[JPRT 105-4-98]
[From the U.S. Government Publishing Office]



Online via GPO Access [wais.access.gpo.gov]
[DOCID: f:46548.wais.wais]

Online via GPO Access [wais.access.gpo.gov]


                        [JOINT COMMITTEE PRINT]


 
                   DESCRIPTION OF REVENUE PROVISIONS
                     CONTAINED IN THE PRESIDENT'S
                   FISCAL YEAR 1999 BUDGET PROPOSAL

                               __________

                         Prepared by the Staff

                                 of the

                      JOINT COMMITTEE ON TAXATION

[GRAPHIC] [TIFF OMITTED] CONGRESS.#13


                           FEBRUARY 24, 1998




                               __________


                   U.S. GOVERNMENT PRINTING OFFICE
 46-548                  WASHINGTON : 1998                            JCS-4-98




                      JOINT COMMITTEE ON TAXATION

                      105th Congress, 2nd Session
                                 ------                                
               SENATE                               HOUSE
WILLIAM V. ROTH, Jr., Delaware,      BILL ARCHER, Texas,
  Chairman                             Vice Chairman
JOHN H. CHAFEE, Rhode Island         PHILIP M. CRANE, Illinois
CHARLES GRASSLEY, Iowa               WILLIAM M. THOMAS, California
DANIEL PARTICK MOYNIHAN, New York    CHARLES B. RANGEL, New York
MAX BAUCUS, Montana                  FORTNEY PETE STARK, California

                     Lindy L. Paull, Chief of Staff
              Mary M. Schmitt, Deputy Chief of Staff (Law)
      Bernard A. Schmitt, Deputy Chief of Staff (Revenue Analysis)



                            C O N T E N T S

                              ----------                              
                                                                   Page
Introduction.....................................................     1

 I. Provisions Reducing Revenues......................................2

        A. Child Care Provisions.................................     2

            1. Expand the dependent care tax credit..............     2
            2. Employer tax credit for expenses of supporting 
                employee child care..............................     7

        B. Energy and Environmental Tax Provisions...............     9

            1. Tax credits.......................................     9
                a. Tax credit for energy-efficient building 
                    equipment....................................     9
                b. Tax credit for purchase of new energy-
                    efficient homes..............................    11
                c. Tax credit for high-fuel-economy vehicles.....    11
                d. Tax credit for combined heat and power 
                    (``CHP'') systems............................    12
                e. Tax credit for replacement of certain circuit 
                    breaker equipment............................    14
                f. Tax credit for certain perfluorocompound 
                    (``PFC'') and hydrofluorocarbon (``HFC'') 
                    recycling equipment..........................    14
                g. Tax credit for rooftop solar equipment........    15
                h. Extend wind and biomass tax credit............    16
            2. Other provisions..................................    22
                a. Tax treatment of parking and transit benefits.    22
                b. Permanent extension of expensing of 
                    environmental remediation costs 
                    (``brownfields'')............................    23

        C. Retirement Savings Provisions.........................    26

             1. Access to payroll deduction for retirement 
                savings..........................................    26
             2. Small business tax credit for retirement plan 
                start-up expenses................................    28
             3. Simplified pension plan for small business 
                (``SMART'')......................................    29
             4. Faster vesting for employer matching 
                contributions....................................    33
             5. Pension ``right to know'' provisions.............    34
             6. Simplified method for improving benefits of 
                nonhighly compensated employees under the safe 
                harbor for 401(k) plans..........................    36
             7. Simplify definition of highly compensated 
                employee.........................................    38
             8. Simplify benefit limits for multiemployer plans 
                under section 415................................    39
             9. Simplify full funding limit for multiemployer 
                plans............................................    40
            10. Eliminate partial termination rules for 
                multiemployer plans..............................    42

        D. Education Tax Provisions..............................    43

            1. Tax credits for holders of qualified school 
                modernization bonds and qualified zone academy 
                bonds............................................    43
            2. Exclusion for employer-provided educational 
                assistance.......................................    48
            3. Eliminate tax on forgiveness of direct student 
                loans subject to income contingent repayment.....    50

        E. Extend Certain Expiring Tax Provisions................    54

            1. Extend the work opportunity tax credit............    54
            2. Extend the welfare-to-work tax credit.............    57
            3. Extend the research tax credit....................    58
            4. Extend the deduction provided for contributions of 
                appreciated stock to private foundations.........    68

        F. Miscellaneous Tax Provisions..........................    71

            1. Increase low-income housing tax credit per capita 
                cap..............................................    71
            2. Extend and modify Puerto Rico tax credit..........    76
            3. Specialized small business investment companies...    80
            4. Accelerate and expand incentives available to two 
                new empowerment zones............................    82
            5. Exempt first $2,000 of severance pay from income 
                tax..............................................    88

        G. Simplification Provisions.............................    90

            1. Optional Self-Employment Contributions Act 
                (``SECA'') computations..........................    90
            2. Statutory hedging and other rules to ensure 
                business property is treated as ordinary property    91
            3. Clarify rules relating to certain disclaimers.....    96
            4. Simplify the foreign tax credit limitation for 
                dividends from ``10/50'' companies...............    97
            5. Interest treatment for dividends paid by certain 
                regulated investment companies to foreign persons    99

        H. Taxpayers' Rights Provisions..........................   101

             1. Suspend collection by levy during refund suit....   101
             2. Suspend collection by levy while offer-in-
                compromise is pending............................   103
             3. Suspend collection to permit resolution of 
                disputes as to liability.........................   104
             4. Require district counsel approval of certain 
                third-party collection activities................   105
             5. Require additional approval of levies on certain 
                assets...........................................   106
             6. Require district counsel review of jeopardy and 
                termination assessments and jeopardy levies......   107
             7. Require management approval of sales of 
                perishable goods.................................   107
             8. Codify certain fair debt collection practices....   108
             9. Payment of taxes.................................   109
            10. Procedures relating to extensions of statute of 
                limitations by agreement.........................   110
            11. Offers-in-compromise.............................   110
            12. Ensure availability of installment agreements....   111
            13. Increase superpriority dollar limits.............   112
            14. Permit personal delivery of section 6672(b) 
                notices..........................................   113
            15. Allow taxpayers to quash all third-party 
                summonses........................................   114
            16. Disclosure of criteria for examination selection.   115
            17. Threat of audit prohibited to coerce tip 
                reporting alternative commitment agreements......   116
            18. Permit service of summonses by mail..............   117
            19. Civil damages for violation of certain bankruptcy 
                procedures.......................................   117
            20. Increase in size of cases permitted on ``small 
                case'' calendar in the Tax Court.................   118
            21. Suspension of statute of limitations on filing 
                refund claims during periods of disability.......   119
            22. Notice of deficiency to specify deadlines for 
                filing Tax Court petition........................   120
            23. Allow actions for refund with respect to certain 
                estates which have elected the installment method 
                of payment.......................................   120
            24. Expansion of authority to award costs and certain 
                fees.............................................   122
            25. Expansion of authority to issue taxpayer 
                assistance orders................................   123
            26. Provide new remedy for third parties who claim 
                that the IRS has filed an erroneous lien.........   124
            27. Allow civil damages for unauthorized collection 
                actions by persons other than the taxpayer.......   125
            28. Suspend collection in certain joint liability 
                cases............................................   126
            29. Explanation of joint and several liability.......   127
            30. Innocent spouse relief...........................   128
            31. Elimination of interest differential on 
                overlapping periods of interest on income tax 
                overpayments and underpayments...................   130
            32. Archive of records of the IRS....................   131
            33. Clarification of authority of Secretary relating 
                to the making of elections.......................   134
            34. Grant IRS broad authority to enter into 
                cooperative agreements with State tax authorities   134
            35. Low-income taxpayer clinics......................   135
            36. Disclosure of field service advice...............   136

II. Provisions Increasing Revenues..................................138

        A. Accounting Provisions.................................   138

            1. Repeal lower of cost or market inventory 
                accounting method................................   138
            2. Repeal non-accrual experience method of accounting   140
            3. Make certain trade receivables ineligible for 
                mark-to-market treatment.........................   141

        B. Financial Products and Institutions...................   143

            1. Defer deduction for interest and original issue 
                discount on convertible debt.....................   143
            2. Disallowance of interest on indebtedness allocable 
                to tax-exempt obligations of all financial 
                intermediaries...................................   146

        C. Corporate Tax Provisions..............................   150

            1. Eliminate dividends-received deduction for certain 
                preferred stock..................................   150
            2. Repeal tax-free conversion of larger C 
                corporations to S corporations...................   152
            3. Restrict special net operating loss carryback 
                rules for specified liability losses.............   155
            4. Clarify definition of ``subject to'' liabilities 
                under section 357(c).............................   157

        D. Insurance Provisions..................................   160

            1. Increase proration percentage for property and 
                casualty insurance companies.....................   160
            2. Capitalization of net premiums for credit life 
                insurance contracts..............................   162
            3. Modify company-owned life insurance (COLI) 
                limitations......................................   165
            4. Modify reserve rules for annuity contracts........   168
            5. Tax certain exchanges of insurance contracts and 
                reallocations of assets within variable insurance 
                contracts........................................   170
            6. Computation of ``investment in the contract'' for 
                mortality and expense charges on certain 
                insurance contracts..............................   174

        E. Estate and Gift Tax Provisions........................   176

            1. Eliminate non-business valuation discounts........   176
            2. Gifts of ``present interests'' in a trust (repeal 
                ``Crummey'' case rule)...........................   180
            3. Eliminate gift tax exemption for personal 
                residence trusts.................................   182
            4. Include qualified terminable interest property 
                (``QTIP'') trust assets in surviving spouse's 
                estate...........................................   184

        F. Foreign Tax Provisions................................   186

            1. Replace sales source rules with activity-based 
                rule.............................................   186
            2. Modify rules relating to foreign oil and gas 
                extraction income................................   187
            3. Apply ``80/20'' company rules on a group-wide 
                basis............................................   190
            4. Prescribe regulations regarding foreign built-in 
                losses...........................................   192
            5. Prescribe regulations regarding use of hybrids....   193
            6. Modify foreign office material participation 
                exception applicable to certain inventory sales..   197
            7. Modify controlled foreign corporation exemption 
                from U.S. tax on transportation income...........   199

        G. Administrative Provisions.............................   201

            1. Increase information reporting penalties..........   201
            2. Modify the substantial understatement penalty for 
                large corporations...............................   203
            3. Repeal exemption for withholding on gambling 
                winnings from bingo and keno in excess of $5,000.   204
            4. Modify the deposit requirement for Federal 
                unemployment (FUTA) taxes........................   204
            5. Clarify and expand mathematical error procedures..   205

        H. Real Estate Investment Trust Provisions...............   207

            1. Freeze grandfathered status of stapled or paired-
                share REITs......................................   207
            2. Restrict impermissible business indirectly 
                conducted by REITs...............................   211
            3. Modify treatment of closely held REITs............   212

        I. Earned Income Tax Compliance Provisions...............   215

            1. Simplification of foster child definition under 
                the earned income credit.........................   215
            2. Clarify the operation of the earned income credit 
                where more than one taxpayer satisfies the 
                requirements with respect to the same child......   216

        J. Other Revenue-Increase Provisions.....................   218

            1. Repeal percentage depletion for non-fuel minerals 
                mined on Federal and formerly Federal lands......   218
            2. Modify depreciation method for tax-exempt use 
                property.........................................   219
            3. Impose excise tax on purchase of structured 
                settlements......................................   221
            4. Reinstate Oil Spill Liability Trust Fund excise 
                tax..............................................   223

III.Other Measures Affecting Receipts...............................225


        A. Reinstate Superfund Excise Taxes and Corporate 
            Environmental Income Tax.............................   225

        B. Extend Excise Taxes on Gasoline, Diesel Fuel, and 
            Special Motor Fuels..................................   226

        C. Convert Airport and Airway Trust Fund Excise Taxes to 
            Cost-Based User Fees to Pay for Federal Aviation 
            Administration Services..............................   230

        D. Tobacco Legislation...................................   235

        E. Other Provisions Affecting Receipts...................   236

            1. Expand use of Federal highway monies to include 
                use for certain ``creative financing'' projects 
                and for State infrastructure bank programs.......   236
            2. Allow Federal housing funds to be used to leverage 
                tax-exempt bond financed low-income housing 
                credit projects..................................   237
            3. Employer buy-in (COBRA continuation coverage) for 
                certain retirees.................................   237
            4. Consumer bill of rights and responsibilities......   238
                              INTRODUCTION

    This pamphlet,1 prepared by the staff of the 
Joint Committee on Taxation, provides a description and 
analysis of the revenue provisions contained in the President's 
Fiscal Year 1999 Budget proposal, as submitted to the Congress 
on February 2, 1999. 2 For the revenue provisions, 
there is a description of present law and the proposal 
(including effective date), a reference to any recent prior 
legislative action or budget proposal submission, and some 
analysis of related issues. The staff budget estimates of the 
President's revenue proposals for fiscal years 1998-2008 will 
be a separate document.
---------------------------------------------------------------------------
    \1\ This pamphlet may be cited as follows: Joint Committee on 
Taxation, Description of Revenue Provisions Contained in the 
President's Fiscal Year 1999 Budget Proposal (JCS-4-98), February 24, 
1998.
    \2\ See Department of the Treasury, General Explanations of the 
Administration's Revenue Proposals, February 1998. Office of Management 
and Budget, Budget of the United States Government, Fiscal Year 1999: 
Analytical Perspectives (H. Doc. 105-177, Vol III), pp. 41-77.
---------------------------------------------------------------------------
    This pamphlet does not include a description of certain 
proposed user fees (other than those associated with the 
financing of the Airport and Airway Trust Fund) contained in 
the President's Fiscal Year 1999 Budget.

                    I. PROVISIONS REDUCING REVENUES

                        A. Child Care Provisions

1. Expand the dependent care tax credit

                              Present Law

In general
    A taxpayer who maintains a household which includes one or 
more qualifying individuals may claim a nonrefundable credit 
against income tax liability for up to 30 percent of a limited 
amount of employment-related dependent care expenses (sec. 21). 
Eligible employment-related expenses are limited to $2,400 if 
there is one qualifying individual or $4,800 if there are two 
or more qualifying individuals. Generally, a qualifying 
individual is a dependent under the age of 13 or a physically 
or mentally incapacitated dependent or spouse. No credit is 
allowed for any qualifying individual unless a valid taxpayer 
identification number (TIN) has been provided for that 
individual. A taxpayer is treated as maintaining a household 
for a period if the taxpayer (or the taxpayer's spouse, if 
married) provides more than one-half the cost of maintaining 
the household for that period.
    Employment-related dependent care expenses are expenses for 
the care of a qualifying individual incurred to enable the 
taxpayer to be gainfully employed, other than expenses incurred 
for an overnight camp. For example, amounts paid for the 
services of a housekeeper generally qualify if such services 
are performed at least partly for the benefit of a qualifying 
individual; amounts paid for a chauffeur or gardener do not 
qualify.
    Expenses that may be taken into account in computing the 
credit generally may not exceed an individual's earned income 
or, in the case of married taxpayers, the earned income of the 
spouse with the lesser earnings. Thus, if one spouse has no 
earned income, generally no credit is allowed.
    The 30-percent credit rate is reduced, but not below 20 
percent, by 1 percentage point for each $2,000 (or fraction 
thereof) of adjusted gross income (AGI) above $10,000. Thus, 
the credit is never completely phased-out for higher-income 
individuals.
Interaction with employer-provided dependent care assistance
    For purposes of the dependent care credit, the maximum 
amounts of employment-related expenses ($2,400/$4,800) are 
reduced to the extent that the taxpayer has received employer- 
provided dependent care assistance that is excludable from 
gross income (sec. 129). The exclusion for dependent care 
assistance is limited to $5,000 per year and does not vary with 
the number of children.

                        Description of Proposal

    The proposal would make several changes to the dependent 
care tax credit. First, the credit percentage would be 
increased to 50 percent for taxpayers with an AGI of $30,000 or 
less. For taxpayers with AGI between $30,001 and $59,000, the 
credit percentage would be decreased by 1 percent for each 
$1,000 of AGI, or fraction thereof, in excess of $30,000. The 
credit percentage would be 20 percent for taxpayers with AGI of 
$59,001 or greater. Second, under the proposal, an otherwise 
qualifying taxpayer would generally qualify for the dependent 
care tax credit if the taxpayer resided in the same household 
as the qualifying child regardless of whether the taxpayer 
contributed over one-half the cost of maintaining the 
household. However, in the case of married couple filing 
separately, the taxpayer claiming the dependent care tax credit 
would still have to satisfy the present-law household 
maintenance test to receive the credit. Third, the dollar 
amounts of the starting point of the new phase-down range and 
the maximum amount of eligible employment-related expenses 
would be indexed for inflation.
    The present-law reduction of the dependent care credit for 
employer-provided dependent care assistance would not be 
changed

                             Effective Date

    Generally, the proposal would be effective for taxable 
years beginning after December 31, 1998. The starting point of 
the phase-down range and the maximum amounts of eligible 
employment-related expenses would be indexed for inflation for 
taxable years beginning after December 31, 1999.

                              Prior Action

    The House version of the Taxpayer Relief Act of 1997 would 
have made two changes relating to the dependent care credit. 
These changes were not enacted. First, the child tax credit 
would have been reduced by one-half of the dependent care 
credit for AGI in excess of $60,000 for married individuals 
filing a joint return, $33,000 for heads of households and 
single individuals, and $30,000 for married individuals filing 
separately. No reduction would have been made with respect to 
dependents who were physically or mentally incapable of self-
care. Second, the sum of the child tax credit and the dependent 
care credit would have been phased out for taxpayers with 
modified AGI in excess of certain thresholds. For these 
purposes, modified AGI would have been computed by increasing 
the taxpayer's AGI by the amount otherwise excluded from gross 
income under Code sections 911, 931, and 933 (relating to the 
exclusion of income of U.S. citizens or residents living 
abroad, residents of Guam, American Samoa, and the Northern 
Mariana Islands, and residents of Puerto Rico, respectively). 
For married individuals filing a joint return, the threshold 
would have been $110,000. For taxpayers filing as a head of 
household or a single individual, the threshold would have been 
$75,000. For married taxpayers filing separate returns, the 
threshold would have been $55,000.

                                Analysis

Overview

    The proposed expansion of the dependent care tax credit 
involves several issues. One issue is the government's role in 
encouraging parents (or ``secondary'' workers in childless 
couples) to work in the formal workplace versus in the home. A 
second issue is the appropriate role of government in providing 
financial support for child care. A third issue involves the 
increased complexity added by this proposal and the effect of 
the phaseout provisions on marginal tax rates. Each of these 
issues are discussed in further detail below.

