to changing cattle prices and changes in feed costs, which is
likely reflected in the weak correlations between cattle and corn
prices.
Hogs and pork
Within a single quarter there is virtually no correlation between
corn prices and hog prices, as measured by nearby futures prices. Given
the length of the breeding and production process (10-12 months), a lag
of at least four quarters between high feed costs and any possible
impact on hog prices would be anticipated. Historically, producers
endured losses for at least two quarters prior to adjusting breeding
inventories; if that behavior pattern still holds, there would
theoretically be a relationship between corn prices lagged five or six
quarters and hog prices. However, the correlations between corn prices
and hog prices for all lagged time periods are very weak (see Table 3).

TABLE 3.--CORN/HOG PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
Correlation
------------------------------------------------------------------------
Current................................................. +0.15
One quarter lag......................................... +0.19
Two quarter lag......................................... +0.18
Three quarter lag....................................... +0.17
Four quarter lag........................................ +0.22
Five quarter lag........................................ +0.19
Six quarter lag......................................... +0.06
Seven quarter lag....................................... -0.01
------------------------------------------------------------------------

Even with a four-quarter lag on corn prices, the correlation of
+0.22 is so weak that it cannot be concluded that higher corn prices
result in higher hog prices. Once again, if higher corn prices were
going to have an impact on pork supply and prices, such impacts would
be expected at least a year from when corn prices rise. However, when
further lags are considered (five, six, and seven quarters), the
correlation actually begins to decline.
Broilers
In the broiler (chicken) sector, there does appear to be a slightly
higher degree of linkage between broiler prices and corn prices. Still,
correlation coefficients below 0.75 (actually, between -0.75 and 0.75)
are considered tenuous at best, and the highest correlation coefficient
between corn and the Georgia dock broiler price is only 0.3 (see Table
4).

TABLE 4.--CORN/BROILER PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
Correlation
------------------------------------------------------------------------
Current................................................. +0.25
One quarter lag......................................... +0.31
Two quarter lag......................................... +0.23
Three quarter lag....................................... +0.12
Four quarter lag........................................ +0.03
------------------------------------------------------------------------

The coefficient of 0.25 within a single quarter indicates a weak
relationship between corn and broiler prices. The fact that the
coefficient with a one-quarter lag is a little higher does suggest that
there is a very weak price relationship; however, over time the
correlation coefficients get smaller (weaker), which indicates that
there is little relationship between the cost of corn and the price of
broilers.
Eggs
While correlations between corn and egg prices were the strongest
observed for any of the livestock/poultry markets, the correlation
coefficients would still be considered statistically weak. Again, a
correlation between -0.75 and 0.75 is generally considered
statistically insufficient to be used in modeling or predictions (for
an equation with a single explanatory variable). Within a single
quarter, or with up to a two-quarter lag in corn prices, the
correlation coefficient between corn and eggs is gravitates around 0.5
(see Table 5). When a further lag in corn prices is considered, the
correlations worsen.

TABLE 5.--CORN/EGG PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
Correlation
------------------------------------------------------------------------
Current................................................. +0.51
One quarter lag......................................... +0.49
Two quarter lag......................................... +0.51
Three quarter lag....................................... +0.39
Four quarter lag........................................ +0.13
------------------------------------------------------------------------

Egg producers have the capability of adjusting short-term
production volumes, which in turn can have fairly immediate impacts on
egg prices. If corn prices were the driver of either ``high'' or
``low'' egg prices, the correlation coefficients would be substantially
higher than those found and presented above. It would appear that other
factors besides corn prices contribute to egg price changes. For
example, egg-product exports have increased to 126 million pounds
during the first 9 months of 2007, compared to 115 million pounds
during the same period in 2006, which has resulted in high egg prices;
the role of high corn prices appears to have been, at most, a secondary
contributor.
Dairy and milk
Again, there is only a moderate degree of correlation between corn
prices and milk prices (stronger than the broiler market but weaker
than the egg market). The correlation coefficients for nearby corn
futures prices and milk prices are shown in Table 6.

TABLE 6.--CORN/MILK PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
Correlation
------------------------------------------------------------------------
Current................................................. +0.27
One quarter lag......................................... +0.41
Two quarter lag......................................... +0.44
Three quarter lag....................................... +0.31
Four quarter lag........................................ +0.13
------------------------------------------------------------------------

vi. relationship between corn prices and consumer food prices
A. Historical relationship between corn prices and consumer food prices
The first question to be asked in determining whether statements
that higher corn prices are causing higher consumer food prices is:
Have corn prices shown a strong relationship with consumer food prices
in the past? In fact, this section shows there has historically been
very little relationship between corn prices and consumer food prices.
This is not surprising, given the results of the last section--if
correlations between corn prices and livestock, poultry, egg, and milk
prices at the wholesale level are weak, than correlations to further
processed products at the retail level should be at least as weak.
Relationships between corn prices and consumer food prices were
evaluated by running a simple regression of corn prices against food
CPI index values. Crop year averages since 1985-1986 were utilized. The
resulting R-squared \3\ value was only 0.04, indicating that variations
in the corn price ``explain'' only 4 percent of the variations in the
food CPI index (see Figure 11). Thus, the corn price would be
considered a statistically insignificant variable in determining what
drives the food CPI.
---------------------------------------------------------------------------
\3\ The R-squared value represents the proportion of the total
variation in the food CPI (the ``y'' variable) that can be explained by
the corn price (the ``x'' variable).

In reality, it would be expected that a change in the corn price
would take time to work its way through the value chain before the food
CPI is affected, so that the impact might not be instantaneous.
However, the R-squared values do not improve when quarterly prices are
used and the corn price is lagged by as many as four quarters (see
Table 7).

TABLE 7.--FOOD CPI AS A FUNCTION OF LAGGED CORN PRICES
------------------------------------------------------------------------
R-squared
Corn price Correlation value
------------------------------------------------------------------------
Current................................. 0.2010 0.0404
One quarter lag......................... 0.1749 0.0306
Two quarter lag......................... 0.1351 0.0183
Three quarter lag....................... 0.0558 0.0031
Four quarter lag........................ -0.0078 0.0001
------------------------------------------------------------------------

Given that a general upward trend in the food CPI is prevalent,
another regression was run using crop-year changes in corn prices
against the crop-year changes in the food CPI. Again, very little of
the food CPI inflation rate can be directly explained by year-to-year
movements in the corn price, as reflected in an R-squared of 0.002 (see
Figure 12). The corn price variable is statistically insignificant in
the regression equation.

While movements in the overall food CPI are not explained well by
the price of corn, it was investigated whether the price of corn has a
greater influence on sub-categories within the food CPI. Similar to the
case with the overall food CPI, the relationship with the product sub-
indices is generally weak, with only eggs having an R-squared over 0.1
(see Table 8 and Table 9). This is true even if lagged corn prices are
used.

TABLE 8.--CORRELATION BETWEEN FOOD CPI SUB-INDICES AND CURRENT/LAGGED CORN PRICES
----------------------------------------------------------------------------------------------------------------
Dairy and Cereals and
Corn prices Beef and Pork CPI Poultry CPI Eggs CPI related bakery
veal CPI products CPI products CPI
----------------------------------------------------------------------------------------------------------------
Current..................... 0.1968 0.1701 0.2164 0.4163 0.1413 0.2186
One quarter lag............. 0.1534 0.1830 0.2286 0.0064 0.1435 0.2006
Two quarter lag............. 0.0947 0.1689 0.2078 0.3782 0.1243 0.1660
Three quarter lag........... -0.0068 0.0939 0.1243 0.2936 0.0491 0.0919
Four quarter lag............ -0.0798 0.0370 0.0427 0.1427 -0.0186 0.0321
----------------------------------------------------------------------------------------------------------------

TABLE 9.--R-SQUARED VALUES FOR FOOD CPI SUB-INDICES REGRESSED AGAINST CURRENT AND LAGGED CORN PRICES
----------------------------------------------------------------------------------------------------------------
Dairy and Cereals and
Corn prices Beef and Pork CPI Poultry CPI Eggs CPI related bakery
veal CPI products CPI products CPI
----------------------------------------------------------------------------------------------------------------
Current..................... 0.0387 0.0289 0.0468 0.1733 0.0200 0.0478
One quarter lag............. 0.0235 0.0335 0.0523 ............ 0.0206 0.0402
Two quarter lag............. 0.0090 0.0285 0.0432 0.1431 0.0154 0.0276
Three quarter lag........... ............ 0.0088 0.0155 0.0862 0.0024 0.0084
Four quarter lag............ 0.0064 0.0014 0.0018 0.0204 0.0003 0.0010
----------------------------------------------------------------------------------------------------------------

The value chain for eggs is relatively more consolidated than other
product value chains, as there are fewer handlers; eggs also generally
have less value added than other food categories, and their price
elasticity of demand is highly inelastic. These are all potential
reasons to explain the slight but notable correlation between the eggs
CPI and the corn price. Still, this relationship is too weak to be
statistically significant. Despite the fact that milk is also
considered to be a highly price-inelastic product, a very weak
correlation with corn prices (lagged or current) is exhibited.
Considering that there are trends in some food CPI sub-indices, an
attempt was again made to determine whether there would be a more
notable relationship between the annual crop-year percent change in the
corn price and the annual crop-year percent change in the food CPI sub-
indices. Again, the eggs CPI had the strongest correlation with corn
prices, but the R-squared value was only 0.30; the corn price variable
was statistically significant at the 5 percent level (the first
regression where this was the case), but it still suggests that only 30
percent of the yearly movements in the eggs CPI can be attributed to
yearly corn price changes (see Table 10). Other correlation and
regression results indicate very weak price relationships--in some
cases negative.

TABLE 10.--RELATIONSHIP BETWEEN ANNUAL CROP-YEAR CHANGES IN FOOD CPI SUB-
INDICES AND CORN PRICE CHANGES
------------------------------------------------------------------------
Correlation R-squared
------------------------------------------------------------------------
Annual crop year percentage change in -0.1078 0.0116
meats (beef and pork) CPI..............
Annual crop year percentage change in -0.0228 0.0005
beef and veal CPI......................
Annual crop year percentage change in -0.1901 0.0361
pork CPI...............................
Annual crop year percentage change in 0.0835 0.0070
poultry CPI............................
Annual crop year percentage change in 0.5505 0.3031
eggs CPI...............................
Annual crop year percentage change in 0.2756 0.0760
cereals and bakery products CPI........
------------------------------------------------------------------------

B. Price spreads among different levels of the value chain
There are several segments in the value chain between the farm and
the consumer. For grains and oilseeds, there are grain elevators, bulk
processors (e.g., flour millers and soybean crushers), further
processors (e.g., packaged food manufacturers), wholesale distributors,
and retail grocery and foodservice establishments that take basic
commodities, transform them and deliver them to the consumer. For
livestock and poultry, there are slaughterhouses and sometimes separate
first-stage and further processors that produce in-tray meat cuts/
poultry and packaged food products containing meats/poultry;
distributors and retailers bring these products to consumers, while
foodservice establishments prepare the meats/poultry before they are
served.
There are various economic factors (supply/demand and costs) and
industry structure issues that determine the margins at each of these
value-chain segments and the degree to which they can pass along cost
increases. The historical price spreads from farm to wholesale and from
wholesale to retail are shown in Figure 13 to Figure 15.

C. Role of margins as shock absorbers
Given the weak correlation between corn prices and livestock,
poultry, egg, and milk prices (at the farm level), it can be
hypothesized that a considerable proportion of the impact of corn price
changes is being absorbed in the value chain in the form of reduced
margins to livestock producers. Importantly, this does not necessarily
mean margins for livestock producers are low or negative, but rather
that they are lower than they would be in the absence of higher corn
prices. This section will look at the historical relationships between
corn prices and production margins, as well as evaluate the impact of
recent corn price changes.
1. Beef cattle
Cow-calf and cattle-feeding margins
Calf-crop levels have been declining steadily since about 1996,
dropping from a level of 40.3 million head to 37.6 million head in
2007. During this same time period, a string of profitable years has
been achieved in the cow-calf sector. Such strong profitability has not
been experienced in the cattle feeding sector, where imputed margins
have been negative since early 2004 (see Figure 16). This followed
uncharacteristically high margins in 2003, which resulted mainly from
the large increase in cattle prices during the last half of that
year.\4\ In fact, over the long term from January 1985 to August 2007,
average cattle feeding margins were negative, by an amount of -$15.42/
head. However, this does not necessarily mean that cattle feeders have
experienced sustained losses over the time period, since there are many
cost markups associated with feedlot operations that are already
included in their margin calculations.
---------------------------------------------------------------------------
\4\ Trade disruptions in the aftermath of the first domestic case
of BSE in Canadian cattle helped boost United States fed cattle prices
to record levels in the fall of 2003.

While total feed costs are undeniably affected by changes in the
corn price, overall margins are not mirror-reflections of corn price
changes. For one, there is often a lagged affect. The corn purchased in
one period does not directly affect the profitability of the feeder
steers being sold that period, but rather those that are being fed to
be sold at a later date. Furthermore, cattle feeders anticipating
higher corn prices will make operational adjustments. They will
purchase fewer feeder cattle or only buy them at reduced prices; they
can make ration adjustments to a degree; and/or they can decrease the
number of days each animal is on feed (reducing total yardage costs and
perhaps total feed consumption). The latter option is achieved by
placing heavier-weight feeder cattle into the feedlot, or selling
fattened cattle at a lower finished weight. There are also many other
factors, such as beef demand, that affect the sales price of finished
cattle but have nothing to do with the corn price.
Another mitigating factor has been the ability of feedlots to
incorporate distillers grains into their feed rations. For each bushel
of corn ground to make ethanol, almost one-third of the material ends
up as distillers grains, and according to industry sources,
approximately 42 percent of the distillers grains consumed in the
United States in 2006 were used in beef cattle rations. Distillers
grains are a high-energy, high-protein feed source that can be used as
a feed substitute for corn. In fact, many recent feeding trials suggest
that feeding wet distillers grains with solubles actually increases
feed efficiency relative to corn.
Table 11 provides cost and revenue data for the U.S. cattle-feeding
industry based on a proprietary feedlot production cost model developed
by Informa. Annual data for calendar years 2004, 2005, and 2006 are
presented. The key assumptions made are that feeder cattle are
purchased and enter the feedlot at 750 pounds and are fed to a
marketing weight of 1,200 pounds live, equivalent to 756 pounds carcass
weight. The cost per head for feeder cattle entering the feedlot over
this 3-year timeframe ranged from $774 in 2004 to $841 in 2006, with
the 2005 cost very similar to 2006.

TABLE 11.--INFORMA FEEDLOT PRODUCTION COST MODEL
[Feedlot production cost model ($/head)]
----------------------------------------------------------------------------------------------------------------
Market Total Market
cost on Total cost of value of Steer
Marketing year 750 lb Feed cost costs in 1,200 lb 1,200 lb Difference carcass
feeder feedlot feeder feeder weight
steer steer steer
----------------------------------------------------------------------------------------------------------------
2004.............................. 774.40 167.92 270.00 1,044.40 1,012.97 -31.43 807
2005.............................. 838.98 135.77 247.16 1,086.14 1,054.46 -31.68 816
2006.............................. 840.99 150.92 268.72 1,109.71 1,035.62 -74.09 833
1,200 lb liveweight fed steer yields an average carcass weight of
756 lbs
----------------------------------------------------------------------------------------------------------------
Source: Informa Economics, Inc.

Feed costs per head for 450 pounds of gain vary primarily with the
cost of corn. Feed costs per head were about $168 in 2004, dropped to
$136 in 2005 as corn prices declined, and then rebounded to about $151/
head in 2006 as corn prices turned higher. Total costs per animal
during the feeding period are also provided; most changes are directly
related to the cost of corn. For the 3 years analyzed, the feed cost as
a percent of total costs ranged from a low of 54.9 percent in 2005 to a
high of 62.2 percent in 2004.
For information purposes, a calculation of the total cost of a
1,200 pound fed steer is provided along with the average market value
for that same animal. As can be seen, margins for feeding these animals
were negative in each year under study, with 2004 and 2005 losses
amounting to just over $31/head while 2006 losses were more than double
that at an estimated $74/head. Of note is the fact that even with a
$32/head lower feed cost per head in 2005 relative to 2004, per-head
production losses were the same in both years which, once again
reflects the disconnect that exists between the cost of corn and the
price of cattle.
Packer margins
Packers have been experiencing the largest sustained losses of any
of the beef supply chain participants. This has been a result of excess
capacity chasing relatively tight supplies. Declining margins in the
early 1990s forced plant shutdowns, and while margins improved in the
mid-1990s, they have declined to historically low levels within the
last 2 years. Figure 17 shows net packer margins since 2002.

2. Hogs
The hog industry has a much more integrated production system than
the cattle industry, and as a result, pork production growth tends to
be relatively stable, increasing at an average pace of 2 percent
annually since 2000. Unlike cattle, hogs can not utilize forages, thus
feed costs tend to account for a relatively large percentage of
variable input costs.
Hog production margins remained high but volatile throughout most
of the 1990s. However, in the late 1990s, producers expanded rapidly at
the same time as the packing industry was reducing capacity, resulting
in a huge price collapse in late 1998 and poor production margins for
the next year. Production margins recovered in 2000 and 2001 only to
turn negative during much of 2002 and 2003, as per capita pork supplies
increased to burdensome levels once again (see Figure 18).

Beginning in late 2003, the U.S. pork industry began to experience
an unprecedented boom in exports, which helped drive demand for pork
and propel prices and margins to much higher levels. Since then, hog
margins have remained mostly in the $20 to $30/head range, peaking
periodically into the $40/head range and dropping down into the teens
in early 2006. The run of profitability since 2004 has been the best on
record. Then, starting in early 2007, as corn prices had begun to
increase significantly, hog margins took a slight decrease down into
the $5-$25/head range, as the higher cost of gain offset hog prices,
which remained favorable up through the summer of 2007. In the fall of
2007, on large production increases, hog production margins finally
began to turn negative, ending the longest uninterrupted run of profits
on record for the industry.
In Table 12, the total production cost per hog is calculated and
converted to a total cost per cwt lean; it then is compared to the
annual average market value per cwt lean to give an indication of
production margins. The 2004-2006 time period was the best ever in
terms of profitability for the hog production sector. Given that the
long-term average margin for producers would fall somewhere in the $7-
$8/cwt lean range, the United States industry headed into 2007 with a
strong equity and financial condition fully able to withstand potential
margin pressures arising from higher corn costs.

TABLE 12.--HOG PRODUCTION COST MODEL
[Farrow to finish cost of production model]
----------------------------------------------------------------------------------------------------------------
Total Market
Feed Total cost value Margin
cost $/ cost $/ per $/ per $/ per cwt Live Carcass
head head cwt cwt lean weight weight
lean lean
----------------------------------------------------------------------------------------------------------------
2004............................................. 49.00 114.00 57.41 71.74 14.33 262.00 199.30
2005............................................. 37.00 103.00 51.09 68.28 17.19 264.00 200.70
2006............................................. 40.00 105.00 52.03 64.41 12.38 265.00 201.10
Butcher hog fed to 265 pounds
----------------------------------------------------------------------------------------------------------------
Source: Informa Economics, Inc.

3. Poultry: broilers and eggs
Broilers
The broiler industry is a highly integrated and concentrated
industry with the top 25 production operations accounting for a large
percentage of industry output. Since the decision making at the
production level is consolidated into few hands, the broiler industry
has the capability of making rather quick and meaningful production
adjustment decisions.
There appears to be very little correlation between historical
poultry margins and the price of corn (see Figure 19). In fact, when
corn prices were at their lowest in early 2006, poultry margins were
negative, and as corn prices began to take off, poultry margins climbed
(although they took a brief dip when corn prices peaked in early 2007).
In early 2003, poultry margins took a swing from negative to positive,
despite relatively stagnant corn prices. This was a direct result from
a cutback in production taken after the margin losses in 2002 and 2003.
This cutback in production along with record high prices in late 2003
and early 2004 led to record high margins by mid-2004. Then, as exports
dropped off due to the high poultry prices, margins began to decline.
Corn prices throughout all of this have had relatively little effect.
In fact, the record-high margins in mid-2004 directly followed a corn
price spike in the preceding months.

As of November 2007, nearby CBOT corn futures were about $4/bushel,
while soybean meal has been averaging near $220/ton. Based on these
feed input prices, the feed cost per pound of broiler meat produced has
risen to 25 cents compared to an average of 20.6 cents in 2006. This
appreciation in feed costs has raised total production costs to nearly
56 cents per pound. Even with this advance in feed costs, sales values
for both whole birds and broiler parts are providing a weighted
industry return of nearly 14 cents per pound (see Table 13).
With financial returns of this magnitude, odds favor the industry
increasing production rather than maintaining the slight reductions
that started last fall and lasted through the first quarter of 2007.
The industry did initiate a production rollback in the fall of 2006 due
to poor margins; the weak margin situation was due to weak product
prices in combination with rising feed costs. The production declines
were large enough to raise product prices, and now that sales values
have recovered so too have margins.

TABLE 13.--BROILER PRODUCTION COSTS AND IMPACT OF HIGHER CORN PRICE
[U.S. broilers]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Weighted
net
returns
Whole Cutout (80
Average Feed Other Total broiler net percent
Average eviscerated cost per cost per cost per net returns cutout,
liveweight weight RTC RTC RTC returns per RTC 20
pound pound pound per RTC pound percent
pound whole
broilers)
per RTC
--------------------------------------------------------------------------------------------------------------------------------------------------------
2004.............................................................. 5.27 3.82 22.58 30.84 53.43 21.24 16.45 17.41
2005.............................................................. 5.38 3.90 19.52 30.84 50.36 22.46 10.21 12.66
2006.............................................................. 5.47 3.96 20.60 30.84 51.45 16.80 0.00 3.36
2007 ($4.00/bu corn).............................................. 5.45 3.95 25.00 30.84 55.85 18.30 12.92 13.99
2007 ($4.50/bu corn).............................................. 5.41 3.92 27.49 30.84 58.33 7.06 -4.05 -1.83
--------------------------------------------------------------------------------------------------------------------------------------------------------

Eggs
Table 14 provides estimates of shell egg production costs. The feed
cost per dozen eggs produced has varied from a low of 23.95 cents per
dozen in 2005 to a high of 27.54 cents in 2004. Costs in 2006 for the
feed component of production costs averaged 25.49 cents per dozen.
Based on shell egg selling prices in the past 3 years, margins have
been rather variable. In 2004, margins averaged over 18 cents per dozen
even though feed costs were high, helped by very firm egg prices. Lower
feed costs in 2005 were accompanied by weak egg prices and margins
slipped to 5.41 cents before recovering to 10 cents per dozen in 2006.
As with other livestock sectors, changes in feed costs have not been
correlated with producer margins.

TABLE 14.--EGG COST OF PRODUCTION MODEL
[Table egg cost of production model]
----------------------------------------------------------------------------------------------------------------
Urner Barry MW
Feed cost per Total cost per Margin per shell egg
dozen dozen dozen price
----------------------------------------------------------------------------------------------------------------
2004............................................ $27.54 $49.80 $18.04 $86.54
2005............................................ 23.95 45.72 5.41 68.80
2006............................................ 25.49 47.37 10.00 75.44
$4.00 corn...................................... 32.61 55.25 20.90 92.71
$4.50 corn...................................... 34.75 57.75 18.40 92.71
----------------------------------------------------------------------------------------------------------------

Despite the highest feed costs in over 10 years, margins for the
industry are the best in many years due to very strong egg prices. With
average shell egg prices projected to be near 93 cents per dozen,
production margins are very strong and this suggests the potential for
expanding production rather than production declines.
4. Milk
Estimated milk production margins have averaged $9.35/cwt over the
time period from January 2000 to September 2007. Milk margins declined
in 2002-2003 when corn prices increased, but margins climbed as corn
prices spiked in 2003-2004 (see Figure 20). Both corn prices and milk
margins declined during the latter part of 2004 and most of 2005.
Despite current corn prices taking off, beginning in early 2007, milk
margins have climbed to record high levels. This suggests that corn
prices are a very minor determinant of milk production margins and are
not a primary driver of milk prices.

Milk margins have been strong the past year largely as a result of
rising milk prices, which have been driven by demand increases. U.S.
milk consumption is increasing, and world dairy demand is also
increasing. This world demand increase follows strong economic growth
in many developing countries, and it is compounded by the fact that
many major milk-producing countries, such as Australia, have been
experiencing drought, thus tightening world milk and dairy supplies.
Due to this strong global demand, U.S. exports of dairy products have
increased significantly, and this has supported domestic price
increases of milk and milk products.

VII. DRIVERS OF FOOD PRICE INFLATION

Given that historical data shows little relationship between corn
prices and consumer food prices, the question arises: What does drive
consumer food prices? This section will explore various factors
affecting consumer food price inflation. In summary, food price
inflation is caused by a complex set of factors.
A. Summary of usda models of the food CPI
USDA-ERS periodically forecasts the food CPI, and it is frequently
asked to evaluate the impact of input price changes. The agency has
three different models it uses to analyze the food CPI, with the choice
of model depending on whether or not the objective calls for an
analysis of short-run or long-run impacts. The ERS price-spread model
and input-output model are used to analyze short-run impacts, while the
variable proportions model is used in long-run analyses.
The price-spread model uses a weighted sum of percent changes in
input prices from 16 food industries to estimate input price change
effects on at-home food prices, where each input change is weighted by
its respective cost share. It is assumed that each firm in each of the
16 food industries produces a single end-product; accordingly, the
model combines a farm commodity with a set of non-farm inputs in fixed
proportions.
Alternatively, the input-output model, while similar to the price-
spread model, considers the indirect effects of changing input costs.
For example, an increase in energy will not only affect the cost of
producing the food item, but it will also impact the costs of producing
other food production inputs. This model uses a system of equations
from 50 food industries and 430 nonfood industries. Both of the short-
run models assume that consumers do not respond to retail price changes
and that food producers do not alter their input proportions.\5\
---------------------------------------------------------------------------
\5\ This may be a rather strong assumption, especially for certain
food products in which demand is elastic, there are multiple substitute
products available to consumers, or for which there are substitute
products available within the production process.
---------------------------------------------------------------------------
However, the long-run model, the variable proportions model,
relaxes these short-run restrictions. This eight-market food model uses
a system-of-equations approach: (1) the first equation relates the
industry's retail price to the price of one marketing or non-farm
input, the exogenous farm supply, and the shift in consumer demand; and
(2) the second equation relates the industry's farm price with the same
three variables. Analyses using the variable proportions model have
shown that changes in input prices do not always lead to food price
increases. This effect is mitigated by firms altering their input
proportions and by changing consumer demand.\6\
---------------------------------------------------------------------------
\6\ Reed, A.J., K. Hanson, H. Elitzak, and G. Schluter. 1997.
``Changing Consumer Food Prices: A User's Guide to ERS Analyses.''
Technical Bulletin #1862. Economic Research Service, Washington, DC.
---------------------------------------------------------------------------
The ERS lists four key factors as influencing how input cost
increases affect food prices.\7\ The first is the share of total costs
accounted for by the input (this is discussed in detail below). The
second is whether or not the input has adequate substitutes in the
production process. the third is whether or not consumers have good
substitutes for the food product. Last is the time period considered.
In the short run, producers and consumers might not be able to adjust
to price changes. If the price change is permanent, such adjustments
can be made, but on the other hand, this might cause some firms to go
out of business, causing the price increase to be greater in the long
run.
---------------------------------------------------------------------------
\7\ Economic Research Service. 2007. ``Food CPI, Prices, and
Expenditures: How Changes in Input Costs Affect Food Prices.''
Retrieved from www.ers.usda.gov/Briefing/CPIFoodAndExpenditures/
howchangesininputcostsaffectf.
---------------------------------------------------------------------------
B. Food marketing costs
1. Composition of the retail food dollar
The share of the final food product price accounted for by the cost
of commodities purchased from producers has declined over the years.
According to consumer expenditure data collected by the BLS and
reported by the USDA, the ``farm value'' accounts for 19 percent of
total food costs. This proportion has declined significantly from 37.2
percent in 1973 (see Figure 21).
The remaining portion of total retail food costs (i.e., in addition
to the farm value) is known as the marketing bill. The marketing bill
includes labor, packaging, transportation, energy, profits,
advertising, depreciation, rent, interest, repairs, business taxes, and
other costs.
With the decrease in the share of the food dollar accounted for by
the farm value of raw materials, corn price changes have a declining
impact on the overall food retail price. Furthermore, within many food
items, corn constitutes only a portion of the farm value. Thus, in
items where corn is only one of several farm inputs, total food costs
attributable to the cost of corn will be on average even less than 19
percent.
While 19 percent represents the average share of farm value in the
retail food dollar, this percentage varies considerably among food
items. Table 15 provides the most current annual average data available
for food categories for which the USDA estimates the farm value share
of the retail food price.\8\
---------------------------------------------------------------------------
\8\ The most recent annual average data available for cereals and
bakery products, fats and oils, and dairy were for 2005. Annual
averages were available for 2006 for meat product data.

TABLE 15.--FARM VALUE SHARE OF RETAIL FOOD PRICE BY FOOD CATEGORY
------------------------------------------------------------------------
Farm value as
Food product category percentage of
retail price
------------------------------------------------------------------------
Cereals and bakery items................................ 6
Beef.................................................... 47
Pork.................................................... 30
Chicken................................................. 36
Dairy products.......................................... 36
Fats and oils........................................... 17
------------------------------------------------------------------------

The farm value share of the food dollar is provided for specific
food products rather than categories in Table 16. The product examples
that were selected for the table either are derived from corn or are
commodities affected by the corn market (e.g., livestock, poultry,
wheat, and soybeans). Again, total farm-based input costs are shown,
not only the cost of corn.

TABLE 16.--EXAMPLES: COST OF FARM INPUTS AS A SHARE OF PRICES OF SELECT RETAIL FOOD PRODUCTS
----------------------------------------------------------------------------------------------------------------
Cost of
Farm value Example retail input(s)
Food product share of prices (price purchased from
retail price per pound) farm (price
(percentage) per pound)
----------------------------------------------------------------------------------------------------------------
Milk, \1/2\ gal................................................. 34 $3.84 $1.31
Flour, wheat, 5 lbs............................................. 19 0.36 0.07
Bread, 1 lb..................................................... 5 1.21 0.06
Margarine, 1 lb................................................. 15 1.26 0.19
Corn flakes, 18 oz. box......................................... 4 1.65 0.07
Corn syrup, 16 oz. bottle....................................... 3 1.57 0.05
Ground beef, 1 lb............................................... 47 2.37 1.11
Bacon, sliced................................................... 28 3.78 1.06
Chicken, fresh whole............................................ 47 1.14 0.54
----------------------------------------------------------------------------------------------------------------
Sources: USDA, ERS (utilizing most current data available for each food product category, as of October 2007)

VIII. PERSPECTIVE ON COMMODITY PRICE INFLATION

Although it has been shown in the preceding sections of this report
that corn price changes have, at most, a weak correlation with changes
in the food CPI, additional context can be provided to this report by
examining not only the higher corn prices that have occurred since fall
2006 but also the environment of general commodity price inflation in
which this has been occurring.
A. Corn prices
The ``conventional wisdom'' expressed in the media is that a
dramatic increase in the use of corn in ethanol production caused corn
prices to increase substantially, particularly since the fall of 2006.
However, even the reason for the increase in corn prices is more
complex than indicated by the media.
Fueled by a record yield, the United States harvested a record corn
crop of 11.8 billion bushels in 2004. In 2005, acreage remained steady,
but a more historically consistent yield led production to fall to 11.1
billion bushels. Then, in the spring of 2006, price signals in the
futures markets gave farmers the incentive to plant more soybeans, and
the acreage planted to corn fell by 3.5 million acres. Combined with
relatively flat yields, corn production fell for the second year in a
row, to 10.5 billion bushels.
Thus, corn production fell by 1.3 billion bushels over 2 years,
even though the usage of corn in ethanol production expanded from 1.3
billion bushels in 2004-2005 to 2.1 billion bushels in 2006-2007 (see
Figure 22). Yet, the ethanol industry was not the only source of
additional demand. U.S. corn exports, which were 1.8 billion bushels in
2004-2005, rose to 2.1 billion bushels in both 2005-2006 and 2006-
2007--a level that was at the top of the range experienced over the
previous decade. So, it was basic supply and demand--a reduction in
supply and an increase in demand from both ethanol and exports--that
led to prices moving higher in the fall of 2006.

Then, in 2007, U.S. farmers proved that they could respond to the
market's need for more corn. In the 1996 and 2002 Farm bills, producers
had been relieved of the base-acre and set-aside systems that had
previously restricted what they could plant, and they now had ``freedom
to farm''--the ability to allocate their crop acreage as they saw fit,
with few remaining constraints. With this freedom and corn prices that
provided a significant net revenue premium per acre over soybeans,
farmers planted 93.6 million acres of corn in 2007--the highest level
since the 1940s. As of November 2007, the USDA estimates the crop at a
record 13.2 billion bushels (see Table 17).
As was mentioned earlier in this report, the level of corn stocks
at the end of the crop year relative to the volume of corn consumed
during the year is a key factor in the pricing of corn. At the end of
2004-2005, when the previous record crop was harvested, the stocks-to-
use ratio was nearly 20 percent, which is plentiful by recent
historical standards. However, with lower production and rising ethanol
usage and exports, the stocks-to-use ratio was cut almost in half, to
just under 12 percent, in 2006-2007. This was reflected in
substantially higher prices.
Despite Informa's projections of an almost 800-million-bushel
increase in the corn grind for ethanol and an additional 250 million
bushels of exports, the record crop of 2007 is forecast to allow stocks
to build to over 2.1 billion bushels by the end of the crop year,
allowing the stocks-to-use ratio to rebound to 17.1 percent. Normally,
this would be expected to allow prices to ease significantly. However,
soybean oil prices have been lifted by rising crude oil (petroleum)
prices, and as a result the pace of soybean consumption is expected to
bring stocks to meager levels by the end of the 2007-2008 crop year,
and if there is not a rebound in soybean acres planted in 2008 stocks
could reach unsustainably low levels. This has led to upward pressure
on soybean prices, and in order for corn acreage not to fall too far in
the face of continued ethanol industry expansion--and likely continued
strength in exports given weakness in the U.S. Dollar--the market has
maintained relatively high corn futures prices.
Based on futures prices as of November 2007, farmers would be
expected to plant nearly 89 million acres of corn in 2008. If this were
to occur, Informa's forecast of the stocks-to-use ratio for 2008-2009
would be 16.5 percent, which is ample but not burdensome. The national
average farm price for corn, which Informa forecasts to be $3.25/bu in
2007-2008 would be forecast to fall to $2.85/bu in 2008-2009 under this
scenario.
However, absent a very favorable soybean yield in 2008, such a high
level of corn plantings would likely not allow soybean production to be
sufficient to prevent stocks from falling to an unsustainable level,
and prices would have to rise even further to ration demand.
Accordingly, it is expected that by the spring of 2008 the market will
anticipate this imbalance, and corn acres will be reduced further, with
balance perhaps occurring at roughly 86 million acres of corn. In this
case, even with no change in the demand forecast, the stocks-to-use
ratio for corn would be forecast to recede to 12.7 percent in 2008-
2009, which would be sufficient and would allow corn prices to come
down.

