[Joint House and Senate Hearing, 112 Congress]
[From the U.S. Government Publishing Office]
TAX REFORM AND THE TAX TREATMENT
OF DEBT AND EQUITY
=======================================================================
JOINT HEARING
BEFORE THE
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
AND THE
FINANCE COMMITTEE
U.S. SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
__________
July 13, 2011
__________
Serial No. 112-14
__________
Printed for the use of the Committee on Ways and Means
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COMMITTEE ON WAYS AND MEANS
DAVE CAMP, Michigan, Chairman
WALLY HERGER, California SANDER M. LEVIN, Michigan
SAM JOHNSON, Texas CHARLES B. RANGEL, New York
KEVIN BRADY, Texas FORTNEY PETE STARK, California
PAUL RYAN, Wisconsin JIM MCDERMOTT, Washington
DEVIN NUNES, California JOHN LEWIS, Georgia
PATRICK J. TIBERI, Ohio RICHARD E. NEAL, Massachusetts
GEOFF DAVIS, Kentucky XAVIER BECERRA, California
DAVID G. REICHERT, Washington LLOYD DOGGETT, Texas
CHARLES W. BOUSTANY, JR., Louisiana MIKE THOMPSON, California
PETER J. ROSKAM, Illinois JOHN B. LARSON, Connecticut
JIM GERLACH, Pennsylvania EARL BLUMENAUER, Oregon
TOM PRICE, Georgia RON KIND, Wisconsin
VERN BUCHANAN, Florida BILL PASCRELL, JR., New Jersey
ADRIAN SMITH, Nebraska SHELLEY BERKLEY, Nevada
AARON SCHOCK, Illinois JOSEPH CROWLEY, New York
LYNN JENKINS, Kansas
ERIK PAULSEN, Minnesota
KENNY MARCHANT, Texas
RICK BERG, North Dakota
DIANE BLACK, Tennessee
TOM REED, New York
Jon Traub, Staff Director
Janice Mays, Minority Staff Director
______
COMMITTEE ON FINANCE
MAX BAUCUS, Montana, Chairman
JOHN D. ROCKEFELLER IV, West ORRIN G. HATCH, Utah
Virginia CHUCK GRASSLEY, Iowa
KENT CONRAD, North Dakota OLYMPIA J. SNOWE, Maine
JEFF BINGAMAN, New Mexico JON KYL, Arizona
JOHN F. KERRY, Massachusetts MIKE CRAPO, Idaho
RON WYDEN, Oregon PAT ROBERTS, Kansas
CHARLES E. SCHUMER, New York MICHAEL B. ENZI, Wyoming
DEBBIE STABENOW, Michigan JOHN CORNYN, Texas
MARIA CANTWELL, Washington TOM COBURN, Oklahoma
BILL NELSON, Florida JOHN THUNE, South Dakota
ROBERT MENENDEZ, New Jersey RICHARD BURR, North Carolina
THOMAS R. CARPER, Delaware
BENJAMIN L. CARDIN, Maryland
Russell Sullivan, Staff Director
Chris Campbell, Republican Staff Director
C O N T E N T S
__________
Page
Advisory of July 13, 2011 announcing the hearing................. 2
WITNESSES
Mr. Thomas A. Barthold, Chief of Staff, Joint Committee on
Taxation
Testimony A.................................................. 10
Testimony B.................................................. 157
Dr. Mihir A. Desai, Mizuho Financial Group Professor of Finance,
Harvard Business School
Testimony.................................................... 269
The Honorable Pamela F. Olson, Partner, Skadden, Arps, Slate,
Meagher & Flom, Former Assistant Secretary of the Treasury for
Tax Policy
Testimony.................................................... 259
Mr. Victor Fleischer, Associate Professor of Law, University of
Colorado Law School
Testimony.................................................... 267
Dr. Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship,
Massachusetts Institute of Technology Sloan School of
Management, former Economic Counsellor and Director of the
Research Department at the Inter-national Monetary Fund
Testimony.................................................... 295
QUESTIONS FOR THE RECORD
Mr. Thomas A. Barthold........................................... 330
Dr. Mihir A. Desai............................................... 340
SUBMISSIONS FOR THE RECORD
Sen. Olympia J. Snowe, Statement................................. 343
National Association of Home Builders, Statement................. 345
The Center for Fiscal Equity, Statement.......................... 353
JOINT HEARING ON TAX REFORM AND THE
TAX TREATMENT OF DEBT AND EQUITY
----------
WEDNESDAY, JULY 13, 2011
U.S. House of Representatives,
Committee on Ways and Means,
Washington, D.C.
The joint hearing met, pursuant to call, at 9:07 a.m., in
Room HVC210, Capitol Visitors Center, the Honorable Dave Camp
[chairman of the House Committee on Ways and Means] presiding.
[The advisory of the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
Chairmen Camp and Baucus Announce
Joint Hearing on Tax Reform and the
Tax Treatment of Debt and Equity
Wednesday, July 13, 2011
Congressman Dave Camp (R-MI), Chairman of the House Committee on
Ways and Means, and Senator Max Baucus (D-MT), Chairman of the Senate
Committee on Finance, today announced that the Committees will hold a
joint hearing to review the tax treatment of debt and equity and to
consider distinctions in the treatment of each in the context of
comprehensive tax reform. In connection with the hearing, the staff of
the Joint Committee on Taxation (JCT) will release two reports that
analyze the taxation of household debt and business debt. The joint
hearing will take place on Wednesday, July 13, 2011, in Room HVC-210 of
the Capitol Visitor Center, beginning at 9:00 A.M.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committees and for
inclusion in the printed record of the hearing. A list of invited
witnesses will follow.
BACKGROUND:
At the March 15, 2011 organizational meeting of the Joint Committee
on Taxation, Chairman Camp and Chairman Baucus--in their capacities as
JCT Chair and Vice Chair, respectively--directed JCT staff to analyze
how debt financing is taxed relative to equity financing and to report
on the effects of such differences on household and business debt
levels. Chairman Camp and Chairman Baucus believe that the policy and
economic information provided by JCT staff will be important for the
tax-writing committees to consider in the formulation of comprehensive
tax reform legislation. The two JCT reports will be formally presented
to the Ways and Means Committee and Senate Finance Committee at the
joint hearing.
With regard to the joint hearing, Chairman Camp made the following
statement:``The relative taxation of debt and equity has serious
consequences for the economy and job creation, and it needs to be given
careful consideration in the context of comprehensive tax reform. With
both the Ways and Means Committee and the Senate Finance Committee
actively pursuing tax reform, it will be critical for Congress's two
tax-writing panels to be working together closely. I look forward to
having our two committees convene this historic joint hearing--the
first on a tax issue since 1940--to receive these staff reports on this
important issue.''
Chairman Baucus said, ``As part of tax reform, we must examine how
we can improve our economy and create jobs, and to do so, we need to
ask how to encourage businesses to invest in growth. This hearing will
look at the effects of different tax treatment of debt and equity on
our economy. We'll need to work together to simplify and improve our
tax code to help businesses create jobs, which is why these joint
hearings between our two committees are so important.''
FOCUS OF THE HEARING:
The hearing will focus on the taxation of debt and equity and the
broader economic implications of this treatment. At the hearing, JCT
staff will formally present two reports on the taxation of debt
financing relative to equity financing. These JCT staff reports were
requested by Ways and Means Committee Chairman Camp and Senate Finance
Committee Chairman Baucus at the organizational meeting of the Joint
Committee on Taxation on March 15, 2011.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Please Note: Any person(s) and/or organization(s) wishing to submit
written comments for the hearing record must follow the appropriate
link on the hearing page of the Committee website and complete the
informational forms. From the Committee homepage, http://
waysandmeans.house.gov, select ``Hearings.'' Select the hearing for
which you would like to submit, and click on the link entitled, ``Click
here to provide a submission for the record.'' Once you have followed
the online instructions, submit all requested information. ATTACH your
submission as a Word document, in compliance with the formatting
requirements listed below, by the close of business on Wednesday, July
27, 2011. Finally, please note that due to the change in House mail
policy, the U.S. Capitol Police will refuse sealed-package deliveries
to all House Office Buildings. For questions, or if you encounter
technical problems, please call (202) 225-3625 or (202) 225-2610.
FORMATTING REQUIREMENTS:
The Committee relies on electronic submissions for printing the
official hearing record. As always, submissions will be included in the
record according to the discretion of the Committee. The Committee will
not alter the content of your submission, but we reserve the right to
format it according to our guidelines. Any submission provided to the
Committee by a witness, any supplementary materials submitted for the
printed record, and any written comments in response to a request for
written comments must conform to the guidelines listed below. Any
submission or supplementary item not in compliance with these
guidelines will not be printed but will be maintained in the Committee
files for review and use by the Committee.
1. All submissions and supplementary materials must be provided in
Word format and MUST NOT exceed a total of 10 pages, including
attachments. Witnesses and submitters are advised that the Committee
relies on electronic submissions for printing the official hearing
record.
2. Copies of whole documents submitted as exhibit material will not
be accepted for printing. Instead, exhibit material should be
referenced and quoted or paraphrased. All exhibit material not meeting
these specifications will be maintained in the Committee files for
review and use by the Committee.
3. All submissions must include a list of all clients, persons and/
or organizations on whose behalf the witness appears. A supplemental
sheet must accompany each submission listing the name, company,
address, telephone, and fax numbers of each witness.
The Committee seeks to make its facilities accessible to persons
with disabilities. If you are in need of special accommodations, please
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
business days' notice is requested). Questions with regard to special
accommodation needs in general (including availability of Committee
materials in alternative formats) may be directed to the Committee as
noted above.
Note: All Committee advisories and news releases are available on
the World Wide Web at http://www.waysandmeans.house.gov/.
Chairman CAMP. Good morning, and thank you all for joining
us this morning. According to the Congressional Research
Service, the last time both the House Ways and Means and the
Senate Finance Committees met together for a joint hearing on
tax issues was 1940, more than 70 years ago, to discuss a war
profits tax.
And while I have said that I have been looking forward to
our two committees working closely together on tax reform, I
hope that you all know I didn't necessarily mean that we would
be squeezed in here quite so tightly. But it is a beautiful new
room, and I appreciate the opportunity to be able to use it.
I want to thank Senator Baucus and his staff, and all of
the staffs, for working out the details. And also, I want to
thank my colleagues in both the House and Senate for being here
today. It is a clear illustration of how serious the issue of
tax reform is to both of these committees and, of course, to
the American economy.
As former Treasury Secretary James Baker said at the April
6th Joint Tax Committee hearing, ``Tax reform has something in
it for everybody.'' For an American family, it means greater
simplicity, fairness, and predictability, so that families can
plan and prosper. And for employers and their employees,
transforming our tax code is critical to making America a more
vibrant competitor abroad, and a more attractive place to
invest and create the jobs we need here at home.
However, before we can begin to tackle and craft a plan for
comprehensive tax reform, we must take the time to better
understand how the current code influences our economy and the
decisions made by families and businesses. The issue of debt
and equity, the topics of our hearing today, is among the most
complex issues we must grapple with, and among the most
important to get right in moving forward.
Earlier this week, the staff of the Joint Tax Committee
issued two reports responding to a request Chairman Baucus and
I made, one on household debt, and one on business debt. The
report on household debt examines provisions in current law
related to the deduction of interest expenses, including
personal interest deductions for mortgage interest, interest on
student loans, and investment interest.
The business debt report focuses more on the tax treatment
of debt, relative to equity, and its implication for corporate
capital structures. These are all crucial issues, and I think
it is fitting to have both of Congress's tax-writing committees
here today to receive these reports and hear from our
distinguished panel of experts.
And before I yield to my friend from Montana, I would like
to just take a moment to congratulate him on his recent
marriage. And I now recognize Senator Baucus for his opening
statement.
Chairman BAUCUS. Oh, well, thank you very much, Mr.
Chairman. That was something I did not expect. That is very
thoughtful, that is very sensitive, is very nice, and I deeply
appreciate it.
Also, I appreciate our holding a joint hearing. I think
there is an opportunity here for the Ways and Means Committee
and the Finance Committee to work together in many areas--in
this case, with tax reform, both individual and corporate. We
have been working together, we have already set good precedent
by working out an agreement with the trade adjustment
assistance, you and I and our staffs, and I hope that is good
precedent for future cooperation, because both--with us working
together, it is clear that we are more likely to get something
accomplished than if we don't. And I deeply appreciate that.
The author, Henry Wheeler Shaw, once wrote--and I quote
him--``Debt is like any other trap: easy enough to get into,
but hard enough to get out of.'' We meet together today because
we share a common goal. We believe the tax code should boost
American competitiveness, should encourage economic growth and
job creation. It should be fair, simple, efficient, and
certain. And it should also not encourage households or
businesses to take on too much debt that they cannot get out
of.
Today we examine the taxation of debt and equity. Right now
we are confronting a massive debt problem due, in part, to 2008
financial crisis. The year before the crisis, the 5 major
investment banks had a leverage ratio of 40 to 1, which means
for every $40 in assets, there is only $1 in equity to cover
losses. This raises the question of whether excessive private
debt played a major role in creating that meltdown.
As we work to emerge from that crisis, we seek to
understand how our tax code affects private debt, and how does
debt affect stability and growth. Does the code encourage
households and businesses to become more leveraged? Do tax
preferences for corporate debt or equity provide incentive for
riskier capital structures? And did the tax code's treatment of
debt contribute to the crisis?
We clearly did not want to encourage households and
business to assume too much. Yet we want to ensure that
businesses can borrow at modest rates, because that is an
essential step on the road to economic recovery.
In today's code it can be hard to tell what is considered
borrowing and what is equity investment. A business can make an
infusion of cash that looks like either one. And naturally,
some businesses choose to cast their financing in a light that
gets the best tax treatment. But this requires sophisticated
tax planning, which not everyone can afford.
Debt and equity can both be vital tools in today's economy.
But as we work to inspire growth, we must make sure our code
does not encourage businesses and individuals to put themselves
in precarious positions. Tax reform should simplify these
issues, make our code fairer. Americans deserve a tax system
they can understand and benefit from, without an extensive tax
planner.
So, let us work together to address these issues, make our
code more competitive, more fair. Let us find creative
solutions to our nation's pressing problems. Given all the debt
discussion, Mr. Chairman, it is my hope that as that proceeds
in whatever way it does proceed, that we, in the meanwhile,
have extensive hearings on tax reform, individual and
corporate, because I think that will provide a good foundation
for whatever we do this year or next, or perhaps even in 2013.
But let us work together, have our separate hearings, have
joint hearings, but provide a real service to our country.
Thank you.
Chairman CAMP. Well, thank you, Chairman Baucus. And let me
now yield to the ranking member of the Ways and Means
Committee, Mr. Levin, for his opening statement.
Mr. LEVIN. Thank you very much. I think you noticed this is
the first time I have been in this room. There are TV sets
here. I want you to know that they have been, I think, turned
off. I noticed that FOX News, CNN, and ASPN is on these sets. I
am not sure why. I missed the baseball game last night. But I
think we have turned it off.