Work outside of the home

    One of the many factors influencing the decision as to 
whether the second parent in a two-parent household works 
outside the home is the tax law. 3 The basic 
structure of the graduated income tax may act as a deterrent to 
work outside of the home. The reason for this is that the 
income tax taxes only labor whose value is formally recognized 
through the payment of wages. 4 Work in the home, 
though clearly valuable, bears no taxation. One way to see the 
potential impact of this bias is to consider the case of a 
parent who could work outside the home and earn $10,000. Assume 
that in so doing the family would incur $10,000 in child care 
expenses. Thus, in this example, the value of the parent's work 
inside or outside the home is recognized by the market to have 
equal value. 5 From a purely monetary perspective 
(ignoring any work-related costs such as getting to work, or 
buying clothes for work), this individual should be indifferent 
as between working inside or outside the home. The government 
also should be indifferent to the choice of where this parent 
expends the parent's labor effort, as the economic value is 
judged to be the same inside or outside the home. However, the 
income tax system taxes the labor of this person in the formal 
marketplace, but not the value of the labor if performed in the 
home. Thus, of the $10,000 earned in the market place, some 
portion would be taxed away, leaving a net wage of less than 
$10,000. 6 This parent would be better off by 
staying at home and enjoying the full $10,000 value of home 
labor without taxation. 7
---------------------------------------------------------------------------
    \3\ This discussion applies to childless couples as well.
    \4\ Barter transactions involving labor services would generally be 
subject to income taxation as well.
    \5\ A neutral position is taken in this analysis as to whether 
actual parents can provide better care for their own children than can 
other providers. Thus, since the child care can be obtained in the 
marketplace for $10,000 in this example, it is assumed that this is the 
economic value of the actual parent doing the same work.
    \6\ The tax on ``secondary'' earners may be quite high, as the 
first dollar of their earnings are taxed at the highest Federal 
marginal tax rate applicable to the earnings of the ``primary'' earning 
spouse. Additionally, the earnings will face social security payroll 
taxes, and may bear State and local income taxes as well. For further 
discussion of this issue, see Joint Committee on Taxation, Present Law 
and Background Relating to Proposals to Reduce the Marriage Tax Penalty 
(JCX-1-98), January 27, 1998.
    \7\ Even with the present lower child care credit, the net wage 
would still be lower because of the social security taxes and any 
income taxes for which the taxpayer would be liable.
---------------------------------------------------------------------------
    Because labor in the home bears no taxation, most 
economists view the income tax as being biased towards the 
provision of home labor, resulting in inefficient distribution 
of labor resources. For example, if the person in the above 
example could earn $12,000 in work outside the home and pay 
$10,000 in child care, work outside the home would be the 
efficient choice in the sense that the labor would be applied 
where its value is greatest. However, if the $12,000 in labor 
resulted in $2,000 or more in additional tax burden, this 
individual would be better off by working in the home. The 
government could eliminate or reduce this bias in several ways. 
First, it could consider taxing the value of ``home 
production.'' Most would consider this not feasible for 
administrative reasons and unfair. The second alternative would 
be to try to eliminate or reduce the burden of taxation on 
``secondary'' earners when they do enter the formal labor 
force. This approach has been used in the past through the two-
earner deduction (from 1982-1986), which allows a deduction for 
some portion of the earnings of the lesser-earning spouse. 
8 Another approach, and part of present law, is to 
allow a tax credit for child care expenses, provided both 
parents (or if unmarried, a single parent) work outside the 
home. This latter approach is targeted at single working 
parents and two-earner families with children, whereas the two-
earner deduction applied to all two-earner couples regardless 
of child care expenses.
---------------------------------------------------------------------------
    \8\ Joint Committee on Taxation, Present Law and Background 
Relating to Proposals to Reduce the Marriage Tax Penalty (JCX-1-98) at 
6, January 27, 1998.
---------------------------------------------------------------------------
    The proposal to expand the dependent care credit would 
reduce the tax burden on families that pay for child care 
relative to all other taxpayers. Alternatives such as expanding 
the child tax credit or the value of personal exemptions for 
dependents would target tax relief to all families with 
children regardless of the labor choices of the parents. 
However, families without sufficient income to owe taxes would 
not benefit. If the objective were to further assist all 
families with children, including those with insufficient 
income to owe taxes, one would need to make the child credit 
refundable.
    Proponents of the proposal argue that child care costs have 
risen substantially, and the dependent care credit needs to be 
expanded to reflect this and ensure that children are given 
quality care. Opponents would argue that the current credit is 
a percentage of expenses, and thus as costs rise so does the 
credit. However, to the extent one has reached the cap on 
eligible expenses, this would not be true. Furthermore, the 
maximum eligible employment-related expenses and the income 
levels for the phaseout have not been adjusted for inflation 
since 1982 when the amounts of maximum eligible employment-
related expenses were increased. It also could be argued that 
the increase is needed to lessen the income tax's bias against 
work outside of the home. However, the increase in the number 
of two-parent families where both parents work might suggest 
that any bias against work outside of the home must have been 
mitigated by other forces, such as perhaps increased wages 
available for work outside of the home. Others would argue that 
the increasing number of two-earner couples with children is 
not the result of any reduction in the income tax's bias 
against work outside of the home, but rather reflects economic 
necessity in many cases.
    Opponents of the proposal contend that all families with 
children should be given any available tax breaks aimed at 
children, regardless of whether they qualify for the dependent 
care tax credit. This latter group may cite as support for 
their position that the size of the personal exemption for each 
dependent is much smaller than it would have been had it been 
indexed for inflation in recent decades. In their view, even 
with the addition of the child tax credit, the current tax Code 
does not adequately account for a family with children's 
decreased ability to pay taxes.
    It is not clear whether opponents of the proposal also 
believe that there should be biases in the income tax in favor 
of a parent staying at home with the children. It should be 
noted that married couples with children in which both parents 
work are often affected by the so-called marriage penalty. 
9 Conversely, those for whom one parent stays at 
home generally benefit from a ``marriage bonus.'' The proposal 
to increase the dependent care credit can be thought of as a 
proposal to decrease the marriage penalty for families with 
children. 10
---------------------------------------------------------------------------
    \9\ See Joint Committee on Taxation, Present Law and Background 
Relating to Proposals to Reduce the Marriage Tax Penalty (JCX-1-98) at 
10, January 27, 1998.
    \10\ Married couples with children in which both spouses work and 
that receive a marriage bonus would also benefit from the dependent 
care proposal.
---------------------------------------------------------------------------
    Thus, in general, the marriage penalty creates an incentive 
for one of the parents to stay at home. Proposals to eliminate 
or reduce the marriage penalty that do not also increase the 
marriage bonus may imply that there will be greater incentives 
for both parents to work outside of the home. For example, the 
marriage penalty proposals that would tax the husband and wife 
separately at the single schedule, thus eliminating the 
marriage penalty, would imply that the stay-at-home parent 
would now face a tax liability on any labor income that is 
lower than he or she would have faced if the couple were taxed 
under the married joint schedule of present law. Hence, this 
taxpayer would have a greater incentive to work outside the 
home.

The appropriate role of government

    Another argument against the proposal is that, by giving an 
increased amount of credit based on money spent for child care, 
the proposal contributes to a distortion away from other forms 
of consumption and an incentive to overspend on child care. A 
counter-argument is that there are positive externalities to 
quality child care, and thus a distortion that encourages 
additional spending on child care is good for society. However, 
opponents would counter this argument with a similar argument 
that the best quality child care will come from the actual 
parents, and thus if there should be any bias in the provision 
of child care for reasons of quality it should be a bias 
towards parents providing their own child care. Such an 
argument is less tenable, however, for single parents for whom 
work outside of the home is a necessity. Another response is 
that, given the assumption that the government should subsidize 
child care, there are better ways to improve availability and 
affordability of adequate child care than through the tax code. 
It is possible that a direct spending initiative would be more 
efficient and administrable.

Complexity and marginal rate issues

    Some argue that the increased number (see the discussion of 
the employer tax credit for expenses of supporting employee 
child care in Part I.A.2., below of this pamphlet) and 
complexity of provisions in the tax code for social purposes 
(e.g., this proposal) complicates the tax system and undermines 
the public's confidence in the fairness of the income tax. 
Others respond that tax fairness should sometimes outweigh 
simplicity for purposes of the tax Code.
    Some argue that the replacement of the maintenance of 
household test with a residency test is a significant 
simplification. Others respond that taxpayers' compliance 
burden will not be significantly reduced because the dependency 
requirement which is retained under the proposal requires the 
application of a set of rules with a compliance burden similar 
to that of the maintenance of household test.
    The proposal's modifications relating to the phase-out of 
the credit raise the tax policy issue of complexity. By phasing 
out the dependent care credit over the $30,000 to $60,000 
income range, many more families are likely to be in the phase-
out ranges and thus have their marginal tax rates raised by 
this proposal relative to current law, which phases out a 
portion of the credit over the income range of $10,000 to 
$30,000. The increased number of families required to apply a 
phase-out alone is an increase in complexity. Additionally, the 
taxpayer's phaseout occurs at a steeper rate than under present 
law. Present law has a reduction in the credit rate of 1 
percent for each additional $2,000 of AGI in the phase-out 
range. This proposal would reduce the credit rate by 1 percent 
for each $1,000 of AGI in the phase-out range. The marginal tax 
rate implied by the phaseout is thus twice as great as the 
marginal tax rate under present law. Under present law, a 
taxpayer with maximum eligible expenses of $4,800 will thus 
lose $48 in credits for each $2,000 of income in the phase-out 
range, which is equivalent to a marginal tax rate increase of 
2.4 percentage points ($48/$2,000). Under the proposal, 
marginal tax rates would be increased by 4.8 percentage points 
($48/$1,000) for those in the phase-out range. Thus, the 
dependent care credit could decrease work effort for two 
reasons. By increasing marginal tax rates for those in the 
phase-out range, the benefit from working is reduced. 
Additionally, for most recipients of the credit, after-tax 
incomes will have been increased, which would enable the 
taxpayer to consume more of all goods, including leisure. A 
positive effect on labor supply will exist for those currently 
not working, for whom the increased credit might be an 
incentive to decide to work outside of the home. 11
---------------------------------------------------------------------------
    \11\ For further discussion of the impact of this provision on 
marginal tax rates and labor supply, see Joint Committee on Taxation, 
Present Law and Analysis Relating to Individual Effective Marginal Tax 
Rates (JCS-3-98), February 3, 1998.
---------------------------------------------------------------------------

2. Employer tax credit for expenses of supporting employee child care

                              Present Law

    Generally, present law does not provide a tax credit to 
employers for supporting child care or child care resource and 
referral services. 12 An employer, however, may be 
able to claim such expenses as deductions for ordinary and 
necessary business expenses. Alternatively, the taxpayer may be 
required to capitalize the expenses and claim depreciation 
deductions over time.
---------------------------------------------------------------------------
    \12\ An employer may claim the welfare-to-work tax credit on the 
eligible wages of certain long-term family assistance recipients. For 
purposes of the welfare-to-work credit, eligible wages includes amounts 
paid by the employer for dependent care assistance.
---------------------------------------------------------------------------

                        Description of Proposal

Employer tax credit for supporting employee child care

    Under the proposal, taxpayers would receive a tax credit 
equal to 25 percent of qualified expenses for employee child 
care. These expenses would include costs incurred: (1) to 
acquire, construct, rehabilitate or expand property that is to 
be used as part of a taxpayer's qualified child care facility; 
(2) for the operation of a taxpayer's qualified child care 
facility, including the costs of training and continuing 
education for employees of the child care facility; or (3) 
under a contract with a qualified child care facility to 
provide child care services to employees of the taxpayer. To be 
a qualified child care facility, the principal use of the 
facility must be for child care, and the facility must be duly 
licensed by the State agency with jurisdiction over its 
operations. Also, if the facility is owned or operated by the 
taxpayer, at least 30 percent of the children enrolled in the 
center (based on an annual average or the enrollment measured 
at the beginning of each month) must be children of the 
taxpayer's employees. If a taxpayer opens a new facility, it 
must meet the 30-percent employee enrollment requirement within 
two years of commencing operations. If a new facility failed to 
meet this requirement, the credit would be subject to 
recapture.
    To qualify for the credit, the taxpayer must offer child 
care services, either at its own facility or through third 
parties, on a basis that does not discriminate in favor of 
highly compensated employees.

Employer tax credit for child care resource and referral services

    Under the proposal, a taxpayer would be entitled to a tax 
credit equal to 10 percent of expenses incurred to provide 
employees with child care resource and referral services.

Other rules

    A taxpayer's total of these credits would be limited to 
$150,000 per year. Any amounts for which the taxpayer may 
otherwise claim a tax deduction would be reduced by the amount 
of these credits. Similarly, if the credits are taken for 
expenses of acquiring, constructing, rehabilitating, or 
expanding a facility, the taxpayer's basis in the facility 
would be reduced by the amount of the credits.

                             Effective Date

    The credits would be effective for taxable years beginning 
after December 31, 1998.

                              Prior Action

    The Senate version of the Taxpayer Relief Act of 1997 would 
have provided a temporary tax credit (taxable years 1998 
through 2000) equal to 50 percent of an employer's qualified 
child care expenses for each taxable year. The maximum credit 
allowable would not have exceeded $150,000 per year. This 
provision was not included in the final conference agreement of 
the Taxpayer Relief Act of 1997.

                                Analysis

    It is argued that providing these tax benefits may 
encourage employers to spend more money on child care services 
for their employees and that increased quality and quantity of 
these services will be the result. On the other hand, less 
desirable results may include a windfall tax benefit to 
employers who would have engaged in this behavior without 
provision of these tax benefits, and a competitive disadvantage 
for nonprofit child care providers who cannot take advantage of 
these new tax benefits.
    Opponents of the proposal argue that adding complexity to 
the tax Code can undermine the public's confidence in the 
fairness of the tax Code, and that the country's child care 
problems and other social policy concerns can be more 
efficiently addressed through a spending program than through a 
tax credit. Proponents argue that any additional complexity in 
the tax law is outweighed by increased fairness. They contend 
that present law has not taken into account the changing 
demographics of the American workforce and the need to provide 
improved child care for the ever increasing numbers of two-
earner families.

               B. Energy and Environmental Tax Provisions

1. Tax credits

            a. Tax credit for energy-efficient building equipment

                               Present Law

     No income tax credit is provided currently for investment 
in energy-efficient building equipment.
     A 10-percent energy credit is allowed for the cost of new 
property that is equipment (1) that uses solar energy to 
generate electricity, to heat or cool a structure, or to 
provide solar process heat, or (2) used to produce, distribute, 
or use energy derived from a geothermal deposit, but only, in 
the case of electricity generated by geothermal power, up to 
the electric transmission stage, and which meet performance and 
quality standards prescribed by the Secretary of the Treasury 
(after consultation with the Secretary of the Energy). Public 
utility property does not qualify for the credit (sec. 48B(a)).
     A taxpayer may exclude from income the value of any 
subsidy provided by a public utility for the purchase or 
installation of an energy conservation measure. An energy 
conservation measure means any installation or modification 
primarily designed to reduce consumption of electricity or 
natural gas or to improve the management of energy demand with 
respect to a dwelling unit (sec. 136).

                         Description of Proposal

     A credit would be provided for the purchase of certain 
types of highly energy-efficient building equipment: fuel 
cells, electric heat pump water heaters, advanced natural gas 
and residential size electric heat pumps, and advanced central 
air conditioners. The credit would equal 20 percent of the 
purchase price, subject to a cap. The credit would be 
nonrefundable. For businesses, it would be subject to the 
limitations on the general business credit and would reduce the 
basis of the equipment.
     To be eligible for the credit, the specific technologies 
would have to meet the following criteria:
          Fuel cells generate electricity and heat using an 
        electrochemical process. To qualify for the credit, 
        fuel cell technologies would be required to have an 
        electricity-only generation efficiency greater than 35 
        percent. Fuel cells with a minimum generating capacity 
        of 50 kilowatts would be eligible for the credit.
          Electric heat pump hot water heaters use electrically 
        powered vapor compression cycles to extract heat from 
        air and deliver it to a hot water storage tank. 
        Qualifying heat pump water heaters would be required to 
        yield an Energy Factor greater than or equal to 1.7 in 
        the standard Department of Energy (``DOE'') test 
        procedure.
          Electric heat pumps (``EHP'') use electrically 
        powered vapor compression cycles to extract heat from 
        air in one space and deliver it to air in another 
        space. EHP technologies with a heating efficiency 
        greater than or equal to 9 HSPF and a cooling 
        efficiency greater than or equal to 15 SEER would 
        qualify for the credit.
          Natural gas heat pumps use either a gas-absorption 
        cycle or a gas-driven engine to power the vapor 
        compression cycle to extract heat from one source and 
        deliver it to another. Qualifying natural gas heat 
        pumps would be those with a coefficient of performance 
        for heating of at least 1.25 and for cooling of at 
        least 0.70.
           Central air conditioners would be required to have 
        an efficiency equal to or greater than 15 SEER to 
        qualify for the credit.
          Advanced natural gas water heaters use a variety of 
        mechanisms to increase steady state efficiency and 
        reduce standby and vent losses. Only natural gas water 
        heaters with an energy factor of at least 0.80 in DOE 
        test procedures would qualify for the credit.

                             Effective Date

     The credit would generally be available for final 
purchases from unrelated third parties between December 31, 
1999, and before January 1, 2004, for use within the United 
States. The credit for fuel cells would be available for 
purchases after December 31, 1999, and before January 1, 2005.

                              Prior Action

     No prior action.
             b. Tax credit for purchase of new energy-efficient homes

                               Present Law

     No deductions or credits are provided currently for the 
purchase of energy-efficient new homes.
     A taxpayer may exclude from income the value of any 
subsidy provided by a public utility for the purchase or 
installation of an energy conservation measure. An energy 
conservation measure means any installation or modification 
primarily designed to reduce consumption of electricity or 
natural gas or to improve the management of energy demand with 
respect to a dwelling unit (sec. 136).

                         Description of Proposal

     A tax credit of up to $2,000 would be available to 
purchasers of highly energy-efficient new homes. To claim the 
credit, the taxpayer must use the new home as the taxpayer's 
principal residence, and the new home must use at least 50 
percent less energy for heating, cooling and hot water than the 
Model Energy Code standard for single family residences. The 
tax credit would be one percent of the purchase price of the 
home up to a maximum credit of $2,000 for eligible homes 
purchased in the five-year period beginning January 1, 1999, 
and ending December 31, 2003. The credit would be available for 
an additional two years, i.e., for homes purchased January 1, 
2004, through December 31, 2005, with a maximum credit of 
$1,000.

                             Effective Date

     The credit would generally be available for final homes 
purchased after December 31, 1998, and before January 1, 2006.

                              Prior Action

     No prior action.
             c. Tax credit for high-fuel-economy vehicles

                               Present Law

     A 10-percent tax credit is provided for the cost of a 
qualified electric vehicle, up to a maximum credit of $4,000 
(sec. 30). A qualified electric vehicle is a motor vehicle that 
is powered primarily by an electric motor drawing current from 
rechargeable batteries, fuel cells, or other portable sources 
of electrical current, the original use of which commences with 
the taxpayer, and that is acquired for the use by the taxpayer 
and not for resale. The full amount of the credit is available 
for purchases prior to 2002. The credit begins to phase down in 
2002 and phases out in 2005.
     Certain costs of qualified clean-fuel vehicle property may 
be expensed and deducted when such property is placed in 
service (sec. 179A). Qualified clean-fuel vehicle property 
includes motor vehicles that use certain clean-burning fuels 
(natural gas, liquefied natural gas, liquefied petroleum gas, 
hydrogen, electricity and any other fuel at least 85 percent of 
which methanol, ethanol, any other alcohol or ether. The 
maximum amount of the deduction is $50,000 for a truck or van 
with a gross vehicle weight over 26,000 pounds or a bus with 
seating capacities of at least 20 adults; $5,000 in the case of 
a truck or van with a gross vehicle weight between 10,000 and 
26,000 pounds; and $2,000 in the case of any other motor 
vehicle. Qualified electric vehicles do not qualify for the 
clean-fuel vehicle deduction. The deduction phases down in the 
years 2002 through 2004.

                         Description of Proposal

     The proposal would provide two temporary tax credits for 
the purchase of fuel efficient vehicles:
          (1) Credit for vehicles with triple the base fuel 
        economy.--This credit would be $4,000 for each vehicle 
        that has three times the base fuel economy for its 
        class. The $4,000 credit would be available for 
        purchases of qualifying vehicles after December 31, 
        2002, and before January 1, 2007. The credit amount 
        would phase down to $3,000 in 2007, $2,000 in 2008, and 
        $1,000 in 2009, and would phase out in 2010.
          (2) Credit for vehicles with twice the base fuel 
        economy.--This credit would be $3,000 for each vehicle 
        that has twice the base fuel economy for its class. The 
        $3,000 credit would be available for purchases of 
        qualifying vehicles after December 31, 1999, and before 
        January 1, 2004. The credit amount would phase down to 
        $2,000 in 2004, $1,000 in 2005, and would phase out in 
        2006.
     These credits would be available for all qualifying light 
vehicles, including cars, minivans, sport utility vehicles, 
light trucks, and hybrid and electric vehicles. Taxpayers who 
claim one of these credits would not be able to claim the 
qualified electric vehicle credit or the deduction for clean-
fuel vehicle property for the same vehicle.

                             Effective Date

     The credit would generally be available for vehicles 
purchased January 1, 1999, and December 31, 2010.

                              Prior Action

     No prior action.
             d. Tax credit for combined heat and power (``CHP'') 
                    systems

                               Present Law

     Combined heat and power (``CHP'') systems are used to 
produce electricity and process heat and/or mechanical power 
from a single primary energy source. A tax credit is currently 
not available for investments in CHP systems.
     Depreciation allowances for CHP property vary by asset use 
and capacity. Assets employed in the production of electricity 
with rated total capacity in excess of 500 kilowatts, or 
employed in the production of steam with rated total capacity 
in excess of 12,500 pounds per hour, and used by the taxpayer 
in an industrial manufacturing process or plant activity (and 
not ordinarily available for sale to others), have a general 
cost recovery period of 15 years. Electricity or steam 
production assets of lesser rated capacity generally are 
classified with other manufacturing assets and have cost 
recovery periods of five to ten years. Assets used in the steam 
power production of electricity for sale, including combustion 
turbines operated in a combined cycle with a conventional steam 
unit, have a 20-year recovery period. Other turbines and 
engines used to produce electricity for sale have a 15-year 
recovery period. Assets that are structural components of 
buildings have a recovery period of either 39 years (if 
nonresidential) or 27.5 years (if residential). For assets with 
recovery periods of 10 years or less, the 200-percent declining 
balance method may be used to compute depreciation allowances. 
The 150-percent declining balance method may be used for assets 
with recovery periods of 15 or 20 years. The straight-line 
method must be used for buildings and their structural 
components.

