[Senate Hearing 114-89]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 114-89

                     TAX REFORM, GROWTH, AND EFFICIENCY

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

                                HEARING

                               BEFORE THE

                          COMMITTEE ON FINANCE
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             FIRST SESSION

                               __________

                           FEBRUARY 24, 2015

                               __________


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                          COMMITTEE ON FINANCE

                     ORRIN G. HATCH, Utah, Chairman

CHUCK GRASSLEY, Iowa                 RON WYDEN, Oregon
MIKE CRAPO, Idaho                    CHARLES E. SCHUMER, New York
PAT ROBERTS, Kansas                  DEBBIE STABENOW, Michigan
MICHAEL B. ENZI, Wyoming             MARIA CANTWELL, Washington
JOHN CORNYN, Texas                   BILL NELSON, Florida
JOHN THUNE, South Dakota             ROBERT MENENDEZ, New Jersey
RICHARD BURR, North Carolina         THOMAS R. CARPER, Delaware
JOHNNY ISAKSON, Georgia              BENJAMIN L. CARDIN, Maryland
ROB PORTMAN, Ohio                    SHERROD BROWN, Ohio
PATRICK J. TOOMEY, Pennsylvania      MICHAEL F. BENNET, Colorado
DANIEL COATS, Indiana                ROBERT P. CASEY, Jr., Pennsylvania
DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
TIM SCOTT, South Carolina

                     Chris Campbell, Staff Director

              Joshua Sheinkman, Democratic Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------                              

                           OPENING STATEMENTS

                                                                   Page
Hatch, Hon. Orrin G., a U.S. Senator from Utah, chairman, 
  Committee on Finance...........................................     1
Wyden, Hon. Ron, a U.S. Senator from Oregon......................     2

                               WITNESSES

Boskin, Michael J., Ph.D., Tully M. Friedman professor of 
  economics and Hoover Institution senior fellow, Stanford 
  University, Stanford, CA.......................................     5
Diamond, John W., Ph.D., Edward A. and Hermena Hancock Kelly 
  fellow in public finance, Baker Institute for Public Policy, 
  Rice University, Houston, TX...................................     7
Tyson, Laura D'Andrea, Ph.D., professor of business 
  administration and economics and director, Institute for 
  Business and Social Impact, Haas School of Business, University 
  of California, Berkeley, CA....................................     8
Gravelle, Jane G., Ph.D., Senior Specialist in Economic Policy, 
  Congressional Research Service, Library of Congress, 
  Washington, DC.................................................    11

               ALPHABETICAL LISTING AND APPENDIX MATERIAL

Boskin, Michael J., Ph.D.:
    Testimony....................................................     5
    Prepared statement...........................................    35
    Responses to questions from committee members................    42
Diamond, John W., Ph.D.:
    Testimony....................................................     7
    Prepared statement...........................................    44
    Responses to questions from committee members................    55
Gravelle, Jane G., Ph.D.:
    Testimony....................................................    11
    Prepared statement...........................................    56
    Responses to questions from committee members................    63
Hatch, Hon. Orrin G.:
    Opening statement............................................     1
    Prepared statement...........................................    76
Portman, Hon. Rob:
    ``Valeant-Salix Deal Shows Why Inverted Companies Will Keep 
      Winning,'' by Maureen Farrell, Wall Street Journal, 
      February 23, 2015..........................................    77
Tyson, Laura D'Andrea, Ph.D.:
    Testimony....................................................     8
    Prepared statement...........................................    78
    Responses to questions from committee members................    85
Wyden, Hon. Ron:
    Opening statement............................................     2
    Prepared statement...........................................    87

                             Communication

National Small Business Network..................................    89

                                 (iii)

 
                   TAX REFORM, GROWTH, AND EFFICIENCY

                              ----------                              


                       TUESDAY, FEBRUARY 24, 2015

                                       U.S. Senate,
                                      Committee on Finance,
                                                    Washington, DC.
    The hearing was convened, pursuant to notice, at 10:20 
a.m., in room SD-215, Dirksen Senate Office Building, Hon. 
Orrin G. Hatch (chairman of the committee) presiding.
    Present: Senators Crapo, Thune, Isakson, Portman, Coats, 
Scott, Wyden, Schumer, Cantwell, Bennet, Casey, and Warner.
    Also present: Republican Staff: Mark Prater, Deputy Staff 
Director and Chief Tax Counsel; and Jeff Wrase, Chief 
Economist. Democratic Staff: Ryan Abraham, Senior Tax and 
Energy Counsel; Adam Carasso, Senior Tax and Economic Advisor; 
Michael Evans, Chief General Counsel; and Todd Metcalf, Chief 
Tax Counsel.

 OPENING STATEMENT OF HON. ORRIN G. HATCH, A U.S. SENATOR FROM 
              UTAH, CHAIRMAN, COMMITTEE ON FINANCE

    The Chairman. The committee will come to order. I want to 
welcome everyone to today's hearing to discuss tax reform, 
growth, and efficiency. I also want to thank our witnesses for 
appearing before the committee today.
    Dr. Boskin, we are happy to have you as well. I missed you 
inside, I think. We are really happy to have you here, all of 
you.
    While there are many objectives for tax reform, growth in 
jobs, wages, and the economy, along with improved efficiency of 
resource allocation, rank among the top. Many of us on the 
committee believe that tax reform is no longer optional. 
Rather, it is essential to help get our economy moving again, 
and I believe there is bipartisan agreement on the need for tax 
reform.
    Ranking Member Wyden, for example, has been invested in 
reform for about a decade now. Other members of this committee 
have worked diligently in recent years to examine available 
options and tradeoffs. Our efforts continue with bipartisan 
working groups that we established to engage in studying the 
issues, examining tradeoffs, considering options, and arriving 
at recommendations.
    The Obama administration also remains interested in 
bipartisan efforts to reform the tax code, with particular 
interest in business tax reform. I disagree with most of the 
aggressive, often anti-growth proposals in the President's 
recent budget aimed at significantly higher taxes on capital, 
as well as on savings and investment. Nonetheless, I welcome 
willingness on the part of the administration to engage in 
dialogue about how to reduce tax burdens on American businesses 
of all types, and how to improve the system for working 
American families. And while there is no shortage of interest 
in tax reform, we need to continue to work in a bipartisan way 
toward action.
    Today's hearing will allow us to hear from an expert panel 
of witnesses about their views on how we can reform the tax 
system to promote growth in wages, jobs, and the economy and, 
at the same time, reduce economic inefficiencies.
    Issues surrounding how best to promote the efficient 
allocation and utilization of resources accompany any objective 
for promoting growth. In my view, we should minimize tax 
provisions that stand in the way of efficiently utilizing 
resources. And, while there are many issues surrounding how 
society values resource allocations, there are striking areas 
of our existing tax system that need attention.
    For example, our statutory and effective corporate tax rate 
is far too high relative to our international competitors. This 
impedes the ability of U.S. firms to compete. And there are 
many tax-driven distortions in the tax code, but the list is 
too long for me to cover in the limited time I have available 
in my opening remarks.
    By now I hope that everyone is clear on the principles that 
I believe should guide us as we examine tax reform. Prominent 
among those principles is that tax reform should significantly 
reduce economic distortions that are present under the current 
income tax system and promote growth in our economy.
    I want to ask that each witness on today's panel identify 
in their remarks today what they believe are the most damaging 
aspects of our existing tax system from the perspective of 
growth in the economy and efficient utilization of resources.
    Finally, let me just say that we must always remember that 
tax revenue comes from the economy and not from Congress. Tax 
revenue comes from the hard work of American households and 
businesses and not from bureaucrats in government. Congress 
should act as stewards of the resources it extracts from 
American households and businesses, not as primary claimants on 
those resources.*
---------------------------------------------------------------------------
    * For more information, see also, ``Economic Growth and Tax 
Policy,'' Joint Committee on Taxation staff report, February 20, 2015 
(JCX-47-15), https://www.jct.gov/publications.html?func= 
startdown&id=4736.
---------------------------------------------------------------------------
    [The prepared statement of Chairman Hatch appears in the 
appendix.]
    The Chairman. With that, I am pleased to turn to our 
ranking member, Senator Wyden, for his opening remarks.

             OPENING STATEMENT OF HON. RON WYDEN, 
                   A U.S. SENATOR FROM OREGON

    Senator Wyden. Thank you very much, Mr. Chairman. And, as 
you and I have discussed, there truly is a bipartisan window 
now for tax reform, and I very much look forward to working 
with you.
    For our guests and for all concerned, I think Chairman 
Hatch is absolutely right that right at the heart of this 
debate is reducing the distortions, the economic distortions, 
that are brought about through this economic straightjacket of 
a tax code that we have today.
    Now, 2 weeks ago, the Finance Committee heard from two 
former Senators, a Republican and a Democrat, both architects 
of the 1986 Tax Reform Act, and they discussed an approach to 
tax reform that became law. It turned the impossible into the 
possible, and it was modern, it was targeted, and it found 
smart ways to spark economic growth.
    Among other provisions of that proposal, they gave equal 
tax treatment to income from wages and income from investments. 
That is crucial to middle-class fairness. They preserved and 
expanded important policies that rewarded hard work, helped 
families buy homes, and made it easier to afford college. I 
think it is also important to note that they avoided partisan 
processes, like budget reconciliation, that would put the 
outcome at risk.
    Now everyone here, especially our four guests, has been 
part of umpteen academic conversations about tax reform. Two 
weeks ago, this committee discussed an approach that actually 
worked. So in my view, it makes sense to build on that kind of 
bipartisan wisdom, and we ought to take on the challenge of 
developing a new modern plan that fits today's economy.
    There are a host of examples where our broken tax system 
needs fixing. I just came from three town hall meetings across 
my State, and one of the concerns I hear at every one of these 
community meetings is the skyrocketing cost of childcare. For a 
long time, Americans have looked at mortgages, college tuition, 
and retirement savings as the big ticket expense for most 
families. Parents today say that that list is incomplete 
without considering childcare.
    The programs in the tax code intended to make childcare 
more affordable have not kept up. Too often the benefits do not 
cut it. A lot of families get no assistance at all. For many, 
it is too meager. So a lot of parents across this country have 
a difficult choice. Do they both continue working and take on 
the huge expense of childcare, or will one of them have to 
sacrifice their career and stay home? That is a barrier to work 
that tax reform should pursue in order to make it possible for 
those families to get ahead.
    Just like in 1986, it is time again to give fair treatment 
to wages and wealth. The code punishes middle-class wage 
earners by taxing their income at a higher rate than 
investments. Leveling the playing field is a matter of basic 
fairness. We heard 2 weeks ago that policymakers recognized 
that fact in 1986, and they ought to do it again.
    The tax code also needs to encourage more investment in our 
country. It should do more to drive innovation, support 
manufacturing, and draw high-skill, high-wage jobs to America 
and our communities.
    Today's broken code puts the U.S. at a competitive 
disadvantage in the world, and that too needs to change.
    One last lesson from 1986 to remember: it would be a costly 
mistake for tax reform to heap a heavier burden on the middle 
class. That is a surefire way to slow down growth and set 
middle-class families back. A lot of families who struggle to 
make ends meet find assistance through the tax code. Let us not 
make life harder for them.
    It makes a lot more sense to take the proven, modern 
approach to tax reform, an approach that I would summarize in a 
sentence: let us give everybody in America the chance to get 
ahead. That was what was done in 1986 on a bipartisan basis. 
Let us build on it.
    Thank you, Chairman Hatch.
    The Chairman. Thank you, Senator Wyden.
    [The prepared statement of Senator Wyden appears in the 
appendix.]
    The Chairman. Our first witness is Dr. Michael Boskin. Dr. 
Boskin is the T.M. Friedman professor of economics and senior 
fellow at the Hoover Institution at Stanford University. He is 
also a research associate at the National Bureau of Economic 
Research.
    Dr. Boskin served as Chairman of the President's Council of 
Economic Advisers between 1989 and 1993, where I got acquainted 
with him. He chaired the highly influential Blue Ribbon 
Commission on the Consumer Price Index, whose report has 
transformed the way government statistical agencies around the 
world measure inflation, GDP, and productivity.
    Dr. Boskin received his B.A. with highest honors and the 
Chancellor's Award as outstanding undergraduate in 1967 from 
the University of California at Berkeley, where he also 
received his M.A. and Ph.D. in economics.
    In addition to Stanford and the University of California, 
he has taught at Harvard and Yale. He is the author of more 
than 100 books and articles and is internationally recognized 
for his research on economic growth, tax and budget theory and 
policy, Social Security, U.S. saving and consumption patterns, 
and the implications of changing technology and demography on 
capital labor and product markets.
    We are pleased to have you here today.
    Our next witness after Dr. Boskin will be Dr. John Diamond. 
Dr. Diamond is the Edward A. and Hermena Hancock Kelly fellow 
in public finance at the Baker Institute at Rice University and 
an adjunct professor of economics. He is also the CEO of Tax 
Policy Advisors, LLC.
    Dr. Diamond's research interests include Federal tax and 
expenditure policy, State and local public finance, and the 
construction and simulation of computable general equilibrium 
models. His current research focuses on the economic effects of 
corporate tax reform, the economic and distributional effects 
of fundamental tax reform, portfolio allocation, and various 
other tax policy issues.
    He is co-editor of ``Fundamental Tax Reform: Issues, 
Choices, and Implications,'' issued in 2008 by the MIT Press. 
Dr. Diamond is the forum editor for the National Tax Journal 
and served on the staff of Congress's Joint Committee on 
Taxation between 2000 and 2004. He received his Ph.D. in 
economics from Rice University.
    Our next witness after Dr. Diamond will be Dr. Laura 
D'Andrea Tyson. Dr. Tyson is professor of business 
administration and economics and director of the Institute for 
Business and Social Impact at the Haas School of Business at 
the University of California at Berkeley.
    She served as dean of the London Business School from 2002 
to 2006 and as dean of the Haas School from 1998 to 2001. From 
2011 to 2013, she was a member of President Obama's Council of 
Jobs and Competitiveness. And from 2009 to 2011, she was on the 
President's Economic Recovery Advisory Board.
    She served in the Clinton administration as Chair of the 
Council of Economic Advisers and served as the President's 
National Economic Advisor. Dr. Tyson received her Ph.D. in 
economics from the Massachusetts Institute of Technology.
    Our final witness today will be Dr. Jane Gravelle. Dr. 
Gravelle is a Senior Specialist in Economic Policy in the 
Government and Finance Division of the Congressional Research 
Service of the Library of Congress. She specializes in the 
economics of taxation, with emphasis on effects of tax policies 
on economic growth and resource allocation.
    Her recent papers have addressed fiscal stimulus, tax 
rebates, consumption taxes, dynamic revenue estimating, 
investment subsidies, capital gains taxes, individual 
retirement accounts, estate and gift taxes, charitable 
contributions, tax reform, and corporate taxation. That is a 
mouthful.
    She is also the editor of a biennial congressional 
compendium on tax expenditures. Dr. Gravelle is the author of 
numerous articles in books and professional journals. She is 
the author of ``The Economic Effects of Taxing Income from 
Capital'' and co-editor of the Encyclopedia of Taxation and Tax 
Policy.
    Dr. Gravelle received a B.A. and an M.A. in political 
science from the University of Georgia and a Ph.D. in economics 
from the George Washington University.
    We are honored to have all four of you with us today, and 
we appreciate you taking time from your busy schedules to be 
with us. We look forward to your remarks, and anything that 
will help this committee to do a better job, we are for.
    So thank you for being here. We will start with Dr. Boskin, 
and then we will just go across the board.

   STATEMENT OF MICHAEL J. BOSKIN, Ph.D., TULLY M. FRIEDMAN 
 PROFESSOR OF ECONOMICS AND HOOVER INSTITUTION SENIOR FELLOW, 
               STANFORD UNIVERSITY, STANFORD, CA

    Dr. Boskin. Thank you, Chairman Hatch, Ranking Member 
Wyden, other distinguished members of the committee. It is a 
pleasure to be back before the Finance Committee again.
    My time at the Finance Committee dates all the way back to 
Senator Long as chairman, and I have had the pleasure of 
working with the committee on many issues, including the 1986 
tax reform that Senator Wyden mentioned. I do believe that if 
the stars align and once again you can pull the rabbit out of 
the bag, or do the impossible, a major tax reform has the 
potential to dramatically improve economic performance.
    There are many aspects of the economy and of society that 
reform would affect, but I think its effect on economic growth 
is by far the most important. President Kennedy used to say 
that a rising tide lifts all boats. That is a bit of an 
exaggeration, but it does lift a lot more than any other tide, 
and it leaves far fewer stranded or sunk.
    So in my view, other than our national security, restoring 
a more strongly growing economy is the Nation's most important 
priority. And it will also provide the revenues and the 
resources to supply services to the disadvantaged as needed.
    The country's long-run potential is roughly the sum of its 
growth of the labor force and productivity, and productivity 
has declined substantially in recent years. Part of that is due 
to the recession, but even trying to net that out, economists 
are debating whether the technology that enhances productivity 
is waning and that the current and likely future evolution of 
technology will be not as attuned to increasing productivity 
and generally raising incomes. That is a debate that continues, 
and no one can really know what the next wave of technology 
will be. But the argument is that automobiles, electricity, 
things like that were far more fundamental than social 
networking and nanotechnology are likely to be.
    We will see. But if we do not raise the rate of 
productivity growth, or we do not have a lot more workers than 
currently projected, our long-run fiscal position will be dire 
as the baby boomers continue to retire and the pressures on 
Social Security and Medicare mount. By my calculation, you 
would wind up having to raise the tax rates on middle-class 
families to unprecedented levels of 60 percent perhaps.
    So aside from national security, that is our top priority. 
Taxes affect economic growth through their effect on saving, 
investment, technical change, entrepreneurship, and things of 
that sort. While other policies--regulation, trade, education, 
training, immigration, monetary policies--affect these things, 
tax and spending and, therefore, also debt policy are likely to 
be the most important.
    Especially onerous, especially worrisome, is heavy taxation 
of capital that depresses capital formation, when we look at 
the combination of our corporate tax and the taxation of 
corporate source income at the personal level.
    You can think of a level playing field both sideline to 
sideline, that is among types of investment, and goalpost to 
goalpost, and the purest way to get neutrality in both those 
directions is to have a consumed income tax which could be as 
progressive as desired, but would, by taxing the cash flows of 
businesses, be much simpler than our current system, although 
there would be a difficult transition to it. A large body of 
research suggests that there are very large potential gains 
from such a reform, and, of course, they would be scaled down 
if we only partially improve the system. In his presidential 
address to the American Economic Association, our most 
distinguished macroeconomist, Robert Lucas, estimates that that 
would increase incomes 7.5 to 15 percent every year from the 
phase-in forever.
    Our relatively low national saving and investment rates are 
one of the reasons productivity is down, and one of the reasons 
hiring has lagged until the last several months. This is 
especially onerous because we have large unfunded liabilities 
in our social insurance programs and a rapidly growing debt. 
So, adding the disincentives from heavy capital taxation, we 
wind up having too little saving in investment and future 
growth.
    Our corporate tax system, as Chairman Hatch mentioned, has 
the highest rate in the world of any advanced economy. We also 
do not have a territorial system, instead taxing worldwide 
income, unlike many other countries. Most other of our 
competitors have been reducing their corporate taxes. And 
while, when you look at the effective rate, accounting for 
deductions and credits, we are not nearly as far out of line, 
we still are out of line, especially when you include the 
personal taxes.
    In short, we have a corporate tax system that is more in 
tune with 1965 than 2015. The OECD concludes in an exhaustive 
study that corporate taxes are the most harmful to growth.
    So I think that moving toward a few tax rates with the top 
rate considerably lower than it is now, with a corporate rate 
that is roughly similar, and moving more toward consumed income 
on a broader base with most other preferences removed or 
capped, would be a tremendous improvement to the economy.
    That is not going to be an easy thing to do, as Senator 
Long's famous quip about ``don't tax you, don't tax me, tax the 
fellow behind the tree'' implies. But if you go bold and try to 
do something broad and everybody shares some of the pain and 
gets most of the gain, I think it is doable.
    The evolution of taxes and spending (and therefore also 
debt) will be a primary determinant of whether our economy 
rekindles a successful dynamism and provides rising standards 
of living and upward mobility that it has not provided for some 
time or whether, like Europe, we complacently slide into more 
economic stagnation.
    Thank you.
    The Chairman. Thank you so much.
    [The prepared statement of Dr. Boskin appears in the 
appendix.]
    The Chairman. Dr. Diamond, we will hear your testimony now.

  STATEMENT OF JOHN W. DIAMOND, Ph.D., EDWARD A. AND HERMENA 
  HANCOCK KELLY FELLOW IN PUBLIC FINANCE, BAKER INSTITUTE FOR 
          PUBLIC POLICY, RICE UNIVERSITY, HOUSTON, TX

    Dr. Diamond. Chairman Hatch, Ranking Member Wyden, and 
members of the committee, it is an honor to present my views on 
the importance of tax reform in promoting economic growth.
    Serious consideration should be given to adopting a 
consumption-based reform rather than an income-based reform. 
However, if 
consumption-based tax reform is not feasible, current, personal 
income tax provisions that encourage saving should be 
maintained, but simplified. In addition, we should reduce the 
burden of the corporate income tax on investment income, 
possibly by adopting a cash-flow business tax.
    In my written testimony, I discuss the macroeconomic 
effects of various proposals. In general, the results indicate 
that consumption-based reforms increase economic growth more 
than reforms of the current income tax system.
    However, there are two keys that would lead to increases in 
the growth from base-broadening, rate-reducing income tax 
reforms. First, accelerated depreciation should be retained 
instead of being used as a base-broadening provision. Second, 
even though territorial tax reform is likely to have fairly 
modest growth effects, repealing deferral could lead to 
significant losses in output to the extent it adversely affects 
the competitiveness of U.S. corporations.
    There is a strong case for tax reform. Total revenues are 
projected to increase from 17.6 percent to 19.4 percent by 
2039. The Federal debt is projected to increase from 74 percent 
to 106 percent of GDP over that same period. Whether revenue as 
a share of GDP remains at the projected level or is increased 
as part of a larger fiscal reform, it is imperative that the 
U.S. reform its tax system to reduce economic distortions, 
otherwise the combinations of a rising share of taxes as a 
percentage of GDP and a relatively distortionary tax system 
could significantly hamper economic growth.
    The last major reform was in 1986. Since that time, 
however, many countries have reformed their tax structures. As 
a result, the U.S. now has the highest statutory corporate tax 
rate in the industrialized world.
    Proponents of corporate reform argue that high tax rates 
discourage investment and capital accumulation and, thus, 
reduce productivity and economic growth. In addition, the 
combination of a high statutory tax rate, coupled with a wide 
variety of tax preferences, distorts the allocation of 
investment across asset types and industries and reduces the 
productivity of the Nation's assets. It also exacerbates the 
many efficiencies of the corporate income tax, including 
distortions of business decisions regarding the method of 
finance and organizational form.
    There is also widespread discontent with the individual 
income tax system. High individual income tax rates coupled 
with widespread tax preferences distort decisions regarding 
labor supply, saving, and consumption. They also significantly 
complicate tax administration and compliance, and encourage 
avoidance and evasion.
    These developments have not gone unnoticed, as numerous 
proposals for tax reforms have been put forward. These 
proposals range from base-broadening, rate-reducing reforms to 
various 
consumption-based reforms.
    Studies by the OECD, Alan Viard and myself, and the Joint 
Committee on Taxation show that corporate taxes are most 
harmful to economic growth, followed by individual income 
taxes. Proposals to increase personal exemptions and deductions 
are likely to reduce economic growth. Thus, policymakers should 
adopt a tax system characterized by low capital and labor 
income tax rates and minimal tax expenditures. A sweeping 
reform of the tax system is well overdue. While there are many 
proposals that are worthy of consideration, we must ultimately 
choose just one.
    It is my view that macroeconomic analysis can play a key 
role in offering guidance in that process.
    Thank you.
    The Chairman. Thank you, Dr. Diamond.
    [The prepared statement of Dr. Diamond appears in the 
appendix.]
    The Chairman. Dr. Tyson, it is good to welcome you back.

STATEMENT OF LAURA D'ANDREA TYSON, Ph.D., PROFESSOR OF BUSINESS 
   ADMINISTRATION AND ECONOMICS AND DIRECTOR, INSTITUTE FOR 
BUSINESS AND SOCIAL IMPACT, HAAS SCHOOL OF BUSINESS, UNIVERSITY 
                  OF CALIFORNIA, BERKELEY, CA

    Dr. Tyson. Thank you very much. It is a pleasure to be 
here. Thank you very much, Senator Hatch. And thank you, 
Ranking Member Wyden and other members of the committee.
    I am happy to be here to talk about tax reform, growth, and 
efficiency. As you heard, I am Laura Tyson, and I am a 
professor of business and economics. The views in the testimony 
are my own. It was not mentioned that I do serve as one of two 
economic advisors to the Alliance for Competitive Taxation, 
which is a coalition of American companies that favor 
comprehensive corporate tax reform.
    I feel it is important to note for the record that my views 
here today are my own and also to point out that, as far as the 
coalition is concerned, we do also have Doug Holtz-Eakin, who 
is also serving as an economic advisor. So we give bipartisan 
economic advice.
    My written remarks and my oral remarks focus on corporate 
tax reform, but many of the points have already been made by 
Dr. Diamond and by both Senators, so I will try to keep my 
remarks brief and also to note that, although it is not in my 
written testimony, I certainly do support using the tax system 
to support childcare, education, and savings. Consumption-based 
taxes have been mentioned by the previous speakers, but not 
mentioned is the possibility of using a particular consumption-
based approach, which is a carbon tax. I know when Senator 
Bradley was here last time, he talked about a way to shift the 
tax burden away from things we do not want to tax, like labor, 
to things we do want to tax, like carbon. So that is something 
we might discuss as well.
    As far as my views on corporate tax reform go, first of 
all, as has been noted, the main argument here is that we need 
a significant reduction in our corporate income tax rate. It is 
entirely out of line with rates around the world. Other 
countries have been slashing their rates over the past 30 years 
while we have kept our rate constant. Countries around the 
world use these reductions in rates to make their place, their 
location, an attractive location for investment by their 
companies and by foreign companies.
    Capital has become increasingly mobile. When we set the 
corporate tax rate in 1986, capital was much less mobile. Most 
of the investment was in tangible assets, not intangible 
assets, and most U.S. multinational companies did not face a 
lot of competitors from around the world.
    All that has changed. So the growing gap between the U.S. 
rate and the rates in the rest of the world has implications 
for the competitiveness of the U.S. as a place to do business, 
and the competitiveness of U.S. companies. So I think the pro-
growth and pro-investment rationale for a significant reduction 
in the corporate tax rate is absolutely very clear.
    It is also clear that we should go as far as we can toward 
paying for a corporate tax rate reduction by getting rid of the 
many preferences, credits, loopholes, and special treatments 
that riddle our corporate tax system and create distortions 
that affect economic growth and efficiency. I think there is 
widespread agreement about that. However, as we broaden the 
base to pay for a reduction in the corporate tax rate, we have 
to be mindful of the fact that there are some deductions--and 
John mentioned one of them: accelerated depreciation--which 
economists believe actually enhance new investments.
    So we have to be very careful how we broaden the base so as 
not to discourage the very investment we want to encourage by a 
lower corporate rate.
    The final issue that I think there is agreement on, but 
disagreement about how best to do it, is how to tax the foreign 
earnings of U.S. multinational companies. I have a lot of 
evidence in my written testimony to the effect that U.S. 
multinational companies are a major source of jobs, 
productivity growth, investment, and R&D in the United States. 
They are highly disadvantaged in the current system by the high 
corporate rate and by the U.S. effort to tax their worldwide 
income.
    They have used every single possible mechanism that exists 
in the current code, including deferral, to address the 
competitive disadvantages that come from the high U.S. rate and 
the worldwide U.S. corporate tax system. It is now time, 
though, to change that. My own proposal is based on the notion 
that we have to move to a territorial tax system consistent 
with the practices of our major competitor countries, where the 
major competitors of U.S. multinationals reside.
    We can adopt strict, tough, anti-abuse measures. All of the 
other developed countries with territorial systems have done 
that. They have not moved to a worldwide system. They have 
dealt with profit shifting and income shifting and those kinds 
of concerns by anti-abuse measures, and we should follow their 
lead, and we should work with them in the OECD to develop 
multilateral anti-abuse mechanisms.
    Finally, let me say in passing something I think 
illustrates the different directions that the U.S. might go in 
from the rest of the world, with negative results. The rest of 
the world--look at Europe right now, where almost half of the 
income of U.S. multinationals comes from. Europe is 
aggressively moving toward patent boxes to even lower corporate 
rates, preferential rates--5 percent, 6 percent, 10 percent--on 
tangible assets and intangible income. They are trying to 
attract the real economic activity--the R&D, the intangible 
assets, and the income stream--from U.S. multinationals by 
offering them very preferential rates.
    What are we doing? Well, the Obama administration--and I 
support almost all of their tax proposals, but the one that I 
have reservations about is the proposal to impose a minimum tax 
on the foreign earnings of U.S. multinational companies.
    So, as the rest of the world is saying, ``Here is a 
preferential rate, come,'' companies from other countries will 
be able to come. But U.S.-based companies will not, because we 
will subject them to a minimum tax, which means they will not 
be able to take advantage of the patent boxes offered 
elsewhere.
    So we have the rest of the world pursuing what I would call 
a carrot approach to attracting the activities and income of 
U.S. corporations, while we adopt a stick approach that imposes 
a minimum tax on their earnings around the world. To safeguard 
their domestic tax base, other countries are lowering their 
corporate tax rates, maintaining territorial tax systems, and 
adopting anti-abuse procedures which are serious and adequate. 
And I think we can do that, and I think we should do that.
    Thank you very much.
    The Chairman. Thank you, Doctor.
    [The prepared statement of Dr. Tyson appears in the 
appendix.]
    The Chairman. Dr. Gravelle, we will take your testimony 
now.

  STATEMENT OF JANE G. GRAVELLE, Ph.D., SENIOR SPECIALIST IN 
  ECONOMIC POLICY, CONGRESSIONAL RESEARCH SERVICE, LIBRARY OF 
                    CONGRESS, WASHINGTON, DC