Chairman BAUCUS. Yours isn't off.
Mr. LEVIN. No.
[Laughter.]
Mr. LEVIN. I pushed it and it says, ``U.S. House Guest, no
new messages.''
[Laughter.]
Mr. LEVIN. As you mentioned, Mr. Camp, this is the first
time since 1940 that there has been this kind of a combined
meeting on tax issues. And, as we know, it is scheduled, and we
will discuss certain aspects of the current tax law relating to
debt and equity.
But let me make this comment that I deeply feel. Because of
the uniquely serious challenge facing this nation, action on
the debt limit, today would seem most appropriate, if we are
gathering to discuss this challenge. The issue, the debt limit,
is squarely within the jurisdiction of our two committees.
That does not mean that the specific topic before us is
unimportant. Indeed, if we are to seriously address tax reform,
issues relating to debt and equity must be considered and, like
other significant issues, done so in depth and with open
debate.
As our witnesses' prepared testimony very much
demonstrates, the subject is complex and answers do not always
automatically fall into usual ideological frameworks. But I
fear the chances of the discussion at this joint hearing
leading to fruitful action have been dimmed immeasurably by the
environment created on the overarching action on the debt
ceiling.
Yesterday, Senator McConnell said--and I quote--``After
years of discussions and months of negotiations, I have little
question that as long as this President is in the Oval Office,
a real solution is probably unattainable.'' In my judgement,
this approach politicizes and can poison the well for tax
reform in the near future. It also flies in the face of basic
facts. President Obama inherited a debt that had risen under
President Bush from 5.7 trillion to 10 trillion. And he
inherited a record 1.5 trillion deficit that had wiped out the
record surplus inherited by President Bush.
President Obama has said very clearly that we need a
balanced framework to reduce the deficit now and in the future,
while allowing for needed investments to promote economic
growth and job creation. It is not helpful to walk away from
the table. It is not helpful to insist on an ideological agenda
that cannot become law.
We should hear and review carefully the testimony now to be
presented to us by our distinguished--and if you have read
these documents in advance--very knowledgeable witnesses. But
my fear is that any insights that we gain in the process today
will be washed away if the debt ceiling is not raised and we
suffer the momentous consequences that would result from
destroying the full faith and credit of the United States of
America.
Thank you, Mr. Chairman.
Chairman CAMP. Thank you. I now yield to the ranking member
of the Senate Finance Committee, Senator Hatch, for his opening
statement.
Senator HATCH. Well, thank you, Chairmen Baucus and Camp,
for this historic hearing. And thank you, Mr. Barthold, and the
staff of the Joint Committee on Taxation for producing this
important report on the tax treatment of debt and equity, and
we appreciate you other witnesses, as well.
Tax reform should be based on the same three principles
that led to the enactment of the Tax Reform Act of 1986:
fairness, simplicity, and economic growth. I am very much
looking forward to hearing what our witnesses have to say on
these three principles, as they relate to the tax treatment of
debt and equity.
Allow me to share a few of my initial thoughts, first with
respect to individuals, and then with respect to corporations,
on the topic of debt and equity.
On the individual side, we can all agree that savings and
investment is a good thing, and that the savings rate in the
United States has traditionally been low when compared to many
other countries. But an income tax system, by its nature,
discourages savings and investment by taxing the returns to
such savings and investment. This was an observation made by
John Stuart Mill over 160 years ago. Thus, the code encourages
consumption, and even ``negative savings.'' That is, debt.
Our tax system encourages the use of debt, rather than
equity, in the area of corporate finance, as well as household
finance. If a corporation is in need of additional funds, our
tax system encourages the corporation to borrow money, rather
than raising funds by issuing stock. And why? Because any
interest payments on the borrowing are deductible, while any
dividends paid on the stock are not deductible.
In addition, many U.S. multinational corporations are
sitting on large piles of cash. Yet these corporations are
borrowing money. One reason is that their cash is trapped
offshore, and the corporations will be subject to a 35 percent
U.S. tax on repatriating the cash back to the United States.
The increased use of debt by both households and
corporations makes both more vulnerable to the risks of
bankruptcy and other downturns in the economy.
I would like to thank our witnesses for attending this
historic hearing. I thank our two chairmen and all others on
this--on these two very important committees. And I look
forward to the comments of our witnesses here today on the tax
treatment of debt and equity.
So, again, Chairman Camp and Chairman Baucus, thank you
very much for this important hearing that you have called on
tax reform. I appreciate it.
Chairman CAMP. Well, thank you, Senator Hatch. And without
objection, any other Member who wishes to have an opening
statement included in the formal record may submit one in
writing.
We are fortunate to have a panel of witnesses here this
morning with a wealth of experience in private practice,
academia, and government. And let me briefly introduce them.
First, I would like to welcome Tom Barthold, the chief of
staff for the Joint Committee on Taxation. We thank you and
your staff for your efforts in putting together the household
and business debt reports for today's hearing, and we look
forward to your presentation.
Second, we will hear from Pam Olson, who is currently
serving as the head of the Washington office tax group of the
law firm Skadden, Arps, and has also formerly served as the
Assistant Secretary for Tax Policy at the Treasury Department,
and has held several positions at the IRS.
Third, we will hear from Victor Fleischer, who is an
associate professor of law at the University of Colorado Law
School. His research is focused on tax planning and the
structuring of corporate transactions.
And fourth, we will hear from Mihir Desai, who is a
professor of finance at Harvard Business School, and recently
accepted an appointment as a tenured professor of law at
Harvard Law School. He is also a research associate in the
National Bureau of Economic Research's public economics and
corporate finance program.
And finally, we will hear from Simon Johnson, the Ronald A.
Kurtz professor of entrepreneurship at the Massachusetts
Institute of Technology. He is also a senior fellow at the
Peterson Institute for International Economics in Washington,
D.C. And from March 2007 to August 2008, Mr. Johnson was an
economic counselor and director at the research department at
the International Monetary Fund.
Thank you all for being here with us today. The committee
has received each of your written statements, and they will be
made part of the formal record. Each of you will be recognized
for five minutes for your oral remarks.
And, Mr. Barthold, we will begin with you, and you are
recognized for five minutes.
STATEMENT OF THOMAS A. BARTHOLD, CHIEF OF STAFF, JOINT
COMMITTEE ON TAXATION
Mr. BARTHOLD. Well, thank you very much, Chairman Camp,
Chairman Baucus, Mr. Levin, and Senator Hatch, and members of
the committees. It is my pleasure to deliver to the Ways and
Means Committee and the Finance Committee two reports requested
by the chairmen relating to the tax treatment of the use of
debt by households and the use of debt finance, as compared to
equity finance, by business.
Now, the Joint Committee's staff's efforts in these reports
was to describe what the law is, and what incentives the law
might create. And I will just use my brief time here to
highlight a few points.
First, while, as was noted in some of the opening
statements, the recent recession raised valid concerns about
leverage in the U.S. economy, it is important to remember that
there are many sound economic reasons for both households and
businesses to finance with debt. Debt is not inherently a bad
thing.
Now, relative to the growth of the economy, as measured by
the gross national product, over the past 25 years non-
financial corporate debt has been largely unchanged, while the
debt of the household sector and the debt of the Federal
Government have increased by more than 50 percent each. This is
shown in table I of each of the two documents that we prepared.
In looking at the household debt, the primary source of the
growth of household debt is the growth of mortgage debt, and
that is documented in figure 3 on page 18 of the household
document. As you know, mortgage interest is favored as an
itemized deduction in the Internal Revenue Code.
Yet over this same 25-year period where we see this
substantial growth in household debt, Congress has generally
lowered individual tax rates, which lowers the benefit of that
interest deduction, Congress has capped the aggregate amount of
acquisition indebtedness that a taxpayer may claim as part of
the itemized deduction, and Congress has limited the interest
deductibility of home equity debt. With those factors, it is
difficult to conclude that the deductibility of mortgage
interest would explain the growth of household debt over that
period.
On the business side, one cannot discuss debt finance
without discussing equity finance. And, as our staff report
details, there are tax rules that create incentives to choose
debt finance over equity finance. Most initially, for the
issuer, the deductibility of interest expense and, oppositely,
the non-deductibility of dividends, make debt a cheaper source
of capital for the business.
Also, other incentives exist to choose debt finance. In a
partnership, for partners, the inclusion of debt at the
partnership level increases the partners' basis, and increases
the limit on the deductibility of partner shares of partnership
losses and deductions. Debt finance of investments can create
interest deductions that can shelter other taxable income of
the business, and can lead, in some situations, to negative
effective tax rates on returns to investment.
On the other hand, there are also tax rules that favor
equity finance. At the individual level, the individual
investor may often prefer equity finance because, under present
law, there are low rates of--relatively low rates of tax on
dividend income, compared to interest income. And if the
investor recognizes a capital gain that results from the
retained earnings of the business, that is also taxed at a
lower rate than would be interest income.
For a corporate equity holder, there are low effective tax
rates from the dividends received deduction, whereas a
corporation which had lent money would be paying tax on the
interest earned at full corporate rates. For both investors and
issuers, equity promotes the possibility of tax-free mergers,
and reorganizations, facilitating fluidity in the business
sector.
Taxpayers have considerable flexibility to design
instruments that are characterized as debt or equity under the
code. And it is difficult to create bright-line rules to
distinguish debt from equity. The courts, through time, have
identified multiple indicia of what is debt. And because of
these factors, instruments can be constructed that, as an
economic matter, and as our two finance experts can probably
explain better than I, that can blend the characteristics of
debt and equity.
In the 1950s, the Congress attempted to define ``debt'' and
``equity'' in the Internal Revenue Code, but retreated from
that effort. Treasury has the authority to issue regulations to
identify debt and equity but has never exercised that authority
to do so.
I think those are some broad points that you can draw from
our reports. Thank you for the opportunity to prepare this
material for you. We would be--our staff would be happy to
provide more detailed work on any questions that might arise in
today's hearing. And, of course, I am happy to answer any
questions that you may have today.
[The prepared statements of Mr. Barthold follow:]
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Chairman CAMP. Thank you, Mr. Barthold.
Ms. Olson, you are recognized for five minutes.
STATEMENT OF PAMELA F. OLSON, PARTNER, SKADDEN, ARPS, SLATE,
MEAGHER & FLOM, FORMER ASSISTANT SECRETARY OF THE TREASURY FOR
TAX POLICY
Ms. OLSON. Thank you, Chairman Camp, Chairman Baucus,
Senator Hatch, Mr. Levin, distinguished members of the
committee. Thank you for inviting me to testify this morning.
I am appearing on my own behalf, and not on behalf of any
client or other organization. And the views I express are
solely my own, and are based on my experiences in both the
private and the public sector.
My compliments, first, to the chairmen, for your decision
to tackle tax reform on a bicameral and bipartisan basis. The
tax code's treatment of debt and equity is one of many issues
that should be considered carefully as Congress considers
reform of the tax system.
It has been observed that the one law Congress cannot
repeal is the law of unintended consequences. Individuals and
businesses respond to economic incentives and disincentives,
including those provided through the tax laws. It is important
for the tax-writing committees to be cognizant of the tax
system's incentives and disincentives, particularly with
respect to the disparate treatment of debt and equity, so that
potential consequences can be factored in as you consider
reform of the tax system.
In its current form, as Mr. Barthold has observed, the
Internal Revenue Code provides an incentive for businesses to
raise capital through the issuance of debt, rather than equity.
The incentive arises from the interplay of the two features of
our tax system that he identified as well, the double taxation
of corporate income, and the tax deductibility of interest
payments.
Incurring debt serves as a straightforward means of
mitigating the double tax on corporate income. It is worth
noting that the disparate treatment of debt and equity has been
the subject of numerous disputes between taxpayers and the
Internal Revenue Service that continue today, and that there
have been several failed efforts to draw a bright line between
the two, both legislatively and administratively. Treasury and
the IRS proposed regulations under Code Section 385 back in the
1980s that were subsequently withdrawn.
The impact of the Internal Revenue Code's preferential
treatment of debt has been a concern for a number of years, and
has led to proposals to neutralize or equalize the tax
treatment of debt and equity. The disparate treatment of debt
and equity, particularly the double tax on dividends, has also
given rise to corporate governance concerns, which affected the
Treasury Department's design of a dividend exclusion proposal
that was included in the Bush administration's fiscal year 2004
budget.
Prior to 2003, the tax on dividends brought the top tax
rate on corporate income distributed as dividends to nearly 60
percent, creating an opportunity for corporate managers to cite
the tax inefficiency of dividend payments as a basis for
reinvesting corporate profits, rather than distributing them as
dividends.
The payment of dividends is a healthy financial discipline,
because it requires free cash flow to fund the payment. But
that discipline was dulled by the tax disincentive to paying
dividends. Prior to 2003, the lower tax rate on capital gains
made methods of delivering capital gains to shareholders, such
as stock redemption, a more tax-efficient means of distributing
excess cash to shareholders.
The 2003 dividend exclusion proposal would have brought a
measure of transparency to corporate taxes as well, because
dividends would only have been excludible, to the extent they
were paid out of earnings on which corporate tax had been paid.
The attractiveness of tax-free dividends was seen as giving
corporations an incentive to pay income tax, at least to the
extent of dividends expected to be paid to shareholders, and
shareholders an interest in the extent to which the corporation
had paid tax. Thus, the proposal could have reduced the value
of corporate tax incentives, by preventing the value of those
incentives from flowing through to the shareholders.
There are simpler means of reducing or eliminating the
double tax on equity, including the reduced rate Congress
ultimately adopted, or making dividends deductible at the
corporate level. A dividends paid deduction would have a
significant effect on tax revenues, because it would have the
effect of eliminating all tax on dividend income, where the
stock is held by a tax-exempt entity, as is the case with
interest income, where the indebtedness is held by a tax-exempt
entity. Thus, a dividends paid deduction could result in the
removal from the U.S. tax base of a significant amount of
corporate income.
As the tax-writing committees consider tax reform options,
one simple means by which to reduce the preference for debt
financing is to lower the corporate tax rate. The preference
for debt financing is a result of the ability to deduct
interest payments from taxable income, and lowering corporate
tax rates would reduce the value of the interest deduction,
thus reducing the disparity in the taxation of debt and equity
investments.
Besides reducing the distortion between debt and equity
financing, lowering the corporate rate would have the benefit
of more closely aligning our rate with rates of other
countries, which have fallen in recent years.
Another reform option would be to integrate the corporate
and individual tax systems, along the lines of the Bush
administration's 2004 budget proposal, by eliminating the
shareholder level tax on corporate income distributed as
dividends. The dividend exclusion proposal could eliminate the
debt financing incentive associated with double taxing the
return to corporate equity investment.
You could also go for full parity between debt and equity,
through the adoption of a comprehensive business income tax,
which has also been studied by the Treasury Department.
In considering corporate tax reform, I encourage the
committees to make sound policy the primary objective.
Thank you for the opportunity to testify. I would be
pleased to respond to questions you may have.