                        Description of Proposal

     The proposal would establish a 10-percent tax credit for 
certain CHP systems with an electrical capacity in excess of 50 
kilowatts (or with a capacity to produce mechanical power 
equivalent to 50 kilowatts). Investments in qualified CHP 
systems that are assigned cost recovery periods of less than 15 
years would be eligible for the credit, provided that a 15 year 
recovery period and 150-percent declining balance method are 
utilized to calculate depreciation allowances. Property placed 
in service outside the United States would be ineligible for 
the credit.
     A qualified CHP system would be defined as equipment used 
in the simultaneous or sequential production of electricity, 
thermal energy (including heating and cooling and/or mechanical 
power), and mechanical power. A qualified CHP system would be 
required to produce at least 20 percent of its total useful 
energy in the form of both (1) thermal energy, and (2) electric 
and/or mechanical power. For CHP systems with an electrical 
capacity of 50 megawatts or less, the total energy efficiency 
of the system would have to be greater than 60 percent. For 
larger systems, the total energy efficiency would have to 
exceed 70 percent. For this purpose, total energy efficiency 
would be calculated as the sum of the useful electrical, 
thermal, and mechanical power produced, measured in Btus, 
divided by the lower heating value of the primary energy 
supplied. Taxpayers would be required to obtain proper 
certification by qualified engineers for meeting the energy 
efficiency and percentage-of-energy tests, pursuant to 
regulations to be issued by the Secretary of the Treasury.
     The credit would be subject to the limitations on the 
general business credits. The depreciable basis of qualified 
property for which the credit is taken would be reduced by the 
amount of the credit. Regulated public utilities claiming the 
credit would be required to use a normalization method of 
accounting with respect to the credit. Taxpayers using the 
credit for CHP systems would not be entitled to any other tax 
credit for the same equipment.

                             Effective Date

     The credit would apply to investments in CHP systems 
placed in service after December 31, 1998, but before January 
1, 2004.

                              Prior Action

    No prior action.
            e. Tax credit for replacement of certain circuit breaker 
                    equipment

                              Present Law

    No tax credits are provided currently for the purchase of 
large power circuit breakers used in the transmission and 
distribution of electricity.

                        Description of Proposal

    A tax credit would be available for the installation of new 
power circuit breaker equipment to replace certain older power 
circuit breakers. The tax credit would be 10 percent of 
qualified investment. To be eligible for the credit, the 
replaced power circuit breakers must be dual pressure circuit 
breakers that contain sulfur hexaflouride (``SF6''), have a 
capacity of at least 115kV, and have been installed by December 
31, 1985. The replaced circuit breaker equipment must be 
destroyed so as to prevent its further use. The credit would be 
subject to the limitations on the general business credit. The 
depreciable basis of qualified property for which the credit is 
taken would be reduced by the amount of the credit claimed.

                             Effective Date

    The credit would be available for new equipment placed in 
service in the five year period beginning January 1, 1999, and 
ending December 31, 2003.

                              Prior Action

    No prior action.
            f. Tax credit for certain perfluorocompound (``PFC'') and 
                    hydroflurocarbon (``HFC'') recycling equipment

                              Present Law

    No tax credits are provided currently for the purchase of 
perfluorocompound (``PFC'') and hydrofluorocarbon (``HFC'') 
recycling equipment. Semiconductor manufacturers who install 
equipment to recover or recycle PFC and HFC gases used in the 
production of semiconductors may depreciate the cost of that 
equipment over 5 years.

                        Description of Proposal

    A tax credit would be available for the installation of PFC 
and HFC recovery/recycling equipment in semiconductor 
manufacturing plants. The tax credit would be 10 percent of 
qualified investment. The credit would be subject to the 
limitations on the general business credit. The depreciable 
basis of qualified property for which the credit is taken would 
be reduced by the amount of the credit claimed. Equipment would 
qualify for the credit only if it recovers at least 99 percent 
of PFCs and HFCs.

                             Effective Date

    The credit would apply to property placed in service after 
December 31, 1999, and before January 1, 2004.

                              Prior Action

    No prior action.
            g. Tax credit for rooftop solar equipment

                              Present Law

    Nonrefundable business energy tax credits are allowed for 
10 percent of the cost of qualified solar and geothermal energy 
property (sec. 48(a)). Solar energy property that qualifies for 
the credit includes any equipment that uses solar energy to 
generate electricity, to heat or cool (or provide hot water for 
use in) a structure, or to provide solar process heat.
    The business energy tax credits are components of the 
general business credit (sec. 38(b)(1)). The business energy 
tax credits, when combined with all other components of the 
general business credit, generally may not exceed for any 
taxable year the excess of the taxpayer's net income tax over 
the greater of (1) 25 percent of net regular tax liability 
above $25,000 or (2) the tentative minimum tax. For credits 
arising in taxable years beginning after December 31, 1997, an 
unused general business credit generally may be carried back 
one year and carried forward 20 years (sec. 39).

                        Description of Proposal

    A tax credit would be available for purchasers of rooftop 
photovoltaic systems and solar water heating systems located on 
or adjacent to the building for uses other than heating 
swimming pools. The credit would be equal to 15 percent of 
qualified investment up to a maximum of $1,000 for solar water 
heating systems and $2,000 for rooftop photovoltaic systems. 
This credit would be nonrefundable. For businesses, this credit 
would be subject to the limitations of the general business 
credit. The depreciable basis of the qualified property would 
be reduced by the amount of the credit claimed. Taxpayers would 
have to choose between the proposed credit and the present 
business energy credit for each investment.

                             Effective Date

    The proposal would be effective for equipment placed in 
service after December 31, 1998 and before January 1, 2004 for 
solar water heating systems, and for equipment placed in 
service after December 31, 1998 and before January 1, 2006 for 
rooftop photovoltaic systems.

                              Prior Action

    No prior action.
            h. Extend wind and biomass tax credit

                              Present Law

    An income tax credit is allowed for the production of 
electricity from either qualified wind energy or qualified 
``closed-loop'' biomass facilities (sec. 45). The credit is 
equal to 1.5 cents (plus adjustments for inflation since 1992) 
per kilowatt hour of electricity produced from these qualified 
sources during the 10-year period after the facility is placed 
in service.
    The credit applies to electricity produced by a qualified 
wind energy facility placed in service after December 31, 1993, 
and before July 1, 1999, and to electricity produced by a 
qualified closed-loop biomass facility placed in service after 
December 31, 1992, and before July 1, 1999. Closed-loop biomass 
is the use of plant matter, where the plants are grown for the 
sole purpose of being used to generate electricity. It does not 
apply to the use of waste materials (including, but not limited 
to, scrap wood, manure, and municipal or agricultural waste). 
It also does not apply to taxpayers who use standing timber to 
produce electricity. In order to claim the credit, a taxpayer 
must own the facility and sell the electricity produced by the 
facility to an unrelated party.
    The credit for electricity produced from wind or closed-
loop biomass is a component of the general business credit 
(sec. 38(b)(1)). This credit, when combined with all other 
components of the general business credit, generally may not 
exceed for any taxable year the excess of the taxpayer's net 
income tax over the greater of (1) 25 percent of net regular 
tax liability above $25,000 or (2) the tentative minimum tax. 
For credits arising in taxable years beginning after December 
31, 1997, an unused general business credit generally may be 
carried back one taxable year and carried forward 20 taxable 
years.

                        Description of Proposal

    The proposal would extend for five years the placed in 
service date for the income tax credit for electricity produced 
from wind and closed-loop biomass. Thus, the credit would be 
available for qualifying electricity produced from facilities 
placed in service before July 1, 2004. As under present law, 
the credit would be allowable for a period of ten years after 
the facility is placed in service.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    A provision to extend this credit for two years (i.e., for 
facilities placed in service before July 1, 2001), was included 
in the Senate version of the Taxpayer Relief Act of 1997, but 
was not included in the final conference agreement. A provision 
to sunset the credit was included in the House version of the 
Balanced Budget Act of 1995.

                           Analysis for a.-h.

General rationale for tax benefits for energy conservation and 
        pollution abatement

    The general rationale for providing tax benefits to energy 
conservation and pollution abatement is that there exist 
externalities in the consumption or production of certain 
goods. An externality exists when, in the consumption or 
production of a good, there is a difference between the cost or 
benefit to an individual and the cost or benefit to society as 
a whole.\13\ When the social costs of consumption exceed the 
private costs of consumption, a negative externality exists. 
When the social benefits from consumption or production exceed 
private benefits, a positive externality is said to exist. When 
negative externalities exist, there will be overconsumption of 
the good causing the negative externality relative to what 
would be socially optimal. When positive externalities exist, 
there will be underconsumption or production of the good 
producing the positive externality. The reason for the 
overconsumption or underconsumption is that private actors will 
in general not take into account the effect of their 
consumption on others, but only weigh their personal cost and 
benefits in their decisions. Thus, they will consume goods up 
to the point where their marginal benefit of more consumption 
is equal to the marginal cost that they face. But from a social 
perspective, consumption should occur up to the point where the 
marginal social cost is equal to the marginal social benefit. 
Only when there are no externalities will the private actions 
lead to the socially optimal level of consumption or 
production, because in this case private costs and benefits wil 
be equal to social costs and benefits.
---------------------------------------------------------------------------
    \13\ It should be noted that the social cost or benefit includes 
the cost or benefit to the individual actually doing the consuming or 
producing.
---------------------------------------------------------------------------
    Pollution is an example of a negative externality, because 
the costs of pollution are borne by society as a whole rather 
than solely by the polluters themselves. In the case of 
pollution, there are two possible government interventions that 
could produce a more socially desirable level of pollution. One 
such approach would be to set a tax on the polluting activity 
that is equal to the social cost of the pollution. Thus, if 
burning a gallon of gasoline results in pollution that 
represents a cost to society as a whole of 20 cents, it would 
be economically efficient to tax gasoline at 20 cents a gallon. 
By so doing, the externality is said to be internalized, 
because now the private polluter faces a private cost equal to 
the social cost, and the socially optimal amount of consumption 
will take place. An alternative approach would be to employ a 
system of payments, such as perhaps tax credits, to essentially 
pay polluters to reduce pollution. If the payments can be set 
in such a way as to yield the right amount of reduction (that 
is, without paying for reduction more than the reduction is 
valued, or failing to pay for a reduction where the payment 
would be less than the value of the pollution reduction), the 
socially desirable level of pollution will result.14 
The basic difference between these two approaches is a question 
of who pays for the pollution reduction. The tax approach 
suggests that the right to clean air is paramount to the right 
to pollute, as polluters would bear the social costs of their 
pollution. The alternative approach suggests that the pollution 
reduction costs should be borne by those who receive the 
benefit of the reduction.
---------------------------------------------------------------------------
    \14\ It should be noted that this approach would be unwieldy to 
implement, as it would in general require case by case decisions as to 
the expenditure of funds to reduce pollution, rather than relying on 
market mechanisms once a socially efficient price has been set, as 
through the appropriate tax. Also, it can be difficult to measure 
pollution reduction, as the base from which the reduction is measured 
would necessarily be somewhat arbitrary. As a related matter, a general 
policy of paying for pollution reduction could, in theory, lead to 
threats to pollute in order to extract the payment.
---------------------------------------------------------------------------
    In the case of a positive externality, the appropriate 
economic policy would be to impose a negative tax (i.e. a 
credit) on the consumption or production that produces the 
positive externality. By the same logic as above, the 
externality becomes internalized, and the private benefits from 
consumption become equal to the social benefits, leading to the 
socially optimal level of consumption or production.

Targeted investment tax credits

    Seven of the President's revenue proposals related to 
energy and the environment are targeted investment tax credits 
designed to encourage investment in certain assets that reduce 
the emissions of gases related to atmospheric 
warming.15 The following general analysis of 
targeted tax credits is applicable to these proposals.
---------------------------------------------------------------------------
    \15\ Another credit proposal, a production credit for electricity 
produced from wind or biomass, is discussed below.
---------------------------------------------------------------------------
    As a general matter of economic efficiency, tax credits 
designed to influence investment choices should be used only 
when it is acknowledged that market-based pricing signals have 
led to a lower level of investment in a good than would be 
socially optimal. In general, this can occur in a market-based 
economy when private investors do not capture the full value of 
an investment--that is, when there are positive externalities 
to the investment that accrue to third parties who did not bear 
any of the costs of the investments.16 For example, 
if an individual or corporation can borrow funds at 10 percent 
and make an investment that will return 15 percent, they will 
generally make that investment. However, if the return were 15 
percent, but only 8 percent of that return went to the 
investor, and 7 percent to third parties, the investment will 
generally not take place, even though the social return (the 
sum of the return to the investor and other parties) would 
indicate that the investment should be made. In such a 
situation, it may be desirable to subsidize the return to the 
investor through tax credits or other mechanisms in order that 
the investor's return is sufficient to cause the socially 
desirable investment to be made. In this example, a credit that 
raised the return to the investor to at least 10 percent would 
be necessary. Even if the cost of the credit led to tax 
increases for the third parties, they would presumably be 
better off since they enjoy a 7-percent return from the 
investment, and the credit would only need to raise the return 
to the investor by 2 percent for him or her to break even. 
Thus, even if the third parties would bear the full cost of the 
credit, they would, on net, enjoy a 5-percent return to the 
investment (7 percent less 2 percent).17
---------------------------------------------------------------------------
    \16\ Investment in education is often cited as an example where the 
social return may exceed the private return, i.e., there are positive 
externalities.
    \17\ The actual calculation as to whether the credit would improve 
economic efficiency should also consider the economic costs imposed to 
raise the necessary tax revenues to pay for the credit. Unless taxation 
is perfectly efficient (i.e., no distortions are imposed in raising tax 
revenue), the costs to society of raising a dollar in public funds will 
exceed a dollar. For a discussion of this issue, see Charles Ballard, 
John Shoven, and John Whalley, ``General Equilibrium Computations of 
the Marginal Welfare Costs of Taxes in the United States,'' American 
Economic Review 75, March 1985, pp. 128-38; and Charles Ballard, John 
Shoven, and John Whalley, ``The Total Welfare Cost of the United States 
Tax System: A General Equilibrium Approach,'' National Tax Journal 38, 
June 1985, pp. 125-40.
---------------------------------------------------------------------------
    There are certain aspects of targeted tax credits that 
could impair the efficiency with which they achieve the desired 
goal of reduced atmospheric emissions. By targeting only 
certain investments, other more cost-effective means of 
pollution reduction may be overlooked. Many economists would 
argue that the most efficient means of addressing pollution 
would be through a direct tax on the pollution-causing 
activities, rather than through the indirect approach of 
targeted tax credits for certain technologies. By this 
approach, the establishment of the economically efficient 
prices on pollutants, through taxes, would result in the 
socially optimal level of pollution. This would indirectly lead 
to the adoption of the technologies favored in the President's 
budget, but only if they were in fact the most socially 
efficient technologies. In many cases, however, establishing 
the right prices on pollution-causing activities through taxes 
could be administratively infeasible, and other solutions may 
be more appropriate. For example, with respect to the 
President's proposal to provide a tax credit for the 
replacement of certain circuit breaker equipment because of the 
sulfur hexaflouride gas that they can leak, it would likely be 
impractical to set a tax on any leaking that occurs and to 
monitor the leaking. The President's proposal to provide a tax 
credit for their replacement could be the best policy because 
of its simplicity.18
---------------------------------------------------------------------------
    \18\ The same result could be effected through a direct mandate to 
replace the equipment, or a sufficiently high tax on the continued use 
of the old circuit breakers (as opposed to a tax on the leaking of the 
sulfur hexaflouride gas). This, again, is a question of who should bear 
the costs of the replacement.
---------------------------------------------------------------------------
    A second potential inefficiency of investment tax credits 
is one of budgetary inefficiency, in the sense that their 
budgetary costs could be large relative to the incremental 
investment in the targeted activities. The reason for this is 
that there will generally have been investment in the 
activities eligible for the credit even in the absence of the 
credit. Thus, for example, if investors planned to invest a 
million dollars in an activity before a 10-percent credit, and 
the credit caused the investment to rise $100,000 to $1.1 
million because of the credit, then only $100,000 in additional 
investment can be attributed to the credit. However, all $1.1 
million in investments will be eligible for the 10-percent 
credit, at a budgetary cost of $110,000 (10 percent of 1.1 
million). Thus, only $100,000 in additional investment would be 
undertaken, at a budgetary cost of $110,000. Because there is a 
large aggregate amount of investment undertaken without general 
investment credits, introducing a general credit would 
subsidize much activity that would have taken place 
anyway.19
---------------------------------------------------------------------------
    \19\ For a general discussion of the effects of tax policy on 
business fixed investment, see Alan Auerbach and Kevin Hassett, ``Tax 
Policy and Business Fixed Investment in the United States,'' Journal of 
Public Economics, Vol. 47, No. 2, March 1992.
---------------------------------------------------------------------------
    Targeted credits like the President's proposals, on the 
other hand, are likely to be more cost effective, from a budget 
perspective, in achieving the objective of increased 
investment, if only for the reason that a government would 
likely not consider their use if there were already extensive 
investment in a given area.20 Thus, investment that 
would take place anyhow is not subsidized, because there 
presumably is not much of such investment taking place. The 
presumption behind the targeted tax credits in the President's 
budget proposals is that there is not sufficient investment in 
the targeted areas because the alternative and more emissions-
producing investments are less costly to the investor. Hence, a 
tax credit would be necessary to equalize costs and encourage 
investment in the favored activity.
---------------------------------------------------------------------------
    \20\ For example, there would be no need for a targeted tax credit 
for construction of coffee shops, as most would agree that the 
operation of the free market leads to a sufficient number of coffee 
shops.
---------------------------------------------------------------------------
    A final limitation on the efficiency of the proposed 
credits is their restricted availability. The proposed tax 
credits come with several limitations beyond their stipulated 
dollar limitation. Specifically, they are all nonrefundable and 
cannot offset tax liability determined under the AMT. One 
proposal, the credit for rooftop solar equipment, has a cap on 
the dollar amount of the credit, and thus after the cap is 
reached the marginal cost of further investment becomes equal 
to the market price again, which is presumed to be inefficient. 
The impact of these limitations is to make the credit less 
valuable to those without sufficient tax liability to claim the 
full credit, for those subject to the AMT, or those who have 
reached any cap on the credit. Given the arguments outlined 
above as to the rationale for targeted tax credits, it is not 
economically efficient to limit their availability based on the 
tax status of a possible user of the credit. It can be argued 
that, if such social benefits exist and are best achieved 
through the tax system, the credit should be both refundable 
and available to AMT taxpayers. Some would argue that making 
the credits refundable may introduce compliance problems that 
would exceed the benefits from encouraging the targeted 
activities for the populations lacking sufficient tax liability 
to make use of the credit. With respect to the AMT, the 
rationale for the limitation is to protect the objective of the 
AMT, which is to insure that all taxpayers pay a minimum 
(determined by the AMT) amount of tax. Two differing policy 
goals thus come in conflict in this instance. Similarly, caps 
on the aggregate amount of a credit that a taxpayer may claim 
are presumably designed to limit the credit's use out of some 
sense of fairness, but again, this conflicts with the goal of 
pollution reduction.
    A justification for targeted tax credits that has been 
offered with respect to some pollution abatement activities, 
such as home improvements that would produce energy savings 
(installation of energy saving light bulbs or attic insulation, 
for example), is that the investment is economically sound at 
unsubsidized prices, but that homeowners or business owners are 
unaware of the high returns to the investments.21 
The argument for targeted tax credits in this case is that they 
are needed to raise the awareness of the homeowner, or to lower 
the price sufficiently to convince the homeowner that the 
investment is worthwhile, even though the investment is in 
their interest even without the subsidy. These arguments have 
been called into question recently on the grounds that the 
returns to the investments have been overstated by 
manufacturers, or are achievable only under ideal 
circumstances. This view holds that the returns to these 
investments are not dissimilar to other investments of similar 
risk profile, and that homeowners have not been economically 
irrational in their willingness to undertake certain energy 
saving investments.22 Of course, to the extent that 
there are negative externalities from the private energy 
consumption, these households, though making rational private 
choices, will not make the most socially beneficial choices 
without some form of subsidy.
---------------------------------------------------------------------------
    \21\ See Jerry A. Hausman, ``Individual Discount Rates and the 
Purchase and Utilization of Energy-Using Durables,'' Bell Journal of 
Economics and Management Science, vol. 10, Spring 1979. Hausman's study 
concluded that the mean household discount rate for evaluating the 
purchase of a more efficient room air conditioner was between 15 and 25 
percent in 1975 to 1976. These discount rates generally exceeded 
consumer loan rates at that time. In addition, information about the 
relative efficiency of different models was available. During this time 
period, room air conditioners carried information tags reporting the 
energy efficiency and expected operating costs of various models.
    \22\ See Gilbert Metcalf and Kevin Hassett, ``Measuring the Energy 
Savings from Home Improvement Investments: Evidence from Monthly 
Billing Data'', Working paper No. 6074, National Bureau of Economic 
Research, June 1997.
---------------------------------------------------------------------------
    A final justification offered for targeted tax credits in 
some instances is to ``jump start'' demand in certain infant 
industries in the hopes that over time the price of such goods 
will fall as the rewards from competition and scale economies 
in production are reaped. However, there is no guarantee that 
the infant industry would ultimately become viable without 
continued subsidies. This argument is often offered for 
production of electric cars--that if the demand is sufficient 
the production costs will fall enough to make them ultimately 
viable without subsidies. This justification is consistent with 
the current proposals in that the credits are available only 
for a limited period of time.