TABLE 17.--U.S. CORN BALANCE SHEET
--------------------------------------------------------------------------------------------------------------------------------------------------------
97/98 98/99 99/00 00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 08/09
--------------------------------------------------------------------------------------------------------------------------------------------------------
Planted acres............................... 79.5 80.2 77.4 79.6 75.7 78.9 78.6 80.9 81.8 78.3 93.6 88.9
Harvested acres............................. 72.7 72.6 70.5 72.4 68.8 69.3 70.9 73.6 75.1 70.6 86.1 81.8
Yield....................................... 126.7 134.4 133.8 136.9 138.2 129.3 142.2 160.4 148.0 149.1 153.0 160.0
===========================================================================================================
Beginning inventories (September 1)......... 883 1,308 1,787 1,718 1,899 1,596 1,087 958 2,114 1,967 1,304 2,117
Production.................................. 9,207 9,759 9,431 9,915 9,503 8,967 10,089 11,807 11,114 10,535 13,168 13,083
Imports..................................... 9 19 15 7 10 14 14 11 9 12 10 10
-----------------------------------------------------------------------------------------------------------
Total supply.......................... 10,099 11,085 11,232 11,639 11,412 10,578 11,190 12,776 13,237 12,514 14,482 15,209
===========================================================================================================
Feed and residual........................... 5,479 5,469 5,665 5,842 5,864 5,563 5,795 6,158 6,155 5,598 5,700 5,400
Food/seed/industrial........................ 1,805 1,846 1,913 1,957 2,047 2,340 2,537 2,686 2,981 3,488 4,290 5,500
Of which: ethanol for fuel.............. 481 526 566 628 706 996 1,168 1,323 1,603 2,117 2,900 4,100
===========================================================================================================
Domestic use............................ 7,284 7,316 7,578 7,799 7,911 7,903 8,332 8,844 9,136 9,086 9,990 10,900
Exports..................................... 1,507 1,983 1,937 1,941 1,905 1,588 1,900 1,818 2,134 2,124 2,375 2,150
-----------------------------------------------------------------------------------------------------------
Total use............................. 8,791 9,298 9,515 9,740 9,815 9,491 10,232 10,662 11,270 11,210 12,365 13,050
===========================================================================================================
Ending inventories (August 31).............. 1,308 1,787 1,718 1,899 1,596 1,087 958 2,114 1,967 1,304 2,117 2,159
===========================================================================================================
Stocks/use (percent)........................ 14.9 19.2 18.1 19.5 16.3 11.4 9.4 19.8 17.5 11.6 17.1 16.5
===========================================================================================================
Futures price ($/bu)........................ 2.57 2.16 2.10 2.09 2.15 2.37 2.64 2.12 2.23 3.54 3.55 3.25
Farm price ($/bu)........................... 2.43 1.94 1.82 1.85 1.97 2.32 2.42 2.06 2.00 3.03 3.25 2.85
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: USDA, CBOT (History); Informa Economics.

Thus, producers have demonstrated their ability to respond swiftly
to market conditions in making their acreage decisions. Assuming normal
weather, this ability and willingness to shift acres is expected to
mitigate any further inflationary pressures on corn prices through at
least the 2008-2009 crop year, despite expectations for continued rapid
growth in the ethanol industry. As a final note, there is evidence that
the biotech corn traits that were first introduced in the United States
in 1996 and have been gaining broader adoption in recent years have led
to the potential for above-trend yields to be achieved; to the extent
that this occurs or technology developments accelerate, this would
further mitigate any upward pressure on corn prices.
B. General commodity and macroeconomic inflation
The increase in corn prices since the fall of 2006 is not occurring
in a vacuum, and in fact the Reuters/Jeffries CRB index, an index of
commodity prices, has more than doubled since 2001 (see Figure 23). The
index is a weighted average of the prices of 19 commodities in three
categories: energy, agriculture, and metals.

Crude oil, heating oil, and unleaded gasoline carry one-third of
the overall weighting of the index. Therefore, it is not surprising
that the index has been on a prolonged run as crude oil prices have
surged from around $20/barrel in November 2001 to almost $100/barrel in
November 2007 (see Figure 24).

However, the weighting of energy commodities in the index masks the
fact that the prices of metals and, more recently, agricultural
commodities have been increasing. There is some interrelation of the
price increases, as the demand for basic materials that has been
generated by the strong economic growth in developing countries,
especially China and India, encompasses not only energy but also
metals. Higher energy prices have been a contributor to higher
agricultural commodity prices as well, since they have fostered higher
prices for ethanol and biodiesel and the expansion of those industries.
Moreover, the depreciation of the U.S. Dollar, which has been
particularly acute in the fall of 2007, has affected the prices of
multiple commodities, making U.S. corn more affordable and thereby
increasing export demand, and contributing to the rise in oil prices
(see Figure 25).

In summary, corn has been one of several commodities that have
experienced upward price pressure in recent years. Historically, rising
prices for commodities in general--not corn in isolation--have
contributed to overall macroeconomic inflation (see Figure 26). This
was particularly the case during and after the oil price shocks of the
1970s. However, as the U.S. economy has become more service oriented
and the manufacturing sector has accounted for a declining share of
gross domestic product, there has been less of a direct impact of
higher commodity prices on general inflation. Productivity gains have
also helped dampen inflation.

IX. CONCLUSIONS

While there have been a number of stories in the media over the
last year indicating that consumer food prices are being driven higher
by an ethanol-induced increase in corn prices, there is little evidence
of such a simplistic cause-and-effect linkage. In reality, a complex
set of factors drives the food CPI. In fact, the marketing bill,
defined as the portion of the food dollar that is not related to the
farm value of raw materials, has a stronger relationship with the food
CPI than does the cost of corn. While an increase in corn prices will
affect certain industries--for example, causing livestock and poultry
feeding margins to be lower than they otherwise would have been--the
statistical evidence does not support a conclusion that there is a
strict ``food-versus-fuel'' tradeoff that is automatically driving
consumer food prices higher.

APPENDIX A: BACKGROUND ON THE ``FOOD VS. FUEL'' DEBATE

A. Media coverage
There has been no shortage of media attention given to the food-
versus-fuel debate since late 2006. Major news sources such as The
Washington Post, Los Angeles Times, CBS News, U.S. News & World Report,
and The Wall Street Journal have run stories indicating that rising
corn demand is causing an increase in consumer food prices. The
following quotes are representative of stories and editorials that have
been carried by the media:
--``Corn prices in America have spiked. And since corn is also a
prime ingredient for animal feeds and sweeteners, prices
likewise are rising for poultry, beef and everything from soft
drinks to candy.'' (The Washington Post; June 30, 2007)
--``While we worry about gas prices, the cost of milk, meat, and
fresh produce silently skyrockets. So like the end of cheap
energy, is the era of cheap food also finally over?''
(Washington Times; June 30, 2007)
--``. . . rising food prices are threatening the ability of aid
organizations to help the world's hungriest people . . .''
(Christian Science Monitor, quoted by CBS News; July 29, 2007)
--``Food prices were up 3.9 percent in April over a year ago. The
overall inflation rate in the same period: 2.6 percent. Over
the past 5 years, food prices have risen 12.2 percent
nationwide. . . . Fuel costs and rising demand for corn are
helping to drive the higher prices, experts said. Corn, for
instance is in growing demand to make ethanol. Because it's
used so much in cattle feed, that's pushing up prices for meat,
milk, and eggs.'' (Chicago Sun Times; June 6, 2007)
--``Ethanol already consumes so much corn that signs of strain on the
food supply and prices are rippling across the marketplace.''
(U.S. News & World Report; February 4, 2007)
--``Further, there's only so much farmland to go around. To meet the
Senate's 2022 renewable-fuels mandate of 35 billion gallons
using corn would take 96 million acres. Last year, the entire
corn crop, most of which went to food, was grown on 80 million
acres. The only source of unused farmland is 37 million acres
in the Federal Conservation Reserve Program, under which the
Government rents cropland from farmers for wetlands and
wildlife.'' (L.A. Times; August 20, 2007)
However, not all mainstream media reports have drawn a simplistic
link between ethanol production and food prices. Bad weather,
increasing export demand for certain food products, and high
transportation costs resulting from rising fuel prices also have been
cited as being additional drivers of recent food price increases.
Additionally, the declining cost of corn as a proportion of total food
prices has been used as a counter-argument, particularly regarding the
prices of higher value-added products. Recently, the U.S. Department of
Agriculture (USDA) acting Secretary Chuck Conner was noted as saying,
``Ethanol fuel is getting too much of the blame for what's happening in
grocery store aisles'' (Food and Fuel America; October 5, 2007).
While the statements made in the mainstream media are what reach
the general public, there is not necessarily much analytic rigor behind
them. Given all the claims and counter-arguments in the media, and
given the importance of the policy debate occurring regarding renewable
fuels, it is useful to look at more in-depth, analytically oriented
research on whether there is a connection between ethanol production
and consumer food prices.
B. Research publications
Despite the considerable amount of attention given to this topic by
the media, relatively few studies have been conducted to provide
evidence supporting one side or the other on this issue.
1. Center for Agricultural and Rural Development
A study entitled ``Emerging Biofuels: Outlook of Effects on U.S.
Grain, Oilseed, and Livestock Markets'' (May 2007) was conducted by the
Center for Agricultural and Rural Development (CARD) at Iowa State
University. This study utilized a multi-product, multi-country,
deterministic partial-equilibrium model to evaluate the impacts of
ethanol production on planted acreage, crop prices, livestock
production and prices, trade, and retail food costs. The analysis
assumes current tax credits and trade policies are maintained.
Essentially, the study authors customized the modeling system of the
Food and Agricultural Policy Research Institute (FAPRI), which models
supply and demand for all important temperate-climate agricultural
products. This model was then utilized to analyze long-run equilibrium
prices under several ethanol outlook scenarios.
The CARD study concluded that ethanol expansion will cause long-run
crop, livestock, and retail food price increases. The study predicted
that in the long run, general food prices (food at home and food away
from home) will increase 0.7 percent to 1.8 percent more than they
otherwise would have.
There were two basic ethanol scenarios considered. Under the
baseline oil-price assumption, model results indicate a 0.7 percent
increase in food prices due to ethanol production. If oil prices were
$10/barrel higher than the baseline assumption, the ethanol impact on
food prices increases to 1.8 percent. The highest increases are
predicted for at-home food prices (0.9 percent-2.2 percent), whereas
away-from-home food-price increases are slightly more modest (0.6
percent-1.5 percent).
The study then deconstructs the predicted increase in prices of
food consumed at home into more specific food item categories,
predicting that the greatest inflationary pressure will be evident in
the eggs market. The range in consumer egg price inflation as a result
of ethanol production is estimated between 5.4 percent and 13.5
percent. Additional consumer price inflation is estimated to range
between 2.5 percent and 6.3 percent for meats, between 1.4 percent and
3.5 percent for dairy, and 0.5 percent to 1.2 percent for cereal and
bakery products.
2. National Corn Growers Association/Advanced Economics
Solutions
The National Corn Growers Association (NCGA) released a report in
March 2007 addressing the impact of higher corn prices on consumer food
prices. They compiled the analyses/reports of the USDA, the Bureau of
Labor Statistics (BLS), and Advanced Economics Solutions (AES, a
consulting firm commissioned by the NCGA to analyze the impact of
increased corn prices on retail food prices). Given USDA estimates of
food input costs as a percentage of retail food prices and hypothetical
corn prices of $3.50 to $4.00 per bushel (bu), AES estimated that
retail prices for meat, poultry, fish, and eggs would be 4 percent to
11 percent higher than they otherwise would have been during the 2007-
2009 period. As for consumer dairy prices, increases in the range of
4.3 to 8.3 percent were predicted. The study predicts a much lower
increase in price inflation levels for cereal/bakery items of 0.67
percent to 1 percent annually. However, an important assumption behind
the study is that while food-processing margins might be compressed in
the short run due to higher corn prices, in the long run all of the
increase in corn prices will be passed on to consumers.
3. U.S. Department of Agriculture
The publication ``USDA Agricultural Projections'' (February 2007),
which was also incorporated into the NCGA report, projected market
impacts related to ethanol supply; corn production, prices, and usage;
other crop production and prices; livestock production and prices
(including the impact of distiller's grains); and farmland values. The
study concluded:
--Consumer price inflation rates for red meats, poultry, and eggs
will exceed the general inflation rate between 2008 and 2010,
raising the inflation rate of food prices (all food) above the
general inflation rate by as much as about 0.5 percent;
--Despite this initial period of higher food price inflation, on
average, retail food prices will increase less than the general
inflation rate over the next 10 years (the food-price inflation
rate is predicted to fall below the general inflation rate
after 2010); and
--Highly processed foods, such as cereals and bakery products, will
rise at a rate near the general inflation rate.\9\
---------------------------------------------------------------------------
\9\ Since the USDA projections were released in February 2007, some
of the assumptions are now out of date. For instance, study authors did
not foresee 93 million acres planted to corn in 2007, or wheat supply
issues that have caused a spike in wheat prices.
---------------------------------------------------------------------------
4. American Farm Bureau Federation
The American Farm Bureau Federation published an article (July
2007) in which it indicated that while meat and dairy consumer price
indices (CPI) have increased more than the ``core CPI'' (i.e., the
average rate of inflation in the general economy, excluding food and
energy prices), these increases are not related to corn prices. The
analysis illustrates that recent corn price increases are not related
to meat and dairy prices (on-farm). The point is made in the article
that meat prices were increasing long before corn prices started to
increase. It concludes that with little relationship between corn
prices and meat and dairy prices, very little of the increase in food
costs--particularly for meat and dairy products--can statistically be
attributed to increased corn prices.

Senator Brownback. The figure that I've seen is that it
reduces the price 15 percent; the gasoline price in the country
would be 15 percent higher if not for ethanol. So I think we've
got to look at this thing as an overarching supply and demand
situation. While you take corn out of the market to make
ethanol, it doesn't go in the trash can; it goes in the gas
tank; and that there's a supply and demand there that has a
positive impact.
Plus, I was looking at the prices. In this country we don't
eat that much corn directly. We do some, but mostly it's fed to
livestock. So it has an indirect impact on the overall food
prices in this country. You can escalate corn prices 40 percent
with having minimal, less than 1 percent, impact on overall
food prices in the country.
Do you chart that number or look at that number?
Mr. Lukken. Yes, we look at all sorts of fundamental
numbers like that, yes.
Senator Brownback. I hope you can supply that one to us as
well.
Thank you, Mr. Chairman.
[The information follows:]

Senator Durbin. Chairman Lukken, thank you very much. We
appreciate your testimony today. We look forward to sending you
some questions in writing, myself and other members of the
subcommittee, and hope you can give us some timely answers.
Mr. Lukken. Thank you for allowing me to testify.
Senator Durbin. You bet.
SECURITIES AND EXCHANGE COMMISSION

STATEMENT OF HON. CHRISTOPHER COX, CHAIRMAN
Senator Durbin. Chairman Cox, welcome to the subcommittee.
Senator Brownback and I are minimizing our opening statements
so that we'll have a few more moments to ask questions and not
take too much of your own time. If you would like to summarize
your opening statement, the entire written statement will be
made part of the record.

SUMMARY STATEMENT

Mr. Cox. Thank you very much, Mr. Chairman, Senator
Brownback, and members of the subcommittee. Thank you for the
opportunity to testify today about the President's fiscal year
2009 budget request for the SEC.
I'll begin by saying that, in return for the SEC's not
quite $1 billion budget, the taxpaying public is getting
significant value. The SEC oversees the nearly $44 trillion in
securities trading annually on U.S. equity markets, the
disclosures of about 13,000 public companies, and the
activities of about 11,000 investment advisers, 1,000 fund
complexes, and 5,700 broker-dealers.
The Commission is active on a number of fronts working to
protect investors, promote capital formation, and foster
healthy markets. The failure of Bear Stearns has brought to the
fore the regulatory gap in the supervision of investment banks.
Although Federal law provides for supervision of commercial
banks, no such scheme exists for the largest investment banks.
The Commission created the voluntary Consolidated Supervised
Entities (CSE) Program to partly fill this gap. Without this
voluntary program, there would have not been any consolidated
information available to regulators, including the New York
Fed, when Bear Stearns precipitously lost liquidity in mid-
March 2008.
While the CSE program is at present voluntary and receives
no dedicated funding from the Congress, we understand that
Congress may be acting to fill this gap. I strongly support
this because of the fact that even today the SEC has no
explicit statutory mandate to supervise the Nation's investment
banks on a consolidated basis. It is a statutory no-man's-land
that should not be tolerated indefinitely.
For the meantime, I have prepared information for the
subcommittee concerning the SEC's proposed increases to the
staffing in the CSE Program that I have submitted along with my
testimony.
In addition to the important work of investment bank
supervision, the Congress recently gave the Commission
significant new statutory authority over credit rating
agencies. That has permitted us to register credit rating
agencies with the SEC beginning last fall. As of the end of
September 2007, seven credit rating agencies, including those
that are most active in rating subprime securities, became
subject to the Commission's new oversight authority.
In the 6\1/2\ months since the Commission's authority over
these credit rating agencies went into effect, two additional
ratings agencies have registered with the Commission, so that
now there are nine nationally recognized statistical rating
organizations registered with the SEC and in competition in the
marketplace.
We have aggressively used our new examination authority
under the new law to evaluate whether credit rating agencies
are adhering to their published methodologies for determining
ratings and managing conflicts of interest. We will shortly
publish the findings of these examinations, which have focused
on the three largest firms most active in rating subprime-
related securities, and we will soon propose significant new
rules governing credit rating agencies that build on the
lessons learned from the recent subprime market turmoil.
Through the SEC's broader inspection and examination
program, the SEC is focusing on securities firms and the
adequacy of their controls over valuation, their controls to
prevent insider trading, the level of protection they provide
to seniors in our markets, and the adequacy of their compliance
programs to prevent, detect, and correct violations of the
securities laws.
The SEC is also working closely with our fellow regulators
to promote the fairness and stability of the markets. Under the
recently concluded MOU with the CFTC to which you just
referred, Mr. Chairman, and Mr. Chairman Lukken has just talked
to you about, we have established what we hope will be a
durable process to better regulate today's increasingly
interconnected markets.
To better anticipate future problems across all areas of
the securities markets, we are more than doubling the size of
the SEC's Office of Risk Assessment. The newly expanded office
will help throughout the Commission to look around the corners
and over the horizon in order to identify potentially dangerous
practices before they impact large numbers of investors and the
economy as a whole.
From both a budget and a policy standpoint, the SEC is
first and foremost a law enforcement agency. The budget
submission for fiscal 2009 would represent the largest amount
of money ever devoted by the agency to pursuing wrongdoers in
all corners of the securities markets. To lever the
effectiveness of that investment, we are using new technology,
including a new agency-wide enforcement database called the
Hub, along with improved management of resources to focus our
enforcement efforts on the areas of greatest risk for
investors.
The Enforcement Division is aggressively investigating
possible fraud, market manipulation, and breaches of fiduciary
duty in the subprime area through our subprime working group.
It's also pursuing significant investigations of insider
trading, wrongdoing in the municipal bond market, Internet and
microcap fraud, and scams against seniors. We've taken
additional steps to safeguard investors and protect the
integrity of the markets by redoubling our efforts to stamp out
abusive naked short selling, including recently proposing a
rule that would explicitly target naked short selling as fraud.
The SEC is also building upon its growing success in
returning funds to harmed investors. Since the agency first
received authority from Congress under the Sarbanes-Oxley Act
to use FAIR funds, we have returned a total of more than $3.7
billion to harmed investors. We expect to distribute another
three-quarters of $1 billion in the next 6 months alone, aided
by the establishment of a dedicated Office of Distributions and
Collections and a new computer tracking system for investor
funds from penalties and other sources called Phoenix.
The SEC's efforts in the international arena have by
necessity been a key focus of my chairmanship. The world's
regulatory and enforcement authorities are finding that we have
to collaborate if we are to protect our own investors.
Accordingly, the SEC is working closely with our international
counterparts to monitor the markets and pursue fraudsters
wherever they run.
We're also exploring the idea of mutual recognition among a
very few high standards countries with robust regulatory and
enforcement regimes in order to strengthen our level of
cooperation.
In recognition of the interconnectedness of global markets,
the SEC is continuing to expand our own expertise in
international financial reporting standards and to explore
additional ways that U.S. investors might benefit from the
increased comparability of investments in the marketplace that
would result from using a truly global high-quality standard.
This year, after years of experience through the SEC's
voluntary interactive data pilot program, the Commission will
consider beginning to migrate public company filing with the
SEC to interactive data. That would allow investors to have far
easier access to information from the paper forms and financial
statements that companies have filed since the 1930s. In
addition, they would be able to use computers to easily and
instantly compare information about the companies and funds in
which they invest.
There are other investor-friendly improvements in store for
mutual fund disclosure. In the coming months the SEC will
consider allowing investors to have access to a summary
prospectus for mutual funds that would succinctly present key
facts about their funds up front and, with progressively more
detailed information available in layers, give them an
opportunity to exploit the Internet's easy search capabilities.

PREPARED STATEMENT

Mr. Chairman, these are only some of the highlights of what
the agency has recently been focused on and what we have
planned for the coming year. The SEC's mandate is as broad as
it is important to America's investors and to our markets. On
behalf of the agency, let me thank you for the support that you
and this subcommittee have so well provided for these vital
efforts. I want to thank you for this opportunity to discuss
the SEC's appropriation for fiscal 2009, and I look forward to
working with you to meet the needs of our Nation's investors.
I'll be happy to answer your questions.
[The statement follows:]

Prepared Statement of Christopher Cox

Chairman Durbin, Ranking Member Brownback, and members of the
subcommittee: Thank you for the opportunity to testify today about the
President's fiscal year 2009 budget request for the Securities and
Exchange Commission.
As you know, until this year the Congress had not increased the
SEC's budget for 3 years. If the President's budget request for another
increase next year is approved, then after years of flat budgets, the
SEC will have received a roughly four percent increase over 2 years.
After taking inflation and pay increases into account, this budget for
fiscal year 2009 would permit the SEC to keep staffing on par with
levels in fiscal year 2007--at about 3,470 full-time equivalents.
In return for the SEC's not-quite $1 billion budget, the tax-paying
public gets significant value. The SEC oversees the nearly $44 trillion
in securities trading annually on U.S. equity markets; the disclosures
of almost 13,000 public companies; and the activities of about 11,000
investment advisers, nearly 1,000 fund complexes, and 5,700 broker-
dealers. By way of illustration, let me outline some of what the agency
achieved during fiscal year 2007.

REVIEW OF FISCAL YEAR 2007

For the SEC's Enforcement Division, which polices the markets and
helps keep investors' money safe, fiscal year 2007 was truly a notable
year. The Division's results are impressive both in the number of cases
filed--the second highest in Commission history--and in their
substance, covering a range of topics of critical importance to
investors.
Among many highlights, the Commission brought one of the most
significant insider trading cases in 20 years. We filed options
backdating cases against executives at companies in a range of
industries, to stamp out that notorious abuse. Even non-investors
benefited from the Commission's efforts: our anti-spam initiative was
credited with a 30 percent reduction in the volume of stock market spam
emails in an independent industry review. In all, the SEC forced
wrongdoers to give up more than $1 billion in illegal profits and pay
more than $500 million in financial penalties. In the 17 years since
the Congress gave the SEC authority to collect penalties against
companies, this is the fifth highest penalties and disgorgement total
ever, and $1 billion above the pre-Enron average of the 1990s.
The SEC also continued to aggressively combat scams targeting the
retirement savings of America's senior citizens. In fiscal year 2007,
the Enforcement Division brought 30 enforcement actions involving
investment fraud, abusive sales practices, and other schemes aimed
against seniors. In addition, our examination and investor education
programs joined with other regulators, law enforcement agencies, the
Financial Industry Regulatory Authority, and others to conduct
examination sweeps and sponsor events to educate seniors across the
country.
The Commission also reached an important new agreement to share
enforcement and examination information with the Financial Crimes
Enforcement Network (FINCEN), to assist in the identification,
deterrence, and interdiction of terrorist financing and money
laundering. The agreement will help ensure that SEC-regulated firms
have robust anti-money laundering programs and identify financial
institutions that are in violation of the Bank Secrecy Act.
The SEC's examination program also worked to identify compliance
issues at brokerage firms and investment advisers and correct such
problems before they could harm investors. In fiscal year 2007, the SEC
conducted more than 2,400 examinations of investment advisers and
investment companies, broker-dealers, transfer agents, and self-
regulatory organizations. Overall, 75 percent of investment adviser and
investment company examinations and almost 82 percent of broker-dealer
examinations revealed some type of deficiency or control weakness.
Importantly, most examinations resulted in improvements in the firms'
compliance programs. Where appropriate, inspection results were
referred for enforcement action.
In fiscal year 2007, we also initiated a new program for broker-
dealer chief compliance officers that seeks to help them improve their
compliance programs, called the CCOutreach BD program. This program has
been a great success, involving hundreds of participants.
On the regulatory front, the Commission reformed the implementation
of Section 404 of the Sarbanes-Oxley Act, to fulfill the congressional
intent that the law's objectives be achieved without waste and
inefficiency. These reforms included Commission approval of a new
auditing standard to ensure that 404 audits are conducted in a more
cost-effective way, and that they focus on areas that truly matter to
investors. The Commission also adopted Section 404 guidance for
management, who previously had to rely on the rules intended for
auditors. Currently, the staff is undertaking a study to determine
whether as a result of these reforms Section 404 is in fact being
implemented in a manner that is efficient and that will be cost-
effective for smaller reporting companies. The study will be completed
before small companies are required to have their first audit under
Section 404. In addition, during 2007 the Commission approved a series
of reforms to help smaller companies gain faster and easier access to
the financial markets when they need it.
One of the most significant disclosure initiatives in the
Commission's history was our new comprehensive disclosure regime for
executive compensation, which took effect in 2007. These new rules
require every public company to provide a single number stating total
compensation for their top officers. For the first time, all forms of
compensation are in one place for investors to analyze, and companies
are required to provide plain English statements of their compensation
policies. The complete and readily accessible information about
executive pay that this initiative has opened up to investors has
provided a valuable new insight into corporate governance in the
Nation's public companies.
Also in 2007, the SEC broke an 8-year logjam by publishing final
rules to implement the Gramm-Leach-Bliley Act's bank-broker provisions.
This will benefit investors who utilize banks as well as brokers to
help achieve their financial objectives. And we approved the merger of
the NYSE and NASD's regulatory arms, with the goal of creating a single
set of rules and eliminating the regulatory gaps between markets that
often made enforcement difficult.
The Commission also significantly intensified its contacts with its
counterparts across the globe. As Chairman, I executed agreements with
the College of Euronext Regulators, the German Federal Financial
Supervisory Authority, and the UK's Financial Services Authority and
Financial Reporting Council, all aimed towards enhancing information-
sharing on enforcement and supervisory matters. The Commission also
approved the merger of the New York Stock Exchange and Euronext;
streamlined the deregistration requirements for foreign private
issuers, removing a significant deterrent to listing on U.S. exchanges;
and authorized foreign firms to use IFRS as published by the
International Accounting Standards Board in preparing their disclosures
in the United States. These important steps have helped facilitate
cross-border capital formation and helped our market better integrate
with the rest of the world.
Administratively, we undertook major reforms to improve the
effectiveness of the SEC's operations. In 2007, the SEC significantly
augmented its investor education and advocacy functions. To
reinvigorate the agency's emphasis on the needs of retail investors, we
created the Office of Policy and Investor Outreach which will assess
the views of individual investors and help inform the agency's
policymaking. The new Office of Investor Education is focused
exclusively on promoting financial literacy and helping investors gain
the tools they need to make informed investment decisions.
In 2007, the SEC took major steps to foster the widespread use of
interactive data in corporate disclosures. Interactive data will
empower investors to obtain and compare information about their
investments far more easily than ever before. This initiative will
completely remake financial disclosure. Instead of an electronic filing
cabinet for 1930s-style forms, which was the SEC's EDGAR system, every
item within an income statement or a balance sheet will be individually
searchable and downloadable. Investors and the entire marketplace will
be able to compare any information they choose for thousands of
companies in an instant. RSS feeds will send the latest SEC filings to
investors' desktops or handhelds, without their even having to know a
form was filed.
Overall in fiscal year 2007, the SEC had one of the most productive
years in its history, aggressively pursuing wrongdoing and tackling
fundamental reforms in the securities markets, all on behalf of
America's investors.

FISCAL YEAR 2008 TO DATE

Already in fiscal year 2008, the Commission has been active on a
number of fronts working to protect investors, promote capital
formation, and foster healthy markets. And our agenda in the coming
months is no less ambitious.
Oversight of the Markets
The failure of Bear Stearns has brought to the fore the regulatory
gap in the supervision of investment banks. Although Federal law
provides for supervision of commercial banking by bank regulatory
agencies, no such scheme exists for the largest investment banks.
Because the law fails to provide for supervision of even the largest
globally active firms on a consolidated basis, the Commission created
the Consolidated Supervised Entities (CSE) program to fill this gap,
beginning in 2004. Without this voluntary program there would not have
been any consolidated information available to regulators, including
the Federal Reserve Bank of New York, when Bear Stearns precipitously
lost liquidity in mid-March 2008. This program, which is necessary to
monitor for, and act quickly in response to, any financial or
operational weaknesses that might place regulated entities or the
broader financial system at risk, is providing the basis for
significant new collaboration with the Federal Reserve.
Building on the new statutory authority from Congress that enabled
the SEC to register and examine credit rating agencies, as nationally
recognized statistical rating organizations, beginning in late
September 2007, the SEC has launched a new program to oversee credit
rating agencies. This is also a vitally important topic in light of
recent market events. Under this new authority, the Commission is
conducting inspections of rating agencies to evaluate whether they are
adhering to their published methodologies for determining ratings and
managing conflicts of interest. Given the recent problems in the
subprime market, the SEC has been particularly interested in whether
the rating agencies' involvement in bringing mortgage-backed securities
to market impaired their ability to be impartial in their ratings. We
will shortly propose additional rules building on the lessons learned
from the subprime market turmoil. These proposals may include, among
other things, requiring better disclosure of past ratings, so as to
facilitate competitive comparisons of rating accuracy; enhancing
investor understanding of the differences in ratings among different
types of securities; regulating and limiting conflicts of interest;
reducing reliance on ratings per se, as opposed to the underlying
criteria that ratings are thought to represent; and disclosing the role
of third-party due diligence in assigning ratings. This will continue
to be an area of emphasis for the Commission in the coming fiscal year.
Currently neither the CSE nor the credit rating agency programs
receive dedicated funding from the Congress. We understand that
Congress may be acting to fill this gap, and I believe such a move
would help formalize and strengthen these two critical programs. We
have prepared some information about this proposal that I have
submitted along with my testimony.
The SEC is also working closely with our fellow regulators to
promote the fairness and stability of the markets. Under a recently
concluded Memorandum of Understanding with the Commodity Futures
Trading Commission, we have established a durable process to better
address the regulatory issues that in today's increasingly
interconnected markets don't respect regulatory boundaries drawn up
decades ago. The agreement that I signed with Acting Chairman Lukken
establishes a permanent regulatory liaison between the two agencies,
provides for enhanced information sharing, and sets forth several key
principles guiding their consideration of novel financial products that
may reflect elements of both securities and commodity futures or
options.
To anticipate future problems, I announced in February 2008 a
program to more than double the size of the SEC's Office of Risk
Assessment, created under the leadership of my predecessor, Chairman
Bill Donaldson. With additional staff experts and the right
surveillance tools, the newly expanded Office will help staff
throughout the Commission look around the corners and over the horizon
to identify potentially dangerous practices before they impact large
numbers of investors and the economy as a whole.
Enforcement
The SEC is continuing to pursue wrongdoers in all corners of the
securities markets, while also applying enforcement resources to the
areas that pose the greatest risks to investors.
The Enforcement Division's subprime working group is aggressively
investigating possible fraud, market manipulation, and breaches of
fiduciary duty. Among the issues we are looking at is whether financial
firms made proper disclosures about their holdings and their
valuations, whether insiders used non-public information to gain from
the recent market volatility, and whether naked short sellers illegally
manipulated the market.
The Enforcement Division is also investigating insider trading
among large institutional traders; wrongdoing in the municipal bond
market; Internet and microcap fraud; and scams against seniors.
In fiscal year 2008, the SEC is building upon its growing success
in returning funds to harmed investors. Since the agency first received
authority under the Sarbanes-Oxley Act of 2002 to use Fair Funds to
compensate victims, we have returned a total of more than $3.7 billion
to wronged investors. We expect to distribute another $750 million in
the next 6 months alone. To further professionalize the agency's
execution in this area, I have created the Office of Collections and
Distributions, which is led by a Director who reports to the Executive
Director and the Chairman. As part of this initiative, the agency has
deployed a new computer tracking system, called Phoenix, which with
additional enhancements this year will help to speed the return of
investors' money and maintain appropriate internal controls.
Another major productivity enhancement in the Enforcement Division
is ``The Hub,'' an agency-wide database that gives all enforcement
staff access to the entire inventory of investigations. By giving line
staff a window into this deep knowledge base, and permitting senior
management to direct the resources of the national enforcement program
quickly and effectively when necessary, The Hub is significantly
increasing the effectiveness of our enforcement dollars. Additional
features being rolled out in the coming months will help Division staff
more readily access performance information, coordinate more
effectively with our examination staff, and better manage their
investigative documents throughout the enforcement lifecycle.
International Enforcement and Regulatory Issues
The SEC's efforts in the international arena, which have markedly
increased in recent years, have by necessity been a key focus of my
Chairmanship. The time is long past when the SEC, or any financial
regulator, can feel safe that by scrutinizing just the activities
within its national borders, it can comprehend all the potential
dangers ahead. In a world where capital flows freely across borders,
problems or issues in one corner of the globe rarely stay there. The
world's regulatory and enforcement authorities are finding that we have
to collaborate if we hope to protect our own investors. Accordingly,
the SEC is working closely with our international counterparts to
monitor the markets and pursue fraudsters wherever they may run. We are
also exploring the idea of mutual recognition among a very few high-
standards countries with robust regulatory and enforcement regimes.
In recognition of the interconnectedness of global markets, the SEC
will continue to expand our own expertise in IFRS, and explore
additional ways that U.S. investors might benefit from increased
comparability using a high-quality international standard. The
continued integration of our own domestic accounting standards and IFRS
will enhance the quality of both, while improving the reliability,
clarity, and comparability of financial disclosure for American
investors.

Disclosure
The SEC is committed to making public company disclosure more
useful to investors. Under the leadership of the Office of Interactive
Disclosure, the SEC is building upon our recent successes in
constructing a foundation for the widespread use of interactive data.
After years of experience through the SEC's voluntary pilot program,
the Commission will consider a rule in 2008 that requires the use of
interactive data by reporting companies, as well as other proposals to
expand interactive data reporting by mutual funds and other market
participants. These efforts will be aimed at giving investors the
ability to easily find and compare key data about the companies and
funds in which they invest.
There are other investor-friendly improvements in store for mutual
fund disclosure. Too many investors today throw away their mutual fund
disclosures instead of reading them. Too often, the prospectuses are
laden with legalese that makes them nearly impenetrable for the average
person. In the coming months, the SEC will consider authorizing mutual
funds to issue a summary prospectus that will be more user-friendly for
investors. If adopted, the summary document would succinctly present
key facts about the fund up front, with more detailed information
available for investors on the Internet or in paper upon request. The
agency also is preparing help for investors at the time they buy a
mutual fund to learn about fees, expenses, and conflicts of interest.
Another important initiative relates to the $2.5 trillion worth of
municipal securities currently outstanding, about two-thirds of which
is owned either directly or indirectly by retail investors. Despite its
size and importance, this market has many fewer protections for
investors than exist in the corporate market. For example, investors
often find it difficult even to get their hands on the disclosure
documents for the municipal securities they own. To address this
shortcoming, the Commission is working to authorize the creation of an
online computer database, which would give investors in municipal
securities electronic access to disclosures filed in connection with
their investments. I have also urged our authorizing committees in the
House and in the Senate to update the SEC's authority in this area.

Investor Protection
The Commission has very recently taken additional steps to
safeguard investors and protect the integrity of the markets during
short selling transactions by proposing a rule that would specify that
abusive ``naked'' short selling is a fraud. In a naked short sale, the
seller does not borrow or arrange to borrow the securities in time to
make delivery to the buyer within the standard 3-day settlement period
for trades. As a result, the seller fails to deliver stock to the buyer
when delivery is due. This is known as a ``failure to deliver.'' When
sellers intentionally fail to deliver securities to the buyer as part
of a scheme to manipulate the price of a security, or possibly to avoid
borrowing costs associated with short sales, they should be subject to
enforcement action by the Commission for violation of the securities
laws.
The Commission is also working to protect Americans' pension fund
investments. In March 2008, the Commission issued a special report
reminding public pension funds of their responsibilities under the
Federal securities laws, and warning them that they assume a greater
risk of running afoul of anti-fraud and other provisions if they do not
have adequate compliance policies and procedures in place to prevent
wrongdoing in their money management functions.
To protect investor privacy and to help prevent and address
security breaches at the financial institutions the SEC regulates, the
Commission proposed new rules that provide more detailed standards for
information security programs. The proposed rules provide more specific
requirements for safeguarding information and responding to information
security breaches. The Commission also extended these privacy
protections to other entities registered with the Commission.
The Commission has also proposed an expedited process to speed up
the availability to the investing public of exchange-traded funds
(ETFs). ETFs are similar to traditional mutual funds, but issue shares
that trade throughout the day on securities exchanges. The proposed
rules would eliminate a barrier to entry for new participants in this
fast-growing market, while preserving investor protections. The
Commission also proposed enhanced disclosure for ETF investors who
purchase shares in the secondary markets.
Mr. Chairman, these are only some of the highlights of what the
agency has recently been focused on, and what we have planned for the
coming year. The SEC's mandate is as broad as it is important to
America's investors and our markets. On behalf of the agency, let me
thank you for the support that you and this Committee have so well
provided for these vital efforts.