[The prepared statement of Ms. Olson follows:]
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Chairman CAMP. Thank you very much.
Mr. Fleischer, you are recognized for five minutes.
STATEMENT OF VICTOR FLEISCHER, ASSOCIATE PROFESSOR OF LAW,
UNIVERSITY OF COLORADO LAW SCHOOL
Mr. FLEISCHER. Thank you for inviting me to participate
today. I am an associate professor of law at the University of
Colorado, where I teach deals, partnership tax, and tax policy.
My research focuses on how tax shapes the structuring of deals,
and so I will focus my testimony from that perspective today.
The main point that I want to make is that the debt equity
distortion is costly on two levels. The first level of cost is
obvious. Deals are restructured to reduce taxes, which erodes
the tax base. This is the explicit cost of the debt-equity
distortion.
The second level of cost is implicit. When a corporation
restructures a deal to reduce taxes, the restructuring imposes
an implicit cost on the corporations themselves. It adds
complexity to their capital structure, distorts corporate
governance, and even changes critical business decisions.
The debt-equity distortion imposes an additional implicit
cost on the public, in the form of increased systemic risks,
taxpayer bailouts, and the like. It also encourages a lot of
wasteful tax planning. One can think of these implicit costs
collectively as the collateral damage of the debt-equity
distortion.
The best way to reduce this collateral damage is to
eliminate the underlying distortion in the tax code. Legal
distinctions in the tax code that have no basis in underlying
economics are almost always a bad idea. The tax lawyers that I
know are very, very clever. If you give them an economic
incentive to turn equity into debt, or a corporation into a
partnership, or ordinary income into capital gain, they will
work tirelessly until you are convinced that a dog is properly
treated as a cat for tax purposes.
With that introduction, I will briefly elaborate on the
implicit cost of the debt-equity distortion. The first implicit
cost is risky managerial behavior. As firms take on more debt,
common stock behaves economically like a risky stock option,
giving executives unlimited upside, but limited downside risk.
With enough debt, it even becomes rational for executives to
make negative expected value bets with company assets. The debt
holders, not the executives, bear most of the downside risk.
The second cost is the social cost from increased
bankruptcies and systemic risk. Excessive leverage fuels risky
speculation that has repercussions, even for taxpayers that
never engage in risky behavior themselves. The problem is
especially acute with banks and other financial institutions,
because the externalized social costs are larger than in other
sectors.
The third cost is wasteful tax planning. In a world without
tax distortions, corporations would make financing decisions
based on market conditions, not a tax calculation. Instead,
many corporations and financial institutions, in particular,
issue new financial products to engage in regulatory arbitrage,
exploiting the inconsistencies of two different regulatory
regimes.
In the typical scenario, bank executives want to increase
the amount of leverage in the firm to reduce taxes and to
supercharge return on equity. But taking on too much debt runs
afoul of banking regulations and the guidelines of credit
agencies.
Platoons of lawyers and investment bankers then create
complex new financial products that qualify as debt for tax
purposes, and equity for financial accounting or credit agency
purposes, or as tier one capital for bank regulatory purposes.
These hybrid instruments allow financial institutions to appear
safer by appearing to have greater equity capital. In fact,
they mask an increase in debt. They are dogs that are treated
as cats for tax purposes.
AIG, Lehman Brothers, Bear Stearns, and other failed
institutions all had large amounts of these hybrid instruments
on their balance sheets before the crash. These instruments did
not perform well in the financial crisis. Because they
typically contained ongoing obligations to make cash payments,
the instruments were properly perceived by trading
counterparties as debt obligations that would not provide a
cushion in the way that real equity would. The resulting loss
and instability was borne largely by the public, and not the
banks themselves.
So, what is the bottom line? The best solution is a broader
corporate tax reform effort that would eliminate the debt
equity distortion all together. There are several different
ways to do this, including eliminating the deduction for
interest, allowing a deduction for corporate equity, or moving
to a corporate cash flow or consumption tax system.
If Congress is interested in moving more immediately on the
debt-equity distortion, my suggestion is to focus on financial
institutions. Financial institutions are where the problem is,
they have the most excessive leverage, and the failure of a
systemically risky financial institution imposes enormous
social costs.
One approach would be to eliminate the deduction of
interest by financial institutions to the extent that debt-
equity ratio exceeds five to one. The goal of such a limit is
not to punish banks, but rather to remove the tax incentive to
increase leverage beyond the ratio that would arise in a world
without taxes.
I would be happy to answer any questions you may have, and
I thank you for the honor of participating in this hearing.
[The prepared statement of Mr. Fleischer follows:]
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Chairman CAMP. Thank you very much, Mr. Fleischer.
Mr. Desai, you will be recognized for five minutes.
STATEMENT OF MIHIR A. DESAI, MIZUHO FINANCIAL GROUP PROFESSOR
OF FINANCE, HARVARD BUSINESS SCHOOL
Mr. DESAI. Chairman Baucus, Chairman Camp, and members of
the committees, it is a pleasure to appear before you today to
discuss tax reform and the treatment of debt and equity. I am a
professor of finance at Harvard Business School, professor of
law at Harvard Law School, and a research associate of the
National Bureau of Economic Research.
In my comments, I want to describe the fundamental problem
raised by the current tax treatment of debt and equity, how
changes in the economy and the tax system have raised novel
complications to this underlying problem, and outline several
alternative solutions. As an aside, I will comment on the
possibility that the tax treatment of debt and equity
contributed to the recent financial crisis.
My written testimony can be summarized in five points.
First, a classical corporate income tax with an entity level
and individual level taxation creates the potential for
asymmetric treatment of debt and equity income. This asymmetric
treatment can distort financing, organizational form, and
investment decisions.
In the U.S. system, equity income is taxed twice, while
debt income is taxed once, though assessing the actual relative
tax burdens of equity and debt income is complicated by several
factors. Indeed, the simple narrative that debt is tax favored
is not necessarily true, nor is it borne out by recent patterns
in the data, as I elaborate on in my recent testimony. In
addition to distorting financing choices, the differential in
tax treatment creates a host of opportunities for financial
engineers to innovate around that distinction.
Second, this asymmetric treatment of debt and equity income
has been complicated by three significant developments that any
reform measure should grapple with. The first development is
the rapid globalization of firms and capital markets. This
development makes the tax treatment of multinational firms and
transfer pricing concerns central to the corporate tax, creates
situations where investor-level taxation now often involves
foreign investors, and allows the possibility of allocating
various headquarter and domicile functions across multiple
jurisdictions.
The second development is that the simple characterization
of entity-level taxation and taxable investors that is
customary to use in these discussions does not reflect two very
rapid--two very important developments: the rapid rise of pass-
through entities for business income, and the rise of tax-
exempt investors as major players in the capital markets.
The third development is that corporate tax is now largely
for public corporations, where financial reporting incentives
compete with tax obligations, and these incentives can
compromise tax policy goals.
My third major point is that while excessive leverage is
sometimes associated with the tax code because of a presumed
debt bias for corporations, concerns over the role of tax
policy in fostering the financial crisis appear unfounded. It
is difficult to describe significant roles for tax incentives
in the housing market or for financial institutions as primary
or secondary actors in the drama of the financial crisis.
For the non-financial corporate sector, where the presumed
debt bias is thought to exist, the startling fact is how
unlevered that sector was, prior to the crisis. In particular,
as Senator Hatch outlined, the rise of cash balances and the
decline of net debt is the dominant corporate finance trend of
the last decade.
A brief and remarkable burst in leverage buy-out activity
that is not related to changed--to tax incentives is likely
responsible for the perception of excessive leverage in the
non-financial sector. The increased reliance on equity
financing also speaks to the potential scope of the current
bias towards debt. In my opinion, the excesses of financial-
sector leverage, which are very important, are best addressed
through regulatory approaches, rather than tax instruments.
Fourth, the corporate tax is ripe for reform for many
reasons, but excessive leverage may not rank highly amongst
them, in my view. In my testimony, I highlight three approaches
to the debt equity distinctions: regulatory, structural, and
rate solutions all can be deployed to correct perceived
concerns regarding the debt equity distinction. Regulatory
approaches which provide arbitrary limits to leverage must be
crafted with care, as they can create added complexities with
limited payoffs.
If the stripping of earnings by multinational firms is the
concern, then new regulation should be integrated with current
policy instruments that already target that problem, such as
interest allocation rules and Section 163(j). Indeed, a lowered
corporate rate is likely the best antidote to that behavior.
If firm leverage is the concern, then limits on interest
deductibility must consider how highly-levered industries and
organizational forms will be impacted, and the consequent
effects on their cost to capital and investment levels. Given
the uncertainty of the current debt bias, such regulations
would appear to engender more tax planning than economic
benefits.
Fifth, reforming the corporate tax structurally via
comprehensive business income tax can provide a solution-based
symmetric treatment of debt and equity, can undo distortions to
organizational form decisions, and provide a first step towards
fundamental tax reform.
A more modest approach to modernizing the corporate tax
should couple a rate reduction with a move toward
territoriality that is funded by better alignment of book and
tax reporting, and by some taxation of non-C corporation
business income.
As other countries have learned, reducing rates,
simplifying international taxation, and broadening the base,
are cornerstones of reforms that can improve the lives of
American workers and the firms that employ them. Such reform
efforts, rather than regulatory approaches that target
excessive leverage, would best advance your admirable agenda of
strengthening tax policy and America's economic future.
Thank you, and I look forward to any questions you might
have.
[The prepared statement of Mr. Desai follows:]
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Chairman CAMP. Thank you, Mr. Desai.
Mr. Johnson, you are recognized for five minutes.
STATEMENT OF SIMON JOHNSON, RONALD A. KURTZ PROFESSOR OF
ENTREPRENEURSHIP, MASSACHUSETTS INSTITUTE OF TECHNOLOGY SLOAN
SCHOOL OF MANAGEMENT, FORMER ECONOMIC COUNSELOR AND DIRECTOR OF
THE RESEARCH DEPARTMENT AT THE INTERNATIONAL MONETARY FUND
Mr. JOHNSON. Thank you very much. I would like to speak
about household debt, non-financial corporate sector debt, and
financial sector debt as three separate issues for your
consideration.
However, there is a common problem across all these kinds
of debt which is now, I think, apparent to all American
homeowners. If you buy a house that costs $1 million with only
$5,000 down--so the rest is leverage--you are much more at risk
when house prices go down than if you had put down $50,000 or
$500,000. You also, of course, get great upside if house prices
go up. You get a better return on your equity.
And the issue, I think, before us, certainly with regard to
the previous financial crisis, and also with regard to what may
happen in the future, is to what extent individuals or
corporations create a spillover, an externality, a form of
system risk when they choose to be over-leveraged, from a
social point of view.
Now, looking at households, I am afraid--I think it is
somewhat obvious--that the tax code has encouraged households,
over a long period of time--and it wasn't the primary
instigator of the crisis, but it encourages households to
massively over-leverage, to take on a great deal of risk, which
they may or may not fully understand themselves.
But, in any case, it creates really bad macroeconomic
consequences when house prices go down. I would strongly urge
you to consider phasing out the mortgage interest deduction
over a long period of time, such as 20 years. This has been
done in other countries. If handled properly, it would not be
disruptive and dangerous. Obviously, I am not proposing to do
it right away.
On the non-financial corporate side, I think we don't have
a major problem. I agree with what the previous witnesses have
said, with regard to the attractiveness of making the system
more neutral between debt and equity. And I think there are a
number of reforms you could do, either lower the tax of equity
or lower the deduction for interest payments, or, even better,
move to a new system, a more integrated system for corporate
taxation, perhaps also with individual taxation.
That, I think, is not the pressing number-one issue,
though, with regard to macro risks and financial stability.
Those risks are about the financial sector. And Senator Baucus
said it exactly right at the beginning. We had financial firms
going into the crisis in 2008 with leverage of at least 40 to
1. And that was not--those are not isolated examples. We have
tried for a long time, through regulation, to limit leverage,
to have so-called capital requirements, which have a similar
effect to leverage caps, and it hasn't worked.
Not only that, but the Basel III attempt to limit leverage,
to require more capital, the major international response to
the crisis, has also not had a dramatic effect, either now or
in terms of what will happen later in the cycle, as firms want
to take on more leverage.
For the financial sector, it is very clear that the top
bankers and traders are paid on a return on equity basis. If
they have less equity in the business, and things go well, they
get nice compensation. If things go badly, there is a downside
risk.
But who, I would ask you, bears that downside risk? It is
largely borne by the rest of the economy, by the non-financial
sector, by households, either--whether or not you are in favor
of bail-outs, whether or not you think you will get a bail-out
doesn't matter. You will get an awful recession, you will get
devastating losses. You get an increase of debt to GDP, if you
just want to think in fiscal terms.
As Mr. Levin pointed out, the debt level has gone up
dramatically in the past few years in the United States, mostly
because of the recession caused by the excessive leverage in
the financial system. It makes no sense to have a tax code that
encourages that leverage, at the same time as we try and pull
it back rather ineffectively with regulation. At a minimum, the
tax code should be neutral between debt and equity for
financial sector firms.
I, though, would strongly advise you to follow the lead of
some other countries in taxing excessive leverage. In the UK
they now have a tax of 7.5 basis points on what they define as
excessive leverage. That tax, I think, is actually rather low,
if you consider that the International Monetary Fund and other
organizations assess the value of being too big to fail, the
funding advantage you get from being a mega-bank today--not
just in the United States; in other countries, as well--that
funding advantage is 50 basis points, half a percentage point.
We should be taxing away that advantage.
I would actually suggest going--speaking to the points made
by Mr. Hatch. If you want a fair, simple, and pro-growth
system, you should tax excessive leverage in the financial
system and use the revenue that generates to reduce corporate
taxation for the non-financial sector, because the non-
financial sector is what really got hit hard.
That is why the jobs aren't coming back.
That is why this has turned out to be such a painful
recession. Thank you.
[The prepared statement of Mr. Johnson follows:]
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Chairman CAMP. Well, thank you, Mr. Johnson. We will now
proceed with Member questions for witnesses. And due to the
joint nature of today's hearing, questioning will alternate
between members of the Senate, as recognized by Chairman
Baucus, and members of the House, as recognized by myself, for
a single round of questioning.
Senators will be recognized in an order consistent with
rules and practices used at Senate Finance Committee hearings.
House members will be recognized in an order consistent with
rules and practices used at Ways and Means Committee hearings.
And each Member will have three minutes to question
witnesses. I realize this is a little shorter than we are used
to having in the Ways and Means Committee. But in order to
accommodate everyone, we want to hold to the three minutes for
each Member.
So, with that, let me invite Chairman Baucus to begin the
questioning.
Chairman BAUCUS. Thank you, Mr. Chairman. I am curious
about this question--the degree to which financial institution
over-leveraging and the ability of those companies to create an
infinite number of financial products to affect their own needs
should best be dealt with through the code, or best dealt with,
as Mr. Desai said, through the regulatory regime. Or, is there
some combination--are there some areas where maybe a tax change
to the tax code is better? There is some general feeling
lowering the rate, and trying to flatten the corporate tax code
a little bit helps.