Production credit for wind and biomass

    The wind and biomass tax credit is different from the other 
tax credits in that the credit amount is based on production, 
rather than on investment. Some argue that a production credit 
provides for a stream of tax benefits, rather than an up-front 
lump sum, and that the stream of benefits can help provide 
financing for investment projects that would use wind or 
biomass facilities. On the other hand, an up-front tax credit 
provides more certainty, as the future production credits could 
possibly be curtailed by future Congresses. In general, 
investors prefer certainty to uncertainty, and thus may 
discount the value of future production credits. Another 
difference between a production credit and an investment credit 
is that the latter provides only a temporary distortion to the 
market--once the investment is made, normal competitive market 
conditions will prevail and the rational firm will only produce 
its end product if it can cover its variable costs. With a 
production credit, a firm may actually profitably produce even 
though it cannot cover its variable costs in the absence of the 
credit. This would generally be considered an economically 
inefficient outcome unless there are positive externalities to 
the production of the good that exceed the value of the 
credit.23 If it is presumed that the electricity 
produced from wind or biomass substitutes for electricity 
produced from the burning of fossil fuels, economic efficiency 
will be improved so long as the credit does not have to be set 
so high in order to encourage the alternative production that 
it exceeds the value of the positive externality. On the other 
hand, by making some production of electricity cheaper, it is 
possible that the credit could encourage more electricity 
consumption. On net, however, there would be less electricity 
produced from fossil fuels.
---------------------------------------------------------------------------
    \23\ In the present case, the positive externality is thought to be 
pollution abatement. While pollution abatement per se does not occur 
from the production of electricity from wind, the presumption is that, 
indirectly, pollution is abated because less electricity is produced 
from the burning of fossil fuels.
---------------------------------------------------------------------------

2. Other provisions

            a. Tax treatment of parking and transit benefits

                              Present Law

    Under present law, qualified transportation fringe benefits 
provided by an employer are excluded from an employee's gross 
income. Qualified transportation fringe benefits include 
parking, transit passes, and vanpool benefits. In addition, in 
the case of employer-provided parking, no amount is includible 
in income of an employee merely because the employer offers the 
employee a choice between cash and employer-provided parking. 
Transit passes and vanpool benefits are only excludable if 
provided in addition to, and not in lieu of, any compensation 
otherwise payable to an employee. Under present law, up to $175 
per month (for 1998) of employer-provided parking and up to $65 
per month (for 1998) of employer-provided transit and vanpool 
benefits are excludable from gross income. These dollar amounts 
are indexed for inflation.

                        Description of Proposal

    The proposal would permit employers to offer their 
employees transit and vanpool benefits in lieu of compensation. 
The proposal would also raise the monthly limit on employer-
provided transit and vanpool benefits excludable from gross 
income to the limit on employer-provided parking benefits 
($175). As under present law, this amount would be indexed for 
inflation.

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would equalize the tax treatment of employer-
provided transit and vanpool benefits with the tax treatment of 
employer-provided parking benefits. This equalization would 
appear to eliminate the tax disincentives for providing transit 
and vanpool benefits relative to parking benefits. In addition, 
it would eliminate possible confusion for employers that 
inadvertently structure a transit program that offers cash in 
lieu of parking and other transit benefits. In such cases, the 
employer may intend the program to qualify for tax exclusion, 
but it may result in taxation.
    On the other hand, some question whether it is appropriate 
to provide a cash election for any transportation benefits, as 
this merely allows employees to convert taxable income into 
nontaxable income.
    The equalization of the tax treatment of transit benefits 
and parking benefits is economically desirable in the sense 
that it eliminates a distortion that currently favors parking 
benefits, and hence driving to work, over transit benefits that 
encourage use of public transportation (and the latter is 
recognized to be more energy efficient, producing less 
pollution per passenger-mile). However, the proposal represents 
further subsidies to transportation in general, and thus 
encourages more use of transportation over other 
goods.24 Such subsidies are only desirable if we 
believe that, from a social perspective, expenditures on 
transportation have positive externalities. In general, the 
opposite view is held, as the burning of fossil fuels in 
transportation is a major source of pollution. Furthermore, 
additional use of transportation also causes more congestion, 
which has a negative impact on all users of the transportation 
infrastructure. Such subsidies may encourage people to live 
further from their place of work than they otherwise would, 
which requires more energy consumption to get to work. 
Furthermore, such subsidies encourage the use of cars or public 
transportation, both of which use fossil fuels, over more 
environmentally friendly forms of transportation such as 
walking or bicycling to work, or telecommuting from home, which 
do not benefit from any special tax incentives.
---------------------------------------------------------------------------
    \24\ An alternative proposal would have been to equalize the 
treatment of parking benefits by putting them on the same footing as 
transit under current law, rather than the other way around. This would 
have represented less of a subsidy to transportation in general.
---------------------------------------------------------------------------
            b. Permanent extension of expensing of environmental 
                    remediation costs (``brownfields'')

                              Present Law

    Code section 162 allows a deduction for ordinary and 
necessary expenses paid or incurred in carrying on any trade or 
business. Treasury regulations provide that the cost of 
incidental repairs which neither materially add to the value of 
property nor appreciably prolong its life, but keep it in an 
ordinarily efficient operating condition, may be deducted 
currently as a business expense. Section 263(a)(1) limits the 
scope of section 162 by prohibiting a current deduction for 
certain capital expenditures. Treasury regulations define 
``capital expenditures'' as amounts paid or incurred to 
materially add to the value, or substantially prolong the 
useful life, of property owned by the taxpayer, or to adapt 
property to a new or different use. Amounts paid for repairs 
and maintenance do not constitute capital expenditures. The 
determination of whether an expense is deductible or 
capitalizable is based on the facts and circumstances of each 
case.
    Under Code section 198, taxpayers can elect to treat 
certain environmental remediation expenditures that would 
otherwise be chargeable to capital account as deductible in the 
year paid or incurred. The deduction applies for both regular 
and alternative minimum tax purposes. The expenditure must be 
incurred in connection with the abatement or control of 
hazardous substances at a qualified contaminated site. In 
general, any expenditure for the acquisition of depreciable 
property used in connection with the abatement or control of 
hazardous substances at a qualified contaminated site does not 
constitute a qualified environmental remediation expenditure. 
However, depreciation deductions allowable for such property, 
which would otherwise be allocated to the site under the 
principles set forth in Commissioner v. Idaho Power Co.\25\ and 
section 263A, are treated as qualified environmental 
remediation expenditures.
---------------------------------------------------------------------------
    \25\ Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding 
that equipment depreciation allocable to the taxpayer's construction of 
capital facilities must be capitalized under section 263(a)(1)).
---------------------------------------------------------------------------
    A ``qualified contaminated site'' generally is any property 
that: (1) is held for use in a trade or business, for the 
production of income, or as inventory; (2) is certified by the 
appropriate State environmental agency to be located within a 
targeted area; and (3) contains (or potentially contains) a 
hazardous substance (so-called ``brownfields''). Targeted areas 
are defined as: (1) empowerment zones and enterprise 
communities as designated under present law and under the Act 
26 (including any supplemental empowerment zone 
designated on December 21, 1994); (2) sites announced before 
February 1997, as being subject to an Environmental Protection 
Agency (``EPA'') Brownfields Pilot; (3) any population census 
tract with a poverty rate of 20 percent or more; and (4) 
certain industrial and commercial areas that are adjacent to 
tracts described in (3) above.
---------------------------------------------------------------------------
    \26\ Thus, the 22 additional empowerment zones authorized to be 
designated under the Taxpayer Relief Act of 1997, as well as the D.C. 
Enterprise Zone, are ``targeted areas'' for purposes of this provision.
---------------------------------------------------------------------------
    Both urban and rural sites qualify. However, sites that are 
identified on the national priorities list under the 
Comprehensive Environmental Response, Compensation, and 
Liability Act of 1980 (``CERCLA'') cannot qualify as targeted 
areas. The chief executive officer of a State, in consultation 
with the Administrator of the EPA, was authorized to designate 
an appropriate State environmental agency. If no State 
environmental agency was so designated within 60 days of the 
date of enactment, the Administrator of the EPA was authorized 
to designate the appropriate environmental agency for such 
State. Hazardous substances generally are defined by reference 
to sections 101(14) and 102 of CERCLA, subject to additional 
limitations applicable to asbestos and similar substances 
within buildings, certain naturally occurring substances such 
as radon, and certain other substances released into drinking 
water supplies due to deterioration through ordinary use.
    In the case of property to which a qualified environmental 
remediation expenditure otherwise would have been capitalized, 
any deduction allowed under the Act is treated as a 
depreciation deduction and the property is treated as section 
1245 property. Thus, deductions for qualified environmental 
remediation expenditures are subject to recapture as ordinary 
income upon sale or other disposition of the property. In 
addition, sections 280B (demolition of structures) and 468 
(special rules for mining and solid waste reclamation and 
closing costs) do not apply to amounts which are treated as 
expenses under this provision.
    The provision applies only to eligible expenditures paid or 
incurred in taxable years ending after August 5, 1997, and 
before January 1, 2001.

                        Description of Proposal

    The proposal would eliminate the requirement that 
expenditures must be paid or incurred in taxable years ending 
before January 1, 2001, to be deductible as eligible 
environmental remediation expenditures. Thus, the provision 
would become permanent.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The special expensing for environmental remediation 
expenditures was enacted as part of the Taxpayer Relief Act of 
1997.

                                Analysis

    The proposal to make permanent the expensing of brownfields 
remediation costs would promote the goal of environmental 
remediation and remove doubt as to the future deductibility of 
remediation expenses. Removing the doubt about deductibility 
may be desirable if the present law expiration date is 
currently affecting investment planning. For example, the 
temporary nature of relief under present law may discourage 
projects that require a significant ongoing investment, such as 
groundwater clean-up projects. On the other hand, extension of 
the provision for a limited period of time would allow 
additional time to assess the efficacy of the law, adopted only 
recently as part of the Taxpayer Relief act of 1997, prior to 
any decision as to its permanency.
    The proposal is intended to encourage environmental 
remediation, and general business investment, in sites located 
in enterprise communities and empowerment zones, the original 
EPA Brownfields Pilots, or in census tracts with poverty rates 
of 20 percent or more, or certain adjacent tracts. With respect 
to environmental remediation, it is not clear that the 
restriction to certain areas will lead to the most socially 
desirable distribution of environmental remediation. It is 
possible that the same dollar amount of expenditures for 
remediation in other areas could produce a greater net social 
good, and thus the restriction to specific areas diminishes 
overall efficiency. On the other hand, property located in a 
nonqualifying area may have sufficient intrinsic value so that 
environmental remediation will be undertaken absent a special 
tax break. With respect to environmental remediation tax 
benefits as an incentive for general business investment, it is 
possible that the incentive may have the effect of distorting 
the location of new investment, rather than increasing 
investment overall.\27\ If the new investments are offset by 
less investment in neighboring, but not qualifying, areas, the 
neighboring communities could suffer. On the other hand, the 
increased investment in the qualifying areas could have 
spillover effects that are beneficial to the neighboring 
communities.
---------------------------------------------------------------------------
    \27\ For a discussion of the economic effects of enterprise zones, 
see Leslie E. Papke, ``What Do We Know About Enterprise Zones,'' in Jim 
Poterba, ed., Tax Policy and the Economy, 7 (Cambridge, MA: The MIT 
Press), 1993.
---------------------------------------------------------------------------
    Further, permanently extending the brownfields provision 
raises administrative issues. For example, it is unclear 
whether currently qualified zone sites will continue to qualify 
after such designation expires, by law, after 10 years. 
Similarly, it is unclear whether the application to census 
tracts (currently defined by the 1990 census) with poverty 
rates of 20 percent or more (or certain adjacent tracts) 
applies to tracts that meet such qualifications on (1) August 
5, 1997 (the effective date of the original brownfields 
legislation), (2) the effective date of this proposal, or (3) 
the date of the expenditure.

                    C. Retirement Savings Provisions

1. Access to payroll deduction for retirement savings

                              Present Law

    Under present law, an employer may establish a payroll 
deduction program to help employees save for retirement through 
individual retirement arrangements (``IRAs''). Under a payroll 
deduction program, an employee may contribute to an IRA by 
electing to have the employer withhold amounts from the 
employee's paycheck and forward them to the employee's IRA. 
Payroll deduction contributions are included in the employee's 
wages for the taxable year but the employee may deduct the 
contributions on the employee's tax return, subject to the 
normal IRA contribution rules.
    The legislative history of the Taxpayer Relief Act of 1997 
provides that employers that choose not to sponsor a retirement 
plan should be encouraged to set up a payroll deduction system 
to help employees save for retirement by making payroll 
deduction contributions to their IRAs. The Secretary of 
Treasury is encouraged to continue his efforts to publicize the 
availability of these payroll deduction IRAs.
    Under present law, an IRA payroll deduction program may be 
exempt from the provisions of Title I of (the Employer 
Retirement Income Security Act of 1974, as amended (``ERISA''), 
which include reporting and disclosure and fiduciary 
requirements. In general, ERISA regulations provide an 
exception from the provisions of Title I of ERISA for an IRA 
payroll deduction program in which the employer merely 
withholds amounts from the employee's paycheck and forwards 
them to the employee's IRA. A payroll deduction program may be 
subject to Title I of ERISA if, for example, an employer makes 
contributions to the program or an employer receives more than 
reasonable compensation for services rendered in connection 
with payroll deductions.

                        Description of Proposal

    Under the proposal, contributions of up to $2,000 made to 
an IRA through payroll deduction generally would be excluded 
from an employee's income and, accordingly, would not be 
reported as income on the employee's Form W-2. However, the 
amounts would be subject to employment taxes and would be 
reported as a contributions to an IRA on the employee's W-2. In 
the event the amounts would not have been deductible had the 
employee contributed directly to an IRA, the employee would be 
required to include the amounts in income on the employee's tax 
return.

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to encourage employers to offer 
payroll deduction programs to their employees and encourage 
employees to save for retirement. While present law permits 
such payroll deductions, the proposal is designed to make it 
more attractive (and more widely utilized) by providing 
employees with a convenient way to obtain the tax benefit for 
IRA contributions that will eliminate the need for many 
employees to report the contributions on their tax returns and 
enable some employees to use simpler tax forms. The proposal 
does not increase the present-law benefit of making 
contributions to an IRA.
    It is not clear whether the proposal will have the desired 
effect. Increased IRA participation may not result because 
there is no change in the economic incentive to make IRA 
contributions. On the other hand, by increasing the convenience 
of making contributions, some taxpayers may participate who 
would not otherwise participate and more taxpayers may begin to 
save on a regular basis. Oppositely, some analysts have noted 
that under present law many IRA contributions are not made 
until immediately prior to the date the taxpayer files his or 
her tax return. Such taxpayer may not be motivated by the long-
term economic benefits of an IRA, but rather by a short-term 
desire to affect the immediate consequence of tax filing. The 
proposal may or may not affect the psychology of such 
taxpayers.
    For the proposal to be effective, employers must create 
payroll deduction programs. In order to do so, employers may 
have to revise current payroll systems. Employers may not be 
willing to incur the costs of establishing and maintaining a 
payroll deduction program. The proposal does not create a 
direct economic incentive for employers to incur such costs. On 
the other hand, if employees find the payroll deduction program 
attractive and know such payroll options are available 
elsewhere, employers may find it to their benefit to extend 
this payroll deduction option to their employees. In addition, 
the proposal does not address certain fiduciary issues under 
the present-law ERISA rules. Without some modification, 
employers may be unwilling to establish payroll deduction plans 
out of concern that they will be considered plan 
fiduciaries.\28\
---------------------------------------------------------------------------
    \28\ The Administration has indicated that the Department of Labor 
will address fiduciary issues relating to payroll deduction IRAs.
---------------------------------------------------------------------------
    The exclusion provided by the proposal may be confusing for 
some employees (e.g., employees who simultaneously participate 
in a qualified plan and who have AGI in excess of $50,000). 
They may mistakenly believe they are entitled to the exclusion 
when they are not because of the IRA deduction income phase-out 
rules. In addition, some employees could mistakenly claim both 
the exclusion and the deduction on their return.

2. Small business tax credit for retirement plan start-up expenses

                              Present Law

    Under present law, the costs incurred by an employer 
related to the establishment and maintenance of a retirement 
plan (e.g., payroll system changes, investment vehicle set-up 
fees, consulting fees, etc.) generally are deductible by the 
employer as an ordinary and necessary expense in carrying on a 
trade or business.

                         Description of Proposal

    The proposal would provide a three-year tax credit, in lieu 
of a deduction, for 50 percent of the administrative and 
retirement-education expenses for any small business that 
adopts a new qualified defined benefit or defined contribution 
plan (including a section 401(k) plan), SIMPLE plan, simplified 
employee pension (``SEP''), or payroll deduction IRA 
arrangement. The credit would apply to 50 percent of the first 
$2,000 in administrative and retirement-education expenses for 
the plan or arrangement for the first year of the plan or 
arrangement and 50 percent of the first $1,000 of 
administrative and retirement-education expenses for each of 
the second and third years.
    The credit would be available to employers that did not 
employ, in the preceding year, more than 100 employees with 
compensation in excess of $5,000, but only if the employer did 
not have a retirement plan or payroll deduction IRA arrangement 
during any part of 1997. In order for an employer to get the 
credit, the plan would have to cover at least two individuals. 
In addition, if the credit is for the cost of a payroll 
deduction IRA arrangement, the arrangement would have to be 
made available to all employees of the employer who have worked 
with the employer for at least three months.
    The small business tax credit would be treated as a general 
business credit and the standard carry forward and backward 
rules would apply.

                             Effective Date

    The credit would be effective beginning in the year of 
enactment and would be available only for plans established on 
or before December 31, 2000. For example, if an eligible 
employer adopted a plan in the year 2000, the credit would be 
available for the years 2000, 2001, and 2002.

                              Prior Action

    No prior action.

                                Analysis

    Establishing and maintaining a qualified plan involves 
employer administrative costs both for initial start-up of the 
plan and for on-going operation of the plan. These expenses 
generally are deductible to the employer as a cost of doing 
business. The cost of these expenses to the employer is reduced 
by the tax deduction. Thus, for costs incurred or $C, the net, 
after-tax cost is $C(1-t) where t is the employer's marginal 
tax rate. The employer's tax rate may be either the applicable 
corporate tax rate or individual marginal tax rate, depending 
on the form in which the employer does business (e.g., as a C 
corporation or a sole proprietor). Under the proposal, a 50-
percent credit could be claimed for eligible costs in lieu of 
the deduction. Thus for qualifying costs, C, the net cost to 
the employer would be C(1-0.5) or (.5)C. The proposal would 
reduce the cost of establishing a plan by the difference 
between the employer's marginal tax rate and 50 percent 
multiplied by up to $2,000 in the first year or by up to $1,000 
in the second or third years. At most the cost reduction would 
be $700 (the difference between the lowest marginal tax rate of 
15 percent and the proposed credit rate of 50 percent 
multiplied by $2,000) in the first year and $350 for the second 
and third years. The additional cost saving under the proposal 
compared to present law could be as little as $208 in the first 
year and $104 dollars in the second and third years. For a 
taxpayer in the 39.6-percent marginal income tax bracket.
    By reducing costs, providing a tax credit for the costs 
associated with establishing a retirement plan may promote the 
adoption of such plans by small businesses. On the other hand, 
it is unclear whether the magnitude of the cost saving provided 
by the proposed tax credit will provide sufficient additional 
incentive for small businesses to establish plans. In some 
cases the credit may be inefficient because it may be claimed 
by employers who would have established a plan in any event.

3. Simplified pension plan for small business (``SMART'')

                              Present Law

    Any employer, including a small employer, may adopt a 
qualified plan for its employees. In addition, present law 
contains some special plans designed specifically for small 
employers. Present law provides for a simplified retirement 
plan for small business employers called the savings incentive 
match plan for employees (``SIMPLE'') retirement plan. A SIMPLE 
plan can be either an individual retirement arrangement 
(``IRA'') for each employee or part of a qualified cash or 
deferred arrangement (``401(k) plan''). SIMPLE plans can be 
adopted by employers who employ 100 or fewer employees who 
received at least $5,000 in compensation and who do not 
maintain another employer-sponsored retirement plan. Under a 
SIMPLE retirement plan, employees can elect to make pre-tax 
deferrals of up to $6,000 per year. Employers are required to 
make either a matching contribution of up to 3 percent of the 
employee's compensation or, alternatively, the employer can 
elect to make a lower percentage contribution on behalf of all 
eligible employees. Employees are 100 percent vested in all 
contributions made to their accounts. A SIMPLE retirement plan 
cannot be a defined benefit plan.
    Alternatively, small business employers may offer their 
employees a simplified employee pension (``SEP''). SEPs are 
employer-sponsored plans under which employer contributions are 
made to individual retirement arrangements (``IRAs'') 
established by the employees. Contributions under a SEP 
generally must bear a uniform relationship to the compensation 
of each employee covered under the SEP (e.g., each employee 
receives a contribution to the employee's IRA equal to 5 
percent of the employee's compensation for the year).