    Dr. Gravelle. Thank you very much for inviting me.
    Economists actually distinguish between efficiency effects, 
which are the cost of distortions, and growth effects, the 
increase or decrease in, say, labor or capital due to tax 
changes. For example, if a marginal rate cut increases labor 
supply, the growth effect is the value of increased output, but 
the efficiency gained is increased income minus the loss in the 
value of leisure or unpaid work, such as childcare.
    Some efficiency gains might not increase output at all or 
would have a negligible effect, such as the substitution of one 
type of capital investment or consumption item for another, but 
they nevertheless increase well-being.
    Some estimates place the total efficiency cost of the 
income tax system at around 2.5 percent of GDP. This is 
comparing to a head tax or a lump sum tax. So we could only 
gain part of that through income tax reform.
    To me, the most likely area where efficiency gains could be 
achieved in tax reform is in reducing the differences in the 
effective tax rates of different types of investments. The 
returns on owner-occupied housing and corporate debt-financed 
investment are taxed at negligible or even negative rates, 
while corporate equity is taxed at 35 percent. Within business 
assets, equipment is favored over structures because of more 
generous depreciation. Some industries are favored over others 
because of the production activities deduction.
    While there are many considerations in designing tax 
reform--and, of course, CRS never recommends any actual 
reform--some changes that would narrow these differentials are: 
disallowing a portion of corporate interest deductions, slowing 
depreciation for equipment, repealing or narrowing the 
production activities deduction, and limiting the benefit of 
itemized deductions for mortgage interest and property tax, 
while using some of these revenues to reduce the corporate tax 
rate.
    The largest corporate tax expenditure now is the deferral 
of tax on income earned abroad. That may have some efficiency 
effects, but they are small because the effective tax rates--
effective tax rates--in different countries are actually quite 
similar. So the main effect of deferral appears to be a fairly 
significant revenue loss due to profit shifting.
    I just looked at some data on the Cayman Islands, and 
multinational profits in the Cayman Islands in 2010 were 2,000 
percent of GDP. Significant efficiency gains from changing the 
distortions in labor supply, the choice between consumption and 
leisure or savings, are unlikely to be achieved.
    Turning to growth or output effects, the effects of a tax 
reform on economic growth depend on whether the tax reform is 
revenue-neutral, especially in the longer run, or either raises 
or loses revenue.
    Three types of effects may influence the output effect of a 
tax change: the short-run demand-side stimulus or 
contractionary effect; the crowding out or, in effect, whether 
the increase or decrease in the deficit reduces or increases 
funds available for investment; and supply-side effects, where 
labor supply and savings respond to tax rates.
    The demand stimulus from a tax cut is transitory. The 
crowding in or out effect happens gradually over time, but it 
grows continually. Supply-side effects are typically due to 
labor supply in the budget horizon as capital takes some time 
to accumulate or decline, unless investment flows in or out 
from abroad.
    As illustrated in a study by the Joint Committee on 
Taxation in 2005, a tax cut may increase output in the short 
run, but ultimately the crowding out of private investment from 
the revenue loss, which grows continually, will decrease output 
in the long run.
    As also illustrated in the JCT study of former Ways and 
Means Chairman Camp's tax reform proposal, using their in-house 
model, the output effect of tax reform is likely to be small on 
the budget horizon. No long-run estimates were provided, but it 
is likely that the Camp proposal loses significant revenue in 
the long run and would eventually cause a reduction in output 
through crowding out.
    It should not be surprising that a revenue-neutral tax 
reform is unlikely to have a significant effect on output, 
given the necessity of base-broadening, which also affects 
marginal effective tax rates.
    Alan Auerbach and Joel Slemrod, two very prominent 
economists, for example, found that the Tax Reform Act of 1986, 
a widely hailed tax reform, left growth effects roughly 
unchanged.
    It is difficult to design such a reform, especially if the 
reform is also pursuing other goals such as distributional 
neutrality and simplicity. However, tax reform can nevertheless 
achieve efficiency gains, and it can achieve simplicity.
    Thank you.
    [The prepared statement of Dr. Gravelle appears in the 
appendix.]
    The Chairman. Thanks to all four of you. This has been 
extremely interesting to me, and I appreciate the effort you 
put into your comments to appear before this committee.
    Let me just ask, Dr. Boskin and Dr. Diamond, both of you 
are well-aware that the United States has a classical system of 
taxing corporate income; that is, corporate income is taxed 
first at the corporate level and the second time at the 
shareholder level when the income is distributed as a dividend.
    I have two questions. First, should we integrate the 
corporate and shareholder level of taxes so that all business 
income, whether earned by a corporation or a pass-through 
entity, is subject to only a single level of tax?
    Second, how should corporate integration be achieved if we 
choose to go that route?
    Dr. Boskin, we will start with you.
    Dr. Boskin. Chairman Hatch, I totally agree that we ought 
to integrate, if we can. We can do that in a variety of ways, 
but on the personal side by reducing or minimizing the personal 
tax on corporate distributions. On the corporate side, some 
have proposed even junking the corporate tax. That I believe 
would decrease the taxes on foreigners holding U.S. assets, so 
perhaps that is not a perfect solution.
    So I think that basically what I would do is, in lieu of 
that, if that was the approach, my view from the corporate side 
is, I would attribute the corporate income and the taxes paid 
by the corporation to the individuals who held the corporation.
    Those are the two conceptual ways. There are many details 
that I would be happy to work with staff on at some point. I am 
sure others here would too. But those are the two ways. But I 
think this is a very, very high priority. Corporate source 
income is the most heavily taxed income in our society.
    Dr. Diamond. I agree with Dr. Boskin. My one concern would 
be on international issues. So integration obviously would 
decrease distortions and equalize the treatment of debt and 
equity. It would equalize the treatment across organizational 
form and how corporations distribute dividends or dividends 
versus share repurchases.
    But there are international issues that we would still have 
to deal with, and I think those are important to consider. I 
would also toss out there another method not related to this--
not related, but close--which is something like an allowance 
for corporate equity that would achieve many of the same goals, 
although it has some revenue issues as far as how we pay for 
it.
    The Chairman. Thank you. Let me ask this question for the 
whole panel.
    Most agree that the U.S. statutory corporate tax rate is at 
the top relative to our international competitors, and that the 
U.S. effective corporate tax rate is above the international 
average. My question for each of the panelists is whether you 
agree that the U.S. corporate effective tax rate is at least 
above average relative to our international competitors and 
whether that is something that may inhibit growth in our total 
U.S. economy.
    Dr. Boskin?
    Dr. Boskin. Absolutely, Chairman Hatch. Absolutely. I 
believe that the corporate rate, when you take account of all 
the exemptions and deductions, is as far out of line as the 
statutory rate, but it is still high, particularly when you 
include the taxes at the personal level.
    So redressing that, I believe, would be very beneficial to 
growth. There are kind of two growth effects conceptually. One 
is on capital formation and future incomes, most of which would 
be in higher future wages, by the way. It is important to note 
the primary beneficiaries would be workers.
    The other is, when our tax is out of line with other 
countries, as Dr. Tyson and Dr. Diamond have suggested, we wind 
up affecting the allocation of activity between the United 
States and other countries. So getting that equalized or 
getting down to something that is not so far out of line would 
both bring more activity back into the United States and spur 
growth, and both of those things would be good for American 
labor.
    The Chairman. Dr. Diamond?
    Dr. Diamond. Yes. We have lost an 18-percentage-point 
advantage in the statutory rate since 1986, and we have lost a 
6-percentage-point advantage in the marginal effective tax rate 
since 1986. So we are definitely less competitive now than we 
were in 1986.
    My research and a lot of work I have been doing has been on 
the effect of income shifting, and that is mainly driven by the 
statutory tax rate. And so reducing the statutory tax rate 
would bring income home, and the great thing is, that could be 
used to reduce the rate as opposed to, say, base-broadening 
provisions like eliminating accelerated depreciation.
    I am all for widening the tax base and getting rid of base-
narrowing provisions, except in the case of accelerated 
depreciation.
    The Chairman. Dr. Tyson?
    Dr. Tyson. So I agree with both previous comments. What I 
would point out is that the main way in which U.S. companies 
have reduced their effective tax rate (and, nonetheless, we 
still have had a decline in our competitive position even on 
that number), is the deferral option in current law. Deferral 
has led to a significant increase in the amount of foreign 
earnings U.S. corporations hold abroad, and a growing share of 
their real economic activity has moved abroad. As their markets 
have moved abroad, they have built up foreign earnings, and 
then they have avoided the worldwide net of the U.S. corporate 
tax code on these earnings through deferral. That is what they 
do. It is completely understandable.
    Those deferred earnings are not available for use in the 
United States. They are not available directly for investment 
and job creation in the United States. And they are costly to 
the companies themselves in terms of the suboptimal use of 
their balance sheets.
    So deferral has been an important part of the system that 
we put together in 1986, but the whole system does not work 
anymore relative to what our competitors are doing, which is 
why I think we do need to move away from the deferral worldwide 
approach to a territorial approach.
    I do think, and Dr. Gravelle mentioned it in her testimony, 
that there is a significant amount of profit shifting going on 
in the world, as well as real economic activity shifting and 
the income associated with that.
    To get at the profit-shifting issue, it seems to me we have 
to look at anti-abuse provisions to deal with that, but that 
does not take away from the fact that we should have a much 
lower rate, a much broader base, and end deferral. If we end 
deferral with a much lower rate, I believe we will get 
significant repatriations of those funds over time.
    Under these circumstances, the flows of foreign earnings 
will look much different going forward, and I think that will 
be beneficial to the U.S. economy.
    The Chairman. Thank you. My time is up. Dr. Gravelle, if 
you could, keep your remarks short, but take the time you need.
    Dr. Gravelle. I will try. I have the CRS paper for 
international tax rate comparisons that indicates that average 
effective tax rates are about the same around the world with 
respect to either the OECD countries or the 15 largest 
countries, which include the BRIC countries: Brazil, Russia, 
India, China.
    There are slightly higher rates for marginal tax rates, but 
certainly not the differential. That is why in my testimony I 
said I think the real distortion--there is not really much of a 
distortion with respect to real investment due to our tax 
system, but there is a big problem with profit shifting.
    I also recently updated my tax haven paper which shows the 
enormous growth in profits of multinationals in places like 
Bermuda, Cayman Islands, the BVIs, showing that this is a 
worsening problem and has a lot of revenue potential. It is $83 
billion now as a revenue loss.
    But I do not think the average effective tax rates are very 
different.
    The Chairman. Thank you.
    Senator Wyden?
    Senator Wyden. Thank you very much, Mr. Chairman.
    I very much appreciate this panel. We have four very 
distinguished scholars, and certainly you have raised critical 
issues. I see my friend Senator Coats there. He and I and 
Senator Gregg, former Senator Begich, we wrestled with all of 
these as part of putting together our legislation.
    My concern is, if I suddenly put the four of you into one 
of those town meeting audiences, everybody's eyes would glaze 
over as we talked about these things. And the question is going 
to be, how are we going to find some way to jumpstart this 
effort in a fashion that is really going to get people's 
attention and make it attractive for the public to be part of? 
Because I think right now it is sort of seen as root canal work 
and just kind of an academic exercise that a handful of us get 
into.
    So let me start with you, Dr. Gravelle, because you have 
thought about this. Right now, Americans are in the middle of 
filling out this blizzard of tax forms and wading through the 
rules and getting their W-2s and trying to find all their 
records. It is going to take them more than 6 billion hours 
this year to do that. It is going to cost us over $168 billion 
annually to comply.
    One of the ways I think we can get people seriously 
interested in reform is just to tell them, we could get rid of 
this mess, we can get rid of this mess, possibly put your taxes 
on a postcard, certainly for an awful lot of people, 
particularly middle-class people, and save them time and money 
and get them their springtime back.
    What do you think about that? Would that be, Dr. Gravelle, 
one way to maybe jumpstart this?
    I want all of you to understand that I am very respectful 
of the issues that we are talking about, because they are 
important. I am concerned we are not going to get to those 
issues because the public is going to say, they are back in 
this discussion about all this dense stuff. What I really want 
to do is get rid of this mess and come up with something 
simple, and then I will be interested in talking to you about 
it.
    Dr. Gravelle?
    Dr. Gravelle. Well, I would agree. I do not think 
multinational profit shifting appeals to a normal taxpayer.
    Senator Wyden. You don't think? [Laughter.]
    Dr. Gravelle. I do think, and as you know, in yours and 
Senator Coats's tax reform proposal, there are things we can do 
to the tax law to simplify it, maybe do something that would 
increase the standard deduction so fewer people would be 
itemizing. There are lots of little things that I could talk 
about, but I think if we go through the tax expenditures, we 
can see a lot of things that you could change.
    So the first step would be to make the system simpler for 
the vast swath of ordinary people who do not have hedge funds 
and do not have complicated investments, to simplify their tax 
filing. Then I think we need to try to think of innovative ways 
to actually do the tax filing, to look into the possibility of 
a return-free system, at least for some taxpayers, to look into 
how electronically we can ease the sort of burden on taxpayers.
    The information the taxpayer gets on the W-2s and on the 
1099s, right now I think the W-2s marinate at the Social 
Security Administration for a while right now. But there should 
be a way to provide that information and maybe even have pre-
filled-out forms.
    We need to kind of open ourselves to nontraditional ideas, 
I think, in this age of incredible technology. So those two 
things: think of how to help people file returns, and think of 
how to do something to make their lives simpler while still 
collecting the revenue we need.
    Senator Wyden. That is helpful, and I appreciate it and all 
your scholarship, Dr. Gravelle.
    Let me ask the other three of our distinguished panel 
members about one other potential lever into this discussion, 
and that is infrastructure funding.
    What the topic has been for this hearing--I think a correct 
one that Chairman Hatch has selected--is growth. You cannot 
have big league economic growth with little league 
infrastructure. There are, as we all know, billions of dollars, 
billions of dollars, sitting on the sidelines, and I think we 
can get a significant portion of that into infrastructure. We 
heard testimony from Jay Drew of S&P last year, and he told the 
committee that $100 billion of private capital could be 
invested in U.S. infrastructure with the proper incentives.
    In this room, I sort of prosecuted the cause for years for 
Build America Bonds. And I was sort of surprised to even be 
called on at the end of the Recovery Act, on the last night, 
and people said, ``What do you think we might do with those?'' 
I said, ``Maybe we will generate a few billion dollars worth of 
sales,'' and people said, ``Great, let's do it.''
    We generated more than $180 billion worth of sales of Build 
America Bonds in like a year and a half. So I would be very 
interested in--why don't we take this side of the panel?
    The question is, what might the committee do as another 
lever to get people interested and communities interested in 
tax reform on the question of making it attractive for the 
private sector to invest in infrastructure?
    Why don't we start with you, Dr. Tyson, and just maybe go 
down the row?
    Dr. Tyson. First of all, I just want to say that I was a 
huge fan of Build America Bonds, and I am very, very sorry we 
did not keep them.
    I am not sure, however, that infrastructure is such a 
compelling argument for town hall meetings. I do not know. I 
will leave that for you to assess.
    Senator Wyden. Well, I will tell you, when you mention 
infrastructure, the first thing they say is, ``Why can't we get 
that part of the freeway fixed?''
    Dr. Tyson. But I think also I would say, as an economist, 
and say also at town hall meetings, certainly in certain parts 
of the country, in much of the country now, people also worry 
about climate change and carbon.
    I would say I would probably link to the view that there is 
growing bipartisan support, certainly at the State and local 
levels, for either a gasoline tax solution or, more broadly, a 
carbon tax solution, which does a couple of things. It actually 
goes after carbon emissions--a ``bad'' we want to discourage. 
And it creates a lot of revenue that can be used for 
intelligent infrastructure improvements, and over time it will 
add to the increasing carbon efficiency of our trandportation 
fleets. A carbon tax of a relatively small amount over many 
years would generate a lot of revenue to deal with our long-
term deficit problem.
    So I might go to a town hall meeting and say, yes, we need 
infrastructure, but how do we finance it in a sustainable way 
long-term? We have had a gasoline tax which did not go anyplace 
for years, despite what happened to the inflation rate, despite 
what happened to the fuel efficiency of cars, which brought the 
gasoline tax revenue down.
    We have a Highway Trust Fund which is going to go bankrupt. 
We need to finance that in a sustainable way. Let us finance it 
by a carbon tax, which casts a broader net than a gasoline tax.
    But I also want to say I think the town hall situation does 
make it complicated to make the argument, which I believe and I 
think you believe as well, that there are certain items in the 
individual tax code which we want to promote for middle-class 
families.
    We want to promote childcare. We want to promote a second-
earner tax credit. We want to make the Earned Income Tax Credit 
more generous. We want to consolidate, but amplify tax benefits 
for education and retirement savings.
    Those are all things you really cannot do on a postcard, 
you really cannot do without having sufficient special 
individual tax provisions.
    Those things, I think, are all meaningful and important to 
do for middle-class families. I think they work well in town 
halls. They move away from the simplicity argument.
    Senator Wyden. The only thing I would say, Dr. Tyson--my 
time has expired--on the proposal that Senator Coats and 
Senator Gregg and I put together which protects those middle-
class breaks, the people at Money magazine took our form, 30 
lines long, 30-31 lines long, filled it out in 45 minutes.
    Dr. Tyson. Well then, perfect. You have solved that 
problem. I certainly believe in those kinds of reforms.
    The Chairman. Senator Coats?
    Senator Wyden. Mr. Chairman, I just think we have two other 
distinguished panelists. Could they just comment very briefly--
--
    The Chairman. Sure.
    Senator Wyden [continuing]. Because I am way over my time. 
You do not have to, but maybe you are interested on this 
question of how do we make it attractive to start this debate 
and talk about things people actually care about.
    Dr. Diamond. I will just state briefly, I do not think I am 
going to invest in any economic-based reality TV shows, 
because, even as we try to make it attractive, we always revert 
to the weeds.
    A few years back, I worked for the New Zealand Treasury 
Department on a project they had me working on, and I was 
impressed with the cleanness of their tax code. And I asked 
their treasury officials, ``How did you get your tax code so 
clean?''
    Their approach was to toss everything out and then to make 
people argue for why it should be in, and I think that would 
generate a lot of interest if we just toss everything out and 
say, if you want it back in, you have to make a credible cost-
benefit analysis of why this provision should be in.
    The Chairman. I would like to do that. [Laughter.]
    Senator Wyden. Dr. Boskin?
    Dr. Boskin. I would strongly endorse your initial 
statement, Senator Wyden, that simplicity is a big part of 
this. There is an immense frustration with our tax system. Six 
billion hours is a lot of time, and I would guess 5.95 billion 
of those are spent in extreme frustration.
    So I think that the cost is immense. I think people would 
be willing to sacrifice some special features for a lower rate 
and a great deal of simplicity.
    The second thing I would try to emphasize would be 
transparency. I think there is a lot of suspicion that somebody 
else is getting a break I am not getting, and simplification is 
one way to get transparency, so I strongly endorse that.
    On infrastructure, as I have said many times, I strongly 
support every infrastructure project that passes a rigorous 
cost-benefit test based on national criteria, not just that 
some local government is getting a very heavy subsidy from the 
Federal Government and so they will do something that may have 
very modest benefits nationally, but where people in Oregon and 
Utah are paying to finance some project in Georgia or Indiana, 
if I may, Senator Coats.
    So I am very strongly supportive in that sense. But I do 
believe that we should be focusing on tax reform, primarily par 
tax reform. The more other issues you involve--everybody has 
their favorite other thing they are going to want to tag onto 
that. For Laura, maybe it is carbon. For somebody else, it is 
infrastructure. For somebody else, it is something else. And 
then you are back in the problem of not having sufficient 
leeway and room to just get rid of a lot of preferences or cap 
them and lower the rates considerably.
    So I would say lower rates, broader base, simplification, 
and emphasize simplification when you are trying to get the 
public involved.
    Senator Wyden. The irony is, that is really what Senator 
Gregg and Senator Coats and I really focused on in our 
bipartisan bill, and that is what you have trouble kind of 
engaging people around. So that is why somebody like me will 
ask a question like I did. But I look forward to working with 
you.
    Thank you, Mr. Chairman.
    The Chairman. Senator Coats?
    Senator Coats. Thank you, Mr. Chairman.
    This is a very interesting discussion here, and Senator 
Wyden is generous in mentioning my name along with Senator 
Gregg. I inherited from Senator Gregg 2\1/2\ years, I think, of 
intense work that he and Senator Wyden did in putting together 
a proposal.
    We have said from the very beginning, it is not set in 
concrete. It is a starting basis, a platform which can provide 
for simplicity, provide for more fairness--things that attract 
people to the idea of tax reform. But another one of those 
issues is revenue neutrality, and I would like to ask you about 
that, although I should mention the fact that Senator Wyden and 
I are still working, as was Senator Gregg, on the whole issue 
of territorial taxation.
    I appreciate your testimony on that, because the whole 
issue of deferral versus getting to a point where we have that 
competitiveness, all, from my standpoint, goes to the fact that 
also attracts people at town meetings, and that is economic 
growth.
    So I want to switch from that into the revenue neutrality 
issue and get your take on what best promotes economic growth: 
revenue neutrality. And clearly there is an issue here relative 
to comprehensive tax reform and the argument over the tax 
increase, in many cases for additional spending, whether it be 
on infrastructure or whether it be on childcare or whether it 
be on any number of things.
    The argument is made that we cannot go to revenue 
neutrality on this; we need to have revenue coming to the 
Federal Government through the tax code so that we can spend it 
on needed programs. The problem is, everybody has a different 
opinion of what those needed programs are.
    But I would like to just have the panel comment, and that 
is really my only question, Mr. Chairman, on that whole 
question of revenue neutrality versus increasing taxation 
through any means of various reforms.
    Dr. Boskin. Senator Coats, I would stick with revenue 
neutrality. I think the easiest way to lose people in town hall 
meetings is to say we are going to change the tax code and we 
are going to raise your taxes. So I think that Senator Wyden's 
constituents in Oregon might not be too happy about that in 
those town hall meetings if we are going to try to raise a 
bunch of revenue. That is number one.
    Number two, there is the tie of the spending side of the 
budget to the tax side of the budget. If we run deficits and 
accumulate debt, that commits us to pay interest in the future, 
the present value of which will be equal to the deficit that we 
run today.
    So it is deferring taxes. So we should not kid ourselves 
that if we are losing a lot of revenue, that is not going to 
cause problems later. And if we raise a bunch of revenue and 
then spend it, or if we commit ourselves to a spending program 
which requires higher taxes in the future, that will also harm 
growth.
    So I would stick to revenue neutrality as closely as you 
can--I mean, these are approximations done by the people at 
Joint Tax and so on--as the primary vehicle for getting tax 
reform going.
    Senator Coats. Dr. Diamond?
    Dr. Diamond. I think revenue neutrality is an important 
assumption in order just to get reform passed, because if not, 
you will have more losers. If you are going to raise more 
revenue, then you are going to have more losers, and that is 
going to be a problem. If we are not raising enough revenue, we 
are going to have an increasing debt, and that is going to 
decrease economic growth.
    So when I was at the Joint Committee in 2003, we analyzed 
the Bush tax reform, which reduced rates on capital income but 
did not finance it. And the positive effects of the Bush tax 
cuts were seen in the window, and then we did actually report 
some results showing that increasing deficits were tending to 
offset those effects, and in the long run they would have 
completely offset had there been no change in spending.
    So I think revenue neutrality is important. I also think it 
is important to think about revenue neutrality in a long-run 
sense.
    I can give you two examples of two different tax reforms. 
We could have a tax reform that raises capital gains and 
dividend rates and increases, say, the Child Tax Credit versus 
a tax reform that reduces capital gains revenues and decreases 
the Child Tax Credit.
    One of those is going to--and let us say they increase it 
by the same amount. They are both $300 billion. So in a static 
basis, they would be revenue-neutral. But the increase in the 
rates and the increase in the child credit is going to reduce 
GDP and in the long run lose revenues, where the decrease in 
the gains rate and the decrease in child credits would actually 
raise revenue in the long run.
    I think it is important that we recognize that different 
proposals have different macroeconomic effects which affect 
long-run neutrality.
    Senator Coats. Thank you.
    Dr. Tyson?
    Dr. Tyson. This is a complicated issue. I will say I raised 
the concern I have about revenue neutrality when I talked about 
corporate tax reform, because we are not only talking about 
revenue neutrality overall, but we are also talking about 
revenue neutrality within pieces, like, corporate tax reform 
should be revenue-neutral or business reform should be revenue-
neutral.
    Actually, a lot of what we have been discussing here would 
suggest that revenue neutrality in corporate tax reform might 
not be right, because, if you think a major flaw in the current 
system is the high taxation of capital income, you might 
actually want to reduce that. In which case you would not want 
to offset a cut in the corporate tax rate by base-broadening 
that increases the taxation of capital income in other ways. So 
I do think we have to be careful of what we mean by revenue 
neutrality.
    I think we have a distorted tax code, in part, because--
over all the years I have been involved in public policy--when 
we cannot come to an agreement on spending on something which 
people in the town hall might want, instead we introduce a tax 
credit. We can come to an agreement on that, and so we pass 
that.
    So a lot of things that are tax credits are there because 
there is a sense we should be doing something to deal with 
childcare or deal with education or deal with community 
colleges, but we cannot get an agreement on the spending, so we 
agree on the tax credit.
    So I do think that in going after lower tax rates and 
revenue neutrality, if that is the goal, we have to recognize 
that we may, in order to do that, have to increase spending on 
some things that we currently support through tax credits and 
that we want to continue to promote. Revenue neutrality in 
corporate tax reform can be a dangerous goal. I would much 
rather have us look at individual corporate tax provisions and 
try to assess their effect on growth and efficiency rather than 
hamstring the whole process with an overall constraint of 
revenue neutrality.
    However, as I think one of my colleagues mentioned, that 
just may be the political hamstring that you have to deal with, 
in which case one has to recognize that revenue neutrality does 
not mean that there will not be winners and losers. And in this 
struggle for what kind of tax reform we should have, we need to 
think about that from the point of view of what people in the 
town hall would want, and we also have to think about that in 
terms of, say, what should be our corporate tax code as a long-
run contributor to U.S. economic growth?
    Senator Coats. Dr. Gravelle?
    Dr. Gravelle. Well, I do not envy your position. I do think 
that revenue neutrality makes it easier to design and sell tax 
reform. I think that is what they did in 1986.
    However, we are also clearly in an unsustainable debt 
position, and it is basically due to the growth of, not the 
discretionary spending or defense, it is mostly due to the 
growth in things like Medicare and Social Security, and that is 
going to have to be dealt with.
    I read the CBO paper on the long-run budget outlook, and it 
looks to me as if it would be very difficult to solve that debt 
problem solely on the spending side. Unless we are willing to 
make cuts in Social Security and cuts in Medicare, that would 
just be very, very difficult to do.
    I think along the way you could think about some of the 
types of taxes that Laura has talked about: a gasoline tax, 
maybe a carbon tax. But somewhere down the road that difficult 
decision is going to have to be made as to what kinds of taxes 
are probably going to have to be increased.
    But maybe in the short run, revenue neutrality is a way to 
frame and control whatever you are doing. So I could go either 
way. I could say you might want to use tax reform to try to 
raise revenue, if you can. Sooner or later, you are going to 
probably have to deal with it.
    Senator Coats. Thank you. My time is up. I would just 
comment and say I agree with Dr. Boskin's point that we need 
to, in tandem, address the runaway entitlement spending along 
with comprehensive tax reform, because those two elements, at a 
minimum, I think are necessary to be addressed.
    Unfortunately, we have had several attempts at that, as you 
know, over the past 3 or 4 years, all coming up short. But I 
think the reality is that putting those two together is going 
to be very important to get us on the right balance in terms of 
dealing with the future. Otherwise, if you just do one or the 
other, it is going to be a significant distortion.
    Mr. Chairman, thank you for the extra time.
    The Chairman. All right. Now, I am going to have to ask 
people to keep their questions and responses within the 5-
minute rule. We have been going over, and it is starting to 
irritate some of our colleagues. So if we could do that, I 
would be very appreciative. You just cannot ask a question to 
the whole group--and all of us have been guilty of this--at the 
end of 5 minutes and it takes 10 minutes instead of 5, because 
it is not fair to the other folks.
    But I hesitate to hold others to that account since we have 
been so bad so far, and I do not blame anybody. And this is 
such an interesting panel, it is very difficult to do these 
things within a 5-minute thing.
    So I am going to try to be liberal. Senator Casey, we will 
call on you first. We will see if you can live within the 
constraints.
    Senator Casey. Mr. Chairman, I will comply as best I can. 
Thank you very much.
    I want to thank the panel. I know I missed much of the 
testimony. So I am grateful to have the chance to get maybe two 
questions in, one on poverty and one on tax rates.
    Dr. Tyson, I will start with you and, in particular, in 
addition to your testimony, your op-ed in the New York Times of 
March 7th of last year, 2014, where you said, and I am quoting, 
``The biggest and most successful of the Federal Government's 
antipoverty programs next to Social Security, reducing the 2012 
poverty rate by 3 percentage points and the poverty rate for 
children by 6.7 percentage points,'' are the two that you have 
addressed, meaning the Earned Income Tax Credit and the Child 
Tax Credit.
    So the question is, in light of that assertion--which I am 
glad you made, and I am glad that we will keep making--even 
though both have bipartisan support, in light of the points you 
made and in light of the bipartisan support for both of them 
encouraging labor force participation and allowing lower- and 
moderate-income taxpayers to contribute to the economy, as we 
consider tax reform, how important do you think it is to both, 
I would argue, enhance, but at least maintain both of these 
poverty-reducing strategies?
    Dr. Tyson. I am one of the people who always runs over. So 
I am going to be brief here.
    I said in my opening remarks, although my written testimony 
focused on corporate tax, which I thought was the topic of the 
day, that I absolutely support such measures, as I did when I 
wrote my 2014 NYT column, and I support proposals to enhance 
them and amplify them.
    For example, the Earned Income Tax Credit for single 
workers, the childcare credit for families, the second earner 
credit, taking away some of the tax disincentives of having a 
second earner, I think these are very, very important 
antipoverty devices, along with, of course, what has been 
embraced around the country, but not yet in Washington, and 
that is an increase in the minimum wage.
    Senator Casey. I would agree, but thank you for 
highlighting that.
    Dr. Gravelle, I wanted to move to another topic, which is 
the tax rates. You have studied, as others here today have, I 
know, the effective tax rates in the United States that our 
businesses pay depending on the type of activities they engage 
in. In particular, the study that you have shows--and others 
have indicated as well--that our marginal effective tax rate on 
purchases of business structures or equipment is much lower 
than the statutory rate--an important point to make.
    But I wanted to ask you, when we consider a whole range of 
tax reform ideas, what would you hope that we would do to 
ensure that corporate tax reform is broadly neutral in its 
impact on both different industries and businesses?
    Dr. Gravelle. The single biggest distortion that I found is 
the distortion between debt and equity. So there is a huge 
difference between debt and equity investments, made worse when 
you have inflation, because you deduct a nominal rate but only 
tax a real return, or less than a real return if you have 
accelerated depreciation.
    I believe the Wyden-Coats bill does an adjustment for 
inflation for interest, but that would be sort of the first 
thing I would look at.
    The second would be--again, CRS is not recommending any of 
this. So these are just ways you can reduce distortions. 
Secondly, there is a smaller distortion between business 
equipment and structures. It kind of happened by accident 
because inflation fell. We had it right in 1986 pretty much, 
but those differentials arose because we do not have an 
inflation-indexed system. So that system was right for a 5-
percent inflation, but too generous for a 2-percent inflation.
    Also, the third thing is the production activities 
deduction. I think I testified earlier before this committee 
that if you did not want to give it up entirely, you could 
confine it to corporate manufacturing or you could repeal it 
entirely. But it favors certain kinds of industries over 
others, and it is very complicated to deal with.
    So those are the main things. I noticed that there was a 
capitalization of advertising expensing in Chairman Camp's 
bill. I think that is worth taking a look at it.
    I am not sure capitalizing R&D is that good an idea, 
because R&D has these very large spillover benefits. So those 
are the main things that I think you would want to look at to 
even out the tax rate.
    Senator Casey. Well, now that I am 22 seconds over, Dr. 
Diamond and Dr. Boskin, I will submit a question for the 
record, if you could answer in writing, and Dr. Tyson as well, 
on capital-intensive industries we are concerned about--our 
manufacturers--and the impact of tax reform.
    Mr. Chairman, I came close.
    The Chairman. You did.
    Senator Casey. Thank you.
    The Chairman. I appreciate it. Senator Isakson?
    Senator Isakson. Let the record reflect I was not the one 
complaining about that, Mr. Chairman. Senator Casey did a great 
job.
    With Dr. Tyson here, I was reading Dr. Tyson's resume, and 
it reminded me of 1983 when I went to the London Business 
School, where you were the dean, I believe, in 2000. Great 
school; I learned a lot.
    But it reminded me in this conversation that 1983 was the 
year Ronald Reagan pushed out eligibility for Social Security 
because Social Security was going under, and 3 years later is 
when he simplified the tax code and the number of marginal 
rates went from 11 to 3.
    Maybe it is time--listening to Senator Coats's questions 
and your responses--we ought to revisit those two principles of 
reforming entitlements and simplifying the code. Would you 
agree with that?
    Dr. Tyson. I certainly think we should look at both of 
those things. I think we absolutely agree here. There are a lot 
of distortions that can be adjusted.
    I will also talk about a distortion for a minute in terms 
of targeting, just targeting. Imagine--we have done a lot in 
our society to encourage retirement savings. This is an 
example. We want to encourage retirement saving. But if you 
look at what we have done, 80 percent of that tax expenditure 
goes to the top 20 percent of the income distribution, and the 
top 20 percent of the income distribution are pretty high 
savers.
    The problem is that 60 percent of the workers in the United 
States are basically saving inadequately. So one of the ways 
you can deal with this is through simplification. You can 
simplify, and you can also better target what you want to 
target.
    As far as our Social Security and Medicare systems, I would 
say, yes, we have to continue to look at them. I would point 
out that right now our long-run budget outlook looks vastly 
improved because of the slowdown in health care spending that 
has occurred following the enactment of the Affordable Care 
Act.
    So I do not think we know what those lines are going to 
look like. We know what the Social Security line is going to 
look like, and there are numerous proposals from commissions 
going back as far as the 1980s to deal with that issue.
    I would detach Social Security and health, and I would 
follow the trends in both. And there are a large number of 
things we could do in each area.
    It is a long-winded way of saying, ``Yes, we need to look 
at both.''
    Senator Isakson. To be shorter-winded, let me make one 
other acknowledgment. I went to the University of Georgia, and 
I am so proud Dr. Gravelle is a double dog, two degrees from 
the University of Georgia. Congratulations.
    Dr. Boskin, in your testimony, you favored a consumption 
tax, and you referred to a consumed income tax, if I am 
correct. Is that right?
    Dr. Boskin. Yes.
    Senator Isakson. Is that a sales tax?
    Dr. Boskin. A sales tax or a value-added tax are ways to 
tax consumption, but I prefer doing it through the income tax. 
Income is your consumption plus your saving. So if we had a 
broad, simplified saving deduction in the income tax, you would 
be taxing that part of the income which was consumed, and you 
could then have all the flexibility of dealing with personal 
circumstances that the income tax allows.
    I personally would only favor moving more toward the 
transaction side of consumption tax if it was to replace 
existing taxes. Just adding it onto the existing taxes I think 
would be a bad idea. That is how Europe grew to be a much 
bigger-government, stagnant, slow-growth part of the world.
    Senator Isakson. The so-called fair tax, which has been 
proposed--I am sure you have probably read the book----
    Dr. Boskin. Yes, sure.
    Senator Isakson [continuing]. Does exactly that. It repeals 
the payroll tax, the inheritance tax, and the income tax and 
replaces it with a sales tax, which, I might point out, Mr. 
Chairman, does answer the one question nobody else could 
answer, and that is how you change the tax code at a town hall 
meeting.
    The one subject that you can bring up at a town hall 
meeting is the fair tax. When you use that terminology and you 
talk about spreading the load and doing it on consumption, it 
is extremely popular.
    But my question for you, Dr. Boskin--you also mentioned the 
difficulties in the transition, and that is what happened with 
the 1986 Tax Act. When passive loss was offset, offsetting 
earned income was taken away, and it really tanked a number of 
businesses.
    Have you looked at a good transition from where we are to a 
simpler tax?
    Dr. Boskin. Yes. And there are several models for that that 
have been worked out by people who have thought very deeply 
about this, including people who are prominent academics but 
spent part of their life in the Treasury.
    So there are roadmaps, but I do want to emphasize that they 
are not simpler. We will get to a simpler tax, but in the 
interim, you have the new tax plus the transition rules, which 
themselves are complicated.
    I would also add, in your comment about entitlements, that 
you are exactly right. First of all, the slowed down health 
care spending started early in the previous decade, way before 
the recession and the health care law. There is a big debate 
among health economists whether that will continue or whether 
it will turn back up. Most think it will turn back up.
    The other big trend in this period is the slowdown in 
productivity. We would need both productivity to rebound and 
health care spending to stay slowly growing for the long-run 
entitlement problem to be substantially reduced.
    I think it is unlikely that both of those things will 
occur, and, therefore, you are quite correct. Entitlement 
reform is tax reform, because otherwise taxes will have to go 
up to pay for all this.
    I would also add, relative to something that was said 
before, you do not have to cut anything. You have to slow its 
growth and do that in a way that compounds gradually over a 
long span of time so people 30, 40, 50 years from now will get 
less than they would have gotten if the current benefits 
changed, but probably more than people in like circumstances 
are getting now.
    Senator Isakson. Thanks to all the panelists. I appreciate 
your time and interest.
    The Chairman. Thank you, Senator.
    Senator Thune?
    Senator Thune. Thank you, Mr. Chairman. Thanks to you and 
Senator Wyden for having this hearing.
    In my view, robust economic growth is the primary reason 
for tax reform, and no matter the challenge facing our Nation, 
it strikes me that whether we are talking about stagnant wages 
or lack of economic mobility or the looming entitlement crisis, 
that faster, long-term growth is without question a vital part 
of the solution. So I look forward to a tax reform that 
recognizes that a more efficient and less distortive tax system 
is critical to American economic well-being going forward.
    I want to ask a question perhaps, Mr. Boskin, that you 
could speak to. That is, the norm when we talk about the high 
U.S. corporate tax code is, we think about its negative effect 
on businesses. But the truth is that a high corporate tax rate 
also hurts workers, particularly in a global economy where 
capital is mobile.
    There was a study in 2009 by the Congressional Budget 
Office that found that labor bears 70 percent of the corporate 
tax burden in an open economy. So, having said that, in your 
view, what would a reduction in the corporate tax rate mean for 
American workers in the global economy and, specifically, would 
it result in lower or higher wages over time? Your opinion.
    Dr. Boskin. Senator Thune, you are exactly right. It would 
result in higher wages, because it would increase productivity 
by increasing investment.
    It all depends also on what else was done, obviously, and 
what the depreciation allowance is. I favor retaining strong 
capital cost recovery provisions with limits for excessive 
debt, and so on. But undoubtedly the biggest winners would be 
American workers--more jobs, higher wages, absolutely.
    Senator Thune. This I would direct to any of you. There is 
a debate that goes on among economists between those who 
believe that a lower rate is the key component for growth and 
those who focus more on cost recovery.
    Maybe you have already batted this around a little bit 
today, but I am wondering where each of you falls on that 
question. Should the focus as we go through this exercise be 
lower rates, even if depreciable lives are extended to achieve 
the lower rates, or should we keep a focus on cost recovery?
    Dr. Diamond. The standard economic story is that when you 
lower the rate, you give a windfall gain to existing capital 
assets. That is a windfall gain that is not given--that is lost 
revenue that could be used to lower the rate further if you 
targeted your incentive just to new investments. So generally, 
an investment incentive is seen as more efficient than just 
pure rate reduction.
    Some work I have been doing has looked at one more piece of 
that puzzle, which is that rate reduction tends to have another 
positive benefit in that it brings income home from abroad due 
to reduced income shifting.
    There are lots of uncertainties about the size and the 
amount of income. So the initial size of income shifted abroad, 
as well as how much income would return home when we lower the 
rate, and how large of a rate decrease you need to get a 
significant amount of income home, those three issues should be 
considered together, in my view, given the globalization of the 
economy over the last 20 years.
    Senator Thune. Dr. Tyson?
    Dr. Tyson. I agree with that. I just want to emphasize, on 
the isue of how much money might come back, that we need to 
distinguish here between money that is already out there and 
future flows.
    If we do not get this right, what we are doing as the world 
continues to change around us is--and I mentioned patent boxes 
in my conversation at the beginning--we are continuing to make 
it less and less attractive for these activities and assets to 
remain in the United States.
    So if you are an entrepreneur, an innovator, starting 
something new and thinking about where are you going to 
incorporate, where are your real markets? Your real markets may 
be 60 percent outside the United States, 70 percent outside the 
United States, and 30 percent here. The tax disadvantages of a 
very high statutory rate and a non-territorial system, perhaps 
with a minimum tax attached to that, are basically an incentive 
not to incorporate in the U.S. and to shift future flows of 
foreign earnings abroad.
    I think we have to distinguish those flows, which I worry a 
lot about because, again, the U.S. companies are competing 
around the world with companies that have very different tax 
homes, and those tax homes are increasingly more attractive 
than the U.S. tax home.
    That is part of the reason why we saw the wave of 
inversions that we have seen. You could imagine that also 
leads, if we do not adjust this, to more and more future 
foreign acquisitions of U.S. companies. I worry about the flows 
two ways: the deferral flows, taking the money back that is out 
there, and future flows.
    Senator Thune. Very quickly. C corps, pass-throughs, 
business income, should it be taxed the same? If we do this, do 
we need to deal with the pass-through issue at the same time we 
deal with the corporate tax rate?
    Dr. Gravelle. Well, I do not see how you could deal with 
corporate tax reform without dealing with pass-throughs, 
because any base-broadening things you do would affect them as 
well.
    There is a proposal the administration has made to tax 
large pass-throughs like LLCs--and it just appeared recently 
because they were allowed by State law, and they really act 
like corporations, those big ones, those pass-throughs--and 
also possibly maintain some cash flow accounting or something 
like that for smaller businesses.
    But I wanted to mention your earlier question about 
accelerated depreciation versus corporate rates. You have a 
tradeoff, as usual. If you want to equalize the tax on 
different kinds of assets, then you need to do something about 
accelerated depreciation for equipment or lower it for 
everything else, however you want to do it.
    But it is true what John said, in general. If you do it--
and I have talked about this before the committee--if you trade 
revenue rate cuts for accelerated depreciation on a revenue-
neutral basis, you raise the cost of capital because you get 
this windfall.
    So it is just something you are stuck with. You have to 
decide which is more important.
    Senator Thune. Thank you. Thank you, Mr. Chairman.
    The Chairman. Senator Scott?
    Senator Scott. Thank you, Mr. Chairman.
    Dr. Tyson, I would like to continue on that stream of 
consciousness and perhaps amplify it from the South Carolina 
perspective.
    If you look at South Carolina, we are the home to some 
really amazing corporations. We have companies that are 
headquartered in America doing business in South Carolina, such 
as General Electric. We have other companies, like Michelin, 
that are headquartered elsewhere in the world, and the 
treatment of their profits is very important in the 
conversation you were just having with the Senator a few 
minutes ago. With our current tax code, that means that a lot 
of those profits are going to be locked out due to the 35-
percent tax rate that would have been paid on profits.
    When you look at the reality of our tax code at 35 percent, 
if you bring home overseas profits, you are taxed again. If you 
are Michelin, you bring those profits home and you have a 95-
percent exemption.
    When you look at the President's proposal of a 14-percent 
tax wherever profit is made in the world--you are going to tax 
it and then we are going to go to a normalized 19-percent 
rate--the fact of the matter is that this is not only 
anticompetitive, this is a game-changing experience on behalf 
of corporations that would then be participating in a global 
economy without the ability to compete.
    Is that the sense that you have as well, or is it not that 
frustrating to you? Your hands are beating over there and you 
do not have a drum set, so I assume that you have a----
    Dr. Tyson. I want to distinguish between--I did not talk in 
either my written testimony or my comments so far about the 14-
percent rate which is on the stock of deferred earnings that 
are outside the United States. This gets to the issue really of 
the transition. If we are going to transition to another system 
of a lower rate, that is going to encourage future 
repatriations to come back. One way to finance the lower rate 
is to deal with some transition tax on those deferred balances, 
and that was part of Chairman Camp's proposal. It has been part 
of the Obama administration's proposal, although the Obama 
administration proposal then goes in a different direction 
thereafter.
    So the first thing is, we need--I assume that in any 
corporate tax reform, there is going to be some transition tax 
on those balances. There is a question about the magnitude, and 
there is a question about how that revenue should be used. 
Possibly it should be ploughed back into financing the 
corporate tax reform.
    Senator Scott. To lower the rate.
    Dr. Tyson. Right. So that is one way to do it. As far as 
the 19 percent, there is a lot of discussion of that in my 
testimony, and, since I am limited in time, I will not go 
through it other than to say that, effectively speaking, what 
that does is, country-by-country in every year, the minimum 
effective tax rate that a U.S. company has to pay is 22.4 
percent, and that is at a time when a lot of the countries in 
which it is operating are bringing down their effective tax 
rate through patent boxes and things like that, which will make 
it easier for the Michelins of the world to compete for those 
patent boxes and much harder for the U.S. companies to compete 
for them.
    Senator Scott. Yes. Thank you, ma'am.
    Dr. Boskin, in the context of the graying of America's baby 
boomers and the disappearing of defined benefit retirement 
plans, it seems to me that labor force participation should be 
rising, not falling, as we have seen.
    Even for individuals 55 years and older, the labor force 
participation rate has been relatively flat since the crisis 
after rising pretty steadily throughout the 1990s. As we view 
our revenue stream, how should we consider the effects of 
demographic shifts in labor force participation on the long-
term health of our government and, hence, our economy? Where is 
the place for tax reform in this conversation?
    I have spent some time just thinking through where we are, 
where we are going, and what that means from an economic 
standpoint, with fewer people being able to rely on a specific 
dollar amount coming into the household every month and now 
having a lump sum that they are going to have to figure out how 
to manage.
    It seems like we should have an uptick in labor force 
participation and not really a steady decline.
    Dr. Boskin. Senator Scott, I think you are onto something 
very important. In the short run, when labor force 
participation has plummeted, about half of that, maybe a third 
to half of it is due to the baby boomers retiring and the 
people entering the labor force being a relatively smaller 
cohort because of lower fertility behind them.
    But a large fraction of it has to do with a variety of 
incentives that have been created for people to leave the labor 
force or to support them if they do. Some of these were 
temporary things in the midst of the Great Recession when needs 
were exigent, and they have not been scaled back. There is a 
lot of evidence that a sizeable part of the decline has been 
because of the increase of various types of transfer payment 
programs.
    So we need to better balance those programs being there for 
people who need them and then to phase them down so that people 
have more of an incentive to search and reenter the labor 
market.
    In the long run, we are going from around three workers per 
retiree to two, a 50-percent decrease--much less than some of 
our European competitors, but that is still going to be an 
immense burden, and it is a big part of why the entitlement 
cost crisis is likely to lead to intense pressures both on the 
budget, therefore on taxes, but also on private family 
situations.
    So all that suggests we ought to make sure we retain, 
simplify, maybe even enhance our saving incentives from the tax 
code so people can save for their own retirement, number one; 
and, number two, we need to make sure that we do not have tax 
rates any higher than they need to be.
    Let me emphasize that we need to have sufficient revenue to 
fund the necessary functions of government, but with more 
effective targeting of our spending. That will help. But 
keeping the tax rates as low as possible on the broadest 
possible base would help as well.
    Senator Scott. Thank you, Mr. Chairman. Just one final 
comment, if you would allow, sir. I think perhaps when we 
evaluate the labor participation rate and how it has gone from 
65 percent to 62 and its impact on us celebrating a 5.7-percent 
unemployment rate, in fact, the real challenge for us is the 
revenue stream that is no longer coming in. And I would also 
suggest that, while this is certainly a tax reform 
conversation, the larger looming challenge from an entitlement 
conversation needs to be woven into the picture that we have in 
defining the health or the lack thereof in our economy.
    Dr. Boskin. Absolutely, Senator Scott. The headline 
unemployment rate, the decline, is overstating the improvement 
in the economy some, because so many people are still out of 
the labor force.
    It is not just the revenue we need. We need more robust 
growth to pull those people back in and give them jobs and 
opportunity and income.
    Senator Scott. Thank you, sir. Thank you, Mr. Chairman.
    The Chairman. Senator Portman?
    Senator Portman. Thank you, Mr. Chairman.
    To go back just to the beginning of the recession and take 
the labor force participation rate then, I think the 
unemployment rate was about 10 percent, and at the beginning of 
the administration, high 9s. So those unemployment numbers are 
clearly unacceptable, and that is why we need tax reform, 
because it is one thing that can actually give the economy a 
shot in the arm.
    I found your testimony really compelling. I was here 
earlier to get to hear all of you. And I think this is an 
urgent issue, not just an important issue, and I am really glad 
you are here, and I am glad the chairman and the ranking member 
not just wanted to have this hearing, but are willing to push 
forward on this issue.
    They both said the same thing at the beginning, which is 
that this is an area where we can actually make progress on a 
bipartisan basis. And it is urgent for our workforce, for 
American workers, and for their ability to have rising 
salaries. We have to have a more competitive code.
    So let me just, if I could, Mr. Chairman, put something in 
the record. This was in the Wall Street Journal yesterday. This 
says the ``Valeant-Salix Deal Shows Why Inverted Companies Will 
Keep Winning.'' Amazing story.
    The Chairman. Without objection, we will put it in the 
record.
    [The article appears in the appendix on p. 77.]
    Senator Portman. It says that Valeant just bought Salix for 
$10 billion. It says it is a clear sign that inverted companies 
have a clear edge in deal-making. Actually, it is not. It is a 
clear sign that all foreign-owned businesses have a clear 
advantage.
    Let me just tell you, Valeant inverted back in 2010. They 
are now Canadian-domiciled. Salix tried to follow suit last 
year. They wanted to go to Italy. That deal fell apart after 
Treasury cracked down on these so-called inversions. And now 
Salix is being purchased by Valeant. So there it is.
    Here is what is even more interesting to me. All but one of 
the bidders for Salix had non-U.S. headquarters, all of them 
except one. The one U.S. bidder was Mylan, which is in the 
process of moving its headquarters to the Netherlands. So I 
would like to submit this for the record.
    You know I am a beer drinker. I love to make this point. 
You cannot find American beer anymore because the largest 
market share is Sam Adams with 1.4 percent. It is because of 
our tax code that this is happening.
    And we will look back 5 or 10 years from now at this 
testimony you all gave and say, ``Why did we not listen to 
them?'' And it is bipartisan, it is nonpartisan. It is not 
about who is up, who is down. It is about simply creating an 
environment for success.
    So I thank you all for being here and for making that point 
so clearly. I told Dr. Tyson I liked her testimony. Here is 
part of it that I like, but it is so troubling.
    The global Fortune 500 U.S. participation has declined more 
than any other country--any other country--from 179 down to 
128, and the foreign-based competitors to American companies 
are all headquartered in countries with lower rates.
    By the way, 93 percent of them are in countries that have a 
territorial system. So we are getting left behind. We are on 
the sidelines just watching this happen.
    The one issue I think we do not do a good enough job of 
pointing out is that this is about workers, and one reason I 
really liked your testimony, Dr. Boskin, is because you talked 
about that.
    If you could, just go into a little more detail on why this 
is about workers. We have the CBO study that shows 70 percent 
of the corporate tax burden is borne by the workers. We have 
this AEI study. They looked at 72 countries over 22 years. They 
found that for every 1 percent increase in corporate tax rates, 
wages decreased by 1 percent. You have this Federal Reserve 
Bank of Kansas City study that shows a 10-percent increase in 
corporate taxes reduces annual gross wages by 7 percent.
    We all want to see an economy where there are rising wages, 
and, unfortunately, that is not happening now. We all want to 
see 
middle-class families be able to get ahead.
    Tell us why corporate tax reform should matter.
    Dr. Boskin. Senator Portman, you are exactly right. Over 
time, wages tend to reflect productivity growth, not perfectly, 
but roughly. And the clearest evidence we have is that higher 
investment rates lead to higher productivity.
    Fixing some of these issues of where real activity is 
located with corporate reform and overall reform would increase 
productivity and increase growth. Most of the benefits of that 
growth would go to workers in increased wages.
    In the short run, it would also help reduce this excess 
unemployment. It would give growth a boost and, therefore, 
reduce the number of people out of the labor force as people 
have an opportunity to reenter with decent jobs.
    So I think overwhelmingly the evidence is that the benefits 
would go to workers, not 100 percent, but 70 percent by the CBO 
study is probably about right.
    Senator Portman. Which is so badly needed right now. The 
other thing that was brought up here earlier by Dr. Diamond was 
the macroeconomic analysis being helpful.
    We have had this debate back and forth over the last few 
years. In fact, there was an amendment passed during the budget 
resolution discussion a few years ago, the only budget 
resolution discussion we have had--hopefully we will have 
another one this year--about providing a macroeconomic score 
not just for the final product, but, as Dr. Diamond has said, 
for the process, so that you have some sense at least what is 
pro-growth and what is not.
    Can you tell us, Dr. Diamond or Dr. Tyson or Dr. Gravelle, 
why that is so important?
    Dr. Diamond. I think it is important. If you just take a 
very popular management adage, which is, if you cannot measure 
it, you cannot manage it, I think that is true for our economy.
    If we cannot measure what different reforms will do, what 
the impacts will be, then how can we expect to get the tax 
reform to its most efficient form?
    On this corporate reform issue, a problem I have with the 
strict just base-broadening, rate-reducing approach is that we 
do leave all of the current flaws in the system, the flaws that 
Jane has brought up, with different treatment of different 
types of assets, if we have accelerated depreciation for 
equipment but not for structures. At the same time, if we just 
lower the rate a little, have a very timid reform, it is not 
going to have a big impact on growth.
    Maybe we should do something more to really create a new 
modern income tax approach. I think Alan Auerbach has given a 
good framework for that of moving to a destination-based cash-
flow tax. So we would reduce our effective rate on capital 
income to zero. We would now lead the world in the lowest tax 
on investment and corporate income, and I think that would be a 
great thing for the U.S.
    Senator Portman. Are there any other comments on that? Then 
my time is expired.
    Dr. Tyson. Can I just say that I completely agree with the 
notion that we should be assessing our macroeconomic policy and 
the composition of our fiscal policy in terms of the growth and 
efficiency issues we have been focused on today.
    I do want to indicate, however, that there are certain 
areas of spending where we also need to take this look. So we 
are under-investing in our infrastructure. That has effects on 
efficiency and growth over time. We are under-investing in 
research and development and basic science. We have cut that 
way back, and we continue to threaten that.
    Probably of all of the tax incentives which appear to work 
and of all the evidence of government spending that appears to 
generate long-term positive growth effects, R&D is the area. So 
I would say if we are going to do this, we need to focus on 
both the tax side and the spending side on research and 
development.
    And I would add here education, because we have been 
talking about labor force participation rates. And technology 
and the technological requirements of skills are changing, and 
the skills of the labor force are not keeping pace, and that 
keeps more people out of the labor force. So we have to focus 
on the returns to education, and on making adequate investments 
in education.
    Senator Portman. And for those people who are in the 
process, we will achieve higher productivity because of better 
skills training.
    Thank you, Mr. Chairman. Thanks for your indulgence.
    The Chairman. Thank you, Senator Portman.
    Senator Grassley?
    Senator Grassley. Thank you very much. And if you wonder 
why I did not give you the proper attention by coming here at 
the last minute, I was just chairing another committee on sex 
trafficking.
    I am going to go to Dr. Boskin with one question and then 
one question for Dr. Diamond, and the rest I will put in the 
record.
    Dr. Boskin, you dealt with the distortions of high marginal 
tax rates, and I am sure you are aware that low-income people 
sometimes have the highest marginal rates or very high marginal 
rates because of phase-out of certain benefits.
    One statistic I have from the Budget Office is that in 
2013, the average marginal effective tax rate faced by low- to 
moderate-income workers was 32 percent. While that 32 percent 
is average, many low-income individuals may experience marginal 
effective rates far exceeding the top statutory rate of 39.6 
percent paid by the wealthy.
    So my question to you is, in your view, what do such high 
marginal rates mean for low-income individuals attempting to 
advance up the economic ladder? And probably more importantly, 
does it have any consequences for the entire economy?
    Dr. Boskin. The answer is ``yes'' in both cases, Senator 
Grassley. It obviously is one reason why the labor force 
participation is modest at those levels.
    There are some features that have tried to redress that. 
The Earned Income Tax Credit has incentives in both directions, 
but on balance is less distortive than what it replaced.
    But I would say that a big part of the problem is, we have 
so many programs and people are eligible and the rules about 
them are so, not only complicated for the people involved, but 
they wind up enforcing very substantial phase-outs because of 
the interaction of the programs.
    One of the ways we could develop some resources for 
necessary spending that Dr. Tyson mentioned would be to make 
the current set of programs in so many areas a lot more 
effective and efficient.
    We have 100 antipoverty programs, we have 46 job training 
programs, et cetera. We should have a small number that work 
well, and we could save a lot of money, target it better, and 
it would be better for the people and the economy. We would get 
more work. People would have a better incentive to invest in 
climbing up the ladder, to invest in their skills.
    I think that, on balance, it is time to do that as well as 
reform the tax code.
    Senator Grassley. Dr. Diamond, your testimony touches on 
the need for fundamental tax reform to be guided by principles 
of horizontal equity.
    Too often the current debate on tax reform has been 
preoccupied by talking points about so-called ``wealthy'' not 
paying their fair share, but the truth is, provisions of the 
current tax code that seek to encourage or discourage certain 
types of activity not only result in a handful of well-to-do 
taxpayers paying low tax rates but also a wide disparity in tax 
rates within income groups.
    So I would like to have you elaborate more on how the 
principle of horizontal equity has been eroded since 1986 and 
what that means to economic efficiency.
    Dr. Diamond. I think it is an important concept that we 
treat people in equal circumstances equally, and that is the 
concept of horizontal equity. It is that two taxpayers who are 
virtually the same should be treated in an equal manner.
    The problem with horizontal equity is that, as we treat 
different people differently, we give them incentives to shift 
their behavior. Most of the horizontal equity is driven by the 
plethora of preferences that we give and that are available 
under the income tax. So that creates a different situation for 
one person who is very similar to another person.
    Often this is looked at between single-earner families 
versus dual-earner families, and you try to compare the taxes 
they pay. Often one faces a much higher tax burden than the 
other, or one faces a tax benefit while the other faces a tax 
burden.
    So it is important. I think it is just important, from an 
equity goal and just so the system seems fair, that we treat 
people who are equal equally.
    Senator Grassley. Thank you, Mr. Chairman. I will submit 
other questions for the record.
    The Chairman. Thank you, Senator Grassley.
    We are grateful to all four of you. You have come up with 
an awful lot of good suggestions for us, and I want to thank 
you for appearing here today.
    I also want to thank all the Senators who participated.
    Any questions for the record should be submitted no later 
than Tuesday, March 3rd.
    We will adjourn this hearing at this time. Thank you for 
your time. We really appreciate it.
    [Whereupon, at 12:10 p.m., the hearing was concluded.]