CONCLUSION

The budget request for fiscal year 2009 will allow the SEC to
continue to aggressively pursue each of these ongoing initiatives on
behalf of investors, as well as to address new risk areas as they
emerge. As I mentioned, the request will allow the SEC to fully
maintain our current program of strong enforcement, examinations and
inspections, disclosure review, and regulation.
The request also will cover merit raises for SEC staff, as the
agency transitions to a new performance evaluation system. This new
five-level rating system has been developed in conjunction with the
National Treasury Employees' Union to provide more individualized
feedback to staff, based on clear performance criteria. The system has
been piloted in our Office of Human Resources, and will next be
extended to the agency's senior managers. The rest of the agency's
employees are scheduled to transition into the program next year.
I want to thank you for this opportunity to discuss the SEC's
appropriation for fiscal year 2009. I look forward to working with you
to meet the needs of our Nation's investors, and I would be happy to
answer any questions you may have.

STAFFING LEVELS

Senator Durbin. Thank you very much, Chairman Cox.
Let me try to reconcile budget request with some of the
policy statements you've made. If I understand the President's
budget request for 2009, it calls for 3,409 permanent staff at
the SEC, which would be a reduction anywhere between 94 and 100
employees, and over the last 3 or 4 years you've had about an
11 percent reduction in your enforcement activities. Does that
sound about right?
Mr. Cox. All the way up to the 11 percent reduction in
enforcement activities. We have within our overall budget,
which is----
Senator Durbin. Staffing reduction. I'm sorry, staffing
reduction of 11 percent since 2005.
Mr. Cox. Yes, we have had budget freezes, as you know, from
Congress through continuing resolutions in 2006 and 2007. So
holding at the same dollar figure for two fiscal years in a
row, combined with the fact that we have a built-in ratchet of
about 5 percent just standing steady because of cost-of-living
allowances, merit pay, and promotions within the agency and an
historically low turnover rate, means that, with two-thirds of
the total budget going to personnel, it is impossible to
maintain even the same staffing numbers year to year at higher
dollar levels.
But what we have done within the overall budget number is
to prioritize enforcement and also the Division of Trading and
Markets and its market supervisory responsibilities, so that in
the last fiscal year we have brought the second highest number
of enforcement actions in the agency's 74-year history.
Likewise, we have the highest number of respondents in actions
in years by quite a wide margin.

OVERSIGHT OF INVESTMENT BANKS

Senator Durbin. So I want to applaud your efficiencies and
what you have achieved. But if you continue to reduce the
number of staff that are working in some of these sections,
some of these divisions within the SEC, it clearly would have
an impact on your future activity. One of the things that you
raise is something that I'm concerned about. You mentioned the
Bear Stearns situation, in which the head of the Federal
Reserve as well as the Secretary of the Treasury decided to
step in and to help Bear Stearns through a rough patch.
Without judging the wisdom of that decision, and I think it
was necessary personally, it seems to have opened up a new area
of concern and responsibility. You talked about the gap in
enforcement for investment banks. I don't know what the most
current figure is, but I heard at one time that we have opened
our discount window to the tune of about $200 billion in
borrowing by these investment banks.
The obvious question is, the entities that are borrowing
the money now from the Federal taxpayers through the discount
window, what kind of oversight and supervision we have of these
entities. I think what I heard in your opening statement is the
suggestion that the SEC may play a role in that or could or
should play a role in that.
Reconcile these two things--reducing the number of staffers
in your budget and expanding your responsibilities to include
investment banks to make sure that at the end of the day the
taxpayers of America don't end up holding the bag as investment
banks use the discount window.
Mr. Cox. Well, Mr. Chairman, you're absolutely right about
the importance of that function of overseeing and supervising
investment banks. In addition, I would add to that, the SEC
also has been given very recently a significant new function
related to subprime issues and that is oversight and regulatory
authority over credit rating agencies. Both of these functions
are prioritized within the SEC's budget, but something has to
give. It has to come from some place.
So, if the SEC's budget were to be frozen on a continued
basis, we would run out of potential savings. The largest area
of potential savings I have been able to find thus far is the
agency's historical function of maintaining a filing and
information service that was essentially related to the 1930s-
era idea of having paper forms. We had people walk into the SEC
and inspect documents. With the Internet we didn't need that
any longer, and so we were able to free up about 100 positions
within the agency and put those slots to better use.
But the opportunity to find efficiencies like that is a
very steep declining curve.
Senator Durbin. Historically, the SEC has relied on fees
and collections to defer their costs of operation to some
extent; is that not the case?
Mr. Cox. Well, it is partly true, but in a way that
concerns me some days, not entirely true, because, while we do
collect a good deal in the way of fees, all of our funds are
appropriated.
Senator Durbin. All of your funds----
Mr. Cox. We cannot live off of the fees we collect.

IMPOSITION OF USER FEES

Senator Durbin. I understand that part. But what I'm
driving at is, I'm trying to reconcile the earlier question:
Where will you find some future SEC Chairman, where will they
find the resources to now keep a close eye on investment banks
using the discount window, borrowing from American taxpayers?
It seems that there should be, and it may not exist today, some
fee collection that would fund that Government responsibility.
Has that been proposed by the administration or anyone to your
knowledge?
Mr. Cox. Well, indeed, were this subcommittee willing to do
so, taking the existing stream of fees that the SEC already
collects and dedicating it to SEC operations would provide a
good deal of consistency to the budget.
Senator Durbin. But those fees are not collected from
investment banks currently, are they?
Mr. Cox. No, they are not, and we could, I suppose--I
should say, Congress could--fashion a new kind of fee. But in
any case, the difference between the fees that the SEC's
responsible for collecting and our appropriation is already
significant. There's a big delta there.
Senator Durbin. But it would seem, in fairness, that if
this branch of our economy is going to be reviewed, there's
oversight, that the cost of that oversight shouldn't be borne
by another sector of the economy, collection of fees from some
other entity. That doesn't seem to track. At least, I don't
know in this detail, but it would seem that collecting a fee
from the supervised entity is more reasonable.
Mr. Cox. Well, I think at least in the SEC's experience we
have subsisted entirely on the basis of appropriated funds, and
so there has been no effort with respect to any of the agency's
programs to match some form of fee collection with our
function.
Senator Durbin. Thank you.
Senator Brownback.
Senator Brownback. Thank you very much, Mr. Chairman.

SUBPRIME MORTGAGE CRISIS

Welcome, Chairman Cox. I want to look at what led up to the
subprime debacle that we've had. You can go back after these
crises are over and look at how did all this occur and you hope
to learn lessons from that.
I went and met with my realtors in Kansas and different
bankers and they said: Oh, yeah, yeah, we knew this was going
on; we weren't making any of the loans, but people were out
trolling and originating subprime mortgages to people we had
never lent to. I even had one banker say to me: Yes, I
originated one of the loans that I would never have made, but
then put it into the pool for the subprime fund. And I thought,
well, at least he admitted it, I guess, but he would never have
made it, but it got into then the securitized overall fund.
I want to enter into the record, Mr. Chairman, an article
in the New York Times magazine from April 27, 1996, Thomas
Friedman, a New York Times columnist, remarked in the ``News
Hour with Jim Lehrer'' that: ``There are two superpowers in the
world, the United States and Moody's bond rating service, and
it is sometimes unclear which is more powerful.''
[The information follows:]

[From The New York Times, April 27, 2008]

Triple-A Failure
(By Roger Lowenstein)
The Ratings Game
In 1996, Thomas Friedman, the New York Times columnist, Thomas
Friedman, the New York Times columnist, remarked on ``The NewsHour With
Jim Lehrer'' that there were two superpowers in the world--the United
States and Moody's bond-rating service--and it was sometimes unclear
which was more powerful. Moody's was then a private company that rated
corporate bonds, but it was, already, spreading its wings into the
exotic business of rating securities backed by pools of residential
mortgages.
Obscure and dry-seeming as it was, this business offered a certain
magic. The magic consisted of turning risky mortgages into investments
that would be suitable for investors who would know nothing about the
underlying loans. To get why this is impressive, you have to think
about all that determines whether a mortgage is safe. Who owns the
property? What is his or her income? Bundle hundreds of mortgages into
a single security and the questions multiply; no investor could begin
to answer them. But suppose the security had a rating. If it were rated
triple-A by a firm like Moody's, then the investor could forget about
the underlying mortgages. He wouldn't need to know what properties were
in the pool, only that the pool was triple-A--it was just as safe, in
theory, as other triple-A securities.
Over the last decade, Moody's and its two principal competitors,
Standard & Poor's and Fitch, played this game to perfection--putting
what amounted to gold seals on mortgage securities that investors swept
up with increasing elan. For the rating agencies, this business was
extremely lucrative. Their profits surged, Moody's in particular: it
went public, saw its stock increase sixfold and its earnings grow by
900 percent.
By providing the mortgage industry with an entree to Wall Street,
the agencies also transformed what had been among the sleepiest corners
of finance. No longer did mortgage banks have to wait 10 or 20 or 30
years to get their money back from homeowners. Now they sold their
loans into securitized pools and--their capital thus replenished--wrote
new loans at a much quicker pace.
Mortgage volume surged; in 2006, it topped $2.5 trillion. Also,
many more mortgages were issued to risky subprime borrowers. Almost all
of those subprime loans ended up in securitized pools; indeed, the
reason banks were willing to issue so many risky loans is that they
could fob them off on Wall Street.
But who was evaluating these securities? Who was passing judgment
on the quality of the mortgages, on the equity behind them and on
myriad other investment considerations? Certainly not the investors.
They relied on a credit rating.
Thus the agencies became the de facto watchdog over the mortgage
industry. In a practical sense, it was Moody's and Standard & Poor's
that set the credit standards that determined which loans Wall Street
could repackage and, ultimately, which borrowers would qualify.
Effectively, they did the job that was expected of banks and government
regulators. And today, they are a central culprit in the mortgage bust,
in which the total loss has been projected at $250 billion and possibly
much more.
In the wake of the housing collapse, Congress is exploring why the
industry failed and whether it should be revamped (hearings in the
Senate Banking Committee were expected to begin April 22). Two key
questions are whether the credit agencies--which benefit from a unique
series of government charters--enjoy too much official protection and
whether their judgment was tainted. Presumably to forestall criticism
and possible legislation, Moody's and S.&P. have announced reforms. But
they reject the notion that they should have been more vigilant.
Instead, they lay the blame on the mortgage holders who turned out to
be deadbeats, many of whom lied to obtain their loans.
Arthur Levitt, the former chairman of the Securities and Exchange
Commission, charges that ``the credit-rating agencies suffer from a
conflict of interest--perceived and apparent--that may have distorted
their judgment, especially when it came to complex structured financial
products.'' Frank Partnoy, a professor at the University of San Diego
School of Law who has written extensively about the credit-rating
industry, says that the conflict is a serious problem. Thanks to the
industry's close relationship with the banks whose securities it rates,
Partnoy says, the agencies have behaved less like gatekeepers than gate
openers. Last year, Moody's had to downgrade more than 5,000 mortgage
securities--a tacit acknowledgment that the mortgage bubble was abetted
by its overly generous ratings. Mortgage securities rated by Standard &
Poor's and Fitch have suffered a similar wave of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
The business of assigning a rating to a mortgage security is a
complicated affair, and Moody's recently was willing to walk me through
an actual mortgage-backed security step by step. I was led down a
carpeted hallway to a well-appointed conference room to meet with three
specialists in mortgage-backed paper. Moody's was fair-minded in
choosing an example; the case they showed me, which they masked with
the name ``Subprime XYZ,'' was a pool of 2,393 mortgages with a total
face value of $430 million.
Subprime XYZ typified the exuberance of the age. All the mortgages
in the pool were subprime--that is, they had been extended to borrowers
with checkered credit histories. In an earlier era, such people would
have been restricted from borrowing more than 75 percent or so of the
value of their homes, but during the great bubble, no such limits
applied.
Moody's did not have access to the individual loan files, much less
did it communicate with the borrowers or try to verify the information
they provided in their loan applications. ``We aren't loan officers,''
Claire Robinson, a 20-year veteran who is in charge of asset-backed
finance for Moody's, told me. ``Our expertise is as statisticians on an
aggregate basis. We want to know, of 1,000 individuals, based on
historical performance, what percent will pay their loans?''
The loans in Subprime XYZ were issued in early spring 2006--what
would turn out to be the peak of the boom. They were originated by a
West Coast company that Moody's identified as a ``nonbank lender.''
Traditionally, people have gotten their mortgages from banks, but in
recent years, new types of lenders peddling sexier products grabbed an
increasing share of the market. This particular lender took the loans
it made to a New York investment bank; the bank designed an investment
vehicle and brought the package to Moody's.
Moody's assigned an analyst to evaluate the package, subject to
review by a committee. The investment bank provided an enormous
spreadsheet chock with data on the borrowers' credit histories and much
else that might, at very least, have given Moody's pause. Three-
quarters of the borrowers had adjustable-rate mortgages, or ARMs--
``teaser'' loans on which the interest rate could be raised in short
order. Since subprime borrowers cannot afford higher rates, they would
need to refinance soon. This is a classic sign of a bubble--lending on
the belief, or the hope, that new money will bail out the old.
Moody's learned that almost half of these borrowers--43 percent--
did not provide written verification of their incomes. The data also
showed that 12 percent of the mortgages were for properties in Southern
California, including a half-percent in a single ZIP code, in
Riverside. That suggested a risky degree of concentration.
On the plus side, Moody's noted, 94 percent of those borrowers with
adjustable-rate loans said their mortgages were for primary residences.
``That was a comfort feeling,'' Robinson said. Historically, people
have been slow to abandon their primary homes. When you get into a
crunch, she added, ``You'll give up your ski chalet first.''
Another factor giving Moody's comfort was that all of the ARM loans
in the pool were first mortgages (as distinct from, say, home-equity
loans). Nearly half of the borrowers, however, took out a simultaneous
second loan. Most often, their two loans added up to all of their
property's presumed resale value, which meant the borrowers had not a
cent of equity.
In the frenetic, deal-happy climate of 2006, the Moody's analyst
had only a single day to process the credit data from the bank. The
analyst wasn't evaluating the mortgages but, rather, the bonds issued
by the investment vehicle created to house them. A so-called special-
purpose vehicle--a ghost corporation with no people or furniture and no
assets either until the deal was struck--would purchase the mortgages.
Thereafter, monthly payments from the homeowners would go to the S.P.V.
The S.P.V. would finance itself by selling bonds. The question for
Moody's was whether the inflow of mortgage checks would cover the
outgoing payments to bondholders. From the investment bank's point of
view, the key to the deal was obtaining a triple-A rating--without
which the deal wouldn't be profitable. That a vehicle backed by
subprime mortgages could borrow at triple-A rates seems like a trick of
finance. ``People say, `How can you create triple-A out of B-rated
paper?' '' notes Arturo Cifuentes, a former Moody's credit analyst who
now designs credit instruments. It may seem like a scam, but it's not.
The secret sauce is that the S.P.V. would float 12 classes of
bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have
first priority on the cash received from mortgage holders until they
were fully paid, then the next tier of bonds, then the next and so on.
The bonds at the bottom of the pile got the highest interest rate, but
if homeowners defaulted, they would absorb the first losses.
It was this segregation of payments that protected the bonds at the
top of the structure and enabled Moody's to classify them as triple-A.
Imagine a seaside condo beset by flooding: just as the penthouse will
not get wet until the lower floors are thoroughly soaked, so the
triple-A bonds would not lose a dime unless the lower credits were
wiped out.
Structured finance, of which this deal is typical, is both clever
and useful; in the housing industry it has greatly expanded the pool of
credit. But in extreme conditions, it can fail. The old-fashioned
corner banker used his instincts, as well as his pencil, to apportion
credit; modern finance is formulaic. However elegant its models,
forecasting the behavior of 2,393 mortgage holders is an uncertain
business. ``Everyone assumed the credit agencies knew what they were
doing,'' says Joseph Mason, a credit expert at Drexel University. ``A
structural engineer can predict what load a steel support will bear; in
financial engineering we can't predict as well.''
Mortgage-backed securities like those in Subprime XYZ were not the
terminus of the great mortgage machine. They were, in fact, building
blocks for even more esoteric vehicles known as collateralized debt
obligations, or C.D.O.'s. C.D.O.'s were financed with similar ladders
of bonds, from triple-A on down, and the credit-rating agencies' role
was just as central. The difference is that XYZ was a first-order
derivative--its assets included real mortgages owned by actual
homeowners. C.D.O.'s were a step removed--instead of buying mortgages,
they bought bonds that were backed by mortgages, like the bonds issued
by Subprime XYZ. (It is painful to consider, but there were also third-
order instruments, known as C.D.O.'s squared, which bought bonds issued
by other C.D.O.'s.)
Miscalculations that were damaging at the level of Subprime XYZ
were devastating at the C.D.O. level. Just as bad weather will cause
more serious delays to travelers with multiple flights, so, if the
underlying mortgage bonds were misrated, the trouble was compounded in
the case of the C.D.O.'s that purchased them.
Moody's used statistical models to assess C.D.O.'s; it relied on
historical patterns of default. This assumed that the past would remain
relevant in an era in which the mortgage industry was morphing into a
wildly speculative business. The complexity of C.D.O.'s undermined the
process as well. Jamie Dimon, the chief executive of JPMorgan Chase,
which recently scooped up the mortally wounded Bear Stearns, says,
``There was a large failure of common sense'' by rating agencies and
also by banks like his. ``Very complex securities shouldn't have been
rated as if they were easy-to-value bonds.''
The Accidental Watchdog
John Moody, a Wall Street analyst and former errand runner, hit on
the idea of synthesizing all kinds of credit information into a single
rating in 1909, when he published the manual ``Moody's Analyses of
Railroad Investments.'' The idea caught on with investors, who
subscribed to his service, and by the mid-20s, Moody's faced three
competitors: Standard Statistics and Poor's Publishing (which later
merged) and Fitch.
Then as now, Moody's graded bonds on a scale with 21 steps, from
Aaa to C. (There are small differences in the agencies' nomenclatures,
just as a grande latte at Starbucks becomes a ``medium'' at Peet's. At
Moody's, ratings that start with the letter ``A'' carry minimal to low
credit risk; those starting with ``B'' carry moderate to high risk; and
``C'' ratings denote bonds in poor standing or actual default.) The
ratings are meant to be an estimate of probabilities, not a buy or sell
recommendation. For instance, Ba bonds default far more often than
triple-As. But Moody's, as it is wont to remind people, is not in the
business of advising investors whether to buy Ba's; it merely publishes
a rating.
Until the 1970s, its business grew slowly. But several trends
coalesced to speed it up. The first was the collapse of Penn Central in
1970--a shattering event that the credit agencies failed to foresee. It
so unnerved investors that they began to pay more attention to credit
risk.
Government responded. The Securities and Exchange Commission, faced
with the question of how to measure the capital of broker-dealers,
decided to penalize brokers for holding bonds that were less than
investment-grade (the term applies to Moody's 10 top grades). This
prompted a question: investment grade according to whom? The S.E.C.
opted to create a new category of officially designated rating
agencies, and grandfathered the big three--S.&P., Moody's and Fitch. In
effect, the government outsourced its regulatory function to three for-
profit companies.
Bank regulators issued similar rules for banks. Pension funds,
mutual funds, insurance regulators followed. Over the 1980s and 1990s,
a latticework of such rules redefined credit markets. Many classes of
investors were now forbidden to buy noninvestment-grade bonds at all.
Issuers thus were forced to seek credit ratings (or else their
bonds would not be marketable). The agencies--realizing they had a hot
product and, what's more, a captive market--started charging the very
organizations whose bonds they were rating. This was an efficient way
to do business, but it put the agencies in a conflicted position. As
Partnoy says, rather than selling opinions to investors, the rating
agencies were now selling ``licenses'' to borrowers. Indeed, whether
their opinions were accurate no longer mattered so much. Just as a
police officer stopping a motorist will want to see his license but not
inquire how well he did on his road test, it was the rating--not its
accuracy--that mattered to Wall Street.
The case of Enron is illustrative. Throughout the summer and fall
of 2001, even though its credit was rapidly deteriorating, the rating
agencies kept it at investment grade. This was not unusual; the
agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally
dropped Enron's bonds to subinvestment grade. Although its action
merely validated the market consensus, it caused the stock to collapse.
To investors, S.&P.'s action was a signal that Enron was locked out of
credit markets; it had lost its ``license'' to borrow. Four days later
it filed for bankruptcy.
Another trend that spurred the agencies' growth was that more
companies began borrowing in bond markets instead of from banks.
According to Chris Mahoney, a just-retired Moody's veteran of 22 years,
``The agencies went from being obscure and unimportant players to
central ones.''
A Conflict of Interest?
Nothing sent the agencies into high gear as much as the development
of structured finance. As Wall Street bankers designed ever more
securitized products--using mortgages, credit-card debt, car loans,
corporate debt, every type of paper imaginable--the agencies became
truly powerful.
In structured-credit vehicles like Subprime XYZ, the agencies
played a much more pivotal role than they had with (conventional)
bonds. According to Lewis Ranieri, the Salomon Brothers banker who was
a pioneer in mortgage bonds, ``The whole creation of mortgage
securities was involved with a rating.''
What the bankers in these deals are really doing is buying a bunch
of I.O.U.'s and repackaging them in a different form. Something has to
make the package worth--or seem to be worth--more that the sum of its
parts, otherwise there would be no point in packaging such securities,
nor would there be any profits from which to pay the bankers' fees.
That something is the rating. Credit markets are not continuous; a
bond that qualifies, though only by a hair, as investment grade is
worth a lot more than one that just fails. As with a would-be immigrant
traveling from Mexico, there is a huge incentive to get over the line.
The challenge to investment banks is to design securities that just
meet the rating agencies' tests. Risky mortgages serve their purpose;
since the interest rate on them is higher, more money comes into the
pool and is available for paying bond interest. But if the mortgages
are too risky, Moody's will object. Banks are adroit at working the
system, and pools like Subprime XYZ are intentionally designed to
include a layer of Baa bonds, or those just over the border. ``Every
agency has a model available to bankers that allows them to run the
numbers until they get something they like and send it in for a
rating,'' a former Moody's expert in securitization says. In other
words, banks were gaming the system; according to Chris Flanagan, the
subprime analyst at JPMorgan, ``Gaming is the whole thing.''
When a bank proposes a rating structure on a pool of debt, the
rating agency will insist on a cushion of extra capital, known as an
``enhancement.'' The bank inevitably lobbies for a thin cushion (the
thinner the capitalization, the fatter the bank's profits). It's up to
the agency to make sure that the cushion is big enough to safeguard the
bonds. The process involves extended consultations between the agency
and its client. In short, obtaining a rating is a collaborative
process.
The evidence on whether rating agencies bend to the bankers' will
is mixed. The agencies do not deny that a conflict exists, but they
assert that they are keen to the dangers and minimize them. For
instance, they do not reward analysts on the basis of whether they
approve deals. No smoking gun, no conspiratorial e-mail message, has
surfaced to suggest that they are lying. But in structured finance, the
agencies face pressures that did not exist when John Moody was rating
railroads. On the traditional side of the business, Moody's has
thousands of clients (virtually every corporation and municipality that
sells bonds). No one of them has much clout. But in structured finance,
a handful of banks return again and again, paying much bigger fees. A
deal the size of XYZ can bring Moody's $200,000 and more for
complicated deals. And the banks pay only if Moody's delivers the
desired rating. Tom McGuire, the Jesuit theologian who ran Moody's
through the mid-90s, says this arrangement is unhealthy. If Moody's and
a client bank don't see eye to eye, the bank can either tweak the
numbers or try its luck with a competitor like S.&P., a process known
as ``ratings shopping.''
And it seems to have helped the banks get better ratings. Mason, of
Drexel University, compared default rates for corporate bonds rated Baa
with those of similarly rated collateralized debt obligations until
2005 (before the bubble burst). Mason found that the C.D.O.'s defaulted
eight times as often. One interpretation of the data is that Moody's
was far less discerning when the client was a Wall Street securitizer.
After Enron blew up, Congress ordered the S.E.C. to look at the
rating industry and possibly reform it. The S.E.C. ducked. Congress
looked again in 2006 and enacted a law making it easier for competing
agencies to gain official recognition, but didn't change the industry's
business model. By then, the mortgage boom was in high gear. From 2002
to 2006, Moody's profits nearly tripled, mostly thanks to the high
margins the agencies charged in structured finance. In 2006, Moody's
reported net income of $750 million. Raymond W. McDaniel Jr., its chief
executive, gloated in the annual report for that year, ``I firmly
believe that Moody's business stands on the `right side of history' in
terms of the alignment of our role and function with advancements in
global capital markets.''
Using Weather in Antarctica To Forecast Conditions in Hawaii
Even as McDaniel was crowing, it was clear in some corners of Wall
Street that the mortgage market was headed for trouble. The housing
industry was cooling off fast. James Kragenbring, a money manager with
Advantus Capital Management, complained to the agencies as early as
2005 that their ratings were too generous. A report from the hedge fund
of John Paulson proclaimed astonishment at ``the mispricing of these
securities.'' He started betting that mortgage debt would crash.
Even Mark Zandi, the very visible economist at Moody's forecasting
division (which is separate from the ratings side), was worried about
the chilling crosswinds blowing in credit markets. In a report
published in May 2006, he noted that consumer borrowing had soared,
household debt was at a record and a fifth of such debt was classified
as subprime. At the same time, loan officers were loosening
underwriting standards and easing rates to offer still more loans.
Zandi fretted about the ``razor-thin'' level of homeowners' equity, the
avalanche of teaser mortgages and the $750 billion of mortgages he
judged to be at risk. Zandi concluded, ``The environment feels
increasingly ripe for some type of financial event.''
A month after Zandi's report, Moody's rated Subprime XYZ. The
analyst on the deal also had concerns. Moody's was aware that mortgage
standards had been deteriorating, and it had been demanding more of a
cushion in such pools. Nonetheless, its credit-rating model continued
to envision rising home values. Largely for that reason, the analyst
forecast losses for XYZ at only 4.9 percent of the underlying mortgage
pool. Since even the lowest-rated bonds in XYZ would be covered up to a
loss level of 7.25 percent, the bonds seemed safe.
XYZ now became the responsibility of a Moody's team that monitors
securities and changes the ratings if need be (the analyst moved on to
rate a new deal). Almost immediately, the team noticed a problem.
Usually, people who finance a home stay current on their payments for
at least a while. But a sliver of folks in XYZ fell behind within 90
days of signing their papers. After six months, an alarming 6 percent
of the mortgages were seriously delinquent. (Historically, it is rare
for more than 1 percent of mortgages at that stage to be delinquent.)
Moody's monitors began to make inquiries with the lender and were
shocked by what they heard. Some properties lacked sod or landscaping,
and keys remained in the mailbox; the buyers had never moved in. The
implication was that people had bought homes on spec: as the housing
market turned, the buyers walked.
By the spring of 2007, 13 percent of Subprime XYZ was delinquent--
and it was worsening by the month. XYZ was hardly atypical; the entire
class of 2006 was performing terribly. (The class of 2007 would turn
out to be even worse.)
In April 2007, Moody's announced it was revising the model it used
to evaluate subprime mortgages. It noted that the model ``was first
introduced in 2002. Since then, the mortgage market has evolved
considerably.'' This was a rather stunning admission; its model had
been based on a world that no longer existed.
Poring over the data, Moody's discovered that the size of people's
first mortgages was no longer a good predictor of whether they would
default; rather, it was the size of their first and second loans--that
is, their total debt--combined. This was rather intuitive; Moody's
simply hadn't reckoned on it. Similarly, credit scores, long a mainstay
of its analyses, had not proved to be a ``strong predictor'' of
defaults this time. Translation: even people with good credit scores
were defaulting. Amy Tobey, leader of the team that monitored XYZ, told
me, ``It seems there was a shift in mentality; people are treating
homes as investment assets.'' Indeed. And homeowners without equity
were making what economists call a rational choice; they were
abandoning properties rather than make payments on them. Homeowners'
equity had never been as high as believed because appraisals had been
inflated.
Over the summer and fall of 2007, Moody's and the other agencies
repeatedly tightened their methodology for rating mortgage securities,
but it was too late. They had to downgrade tens of billions of dollars
of securities. By early this year, when I met with Moody's, an
astonishing 27 percent of the mortgage holders in Subprime XYZ were
delinquent. Losses on the pool were now estimated at 14 percent to 16
percent--three times the original estimate. Seemingly high-quality
bonds rated A3 by Moody's had been downgraded five notches to Ba2, as
had the other bonds in the pool aside from its triple-A's.
The pain didn't stop there. Many of the lower-rated bonds issued by
XYZ, and by mortgage pools like it, were purchased by C.D.O.'s, the
second-order mortgage vehicles, which were eager to buy lower-rated
mortgage paper because it paid a higher yield. As the agencies endowed
C.D.O. securities with triple-A ratings, demand for them was red hot.
Much of it was from global investors who knew nothing about the U.S.
mortgage market. In 2006 and 2007, the banks created more than $200
billion of C.D.O.'s backed by lower-rated mortgage paper. Moody's
assigned a different team to rate C.D.O.'s. This team knew far less
about the underlying mortgages than did the committee that evaluated
Subprime XYZ. In fact, Moody's rated C.D.O.'s without knowing which
bonds the pool would buy.
A C.D.O. operates like a mutual fund; it can buy or sell mortgage
bonds and frequently does so. Thus, the agencies rate pools with assets
that are perpetually shifting. They base their ratings on an extensive
set of guidelines or covenants that limit the C.D.O. manager's
discretion.
Late in 2006, Moody's rated a C.D.O. with $750 million worth of
securities. The covenants, which act as a template, restricted the
C.D.O. to, at most, an 80 percent exposure to subprime assets, and many
other such conditions. ``We're structure experts,'' Yuri Yoshizawa, the
head of Moody's' derivative group, explained. ``We're not underlying-
asset experts.'' They were checking the math, not the mortgages. But no
C.D.O. can be better than its collateral.
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The
ratings were derived using a mathematical construct known as a Monte
Carlo simulation--as if each of the underlying bonds would perform like
cards drawn at random from a deck of mortgage bonds in the past. There
were two problems with this approach. First, the bonds weren't like
those in the past; the mortgage market had changed. As Mark Adelson, a
former managing director in Moody's structured-finance division,
remarks, it was ``like observing 100 years of weather in Antarctica to
forecast the weather in Hawaii.'' And second, the bonds weren't random.
Moody's had underestimated the extent to which underwriting standards
had weakened everywhere. When one mortgage bond failed, the odds were
that others would, too.
Moody's estimated that this C.D.O. could potentially incur losses
of 2 percent. It has since revised its estimate to 27 percent. The
bonds it rated have been decimated, their market value having plunged
by half or more. A triple-A layer of bonds has been downgraded 16
notches, all the way to B. Hundreds of C.D.O.'s have suffered similar
fates (most of Wall Street's losses have been on C.D.O.'s). For Moody's
and the other rating agencies, it has been an extraordinary rout.
Whom Can We Rely On?
The agencies have blamed the large incidence of fraud, but then
they could have demanded verification of the mortgage data or refused
to rate securities where the data were not provided. That was, after
all, their mandate. This is what they pledge for the future. Moody's,
S.&P. and Fitch say that they are tightening procedures--they will
demand more data and more verification and will subject their analysts
to more outside checks. None of this, however, will remove the conflict
of interest in the issuer-pays model. Though some have proposed
requiring that agencies with official recognition charge investors,
rather than issuers, a more practical reform may be for the government
to stop certifying agencies altogether.
Then, if the Fed or other regulators wanted to restrict what sorts
of bonds could be owned by banks, or by pension funds or by anyone else
in need of protection, they would have to do it themselves--not farm
the job out to Moody's. The ratings agencies would still exist, but
stripped of their official imprimatur, their ratings would lose a
little of their aura, and investors might trust in them a bit less.
Moody's itself favors doing away with the official designation, and it,
like S.&P., embraces the idea that investors should not ``rely'' on
ratings for buy-and-sell decisions.
This leaves an awkward question, with respect to insanely complex
structured securities: What can they rely on? The agencies seem utterly
too involved to serve as a neutral arbiter, and the banks are sure to
invent new and equally hard-to-assess vehicles in the future. Vickie
Tillman, the executive vice president of S.&P., told Congress last fall
that in addition to the housing slump, ``ahistorical behavorial modes''
by homeowners were to blame for the wave of downgrades. She cited
S.&P.'s data going back to the 1970s, as if consumers were at fault for
not living up to the past. The real problem is that the agencies'
mathematical formulas look backward while life is lived forward. That
is unlikely to change.

Senator Brownback. It goes through how these rating
agencies rated these subprime mortgages with an AAA score. I'm
trying to piece all this together in hindsight. So, people are
originating these loans that locals would not make because it
isn't up to their standards. And when you put them all
together, it somehow magically transforms into an AAA-rated
bond entity that is cited in this article.
I go back on it, Chris, and ask: What should we be doing
differently to keep this from happening again? Obviously, we're
in a credit crunch and so we're not going to have a lot of
money flowing at the moment. Are there things we should be
doing to either oversee or rank the bond raters? Should we
provide greater oversight on the mortgage originating entities,
to make sure that data is there and that the loan is worthy? I
think that this whole system is a series of bad practices,
trying to get people into loans that they shouldn't have and
then catching them in the net.
What's the lesson learned here?
Mr. Cox. Well, first, yes to both of your questions. These
are both areas that Congress and regulators should take very
serious interest in and make big changes in. We are not the
front-line regulators for the mortgage industry, but I feel
comfortable as Chairman of the SEC commenting on this because
of the big impact that it has had in the securities markets,
and focusing on proper oversight of mortgage origination is of
vital importance for regulators and for lawmakers.

OVERSIGHT OF CREDIT RATING AGENCIES

With respect to credit rating agencies, the Congress has
done a very important and wise thing very recently in the
Credit Rating Agency Act, giving the SEC brand new authority to
regulate and oversee credit rating agencies that presently we
are exercising vigorously. Up until a few months ago, until the
end of September last year, the credit rating agency industry
was essentially unregulated. Now that is completely changed. We
are in the midst of a very broad investigation of the three
largest credit rating agencies that rated most of the subprime-
related securities. We will report publicly our findings from
that examination very soon. The findings of that examination
will also inform our ongoing rule-writing that we expect to
complete this year. We expect to propose very, very soon new
rules to govern, for example, conflicts of interest in that
industry, to prohibit certain practices, to make sure that
there is full disclosure of things like due diligence in
preparation of these ratings, that there's full understanding
and disclosure of the various methodologies, and that there's
healthy competition in that industry.
None of this existed before. These are big changes and they
are very, very necessary.

FINANCIAL SERVICES REGULATORY STRUCTURE

Senator Brownback. Would you mind commenting on the
Secretary's comments about the need for changes due to new
business structures? He's saying we need to consolidate several
of these agencies and remove blind spots. Just your thoughts on
that.
Mr. Cox. Modernization of financial services regulation,
which is the general topic that was broached by the Treasury
blueprint, is I think very high on everybody's agenda, in the
Congress, certainly for all of us at the SEC and for other
regulatory agencies, but also around the world, and in
international fora such as the Financial Stability Forum and
IOSCO.
The reason is that our regulatory structure is old. It's
got quite a pedigree, a distinguished one, but the major
regulatory agencies go back to the first part of the 20th
century. Our agency is going to turn 75 years old in just a few
months. This is already the 75th anniversary of the 1933 act.
So as markets have changed, as the products that Walt
Lukken and the CFTC regulate have morphed in such dramatic ways
in the 21st century into competitors for products that the SEC
regulates, our system has to take that into account. It's very
hard to do that, I understand, because of both constituencies
in the marketplace who've become accustomed to the existing
regulatory structure, because of difficulties in Congress
related to different jurisdictions and different committees,
and because of some very difficult substantive choices that
would have to be made about which model to pick and how to
integrate it.
So it's surpassingly difficult. But I think the topic is
the right one to focus on because we have to do a better job of
integrating regulatory responsibilities if we're going to keep
abreast of what's going on, not only in our own country but in
interconnected ways around the world.
Senator Brownback. Thank you, Mr. Chairman.