                        Description of Proposal

In general

    The proposal would create a new simplified pension plan for 
small business employers called the Secure Money Annuity or 
Retirement Trust (``SMART'') Plan. The SMART Plan would combine 
the features of both a defined benefit plan and a defined 
contribution plan. As is the case with qualified retirement 
plans, contributions to the SMART Plan would be excludable from 
income, earnings would accumulate tax-free, and distributions 
would be subject to income tax (unless rolled over).

Employer and employee eligibility and vesting

    The SMART Plan could be adopted by an employer who (1) 
employs 100 or fewer employees who received at least $5,000 in 
compensation in the prior year, (2) is not a professional 
service employer (i.e., an employer substantially all of the 
activities of which involve the performance of services in the 
fields of health, law, engineering, architecture, accounting, 
actuarial services, performing arts, or consulting), and (3) 
has not maintained a defined benefit pension plan or money 
purchase pension plan within the preceding five years. All 
employees who have completed two years of service with at least 
$5,000 in compensation and who are reasonably expected to 
receive $5,000 in compensation in the current year would 
participate in the SMART Plan. An employee's benefit would be 
100 percent vested at all times.

Benefits and funding

    SMART Plans would provide a fully funded minimum defined 
benefit. Each year the employee participates, the employee 
would earn a minimum annual benefit at retirement equal to 1 
percent or 2 percent of compensation for that year. For 
example, if an employee participates for 25 years in a SMART 
Plan, and the employer had elected a 2 percent benefit, and the 
employee's average salary over the entire period was $50,000, 
the employee would accrue a minimum benefit of $25,000 per year 
at age 65. An employer could elect, for each of the first 5 
years the SMART Plan is in existence, to provide all employees 
with a benefit equal to 3 percent of compensation. The maximum 
compensation that could be taken into account for a year would 
be $100,000 (indexed for inflation). Each year the employer 
would be required to contribute an amount on behalf of each 
participant sufficient to provide the annual benefit accrued 
for that year payable at age 65, using specified actuarial 
assumptions (including a 5 percent annual interest rate).
    Funding would be provided either through a SMART Plan 
individual retirement annuity (``SMART Annuity'') or through a 
trust (``SMART Trust''). In the case of a SMART Trust, each 
employee would have an account to which actual investment 
returns would be credited. If a participant's account balance 
were less than the total of past employer contributions 
credited with 5 percent interest per year, the employer would 
be required to make up the shortfall. If the investment returns 
exceed the 5 percent assumption, the employee would be entitled 
to the larger account balance. In the case of a SMART Annuity, 
each year the employer would be required to contribute the 
amount necessary to purchase an annuity that provides the 
benefit accrual for that year on a guaranteed basis.
    The required contributions would be deductible under the 
rules applicable to qualified defined benefit plans. An excise 
tax would apply if the employer failed to make the required 
contributions for a year.

Distributions

    No distributions would be allowed from a SMART Plan prior 
to the employee's attainment of age 65, except in the event of 
death or disability, or where the account balance of a 
terminated employee does not exceed $5,000. However, an 
employer could allow a terminated employee who has not yet 
attained age 65 to directly transfer the individual's account 
balance from a SMART Trust to either a SMART Annuity or a 
special individual retirement account (``SMART Account'') that 
is subject to the same distribution restrictions as the SMART 
Trust. If a terminated employee's account balance did not 
exceed $5,000, the SMART Plan would be allowed to make a 
cashout of the account balance. The employee would be allowed 
to transfer such distribution tax-free to a SMART Annuity, a 
SMART Account, or a regular IRA.
    SMART Plans would be subject to the qualified joint and 
survivor annuity rules that apply to qualified defined benefit 
plans. Lump sum payments also could be made available. In 
addition, an employer could allow the transfer of a terminated 
employee's account balance from SMART Trust to either a SMART 
Annuity or a SMART Account.
    Distributions from SMART Plans would be subject to tax 
under the present-law rules applicable to qualified plans. A 
20-percent additional tax would be imposed for violating the 
pre-age 65 distribution restrictions under a SMART Annuity or 
SMART Account.

PBGC guarantee and premiums

    The minimum guaranteed benefit under the SMART Trust would 
be guaranteed by the Pension Benefit Guarantee Corporation 
(``PBGC''). Reduced PBGC premiums would apply to the SMART 
Trust. Neither the PBGC guarantee, nor PBGC premiums, would 
apply to the SMART Annuity or SMART Account.

Nondiscrimination requirements and benefit limitations

    SMART Plans would not be subject to the nondiscrimination 
or top-heavy rules applicable to qualified retirement plans. 
SMART Plans also would not be subject to the limitations on 
benefits under qualified plans. However, if an employer 
maintained a SMART Plan, and then terminated it and established 
a qualified defined benefit plan, the SMART Plan accruals would 
be taken into account for purposes of the limitations 
applicable to the defined benefit plan.

Other rules

    Other plans maintained by the employer.--An employer that 
maintained a SMART Plan could not maintain additional tax-
qualified plans, other than a SIMPLE plan, a 401(k) plan, or a 
403(b) tax-sheltered annuity plan under which the only 
contributions that are permitted are elective contributions and 
matching contributions that are not greater than those provided 
for under the design-based safe harbor for 401(k) plans.
    Reporting and disclosure.--SMART Plans would be subject to 
simplified reporting requirements.
    Employee contributions.--No employee contributions would be 
permitted to a SMART Plan.
    IRS model.--The IRS would be directed to issue model SMART 
Plan provisions or a model SMART Plan document. Vendors and 
employers would have the option of using their own documents 
instead of the models.
    Coordination with IRA deduction rules.--SMART Plans would 
be treated as qualified plans for purposes of the IRA deduction 
phase-out rules. Thus, employees who participated in a SMART 
Plan and had modified adjusted gross income in excess of the 
applicable thresholds would be phased out of making deductible 
IRA contributions. This rule currently applies to SEPs and 
SIMPLE Plans.
    Calendar plan year.--The plan year for all SMART Plans 
would be the calendar year, which would be used in applying 
SMART Plan contribution limits, eligibility, and other 
requirements.

                             Effective Date

    The proposal would be effective for calendar years 
beginning after 1998.

                              Prior Action

    A similar proposal (H.R. 1656) was introduced in the House 
in 1997.

                                Analysis

    Under present law, small businesses have many options 
available for providing retirement benefits for their 
employees, including establishing SIMPLE plans and SEPs not 
available to larger employers. Nevertheless, retirement plan 
coverage is lower among smaller employers. There may be a 
number of reasons for such lower coverage. Some believe the 
retirement plan coverage for small business employers continues 
to be inadequate. They argue that the limits are not sufficient 
to induce owners to establish a plan because the owners will 
not be able to receive as high a retirement benefit as they 
would like. Others point out that the limits are high enough to 
allow significant retirement benefits (the lesser of $130,000 
per year or 100 percent of compensation), and that there are 
other causes for the low small employer plan coverage, such as 
the administrative burdens and costs, and the unpredictability 
of funding requirements associated with defined benefit plans 
that may inhibit small business employers from adopting and 
maintaining such plans. It also may be that the costs of 
contributing to a plan are too high for small employers. 
Providing small business employers with an additional option 
for providing retirement benefits for their employees, the 
SMART Plan may provide greater benefits for employees while 
reducing the costs of establishing and maintaining a retirement 
plan. However, there is an issue concerning which employees 
will actually benefit from participating in a SMART Plan. 
Because the SMART Plan benefits are based on a formula that 
takes into account a participant's age and years of service 
with the employer who established the SMART Plan, those older 
employees with long service records will receive the greatest 
benefits. In many cases, the older employees with the longest 
service records will be the higher paid employees. Generally, 
younger employees with shorter service records would receive a 
greater benefit under a defined contribution plan, SIMPLE or 
SEP.

4. Faster vesting for employer matching contributions

                              Present Law

    Under present law, a participant's employer-provided 
benefits under a qualified plan must either be fully vested 
after the participant has completed 5 years of service, or must 
become vested in increments of 20 percent for each year 
beginning after 3 years of service, with full vesting after the 
participant completes 7 years of service. If a plan is a ``top-
heavy plan'', employer contributions either must be fully 
vested after the participant has completed 3 years of service, 
or must become vested in increments of 20 percent for each year 
beginning after 2 years of service, with full vesting after the 
participant completes 6 years of service. Employer matching 
contributions on behalf of a participant under a section 401(k) 
plan are generally subject to these vesting rules. However, 
employer matching contributions that are treated as elective 
contributions for purposes of the actual deferral percentage 
test under section 401(k) (``qualified matching 
contributions'') must be fully vested immediately.

                        Description of Proposal

    Under the proposal, employer matching contributions under 
401(k) plans (or other qualified plans) would be required 
either to be fully vested after an employee has completed 3 
years of service, or to become vested in increments of 20 
percent for each year beginning after the employee has 
completed 2 years of service, with full vesting after the 
employee has completed 6 years of service. Qualified matching 
contributions used to satisfy the 401(k) actual deferral 
percentage test would continue to be fully vested immediately, 
as under present law.

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1998, with an (unspecified) extended 
effective date for plans maintained pursuant to a collective 
bargaining agreement.

                              Prior Action

    No prior action.

                                Analysis

    The popularity and importance of 401(k) plans has grown 
substantially over the years. Employers often choose to 
contribute to 401(k) plans by matching the salary reduction 
contributions made by employees. The general justification for 
accelerating the vesting of employer matching contributions 
focuses on the mobile nature of today's workforce and the 
substantial risk that many participants will leave employment 
before fully vesting in employer matching contributions. 
Shortening the vesting period is consistent with encouraging 
retirement savings, proponents argue.
    Opponents may counter that in some cases accelerating the 
vesting schedule of employer matching contributions may reduce 
overall retirement savings by making plans more expensive for 
some employers. Because matching contributions that are 
forfeited are used by some employers to reduce the 
contributions of the employer in subsequent years, these 
employers may find that the shorter vesting period increases 
their plan costs. This could cause employers to eliminate or 
reduce the matching contribution. Reductions in matching 
contributions may in turn reduce employee participation in 
401(k) plans, because employer matching contributions are a 
significant feature of plans that for many employees may 
provide the economic incentive to participate in the plan.
    Employers may use vesting schedules that are not immediate 
to promote longer job attachment from employees that may enable 
the employer and employee to reap benefits of job specific 
training the employee may have received when initially employed 
by the employer. Reducing the time to full vesting may cause 
the employer to make changes in other forms of compensation or 
to reduce training to balance against whatever costs 
accelerated vesting may create.

5. Pension ``right to know'' provisions

                              Present Law

Spouse's right to know distribution information

    In general, a qualified pension plan is required to provide 
automatic survivor benefits for married participants. In the 
case of a married participant who commences distribution of 
retirement benefits, the benefit must be distributed in the 
form of a qualified joint and survivor annuity. A qualified 
joint and survivor annuity distributes the retirement benefit 
over the life of the participant and continues to pay at least 
one-half of the benefit amount to the surviving spouse 
following the participant's death. In the case of a married 
participant who dies prior to the commencement of retirement 
benefits, the surviving spouse must be provided with a 
qualified preretirement survivor annuity. A qualified 
preretirement survivor annuity provides the surviving spouse 
with a benefit that is not less than what would have been paid 
under the survivor portion of the qualified joint and survivor 
annuity. Certain defined contribution plans, (such as profit 
sharing and 401(k) plans) are not required to provide these 
survivor annuities provided certain conditions are satisfied, 
including that the spouse be the beneficiary of the 
participant's entire account balance.
    Plans subject to the survivor annuity requirements may 
permit participants to waive the right to receive these 
annuities provided certain conditions are satisfied. In 
general, these conditions include (1) providing the participant 
with a written explanation of the terms and conditions of the 
survivor annuity, (2) the right to make, and the effect of, a 
waiver of the annuity, (3) the rights of the spouse to waive 
the survivor annuity, and (4) the right of the participant to 
revoke the waiver. In addition, the spouse must provide a 
written consent to the waiver, witnessed by a plan 
representative or a notary public, which acknowledges the 
effect of the waiver.

Election periods and right to know employer contribution formula

    Under present law, there are certain nondiscrimination 
tests that apply to contributions made to 401(k) plans. In 
general, the actual deferral percentage (``ADP'') test applies 
to the elective contributions of all employees under the plan 
and the average contribution percentage (``ACP'') test applies 
to employer matching and after-tax employee contributions. The 
ADP test is satisfied if the average percentage of elective 
contributions for highly compensated employees does not exceed 
the average percentage of elective contributions for nonhighly 
compensated employees by a specified percentage. The ACP test 
is similar but it tests the average contribution percentages of 
the highly compensated employees and nonhighly compensated 
employees.
    As an alternative to annual testing under the ADP and ACP 
tests, the Small Business Job Protection Act of 1996 provides 
two alternative ``design-based'' 401(k) safe harbors, effective 
beginning in 1999. If the employees are provided a specified 
matching contribution (or a specified nonelective 
contribution), the employer can avoid all ADP and ACP testing 
of employee elective contributions and employer matching 
contributions. There are similar safe-harbor designs under the 
SIMPLE plan and the SIMPLE 401(k) plan. Under the SIMPLE plans, 
employees must be provided annual 60-day election periods and 
notification tied to those election periods. Unlike the SIMPLE 
plans, for 401(k) plans using the safe harbor designs there are 
no specific requirements that prescribe the length and 
frequency of the election period or that tie the timing of the 
notice describing employee rights and obligations under the 
plan.

                        Description of Proposal

Spouse's right to know distribution information

    The proposal would provide that when an explanation of a 
plan's survivor benefits is provided to participants, a copy of 
the explanation would be required to be provided to the 
participant's spouse. If the last known mailing address of the 
participant and spouse is the same, then the explanation and a 
copy of the explanation can be provided in a single mailing 
addressed to the participant and the spouse.

Election periods and right to know employer contribution formula

    The proposal would require employers who use one of the 
safe harbor designs to avoid ADP and ACP testing to provide 
notice and contribution opportunities comparable to those 
provided under SIMPLE plans. Thus, employees would have to be 
offered an opportunity to elect to make contributions (or 
modify a prior election) during a 60-day period before the 
beginning of each year and a 60-day period when they first 
become eligible. In addition, the present law requirement that 
employers provide employees with notice of their rights to make 
contributions and notice of the safe harbor contributions 
formula the employer is currently using (in order to notify 
employees of their rights and obligations) would be modified to 
require the notice within a reasonable period of time before 
the 60-day periods begin rather than before the beginning of 
the year.

                             Effective Date

    The proposals would be effective for years beginning after 
December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    The pension right to know proposals would add two new plan 
administration requirements. In one case, additional 
information must be provided to spouses of plan participants 
and in the other case employees must be provided specified 
notice and election periods when an employer chooses to use the 
401(k) safe harbors. In both cases, it can be argued that the 
requirements are necessary so that the individuals affected 
understand their rights and have the opportunity to make 
informed decisions regarding their benefit entitlements. On the 
other hand, the proposals may add to the costs of sponsoring a 
plan.

6. Simplified method for improving benefits of nonhighly compensated 
        employees under the safe harbor for 401(k) plans

                              Present Law

    Under present law, special nondiscrimination tests apply to 
contributions made to 401(k) plans. In general, the actual 
deferral percentage (``ADP'') test applies to the elective 
contributions of all employees under the plan and the average 
contribution percentage (``ACP'') test applies to employer 
matching and after-tax employee contributions. The ADP test is 
satisfied if the average percentage of elective contributions 
for highly compensated employees does not exceed the average 
percentage of elective contributions for nonhighly compensated 
employees by more than a specified percentage. The ACP test is 
similar but it tests the average contribution percentages 
(i.e., employer matching and after-tax employee contributions) 
of the highly compensated employees and nonhighly compensated 
employees.
    As an alternative to annual testing under the ADP and ACP 
tests, the Small Business Job Protection Act of 1996 provides 
two alternative ``design-based'' 401(k) safe harbors, effective 
beginning in 1999. Under the safe harbor, if the employees are 
provided a specified matching contribution or a specified 
nonelective contribution, ADP and ACP testing of employee 
elective contributions and employer matching contributions is 
not required. Under the matching contribution safe harbor, the 
employer would have to make nonelective contributions of at 
least three percent of compensation for each nonhighly 
compensated employee eligible to participate in the plan. 
Alternatively, under the other safe harbor, the employer would 
have to make a 100 percent matching contribution on an 
employee's elective contributions up to the first 3 percent of 
compensation and a matching contribution of at least 50 percent 
on the employee's elective contributions up to the next 2 
percent of compensation.

                        Description of Proposal

    The proposal would modify the section 401(k) matching 
formula safe harbor by requiring that, in addition to the 
matching contribution, employers would have to make a 
contribution of one percent of compensation for each eligible 
nonhighly compensated employee, regardless of whether the 
employee makes elective contributions.

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1998, when the 401(k) designed-based safe harbors 
become effective.

                              Prior Action

    No prior action.

                                Analysis

    The special nondiscrimination rules for 401(k) plans are 
designed to ensure that nonhighly compensated employees, as 
well as highly compensated employees, actually receive benefits 
under the plan. The nondiscrimination rules give employers an 
incentive to make the plan attractive to lower- and middle-
income employees (e.g., by providing a match) and to undertake 
efforts to enroll such employees, because the greater the 
participation by such employees, the more highly compensated 
employees can contribute to the plan.
    The design-based safe harbors were designed to achieve the 
same objectives as the special nondiscrimination rules, but in 
a simplified manner. The nonelective safe harbor ensures a 
minimum benefit for employees covered by the plan, and it was 
believed that the required employer match would be sufficient 
incentive to induce participation by nonhighly compensated 
employees. It was also hoped that the design-based safe harbors 
would reduce the complexities associated with qualified plans, 
and induce more employers to adopt retirement plans for their 
employees.
    Some are concerned that the safe harbors will not have the 
intended effect, but instead will result in less participation 
by rank-and-file employees, in part because employers will no 
longer have a financial incentive to encourage employees to 
participate.
    Requiring employers who use the section 401(k) matching 
formula safe harbor to make an additional one percent 
nonelective contribution for each eligible nonhighly 
compensated employee, whether or not the employee makes 
elective contributions to the plan, will provide a minimum 
benefit for employees covered in the plan and also may 
encourage more employees to contribute to the plan and help 
ensure that lower- and middle-income employees receive some 
benefits. On the other hand, some argue that the purpose of the 
safe harbor formulas is to encourage more employers to sponsor 
401(k) plans by eliminating the costs associated with annual 
testing. Adding a required employer contribution increases 
costs to employers and may impede the establishment of 
retirement plans. Some also believe that it is inappropriate to 
require a contribution to a 401(k) plan if employees do not 
make any elective deferrals. Under this view, retirement 
savings is a shared obligation of the employer and employee.

7. Simplify definition of highly compensated employee

                              Present Law

     Under present law, an employee is treated as highly 
compensated if the employee (1) was a 5-percent owner of the 
employer at any time during the year or the preceding year or 
(2) either (a) had compensation for the preceding year in 
excess of $80,000 (indexed for inflation) or (b) at the 
election of the employer had compensation for the preceding 
year in excess of $80,000 (indexed for inflation) and was in 
the top 20 percent of employees by compensation for such year.

                        Description of Proposal

    The proposal would eliminate the top-paid group election 
from the definition of highly compensated employee. Under the 
new definition, an employee would be treated as a highly 
compensated employee if the employee (1) was a 5-percent owner 
of the employer at any time during the year or the preceding 
year, or (2) for the preceding year, had compensation in excess 
of $80,000 (indexed for inflation).

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would further simplify the definition of 
highly compensated employee by eliminating the top-paid group 
election. Permitting elections that may vary from year to year 
increases complexity as employers that may benefit from the 
election may feel it necessary to run tests under both options. 
In addition, by use of the election, it is possible for 
employees earning very high compensation (in excess of $80,000) 
to be treated as nonhighly compensated for testing purposes if 
the employer has a sufficient percentage of high-paid employees 
in its workforce (i.e., if employees earning more than $80,000 
are in the top paid 20 percent of employees). This would allow 
some employers to effectively eliminate benefits for low- and 
moderate-wage workers without violating the nondiscrimination 
rules. The proposal may help ensure that the simplified 
definition of highly compensated employee better reflects the 
purpose of promoting meaningful benefits for low- and moderate-
wage workers, not only the high paid. On the other hand, some 
would argue that the greater flexibility provided to employers 
under present law is appropriate. Without the flexibility in 
testing, some employers may reduce plan benefits or choose to 
terminate plans, reducing aggregate pension coverage and 
potentially reducing aggregate retirement saving.

8. Simplify benefit limits for multiemployer plans under section 415

                              Present Law

     In general, under present law, annual benefits under a 
defined benefit pension plan are limited to the lesser of 
$130,000 (for 1998) or 100 percent of average compensation for 
the 3 highest years. Reductions in these limits are generally 
required if the employee has fewer than10 years of service or 
plan participation. If benefits under a defined benefit plan begin 
before social security retirement age, the dollar limit must be 
actuarially reduced to compensate for the early commencement.