                            A P P E N D I X

              Additional Material Submitted for the Record

                              ----------                              


   Prepared Statement of Michael J. Boskin, Ph.D., Tully M. Friedman 
 Professor of Economics and Hoover Institution Senior Fellow, Stanford 
                               University
    Chairman Hatch, Ranking Member Wyden, and other distinguished 
members of the Committee, it is a pleasure to renew my long-standing 
association with the Senate Finance Committee, which dates back several 
decades, to the Chairmanship of Senator Long. I've worked with the 
Committee on issues ranging from the Tax Reform Act of 1986 to 
improving the nation's measures of inflation and indexing government 
programs. I recall the pivotal role Senators Packwood and Bradley, and 
Roth and Moynahan, played in those times. I know that both of you and 
other members of the Committee have already given much time and effort 
to tax reform issues. So I will keep my response brief, highlighting a 
few key issues. I ask that my full written testimony be entered in the 
record.
                            i. introduction
    Views of what constitutes the ``best'' tax system date almost from 
the dawn of political philosophy. The suggested ways to balance 
concerns with economic efficiency, equity, administrative simplicity 
and reliability have evolved considerably since the 18th century when 
Adam Smith enunciated these Four Canons of Taxation and Colbert 
famously quipped that ``the art of taxation consists in so plucking the 
goose as to obtain the largest possible amount of feathers with the 
smallest possible amount of hissing.'' But modern research and teaching 
on taxation issues still emphasizes efficiency and equity and their 
tradeoffs. How and how much do various taxes affect economic growth, 
resource allocation, the distribution of well-being and revenue?

    Before turning to that subject, let me emphasize the likely large 
payoff to a better tax system. There is a tremendous opportunity to 
improve the federal system of corporate and personal income taxation in 
a manner that will significantly boost economic growth. To be sure, 
regulation, trade, education, training, immigration and monetary 
policies can also promote or hinder growth, but tax and spending--and 
therefore debt--policy reforms are likely to be the most potent.

    When the government collects taxes to finance spending, it distorts 
the allocation of resources. The tax will affect private decisions. Our 
income taxes doubly (even triply) tax some types of saving and thus 
distorts the incentive to consume versus save or, alternatively, to 
consume in the present versus the future, e.g. at retirement. Both 
income and payroll taxes distort the incentive to work, etc.

    The severity of these distortions depends on two things: first, the 
size of the ``tax wedge.'' How high is the real effective marginal tax 
rate that drives a wedge between the before and after tax prices paid 
and received by economic agents? For example, between the before-tax 
return to investment and the after-tax return to saving; between the 
wages paid by employers and those received by workers, and so on. 
Second, how sensitive, or, using economists' jargon, elastic, is the 
activity to changes in tax rates? Numerous studies, including my own, 
show that some activities are quite sensitive to tax rates, for 
example, the realization of capital gains and the labor supply of 
second earners in families, whereas others, for example tobacco 
consumption, are much less sensitive. The combination of the size of 
the wedge and the sensitivity of the activity to it determines the 
severity of the tax distortion.

    The burden that these tax distortions impose on the economy goes up 
with the square of marginal tax rates. Doubling the tax rate quadruples 
the inefficiency or waste or harm done by the tax distortion. Thus, 
high marginal tax rates are very bad for the economy. This is not a 
doctrinal issue. It has to do with the area under supply and demand 
curves. When the cost of these distortons is included, the cost to the 
economy of each additional tax dollar is about $1.30 or $1.40. Thus, a 
key to the quality of the tax system--how badly it distorts the 
economy, hinders growth, misallocates resources--is the level of 
effective marginal tax rates. The lower the effective marginal tax 
rates, the smaller the distortion of private decisions.

    The tax dollar (which costs the economy $1.30 or so per dollar 
raised) is put into a bucket. Some of it leaks out in overhead, waste, 
and so on. (That is also true in the private sector, although 
competition tends to reduce such inefficiency.) In a well-managed 
government program, the government may spend $.90 of that dollar on 
achieving its goals. Inefficient programs would be much lower, e.g. 
$.40 on the dollar. Thus, another key to an efficient tax system is 
effective spending that both fulfills important societal needs and 
keeps the revenue needed to the minimum necessary.

    The effective tax rates on private activity can be quite different 
from statutory rates because they interact with the tax base and can 
cascade across several taxes and levels of government. For example, 
state and local income taxes and may add to the distortions caused by 
the federal income tax. Clearly, the broader the tax base, the lower 
the rates to raise any given amount of revenue. Hence, most economists 
agree that broad bases and low rates are hallmarks of a good tax 
system. Narrow bases and high rates do much more harm.
               ii. five big-picture tests for tax reform
    I have five big-picture standards or tests that I apply to tax 
reform proposals. I will focus primarily on the first, economic 
performance, particularlyeconomic growth, not only because that is the 
subject of this hearing, but also because it is growth that makes 
everythng else possible: rising living standards, revenue to fund 
government programs, etc.
1. Will tax reform improve the performance of the economy?
    By far the most important aspect of economic performance is the 
rate of economic growth, because that growth determines future living 
standards. The economy's potential output grows at roughly the rate of 
productivity growth plus the rate of labor force growth. It is well 
known that the current economic recovery has been anemic relative to 
previous recoveries from deep recessions (Figure 1). We should have 
been growing at 4%, not the barely over 2% of the past five and a half 
years. And we should not settle for the anemic growth projections 
currently being made, e.g. 2.1% long-run growth by CBO. The nation's 
top economic priority must be to strengthen productivity, labor force 
participation, and skills, and to slow the increase in the ratio of 
retirees to workers.

    The most important way the tax system affects long-run economic 
growth is through the rates of saving, investment, entrepreneurship, 
work (see Figure 2) and human capital investment. Business investment 
has been especially lagging in recent years. These heavily influence 
productivity, output per worker, the prime determinant of wages on 
average over time. Productivity has been very weak in recent years 
(Figure 3), and economists are debating whether this is from a drying 
up of fundamental productivity-enhancing innovation, just cyclical 
weakness, or ``secular stagnation.''

    Modern academic public economics concludes that heavy capital 
income taxation at the corporate and/or personal level substantially 
harms capital formation and growth. This is why most prominent academic 
economists who have studied the issue recommend taxing consumption, or 
that part of income which is consumed. Such a tax, in its pure form 
(and all real world taxes are compromises in this regard) is neutral 
between saving and consumption (intertemporal neutrality) and also 
among types of investment (atemporal neutrality). Think of 
intertemporal neutrality as a level playing field goalpost to goalpost 
and atemporal neutrality as level sideline to sideline. Even a perfect 
income tax (which would require accurately measuring true economic 
depreciation and inflation adjustment, among other issues) would only 
achieve atemporal neutrality, not the far more important intertemporal 
neutrality. A pure consumption tax, however levied, would guarantee 
both. A growing body of research suggests that reforming the corporate 
and personal income taxes into consumption taxes levied at the lowest 
possible tax rates is the most potent policy reform available to boost 
growth.\1\
---------------------------------------------------------------------------
    \1\ In chronological order to see the development of ideas, see 
Boskin (1978), Summers (1981), Lucas (1990 and 2003), Prescott (2002).

[GRAPHICS NOT AVAILABLE IN TIFF FORMAT] 


    Nobel laureate Professor Robert Lucas, in his research and 2002 
Presidential address to the American Economic Association, concludes 
that removing the tax distortions to saving and investment and lowering 
marginal tax rates are by far the most important avenue for improving 
economic well-being ofany potential public policy reform. Indeed, a 
pure consumption tax at historical tax levels would add 7\1/2\%-15% to 
income per year, mostly in higher wages.That's the better part of a 
---------------------------------------------------------------------------
decade of gains in per capita incomes.

    The U.S. national saving and investment rates are low, in part 
because the current tax system, on balance, is biased against them. 
Redressing thatimbalance is very important and should be a major 
component of tax reform. That is especially so, given the closely 
related negative side effects on saving and investment from the growth 
of the national debt and unfunded social insurance transfers to the 
elderly. On this test, low-rate consumption taxes work best, high-rate 
income taxes worst.\2\
---------------------------------------------------------------------------
    \2\ The broader the tax base, the lower the rate or rates. But 
deductions and/or credits are theoretically desirable under some 
circumstances in an optimal tax system. See Stiglitz and Boskin (1977) 
and Feldstein (1980).
---------------------------------------------------------------------------
2. Will tax reform affect the size of government?
    Tax reforms that more closely tie the payment of taxes to 
expenditures will promote a more effective and efficient government for 
the broadest population. A new tax--a broad-based consumption tax, like 
a European VAT, for example--may just be piled on top of the existing 
taxes and used to raise revenue to grow government. This is what has 
happened in many European countries and is a major detriment to their 
economic performance.
3. Will a new tax structure affect federalism?
    Tax reforms can affect the federal system in many ways. Some types 
of federal tax reforms would implement taxes heavily relied on by state 
and local government, e.g. retail sales taxes (or VAT). We should favor 
those that strengthen federalism and devolve authority and resources to 
state and local government rather than agglomerate them at the federal 
level.
4. Will a new tax structure likely endure?
    We have had over 20 pieces of major tax legislation since I first 
met with this Committee, more than one every Congress. I have advised 
on many of them. We should be concerned that we might move to a better 
tax system only to undo it shortly thereafter. In 1986, the trade-off 
was lower rates for a broader base. That was slightly undone in 1990, 
substantially so in 1993; then rates were reduced, then raised and 
raised again, especially at the top and on capital income. 
Simultaneously the base, on balance, has eroded. A more stable tax 
system would reduce uncertainty and complexity and, cet. par., increase 
investment and growth.

    Estimates of the annual compliance burden range into the many 
billions of dollars, including the (many frustrating) hours devoted to 
that task. The tax system is clearly too complex. If a new tax, even 
one deemed administratively simple itself, were added without removing 
the income taxes, large additional administrative and compliance costs 
would result. Remarkably, the system of voluntary compliance yields a 
very high percentage of income tax liabilities actually due, especially 
when viewed relative to other countries. That speaks well of Americans' 
basic values. But there is episodic concern, for example in Treasury, 
that the system of voluntary compliance will be decreasingly effective 
over time and the nation will be driven to transactions taxes unless a 
simpler tax system replaces the current complex income tax system.
5. Over time, will tax reform contribute to a prosperous, stable 
        democracy?
    Will tax reform alter the number of people on the income tax rolls? 
Or the number receiving income from government? Or alter the ability of 
the economy to promote upward economic mobility? We now have a higher 
ratio of people who are net income recipients to people who are net 
taxpayers--many are both income taxpayers and benefit recipients--than 
at any time in recent history. That reflects several causes. First, the 
harm to many from the deep recession and the government's response to 
it; second, changes in the distribution of income, due primarily to 
technology and globalization in recent decades; third, the growth of 
traditional transfer payments, and the EITC and other features of the 
income tax itself. We must deal with this both on the tax side 
(underground economy, chary of too many off the income tax rolls) and, 
on the transfer payment side, especially entitlement cost growth which 
is is increasingly crowding out everything else in the budget.
                                 equity
    Another important criterion of tax policy is equity, horizontal 
(the equal treatment of equals) and vertical (the distribution of the 
tax burden, or more generally, the distribution of taxes and 
transfers). While equity is important, efficiency and growth require 
that the rate(s) be as low as possible, including the top rate on the 
most economically productive people and small businesses, but high 
enough to finance the necessary functions of government. There has been 
a substantial increase in, and debate about, higher taxes on the 
``rich.'' Equity is certainly an important criterion for tax policy. 
But it is useful to remember that over the period since 1980, when most 
studies show more rapid gains in higher incomes, taxes became more 
progressive (CBO). Indeed, the U.S. has the most progressive tax system 
in the OECD. The top 1% of taxpayers, with 22% of income, pay 38% of 
income taxes, whereas almost half pay none (some pay payroll taxes and, 
of course, in most states, sales taxes). Most importantly, most 
redistribution occurs, and should occur, on the spending side of the 
budget. The post-tax and transfer distribution of income, is less 
unequal, as is the distribution of consumption, than the distribution 
of market income, the focus of most studies. Indeed, for many people, 
consumption better measures long-run average income than does current 
income.

    Finally, whatever one's views are about tax rates on higher 
incomes, it is important to understand that taxes on the rich tend also 
to be taxes on getting rich. And we must be careful not to create 
obstacles to getting ahead, which is the most basic force driving the 
economy.

    A progressive consumed income tax can thus be designed to be far 
less harmful to economic growth than the current individual and 
corporate income taxes, while allowing subtantial flexibility in 
treatment of households in different circumstances.
                          corporate tax reform
    The U.S. has the highest corporate income tax rate of any advanced 
economy (50% higher than the OECD average (Figure 4) and is one of the 
few that still taxes worldwide income. At the time of the 1986 reform, 
we were about at the OECD average. But most countries have since 
lowered their corporate taxes. Many major competitors, Germany and 
Canada among them, have reduced their corporate tax rates, rendering 
American companies less competitive globally, harming our companies and 
their workers. Of course, various credits and deductions--such as for 
depreciation and interest--reduce the effective corporate tax rate. 
Corporate income is taxed a second time at the personal level, as 
either dividends or capital gains, the taxes on which have been raised 
recently. Netting everything, including the personal taxes paid on 
corporate source income, our corporate source income taxation retards 
and misaligns investment, and these problems will only get worse as 
more and more capital becomes internationally mobile. We have a 
corporate tax better tuned to 1965 than 2015.

[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]


    This complex array of taxes on corporate income produces a series 
of biases and distortions. The most important is the bias against 
capital formation, which decreases the overall level of investment and 
therefore future labor productivity and wages. To repeat, most of the 
corporate income tax is shifted onto labor, e.g. by decreased capital 
formation. Also important are the biases among types of investments, 
depending on the speed of tax vs. true economic depreciation; against 
corporate (vs. non-corporate) investment; and in favor of highly 
leveraged assets and industries. These biases assure significant 
impediments to overall capital formation that vary systematically. 
There is considerable evidence that high corporate taxes are 
economically dangerous. An exhaustive study by the OECD concluded that 
``Corporate taxes are found to be most harmful for growth, followed by 
personal income taxes and then consumption taxes.''

    Thus virtually every major tax reform proposal in recent decades 
has centered on lowering tax rates and broadening the tax base, Most 
porposals moving toward taxing broad consumed income, and reducing the 
double taxation of corporate source income. This could be accomplished 
by junking the separate corporate income tax, integrating it with the 
personal income tax (e.g. attributing corporate income and taxes to 
shareholders or eliminating personal taxes on corporate distributions), 
and/or allowing an immediate tax deduction (expensing) for investment, 
which cancels the tax at the margin on new investment and hence is a 
priority of most economists. And in the personal tax, by expanding or 
eliminating the limits on tax-deferred saving. The Hall-Rabushka Flat 
Tax, the Bradford progressive consumption tax, the Nunn-Domenici tax, a 
value-added tax (VAT), the Fair Tax retail sales tax, four decades of 
Treasury proposals, the 2005 President's Tax Commission proposals, the 
Simpson-Bowles Commission proposals, Wyden-Gregg and the December 2014 
Committee background paper contain in varying degrees elements moving 
in this direction. The tax changes of the past few years have moved in 
the opposite direction: higher rates on a narrower base and higher 
rates on capital income.

    Tax reform to strengthen economic growth should therefore move 
toward lower rates on a broader, more consumed income base. If the 
reform is designed to be 
revenue-neutral in static estimates, the actual revenue produced by 
broadening the base and lowering the rates is likely to be somewhat 
higher, as taxable income would increase more due to faster growth and 
less tax avoidance than typically assumed (Feldstein). Any such 
``revenue dividend'' relative to revenue estimates might wisely be 
devoted to reducing deficits and debt or additional growth promoting 
fiscal changes.

    Reducing the corporate rate would help strengthen what is an 
historically anemic recovery (Figure 1) from such a deep recession. The 
late Arthur Okun, CEA Chair under President Johnson, concluded that the 
corporate tax cut was the most powerful of the Kennedy tax cuts in 
strengthening slow growth. Replacing the current tax system with a 
revenue-neutral equivalent of the reforms mentioned above, phased in 
over a few years, would also strengthen the economy long-term. American 
workers would benefit from more jobs in the short run and higher wages 
in the long run.

    However, if tax reform includes a new tax that is used to grow 
government substantially, it will seriously erode our long-run standard 
of living. The VAT has served that purpose in Europe and, while better 
than still-higher income taxes, the larger-sized governments it has 
enabled there are the prime reason European incomes per capita are 30% 
or more lower than ours. Trading a good tax reform for a much larger 
government is beyond foolish. No tax reform can offset losses that 
large. Hence, a VAT should only be on the table if it replaces other 
taxes and is accompanied by rigorously enforceable spending control 
that prevents the need for much higher taxes.

    The economies of Western Europe set their taxes and government 
spending at about half of GDP. In the United States, the figure has 
averaged about one-third (including state and local government). We 
have demonstrated we can make that level of government in the economy 
consistent with solid economic growth and rising standards of living, 
whereas a substantially higher tax burden is much less likely to be so. 
The negative correlation between economic growth rates and tax burdens 
in the OECD countries is suggestive. (Of course, there are any other 
factors that influence growth rates and per capital income 
differentials.) Moving from U.S. levels to Western European levels 
might cut the growth rate by a full percentage point. Over a generation 
or two, that cumulates to huge differences in standards of living.

    So any sensible strategic management of our economic affairs starts 
with preventing much higher taxes and spending. Projections of 
entitlement growth imply marginal tax rates on the broad middle class 
of 60% or more. Simply put, entitlement reform, also the purview of 
this Committee, is also tax reform.
                               conclusion
    We have a small window of opportunity to reform our tax system and 
strengthen economic growth before demographics drive higher entitlement 
spending financed by higher taxes on a dwindling fraction of the 
population. Witness how difficult it is for the Europeans to make 
reforms which we would consider quite modest, even from much higher 
levels of spending and taxes.

    Our collective interest is in keeping the overall hand of 
government in the economy modest, targeted and effective, and thereby 
keeping tax rates as low as possible. Reforming the corporate and 
personal income taxes with broader bases and lower rates less inimical 
to economic growth should be the Committee's top priority.

    If major reform of the corporate and personal income taxes proves 
politically infeasible and, as some assume, only modest corporate 
reform is possible, it is important to bear in mind the many linkages 
between the corporate and personal taxes and the desirability of 
eventually keeping the top personal rate and the corporate rate roughly 
equal. Most businesses are not C-corporations and their income is taxed 
under the individual income tax.

    But if the stars align, as they eventually did in 1986, to lower 
rates on a broader base of both taxes, something like three individual 
rates with a top rate of 30% or less, as with Simpson-Bowles and some 
other proposals mentioned above, with simplified saving incentive 
features and a corporate rate roughly equal to the top personal rate, 
with simplified but rapid capital cost recovery and territoriality, 
with a broader base by limiting or capping preferences, would spur 
economic growth in the short and long run.

    Senator Long's famous dictum, that tax reform means ``Don't tax 
you, don't tax me, tax the fellow behind the tree,'' reflects the 
trench warfare focused on narrow issues of limiting this deduction or 
that credit that tax legislation engenders. So much more than that is 
at stake for our country. The evolution of taxes and spending will be 
one, perhaps the primary, determinant of whether America rekindles a 
successful dynamic economy providing rising standards of living, upward 
economic mobility, and the resources to support the disadvantaged; or 
whether, like Europe, it slides into complacent economic stagnation.
References
Boskin, M. ``Notes on the Tax Treatment of Human Capital'', in U.S. 
Department of the Treasury, Proceedings of the Treasury Conference on 
Tax Policy, 1975.

Boskin, M. ``Taxation, Saving and the Rate of Interest,'' Journal of 
Political Economy, April 1978.

Feldstein, M., ``The Theory of Tax Expenditures'', in H. Aaron and M. 
Boskin, eds., The Economics of Taxation, Brookings, 1980.

Hall, R. and A. Rabushka, Low Tax, Simple Tax, Flat Tax, Stanford, CA, 
Hoover Press, 1983.

Lucas, R., ``Analytical Foundations of Supply-Side Economics'', Oxford 
Economic Papers, 1990.

Lucas, R. ``Presidential Address,'' American Economic Review, 2003.

Prescott, E., ``Prosperity and Depression,'' American Economic Review, 
2002.

Stiglitz, J. and M. Boskin, ``Some Lessons from the New Public 
Finance,'' American Economic Review, 1977.

Summers, L., ``Capital Taxation and Accumulation In a Life-Cycle Growth 
Model,'' American Economic Review, 1981.
                                 ______
                                 
     Questions Submitted for the Record to Michael J. Boskin, Ph.D.
               Questions Submitted by Hon. Orrin G. Hatch
    Question. Dr. Gravelle's testimony argues that ``. . . it should 
not be surprising that a revenue neutral tax reform is unlikely to have 
a significant effect on output, given the necessity of base broadening 
to lower rates.'' In support of the argument, a study is cited that 
assessed the Tax Reform Act of 1986--or TRA86--and concluded, according 
to Dr. Gravelle's summary, that it ``left incentives roughly 
unchanged.'' Given that, you wouldn't expect much in terms of growth 
effects from a revenue neutral reform exercise. Before getting to my 
question, I would note that the 1997 study in question does conclude 
that, at the time, ``. . . saying that a decade of analysis has not 
taught us much about whether TRA86 was a good idea is not at all the 
same as saying it was not in fact a good idea. We think it was.'' 
Moreover, since that analysis, a Nobel Prize winning economist and his 
coauthor have provided evidence that tax reforms in 1986 coupled with 
changes in regulations 
governing retirement holdings help account for large long-run increases 
in corporate equity values relative to GDP, something that I would 
think is a positive for the economy and everyone with a retirement 
account. My question to the Panel is whether everyone agrees that it is 
``simply difficult, if not impossible'' to design a revenue neutral tax 
reform plan that would have significant enough effects on incentives to 
increase economic growth?

    Answer. It is possible to design a revenue-neutral tax reform that 
would have significant incentives to increase economic growth. The 
revenue-neutral tax reform that would most likely increase economic 
growth would involve a broadening of the tax bases and a lowering of 
the corporate and personal rates, combined with a shift of the broader 
base to consumed income. Such a reform, even with due allowance for the 
likely partial erosion of such a pure tax reform in the legislative 
process, would increase saving, investment, and capital formation and 
therefore growth and future incomes.

    Question. Dr. Boskin, many agree that a wholesale switch from the 
existing income tax system to one based on consumption would generate 
significant economic gains and increased standards of living. Of 
course, transitioning from one system to another would involve a lot of 
work, but the possible gains make it worth considering. However, some 
who look to consumption taxes see them as possible additions to the 
income tax system which would generate a European-like system in which 
we tax both income and consumption. Dr. Boskin, given experiences of 
other countries, and European countries in particular, do you believe 
that it would be a good idea to retain much of our income-based system 
of taxation and add a consumption tax, perhaps in the form of a VAT, 
onto the income tax?

    Answer. I do not believe it would be a good idea to add a broad 
federal consumption tax on top of the existing tax system. That would 
likely fuel a further unnecessary growth of government to the detriment 
of the economy. I do believe that replacing the corporate and personal 
income tax with a broad-base value-added tax or an integrated corporate 
and personal income tax system based on consumed income would be a good 
idea. But only if combined with some way to control spending so that 
the broad-based consumption tax did not just grow and grow.
                                 ______
                                 
                 Questions Submitted by Hon. John Thune
    Question. Some have proposed a cash-flow tax rather than our 
current system for taxing business income. Such a model would move 
towards taxing consumption by allowing business to fully deduct all of 
their capital investments in a given year. Have you looked at cash-flow 
tax reform proposals and do you believe they generally promote economic 
growth? If so, why is this the case?

    Answer. Yes, I believe that a properly designed cash-flow tax 
reform proposal would increase economic growth because it would 
increase saving and investment. The deepest analysis of this type of 
reform is by the late David Bradford in several works, starting with 
Blueprints for Basic Tax Reform when he was at the Treasury and 
culminating in a series of books and articles on what he called ``The 
X-Tax.''

    Question. In order to boost growth, you mentioned reforming 
corporate and personal income taxes into low tax rate consumption 
taxes. Could you further explain how the current tax system is likely 
causing an imbalance in U.S. national saving and investment rates?

    Answer. The U.S. has a very low personal and national saving rate, 
compared both to our history and to other countries. When desired 
investment exceeds saving, America must import capital to finance the 
difference. Our tax system, which doubly and triply taxes some saving, 
is one cause of this shortfall. Our current tax system taxes some types 
of saving once; others, up to four times. The latter occurs when 
saving, outside of household tax-deferred accounts such as IRAs and 
401ks, is invested in taxable corporate activities which later are 
subject to the estate tax. The double taxation in the personal income 
tax--first when income is earned and then when saving earns a return 
that is taxable, plus the corporate tax plus the estate tax--is the 
heaviest taxation of saving. At the other extreme, saving inside tax-
deferred accounts is only taxed once and, if invested in the non-
corporate business sector, does not directly pay the corporate tax and, 
if below the exemption level in the estate tax, is therefore only 
directly taxed once. The deductibility of interest and depreciation 
plus the special tax treatment of housing are items that tend to reduce 
the taxation of saving. It should be added that the low national saving 
rate in the United States, because it is below the rate of investment 
and therefore requires importing capital from abroad to finance the 
difference, is jointly determined with the trade deficit.

    Question. You state that a progressive consumed income tax can be 
designed to be ``far less harmful to economic growth than the current 
individual and corporate income taxes.'' How would you design such a 
tax so as to maximize economic growth but maintain progressivity?

    Answer. The best way to redesign the tax code to maximize economic 
growth, for any given level of government spending, is to expand the 
tax base of both the personal and corporate income taxes, lower the tax 
rates, and allow full expensing of investment (adjusted for debt and 
interest) and a deduction for all personal saving (likewise adjusting 
for debt and interest). That would leave the tax base as consumption 
quite broadly defined. Better still would be to integrate the personal 
and corporate income taxes. Substantial progressivity could be 
maintained in a consumed income tax with two or more tax rates at the 
household level, above some exempt amount. Even a flat rate tax above 
an exempt amount would be progressive. It would have a rate of zero up 
to the exempt amount; then an average tax rate would rise with income, 
until reaching the flat positive rate at high incomes. Adding a second 
and/or third rate could make the tax more progressive still.

    Question. You note that the OECD has found that corporate taxes are 
the most harmful to growth and that, in your view, high corporate taxes 
can be ``economically dangerous.'' Please elaborate on exactly what you 
mean by this statement.

    Answer. The U.S. has the highest statutory corporate tax rate of 
any advanced economy, 50% above the OECD average. The effective tax 
rate, accounting for deductions, is also out of line, but not as far. 
While there are many factors that determine the location of economic 
activity, business taxes are certainly one of them. Many types of 
capital are quite mobile among locations, even within the United 
States, let alone between the United States and other countries. Other 
things being equal, businesses will try to locate their activity in 
such a way as to minimize their taxes, shifting some economic activity 
abroad to the detriment of our economy. With less investment than 
otherwise, American workers will have lower productivity, which will 
harm their future wages.

    The U.S. is also one of the very few countries that taxes its 
multinational companies on their worldwide income, an additional 
competitive disadvantage in the global marketplace.
                                 ______
                                 
  Prepared Statement of John W. Diamond, Ph.D., Edward A. and Hermena 
    Hancock Kelly Fellow in Public Finance, Rice University's Baker 
    Institute for Public Policy, and CEO, Tax Policy Advisers, LLC*
---------------------------------------------------------------------------
    * The opinions expressed herein are solely my own and do not 
represent the views of the Baker Institute, Rice University, Tax Policy 
Advisers, LLC, or any other organization.
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                            i. introduction
    Chairman Hatch, Ranking Member Wyden, and Members of the Committee, 
thank you for inviting me to present my views on the importance of tax 
reform in promoting growth and efficiency. My testimony will focus on 
the case for tax reform, general principles that I believe should guide 
the evaluation of tax reform, and a discussion of the potential 
economic effects of various tax reform proposals put forth in the last 
decade. Given the fiscal crisis facing the United States, it is my view 
that tax reform must minimize the distortionary effects of taxation 
wherever feasible, seek to maximize long-run economic growth, and make 
simplicity a priority to achieve reductions in compliance and 
enforcement costs.
                      ii. the case for tax reform
    Individual income tax revenues as a share of GDP are projected to 
increase significantly even before any policy changes are adopted to 
address the unsustainable nature of the U.S. budget. The Congressional 
Budget Office (2014, hereafter CBO) predicts individual income taxes 
will increase from 8.1 percent of GDP in 2014 to 9.5 percent of GDP in 
2025. Under the CBO baseline, individual income taxes are projected to 
continue to increase to above 10 percent by 2039. Total revenues are 
projected to increase from 17.6 percent of GDP to 19.4 percent of GDP 
(only 1.6 percent below the Fiscal Commission target of 21 percent). 
Unfortunately, these built-in tax increases are not near large enough 
to offset the projected increases in spending. CBO projects that 
federal debt held by the public will increase from 74 percent of GDP in 
2014 to 106 percent of GDP in 2039 (even under favorable budget 
assumptions about current law and ignoring the negative effects of 
higher debt). The obvious conclusion is that the major problem facing 
the United States is the unsustainable nature of spending increases 
moving forward. Whether revenue as a share of GDP remains at the 
projected level or is increased as part of a grand bargain, it is 
imperative that the United States reform its tax system to reduce 
economic distortions and maximize economic growth. Otherwise, the 
combination of rising taxes as a share of GDP and a relatively 
distortionary tax system could significantly hamper economic growth. 
This is particularly important given that, in general, economic 
distortions increase exponentially with the rate of tax.

    Indeed, the income tax system in the United States is ripe for 
reform. The last fundamental reform of the system was the much-
celebrated Tax Reform Act of 1986 (TRA86), which followed the classic 
model of a base-broadening, rate-reducing (BBRR) reform that financed 
significant corporate and personal rate cuts with the elimination of a 
wide variety of tax preferences. In the interim, however, many 
countries around the globe have reformed their tax structures. This is 
especially true for corporate income taxes abroad, where many nations--
at least partly in response to the inexorable forces of globalization 
and international tax competition (Zodrow, 2010)--have dramatically 
reduced statutory rates while enacting base-broadening measures that 
have kept corporate tax revenues roughly constant as a share of GDP 
(Bilicka and Devereux, 2012). As a result, the United States, which was 
a relatively low tax country after TRA86, now has the highest statutory 
corporate tax rate in the industrialized world, and has also lost its 
advantage in marginal effective corporate tax rates (which take into 
account other features of a tax system, including accelerated 
deductions for depreciation and other investment allowances).