BROKER-DEALER RULEMAKING

Senator Durbin. Mr. Chairman, on March 19, 2007, the SEC
published a proposed rule on amendments to financial
responsibility rules for broker-dealers. In the notice the SEC
asked for comments on changes to the rules on net capital,
customer protection, books and records, notification rules. I
understand that some of these proposed amendments have been
sought by the financial services community for a number of
years.
Among the changes proposed are reduction in capital
charges, haircut for money market mutual funds, and the
inclusion of certain money market mutual funds as qualified
securities eligible for deposit in the special reserve account.
It's my understanding that the comment period closed last
June, and since it will soon be a full year since the comment
period on the proposed rule elapsed, what is the current status
of this rulemaking?
Mr. Cox. Mr. Chairman, we are very interested in this
subject. We have taken a fresh look at it in light of all the
market turmoil to make sure that this is the right time to be
embarking on these kinds of changes. But the comment that we
have received has included much favorable comment, and so this
is very much on the rulemaking agenda of the Commission at this
time.
Senator Durbin. Since it's been a year, what is the
anticipated release date for your final rule?
Mr. Cox. We don't have a calendar date right now for
further action on this proposal. But I would be happy, Mr.
Chairman, to report back to you in real time about what the
prognosis for that is.
Senator Durbin. If you would, please.
Are you soliciting additional comments?
Mr. Cox. No, I believe the comment period is closed. Let me
check and make sure that's the case.
Yes, that is the case.
Senator Durbin. Is there a plan to reissue a new proposal
or are you going to stick with the original proposal?
Mr. Cox. I think that the opportunity to fashion a final
rule based not only on the proposal but the questions that were
asked and the comments that were received should be sufficient
so that it would not be required that we repropose it.
Senator Durbin. If you'd kind of let me know just in
general terms when that might happen.

SECURITIES LITIGATION REFORM

Last August, a group of law professors asked your agency to
convene a series of roundtables on the topic of securities
litigation reform, and the ``Wall Street Journal'' reported
that the forums would occur early next year, implying this
year, 2008. Can you tell me if such roundtables are planned or
under way?
Mr. Cox. Mr. Chairman, this was a suggestion in chief from
academics led by, among others, Professor Langwood at
Georgetown. It is one that I think for a variety of reasons
many people agree the Commission should act upon. There are a
variety of reasons across the ideological spectrum and across
the markets that people have interest and concerns with this
general topic.
My own interest in this topic and experience with it
suggests to me that it is best taken up in a bipartisan way. We
have currently a short-handed Commission comprised only of
Republican commissioners and so I have wanted to wait before we
had any such roundtable, even though of course we could always
have a balanced panel, to make sure we also had a balanced
Commission that can give the public confidence that we're
handling this very important issue with great care and not in
any political way.

DIVESTMENT DISCLOSURES

Senator Durbin. Last question I have. Two weeks ago the SEC
adopted rules requiring a registered investment company
disclose when it divests from securities of issuers that the
fund determines conduct or have direct investments in certain
business operations in Sudan. These rules were mandated under
the Sudan Accountability Investment Act signed into law on
December 31 of last year.
How will the SEC track these particular divestment
disclosures?
Mr. Cox. Mr. Chairman, as you know, we acted with great
alacrity to do what was required by the statute, and we are
energetically going to implement it as well, through the
Division of Corporation Finance and our Office of Risk
Assessment.
Senator Durbin. So how would an investor be able to quickly
determine that a particular company has made such a disclosure,
for example?
Mr. Cox. I'm sorry?
Senator Durbin. How would an individual investor be able to
determine that a particular company has made such a disclosure?
Mr. Cox. Well, all of these filings will be made public and
we have taken some very recent measures to provide for full
text search capability of filings that are available on our
EDGAR online disclosure system.
Senator Durbin. Good. Thank you.
Senator Brownback, any further questions?
Senator Brownback. No questions.
Senator Durbin. Chairman Cox, thanks. We appreciate your
coming by. We're glad you're working with the CFTC on a
memorandum of understanding and how that you'll continue that
cooperative arrangement. I asked when they formed this
subcommittee to bring these two agencies under the
subcommittee's jurisdiction. There are so many things that you
do have in common, at least in terms of the integrity of the
marketplace. I hope that that conversation continues outside
this room.
Thank you for being here today.
Mr. Cox. Thank you very much, Mr. Chairman.

ADDITIONAL COMMITTEE QUESTIONS

Senator Durbin. Any questions for the record will be
submitted to those who have testified, in the hopes that there
will be prompt replies so we can complete our work.
[The following questions were not asked at the hearing, but
were submitted to the Commission for response subsequent to the
hearing:]

Questions Submitted by Senator Richard C. Shelby

CRA PROGRAM

Question. Chairman Cox, in your testimony you indicated that the
SEC's credit rating agency program's costs are approximately $2.2
million. Would you please discuss how these funds would be allocated
within the program? How would having a dedicated funding source for the
program improve the SEC's ability to administer the program?
Answer. The SEC created the credit rating agencies program in
September 2007 as a result of the enactment of the Credit Rating Agency
Reform Act, to ensure that rating agencies are adhering to their
published methodologies for determining ratings and managing conflicts
of interest. The Act also provides the Commission with authority to
write new regulations in this area and inspect the nationally
recognized statistical rating organizations for compliance with
applicable rules and policies. The SEC's proposed budget for fiscal
year 2009 would increase the number of staff responsible for
implementing the Credit Rating Agency Reform Act from 7 to 20 positions
for oversight and inspections of credit rating agencies. This would
nearly triple the number of staff dedicated to the program. Having
dedicated funding would give the credit rating agency program more
legislative structure and formality and ensure that the agency's
allocation of resources was in line with the intent of Congress.

CSE PROGRAM

Question. Chairman Cox, over the past several months our economy
has been plague by a liquidity crisis triggered by poorly underwritten
subprime loans and structured finance products. The investment banks
the SEC regulates as part of the CSE program were among the most active
players in both the subprime and structured finance markets. They
structured and underwrote many of the financial instruments now causing
so many problems for our economy.
--If the SEC was properly monitoring the CSE firms, why did it fail
to raise the alarm about the decline in underwriting and
lending standards?
--How much responsibility does the SEC bear for the deterioration of
lending and underwriting standards by CSE firms and their
subsidiaries?
Answer. The President's Working Group noted in their March report
to the President that a principal underlying cause of the turmoil in
financial markets was ``a breakdown in underwriting standards for
subprime mortgages'' which then rippled through the system as these
substandard mortgages were securitized. However, the SEC has no
authority over mortgage underwriting standards. The consolidated
supervised entities program does not change this reality. Under the
Commission's new authority to supervise credit rating agencies, the
Commission has recently proposed new rules designed to increase
accountability and competition among credit rating agencies, as their
ratings may have played a significant role in the market acceptance of
subprime-related securities.

ENFORCEMENT

Question. Chairman Cox, earlier today at a hearing of the Banking
Committee, former SEC Chairmen Arthur Levitt stated that the SEC needs
substantial increases in its enforcement budget and that it does not
have the manpower to properly enforce our securities laws.
--How many personnel are presently employed by the Division of
Enforcement, and how has that figured changed over the past 10
years?
Answer. In fiscal year 2008, the Enforcement program has over 1,100
permanent FTE which is more than 30 percent higher than the size of the
enforcement program since 1998.

[Dollars in millions]
------------------------------------------------------------------------
Enforcement
Program
Enforcement Salaries and
Program FTE Benefits
Obligations
------------------------------------------------------------------------
1998.................................... 852 ( \1\ )
1999.................................... 811 ( \1\ )
2000.................................... 824 ( \1\ )
2001.................................... 904 ( \1\ )
2002.................................... 925 ( \1\ )
2003.................................... 935 ( \1\ )
2004.................................... 1,144 $168.8
2005.................................... 1,232 195.4
2006.................................... 1,157 200.6
2007.................................... 1,111 197.8
2008 (Budget)........................... 1,124 210.0
------------------------------------------------------------------------
\1\ Not available.

Question. Also, how do the number of SEC enforcement actions and
the amount disgorgements orders during your tenure compare to the
levels seen when Chairmen Levitt was at the Commission?
Answer. In fiscal year 2007, the Commission brought the second
highest number of cases in the Commission's history including the
largest number of corporate penalties cases ever. The chart below,
provides the requested information on the nearly seven full fiscal
years of Chairman Levitt's tenure and the two full fiscal years of my
tenure.

[Dollars in millions]
------------------------------------------------------------------------
Average
Average Number Disgorgements
of Enforcement and Penalties
Actions Per Ordered Per
Year Year
------------------------------------------------------------------------
Arthur Levitt, Chairman, July 1993-Feb. 490 $608
2001...................................
Christopher Cox, Chairman, August 2005- 615 2,483
present................................
------------------------------------------------------------------------
Note: Figures for Chairman Levitt are totals for fiscal year 1994-fiscal
year 2001. Figures for Chairman Cox are totals for fiscal year 2005-
fiscal year 2007.

The following table shows the specific figures for each fiscal year
during Chairman Levitt's and my tenures:

[Dollars in millions]
------------------------------------------------------------------------
Disgorgements
Enforcement and Penalties
Actions Ordered
------------------------------------------------------------------------
Under Chairman Levitt:
1994................................ 497 $764
1995................................ 486 1,028
1996................................ 453 392
1997................................ 489 263
1998................................ 477 477
1999................................ 525 841
2000................................ 503 488
Under Chairman Cox:
2006................................ 574 3,365
2007................................ 655 1,601
------------------------------------------------------------------------

SUBCOMMITTEE RECESS

Senator Durbin. This meeting of the subcommittee will stand
recessed. Thank you.
[Whereupon, at 4:12 p.m., Wednesday, May 7, the
subcommittee was recessed, to reconvene subject to the call of
the Chair.]

FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2009

----------

WEDNESDAY, MAY 14, 2008

U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 3:35 p.m., in room SD-192, Dirksen
Senate Office Building, Hon. Richard J. Durbin (chairman)
presiding.
Present: Senators Durbin and Brownback.

FEDERAL TRADE COMMISSION

STATEMENT OF HON. WILLIAM E. KOVACIC, CHAIRMAN
ACCOMPANIED BY HON. JON LEIBOWITZ, COMMISSIONER

OPENING STATEMENT OF SENATOR RICHARD J. DURBIN

Senator Durbin. Good afternoon. I'm pleased to welcome you
to this hearing today before the Financial Services and General
Government Appropriations Subcommittee.
I apologize for the late start. We had a rollcall vote on
the floor, and Senator Reid was called to a funeral service in
Arlington for a fallen soldier from Nevada, and I had to fill
in for a few minutes there. I thank Senator Brownback as well
for his patience in waiting for my arrival.
Today's hearing focuses on the President's fiscal year 2009
budget request for the Federal Trade Commission (FTC).
Testifying before us this afternoon is Chairman William Kovacic
and Commissioner Jon Leibowitz.
I welcome my colleagues to the dais and those who will
appear in short order.
The FTC, Federal Trade Commission, has two important and
related missions: to protect consumers and to preserve
competition in the marketplace. These missions really hit home
when it comes to American consumers as they face skyrocketing
prices at gasoline pumps, struggle with home mortgages they may
not be able to pay back, and worry about identity theft and
privacy in our increasingly intrusive world. The FTC pursues
both of its consumer protection and competition missions by
identifying illegal practices, stopping them through law
enforcement, and preventing them through consumer and business
education. It also adds to the public knowledge and dialogue by
conducting research, advocating for consumers, and representing
American consumer interests.
I am pleased to see the FTC has a strong record on these
missions. The agency has received numerous awards for its
consumer education programs. Its implementation of the Do Not
Call program has enjoyed success in curbing most unwanted
telemarketing calls. There are still some of them getting
through we will have to talk about. And last year, the FTC
received a clean audit opinion for the 11th straight year in a
row. Congratulations. With these and other accomplishments, I
think the FTC has much to be proud of.
The President's budget requests $256.2 million for fiscal
year 2009, increased $12.3 million, or about 5 percent, over
current year funding. This request will provide additional
funding for consumer protection, including three additional
FTE's dedicated to financial services. I am glad you are
looking in this area. We are all too familiar with the fraud
and deception in the mortgage industry, so this is certainly a
good idea.
This request also would provide additional funding for the
FTC's Competition Bureau, including eight additional FTEs. Your
role as consumer watchdog for anticompetitive behavior is
especially crucial in today's market for gasoline, diesel fuel,
and jet fuel.
As you know, based on a letter I recently sent to you, I am
very concerned about the spike in fuel prices. Drivers across
America are paying higher and higher prices at the pump. Air
travelers and consumers are also feeling the heat. Projections
suggest the situation could get worse. Yet, somehow these
record-breaking prices are coming at a time when the oil
industry is reporting record-breaking profits.
This chart points out something that an executive from an
airline told me just a couple weeks ago when we talked about
the increasing cost of jet fuel and what it was doing to the
airline industry across America. He had made a phone call to a
chief executive officer (CEO) of the same airline who had his
job about 15 to 20 years ago, and this former CEO said, I do
not understand how you can even operate with the so-called
crack spreads today, crack spread being the difference between
the crude oil and the refined product.
That differential used to be in the $1 to $5 range. Now it
is in the $40 range. And so as you see the price of a barrel of
oil going up--I do not know what it is today. I think yesterday
it was $127--you have to know that ultimately the consumer will
pay even more because the spread between crude oil and refined
product just continues to grow exponentially, making it
increasingly difficult to be competitive for all users of
refined oil products. That would include families, businesses,
farmers, truckers, airlines, transit agencies, and all of the
above.
I am happy that you will be here to testify about this and
other issues, perhaps commenting on the letter that I sent
requesting an inquiry. And before turning it over to you for
presentation, I would like to invite my colleague, Senator
Brownback, to speak.

STATEMENT OF SENATOR SAM BROWNBACK

Senator Brownback. Thank you, Mr. Chairman, for holding the
hearing. I look forward to the presentation that is going to be
coming up from our colleagues and to our question and answer
session. I think this is an important hearing on some very
substantive issues.
I have worked with the FTC over many years on a number of
topics, and I have found the Commission very good to work with.
I appreciate their mission. I think it is crucial and a
delicately balanced one of protecting consumers from fraud and
predatory scams, while at the same time not interfering with
legitimate business activities. Protecting consumers from
identity theft and credit fraud, enforcing the Do Not Call
Registry, and prohibiting the marketing of media violence to
children, the Commission has a valuable role in our Government.
To carry out its mission, the FTC must look carefully at
the facts to guide its efforts. It cannot rely on anecdotes or
speculation. It is a difficult function. It requires objective
inquiry, analysis, and deliberation. It is not a function that
can be exercised properly by a rush to judgment that is based
on a theory or popular opinion.
Mr. Chairman, all of us are very concerned and troubled by
the exorbitant prices that consumers are paying at the pump. In
my State and across the country, farmers, truck drivers, and
all working families are facing painfully high prices to put
gas in their cars and trucks and to put food on their tables. I
would say, Mr. Chairman, if oil companies have acted in an
anticompetitive fashion that has harmed consumers, then throw
the book at them. I have no qualms about doing that whatsoever,
and it should be done and it should be the function of the
Government to do it.
Now, let us make sure that they are not colluding and
engaging in anticompetitive activities. We must do that. But
let us base those claims on facts and not anecdotes and let us
find answers and not excuses. And we must pursue real solutions
rather than political gain.
In the same way that we admonish our colleagues not to
scapegoat ethanol for rising food prices here in the United
States and abroad, we need to examine carefully the data and
facts surrounding higher gasoline prices. As you and I know,
Mr. Chairman, if it were not for the increased use of ethanol
and the blending of gasoline, prices at the pump would be some
29 cents to 40 cents higher per gallon. That may explain in
part why crude oil prices have risen faster and further than
prices at the pump, and we have a chart that I wanted to show
on this.
Since January of this year, crude prices are up 21 percent,
while gasoline prices are up 19 percent. Since January 2007,
the difference is even more pronounced. Crude prices are up 106
percent while gasoline prices are up 94 percent.
The latest data from the Energy Information Administration
(EIA) in March 2008 shows that 71.8 percent of the price of a
gallon of gasoline is attributable to the raw crude oil input.
In March 2007, crude oil accounted for only 52.3 percent of the
cost of a gallon of gasoline. In March 2000, crude oil
accounted for 44.6 percent of a gallon of gasoline. And that is
on the charts.
Crude oil costs are the unmistakable driving force behind
the rise in gasoline prices, and for that we need to look in
part at our own body here. We have made choices to refuse to
allow drilling off the continental shelf and in Arctic National
Wildlife Refuge (ANWR). We have chosen to allow antidevelopment
and, I believe, antigrowth activists to block any attempt to
expand our Nation's refining capacity. We need to revisit those
decisions just as much as we need to examine the behavior of
private enterprises.
It is unfortunate the Government is not called to task for
its own role in distorting markets and placing increased costs
on consumers. Decisions that our Government has made regarding
energy policy have contributed to the higher prices that
consumers are now paying. And even though the percentage of
retail gasoline prices and taxes represent a decline from 32.1
percent in January 2000 to 12.3 percent in March 2008, the
actual amount of the tax has not. In January 2000, taxes
accounted for 41.4 cents per gallon. In March 2008, they
accounted for 39.9 cents per gallon.
I urge the FTC to use its resources to examine diligently
and thoroughly all aspects of this issue. In the past, FTC has
determined, except in a few isolated cases, that market forces
were responsible for large changes in gasoline prices, not
anticompetitive actions by the industry. But if you find those
anticompetitive actions, we want to know about it and we want
them pursued. Let us not think that we need to change the rules
or alter the objectivity of scientific analysis and facts just
to get the answer we want.
I want to thank you, Mr. Chairman, for holding this
hearing. I look forward to the testimony of the witnesses and a
chance to question them.
Senator Durbin. Thank you, Senator Brownback.
As you can tell, we have a slightly different view of the
world, and luckily the Federal Trade Commission is here to be
the ultimate arbiter.
We want to thank Chairman Kovacic, who will be allowed to
make an opening statement, followed by Commissioner Leibowitz.
Mr. Chairman.

SUMMARY STATEMENT OF WILLIAM E. KOVACIC

Mr. Kovacic. Thank you, Chairman Durbin and Ranking Member
Brownback. You could not have put the arbitration position in
better hands.
We are delighted to have the opportunity to speak to the
budget request and to give you a sense of how we would use the
funds that have been sought. To divide the labor today, I would
like to talk a bit about the competition mission, and my
colleague, Commissioner Leibowitz, will address the consumer
protection mission.
I want to talk about several areas that are examples of the
respects in which I think this true modern success story in
public administration provides an excellent return to consumers
for the resources you have entrusted us with. Our basic
philosophy in competition policy, I think, truly matches the
intuition that motivates both of your comments about what we
should be doing. We try to use our resources in areas that are
of the greatest concern to consumers, and we have tried to
address them by using the varied tools you put at our disposal.
You not only made us, nearly a century ago, a law enforcement
agency, but you entrusted us with research capabilities to get
underneath the surface, to understand more fundamentally what
is going on in our industries, and to not simply use the
prosecution of lawsuits, but the formulation of rules, consumer
education, and publicity as tools for formulating adjustments
that we can control ourselves, but advising you as well about
what policies should do.
Let me single out several areas of principal concern to us,
the areas, among others, in which we will devote our efforts in
the competition area with the proposed budget of $256 million.
First and foremost, energy. I share your view that there is
no single field of endeavor for us that is more important to
the American public, and we expect to approach it, among other
areas, in two ways.
As you know, earlier this month we issued an advance notice
of proposed rulemaking to explore approaches for applying the
market manipulation authority that this body gave us in
December. We anticipate that the rulemaking process will be
concluded in this calendar year, and there is nothing that my
colleagues and I will devote more effort to see addressed as
expeditiously and effectively within our agency.
At the same time, we are deeply concerned with structural
changes in this sector that can affect the price at which
petroleum products, natural gas, other energy products are
delivered to consumers. Within the past 12 months, we
challenged a natural gas distribution merger in Pittsburgh,
which ultimately resulted in the abandonment of the
transaction. We brought a case against a combination of two
refiners in the southwestern United States involving Western
refining and Giant industries. In this we were unsuccessful in
obtaining a preliminary injunction. But both matters are
indicative of our willingness in all areas to scrutinize very
carefully structural adjustments or proposed changes in the
industry that would affect competition in this sector.
The second area that is certainly close behind is health
care. Two priorities I want to flag for you. The first is our
continuing commitment to monitor and to challenge
anticompetitive pay-for-delay settlements. Our prosecution of
the Cephalon case is the latest in our efforts to ensure that
the arrangements that Congress set in place with the Hatch-
Waxman Act and the promise of lower prices through the
provision of generic drugs to consumers are not lost. And even
though we have suffered setbacks in a couple of these matters
in the courts of appeals, we will continue to press as
effectively as we can for successful judicial resolution of
these matters. Cephalon is part of our commitment in that area.
We are here also examining structural changes in the
sector. Only recently we filed a challenge to a merger in
northern Virginia that involves hospital providers, INOVA and
the Prince William County Health Care System, again an
indication of our commitment to monitor structural changes in
this and other important sectors that would affect the price
that consumers pay for healthcare.
In the real estate area, we have brought cases involving
what we feel are inappropriate arrangements involving multiple
listing services.
In the area of standards setting, we were unsuccessful in
our Rambus case, but within the past couple of years, our
successful challenge to an effort by Unocal to distort the
process by which the State of California sets standards for
gasoline to be sold in that State, resulted in a settlement
that has yielded, we believe, benefits of at least $500 million
a year to consumers.
And the last item I want to mention is the very generous
allotment that this subcommittee and the Congress as a whole
gave us to pursue international matters. We have extended our
efforts to work more effectively with our counterparts abroad
to provide technical assistance to new competition systems,
China, India, among others, and to pursue effective
international cooperation under the framework of the SAFE WEB
legislation that Congress also enacted in 2006.

PREPARED STATEMENT

Last, I want to mention that we are undertaking a basic
self-assessment. We are looking ahead to our centennial in
2014, and we are going to be asking ourselves, with respect to
all areas of our operations, are we the agency that Congress
intended us to be, what steps can we take to get there? This
will fold well into other areas in which Congress has directed
us: to examine ourselves, to identify our possibilities for
greatness, and to allow no power persuasion to deter us from
that mission.
Thank you.
Senator Durbin. Thank you, Mr. Chairman.
[The statement follows:]

Prepared Statement of Hon. William E. Kovacic

INTRODUCTION

Chairman Durbin, Ranking Member Brownback, and members of the
subcommittee, thank you for inviting us to testify today in support of
the Federal Trade Commission's (FTCs) fiscal year 2009 appropriation
request and to discuss some of the work we will be doing next year. The
Commission looks forward to working with you to further the interests
of American consumers.
The FTC, though small, is the one Federal agency with both consumer
protection and competition jurisdiction across broad sectors of the
economy. It enforces, among a broad range of other laws, Section 5 of
the Federal Trade Commission Act, which prohibits business practices
that are harmful to consumers because they are anticompetitive,
deceptive, or unfair.
The Report attached to this testimony, ``The FTC in 2008: A Force
for Consumers and Competition'' provides a detailed overview of the
scope of our work. The FTC has pursued a vigorous and effective law
enforcement program in a dynamic marketplace that is increasingly
global and characterized by changing technologies. Through the efforts
of a dedicated staff, the FTC continues to handle a growing workload.
This testimony summarizes the FTC's budget request for fiscal year
2009, and describes some of its major activities. To meet the
challenges of our Consumer Protection and Maintaining Competition goals
in fiscal year 2009, the FTC requests $256,200,000 and 1,102 FTE. The
fiscal year 2009 request represents an increase of $12,336,000 and 18
FTE over the fiscal year 2008 enacted levels.
Looking further into the future our success will require continued
efforts to improve the institutional mechanism through which we execute
our responsibilities. In the coming months we will undertake a program
to identify the way ahead. Our focus will extend beyond the next few
years, and we will ask what the Agency should look like when our
centennial arrives in 2014, and beyond. This self-assessment will
include a combination of internal deliberations and external
consultations in the United States and overseas with the community of
Government and non-Government bodies that have an interest in
competition and consumer protection policy.

CONSUMER PROTECTION MISSION

In the consumer protection area, the Commission is active in a
variety of efforts to protect the public from unfair, deceptive, and
fraudulent practices in the marketplace, including law enforcement
targeting telemarketing fraud, deceptive marketing of health care
products, consumer fraud against Hispanics, and business opportunity
and work-at-home schemes. The Commission also has an active program of
consumer and business education and outreach. This testimony highlights
seven key priorities for the FTC in fiscal year 2009: financial
practices; technology (spyware, spam, and behavioral advertising); Do
Not Call; privacy and data security; green claims; food marketing to
children; and entertainment industry marketing to children.

Financial Practices
The Commission will continue its important work to protect
consumers of financial services, focusing on every stage of the
consumer credit life cycle, from the advertising and marketing of
financial products to debt collection and debt relief. The Commission
is particularly concerned at this time about the rise in mortgage
foreclosures and delinquencies in the subprime market and its impact on
communities.
In the past decade, the Agency has brought 22 actions focused on
the mortgage lending industry, with particular attention to the
subprime market, alleging that lenders and servicers have engaged in
unfair and deceptive advertising and mortgage servicing practices.
Through these cases, the FTC has recovered more than $320 million for
consumer redress. In addition, these cases serve as notice to the
industry generally not to engage in the practices identified as unfair
or deceptive. Most of these mortgage cases are complex and take
considerable resources to investigate and prosecute, often requiring
considerable litigation, in order to obtain adequate redress for
consumers and other remedies. The Commission continues its important
work in this area.
The Agency is currently investigating the ads of a dozen companies
for improperly promoting mortgage products, such as ads that announce
low ``teaser'' rates without explaining that those rates apply for a
short period of time and can increase substantially after the loan's
introductory period. Commission staff has reviewed hundreds of mortgage
advertisements and sent warning letters to 200 mortgage lenders because
their ads did not appear to comply with laws the Commission enforces.
Staff is examining these companies' more recent advertisements and,
where they are noncompliant, the Commission will follow up by bringing
cases.
With the rapid increase in mortgage delinquencies and foreclosures,
the FTC has also intensified its efforts to protect consumers from
mortgage foreclosure rescue scams. Most of these cases involve
allegations of scammers who falsely promise that they can save
consumers' homes from foreclosure.\1\ Since February of this year, the
Commission has announced four cases targeting such foreclosure rescue
scams.\2\ Commission staff also continues to conduct outreach and to
share enforcement resources with State and local authorities through
seven regional task forces in cities with high foreclosure rates.
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\1\ In testimony on February 13, 2008 before the Senate Special
Committee on Aging on foreclosure rescue fraud, the Commission set
forth a more complete description of the FTC's efforts to address such
fraud. The FTC's testimony is available at http://www.ftc.gov/os/
testimony/P064814foreclosure.pdf.
\2\ FTC v. Safe Harbour Foundation, No. 08 C 1185 (N.D. Ill. filed
Feb. 25, 2008), available at http://www.ftc.gov/os/caselist/0823028/
index.shtm; FTC v. Mortgage Foreclosure Solutions, Inc., No. 8:08 CV-
00388 (M.D. Fla. filed Feb. 26, 2008) available at http://www.ftc.gov/
os/caselist/0823021/index.shtm; FTC v. National Hometeam Solutions,
Inc., No. 4:08-CV-00067 (E.D. Tex. filed Feb. 26, 2008), available at
http://www.ftc.gov/os/caselist/0823076/index.shtm. FTC v. Foreclosure
Solutions, LLC, No. 1-08-CV-01075 (N.D. Ohio filed Apr. 28, 2008),
available at http://www.ftc.gov/os/caselist/0723131/index.shtm. Last
month, The Bear Stearns Companies, Inc. (``Bear Stearns'') disclosed
that FTC staff has notified its mortgage servicing subsidiary, EMC
Mortgage Corporation (``EMC''), that the staff believes EMC and its
parent Bear Stearns have violated a number of Federal consumer
protection statutes in connection with its servicing activities. Bear
Stearns further disclosed that FTC staff offered an opportunity to
resolve the matter through consent negotiations before seeking approval
from the Commission to proceed with the filing of a complaint.
According to the disclosure, EMC expects to engage in such discussions
with Commission staff. Form 10-K, Bear Stearns Mortgage Funding Trust
2007-AR4 (CIK No. 1393708), at Item 1117 of Reg AB, Legal Proceedings
(filed Mar. 31, 2008), available at www.sec.gov/Archives/edgar/data/
1393708/000105640408001164/0001056404-08-001164.txt. The FTC cannot
comment further on this ongoing law enforcement investigation.
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The Commission's actions to protect consumers of financial services
extend beyond mortgage lending to a wide range of non-mortgage
financial services. Earlier this year, the Commission announced that
three payday lenders agreed to settle FTC charges that their
advertising violated the Truth in Lending Act by failing to provide
interest information required by Federal law. This information helps
consumers compare the costs of these payday loans to other payday loans
and to alternative forms of short-term credit.\3\ The settlements have
been accepted for public comment.
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\3\ CashPro, File No. 072-3203 (Feb. 2008); American Cash Market,
Inc., File No. 072-3210 (Feb. 2008); Anderson Payday Loans, File No.
072-3212 (Feb. 2008) (all available at http://www.ftc.gov/opa/2008/02/
amercash.shtm).
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In this economy, consumers with high levels of debt are
particularly vulnerable to debt collection abuses, as well as debt
negotiation and debt consolidation scams. Last November, the Commission
announced its largest civil penalty in a debt collection case $1.375
million.\4\ In addition, the Commission has prosecuted more than 60
companies engaged in deceptive debt negotiation, debt consolidation,
and credit repair practices. The Commission plans to continue its
important work in this area in fiscal year 2009.
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\4\ United States v. LTD Financial Services, Inc., Civ. No. H-07-
3741 (S.D. Tex. filed Nov. 5, 2007), available at http://www.ftc.gov/
os/caselist/0523012/index.shtm.
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Technology (Spyware, Spam, and Behavioral Advertising)
The Commission has been at the forefront of protecting consumers
from such technological threats as spam and spyware. The Agency has
brought more than 100 spam and spyware cases. Earlier this year, the
Agency announced its largest civil penalty in a spam case $2.9 million
against a company allegedly using deceptive email to offer ``free''
gifts that were not, in fact, free.\5\
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\5\ United States v. Valueclick, No. CV08-01711 MMM (rzx) (C.D.
Cal. filed Mar. 13, 2008), available at http://www.ftc.gov/os/caselist/
0723111/index.shtm.
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In addition, the Agency identifies and studies potential consumer
protection issues raised by new technologies. For example, last week,
the Commission hosted a town-hall meeting on mobile marketing, which
examined such topics as consumers' ability to control mobile
applications; the challenges presented by small screen disclosures;
practices targeting children and teens; evolving security threats and
solutions; and next-generation products and services.
The Commission also continues to examine behavioral advertising,
the practice of collecting information about consumers' online habits
in order to deliver targeted advertising.\6\ Following a workshop on
behavioral advertising last fall, the Commission staff released a set
of proposed principles to guide the development of self-regulation in
this area and sought comment on these principles.\7\ The deadline for
comments was April 11; the Agency received numerous detailed and
thorough comments, which it is currently reviewing.
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\6\ See http://www.ftc.gov/bcp/workshops/ehavioral/index.shtml.
\7\ See Press Release, FTC Staff Proposes Online Behavioral
Advertising Privacy Principles (Dec. 20, 2007), available at http://
www.ftc.gov/opa/2007/12/principles.shtm.
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Do Not Call
The Commission continues aggressively to implement and enforce the
National Do Not Call Registry. The Commission is grateful that Congress
made participation in the Do Not Call Registry permanent so that
consumers will continue to enjoy its benefits without having to re-
register. In November 2007, the Commission announced six new
settlements and one new Federal court action against companies that
violated the Do Not Call provisions of the Telemarketing Sales Rule.
The six settlements resulted in $7.7 million in civil penalties for Do
Not Call violations.\8\
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\8\ See Press Release, FTC Announces Law Enforcement Crackdown On
Do Not Call Violators, Nov. 7, 2007, available at http://www.ftc.gov/
opa/2007/11/dncpress.shtm.
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Privacy and Data Security
Privacy and data security continue to be high priorities for the
Commission. In the past 6 months, the Commission announced six new data
security cases,\9\ bringing the total number of FTC data security cases
to 20. Most recently, the Commission announced cases against TJX and
Reed Elsevier, the parent company of Lexis Nexis, alleging that the
companies engaged in unfair practices by failing to employ reasonable
and appropriate security measures to safeguard sensitive data. The
settlements have been accepted for comment, and would require the
companies to implement comprehensive data security programs and third-
party assessments biennially for 20 years.\10\
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\9\ United States v. American United Mortgage Company, No. 07C 7064
(N.D. Ill. filed Dec. 17, 2007), available at http://www.ftc.gov/opa/
2007/12/aumort.shtm; Life is good, Inc., Docket C-4216 (Apr. 2008),
available at http://www.ftc.gov/os/caselist/0723046/index.shtm; In the
Matter of Goal Financial, LLC., Docket No. C-4216 (Mar. 2008),
available at http://www.ftc.gov/os/caselist/0723013/index.shtm
(settlement accepted for public comment); United States v. Valueclick,
No. CV08-01711 MMM (rzx) (C.D. Cal. filed Mar. 13, 2008), available at
http://www.ftc.gov/os/caselist/0723111/index.shtm; The TJX Companies,
File No. 072-3055 (Mar. 2008), available at http://www.ftc.gov/os/
caselist/0723055/index.shtm (settlement accepted for public comment);
Reed Elsevier, Inc. and Seisint, Inc., File No. 052-3094 (Mar. 2008),
available at http://www.ftc.gov/os/caselist/0523094/index.shtm
(settlement accepted for public comment).
\10\ The TJX Companies, File No. 072-3055 (Mar. 2008), available at
http://www.ftc.gov/os/caselist/0723055/index.shtm; In the Matter of
Reed Elsevier, Inc. and Seisint, Inc., File No. 052-3094 (Mar. 2008),
available at http://www.ftc.gov/os/caselist/0523094/index.shtm.
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The FTC has also been active on data security education. It has
distributed more than 3 million copies of its consumer education
publication ``Take Charge: Fighting Back Against ID Theft.'' The FTC
also published a guide for businesses on data security, Protecting
Personal Information: A Guide for Business, and launched an
interactive, online video tutorial designed to educate businesses using
real-life scenarios. The Agency has also begun to hold regional
workshops for businesses on how to plan and manage data security. The
first workshop took place April 15 in Chicago.

Green Marketing
In response to a virtual explosion of green marketing over the past
year, the Commission has accelerated its review of its environmental
marketing guidelines, also known as the Green Guides.\11\ In November
2007, the FTC published a Federal Register Notice seeking public
comment on the Guides. Given the importance of green marketing and the
proliferation of new claims, the Commission also announced that it
would hold a series of workshops in aid of the Guide review. The
Commission hosted the first of these events on January 8, 2008,
addressing the marketing of carbon offsets and renewable energy
certificates. The second workshop, on green packaging, took place on
April 30, 2008, and a third workshop, on green claims related to
textiles and building materials, is planned for this July. The
Commission will use the information it receives at these workshops to
inform its review of the Green Guides, conduct enforcement actions, and
educate consumers.
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\11\ See Press Release, FTC Reviews Environmental Marketing Guides,
Announces Public Meetings (Nov. 26, 2007), available at http://
www.ftc.gov/opa/2007/11/enviro.shtm.
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Food Marketing to Children
The Commission continues its efforts to combat childhood obesity.
In early August, the Commission issued compulsory process orders to 44
food and beverage companies and quick-service restaurants, asking for
information on their expenditures and activities targeted toward
children and adolescents. All of the targeted companies have submitted
their responses, and staff is analyzing the submissions. Staff will
prepare a report, submit it to Congress, and release it publicly this
summer. The report will be an important tool for tracking the
marketplace's response to childhood obesity and identifying where more
action is needed.

Entertainment Marketing to Children
The Commission continues to monitor the marketing of violent
entertainment to children and encourage industry self-regulation in
this area. Since 2000, the FTC has issued six reports on the marketing
of movies, music, and video games containing content that may not be
appropriate for children.\12\ The Commission's reports generally
document improvement by all three industries in providing rating or
labeling information in advertising. The Commission has also conducted
five ``undercover shops,'' in which underage teenagers try to purchase
media rated or labeled as containing inappropriate content. These
undercover shops have demonstrated steady improvement in retail
enforcement of the age ratings.
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\12\ Moreover, in 2006, the Commission initiated and settled an
action against Take-Two Interactive Software, Inc. and Rockstar Games,
Inc., the creators and distributors of the popular Grand Theft Auto:
San Andreas video game, because they advertised the Entertainment
Software Rating Board (``ESRB'') rating for the game but failed to
disclose that the game discs contained potentially viewable sexually
explicit content that was unrated by the ESRB. Take-Two Interactive
Software, Inc., No. C-4162 (July 21, 2006), available at http://
www.ftc.gov/os/caselist/0523158/0523158.shtm.
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Last week, the Commission released the results of its fifth
undercover shop. These results show improvement, particularly by the
video game industry, which denied sales of Mature-rated games to our
underage shoppers 80 percent of the time. This is a dramatic
improvement from where the industry started 8 years ago, when nearly 9
out of 10 underage shoppers were able to buy these games. There are,
however, still areas for improvement. For example, roughly half of our
undercover shoppers were able to purchase R-rated or unrated DVDs and
explicit content music. The Commission will continue to monitor self-
regulatory efforts in this area.