I only have three minutes. I would like to throw in the
implication of pass-throughs, the rise of pass-throughs. What
effect does the rise of pass-throughs have? I will see a little
bit of difference between you, Mr. Johnson, and Mr. Desai and
Mr. Fleischer. But if you could--the three of you--just briefly
comment on that basic question. Which is more important, and
what about pass-throughs?
Mr. FLEISCHER. So, on the question of whether we should try
and address excessive leverage through the tax code or through
regulatory responses, the answer is yes to both.
On the tax side, I think what is important is to remove the
extra incentive to borrow. I don't think we should use the tax
system to try and solve all of our issues in the bank
regulatory area. The critical thing on the tax side is to try
and make it more neutral.
On pass-throughs, I think the development of pass-
throughs--it used to be that when you think of a partnership,
you think of a small business. Now we see very large companies,
including large financial institutions like hedge funds that
are organized as partnerships. To me, that shows they are very
sensitive to tax distortions, and will do--will go to great
lengths to try and avoid the corporate tax.
Chairman BAUCUS. So what is the solution?
Mr. FLEISCHER. Well, as I said, I think the short-term
solution, if you want something in the short run, would be to
limit or cap the deductibility of interest by financial
institutions, based on a leverage ratio. And I could talk more
about comprehensive tax reform, but in the short run--
Chairman BAUCUS. Okay, thank you. Mr. Desai?
Mr. DESAI. So, you know, just briefly, to outline what the
possibilities are, I think--within the tax policy realm I think
there are several variants.
One is what would be called a financial transaction tax,
which would be akin to kind of throwing sand in the wheels of
financial markets, for the purpose of kind of disrupting
excessive levels of transactions.
The second type would be financial activities taxes, where,
you know, broadly, anybody involved in finance has a specific
kind of tax.
One could have a too-big-to-fail kind of tax, which is if
your assets are above some threshold level, then you have
potentially to pay an extra tax.
You know, roughly speaking, I think that is the variance
that one can have. And then, of course, one can limit interest
deductibility.
So, you know, I think the first thing to realize is
financial institutions are highly specialized. And
understanding them is extremely difficult. And in situations
like that, regulatory apparatuses are best used. That doesn't
mean that we succeeded in the past, but it also doesn't mean
that we should try a tax instrument in a very complex setting
with highly responsive taxpayers and a lot of institutional
detail.
So, that is why I am very skeptical about tax instruments
to address financial leverage. Not because it is not a problem,
but because I think there are better ways to do it. And I
understand there has been a failure to do it, but there is
little evidence that--in my mind--that these kinds of taxes are
little more than kind of a representation of the vengeance that
many of us feel--
Chairman BAUCUS. But Mr. Johnson says the financial
planners just plan all around any financial regulations that
you come up with. They are so clever--
Mr. DESAI. Well, indeed they are--
Chairman BAUCUS. And they are so driven to try to find a
product that will yield the greatest return.
Mr. DESAI. Indeed they are, and they will do even more so
when one tries to think about a tax instrument. And that just
means that we need to strengthen regulatory approaches, where I
think that specialized knowledge exists, where we can actually
govern them in a much more thoughtful way than through the tax
system.
And finally, I will just say that it is useful to remember
that a lot of the leverage was hidden, right? So let's think
about Lehman Brothers. I don't think anybody knew how levered
they were. And that is a part of this crisis, which is there
was behavior that was even beyond the realm that you might have
imagined.
Chairman BAUCUS. Mr. Johnson, your thoughts?
Mr. JOHNSON. Whether you like it or not, Senator, the Code
impacts the leverage choice these firms make. I think we all
agree with what the JCT staff has determined, that this is a
big bias towards debt, including for the financial sector.
It makes no sense to have regulation and tax code pointing
opposite directions here. I work a great deal on regulation
with regulators, and I am very supportive of what they are
trying to do. But it is not enough. They are all so
constrained, perhaps by their own choice, but they are
constrained by international approach to regulation, including
Basel III on capital, where the Japanese, the Germans, and the
French were the--provided the lowest common denominator. So,
why should we regard that as the last word, as the appropriate
constraint on the extent--excessive leverage?
I agree with Mr. Fleischer. There are many appropriate ways
to tax excessive leverage, including a version of a thin
capitalization tax, which is part of what he discussed. And the
IMF made a very good report to the G-20 on exactly these issues
that I commend to all of you.
Chairman BAUCUS. Thank you very much. Appreciate it. Thank
you, Chairman.
Chairman CAMP. Well, thank you. Mr. Desai, you, in your
testimony, say that a lower corporate tax would alleviate
pressure on the tax bias in favor of debt over equity. Can you
explain how a lower tax rate would address the sort of debt-
equity bias that we have heard about?
Mr. DESAI. Sure. And I think Mr. Barthold made reference to
this as well, which is the most simple version of this is that
that entity-level taxation is part of the problem. And so,
reducing that rate ends up taking away that distortion, to some
degree.
But it kind of goes further than that, insofar as one of
the problems here is not just debt in the aggregate for non-
financial corporations, but the possibility that the corporate
tax base is being eroded in the U.S. by earnings stripping,
which I think is a widespread concern. And there, you know,
lowering statutory rates is a very valuable thing to do,
because it takes out that incentive for relocating profits
outside of the United States.
So, I would say it is at two levels. It is at one level of
the system, which is part of the reason why the system may be
tax biased towards debt, is because of the high corporate tax
rate, the high deduction. And once you take that away, you
reduce that. And second, if we think that earnings stripping
and reallocations of income, which are legitimate concerns
today, given how easy it is to reallocate income, then lowering
the rate has the additional salutary effect of taking away that
incentive.
Chairman CAMP. There seems to be a general consensus that
the federal tax code favors debt over equity for C-corporations
and financial firms. And to the extent that you consider this a
problem, is the solution to change the treatment of equity, or
the treatment of debt? And how would any of those changes to
the treatment of debt and equity affect taxpayers that take
advantage of the current debt bias?
And if each of you would like to just briefly answer--I
don't know if, Mr. Barthold, you really want to address that--
but why don't we start with Ms. Olson and just quickly go down
the line? And I know time is short.
Ms. OLSON. I think you can go either direction. I mean I
think right now we have a little bit too much of a bias towards
debt and against equity. And so I think you can go in either
direction. You could go in the direction of reducing the double
tax on corporate income, or you could go in the direction of
some restrictions on interest.
I think if you go in the direction of some restrictions on
interest, you need to first think about significantly reducing
the corporate rate, and you need to think about transition,
because there are capital structures in place that would be
significantly affected by that kind of a change.
Chairman CAMP. All right. Mr. Fleischer?
Mr. FLEISCHER. I largely agree with that. My preference
would be to limit the--on the interest side, to limit interest
deductions. And the big benefit there is that you could reduce
corporate tax rates, which reduces all sorts of distortions and
incentives to tax planning. Thank you.
Mr. DESAI. Just briefly I would say that, you know, I think
this is an opportunity that one shouldn't squander, and there
is the possibility of more comprehensive approaches. Mr. Rangel
has put forward things, other folks have put forward things,
and I think that is a very useful opportunity.
So, to try to fix this on the margin is not as advisable as
something like the comprehensive business income tax, which I
think would be very useful.
Chairman CAMP. Thank you. Mr. Johnson?
Mr. JOHNSON. My suggestion for the non-financial sector is
to have an allowance for corporate equity, where you are
allowed to deduct some of the dividends payments, based on an
assessment of what is the normal rate of return on capital.
But for the financial sector, I think you have to go
further. For the financial sector, I am proposing that you tax
excessive leverage, because that is what generates the big
negative--now, it is a form of pollution, a very bad form of
pollution that doesn't hit you every year. But every 5 to 10
years you are going to have some very nasty consequence to
this. And you should take that revenue and use that as general
revenue, and use that to reduce tax rates on other parts of the
economy. Because it is those parts of the economy that are
going to be hit very hard when the banks go bad again.
Chairman CAMP. All right, thank you. Chairman Baucus?
Chairman BAUCUS. Thank you. We will experiment with this
new regime here. Under Senate rules, we go according to a first
come first served, early bird system. And the earliest bird
that arrived from the Senate was Senator Hatch. You are next.
Senator HATCH. Well, thank you. Thank you, Mr. Chairman,
and both of you.
Professor Desai, this is a question for you. And I would
like it also to be answered by Ms. Olson and Mr. Barthold, if
they could weigh in briefly on this question, as well.
Professor Desai, in your written testimony you said that
``the current corporate tax system has the worst of all worlds:
high statutory rates and low average rates.'' Could you please
explain that a little bit more?
For instance, if--say the average rate is 17.5 percent, and
say that the statutory rate is 35 percent, and the ratio of
average rate to statutory rate would be 1 to 2, as I see it. Do
you think there is some ideal ratio--one to one, maybe? Or
would it actually be ideal to have a statutory rate somewhat
lower than the average rate, if that could be accomplished?
And if you would, go weigh in on that and then, after that,
Ms. Olson and Mr. Barthold.
Mr. DESAI. So, I guess what I was trying to get at there is
a few things. The first is the statutory rate is high. And by
``high,'' I mean by global standards the statutory rate is
high.
When I said it was the worst of all worlds, if one is going
to have a high statutory rate, one would like lots of revenue,
presumably, or at least there would be some benefit that would
come from that. And we are living in a world where we are not
getting that.
So, we have highly responsive taxpayers, we have very high
statutory rates, which, on the margin, is distorting
incentives, as we know marginal rates will do. And we are not
collecting very much.
So, the promise of tax reform, of course, that other
countries have embarked on and that I hope you embark on, is
lower rates, broader base, and bringing together statutory and
average rates in a way that is much more consistent with
economic efficiency and, I should mention, is also more
consistent with political viability. The corporate tax is now
viewed--I think widely by the American people--as something
that is not paid at all. And it discredits the overall tax
system and, I think, has a wide series of repercussions. So,
bringing those two back in line is, I think, a very worthy
goal.
Senator HATCH. Thank you. Ms. Olson?
Ms. OLSON. I agree with Mr. Desai's comments. I do think
that it would be much better if we had a lower statutory rate,
and if we did some things to broaden the base, which would have
the effect of increasing the effective rate, or bringing the
effective tax rate closer to the statutory rate.
The differences now, I think, of the ways in which the tax
code directs resources, as opposed to resources being directed
on the basis of what produces the best pre-tax return. And we
will maximize national income, and therefore, economic growth,
if we remove some of those distortions.
Mr. BARTHOLD. Senator Hatch, I will probably just re-
emphasize a point that Mihir Desai made. When we are looking at
the statutory rate, we are usually thinking of it as the
marginal tax rate that applies, and economists emphasize the
importance of marginal tax rates. Because, at the margin, that
influences the next investment that will be made, or the next
financing choice that will be made.
And so, high marginal tax rates tend to distort choice.
They could promote more debt than equity. They could promote
tax shelter behavior. They can reduce incentives to invest,
which reduces incentives for future growth. And so, that is why
economists generally are always in favor of lower marginal tax
rates. As to an optimal ratio of marginal to average, remember
that average also reflects a number of other policy concerns
that Members may have in the design of the tax code. And so,
the optimality of that is your decision.
Senator HATCH. Well, thank you. My time is up, Mr.
Chairman.
Chairman CAMP. Mr. Levin is recognized for three minutes.
Mr. LEVIN. Thank you, Mr. Chairman. Now, this has been, I
think, interesting and, I hope, helpful. I do think that the
complexities emphasize that as we approach these issues we kind
of need to leave ideology at the door, and try to dig into
these issues.
In a sense, it is easy to say lower the rates and broaden
the base. The problem is when we start talking about how you
broaden the base. And that is not at all easy. We have held
hearings, for example, on transfer pricing. And it is not easy.
We have held hearings on tax havens. And there is often
disagreement about that.
By the way, let me just say quickly on the mortgage
interest deduction--some of you have mentioned it--I just urge
that we be careful about our proposals. That--because that is
one way to kind of lower the rate, but the impact, when you
look at the distributional analysis of mortgage interest, it
has been very much a middle-income tax provision. And I think
most of us have to ask where we would be if it hadn't been in
existence the last 40 years. And there are some problems of
excess, but I think we have to be careful about not throwing
out the baby with the bath water.
So let me, on corporate, ask each of you just directly--
some of you have already expressed yourselves--do each of you
favor taxation of excessive leverage in the corporate sector?
Yes or no, or however you would like to modify that.
Ms. Olson, let's start with you. I won't ask Mr. Barthold.
Ms. OLSON. I would go in the direction of eliminating some
of the bias between debt and equity. I don't think I would
think that it would be a great idea to tax excessive leverage,
because I am not sure how we would define it, or how we would
apply it. I had some experience with Section 163(j) proposals
when I was at the Treasury Department. We made an effort to try
to cap interest deductions, and it didn't turn out very well.
Mr. LEVIN. All right. Mr. Fleischer, there are just 20
seconds left, I see here.
Mr. FLEISCHER. I favor removing the tax incentives to be
excessively levered. Going beyond that, you have to proceed
carefully. If you want to impose a kind of penalty tax on
excessive leverage, I might support that. But you would have to
be careful in the design.
Mr. LEVIN. Mr. Desai?
Mr. DESAI. No on very targeted things towards excessive
leverage.
And on your point about revenue, you are absolutely right
on broadening the base. There are two solutions in my
testimony. One is the non-corporate business income, which has
grown enormously, and then the second is the gap between book
and tax income, which also, I think, can generate some revenue.
Mr. LEVIN. Mr. Johnson, I think you have already spoken,
so--
Mr. JOHNSON. But if I could just add, the tax on excessive
leverage is where European Union is heading, including the UK.
London is our major competitor, vis-a-vis New York. So we are
behind the curve on taxing excessive leverage, compared to
major comparative countries.
Mr. LEVIN. Thank you. Thank you, Mr. Chairman.
Chairman BAUCUS. Okay. Next is Senator Wyden.
Senator WYDEN. Thank you, Mr. Chairman. And, Chairman
Baucus and Chairman Camp, let me thank you both for your
bipartisan leadership in putting together this important
hearing.
I believe that tax reform is now the major unused tool in
the economic recovery toolshed. The Federal Reserve has cut
interest rates repeatedly. The Economic Recovery Act was
passed. Numerous initiatives are in place to help hard-hit
homeowners. But bipartisan tax reform is now sitting, in effect
ready, in the economic recovery toolshed. And I hope, as we
consider this, we know that a variety of factors go into job
creation, but the last time there was bipartisan tax reform,
our country created 6.3 million new jobs in the 2 years after
it was passed.
Now, on the debt equity issue specifically, Mr. Barthold, a
question for you. Senator Coats of Indiana and I put in, as
part of our broad tax reform, an idea that suggests that one
way to make the tax code less tilted towards debt finance is to
disallow a portion of the deduction for interest cost that is
attributable to inflation. That would make the interest on debt
a bit less deductible and, in turn, would make equity finance a
bit more attractive.