    Proponents of corporate income tax reform argue that such high tax 
rates (1) discourage investment and capital accumulation and thus 
reduce productivity and economic growth; (2) discourage foreign direct 
investment in the United States while encouraging U.S. multinational 
companies (MNCs) to invest abroad; and (3) encourage U.S. and foreign 
multinationals investing in the United States to engage in income 
shifting, using a variety of techniques to move revenues to low tax 
countries and deductions to the relatively high tax United States. In 
addition, the combination of a high statutory tax rate coupled with a 
wide variety of tax preferences distorts the allocation of investment 
across asset types and industries and reduces the productivity of the 
nation's assets while exacerbating the many inefficiencies of the 
corporate income tax, including distortions of business decisions 
regarding the method of finance (debt vs. equity in the form of 
retained earnings or new share issues), organizational form (corporate 
vs. non-corporate), and the mix of retentions, dividends paid, and 
share repurchases (Nicodeme, 2008).

    A separate issue that has attracted a great deal of attention is 
the tax treatment of U.S. and foreign MNCs under current law. Following 
recent reforms in the United Kingdom and Japan, the United States is 
now the only major industrialized country that operates a worldwide tax 
system under which the foreign-source income earned by U.S. 
subsidiaries is subject to a residual U.S. tax when repatriated to the 
U.S. parent, subject to a credit for foreign taxes paid. By comparison, 
most other countries--e.g., 28 of the 34 Organisation for Economic 
Cooperation and Development (OECD) nations--operate a territorial 
system under which the active 
foreign-source income of their domestically headquartered MNCs is 
largely exempt from any residual domestic taxation. Proponents of a 
move toward a territorial tax system in the United States argue that it 
would improve the international competitiveness of U.S. multinationals 
and end the current tax disincentive for the repatriation of foreign-
source income that arises as firms defer repatriation to avoid paying 
residual U.S. taxes.

    There is also widespread discontent with the individual income tax 
system. The top marginal tax rate has increased to 39.6 percent from 
the 28 percent enacted under TRA86, while the number and value of 
individual tax preferences has grown substantially. Tax expenditures 
are defined as ``revenue losses attributable to the provisions of the 
Federal tax laws which allow a special exclusion, exemption, or 
deduction from gross income or which provide a special credit, a 
preferential rate of tax, or a deferral of tax liability'' by the 
Congressional Budget and Impoundment Act of 1974 (Joint Committee on 
Taxation, 2014). According to the U.S. Governmental Accountability 
Office tax expenditures are approaching the size of discretionary 
spending in 2013.\1\ The arguments for reform are the same as those 
made during the debates surrounding TRA86 (McLure and Zodrow, 1987; 
Diamond and Zodrow, 2011): high individual tax rates coupled with 
widespread tax preferences inefficiently distort decisions regarding 
labor supply, saving, consumption patterns, and methods of 
compensation; significantly complicate administration of and compliance 
with the tax system; encourage tax avoidance and evasion; and result in 
a tax system that is widely perceived to be fundamentally unfair.
---------------------------------------------------------------------------
    \1\ The GAO issue summary is located at http://www.gao.gov/
key_issues/tax_expenditures/issue_summary#t=0.

    These developments have not gone unnoticed in the United States. 
Numerous proposals for reform have emerged. These include the reports 
of the President's Advisory Panel on Federal Tax Reform (2005), the 
National Commission on Fiscal Responsibility and Reform (2010), and the 
Debt Reduction Task Force of the Bipartisan Policy Center (2010). In 
addition, the co-chairs of President Obama's 2010 fiscal commission, 
Erskine Bowles and Alan Simpson, issued A Path Forward to Securing 
America's Future, which included $2.5 trillion in deficit reduction, a 
BBRR reform of both the corporate and individual income tax systems 
that would raise almost $600 billion for deficit reduction, and a 
switch to a territorial tax system for international income. The most 
comprehensive proposal for reforming the corporate and individual 
income tax systems was put forth as a legislative discussion draft on 
February 26, 2014 by Rep. Dave Camp (R-MI), Chairman of the House Ways 
and Means Committee.\2\ However, others have also put forth reform 
proposals. Senate Finance Committee member Benjamin Cardin (D-MD) 
introduced a proposal to impose a 10 percent progressive consumption 
tax that would reduce or eliminate individual income tax rates for most 
individuals (while maintaining the charitable deduction, state and 
local tax deductions, health and retirement benefits, and the mortgage 
interest deduction) and reduce the corporate income tax rate to 17 
percent. House Ways and Means Committee member Devin Nunes (R-CA) is 
working on a proposal to reform business taxes so that the tax rate on 
corporate and non-corporate businesses would be 25 percent on net 
business income. The proposal would allow businesses to expense new 
investments, would limit interest expense deductions, and repeal other 
existing deductions and credits. This bill does not deal with 
individual tax issues. Chairman Ryan of the House Ways and Means 
Committee has stated that tax reform is a major component of the 
Republican plan to promote economic growth and listed key goals of tax 
reform, while Finance Chairman Hatch and Ranking Member Wyden 
established working groups to examine key issues and develop proposals. 
The President released a framework for business tax reform in 2012 that 
would reduce the corporate tax rate to 28 percent and broaden the base 
by taking away business tax preferences. However, on the individual 
side, the President's proposals are at odds with most reforms and would 
be best described as a plan to increase tax rates on capital income 
(mainly on capital gains and dividend income) and tax expenditures (new 
$500 second earner tax credit and an increase in the child credit to 
$3,000 per child under five). The phase-outs of the expanded credits 
would also increase marginal individual income tax rates on labor 
income for some individuals.
---------------------------------------------------------------------------
    \2\ The legislative text of the discussion draft is available at 
http://waysandmeans.house.gov/UploadedFiles/
Statutory_Text_Tax_Reform_Act_of_2014_Discussion_Draft_022614.pdf. 
Analysis of the draft legislation by the Joint Committee on Taxation is 
available at
    https://www.jct.gov/.

    The dilemma facing policymakers is choosing the structure of a tax 
reform package to meet several different goals.
        iii. general principles for evaluating reform proposals
    Numerous criteria might be utilized to evaluate tax reform 
proposals. In my view any viable reform proposal should satisfy at 
least the following five criteria.
A. Revenue Neutrality
    Fundamental reform of the income tax structure is sufficiently 
difficult that the process of reform should not be encumbered by a 
requirement to raise additional revenues, which would ensure that many 
if not most taxpayers would end up being ``losers'' from reform and 
make the passage of reform virtually impossible from a political 
perspective. To the extent that additional revenues will be needed to 
address our nation's deficit and debt problems, it is better to raise 
additional revenues by reforming the structure of the tax system in 
conjunction with spending reforms that reduce expenditures as part of a 
sweeping fiscal reform package. Thus, the process can be separated into 
a two-stage approach to reform--a revenue-neutral fundamental tax 
reform, followed by fiscal reform that reduces future budget deficits 
while reaching a compromise on distributional issues and the 
politically acceptable size of the government. However, it may be 
reasonable to reverse the order of the two-stage process. For example, 
President Obama's fiscal commission adopted targets for revenue (21 
percent) and spending (22 percent in the short run and 21 percent in 
the long run) as a share of GDP.

    Decisions regarding the size and scope of government must be left 
to the political process: a host of instruments, including the use of 
budget rules to limit expansions of the size of government, are 
available to reduce current deficits. But perpetuating a highly 
inefficient and complex tax system in the hopes that it might limit the 
growth of government is an extremely costly and highly inappropriate 
way of achieving that goal.

    Also, revenue neutrality must be defined broadly to include long-
run neutrality. This ensures that the long-run implications of 
provisions that accelerate revenues (e.g., conversion of retirement 
savings from traditional IRAs and similar accounts to Roth IRAs) are 
fully taken into account. At the same time, the definition of revenue 
neutrality, especially in the long run, should be broad enough to take 
into account conservative estimates of the dynamic revenue effects of 
reform-induced increases (or decreases) in economic growth.
B. Equity: Distributional Neutrality and Horizontal Equity
    Again, following the approach that was successful in the passage of 
TRA86, tax reform should be approximately distributionally neutral 
(using a reasonable revenue baseline). As in the case of revenue 
neutrality, fundamental tax reform is difficult enough from a political 
perspective without complicating matters further by attempting to 
redistribute the tax burden across income classes.

    Also, another dimension of equity--the equal treatment of 
households with similar taxpaying capacity, or horizontal equity--
should guide all proposals for fundamental tax reform, as it did in 
TRA86 and as recommended by virtually all public finance specialists. 
Note that the implications of adopting horizontal equity as a prime 
criterion for evaluating reform proposals are far-reaching. In 
particular, it implies that all forms of compensation, including 
currently untaxed fringe benefits, should be included in the tax base 
to the extent administratively feasible.
C. Simplicity
    Tax simplicity is often emphasized in early discussions of 
fundamental tax reform, but is usually largely ignored as the process 
of tax reform unfolds. This time around simplification should be 
advanced as an essential criterion for any current reform of the tax 
system. While some tax complexity is unavoidable in measuring income 
accurately in today's complex economy, nevertheless there are many 
areas in which the tax code could be simplified significantly without 
seriously compromising accurate income measurement--for example, in the 
taxation of capital income, ad hoc adjustments for inflation that 
assume the Federal Reserve Board is successful in achieving its goal of 
maintaining inflation at around a 2 percent rate, rather than an 
elaborate system of comprehensive inflation indexing. More generally, 
any reform should adopt the simplification measures recommended in the 
2005 Tax Panel report, including simplifying and coordinating various 
individual income tax credits including the standard deduction, 
personal exemptions, and the earned income tax credit; collapsing the 
current wide array of saving and investment incentives into a very 
small number of simplified plans; simplifying business accounting 
rules, especially for small businesses and in the area of depreciation 
allowances; and eliminating the alternative minimum tax.
D. Economic Efficiency and Tax Neutrality
    An essential element of any successful tax reform proposal is the 
elimination of tax-induced distortions of economic decision-making 
(other than in a few very narrowly defined activities with widespread 
economic effects, such as investment in research and development and 
the emission of pollutants). As stressed in the debate surrounding 
TRA86, the government should in general not be engaged in an implicit 
industrial policy by distorting investment decisions through 
differential tax treatment of various investment activities and 
business sectors, and similarly should avoid distorting individual 
consumption decisions. While from a theoretical perspective economic 
efficiency can require differential tax rates, in practice, when one 
tempers efficiency considerations with equity concerns and takes into 
account the economic difficulties in determining an optimally 
differentiated tax structure and the political and administrative 
problems of implementing it successfully, simple economic neutrality--
uniform tax rates on similar activities in the context of broad-based 
low-rate taxes--is a reasonable approximation to an efficient tax 
structure. Accordingly, economic neutrality should be a key guiding 
principle in the formulation of any fundamental tax reform proposal. 
This, in turn, has several implications.

    Most fundamentally, the general approach to reform should follow 
the traditional path used in TRA86 of eliminating as many tax 
preferences as is politically feasible and using the resulting revenues 
to drastically lower marginal tax rates. This implies that the 
elimination of many preferences that have long been considered 
sacrosanct, even those not touched in TRA86, should be considered 
seriously. Note that such reforms are desirable on efficiency, equity, 
and simplicity grounds, and also to limit government expenditures that 
occur through the tax system and are thus subject to less scrutiny than 
direct expenditures. Moreover, many tax preferences are poorly designed 
in any case. The home mortgage interest deduction, discussed further 
below, is an excellent example. Although its primary purpose is to 
encourage home ownership over renting, it is very poorly designed to 
achieve this goal, as it offers little or nothing to low-and middle-
income individuals who do not itemize, have total deductions that are 
less than or roughly equal to the standard deduction, or are subject to 
relatively low marginal tax rates. Instead, the vast majority of the 
benefits of the home mortgage interest deduction accrue to high-income 
taxpayers, encouraging overconsumption of housing at the expense of 
less investment in the rest of the economy.

    In addition, neutral tax treatment should also be applied to saving 
decisions, that is, current consumption should not be favored over 
future consumption. In principle, this implies the tax base should be 
consumption rather than income. If the replacement of the income tax 
with a full-fledged consumption-based tax is not feasible at the 
current time, current personal income tax provisions that encourage 
saving should be maintained (although they should be simplified, along 
the lines described previously), and serious consideration should be 
given to reducing the burden of the corporate income tax on investment 
income. This would help alleviate the distortionary costs associated 
with the double taxation of corporate income.
E. Favorable Environment for Foreign Investment
    Finally, in today's globalized economy, the income tax system in 
the U.S. should not put our multinational companies at a disadvantage 
relative to competing firms based in other countries; at the same time 
it should discourage tax evasion and tax avoidance, especially in the 
form of income shifting to low-tax countries. In particular, the tax 
system should not discourage foreign investment by U.S. multinationals 
or discourage investment in the U.S. by foreign multinationals. 
Although a full discussion of the intricacies of the tax treatment of 
foreign investment is far beyond the scope of this testimony, note that 
(1) in order to make investing in the U.S. attractive to foreign 
multinationals, the taxation of capital income in the U.S. should be 
concentrated at the individual level; (2) the ``territorial'' system 
advocated in the ``Simplified Income Tax'' proposed by the 2005 Tax 
Panel has the advantage of putting U.S. multinationals on an equal 
footing with most of their competitors, but exacerbates incentives for 
shifting income abroad and requires complex allocations of U.S. costs 
across domestic and foreign activities; (3) any approach that instead 
increased the inclusion of foreign income in the tax base of U.S. firms 
(e.g., the elimination of deferral) should be accompanied by corporate 
income tax rate reductions that would leave effective tax rates 
approximately constant; and (4) another advantage of low statutory 
rates under the corporate income tax is that they reduce incentives for 
income shifting to other countries with relatively low tax rates.
          iv. economic effects of various tax reform proposals
    An important argument in favor of macroeconomic analysis is that it 
would potentially inform policy makers explicitly about the long-run 
growth effects of alternative policies, and thus allow for the adoption 
of a more efficient tax system and increased long-run economic growth. 
This section discusses the macroeconomic effects of various tax 
policies and reform proposals in an effort to inform the debate on 
structuring tax reform.
A. Several Studies Comparing the Macroeconomic Effects of Various Taxes
    The Organisation for Economic Co-operation and Development (OECD, 
2008) compares different types of taxes in terms of their effects on 
economic growth. The OECD study concludes that corporate taxes are the 
most harmful to growth, followed by personal income taxes (including 
payroll taxes). High marginal personal income tax rates are also shown 
to discourage entrepreneurial activity. By comparison, consumption 
taxes have smaller negative effects on growth, while property taxes are 
estimated to be the least harmful. These results are broadly consistent 
with a large body of research that argues that consumption-based taxes 
are generally more efficient than income-based taxes, and that 
increases in corporate income and dividend taxes create large 
distortions relative to other taxes and should be minimized. In fact, 
the downward pressure on corporate tax rates around the world is 
evidence that many countries view high corporate tax rates as a 
impediment to growth, especially with an increasingly integrated global 
economy and an increase in the mobility of the capital stock.

    Diamond and Viard (2008) draw similar conclusions. They analyzed 
the macroeconomic effects of a permanent tax rate reduction on 
different types of income, including wage, interest, dividend, and 
corporate income, as well as the effects of a permanent increase in tax 
credits and deductions. They used the DZ model to simulate each of 
these tax rate reductions assuming that the reduction was debt-financed 
for 10 years and then paid for by either a reduction in discretionary 
transfer payments or an across-the-board tax increase. The magnitude of 
the tax reduction is determined so that the decrease in revenue over 
the 10-year period following enactment is $500 billion with no 
behavioral responses. They found that the wage, dividend and corporate 
rate reductions led to an increase in GDP in the long run if 
discretionary transfer payments were reduced. The increase in GDP was 
largest for the reduction in dividend and corporate tax rates. Note 
that an increase in personal tax credits decreased GDP in this case. If 
the cuts were offset by an across-the-board tax increase, the effect on 
GDP was negative for all of the tax cuts except for the dividend tax 
cut, which had no effect on GDP. The largest decrease in GDP (0.8 
percent) occurred for the increase in tax credits (i.e., spending 
through the tax system). The implication is clear: a broad-based, low-
rate tax system will increase economic growth while a narrow-based, 
high-rate tax system will reduce economic growth. President Obama's 
latest proposals move the United States toward a more narrow-based, 
high-tax rate system. These proposals are likely to reduce job growth 
and living standards in the United States and should be rejected.

    The Joint Committee on Taxation (2005, hereafter JCT) examined the 
macroeconomic effects of three proposals that each provide $500 billion 
in tax reductions. The three proposals examined were a decrease in 
individual income tax rates, an increase in the personal exemption, and 
a decrease in the corporate income tax rate. They showed that an 
individual rate reduction would increase GDP by 0.3-0.4 percent in the 
long run if government spending were decreased to stabilize the debt to 
GDP ratio after 10 years. In the case of no fiscal offset, so that debt 
increases as a share of GDP, the individual rate reduction led to a 
decrease in GDP in the long run ranging from 0.2-0.5 percent. A 
corporate rate reduction led to an increase in GDP in the long run 
ranging from 0.5-0.9 percent if government spending were decreased to 
stabilize the debt to GDP ratio after 10 years, an increase in GDP 
ranging from 0.5-0.6 percent in the long run with a decrease in 
personal exemptions, and an increase in GDP in the long run ranging 
from 0.0-0.3 percent with no fiscal offset (the case in which debt 
increases as a share of GDP). Finally, they reported that an increase 
in personal exemptions led to an decrease in GDP in the long run 
ranging from 0.4-0.7 percent with no fiscal offset, and that an 
increase in personal exemptions increased GDP in the long run by 0.1-
0.2 percent if it is offset with a decrease in government spending 
(substituting spending through the tax code for direct spending). The 
results indicate that corporate tax reductions have the largest growth 
effects, followed by individual income tax reductions, and then an 
increase in the personal exemption (which reduces growth unless 
government spending is reduced). The order of the growth effects of the 
tax reductions is consistent with the findings reported in OECD (2008) 
and Diamond and Viard (2008). This implies that to maximize U.S. 
economic growth policymakers should adopt a tax system characterized by 
low capital income tax rates, low individual income tax rates, and 
minimal tax expenditures. To achieve this outcome, the United States 
could follow the BBRR reform approach such as the Tax Reform Act of 
1986 or a modification of the recently proposed Tax Reform Act of 2014. 
Alternatively, the United States could also adopt a more modern 
approach and move toward some form of a consumption-based tax system.
B. Dynamic Analysis of the Tax Reform Act of 2014
    The Tax Reform Act of 2014 was a comprehensive proposal for reform 
of both the corporate and personal income tax systems. The corporate 
income tax (CIT) reform was structured as a traditional base-
broadening, rate-reducing reform. The plan would have lowered the CIT 
rate to 25 percent, phased in over five years, and eliminated a variety 
of business tax preferences, including accelerated depreciation (so 
that tax depreciation would approximate economic depreciation), 
expensing of research and development costs and half of advertising 
costs, and the deduction for domestic production. The plan would have 
not allowed the last-in first-out (LIFO) inventory accounting rule and 
would have permanently created a 15 percent tax credit for research and 
development expenses.

    The reform also changed the treatment of foreign source income, 
including moving to a 95 percent participation exemption (territorial) 
system. In this case, the effective tax rate is roughly 1.25 percent 
with a 25 percent CIT rate. It also allowed for current taxation of 
foreign source income from intangibles, defined as income in excess of 
10 percent on basis in depreciable assets (excluding other subpart F 
income and commodities income) due to foreign sales at a minimum tax 
rate of 15 percent (25 percent for U.S. sales), subject to foreign tax 
credits. The 15 percent rate also applied to intangibles income (income 
in excess of 10 percent on basis in depreciable assets other than from 
commodities) on sales to foreign markets from the United States. The 
reform would have limited subpart F income to low-taxed income and 
created a minimum tax of 12.5 percent for foreign sales and active 
financial services income, in addition to the minimum tax rates noted 
above. There was also a one-time tax on the stock of unrepatriated 
profits, at an 8.75 percent rate on cash and equivalents and at a 3.5 
percent rate on illiquid assets.

    The plan would have also reformed the tax treatment of individual 
income by broadening the tax base and lowering the rates on individual 
income. It would have included a 10 and 25 percent rate bracket, with a 
10 percent surtax on high-income households (above $450,000 for married 
couples). The standard deduction, child credit, and the 10 percent 
bracket would have been phased out for high-income households. The plan 
would have repealed itemized deductions for state and local (non-
business) taxes, medical expenses, personal exemptions, and the 
alternative minimum tax. In addition, it would have limited the 
mortgage interest deduction. Capital gains and dividends would have 
been taxed as normal individual income after a 40 percent exclusion.

    The Diamond-Zodrow computable general equilibrium model was used to 
simulate the effects of TRA 2014. The model is structured so that 
consumers choose consumption, labor supply, and saving to maximize 
welfare over their lifetimes. The model includes 55 adult generations 
(intended to capture an adult's working life from age 23 to 78) alive 
at any point in time, and is thus typically described as an overlapping 
generations model. Firms choose labor demand and the time path of 
investment to maximize profits, subject to adjustment costs. The model 
includes five different production sectors, including a multinational 
corporation (MNC), a domestic corporation, a non-corporate (pass-
through) firm, and owner-and rental-housing sectors. In addition, the 
corporate firms have a variable debt-to-equity ratio. The government 
uses corporate and personal income taxes to finance a fixed level of 
government services. The model must begin and end in a steady-state 
equilibrium with all key macroeconomic variables growing at an 
exogenous growth rate (which equals population plus productivity 
growth). The model is calibrated to roughly match the U.S. economy in a 
given base year.

    The model includes domestic and foreign MNCs (parents and 
subsidiaries) with highly mobile firm-specific capital (FSK) that earns 
above-normal returns, and relatively immobile ordinary capital that 
earns normal returns. This approach follows Becker and Fuest (2011) who 
argue that differential capital mobility is an important part of 
modeling international capital flows. All of the multinational 
corporations--the U.S.-MNC parent firm and its foreign subsidiary, and 
the foreign-based 
RW-MNC parent firm and its U.S. subsidiary--are assumed to have 
analogous production functions. The modeling approach we utilize 
generally follows the approach for firm-specific capital developed by 
de Mooij and Devereux (2009) and Bettendorf, Devereux, van der Horst, 
Loretz, and de Mooij (2009). The MNC is assumed to own a unique firm-
specific production input (FSK)--such as patents or other proprietary 
technology, brand names, or good will--coupled with unique managerial 
skills and knowledge of production processes, which allow it to 
permanently earn above-normal returns. This firm-specific factor is 
treated as ``quasi-fixed,'' as it is assumed to be fixed in total 
supply in any given period, but this fixed amount can be reallocated 
across the United States and the rest of the world (ROW). The main role 
of this assumption is to determine the fraction of production using FSK 
that occurs in the United States relative to the rest of the world. The 
elasticity of the location of production that uses FSK (whether FSK is 
used in the U.S. or ROW) with respect to the tax rate differential is 
assumed to be 8.6, which is calculated from the assumption that the 
capital-share-weighted aggregate portfolio elasticity of all capital 
(both FSK and ordinary capital) is 3.0. The basic idea is that the 
location decision of where to use FSK is highly elastic with respect to 
the tax rate differentials, although we do phase in over time the 
reallocation of production involving FSK in response to changes in 
relative taxes. In addition, MNCs engage in income shifting that 
depends on the tax differential between the U.S. and ROW, including tax 
havens. MNCs must make a repatriation decision and are subject to a 
residual U.S. tax on repatriations. The model includes foreign trade, 
international capital mobility, and foreign ownership of domestic 
capital. Ordinary capital (capital that earns a normal rate of return) 
is disaggregated into structures, equipment, and inventories.

    Table 1 shows the Diamond and Zodrow (2014) analysis of TRA 2014, 
which was prepared for the Business Round Table (BRT). The most 
important factor is the reduction in income shifting as the CIT rate 
declines. In addition, other important factors include the move to a 
territorial tax system, the more efficient allocation of the ordinary 
capital stock (K), and the reallocation of FSK (although this effect 
has a relatively small affect on the results).


            Table 1: Diamond-Zodrow Analysis of Camp for BRT
------------------------------------------------------------------------
       Variable    % Change in Year:
                                                5        10        LR
------------------------------------------------------------------------
GDP.......................................      1.2       2.2       3.1
Ordinary capital stock (K)................      0.5       1.3       5.0
Firm-specific capital (FSK) stock.........     16.7      23.5      23.5
Reduction in income shifting (IS).........     35.3      57.1      57.1
Labor supply (hours worked) (L)...........      0.5       0.3       0.3
CIT rate (%)..............................     25.0      19.9      19.9
------------------------------------------------------------------------


    The DZ model includes differential capital mobility by having one 
capital good that is relatively immobile and another capital good that 
is assumed to be highly mobile. An important question is how this 
assumption affected the reported results. Table 2 shows the effects of 
adopting TRA 2014 under the assumption that all capital is relatively 
immobile (both capital goods have an elasticity of 0.5 with respect to 
the tax rate differential). In this case, GDP increases by 1.3 percent 
instead of 1.2 percent five years after reform, by 1.7 percent instead 
of 2.2 percent 10 years after reform, and by 3.0 percent instead of 3.1 
percent in the long run. Without differential mobility, FSK increases 
by 0.6 percent five years after reform and 1.1 percent in the long run 
instead of 16.3 percent and 23.5 percent. The labor supply increase is 
slightly higher in this case. This demonstrates that the addition of 
FSK is not driving the results in the DZ analysis. Although the 
reallocation of FSK to the United States increases production of the 
good produced by the U.S. multinational, the GDP effects of this 
reallocation are offset by other factor reallocations, especially a 
return of ordinary capital to the rest of the world.


       Table 2: Diamond-Zodrow Analysis of Camp with Immobile FSK
------------------------------------------------------------------------
       Variable    % Change in Year:
                                                5        10        LR
------------------------------------------------------------------------
GDP.......................................      1.3       1.7       3.0
Ordinary capital stock (K)................      1.0       1.9       5.1
Firm-specific capital (FSK) stock.........      0.6       1.1       1.1
Reduction in income shifting (IS).........     35.4      57.6      56.9
Labor supply (hours worked) (L)...........      0.7       0.5       0.5
CIT rate (%)..............................     24.9      17.9      18.0
------------------------------------------------------------------------


    By comparison, the Tax Foundation found much smaller results, with 
only a 0.2 percent increase in GDP in long run. The small size of its 
result is attributable primarily to a reduction in the capital stock of 
0.2 percent as the cost of capital increases under TRA 2014. The Tax 
Foundation predicted that labor supply would increase by 0.5 percent. 
But, the Tax Foundation analysis discusses, then ignores, the benefits 
of reduced income shifting, the benefits of reallocation of firm-
specific capital to the United States, and the benefits of moving to a 
territorial system. The DZ analysis included these factors in modeling 
the effects of the Camp proposal.

    However, the DZ model can be used to find similar effects to those 
presented by the Tax Foundation. For example, using the DZ model and 
simulating the effects of a similar (the base broadeners are slightly 
different) CIT reform (but no individual income tax reform) while 
ignoring the three factors above produces significantly negative 
effects, with GDP down 1.7 percent in long run, and a CIT rate 
reduction to only 31.4 percent (reducing the rate to 25 percent would 
produce results more similar to the Tax Foundation results). In 
particular, this illustrates the significant impact on GDP of reversing 
income shifting and using the revenue gains from reform to further 
lower the corporate income tax rate.

    There are several lessons that can be drawn from these simulations. 
First, a BBRR reform that repeals targeted investment incentives--such 
as eliminating accelerated depreciation or other incentives that affect 
investment at the margin--to finance rate reductions grants a windfall 
gain to existing capital by reducing the tax rate applied to such 
capital, with the windfall exacerbated by the existence of above-normal 
rates of return. The resulting increase in the cost of capital reduces 
investment and output, and makes it much less likely that a BBRR reform 
will result in positive macroeconomic effects in both the short and 
long run.

    Second, the international considerations stressed above make it 
more likely that a BBRR reform will generate positive macroeconomic 
effects. A reduction in the statutory corporate income tax rate will 
result in a reallocation of highly mobile firm-specific capital that 
earns above-normal returns to the United States--although this effect 
is offset to a significant extent by other general equilibrium effects, 
including the return of ordinary capital to the rest of the world and a 
reduction in labor supply. More importantly, a reduction in the 
statutory corporate income tax rate reverses some income shifting from 
the U.S., which provides a ``free'' source of revenue--effectively a 
CIT rate cut without the costs of base broadening--that significantly 
increases the benefits of a BBRR reform. In addition, the changes in 
trade that accompany a reversal of income shifting also have important 
effects, increasing net exports and thus output. Note, however, that 
the amount of income shifting in the initial equilibrium, as well as 
the extent of the reversal of this income shifting with a reduction in 
the CIT rate in the United States, are open to debate, and that the 
macroeconomic benefits of a BBRR reform would be significantly reduced 
if the extent to which income shifting is reversed with U.S. CIT rate 
cuts were smaller than assumed in the simulations.

    Third, although the simulations indicate that the net macroeconomic 
effects of the particular territorial tax reform analyzed are positive, 
the gains from such a reform are fairly modest. This is not surprising: 
since the current worldwide tax system--which taxes foreign source 
income only when repatriated and allows foreign tax credits (including 
cross-crediting of taxes from high-tax countries against income from 
low-tax countries)--imposes a very low residual U.S. tax rate on 
repatriations, switching to a territorial system is likely to have 
relatively limited macroeconomic effects. However, this also implies 
that repealing deferral could lead to significant losses in output to 
the extent it adversely affects the U.S. MNCs ability to compete with 
foreign MNCs.

    Finally, as noted above, the net effect of all these factors 
implies that the macroeconomic effects of a BBRR reform depend very 
much on both the details of the specific reform proposal and the 
context in which it is imposed. These results indicate that a BBRR 
reform is more likely to result in positive macroeconomic effects if 
(1) the initial amount of income shifting is large and is reduced 
significantly when the statutory CIT rate in the United States 
declines; (2) accelerated depreciation is retained instead of being 
used as a base broadening provision; and (3) the BBRR reform includes a 
move to a territorial system of the type analyzed in the report, that 
is, one that includes anti-base erosion provisions that are 
sufficiently effective that the tax sensitivities of international 
capital and income shifting are the same as prior to the enactment of 
the reform.
C. The President's Advisory Panel on Federal Tax Reform
    The President's Advisory Panel on Federal Tax Reform (the Tax 
Panel) was charged with developing options for reforming the current 
federal income tax system that are simple, fair and pro-growth. This 
section discusses the economic growth effects of the three tax reform 
options discussed by the Tax Panel. The report showed that the largest 
increases in capital accumulation and economic growth were associated 
with the reforms that most resembled a move from an income to a 
consumption tax. This result is consistent with a wide body of previous 
research (Altig et al., 2001; Auerbach and Kotlikoff, 1987; Joint 
Committee on Taxation, 1997).

    The Tax Panel's Progressive Consumption Tax (PCT) is a modified 
version of David Bradford's X-tax. The plan is a bifurcated 
subtraction-method VAT where labor compensation is deducted at the 
business level and taxed at the individual level at progressive rates 
of 15, 25, and 35 percent. All business investment is expensed and 
interest is not included nor deducted from the tax base. The PCT 
proposed reforming the mortgage interest deduction to a 15 percent tax 
credit for mortgage interest payments that was capped and 
nonrefundable.

    The PCT was structured as a business cash flow tax and a tax on 
wages above the threshold of $115,000 for married couples at a 
statutory rate of 35 percent. The PCT provided subsidies to debt-
financed owner-occupied housing (through the 15 percent mortgage 
interest credit). In general, the primary distinction between income-
and consumption-based taxes is that under an income tax the normal 
return to capital is taxed, while under a consumption tax the normal 
return to capital is exempt from tax. In the case of the PCT, expensing 
of new business investment reduces the marginal effective tax rate on 
the normal rate of return to zero (since the value of the upfront 
deduction just equals the present value of tax paid on the normal 
return to the investment).

    While the business cash flow tax effectively exempts the normal 
rate of return on new investments from taxation, it does impose a one-
time tax on business capital existing at the time of reform to the 
extent that transition relief is not provided. The PCT would have 
included transition relief for old capital of approximately $400 
billion during the first four years after the enactment reform. The 
present value of the transitional depreciation deductions is 
approximately one-quarter of the value of future depreciation 
deductions under current law, which implies that the vast majority of 
existing business capital faces a one-time tax.

    Adopting a consumption tax should lead to more saving and 
investment, and thus higher levels of output and consumption in the 
long run. The Panel reported that in the long-run the capital stock 
increased by 15.2 percent, national income increased by 4.0 percent, 
and consumption increased by 3.4 percent (all results are from a closed 
economy version of the DZ model and relative to initial baseline 
values). These results are similar to other results found in the 
literature. For example, using an OLG model, Altig et al. (2001) 
estimated that an X-tax would lead to a 6.4 percent long-run increase 
in national income and a 21 percent increase in the capital stock.

    The Growth and Investment Tax (GIT) is similar to the PCT but 
includes an additional tax on interest, dividends and capital gains at 
a rate of 15 percent at the individual level. This allows for lower tax 
rates on business cash-flow and wages compared to the PCT. The plan 
also expands the opportunities to save in tax-preferred accounts. Given 
this, the marginal effective tax rate is only 5.2 percentage points 
higher under the GIT compared to the PCT because of the expanded 
savings accounts and the relatively low statutory tax rate on 
individual capital income. This implies that the growth effects for the 
GIT should be almost as large as those under the PCT. In this case, 
moving to full expensing of business investment encourages new 
investment and thus an increase in the size of the economy in the long 
run, which is mitigated slightly by the increase in taxation of capital 
income at the individual level. For example, the capital stock 
increases by 11.1 percent in the long run (using the OLG model)--this 
is about 70 percent of the growth in the capital stock under the PCT. 
The size of the economy is projected to increase by 3.3 percent in the 
long run.

    The Tax Panel also recommended the Simplified Income Tax (SIT). The 
plan reduces the double taxation of corporate income by providing full 
dividend exclusion and 75 percent exclusion of capital gains on 
corporate stock. Other capital gains are taxed at ordinary rates. This 
reform called for a reduction in the corporate income tax rate to 31.5 
percent and a reduction in the top individual income tax rate to 33 
percent. The rate reductions were financed by broadening the individual 
and business tax bases. As in the GIT, tax preferred saving 
opportunities were also expanded. The plan also proposed a simplified 
system for depreciation allowances that would slow down the cost 
recovery for capital. The net effect was a 2 percentage point reduction 
in the effective marginal tax rate on capital income. This implies that 
the SIT would have limited effects on the size of the long-run capital 
stock and economic growth. For example, the capital stock is only 1.4 
percent higher in the OLG model simulations, and the long-run increase 
in the size of the economy is 1.2 percent.

    In the end, the Tax Panel did not recommend switching to a 
consumption-based tax system (such as the PCT); instead the Tax Panel 
recommended the GIT and SIT, even though the growth effects of the 
consumption-based tax were larger. However, given the fiscal challenges 
facing the United States it may be time to adopt a reform that 
maximizes the accumulation of capital and economic growth in the long 
run, especially if it can implemented in a manner that maintains 
distributional neutrality as argued for above.
D. Other Ambitious Reform Proposals
    As mentioned in the introduction there are a number of other reform 
proposals other than those discussed above. For example, Auerbach 
(2010) proposes reforming the current corporate income tax system by 
allowing an immediate deduction for all new investment as a replacement 
for the current depreciation system and moving to a system that only 
taxes transactions that occur in the United States (i.e., a 
destination-based cash-flow tax). In addition, the proposal would allow 
for the symmetric treatment of debt and equity by including the 
proceeds of new debt in the tax base and excluding the repayment of 
debt. Auerbach argues that such a reform would reduce the most 
distortionary and complex problems with the current corporate tax 
system, increase progressivity, and increase output potentially by as 
much as 5 percent. He also argues that maintaining the current 
corporate tax system and reducing the tax rate, as proposed under a 
BBRR approach, ``would leave in place all the flaws of the existing 
system,'' such as the tax bias favoring debt finance under the current 
income tax (which arises because interest on debt is deductible but 
dividends paid to shareholders are not).

    Diamond and Zodrow (2011) propose that as part of the process of 
fundamental tax reform, serious consideration should be given to the 
implementation of an ``allowance for corporate equity'' or ``ACE'' that 
would result in roughly uniform treatment of debt and equity finance 
and lower the taxation of investment income at the business level to 
that associated with a consumption-based tax. This approach, which was 
recommended recently by the tax reform commission headed by Nobel Prize 
winning economist James Mirrlees in the United Kingdom and has been 
implemented successfully in a small number of countries, allows firms 
an extra deduction equal to the product of the book value of equity 
capital and a risk-free nominal interest rate. The economic effect of 
the ACE is to put debt and equity finance on an equal footing at the 
business level, as the ACE deduction for equity-financed investment is 
comparable to the deduction of interest expense for debt-financed 
investment. Moreover, the ACE approach can be applied to all 
businesses, perhaps with an exception for small firms, and thus would 
eliminate the current income tax bias against corporate entities.

    There are certainly other proposals that are worthy of 
consideration as well.
                             v. conclusion
    Several recent reports on fixing our nation's fiscal crisis have 
focused attention on the need for fundamental reform of the corporate 
and personal income tax systems. While several factors seem to make the 
enactment of such a reform somewhat more difficult than in 1986, a 
sweeping reform of the tax system is well overdue. In my view, given 
the fiscal crisis facing the United States, fundamental reform must 
minimize the distortionary effects of taxation wherever feasible, seek 
to maximize long-run economic growth, and make simplicity a more 
important goal to achieve reductions in compliance and enforcement 
costs. While there are many proposals that are worthy of consideration, 
we must ultimately choose one. Macroeconomic analysis of various 
proposals and provisions should offer guidance in that process.

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Auerbach, Alan J. and Laurence J. Kotlikoff, 1987. Dynamic Fiscal 
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Auerbach, Alan, 2010. ``A Modern Corporate Tax,'' The Hamilton Project, 
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Bettendorf, Leon, Michael P. Devereux, Albert van der Horst, Simon 
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Bilicka, Katarzyna, and Michael Devereux, 2012. ``CBT Corporate Tax 
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Bowles, Erskine and Alan Simpson, 2013. ``A Bipartisan Path Forward to 
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Congressional Budget Office, 2014. The Long-Term Budget Outlook. 
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de Mooij, Ruud, and Michael P. Devereux, 2009. ``Alternative Systems of 
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Diamond, John W., and Alan D. Viard, 2008. ``Welfare and Macroeconomic 
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Diamond, John W., and George R. Zodrow, 2014. ``Dynamic Macroeconomic 
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Diamond, John W., and George R. Zodrow, 2011. ``Fundamental Tax Reform: 
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McLure, Charles E., Jr., and George R. Zodrow, 1987. ``Treasury I and 
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                                 ______
                                 
      Questions Submitted for the Record to John W. Diamond, Ph.D.
               Questions Submitted by Hon. Orrin G. Hatch
    Question. Dr. Gravelle's testimony argues that ``. . . it should 
not be surprising that a revenue neutral tax reform is unlikely to have 
a significant effect on output, given the necessity of base broadening 
to lower rates.'' In support of the argument, a study is cited that 
assessed the Tax Reform Act of 1986--or TRA86--and concluded, according 
to Dr. Gravelle's summary, that it ``left incentives roughly 
unchanged.'' Given that, you wouldn't expect much in terms of growth 
effects from a revenue neutral reform exercise. Before getting to my 
question, I would note that the 1997 study in question does conclude 
that, at the time, ``. . . saying that a decade of analysis has not 
taught us much about whether TRA86 was a good idea is not at all the 
same as saying it was not in fact a good idea. We think it was.'' 
Moreover, since that analysis, a Nobel Prize winning economist and his 
coauthor have provided evidence that tax reforms in 1986 coupled with 
changes in regulations governing retirement holdings help account for 
large long-run increases in corporate equity values relative to GDP, 
something that I would think is a positive for the economy and everyone 
with a retirement account. My question to the Panel is whether everyone 
agrees that it is ``simply difficult, if not impossible'' to design a 
revenue neutral tax reform plan that would have significant enough 
effects on incentives to increase economic growth?

    Answer. While it is difficult to design a revenue neutral tax 
reform plan that has significant effects on economic growth, it is 
certainly not impossible.