COMPETITION MISSION

The Commission has an active enforcement agenda to promote and
protect competition, focusing on areas that are highly important to
consumers, such as health care, energy, real estate, and high
technology and standard setting. The Commission scrutinizes mergers in
many industries, filing actions to enjoin those that are likely to be
anticompetitive and ordering divestitures where appropriate to preserve
competition while allowing the beneficial aspects of the merger to
proceed. The Commission also polices anticompetitive conduct, with a
particular focus on competitor collaboration and exclusionary conduct.
Additionally, the Commission promotes sound competition policy through
myriad research and reports, studies, hearings, workshops, advocacy
filings, and amicus briefs. The Commission is also very active on the
international front, developing strong working relationships with
foreign antitrust agencies, cooperating on cross-border cases,
promoting convergence on competition policies, and offering technical
assistance to countries with relatively new competition laws.
This portion of the testimony highlights several important recent
developments in the Commission's competition agenda.
Health Care (Pay-For-Delay Settlements and Hospital Mergers)
In the health care area, the Commission is continuing its efforts
to prevent brand name drug companies from paying generic competitors to
stay out of the market, thereby depriving consumers and other payers of
significant savings. In February 2008, the Commission filed a case
charging that Cephalon, a pharmaceutical manufacturer, engaged in
illegal conduct to prevent competition for its branded drug,
Provigil,\13\ by paying four competing firms to refrain from selling
generic versions of the drug until 2012.\14\ The Commission's complaint
alleges that Cephalon's conduct constituted an abuse of monopoly power
that is unlawful under Section 5 of the FTC Act. The Commission also
has several other exclusion payment (``pay-for-delay settlement'')
investigations ongoing.
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\13\ Provigil is used to treat excessive sleepiness in patients
with sleep apnea, narcolepsy, and shift-work sleep disorder.
\14\ FTC v. Cephalon, Inc., No. 1:08-cv-00244 (D.DC. filed Feb. 13,
2008), available at http://www.ftc.gov/os/caselist/0610182/
080213complaint.pdf.
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These deals are a growing problem due to two court decisions taking
a lenient view of the practice. Between 2000 and 2004, there were no
patent settlements in which the generic received compensation and
agreed to stay off the market, but after the two court decisions in
2005, there were 3 such agreements in fiscal year 2005 and 14 in fiscal
year 2006. The Commission strongly supports legislation to address
competitive problems with pay-for-delay settlements. We note that bills
have been introduced in both chambers, and thank you, Mr. Chairman, for
your sponsorship of the bipartisan Senate bill.\15\
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\15\ Preserve Access to Affordable Generics Act, S. 316, 110th
Cong. (2007) (as reported by S. Comm. on the Judiciary).
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Last week the Commission voted to challenge the Inova Health
System's proposed acquisition of the Prince William Health System. The
proposed merger would combine Inova, the largest hospital system in
Northern Virginia, with the Prince William Hospital in Prince William
County, Virginia. The Commission alleges that the merger would
eliminate the existing, significant price and non-price competition
between these hospitals, particularly in the fast-growing western
suburbs of Northern Virginia, leading to higher health care costs for
the employers and residents of Northern Virginia.

Energy
The Commission shares the concerns of lawmakers, businesses, and
American consumers about rapidly increasing prices for crude oil,
gasoline,\16\ diesel fuel, jet fuel, and natural gas, and currently
engages in a wide range of activities to prevent improper industry
conduct causing such price rises. Under new authority to promulgate
regulations provided in Section 811 of the Energy Independence and
Security Act of 2007 (EISA), this month the Commission issued an
Advance Notice of Proposed Rulemaking (ANPR) regarding manipulation of
wholesale crude oil, gasoline, or petroleum distillate markets. The
ANPR, available on the Commission's website and in the Federal
Register, solicits public comments on determining whether and in what
ways the Commission should develop a rule defining and prohibiting
market manipulation in the petroleum industry.\17\ The 30-day public
comment period runs through June 6, 2008, and the Commission
anticipates concluding the rulemaking process this year. In addition,
Section 812 of that act prohibits knowingly reporting false data to a
Federal agency under a mandatory reporting requirement, with the
intention of affecting the Agency's data compilations for statistical
or analytical purposes. The section provides for Commission enforcement
with substantial penalties.
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\16\ The Commission actively and continuously monitors retail and
wholesale prices of gasoline and diesel fuel, looking for ``unusual''
price movements and then examining whether any such movements might
result from anticompetitive conduct that violates Section 5 of the FTC
Act. FTC economists have developed a statistical model for identifying
such movements. The Agency's economists regularly scrutinize price
movements in 20 wholesale regions and approximately 360 retail areas
across the country.
\17\ FTC Seeks Public Comment on Rulemaking to Prohibit Market
Manipulation in the Petroleum Industry, Press Release, May 1, 2008,
available at: http://www.ftc.gov/opa/2008/05/anpr.shtm, 73 Fed. Reg.
25614 (May 7, 2008).
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To protect and promote competition in the energy industry, the
Commission reviews mergers and investigates pricing and other
conduct.\18\ Over the past several years, the Commission has challenged
many mergers in this industry, obtaining significant divestitures to
preserve competition.\19\
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\18\ In 2005, the Commission settled an enforcement action charging
that Unocal deceived the California Air Resources Board (``CARB'') in
connection with regulatory proceedings to develop the reformulated
gasoline standards that CARB adopted. We believe the settlement
continues to result in an estimated $500 million of consumer savings at
the pump each year. See the discussion in Section III.D below.
\19\ These include Mobil/Exxon, British Petroleum/Amoco, Chevron/
Texaco, and Phillips Petroleum/Conoco.
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In the past year, we have acted to block acquisitions in the
natural gas and petroleum industries that we believed could raise
prices to consumers. In January 2008, Equitable Resources abandoned its
proposed acquisition of the Peoples Natural Gas Company, a subsidiary
of Dominion Resources, after the Third Circuit took the unusual step of
granting the Commission's motion for an injunction pending appeal, and
vacated the District Court's ruling dismissing the Commission's
complaint.\20\ The Commission alleged that parties were each others'
sole competitors in the distribution of natural gas to non-residential
customers in the Pittsburgh area and the transaction would have
resulted in a monopoly for many customers. Moreover, in May 2007, the
Commission brought an enforcement action in the oil and gasoline
industry when it issued an administrative complaint and initiated a
Federal court action to block Western Refining, Inc.'s $1.4 billion
proposed acquisition of rival energy company Giant Industries, Inc. The
Commission brought the action in an effort to preserve competition in
the supply of bulk light petroleum products, including motor gasoline,
diesel fuels, and jet fuels, in northern New Mexico. After a week-long
trial, the Federal district court denied the Commission's motion for a
preliminary injunction.\21\ The Commission is continuing to examine and
address a wide range of issues in the energy markets.\22\
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\20\ See FTC v. Equitable Resources, Inc., No. 07-2499 (3rd Cir.
2008), available at http://www.ftc.gov/os/caselist/0610140/
080204ftcmovacateequitabledecision.pdf.
\21\ The Commission subsequently dismissed its administrative
complaint, concluding that further prosecution would not be in the
public interest.
\22\ For example, in November 2007, the Commission issued its third
annual report on the state of ethanol production in the U.S. The report
noted that, as of September 2007, 13 firms had entered into the
production of ethanol during the preceding year, bringing the total
number of U.S. producers to 103. As new firms have entered, the market,
which is unconcentrated by any measure of capacity or production, has
become even more unconcentrated. 2007 Federal Trade Commission Report
of Ethanol Market Concentration (Nov. 2007) available at http://
www.ftc.gov/reports/ethanol/2007ethanol.pdf.
Additionally, the Commission is preparing its first report for the
Committees on Appropriations summarizing the Commission's activities
relating to ongoing reviews of mergers, acquisitions, and other
transactions in the oil and natural gas industries, the investigation
of pricing behavior or any potential anticompetitive actions in those
industries, and the resources that the Commission has devoted to such
reviews and investigations during the 6-month period.
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Real Estate
In another area critical to consumers, the Commission continues to
challenge realtor board rules that restrain competition and hinder
consumer choice in markets throughout the country. The Commission's
cases allege that associations of competing real estate agents have
adopted rules that limit competition from non-traditional and discount
brokers by restricting these brokers from, in part, placing listings on
MLS Internet sites, thus harming consumers who may prefer to list with
less expensive or non-traditional brokers. Six of our cases were
resolved by consent order requiring each realtor board to discontinue
enforcing the policies that, the Commission alleged, kept
nontraditional brokers from competing. A seventh investigation led to
an administrative complaint against a realtor group, which after a full
administrative trial and dismissal of the complaint against the
realtors by the ALJ is on appeal before the Commission. Oral arguments
were held in April, and a Commission opinion is expected in the next
months. The Commission also settled an action raising similar concerns
with a Milwaukee-based realtor group in the past year.\23\
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\23\ Press Release, FTC Charges Milwaukee MLS with Illegally
Restraining Competition (Dec. 12, 2007), available at http://
www.ftc.gov/opa/2007/12/mls.shtm.
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High Technology and Standard Setting
The Commission continues to remain vigilant against mergers and
conduct that would distort competition in the high technology industry.
One such enforcement case that the Commission has brought is the case
against Rambus. In June 2002, the Commission charged Rambus with
unlawfully monopolizing four computer memory technologies that were
incorporated into industry standards for dynamic random access memory
chips, widely used in personal computers, servers, printers, and
cameras. In July 2006, the Commission found that Rambus had illegally
acquired monopoly power through exclusionary acts, and issued an order
limiting the royalty rates Rambus may collect under its licensing
agreements.\24\ On April 22, 2008, the D.C. Circuit Court of Appeals
set aside the Commission's Order and remanded the case for further
proceedings before the Commission. The Commission is reviewing the
Court of Appeals opinion and will decide in the next few weeks whether
to appeal the decision to the full D.C. Circuit or the Supreme Court.
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\24\ Press Release, FTC Issues Final Opinion and Order in Rambus
Matter (Feb. 5, 2007), available at http://www.ftc.gov/opa/2007/02/
070502rambus.htm.
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The Commission has previously addressed the substantial consumer
harm, including higher prices, that can result from the alleged abuse
of standard-setting processes. In 2003, the Commission successfully
challenged Unocal's alleged illegal acquisition of monopoly power in
the technology market for producing Phase 2 ``summer-time'' gasoline a
formulation of low- emissions gasoline mandated for sale and use in
California for up to 8 months of the year by misrepresenting that
certain information was non-proprietary and in the public domain, while
at the same time pursuing patents that would enable it to charge
substantial royalties if the information was incorporated into
California Air Resources Board (``CARB'') standards. The complaint
alleged that Unocal induced CARB to adopt standards for this gasoline
that substantially overlapped with Unocal's patent rights. The
Commission's success is estimated to have saved California consumers
over $500 million per year at the pump.
Other
The Commission's efforts to maintain competition are not limited to
high profile industries. In January 2008, the U.S. Court of Appeals for
the Fifth Circuit upheld a Commission order requiring Chicago Bridge &
Iron Co., N.V. and its United States subsidiary (CB&I) to divest assets
acquired from Pitt-Des Moines, Inc. used in the business of designing,
engineering, and building field-erected cryogenic storage tanks.\25\
The Commission had ruled in 2005 that CB&I's acquisition of these
assets in 2001, would likely result in a substantial lessening of
competition or tend to create a monopoly in four markets for industrial
storage tanks in the United States. The court endorsed the Commission's
findings that the merged firms controlled over 70 percent of the
market, and that new entry was unlikely given the high entry barriers
and based on the incumbents' reputation and control of skilled crews.
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\25\ FTC v. Chicago Bridge & Iron Co., No. 05-60192 (5th Cir. 2008)
available at http://www.ftc.gov/os/adjpro/d9300/
080125opinion.pdf.http://www.ftc.gov/opa/2008/01/cbi.shtm
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The Commission continues to appeal its case against Whole Foods
Market, Inc.'s acquisition of its chief rival, Wild Oats Markets, Inc.,
on the grounds that the district court failed to apply the proper legal
standard that governs preliminary injunction applications by the
Commission in Section 7 cases. The Court of Appeals for the District of
Columbia Circuit heard oral arguments on this case on April 23, 2008.

NEEDED RESOURCES FOR FISCAL YEAR 2009

To meet the challenges of its Consumer Protection and Maintaining
Competition goals in fiscal year 2009, the FTC requests $256,200,000
and 1,102 FTE. The fiscal year 2009 request represents an increase of
$12,336,000 and 18 FTE over the fiscal year 2008 enacted levels.
The Commission seeks these additional resources to continue to
build on its record of accomplishments in enhancing consumer protection
and protecting competition in the United States and, increasingly,
abroad. The increase of $12,336,000 that the Commission is seeking in
fiscal year 2009 includes:
--$7,989,000 in mandatory cost increases associated with contract
expenses (CPI adjustment) and personnel (salaries and with-in-
grade increases);
--$2,847,000 for 18 additional FTE;
--10 FTE for Consumer Protection to protect consumers from unfair
and deceptive practices in the financial services
marketplace; protect consumers' privacy; improve compliance
with FTC orders; pursue foreign-located evidence of fraud
perpetrated against U.S. consumers; advocate the adoption
of foreign data privacy laws and procedures that are
compatible with American law; and provide support for the
effective operation of this program; and
--8 FTE for Maintaining Competition to meet the increased workload
required to challenge anticompetitive mergers and assure
that the marketplace is free from anticompetitive business
practices in the health care, pharmaceutical, energy, and
technology sectors; promote convergence in competition
policy of foreign enforcement practices; and provide
support for the effective operation of this program;
--$1,500,000 for non-FTE program needs;
--$1,100,000 for Consumer Protection;
-- $500,000 for ``Green'' marketing research, education campaign,
and enforcement;
-- $250,000 for high-tech tools to stop fraudsters;
-- $250,000 for marketing and advertising of food to children;
-- $100,000 for privacy and identity theft and deceptive and
unfair practices in mobile marketing; and
-- $400,000 for Maintaining Competition to meet the challenges of
an increased enforcement agenda and associated litigation
and outreach efforts.
The majority of the funding for the FTC's fiscal year 2009 budget
request will be derived from offsetting collections; HSR filing fees
and Do Not Call fees will provide the Agency with an estimated
$189,800,000 in fiscal year 2009. The FTC anticipates that the
remaining funding needed for the Agency's operations will be through a
direct appropriation of $66,400,000 from the General Fund in the U.S.
Treasury. The FTC appreciates the strong support it has received from
Congress to serve its critical mission of protecting the American
consumer and ensuring competition in the marketplace. With the
increased funding made available to the FTC in the fiscal year 2008
appropriation for high priority activities including subprime lending,
identity theft, the U.S. SAFE WEB Act, market manipulation of
petroleum, maintaining competition, and training and technical
assistance for developing nations, the FTC will be able to address
critical consumer problems at present and anticipate, adapt, and
mitigate the challenges of the future.

CONCLUSION

We appreciate the opportunity to appear before you today to discuss
the Commission's work and our fiscal year 2009 budget request, and look
forward to continuing to work together.

Senator Durbin. Commissioner Leibowitz.

SUMMARY STATEMENT OF HON. JON LEIBOWITZ

Mr. Leibowitz. Thank you, Mr. Chairman, Ranking Member
Brownback. Let me begin by speaking briefly about the
Commission generally before I turn to the FTC's consumer
protection efforts.
From my perspective, the Commission's biggest challenge is
that we are a small agency--we have fewer than 1,100 full-time
equivalents (FTEs)--but we are tasked with a big mission:
protecting competition and consumers across broad swaths of the
economy. The constant challenge for us is not only to
effectively leverage our limited resources--I think we do that
quite well--but also to ensure that the quality of our work is
not strained by the quantity of demands placed upon us.
In the past few years, Congress has enacted new laws,
several very important ones, that the FTC is charged with
enforcing: CAN-SPAM, the Fair and Accurate Credit Transactions
Act (FACT), the Children's Online Privacy Protection Act
(COPPA), to name just a few.
Put simply, implementing and enforcing these laws takes
resources. For that reason, we deeply appreciate your efforts
to ensure that we have the budget we need. Speaking for myself,
I am enormously grateful for the $3 million your subcommittee
authorized last year above the administration's request. That
enabled us to hire additional employees to bolster our
enforcement efforts, especially in the areas of financial fraud
and anticompetitive behavior by pharmaceutical companies, which
Chairman Kovacic talked about.
Mr. Chairman, the rest of my remarks will focus on some of
our consumer protection priorities. I am going to try to do six
priorities in 3 minutes.
First, financial services. Chairman Durbin, you mentioned
mortgages, and we currently have multiple investigations
underway in the subprime market, including two that the targets
themselves have made public: investigations of Bear Stearns,
for servicing subprime mortgage loans; and of CompuCredit, a
leading provider of subprime credit cards. We also are
investigating mortgage brokers whose advertising, for example,
touted preposterously low interest rates without disclosing
that they would increase substantially after a short
introductory period. In the past decade, we have brought 22
actions against the mortgage lending industry and obtained more
than $320 million in consumer redress.
Indeed, if you combine all the consumer redress,
disgorgement, and fines we collect with our Hart-Scott-Rodino
and Do Not Call fees, the agency brings back more money to
American consumers than it costs.
Second, Do Not Call. The great American philosopher, Dave
Barry, has called the Do Not Call Registry the most popular
Government program since the Elvis stamp. It has helped
preserve the sanctity of the American dinner hour, and we are
grateful that Congress made Do Not Call permanent last year.
There are nearly 160 million phone numbers registered on Do Not
Call and----
Mr. Kovacic. How many?
Mr. Leibowitz. 160 million registered, and to date we have
brought 36 cases against violators.
Third, technology. The Commission has initiated more than
100 spam and spyware actions, and has helped to substantially
reduce the nuisance adware problems that have caused literally
billions of unwanted pop-up ads on Americans' computers.
We have also held hearings on emerging technologies and
practices such as behavioral marketing; that is, the monitoring
of consumers' online behavior to deliver targeted advertising.
Commission staff recently issued a set of proposed behavioral
advertising principles for public comment designed to push
self-regulation in the right direction.
Fourth, privacy and data security. Safeguarding consumers'
sensitive personal information remains a priority for us. To
date, the FTC has brought 20 enforcement actions challenging
data breaches and inadequate data security practices.
Fifth, so-called green claims. In the past year or two,
there has been an explosion of environmental advertising claims
like ``sustainable'', ``renewable'', and ``carbon neutral''. In
response, we are holding a series of workshops and updating our
environmental marketing guidelines, better known as the Green
Guides.
Sixth and finally, an issue I know both of you are
interested in, marketing to children. The Commission continues
its efforts to combat childhood obesity and foster appropriate
food marketing to kids. Last August, the Commission subpoenaed
44 food and beverage companies seeking information on their
activities targeted to children. Staff is preparing a report
based on what we have learned, and we expect to release it this
summer.
The Commission also continues to monitor entertainment
industry marketing practices. Since 2000, the FTC has issued
six reports on the marketing of movies, music, and video games
containing violent content. And last week we released the
results of our fifth undercover shopping survey in which
underage teenagers tried to buy media labeled as containing
inappropriate content. These reports and surveys generally show
industry improvement, although further progress would be
helpful, especially in the growing marketing of unrated DVDs.
Our efforts are designed to encourage further self-regulation
in this area. We believe they have been helpful.
With that, I will exercise some self-regulation of my own
and stop talking. And I am happy to answer questions.
Senator Durbin. Thank you, and I think we will have a few.

TRENDS IN THE OIL MARKET

Chairman Kovacic, I wrote you a letter on April 23 urging
the FTC to investigate trends in the oil market. We have seen a
sudden widening of the difference between crude oil and certain
refined petroleum product prices, the so-called crack spread.
This crack spread for middle distillate fuels like diesel, home
heating oil, and jet fuel has spiked recently, leading to two
trends I wrote you about.
First, while gasoline has typically been more expensive
than diesel fuel, we have recently seen that trend dramatically
reversed. The national average for retail gas, $3.72; the
average for diesel fuel, $4.33 a gallon, a difference of 61
cents.
Second, we are seeing a spike in jet fuel costs having a
major impact on struggling airlines. Yesterday CNN quoted the
CEO of a consumer airline ticket web site as expecting ``at
least two more price increases before the end of May.''
These trends are not linked to changes in crude oil prices
or taxes. The crude feedstock for diesel and gasoline is
identical, about $3 a gallon, and Federal gas and diesel taxes
have not changed for almost 15 years.
I would like to just make a comment. First, I do not think
these charts are inconsistent. What Senator Brownback has shown
us is that as crude oil prices have gone up, so too has the
cost of the refined product, in this case I believe gasoline. I
do not quarrel with that.
But this one tells you that the difference between the two
is much wider than it once was, and that difference is the
refining add-on cost to the basic crude product. And within
that add-on cost for refining, the so-called crack spread,
turns out to be a world of profit for the oil companies now
registering and reporting not only record oil company profits,
but record profits for American businesses. No one has ever
been quite this successful in our capital system.
So the question I have is this. Has the FTC been monitoring
these trends? Do you plan to initiate a comprehensive
investigation or inquiry? And what is driving this?
Mr. Kovacic. Thank you, indeed, for your letter, Chairman
Durbin.
For about the past 3 or 4 years, we have had a program in
place to monitor on a retail and wholesale basis price changes
concerning gasoline and diesel. The program has not covered jet
fuel as well. But we have been examining anomalies as they
appear in the pricing and distribution of these products. With
your letter in hand, we are expanding our examination of these
issues and we are taking a look very closely at both trends in
diesel and jet fuel.
I do not have specific results to report to you at the
moment, although I do make the offer to meet with you and with
my staff as we do learn more from the results of this
examination, and I make myself, along with my staff, available
to discuss this with you.
What we are seeing in part is that this is an international
pattern. That is, from our quick examination to date, these are
trends that characterize practice in global markets, Singapore,
Europe.
We are also noticing that one notable feature has been a
dramatic increase in demand for diesel in recent years. That
is, in Europe, in Asia, in a number of areas where we have been
able to examine very closely and compare with our own
experience, there has been a significant increase in the demand
for diesel. We see that as one factor that has probably made
the two lines cross that you were referring to before.
Another relationship we are looking at quite carefully is
that in the stratum of the refining process, the barrel that is
being produced--there is a very close interaction between
production capacity and the production of both jet fuel and
diesel, kerosene and diesel together. We are looking very
carefully at how adjustments in production process and capacity
allocation decisions have affected that.
But let me emphasize that your inquiry and others that we
have received from your colleagues in this body and across the
Capitol--we are looking at this very carefully. I make myself
at your disposal to report to you on what we see as the
consequence of this deeper look at both diesel and jet fuel.
Senator Durbin. Thank you. I am glad that the FTC is going
to initiate this inquiry, and I am sure it will expand even
beyond the questions that I have asked. I hope that it will
include questions about refinery capacity and unused capacity.
I find it hard to imagine why we are still dealing with about
85 percent use of refinery capacity in a country where the
prices are so high.
Second, I hope you will at least explore the question as to
whether and, if so, how much the United States is exporting in
terms of refined product or even crude product for that matter.
There have been calls for us to drill in the Arctic National
Wildlife Refuge and other places offshore that are
controversial from an environmental viewpoint, and I certainly
hope that before we would even consider such a thing, that we
would look at other alternatives that would spare these areas
from creating any kind of environmental hardship.
Let me turn it over to my colleague and I will return with
some more questions.
Senator Brownback. Thank you, Mr. Chairman.
Examining the data, I think we are using similar charts. It
looks like the crack spread has flipped between 2007 to 2008. I
have somebody who understands and analyzes this more, but if
you look at what has happened on the spot oil price, this chart
goes from 2001 to 2008. Yours goes from 2002 to 2007. There has
been substantial movement. But I would just point out over a
longer period of time, these two track together and you are
going to see an increase in gasoline prices.
If there has been market manipulation, I want us to
absolutely go after people with hammer and tong on it so that
we can get at the bottom of this.
I understand the FTC has recently announced an advance
notice of proposed rulemaking on market manipulation of oil and
gas prices. How do you see this rule helping the American
consumer? What are you targeting? And I know you cannot talk on
some of the specifics of this from our previous discussion, but
can you give us any thought of what the American consumer can
see out of the FTC as a result of this?
Mr. Kovacic. What I am going to do, Senator, is to give you
a snapshot of what was in that notice as an indication of what
we will be looking at and, as you mentioned, to be enormously
cautious in offering any specific views about what we might do
to avoid a possibility of prejudgment.
We intend to examine very carefully a variety of scenarios
that are laid out in the advance notice. Among the scenarios
for which we have sought comment involves the possibility that
there has been fraud with respect to the reporting of
information to public authorities, or fraud or
misrepresentation with respect to the reporting of information
to private bodies that collect and report information on
pricing and transactions.
We intend to look very carefully at a collection of
scenarios that are closely related to those that our other
Federal agencies, the Federal Communication Commission (FCC),
Federal Energy Regulatory Commission (FERC), and Commodity
Futures Trading Commission (CFTC) have examined in the course
of applying manipulation authority. Have there been deliberate
efforts in specific instances to exploit shortage conditions as
an opportunity to raise prices? Have there been traditional
forms of manipulation that would fit within a conventional
antitrust or competition context, that is, including the
possibility of collusion, improper behavior to exclude other
firms?
As laid out in the notice, this range of possibilities,
some of them familiar to the concepts that you were alluding to
before, Senator, involving outright collusion, traditional
antitrust actionable behavior, but not antitrust behavior in
many instances examined by our fellow Federal agencies in
different settings. Those are the scenarios in the notice that
we have asked others to comment upon, and we do welcome the
comments before the comment period closes in early June.
Mr. Leibowitz. Yes. And let me just echo what the Chairman
has said. We put out, I think, a 38-page advance notice of
proposed rulemaking. I think that is the right approach to take
because, after all, we have a lot of experience with antitrust,
but we do not have a lot of experience with manipulation beyond
the antitrust laws.
And in the ANPR--and again, I do not want to talk in too
much detail because we do not want to be accused of prejudging;
we do not want to be asked to be recused--we show other
examples, examples that we want commented on, like very public
announcements or pre-announcements of refinery shutdowns, or
moving product away from an area where there is a shortage to
drive up prices. And so those are the things we want comments
on, and we are committed to, I think, completing--we certainly
anticipate completing the rulemaking process by the end of the
year.
Senator Brownback. Good. I think that is good and I think
it is going to be very useful to be able to see that kind of
information. As you may know from last week's hearing, we had
the CFTC here, and we were talking about market manipulation by
large hedge funds, index funds on commodity prices overall. And
I think there is more to be looked at there.

FOOD MARKETING TO CHILDREN

On another area, Senator Harkin and I have been working
closely together over the last year examining the effects of
food marketing to kids. I am very interested in the
comprehensive analysis the FTC has undertaken on the types and
amounts of food marketing directed at children. It is my
understanding the report is due to be released this summer. You
have worked on these topics. I have worked with you on these
topics before, as you mentioned, Mr. Leibowitz, and on target
marketing of violent entertainment to children.
What kind of information should we expect to see in this
report that you are going to be putting out on target marketing
of food to children?
Mr. Kovacic. Jon?
Mr. Leibowitz. Well, we hope to complete our report this
summer. We did a workshop on this issue. We sent out a number
of subpoenas to the major fast food restaurants and food
companies.
Maybe we can come in and brief your staff about this. But
we are trying to figure out exactly how the targeting is being
done and what effect it may have on children. And as you know,
because I know you are involved in the FCC task force,
childhood obesity has gone up dramatically in the last
generation. What used to be called adult-onset diabetes cannot
be called that anymore because so many children have it. We
think part of that may be due to the foods that they are
eating, and so we are taking a look at this marketing and we
hope to have something useful to say in the report in the next
couple of months. But we will come in and talk to you about it
beforehand.
Mr. Kovacic. I think, Senator, what you certainly can
expect to see is what probably will be the best empirical view
that a public agency has had to date about some of the
phenomena that are being addressed. We are undertaking a very
careful effort to gather data company by company to give you
and the larger public a clear view of the advertising trends at
issue. This study will be based, again related to a point that
both of you made before, as much as possible, on a carefully
developed empirical foundation and not simply on hunches.
Senator Brownback. Thank you.

SPECULATION IN THE OIL MARKET

Senator Durbin. Chairman Kovacic, last week the Wall Street
Journal's Market Watch quoted an industry analyst as estimating
that about $25 to $30 of price per barrel of crude oil may be
attributed solely to speculation. Have you looked into how the
futures market is influencing the price of gasoline or other
energy products? And if so, what steps do you think should be
taken to protect consumers from any excessive speculation?
Mr. Kovacic. To this point, we have not examined that in a
detailed way, Mr. Chairman. What we have seen from our work in
the past, looking at the links between futures trading activity
and current prices, is that efforts on the part of individual
investors to anticipate future developments and make
investments unmistakably play some role in setting current
prices. What we are not certain of is how much. That is, is it,
in the case of the individual quoted in the article, $25 or $30
a barrel? Is it $5 or $10 a barrel? Is it $1 a barrel? That is
something we do not know.
I would anticipate pursuing two avenues on this issue. One
is in the course of the rulemaking process; one possible avenue
identified in the advance notice is to devote closer attention
as part of the authority. That is, one possible application of
our authority might be to examine these issues in much closer
detail.
A second one that I detect in your questioning of Walt
Lukken from the CFTC and to some extent with Chris Cox is a
concern that whatever we do, we make the best possible use of
knowledge that already resides in other public authorities that
have been examining this. So in addition to our consultation
with them as part of the rulemaking process, we are separately
going to work as carefully as possible with the CFTC, with the
SEC, and indeed, with FERC, though they do not deal with
petroleum prices as such, to see the extent to which we can
explore these issues together and to make sure that as our own
research program is formulated and, as an enforcement program
is developed, that we take the fullest possible advantage of
what they have learned. I have met with Chairman Lukken on this
point. I have met with Chairman Kelleher, and I anticipate
meeting with Chairman Cox as well to ensure that whatever we do
builds on the foundation they have already constructed.
Senator Durbin. It is no secret that Chicago, which I
represent, is very interested in the futures markets.
Mr. Kovacic. There are futures markets in Chicago, yes.
Senator Durbin. So I am trying my best to look at this in
an honest fashion, and when I ask the industry, they say do not
forget we are one player, and there are other markets that
people can choose to use outside of the United States. And if
we take action in the hopes of having impact on speculation, it
may just drive the futures activities to other countries. I
assume that will be taken into consideration?
Mr. Kovacic. Indeed. As a consequence of the augmentation
of resources that you provided us last year for international
matters, we have a much better platform today than we did 2
years ago to work with our foreign counterparts. I suspect it
would surprise neither of you that the issue of energy prices,
both with respect to current prices and futures markets, is an
acute matter of concern to our counterparts at the Office of
Fair Trading in London, to our counterparts in the
Bundeskartellamt in Bonn, to our counterparts at the ACCC in
Canberra, and to Canada's Competition Bureau in Ottawa. There
is no issue, I would suspect, that is more important or
compelling to all of us.
And we do have increasingly effective means to cooperate
with each other. So the international dimension of this problem
will be a crucial element of what we do. Again, by way of
thanking you for looking over the horizon to think of the kinds
of resources that provide a better basis for us for doing that
work and taking that into account, we are in a much better
position to do that now than we were previously.
Mr. Leibowitz. Yes. And if I can just add, I agree with
everything that the Chairman just said, and we are also going
to be reaching out in the rulemaking process to buyers, to
customers, and to consumer groups because we really need to
learn about this area as we go forward with our manipulation
authority.

DO NOT CALL

Senator Durbin. Commissioner Leibowitz, you mentioned the
Do Not Call Registry that Dave Barry had just kind things to
say in reference to. And it is my understanding that there are
now some 145 million active telephone number registrations in
our country, maybe even higher.
Mr. Leibowitz. It is up to 160 million now. It grows every
day.
Senator Durbin. I also understand the FTC has received over
1.2 million consumer complaints alleging violations of the
registry. How are you responding? What remedies or relief do
you have available when you find violations?
Mr. Leibowitz. Well, that is a really good question. We do
collect complaints and that is how we prioritize, in a large
way, the law enforcement actions that we take. We have actually
brought 36 cases against violators thus far. I think last year,
we recovered $7.7 million in fines.
We are fortunate that when we have violations of Do Not
Call, we are able to fine malefactors. For most violations of
the FTC Act, however, we do not have fining authority. That is
an issue that is being discussed in the context of the
reauthorization that is going through the Commerce Committee.
But we take Do Not Call very, very seriously. We think it
is a wonderful program and an unequivocally successful one, and
we spend a lot of resources to make sure that we go after
people who are in violation of it.
Senator Durbin. Thank you.
Senator Brownback.

MARKETING ADULT-RATED ENTERTAINMENT TO CHILDREN

Senator Brownback. Gentlemen, I want to look at the FTC
study that previously done on target marketing of adult-rated
entertainment material for children. I appreciate you handing
me your FTC press release about undercover shoppers finding it
more difficult to buy ``M'' rated games.
You may recall some of the ground-breaking studies and work
that were done as the Commerce Committee was pushing on this
issue. Mr. Leibowitz, you were working with Herb Kohl. I have
worked on it with Senator Lieberman. John McCain was chairing
the Commerce Committee when we moved into this area.
Are you looking still at the target marketing of the adult
material? This is on the ability to purchase, but not the
target marketing of this.
I want to suggest that what you studied in the target
marketing of entertainment to underage consumers may be the way
you want to study the comparable target marketing of material
in the food consumption area. Are you updating the target
marketing survey on the entertainment material?
Mr. Leibowitz. Yes. We will be doing another report. We
have done six in the last 8 years, I believe, and so we will be
doing another entertainment industry marketing report probably
sometime toward the end of this year or next year.
And we do look at targeted marketing. In the context of our
food marketing to children report, we will be looking at, for
example, Internet advertising to kids and the propriety of it
and the types of advertising we are seeing. I think in our last
report on entertainment industry marketing, we saw that ratings
were not as well associated with Internet advertising as they
were with, for example, print advertising.
Senator Brownback. I think this is a key area for us. You
have correctly identified that we are all seeing this huge
onslaught on obesity, particularly in children. We are looking
at a possibility of a generation that may not live as long as
their parents did and this would be a first for this country, a
lot of the problem is just based upon a lack of healthy eating
habits.
We are seeing target marketing taking place here, which we
saw in the entertainment industry. You guys doing that survey
and putting the information out was something that was very
helpful to the Congress, and I think it would be very helpful
to the country to expose the problem of target marketing of
food to children, if it is what is taking place here. This is
why it is so hard for mom or dad to go for the Healthy Choice
when they are taking the kids to the grocery store or to the
fast food restaurant. And the kids say no, as they pull back
the other way. We can try to help the parents in that
situation. I think it would be very beneficial.
Might I make a suggestion to both of you? I have recently
met with the head of the National Institute of Mental Health.
The understanding of how the mind works is getting much better.
Now, we are a long ways from understanding the most complex
physical entity in the entire cosmos. It is the human mind. And
then there is a subset of that, the child's mind, even maybe
more difficult to understand.
Mr. Leibowitz. And I have two young children, so I know
exactly what you are talking about.
Senator Brownback. And it is not fully developed until--I
think they are saying now--the age of 23 on average.
But I found it very interesting what we do know. By meeting
with them, I might suggest that you bring out some of the
experts from the National Institute of Mental Health or you
yourself go there and have them tell you what do we know and
what do we not know because I think you will find it
interesting to your own perspective about regulating
advertising or looking at advertising. To ask the question of
what is really happenning within this mind, and what do we know
and what do we not know, what are we unlikely to know. I think
it would be advantageous.
One quick final comment. I hope when you do the gasoline
study, which I think can be very helpful, you will look at
overall supply and demand situations globally and the effects
of transportation because in any sort of global commodity
business is effected by supply and demand. The big differential
is transportation cost of that commodity. While we may have
disputes about domestic production of oil, it does have a
significant impact and a more pronounced impact domestically.
And I hope you would look into this.
I do not want anything left off the table on this as we
look at this very key area and an area of deep concern to us
and to the country. I think you guys can provide some overall
data to use in this tough time of increasing energy costs.
Mr. Kovacic. Senator, your comment about the consultation
with the authorities at the National Institute of Mental Health
fits very well into an approach that we have taken to heart on
consultations with others. Indeed, one line of research that we
have been spending more time on is the larger question about
how people absorb information, what do they understand, adults
and children, from the downpour of information that swamps each
of us every day. When they see a mandated disclosure, what do
they take away from it? We had a very good workshop on what is
called behavioral economics, which really goes to this question
in many ways, of how people understand images or messages that
are being brought to them. So that fits very well--your thought
about how to approach that--with other things we are doing, and
I will certainly bring that back to my colleagues.
On the point about energy, I think it is our responsibility
within the sphere of work we do to be as active and effective
as we possibly can. And we cannot possibly shed responsibility
by saying the problem lies elsewhere. In the full scope of
authority we have, our principal duty is to use that authority
as effectively as we possibly can.
I think another part of our responsibility that you have
touched on--and I think it is really implicit in larger
discussion we have had--is our obligation to participate in
larger discussions about what energy policy should be, larger
discussions about how we live from what we see in our consumer
protection and competition side, how we consume, how our lives
are structured in a way that drives demand in certain
directions, how people can make adjustments from existing
lifestyles in ways that could affect consumption patterns, and
indeed, on the supply side, what challenges we face in ensuring
that there are adequate supplies.
And I think beyond the narrow niche of competition and
consumer protection, as important as those are to both of us,
we would like to be part of that larger discussion about
looking ahead as a country, what bigger challenges we must face
in order to resolve these and related problems. We would
eagerly enjoy being part of that discussion as well.
Senator Brownback. Thank you, Mr. Chairman.