                        Description of Proposal

    Under the proposal, the 100-percent-of-compensation limit 
on defined benefit plan benefits would not apply to 
multiemployer plans. In addition, certain survivor and 
disability benefits payable under multiemployer plans would be 
exempt from the adjustments for early commencement of benefits 
and for participation and service of less than 10 years.

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1998.

                              Prior Action

    The proposal was included in the Administration's 1995 
Pension Simplification Proposal,\29\ in the Small Business Job 
Protection Act of 1996 as passed by the Senate, and in the 
Taxpayer Relief Act of 1997 as passed by the Senate.
---------------------------------------------------------------------------
    \29\ See Department of the Treasury, Department of Labor, General 
Explanation of the Administration's Pension Simplification Proposal 
(September 1995).
---------------------------------------------------------------------------

                                Analysis

    The limits on benefits under qualified plans were designed 
to limit the tax benefits and revenue loss associated with such 
plans, while still ensuring that adequate retirement benefits 
could be provided. The 100-percent-of-compensation limitation 
reflects Congressional judgment that a replacement rate of 100-
percent-of-compensation is an adequate retirement benefit.
    The stated rationale for the proposal is that the qualified 
plan limitations present significant administrative problems 
for many multiemployer plans which base benefits on years of 
credited service not compensation. In addition, it is argued 
that the 100-percent of compensation rule produces an 
artificially low limit for employees in certain industries, 
such as building and construction, where wages vary 
significantly from year to year.
    Others argue that the limits on benefits under qualified 
plans create administrative problems for all plan sponsors, and 
that these problems are no greater for multiemployer plans than 
for any other plan. In addition, it is argued that there is no 
justification for higher benefit limitations for multiemployer 
plans, as persons affected by these limits are not all 
participants in multiemployer plans. Providing a special rule 
for such plans would merely create inequities among plan 
participants based upon the type of plan in which they are a 
participant. For example, many individuals work in industries 
where wages may vary significantly from year to year, but not 
all of those employees are participants in multiemployer plans. 
To the extent that the qualified plan limits are deemed to 
inappropriately reduce benefits in such (or similar cases), it 
is argued that it would be more equitable to provide an across 
the board rule that is not based upon the type of plan. If it 
is believed that a 100-percent of compensation limitation is 
not appropriate, it is not clear why only participants in 
multiemployer plans should receive the benefit of a higher 
limit.

9. Simplify full funding limit for multiemployer plans

                              Present Law

    Under present law, employer deductions for contributions to 
a defined benefit pension plan cannot exceed the full funding 
limit. In general, the full funding limit is the lesser of a 
plan's accrued liability and 150 percent of current liability. 
The 150 percent of current liability limit is scheduled to 
increase gradually, beginning in 1999, until it is 170 percent 
in 2005 and thereafter.
    Defined benefit pension plans are required to have an 
actuarial valuation no less frequently than annually.

                        Description of Proposal

    Under the proposal, the current liability full funding 
limit would not apply to multiemployer plans. In addition, such 
plans would be required to have an actuarial valuation at least 
once every three years. Changes would be made to the 
corresponding provisions of title I of the Employee Retirement 
Income Security Act of 1974, as amended.

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1998.

                              Prior Action

    The proposal was included in the Administration's 1995 
Pension Simplification Proposal.\30\
---------------------------------------------------------------------------
    \30\ Ibid.
---------------------------------------------------------------------------

                                Analysis

    The current liability full funding limit was enacted as a 
balance between differing policy objectives. On one hand is the 
concern that defined benefit pension plans should be funded so 
as to provide adequate benefit security for plan participants. 
On the other hand is the concern that employers should not be 
entitled to make excessive contributions to a defined benefit 
pension plan to fund liabilities that it has not yet incurred. 
Such use of a defined benefit plan was believed to be 
equivalent to a tax-free savings account for future 
liabilities, and inconsistent generally with the treatment of 
unaccrued liabilities under the Internal Revenue Code. The 
current liability full funding limit was increased in the 
Taxpayer Relief Act of 1997 because the Congress believed that 
the 150-percent limit unduly restricted funding of defined 
benefit pension plans.
    Proponents of the proposal argue that employers have no 
incentive to make excess contributions to a multiemployer plan, 
because the amount an employer contributes to the plan is set 
by a collective bargaining agreement and a particular 
employer's contributions are not set aside to pay benefits 
solely to the employees of that employer.
    Others would argue that it is inappropriate to provide 
special rules based on the type of plan. While many 
multiemployer plans restrict the ability of the employer to 
obtain reversions of excess plan assets on termination of the 
plan, not all do, so that an employer may still have an 
incentive to fund unincurred liabilities in order to obtain tax 
benefits. Also, many plans that are not multiemployer plans 
restrict the ability of employers to obtain excess assets, 
limiting any incentive to make excess contributions.
    Others argue that the proposal should be extended to all 
collectively bargained plans (i.e., including single-employer 
plans).

10. Eliminate partial termination rules for multiemployer plans

                              Present Law

    Under present law, tax-qualified plans are required to 
provide that plan benefits become 100 percent vested (to the 
extent funded) upon the termination or partial termination of a 
plan. Whether a partial termination has occurred in a 
particular situation is generally based on all the facts and 
circumstances. Situations that can result in a partial 
termination include, for example, the exclusion from the plan 
of a group of employees previously covered under the plan due 
to a plan amendment or termination of employment by the 
employer. In addition, if a defined benefit plan stops or 
reduces future benefit accruals under the plan, a partial 
termination of the plan is deemed to occur if, as a result of 
the cessation or reduction in accruals a potential reversion to 
the employer or employers maintaining the plan is created or 
increased. If no such reversion is created or increased, a 
partial termination is not deemed to occur; however, a partial 
termination may be found to have taken place under the 
generally applicable rule.

                        Description of Proposal

    The requirement that plan participants must be 100-percent 
vested upon partial termination of a plan would be repealed 
with respect to multiemployer plans.

                             Effective Date

    The proposal would be effective with respect to partial 
terminations that begin after December 31, 1998.

                              Prior Action

    The proposal was included in the Administration's 1995 
Pension Simplification Proposal and in the Taxpayer Relief Act 
of 1997 as passed by the Senate.\31\
---------------------------------------------------------------------------
    \31\ Ibid.
---------------------------------------------------------------------------

                                Analysis

    The partial termination rules help to protect the benefits 
of plan participants in circumstances that do not give rise to 
a complete termination. In some cases, the partial termination 
rules prevent avoidance of the rule requiring vesting upon 
complete termination.
    Proponents of the proposal argue that the partial 
termination rules are not necessary to protect multiemployer 
plan participants in the case of terminations due to reductions 
in force, because the multiemployer plan structure itself 
provides protections. That is, participation in the plan is not 
tied to employment with a particular employer, so that an 
individual who terminates employment with one employer may 
continue participation in the plan if the individual is 
employed by an employer participating in the plan.
    Others question whether the plan structure will protect 
participants in the same manner as the partial termination 
rules. There is no assurance that an individual will continue 
participation in the plan after an event that would give rise 
to a partial termination. In addition, others argue that the 
multiemployer plan structure provides no special protection if 
the partial termination is due to a plan amendment regarding 
eligibility or due to cessation or reduction of accruals under 
a defined benefit pension plan.

                      D. Education Tax Provisions

1. Tax credits for holders of qualified school modernization bonds and 
        qualified zone academy bonds

                              Present Law

Tax-exempt bonds

    Interest on State and local governmental bonds generally is 
excluded from gross income for Federal income tax purposes if 
the proceeds of the bonds are used to finance direct activities 
of these governmental units, including the financing of public 
schools (sec. 103).

Qualified zone academy bonds

    Certain financial institutions (i.e., banks, insurance 
companies, and corporations actively engaged in the business of 
lending money) that hold ``qualified zone academy bonds'' are 
entitled to a nonrefundable tax credit in an amount equal to a 
credit rate (set monthly by the Treasury Department) multiplied 
by the face amount of the bond (sec. 1397E). The credit rate 
applies to all such bonds issued in each month. A taxpayer 
holding a qualified zone academy bond on the credit allowance 
date (i.e., each one-year anniversary of the issuance of the 
bond) is entitled to a credit. The credit is includible in 
gross income (as if it were an interest payment on the bond), 
and may be claimed against regular income tax and AMT 
liability.
    The Treasury Department will set the credit rate each month 
at a rate estimated to allow issuance of qualified zone academy 
bonds without discount and without interest cost to the issuer. 
The maximum term of the bond issued in a given month also is 
determined by the Treasury Department, so that the present 
value of the obligation to repay the bond is 50 percent of the 
face value of the bond. Such present value will be determined 
using as a discount rate the average annual interest rate of 
tax-exempt obligations with a term of 10 years or more issued 
during the month.
    ``Qualified zone academy bonds'' are defined as any bond 
issued by a State or local government, provided that (1) at 
least 95 percent of the proceeds are used for the purpose of 
renovating, providing equipment to, developing course materials 
for use at, or training teachers and other school personnel in 
a ``qualified zone academy'' and (2) private entities have 
promised to contribute to the qualified zone academy certain 
equipment, technical assistance or training, employee services, 
or other property or services with a value equal to at least 10 
percent of the bond proceeds.
    A school is a ``qualified zone academy'' if (1) the school 
is a public school that provides education and training below 
the college level, (2) the school operates a special academic 
program in cooperation with businesses to enhance the academic 
curriculum and increase graduation and employment rates, and 
(3) either (a) the school is located in an empowerment zone or 
enterprise community (including empowerment zones designated or 
authorized to be designated\32\), or (b) it is reasonably 
expected that at least 35 percent of the students at the school 
will be eligible for free or reduced-cost lunches under the 
school lunch program established under the National School 
Lunch Act.
---------------------------------------------------------------------------
    \32\ Pursuant to the Omnibus Budget Reconciliation Act of 1993 
(OBRA 1993), the Secretaries of the Department of Housing and Urban 
Development (HUD) and the Department of Agriculture designated a total 
of nine empowerment zones and 95 enterprise communities on December 21, 
1994 (sec. 1391). Designated empowerment zones and enterprise 
communities were required to satisfy certain eligibility criteria, 
including specified poverty rates and population and geographic size 
limitations (sec. 1392). The Code provides special tax incentives for 
certain business activities conducted in empowerment zones and 
enterprise communities (secs. 1394, 1396, and 1397A). In addition, the 
Taxpayer Relief Act of 1997 provides for the designation of 22 
additional empowerment zones (secs. 1391(b)(2) and 1391(g)).
---------------------------------------------------------------------------
    A total of $400 million of ``qualified zone academy bonds'' 
may be issued in each of 1998 and 1999. The $400 million 
aggregate bond cap will be allocated each year to the States 
according to their respective populations of individuals below 
the poverty line.\33\ Each State, in turn, will allocate the 
credit to qualified zone academies within such State. A State 
may carry over any unused allocation into subsequent years.
---------------------------------------------------------------------------
    \33\ See Rev. Proc. 98-9, which sets forth the maximum face amount 
of qualified zone academy bonds that may be issued for each State 
during 1998; IRS Proposed Rules (REG-119449-97), which provides 
guidance to holders and issuers of qualified zone academy bonds.
---------------------------------------------------------------------------

                        Description of Proposal

Qualified zone academy bonds

    The proposal would increase the aggregate bond cap for 
qualified zone academy bonds for 1999 from $400 million to $1.4 
billion. In addition, the proposal would authorize the issuance 
of an additional $1.4 billion of qualified zone academy bonds 
for 2000. As under present law, the aggregate bond cap would be 
allocated to the States according to their respective 
populations of individuals below the poverty line, and States 
could carry over unused allocations into subsequent years.
    The proposal also would expand the list of permissible uses 
of proceeds of qualified zone academy bonds to include new 
school construction. Moreover, the proposal would set the 
maximum term of qualified zone academy bonds at 15 years.

Qualified school modernization bonds

    Under the proposal, State and local governments would be 
able to issue ``qualified school modernization bonds'' to fund 
the construction or rehabilitation of public schools. Similar 
to the tax benefits available to holders of qualified zone 
academy bonds, the holders of qualified school modernization 
bonds would receive annual Federal income tax credits in lieu 
of interest payments. Because the proposed credits would 
compensate the holder for lending money, such credits would be 
treated as payments of interest for Federal income tax purposes 
and, accordingly, would be included in the holder's gross 
income. As with qualified zone academy bonds, the ``credit 
rate'' for qualified school modernization bonds would be set by 
the Secretary of the Treasury so that, on average, such bonds 
would be issued without interest, discount, or premium. The 
maximum term of the bonds would be 15 years.
    In contrast to qualified zone academy bonds, any person 
(and not only financial institutions) holding a qualified 
school modernization bond would be able to claim a tax credit 
under the proposal. Information returns would be required to be 
provided to the holders of qualified school modernization bonds 
and to the IRS with respect to the tax credits related to such 
bonds.
    A total of $9.7 billion of qualified school modernization 
bonds could be issued in each of 1999 and 2000, to be allocated 
among the States. Half of this annual $9.7 billion cap would be 
allocated among the 100 school districts with the largest 
number of low-income children.34 The remaining half 
of the annual cap would be divided among the States and Puerto 
Rico in proportion to their shares of Federal assistance under 
the Basic Grant Formula (contained in Title I of the Elementary 
and Secondary Education Act of 1965), adjusted for amounts 
allocated to the 100 school districts with the largest number 
of low-income children.35 A State, possession, or 
eligible school district would be permitted to carry forward 
any unused portion of its allocation until September 30, 2003.
---------------------------------------------------------------------------
    \34\ The cap would be allocated among the 100 districts based on 
the amounts of Federal assistance each district receives under the 
Basic Grant Formula for Title I of the Elementary and Secondary 
Education Act of 1965. This assistance is based primarily upon the 
number of low- income children residing in the district, with an 
adjustment for differences in per-pupil expenditures.
    \35\ A small portion of the total cap would be set aside for each 
possession (other than Puerto Rico) based on its share of the total 
U.S. poverty population. The relative shares of assistance provided 
under the Basic Grant Formula would be determined by the Secretary of 
the Treasury based on the most recent data available from the 
Department of Education on November 1 of the year prior to the year for 
which the allocation of authority to issue qualified school 
modernization bonds is made.
---------------------------------------------------------------------------
    Under the proposal, a bond would be treated as a qualified 
school modernization bond only if the following three 
requirements are satisfied: (1) the Department of Education 
approves the construction plan of the State or eligible school 
district, which plan must (a) demonstrate that a comprehensive 
survey has been undertaken of the construction and renovation 
needs in the jurisdiction, and (b) describe how the 
jurisdiction will assure that bond proceeds are used as 
proposed; (2) the State or local governmental entity issuing 
the bond receives an allocation for the bond from the State 
educational agency or eligible school district; and (3) at 
least 95 percent of the bond proceeds must be used to construct 
or rehabilitate public school facilities.36 In 
contrast to qualified zone academy bonds, the proposed 
qualified school modernization bonds would not be subject to a 
requirement that private businesses contribute a specified 
amount of goods or services to the local school district.
---------------------------------------------------------------------------
    \36\ In determining whether this third requirement is satisfied, 
taxpayers may rely on principles used to determine satisfaction of 
similar requirements with respect to tax-exempt obligations.
---------------------------------------------------------------------------

                             Effective Date

    The provisions regarding qualified school modernization 
bonds would be effective for such bonds issued in 1999 and 2000 
(and such bonds issued prior to September 30, 2003, with 
respect to unused allocations carried forward from 1999 or 
2000). The provisions regarding qualified zone academy bonds 
would be effective for such bonds issued in 1999 and 2000 (and 
such bonds issued thereafter with respect to unused 
allocations).

                              Prior Action

    The credit for certain holders of qualified zone academy 
bonds (sec. 1397E) was enacted as part of the Taxpayer Relief 
Act of 1997.

                                Analysis

    The President's proposals to expand the allocation for (and 
permissible uses of) zone academy bonds and to establish school 
modernization bonds would subsidize a portion of the costs of 
new investment in public school infrastructure and, in certain 
qualified areas, equipment and teacher training. By subsidizing 
such costs, it is possible that additional investment will take 
place relative to investment that would take place in the 
absence of the subsidy. If no additional investment takes place 
than would otherwise, the subsidy would merely represent a 
transfer of funds from the Federal Government to State and 
local governments. This would enable the State and local 
governments to spend the savings on other government functions 
or to reduce taxes.37 In this event, the stated 
objective of the proposals would not be achieved. If the 
subsidy is successful at encouraging new investment, the 
quality of education could be improved.
---------------------------------------------------------------------------
    \37\ Most economic studies have found that when additional funding 
is made available to localities from outside sources, there is indeed 
an increase in public spending (this is known as the ``fly-paper'' 
effect, as the funding tends to ``stick'' where it is applied). The 
additional spending is not dollar for dollar, however, implying that 
there is some reduction of local taxes to offset the outside funding. 
See Harvey Rosen, Public Finance, Second Ed., 1988, p.530 for a 
discussion of this issue.
---------------------------------------------------------------------------
    To be eligible for the qualified zone academy bonds, State 
and local governments also must obtain private business 
contributions to the qualified zone academy in amounts equal to 
at least 10 percent of the bond proceeds. Such a requirement 
further lowers the costs to State and local governments of a 
successful zone academy bond issue, relative to the amount of 
funds that are made available for the qualified zone academy. 
However, the requirement also makes it more difficult to obtain 
the subsidy from the Federal Government, as private support 
needs to be obtained. The requirement may make it more likely 
that a successful bond issue will represent new, incremental 
investment in qualified zone academies. On the other hand, it 
is not certain that this would be the case, since private 
businesses already could donate to schools if they were so 
motivated. It is possible that the federal subsidy could be 
viewed as a ``matching grant'', motivating more private giving. 
However, it would remain possible that State and local 
governments could receive additional private contributions and 
obtain the Federal subsidy and yet not invest any more funds in 
public education than they would have otherwise. The proposed 
school modernization bonds do not carry the requirement that 
private financing also be found.
    Though called a tax credit, the Federal subsidy for the 
zone academy bonds and the proposed school modernization bonds 
is equivalent to the Federal Government directly paying the 
interest on a taxable bond issue on behalf of the State or 
local government that benefits from the bond 
proceeds.38 To see this, consider any taxable bond 
that bears an interest rate of 10 percent. A thousand dollar 
bond would thus produce an interest payment of $100 annually. 
The owner of the bond that receives this payment would receive 
a net payment of $100 less the taxes owed on that interest. If 
the taxpayer were in the 28-percent Federal tax bracket, such 
taxpayer would receive $72 after Federal taxes. Regardless of 
whether the State government or the Federal Government pays the 
interest, the taxpayer receives the same net of tax return of 
$72. In the case of zone academy bonds and the proposed school 
modernization bonds, no formal interest is paid by the Federal 
Government. Rather, a tax credit of $100 is allowed to be taken 
by the holder of the bond. In general, a $100 tax credit would 
be worth $100 to a taxpayer, provided that the taxpayer had at 
least $100 in tax liability. However, for the zone academy 
bonds and the proposed school modernization bonds, the $100 
credit also has to be claimed as income. Claiming an additional 
$100 in income, though no income is actually realized, costs a 
taxpayer in the 28-percent tax bracket an additional $28 in 
income taxes, payable to the Federal Government. With the $100 
tax credit that is ultimately claimed, the taxpayer nets $72 on 
the bond. The Federal Government loses $100 on the credit, but 
recoups $28 of that by the requirement that it be included in 
income, for a net cost of $72, which is exactly the net return 
to the taxpayer. If the Federal Government had simply agreed to 
pay the interest on behalf of the State or local government, 
both the Federal Government and the bondholder/taxpayer would 
be in the same situation as previously. The Federal Government 
would make outlays of $100 in interest payments, but would 
recoup $28 of that in tax receipts, for a net budgetary cost of 
$72, as before. Similarly, the bondholder/taxpayer would 
receive a taxable $100 in interest, and would owe $28 in taxes, 
for a net gain of $72, as before. The State and local 
government would also be in the same situation in both cases.
---------------------------------------------------------------------------
    \38\ This is true provided that the taxpayer faces tax liability of 
at least the amount of the credit. Without sufficient tax liability, 
the proposed tax credit arrangement would not be as advantageous. 
Presumably, only taxpayers who anticipate having sufficient tax 
liability to be offset by the proposed credit would hold these bonds.
---------------------------------------------------------------------------
    The proposed tax credit arrangement to subsidize public 
school investment, as opposed to the equivalent direct interest 
payment by the Federal Government on behalf of the State or 
locality, raises some questions of administrative efficiencies 
and tax complexity. Because potential purchasers of the bonds 
must educate themselves as to whether the bonds qualify for the 
credit, certain ``information costs'' are imposed on the buyer. 
Additionally, since the determination as to whether the bond is 
qualified for the credit ultimately rests with the Federal 
Government, additional risk is imposed on the investor relative 
to a Federal agreement to directly make the interest payments 
to the bondholders on behalf of the State or locality that 
issues the bond. For these reasons, and the fact that the bonds 
will be less liquid than comparable Federal 
obligations,39 the Treasury Department has decided 
that the zone academy bonds under the proposal will pay a 
credit rate that is 110 percent of the long-term applicable 
Federal rate (AFR).40 Since the Federal Government 
must ultimately determine the eligibility of the bonds for the 
credit, it would appear that an otherwise equivalent direct 
spending program where the Federal Government promises upfront 
to pay the interest would remove some information costs to the 
bondholder as well as the risk of buying a bond that could 
ultimately be deemed to not qualify for the credit. The bonds 
would then presumably bear a lower interest rate, which would 
reduce the effective costs of the program to the Federal 
Government. Additionally, the direct payment of interest would 
involve less complexity in administering the income tax, as the 
interest could simply be reported as any other taxable 
interest. Finally, the tax credit implies that non-taxable 
entities could not take advantage of the bonds to assist school 
investment. In the case of a direct payment of interest, non-
profits would be able to take advantage of the bonds.
---------------------------------------------------------------------------
    \39\ There is also more risk that the principal will not be repaid, 
since investors consider the credit risk of States and localities to be 
greater than that of the Federal Government.
    \40\ The proposed school modernization bonds credit rate would be 
set by the Secretary of the Treasury so that, on average, the bonds 
could be issued without interest, discount, or premium. That rate has 
not yet been established.
---------------------------------------------------------------------------

2. Exclusion for employer-provided educational assistance

                              Present Law

    Under present law (Code sec. 127), an employee's gross 
income and wages do not include amounts paid or incurred by the 
employer for educational assistance provided to the employee if 
such amounts are paid or incurred pursuant to an educational 
assistance program that meets certain requirements. This 
exclusion is limited to $5,250 of educational assistance with 
respect to an individual during a calendar year. In the absence 
of the exclusion, educational assistance is excludable from 
income only if it is related to the employee's current job. The 
exclusion applies with respect to undergraduate courses 
beginning before June 1, 2000. The exclusion does not apply to 
graduate level courses beginning after June 30, 1996.