    We have to be careful in how we implement tax reform and this is 
one argument in favor of dynamic analysis. Consider a simple example. A 
common argument against dynamic analysis is to construct tax reforms 
proposals that have small overall effects on economic growth--usually 
because the proposals have opposing effects. However, this argument 
ignores the fact that showing that a proposal has no impact or a small 
impact is valuable information in the process of constructing tax 
reforms. Alternatively, think about proposals that have similar 
microeconomic scores but different macroeconomic effects. For example, 
consider one policy that raises capital gains and dividend tax rates 
and uses the revenue to increase the child tax credit. Compare this to 
a second policy which cut gains and dividend tax rates and finances the 
static revenue loss with a cut in the child tax credit. The 
microeconomic revenue impacts are similar for these two proposals 
except for some timing effects. However, in terms of efficiency and 
long run economic growth the second policy would dominate the first. 
This is supported by many studies, such as OECD (2008), JCT (2005), and 
Diamond and Viard (2008) which are referenced in my written testimony. 
While it is certainly true that some base-broadening, rate-reducing 
reforms may have negligible or even negative effects on economic 
growth, there are other proposals that would promote economic growth. 
Dynamic Analysis is a useful tool to examine the relative growth 
effects of various reform proposals.

    Question. Dr. Diamond, you are an economist formerly on the staff 
of the Joint Committee on Taxation. I'm interested in your views on 
both conventional revenue estimates as well as estimates that reflect 
macroeconomic analysis. There seems to be a lot of confusion regarding 
the use of macroeconomic analysis of tax reform proposals. Dr. Diamond, 
my question is whether conventional, or static, revenue estimation is a 
more accurate measure for revenue estimates of tax reform proposals 
than macroeconomic analysis, which is sometimes referred to as dynamic 
estimating or scoring?

    Answer. As illustrated by the example in my answer to the previous 
question, the answer depends on the proposal. If the proposal is 
structured to have minimal growth effects then microeconomic and 
macroeconomic scores should be relatively close. However, if a proposal 
increases or decreases economic growth the conventional and dynamic 
scores will diverge. This is important information and it should be 
used to make sure we adopt growth enhancing reforms to the extent it is 
politically feasible.
                                 ______
                                 
  Prepared Statement of Jane G. Gravelle, Ph.D., Senior Specialist in 
  Economic Policy, Congressional Research Service, Library of Congress
    Mr. Chairman and Members of the Committee, I am Jane Gravelle, a 
Senior Specialist in Economic Policy at the Congressional Research 
Service of the Library of Congress. I would like to thank you for the 
invitation to appear before you today to discuss tax reform, growth and 
efficiency.

    Economists distinguish between efficiency effects, the cost of 
distortions, sometimes referred to as deadweight losses, and growth 
effects, the increase or decrease in labor or capital due to tax 
changes. For example, if a marginal tax rate cut increases labor supply 
the growth effect is the value of additional output. The efficiency 
gain is the increased income minus the loss in the value of leisure or 
unpaid work (such as child care).\1\ Thus the efficiency gain would be 
smaller than the growth effect. Some efficiency gains might not 
increase output or would have a negligible effect, such as the 
substitution of one type of capital investment or consumption item for 
another. They nevertheless increase well-being.
---------------------------------------------------------------------------
    \1\ The relationship between output effects and efficiency effects 
can change if average taxes are cut as well. Since increases in income 
decrease labor supply, if the average tax cut or the response to it is 
large enough, labor supply can be reduced, but an efficiency gain will 
remain.

    This testimony first discusses the magnitude of distortions arising 
from the income tax and identifies some specific areas of the tax code 
where efficiency gains might be achieved. It then discusses potential 
growth effects from both revenue neutral tax reform and tax cuts or 
increases.
             efficiency gains from reducing tax distortions
    It is first useful to review the economic literature on the cost of 
distortions in the in the income tax. Jorgenson and Yun,\2\ using a 
dynamic growth model, estimated the total welfare cost of the income 
tax system as 2.4% of GDP, 0.6% due to the corporate income tax and 
1.8% due to the individual income tax. For a variety of reasons, these 
estimates might be lower today.\3\ Feldstein,\4\ using a taxable income 
elasticity,\5\ estimates the efficiency cost of individual income taxes 
at 2.4% of GDP. Subsequent studies of this elasticity have, however, 
found it much lower, yielding an estimate of the efficiency cost of the 
individual income tax of about 1% of GDP.\6\
---------------------------------------------------------------------------
    \2\ Calculated from Dale W. Jorgenson and Kun-Young-Yun, 
Investment: Lifting the Burden: Tax Reform, the Cost of Capital and 
U.S. Economic Growth, MIT Press, Cambridge MA, pp. 287-288. They found 
their results difficult to compare to earlier studies but, in one case 
the estimates appear lower and in the other higher.
    \3\ Individual tax rates are lower than they were in the year of 
the study, which can be important because the deadweight loss rises 
with the square of the tax rate. In addition, the labor substitution 
elasticity (percentage change in labor supply divided by the percentage 
change in marginal wage) is generally lower today; Jorgenson and Yun 
had an elasticity 0.3, while the Joint Committee on Taxation uses 
elasticities in their in-house model of 0.1 and 0.2.
    \4\ Martin Feldstein, Tax Avoidance and the Deadweight Loss of the 
Income Tax, The Review of Economics and Statistics, Vol. 81, No. 4, 
November 1999, pp. 674-680.
    \5\ An elasticity is the percentage change in quantity divided by 
the percentage change in price. In this case, it is the percentage 
change in taxable income induced by a percentage change in tax rate.
    \6\ Congressional Budget Office, Recent Literature on Taxable 
Income Elasticities, by Seth H. Giertz, Technical Paper 2004-16, 
December, 2004. The central tendency of studies was 0.4, compared to an 
elasticity of 1.09 used in the Feldstein article. A subsequent review 
article found even smaller effects from central tendencies, while 
reviewing a range of associated issues. See Emmanuel Saez, Joel Slemrod 
and Seth H. Giertz, ``The Elasticity of Taxable Income with Respect to 
Marginal Tax Rates: A Critical Review,'' Journal of Economic 
Literature, Vol. 50, No. 1, March 2012, pp. 3-50.

    These estimates, which reflect eliminating the income tax system 
and replacing it with a head tax (the only type of tax that produces no 
distortions), provide the upper limit on potential efficiency gains. 
Thus, it is unlikely that efficiency gains from tax reform, which can 
---------------------------------------------------------------------------
only capture part of those effects, will be very large.

    There have also been some estimates, using dynamic models, of broad 
tax reforms such as replacing the income tax with a flat-rate broad-
based income tax, consumption tax or wage tax. The latter two 
replacements eliminate the tax on capital income but increase the tax 
rate on labor income (especially in the move to a wage tax). The 
efficiency gains in these studies ranged from virtually zero to about 
1% of GDP.\7\
---------------------------------------------------------------------------
    \7\ Jorgenson and Yun, op cit., found gains of 0.6% to 1.1% (p. 
335). Two studies reported estimates in the Joint Committee on 
Taxation, Tax Modeling Project and 1997 Tax Symposium Papers, November 
20, 1997, JCS-21-97. Diane Lim Rogers, ``Assessing the Effects of 
Fundamental Tax Reform with the Fullerton-Rogers General Equilibrium 
Model,'' pp.81-82 found that a move to a proportional comprehensive 
income tax, would have welfare gains 0.05 to 0.7%, moving to a 
consumption tax would have gains of 0.06 to 1.0%, and moving to a wage 
tax, gains of 0.2% to 1%. Dale W. Jorgenson and Peter J. Wilcoxin, 
``The Effects of Fundamental Tax Reform and the Feasibility of Dynamic 
Revenue Estimation,'' p. 135, found gains that were essentially zero. 
For the document, see
    https://www.jct.gov/publications.html?func=startdown&id=2940.
    Jane G. Gravelle, ``Income Consumption and Wage Taxation in a Life-
Cycle Model: Separating Efficiency from Redistribution,'' American 
Economic Review, Vol. 81, No. 4, September, 1991, pp. 985-995, found a 
gain of 0.4% for movement to a consumption tax and 0.15% for movement 
to a wage tax. This model, however, included a single uniform tax rate 
on capital income and thus did not capture gains from the reallocation 
of capital assets.

    While savings in compliance costs from simplification are not 
considered part of deadweight losses, it is reasonable to see those 
savings as an efficiency gain. A GAO study that reviewed estimates of 
compliance costs of the federal tax system, while noting the difficulty 
in measuring them, placed them at around 1% of GDP.\8\ Uncertainty in 
the tax law also leads to less than optimal behavior, although the cost 
is not possible to quantify.
---------------------------------------------------------------------------
    \8\ GAO, Summary of Estimates of the Costs of the Federal Tax 
System, GAO-05-878, August 26, 2005, http://www.gao.gov/products/GAO-
05-878.

    What changes might lead to a reduction in distortions that might be 
considered in the context of an income tax reform? Examining the major 
tax expenditures and potential for reform, four areas of revision are 
discussed. Note that while policies that might reduce distortions are 
discussed, CRS does not make policy recommendations and there are many 
other aspects to consider in a tax change.
Reducing Differentials in Returns to Investment
    Returns to investment are differentially taxed by the income tax 
system based on the source of the return.\9\ Owner-occupied housing is 
favored and subject to negligible or negative tax rates due to the 
exclusion of imputed rent and the deduction for mortgage interest and 
property taxes. The corporate sector is taxed more heavily than the 
noncorporate sector, but within the corporate sector debt-financed 
investment is also taxed at zero or negative rates, while the highest 
rates (around 35%) apply to corporate equity investments.
---------------------------------------------------------------------------
    \9\ For tax rates see Corporate Tax Reform: Issues for Congress, 
CRS Report RL34229, by Jane G. Gravelle and Congressional Budget 
Office, Taxing Capital Income: Effective Marginal Tax Rates Under 2014 
Law and Selected Policy Options, December 2014,
    https://www.cbo.gov/publication/49817.

    Within each industry different assets are taxed at different rates. 
Considering the corporate level tax on equity investment, which 
captures the effects of depreciation, buildings are taxed at close to 
statutory rates (35%) and residential buildings are taxed at somewhat 
lower rates, while equipment rates average around 75% of the statutory 
rate (26%). These differences arise from more favorable depreciation 
allowances for equipment. Bonus depreciation, which has expired, has 
lowered the tax rate for an investment in equity to 15% for the past 
seven years.\10\ Certain industries, largely manufacturing, are favored 
over others due to the production activities deduction.\11\ The 
extractive industries are also favored because of generous treatment of 
investments through expensing.
---------------------------------------------------------------------------
    \10\ See Bonus Depreciation: Economic and Budgetary Issues, CRS 
Report R43432, by Jane G. Gravelle.
    \11\ For a review of this provision see The Section 199 Production 
Activities Deduction: Background and Analysis, by Molly F. Sherlock, 
CRS Report R41988.

    Some items that appear as tax expenditures may reduce distortions 
or be relatively neutral. For example, the favorable treatment of 
pension and retirement earnings, to the extent they are invested in 
corporate stock, reduce the tax on corporate equity and bring effective 
tax rates closer to those on owner-occupied housing and non-corporate 
investment. Investment in research and development, which is favored 
compared to other assets (because of expensing and, if made permanent, 
the research and experimentation credit), is often considered to be an 
appropriate target of tax benefits.\12\ That is, an economy may 
underinvest in research because firms do not capture the full social 
benefits of their investments.\13\ Lower taxes on the return to 
investment in advertising, another intangible, is, however, not 
justified on the same grounds.
---------------------------------------------------------------------------
    \12\ For an overview of the credit see Research Tax Credit: Current 
Law and Policy Issues for the 114th Congress, CRS Report RL31181, by 
Gary Guenther; Joseph J. Cordes, ``Research and Experimentation 
Credit,'' in the Encyclopedia of Taxation and Tax Policy, ed. Joseph J. 
Cordes, Robert D. Ebel, and Jane G. Gravelle, Washington D.C., The 
Urban Institute, 2005.
    \13\ See John C. Williams and Charles I. Jones, ``Measuring the 
Social Return to R&D,'' Quarterly Journal of Economics, vol. 113, no. 
4, November 1998, pp. 1,119-1,135 for a review of the evidence showing 
the high social rates of return to research.

    Jorgenson and Yun also made estimates of the efficiency gains from 
eliminating certain asset distortions.\14\ For differentials between 
assets (such as equipment and structures) within sectors, they 
estimated an efficiency gain of 0.1% of GDP. For eliminating the 
intersectoral distortion between corporate and non-corporate business, 
they estimated a gain of 0.02% of GDP. For eliminating the entire 
intersectoral distortion, which would include owner-occupied housing, 
they estimated a gain of 0.8% of GDP.
---------------------------------------------------------------------------
    \14\ Jorgenson and Yun, op. cit., p. 277.

    Gravelle estimated the cost of corporate tax distortions to be 
about 10% to 15% of corporate tax revenue, or about 0.3% of GDP, with 
about a third (0.1%) due to the debt-equity distortion and the 
remainder largely due to the distortion between corporate and all other 
investment.\15\ These amounts would be expected to be lower than the 
Jorgenson and Yun study because of the lower rates on corporate 
dividends and capital gains enacted in 1997 and 2003. Also this 
estimate does not capture the distortion between owner-occupied and 
non-corporate capital or distortions across assets. Neither the 
Jorgenson and Yun nor the Gravelle estimates include the effects of the 
production activities deduction.
---------------------------------------------------------------------------
    \15\ Corporate Tax Reform: Issues for Congress, CRS Report RL34229, 
by Jane G. Gravelle.

    While the full set of changes that would eliminate these 
distortions is probably beyond the scope of a tax reform, there are 
some practical changes in a revenue-neutral tax reform that could 
capture some of these effects. These include disallowing part of the 
deduction for corporate interest, repealing or otherwise limiting the 
production activities deduction, and slowing depreciation and cost 
recovery in the extractive industries, while using these revenue gains 
to reduce the corporate rate. There are a number of smaller but 
significant provisions that favor certain types of investment such as 
the exemption of like-kind exchanges from the capital gains tax, 
exclusion of interest on private activity bonds, and deferral of gain 
in non-dealer installment sales, where repeal would also yield revenue 
for corporate rate reduction. Note, however, that slowing depreciation 
for equipment, while achieving greater neutrality, may also raise the 
cost of capital if exchanged for a rate reduction, since a corporate 
---------------------------------------------------------------------------
rate reduction produces a windfall for the return on existing capital.

    In the individual tax system, repealing the deduction for property 
taxes and capping, otherwise limiting, or repealing the mortgage 
interest deduction would reduce (although not eliminate) the favorable 
treatment of owner occupied housing. Changes that appear relatively 
unrelated (such as eliminating the deduction for state and local income 
taxes and increasing the standard deduction), as was proposed in former 
Chairman of the Ways and Means Committee Dave Camp's tax reform 
proposal, H.R. 1, 113th Congress, would help to reduce this distortion 
by reducing the number of itemizers.
Exclusion of Employer Subsidies for Health Care
    Among the major items in individual tax expenditures is the 
exclusion of employer provided health benefits from employee's income. 
Calculations suggest that the efficiency cost of subsidizing health 
insurance and health spending might be about 0.02% of GDP.\16\ The 
Cadillac tax, enacted as part of the Affordable Care Act and scheduled 
to go into effect in 2018 will reduce this distortion. Further 
reduction could be achieved by lowering the level at which the tax 
applies. Another option to consider is to eliminate the benefits for 
cafeteria plans which may largely be used to exclude the employee's 
portion of health insurance.
---------------------------------------------------------------------------
    \16\ The deadweight loss is approximately the triangle in a supply 
and demand curve intersection that is \1/2\ the change in quantity 
times the change in price. The rule of thumb formula for the deadweight 
loss as a percent of spending is \1/2\E(t2), where E is the 
elasticity and t is the tax rate. The elasticity is assumed to be -0.2. 
See Su Liu and Deborah Chollet, Price and Income Elasticity of the 
Demand for Health Insurance and Health Care Services: A Critical Review 
of the Literature, Mathematica Policy Research, Inc., March 24, 2006, 
at http://www.mathematica-mpr.com/publications/pdfs/priceincome.pdf. 
The assumed tax rate is 25%. To determine current spending on health 
insurance, C*, divide the tax expenditure for FY2014 of $143 billion by 
0.25, which yields $572 billion. Rather than use the formula which 
technically applies only to a small change, the calculation used a 
discrete changed based on a constant elasticity of substitution formula 
C= A((1-t))^E. That result yielded $540 billion, and a 
change in quantity of $32 billion. Multiplying this amount by the tax 
and by \1/2\ yields $8 billion, which, divided by GDP of $17 trillion 
is 0.02%.

    While a straightforward calculation of welfare costs can produce a 
value, caution is suggested in interpreting these measures, since so 
many complications in the health market make it different from ordinary 
markets. Nevertheless, it is likely that reducing spending on very 
generous health insurance would increase efficiency.
Itemized Deduction for Charitable Contributions
    The main individual tax expenditure not already mentioned that 
affects behavior is the deduction for charitable contributions.\17\ 
Applying the same methodology used for health insurance but with 
different parameters yields an estimate of 0.03% of GDP.\18\ Subsidies 
for charitable giving, however, may increase rather than decrease 
efficiency. The level of private charitable contributions is generally 
assumed to be underprovided because individuals can ``free-ride'' on 
others for funding charitable objectives such as low-income assistance, 
education, medical research, and hospitals. At the same time, an 
argument can be made that the induced contributions from the revenue 
loss are likely smaller than the loss itself \19\ and these objectives 
could also be addressed by additional government spending.
---------------------------------------------------------------------------
    \17\ Other provisions in the ten largest individual tax 
expenditures not already addressed are largely motivated by 
distributional objectives: the earned income credit, the child credit, 
and the exclusion of Social Security benefits.
    \18\ Although the size of the tax expenditure was smaller than the 
health exclusion, the elasticity was assumed to be larger, at 0.5. See 
Charitable Contributions: The Itemized Deduction Cap and Other FY2011 
Budget Options by Jane G. Gravelle and Donald Marples, CRS Report 
R40518 for a review of the empirical evidence on elasticities. The 
estimate also assumed a higher tax rate of 35% given the concentration 
of giving in high income classes.
    \19\ If the elasticity is less than one, the induced spending will 
be smaller than the reduced taxes.

    There may be more limited changes outside of repealing the 
deduction, such as allowing only the basis of appreciated property to 
be deducted (or imposing a capital gains tax at the time of gift), 
imposing a floor on the deduction, or requiring payouts for certain 
institutions that hold charitable contributions without distributing 
them that might enhance the efficiency of the tax provision.
International Tax Issues
    The largest corporate tax expenditure is the deferral of tax on 
income from foreign corporations. This provision is probably not 
associated with a significant economic distortion. Evidence suggests 
that, in most cases, the areas where real investment is likely to be 
made, the developed countries, tend to have marginal effective tax 
rates that are relatively similar to those in the United States.\20\ 
While deferral may cause a misallocation of capital, that effect is 
likely to be relatively small compared to GDP. It is more likely, 
especially given the dramatic concentration and growth in profits 
abroad in tax havens,\21\ that this tax expenditure is reflective of 
profit shifting that largely affects revenues rather than the physical 
location of investment.
---------------------------------------------------------------------------
    \20\ See International Corporate Tax Rate Comparisons and Policy 
Implications., CRS Report R41743, byJane G. Gravelle.
    \21\ Tax Havens: International Tax Avoidance and Evasion, CRS 
Report R40623, by Jane G. Gravelle, Senior Specialist in Economic 
Policy, and Gabriel Zucman, ``Taxing across Borders: Tracking Personal 
Wealth and Corporate Profits,'' Journal of Economic Perspectives, Vol. 
28, No. 4, Fall 2014, pp. 121-148.

    Repatriation of income held overseas does trigger a repatriation 
tax, although economic analysis has not settled on the importance, or 
even existence, of that distortion and it has not been measured.\22\ 
The repatriation tax could be eliminated by moving to a territorial 
tax, eliminating deferral and taxing all income currently, or imposing 
a current tax at a lower rate. All are proposals that have been made, 
although repealing deferral would yield enough revenues to reduce the 
corporate tax rate by three percentage points. Such a change might need 
to be accompanied by a provision to further restrict corporate 
inversions. A fully territorial tax might worsen the profit shifting 
problem and additional anti-abuse provisions may be needed.
---------------------------------------------------------------------------
    \22\ For a review of the literature on repatriations see Moving to 
a Territorial Income Tax: Options and Challenges, CRS Report R42624, by 
Jane G. Gravelle.
---------------------------------------------------------------------------
A Note on Labor Supply and Savings
    A revenue-neutral tax reform is unlikely to have much effect on the 
overall distortions in labor supply (or, rather, a distortion between 
consumption and leisure) or savings (a distortion between present and 
future consumption). As an illustration, consider the recent proposal 
by former Chairman of the Ways and Means Committee Dave Camp. Although 
rates, particularly the corporate tax rate, were cut, the overall 
effective tax rate on the return to savings, once provisions are phased 
in, is slightly increased, and the capital stock falls according to 
analysis by the Joint Committee on Taxation (JCT).\23\ Base broadening 
provisions such as slower depreciation, other capital cost recovery 
changes, and the elimination of the production activities deduction 
increased the tax base and more than offset the rate cuts.
---------------------------------------------------------------------------
    \23\ Joint Committee on Taxation, Macroeconomic Analysis of the 
``Tax Reform Act of 2014,'' JCX-22-14, February 26, 2014,
    https://www.jct.gov/publications.html?func=startdown&id=4564.

    With respect to labor supply, although the marginal tax on labor 
income was reduced about four percentage points, the effect on 
distortions is small, estimated at 0.02% of GDP.\24\ This small effect 
is partly due to the small effect of the proposal on tax rates and 
partly due to the small size of the behavioral response. It might also 
be somewhat overstated because some base broadening provisions, which 
were not incorporated, increase the marginal tax rate (such as the 
disallowance of a deduction for state and local income taxes).
---------------------------------------------------------------------------
    \24\ The results from the overlapping generation model used by JCT, 
which does not allow income effects, can be used to determine the 
percentage change in the marginal wage. In that model the labor 
substitution elasticity (percentage change in labor supply divided by 
percentage change in marginal wage) is 0.24 and the effect on labor 
supply is 1.3%. Thus the percentage change in wage is 1.3/0.24, or 
5.41%. Since the percentage change in wage is the change in tax divided 
by one minus the tax rate, the rate change, assuming a marginal tax 
rate of 25%, is 4 percentage points (0.75 times 0.0541). The excess 
burden, using a 0.2 elasticity which is the higher elasticity in the 
JCT's in-house model is (\1/2\) times 0.2 times (0.0541)\2\, and 
multiplied by labor's share of income of approximately two-thirds, is 
0.02% of GDP. At the lower elasticity of 0.01, it is 0.01% of GDP.
---------------------------------------------------------------------------
    Because of the constraints on revenue neutral tax reform, it is 
difficult to achieve significant efficiency gains for the basic 
distortions (in labor supply and saving) in imposing any income tax.
                           effects on growth
    The effects of a tax reform on economic growth depend on whether 
the tax reform is revenue neutral (especially in the longer run) or 
also raises or loses revenue.\25\ It is easiest to explain the expected 
effects on growth by beginning with a simple tax cut, and then 
proceeding to the effect of a revenue neutral proposal.\26\
---------------------------------------------------------------------------
    \25\ Note that growth effects are a one-time change in output and 
not a change in the growth rate. The growth rate is determined by 
factors such as technological advance, labor productivity growth, and 
the growth in the labor force.
    \26\ For a detailed review of macroeconomic modeling see Dynamic 
Scoring for Tax Legislation: A Review of Models, CRS Report R43381, by 
Jane G. Gravelle.

    Three types of effects may influence the output effects of a tax 
change: (1) the short run demand side stimulus effect, (2) the 
crowding-out effect, where the increase or decrease in the deficit 
reduces or increases funds available for investment, and (3) supply 
side effects, where labor supply and savings respond to changes in tax 
rates. Demand stimulus effects from a tax cut or tax increase are 
transitory. The crowding out (or in) effect happens gradually over time 
but grows continually. Supply side effects are typically primarily due 
to labor supply in the budget horizon as capital takes some time to 
---------------------------------------------------------------------------
accumulate or decline (unless investment flows in or out from abroad).

    The magnitude of the stimulus effect from a tax cut is uncertain. 
If the Federal Reserve is targeting inflation and interest rates, it 
may take actions to offset the stimulus effect. As a result the JCT 
typically reports two effects: one where the Fed takes no action and a 
demand side effect occurs, and another where the Fed offsets the 
stimulus. They also generally consider two measures of the labor 
substitution elasticity: 0.2 and 0.1. That is the elasticity that 
measures the response to the marginal wage, and therefore to the 
marginal effective tax rate.

    To illustrate how these effects work, consider a simulation that 
the Joint Committee on Taxation prepared in 2005 of a $500 billion ten-
year tax cut (a tax cut of about 0.3% of GDP) using their in-house 
macroeconomic general equilibrium mode (MEG).\27\ First, consider the 
effect where the Federal Reserve takes no action. A cut in individual 
rates increases output by 0.1% of GDP in the first five years. In the 
second five years output increases by 0.1% of GDP in the high 
elasticity case and by 0.0% in the low elasticity case. By the long run 
(30 years) the tax cut has reduced output of 0.5% and 0.6% 
respectively. Thus the crowding out effect eventually overwhelms the 
supply side effect as the horizon lengthens. When stimulus effects are 
included the effects are larger during the budget horizon (by 0.2 to 
0.4 percent) but the effects are still to reduce output (by 0.2% and 
0.3% of GDP) by 30 years. The fiscal offset delayed the effects of 
crowding out but did not eliminate them. These negative effects will 
continue to grow.
---------------------------------------------------------------------------
    \27\ Joint Committee on Taxation, Macroeconomic Analysis of Various 
Proposals to Provide $500 Billion in Tax Relief, JCX-4-05, March 1, 
2005,
    https://www.jct.gov/publications.html?func=startdown&id=1189.

    For a corporate rate reduction, output increases by 0.1% in the 
first five years and 0.2% in the second five years, but is zero after 
30 years without stimulus effects. With stimulus effects the results 
are larger by about 0.2% and still positive after 30 years, but 
---------------------------------------------------------------------------
decreasing.

    For a tax cut, the crowding out effect dominates eventually because 
it continues to grow indefinitely as long as the tax cut that loses 
revenue is in place. A tax increase would have the opposite effect: it 
would produce some contraction in the short run, but would eventually 
increase output.

    For a truly revenue neutral tax change the stimulus effects and 
crowding out effects should be minimal. In that case, the effects are 
largely due to supply side effects. To illustrate the magnitude of 
these effects consider the JCT's analysis with their in house model of 
former Ways and Means Chairman Dave Camp's tax proposal.\28\ In that 
simulation, with no stimulus effects, the effect on GDP through a labor 
supply effect over the first ten years was 0.1% with the low elasticity 
and 0.2% with the high elasticity. There was, surprisingly, a stimulus 
effect of about 0.3% when it was permitted, which may have been because 
the proposal reduces labor income taxes. No long run estimates were 
provided, but it is likely that the Camp proposal loses significant 
revenue in the long run and would eventually cause a reduction in 
output.\29\
---------------------------------------------------------------------------
    \28\ Joint Committee on Taxation, Macroeconomic Analysis of the 
``Tax Reform Act of 2014,'' JCX-22-14, February 26, 2014,
    https://www.jct.gov/publications.html?func=startdown&id=4564. JCT 
found larger effects, of around 1.5% of output when using an 
alternative overlapping generation (OLG) model. This model cannot 
permit either crowding out or stimulus effects. About half the 
difference between the effects in this model and the MEG model is a 
larger increase in the labor supply response in the OLG model and the 
remainder to a new aspect of the OLG model that treats the shift in the 
ownership of intangible assets (e.g., patents and copyrights) due to 
changes in corporate taxes as having real effects on output. This 
innovation has been used in a European model without explanation or 
justification. See Michael P. Devereux and Ruud de Mooij in ``An 
Applied Analysis of ACE and CBIT Reforms in the EU,'' International Tax 
and Public Finance, vol. 18, no. 1, 2011, pp. 93-120 and Leon 
Battendorf, Michael P. Devereux, Albert van der Horst, Simon Loretz and 
Ruud de Mooij, ``Corporate Tax Harmonization in the EU,'' Economic 
Policy, vol. 63, 2010, 537-590. The authors do not present any 
empirical evidence to support entering what they refer to as firm-
specific capital into the production function, or the importance of it 
in the economy. Since intangible assets can already be used costlessly 
in every location, there is no reason that a shift in ownership of an 
intangible should have an output effect. That is, the location of 
ownership should not change productivity. This point has been also been 
made by William McBride, Some Questions Regarding the Diamond and 
Zodrow Modeling of Camp's Tax Plan, Tax Foundation, March 17, 2014,
    http://taxfoundation.org/blog/some-questions-regarding-diamond-and-
zodrow-modeling-camps-tax-plan. The larger labor supply response is in 
small part due to a larger substitution elasticity, but largely more 
likely explained by the constraints of the OLG model and how it is 
closed, since it cannot permit offsetting labor income effects and 
treats each generation as represented by a single individual. The OLG 
model cannot be used to model a stand-alone tax change because it 
cannot be solved with long run changes in deficits.
    \29\ This longer run revenue loss has been widely discussed. See 
Leonard Burman, ``Hidden Taxes in the Camp Proposal,'' February 27, 
2014,
    http://taxvox.taxpolicycenter.org/2014/02/27/hidden-taxes-in-the-
camp-proposal/; Robert S. McIntyre, ``Camp Is Hiding the True Effects 
of His Tax Plan,'' Tax Notes, April 27, 2014, pp. 91-93, who calculates 
the effects for the second decade of the Camp plan, finding an average 
of $170 billion in losses per year (which would be roughly at 2028 
levels of income); Joseph Rosenberg, ``How Does Dave Camp Pay for 
Individual Tax Cuts? By Raising Revenue from Corporations,'' Urban-
Brookings Tax Policy Center, February 27, 2014,
    http://taxvox.taxpolicycenter.org/2014/02/27/how-does-dave-camp-
pay-for-individual-tax-cuts-by-raising-revenue-from-corporations/; 
Chye-Ching Huang, ``Camp Tax Reform Plan Likely Means Bigger Deficits 
After First Decade,'' Citizens for Budget Policies and Priorities, 
February 26, 2014, http://www.offthechartsblog.org/camp-tax-reform-
plan-likely-means-bigger-deficits-after-first-decade/; Committee for a 
Responsible Federal Budget, ``Revenue Impacts of Camp's Tax Reform 
Proposal,'' February 26, 2014,
    http://crfb.org/blogs/revenue-impacts-camps-tax-reform-proposal; 
statement of John S. Buckley in U.S. Congress, Senate Committee on the 
Budget, Supporting Broad-Based Economic Growth and Fiscal 
Responsibility Through a Fairer Tax Code, April 8, 2014,
    http://www.budget.senate.gov/democratic/public/index.cfm/
hearings?ID=d7254a33-dbd4-44c1-9fcc-7ea85f803f5e, which discusses the 
transitory effects of a number of business provisions; Jane Gravelle, 
The Dynamics of Congressional Policy-Making, in United States Senate, 
Committee on Rules and Administration, The Evolving Congress, S. Prt. 
113-30, December 2014, pp. 457-478.

    The supply side effects in the analysis of the Camp proposal may 
have been somewhat overstated. The JCT analysis captured the direct 
statutory tax rate changes as well as the implicit tax increases from 
phase outs. It also accounted for increases in the marginal tax burden 
due to base broadening, such as the slowing of depreciation. It, 
however, did not account for the effect of base broadening on effective 
marginal tax rates on labor income. For example, disallowing the 
deduction for state and local taxes would increase the marginal tax 
burden on labor income for itemizers. Other base broadening changes may 
be marginal as well. A number of analysts have commented on the 
importance of considering the effects of base broadening on marginal 
effective tax rates and in some cases have questioned whether any 
revenue neutral tax reform could have significant supply side 
effects.\30\
---------------------------------------------------------------------------
    \30\ Alex Brill and Alan Viard, The Benefits and Limits of Income 
Tax Reform, AER Tax Policy Outlook, No. 2, September 2011, http://
www.aei.org/wp-content/uploads/2011/10/TPO-Sept-2011.pdf. For further 
discussion of the issues of base broadening and marginal effective 
rates see Jane G. Gravelle and G. Thomas Woodward, Clarifying the 
Relation Between Base-Broadening and Effective Marginal Tax Rates, by 
Jane G. Gravelle and G. Thomas Woodward, presented at the 2013 meetings 
of the National Tax Association; Congressional Budget Office, Analysis 
of the President's Budgetary Proposals for 2008, Publication 2908. 
March 2007; and Restrictions on Itemized Tax Deductions: Policy Options 
and Analysis, CRS Report R43079, by Jane G. Gravelle and Sean Lowry. 
With respect to corporate reform and base broadening, see Alan Viard, 
The Quickest Way to Wreck Corporate Tax Reform, Real Clear Markets, 
March 27, 2013, http://www.realclearmarkets.com/articles/2013/03/27/
the_quickest_way_to_wreck_corporate_
tax_reform_100226.html.

    It should not be surprising that a revenue neutral tax reform is 
unlikely to have a significant effect on output, given the necessity of 
base broadening to lower rates. Alan Auerbach and Joel Slemrod, for 
example, found that the Tax Reform Act of 1986, a widely hailed tax 
reform, left incentives roughly unchanged.\31\ It is simply difficult, 
if not impossible, to design such a reform, especially if the reform is 
also pursuing other goals such as distributional neutrality and 
simplicity. Many economists see the primary goals of tax reform as 
achieving equity, efficiency and simplicity, rather than growth.
---------------------------------------------------------------------------
    \31\ See ``The Economic Effects of the Tax Reform Act of 1986,'' 
Journal of Economic Literature, Vol. 35, No. 2, June 1997, pp. 589-632. 
Alan Viard, in ``Statutory and Effective Tax Rates: Part 1,'' Tax 
Notes, August 20, 2012, pp. 943-947; and Bruce Bartlett, 
Misunderstanding Tax Expenditures and Tax Rates, Tax Notes, November 
22, 2010, pp. 931-932, also make the general point that revenue neutral 
tax reform is unlikely to alter work incentives.
---------------------------------------------------------------------------
                                 ______
                                 
     Questions Submitted for the Record to Jane G. Gravelle, Ph.D.
               Questions Submitted by Hon. Orrin G. Hatch
    This memorandum responds to follow-up questions related to the 
testimony of Jane Gravelle before the Senate Finance Committee on 
February 24, 2015.

    CRS does not provide policy recommendations. As such, CRS does not 
take a position on whether dynamic scoring should be used by the Joint 
Committee on Taxation (JCT) or Congressional Budget Office (CBO) for 
scorekeeping or budget enforcement purposes. Further, CRS does not take 
a position on which macroeconomic models should be used by those 
required by statute to provide cost or revenue estimates, or economic 
or budget projections. Nor does CRS take a position on whether tax 
reform in general, or any particular tax revision, should be enacted, 
or on whether fiscal stimulus should be used in an underemployed 
economy.

    Question. Your testimony argues that ``. . . it should not be 
surprising that a revenue neutral tax reform is unlikely to have a 
significant effect on output, given the necessity of base broadening to 
lower rates.'' In support of the argument, a study is cited that 
assessed the Tax Reform Act of 1986--or TRA86--and concluded, according 
to your summary, that it ``left incentives roughly unchanged.'' Given 
that, you wouldn't expect much in terms of growth effects from a 
revenue neutral reform exercise. Before getting to my question, I would 
note that the 1997 study in question does conclude that, at the time, 
``. . . saying that a decade of analysis has not taught us much about 
whether TRA86 was a good idea is not at all the same as saying it was 
not in fact a good idea. We think it was.'' Moreover, since that 
analysis, a Nobel Prize winning economist and his coauthor have 
provided evidence that tax reforms in 1986 coupled with changes in 
regulations governing retirement holdings help account for large long-
run increases in corporate equity values relative to GDP, something 
that I would think is a positive for the economy and everyone with a 
retirement account. My question is whether you agree that it is 
``simply difficult, if not impossible'' to design a revenue neutral tax 
reform plan that would have significant enough effects on incentives to 
increase economic growth?

    Answer. Designing a revenue-neutral corporate tax reform that has 
positive effects on output is difficult unless foreign source income is 
taxed more heavily. Designing an individual tax reform to produce 
significant output effects that also aims for distributional 
neutrality, as recent reform proposals have, is also challenging.

    The base broadening provisions in the corporate tax that could be 
used to finance a rate cut (setting aside international tax provisions) 
can be gleaned from many sources such as the tax expenditure list and 
prior proposed legislation. Potential provisions might include slower 
depreciation rates for equipment, eliminating the production activities 
deduction, capitalizing and depreciating research and development and 
advertising expenses, disallowing a portion of corporate interest, and 
eliminating Last-in, First-out (LIFO) inventory accounting. These base 
broadening provisions increase the cost of capital, offsetting, or more 
than offsetting, the benefits of rate reduction. For example, a 
revenue-neutral substitution of slower depreciation for a rate cut will 
increase the cost of capital because the depreciation change applies to 
new investment, but the rate cut also applies to the return on existing 
capital.\1\
---------------------------------------------------------------------------
    \1\ The limited and possibly negative growth effects of financing a 
corporate rate reduction by eliminating provisions that affect marginal 
incentives is discussed in Nicholas Bull, Tim Dowd, and Pamela Moomau, 
``Corporate Tax Reform: A Macroeconomic Perspective,'' National Tax 
Journal, Vol. 64, no. 4, December, 2011, pp. 923-941.

    A reform that imposed higher taxes on foreign source income, which 
could be used to reduce the corporate tax by up to three percentage 
points, would reduce the cost of capital in the United States and 
increase it abroad slightly. However, because the corporate tax is so 
small as a share of the U.S. economy (about 2%), even large changes in 
the tax rate would have limited effects on the economy. In CRS Report 
R41743, International Corporate Tax Rate Comparisons and Policy 
Implications, by Jane G. Gravelle, reducing the corporate rate by ten 
percentage points is estimated to raise output, by attracting capital 
from abroad, by about 0.2%, suggesting that a three percentage point 
---------------------------------------------------------------------------
reduction would increase output by an estimated 0.06%.

    Using individual income tax reform to increase economic growth also 
faces significant challenges. To induce growth, a revenue neutral tax 
reform should cut effective marginal tax rates (which encourage work) 
without cutting average rates. Eliminating many of the tax preferences 
would affect marginal effective tax rates. For example, eliminating the 
deduction for state and local taxes would increase the effective tax 
rate on labor income and income from saving by increasing the share of 
income that is taxed, offsetting the statutory rate reduction. In 
former Ways and Means Chairman Dave Camp's 2014 proposal, this option, 
along with some other restrictions and an increase in the standard 
deduction caused the expected share of taxpayers that itemized to 
decrease substantially. This outcome may be desirable for other 
reasons, but it increases the share of income that is taxed (through 
not only loss of state and local tax deductions but also deductions for 
charitable contributions and mortgage interest). See CRS Report R43079, 
Restrictions on Itemized Tax Deductions: Policy Options and Analysis, 
by Jane G. Gravelle and Sean Lowry, for a discussion of marginal 
effects of restricting itemized deductions.

    The Joint Committee on Taxation (JCT) estimated the effect of 
former Chairman Camp's tax reform proposal at 0.1% to 0.2% of GDP based 
on supply-side effects.\2\ Our understanding is that JCT did not take 
into account some marginal effects of individual base broadening, such 
as eliminating the deduction for state and local taxes.\3\ If some 
marginal effects were not considered, incorporating them would lead to 
smaller growth effects.
---------------------------------------------------------------------------
    \2\ JCT, Macroeconomic Analysis of the ``Tax Reform Act of 2014,'' 
JCX-22-14, February 26, 2014, https://www.jct.gov/
publications.html?func=startdown&id=4564.
    \3\ Based on a statement by Nicholas Bull, Joint Committee on 
Taxation, at a panel discussion on dynamic scoring, Brookings 
Institution, January 26, 2015. He indicated that research underway 
indicated that the effects were small but the research has not been 
completed.