CREDIT CARD PRACTICES

Senator Durbin. So you identified one of your concerns with
financial services as subprime lenders and the like. I would
like to ask you whether you have initiated any kind of
inquiries or investigation into credit card practices.
Mr. Leibowitz. Credit card practices are tricky for us
because they are mostly done through banks, and we do not have
jurisdiction over banks. It is one of the carve-outs, like
common carriers and insurers, that we do not have jurisdiction
over.
We do have a major investigation going on of a large
subprime credit card non-bank company, CompuCredit, and I can
make that public because they have made it public in, I think,
their Securities and Exchange Commission (SEC) filings. So yes.
The answer is yes. We are looking at this.
Senator Durbin. I would think that the credit card aspect
of this might come up in the identity theft investigations.
Mr. Leibowitz. Of course, it does.

IDENTITY THEFT

Senator Durbin. And that is your number one complaint. I
think one out of three consumer complaints relate to identity
theft.
Mr. Leibowitz. That is right.
Senator Durbin. Having been personally victimized a few
years ago and my wife just recently--thank goodness, it was not
any great damage to us. Tell me what you are finding. Are there
things that we should be considering in terms of new
legislation or new policies that might protect the privacy of
American consumers?
Mr. Leibowitz. Well, identity theft is a very major problem
in America. Roughly 10 million people, according to our
surveys, are victims of some sort of identity theft every year.
We are mostly an information clearinghouse on identity
theft because, after all, a lot of identity theft is criminal.
But we do a lot of education on this, and we have some identity
theft brochures, and I believe 3 million people have copies of
them.
Do I think that there is a need for more legislation? I
would like to think about that and get back to you.
But I certainly think it is an area--and I think our staff
certainly thinks it is an area--that we need to keep in the
forefront because it affects so many Americans. And so we spend
a lot of time on the education side, on the compiling of
statistics side, and we are going to stay on top of it.
Mr. Kovacic. I want to underscore Commissioner Leibowitz's
observation about the importance of your support for our
efforts to do education. This is an area where we think that
with greater precaution-taking, many Americans can avoid
circumstances in which they are going to be vulnerable. We
should begin the process of education at the earliest possible
stages of our education system. That is, imagine building into
grade school education equivalence of the precepts that I think
many of us--well, of a certain age at least--tended to learn as
school children. Do not take a ride home with a stranger. If
someone approaches you that you do not know, you do not follow
them around. Basic precepts that might be identified for an
electronic age today. If it is someone you do not know that is
reaching out to you, far more often than not, nothing good is
going to come from that. To tell adults about how to be
discreet in the way in which they disclose information about
themselves. If you receive a telephone solicitation--we will
assume it is a legitimate one seemingly--or if you receive
solicitations over the Internet and you know that you do not
have a bank account with the State National Bank and they are
asking you to verify account information, that is certain to be
a fraud.
So your continuing support for efforts both for us and for
related public institutions to carry on that education function
would be helpful, along with your support for our continuing
efforts to work more extensively with other public
institutions.
As my colleague mentioned, the serious wrongdoers I think
will only be deterred in this area when we take their freedom
away. That means prison sentences. That means criminal
prosecution. And your encouragement and continuing assistance
in our efforts to prepare matters for prosecution by the
Department of Justice, by State prosecutors, by Assistant U.S.
attorneys would be most valuable in this respect.
Mr. Leibowitz. And I absolutely agree with that.

GREEN MARKETING

Senator Durbin. If I could just have one last question, I
think there is one area we have not touched on in the consumer
side, and that is the so-called green marketing that you
mentioned in your summary.
The FTC has been working to review environmental marketing
guidelines, also known as Green Guides. What is the most common
type of problem that you are finding when it comes to green
advertising?
Mr. Leibowitz. Well, what we are beginning to see with the
proliferation of green advertising--of course, if it is
accurate, that is very good. It is good for the environment,
and it is good for consumers to have that option. What we are
beginning to see--and we started this with a workshop process--
is that some of the advertisements are sometimes exaggerated,
and if an advertisement is deceptive, then we are going to do
an investigation and perhaps bring a prosecution. We are just
starting to look at this issue. We think most of the
advertisements we are seeing are good and they are well-
intended, but we are going to police this area. That is what we
are supposed to be doing.
Mr. Kovacic. If I can mention, Mr. Chairman, our recent
workshop on packaging and green claims related to packaging I
think underscored an issue that lies ahead which is in popular
discourse in advertising you see common use of terms like
``sustainable,'' ``green,'' ``green-friendly.'' I suppose in
some way we have a general hunch about what these things mean,
but there could be a source of confusion for consumers as a
whole. What is a sustainable product?
Senator Brownback. Or what does ecoshaped mean? A very
handsome shape, too.
Mr. Kovacic. That is right.
And one of the things we saw in our workshop was--I think
our workshop will help be a catalyst for further efforts by a
variety of private and not-for-profit associations to provide
better definitions for these things, to help establish
standards and focal points for providing meaningful
definitions. That, in turn, is going to assist us in framing
the revision of our guidelines themselves. And as my colleague
mentioned, we are keenly attuned to instances in which someone
says, give me $50, I will plant a tree in the rainforest, to
focus more and more attentively on whether that tree gets
planted.
Senator Durbin. Thank you.
Senator Brownback.
Senator Brownback. I have no further questions.
Senator Durbin. Thank you. It has been a great hearing. You
have a fascinating agency which has received high marks for its
performance for America's taxpayers and our economy, and you
should be proud to be part of it. And we are glad to have you
as part of our appropriation. I thank you for your preparation
for this hearing and your comments.

ADDITIONAL COMMITTEE QUESTIONS

We may send some written questions your way, and I hope you
will have a chance to respond to them in a careful and
expedient way. The hearing record is going to remain open for
about 1 week until Wednesday, May 21, for other subcommittee
members if they would care to submit questions as well.
[The following questions were not asked at the hearing, but
were submitted to the Commission for response subsequent to the
hearing:]

Questions Submitted by Senator Richard J. Durbin

MERGER ACTIVITY

Question. During economic downturns like we're experiencing today,
analysts have reported that merger activity tends to increase.
Has the FTC observed that trend in the past, and if so, does the
fiscal year 2009 budget include an increase to accommodate the increase
in anticipated workload?
Answer. The FTC's data show that the number of merger filings with
the FTC and the Department of Justice tends to grow with increased
merger and acquisition activity during strong economic times. The FTC
has not observed that merger notifications tend to increase during
economic downturns. Notwithstanding the current economic downturn,
however, the FTC budget request for fiscal year 2009 includes an
increase in resources devoted to reviewing mergers--resources that will
be used to address the growing complexity of the transactions that the
agency reviews and the increased need for sophisticated economic
analysis of those transactions.

FRAUD COMPLAINTS

Question. The number of fraud complaints reported to the FTC grew
by almost 30 percent in 2007.
What was the cause of the increase, and how will the fiscal year
2009 request address this problem?
Answer. This increase is due, in large part, to better data
collection and specifically due to a substantial increase in complaints
shared by the Better Business Bureaus (``BBBs''). We received 169,887
complaints from the BBBs in 2007, compared to 20,265 complaints in
2006.
The FTC maintains a broad range of consumer complaint data in
Consumer Sentinel, which is a secure online database of millions of
complaints that we make available to more than 1,700 law enforcement
agencies. Numerous consumers complain directly to the FTC. At the same
time, for many years, the agency has undertaken significant efforts to
obtain complaints from other law enforcers combating fraud, such as the
FBI, U.S. Postal Inspection Service, National Association of Attorneys
General, and Australian Competition and Consumer Commission, as well as
non-governmental entities, such as the BBBs. Pooling consumer complaint
data from multiple sources enhances their utility for law enforcement,
that is, bringing cases, and related purposes. For this reason, each
year we strive to encourage new entities to share data with us and to
increase the amount of data shared by existing contributors.
During fiscal year 2009, we will continue our efforts to increase
complaint data sharing from our partners and, through outreach,
encourage consumers to complain directly to the FTC. Our fiscal year
2009 budget request provides funds to support these important efforts.

SUBPRIME LENDING

Question. The FTC's fiscal year 2009 budget request includes an
increase for protecting consumers from unfair and deceptive practices
in the financial services marketplace.
What tools does the FTC have to investigate predatory lending
practices? What specific steps has the FTC taken in the past year?
Answer. The FTC has effective tools for investigating lending
practices that might violate any of the laws it enforces, which include
the Truth in Lending Act (``TILA''),\1\ the Home Ownership and Equity
Protection Act (``HOEPA''),\2\ and the Equal Credit Opportunity Act.\3\
The Commission also enforces Section 5 of the Federal Trade Commission
Act (``FTC Act''), which more generally prohibits unfair or deceptive
acts or practices in the marketplace.\4\ The FTC has jurisdiction over
nonbank financial companies, including nonbank mortgage companies,
mortgage brokers, and finance companies.
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\1\ 15 U.S.C. Sec. Sec. 1601-1666j (requiring disclosures and
establishing other requirements in connection with consumer credit
transactions).
\2\ 15 U.S.C. Sec. 1639 (providing additional protections for
consumers who enter into certain high-cost refinance mortgage loans).
HOEPA is a part of TILA.
\3\ 15 U.S.C. Sec. Sec. 1691-1691f (prohibiting creditor practices
that discriminate on the basis of race, religion, national origin, sex,
marital status, age, receipt of public assistance, and the exercise of
certain legal rights).
\4\ 15 U.S.C. Sec. 45(a).
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The full range of investigative tools available to the Commission
in its other consumer protection investigations are available in its
lending investigations. Most significantly, the FTC has the authority
under Section 20 of the Federal Trade Commission Act to issue civil
investigative demands to compel the recipient to provide documents,
testimony, and other information to be used in determining whether the
law has been violated and whether to commence a law enforcement action.
The Commission has been very active in investigating mortgage
lending practices in the past year.\5\ Among other things, in June
2007, the agency staff conducted a nationwide review of ads, including
some in Spanish, featuring claims for very low rates or monthly payment
amounts without adequate disclosure of other important loan terms. The
FTC staff reviewed the ads to determine whether they may be deceptive
in violation of Section 5 of the FTC Act or may violate TILA.\6\ The
Commission staff then commenced investigations of or sent warning
letters to advertisers whose ads raised concerns. This included warning
letters that FTC staff sent in September 2007 to more than 200 mortgage
brokers and lenders, and media outlets that carry their advertisements
for home mortgages, informing them that their ads may be unlawful. The
agency staff recently reviewed the current advertising of those who
received warning letters. We will take law enforcement action where
appropriate if this review or other monitoring of mortgage advertising
claims reveals that an advertiser has violated the law.
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\5\ The Commission's April 29, 2008 testimony before the
Subcommittee On Interstate Commerce, Trade, and Tourism of the
Committee On Commerce, Science, and Transportation, United States
Senate provides a comprehensive description of the FTC's law
enforcement, policy, and consumer education work in the subprime
mortgage market in recent years. The testimony is available at http://
www.ftc.gov/os/testimony/P064814subprimelending.pdf.
\6\ See Press Release, FTC Warns Mortgage Advertisers and Media
That Ads May Be Deceptive (Sept. 11, 2007), available at www.ftc.gov/
opa/2007/09/mortsurf.shtm.
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In addition, the FTC plays an important role in preventing unlawful
mortgage discrimination.\7\ At this time, the Commission is conducting
several non-public investigations of mortgage originators for possible
violations of fair lending laws.
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\7\ The Commission's July 25, 2007 testimony before the
Subcommittee on Oversight and Investigations of the House Committee on
Financial Services detailed the Commission's fair lending program. The
testimony is available at www.ftc.gov/os/testimony/P064806hdma.pdf.
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The Commission has also been active in investigating unfair or
deceptive practices by mortgage servicers. Recently, The Bear Stearns
Companies, Inc. (``Bear Stearns'') disclosed that FTC staff has
notified its mortgage servicing subsidiary, EMC Mortgage Corporation
(``EMC''), that the staff believes EMC and its parent Bear Stearns have
violated a number of federal consumer protection statutes in connection
with its servicing activities. Bear Stearns further disclosed that FTC
staff offered an opportunity to resolve the matter through consent
negotiations before seeking approval from the Commission to proceed
with the filing of a complaint. According to the disclosure, EMC
expects to engage in such discussions with Commission staff.\8\ The FTC
cannot comment further on this ongoing law enforcement investigation.
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\8\ Form 10-K, Bear Stearns Mortgage Funding Trust 2007-AR4 (CIK
No. 1393708), at Item 1117 of Reg AB, Legal Proceedings (filed Mar. 31,
2008), available at www.sec.gov/Archives/edgar/data/1393708/
000105640408001164/0001056404-08-001164.txt.
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Previously, in 2003, the Commission, along with HUD, announced a
settlement of allegations that Fairbanks Capital Corp. (now called
Select Portfolio Servicing, Inc.) failed to post consumers' payments
upon receipt, charged unauthorized fees, used dishonest or abusive
tactics to collect debts, and reported to credit bureaus consumer
payment information that it knew to be inaccurate.\9\ In late 2007,
based on a compliance review of the company, the Commission negotiated
modifications to the 2003 consent order. The modified consent order
provides substantial benefits to consumers beyond those in the original
order, including additional refunds of fees paid in certain
circumstances.\10\
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\9\ United States v. Fairbanks Capital Corp., No. 03-12219 (D.
Mass. 2003). The settlement agreement included a $40 million redress
fund for consumers as well as strong injunctive provisions and specific
safeguards to prevent the company from foreclosing on consumers without
cause.
\10\ United States v. Fairbanks Capital Corp., No. 03-12219 (D.
Mass. Sept. 4, 2007) (Modified Stipulated Final Judgment and Order).
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The Commission continues to investigate mortgage servicing
practices for compliance with the law.
In an effort to enhance interagency coordination, the FTC, the
Federal Reserve Board (``FRB''), the Office of Thrift Supervision, and
two associations of state regulators have combined forces to undertake
an innovative law enforcement project. The agencies are jointly
conducting consumer protection compliance reviews and investigations of
certain nonbank subsidiaries of bank holding companies with significant
subprime mortgage operations.\11\
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\11\ See Press Release, FTC, Federal and State Agencies Announce
Pilot Project to Improve Supervision of Subprime Mortgage Lenders (July
17, 2007), available at www.ftc.gov/opa/2007/07/subprime.shtm.
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Finally, the Commission works to protect consumers of subprime
unsecured loans. In June 2008, for example, the Commission filed a
lawsuit charging subprime credit card company CompuCredit Corporation
(``CompuCredit'') and its affiliate with deception in marketing credit
cards.\12\
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\12\ FTC v. CompuCredit Corp., No. 1:08cv1976-BBM-RGV (N.D. Ga.
2008). The FTC's complaint alleges, among other things, that
CompuCredit marketed to consumers with subprime credit ratings a Visa
credit card purportedly providing $300 in credit, using solicitations
that touted in bold headlines that certain up-front fees that did not
apply. Rather than provide consumers with $300 of available credit,
CompuCredit allegedly immediately charged consumers as much as $185 in
fees that it did not disclose adequately in light of the
representations made. These fees left consumers with as little as $115
in available credit. The FTC alleges that CompuCredit deceived
consumers in violation of Section 5 of the FTC Act by misrepresenting
the amount of credit available.
With respect to another Visa credit card CompuCredit offered, the
FTC alleges CompuCredit marketed to consumers with slightly higher
credit scores its Visa credit card purporting to offer ``up to $3,250''
in available credit and touted that the card could be used for any
purpose. The FTC alleges, however, that CompuCredit misrepresented the
amount of available credit because it withheld 50 percent of that
credit for 90 days. CompuCredit allegedly also failed to disclose, or
failed to disclose adequately, that for the first 90 days, the company
would monitor consumers' purchases, and might reduce their credit limit
based on an undisclosed ``behavioral'' scoring model. The Commission
alleges that CompuCredit's misrepresentation as to the amount of
available credit and its failure to disclose adequately that the types
of purchases consumers made could reduce their credit limit were
deceptive acts and practices in violation of Section 5 of the FTC Act.
The FTC's litigation with CompuCredit is ongoing.
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Question. Are there steps that the FTC would have liked to have
taken that it could not because of limits or restrictions in the FTC's
authorities?
Answer. The Commission generally believes that the scope of its
legal authority has not prevented the agency from taking steps to
address the acts and practices of those within its jurisdiction related
to subprime mortgage lending, although the Commission currently lacks
authority to seek civil penalties for HOEPA violations. The FTC,
however, notes that the FRB recently finalized rules under HOEPA and
TILA that will prohibit specific mortgage lending and related practices
the FRB determined were unfair and deceptive under the HOEPA.\13\ Both
the federal banking agencies and the FTC can enforce the new rules as
to the entities they regulate. We note, though, that the federal
banking agencies have the authority to obtain civil penalties against
entities they regulate who violate the new rules, while the FTC does
not.\14\ Enacting legislation allowing the FTC to obtain civil
penalties against entities within the FTC's jurisdiction who violate
the new rules would allow the FTC to enforce the rules more effectively
and better protect consumers in the subprime mortgage market, and it
would level the playing field such that all entities subject to HOEPA
could be subject to civil penalties. We particularly appreciate the
inclusion of provisions in the Committee's fiscal year 2009
appropriations bill that would authorize the FTC to obtain civil
penalties for violations of rules under HOEPA.
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\13\ The rules add four protections for a newly defined category of
``higher-priced'' mortgage loans: (1) they prohibit a lender from
making a loan without regard to borrowers' ability to repay the loan;
(2) they require creditors to verify the income and assets they rely
upon to determine repayment ability; (3) they restrict prepayment
penalties; and (4) they require creditors to establish tax and
insurance escrow accounts for all first-lien mortgage loans. The rules
also prohibit creditors and mortgage brokers from coercing a real
estate appraiser to misstate a home's value. And the rules prohibit
mortgage servicers from engaging in certain practices, such as
pyramiding late fees. The rules also impose specific advertising
standards, banning seven deceptive or misleading advertising practices,
including representing that a rate or payment is ``fixed'' when it can
change.
\14\ Under the Federal Deposit Insurance Act, 12 U.S.C. Section
1818(i)(2), federal banking agencies can obtain civil penalties from
the entities they regulate who violate the laws they enforce, including
TILA and its implementing regulations. The FTC has no comparable
authority to obtain civil penalties from the nonbank entities it
regulates for violations of TILA and its implementing regulations.
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Question. FTC testimony states that the agency has sent warning
letters to 200 mortgage lenders about misleading mortgage
advertisements--for example, promoting low ``teaser rates'' without
explanation of long-term rates. Are these warning letters a strong
enough punishment? Why hasn't the FTC taken enforcement action against
these lenders?
Answer. As explained above, the FTC is following up on these
warning letters with law enforcement, where appropriate. Currently, the
Commission is investigating a number of mortgage originators for
potential deceptive advertising.
Question. To what extent is the FTC coordinating with other
agencies (such as the FBI, the SEC, and HUD) in pursuing predatory
lending?
Answer. The Commission coordinates regularly on financial practices
matters with federal banking agencies, the Department of Justice, and
HUD. For more than a decade, the FTC has been a member of the
Interagency Task Force on Fair Lending, a joint undertaking with DOJ,
HUD, and the federal banking regulatory agencies. Task Force members
meet often to share information on lending discrimination, predatory
lending enforcement, and policy issues. The Commission also has had
several conversations with SEC representatives about the subprime
mortgage market, although our law enforcement activities focus on
different practices in the mortgage industry.
Further, FTC staff are coordinating with other governmental
entities to combat foreclosure rescue fraud. Commission staff are
participating in task forces concerning foreclosure rescue fraud in
seven geographic areas. Task force members in each local area share
information about trends in consumer complaints and work to identify
solutions. For example, the FTC's Southeast Regional Office is working
with a state attorney general's office to identify, investigate, and
prosecute cases. These efforts include close coordination on cases
under investigation. In some cases, the two agencies have divided
responsibility for law enforcement actions; in other cases, the two
agencies are working cooperatively on particular targets. The FTC's
East Central Regional Office is partnering with a local task force to
implement various consumer education and outreach strategies to help
consumers. The Southern California Foreclosure Fraud Task Force, in
which the FTC's Western Region participates, has facilitated the
coordination of prosecutions by civil and criminal authorities at
various levels.

U.S. SAFE WEB ACT

Question. The U.S. SAFE WEB Act, enacted in December 2006, expanded
the FTC's authorities to coordinate with foreign law enforcement
against spam and other unfair and deceptive practices involving foreign
commerce. The FTC's fiscal year 2009 budget request includes additional
funding for staff to pursue foreign-located fraud.
How many FTE are currently dedicated to implementing the U.S. SAFE
WEB Act, and how would additional staff enhance that effort?
Answer. Because the statute provides a wide range of authorities to
the agency, a number of staff members in a number of offices throughout
the agency are involved in implementing it. FTC's Office of
International Affairs (``OIA''), which helped develop the Act and works
to advance international enforcement cooperation, leads the
implementation, including chairing an agency-wide steering group of 9
people and several additional ad hoc members for particular issues. At
least six attorneys in OIA devote substantial time to implementing the
Act, including the Act's provisions on information sharing,
investigative assistance, international agreements, cooperation on
foreign judgment enforcement and asset recovery, enforcement networks
and projects, and foreign staff exchange programs (i.e., the FTC's new
``International Fellows'' program). In addition, a number of other
staff members within OIA as well as in the Bureau of Consumer
Protection, the Office of the General Counsel, the Executive Director's
Office, and others are involved in implementing and making use of the
SAFE WEB authority.
We would use additional staff to enhance our efforts on foreign
judgment enforcement and asset recovery for American consumers,
information sharing and investigative assistance, and our International
Fellows program. We are addressing increasing numbers of requests for
information sharing and investigative assistance regarding cross-border
matters that may aid FTC enforcement actions or may halt frauds
targeting U.S. consumers among others. In addition, we are expanding
our International Fellows program to provide opportunities for foreign
officials to learn first-hand how the FTC operates and for FTC staff
similarly to learn about agencies abroad, thereby improving the ability
of the agencies to coordinate and cooperate on law enforcement matters.
We are also working to take advantage of our enhanced ability through
SAFE WEB to enforce judgments against foreign defendants. With more
staff, we can manage additional use of these and other SAFE WEB tools
to protect American consumers from cross-border fraud.
Question. What are the biggest obstacles to enforce against foreign
fraud? How is the FTC addressing these obstacles?
Answer. The biggest obstacle to enforcing against foreign fraud is
the ability of unscrupulous businesses operating in one jurisdiction to
evade enforcement by using the Internet and long distance telephone
technology to victimize consumers globally and hide behind national
borders and laws. In particular, these actors often exploit the
inability of many foreign law enforcement agencies to identify schemes
and targets and share information about them in a timely and effective
manner because of antiquated laws and regulations.
As described above, the FTC is using the tools of the SAFE WEB Act
to address these obstacles. The key to combating cross-border fraud is
developing better and quicker enforcement cooperation with foreign law
enforcement agencies, including information sharing and investigative
cooperation. While the FTC has always acted aggressively to combat
cross-border fraud, since the Act went into effect at the end of 2006
and implementing regulations in the spring of 2007 the FTC has been
able to obtain heightened success by using the tools of the SAFE WEB
Act. For example, the FTC's enforcement action against Spear Systems,
Inc., alleging international illegal spamming, was significantly
enhanced by the agency's use of its information sharing powers under
SAFE WEB. Information sharing authorized under SAFE WEB assisted
Canadian law enforcement agencies with regard to several cases
targeting telemarketing schemes that allegedly defrauded U.S.
consumers, as part of the FTC's 2008 Telemarketing Sweep--``Operation
Tele-PHONEY.'' The U.S. SAFE WEB Act has been pivotal in allowing the
FTC to take the lead globally in combating cross-border fraud and in
encouraging our foreign law enforcement partners to revise their laws
in light of the global nature of mass-marketing fraud.

GAS PRICES

Question. The FTC's 2006 study on nationwide gas prices \15\
concluded that rising prices could be explained entirely by market
forces, not illegal anticompetitive behavior or other activity designed
to increase prices relative to costs or to reduce output.
---------------------------------------------------------------------------
\15\ Federal Trade Commission Report On Spring/Summer 2006
Nationwide Gasoline Price Increases (August 2007) (available at http://
www.ftc.gov/reports/gasprices06/P040101Gas06increase.pdf); Dissenting
Statement of Commissioner Jon Leibowitz Regarding the Federal Trade
Commission and Department of Justice Antitrust Division Report on
Spring/Summer 2006 Nationwide Gasoline Price Increases (available at
http://www.ftc.gov/reports/gasprices06/P010401Gas06dissent.pdf).
---------------------------------------------------------------------------
Commissioner Leibowitz filed a dissent to the 2006 report, writing:
``. . . the question you ask determines the answer you get: whatever
theoretical justifications exist don't exclude the real world threat
that there was profiteering at the expense of consumers.''
Is the FTC asking the wrong questions when it comes to
investigating these high gas prices? And if so, what is the right
question to ask so that we can get to the heart of what Commissioner
Leibowitz calls ``profiteering at the expense of consumers?''
Answer. For the most part the Agency is asking the right questions,
especially today. But I was hoping that the 2006 gas price
investigation and the resulting report would cover potential misconduct
by oil companies. Instead, staff constructed a theoretical model of
legitimate behavior and attempted to determine whether that model could
explain gas prices (we could not have uncovered anticompetitive conduct
by oil companies because we were not looking for it). To be fair, and
as I noted in my 2007 statement, when we began the investigation for
the 2006 Report, staff had just finished a major report relating the
gas price run-up in the wake of hurricanes Katrina and Rita.\16\ In
that investigation, staff found no antitrust violations but did find
what in my view was inappropriate profit-taking by the oil companies in
the wake of a disaster, including price-gouging as that term was
defined by Congress.
---------------------------------------------------------------------------
\16\ See Dissenting Statement at 1; see also Federal Trade
Commission Report on the FTC's Investigation of Gasoline Price
Manipulation and Post-Katrina Price Increases (May 2006) (available at
http://www.ftc.gov/reports/
060518PublicGasolinePricesInvestigationReportFinal.pdf).
---------------------------------------------------------------------------
Going forward, the Commission, in its ongoing rulemaking
proceeding, is considering assessing conduct under a standard set out
in the Energy Independence Security Act of 2007. To the extent that the
profiteering was a result of manipulation of gas prices by individual
oil companies, it is possible that a result of the rulemaking
proceeding may make it easier to prevent that in the future.\17\
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\17\ Information on the Commission's rulemaking proceeding is
available at http://www.ftc.gov/ftc/oilgas/index.html.
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The report on the 2006 nationwide price increases was not based on
theoretical justifications. Rather it was an analysis and description
of the factual evidence of the economic developments actually
experienced that could account for the price spikes: facts concerning
upward price pressure stemming from seasonal effects on both the demand
for and the supply of gasoline, increases in prices for crude oil and
ethanol, reductions in refining capacity due to the transition to
ethanol, and other identified market factors. This fact-based analysis
led to the conclusion that such developments adequately explained the
2006 price increases and that the price phenomena did not indicate
anticompetitive conduct.
With respect to the right question to address ``profiteering at the
expense of consumers,'' this has to depend on what is meant by
``profiteering.'' To the extent it is intended to refer to the sheer
size of profits, decisions on how to address this, such as through
fiscal policy or price controls, are very fundamental policy
determinations that are properly reserved for Congress. The Commission,
however, must--and does--continue zealously to seek out and prevent any
violations of the antitrust laws, including those that illegally raise
prices and profits. Furthermore, Congress has given the Commission
authority with respect to manipulative or deceptive devices or
contrivances regarding this industry, and, as Commissioner Leibowitz
notes above, the Commission is currently engaged in a rulemaking
proceeding under this authority.
Question. Commissioner Leibowitz cited that among other things, the
investigation found ``disturbing conduct by . . . petroleum
companies.''
What disturbing conduct did the FTC observe? What action did the
FTC take, and does the agency continue to see this kind of behavior?
Answer. As described above, the Katrina Report found that there was
price gouging (under the Congressional definition) by some oil
companies in the wake of the disaster. And it is disturbing that oil
companies made record profits even as many consumers suffered from high
energy prices in the affected area. The conduct found was not a
violation of the antitrust laws however. Going forward, the Commission,
in its ongoing rulemaking proceeding is considering assessing conduct
under a standard set out in the Energy Independence Security Act of
2007 and it may ultimately be that we look at certain oil company
behavior using a broader definition of misconduct.
Neither the major investigation reported in the Katrina report nor
the careful analysis the following year of the 2006 price spikes showed
evidence of behavior inconsistent with competitive responses to market
conditions. In particular, with respect to the Katrina aftermath, the
agency's extensive investigation found that the market, including price
increases for a period of time, functioned appropriately to enable
increased supply to flow into the affected areas and to reduce prices
to consumers swiftly. With respect to the ``price gouging'' identified
in the Commission's post-Katrina report, in fifteen instances prices
met the statutory definition of ``price gouging'' laid down for the
study, but all except one were explainable by identifiable market
factors other than those incorporated into that definition. As noted,
the agency continues to scrutinize the industry carefully to identify
possible anticompetitive activity, and to investigate and take
enforcement action whenever warranted. In addition, as noted, the
agency is conducting a rulemaking proceeding under its new authority to
prohibit manipulative or deceptive devices or contrivances and our
expectation is that this proceeding will be completed this year.

RESOURCES FOR PRICE MONITORING

Question. The President ordered the 2006 study of nationwide gas
prices in April of 2006, yet the FTC report was published in August
2007--a full 16 months later.
If the FTC is conducting real-time monitoring of gas prices for
anticompetitive behavior, why did it take 16 months to come to a
conclusion on this study? How can the FTC stop oil companies in their
tracks if investigations take this long?
Answer. The inquiry into the 2006 price increases--conducted
jointly with the Department of Justice and with assistance from the
Department of Energy's Energy Information Administration--focused on
the gasoline price increases experienced nationwide in the spring and
summer of that year. The inquiry identified six broad market factors
that appeared to contribute to the national average price increases
during the spring and summer of 2006: seasonal effects, increases in
crude oil prices, increases in ethanol prices, capacity reductions due
to the transition to ethanol, reductions in refiners' ability to
produce gasoline, and increases in demand. It required careful
financial and economic analysis of price and cost data spanning an
extended period of time, supplemented by interviews with refiner
personnel and a review of key company documents, to identify the
relative contribution of each factor to the price increases and
conclude that those market factors provided an adequate explanation for
the price increases without giving rise to an inference of
anticompetitive behavior.
In this instance, the FTC Gasoline and Diesel Price Monitoring
Project was of limited value in explaining the nationwide, average
increases, because the project's model is designed to focus on a
different phenomenon--i.e., whether an observed difference between two
retail or wholesale areas' local gasoline or diesel prices departs from
the difference that one would expect based on historical statistical
relationships.
As you know, the FTC is primarily a law enforcement agency rather
than a supervisory or regulatory agency. As a law enforcement agency,
the FTC is empowered to take legal action to challenge suspect behavior
under the federal laws it enforces. In such proceedings, the FTC must
meet burdens of proof as determined by the relevant statutes and as
interpreted by the federal courts. For practices that do violate a
federal law, the FTC has available a wide variety of remedies to halt
the practices and reverse their harmful results. I also note that the
task involved in this investigation is not necessarily the same as that
of a law enforcement investigation, which may stem, for example, from a
merger filing, information on specific company acts, or a more
localized or straightforward pricing anomaly rather than a nationwide
price movement.
Question. Does the FTC have sufficient resources to analyze the oil
and gas markets quickly enough to promptly act and stop anticompetitive
behavior?
Answer. The FTC believes that its fiscal year 2009 funding request
would provide sufficient resources to meet the agency's Consumer
Protection and Maintaining Competition goals, including those involving
oil and gas markets. I note, however, that the budgets that serve as
the basis of the appropriations requests are prepared many months
before requests are submitted to Congress, and they cannot always
predict changes to the agency's work that are dictated by emerging
events or Congressional directives or requests. A recent example of
this is the new statutory authority Congress gave the FTC to prescribe
anti-manipulation rules in the energy sector. The Commission will
continue, as it has in the past, to redistribute existing resources to
meet these new demands, while assessing the need for additional
resources.