                        Description of Proposal

    The proposal would expand the exclusion for employer-paid 
educational assistance to graduate education, and extend the 
exclusion (as applied to both graduate and undergraduate 
education) through May 2001.

                             Effective Date

    The proposal to extend the exclusion for undergraduate 
courses would be effective for courses beginning before June 1, 
2001. The exclusion with respect to graduate-level courses 
would be effective for courses beginning after June 30, 1998 
and before June 1, 2001.

                              Prior Action

    A similar proposal to extend the exclusion to graduate-
level courses was included in the President's fiscal year 1997 
budget proposal and in the 1997 Senate bill.

                                Analysis

    The exclusion for employer-provided educational assistance 
programs is aimed at increasing the levels of education and 
training in the workforce. The exclusion also reduces 
complexity in the tax laws. Employer-provided educational 
assistance benefits may serve as a substitute for cash wages 
(or other types of fringe benefits) in the overall employment 
compensation package. Because of their favorable tax treatment, 
benefits received in this form are less costly than cash wages 
in terms of the after-tax cost of compensation to the employee.
    Present-law section 127 serves to subsidize the provision 
of education and could lead to larger expenditures on education 
for workers than would otherwise occur. This extra incentive 
for education may be desirable if some of the benefits of an 
individual's education accrue to society at large through the 
creation of a better-educated populace or workforce, i.e., 
assuming that education creates ``positive externalities.'' In 
that case, absent the subsidy, individuals would underinvest in 
education (relative to the socially desirable level) because 
they would not take into account the benefits that others 
indirectly receive. To the extent that expenditures on 
education represent purely personal consumption, a subsidy 
would lead to overconsumption of education.41
---------------------------------------------------------------------------
    \41\ For a broader discussion of social and private benefits from 
education and an analysis of subsidies to education, see Joint 
Committee on Taxation, Analysis of Proposed Tax Incentives for Higher 
Education (JCS-3-97), March 4, 1997, pp.19-23.
---------------------------------------------------------------------------
    Because present-law section 127 provides an exclusion from 
gross income for certain employer-provided education benefits, 
the value of this exclusion in terms of tax savings is greater 
for those taxpayers with higher marginal tax rates. Thus, 
higher-paid individuals, individuals with working spouses, or 
individuals with other sources of income may be able to receive 
larger tax benefits than their fellow workers. Section 127 does 
not apply, however, to programs under which educational 
benefits are provided only to highly compensated employees.
    In general, in the absence of section 127, the value of 
employer-provided education is excludable from income only if 
the education relates directly to the taxpayer's current job. 
If the education would qualify the taxpayer for a new trade or 
business, however, then the value of the education generally 
would be treated as part of the employee's taxable 
compensation. Under this rule, higher-income, higher-skilled 
individuals may be more able to justify education as related to 
their current job because of the breadth of their current 
training and responsibilities. For example, a lawyer or 
professor may find more courses of study directly related to 
his or her current job and not qualifying him or her for a new 
trade than would a clerk.
    The section 127 exclusion for employer-provided educational 
assistance may counteract this effect by making the exclusion 
widely available. Proponents argue that the exclusion is 
primarily useful to non-highly compensated employees to improve 
their competitive position in the work force. In practice, 
however, the scant evidence available seems to indicate that 
those individuals receiving employer-provided educational 
assistance are somewhat more likely to be higher-paid 
workers.42 The amount of the education benefits 
provided by an employer also appears to be positively 
correlated with the income of the recipient worker. Such 
evidence is consistent with the observation that, in practice, 
the exclusion is more valuable to those individuals in higher 
marginal tax brackets. A reformulation of the incentive as an 
inclusion of the value of benefits into income in conjunction 
with a tax credit could make the value of the benefit more even 
across recipients subject to different marginal tax 
brackets.43
---------------------------------------------------------------------------
    \42\ See, for example, Coopers & Lybrand, ``Section 127 Employee 
Educational Assistance: Who Benefits? At What Cost?,'' June 1989, p. 
15, and Steven R. Aleman, ``Employer Education Assistance: A Profile of 
Recipients, Their Educational Pursuits, and Employers,'' CRS Report, 
89-33 EPW, January 10, 1989, p. 9.
    \43\ If the credit were nonrefundable, then to the extent that a 
taxpayer reduces his or her tax liability to zero, he or she may not be 
able to receive the full value of the credit.
---------------------------------------------------------------------------
    Reinstating the exclusion for graduate-level employer-
provided educational assistance may enable more individuals to 
seek higher education. Some argue that greater levels of higher 
education are important to having a highly trained and 
competitive workforce, while others argue that the tax benefits 
from extending the exclusion to graduate-level education will 
accrue mainly to higher-paid workers. Others would argue that 
it would be desirable to extend the exclusion to graduate-level 
education, but that limiting the exclusion in this manner is 
appropriate given budgetary constraints.
    In addition to furthering education objectives, the 
exclusion for employer-provided educational assistance may 
reduce tax-law complexity. In the absence of the exclusion, 
employers and employees must make a determination of whether 
the exclusion is job-related. This determination is highly 
factual in nature, and can lead to disputes between taxpayers 
and the IRS, who may come to different conclusions based on the 
same facts. The exclusion eliminates the need to make this 
determination.
    The exclusion for employer-provided education has always 
been enacted on a temporary basis. It has been extended 
frequently, and often retroactively. The past experience of 
allowing the exclusion to expire and subsequently retroactively 
extending it has created burdens for employers and employees. 
Employees may have difficulty planning for their educational 
goals if they do not know whether their tax bills will 
increase. Employers have administrative problems determining 
the appropriate way to report and withhold on educational 
benefits each time the exclusion expires before it is extended. 
Providing greater certainty by further extending the exclusion 
may reduce administrative burdens and complexity, as well as 
enable individuals to better plan for their educational costs.

3. Eliminate tax on forgiveness of direct student loans subject to 
        income contingent repayment

                              Present Law

Code section 108(f)

    In the case of an individual, gross income subject to 
Federal income tax does not include any amount from the 
forgiveness (in whole or in part) of certain student loans, 
provided that the forgiveness is contingent on the student's 
working for a certain period of time in certain professions for 
any of a broad class of employers (sec. 108(f)).
    Student loans eligible for this special rule must be made 
to an individual to assist the individual in attending an 
educational institution that normally maintains a regular 
faculty and curriculum and normally has a regularly enrolled 
body of students in attendance at the place where its education 
activities are regularly carried on. Loan proceeds may be used 
not only for tuition and required fees, but also to cover room 
and board expenses (in contrast to tax free scholarships under 
section 117, which are limited to tuition and required fees).
    The loan must be made by (1) the United States (or an 
instrumentality or agency thereof), (2) a State (or any 
political subdivision thereof), (3) certain tax-exempt public 
benefit corporations that control a State, county, or municipal 
hospital and whose employees have been deemed to be public 
employees under State law, or (4) an educational organization 
that originally received the funds from which the loan was made 
from the United States, a State, or a tax-exempt public benefit 
corporation. In addition, an individual's gross income does not 
include amounts from the forgiveness of loans made by 
educational organizations (and certain tax- exempt 
organizations in the case of refinancing loans) out of private, 
nongovernmental funds if the proceeds of such loans are used to 
pay costs of attendance at an educational institution or to 
refinance outstanding student loans 44 and the 
student is not employed by the lender organization. In the case 
of loans made or refinanced by educational organizations (as 
well as refinancing loans made by certain tax-exempt 
organizations) out of private funds, the student's work must 
fulfill a public service requirement.45 The student 
must work in an occupation or area with unmet needs and such 
work must be performed for or under the direction of a tax-
exempt charitable organization or a governmental entity.
---------------------------------------------------------------------------
    \44\ A technical correction is required to clarify that gross 
income does not include amounts from the forgiveness of loans made by 
educational organizations and certain tax-exempt organizations to 
refinance any existing student loan (and not just loans made by 
educational organizations). A provision to this effect is included in 
Title VI (sec. 604(e)) of H.R. 2676, the Tax Technical Corrections Act 
of 1997, as passed by the House on November 5, 1997.
    \45\ A technical correction is required to clarify that refinancing 
loans made by educational organizations and certain tax-exempt 
organizations must be made pursuant to a program of the refinancing 
organization (e.g., school or private foundation) that requires the 
student to fulfill a public service work requirement. A provision to 
this effect is included in Title VI (sec. 604(e)) of H.R. 2676, the Tax 
Technical Corrections Act of 1997, as passed by the House on November 
5, 1997.
---------------------------------------------------------------------------

Federal Direct Loan Program; income-contingent repayment option

    A major change in the delivery of Federal student loans 
occurred in 1993. The Student Loan Reform Act (SLRA), part of 
the Omnibus Budget Reconciliation Act of 1993, converted the 
Federal Family Education Loans (FFEL), which were made by 
private lenders and guaranteed by the Federal Government, into 
direct loans made by the Federal Government to students through 
their schools (the William D. Ford Direct Loan 
Program).46 The Direct Loan Program began in 
academic year 1994-95 and was to be phased in, with at least 60 
percent of all student loan volume to be direct loans by the 
1998-1999 academic year.
---------------------------------------------------------------------------
    \46\ For a comprehensive description of the Federal Direct Loan 
program, see U.S. Library of Congress, Congressional Research Service, 
``The Federal Direct Student Loan Program,'' CRS Report for Congress 
No. 95-110 EPW, by Margot A. Schenet (Washington, D.C.) updated October 
16, 1996.
---------------------------------------------------------------------------
    Federal Direct Loans include Federal Direct Stafford/Ford 
Loans (subsidized and unsubsidized), Federal Direct PLUS loans, 
and Federal Direct Consolidation loans. The SLRA requires that 
the Secretary of Education offer four alternative repayment 
options for direct loan borrowers: standard, graduated, 
extended, and income-contingent. However, the income-contingent 
option is not available to Direct PLUS borrowers. If the 
borrower does not choose arepayment plan, the Secretary may 
choose one, but may not choose the income-contingent repayment 
option.47 Borrowers are allowed to change repayment plans at 
any time.
---------------------------------------------------------------------------
    \47\ Defaulted borrowers of direct or guaranteed loans may also be 
required to repay through an income-contingent plan for a minimum 
period.
---------------------------------------------------------------------------
    Under the income-contingent repayment option, a borrower 
must make annual payments for a period of up to 25 years based 
on the amount of the borrower's Direct Loan (or Direct 
Consolidated Loan), adjusted gross income (AGI) during the 
repayment period, and family size.48 Generally, a 
borrower's monthly loan payment is capped at 20 percent of 
discretionary income (AGI minus the poverty level adjusted for 
family size).49 If the loan is not repaid in full at 
the end of a 25-year period, the remaining debt is canceled by 
the Secretary of Education. There is no community or public 
service requirement.
---------------------------------------------------------------------------
    \48\ The Department of Education revised the regulations governing 
the income-contingent repayment option, effective July 1, 1996. See 
Federal Register, December 1, 1995, pp. 61819-61828.
    \49\ If the monthly amount paid by a borrower does not equal the 
accrued interest on the loan, the unpaid interest is added to the 
principal amount. This is called ``negative amortization.'' Under the 
income-contingent repayment plan, the principal amount cannot increase 
to more than 110 percent of the original loan; additional unpaid 
interest continues to accrue, but is not capitalized.
---------------------------------------------------------------------------

                        Description of Proposal

    The exclusion would be expanded to cover forgiveness of 
direct student loans made through the William D. Ford Federal 
Direct Loan Program where loan repayment and forgiveness are 
contingent on the borrower's income level.

                             Effective Date

    The proposal would be effective for loan cancellations 
after December 31, 1998.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal, as well as in the House and Senate 
versions of the Taxpayer Relief Act of 1997. The proposal was, 
however, dropped in conference.

                                Analysis

    There are three types of expenditures incurred by students 
in connection with their education: (1) direct payment of 
tuition; (2) payment via implicit transfers received from 
governments or private persons; and (3) forgone wages. The 
present-law income tax generally treats direct payments of 
tuition as consumption, neither deductible nor amortizable. By 
not including the implicit transfers from governments or 
private persons in the income of the student, present law 
offers the equivalent of expensing of those expenditures 
undertaken on behalf of the student by governments and private 
persons. This treatment that is the equivalent of expensing 
also is provided for direct transfers to students in the form 
of qualified scholarships excludable from income. Similarly, 
because forgone wages are never earned, the implicit 
expenditure incurred by students forgoing present earnings also 
receives expensing under the present-law income 
tax.50
---------------------------------------------------------------------------
    \50\ For a more complete discussion of education expenses under a 
theoretical income tax and the present-law income tax prior to changes 
made in the 1997 Act, see Joint Committee on Taxation, Analysis of 
Proposed Tax Incentives for Higher Education (JCS-3-97), March 4, 1997, 
pp.19-23.
---------------------------------------------------------------------------
    The Federal Government could help a student finance his or 
her tuition and fees by making a loan to the student or 
granting a scholarship to the student. In neither case are the 
funds received by the student includable in taxable income. 
Economically, a subsequent forgiveness of the loan converts the 
original loan into a scholarship. Thus, as noted above, 
exempting a scholarship or forgiving a loan is equivalent to 
permitting a deduction for tuition paid.
    While section 117 generally excludes scholarships from 
income to the extent it is used for qualified tuition and 
related expenses regardless of the recipient's income level, 
certain other education tax benefits are subject to expenditure 
and income limitations. For example, The HOPE credit limits 
expenditures that qualify for tax benefit to $2,000 annually 
(indexed for inflation after the year 2000) and the Lifetime 
Learning credit limits expenditures that qualify for tax 
benefit to $5,000 annually ($10,000 beginning in 
2003).51 In addition, the HOPE and Lifetime Learning 
credits are limited to taxpayers with modified adjusted gross 
incomes of $50,000 ($100,000 for joint filers) or less. No 
comparable expenditure or income limitations would apply to 
individuals who benefit from loan forgiveness under the 
proposal. For example, the expenditure limitation contained in 
section 117 would not apply; thus, the provision could permit 
students to exclude from income amounts in excess of qualified 
tuition and related expenses that would have been excludable 
under section 117 had the loan constituted a scholarship when 
initially made. However, it could be argued that expenditure 
limits are not necessary because the Federal Direct Loan 
program includes restrictions on the annual amount that a 
student may borrow, and that income limitations are unnecessary 
because an individual who has not repaid an income contingent 
loan in full after 25 years generally would be a lower-income 
individual throughout most of that 25-year period.
---------------------------------------------------------------------------
    \51\ For a more complete description of the HOPE and Lifetime 
Learning credits, see Joint Committee on Taxation, General Explanation 
of Tax Legislation Enacted in 1997 (JCS-23-97), December 17, 1997, pp. 
11-20.
---------------------------------------------------------------------------
    In addition, expanding section 108(f) to cover forgiveness 
of Federal Direct Loans for which the income-contingent 
repayment option is elected does not appear to be consistent 
with the conceptual framework of 108(f). There is no explicit 
or implicit public service requirement for cancellation of a 
Federal Direct Loan under the income-contingent repayment 
option. Rather, the only preconditions are a low AGI and the 
passage of 25 years.
    As of May 1, 1996, 15 percent of the Direct Loan borrowers 
in repayment had selected the income-contingent 
option.52 Among those who choose the income-
contingent repayment option, the Department of Education has 
estimated that slightly less than 12 percent of borrowers will 
fail to repay their loans in full within 25 years and, thus, 
will have the unpaid amount of their loans discharged at the 
end of the 25-year period.53 In this regard, it is 
important to note that the primary revenue effects associated 
with this provision would not commence until 2019-25 years 
after the program originated in 1994.
---------------------------------------------------------------------------
    \52\ The Federal Direct Student Loan Program, p.12. The Department 
of Education estimates that approximately 60 percent of borrowers will 
be in a repayment plan other than the standard 10-year repayment plan.
    \53\ See Federal Register, September 20, 1995, p. 48849.
---------------------------------------------------------------------------

               E. Extend Certain Expiring Tax Provisions

1. Extend the work opportunity tax credit

                              Present Law

    The work opportunity tax credit (``WOTC'') is available on 
an elective basis for employers hiring individuals from one or 
more of eight targeted groups. The credit generally is equal to 
a percentage of qualified wages. The credit percentage is 25 
percent for employment of at least 120 hours but less than 400 
hours and 40 percent for employment of 400 hours or more. 
Qualified wages consist of wages attributable to service 
rendered by a member of a targeted group during the one-year 
period beginning with the day the individual begins work for 
the employer. For a vocational rehabilitation referral, 
however, the period begins on the day the individual begins 
work for the employer on or after the beginning of the 
individual's vocational rehabilitation plan as under prior law.
    Generally, no more than $6,000 of wages during the first 
year of employment is permitted to be taken into account with 
respect to any individual. Thus, the maximum credit per 
individual is $2,400. With respect to qualified summer youth 
employees, the maximum credit is 40 percent of up to $3,000 of 
qualified first-year wages, for a maximum credit of $1,200. The 
credit expires for wages paid to, or incurred with respect to, 
qualified individuals who begin work for the employer after 
June 30, 1998.
    The deduction for wages is reduced by the amount of the 
credit.

                        Description of Proposal

    The proposal would extend the WOTC for 22 months (through 
April 30, 2000).

                             Effective Date

    The proposal would be effective for wages paid to, or 
incurred with respect to, qualified individuals who begin work 
for the employer after June 30, 1998 and before May 1, 2000.

                              Prior Action

    The Taxpayer Relief Act of 1997 provided for several 
modifications to the WOTC and extended the credit for wages 
paid to, or incurred with respect to, qualified individuals who 
begin work for the employer before July 1, 1998.

                                Analysis

Overview

    The WOTC is intended to increase the employment and 
earnings of targeted group members. The credit is made 
available to employers as an incentive to hire members of the 
targeted groups. To the extent the value of the credit is 
passed on from employers to employees, the wages of target 
group employees will be higher than they would be in the 
absence of the credit.54
---------------------------------------------------------------------------
    \54\ For individuals with productivity to employers lower than the 
minimum wage, the credit may result in these individuals being hired 
and paid the minimum wage. For these cases, it would be clear that the 
credit resulted in the worker receiving a higher wage than would have 
been received in the absence of the credit (e.g., zero).
---------------------------------------------------------------------------
    The basic rationale for the WOTC is that employers will not 
hire certain individuals without a subsidy because either the 
individuals are stigmatized (e.g., convicted felons) or the 
current productivity of the individuals is below the prevailing 
wage rate. Where particular groups of individuals suffer 
reduced evaluations of work potential due to membership in one 
of the targeted groups, the credit may provide employers with a 
monetary offset for the lower perceived work potential. In 
these cases, employers may be encouraged to hire individuals 
from the targeted groups, and then make an evaluation of the 
individual's work potential in the context of the work 
environment, rather than from the job application. Where the 
current productivity of individuals is currently below the 
prevailing wage rate, on-the-job-training may provide 
individuals with skills that will enhance their productivity. 
In these situations, the WOTC provides employers with a 
monetary incentive to bear the costs of training members of 
targeted groups and providing them with job-related skills 
which may increase the chances of these individuals being hired 
in unsubsidized jobs. Both situations encourage employment of 
members of the targeted groups, and may act to increase wages 
for those hired as a result of the credit.
    As discussed below, the evidence is mixed on whether the 
rationales for the credit are supported by economic data. The 
information presented is intended to provide a structured way 
to determine if employers and employees respond to the 
existence of the credit in the desired manner.