    Some base broadening approaches might be less likely to have 
marginal effects, such as imposing percentage of income floors on 
itemized deductions. If the objective of tax reform is to eliminate 
distortions, floors would be less effective than ceilings or repeal of 
a deduction in reducing the tax incentive to spend on the tax-favored 
activity. Some floors on itemized deductions are already in place, 
(e.g., medical expenses and casualty losses) and a floor has been 
---------------------------------------------------------------------------
proposed for charitable deductions.

    Note that tax reforms that reduce revenue may induce supply-side 
responses, but these effects would be offset eventually by the negative 
effects of crowding out of private investment through increased 
deficits.

    Question. Dr. Gravelle, your testimony states, with respect to 
deferral of tax on income from foreign corporations, that ``This 
provision is probably not associated with a significant economic 
distortion. Evidence suggests that, in most cases, the areas where real 
investment is likely to be made, the developed countries tend to have 
marginal effective tax rates that are relatively similar to those in 
the United States. While deferral may cause a misallocation of capital, 
that effect is more likely to be relatively small compared to GDP.'' 
Dr. Gravelle, given that it is CRS's reading of the evidence that 
deferral is not a significant distortion and, to the extent it causes 
misallocated capital, the effect is small, it seems fair to conclude 
that a shift to a fully territorial tax with adequate base erosion 
provisions would be, at worst, relatively harmless.

    Given the Congressional Research Service's reading of the evidence 
that deferral is not a significant distortion and, to the extent it 
causes misallocated capital, the effect is small, it seems fair to 
conclude that a shift to a fully territorial tax with adequate base 
erosion provisions would be, at worst, relatively harmless. Do you 
agree?

    Answer. Given the closeness of effective tax rates, it seems 
unlikely that territorial taxation (or ending deferral for that matter) 
would have much effect on the allocation of capital investment. 
Territorial taxation would increase the incentive for profit shifting 
and its effect on corporate revenue, but this consequence could be 
avoided by adequate base erosion provisions. Addressing profit shifting 
through leveraging is straightforward: allowing interest deductions 
that are proportional to earnings in each country. Designing an 
effective system (outside of current taxation of foreign source income) 
that prevents the shifting of intangible income through transfer 
pricing, however, is more difficult.

    Question. In a January 6, 2014 Congressional Research Paper, you 
identified in Table 3 of the paper the following ``Table 3 reports the 
Markle and Shackelford study that estimates the effective tax rate of 
domestic firms in different countries. Because a smaller number of 
countries are examined, Table 3 compares the U.S. rate with that of the 
six large countries.'' It is not clear what is meant by ``a smaller 
number of countries are examined.'' Smaller than what; examined by 
whom?

    Answer. This statement referred to the previous results, primarily 
in Table 1 which included the Organization for Economic Development and 
Cooperation (OECD) member states. The Markle and Shackelford paper 
reported rates for fourteen countries other than the United States, but 
only six are large countries, five could be considered tax havens, and 
three are small countries.

    Question. The figures in Table 3 of your January 6, 2014 paper are 
for ``Six Large Countries'' taken to be Canada, France, Germany, India, 
Japan, and the United Kingdom, with the source listed as Kevin S. 
Markle and Douglas A. Shackelford, ``Cross-Country Comparisons of 
Corporate Income Taxes,'' working paper, February 2011. Those authors, 
using data on more than the six countries that you choose, conclude 
that ``Japanese multinationals consistently face the highest ETRs. 
American multinationals face among the next highest ETRs.'' Using the 
six countries that you choose, my staff has not been able to replicate 
the numbers that you report in your Table 3, so please provide the data 
that you used. Please also explain why you chose to only look at six of 
the many countries considered by Markle and Shackelford, and why you 
selected the particular countries that you chose to include.

    Answer. The figures in Table 3 have been revisited. The rate for 
Canada has been revised (29.5% previously, compared to 14% as revised). 
Australia at 22% was also included and the weighted and unweighted 
numbers in Table 3 in the report were inadvertently reversed. 
Correcting the Canadian rate and excluding Australia produces an 
unweighted tax rate of 22.3% and a weighted rate of 25.1%, compared to 
previous numbers of 24.5% and 26.2%. These numbers have been corrected 
in a technical update of the report.\4\
---------------------------------------------------------------------------
    \4\ The tax rates were Canada, 14%; France, 25%; Germany, 16%, 
India, 22%; Japan, 37%; and the UK 20%. The respective GDP estimates 
(in billions) are: $1,336, $2,649, $3,330, $1,310, $5,086, and $2,174.

    Markle and Shackelford did not have a random sample of countries or 
one defined by a particular standard (such as the OECD), and the larger 
countries that are more likely to be targets for investment (Canada, 
France, Germany India, Japan and the UK) were included. Countries that 
are considered to be tax havens (Bermuda, the Cayman Islands, Taiwan, 
Malaysia, and Switzerland) and the three small economies (Australia, 
Sweden, and South Africa) were excluded, as they are not likely targets 
---------------------------------------------------------------------------
for significant investment.

    Question. The Congressional Research Service (CRS), takes a dim 
view of the use of macroeconomic analysis of major tax proposals, 
arguing that economic modelling is too full of uncertainties to be 
reliable. Yet, the default is an unacceptable status quo that 
counterfactually assumes that a major tax reform proposal will have no 
lasting effect on important macroeconomic aggregates such as the gross 
domestic product or employment. While CRS argues against use of certain 
economic analysis for tax proposals, it seems to at the same time 
welcome old-fashioned Keynesian stimulus ``bang for the buck'' 
estimates of so-called ``stimulus'' policies. Those estimates, of 
course, posit a change in spending or taxes and trace out dynamic 
effects, using uncertain economic models, on things like GDP and 
employment.

    Why does CRS take a negative view of using uncertain macroeconomic 
projections for things like tax reform proposals but a positive, 
accepting view of using uncertain macroeconomic projections for things 
like stimulus proposals?

    Answer. As noted previously, CRS takes no position on whether 
Congress should adopt policies such as dynamic scoring or fiscal 
stimulus. The CRS reports on these topics raise considerations for 
Congress as they debate policy options.

    The CRS report on dynamic scoring \5\ and various CRS reports on 
the use of fiscal stimulus in the recession (such as the fiscal cliff 
report \6\) are addressing different issues. The dynamic scoring issue 
relates to scorekeeping rules which were developed to meet budget 
enforcement constraints. At the time the dynamic scoring paper was 
written, incorporating macroeconomic effects (at that time advisory) 
into a single official score was under discussion, and was adopted in 
House rules for the 114th Congress (H. Res. 5). The fiscal stimulus 
reports are reviewing widely held views of the effects on unemployment 
of tax cuts or spending increases and are about policy issues.
---------------------------------------------------------------------------
    \5\ CRS Report R43381, Dynamic Scoring for Tax Legislation: A 
Review of Models, by Jane G. Gravelle.
    \6\ For example, CRS Report R42700, The ``Fiscal Cliff'': 
Macroeconomic Consequences of Tax Increases and Spending Cuts, by Jane 
G. Gravelle.

    The CRS report on dynamic scoring did not take the view that tax 
cuts do not have macroeconomic effects but rather discusses some 
reasons certain types of effects might not be appropriate for dynamic 
scoring. Perhaps the most important of these is whether the short-run 
effects of a demand-side stimulus should be taken into account. 
Although both the dynamic scoring report and the fiscal cliff report 
indicate uncertainty about the magnitude of demand side effects, 
reasons for excluding these effects from the scoring of tax policies do 
not hinge solely on uncertainty. Rather, a major reason for raising the 
issue of including demand side effects is that such effects are 
transitory. As the report states with reference to demand side effects: 
``The most basic argument is that changes in the tax code shouldn't 
depend on the fiscal timing, as tax changes can be hard to reverse. A 
permanent tax cut should, it may be argued, not be viewed more 
favorably because it was enacted in a recession.'' The report also 
notes that these demand side effects (as well as crowding out effects) 
occur with spending changes as well which were not subject to dynamic 
analysis at that time. (The current House rule includes dynamic scoring 
for mandatory spending changes but not appropriations.) Also at issue 
is whether the Federal Reserve would offset the fiscal stimulus, an 
action much less likely while the economy was still well below full 
employment, as was the case with the fiscal cliff issue. The fiscal 
cliff report and related CRS reports were prepared as Congress 
considered stimulus in light of the largest output gap since the Great 
---------------------------------------------------------------------------
Depression.

    Based on economic theory and empirical evidence, fiscal stimulus 
and crowding out effects are certain in direction, although uncertain 
in magnitude. For a revenue neutral change, supply-side effects depend 
on models and elasticities, as discussed in the dynamic scoring report. 
When they closely reflect the empirical evidence, revenue effects from 
supply-side responses are small and, for a tax cut that increases the 
deficit, likely to be offset in the long run by crowding out.\7\
---------------------------------------------------------------------------
    \7\ In JCT's estimate of effects of tax reduction using their 
macroeconomic growth model (MEG) and excluding macroeconomic effects, 
only a corporate rate cut had a revenue offset above 10% (13.2%). The 
individual rate cut had a 7.7% offset and a personal exemption increase 
0.5%. All proposals eventually led to negative effects in the long run. 
See JCT, Macroeconomic Analysis of Various Proposals to Provide $500 
Billion in Tax Relief, JCX-4-05, March 1, 2005, at https://www.jct.gov/
publications.html?func=startdown&id=1189.

    Question. When CRS discusses stimulus proposals, at times it 
provides special attention to forecasts and multipliers developed by 
Moody's Analytics, a consulting firm, and listed as having been 
developed by forecaster Mark Zandi. Sometimes, Zandi's estimates are 
provided along with ranges of estimates presented by the Congressional 
Budget Office, where those ranges subsume estimates provided by Zandi's 
models. Why do Moody's Analytics estimates garner such extra attention 
---------------------------------------------------------------------------
by CRS?

    Answer. Zandi's results were used because they were available and 
widely cited. He provided estimates of the effects of multipliers for 
different types of stimulus proposals (spending, tax cuts for lower 
income individuals, tax cuts for higher income individuals, tax cuts 
for business, etc.). Much of the discussion in the fiscal cliff and 
other papers was about what types of stimulus were most effective. The 
fiscal cliff report also provided CBO estimates for different types of 
stimulus. The report also included overall effects for forecasts by 
Morgan Stanley, Goldman Sachs, and Global Insight.\8\
---------------------------------------------------------------------------
    \8\ Zandi's estimates by type of proposal along with CBO's 
estimates are included in two other papers on fiscal stimulus: CRS 
Report R41578, Unemployment: Issues in the 113th Congress, by Jane G. 
Gravelle and CRS Report R41849, Can Contractionary Fiscal Policy Be 
Expansionary?, by Jane G. Gravelle and Thomas L. Hungerford. Other 
reports that address the effectiveness of various fiscal policies and 
that do not refer to Zandi include CRS Report RL33657, Running 
Deficits: Positives and Pitfalls, by D. Andrew Austin, CRS Report 
R41034, Business Investment and Employment Tax Incentives to Stimulate 
the Economy, by Thomas L. Hungerford and Jane G. Gravelle; CRS Report 
RS21126, Tax Cuts and Economic Stimulus: How Effective Are the 
Alternatives?, by Jane G. Gravelle; CRS Report RS22790, Tax Cuts for 
Short-Run Economic Stimulus: Recent Experiences with Rebates and Bonus 
Depreciation, coordinated by Jane G. Gravelle; CRS Report R40178, Tax 
Cuts on Repatriation Earnings as Economic Stimulus: An Economic 
Analysis, by Donald J. Marples and Jane G. Gravelle; CRS Report 
RL31134, Using Business Tax Cuts to Stimulate the Economy, by Jane G. 
Gravelle.

    Question. Of course, the reliability of estimates from 
macroeconometric forecasting models depend on underlying assumptions in 
the models, including assumptions about wage or price rigidities that 
often have questionable empirical support, assumptions about economic 
agents willingly foregoing perceived gains from trade, assumptions 
about invariance of decision rules of economic agents to changes in the 
economic environment that they face, questionable identifying 
assumptions, and the like. Yet those assumptions do not seem to gather 
the same level of scrutiny in CRS reports as what are often referred to 
as ``rigid'' assumptions used in intertemporal models. Does CRS believe 
that assumptions used in many intertemporal models are in some sense 
more rigid than those used in macroeconomic forecasting models such as 
---------------------------------------------------------------------------
those constructed by Moody's Analytics?

    Answer. Note that the CRS report on dynamic scoring questioned 
including short-term cyclical effects from forecasting models largely 
based on their transitory nature, as noted in a previous response.

    Macroeconomic forecasting models are certainly detailed and depend 
on the behavioral responses, but their structure is generally 
straightforward (ISLM models can roughly be captured in four equations) 
and the conditions for fiscal effects to occur are also generally 
straightforward (basically sticky wages and prices). Moreover, there 
are many forecasters whose results can be compared and they all have 
powerful incentives to get forecasts correct.\9\ Forecasters also 
produce short term results that can quickly be compared with actual 
outcomes.
---------------------------------------------------------------------------
    \9\ The Blue Chip Consensus forecast aggregates the results of 50 
private forecasters.

    JCT has most recently used a macroeconomic growth model that can 
reflect effects on unemployed resources as well as labor supply, along 
with an intertemporal model in the form of an overlapping generations 
(OLG) model. CBO also uses an OLG model, in addition to a growth model 
with a labor supply response. Intertemporal models do not contain 
direct labor supply responses. They are motivated by a desire to link 
microeconomic-based decisions to macroeconomic outcomes and trends and, 
in the case of the OLG model, to also estimate welfare effects of tax 
and spending changes. Therefore, individual choice is based on a 
utility function in which rational individuals choose leisure or 
consumption over a life time with perfect foresight. Behavioral 
responses flow from this utility function. Because labor supply 
responses are not entered directly in the model there are a number of 
constraints from the limits of the original utility function. In that 
sense, they are more rigid and less transparent than a growth model 
that includes direct labor supply function. They are also more 
difficult to construct and solve, and, to our knowledge, in contrast to 
the many macroeconomic forecasters, only two OLG models are currently 
in use for analyzing tax policy.\10\ Although modelers may try to 
produce reasonable responses, these models have some significant 
restrictions that derive from their basic structure (see answer to next 
subpart below). Intertemporal models have been an active area of 
academic research, but are not generally used in forecasting.
---------------------------------------------------------------------------
    \10\ The JCT OLG model is leased from Tax Policy Advisors LLC which 
also uses the model to estimate tax effects. The CBO model was 
constructed by CBO. Infinite horizon models that represent the economy 
as a single infinitely lived individual have also been used by JCT and 
CBO in the past.

    Question. When CRS refers to assumptions used in intertemporal 
---------------------------------------------------------------------------
models as ``rigid assumptions,'' what is meant by a rigid assumptions?

    Answer. OLG intertemporal models used in tax analysis are based on 
an additive utility function over time, of a composite within period 
function of leisure and consumption that is characterized by constant 
returns to scale and a constant elasticity of substitution.\11\ 
Individuals choose consumption and leisure over time, with perfect 
foresight. There is an extensive discussion of the issues with 
intertemporal models in the CRS Report CRS Report R43381, Dynamic 
Scoring for Tax Legislation: A Review of Models, by Jane G. Gravelle. 
Briefly, some of the issues are:
---------------------------------------------------------------------------
    \11\ This is the form of utility function that appears in OLG 
models. Some infinite horizon models have been developed that employ 
additive leisure and consumption in the within-period utility function. 
There is also an extensive literature that attempts to relax some of 
the assumptions of an additive intertemporal utility function with a 
constant discount rate, but these functions are difficult to calibrate 
and solve.

    (1) The models introduce intertemporal substitution of labor with 
respect to changes in wages over time but are unable to account for 
institutional rigidities that in most cases prevent workers from easily 
---------------------------------------------------------------------------
entering and exiting the labor force or changing hours.

    (2) The form of the utility function forces the income elasticity 
of leisure and consumption in the within period function to be one, 
which makes it difficult to calibrate the model to match empirical 
evidence. In addition, the embedding of this function in an 
intertemporal utility function adds to the difficulties of making the 
model's responses consistent with empirical evidence.

    (3) The form of the utility function makes labor a function of the 
rate of return, a relationship many might find implausible and for 
which no empirical data exist.

    (4) The additive time-separable utility function makes substitution 
elasticities between close-together periods (e.g., next year) the same 
as between far-apart periods (e.g. 20, years in the future). It is 
reasonable to think of close-together periods as closer substitutes 
than far-apart time periods. There is no empirical evidence that 
relates to substitution between far-apart periods, only close-together 
ones, but the effects can be quite large when rates of return change.

    (5) Models do not permit marriage, which could affect savings 
behavior, particularly in the infinite horizon model.

    (6) Because the model has to be solved at infinity it cannot permit 
a deficit or surplus which would grow over time. Some other policy has 
to be introduced to close the model and, in effect, the model cannot be 
used for a stand-alone tax proposal that reduces or increases tax 
revenues, even in the short or intermediate term, unlike the in-house 
macroeconomic growth model also used by JCT. The outcome will depend on 
the additional policy assumed. Moreover, it is not possible to capture 
the effects of crowding out investment through borrowing.

    Question. In analyzing tax reform, economic effects, and economic 
efficiency, policymakers will rely to some extent on accompanying 
macroeconomic analyses of tax reform proposals produced by the Joint 
Committee on Taxation and, perhaps to a degree, by the Congressional 
Budget Office. Traditionally, ``scoring'' practice has involved use of 
macroeconomic analyses of significant tax reform proposals that hold 
fixed the assumed future path for steady-state growth and sometimes 
levels of important macroeconomic aggregates such as gross national or 
domestic produce, the size of the labor force, and other aggregates--
often described as ``static'' scoring. Use of macroeconomic analysis 
that allows for long lasting, or steady-state, reform effects on 
important macroeconomic aggregates is sometimes referred to as dynamic 
scoring. CRS has produced numerous papers on dynamic scoring, many of 
which you have authored. For example, you wrote a CRS report published 
in July, 2014, which provides CRS views on dynamic scoring.

    The report identifies that ``Many uncertainties arise with respect 
to dynamic scoring, which depend on the type of model used, the 
behavioral responses build into the models, and assumptions about 
activities of other agents or supplemental policies that are necessary 
to solve some types of models.'' Of course, there also exist many of 
the same uncertainties in traditional static scoring given, as your 
report notes, that ``many behavioral responses are already included in 
conventional revenue estimates.'' As an example, you point out that 
``increasing capital gains taxes is assumed to cause a reduction in 
realizations that reduces the potential revenue gains.'' Is it CRS's 
position that static scoring in some sense is less uncertain than 
dynamic scoring? If so, please explain why.

    Answer. For two reasons, conventional scoring is likely to be less 
uncertain. First, although some revenue estimates are difficult because 
of lack of data (e.g., the 2004 repatriation holiday that allowed firms 
to return foreign source income at a lower tax rate) and some 
behavioral responses such as capital gains realizations may rely on 
uncertain microeconomic behavioral responses, these cases are probably 
the exception rather than the rule. Most estimates, particularly of 
significant tax changes, such as rate changes, changes in personal 
exemptions, standard deductions, itemized deductions, depreciation, the 
production activities deduction, etc. can be fairly precisely estimated 
because the data appear on tax returns and these data can be relatively 
easily projected into the future. Moreover, exclusions that are not 
reported on tax returns are available, in many cases, on other 
extensive data bases. Traditional revenue estimating, on average, is 
relatively precise.

    Second, whatever the uncertainties of conventional estimates, 
dynamic scoring adds an additional layer of uncertainty. That is, 
dynamic scoring adds some variance so that the new score will be more 
variable than the old.

    Question. The report also identifies that ``The infinite horizon 
model, however, is incompatible with perfectly mobile international 
capital.'' Please explain what that means.

    Answer. An infinite horizon model, to achieve a steady-state growth 
in consumption, always forces the after-tax rate of return to converge 
to its original value (i.e., it is characterized by an infinite 
elasticity of savings). When combined with an open economy with 
perfectly mobile capital, the model can only reach a steady state with 
a corner solution, where one country's residents own all of the capital 
in the world. (Actually, for that matter, the infinite horizon model is 
incompatible with differences in state personal income taxes in the 
United States or with individuals with different preferences.) This 
open economy outcome occurs because the residents of each country 
require a certain after-tax return in every country but if residents 
face different residence-based tax rates, they will require different, 
yet equal, pre-tax returns around the world, which can only hold for 
one country.

    To explain why this happens consider a world composed of two 
countries, A and B, each earning an after-tax (and pre-tax) return with 
no taxes of 5%. In a closed economy, if A is suddenly subjected to a 
50% tax (which causes the after-tax return to fall to 2.5%), the 
residents will begin reducing their savings because the return has 
fallen. They will continue to reduce the capital stock, driving up the 
pre-tax return as capital becomes scarcer, until the pre-tax return 
rises to 10% and the after-tax return back to 5%.

    In an open economy, however, as the residents of A push up the pre-
tax return, residents of B will invest in A, which will also cause the 
pre-tax return in B to rise as capital becomes scarcer in B. Now B is 
out of equilibrium and the higher after-tax return causes them to 
increase savings, which lowers returns everywhere and puts more 
pressure on A to decrease savings. A continues to decrease its capital, 
and B to increase it, until B owns everything.

    Question. The report also discusses a ``new version of the OLG 
model used by JCT'' and possible effects in the model of innovations in 
a firm's intellectual property. Please explain CRS's understanding of 
how intellectual property enters into a firm's production function and 
decision making in the new version of the OLG model used by JCT.

    Answer. The output effects in the JCT OLG model of the Camp 
proposal are higher than can be accounted for by changes in capital and 
labor.\12\ The percentage change in output, roughly, is equal to the 
sum of the percentage change in labor multiplied by the labor income 
share and the percentage change in capital multiplied by capital income 
share. JCT does not report labor and capital income shares, but using a 
rule-of-thumb of \2/3\ labor and \1/3\ capital, the output increase 
from their in-house macroeconomic growth (MEG) model assuming a labor 
substitution elasticity of 0.2, given a 0.3% increase in labor and a 
0.1% increase in capital (in the first five years), would be 0.2%.\13\ 
That is the percentage change in GDP reported. For the OLG model with a 
1.4% increase in labor and a 0.2% increase in capital, the expected 
increase in GDP would be 1%. The increase in GDP reported for the OLG 
model in the first five years is, however, 1.8%, not 1%.
---------------------------------------------------------------------------
    \12\ JCT, Macroeconomic Analysis of the ``Tax Reform Act of 2014,'' 
JCX-22-14, February 26, 2014, https://www.jct.gov/
publications.html?func=startdown&id=4564.
    \13\ That is 0.3% times \2/3\ plus 0.1% times \1/3\ equals 0.233% 
which would be rounded to 0.2%.

    Additional information on the possible source of the extra 0.8% 
increase in output that cannot be explained by capital or labor inputs 
in the OLG model can be found in a study using the same model sponsored 
by the Business Roundtable.\14\ In this simulation, as well, the 
increases in capital and labor could not explain the increases in 
output. For example, the 0.5% increase in labor and the 0.2% change in 
the capital stock in year 2 suggest an increase of 0.4%, but the 
increase was 0.9%, indicating a 0.5% difference. In year 5, it 
accounted for a 0.7% difference. These unexplained amounts are slightly 
smaller than in the JCT OLG model but are similar enough, given 
rounding.
---------------------------------------------------------------------------
    \14\ John W. Diamond and George R. Zodrow, Dynamic Macroeconomic 
Estimates of the Effects of Chairman Camp's 2014 Tax Reform Proposal, 
Tax Policy Advisers LLC, Prepared for the Business Roundtable. http://
businessroundtable.org/sites/default/files/reports/Diamond-
Zodrow%20Analysis%20for%20Business%20Roundtable_Final%20for%20Release.pd
f.

    The significantly greater effect of the new version of the OLG 
model used by JCT, as indicated in the Business Roundtable study, 
appears to result in large part from the shift of intellectual property 
from foreign countries to the United States which is not reported in 
the JCT analysis.\15\ As in the MEG model, there was shifting of 
physical capital from abroad (which is reflected in the calculations 
above for labor and capital).\16\ In the Business Roundtable study, the 
stock of intellectual property increased by 6.9% in year 2 and 16.7% in 
year 5. The authors of the Business Roundtable study (and heads of Tax 
Policy Advisors LLC) indicate that this shift enhances the productivity 
of labor and capital, although they did not specify in that paper how 
this effect occurs. We confirmed with John Diamond, coauthor of the 
Business Roundtable paper and constructor of the OLG model, that 
intellectual property (which the authors refer to as firm specific 
capital) is entered as an element of the production function, just as 
labor and physical capital is.
---------------------------------------------------------------------------
    \15\ JCT indicates that this modeling follows that of Michael P. 
Devereux and Ruud de Mooij in ``An Applied Analysis of ACE and CBIT 
Reforms in the EU,'' International Tax and Public Finance, vol. 18, no. 
1, 2011, pp. 93-120 and Leon Battendorf, Michael .P. Devereux, Albert 
van der Horst, Simon Loretz and Ruud de Mooij, ``Corporate Tax 
Harmonization in the EU,'' Economic Policy, vol. 63, 2010, pp. 537-590. 
The authors do not present any empirical evidence to support entering 
what they refer to as firm-specific capital into the production 
function, or the importance of it in the economy.
    \16\ The Business Roundtable simulation differed from JCT in other 
ways, but these would not cause significant short-term differences.

    There are two issues that can be raised with this new channel of 
growth. The first is that the assumed semi-elasticity (percentage 
change in profits divided by the percentage point change in the tax 
rate differential) reported for profit shifting is 8.6. The consensus 
elasticity from the literature for profit shifting, which should be the 
same, is 0.8.\17\ Roughly speaking, the output effects should be less 
than \1/10\ of the effect, or less than 0.1% of GDP if the consensus 
elasticity were used.
---------------------------------------------------------------------------
    \17\ Dhammika Dharmapala, ``What Do We Know About Base Erosion and 
Profit Shifting? A Review of the Empirical Literature,'' Illinois 
Public Law and Legal Theory Research Papers Series, No. 14-23, December 
2013.

    More importantly, intellectual capital is not located 
physically.\18\ Once it exists it can be used everywhere. For example, 
when a firm discovers a drug such as Lipitor, it uses the formula no 
matter where the pills are made. When a firm develops the technology 
for a smart phone, or a search algorithm, that knowledge can be applied 
to production everywhere. It does not matter if the patent is held in 
country A and licensed to country B, or vice versa. Therefore, shifting 
ownership of intellectual property to the U.S. cannot increase 
productivity in the U.S. because that input is already in existence. 
The intellectual property effect is about revenues, not output. The 
case is similarly weak for marketing intangibles. For general property 
such as trademarks, firms like Starbucks and products like Coca-Cola 
share the benefits of trademarks regardless of where ownership rights 
are held.
---------------------------------------------------------------------------
    \18\ An exception might be intangible capital embedded in work 
force skills, but this property is relatively immobile since it is 
embedded in immobile labor.

---------------------------------------------------------------------------
    The Tax Foundation made a similar point:

        ``. . . Diamond and Zodrow find that U.S. workers and ordinary 
        capital would be more productive under Camp's plan due to 
        patents and other intangibles sited in the U.S. rather than in 
        the foreign subsidiaries of U.S. multinational companies. It is 
        unclear how Apple workers or Apple machines, for example, would 
        be significantly more productive if Apple patents were sited in 
        the U.S. Are the patents somehow inaccessible currently by the 
        U.S. parent company?'' \19\
---------------------------------------------------------------------------
    \19\ William McBride, Some Questions Regarding the Diamond and 
Zodrow Modeling of Camp's Tax Plan, Tax Foundation, March 17, 2014,
    http://taxfoundation.org/blog/some-questions-regarding-diamond-and-
zodrow-modeling-camps-tax-plan.

    At this time, the JCT's OLG modeling of the Camp proposal appears 
to rely on economic modeling with magnitudes of shifting larger than 
can be supported by the empirical evidence, and with output effects 
---------------------------------------------------------------------------
unlikely to be realized regardless of the amount of shifting.

    Question. The report, and in other of your CRS reports, provides a 
threefold CRS decomposition of effects in a dynamic estimate: short-run 
stimulus; long-run crowding out; and supply-side responses.

    i. Is this a standard decomposition in the economics profession, or 
one unique to CRS?

    ii. In discussing the short-run stimulus (or ``demand'') effects, 
the July, 2014 report identifies that ``These effects only occur in an 
underemployed economy (otherwise the stimulus increases the price 
level) and they are transitory because eventually the economy would 
have returned to full employment without the stimulus.'' On that basis, 
the report argue that ``this effect might be inappropriate to consider 
in dynamic estimation'' because a permanent tax policy change should 
not depend on short-run effects that will not persist and may depend on 
initial conditions. Does this mean that CRS believes that the initial 
conditions (i.e., state of the economy when a reform in begun) and 
transition to a new steady state ought not be considered and 
macroeconomic analysis of a tax reform proposal should involve only 
comparison of an initial steady state with a new steady state, ignoring 
transitional dynamics?

    iii. In discussing supply-side effects, the report identifies that 
CRS believes that ``Intertemporal models, in particular, have results 
that are driven by assumptions embedded in the nature of the model, but 
which appear unrealistic and have no empirical support in some cases.'' 
Models do, of course, have results that depend on assumptions made in 
their construction, and that is not unique to intertemporal models. 
However, CRS seems to believe that intertemporal models have 
assumptions that appear unrealistic. It is not clear what that means, 
since model assumptions are often intentional abstractions from aspects 
of reality that are not critical for the purpose for which the model is 
constructed, and are therefore unrealistic by design. What assumptions 
(not parameterizations) of intertemporal models does CRS believe are 
unrealistic? What assumptions of intertemporal models do not have 
empirical support? In cases in which parameter values are not well 
defined by empirical support, what assumptions are there that could not 
be altered in sensitivity analysis performed to check model 
implications for robustness?

    Answer. In answer to question (i), this decomposition follows 
earlier policy debates on the macroeconomic effects of fiscal policy 
changes. Economists testifying at a 1995 hearing convened to discuss 
dynamic scoring issues distinguished between demand side (or cyclical) 
and supply-side (or permanent growth) effects.\20\ Most did not discuss 
crowding out (possibly because it has little effect in the five-year 
budget horizon), but former Chairman of the Federal Reserve, Paul 
Volcker mentioned crowding out as a separate force that would offset 
supply-side effects. These are also the effects for which JCT often 
provides sensitivity analysis by presenting a case where cyclical 
effects are excluded and also a case where both cyclical and crowding 
out effects are excluded. Finally JCT uses an intertemporal model that 
only permits one of these effects (supply-side), which would seem to be 
an important consideration in examining the effects from this model.
---------------------------------------------------------------------------
    \20\ The economists testifying at the hearing included Robert 
Reischauer, director of CBO, former and current chairmen of the Federal 
Reserve Paul Volcker and Alan Greenspan, former CBO director Rudolph 
Penner, Henry Aaron of the Brookings Institution, professors Michael 
Boskin and Martin Feldstein, and Norman Ture from the Institute for 
Research on the Economics of Taxation. See Review of Congressional 
Budget Cost Estimating, Joint Hearing before House and Senate Budget 
Committees, 104th Congress, Serial 104-1, January 10, 1995.

    In answer to (ii), as discussed earlier, there is a case to be made 
for excluding cyclical effects which are transitory at best and which 
depend on the state of the economy when a tax change is made. Most of 
the economists participating in the 1995 hearing either supported 
excluding demand side-effects or suggested caution in considering those 
effects.\21\ For supply-side effects and crowding-out, understanding 
effects both inside and outside the budget window would be informative, 
particularly when tax changes themselves are transitory or phased in. 
Longer term results would also more fully reflect induced capital 
accumulation as well as crowding-out. Note that there can be no steady 
state in models where crowding out (or crowding-in) occurs because this 
effect grows within limit.
---------------------------------------------------------------------------
    \21\ Perhaps the most extensive discussion of demand-side effects 
was by Henry Aaron, who stated, under the heading Aggregate Demand 
Effects: ``These demand effects are purely short-run, however. They 
have no significant impact on the long run path of economic activity. 
Thus, tax or expenditure policy, as well as monetary policy, can change 
overall demand for a period of months or even for a few quarters. But, 
unless they alter potential output, they do not affect the long-run 
path of economic activity, and therefore produce no enduring change in 
revenues. This fact is one of three major reasons why revenue 
estimators make no attempt to take these effects into account.'' (p. 
156). Aaron goes on to note that such estimates are impossible to make 
in any case because they depend on actions by the Federal Reserve as 
well as foreign central banks and foreign governments. He also notes 
the wide variation in estimated multipliers. Alan Greenspan states: 
``There are a number of ways of looking at this, but I would suggest 
that including aggregate demand effects would be confusing, if not 
misleading, in many if not most contexts. Among other things, the scope 
for realizing such demand effects on economic activity would be a 
function of the particular phase of the business cycle and could be 
viewed in a sense as transitory. Particularly when we are addressing 
the problem of a long-run structural deficit, the focus should be on 
how fiscal actions affect the potential of the economy to produce 
greater output and taxable income on a sustained ongoing basis. Thus, 
if a more dynamic scoring were to be adopted, I would recommend 
limiting the analysis to appropriate supply-side effects.'' (p. 127). 
Martin Feldstein refers readers to his Wall Street Journal article of 
December 14, 1994, ``The Case for Dynamic Analysis,'' where he states, 
in discussing why analysts ignore labor supply and capital stock: ``The 
most plausible explanation is that the revenue estimators do not want 
to contaminate the estimated long-term effects of proposed tax changes 
with their potential temporary cyclical effects. The tax analysts are 
correct to ignore the potential cyclical effects of tax policy because 
the Federal Reserve can be expected to use monetary policy to offset 
them.'' (p. 195). Robert Reischauer suggests that including cyclical 
effects is problematic, in part, because of the potential for offset by 
the Federal Reserve (pp. 8-9). Paul Volcker suggests caution about 
cyclical effects when the economy is operating at close to full 
employment, which could lead to inflation and eventually induce 
contraction (p. 77). Michael Boskin states: ``It is common to separate 
dynamic effects into demand side and supply side effects. I believe 
under normal circumstances (i.e. except in deep long-lived recessions) 
it is a reasonable working hypothesis that demand side effects should 
be presumed to be negligible and/or likely on balance to be offset by 
monetary policy. In any event most proposals under current budget law 
will be parts of packages that do not increase the usual, if 
controversial, measure of demand side stimulus--the standardized 
employment surplus.'' (p. 185). This last statement appears to relate 
to the lack of effect on potential output. Norman Ture urges the use of 
a neoclassical model which would exclude demand side effects and reject 
any model that, in his terms ``employs a first order income effect.'' 
(p. 209) He appears in the preceding discussion to not see demand-side 
effects as valid.

    In answer to (iii), some of the problems in intertemporal models 
are outlined in the answers to question 3 which identify two responses 
without empirical basis: the elasticity of substitution between farther 
apart periods and the responsiveness of labor supply to the interest 
rate. A time consistent intertemporal utility function that could yield 
declining substitution across periods that are farther apart would be 
ideal to test the importance of the first, but thus far, to our 
knowledge, a model with such a function has not been constructed. One 
could only test the overall importance of this issue by reducing the 
overall intertemporal substitution elasticity to zero, which would also 
eliminate the response of labor supply to the interest rate. Such a 
sensitivity analysis would be helpful, but it would not test for the 
---------------------------------------------------------------------------
effect of differing elasticities across time periods.

    The other features of intertemporal models that one could argue are 
unrealistic are perfect foresight and the assumption that individuals 
make choices in every period about allocating leisure and consumption 
across their remaining life, asexual reproduction, and the absence of 
institutional constraints that affect intertemporal shifts in labor 
supply and choice of hours. The models actually used also have a single 
representative agent (either overall or for each generation), and do 
not allow the separation of the suppliers of labor and the suppliers of 
capital, or separation by income class (although this could be remedied 
in the OLG by redesigning the model). The infinite horizon model, now 
not currently used by JCT, could separate spenders and savers, which 
has been done in other cases.

    Question. The report places a great deal of scrutiny to assumptions 
involved with intertemporal models, many of which are worth keeping in 
mind. However, many of the assumptions or features of the models seem 
not to be focused on their abilities to provide useful information 
about how the economy might respond to large-scale tax changes. And, of 
course, assumptions can be modified if the purpose of a model is 
modified. The report comments on assumptions about: expectation 
formation; horizons; inclusion, or not, of marriage and fertility 
choices, etc. Is it symmetrically important to scrutinize those same 
assumptions in other macroeconomic models, such as those emphasizing 
``multipliers'' that stem from ``demand'' effects when macroeconomic 
aggregates are assumed to be determined outside of an equilibrium 
construct?

    Answer. Macroeconomic models that focus on or include demand-side 
effects are not sensitive to assumptions about how consumer preferences 
are modeled, but are more closely grounded in data.\22\
---------------------------------------------------------------------------
    \22\ The MEG is a hybrid that includes demand side effects, labor 
supply, and choices of consumption (not leisure) over time using a 
myopic model. The latter has only to do with generating a supply-side 
savings response.

    Question. The report identifies that ``A large body of evidence 
suggests the labor supply response to increase in wages is small, 
varies across workers, and can be negative for men.'' It then goes on 
to say that ``This evidence includes historical observation, cross 
section econometric studies, and estimates from experiments.'' Of 
course, there has been a great deal of careful research modelling, 
discussing, and comparing microeconomic and macroeconomic labor supply 
elasticities. Much of the evidence that CRS seems to weigh most heavily 
involves microeconomic elasticities estimated from variations used to 
estimate responsiveness at the intensive or, sometimes, the extensive 
margin for individuals. Yet, we observe large fluctuations in aggregate 
hours of work in response to small fluctuations in worker productivity, 
leading some to believe that the Frisch intertemporal substitution 
elasticity, which is important to aggregate fluctuations, may be large. 
There have been disagreements for some time between those who point to 
estimates of labor supply elasticities from microeconometric studies, 
like those most often emphasized by CRS, and those who indicate that 
aggregate fluctuations lead them to infer larger elasticities. Is CRS 
aware of any aggregation theory that could reconcile competing ideas 
---------------------------------------------------------------------------
about whether the high or low elasticity view could be reconciled?

    Answer. The basic concern about Frisch (intertemporal) labor 
substitution elasticities derived from business cycle data is that 
these estimates usually rest on assuming that unemployment during 
downturns is voluntary (the real business cycle model). Since wages 
vary much less than employment, a large elasticity is required to 
explain this large change in labor with a small change in wages. These 
elasticities are usually in the range of 2 to 4. That is, the shock to 
wages causes workers to leave the workforce. An ISLM model would see 
this phenomenon as due to rigidities in changing the wage to 
accommodate shocks, resulting in involuntary unemployment. In that 
view, the methodology used to derive Frisch elasticities would produce 
elasticities that are too high. This issue of involuntary unemployment 
is the major reason for questioning the Frisch macro elasticities.

    Given a view that unemployment in a recession is largely 
involuntary, microeconomic data are more appropriate to use in 
estimating the Frisch elasticity. As outlined in the review of Frisch 
elasticities by CBO \23\ and also in the CRS report on dynamic scoring, 
some studies have criticized the microeconomic estimates, but CBO 
concludes that small estimates of the Frisch elasticity averaging 
around 0.4 are appropriate for their models. It appears that the two 
types of elasticities cannot be reconciled.
---------------------------------------------------------------------------
    \23\ Felix Reichling and Charles Whalen, Review of Estimates of the 
Frisch Elasticity of Labor Supply, Congressional Budget Office, Working 
Paper 2012-13. October 2012, http://www.cbo. gov/sites/default/files/
cbofiles/attachments/10-25-2012-Frisch_Elasticity_of_Labor_Supply.pdf.