PRICE GOUGING

Question. What is the FTC's opinion on federal anti-price gouging
legislation? On the state level, has the agency observed a deterrent
effect? Would federal price gouging laws enhance state laws?
Answer. The Commission has testified on several occasions that
federal price gouging legislation likely would harm consumers by
reducing the incentives and increasing the risks for refiners to move
additional supply into affected areas and take other steps to respond
to market forces after natural disasters.\18\ After Hurricanes Katrina
and Rita in 2005, gasoline prices briefly spiked higher in many parts
of the country. Consumers understandably are upset when they face
dramatic price increases within very short periods of time, especially
during a disaster. But price gouging laws--particularly inasmuch as
they could well deter firms from taking beneficial steps to respond to
post-disaster shortages--likely will do consumers more harm than good.
Law enforcement actions premised on a notion of restricting price
increases essentially are a form of price control, which could produce
longer lines at the pump and prolong the gasoline crisis. Although no
consumer likes price increases, such an increase in fact can help to
make the gasoline shortage less intense and shorter-lived than it
otherwise would have been.
---------------------------------------------------------------------------
\18\ Commissioner Leibowitz notes that, as he has stated in his
concurrence to the Commission's report ``Investigation of Gasoline
Price Manipulation and Post-Katrina Gasoline Price Increases,'' twenty-
nine states and the District of Columbia have price gouging laws that
provide for either civil or criminal penalties and, in some situations,
both. Six of these states and the District of Columbia expressly are
permitted by their statutes to cap price increases during an emergency.
Most of these price gouging statutes require an emergency declaration
and, to the Commissioner's mind, seem entirely unthreatening to the
operation of the free market--and, indeed they may serve a salutary
purpose of discouraging outliers from profiteering in the aftermath of
a disaster.
---------------------------------------------------------------------------
Prices play a critical role in our economy: they signal producers
to increase or decrease supply, and they also signal consumers to
increase or decrease demand. In a period of shortage--particularly with
a product, like gasoline, that can be sold in many markets around the
world--higher prices create incentives for suppliers to send more
product into the market, while also creating incentives for consumers
to use less of the product. For instance, sharp increases in the price
of gasoline can help curtail the panic buying and ``topping off''
practices that cause retailers to run out of gasoline. In addition,
higher gasoline prices in the United States in the wake of the 2005
hurricanes resulted in the shipment of substantial additional supplies
of foreign gasoline to the United States.\19\ If price gouging laws
distort these natural market signals, markets may not function well and
consumers would be worse off.
---------------------------------------------------------------------------
\19\ Total gasoline imports into the United States for September
and the first three weeks of October 2005 (after the August hurricanes)
were approximately 34 percent higher than imports over the same seven-
week period in 2004. See U.S. Dep't of Energy, Energy Information
Admin., U.S. Weekly Gasoline Imports (Oct. 26, 2005), available at
http://www.eia.doe.gov/oil_gas/petroleum/info_glance/gasoline.html.
---------------------------------------------------------------------------
To be sure, there may be situations in which sellers go beyond the
necessary market-induced price increase. A seller might misjudge the
market and attempt to charge prices substantially higher than
conditions warrant or than its competitors are charging. News stories
of gasoline retailers panicking and setting prices of $6.00 per gallon
after Katrina are evidence of such misjudgments. But the market--not
price gouging laws--is the most effective cure for these. Temporary
prices that are wildly out of line with competitors' prices do not last
when consumers quickly discover that other stations are charging lower
prices. A single seller in a market structured like gasoline retailing
cannot unilaterally raise prices for long above the level justified by
supply and demand factors. The few retailers who raised prices to the
$6.00 level reduced them just as quickly when it became apparent that
they had misjudged the market.
A price gouging law likely would be difficult to enforce fairly.
The difficulty for gas station managers, as well as for enforcers,
often is knowing when the managers have raised prices ``too much,'' as
opposed to responding to reduced supply conditions. It can be very
difficult to determine the extent to which any more moderate price
increases are necessary. Examination of extant state price gouging laws
and of the federal gasoline price gouging legislation that has been
introduced indicates that the offense of ``price gouging'' is difficult
to define. For example, some bills define ``gouging'' as consisting of
a 10 or 15 percent increase in average prices, while most leave the
decision to the courts by defining gouging in nebulous terms such as
``gross disparity'' or ``unconscionably excessive.'' Some, but not all,
make allowances for the extra costs that may be involved in providing
product in a disaster area. Few, if any, proposed federal bills or
state laws take account of market incentives for sellers to divert
supply from their usual customers in order to supply the disaster area,
or incentives for consumers to reduce their purchases as much as
possible, minimizing the shortage. Ultimately, the inability to agree
on what should be prohibited indicates the risks in developing and
enforcing a federal statute that could be counterproductive to
consumers' best interest. Moreover, much legislation provides
substantial criminal penalties for those found guilty of ``price
gouging''--a feature of the legislation that is likely to persuade
significant numbers of merchants to close down operations rather than
run the risk of going to prison for raising prices enough to cover
ongoing costs and maintain adequate supplies.
For all of these reasons, a majority of the Commission has
concluded that federal price gouging legislation would harm consumers
overall.
The Commission has not studied state price gouging laws in depth to
determine if they actually have any deterrent effect.\20\ Because of
the potential overall harm to consumers of price gouging laws, I cannot
say that a federal law would be likely to enhance the states' ability
to protect consumers.
---------------------------------------------------------------------------
\20\ The Commission's report following Hurricanes Katrina and Rita
noted that the prices of nearly all the retailers subjected to state
enforcement actions were consistent with market trends or other market-
based factors.
---------------------------------------------------------------------------
STRATEGIC PETROLEUM RESERVE

Question. A provision suspending the acquisition of petroleum for
the Strategic Petroleum Reserve passed the Senate recently. Based on
the FTC's historical models, would the suspension have significant
effect on prices a the pump?
Answer. As noted above, the FTC's Gasoline and Diesel Price
Monitoring Project--with its focus on historical differences in local
gasoline or diesel prices in retail or wholesale areas--is not designed
to predict how changes in crude oil availability might affect crude oil
prices or gasoline or diesel prices. Accordingly, the Monitoring
Project model cannot provide any insight into the possible effects on
prices at the pump of a suspension of additions to the Strategic
Petroleum Reserve.
______

Questions Submitted by Senator Sam Brownback

GASOLINE PRICES

Question. On May 23, 2007, the FTC testified before the Joint
Economic Committee that ``mergers of private oil companies have not
significantly affected worldwide concentration in crude oil. This fact
is important, because crude oil prices historically have been the chief
determinant of gasoline prices.'' Given the fact that the share of
gasoline prices attributable to crude oil costs haves risen to 71.8
percent from around 50 percent a year ago, would you say that crude oil
costs are likely an even stronger determinant today?
Answer. The average spot price of crude oil, as reported by the
Energy Information Administration, nearly doubled between May 2007 and
May 2008, from a monthly average of $67 per barrel to approximately
$125 per barrel. Crude oil prices rose even more after May 2008,
varying daily between about $130 and $145 per barrel during June and
the first three weeks of July. This increase in crude oil prices has by
far outstripped changes in any other element relevant to the production
of gasoline. Crude oil prices are a stronger determinant of gasoline
prices today because any given percentage change in crude oil prices
from current levels will have a greater impact on pump prices than in
previous years, when crude oil prices were dramatically lower.

ETHANOL

Question. Has the FTC looked at concentration in the ethanol
market? Is concentration increasing or decreasing?
Answer. The FTC has closely scrutinized and reported on production
and concentration in the United States ethanol market since late 2005.
In November 2007, the Commission issued its third annual report on the
U.S. industry. The series of FTC reports shows that concentration in
the industry has been decreasing. The 2007 report noted that, as of
September 2007, 13 firms had entered into the production of ethanol
during the preceding year, bringing the total number of U.S. producers
to 103.\21\ As new firms have entered, the market, which is
unconcentrated by any measure of capacity or production, has become
even more unconcentrated.
---------------------------------------------------------------------------
\21\ Federal Trade Commission, 2007 Report on Ethanol Market
Concentration (Nov. 2007), available at http://www.ftc.gov/reports/
ethanol/2007ethanol.pdf.
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TELECOMMUNICATIONS

Question. The proposed Reauthorization bill S. 2831, which is
currently before the Senate Commerce Committee, proposes a waiver of
the telecommunications common carrier exemption. This exemption bars
the agency from reaching certain conduct of telecommunications
companies. The Commission has testified in favor of the repeal of the
exemption. However in seeking this new authority, the FTC has never
cited an instance where the FCC failed to fulfill its responsibilities.
The Telecommunications Consumers Division within the FCC's Enforcement
Bureau investigates the practices of companies engaged in various
telecommunications-related activities. So, the FCC already is
exercising its statutory authority in the precise areas in which the
FTC seeks jurisdiction. If this exemption were to be lifted what would
be the benefit? What could the FTC accomplish or reach that is not
currently dealt with? Because, to permit two different agencies to
impose regulations covering the same type of conduct could very easily
become unduly burdensome on companies, while not providing a
corresponding benefit to or protection for consumers.
Answer. The FTC's request that Congress repeal the FTC Act
exemption for common carriers as applied to providing telecommunication
services is not a commentary on or reflection of concern about the work
done by the FTC's sister agency, the Federal Communications Commission.
Indeed, over the years, the FTC has worked closely with the FCC on
numerous issues of joint interest. Currently, the two agencies
coordinate enforcement of their overlapping Do Not Call rules, and the
FCC is a member of the federal-state law enforcement task force on
prepaid calling cards that the FTC established last year.
The two agencies, however, have very different missions and law
enforcement tools. The FTC is the nation's consumer protection
authority and, as such, has extensive experience investigating and
bringing federal court and administrative actions against companies
engaged in deceptive and unfair practices. As a result, the FTC has
substantial litigation experience and a robust body of case law to rely
on in seeking to stop deceptive or unfair acts and practices that harm
consumers, and to get money back for injured consumers.
The common carrier exemption dates from a period when
telecommunications were provided by highly-regulated monopolies. The
exemption as applied to telecommunications services is now outdated,
and the FTC has repeatedly found its consumer protection work impeded
by the exemption in ways that are detrimental to consumers. Most
recently, the common carrier exemption has been an issue in two FTC
cases against the distributors of prepaid calling cards. In those
cases, the FTC has alleged that the distributors engaged in deceptive
marketing practices by misrepresenting the number of calling minutes
provided by their cards and failing to disclose or to adequately
disclose fees and charges associated with their cards. FTC v. Clifton
Telecard Alliance One LLC, No. 2:08-cv-01480-PGS-ES (D.N.J.) (filed
March 25, 2008); and FTC v. Alternatel, Inc., No. 08-21433-CIV-Jordan/
McAliley (S.D. Fla.) (filed May 19, 2008).\22\ In both cases, the FTC
sought and received temporary restraining orders prohibiting defendants
from, inter alia, misrepresenting the number of calling minutes
provided by the cards they distribute, and failing to disclose fees and
charges that reduce the value of their calling cards. Because of the
common carrier exemption, the FTC has not pursued the carriers that
provide the telecommunications services for the cards at issue. As a
result, in both cases the defendants have moved to dismiss the FTC's
case on the grounds that the underlying telecommunications carriers are
necessary parties that cannot be joined by the FTC, because of the
common carrier exemption. Although the FTC has opposed defendants'
motions, and is confident that it will win on the merits, the exemption
has created a litigation issue for the FTC. More fundamentally, the
exemption directly impedes the FTC's ability to hold carriers
accountable for their role in allegedly deceptive and unfair practices
in the calling card industry.
---------------------------------------------------------------------------
\22\ In the Clifton case the Commission has also alleged that
defendants failed to disclose or to adequately disclose that the value
of their cards may be reduced even when a call does not connect.
---------------------------------------------------------------------------
The prepaid calling card industry is not an isolated example of an
area in which the common carrier exemption hampers the FTC's ability to
protect consumers from deceptive and unfair acts or practices. As
information, entertainment, and payment systems converge, common
carriers are providing an increasing number of new services. Now,
consumers can purchase their voice services bundled with Internet
access services and video services. Moreover, landline and cellular
carriers bill consumers for unlimited numbers of services provided by
third parties. The FTC has brought dozens of cases against companies
that the FTC alleges have crammed unauthorized charges onto consumers'
phone bills.\23\ The common carrier exemption, however, has given rise
to issues that complicate litigation in some of these cases,\24\ and
has impeded the Commission's ability to consider whether and to what
extent phone companies should be held responsible for placing those
charges on their customers' phone bills.
---------------------------------------------------------------------------
\23\ See, e.g., FTC v. Verity International Ltd., 335 F. Supp. 2d
479 (S.D.N.Y. 2004), aff'd in part, rev'd in part, 443 F.3d 48 (2d Cir.
2006), cert. denied, 127 S. Ct. 1868 (2007); FTC v. Nationwide
Connections, Inc., No. 06-80180-CIV-Ryskamp/Vitunack (S.D. Fla. 2006);
FTC v. Websource Media, LLC., No. H-06-1980 (S.D. Tex. 2006); FTC v.
Epixtar Corp., No. 03-CV-8511 (DAB) (S.D.N.Y. 2003); FTC v. Sheinkin,
No. 2-00-363618 (D.S.C., 2000); FTC v. Mercury Marketing of Delaware,
Inc., No. 00-CV-3281 (E.D. Pa. 2000); FTC v. Int'l Telemedia Assocs.,
Inc., No. 1-98-CV-1925 (N.D. Ga. 1998); FTC v. Audiotex Connection,
Inc., No. C-97 0726 (DRH) (E.D.N.Y. 1997).
\24\ For example, in FTC v. Verity International Ltd., the
Commission alleged that the defendants orchestrated a scheme whereby
consumers seeking online entertainment were disconnected from their
regular ISPs and reconnected to a Madagascar phone number. The
consumers were then charged between $3.99 and $7.78 per minute for the
duration of each connection. AT&T and Sprint--which were not parties to
the FTC enforcement action--had carried the calls connecting the
consumers' computers to the defendants' servers. The defendants
therefore argued that the entertainment service in question was
provided on a common carrier basis and thus outside the FTC's
jurisdiction. One defendant also claimed to be a common carrier itself
and hence beyond FTC jurisdiction. Although both the District Court and
the Court of Appeals rejected those arguments, the FTC had to expend
substantial time and resources litigating the question of jurisdiction.
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MORTGAGE MARKETING

Question. Could you elaborate for the record on some of the most
egregious examples of unfair and deceptive advertising that the FTC has
reviewed in connection with mortgage brokerage activities? What are the
underlying themes--is it rates that adjust after a month, unclear
disclosures of what the terms are, failure to disclose that the quoted
terms didn't include escrow information clearly, or represented a type
of bait and switch approach? Just give us a flavor of some of the most
significant aspects of this type of marketing.
Answer. The Commission has been actively investigating mortgage
lending practices for many years.\25\ In June 2007, the agency staff
conducted a nationwide review of mortgage ads, including some in
Spanish, featuring claims for very low rates or monthly payment amounts
without adequate disclosure of other important loan terms. The FTC
staff reviewed the ads to determine whether they may be deceptive in
violation of Section 5 of the FTC Act or may violate the Truth in
Lending Act (``TILA'').\26\ The Commission staff then commenced
investigations of or sent warning letters to advertisers whose ads
raised concerns. This included warning letters that FTC staff sent to
more than 200 mortgage brokers and lenders, and media outlets that
carry their advertisements for home mortgages, informing them that
their ads may be unlawful. The agency staff recently reviewed the
current advertising of those who received warning letters. We will take
law enforcement action where appropriate if this review or other
monitoring of mortgage advertising claims reveals that an advertiser
has violated the law.
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\25\ The Commission's April 29, 2008 testimony before the
Subcommittee On Interstate Commerce, Trade, and Tourism of the
Committee On Commerce, Science, and Transportation, United States
Senate provides a comprehensive description of the FTC's law
enforcement, policy, and consumer education work in the subprime
mortgage market in recent years. The testimony is available at http://
www.ftc.gov/os/testimony/P064814subprimelending.pdf.
\26\ See Press Release, FTC Warns Mortgage Advertisers and Media
That Ads May Be Deceptive (Sept. 11, 2007), available at www.ftc.gov/
opa/2007/09/mortsurf.shtm.
---------------------------------------------------------------------------
Through our deceptive mortgage advertising sweep and other
monitoring of mortgage ads, the FTC has reviewed many mortgage ads for
problematic claims. The ads frequently tout the most favorable terms of
a mortgage without revealing critical facts consumers need to make
well-informed decisions. We have encountered numerous ads offering low
rates or monthly payments without disclosing adequately significant
limitations or conditions. For example, an ad may tout that a mortgage
is available with only ``1 percent Payments,'' yet fail to disclose
that 1 percent is not an interest rate or that this payment rate only
applies during a brief introductory period. We have also encountered
ads offering loans with ``fixed'' low rates or monthly payments which
in fact are loans with adjustable rates or payments. For instance, an
ad may state in large bold print, ``30-Year Fixed, 1.99 percent.'' Only
at the bottom or reverse side, in tiny print, will it reveal that it is
only fixed for the first year, and that after that will increase every
year by as much as 7 percent.

DEBT RELIEF

Question. Can you outline examples of some of the most egregious
cases of consumer fraud that you've witnessed in the Debt Relief/Debt
Counseling arena? Obviously, people are hurting and looking for hope
when they go to these services. What characteristics delineate the
legitimate players in the market from those simply looking to prey upon
desperate people?
Answer. The Commission has prosecuted about a dozen companies that
it alleged falsely promised lifelines to consumers overwhelmed with
credit card debt.\27\ Some examples of egregious alleged conduct
include the following cases:
---------------------------------------------------------------------------
\27\ FTC v. Debt-Set, No. 07-558 (D. Colo. 2007); FTC v. Select
Personnel Mgmt., Inc., No. 07-0529 (N.D. Ill. 2007); FTC v. Dennis
Connelly, No. 06-701 (C.D. Cal. 2006); FTC v. Express Consolidation,
No. 06-61851 (S.D. Fla. 2006); US v. Credit Found. of Am., No. 06-3654
(C.D. Cal. 2006); FTC v. Debt Solutions, Inc., No. 06-0298 (W.D. Wash.
2006); FTC v. Debt Mgmt. Found. Servs., Inc., No. 04-1674 (M.D. Fla.
2004); FTC v. Integrated Credit Solutions, Inc., No. 06-00806 (M.D.
Fla. 2006); FTC v. National Consumer Council, Inc., No. 04-0474 (C.D.
Cal. 2004); FTC v. Better Budget Fin. Servs., Inc., No. 04-12326 (D.
Mass. 2004); FTC v. Innovative Sys. Tech., Inc., d/b/a Briggs & Baker,
No. 04-0728 (C.D. Cal. 2004); FTC v. Jubilee Fin. Servs., Inc., No. 02-
6468 (C.D. Cal. 2002).
---------------------------------------------------------------------------
In its largest case in this area, the FTC sued AmeriDebt, Inc., a
purported credit counseling organization.\28\ The Commission alleged
that AmeriDebt deceived consumers with claims that it was a non-profit
organization that provided bona fide debt counseling services. In fact,
the FTC alleged, AmeriDebt funneled profits to affiliated for-profit
entities and individuals. The Commission also alleged that AmeriDebt
deceived customers by claiming that it did not charge an up-front fee
when, in fact, AmeriDebt kept its clients' first payments as a fee,
rather than disbursing the money to their creditors as promised. The
FTC's settlement with AmeriDebt, which filed for bankruptcy during the
litigation, bans the company from the industry. Subsequently, on the
eve of trial, AmeriDebt's founder agreed to a $35 million
settlement.\29\
---------------------------------------------------------------------------
\28\ FTC v. AmeriDebt, Inc., No. 03-3317 (D. Md. 2003).
\29\ See FTC v. AmeriDebt, Inc., No. 03-3317 (D. Md. Jan. 9, 2006)
(Stipulated Final Judgment and Permanent Injunction as to DebtWorks,
Inc. and Andris Pukke). Subsequently, the court-appointed receiver
determined that primary defendant Andris Pukke had hidden assets from
the FTC, and the court entered a judgment requiring him to turn over
tens of millions of dollars' worth of additional assets. Because he
resisted turning over his assets even after the court found him in
contempt of court, the Court ordered his incarceration pending full
cooperation, lasting almost a month.
---------------------------------------------------------------------------
In another case, the Commission sued a Canadian telemarketer,
alleging that it preyed on American consumers by falsely promising
that, for an upfront fee of $700, it would provide interest rate
reduction services for consumers with high-interest credit cards.\30\
Although the telemarketer claimed affiliation with consumers' credit
card companies, the extent of its services consisted of a single call
to the creditor asking for an interest rate reduction, which was
routinely denied. The Commission also alleged that the defendant did
not honor its refund guarantee to consumers who did not experience the
promised substantial savings.
---------------------------------------------------------------------------
\30\ FTC v. Select Personnel Mgmt., Inc., No. 07-0529 (N.D. Ill.
2007) (litigation ongoing).
---------------------------------------------------------------------------
The Commission also has brought actions against for-profit debt
settlement companies, alleging that defendants falsely promised to
reduce substantially credit card debt.\31\ In those cases, defendants
allegedly deceived consumers into paying hundreds or thousands of
dollars in upfront fees by misrepresenting that they would obtain lump
sum settlements of consumers' credit card debt. In fact, the Commission
alleged that defendants kept the upfront fees and had little if any
success in obtaining the promised settlements.
---------------------------------------------------------------------------
\31\ E.g., FTC v. Debt-Set, No. 07-558 (D. Colo. 2007).
---------------------------------------------------------------------------
There are a number of features for consumers to look for when
assessing the legitimacy of debt relief services being offered. The
legitimate non-profit credit counseling agencies commonly provide free
budget analysis for consumers seeking a manageable debt repayment plan.
They do not charge substantial fees for services. After reviewing a
consumer's financial condition, the these legitimate agencies explain
the possible options for the consumer. If consumers have sufficient
income, the agencies can negotiate a debt consolidation plan (known as
a ``debt management plan'') directly with the creditors on behalf of
the consumer. The consumer then pays the agency one monthly amount
which the agency then disburses to the creditors. The Commission's
education and outreach program in this area includes a number of
publications to help consumers who are seeking debt relief
services.\32\
---------------------------------------------------------------------------
\32\ Consumer education materials on debt relief and credit
counseling issues are directly accessible from the FTC's webpage,
Credit and Loans: In Debt?, available at www.ftc.gov/bcp/menus/
consumer/credit/debt.shtm. In Spanish, the materials are available from
the FTC's webpage, Credito y Prestamos: oEndeudado?, available at
www.ftc.gov/bcp/menus/consumer/credit/debt_es.shtm.
---------------------------------------------------------------------------
REAL ESTATE MARKETS

Question. Can you discuss for the record any inquiries the FTC has
made into ``infomercial'' type marketing of ``get rich easy'' real
estate investment schemes? Have you looked at the role those programs
may have played in encouraging irresponsible speculation in the real
estate market, including flipping activities that went bad? Or the
degree to which those programs included suggestions that participants
engage in occupancy fraud that led to a high degree of early payment
defaults?
Answer. The Commission's testimony emphasized recent law
enforcement and outreach efforts to tackle deceptive and unfair
practices involving mortgage lending and servicing, and to halt
mortgage foreclosure rescue scams, which impact the real estate market.
As a general matter, we know that scam artists seize upon ``hot''
areas, such as real estate investment, to promote fraudulent business
opportunities as ``get rich quick'' schemes. Such scammers promote
their false promises of wealth through any medium, including
infomercials.
The Commission has aggressively targeted the broad range of
business opportunity frauds. In December 2006, the agency spearheaded
``Project FAL$E HOPE$,'' which was a coordinated civil and criminal
crackdown by federal and state law enforcers targeting more than 100
bogus business opportunities.\33\ As part of that sweep, the FTC
announced partial settlements in the Commission's pending case against
a group of defendants that the FTC alleged telemarketed a product that
purportedly instructed consumers on how to make easy money buying and
selling privately held mortgages. In 2007, the Court issued summary
judgment in the case by against the remaining defendants ordering them
to pay $17 million in consumer redress.\34\ The agency is generally
aware that some real estate investment schemes have been promoted
through infomercials, but it is not aware of any clear connection
between such investment schemes and irresponsible speculation or
occupancy fraud in the marketplace.
---------------------------------------------------------------------------
\33\ http://www.ftc.gov/opa/2006/12/falsehopes.shtm.
\34\ http://www.ftc.gov/opa/2007/05/stefanchik.shtm.
---------------------------------------------------------------------------
The FTC will continue to challenge false ``get rich quick'' claims
that promote bogus investment opportunities, including those involving
real estate, and will continue to combat deceptive and unfair practices
that impact the real estate market.

CONCLUSION OF HEARINGS

Senator Durbin. If there are no further questions, the
subcommittee stands recessed.
[Whereupon, at 4:30 p.m., Wednesday, May 14, the hearings
were concluded, and the subcommittee was recessed, to reconvene
subject to the call of the Chair.]

Material Submitted Subsequent to the Hearings

[The following agencies were unable to testify and have
submitted statements for inclusion in the record.]

OFFICE OF PERSONNEL MANAGEMENT

Prepared Statement of the Honorable Linda M. Springer, Director
Mr. Chairman and members of the subcommittee: I appreciate the
opportunity to submit for the record a statement addressing the
appropriations request for the Office of Personnel Management (OPM) for
fiscal year 2009.
As you know, OPM provides a variety of products and services to the
nearly 1.8 million employees in the Federal Government. Some of our
products and services include managing health insurance for
approximately 8 million current and former Federal employees and their
families, administering retirement services for over 2 million retirees
from all branches of Government, completing 90 percent of background
investigations for industry and Federal agencies, and administering
career development programs. As the OPM Director, I am committed to
successfully delivering on our responsibilities on a timely basis. In
short, I believe the American citizens and the Federal civilian
workforce expect us to get things done, and our fiscal year 2009 budget
request will allow us to do just that.
We are requesting $20 billion to carry out our mission in fiscal
year 2009. Of this total, $19.8 billion is requested for mandatory
programs and $228.9 million for discretionary activities. The
discretionary request reflects $211 million for Salaries and Expenses--
including transfers from the Trust Fund Accounts of $118.1 million--and
$18 million for the Office of the Inspector General. The total
discretionary request reflects a net decrease of $15.4 million compared
to the fiscal year 2008 enacted level. I also want to note that OPM
operates a revolving fund for the administration and operations of a
number of programs including our Federal investigative services and
Government-wide training efforts.

RETIREMENT CLAIMS PROCESSING AND BENEFITS PROGRAMS

OPM's request includes funding to improve the services it delivers
to Federal employees, annuitants, and their families through the
retirement and insurance programs.
On February 25, 2008, OPM began the rollout of the first ever
Federal electronic retirement system. The budget requests an additional
$15.2 million in No-Year Trust funds for continuation of this project.
These funds will allow OPM to continue the conversion of millions of
paper retirement records to electronic data and contract for the
information technology needed for the system so that retirees can
receive full payments once they separate from service eliminating
interim payments at reduced amounts. At full rollout, employees will be
able to model their retirement and initiate the process.

FEDERAL EMPLOYEES HEALTH BENEFITS PROGRAM (FEHB)

As the administrator of the FEHBP, OPM will continue to negotiate
and contract with private insurance companies that offer a broad range
of health insurance benefits, including high-deductible health plans
with Health Savings Accounts and consumer-driven health plan options.
As such, OPM will spend $26 million in fiscal year 2009 to ensure the
viability of the Program's 283 health care plans covering over 8
million people. As usual, OPM will continue to carry out tough
negotiations with health carriers to contain premium hikes. Over the
years these negotiations have resulted in employee premiums that are
substantially lower than those of the private sector while maintaining
benefit levels, and continuing to provide, improve, and expand tools so
customers can make informed health insurance decisions. In fact, the
FEHBP increase for 2008 was 2.1 percent, compared to an average 8.7
percent increase for the private sector and a 6.3 percent increase for
the California Public Employees' Retirement System during that same
year.

HUMAN RESOURCES MANAGEMENT

In fiscal year 2009, OPM will pursue policy initiatives that
continue to reform human resources management in Federal agencies. We
will work with the Department of Defense to ensure the reforms underway
link pay to performance in a fair and consistent manner. At the same
time, OPM will work with other agencies engaged in implementing
Alternative Personnel Systems to assess the lessons learned from
various modernization efforts. Mr. Chairman, in the last half-century,
the Federal workforce has changed significantly, and the old personnel
system has not kept pace. We are, therefore, striving to modernize the
systems designed to recruit and retain federal employees.
The fiscal year 2009 budget will allow OPM to maintain the
competitiveness of Federal employee compensation and benefits by
exploring ways to refine market adjustments to Federal pay, and
providing Federal employees with opportunities, benefits, and service
delivery that compare favorably with other employers. For instance, OPM
will continue to develop new workforce recruitment strategies and
tools, and further improve the hiring process by developing a life-
cycle reform model for agencies to adopt to streamline the current
recruitment process. And last but not least, OPM will spend $200,000 to
continue to support the Nation's returning Veterans by providing
assistance in finding job opportunities with the Federal Government.

IMPLEMENTING HUMAN CAPITAL STANDARDS FOR SUCCESS

OPM will use requested funds to engage Federal agencies in
implementing the Human Capital Assessment and Accountability Framework,
and other best practices in human capital management, in keeping with
the Merit System Principles, veterans' preference, and other standards.
At the beginning of fiscal year 2008, 17 of the 26 agencies reporting
under the President's Management Agenda Scorecard have met these
standards, up from 11 in 2006, eight in 2005, and zero in 2003. As a
result, more than 99 percent of the Federal civilian workforce is
employed by agencies that have made significant progress toward meeting
these standards.
Through its Compliance Program, OPM will continue to evaluate,
review, and ensure agencies comply with Merit System Principles and
veterans' preference, and to ensure whistleblower protection and other
rights and privileges are honored and protected. OPM will strengthen
this program through a human capital accountability system that holds
agencies accountable for adhering to these principles, laws, and rules,
as well as the human capital best practices referenced above.

HUMAN RESOURCES LINE OF BUSINESS

In 2009, OPM will continue to be a leader in the President's
Management Initiative for Expanded Electronic Government and has
included $7,202,000 in its request for this purpose. The requested
resources will support the Human Resources Line of Business (HR LOB)
and Enterprise Human Resources Integration (EHRI). HR LOB will continue
to identify and document common functional, technical, and data
requirements consistent with Federal human resources policies and will
work toward the establishment of Federal and private sector Shared
Service Centers to meet these requirements. During 2009, the EHRI
project will continue to modernize how the Federal Government
maintains, stores, protects, and transmits information on human
resources transactions.

SECURITY-RELATED ACTIVITIES

The fiscal year 2009 request includes funding for a number of
important security-related activities. OPM will implement Homeland
Security Presidential Directive 12 (HSPD-12), Policy for a Common
Identification Standard for Federal Employees and Contractors, which
was signed by the President on August 27, 2004. This mandates the
circulation of a Federal standard for a secure and reliable form of
identification for Federal employees and contractors. HSPD-12
requirements will enhance OPM's strategic goal of improving security
and emergency planning actions throughout the agency.

REVOLVING FUND

OPM also provides a variety of ongoing services that are financed
by other agencies through our revolving fund. These services include
providing one-stop access to high-quality e-Training products and
services; offering professional development and continuous learning for
Federal managers and executives; providing employment information and
assessment services; automating other agencies' staffing systems;
providing examining services when requested by an agency; providing
technical assistance and consulting services on all facets of Human
Resources management; testing potential military personnel for the
Department of Defense where it is cost-effective for OPM to do so;
managing the selection, coordination, and development of Presidential
Management Fellows; and conducting investigations for employees to
determine whether they are suitable for employment, as well as more in-
depth investigations for employees whose positions require security
clearances. For those ongoing revolving fund responsibilities, the
fiscal year 2009 budget includes an estimated $1 billion in obligations
and 3,131 FTE to be financed through payments for OPM's services by
other agencies.

MANDATORY PAYMENT ACCOUNTS

The OPM budget request also includes mandatory appropriations to
fund the Government contributions to the health benefits and life
insurance programs for Federal annuitants.
For the approximately 1.9 million annuitants participating in the
Federal Employees Health Benefits Program, we estimate that about $9.6
billion will be needed to pay the Government's share of the cost of
coverage. That represents an increase of $769 million over fiscal year
2008. We estimate that, for the 500,000 annuitants under age 65 who
elect post-employment life insurance coverage, an appropriation of $46
million will be required.
Also, as mandated by the financing system established in 1969 by
Public Law 91-93, liabilities resulting from changes (principally pay
raises) since that year that affect retirement benefits must be
amortized over a 30-year period. For that purpose, we are requesting a
``such sums as may be necessary'' payment to the Civil Service
Retirement and Disability Fund in the amount of $10.2 billion. This
represents an increase of $100 million to cover the service cost of the
Civil Service Retirement System, which is not funded by and for active
employees.
Thank you again for the opportunity to provide for the record a
discussion of OPM's budget request for fiscal year 2009. I would be
pleased to provide any additional information the subcommittee may
need.
______

Prepared Statement of the Honorable Patrick E. McFarland, Inspector
General

Mr. Chairman and members of the subcommittee: Thank you for
providing me this opportunity to discuss the President's fiscal year
2009 request for appropriations for the Office of the Inspector General
at the Office of Personnel Management (OPM). The total request for the
Office of the Inspector General is $18,000,000, which is $600,000 below
the amount enacted for fiscal year 2008. Of our requested amount,
$1,538,000 is from the salaries and expenses/general fund and
$16,462,000 is from the trust funds. These resources are requested to
perform our core functions which include:
--Conducting audits, investigations, and evaluations of agency
programs and operations, including primarily carriers
participating in the Federal Employees Health Benefits Program
(FEHBP), the associated information systems, and internal
agency operations and financial systems; and
--Issuing administrative sanctions, including debarments and
suspensions to health care providers who pose a financial risk
to the FEHBP itself or a health care risk to persons who
receive health insurance coverage through the FEHBP.
The Office of the Inspector General recognizes that oversight of
the retirement, health benefits, and life insurance trust funds
administered by OPM is, and will remain, its most significant
challenge. These trust funds are among the largest held by the United
States Government. Their assets totaled $789.3 billion in fiscal year
2007, their receipts were $97.1 billion, and their annual outlays were
$153.7 billion. The amounts of their balances are material to the
integrity of the Government's financial position. I continue to
allocate the vast majority of the Office of the Inspector General's
efforts and resources to trust fund oversight, and we remain fully
committed to trust fund activities.
OPM makes outlays from the retirement trust funds in the form of
payments to millions of Federal annuity recipients. The health
insurance trust fund provides payments to approximately 270 health
insurance plans nationwide. In turn, the health insurance carriers pay
millions of claims for services filed by their enrollees and health
care providers. We have shown through our audits and investigations
that such health insurance payments may be at risk through improper,
inaccurate or fraudulent claims.
We are obligated to Federal employees and annuitants to protect the
integrity of their earned benefits. Our audit and criminal
investigative work reduces losses due to fraud and improper payments
and recovers misspent funds whenever possible. We have a special
obligation to the Federal agencies and the American taxpayers, who
provide the majority of the funding. We also seek to deter future
occurrences of fraud and abuse within OPM programs, as well as serve to
protect the health and welfare of beneficiaries of OPM programs and
services.
Audits and criminal investigations of the OPM-administered trust
fund programs have resulted in significant financial recoveries to the
trust funds and commitments by program management to recover additional
amounts. From fiscal year 2005 to the present, our office has
cumulative judicial recoveries and audit recommendations to recover
funds exceeding $440 million.
Beginning in 2005, the Office of the Inspector General established
a nationwide field structure. As of 2008, the office has eighteen
investigative and two audit field offices in addition to its
headquarters in Washington, DC. We have determined that the most
effective deployment of investigative staff is to locate them in areas
of the country where FEHBP and retirement benefits are more
concentrated. Experience has shown that criminal investigators located
in these areas often work in cooperation with other law enforcement
entities similarly located, resulting in additional criminal leads and
better protection of OPM programs. In many instances, criminal
investigators located outside of Washington, DC work exclusively on
cases referred to them by local authorities. During fiscal year 2007,
investigative work resulted in 46 arrests, 66 indictments, and 50
convictions.
During fiscal year 2009, we will continue to conduct audits of
pharmacy benefit managers (PBMs), firms contracted by FEHBP carriers to
administer their prescription drug programs. The premiums paid for
prescription drug coverage have risen exponentially over the last ten
years and allegations against PBMs have also increased. It is estimated
that approximately $9.2 billion was paid during 2007 in prescription
drug premiums to experience-rated and health maintenance organization
(HMO) carriers. This represents approximately 28 percent of experience-
rated and HMO carrier premiums paid for health benefits coverage for
Federal employees and annuitants. In fiscal year 2007, we settled a
large civil health care fraud claims case against an FEHBP PBM,
resulting in $97 million returned to the OPM trust fund. We remain
steadfast in our efforts to audit and investigate pharmacy benefits and
pharmaceutical fraud within the FEHBP.
Also during fiscal year 2009, we will further our development of a
data warehouse of health benefits claims. The data warehouse offers the
best opportunity for global detection of erroneous health benefit
payment transactions by medical providers, insurance carriers and
subscribers by accumulating all benefit claims for all fee-for-service
insurance carriers in a single data repository. This effort will
enhance our current claims reviews by enabling the auditors and
investigators to target certain types of potential claim payment errors
on a program-wide rather than on a plan-by-plan basis. This will
provide a significant improvement in our audit efficiency and
effectiveness by offering us the opportunity to address significant
issues of broad concern on a coordinated basis and to recover
overcharges to the program when appropriate.
Currently in the data warehouse, we have data for the top three
experience-rated carriers (Blue Cross Blue Shield, Mail Handlers
Benefit Plan, and Government Employees Health Association),
representing 86 percent of experience-rated plans claims payments. We
are also receiving data from HMO plans with over 500 subscribers. This
includes 85 plans, representing 87 percent of the HMO plans claims
payments. The data is being accumulated and used for basic analysis to
support premium rate calculations. Starting in fiscal year 2009, we
plan to introduce more advanced claims analyses which recognize
potential high risk areas for community-rated carriers.
Our administrative sanctions program has continued to improve its
effectiveness in protecting the FEHBP and its enrollees against
untrustworthy health care providers. This program enforces the FEHBP
sanctions statute, which authorizes suspension or debarment of
providers on the basis of 18 different categories of violations. The
most frequently-encountered violations represent criminal convictions
or loss of professional licensure. The highest priority sanctions cases
involve providers who are the subject of investigation by our Office of
Investigations. We select cases for action on the basis of the
seriousness of the provider's violations and the risks that the
provider poses to the FEHBP and to the health and safety of its
subscribers. We currently have over 30,396 active debarments and
suspensions in effect. We recently completed the conversion and
digitizing of our debarment and suspension paper files and records to
an electronic, searchable database.
Thank you for this opportunity to present our office's resource
request for fiscal year 2009.
______

SELECTIVE SERVICE SYSTEM

Prepared Statement of the Honorable William A. Chatfield, Director

FORWARD

Chairman Durbin and members of this subcommittee, I am honored as
Selective Service Director to present the President's fiscal year 2009
appropriations request of $22,000,000 for the agency. The Congress and
administrations under both parties have acknowledged the wisdom of
maintaining Selective Service as a hedge against unforeseen threats and
as a low-cost insurance policy against underestimating any threat our
Armed Forces might face in a still-dangerous world.
This agency is as determined as ever to make the necessary
adjustments to budget realities and the requirements of combating
terrorism, defending the homeland, and maintaining other priorities
listed in the President's January 28, 2008, State of the Union Address.
Personnel reductions at Selective Service have resulted from planned
attrition and will not involve a reduction-in-force. Meanwhile, the
agency continues its phased reductions in operational readiness while
preserving as much customer service as possible. For example, we are
reducing the number of part-time Reserve Component officers from a
total of 250 to 200 by the end of fiscal year 2008 and to 150 by the
end of 2009. Automated registrations are making it possible to
accomplish our missions without the need for as much face-to-face
contact at the local level. These innovations have required painful
choices, but satisfying our goals will assure a Selective Service that
is beyond reproach, while meeting the needs of its primary customer,
the Department of Defense. I welcome the challenge and appreciate the
opportunity to share my vision for Selective Service with you today.