Now, you all scored that, as part of our proposal, as
raising $163 billion over 10 years. My question is--and see if
we can put this into English--Mr. Barthold, wouldn't that mean
that if you had broad tax reform, and you had that one feature
in it, that means you would have that substantial sum--$163
billion--so you could cut rates for middle class folks, focus
on creating jobs in our country, pay down the deficit? Isn't
that what that score really means?
Mr. BARTHOLD. Senator Wyden, yes, sir. I mean our estimate
was you had a proposal that would limit interest deductibility,
and you chose to do that by measuring the inflation component
annually.
As we noted in our report, there is a substantial amount of
interest expense claimed annually by business. And so, a
reduction in the deductibility of that is a substantial base-
broadener, given the existing--the rest of the Internal Revenue
Code.
Senator WYDEN. Thank you, and thank you for your
professionalism always, for all the Members on both sides of
the aisle.
Question for you, Mr. Fleischer, and we appreciate your
involvement in this, as well. Jane Gravelle, of the
Congressional Research Service, has found that in recent years,
over the life of a loan, about half the value of the interest
deduction is now inflation. Isn't that another argument for
limiting the deduction to its non-inflation component?
Mr. FLEISCHER. I think it is. I think there are different
ways to limit interest deductibility, and I think you want to
think about inflation as one possibility. My own personal
opinion would be for something closer to comprehensive business
income tax, which I think would actually be simpler, along
those lines. But yes, you are right.
Senator WYDEN. Thank you, Mr. Chairman. My time is up.
Chairman CAMP. Thank you. Mr. Herger is recognized for
three minutes.
Mr. HERGER. Thank you, Mr. Chairman. Several of you
mentioned in your testimony that the tax code's bias towards
debt investment may encourage some businesses to take on an
excessively risky amount of debt, increasing the risk of
bankruptcy and the associated cost to society. Among the most
serious of these consequences is a loss of jobs, resulting from
major bankruptcies.
Since one of the most important issues facing Congress is
the urgent need to create jobs, could you--maybe beginning with
you, Mr. Fleischer--comment on whether reforming the tax
treatment of debt and equity might help to create a better
foundation for stable job growth?
Mr. FLEISCHER. I do think it would, and I think you will
probably find some unanimity from the panel. The more simple,
efficient, fair our corporate tax system is, the easier it is
for businesses to make planning decisions, including hiring
workers, going forward.
Mr. HERGER. Thank you. Mr. Desai?
Mr. DESAI. So, just two quick thoughts. You know, the first
is, as I mentioned in my written testimony, it is remarkable
that we have not had more corporate bankruptcies, given the
nature of the credit crisis. And I think that is because the
non-financial corporate sector is under-levered, relative to
historic standards, and we should be happy and grateful for
that nice outcome.
Would it have a salutary effect for kind of--if we kind of
made debt not deductible? The one thing one has to keep in mind
is that the cost of capital would rise, as a consequence of
that.
So, some of the social spillover effects of bankruptcies
that you are worried about would certainly be a benefit. The
cost of capital would likely rise, as a consequence of that.
And that would have some potentially offsetting effects, as
well. So, I am not so sure it is quite easily a job-winner.
Mr. HERGER. Mr. Johnson?
Mr. JOHNSON. As long as we are putting this in the context
of medium-term fiscal consolidation--so, over a 5 to 10-year
horizon, until the financial markets believe you have credible
plans for bringing down the deficit, controlling the deficit,
and preferably bringing down the debt, then yes, I think that
there is ample scope for measures that would encourage short-
term job creation.
But I would strongly caution against focusing only on that.
Experience in Europe, including in the last days and weeks,
tells you that countries that previously thought that they had
an impeccable credit rating can come under market pressure much
more quickly. So, please, whatever you do, put it in the
framework of medium-term, credible, committed fiscal
consolidation.
Mr. HERGER. Ms. Olson?
Ms. OLSON. I think there is definitely some value in doing
whatever we can to make the tax system more rational. And
something along the lines of what you are talking about might
well move in that direction.
Mr. HERGER. Thank you. Thank you, Mr. Chairman.
Chairman BAUCUS. Okay. Next is Senator Stabenow.
Senator STABENOW. Thank you very much, Mr. Chairman. And,
first, a thank you to you and to Chairman Camp for doing what I
hope will become more than just one meeting. I think this is
really important to do, and congratulations.
As we talk about all of this--and we clearly are having
important hearings and discussions on tax reform, which clearly
needs to happen--and we look at how we need to create tax
fairness for small businesses, as well as large, multinational
businesses, how do we create incentives for investments in
American jobs, and in this global economy, and how do we create
incentives for American families to be able to plan themselves
and achieve important goals for their families like home
ownership which has, of course, been under attack, given what
has happened with the fact that the majority of families think
they were saving through equity in their home, and then we've
seen what is happening in the housing market, and so on. And
so, it has been very difficult, I think, obviously, for
families, on a number of fronts.
But there is another area in the code where we encourage
people to save, and that is through the Pension Protection Act
of 2006. And I am wondering, Dr. Desai, if you might respond to
the fact that Congress has allowed firms to auto-enroll
employees into 401(k) plans, but allowing employees to then opt
out if they desire. And the goal was to encourage savings.
However, the Wall Street Journal reported earlier this week
that while more people were now contributing to 401(k) plans,
many of them are making contributions that are actually less
than what they otherwise would be with the typical 3 percent
default.
So, I am wondering if you have suggestions or if any of you
have suggestions on how we can improve this provision to
encourage greater savings as we focus on pensions, which are
another important part of, you know, economic security for
families.
Mr. DESAI. So, Senator Stabenow, I think you are absolutely
right to turn the discussion toward savings, in some sense,
that is underneath it all, one of the most important metrics
that we can measure our success by, especially given the
history of the American citizen over the last several decades
as being a ``dis-saver''.
So--and you are also right to kind of put your finger on
pensions, which are an important piece of the savings picture.
So, just briefly, I think, you know, one of the revolutions
in economics in the last decade or two decades has been about
behavioral biases. And so, when you force people or rather,
when you give them default options that allow them to save
easily, that is an incredibly powerful device, it turns out.
So, I think, in the design of pensions, and in the design
of legislation around pensions, paying attention to default
provisions, and paying attention to making it extremely easy
for a person to save, is a very important part of this.
Of course, one would be remiss without mentioning the
broader point, which is the distortion to saving in the tax
code that is primary is the nature of the income tax. And the
opportunity for fundamental tax reform provides you an even
bigger lever on that than would be otherwise available.
Senator STABENOW. Thank you very much. Thank you, Mr.
Chairman.
Chairman CAMP. Thank you. Mr. Rangel is recognized for
three minutes.
Mr. RANGEL. Thank you, Chairman Camp and Chairman Baucus. I
don't remember the meeting in 1940, but--
[Laughter.]
Mr. RANGEL. But I certainly do welcome this meeting. Not
only do we have Democrats and Republicans looking civil and
acting civil, but we have the House and Senate coming together.
And even though they are close by physically, people don't
recognize how seldom we have a chance to see each other.
This panel is extraordinary. And I think all of us,
especially our chair, is excited about the possibility of tax
reform. And it takes this type of cooperation in order for us
to move forward. And it takes a better understanding of equity
and debt in order to develop a system that is fair and
equitable.
Having said that, there is a big elephant in this room, and
it is called debt ceiling. And until we get that out of the
way, it will be impossible for us to, in a bipartisan way, deal
with this very serious problem that everyone admits is really
dampening our economic growth, by not having a fairer system
with lower corporate rates and closing loopholes.
Having said that, I wonder, Mr. Chairman, whether I would
be out of order if I took advantage of the minds of our great
panel here to ask them, is there anyone here that sees any
connection at all in terms of increasing the debt ceiling, as
we have 17 times to make certain that our great nation pays our
debt, and the solution to the budget problem that we have
which, of course, involves revenue and cut-back in spending?
As economists and people who understand these serious
problems, is there anyone here that sees where there is any
connection between dealing with reduction of our debt and
authorizing the President to increase the debt ceiling? And if
you do, I wish you could share it with me in 30 seconds.
Having seen no response--
Ms. OLSON. Mr. Rangel, I hope that the cooperation you are
seeing here today sets the stage for the debt ceiling
negotiations.
Mr. RANGEL. But you don't see any connection between
increasing the debt ceiling with the President and dealing with
our serious problem with the national debt, do you?
Ms. OLSON. They are all important steps towards getting--
Mr. RANGEL. I know that. God knows every day it is
important. But really, as a professional that has worked with
the Internal Revenue and served presidents in the past, do you
see a connection between the two, except politics, which is not
really why you are here?
Ms. OLSON. I think there are important policies that have
to be addressed. You have got to address them on the spending
side, and you have got to address them on the revenue side. It
is very important for us to get our fiscal house in order
across the board.
Mr. RANGEL. So you do believe that we can hold the question
of debt and spending and revenues with denying the President
the opportunity to pay our debts internationally? You do see a
connection? What Administration did you serve under?
Ms. OLSON. President Bush.
Mr. RANGEL. Oh, okay. I have completed my questions, thank
you.
Chairman CAMP. Thank you, Mr. Rangel.
Chairman BAUCUS. Okay. And I will recognize Senator Nelson
from Florida.
Senator NELSON. I am afraid we are going to fritter away
this opportunity to get tax reform done in this debt ceiling.
But if we had our d'ruthers, the Senate Budget Committee has
come out and said you could do a $4 trillion package and 2
trillion of revenues could come from just eliminating 17
percent of the tax expenditures over the next decade, which
amount to $14 trillion.
So, if you were to whack 17 percent of those tax
expenditures, where would you go first?
Mr. FLEISCHER. So I will start. I have written and
testified previously about some loopholes, some of which might
be characterized as tax expenditures. The carried interest
loophole is the one where I have testified before, and that is
converting--when fund managers convert their labor income into
capital gain.
There are other examples, including the--some of the
treatment of the hybrid instruments that I talked about before
that banks use to exploit the debt equity distinction. So I do
think there is some low-hanging fruit in order to generate
significant revenue.
Mr. DESAI. So just briefly I would say, you know, in
general, in these discussions I am always loathe to
characterize anything as a loophole, because that makes it
sound like it is easy to get rid of. And I think tax
administrators know that there is no free money hanging around
here and we can just snap our fingers and close something and
it will work.
What is at play, of course, are serious policy choices. And
if you want to look at the expenditure side, the tax
expenditure side--you know, I haven't looked at this in the
last week or two, but my understanding, as I recall, is that
the big numbers are going to be on owner-occupied housing,
which is the mortgage interest deduction, and it is going to be
on the preference for employer-provided health insurance.
And as, you know, people have written about, those are both
significant sources of revenue. I think the distortion on
health care choice that's created because the employer
deduction on health insurance is significant, that would be a
place to look. And, you know, of course, housing is hugely
important. But you know, that--I don't think it has to do with
leverage in the financial crisis. But the preference for owner-
occupied housing is another place to look, where you can get
the kind of money that you are talking about.
Mr. JOHNSON. Excessive leverage in the financial sector.
You could be steeply progressive on this. It is the very
biggest banks with their huge debts that pose a
disproportionate risk to the system.
And this is an obvious thing to go after. It is completely
consistent with the broader assessment from the right and from
the left, with regard to the fact that too-big-to-fail has
become a massive government subsidy operation. And while we
have tried to deal with that in various ways, nobody is
impressed. Standard & Poor's just ruled yesterday that they
think the government would still have to come and support major
financial institutions if they fail. That is a systemic risk.
That is pollution. That is a negative externality you should be
taxing on.
Chairman CAMP. Mr. Johnson is recognized.
Mr. JOHNSON of Texas. Thank you, Mr. Chairman. Ms. Olson,
in your testimony you talk about reform alternatives that you
believe could address this bias in the tax code. One of the
reform proposals you mention is the lower corporate tax rate.
In your view, what should that rate be? And how far would that
proposal go toward addressing a bias?
Ms. OLSON. Mr. Johnson, I think that--I am not sure what
the optimal corporate rate is. But I think one of the things we
have to look at is what the rate has fallen to in other
countries around the globe that are major trading partners. And
that would suggest that a rate of somewhere around 25 percent
would be about the top rate. Now, that would include the state
and local rate, which adds about four or five points to the
overall rate. So you've got to take that into account, as well.
I think that companies use leverage for a lot of reasons
besides the interest deduction. In fact, lots of times
companies find that equity capital is less expensive than debt
even taking into account the deduction of interest and the non-
deductibility of dividends.
So, I think that bringing the corporate rate down would go
a long ways towards eliminating the bias that currently exists.
Mr. JOHNSON of Texas. Well, we also eliminate the taxation
of dividends as a measure of improving the system?
Ms. OLSON. I think that there has to be a connection
between the two. And so, to the extent that you have got a high
corporate rate, you need a lower rate on dividends, and vice
versa. If you bring down the corporate rate, you don't need,
perhaps, to reduce the rate on dividends quite as much.
But if you have too high a rate of tax on dividends, you
will give companies a disincentive to pay dividends, and that
has been a problem for us--
Mr. JOHNSON of Texas. Yes, that is kind of double taxation,
isn't it?
Ms. OLSON. Yes.
Mr. JOHNSON of Texas. Okay. Mr. Barthold, the mortgage
interest deduction, did it have a role to play in the tax
underwriting standards? Should we do something about that?
Could you elaborate on what tax incentives could reduce the
cost of renting, as well?
Mr. BARTHOLD. The code currently provides several benefits
for rental housing, to try and increase the supply of rental
housing and reduce rents to moderate to low-income individuals.
There are provisions in Section 42 to provide the low-income
housing tax credit to expand the supply of rental housing to
qualifying lower-income families.
Similarly, under Section 142 of the code, states may issue
tax-exempt bonds to help finance at lower cost multifamily
housing, again, targeted at lower income. So there are
provisions in the Internal Revenue Code to help benefit the
rental market.
But I don't think I am fully addressing your question, sir.
Mr. JOHNSON of Texas. Well, I have kind of run out of time,
so--
Mr. BARTHOLD. Well, the chairman may--since I misspent it,
maybe the chairman will grant an extra 30 seconds?
[Laughter.]
Mr. JOHNSON of Texas. Thank you, Mr. Chairman.
Chairman BAUCUS. Mr. Chairman, we have some votes that are
going to start in the Senate fairly quickly. There are no more
senators at this moment. I think Senator Carper is on his way.
I suggest that you continue on your side. So--well, just
continue on your side. When the vote does occur, the Senate
will cross that bridge when we get there. And when Senator
Carper comes, we can address him, too.
Is he here? Senator Carper? No, he is not here yet. Why
don't you go ahead?
Chairman CAMP. All right, thank you. Mr. Neal is
recognized.
Mr. NEAL. Thank you, Mr. Chairman. And actually, in the
House we have done a pretty good job this year at the Ways and
Means Committee of conducting a lot of hearings, in an effort
to examine how we might revamp the code. But I think that it is
also important to acknowledge today that, unless the
presidential candidates next year take up the issue in earnest,
it is going to be very hard for us, even having accumulated a
great deal of evidence as to how the code might be altered, to,
in fact, make it happen.