    Question. The report refers to a ``large meta-analysis'' of 
estimates of the intertemporal elasticity of substitution (IES), which 
reported a value of 0.6 for the United States. We were unable to locate 
that paper, as referenced, containing the meta-analysis, though we did 
locate a paper by the same title and by the same authors in the William 
Davidson Institute Working Paper series (number 1056) at the William 
Davidson Institute at the University of Michigan. In that paper, the 
authors state that ``An important issue that we do not discuss in this 
paper is publication selection bias. Several commentators have 
suggested that in empirical economics statistically insignificant 
results tend to be underreported and that the resulting mean estimate 
observed in the literature may be biased. . . .'' The CRS report, 
summarizing some variant of the paper that we were able to locate, 
states that ``The authors cautioned that the estimates were aimed at 
comparing across countries and were too large in value because of 
publication bias.'' Please provide a variant of the paper (not the 
companion paper that goes into more depth on ``publication bias'') in 
which the caution about estimates being too large because of 
---------------------------------------------------------------------------
publication bias is made.

    i. The CRS report, after raising the caution above, then goes on to 
use a study of potential effects of various types of possible biases 
reported by one study to show that the IES could be lower than the 0.6 
value, perhaps as low as 0.0. Of course, publication or reporting 
biases could be present in estimates for numerous parameter values 
relevant for economic models and analyses, and the direction of bias is 
not necessarily always clear. Is the estimate of the IES the only 
parameter estimate drawn from the professional literature for which CRS 
believes there could be need for correction because of publication 
bias? If so, are any estimates from professional publications unbiased 
and not subject to publication bias? Why did CRS choose to focus on 
publication bias for the IES estimation alone?

    Answer. We are supplying both papers used for the report with this 
response although in one case the paper has a newer date. They are 
located at http://ies.fsv.cuni.cz/sci/publication/show/id/4868/lang/en 
and at http://meta-analysis. cz/eis/eis.pdf.\24\ They are also 
referenced and linked in CRS Report R43381, Dynamic Scoring for Tax 
Legislation: A Review of Models, by Jane G. Gravelle.
---------------------------------------------------------------------------
    \24\ C Tomas Havraneka, Roman Horvathb, Zuzana Irsovab, and Marek 
Rusnaka, Cross-Country Heterogeneity in Intertemporal Substitution, 
Institute of Economic Studies, Faculty of Social Sciences, Charles 
University in Prague, 2013.
    http://ies.fsv.cuni.cz/sci/publication/show/id/4868/lang/cs; Tomas 
Havranek, Publication Bias in Measuring Intertemporal Substitution, 
Czech National Bank and Charles University, Prague, September 15, 2014, 
http://meta-analysis.cz/eis/eis.pdf.

    The CRS report did not intend to imply that the intertemporal 
elasticity of substitution was the only case where publication bias 
might be a factor and noted that point. This paper was the only 
estimate of publication bias for the relevant elasticities that we were 
able to find. Such an estimate requires a large body of data so that 
---------------------------------------------------------------------------
studies of the other elasticities may not be feasible.

    Question. The CRS report identifies that macroeconomic estimates of 
the Frisch elasticity ``. . . rest on the assumption that unemployment 
during recessions is voluntary . . . Assuming some or most of 
unemployment is involuntary, these estimates overstate the Frisch 
elasticity.'' Is it necessary, for a macroeconomic estimate of the 
Frisch elasticity to be ``large'' that the model used to ``estimate'' 
the elasticity involve only ``voluntary'' unemployment?

    Answer. We are aware of a study that estimated a Frisch elasticity 
in a macroeconomic model with some rigidities, including sticky wages, 
and found a high value.\25\ The approach was a Bayesian one (which 
begins with a set of prior assumptions) and the prior included a high 
intertemporal elasticity of substitution (1.5, while the literature 
suggests around 0.2), which suggests some reservations about the 
findings.
---------------------------------------------------------------------------
    \25\ Frank Smets and Rafael Wouters, ``Shocks and Frictions in US 
Business Cycles: A Bayesian DSGE Approach,'' American Economic Review, 
Vo. 97, No. 3, June 2007, pp. 586-606.

    Question. The paper discusses a survey of Frisch elasticity studies 
performed by Keane and by CBO, and concludes the relevant section with 
``Neither of these studies reference Ball, who found a zero Frisch 
elasticity. For Keane's summary, including this study would reduce the 
mean to 0.34 and the median to 0.17.'' Does this mean that CRS 
identified a study that Keane had not incorporated into his survey--a 
study for which the Frisch elasticity was found to be zero--and is 
putting forward that if you incorporate that zero finding into what 
Keane had averaged and compute a new average, you'd have a lower mean 
and median? If so, using that method of analysis, if we were to find 
some other study that Keane had not incorporated, which found a Frisch 
elasticity that is sufficiently large, could it be put forward that 
including it would generate a larger mean and median estimate as well? 
---------------------------------------------------------------------------
What disciplines this type of extraneous addition process?

    Answer. We reviewed the literature for studies excluded from the 
Keane and CBO surveys; the only additional paper we found was the Ball 
paper, which we reviewed and then referenced.

    Question. In the CRS report, as well as others produced by CRS 
regarding models used by the Joint Committee on Taxation, seemingly 
outsized attention, without much reference to why it is warranted, is 
sometimes given to statements by or views of a Professor named Ballard. 
For example, on page 31 of the July, 2014 report, it is written that 
``Is it possible to make choices that would lead to better 
elasticities? It would require using the time endowment as a tool to 
fit the model to evidence, as suggested by Ballard.'' Where is that 
suggestion made, and why is it important to consider?

    Answer. Charles Ballard, a professor at Michigan State University, 
is one of the few economists in the country to have constructed an OLG 
model. When the JCT convened nine modelers to study macroeconomic 
modeling of tax changes, following the 1995 hearings, Professor Ballard 
was asked to discuss the four intertemporal model results at a 
symposium. The papers and comments were published as a committee print 
and are available on the JCT website.\26\ Professor Ballard's 
discussion is on pp. 152-163, and his suggestion of using the time 
endowment to fit the model's elasticities to correspond to empirical 
estimates of elasticities is on p. 160. As he explains in his 
discussion, the amount of leisure generated by the time endowment 
choice is not of interest, but the labor supply is. Thus, the time 
endowment can be viewed as a free parameter that can be used to reduce 
the elasticities in the model so that they correspond more closely with 
empirical estimates. The CRS report on dynamic scoring contains a 
specific example of how this parameter might be used.
---------------------------------------------------------------------------
    \26\  Joint Committee On Taxation Tax Modeling Project And 1997 Tax 
Symposium Papers, JCS-21-97, November 20, 1997,
    https://www.jct.gov/publications.html?func=startdown&id=2940. 

    Question. The CRS report identifies that ``. . . the assumption of 
equal substitution elasticities between consumption across far apart 
periods means that these models [intertemporal models] still rest on 
unproven, and probably unreasonable assumptions about the elasticity of 
substitution between consumption amounts that are ten or twenty years 
apart.'' Please explain what this means. What, specifically, about an 
intertemporal model's assumptions about preferences or trading 
opportunities gives rise to the model not being reasonable with respect 
to an individual's willingness to substitute consumption or leisure 
across two adjacent periods or two remote periods? What criteria do CRS 
---------------------------------------------------------------------------
use to determine whether or not a model is ``reasonable?''

    Answer. The issue with intertemporal subsitution in these models is 
that although there are estimates of the willingness to substitute 
between the current period and the next period, we have no statistical 
evidence about how willing individuals are to substitute between 
consumption now and, for example, twenty years from now. Changes in the 
rate of return cause larger changes in the price of future consumption 
the farther the time is in the future. For example, an after tax rate 
of return that rises from 5% to 7.5% when taxes are eliminated would 
cause the price to fall by 2.3% one year into the future, 37.5% at 20 
years into the future, and 72.6% at 55 years into the future. Of course 
in perfect foresight models, the saving induced by these changes would 
push returns back down. But these are important price changes which 
also cause abor supply to increase in the present to finance more 
leisure in the future. Thus, shifting to a consumption tax can cause 
very large (and some would say, implausible) results such as a doubling 
of the saving rate or a 4% increase in the labor supply.\27\
---------------------------------------------------------------------------
    \27\ These results were found for their OLG model by Eric Engen, 
Jane Gravelle, and Kent Smetters, ``Dynamic Tax Models: Why They do the 
Things They Do,'' National Tax Journal, Vol. 50, No. 3, September 1997, 
pp. 631-656.

    With no empirical evidence one can only apply introspection to the 
issue of changing elasticities. It would seem intuitive that closer 
together periods are better substitutes than far apart ones. Consider 
this simple example. Suppose you wish to take a one week cruise and 
there is a one-time tax this year on cruise tickets. Would you be more 
likely to postpone your cruise until the next year, or delay it two 
years with a small additional amount of cash available from saving for 
an extra year? A constant elasticity of substitution says that the two 
are equal options, but most people, we suspect, would choose the one 
year delay. The fundamental point is that we don't have evidence of 
constant substitution elasticities, yet this assumption can drive a 
very large response to changing rates of return even if we had the 
correct intertemporal substitution elasticity for close together 
---------------------------------------------------------------------------
periods.

    It is also worth noting that many other aspects of the standard 
utility function of the consumption bundle over time have been 
questioned, and often found to be inconsistent with people's choices in 
experimental economics.\28\
---------------------------------------------------------------------------
    \28\  Shane Frederick, George Loewenstein and Ted O'Donoghue, 
``Time Discounting and Time Preference: A Critical Review,'' Source: 
Journal of Economic Literature, Vol. 40, No. 2, June. 2002, pp. 351-
401.

    Question. CRS reports covering macroeconomics at times refer to 
``mainstream economics'' or ``the mainstream view'' or ``the mainstream 
model'' in reference to aspects of the macroeconomy, such as the 
efficacy of short-term, debt-financed increases in federal spending 
when output and employment are below some measure of a smoothed trend. 
Yet, it is not clear what should be represented as a ``mainstream'' 
view or model. What seems clearer is that macroeconomic research has 
evolved to incorporate better tools of analysis than what were in 
existence decades ago, including dynamic programming, computational 
methods, and use of dynamic, stochastic, general equilibrium models 
that fully articulate the analytical primitives of tastes, 
technologies, trading opportunities, and shock processes. Using those 
tools, and within those frameworks, a host of ``views'' can be 
accommodated, ranging from sticky-wage, sticky-price views of 
macroeconomic fluctuations to a range of other mechanisms for 
explaining business cycle and growth phenomena. Please describe what it 
---------------------------------------------------------------------------
is that CRS takes to be ``mainstream economics.''

    Answer. The report on the fiscal cliff,\29\ while noting that some 
prominent economists disagreed, stated: ``The discussion of economic 
effects in this section may be seen as a mainstream view as reflected 
in the analysis of the Congressional Budget Office, the International 
Monetary Fund, the Federal Reserve Board, other government forecasters, 
and private forecasters.'' And in the report on austerity: \30\ 
``Mainstream economics relies on a basic theory regarding policies to 
expand the economy in a downturn. This theory can be found in economics 
textbooks and is used by government and private forecasters to project 
the path of the economy. This view has been the basis for fiscal and 
monetary policy interventions to stimulate the economy for many years, 
under both Republican and Democratic administrations. Chairman Bernanke 
of the Federal Reserve was referring to this view when he cautioned 
against large and immediate spending cuts.\31\ The basic thrust of the 
model for fiscal policy is that increasing the deficit (whether by 
increasing spending or cutting taxes) expands an underemployed economy, 
and decreasing the deficit (cutting spending or raising taxes) 
contracts it.''
---------------------------------------------------------------------------
    \29\ CRS Report R42700, The ``Fiscal Cliff'': Macroeconomic 
Consequences of Tax Increases and Spending Cuts, by Jane G. Gravelle.
    \30\ CRS Report R41849, Can Contractionary Fiscal Policy Be 
Expansionary?, by Jane G. Gravelle and Thomas L. Hungerford.
    \31\ Bernanke Warns Against Steep Budget Cuts. Reuters, February 9, 
2011, http://www.reuters.com/article/2011/02/09/us-usa-fed-
idUSTRE7183J220110209.

    It may also be interesting to note that when The Initiative on 
Global Markets at the University of Chicago recently surveyed prominent 
academic economists as to whether the stimulus measures in 2009 had 
reduced unemployment out of the 37 that answered the survey (44 were 
contacted), 36 agreed that the stimulus had reduced unemployment.\32\
---------------------------------------------------------------------------
    \32\  See Justin Wolfers, ``What Debate? Economists Agree the 
Stimulus Lifted the Economy,'' New York Times, July 29, 2014, http://
www.nytimes.com/2014/07/30/upshot/what-debate-economists-agree-the-
stimulus-lifted-the-economy.html?_r=0.

    Question. In your written testimony, you write: ``The repatriation 
tax could be eliminated by moving to a territorial tax, eliminating 
deferral and taxing all income currently, or imposing a current tax at 
a lower rate. All are proposals that have been made, although repealing 
deferral would yield enough revenues to reduce the corporate tax rate 
by three percentage points. Such a change might need to be accompanied 
by a provision to further restrict corporate inversions.'' Repealing 
deferral would seem to exacerbate the number of corporate inversions. 
What specific provision would need to be accompanied with repealing 
---------------------------------------------------------------------------
deferral to restrict corporate inversions?

    Answer. There are a number of possible changes that would make 
inversions more difficult or reduce the tax benefits associated with 
them. These provisions are discussed in a recent CRS report.\33\ 
Treasury regulations have been issued to prevent tax-free repatriation 
by lending of the former U.S. company's subsidiaries to the new parent. 
Such rules might be codified or made more significant by taxing 
accumulated deferred earnings of the former U.S. company (sometimes 
described as an exit tax). Another set of proposals would disallow 
inversions if the former U.S. firm maintains 50% control or ownership 
or has 25% of its business activity in the United States. Proposals 
have also been discussed to limit earnings stripping, where the 
inverted firm shifts taxable income out of the United States through 
inter-company loans. Proposals have been made to reduce the current 
limit on interest deductions relative to adjusted income from 50% to 
25% and repeal the alternative safe-harbor debt-to-equity test. Such 
proposals might be applied to all U.S. subsidiaries of foreign parents 
of U.S. firms. An alternative to limiting deductions could be applied 
to all firms by allocating deductible interest in proportion to 
earnings. IRS could also be charged with special scrutiny of transfers 
of intangibles of subsidiaries of the former U.S. firm to ensure that 
they are arm's length.
---------------------------------------------------------------------------
    \33\ CRS Report R43568, Corporate Expatriation, Inversions, and 
Mergers: Tax Issues, by Donald J. Marples and Jane G. Gravelle.
---------------------------------------------------------------------------
                                 ______
                                 
              Prepared Statement of Hon. Orrin G. Hatch, 
                        a U.S. Senator From Utah
WASHINGTON--Senate Finance Committee Chairman Orrin Hatch (R-Utah) 
today delivered the following opening statement at a committee hearing 
on tax reform, growth and efficiency:

    The committee will come to order.

    I want to welcome everyone to today's hearing to discuss tax 
reform, growth, and efficiency. I also want to thank our witnesses for 
appearing before the committee today.

    Many of us on the committee believe that tax reform is no longer 
optional. Rather, it is essential to help get our economy moving again. 
I believe that there is bipartisan agreement on the need for tax 
reform.

    Ranking Member Wyden, for example, has been invested in reform for 
about a decade now. Other members of this committee have worked 
diligently in recent years to examine available options and tradeoffs. 
Our efforts continue with bipartisan working groups that we established 
to engage in studying the issues, examining tradeoffs, considering 
options, and arriving at recommendations.

    The Obama Administration also remains interested in bipartisan 
efforts to reform the tax code, with particular interest in business 
tax reform.

    I disagree with most of the aggressive, often anti-growth, 
proposals in the President's recent budget aimed at significantly 
hiking taxes on capital as well as on savings and investment. 
Nonetheless, I welcome willingness on the part of the administration to 
engage in dialogue about how to reduce tax burdens on American 
businesses of all types, and how to improve the tax system for working 
American families.

    While there is no shortage of interest in tax reform, we need to 
continue to work in a bipartisan way toward action.

    Today's hearing will allow us to hear from an expert panel of 
witnesses about their views on how we can reform the tax system to 
promote growth in wages, jobs, and the economy and reduce economic 
inefficiencies.

    Issues surrounding how best to promote the efficient allocation and 
utilization of resources accompany any objective for promoting growth. 
In my view, we should minimize tax provisions that stand in the way of 
efficiently utilizing resources.

    While there are many issues surrounding how society values resource 
allocations, there are striking areas of our existing tax system that 
need attention. For example, our statutory and effective corporate tax 
rate is far too high relative to our international competitors, which 
impedes the abilities of U.S. firms to compete.

    And there are many tax-driven distortions in the tax code, but the 
list is too long for me to cover in the limited time I have available 
in my opening remarks.

    By now, I hope that everyone is clear on the principles that I 
believe should guide us as we examine tax reform. Prominent among those 
principles is that tax reform should significantly reduce economic 
distortions that are present under the current income tax system and 
promote growth in our economy.

    I want to ask that each witness on today's panel identify in their 
remarks today what they believe are the most damaging aspects of our 
existing tax system from the perspective of growth in the economy and 
efficient utilization of resources.

    Finally, let me just say that we must always remember that tax 
revenue comes from the economy, and not from Congress. Tax revenue 
comes from the hard work of American households and businesses, and not 
from bureaucrats in government. Congress should act as stewards of 
resources it extracts from American households and businesses, not as 
primary claimants on those resources.

    With that, I now turn to Ranking Member Wyden for his opening 
remarks.
                                 ______
                                 
             Submitted for the Record by Hon. Rob Portman, 
                        a U.S. Senator From Ohio

THE WALL STREET JOURNAL

WSJ.COM

February 23, 2015

Valeant-Salix Deal Shows Why Inverted Companies Will Keep Winning

By Maureen Farrell

Valeant Pharmaceuticals International Inc.'s $10 billion acquisition of 
Salix Pharmaceuticals Ltd. is the latest sign that all foreign-owned 
businesses have a clear edge in deal making.

Valeant inverted back in 2010 through a deal with Canada-based Biovail 
Corp., which it used to relocate to Canada from the U.S. and cut its 
tax rate to less than 5%.

Salix tried to follow suit last year, announcing a deal that would have 
moved its headquarters to Italy and cut its tax bill to the low 20%. 
But that deal fell apart shortly after the U.S. Treasury cracked down 
on the economic benefits of tax inversions.

On Monday, Salix became Valeant's target. The deal highlights a simple 
fact: Companies domiciled in lower tax rate countries will have a 
competitive advantage as consolidators.

Companies like Valeant with non-U.S. headquarters and lower tax rates 
can generate immediate cost savings as the deal lowers their target's 
tax burden. That allows these companies to be more aggressive in the 
targets they choose and the price they can pay in comparison with 
similar U.S. companies.

On a conference call, Valeant boasted of a 5% tax rate for the combined 
venture. Salix paid 32.6% of its profits in taxes in 2013. Jason 
Gerberry, an analyst at Leerink Research, estimated that Valeant could 
cut $230 million in costs from taxes at Salix within six months of the 
deal closing.

All but one of the bidders for Salix had non-U.S. headquarters, 
according to the WSJ. The one U.S.-based bidder was Mylan Inc., which 
is in the process of moving its headquarters to the Netherlands through 
a tax inversion it announced in June.

Valeant bought Salix, its largest acquisition ever, months after losing 
out on its attempts to acquire Allergan Inc.

The winner in the battle for Botox-maker Allergan: Actavis PLC, a 
company once based in Parsippany, N.J. but moved to Ireland through a 
2013 $5 billion deal with Warner Chilcott PLC. In early 2014, Actavis 
bought Forest Laboratories Inc., also based in New Jersey, and then 
landed Allergan in a $66 billion deal, slashing taxes all along the 
way.

Valeant has grown nearly as rapidly through acquisitions since it moved 
to Canada. Within two years of inking its deal with Biovail, the WSJ 
reported that Valeant had made 13 takeover bids and succeeded in 11 of 
them. That deal making doubled Valeant's market cap to $16.24 billion. 
Many, but not all of those acquisitions--all several hundred million 
dollars in price or smaller--were U.S.-based companies.

By late 2012, it announced its first multibillion deal, purchasing 
Scottsdale, Ariz.-based Medicis Pharmaceutical Corp. for $2.6 billion. 
The WSJ cited Medicis' 41.6% tax rate in 2011 as a driver of the deal. 
Analysts then predicted roughly $150 million in tax savings from the 
deal.

By May 2013, Valeant agreed to pay more than $8 billion for eye-
products maker Bausch & Lomb, which had been taken private by Warburg 
Pincus in 2007. Its financials were private at the time of its sale to 
Valeant, including its tax rate. (In the small world of pharma 
inversions, Brent Saunders, Bausch & Lomb's CEO at the time of that 
sale, is now the CEO of Actavis).

Upon the announcement of the Salix deal, Valeant's stock popped nearly 
15% Monday. Valeant market cap now stands at $66.7 billion, as its tax 
rate basically stays still at 5%.
                                 ______
                                 
    Prepared Statement of Laura D'Andrea Tyson, Ph.D., Professor of 
   Business Administration and Economics and Director, Institute for 
  Business and Social Impact, Haas School of Business, University of 
                               California
    Chairman Hatch, Senator Wyden, and other members of the committee, 
thank you for the opportunity today to address the issue of tax reform 
and its role in promoting stronger U.S. economic growth and higher 
wages for American workers.

    My name is Dr. Laura Tyson, and I am a professor at the Haas School 
of Business at the University of California Berkeley. I served as the 
Chair of the Council of Economic Advisers and as Chair of the National 
Economic Council under President Clinton. I was a member of President 
Obama's Economic Recovery Advisory Board and his Council on Jobs and 
Competitiveness. I am currently an economic adviser to the Alliance for 
Competitive Taxation, a coalition of American businesses that favor 
comprehensive corporate tax reform.

    The views in this testimony are my own.

    My remarks will focus on corporate tax reform. Over 50 years ago 
under President Kennedy and perhaps as recently as 30 years ago under 
President Reagan, the American economy was the most competitive in the 
world, and the U.S. could design its corporate tax code with little 
consideration of the global economic environment. American companies 
derived most of their income from their domestic operations and to the 
extent they were engaged globally, they were typically larger than 
their foreign-based counterparts.

    But we no longer live in that world. Emerging market economies, 
falling trade barriers, and remarkable leaps in information and 
communications technology have expanded opportunities for U.S. 
companies abroad, but have also heightened global competition among 
companies to gain market share and lower production costs, and 
competition among countries to attract investment and jobs. Our 
corporate tax system was designed for an economy in which U.S. 
multinational companies earned most of their revenues at home, 
international competition was relatively unimportant, and most 
corporate profits were produced by tangible assets, such as machinery 
and buildings. This is not today's world.

    Today, the United States faces growing competition from countries 
around the world for the activity of global companies. And American 
companies face significant and increasing competition from foreign-
based global companies. Since 2000, the number of U.S.-headquartered 
companies in the Fortune Global 500 has declined by more than any other 
country--from 179 to 128. Foreign-based competitors to American 
companies are all headquartered in countries with lower tax rates. 
Further, multinational companies headquartered in other developed 
countries typically operate under territorial tax systems under which 
little or no home-country tax is imposed on their active foreign 
business earnings. Within the Fortune Global 500, 93 percent of the 
companies headquartered in other OECD countries are taxed under 
territorial systems. In addition to tax systems that are more conducive 
for locating business operations and global headquarters, many other 
OECD countries offer educated workforces, major universities, and world 
class infrastructure.

    Our corporate tax system makes it harder for U.S. businesses--small 
and large--to compete with foreign companies, and reduces the 
competitiveness of the U.S. economy as a place to do business and 
create jobs. As a result of numerous credits, deductions and 
exclusions, the current system also results in high compliance costs 
for businesses--estimated at $110 billion in 2009--and undermines the 
efficiency of business decisions in numerous ways. There is widespread 
bipartisan agreement that our corporate tax system is deeply flawed and 
in need of fundamental reform.

    I believe there are ways to reform the corporate tax system that 
will strengthen the competitiveness of U.S. companies, make the United 
States a more attractive place to do business, reward work, and reverse 
the 40-year stagnation of middle class incomes. Such reforms can 
promote simplicity and efficiency in the tax code and be adopted 
without increasing the deficit. In the remainder of my remarks, I will 
suggest changes to current tax rules affecting both the domestic and 
the foreign-earned income of U.S. corporations to achieve these 
objectives.
                          domestic tax reform
    It is important to begin testimony at a hearing about tax reform, 
economic growth and efficiency by noting that of all taxes, corporate 
income taxes are the most harmful to economic growth because they 
reduce the returns to savings and investment.

    After the 1986 tax overhaul, the United States had one of the 
lowest corporate tax rates among developed countries. Since then, 
countries have been slashing their rates in order to encourage 
investment by their domestic companies, to attract investment by 
foreign companies, and to discourage their domestic companies from 
moving their operations and their income to lower-tax foreign 
locations.

    Since 1986, capital has become increasingly mobile, and differences 
in national (statutory) corporate tax rates have a growing influence on 
where multinational companies locate their operations and report their 
income.

    In the most recent and audacious move to attract the activity of 
global companies, the British government has reduced its corporate tax 
rate from 30% in 2007 to 20% beginning next month--half of the combined 
U.S. federal and average state corporate tax rate. Further, since 2013, 
the British government has applied a special tax rate on income from 
patents, which phases down to 10 percent in 2017. Currently 12 EU 
countries have or are implementing such special tax regimes for income 
from intellectual property--commonly called patent boxes--with tax 
rates generally in the range of 5 to 15 percent on such income. These 
patent boxes are recognized as legitimate means to promote innovation 
and economic development provided the income taxed under such regimes 
is substantively connected to in-country activities.

[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]


    The United States now has by far the highest statutory corporate 
tax rate among developed countries. Other researchers, using a variety 
of methods have found that even after accounting for various 
deductions, credits, and other tax-reducing provisions, U.S. companies 
face higher effective corporate tax rates than most of their 
competitors.\1\
---------------------------------------------------------------------------
    \1\ See, Jack Mintz and Duanjie Chen, ``U.S. Corporate Taxation: 
Prime for Reform,'' Tax Foundation, February 2015, showing the United 
States has the second highest marginal effective corporate tax rate of 
95 countries in the world, and Phillip Dittmer, ``U.S. Corporations 
Suffer High Effective Tax Rates by International Standards,'' Tax 
Foundation, September 2011, which provides a survey of nine different 
effective corporate tax rate studies that each show the United States 
is in the highest quartile among countries.

    The relatively high U.S. statutory rate decreases the incentive to 
invest in the United States by both U.S. and foreign firms. Setting the 
rate at a more competitive level would encourage more domestic 
---------------------------------------------------------------------------
investment by U.S. and foreign investors.

    Capital has become increasingly mobile, and differences in national 
statutory corporate tax rates have a growing influence on where 
multinational companies locate their operations and report their 
income. The high U.S. statutory rate magnifies the attractiveness of 
investing in lower-tax locations and increases the incentive to shift 
income out of the United States.

    It is not possible for the United States to stay competitive as a 
place to do business with a statutory corporate tax rate that is more 
than 14 percentage points (58 percent) above the OECD average.

    Higher investment in the United States by both domestic and foreign 
companies would boost economic growth, while the resulting increase in 
capital--new businesses, factories, equipment, and research--would 
improve labor productivity and increase employment. That should, in 
turn, boost real wages over time, as increases in labor productivity 
have historically been closely related to growth in labor incomes, 
although this relationship has weakened over time.

    Productivity gains in the United States are substantially 
attributable to the U.S. activities of multinational companies. A 
Federal Reserve study of labor productivity in the U.S. private sector 
between 1977 and 2000 found that the U.S. multinational sector 
accounted for three-fourths of the increase in labor productivity over 
this period.

    American multinational companies are the chief instrument by which 
our economy competes globally, yet these companies are the most 
affected by the lack of a competitive tax code. Removing the tax 
barriers to the ability of these globally engaged companies to be 
competitive in world markets can pay substantial dividends to the U.S. 
economy.

    In 2012, U.S. multinational companies directly employed 23.1 
million American workers, with average compensation of $76,500, 34 
percent greater than compensation of workers in non-multinational 
companies. Through their supply chains, U.S. multinational companies 
support an estimated 21 million additional U.S. jobs. Spending by the 
employees of U.S. multinational companies and suppliers is estimated to 
support a further 28 million jobs. Overall, more than 71 million U.S. 
jobs are directly or indirectly supported by U.S. companies with global 
operations.

    The competitiveness of globally-engaged U.S. companies matters to 
the health of the U.S. economy. U.S. multinational companies tend to be 
large, capital-intensive, skill-intensive, research-intensive and high 
productivity--all features that contribute to high wage jobs and rising 
living standards. In 2012, they accounted for about 20% of private 
sector U.S. jobs, 23% of U.S. private sector GDP, 30% of U.S. private 
capital investment, and about 76% of all U.S. private sector R&D.

    Despite the rapid growth of their foreign markets, U.S. 
multinational companies still locate significant shares of their real 
economic activities at home--70% of their value added, 66% of their 
employment, 73% of their capital investment, and 84% of their R&D. Much 
of the domestic economic activity of U.S. multinational companies is 
related to their headquarter functions and has significant local 
spillover benefits to the broader economy.

    Further, foreign direct investment by U.S. multinational companies 
is not zero-sum--it increases rather than reduces employment, 
investment, and R&D in the United States. Research has found that each 
10 percent increase in foreign employment is estimated to result in a 
6.5% increase in U.S. employment. Similar complementary relationships 
are found between the foreign affiliate operations and the domestic 
exports, R&D, capital investment, and employee compensation of U.S. 
multinational companies.

    The pro-growth rationale for reducing the U.S. corporate tax rate 
is compelling. There is some evidence that the growth effects from 
corporate rate reduction also provide a significant offset to the cost 
of rate reduction found in conventional estimates that assume no change 
in the size of the economy. This includes past research by the Joint 
Committee on Taxation that finds the feedback effect from corporate 
rate reduction can offset between 12 percent and 28 percent of the 
conventional revenue cost within 5 to 10 years of enactment.\2\ I 
believe with a full accounting for cross-border investment and income 
shifting, the offsets from corporate rate reduction are likely to be 
even greater. But by itself such a cut would reduce corporate tax 
revenues.
---------------------------------------------------------------------------
    \2\ Joint Committee on Taxation, Macroeconomic Analysis of Various 
Proposals to Provide $500 Billion in Tax Relief, (JCX-4-05), March 1, 
2005.

    So how should we finance a rate reduction large enough to have a 
significant effect on the competitiveness of U.S. companies and on the 
competitiveness of the U.S. as a location for investment without 
increasing the deficit? Like most economists, I believe that we can and 
should pay for such a rate reduction mainly by broadening the corporate 
tax base through the elimination of tax breaks and preferences. 
Combining rate reduction with base broadening is the approach adopted 
in the 1986 tax reform and it is the approach advocated by numerous 
---------------------------------------------------------------------------
independent bipartisan commissions and think tanks.

    Base broadening would not only raise revenues to pay for a rate 
reduction, it would also reduce the complexity of the tax code and 
increase its efficiency. The current system of deductions and credits 
not only reduces corporate tax revenues, it also results in large and 
economically unjustifiable differences in effective tax rates across 
economic activities and these differences distort investment decisions, 
often with harmful effects on productivity and growth.

    Given the importance of the statutory corporate tax rate in 
influencing the location of highly profitable and mobile capital, a 
significant reduction in this rate that is paid for by broadening the 
corporate tax base can achieve meaningful efficiency gains and boost 
economic growth. And over time as growth increases, a revenue-neutral 
corporate tax reform will increase corporate tax revenues and reduce 
the deficit.
                        international tax reform
    There is also widespread agreement that, in addition to reducing 
the corporate tax rate and broadening the corporate tax base, the 
United States should reform the way it taxes the foreign earnings of 
U.S. companies.

    With 95% of the world's consumers located outside of the United 
States, American companies need to have a presence in foreign markets 
to compete there. Products need to be tailored to local consumer 
preferences, shipping costs may make it impractical to export certain 
products abroad, and the provision of services requires employees in 
the local market. If a U.S. company isn't established in a given 
foreign market, a non-U.S. competitor will likely win the business 
there.

    Every other G-7 country and 28 of the other 33 OECD member 
countries have international tax systems that allow their globally-
engaged companies to repatriate their active foreign earnings at home 
without paying a significant additional domestic tax. This approach, 
referred to as a participation exemption or territorial tax regime, is 
grounded in the principle of ``capital ownership neutrality''--that is, 
the amount of corporate tax imposed on a company's active foreign 
earnings should be independent of the residence of that company's 
parent.

    The current U.S. system, in contrast, is based on a worldwide 
approach: the foreign earnings of U.S. companies are subject to U.S. 
corporate tax with the amount owed offset by a credit for taxes paid in 
foreign jurisdictions. With the adoption of territorial tax systems by 
the United Kingdom and Japan in 2009, and by thirteen other OECD member 
countries since 2000, the U.S. international tax system now lies far 
outside of international norms.

    The combination of a relatively high corporate tax rate and a 
worldwide approach to taxing active foreign earnings disadvantages 
globally-engaged U.S. companies when they compete in third country 
markets with multinational companies headquartered in territorial 
systems or their local competitors. U.S. multinational companies cannot 
bring profits home from their foreign affiliates without paying the 
high U.S. corporate tax rate, while most foreign-based competitors pay 
only the local tax rate on such profits.

    This combination also reduces the competitiveness of U.S. 
multinational companies in cross-border acquisitions. In such 
acquisitions, a U.S. acquirer of a foreign company owes a U.S. tax on 
the resulting foreign income stream that would not be owed by a foreign 
acquirer headquartered in a territorial system.

    If the United States were to adopt the type of territorial systems 
used by the countries with which we compete, then U.S. multinational 
companies would face the same effective tax rates in foreign markets as 
the foreign firms with which they compete in these markets.

    Current U.S. law attempts to blunt these competitive disadvantages 
for U.S. multinational companies through deferral--allowing U.S. parent 
companies to defer the payment of U.S. corporate tax on the foreign 
earnings of their foreign subsidiaries until they are repatriated.

    Under the current U.S. corporate tax system, U.S.-based 
multinational companies have a strong incentive to keep their foreign 
earnings abroad. Not surprisingly, as their foreign earnings have 
grown--international operations now account for more than half of the 
income of U.S. multinational companies--and as foreign corporate tax 
rates have plummeted, the stock of foreign earnings held abroad by U.S. 
multinational companies has increased. These accumulated foreign 
earnings are currently estimated at about $2.1 trillion, some of which 
has been reinvested to expand their foreign operations and some of 
which is held in cash and other liquid investments.

    For the reasons cited earlier, the competiveness of globally 
engaged American companies matters to the health of the U.S. economy in 
many ways. Deferral is essential to maintaining the competitiveness of 
these companies as long as the United States relies on a worldwide 
approach to corporate taxation and has a relatively high statutory 
corporate tax rate.

    But deferral is not without significant costs for both U.S. 
multinational companies and for the U.S. economy. Deferred earnings are 
``locked out''--the government receives no tax revenues from them and 
they are not directly available for use in the United States by the 
U.S. parent companies. Moreover, U.S. companies incur costs from locked 
out earnings due to the suboptimal use of these earnings and from 
higher levels of domestic debt. Treasury economist Harry Grubert and 
Rutgers economics professor Rosanne Altshuler estimate that the hidden 
cost of retaining profits overseas is about 7 percent of incremental 
deferred foreign income and these costs grow as the stock of that 
income grows.\3\ These costs are a drag on the competitiveness of 
globally-engaged U.S. companies. The current system undermines the 
ability of U.S. companies to compete with foreign companies in the 
acquisitions of U.S. companies. It also makes investments by U.S. 
shareholders in U.S. companies with foreign operations less attractive 
relative to investments in foreign companies that can repatriate 
profits without a corporate tax penalty.
---------------------------------------------------------------------------
    \3\ Harry Grubert and Rosanne Altshuler, ``Fixing the System: An 
Analysis of Alternative Proposals for the Reform of International 
Tax,'' National Tax Journal, September 2013.

    A participation exemption or territorial system similar to those in 
other developed countries would allow U.S. multinationals to put their 
foreign earnings to work in the United States and to compete more 
effectively in foreign markets, which today represent about 80 percent 
of the world's purchasing power and which will become even more 
---------------------------------------------------------------------------
important in the future.

    As part of comprehensive corporate tax reform, the United States 
should adopt a territorial approach to taxing the foreign earnings of 
U.S. multinational companies. Such a system would provide a level 
playing field that supports U.S. companies' global competitiveness. It 
would also eliminate the rising costs associated with locked out 
earnings and boost their repatriation, with significant benefits for 
U.S. output and employment.

    Based on recent research that incorporates conservative 
assumptions, my colleagues and I estimate that under a territorial 
system, U.S. companies would repatriate an additional $100 billion a 
year from future foreign earnings, adding about 150,000 U.S. jobs a 
year on a sustained basis.\4\ We also estimate that under a transition 
plan for taxing the existing stock of deferred foreign earnings, 
similar to one proposed by former Ways and Means Chairman Dave Camp, 
U.S. multinational companies would repatriate about $1 trillion of 
these earnings, adding more than $200 billion to U.S. GDP and about 1.5 
million U.S. jobs in the first few years following enactment.
---------------------------------------------------------------------------
    \4\ Eric Drabkin, Kenneth Serwin, and Laura D'Andrea Tyson, 
``Implications of a Switch to a Territorial Tax System in the United 
States: A Critical Comparison to the Current System,'' Berkeley 
Research Group, November 2013.

    A territorial tax system does have one potential disadvantage: it 
could strengthen the existing incentives of U.S. multinational 
companies to shift their profits to lower-tax jurisdictions. The 
exceptionally high U.S. corporate rate, significant cuts in foreign 
corporate tax rates, the rise of competitors based in territorial 
systems, the deferral option, and the rising importance of patents and 
other intangible assets already make these incentives powerful, and 
---------------------------------------------------------------------------
income-shifting by U.S. multinational companies is already substantial.

    Other developed countries with territorial systems have adopted a 
variety of exceptions and anti-abuse rules to discourage income 
shifting by their multinational companies and to safeguard their 
domestic tax base with successful results. These include rules aimed at 
taxing foreign passive income on a current basis and ``thin cap'' rules 
that limit excessive interest expense. Some countries have not extended 
their territorial systems to foreign affiliates in ``black listed'' tax 
haven countries. In those black listed countries, the foreign tax 
credit system with deferral applies. If base erosion were a particular 
problem of territorial systems, one might have expected some of the 28 
countries in the OECD using territorial tax systems to switch to a 
worldwide tax system like the United States. However, only two OECD 
countries have ever switched to a worldwide tax system (Finland and New 
Zealand) and both subsequently switched back to territorial systems.

    Recent discussions of base protection measures in the United States 
have considered the imposition of a minimum tax under which the foreign 
income of a U.S. multinational company would be taxed currently in the 
United States unless the foreign rate of tax it pays in the foreign 
jurisdiction exceeds some specified minimum rate. This is not a form of 
base protection measure that has been adopted by other OECD countries.

    The Obama Administration's proposed 19 percent minimum tax on 
future foreign earnings is of this form. It would end deferral and 
require that the foreign earnings of a U.S. company be taxed at an 
effective rate of at least 22.4 percent in every foreign jurisdiction 
in which the company operates or else it would have to pay an 
additional tax to the United States at the time this income is earned. 
(The difference between the stated rate of 19 percent and the actual 
result of 22.4 percent is due to the fact that the minimum tax would 
continue to apply until 85 percent of the foreign effective tax rate 
exceeded 19 percent.) Tax owed to the United States would be computed 
on a tax base that excludes a risk-free return on equity invested in 
active assets. Some have suggested that the risk-free return might be 
defined as the return on U.S. Treasuries, areturn significantly lower 
than the return earned on equity investments by U.S. corporations both 
at home and abroad.

    It is notable how the minimum tax approach, which imposes a penalty 
on lower taxed foreign earnings, varies from the incentives being 
offered in other countries like the United Kingdom, with the rule of 
law, educated workforces, major research centers and universities, and 
world class infrastructure. These countries are using tax policy as a 
``carrot'' to attract the income and the operations of U.S. companies 
with significant intangible assets and the positive externalities 
associated with them--including spillover effects boosting innovation, 
productivity, and wages. The minimum tax is a ``stick'' approach to 
capturing the global income of such companies. But this approach cannot 
succeed in the long run when there are foreign-headquartered companies 
capable of operating in the friendly, carrot jurisdictions. Ultimately, 
the minimum tax approach will drive the real economic activity of U.S. 
companies, including the positive externalities associated with them 
and their tax base, to these foreign locations and foreign owners.