WHAT WE DO TODAY

Selective Service is in business to perform two unique functions.
Should the Congress and the President authorize a return to military
conscription, the agency can conduct a draft that is efficient, fair,
and accepted by the public. It is also ready to administer a program of
alternative community service for men who are classified as
conscientiously opposed to military service.
Additionally, each and every day Selective Service continues its
close partnership with the Department of Defense by providing direct
support to Armed Forces recruiting. Specifically, Selective Service
provides names of registrants to the Secretary of Defense for
recruiting purposes, in accordance with the Military Selective Service
Act. Information about Armed Forces opportunities for Active Duty,
National Guard, and Reserves, along with a business reply card, is
enclosed routinely with our registration acknowledgment that Selective
Service sends to each new registrant. For fiscal year 2007, these
contacts totaled nearly 2.2 million young men. Consequently, the
Defense Department benefits by ``piggy-backing'' on our routine
mailings which generate actual recruiting leads. And it reimburses us
for the additional costs in accordance with the Economy Act.
Beyond its compliance with the Military Selective Service Act and
providing these tangible services, the agency also promotes an
intangible national benefit. For present and future generations of
America's young men, Selective Service is a very critical link between
society-at-large and today's volunteer military. It is a reminder that,
as Americans, every young man is personally responsible to ``provide
for the common defence'' in the time-honored tradition of preceding
generations.

AREAS OF EMPHASIS

Air Shows.--I look forward once again in 2008 and continuing in
2009 what I regard as this agency's most creative innovation in meeting
its traditional mission in a climate of budget austerity. I refer to
our success in harnessing the venue, excitement, and patriotism of air
shows.
My vision has been to present the agency in huge, open community
venues across the Nation, highlighting authentic American heroes and
promoting public service and patriotic themes appealing to multiple
generations. The value of this effort presented itself after my
assessment of the agency's capabilities, priorities, and missions. Air
shows are the second most attended spectator events in America,
attracting a high concentration of registration-age men. I remain
convinced that funding this initiative results in a substantial
increase in registration compliance and represents a positive impact on
the influencers of young men. We are conducting this effort by
absorbing the $118,000 expense out of our fiscal year 2008 budget and
will do so again in fiscal year 2009. No new money is involved.
Registration Compliance.--As exciting as the air show initiative
has been, it will not be the only effort to satisfy our statutory
missions. Our operational readiness to perform our traditional missions
has been reduced because of world risk assessments. Selective Service
has always believed only when all eligible young men are in the
manpower pool and accounted for as equally vulnerable would any future
draft be considered completely fair and equitable by the public.
Our latest full year of data collection (CY 2007) indicates 91
percent of legally eligible men (ages 18 to 25) are registered; this is
a 2 percentage point drop from the previous year. The compliance rate
for men who are draft eligible (ages 20 to 25) is 95 percent, a 1
percentage point decrease from CY 2006. Keeping the rates high is very
important because a declining compliance rate contributes to a lack of
public confidence in our ability to administer a fair and equitable
draft.
Naturally, this agency is as determined as ever to make
congressional priorities truly our own. We appreciate the
subcommittee's support for ensuring that our work continues. To the
extent that our traditional mission survives, I will use every resource
to continue to maintain high registration compliance. For example, the
agency will:
Carry on routine updating of the interactive Selective Service
pages on the World Wide Web (www.sss.gov) where online registration,
registration verification, the ability to file changes of information,
and a wealth of other agency information are available to anyone with
access to the Internet. For fiscal year 2007, 83 percent of
registrations reached Selective Service through electronic means, the
same percentage as 2006. Electronic registrations are encouraged
because they are quicker, more cost-effective than processing paper
registrations, and provide better customer service. We are also placing
links to our site with other Federal, State, and local agencies,
schools, and assorted organizations to enhance public education and
facilitate customer responsiveness.
Profit from an increasing number of States that link obtaining a
driver's license or State identification card to the Selective Service
registration requirement. These State and territorial laws currently
provide Selective Service with an average of 71,000 registrations per
month. As of this month, 36 States, 3 territories, and the District of
Columbia have enacted laws. These jurisdictions represent 70.1 percent
of the national 18-year-old male registrant population. We continue to
offer technical expertise to the other States where such legislation is
pending. Data electronic exchanges are the most cost-effective, timely,
and user-friendly registrations available. Selective Service is
committed to aid the remaining 14 States in implementing this easy
method to protect their young men's eligibility for State and Federal
benefits and programs. This program has been a valuable tool to reach
all eligible registrants and is more customer-friendly.
Remain sensitive to the fact that not every household in your
district has a computer, so technological innovations will not
compensate for all resource restraints. The only way for young men in
those households to register is the old-fashioned, pre-Internet way.
That means going to the nearest post office. And that is why we must
devote sufficient resources to printing forms and keeping post offices
well stocked.
Alternative Service Program.--Half of the agency's mission during
any return to conscription is to provide for a supervised term of
alternative civilian service for all men it classifies as conscientious
objectors. A key component of this program, therefore, is reaching out
to employers capable of providing work of ``national importance'' by
becoming members of the Alternative Service Employer Network, or ASEN.
We continue to reach out to historic peace church constituencies, non-
profit organizations, and Government entities. These have, in past
wars, provided the bulk of the assignments we will need to provide our
alternative service workers with employment that benefits the national
health, safety, and welfare.
We have had negotiations with Christian Aid Ministries, Mennonite
Voluntary Services, and others who hope to join the ASEN. We also
continue to have our State Directors visit the projects run by these
organizations to determine their suitability to become ASEN members. In
addition to visiting model project sites, our State Directors have
begun to reach out to our historic conscientious objector
constituencies across America. These contacts and outreach efforts were
previously confined to our headquarters staff. In addition to making it
easier and less expensive for the public to stay in touch with us, this
field effort facilitates the building of the relationships we will need
to successfully meet our goals for this program during any return to
conscription.
Finally, we continue to work toward obtaining employer agreements
with the Public Health Service and the Corporation for Community and
National Service. These two Federal entities will, we hope, play a key
role in providing suitable employment to conscientious objectors in any
future conscription.
Information Technology Modernization.--The agency's Reclassify,
Compliance, and Verification project is intended to allow Selective
Service System to leave the Department of Defense's Military Entrance
Processing Command mainframe and move to a Microsoft Windows system.
However, it is behind schedule. Selective Service hopes to complete the
analysis, scope, and requirements definition during fiscal year 2008,
and we plan to design, code, and test in fiscal year 2009.
Notwithstanding resources expended so far, if our revised schedule is
not met, then the entire project will be shelved pending future
resources and commitment.

NATIONAL IN SCOPE, LOCAL IN SERVICE

While rumors of a future draft will continue to circulate among the
public, private groups, the media, and academia, Selective Service
remains focused on missions mandated by Congress. It manages its
volunteer board members; prepares to administer a program of
alternative community-based service for men classified as conscientious
objectors; and, to the extent possible, updates its conscription plans
and registration procedures. All these efforts are aimed at being ready
to conduct a fair and equitable classification procedure to determine
who should serve when not all can serve during an emergency. To ensure
fairness and equity, each Selective Service board is a gathering of
civic-minded men and women reflecting the racial, cultural and ethnic
diversity of the young men in your districts. Through these volunteers,
a unique bond has been formed at the grass roots with young American
men, society-at-large, and the U.S. Armed Forces. Through the Selective
Service structure, local American communities play a positive role in
providing for the common defense.

CLOSING

Mr. Chairman, Selective Service stands prepared to perform its
time-tested responsibilities when directed. The fiscal year 2009
appropriation request of $22,000,000 will be invested prudently in one
of the Nation's important security assets in an increasingly dangerous
and ambiguous world. Maintaining this adequate funding level would: (1)
provide a compact, cost-efficient civilian structure capable of
expansion in a crisis; (2) provide manpower to the U.S. Armed Forces as
required; and (3) do it fairly, equitably, and within the necessary
timeframes. These outcomes will advance our statutory mandate and
restore the high registration compliance rates so painstakingly
achieved over the last decade. Selective Service remains an active
partner in the national preparedness community, ever watchful for
opportunities to improve.
Thank you, Mr. Chairman. I would be pleased to answer your
questions.
______

COURT SERVICES AND OFFENDER SUPERVISION AGENCY FOR THE DISTRICT OF
COLUMBIA

Prepared Statement of Paul A. Quander, Jr., Director

The Court Services and Offender Supervision Agency (CSOSA)
supervises approximately 15,000 men and women offenders on probation,
parole, or supervised release in the District of Columbia at any given
time. CSOSA includes the D.C. Pretrial Services Agency, which
supervises another 5,000 defendants at any given time to ensure that
they comply with court-imposed release conditions and appear for
scheduled court dates. These agencies make a vital contribution to
public safety in Washington, D.C.
This statement is provided in support of CSOSA's fiscal year 2009
budget request of $202,490,000 including 1,297 permanent positions and
1,293 full time equivalents (FTE). Of this amount, $54,838,000 is
requested for the Pretrial Services Agency (PSA) and $147,652,000 is
requested for the Community Supervision Program (CSP). The fiscal year
2009 request for CSOSA represents a $12,147,000, or 6 percent, increase
over fiscal year 2008 enacted levels.

BACKGROUND

Since CSOSA was created under the National Capital Revitalization
and Self-Government Improvement Act of 1997, we have implemented
significant program enhancements, particularly in post-release
supervision. Probation and parole caseloads have been lowered
dramatically--in many cases by 50 percent--to meet or exceed the
recommended national standard of 50 cases per Community Supervision
Officer (CSO). Since fiscal year 1999, monthly surveillance drug
testing has increased 360 percent; last year, over 8,300 offenders were
tested each month. CSOSA operates six field offices to locate CSOs in
the neighborhoods were offenders live and work, and over 8,000 joint
field visits by CSOs and the Metropolitan Police Department occurred in
those neighborhoods last year. Since fiscal year 2004, CSOSA has placed
over 2,000 high-risk offenders on Global Positioning System (GPS)
monitoring to reinforce compliance and track their location; the
Metropolitan Police Department routinely uses GPS data in crime
investigation.
CSOSA has also received resources for contract substance abuse
treatment to supplement the District's public treatment system. Last
year, we made over 2,400 offender and over 1,600 pretrial defendant
placements in our continuum of services, which includes detox,
residential, transitional housing, and outpatient services. We also
continue to implement the Reentry and Sanctions Center, a residential
program that provides intensive assessment and treatment readiness
services for high-risk offenders and defendants. Since the facility's
opening in 2006, we have placed 1,188 individuals in the program; 88
percent have completed it successfully.
CSOSA recognizes that successful supervision involves both managing
risk through close supervision and addressing need through the
provision of treatment and support services. We have implemented many
enhancements to ensure effective risk management. We work closely with
a variety of Government, non-profit, and faith-based partners to
increase offenders' access to existing services and build additional
capacity in the core need areas of housing, education/training, and
health care. Through the Criminal Justice Coordinating Council's
Reentry Steering Committee, we provide leadership of efforts to address
the needs of supervised offenders, particularly those returning to the
District from incarceration.
One of our most significant accomplishments of the past year has
been the implementation of a new performance management system
(SMARTStat) that tracks a core set of supervision practices down to the
individual case level. Through this system, we can determine the extent
to which cases are being managed effectively. This information is
available to supervisors and branch chiefs, who are encouraged to use
it as part of their case audits and team meetings. The information
forms the basis of regular reviews with the entire CSP executive staff,
during which action items are assigned and outcomes regularly tracked
so that problems can be solved quickly.

2009 BUDGET INITIATIVES

CSOSA's fiscal year 2009 budget contains two initiatives, one for
CSP, which provides information technology resources for post-release
supervision, and one for PSA, which provides resources for supervision
of D.C. Misdemeanor and Traffic Court (drunk driving) cases.
CSP Information Technology Enhancement Initiative
CSP requests $2,583,000 and ten (10) positions to continue building
its information technology infrastructure, including enhancements to
the Supervision Management Automated Records Tracking (SMART) case
management system.
Improving the quality, management, and utility of information has
been a CSP priority since CSOSA's founding. CSP inherited outdated,
cumbersome legacy systems from its predecessor agencies. In 1997, most
probation and parole officers relied on paper case files and lacked
access to personal computers. Developing an automated case management
system and training staff to use it were essential to successful
implementation of the agency's program strategy. CSP launched the
initial version of SMART in 2002, following a remarkably efficient
requirements gathering and application development process.
SMART is now in its third release. From its initial core
supervision tracking functions, the system has expanded to encompass
modules that capture treatment placement and expenditures, the
development of Alleged Violation Reports, vocational and education
assessment, and other critical program functions. We are also
developing an Enterprise Data Warehouse (EDW) as a repository for
historical data that can be used for research and performance
measurement. The EDW is the source of CSP's new performance management
system, SMARTStat, which provides management and staff with complete
visibility into offender supervision practices and effectiveness. CSP
also developed and maintains the District's Sex Offender Registry
(SOR).
CSP's Office of Information Technology (OIT) develops and maintains
the CSP infrastructure, including acquisition, support, maintenance,
and life-cycle replacement of architecture/design/systems enhancements,
the EDW, IT security services, disaster recovery, and operational
services, such as customer support (Help Desk), network management,
change and configuration management, e-mail, and system administration
services.
The requested resources will continue the significant progress made
by CSP OIT to increase the timeliness and accuracy of data used by
agency staff and our partners to make day-to-day law enforcement
decisions affecting public safety in the District. These resources will
be used to continue SMART and SOR enhancements, transition to a next-
generation Service Oriented Architecture platform, continue building
the EDW and performance management platform, and continue improving our
capacity to integrate data with our partner agencies.
The resources will be allocated as follows:
Infrastructure Enhancements
--$300,000 in contract funding to support EDW software, development
and maintenance;
--Five (5) New Positions: Two Systems Engineers (GS-13); One
infrastructure Architect/Project Manager (GS-14); One
Customer Support Specialist (GS-8); One EDW Database
Administrator (GS-13).
SMART Enhancements
--$1,000,000 in contract funding to support SMART, SOR and Data
Sharing development and maintenance;
--Five (5) New Positions: One Systems Integration Architect (GS-
14); One Systems Integration Analyst (GS-13); One
Configuration Manager (GS-13); One Business Intelligence
Analyst (GS-13); and One Technical Writer (GS-13).
CSP OIT currently lacks sufficient staff to sustain operations and
to plan and implement migration to an ``agile'' service-based
infrastructure. Current CSP funding does not provide sufficient ongoing
resources to maintain the current IT infrastructure and continue the
SMART development process. To date, CSP has been able to support the
significant SMART and IT infrastructure accomplishments through delayed
operational costs at two new field units. One of those field units
(Rhode Island Avenue) became operational in fiscal year 2006, and the
other is planned for implementation in fiscal year 2009. Without the
requested fiscal year 2009 resources, planned SMART, partnership/data
sharing and infrastructure improvements will be significantly reduced,
affecting the effectiveness and efficiency of CSP and our law
enforcement partners.
Lack of additional resources will effectively derail investments
made in our information technology (IT) infrastructure over the past 2
years, most of which were implemented to comply with Federal IT
mandates for security, disaster recovery and performance management. It
is vital that CSOSA have the IT capability to effectively perform its
law enforcement and public safety functions for the Nation's capital.
Compared to its Federal counterparts, CSOSA is still very new and very
small. We are still in need of funding for critical IT infrastructure
and developmental initiatives to implement the full scope of the local
public safety functions that CSOSA was created to assume.
PSA Misdemeanor and Traffic Court Supervision Initiative
In our other new budget initiative, PSA requests $3,340,000 and 23
positions for defendant supervision, substance abuse and mental health
assessments, and drug testing services for D.C. Misdemeanor and Traffic
Court (drunk driving) cases.
In 2006, the Office of the Attorney General's (OAG) Criminal
Section papered over 12,400 D.C. misdemeanor and traffic cases. Based
on estimates from the OAG's Public Safety Division and the D.C.
Superior Court, over 3,600 of these cases (29 percent) involved
defendants in need of mental health and/or substance abuse treatment
services. To better address the problems and community safety issues
within this population, beginning in fiscal year 2009, the D.C.
Superior Court and OAG will lead a court-centered, problem-solving
initiative geared to the unique problems and service requirements of
mentally ill and substance abusing arrestees. This initiative will
identify mental health and substance abuse issues in this population
and link defendants to community-based services; ensure the least
restrictive diversion and community supervision options needed to
address public safety and treatment concerns; ensure comprehensive and
individualized treatment and supervision placements; provide a
comprehensive team-oriented approach to addressing health and social
issues geared to a defendant's criminal behavior; and provide
supervision of participants, including court notice for infractions of
supervision conditions.
The initiative already has the support of many local criminal
justice and community partners. Defendants will be referred to the
District of Columbia's Addiction Prevention and Recovery Administration
(APRA) and the Department of Mental Health (DMH) for needed treatment
services. DMH also will establish a crisis care center within the D.C.
Superior Court to temporarily assist defendants with severe mental
health issues. The city's Department of Employment Services (DOES) will
offer job referral and training geared to the special needs of this
population.
The missing elements of the program design are strong defendant
supervision and drug testing, as well as assessments for and linkages
to needed treatment and social services in the community. Therefore,
the D.C. Superior Court and the OAG have requested that PSA provide
supervision, substance abuse and mental health assessments, linkage to
treatment, and drug testing services. Supervision would include
conditions such as weekly drug testing, in-person contact as needed
with a case manager, and referrals to treatment and social service
agencies. Besides helping the OAG, the Court, and other collaborative
partners meet an important strategic goal, this assistance would help
PSA meet its statutory obligation under D.C. Code Sec. 23-1303(h) to
provide supervision to all defendants released with conditions and to
address within this population what potentially may be unacceptable
safety risk to the Washington metropolitan community.
To ensure proper management of treatment and other conditions, as
well as prompt administrative and judicial responses to infractions,
PSA recommends a maximum case manager-to-defendant ratio of 1:75.
The proposed request would fund the following supervision, drug
testing, and treatment assessment personnel costs: 12 Pretrial Service
Officers; 1 supervisory Pretrial Service Officer; 3 Community Treatment
Specialists; 2 Chemists; 1 Laboratory Technician; 3 Drug Testing
Technicians; 1 Program Assistant; and $120,000 for drug testing
supplies (chemical reagents).
PSA data supports enhanced supervision for defendants charged with
serious traffic offenses as well as misdemeanants with serious mental
health and substance abuse needs. Drug-involved defendants are three
times as likely to be rearrested and more than twice as likely to fail
to appear as non-users. Introducing pretrial supervision to the high
risk defendants in D.C. Misdemeanor and Traffic Court who have mental
health and substance abuse challenges will assist the Court in
enhancing public safety and assuring that these defendants keep their
court dates.
This initiative will also enhance PSA's collaborations with the
D.C. Superior Court, OAG, and other criminal justice and community
partners. The proposed initiative is a combined effort to screen,
assess, and supervise potentially high-risk defendants who now receive
little or no supervision and support. No other partner in this
initiative can provide the assessment, supervision, and drug testing of
this population; these services are needed to ensure court appearance
and protect the public.
Adjustments to Base
CSOSA also requests $6,224,000 in adjustments to base to fund
employee cost of living pay raises and general price increases. Of this
amount, $4,620,000 is for CSP, and $1,604,000 is for PSA.

CONCLUSION

CSOSA's budget initiatives reflect the developmental challenges the
agency continues to face. While CSP has implemented a wide range of
program enhancements, such progress necessitates ongoing maintenance
and expansion of IT infrastructure to ensure that our ability to manage
cases efficiently, analyze data, and measure performance keeps pace
with our operations. PSA continues to face the need to collaborate with
and support its partners--most particularly, Superior Court--by
participating in initiatives that will enhance defendant compliance and
protect the public.
Unless CSOSA responds to these challenges, we are at risk of losing
the ground we have gained. These initiatives will enable us to continue
building and supporting a model supervision system that achieves the
benefits CSOSA was established to bring to the District of Columbia:
increased public safety, reduced recidivism, and enhanced systemwide
collaboration.
We appreciate the support we have received to date, and we look
forward to working with the Committee on this request.

LIST OF WITNESSES, COMMUNICATIONS, AND PREPARED STATEMENTS

----------
Page
Allard, Senator Wayne, U.S. Senator From Colorado:
Prepared Statements of.....................................132, 276
Questions Submitted by....................................... 202
Statement of................................................. 131

Brownback, Senator Sam, U.S. Senator From Kansas:
Prepared Statements of...................................5, 42, 133
Questions Submitted by........................32, 92, 251, 249, 403
Statements of....................................132, 209, 255, 372

Chatfield, Honorable William A., Director, Selective Service
System, Prepared Statement of the.............................. 413
Cherecwich, Paul, Jr., Chairman, Internal Revenue Service
Oversight Board................................................ 162
Prepared Statement of........................................ 164
Cox, Hon. Christopher, Chairman, Securities and Exchange
Commission..................................................... 349
Prepared Statement of........................................ 352

Duff, James C., Director, Administrative Office of the U.S.
Courts, the Judiciary.......................................... 66
Prepared Statement of........................................ 68
Durbin, Senator Richard J., U.S. Senator From Illinois:
Opening Statements of......................1, 41, 97, 207, 253, 371
Prepared Statement of........................................ 253
Questions Submitted by.............................23, 82, 228, 395
Statement of................................................. 130

George, J. Russell, Treasury Inspector General for Tax
Administration, Department of the Treasury..................... 148
Prepared Statement of........................................ 150
Gibbons, Hon. Julia S., Judge, U.S. Court of Appeals, Sixth
Circuit; Chair, Budget Committee of the Judicial Conference,
the Judiciary.................................................. 41
Opening Statement............................................ 43
Prepared Statement of........................................ 45

Kelley, Colleen M., National President, National Treasury
Employees Union, Prepared Statement of......................... 109
Kovacic, Hon. William E., Chairman, Federal Trade Commission..... 371
Prepared Statement of........................................ 376
Summary Statement of......................................... 374

Landrieu, Senator Mary L., U.S. Senator From Louisiana, Questions
Submitted by................................................... 201
Leibowitz, Hon. Jon, Commissioner, Federal Trade Commission...... 371
Summary Statement of......................................... 383
Lukken, Hon. Walter L., Acting Chairman, Commodity Futures
Trading Commission............................................. 253
Prepared Statement of........................................ 259
Summary Statement of......................................... 256

McFarland, Honorable Patrick E., Inspector General, Office of
Personnel Management, Prepared Statement of the................ 411
Michel, Paul R., Chief Judge, United States Court of Appeals for
the Federal Circuit, the Judiciary, Prepared Statement of...... 57
Moore, Thomas H., Commissioner, Consumer Product Safety
Commission..................................................... 207
Prepared Statement of........................................ 217
Questions Submitted to....................................... 251

Nord, Nancy A., Acting Chairman, Consumer Product Safety
Commission..................................................... 207
Prepared Statement of........................................ 212
Questions Submitted to....................................... 228

OMB Watch, Prepared Statement of................................. 116
Olson, Nina E., National Taxpayer Advocate, Internal Revenue
Service........................................................ 178
Prepared Statement of........................................ 179
Paulson, Hon. Henry M., Jr., Secretary of the Treasury,
Department of the Treasury..................................... 1
Prepared Statement of........................................ 4

Quander, Paul A., Jr., Director, Court Services and Offender
Supervision Agency for the District of Columbia, Prepared
Statement of................................................... 415

Restani, Jane A., Chief Judge, United States Court of
International Trade, the Judiciary, Prepared Statement of...... 59
Rothstein, Hon. Barbara J., Director, Federal Judicial Center,
the Judiciary, Prepared Statement of........................... 61

Shelby, Senator Richard C., U.S. Senator From Alabama:
Prepared Statement of........................................ 255
Questions Submitted by....................................... 368
Shulman, Douglas, Commissioner, Internal Revenue Service,
Department of the Treasury..................................... 97
Statement of................................................. 134
Prepared Statement of........................................ 136
Spires, Richard, Deputy Commissioner, Internal Revenue Service,
Department of the Treasury..................................... 97
Springer, Honorable Linda M., Director, Office of Personnel
Management, Prepared Statement of the.......................... 409
Stiff, Linda, Deputy Commissioner, Internal Revenue Service,
Department of the Treasury..................................... 97

United States Sentencing Commission, the Judiciary, Prepared
Statement of the............................................... 62

White, James R., Director, Strategic Issues, Government
Accountability Office, Prepared Statement of................... 98

SUBJECT INDEX

----------
Page

COMMODITY FUTURES TRADING COMMISSION

Abstract......................................................... 295
Adequate Staffing to Meet Volume Increases....................... 267
Analysis of Potential Causes of Consumer Food Price Inflation.... 312
As Biofuels Catch on, Next Task is to Deal With Environmental,
Economic Impact................................................ 285
Background and Current Market Events............................. 259
CFTC-SEC Coordination............................................ 280
Commodities: Who's Behind the Boom?.............................. 271
Ethanol Impact on Gas Prices..................................... 281
Evolution of the Markets......................................... 260
Fiscal Year:
2008 Budget.................................................. 262
2009 Budget.................................................. 265
Impact of Biofuels Mandate on Price Increases.................... 279
Index Funds in Oil Markets....................................... 275
Limitations on Open Positions.................................... 274
Long Contracts Held by Index Funds............................... 281
Margin Requirements.............................................. 269
Monitoring Market Fundamentals................................... 270
Program Assessment Rating........................................ 277
Speculation Impact on Energy Futures............................. 268
The Impact of Ethanol Production on U.S. and Regional Gasoline
Prices and on the Profitability of the U.S. Oil Refinery
Industry....................................................... 295
The Relative Impact of Corn and Energy Prices in the Grocery
Aisle.......................................................... 287

CONSUMER PRODUCT SAFETY COMMISSION

Additional Committee Questions................................... 227
All-Terrain Vehicles............................................. 232
Are we Better Off Now?........................................... 226
Building a New Import Surveillance Division...................... 213
CPSC:
Reauthorization.............................................. 224
Safety Work Can Continue in Fiscal Year 2009................. 219
Certification Authority.......................................... 226
Consumer Complaint Database...................................... 225
Data Analysis--New Early Warning System Pilot Program............ 231
Establishing a New Early Warning System.......................... 214
Fiscal Year 2009:
Budget Request............................................... 212
President's Budget........................................... 208
Illinois--Lead in Keychains...................................... 248
Impact of Fiscal Year 2008 Funding............................... 217
Improving CPSC's IT Infrastructure............................... 213
Meeting the Challenge of Imported Products....................... 212
Misinformed Approaches to Consumer Protection.................... 208
Modernizing CPSC's Testing Laboratory............................ 213
Most Important Elements of CPSC Reauthorization Bill............. 225
New Import Safety Initiative...................................221, 228
New Improvements in IT........................................... 229
New Pool and Spa Safety Act...................................... 233
Ongoing CPSC Activities.......................................... 214
Senate CPSC Reauthorization Bill and Cost Estimates.............. 225
Staffing Levels.................................................. 220
Status of CPSC Laboratory........................................ 229
Then and Now..................................................... 207
Update on U.S.-China Agreement................................... 228
What Else Will CPSC Study This Year?............................. 230
Why Does It Take So Long for CPSC to Publish a Final Rule?....... 247
Why are CPSC Goals for Customer Satisfaction Decreasing?......... 232
Will There be a CPSC Presence in China?.......................... 222
Yo-Yo Water Ball................................................. 233

COURT SERVICES AND OFFENDER SUPERVISION AGENCY FOR THE DISTRICT OF
COLUMBIA

Background....................................................... 415
2009 Budget Initiatives.......................................... 416

DEPARTMENT OF THE TREASURY

Additional Committee Questions................................... 22
Alternative Metals for Coins..................................... 20
Bankruptcy.......................................................11, 15
Budgetary Implications of Cuba Sanctions......................... 26
Capital Markets.................................................. 11
Committee on Foreign Investment in the United States (CFIUS)--
Caseload Management............................................ 29
Conflict Minerals................................................ 12
Congo/Coltan..................................................... 38
Cost of Pennies and Nickels...................................... 14
Costs of Coins................................................... 13
Counseling Funding...............................................17, 20
Cross-Border Wire Transfers...................................... 26
Economic Stimulus Rebates........................................ 25
Fiscal Discipline................................................ 4
Hope Now Alliance................................................ 6
Integration of Treasury Into U.S. Intelligence Community......... 30
International:
Programs..................................................... 5
Sanctions:
Cuba..................................................... 24
Sudan.................................................... 24
Loan:
Modifications................................................ 22
Work Outs.................................................... 9, 18
Management of Treasury's IT Systems.............................. 28
Metal Content of Coins........................................... 14
New 24/7 Operations Center....................................... 25
Reduction in Requested CDFI Funding.............................. 24
Repatriation of Funds............................................ 19
Speculators...................................................... 9
Strengthening National Security.................................. 4
Subprime Borrowers............................................... 7
Tax Credits...................................................... 12
Trade............................................................ 23
U.S. Economic Steward............................................ 4

Internal Revenue Service

A Commitment to Service, Enforcement and Modernization........... 138
A Primary Cause: Lack of Resources at the IRS.................... 119
Acknowledgements................................................. 117
Additional Committee Questions................................... 201
Addressing the Tax Gap........................................... 158
Agency Comments.................................................. 109
Bridging the Tax Gap--The Case for Increasing the IRS Budget..... 117
Business Systems Modernization................................... 198
Program Initiative........................................... 170
Colorado Department of Revenue Settlement Offer.................. 205
Conservation Easements........................................... 144
Contracting Out.................................................. 115
Contractors...................................................... 141
Economic Stimulus Act of 2008.................................... 160
Enhance Enforcement of Tax Laws.................................. 157
Expand Internal Tax Collection................................... 126
Fiscal Year 2009 IRS Budget Recommendations...................... 165
Forms and Complexity............................................. 143
Further Progress Made in Implementing BSM, but Challenges and
Risks Remain................................................... 105
Highlights....................................................... 98
Impact of the Tax Gap............................................ 118
Improve Taxpayer Service......................................... 155
Increase Services for EITC Taxpayers............................. 127
Increases Resources for Audits................................... 121
Information Technology/Infrastructure Program Initiatives........ 172
Internal Revenue Service:
Assessment of the Fiscal Year 2009 Budget Request............ 98
Estimates the Cost of Implementing the Economic Stimulus
Legislation may be up to a Total of $767 Million and
Expects Declines in Some Taxpayer Services................. 107
Fiscal Year 2009 Budget Request.............................. 109
Has Enhanced Its Justifications for Initiatives and Could
Benefit From Using ROI Analyses More Broadly, Even With
Their Limitations.......................................... 103
Investing in IRS is a Good Business Decision Supported by the
Public......................................................... 173
Legislative Proposals............................................ 159
Misclassification of Workers..................................... 146
NTEU Staffing Proposal........................................... 111
OPM Prescription Drug Subsidy.................................... 115
Overview of the IRS's Fiscal Year 2009 Budget Request............ 151
Pay Raise........................................................ 114
Private:
Debt Collection............................................142, 196
Tax Collection............................................... 112
Security of the Internal Revenue Service......................... 155
Stimulus Payments..............................................143, 147
Tax:
Enforcement Has to be a Priority............................. 129
Simplification............................................... 199
The $300 Billion Problem: The Tax Gap............................ 117
The Administration's Fiscal Year 2009 Budget Funds Taxpayer
Service and Enforcement........................................ 138
The Fiscal Year 2009 Budget Request Proposes to Maintain Taxpayer
Service at Recent Levels and Increase Enforcement.............. 101
Treasury Inspector General for Tax Administration Fiscal Year
2009 Budget Request............................................ 161
2008 Filing Season.............................................136, 159

FEDERAL TRADE COMMISSION

Additional Committee Questions................................... 395
Competition Mission.............................................. 380
Consumer Protection Mission...................................... 376
Credit Card Practices............................................ 393
Debt Relief...................................................... 406
Do Not Call...................................................... 390
Ethanol.......................................................... 403
Food Marketing to Children....................................... 388
Fraud Complaints................................................. 395
Gas Prices....................................................... 400
Gasoline Prices.................................................. 403
Green Marketing.................................................. 394
Identity Theft................................................... 393
Marketing Adult-rated Entertainment to Children.................. 391
Merger Activity.................................................. 395
Mortgage Marketing............................................... 405
Needed Resources for Fiscal Year 2009............................ 382
Price Gouging.................................................... 402
Real Estate Markets.............................................. 407
Resources for Price Monitoring................................... 401
Speculation in the Oil Market.................................... 389
Strategic Petroleum Reserve...................................... 403
Subprime Lending................................................. 396
Telecommunications............................................... 404
Trends in the Oil Market......................................... 385
U.S. SAFE WEB Act................................................ 399

OFFICE OF PERSONNEL MANAGEMENT

Federal Employees Health Benefits Program (FEHB)................. 409
Human Resources:
Line of Business............................................. 410
Management................................................... 410
Implementing Human Capital Standards for Success................. 410
Mandatory Payment Accounts....................................... 411
Retirement Claims Processing and Benefits Programs............... 409
Revolving Fund................................................... 410
Security-related Activities...................................... 410

SECURITIES AND EXCHANGE COMMISSION

Additional Committee Questions................................... 368
Broker-Dealer Rulemaking......................................... 366
CRA Program...................................................... 368
CSE Program...................................................... 369
Divestment Disclosures........................................... 368
Enforcement...................................................... 369
Financial Services Regulatory Structure.......................... 366
Fiscal Year 2008 to Date......................................... 353
Imposition of User Fees.......................................... 358
Oversight of:
Credit Rating Agencies....................................... 365
Investment Banks............................................. 357
Review of Fiscal Year 2007....................................... 352
Securities Litigation Reform..................................... 367
Staffing Levels.................................................. 356
Subprime Mortgage Crisis......................................... 358
Summary Statement................................................ 349
Triple-A Failure................................................. 359

SELECTIVE SERVICE SYSTEM

Areas of Emphasis................................................ 413
National in Scope, Local in Service.............................. 415
What We Do Today................................................. 413

THE JUDICIARY

Additional Committee Questions................................... 82
Administrative Office:
Challenges................................................... 69
Fiscal Year 2009 Budget Request.............................. 73
Internal Review.............................................. 69
Budgetary Impact of Judges Assuming Senior Status................ 86
Contributions of the:
Administrative Office........................................ 55
Federal Judicial Center...................................... 55
Cost Containment Efforts......................................... 49
Court Security...................................................45, 76
Department of Justice Inspector General Report............... 83
Pilot Project................................................ 44
U.S. Marshals Service........................................ 82
Courthouse Construction..........................................72, 76
San Diego and Los Angeles.................................... 85
Courts of Appeals for the Federal Circuit........................ 78
Current Issues at the Administrative Office...................... 67
Federal Protective Service and Pilot Project..................... 74
Fiscal Year:
2008 Funding.................................................43, 45
2009 Budget Request......................................43, 53, 68
Impact of Increased:
Border Enforcement...........................................47, 88
Increased Immigration Enforcement............................ 44
Implementation of the Court Security Improvement Act............. 85
Increase in Non-Capital Panel Attorney Rate...................... 54
Innovation in the Federal Courts................................. 50
Judicial Authority for Offender Re-entry Programs................ 88
Judiciary Workload............................................... 92
Justification for the Commission's Appropriations Request........ 63
Partnership With the General Services Administration............. 71
Pay for Bankruptcy Case Trustees................................. 81
Planning for the Future.......................................... 70
Projects Under the ``Care of the Building and Grounds of the
Supreme
Court''........................................................ 89
Rent Savings..................................................... 89
Resources Requested.............................................. 62
Retroactivity of Crack Cocaine Sentencing Amendment..........46, 79, 90
Review of the Administrative Office.............................. 67
Role of the Administrative Office................................66, 68
Senior Judges.................................................... 77
At the Court of Appeals for the Federal Circuit.............. 87
Supreme Court Modernization Project.............................. 79
The Center Has Managed Its Appropriation Responsibly............. 62
The Center's:
Contribution to the Courts................................... 61
Fiscal Year 2009 Request..................................... 62
The Judiciary's Workload......................................... 51
Workload in the Federal Courts................................... 81