And I think insisting that after we come up with competing
products, perhaps, or even one product, that the presidential
candidates address the extensive hearings and evidence that we
have assembled--now, Mr. Barthold has heard this question
before, but I want to go back to it because of the hearings
that the Select Revenue Subcommittee held last year.
One of the witnesses testified at that hearing that
foreign-owned multinationals in the United States have a
competitive advantage over U.S.-based corporations, with
respect to certain U.S. investments. The witness stated,
further, that the tax advantage afforded to inbound investors
arises because of their ability to erode the U.S. tax base
through base erosion payments, such as earnings or interest-
stripping payments.
Maybe we might hear from Professors Fleischer or Desai as
to what your thoughts are on whether foreign-owned U.S.
subsidiary corporations engaged in earnings strippings on their
debt-financed U.S. investments have a competitive advantage
over U.S.-owned corporations. And should some of the tax rules
related to debt financing rules be modified in order to prevent
this competitive disadvantage for U.S.-owned corporations?
Mr. FLEISCHER. I am going to defer to Professor Desai on
that.
Mr. DESAI. So I think there are a few things to say. The
first is it is striking that the profitability of foreign
multinationals in the U.S. is low, relative to American firms.
And one explanation for that is, in fact, lots of earnings
stripping by these foreign firms out of the U.S. base. There
are alternative explanations, which is it is hard to make money
in America versus American multinational firms.
But if, in fact, base erosion is the problem, then you have
to ask the question, are they able to do something that
American firms aren't able to do? And at first approximation, I
would have thought that they are subject to the same
regulations and the same rules that American multinational
firms are.
So I understand the source of the concern, which is very
low profitability of foreign firms in the U.S. And I understand
the possibility that part of what is going on here is they are
stripping all their earnings out. What I am less convinced of
is the degree to which that represents earnings stripping or
something else. And given that they face the same rules, it is
a puzzle why they would be more capable, in some sense, than
American firms.
Mr. NEAL. Professor Fleischer?
Mr. FLEISCHER. Well, just to add that there is two ways to
look at that. One--
Mr. NEAL. Yes, there generally is, in tax policy.
Mr. FLEISCHER. Yes. I think Mihir is right. On the other
hand, it also just shows that American multinationals are also
very good at moving profits offshore through things like
transfer pricing.
Mr. NEAL. Okay.
Chairman CAMP. Thank you, Mr. Neal.
Mr. NEAL. Thank you, Mr. Chairman.
Chairman CAMP. Mr. Tiberi is recognized.
Mr. TIBERI. Thank you, Chairman Camp and Chairman Baucus,
for holding this hearing today. Great panel of witnesses, as
well.
I first want to associate myself with the remarks by Mr.
Levin with respect to the home mortgage interest deduction, and
kind of piggyback on something that Mr. Johnson had said.
In addition, on the rental side, Mr. Barthold, you have
rental owners that have the ability to not only take advantage
of the mortgage interest deduction, but a series of other
deductions that, in theory, would reduce, if taken away, their
ability to keep rents lower, meaning if, through the tax code,
you took away deductions from rental housing owners, they would
have to increase the rent. That is not a question, just a
comment.
The question I have is more on the business side to all of
you. Joint Tax actually came out with a report that stated that
the debt to equity issue concerning the Tax Code's preferential
treatment for financing with debt doesn't really apply to
owners of businesses that are pass-through entities.
As we have heard on this committee, more than half of
American businesses are set up as pass-through entities. The
Administration has suggested switching, or changing the way
that pass-through entities are taxed to the corporate side, tax
them as C-corps, instead. Wouldn't that have a negative effect
on those pass-through entities today, and continue to
exacerbate the debt-to-equity issue through the tax code?
Starting with Joint Tax.
Mr. BARTHOLD. Well, thank you, Mr. Tiberi. I think the main
point that you are raising is that the corporate income tax
itself, at its simplest level, is a tax on the return of income
to the equity owners.
Mr. TIBERI. Right.
Mr. BARTHOLD. And it is an extra tax. We have noted on the
panel the double taxation.
So, if you were to make, by whatever criteria, entities
that are currently pass-through entities subject to a second
level of tax, and the tax were just on the return-to-equity
owners, it would increase the relative burden on equity
returns, and so would favor debt financing by those entities,
just as we argued is the case for a C-corporation.
Mr. TIBERI. That is exactly my question. Ms. Olson?
Ms. OLSON. Yes. I agree with that, and I think it would be
better to move in the opposite direction of integrating the
corporate system with the individual system, rather than to
push pass-throughs into the corporate system.
Mr. TIBERI. Thank you.
Mr. FLEISCHER. So I do want to note there are distortions
from debt versus equity in the pass-through context. In a lot
of partnerships they are very flexible vehicles, from a
structuring perspective. And the interest deductions that you
can generate by financing with debt, those deductions can be
moved around to a large extent to one partner or another,
depending on which partner has the higher tax rate. So it
doesn't always match up with the underlying economics.
So, you know, my preference here would be to move towards a
system where pass-throughs and--where--I should say what are
currently pass-throughs and what are currently C-corps are
treated the same. I think doing that, it removes the penalty of
operating in C-corp form, which, from an economic perspective,
doesn't make much sense to me.
Mr. TIBERI. All right, thanks.
Chairman CAMP. Thank you. Thank you, Mr. Tiberi.
Mr. TIBERI. Thank you.
Chairman CAMP. Mr. Thompson is recognized for three
minutes.
Mr. THOMPSON. Thank you, Mr. Chairman. Thanks for holding
the hearing. And thanks to all of you for being here.
There has been--a number of you have mentioned that--the
need to do the tax reform, and the whole idea of lowering the
rate and broadening the base, which, I assume, suggests that
you believe we should pay for any tax reform that we do. It
should be revenue neutral, is that a good assumption? Start
with Ms. Olson.
Ms. OLSON. I think it is important for the country to size
its budget so that there is a better match-up between revenues
and spending. But I think that we have made an awful lot of
decisions throughout our recent history on the basis of our
revenue constraints, and that has led to some bad policy.
Mr. FLEISCHER. So--
Mr. THOMPSON. Revenue-neutral tax reform?
Mr. FLEISCHER. Yes, revenue-neutral is--
Mr. THOMPSON. If we--because of the time, if you could,
just tell me if revenue-neutral tax reform is the way we should
be going.
Mr. FLEISCHER. I think it is the right starting point.
Mr. THOMPSON. Thank you. The rest of you?
Mr. DESAI. Yes. Yes.
Mr. JOHNSON. I think that is a minimum, Mr. Thompson,
revenue neutrality. However, if you were taking on broader tax
reform, including a switch away from an income tax towards a
VAT-type system, then you have the option of being either
revenue neutral, or raising significant revenue in a way that
is not distorting, and doesn't hurt savings, doesn't hurt
investment.
Mr. THOMPSON. Thank you. I just want to point out that on
lowering the rate and broadening the base on the corporate
stuff, if you do away with all the tax expenditures, it only
gets you to about 28 percent, not the 25.
Ms. Olson, what I have been hearing most about here
recently--and it deals with this debt ceiling debate, and I am
hearing from people all over my district. Yesterday, 100-
percent Vietnam--a disabled Vietnam veteran who says if he
doesn't get his Social Security check he is living in his car.
Farm credit folks were in yesterday, and they finance
everything from grapes to rice to pears to walnuts in my
district. And they tell me that it is going to be devastating
for agriculture, and that we--it will take years, decades, to
recover from the loss of not doing the debt ceiling.
Can you tell us how and what the priority would be for
paying our debts, if we don't pass the debt ceiling?
Ms. OLSON. I am afraid that that is not within my area of
expertise.
Mr. THOMPSON. So it would be--from your experience at
Treasury?
Ms. OLSON. No, my experience at Treasury was all on the tax
collection side, as opposed to paying out.
Mr. THOMPSON. Okay, thank you. Can anyone tell us what the
fiscal impact would be if the debt ceiling is not raised? How
many years would it take for us to recover from the hit, even
if it is just a few days or a week or a month without raising
the debt ceiling? I understand that this is a fiscal
consequence that will haunt us forever. Mr. Johnson?
Mr. JOHNSON. Mr. Thompson, we don't know, exactly. We have
never done it. We shouldn't do it. I hope we don't do it. It
would be very bad for the economy, particularly at this point
in time, for all the reasons that you have enumerated.
Chairman CAMP. All right. Thank you very much. Dr. Boustany
is recognized. And because of the discrepancy in the number of
Members, I will be recognizing two Republicans for one Democrat
at this point. So, Dr. Boustany?
Dr. BOUSTANY. Thank you, Mr. Chairman. Let me first express
my support for moving forward with fundamental tax reform,
rather than trying to do this piecemeal with tax policy
changes, because of the distortions that we will create if we
try to do that.
Ms. Olson, in your testimony you mention the adjustments to
the deductibility of interest expense would need to be
considered in connection with any further moves toward
expensing capital investments. And clearly, in recent years we
have seen a number of efforts and laws enacted to spur economic
activity by increasing accelerated depreciation provisions and
moving toward more generous expensing for certain types of
assets.
And at the same time, we have interest remaining as a
deductible expense. So talk a little bit about the distortions
that could be created. Could we, in effect, see negative
effective tax rates and other types of distortions? I would
like all of you to comment on that. Thank you.
Ms. OLSON. Yes. The short answer to your question is yes,
we would see negative tax rates. You know, I think it is sort
of one thing to do it on a temporary basis, where you are
trying to spur some investment, accelerate some investment. It
probably doesn't have the same impact. But certainly, if you
are going to do expensing on a long-term basis as part of
fundamental tax reform, then you do need to look at interest
expense.
Mr. FLEISCHER. I agree. Any time that you are allowing
borrowing to invest in an investment that is going to throw off
tax-exempt income, you have created an opportunity and an
incentive to engage in tax arbitrage. And as I said in my
testimony, tax lawyers are very clever. And once they spot
these opportunities, they are going to try and design
structures to take the fullest advantage.
Mr. DESAI. I would echo what has been said. It is exactly
the reason why one should move not towards incremental efforts,
but to think about this in a systematic way, precisely so we
avoid these kinds of situations, where you can easily end up
with negative effective tax rates.
Mr. JOHNSON. I agree also.
Dr. BOUSTANY. Thank you. I yield back, Mr. Chairman.
Chairman CAMP. Mr. Buchanan is recognized.
Mr. BUCHANAN. Thank you, Mr. Chairman, for the opportunity
today. And I want to thank all the panelists, as well.
Let me just ask you. We are talking about the debt ceiling,
getting people back to work. In the environment we find
ourselves in today, do you think that raising taxes on
individuals or small businesses makes sense, in terms of what
is going on today? Do any of you feel that that makes some
sense as a policy decision, here in Washington? Ms. Olson, I
will start with you.
Ms. OLSON. Well, certainly on a near-term basis, I think we
need to be very careful with anything we do that would raise
taxes. I think one of the most important things we can do for
the country is to get things set so that, for the long term, we
know where we are going to stand. Because I think what we
learned in 2001 was that it was the permanent changes that had
the most impact.
Mr. BUCHANAN. Yes. Mr. Desai, because I'm short on time.
Mr. DESAI. Just briefly, I--
Mr. BUCHANAN. I am talking about individuals and small
businesses. Does it make any sense in the near future to raise
taxes on individuals or small businesses?
Mr. DESAI. To the degree that we want to take a shot at
actually fixing our structural problems, then we are going to
have to raise taxes on someone.
Mr. BUCHANAN. Okay.
Mr. DESAI. At some point. Clearly, there are short-run
consequences of doing it right now.
Mr. BUCHANAN. Now, let me go to the other issue that we are
talking about, debt and equity. And I have had the good fortune
to have been in business for 30 years, and have been involved
in a lot of leverage transactions.
But you look at the 1980s, what happened? I remember the
``predators balls''--that happened with Milken and all those in
the 1980s, and we ended up--in 1990, 1991--with S&L bank
crises. Now we move forward, we find ourselves in this
scenario, of having a lot of leverage.
But at the end of the day, what I find, if you don't have
viable financial institutions, is that you put everything at
risk. And what is happening--at least in Florida; I am sure
around the country is that a lot of these banks that are
leveraged 10 to 1, because they have been taking such a hit to
their equity, they have had to shrink all the banks.
So, not only do you affect the companies that are trying to
create jobs, but you affect a lot of good companies, where they
come in, they scoop all their equity. And that is why it is so
critical, in my experience, that you have sound financial
institutions. And if you go back 100 years, we get in this trap
every 10 or 15 years.
So, Mr. Johnson, do you agree that we have to take a look
at the viability, long-term, of financial institutions, as it
relates to small businesses especially? It is nice to talk
about equity, but it is hard to get equity for small business.
And those are job creators.
Mr. JOHNSON. Absolutely, Mr. Buchanan. If you go back to
when we had a real free market system around finance in this
country, more than 100 years ago, before deposit insurance,
before the Federal Reserve was created, banks at that time
routinely had 30 percent equity. No risk adjustment in that
calculation. Thirty percent equity, relative to their total
assets. And they had big buffers against losses. And when you
had a downturn, they didn't have to cancel all their other
loans, all their good loans. They didn't squeeze out the small
businesses.
We cannot go back to a system without deposit insurance,
unfortunately. We have to recognize that regulation has
encouraged and allowed banks to have too little capital for too
long. If we are going to have big shocks in our economy, going
forward, you need to be discouraging debt and encouraging
equity in the heart of the financial--including big banks and
small community banks.
Chairman CAMP. Thank you, Mr. Buchanan. Mr. Larsen is
recognized for three minutes.
Mr. LARSEN. Thank you, Chairman Camp and Chairman Baucus,
for being a part of this historic hearing. And this comes at a
historic time for the nation.
I would like to know the opinion--we have received letters
from more than 400 CEOs about the pending potential of default
on the--our--the nation's debt. The CEOs, in their letter,
outline--they say that even a technical--technical--default in
this case would have catastrophic events. In 1979 this
happened, even under the well intentions of Congress. It was
late, resulting in interest rates that plagued the country for
the next 10 years.
Given what is happening around the globe as we speak,
what--Moody's downgrading of Ireland again today--what is your
advice to the Congress in terms of acting, given the deadlines
that Treasury Secretary Geithner has outlined?
Mr. JOHNSON. My advice, sir, would be simple, the same
advice as Christine Legarde, the new director of the IMF, has
given to the United States, which is you need to extend the
debt ceiling. You cannot play games with something this
serious. World financial markets are much more fragile than you
might like to believe.
Mr. LARSEN. Mr. Desai?
Mr. DESAI. I would echo that. I think what is worth
considering is exactly why. And one piece of that is the
technical default, which is, you know, people may stop
receiving their payments, which is extremely problematic.