    Adoption of a minimum tax of this magnitude and structured in this 
manner would harm the global competitiveness of American companies that 
earn a large share of their income in global markets. A significant 
share of corporate income earned by U.S. multinationals in Europe would 
likely be subject to the minimum tax. Sixteen of the 28 EU countries 
had statutory tax rates below 22.4 percent in 2014, and effective tax 
rates are likely to be still lower. Further, while the competitors of 
American companies could fully avail themselves of the benefits of the 
current and planned patent boxes in 12 EU countries with tax rates in 
the 5 to 15 percent range, American companies would pay a non-
competitive rate as high as 22.4 percent on such income.

    In such situations, U.S. companies would be at a competitive 
disadvantage in acquiring foreign companies with desirable intellectual 
property. Instead, as a result of their significant global tax 
disadvantage, existing U.S. companies with such property would become 
attractive targets for foreign acquirers and would have even stronger 
incentives to move their headquarters, their R&D and their future 
intellectual property to lower-tax foreign locations with territorial 
systems. And start-up companies based on innovations and intellectual 
property developed in the U.S. would have an incentive to incorporate 
in such locations.

    In a world with highly mobile capital, especially highly profitable 
intangible capital, the United States should move to a hybrid 
territorial system with base protection measures consistent with the 
practices of its major trading partners.

    It would be ill-advised for the United States to adopt unilateral 
approaches, such as the minimum tax approach proposed by the Obama 
Administration, that disadvantage U.S. multinational companies, 
precisely when developed countries are adopting patent boxes and other 
preferential tax measures to attract the income and activity of these 
companies.

    A territorial system along with multilateral cooperation to combat 
base erosion can best protect our tax base and that of our trading 
partners, while reducing the risk of double taxation and the creation 
of barriers to foreign investment. The ongoing OECD Base Erosion and 
Profit Shifting project provides a venue for adoption of base 
protection measures on a multilateral basis and should be considered as 
the appropriate forum for developing such measures. Recentdevelopments 
show that the OECD project is encouraging greater multilateral 
cooperation in international tax policy.
                               conclusion
    The United States last reformed its business tax code in 1986, when 
it had one of the lowest corporate tax rates in the world and the 
competitive dynamics of the global economy were very different. It is 
time for another comprehensive corporate tax reform that, without 
increasing the budget deficit, reduces the tax rate, broadens the tax 
base, makes the corporate tax system simpler and more efficient, and 
adopts a hybrid international system with effective safeguards to 
protect the U.S. tax base.
                                 ______
                                 
   Questions Submitted for the Record to Laura D'Andrea Tyson, Ph.D.
               Questions Submitted by Hon. Orrin G. Hatch
    Question. Dr. Tyson, a little over a year ago, you co-authored a 
report on implications of the United States switching to a territorial 
tax system and stated that ``Our research finds that transitioning to a 
territorial tax system similar to those used by other advanced 
industrial countries would generate a significant amount of economic 
growth and create jobs here in the United States. As lawmakers in 
Washington look for policies to boost economic growth and job creation, 
reforming the corporate tax code to allow American businesses to invest 
their foreign earnings in the United States now and in the future is an 
opportunity that should be considered.'' I have two questions for you, 
Dr. Tyson. First, could you elaborate on the report and on economic 
growth and job creation that can result from switching to a territorial 
tax system? And, second, I wonder if you could comment on the 
Administration's recent proposal to impose a 19 percent minimum tax on 
foreign earnings of U.S. multinationals, including what effect you 
think such a move would have on existing and future U.S. companies.

    Answer. Our study found that by transitioning to a territorial 
system there would be a large increase in repatriated earnings that 
would otherwise be held abroad under the current system. Returning 
these earnings for use in the United States by these companies will 
lead to greater economic activity in the United States and more jobs. 
We looked at the impact of a 95 percent exemption for repatriations of 
active foreign earnings assuming no reduction in the 35-percent 
corporate tax rate.

    Our study estimated the increase in U.S. economic activity through 
two channels. One channel is through the repatriation of foreign 
earnings that has accumulated abroad prior to the enactment of a 
territorial system and the second channel is through the ongoing 
repatriation of future foreign earnings.

    Regarding the first channel, at the time of our study approximately 
$2 trillion were classified by U.S. companies as indefinitely 
reinvested abroad. More recent data show that this has increased to 
$2.3 trillion at the end of 2014. The study assumes that the change to 
a hybrid territorial system would be accompanied by a transition plan 
comparable to that proposed by former House Ways and Means Committee 
Chairman David Camp in 2011. Based on this assumption, the study 
predicts that U.S. companies will repatriate about $1 trillion of these 
earnings that would otherwise be deferred and held abroad indefinitely. 
This increase in repatriations, in turn, will increase investment 
spending directly by some repatriating firms and will increase 
consumption spending by shareholders. Together we estimate these 
increases in spending will increase U.S. GDP by at least $208 billion 
and will create at least 1.46 million jobs.

    The second channel represents the ongoing benefits of a territorial 
system. We estimate that U.S. companies will increase their 
repatriation of future foreign earnings by an estimated $114 billion 
per year. The resulting increase in spending from the return of these 
earnings will increase U.S. GDP by $22 billion annually and create 
154,000 new jobs on a sustained basis.

    Regarding your question on the minimum tax, I believe the minimum 
tax at the rate and structure proposed by the Administration would harm 
the global competitiveness of American companies. U.S. companies 
seeking to operate in foreign markets would be at a disadvantage 
relative to their foreign competitors who could operate free of any 
additional taxes imposed by their home governments. The foreign 
competitors of American companies would be able to benefit from 
incentives offered by the foreign countries in which they operate. U.S. 
companies, however, would find any foreign tax savings that they could 
achieve would be lost through higher U.S. taxes.

    U.S. companies would be at a competitive disadvantage in acquiring 
foreign companies with desirable intellectual property. Instead, as a 
result of their significant global tax disadvantage, existing U.S. 
companies with such property would become attractive targets for 
foreign acquirers and would have even stronger incentives to move their 
headquarters, their R&D and their future intellectual property to 
lower-tax foreign locations with territorial systems. And start-up 
companies based on innovations and intellectual property developed in 
the U.S. would have an incentive to incorporate in such locations.

    The net result would be that economic activity that would otherwise 
have been undertaken by U.S. companies will instead be driven to 
foreign locations and foreign owners, with the U.S. losing the benefit 
from the ownership of highly desirable intellectual property and the 
positive externalities associated with them.

    Question. Dr. Gravelle's testimony argues that ``. . . it should 
not be surprising that a revenue neutral tax reform is unlikely to have 
a significant effect on output, given the necessity of base broadening 
to lower rates.'' In support of the argument, a study is cited that 
assessed the Tax Reform Act of 1986--or TRA86--and concluded, according 
to Dr. Gravelle's summary, that it ``left incentives roughly 
unchanged.'' Given that, you wouldn't expect much in terms of growth 
effects from a revenue neutral reform exercise. Before getting to my 
question, I would note that the 1997 study in question does conclude 
that, at the time, ``. . . saying that a decade of analysis has not 
taught us much about whether TRA86 was a good idea is not at all the 
same as saying it was not in fact a good idea. We think it was.'' 
Moreover, since that analysis, a Nobel Prize winning economist and his 
coauthor have provided evidence that tax reforms in 1986 coupled with 
changes in regulations governing retirement holdings help account for 
large long-run increases in corporate equity values relative to GDP, 
something that I would think is a positive for the economy and everyone 
with a retirement account. My question to the Panel is whether everyone 
agrees that it is ``simply difficult, if not impossible'' to design a 
revenue neutral tax reform plan that would have significant enough 
effects on incentives to increase economic growth?

    Answer. The economy today is much different than in 1986. The 
importance of globalization is far greater, as is the mobility of 
capital. As a result, it is quite likely that capital investments are 
far more responsive to differences in taxation than they were in 1986. 
Highly profitable intangible assets in particular are likely to be 
especially responsive to differences in the statutory tax rate across 
countries. This suggests that rate lowering reforms paid for through 
base broadening may confer larger benefits today than at the time of 
the Tax Reform Act of 1986.

    My own research suggests that adoption of a territorial tax system 
as part of 
revenue-neutral tax reform can provide meaningful improvements to 
incomes of American families and U.S. job creation. In addition, a 
transition to a territorial tax system would make U.S. companies more 
competitive in foreign markets and allow them to increase employment 
opportunities in the United States.

    For all these reasons, I believe the economic case for tax reform 
is even stronger today than at the time of the 1986 Tax Reform Act.

    Question. Dr. Tyson, you have written that corporate taxes are 
harmful to economic growth. You have also written that with ``highly 
mobile capital, it is far easier to collect taxes from individual 
citizens and resident shareholders than from multinational companies.'' 
I wonder whether it makes sense to treat all business entities as pass-
through entities for tax purposes. For example, master limited 
partnerships, which are publicly traded, are taxed as pass-through 
entities, meaning that owners are taxed on their income. My question, 
Dr. Tyson, is whether you believe that we should apply that type of 
regime to all business entities?

    Answer. Increased integration of the corporate and individual 
income tax systems would reduce or eliminate a number of distortions 
caused by the current double tax system including the tax incentive to 
finance with debt rather than equity, the tax disincentive to raise 
capital from public markets, and the tax incentive to retain or 
distribute earnings according to the relationship of corporate and 
shareholder tax rates. Increased integration would reduce or eliminate 
the current law disadvantage to corporate organization relative to 
pass-through or S corporation form. Depending on the design, corporate 
integration also may reduce incentives for corporations to shift 
profits to low-tax foreign jurisdictions.

    There are a variety of ways that the corporate and individual 
income tax systems could be integrated. In practice, countries with 
corporate integration systems have not taxed retained corporate 
earnings at the shareholder level. The 1992 Treasury study discusses 
the possibility of a shareholder allocation system that would treat 
corporate shareholders as partners but would retain the corporate 
income tax as a form of withholding tax.

    The shareholder allocation approach was not Treasury's preferred 
method of corporate integration in the 1992 report for both policy and 
administrative reasons. The policy concerns related to the treatment of 
tax preferences and foreign tax credits while the administrative 
concerns related to the need for corporations to amend their charters, 
keep capital accounts, and report tax information to shareholders like 
partnerships.

    I believe the Treasury shareholder allocation model deserves a 
fresh look, particularly in the context of tax reform that would 
eliminate many corporate tax preferences and move towards a territorial 
tax system, as such a reform would obviate many of the policy concerns 
raised in the Treasury study. In addition, we have had over 25 years of 
experience with publicly traded partnerships that maintain capital 
accounts and report tax information to large numbers of shareholders 
that buy and sell shares throughout the year. In addition, it is 
possible to simplify audit, reporting and other administrative matters 
for large partnerships, such as the elective large partnership rules 
enacted in 1997.
                                 ______
                                 
                 Prepared Statement of Hon. Ron Wyden, 
                       a U.S. Senator From Oregon
    Just two weeks ago, the Finance Committee heard from two former 
Senators--a Republican and a Democrat, both architects of the 1986 Tax 
Reform Act--about an approach to tax reform that worked. It turned the 
impossible into the possible. It was modern, it was targeted, and it 
found smart ways to spark economic growth.

    Their approach gave equal tax treatment to wages and wealth, which 
is crucial for middle-class fairness. It preserved and expanded 
important policies that rewarded hard work, helped families buy homes, 
and made it easier to afford college. And they avoided partisan 
processes like budget reconciliation that put the outcome at risk.

    Everybody here has been a part of umpteen academic conversations 
about tax reform. Two weeks ago, this committee heard about an approach 
that works. In my view, it makes sense to build on that bipartisan 
wisdom. So let's take on the challenge of developing a new, modern plan 
that fits today's economy.

    There is a long list of examples of where our broken tax system 
needs fixing. One that comes up in nearly every Oregon town meeting I 
have is the skyrocketing cost of childcare. For a long time, people 
have looked at home mortgages, college tuition, and retirement savings 
as the big-ticket expenses for most families. Parents today know that 
list is incomplete without childcare.

    But the programs in the tax code intended to make childcare more 
affordable haven't kept up. Too often, their benefits don't cut it. A 
lot of families get no help at all. For many others, it's only a meager 
level of assistance. So a lot of parents are having to make a difficult 
choice. Do they both continue working and take on the huge expense of 
childcare? Or will one of them have to sacrifice their career to stay 
home? That's a barrier to work that tax reform should demolish.

    Just like in 1986, it's time again to give fair tax treatment to 
wages and wealth. The code punishes middle-class wage-earners by taxing 
their income at a higher rate than investments. Leveling the playing 
field is a matter of basic fairness. We heard two weeks ago that 
policymakers recognized that fact in 1986, so they should recognize it 
again today.

    The tax code also needs to encourage more investment in the U.S. It 
should do more to drive innovation, support manufacturing, and draw 
high-skill, high-wage jobs to our shores. Today's broken code puts the 
U.S. at a competitive disadvantage in the world, and that needs to 
change.

    There's another important lesson from 1986 to remember. It would be 
a costly mistake for tax reform to heap a heavier burden on America's 
middle class. That's a surefire way to slow down growth and set middle-
class families back. A lot of families who struggle to make ends meet 
find help through the tax code. So let's not make life harder for them. 
It makes a lot more sense to take the proven, modern approach to tax 
reform that gives everybody a chance to get ahead.

                             Communication

                              ----------                              


                    National Small Business Network

              P.O. Box 639 Corvallis, Oregon 97339-0639  
                     www.NationalSmallBusiness.net

                        Statement for the Record

            Senate Finance Committee Hearing on Tax Reform, 
                         Growth, and Efficiency

                           February 24, 2015

Chairman Hatch and Members of the Committee:

These tax reform recommendations are made as part of a balanced program 
of both tax policy and budget policy actions to restore a sustainable 
Federal fiscal process. They focus primarily on business tax reform 
issues, particularly for small businesses, because of their greater 
importance in promoting economic growth, and because both the 
Administration and Congress have suggested them as a starting point for 
any reform.
Basic Tax System Principals for Economic Growth:
   Simplify and coordinate our overly complex tax code to improve 
        voluntary compliance, provide equitable treatment for all 
        taxpayers, and reduce both taxpayer and IRS administrative 
        expense.

   Make sure business tax reform provides incentives for the growth of 
        small businesses, who provide half of all jobs, as well as for 
        large corporations.

   Encourage long-term direct business investment by taxing only real 
        economic income, not the effect of monetary inflation by 
        adjusting all tax code provisions to reduce inflationary 
        distortions.

   Encourage domestic investment and job creation to the greatest 
        extent possible within the limits of international agreements.

   Assure that any tax reform provides adequate overall revenue to 
        gradually reduce our national debt and restore long-term fiscal 
        stability. Unfortunately, the ``bottom line'' is that tax 
        reform needs to be at least revenue neutral, and will need to 
        be somewhat revenue positive overall to reduce our debt and 
        unfunded future obligations. Although limited deficit spending 
        can stimulate the economy, most economists agree that 
        continuing deficits and our current $18 Trillion national debt 
        reduce economic growth, are a very real threat to the future 
        stability of our economy. Please see our related 
        recommendations on budgeting and Fiscal Reforms for Sustainable 
        Government on our website at www.NationalSmallBusiness.net.
Background:
Taxes are not the cause of our current economic and under employment 
problems. With the exception of payroll taxes, most American businesses 
pay Federal taxes only when they are profitable. The current federal 
tax level on individuals and ``pass-through'' business entities is 
lower than it was during times of economic prosperity and growth, and 
is lower than most other leading industrial nations. The stated tax 
rate on large corporations appears higher than other nations, but when 
adjusted for U.S. business tax incentives and other taxes imposed by 
foreign countries, such as value added taxes, it is similar to other 
leading industrial nations. Even at a time of record corporation 
earnings, corporation income tax revenues have fallen from 5.0% of 
gross domestic product in 1952 to only about 1.6% today. Some of this 
reduction results from smaller corporations converting to subchapter S 
corporations whose income is reported as personal income tax. Some of 
it also appears to result from larger corporations avoiding taxes by 
shifting taxable income to foreign countries with lower tax rates.

For the past 10 years, most Federal tax rates have been lower than 
historical averages, particularly on the very wealthy who are receiving 
an increasing percentage of all income. This is a major cause of our 
spiraling debt. Lower tax rates, particularly on capital gains and 
stock dividends have also encouraged financial speculation which was a 
major cause of the 2008 recession. But as the last 10 years have 
proven, lower tax rates did not promote sustainable domestic economic 
growth.
1. Tax Expenditures and Special Tax Rate Recommendations

Review all tax expenditure provisions and special tax rate incentives 
for their true value as an economic, employment, social, or 
environmental incentive. All tax expenditures and special tax rate 
provisions without fixed expirations should be re-evaluated at least 
every 10 years for possible modification or progressive elimination. 
Pass multi-year targeted tax incentives such as business deductions, 
credits, and accelerated write-offs that are proven to effectively 
support direct domestic business investment and employment. To obtain 
the best economic return from tax expenditures, pass them well in 
advance, and do not waste resources on retroactive incentives.

Tax reform discussion in the 113th Congress ended unsatisfactorily with 
only a last minute 1 year extension of basic business and investment 
incentives, most of which have already expired. Tax law, including tax 
expenditure incentives, can be a major factor in economic decisions by 
both businesses and individuals. Tax policy is also one of the few 
remaining strategic tools to provide targeted economic incentives for 
domestic economic growth. Businesses and investors often focus on short 
term profit, rather than on the long-term sustainability of their 
business; the health of the national economy; or concern for the 
environment. Tax policies that overly ``broaden the base and reduce the 
rate'' would limit the ability of Congress to provide strategic 
incentives for long term economic sustainability and international 
competitiveness.

Flat tax structures tend to encourage short term speculation instead of 
long term direct investment. They also encourage movement of investment 
capital anywhere in the world where the potential return is highest. 
Flatter tax brackets also benefit wealthier investors, particularly if 
capital gains are kept at a lower rate. This would result in an 
increasingly economically segregated national economy, increased 
unemployment, and lower total tax revenue and would further increase 
our unsustainable national debt.

Reducing most current tax expenditures in order to reduce maximum tax 
rates would probably also significantly increase the effective tax 
burden on middle income and small business taxpayers while reducing tax 
revenue from large corporations and the very wealthy. Most tax 
expenditures, including deductions, credits, and preferential tax rates 
are limited either by specific maximum amounts, or maximum overall 
income levels for which the provisions apply. These limits are in place 
to obtain the greatest economic or policy impact with the least loss of 
tax revenue, and often have the greatest incentive effect and benefit 
for middle income taxpayers. Because of the large and growing 
percentage of total taxable income going to the upper 1% of all 
citizens, any reduction in the progressivity of personal tax rates on 
higher incomes will eventually result in an overall reduction in tax 
revenues.

Even though some tax expenditures can have high value in stimulating 
economic activity with long term benefits, many provide little benefit 
in relation to their revenue cost, and some are pure ``pork'' that 
benefits a small number of businesses or individuals. Existing 
Congressional data does not provide an adequate decision making data 
matrix for Congress to accurately evaluate existing tax expenditures, 
deductions, and rate preferences. We recommend that the House and 
Senate Budget Committees and Senate Finance and House Ways and Means 
Committee jointly request the CBO or JCT to develop a current 
comprehensive analysis of the economic benefits of all tax 
expenditures. The report should include at a minimum--

   A summary of the tax expenditure or rate preference, and original 
        reason for it.
   The tax revenue cost over 10 and 20 year periods.
   An estimate of who is actually benefited by the provision, by 
        number and type of taxpayers and by income level; or type of 
        business and total employment and the national economic 
        importance of the provision.
   An evaluation of the total secondary economic benefits and the 
        potential economic multiplier for the expenditure.
   The effectiveness of the tax expenditure in actually causing the 
        desired activity and the potential negative effects of 
        elimination.
   An evaluation of whether there is still a current need for the tax 
        expenditure.
2. Tax Simplicity, Clarity, and Efficiency Recommendations:
One of the key goals of tax reform should be to simplify the complexity 
of the current code, and provide greater tax system clarity and 
equitability for different taxpayer entities. The current code, which 
was built on successive layers of changes by past Congresses, has 
become too complex with too many adjustments, limitations and phase-
outs for taxpayers to understand and comply with. Many provisions 
either purposely or unintentionally negate or limit the effects of 
other provisions.

  A. Increase the role of the Joint Committee on Taxation and Treasury-
    IRS in assisting Members of Congress in the ongoing development of 
    a simpler and better coordinated federal tax code. The complexity 
    of the tax code is the result of many decades of changes and 
    additions by individual Members of Congress layered on top of prior 
    legislation without overall coordination. Many of these provisions 
    conflict with similar or even contrary provisions in existing code. 
    Other provisions have become outdated by changes in technology or 
    business practices. This complexity makes it difficult for 
    taxpayers, and even professional tax preparers, to understand and 
    comply with the code. The complexity also increases the 
    administrative burden on the IRS and makes it difficult for them to 
    provide good taxpayer assistance and assure filing accuracy and 
    taxpayer compliance. Often the IRS has to resolve legislative 
    issues with hundreds of pages of detailed regulations which 
    increases the administrative burden on the IRS, and often just 
    further increases complexity for the taxpayer. JCT and the IRS 
    should develop a joint working group to identify existing code 
    issues requiring better legislative clarity or coordination and a 
    process to develop legislation to resolve them.

  B. Revitalize the management and business system reforms of the 
    Internal Revenue Service to provide better taxpayer assistance for 
    an efficient and equitable administration process. The ability of 
    the IRS to properly and efficiently administer the tax code is 
    currently hindered by incomplete improvements to vital business 
    systems such as data processing and communication technology. The 
    IRS is also facing increased administrative responsibilities, such 
    as the ACA and FATCO, combined with declining budget allocations, 
    and heavy turnover of key staff. With budget cuts, training has 
    been reduced and staff expertise has declined. This is resulting in 
    declining levels of performance in many areas and increased burdens 
    on taxpayers and return preparers. The combination of a complex tax 
    code, declining taxpayer education and assistance, and inadequate 
    IRS budgets will eventually threaten accurate and equitable 
    enforcement of the law. If this happens, it will also reduce 
    collection of the revenue needed for all other Federal programs and 
    services.

  The Congress and Administration need to recommit to the goals of the 
    1998 IRS Reform and Reorganization effort by providing better 
    support for improvements to technology systems and stronger 
    management emphasis on business process re-engineering and greater 
    efficiency in the tax administration process. Commissioner Koskinen 
    is doing a good job trying to identify and resolve problems with 
    the limited resources of the agency. But, the IRS needs increased 
    Congressional budget support and better proactive communication on 
    agency issues. The Administration also needs to complete 
    revitalization of the IRS Oversight Board with additional 
    nominations to assist IRS management with continuing organizational 
    improvements and communication with the Congress.

  C. Provide standard tax code definitions and coordinated inflation 
    adjustments for all limit and rate bracket provisions. Multiple 
    definitions exist for many items of income and types of credits or 
    deductions. These need to be standardized and simplified. Congress 
    needs to review the Internal Revenue Code for fixed limitations and 
    provisions which are long overdue for inflationary adjustments, 
    such as the business gift limitation, and update them. Then, adopt 
    a standard inflationary adjustment provision to replace the myriad 
    of specific provisions in the code for rate brackets and dollar 
    limitations which should have periodic adjustment. The provisions 
    should require a reasonable minimum inflation change before a 
    periodic adjustment is made.

  D. Remove outdated administrative burdens in the tax code such as the 
    remaining ``Listed Property'' reporting requirements on standard 
    business computers and communication equipment. The Small Business 
    Jobs Act of 2010 removed the outdated usage record keeping 
    requirements for employer provided business ``cell phones,'' but 
    failed to remove the equally burdensome and illogical requirements 
    on similar common business communication devices and portable 
    computers. With the merging of cell phones, computers, and cameras 
    into single inexpensive devices, the remaining listed property 
    reporting requirements and deduction limitations for business 
    ``computers'' when used outside a ``qualified office'' also need to 
    be removed. As with cell phones, if there is a legitimate business 
    need for a mobile computer, there is usually little or no 
    additional marginal cost for any personal use of the same 
    equipment, because most hardware is replaced long before the end of 
    its potential usable life. The new IRS repair regulations allow a 
    taxpayer to elect to expense replacement items costing less than 
    $500, which makes the listed property requirements even more 
    illogical.

  E. Protect each state's right to use sales, transaction, or 
    consumption taxes, and simplify retailer remittance of interstate 
    consumption taxes, by passing marketplace equitability legislation. 
    Congress should support effective and efficient interstate 
    collection of state sales and use taxes, and provide an equitable 
    business environment for those businesses that properly collect 
    state sales taxes, by passing marketplace fairness legislation, 
    along with a long-term renewal of the Internet Tax Freedom Act. A 
    federal sales tax administration law would not create any new 
    taxes, but simply enable states that have chosen to use consumption 
    based taxes to efficiently collect them on the growing volume of 
    Internet purchases. It is similar in principle to the many 
    agreements the federal government has with states and foreign 
    countries to exchange tax information to help stop tax evasion. 
    Congress should simplify calculation and reporting of sales taxes 
    for interstate sellers by enabling a single, uniform electronic tax 
    reporting and payment processing system.

3. Capital Gains Tax Reform Recommendations:

  Congress should encourage long term capital investment by adjusting 
    the calculation of long term capital gain on assets held more than 
    5 years to remove taxation of the phantom gain from monetary 
    inflation, to reflect the true constant dollar value of the gain. 
    Calculation of the adjustment should be simple, and require only a 
    multiplication of the dollar gain using IRS supplied existing data 
    on the cumulative inflation change from the year of purchase to the 
    year of sale.

  The current personal income tax code provides a lower tax rate for a 
    ``long-term capital gain'' on an asset held for 366 days. This 
    actually progressively penalizes investments held more than one 
    year because of its failure to adjust for monetary inflation over 
    the investment life. The President's 2015 budget proposal to 
    increase the capital gains tax rate for top bracket earners to 
    24.2% or 28% total, including the 3.8% ACA surtax, would make the 
    inflationary distortion even greater. And, even owners of 
    relatively small businesses would generally be in the maximum rate 
    bracket in the year they sell their business or business property. 
    And most states also add an additional state tax of up to 10% on 
    capital gains. The investments that America needs to build a 
    sustainable economy by starting or growing businesses, or building 
    business infrastructure, are not 366 day investments. True long 
    term business investments may not provide a capital return for 10, 
    20, 30, or 40 years or longer.

  The current law also provides the same tax treatment for individuals 
    to invest in speculative secondary market investments such as 
    traded stocks which, except for new offerings, provide no new 
    economic investment or funding for business growth. Ironically, 
    secondary economic investments actually can have a greater tax 
    benefit because they can be easily sold after 1 year when the tax 
    benefit is greatest. Where the asset is a business or investment 
    property, this short tax incentive peak encourages the owners to 
    focus on short term ``paper'' profitability and the potential for 
    resale, rather than long term growth and sustainability. This 366 
    day peak incentive also encourages financial speculators to 
    purchase and sell off asset rich businesses, rather than operating 
    and growing them.

  Almost all other value comparisons that extend over long periods such 
    as economic statistics, government budgets, and other tax code 
    provisions, are adjusted to remove the effect of inflation. 
    Although compensating for inflation distortion is part of the 
    justification for having a lower tax rate on capital gains, this is 
    a classic case where a ``one size fits all'' approach does not 
    work. To illustrate the progressive disincentive for long term 
    investment under current law, the table below shows the real, after 
    inflation, return and effective tax rate on a sample investment. It 
    assumes a business was started, or an asset was purchased, for $1M 
    in 1962 and held for periods of 2 to 50 years before being sold for 
    $2M. The taxable gain in each case is $1M and the true constant 
    dollar value of the gain from the year of investment was calculated 
    using U.S. Bureau of Labor Statistics CPI Inflation data. As the 
    chart below shows, the effective tax rate on the real inflation 
    adjusted gain grows significantly after 5 years, particularly at a 
    higher tax rate.


----------------------------------------------------------------------------------------------------------------
                                                 Actual Real                            Actual Real
                                      Capital      Constant    Effective     Capital      Constant    Effective
                                     Gains Tax      Dollar     Tax Rate*    Gains Tax      Dollar     Tax Rate*
          Holding Period             paid at a     value of     on real     paid at a     value of     on real
                                      15% rate     the $1M     gain at a     28% rate     the $1M     gain at a
                                                     gain       15% rate                    gain       28% rate
----------------------------------------------------------------------------------------------------------------
2 years...........................     $150,000     $948,800        15.8%     $280,000     $948,000        29.5%
5 years...........................     $150,000     $902,200        16.6%     $280,000     $902,200          31%
1O years..........................     $150,000     $782,800        19.2%     $280,000     $782,800        35.8%
20 years..........................     $150,000     $610,050        24.6%     $280,000     $610,050        45.9%
30 years..........................     $150,000     $419,900        35.7%     $280,000     $419,900        66.7%
40 years..........................     $150,000     $181,900        82.5%     $280,000     $181,900         154%
50 years..........................     $150,000     $131,400       114.2%     $280,000     $131,400         213%
----------------------------------------------------------------------------------------------------------------
* The effective tax rate is the current code tax amount on the paper gain, divided by the actual inflation
  adjusted value of the gain.


  At a 28% tax rate, the federal tax would actually exceed the total 
    real economic gain after only about 35 years. Although an 
    adjustment should really be made on all assets held for more than 5 
    years, the scoring cost of initial correction legislation could be 
    reduced by limiting the adjustment to business property or direct 
    business investments where the taxpayer is and active owner.

4. Small Business ``Pass Through'' Entity Tax Reform Recommendations:

  A. To provide targeted small business growth incentives, with the 
    lowest revenue cost, Congress should differentiate in the personal 
    income tax code all net ``pass-through income'' from a business in 
    which the taxpayer materially participates as ``Small Business 
    Operating Income'' (SBOI). This would include non-salary income 
    from partnerships, ``S'' corporations, farms, and other business 
    income reported on a personal return. Stimulating economic growth 
    through the tax code is complicated by the fact that there are two 
    business taxation systems. Most large businesses pay their taxes 
    through the corporate tax system, which in 2010 collected about 9% 
    of total federal tax revenues. Most smaller business are subchapter 
    ``S'' corporations, partnerships, LLCs, Schedule ``C'' or Schedule 
    ``F'' filers, and pay the taxes on their business operating income 
    on their personal tax return along with their other personal 
    income. The SBA estimates that over 90% of small businesses are 
    pass-through entity taxpayers. As a result, the provisions and 
    rates of the personal tax code can have an unintended negative 
    impact on small business growth. When Congress considers economic 
    stimulus measures or tax system reforms, it is important that both 
    business tax systems be changed in unison. But, unless real pass-
    through business income can be identified and treated separately, 
    any attempt to provide equitable treatment will result in 
    significant revenue loss from non-business taxpayers.

  In 2011 Congress raised effective tax rates on higher income 
    individuals, many of whom are small business owners. Proposed 
    reductions in the large corporation tax rate to 28% or less will 
    potentially shift an even greater percentage of the tax burden onto 
    small businesses and individuals. This will have a significant 
    impact on small and midsize businesses that report their business 
    operating income on the owner's personal return, on top of their 
    other salary and investment earnings. This often results in the 
    small business income being taxed at the highest individual tax 
    rates. When compared to the low tax rates on dividends and capital 
    gains on highly liquid ``traded stocks,'' it is difficult for 
    people to justify the higher risk, and lower after tax return, of 
    most small business investments. Because of their more limited 
    ability to borrow capital, small business operating income must 
    often be reinvested in the business for survival and growth, 
    leaving little cash available to pay the taxes. It is estimated 
    that two thirds of all small business employees' work for firms 
    with 20 to 500 employees, and many of these firms are likely to be 
    impacted by the higher personal tax rates.

  Income resulting from direct business investment and active operation 
    of a business which employs workers and sells a product or service 
    has a much higher value to our overall economy than income 
    resulting from passive speculative activity. By differentiating 
    income from active businesses, Congress can provide targeted tax 
    stimulus with less revenue loss, by not having to provide the same 
    tax treatment on gains from passive investments such as traded 
    stocks.

  B. Congress should enact a lower maximum tax rate, comparable to 
    proposed ``C'' corporation rates, on up to $500,000 of Small 
    Business Operating Income reported on a schedule K1, C, or F, for a 
    business in which the taxpayer materially participates. Matching 
    AMT language must also be enacted to prevent the AMT from 
    nullifying the effect of the provision. This would allow a limited 
    amount of small business income to be taxed at lower rates to 
    encourage equity reinvestment to finance business growth. 
    Calculating the tax on this income separately from other personal 
    wage and investment income will also prevent the taxpayer's other 
    income from pushing the tax rate on the business income into the 
    highest personal rate brackets.

  The Personal Alternative Minimum Tax must also be adjusted for pass-
    through Small Business Operating Income because it is much 
    different than the ``C'' corporation AMT, and significantly impacts 
    tax liability on small business income. The combined reporting of 
    both personal and business operating income on the owner's personal 
    tax return often exceeds the relatively low personal AMT exemption 
    level. This makes taxpayers calculate and pay the additional 
    Alternative Tax on their business income. This is compounded by the 
    lack of deductibility under the AMT of state income taxes, which in 
    some states can exceed 10%. As a result many small businesses pay 
    federal taxes on business ``income'' they never received, since it 
    was paid in state income tax. In contrast, the Corporate AMT only 
    applies if the 3-year average annual business income exceeds 
    $7,500,000.

  In 2013, Congress made inflation indexing of the personal AMT 
    exemption permanent, but failed to correct many of the underlying 
    issues, that have a major impact on small business owners. Taxpayer 
    Advocate Nina Olson has repeatedly addressed this issue in her 
    annual reports to Congress. She has stated that if the individual 
    AMT is not eliminated, then Congress should ``. . . eliminate 
    personal exemptions, the standard deduction, deductible state and 
    local taxes, and miscellaneous itemized deductions, as adjustment 
    items for Individual Alternative Minimum Tax purposes.''

  Ideally, Congress should eliminate the burden of AMT calculation for 
    most taxpayers, although the cost would be high. The tax code 
    should at least provide better equality in the AMT treatment of 
    ``Small Business Operating Income'' reported on a personal Form 
    1040 return, with the far higher ``C'' corporation AMT exemption.

  C. Congress should permanently equalize the deductibility, up to a 
    reasonable cost limit, of individual or group health insurance at 
    the entity level for all forms of businesses, including self-
    employed entrepreneurs, by amending IRC section 162(1)(4). The 
    deductible limit should be adjusted for average health insurance 
    cost inflation. Without Congressional action to re-instate equal 
    exclusion of health insurance from payroll taxes, the 21 million 
    self-employed again face this self-employment tax penalty for 2015, 
    along with other health insurance cost increases.

  D. Congress should permanently enact an exclusion on at least 75% of 
    the gain on Section 1202 qualified small business stock and remove 
    the add-back in the AMT calculation. This could revitalize an 
    important tool for small business financing, particularly if 
    capital gains rates increase in the future. As an alternative, 
    Congress might provide an alternative 20% tax credit for investment 
    in Qualified Small Business Stock held for 5 years or longer.

  E. Provide equitable employee cafeteria benefit options for small 
    business owners.

  F. Congress should make permanent the $500,000 expensing limitation 
    for Section 179 property, so businesses can plan for future new 
    equipment investments when they are needed under consistent rules. 
    Congress should also make permanent, the ability to revoke Section 
    179 expensing on amended returns, and to expense ``off the shelf'' 
    computer software.

  G. Make permanent the inclusion of limited non-structural real 
    property improvements under Section 179 expensing.

  H. Modernize and simplify the qualified home office deduction.

  I. Modernize the unrealistic ``Luxury'' automobile depreciation 
    limitations. Depreciation and expensing limits for vehicles should 
    be adjusted to allow a person who needs to use an automobile for 
    business to fully recover the cost of a $25,000 vehicle, with 100% 
    business use, during the standard 6-year recovery period. That 
    amount should be periodically adjusted for average vehicle costs.

  J. Increase the deductibility of business meals for small businesses 
    up to 75%.

  K. Return the contribution due date for IRA investments to the 
    extended return due date.

5. International Corporate Tax Policy Recommendations:

  Tax the income of U.S. Corporations from controlled foreign business 
    subsidiaries or other investments as current income in the year in 
    which it is earned, on the same basis as income from a U.S. 
    division or investment, less a credit for the foreign income taxes 
    paid. If necessary to facilitate reasonable accounting and tax 
    reporting cycles, some foreign business income could be allowed to 
    be reported in the following tax year. Non income based foreign 
    taxes should also continue to be deductible. The reported income 
    should be based on generally accepted international accounting 
    standards, and be adjusted for any special incentives provided by 
    foreign governments.

  When 60% of international corporate assets consist of difficult to 
    value intangibles, the concept of ``arm's length'' transactions 
    between U.S. corporations and their foreign subsidiaries is no 
    longer practical. The tax code taxes the income from offshore 
    investments of U.S. individuals on the same basis as if the income 
    was received domestically, less the credit for the foreign income 
    taxes paid. The code also taxes businesses with domestic 
    subsidiaries on the basis of their combined income and assets. The 
    same standard should apply to foreign earnings of U.S. 
    corporations. The current tax system does not tax earnings of 
    foreign subsidiaries as U.S. income until they are transferred back 
    to the parent corporation. This allows multinational corporations, 
    particularly those with high intellectual property values, to use 
    inter-division accounting manipulations to transfer taxable profits 
    to divisions in lower tax countries where the earnings can 
    multiply. This not only reduces U.S. tax income, but also creates a 
    tax incentive barrier to recognizing and re-investing those 
    earnings in the U.S. for domestic business growth.

6. National Infrastructure Repair and Improvement Recommendations.

  Good infrastructure is vital to continued economic growth. Congress 
    should, as a beginning step repair our deteriorating transportation 
    systems, by rebuilding the depleted Highway Trust Fund. Increase 
    the Highway fuel tax rates, last set in 1993, from 18.4 cents per 
    gallon for Gasoline to at least 30 cents per gallon, with 
    comparable increases for diesel fuel and further increases in later 
    years. This should have been done years ago and gradually phased 
    in, but the current decline in oil prices provides any opportunity 
    for an increase now without significant economic hardship. Reducing 
    our consumption of greenhouse gas producing carbon fuel, and our 
    strategic dependence on foreign oil, are important national 
    objectives. Let the market based incentive of higher fossil fuel 
    costs reduce unnecessary consumption and emissions. The added 
    revenue can be used to help build a modern transportation 
    infrastructure, including good public transit, rather than 
    continuing to send our dollars to foreign oil supplying countries.

  Good transportation infrastructure is vital to the U.S. economy, but 
    much of our current system is deteriorating and is inadequate for 
    future needs. The federal transportation program, funded by the 
    federal fuels tax, has been the primary source of system 
    improvement funding, along with state and local funds. After years 
    of watching the program go broke from under funding, Congress 
    rushed through a stop gap measure, Pub. L. 113-159, in August of 
    2014 that is neither a logical, nor adequate, solution. It 
    reauthorized funding just until May 31, 2015, and provided no 
    sustainable funding base to rebuild the program. It was ``funded'' 
    with an increased general fund deficit, and short term revenue 
    scoring from requiring businesses to reduce pension plan funding 
    for workers. This was short sighted, and a better solution needs to 
    be developed.

  Transportation projects often take 5 to 30 years from planning to 
    completion and require reliable long term funding sources to be 
    done efficiently. Funding for transportation improvements should 
    also come from those who use and benefit from the system. Because 
    of the progressing changes in modes of transportation and the 
    development of alternative fuel vehicles transportation system 
    funding will probably need to move beyond a simple fuel tax at some 
    point. But, development of new complex funding approaches will 
    probably take years and require major interaction with all the 
    states.

This statement was prepared for the National Small Business Network by:
Eric Blackledge and Thala Taperman Rolnick, CPA

National Small Business Network
P.O. Box 639
Corvallis, OR 97339

Phone 541-829-0033
Fax 541-752-9631

Email [email protected]

Related research and information is available on our website at
www.NationalSmallBusiness.net

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