But it can also become a broader manifestation of a system
that appears broken to the rest of the world. And that is where
we run into really significant problems. So, I am less--you
know, have less of a position on exactly how we fix that, but I
think it is very important that this particular deadline is not
ignored, and taken--
Mr. LARSEN. With regard to the deadline, if I might just
follow up quickly here, before the others respond, is this not
the equivalent of knowing about Lehman Brothers? With all the
other nations that we see in jeopardy, and knowing what we
know, isn't it essential that we act now?
Mr. DESAI. It is essential that we act now. I would caution
us to use parallels to private sector actors, only because the
government is very special. And--
Mr. LARSEN. Point well taken.
Mr. DESAI. And--but I take your point that it is a very
serious issue.
Mr. JOHNSON. I would use the Lehman example. Frankly, the
situation in Europe right now is very bad. It is getting worse.
The eurozone does not have control over the situation in Italy,
in Spain, much more broadly. It is absolutely essential that
the United States remain a beacon of safety and clarity to
international investors. Otherwise, there will be consequences
for all of us around the world.
Mr. LARSEN. Would you say what is at stake is the United
States's reputation as a governing entity, both globally and
domestically?
Mr. JOHNSON. Yes.
Chairman CAMP. Thank you very much. Mr. Smith is
recognized.
Mr. SMITH. Thank you, Chairman Camp, Chairman Baucus, for
holding this hearing today. We have heard a little bit about
home mortgages and home ownership being a priority in our
society, and certainly in the tax code. Could you, starting
with Mr. Fleischer, reflect on the effectiveness of the
mortgage interest deduction? How effective has that been, and
are there any alternatives that you might propose?
Mr. FLEISCHER. Well, I think it has had an impact in
putting more people into houses. And, from that perspective,
that is good. But if you were to take a step back, and try and
think about designing housing policy, it is hard to conceive
that using an interest deduction, a mortgage interest
deduction, would be the right way to accomplish that goal,
particularly one that is not capped at a certain number.
So, for example, allowing it at all on second homes or on
super-expensive homes doesn't make a whole lot of sense to me,
if the goal is to get lower-class and middle-class people into
houses.
Mr. SMITH. And would you propose an alternative in our
public policy, in terms of encouraging home ownership?
Mr. FLEISCHER. Sure. I mean I think in the short run,
limiting the mortgage interest deduction would be beneficial in
the short run. In terms of what the other policy goals are, I
guess I am not quite sure what you are getting at.
I think we do have a lot of people in houses, probably more
than we need to, in fact. There are people that do move around
a lot, and would benefit from some sort of equivalent subsidy
to renters.
Mr. SMITH. Okay. Mr. Desai?
Mr. DESAI. You know, so briefly I would just say that there
is a bit of a puzzle which is, given how large this preference
is, it has not been easy to find evidence of its effects on
behavior. So it is a very large preference.
And then, the question we have to ask--is maybe we like it,
and we have to ask why we like it. And I can think of three
reasons we like it. You know, one is we like it because home
ownership is good. It creates good citizens, it creates good
people. And that is just what we believe. The second is that we
believe the construction sector is very important. And we think
that, in a cyclical recovery, it is potentially something that
you want spur. And finally, maybe you think that it is just a
vehicle for savings, and you want to preference it that way.
I think it is important to kind of nail down which of those
we really believe. We have had very high levels of home
ownership. And it is not clear that more home ownership is
good. We should understand that there are chunks of the
population for which renting is a really good thing to do.
Mr. SMITH. Okay. Mr. Johnson?
Mr. JOHNSON. We are not directly encouraging home
ownership. We are encouraging leverage as part of home
ownership. So we are encouraging households to take on these
very large debt burdens. And there are absolutely other ways to
encourage home--if you want to do it revenue-neutral, we could
reduce the mortgage interest deduction and find other ways to
encourage people to buy first homes, for example, if that is
what you wanted to do, if the goal was home ownership.
I think you should be very clear. We encourage households
to take on and believe in an enormous amount of leverage. And I
think, frankly, many of them didn't understand the risks, the
downside risks, that they now see in many parts of the country.
Mr. SMITH. Okay, thank you. I yield back.
Chairman BAUCUS. I will now recognize Senator Carper.
Senator CARPER. Hi, everybody. Up here, on the right.
Chairman BAUCUS. I see you down there.
Senator CARPER. Pretty big room, isn't it? This is bigger
than the Senate, I think. Glad I found it. It is nice to be
here with the chairman of the Ways and Means Committee. How are
things in Detroit? Those Tigers are in first place in the
American League Central, as we go to the all-star break. That
was good to see, and to see another guy from Michigan, Carl
Edwards's big brother. Sandy, nice to--very nice to be with
you.
To our witnesses, thanks very much for joining us in what
is really a unique setting. And it is kind of fun to do this.
One of the main reasons that tax reform has again become
necessary is the proliferation of new tax breaks that we add to
the tax code, it seems like, every year, as well as some of the
increased use of the existing tax expenditures by taxpayers. I
am told if you add up the cost of these tax expenditures, the
total comes over the next 10 years to something like $15
trillion over the next decade. It is more than the Federal
Government will spend on Social Security or, I believe, on
national defense. No small amount of money.
Some of these tax incentives are for individuals. Some are
for corporations. And some are pretty good policy. Others, less
so. Many--I guess it probably just depends on where you sit, as
to whether or not they make good policy sense. But many tax
preferences are inefficiently designed. Some lose more revenue
than is necessary and don't deliver benefits to the taxpayers
who, arguably, need them the most.
And with those thoughts in mind, tax treatment of debt
versus equity is certainly something that needs to be examined
and, I think, closely. One of the keys to tax reform in 1986,
when I served in the House with some of these fellows here--
including this fellow from Massachusetts, to my right--one of
the keys to reforms that we adopted in 1986 was that Congress,
working with the Reagan administration, partially cleaned up at
least some of the tax preferences, in exchange for lower rates.
I would just like to ask each of our witnesses to take a
couple of seconds and directly and frankly tell our committees
which one policy change--one policy change--would do more than
any other that you can think of to reduce the bias in favor of
debt in the current tax code.
Let me say that again. Just take a couple of seconds and
just tell our committees which one policy change do you think
would do more than anything else you can think of to reduce the
bias in favor of debt in our current tax code. Thanks.
Ms. OLSON. Greater integration of the corporate and
individual tax systems.
Senator CARPER. Say that one more time.
Ms. OLSON. Greater integration of the corporation and
individual tax systems.
Senator CARPER. All right. Thank you.
Mr. FLEISCHER. I agree. I think equalizing the treatment of
debt and equity.
But I will take just a second to add that, you know, 1986
is kind of like the Holy Grail in the tax academy. It was an
amazing achievement that broadened the base and lowered the
rates. And one of the keys to that was sort of not focusing
only on one thing at a time, but focusing on the system as a
whole, and tackling a lot of different tax expenditures at the
same time. I think that that was part of the magic of that
reform.
Senator CARPER. All right, thank you.
Mr. DESAI. One version of the integration proposal would be
the comprehensive business income tax, which--
Senator CARPER. I am sorry, were you saying--
Mr. DESAI. One version of the integration effort would be
the comprehensive business income tax, and I think that is a
very worthwhile way to go.
Senator CARPER. All right, thank you.
Mr. JOHNSON. I suggest that you tax excessive leverage in
the financial sector, and use the proceeds of that to introduce
some deductibility for dividends, therefore equalizing the
treatment of debt and equity.
Senator CARPER. All right. That is an interesting idea.
Thank you. Anybody else?
[No response.]
Senator CARPER. All right. Do--is my time expired? Let me
just ask our chairs.
Chairman CAMP. It has.
Senator CARPER. Yes? Okay. Well, it was great. It was great
while it lasted.
[Laughter.]
Senator CARPER. And it was great to see all of you. Thank
you for those simple, direct answers.
Chairman CAMP. Thank you very much, Senator Carper. Ms.
Jenkins is recognized.
Ms. JENKINS. Thank you, Mr. Chairman, and thank you for
holding this hearing. Thank you all for being here.
In general, since 1945, household debt has steadily
increased. There has been some decrease in the combined
mortgage and consumer debt for households. But the total
combined debt for 2010 is approximately 120 percent of
disposable income. In particular, debt has rapidly increased
since tax reform back in 1986, which eliminated the deduction
for interest on personal credit.
So, my questions for the panel are, is this level of debt
sustainable? Why has household debt increased when no deduction
is available for interest on personal credit? And what is the
appropriate private debt ratio for households, and how long do
you think it will take for us to achieve that? Tom, do you want
to start?
Mr. BARTHOLD. Well, thank you, Ms. Jenkins. You recited the
statistics that we provided to the Members, which I think is--a
first point shows that there is not an obvious link between our
tax policy related to household debt and what has been going on
in the household market.
Also, though, do remember that it is a reasonable and sound
economic matter for households to incur debt. It can be a
matter of when you are young and you are starting out, you
purchase a home. So you carry a large debt load, which you
gradually pay down, as you pay down the mortgage. You may
borrow to purchase automobiles or to furnish the home or to buy
other durable goods. It is part of what--you know, we use the
jargon in the pamphlet that the economists like, of the life
cycle theory of consumption.
So, what that doesn't answer is why has the overall debt
load on households increased. And I don't have a good take on
that. I will defer to my other panelists.
Ms. JENKINS. Ms. Olson?
Ms. OLSON. I think I should defer to the economists down at
the end of the--
Ms. JENKINS. Okay.
Mr. FLEISCHER. I will just add one factor to the mix here,
which is that--which is the housing bubble. So, as real estate
prices were going up, people were able to increase household
debt with larger and larger mortgages to finance current
consumption. I think with the housing bubble burst, I think we
are observing people de-leveraging in significant ways.
Ms. JENKINS. Okay. Mr. Desai?
Mr. DESAI. Well, two things. You know, the first is I think
you are right to put your finger on what is a long-term process
of leverage, and what is going to be a long-term process of de-
leverage, as we move forward. The reasons for it can be
cultural, and they can be economic.
And I think one thing to highlight here, of course, in the
context of the tax code, is the absence of a consumption tax,
or a value-added tax, or the--alternatively, the presence of an
income tax which disfavors saving is a piece of that puzzle.
How much of it is, it is hard to say. But certainly, if we
think about the things that are within our domain and our
ability to control, it is yet another reason to really think
hard about whether the income tax we have now is the right one.
Chairman CAMP. Thank you. Mr. Marchant is recognized.
Mr. MARCHANT. Thank you, Mr. Chairman. Is it fair to say
that the main takeaway from this hearing could be that a way to
bring the equity and debt issue into focus is to devalue the
value of the debt deduction in the code by simplifying the code
and lowering the rate, and making that debt deduction less
valuable?
Also, Mr.--I don't know if Mr. Fleischer or Desai--but I
think one of you said that there were some hybrid debt
instruments that were distorting the system. Could you identify
what those hybrid debt instruments are?
Mr. FLEISCHER. Sure. On the first question, the goal is
neutrality between debt and equity, broadly speaking. And so
you can either do that by limiting interest deductibility, or
what you called lowering the value of that interest deduction,
or you could do it by allowing a deduction for corporate
equity. So, looking at the amount of equity that a firm has,
and allowing them an imputed deduction. Either of those
approaches would achieve tax neutrality.
So, some of the hybrid instruments, I am thinking of
things--they all have trade names that the investment banks
come up with, but I am thinking of things like--Feline Prides
was one of the first, and these are instruments that are part
debt and part equity. And what they do is they get the--on the
balance sheet, or for bank regulatory purposes, they look like
they are equity, but they are deductible. So at one time these
were referred to on Wall Street as tax-deductible preferred
stock.
But, of course, it is not preferred stock. There are
ongoing obligations that the banks have to make to pay to the
people who buy these securities. And so, in the financial
crisis, those--they cannot skip those payments, like you could
with--on stock. So that added to the crisis.
Mr. MARCHANT. Could you limit the tax preference on those
specific instruments without--or would that just--
Mr. FLEISCHER. Well, it is hard, because all you are doing,
then, is kind of moving the line. So there--you can move the
line a little bit, but you are going to see a lot of activity,
then that just shifts to wherever you have moved the line.
Again, tax neutrality would be the better solution.
Mr. MARCHANT. Okay.
Mr. FLEISCHER. And, failing that, a tax on excess leverage
that reduces the value of the interest deduction, I think,
would be a very good short-term solution.
Mr. MARCHANT. Okay. Mr. Desai?
Mr. DESAI. I would just underscore Vic's point about the
futility of line-drawing in the context of managers and
financial engineers, who can capitalize on that kind of line
drawing.
Mr. MARCHANT. Okay.
Chairman CAMP. All right, thank you. Mr. Becerra is
recognized.
Mr. BECERRA. Thank you all for your testimony. And in the
three minutes that I have, let me see if I can focus a bit.
I know we have been talking quite a bit about the treatment
of debt and equity for corporations, how we move forward with
the tax code that tries to reform our system of taxation, and
make us more competitive. But I think most eyes that are
focused on the Congress today, and on Washington, D.C., are
still worried about the debt issues that confront us right now.
Mr. Barthold, perhaps you can give me an answer to this
question. Does increasing the debt ceiling have anything to do
with reducing future spending by the Federal Government?
Mr. BARTHOLD. Well, Mr. Becerra, I am not an expert on the
overall fiscal position of the United States. The members of
Congress vote on outlays and vote on revenues.
Mr. BECERRA. But in terms of future spending, spending next
year, spending in 10 years, if we vote in Congress to increase
the debt ceiling limit today, or before August the 2nd, does
that have anything to do with what we will spend directly in
2020?
Mr. BARTHOLD. Well, sir, as a simple statutory matter, the
two issues are separate.
Mr. BECERRA. Okay. And I know you have had a chance to
speak a bit about this, and I know with the short amount of
time--let me ask Mr. Johnson a question.
Should revenues be part of the debt limit discussion, as we
start to discuss how we move forward in dealing with our
deficits and our national debt? If you want to have an approach
that resolves this issue of our national debt, should revenues
be part of that conversation?
Mr. JOHNSON. In any situation where a fiscal adjustment is
required, such as in the United States today, I would suggest
that you look at both revenue and expenditures. So, yes, I
would definitely include revenues in the discussion.
Mr. BECERRA. And if we are able to resolve these large
deficits and this large national debt in a way that is
comprehensive, long-term, does that help the private sector,
our companies that are trying to do business both here,
domestically, or abroad?
Mr. JOHNSON. Of course. The best thing you could do for the
economic recovery at this point is to have a medium-term fiscal
framework that is completely credible, people understand that
the debt is on a sustainable trajectory. That will bring down
long-term interest rates. That will encourage investment. That
will boost job growth.
Mr. BECERRA. In the alternative, if we take the country to
the brink and say August the 2nd we don't have any solution or
resolution to the debt ceiling issue, what happens in the eyes
of the business community?
Mr. JOHNSON. We don't know what happens, but we don't want
to find out. Other countries that have tried to play these
kinds of games with the financial markets usually end up being
burned. The limited experience we had in the 1970s with the so-
called technical default was it had an impact on base interest
rates for a prolonged period of time. Why would you want to
take that risk?
Chairman CAMP. Thank you. Mr. Berg is recognized.
Mr. BERG. Mr. Chairman, thank you. You know, obviously, I
have been sitting here listening to a lot of analogies. One of
the analogies is between personal household debt and the
Federal Government debt.
And to me, maybe I look at it too simplistically. I think
there is an analogy. People loaded up on residential debt
because they need money. Inflation was driving values up, and
people were able to make that leveraged investment and get a
higher return. I think our U.S. debt has soared out of control
because it has been too easy to simply borrow the money and not
make some of the difficult decisions that need to be made.
I truly think that if we don't take this issue seriously,
and we don't look long-term and have a serious discussion about
how to rebalance and get our country back on track, I think the
private sector and financial markets will say, ``Hey,
Washington still does not get it. They are just going along.''
You know, the fundamental question that we have got here, I
think is, what is the impact of interest deductions? And,
obviously, as we looked at this trend over the last 20-plus
years, it hasn't had that big an impact. Although, in my sense
of things, it is changing business decisions.
So, I have two questions. One question, are we clear that
the deduction on interest is really not the right incentive, as
we move forward? And if it were a revenue-neutral situation,
what would you do with those tax dollars in another way? Would
you just reduce, for example, the corporate rate? Would you
eliminate the interest deduction and focus on the corporate
rate? Or, what would you do with those dollars?
So--you look deep in thought, Tom, so we should start with
you.
Mr. BARTHOLD. Well, I think you have asked the broad
question of how to undertake major tax reform. I mean you could
undertake a tax reform, and maintain deductibility of interest.
You could undertake tax reform. You could create new
preferences for equity. You could, as Ms. Olson has suggested,
and Mihir Desai, integrate corporate tax with the individual
tax, and change overall incentives. But that is--I mean, I
assume that is part of the purpose of this hearing.
Mr. BERG. Well, maybe I asked too many questions. The first
question is, should we keep the interest deduction, in your
opinion on this panel?
And if we didn't have an interest deduction, would you be
here advocating that we put one in?
Mr. BARTHOLD. Well, you know, sir, that I don't advocate
before the committees, I work for the committees. So I will
defer to my colleagues on the panel.
Ms. OLSON. There are certainly good arguments for limiting
the interest deduction. But you can't, in my view, limit the
interest deductions without taking into account a lot of ripple
effects. I think that the interest deduction affects financing
decisions. I don't think it dictates them. I think we make a
mistake any time we think that the tax rules are the things
that ultimately decide what people do. They have an impact on
them.
And if we are going to limit interest deductions, then we
have got to do it on a comprehensive basis. We ought to take a
comprehensive look, and we have got to think about transition.
Things like the comprehensive business income tax set up a
system that is more like the treatment of equity. So you
wouldn't have a deduction for interest on the business side,
but on the recipient side, it wouldn't be taxable income. So
you shift things around, much along the lines of the way
consumption taxes operate.
Chairman CAMP. All right, thank you. Mr. Kind is
recognized.
Mr. KIND. Thank you, Mr. Chairman. I want to thank our
panelists today, an excellent panel. And, Mr. Chairman, I want
to thank you and Chairman Baucus for this format. I think this
is very helpful. I think it makes sense for us to, hopefully in
the future, have more joint hearings like this, so that we can
better coordinate the action in the House and the Senate,
especially over something as important and crucial as
comprehensive tax reform.
Mr. Johnson, let me start with you. I mean you have been an
advocate for some time about taxing excessive leverage right
now. But you had admitted earlier in your testimony in the
Lehman case, and coming out of the financial crisis, that it
was often difficult to be able to identify what excessive
leverage looked like at the time.
Have we made improvements, in regards to--with the passage
of Dodd-Frank or other steps coming out of the financial
crisis--of having a better ability of identifying excessive
leverage when it existed, as opposed to a retrospective look-
back, and then identifying it?
Mr. JOHNSON. It was Mr. Desai who made the point about
Lehman's leverage.
Look, the New York Fed and the SEC were living at Lehman
for the last six months. I think they knew what the leverage
was, and I am sure they could have told you what the excessive
leverage was, if that was the framework. But, more broadly,
taking on the--I think the spirit of your question, which is do
we understand the risks that arise from this kind of leverage,
do we know the damage that can be done, do we know who will be
impacted, all the small businesses and small community banks
will be devastated next time there is a big problem.
Or, if Italy were to run into serious debt problems today,
no, we don't know. The Financial Stability Oversight Council,
which was created for this purpose, as far as we can see from
the outside, does not have a determination on this in any
precise manner. These risks are huge, and they impact the rest
of the economy. And they come directly and immediately from
excessive leverage, particularly in our biggest financial
institutions.
Mr. KIND. Well, let me ask the rest of the panel, maybe
starting with you, Ms. Olson, that, obviously, there are
capital structures that are in place right now, based on the
current tax code as it exists. And we really haven't gotten
into the transition period that we should be considering, when
making these type of changes. But what type of time period do
you think we should realistically be looking at, as far as a
transition pace of tax reform?
Ms. OLSON. Well, that will be determined, at least in part,
by the kind of change that you make, and how--whether it is
very incremental, or whether it is much more comprehensive.
But even incremental change, I think, needs some transition
period of, say, 5 years, 10 years--
Mr. KIND. Well, just the issue that we have been dealing
with mainly today on debt, and the incentives for increased
debt in the tax code today.
Ms. OLSON. Again, I think it would depend on how radical
you want to be in making changes. If the changes are
incremental, then they could be phased in more quickly. But if
they are more radical changes, then you would need a very long
period of time to adjust.
Mr. KIND. Mr. Fleischer, you have an opinion?
Mr. FLEISCHER. I want to go back to the point on excessive
leverage.
Mr. KIND. All right.
Mr. FLEISCHER. It is very difficult to determine even how
much leverage there is, especially once you start thinking
about the embedded leverage in derivatives, and the use of off-
balance-sheet entities.
But the point that I would make is you don't have to get it
exactly right to make things better. Right now, the tax system
is tilted in the wrong direction. And so, any move towards
neutrality is likely to make things much better, rather than
worse.
Mr. KIND. Sure. Mr. Desai?
Chairman CAMP. Quickly, please.
Mr. DESAI. Again, I would echo Pam's comments, that the
scope of the transition has to mirror the scope of the change.
So you can imagine a narrow change that--which I would not
support--but which could be done quickly, or you can imagine a
broader change, which has to embrace the--
Chairman CAMP. thank you.
Mr. KIND. Thank you.
Chairman CAMP. Mr. Reed is recognized.
Mr. REED. Thank you very much, Mr. Chairman. I guess I am
the newest member to the committee, so I get the last question.
I have really enjoyed the testimony--and I find it very
informative--from the panel today. And I do want to focus on
just a very limited area, if we could.
One thing I hear, as I go through my district, from a lot
of younger folks is that the college tuition that they are
facing--and the loan and the debt associated with that tuition
burden--is going through the roof.
I would be interested in anyone from the panel offering
their insight as to whether the subsidies that we provide
through the tax code with the student loan deduction, what
impact, if any, do you see them having in regards to tuition
growth that has clearly been demonstrated over the past few
years?
Mr. JOHNSON. I think you are raising a very important
issue, Mr. Reed, and one that doesn't get enough attention.
Obviously, the issue is what kind of education are you getting
for the money that you are paying, and questions are
increasingly being raised about some parts of the education
sector.
And there are rules in place, as you know. If a
sufficiently high proportion of graduates default on a loan,
then that institution is no longer able to get these kinds of
loans for its applicants. But these rules seem not to be
particularly effective right now.
And perhaps we should consider, on a revenue-neutral basis,
shifting away from this loan structure towards an alternative
way of financing. For example, through using some form of
grants that are based on--also on assessing people's means to
pay for themselves.
Mr. REED. Any other comments from any of the panelist?
Because I am really interested in seeing is the tax code
itself, by allowing the deduction for student loan interest,
encouraging higher tuition costs because of the inflationary
impact of that policy? Does anyone have any counterpoints, or
any other information on that?
Mr. BARTHOLD. Mr. Reed, some people have raised that
possibility, that the incidence--some of the benefit of the
numerous provisions that we have enacted to benefit education
may redound to the providers of education. But the economic
evidence to this point couldn't be described as anything more
than mixed.
Mr. REED. Okay.
Mr. DESAI. I would just echo that, and not just because I
am in the higher education business. But it has been very
difficult to find this out. And, in part, it has to do with the
fact that pricing in higher education is a very curious
practice. And part of what we have seen is increased list
prices, and then lots of discounting with fellowships. So there
is a whole market structure there, which is complicated.
I just want to echo Simon's point, though. A big part of
this concern may be about the heterogeneity in the educational
sector today, which didn't exist 20 years ago, where you have
various different providers providing different kinds of
quality. And that is worth looking at.
Mr. REED. Thank you. My time has expired.
Chairman CAMP. Thank you. Mr. Crowley is recognized.
Mr. CROWLEY. Timing is everything. I am the last man on the
totem pole. But thank you, Mr. Chairman. I appreciate you
holding this hearing, this historic joint hearing between the
House and the Senate on a very important issue of debt in the
tax code.
More pressingly, I think, as has been expressed by many of
my colleagues, we should be talking about the overall issue of
debt.
In three weeks, the U.S. will hit the so-called debt limit,
which is like maxing out on a credit card. But while an
individual with a credit card can stop paying--making future
payments with the card once they hit their limit, the same
can't be said for the U.S. Government.
The spending debt will be financed by debt limit increase--
paying for past obligations, not future spending. For example,
we just can't stop paying out Social Security. We just can't
stop paying out veterans compensation and pensions. We just
can't stop paying out military pay and benefits to our troops
at war.
But if we do not increase the debt limit, that is exactly
what will happen. Funds that were promised--and, in terms of
Social Security, funds that were [sic] even the government's
money, but the people's own money--will not be paid, because we
won't have the funds to do so. Could you imagine if Social
Security checks bounced? It is a real possibility, if Congress
continues to play games on the budget, and if they continue, as
the Senate Republican leader said yesterday, refuse to work
with President Obama on the pressing problems of this country.
The number one job of this Congress should be to create
jobs and get our fiscal house in order, not to play politics
and bow to special interest groups. That is why I salute
President Obama for continually extending his hand in
cooperation and negotiation to work with Congress to ensure we
can meet our obligations of paying out Social Security on
August 3rd, while also working for long-term debt reduction for
our children and our great-grandchildren.
But any debt reduction plan will require a shared
sacrifice. Seniors on Social Security, veterans who rely on
their VA pensions, and the troops in battle should not have to
lose their rightful benefits, while others do not meet that
same sacrifice. And I will oppose a plan that does not involve
shared sacrifice, but makes seniors and veterans and military
families pay the bills created after a decade of fiscal
irresponsibility.
It is amazing that we have people in this room who
supported trillions in tax cuts and two unpaid-for wars, but
now say it is up to veterans and the seniors and the troops to
sacrifice a bit more so millionaires don't have to. This
President is trying to work out returning our country to a
policy of fiscal discipline last seen when President Bill
Clinton was in the office, while ensuring we promote economic
growth and stability. And I urge all of us to focus on this
critical mission, and to stop playing politics and the blame
game.
And with that, I yield back the balance of my time, Mr.
Chairman.
Chairman CAMP. All right. Mr. Paulsen is recognized for
three minutes.
Mr. PAULSEN. Thank you, Mr. Chairman. And I also want to
compliment you for holding the hearing with the Senate, and for
laying the foundation for what we heard from some of our
colleagues and Senator Wyden, in particular, about this being
an important foundation for tax reform for economic growth. And
I think we have heard from our panelists the negative
implications of the preference for debt financing, and ideas
for equalizing the treatment between debt and equity.
And I guess I just want to go back to the design of what
the tax system should look like--what the tax code should look
like, what tax reform should look like--if we are going to
promote economic growth, if we are going to promote jobs. I
mean that should be our number one goal here, I think. Because,
obviously, issues like spending and debt are a big issue. But
we have to increase economic growth.
When you only have 18,000 jobs coming out in the last jobs
report, that is pretty embarrassing. It is embarrassing, when
you think we have got more college graduates probably in
Minnesota than we have jobs coming out nationally.
So, knowing that that's the case, we want a tax code that
is going to promote work, savings, and investment. What should
be the focus on that, in the context of debt and equity? Ms.
Olson?
Ms. OLSON. Well, I think there is a lot of economic
literature that supports the notion of moving in the direction
of a consumption tax. And there are lots of ways to get there.
Something like a comprehensive business income tax would be one
thing that Congress might look at to move in that direction.
Mr. PAULSEN. Yes. Mr. Fleischer, anything to add?
Mr. FLEISCHER. I largely agree with that. I mean I think
the basic principles of what we are aiming for I think a lot of
us agree on, that broad-based lower rates are the place to
start. And to try and reduce the distortions in the code that
lead not only to a reduction in tax revenue, but an incentive
to engage in wasteful tax planning, that from a long-term,
economic perspective, it is not encouraging long-term growth.
Right. And we have had a lot of, I think, comments from the
panelists about lowering the rate, broadening the base. And in
the context of helping small businesses, too, please share if
there is any thoughts on that, because that is a driver of the
economy, is the small business economy.
Mr. DESAI. Right, absolutely. And I think the remarkable
thing, of course, is the level of consensus on what, you know,
tabula rasa, if we started the world, what a good tax code
would look like. And there is a remarkable level of consensus
on that, which is some notion of a consumption tax base,
coupled with progressivity that can be achieved in a variety of
ways.
So, in some sense, that is not the hard part. The hard part
is, you know, where you said--you know, I think sitting where
we sit, I think there is wide consensus about what the code
should look like. But getting there is the harder part.
Mr. PAULSEN. And, Mr. Johnson, before my time runs out?
Mr. JOHNSON. I think you should focus on moving towards a
value-added tax system. And you can make that as progressive or
as not progressive as you want, and you can generate the same
revenue or less revenue or more revenue. There is a variety of
VAT systems around the world.
The U.S. system, taxing income, is always going to get in
the way of your goals. You want to promote work, savings, and
investment. Well, anything that is primarily--or as much income
tax-based in our system is not going to do that. And I think I
would echo--or encourage you to look at the specific proposals
put forward by my colleagues here, and look at other
proposals--for example, that the IMF has available--in terms of
how countries can move and transition smoothly to a VAT system.
Chairman CAMP. All right, thank you.
Mr. PAULSEN. Thank you, Mr. Chairman.
Chairman CAMP. I want to thank our panelists this morning,
all of you, for being here and for participating in the
hearing. I also want to thank Chairman Baucus and the Senate
Finance Committee, as well as their staff, for making this
joint hearing possible.
This hearing is now adjourned.
[Whereupon, at 11:23 a.m., the committees were adjourned.]
[Questions for the Record follow:]
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Sen. Olympia J. Snowe, Statement
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National Association of Home Builders, Statement
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The Center for Fiscal Equity, Statement
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