Efficiency of the credit

    The credit provides employers with a subsidy for hiring 
members of targeted groups. For example, assume that a worker 
eligible for the credit is paid an hourly wage of w and works 
2,000 hours during the year. The worker is eligible for the 
full credit (40 percent of the first $6,000 of wages), and the 
firm will receive a $2,400 credit against its income taxes and 
reduce its deduction for wages by $2,400. Assuming the firm 
faces the full 34-percent corporate income tax rate, the cost 
of hiring the credit-eligible worker is lower than the cost of 
hiring a credit-ineligible worker for 2,000 hours at the same 
hourly wage w by 2,400(1-.34) = $1,584.55 This 
$1,584 amount would be constant for all workers unless the wage 
(w) changed in response to whether or not the individual was a 
member of a targeted group. If the wage rate does not change in 
response to credit eligibility, the WOTC subsidy is larger in 
percentage terms for lower wage workers. If w rises in response 
to the credit, it is uncertain how much of the subsidy remains 
with the employer, and therefore the size of the WOTC subsidy 
to employers is uncertain.
---------------------------------------------------------------------------
    \55\ The after-tax cost of hiring this credit eligible worker would 
be ((2,000)(w)-2,400)(1-.34) dollars. This example does not include the 
costs to the employer for payroll taxes (e.g., Social security, 
Medicare and unemployment taxes) and any applicable fringe benefits.
---------------------------------------------------------------------------
    To the extent the WOTC subsidy flows through to the workers 
eligible for the credit in the form of higher wages, the 
incentive for eligible individuals to enter the paid labor 
market may increase. Since many members of the targeted groups 
receive governmental assistance (e.g., Temporary Assistance for 
Needy Families or food stamps), and these benefits are phased 
out as income increases, these individuals potentially face a 
very high marginal tax rate on additional earnings. Increased 
wages resulting from the WOTC may be viewed as a partial offset 
to these high marginal tax rates. In addition, it may be the 
case that even if the credit has little effect on observed 
wages, credit-eligible individuals may have increased earnings 
due to increased employment.
    The structure of the WOTC (the 40-percent credit rate for 
the first $6,000 of qualified wages) appears to lend itself to 
the potential of employers churning employees who are eligible 
for the credit. This could be accomplished by firing employees 
after they earn $6,000 in wages and replacing them with other 
WOTC-eligible employees. If training costs are high relative to 
the size of the credit, it may not be in the interest of an 
employer to churn such employees in order to maximize the 
amount of credit claimed. Empirical research in this area has 
not found an explicit connection between employee turnover and 
utilization of WOTC's predecessor, the Targeted Jobs Tax Credit 
(``TJTC'').56
---------------------------------------------------------------------------
    \56\ See, for example, Macro Systems, Inc., Final Report of the 
Effect of the Targeted Jobs Tax Credit Program on Employers, U.S. 
Department of Labor, 1986.
---------------------------------------------------------------------------

Job creation

    The number of jobs created by the WOTC is certainly less 
than the number of certifications. To the extent employers 
substitute WOTC-eligible individuals for other potential 
workers, there is no net increase in jobs created. This could 
be viewed as merely a shift in employment opportunities from 
one group to another. However, this substitution of credit-
eligible workers for others may not be socially undesirable. 
For example, it might be considered an acceptable trade-off for 
a targeted group member to displace a secondary earner from a 
well-to-do family (e.g., a spouse or student working part-
time).
    In addition, windfall gains to employers or employees may 
accrue when the WOTC is received for workers that the firm 
would have hired even in the absence of the credit. When 
windfall gains are received, no additional employment has been 
generated by the credit.Empirical research on the employment 
gains from the TJTC has indicated that only a small portion of the 
TJTC-eligible population found employment because of the program. One 
study indicates that net new job creation was between 5 and 30 percent 
of the total certifications. This finding is consistent with some 
additional employment as a result of the TJTC program, but with 
considerable uncertainty as to the exact magnitude.57
---------------------------------------------------------------------------
    \57\ Macro Systems, Inc., Impact Study of the Implementation and 
Use of the Targeted Jobs Tax Credit: Overview and Summary, U.S. 
Department of Labor, 1986.
---------------------------------------------------------------------------
    A necessary condition for the credit to be an effective 
employment incentive is that firms incorporate WOTC eligibility 
into their hiring decisions. This could be done by determining 
credit eligibility for each potential employee or by making a 
concerted effort to hire individuals from segments of the 
population likely to include members of targeted groups. 
Studies examining this issue through the TJTC found that some 
employers made such efforts, while other employers did little 
to determine eligibility for the TJTC prior to the decision to 
hire an individual.58 In these latter cases, the 
TJTC provided a cash benefit to the firm, without affecting the 
decision to hire a particular worker.
---------------------------------------------------------------------------
    \58\ For example, see U.S. General Accounting Office, Targeted Jobs 
Tax Credit: Employer Actions to Recruit, Hire, and Retain Eligible 
Workers Vary (GAO-HRD 91-33), February 1991.
---------------------------------------------------------------------------

2. Extend the welfare-to-work tax credit

                              Present Law

    The Code provides to employers a tax credit on the first 
$20,000 of eligible wages paid to qualified long-term family 
assistance (AFDC or its successor program) recipients during 
the first two years of employment. The credit is 35 percent of 
the first $10,000 of eligible wages in the first year of 
employment and 50 percent of the first $10,000 of eligible 
wages in the second year of employment. The maximum credit is 
$8,500 per qualified employee.
    Qualified long-term family assistance recipients are: (1) 
members of a family that has received family assistance for at 
least 18 consecutive months ending on the hiring date; (2) 
members of a family that has received family assistance for a 
total of at least 18 months (whether or not consecutive) after 
the date of enactment of this credit if they are hired within 2 
years after the date that the 18-month total is reached; and 
(3) members of a family who are no longer eligible for family 
assistance because of either Federal or State time limits, if 
they are hired within 2 years after the Federal or State time 
limits made the family ineligible for family assistance.
    Eligible wages include cash wages paid to an employee plus 
amounts paid by the employer for the following: (1) educational 
assistance excludable under a section 127 program (or that 
would be excludable but for the expiration of sec. 127); (2) 
health plan coverage for the employee, but not more than the 
applicable premium defined under section 4980B(f)(4); and (3) 
dependent care assistance excludable under section 129.
    The welfare-to-work tax credit is effective for wages paid 
or incurred to a qualified individual who begins work for an 
employer on or after January 1, 1998 and before May 1, 1999.

                        Description of Proposal

    The welfare-to-work tax credit would be extended for one 
year, so that the credit would be available for eligible 
individuals who begin work before May 1, 2000.

                             Effective Date

    The proposal would be effective for wages paid to or 
incurred with respect to, qualified individuals who begin work 
for an employer after April 30, 1998 and before May 1, 2000.

                              Prior Action

    The welfare-to-work tax credit was proposed in the 
President's fiscal year 1998 budget proposal and enacted in the 
Taxpayer Relief Act of 1997.

                                Analysis

    Proponents argue that an extension of the welfare-to-work 
tax credit will encourage employers to hire, invest in 
training, and provide certain benefits and more permanent 
employment, to longer term welfare recipients. Opponents argue 
that tax credits to employers for hiring certain classes of 
individuals do not increase overall employment and may 
disadvantage other deserving job applicants. There are also 
concerns about the efficiency of tax credits as an incentive to 
potential employees to enter the job market as well as an 
incentive for employers to retain such employees after they no 
longer qualify for the tax credit (e.g., replacing an employee 
whose wages no longer qualify for the tax credit with another 
employee whose wages do qualify). For a more detailed 
discussion of these issues, refer to the analysis section of 
the extension of the work opportunity tax credit in Part I. 
E.1., above, of this pamphlet.

3. Extend the research tax credit

                              Present Law

General rule

    Section 41 provides for a research tax credit equal to 20 
percent of the amount by which a taxpayer's qualified research 
expenditures for a taxable year exceeded its base amount for 
that year. The research tax credit is scheduled to expire and 
generally will not apply to amounts paid or incurred after June 
30, 1998.59
---------------------------------------------------------------------------
    \59\ A special termination rule applies under section 41(h)(1) for 
taxpayers that elected to be subject to the alternative incremental 
research credit regime for their first taxable year beginning after 
June 30, 1996, and before July 1, 1997.
---------------------------------------------------------------------------
    A 20-percent research tax credit also applied to the excess 
of (1) 100 percent of corporate cash expenditures (including 
grants or contributions) paid for basic research conducted by 
universities (and certain nonprofit scientific research 
organizations) over (2) the sum of (a) the greater of two 
minimum basic research floors plus (b) an amount reflecting any 
decrease in nonresearch giving to universities by the 
corporation as compared to such giving during a fixed-base 
period, as adjusted for inflation. This separate credit 
computation is commonly referred to as the ``university basic 
research credit'' (see sec. 41(e)).

Computation of allowable credit

    Except for certain university basic research payments made 
by corporations, the research tax credit applies only to the 
extent that the taxpayer's qualified research expenditures for 
the current taxable year exceed its base amount. The base 
amount for the current year generally is computed by 
multiplying the taxpayer's ``fixed-base percentage'' by the 
average amount of the taxpayer's gross receipts for the four 
preceding years. If a taxpayer both incurred qualified research 
expenditures and had gross receipts during each of at least 
three years from 1984 through 1988, then its ``fixed-base 
percentage'' is the ratio that its total qualified research 
expenditures for the 1984-1988 period bears to its total gross 
receipts for that period (subject to a maximum ratio of .16). 
All other taxpayers (so-called ``start-up firms'') are assigned 
a fixed-base percentage of 3 percent.60
---------------------------------------------------------------------------
    \60\ The Small Business Job Protection Act of 1996 expanded the 
definition of ``start-up firms'' under section 41(c)(3)(B)(I) to 
include any firm if the first taxable year in which such firm had both 
gross receipts and qualified research expenses began after 1983.
    A special rule (enacted in 1993) is designed to gradually recompute 
a start-up firm's fixed-base percentage based on its actual research 
experience. Under this special rule, a start-up firm will be assigned a 
fixed-base percentage of 3 percent for each of its first five taxable 
years after 1993 in which it incurs qualified research expenditures. In 
the event that the research credit is extended beyond the scheduled 
expiration date, a start-up firm's fixed-base percentage for its sixth 
through tenth taxable years after 1993 in which it incurs qualified 
research expenditures will be a phased-in ratio based on its actual 
research experience. For all subsequent taxable years, the taxpayer's 
fixed-base percentage will be its actual ratio of qualified research 
expenditures to gross receipts for any five years selected by the 
taxpayer from its fifth through tenth taxable years after 1993 (sec. 
41(c)(3)(B)).
---------------------------------------------------------------------------
    In computing the credit, a taxpayer's base amount may not 
be less than 50 percent of its current-year qualified research 
expenditures.
    To prevent artificial increases in research expenditures by 
shifting expenditures among commonly controlled or otherwise 
related entities, a special aggregation rule provides that all 
members of the same controlled group of corporations are 
treated as a single taxpayer (sec. 41(f)(1)). Special rules 
apply for computing the credit when a major portion of a 
business changes hands, under which qualified research 
expenditures and gross receipts for periods prior to the change 
of ownership of a trade or business are treated as transferred 
with the trade or business that gave rise to those expenditures 
and receipts for purposes of recomputing a taxpayer's fixed-
base percentage (sec. 41(f)(3)).

Alternative incremental research credit regime

    Taxpayers are allowed to elect an alternative incremental 
research credit regime. If a taxpayer elects to be subject to 
this alternative regime, the taxpayer is assigned a three-
tiered fixed-base percentage (that is lower than the fixed-base 
percentage otherwise applicable under present law) and the 
credit rate likewise is reduced. Under the alternative credit 
regime, a credit rate of 1.65 percent applies to the extent 
that a taxpayer's current-year research expenses exceed a base 
amount computed by using a fixed-base percentage of 1 percent 
(i.e., the base amount equals 1 percent of the taxpayer's 
average gross receipts for the four preceding years) but do not 
exceed a base amount computed by using a fixed-base percentage 
of 1.5 percent. A credit rate of 2.2 percent applies to the 
extent that a taxpayer's current-year research expenses exceed 
a base amount computed by using a fixed-base percentage of 1.5 
percent but do not exceed a base amount computed by using a 
fixed-base percentage of 2 percent. A credit rate of 2.75 
percent applies to the extent that a taxpayer's current-year 
research expenses exceed a base amount computed by using a 
fixed-base percentage of 2 percent. An election to be subject 
to this alternative incremental credit regime may be made for 
any taxable year beginning after June 30, 1996, and such an 
election applies to that taxable year and all subsequent years 
unless revoked with the consent of the Secretary of the 
Treasury.

Eligible expenditures

    Qualified research expenditures eligible for the research 
tax credit consist of: (1) ``in-house'' expenses of the 
taxpayer for wages and supplies attributable to qualified 
research; (2) certain time-sharing costs for computer use in 
qualified research; and (3) 65 percent of amounts paid by the 
taxpayer for qualified research conducted on the taxpayer's 
behalf (so-called ``contract research expenses'').61
---------------------------------------------------------------------------
    \61\ Under a special rule enacted as part of the Small Business Job 
Protection Act of 1996, 75 percent of amounts paid to a research 
consortium for qualified research is treated as qualified research 
expenses eligible for the research credit (rather than 65 percent under 
the general rule under section 41(b)(3) governing contract research 
expenses) if (1) such research consortium is a tax-exempt organization 
that is described in section 501(c)(3) (other than a private 
foundation) or section 501(c)(6) and is organized and operated 
primarily to conduct scientific research, and (2) such qualified 
research is conducted by the consortium on behalf of the taxpayer and 
one or more persons not related to the taxpayer.
---------------------------------------------------------------------------
    To be eligible for the credit, the research must not only 
satisfy the requirements of present-law section 174 (described 
below) but must be undertaken for the purpose of discovering 
information that is technological in nature, the application of 
which is intended to be useful in the development of a new or 
improved business component of the taxpayer, and must pertain 
to functional aspects, performance, reliability, or quality of 
a business component. Research does not qualify for the credit 
if substantially all of the activities relate to style, taste, 
cosmetic, or seasonal design factors (sec. 41(d)(3)). In 
addition, research does not qualify for the credit if conducted 
after the beginning of commercial production of the business 
component, if related to the adaptation of an existing business 
component to a particular customer's requirements, if related 
to the duplication of an existing business component from a 
physical examination of the component itself or certain other 
information, or if related to certain efficiency surveys, 
market research or development, or routine quality control 
(sec. 41(d)(4)).
    Expenditures attributable to research that is conducted 
outside the United States do not enter into the credit 
computation. In addition, the credit is not available for 
research in the social sciences, arts, or humanities, nor is it 
available for research to the extent funded by any grant, 
contract, or otherwise by another person (or governmental 
entity).

Relation to deduction

    Under section 174, taxpayers may elect to deduct currently 
the amount of certain research or experimental expenditures 
incurred in connection with a trade or business, 
notwithstanding the general rule that business expenses to 
develop or create an asset that has a useful life extending 
beyond the current year must be capitalized. However, 
deductions allowed to a taxpayer under section 174 (or any 
other section) are reduced by an amount equal to 100 percent of 
the taxpayer's research tax credit determined for the taxable 
year. Taxpayers may alternatively elect to claim a reduced 
research tax credit amount under section 41 in lieu of reducing 
deductions otherwise allowed (sec. 280C(c)(3)).

                        Description of Proposal

    The research tax credit would be extended for twelve 
months--i.e., for the period July 1, 1998, through June 30, 
1999.

                             Effective Date

    The proposal would be effective for qualified research 
expenditures paid or incurred during the period July 1, 1998, 
through June 30, 1999.

                              Prior Action

    The research tax credit initially was enacted in the 
Economic Recovery Tax Act of 1981 as a credit equal to 25 
percent of the excess of qualified research expenses incurred 
in the current taxable year over the average of qualified 
research expenses incurred in the prior three taxable years. 
The research tax credit was modified in the Tax Reform Act of 
1986, which (1) extended the credit through December 31, 1988, 
(2) reduced the credit rate to 20 percent, (3) tightened the 
definition of qualified research expenses eligible for the 
credit, and (4) enacted the separate, university basic research 
credit.
    The Technical and Miscellaneous Revenue Act of 1988 (``1988 
Act'') extended the research tax credit for one additional 
year, through December 31, 1989. The 1988 Act also reduced the 
deduction allowed under section 174 (or any other section) for 
qualified research expenses by an amount equal to 50 percent of 
the research tax credit determined for the year.
    The Omnibus Budget Reconciliation Act of 1989 (``1989 
Act'') effectively extended the research credit for nine months 
(by prorating qualified expenses incurred before January 1, 
1991). The 1989 Act also modified the method for calculating a 
taxpayer's base amount (i.e., by substituting the present-law 
method which uses a fixed-base percentage for the prior-law 
moving base which was calculated by reference to the taxpayer's 
average research expenses incurred in the preceding three 
taxable years). The 1989 Act further reduced the deduction 
allowed under section 174 (or any other section) for qualified 
research expenses by an amount equal to 100 percent of the 
research tax credit determined for the year.
    The Omnibus Budget Reconciliation Act of 1990 extended the 
research tax credit through December 31, 1991 (and repealed the 
special rule to prorate qualified expenses incurred before 
January 1, 1991).
    The Tax Extension Act of 1991 extended the research tax 
credit for six months (i.e., for qualified expenses incurred 
through June 30, 1992).
    The Omnibus Budget Reconciliation Act of 1993 (``1993 
Act'') extended the research tax credit for three years--i.e., 
retroactively from July 1, 1992 through June 30, 1995. The 1993 
Act also provided a special rule for start-up firms, so that 
the fixed-base ratio of such firms eventually will be computed 
by reference to their actual research experience (see footnote 
60 supra).
    Although the research tax credit expired during the period 
July 1, 1995, through June 30, 1996, the Small Business Job 
Protection Act of 1996 (``1996 Act'') extended the credit for 
the period July 1, 1996, through May 31, 1997 (with a special 
11-month extension for taxpayers that elect to be subject to 
the alternative incremental research credit regime). In 
addition, the 1996 Act expanded the definition of ``start-up 
firms'' under section 41(c)(3)(B)(I), enacted a special rule 
for certain research consortia payments under section 
41(b)(3)(C), and provided that taxpayers may elect an 
alternative research credit regime (under which the taxpayer is 
assigned a three-tiered fixed-base percentage that is lower 
than the fixed-base percentage otherwise applicable and the 
credit rate likewise is reduced) for the taxpayer's first 
taxable year beginning after June 30, 1996, and before July 1, 
1997.
    The Taxpayer Relief Act of 1997 (``1997 Act'') extended the 
research credit for 13 months--i.e., generally for the period 
June 1, 1997, through June 30, 1998. The 1997 Act also provided 
that taxpayers are permitted to elect the alternative 
incremental research credit regime for any taxable year 
beginning after June 30, 1996 (and such election will apply to 
that taxable year and all subsequent taxable years unless 
revoked with the consent of the Secretary of the Treasury).

                                Analysis

Overview

    Technological development is an important component of 
economic growth. However, while an individual business may find 
it profitable to undertake some research, it may not find it 
profitable to invest in research as much as it otherwise might 
because it is difficult to capture the full benefits from the 
research and prevent such benefits from being used by 
competitors. In general, businesses acting in their own self-
interest will not necessarily invest in research to the extent 
that would be consistent with the best interests of the overall 
economy. This is because costly scientific and technological 
advances made by one firm are cheaply copied by its 
competitors. Research is one of the areas where there is a 
consensus among economists that government intervention in the 
marketplace can improve overall economic efficiency. \62\ 
However, this does not mean that increased tax benefits or more 
government spending for research always will improve economic 
efficiency. It is possible to decrease economic efficiency by 
spending too much on research. It is difficult to determine 
whether, at the present levels of government subsidies for 
research, further government spending on research or additional 
tax benefits for research would increase or decrease overall 
economic efficiency. There is some evidence that the current 
level of research undertaken in the United States, and 
worldwide, is too little to maximize society's well-being. \63\
---------------------------------------------------------------------------
    \62\ This conclusion does not depend upon whether the basic tax 
regime is an income tax or a consumption tax.
    \63\ See Zvi Griliches, ``The Search for R&D Spillovers,'' National 
Bureau of Economic Research, Working Paper No. 3768, 1991 and M. Ishaq 
Nadiri, ``Innovations and Technological Spillovers,'' National Bureau 
of Economic Research, Working Paper No. 4423, 1993. These papers 
suggest that the rate of return to privately funded research 
expenditures is high compared to that in physical capital and the 
social rate of return exceeds the private rate of return.
---------------------------------------------------------------------------
    If it is believed that too little research is being 
undertaken, a tax subsidy is one method of offsetting the 
private-market bias against research, so that research projects 
undertaken approach the optimal level. Among the other policies 
employed by the Federal Government to increase the aggregate 
level of research activities are direct spending and grants, 
favorable anti-trust rules, and patent protection. The effect 
of tax policy on research activity is largely uncertain because 
there is relatively little evidence about the responsiveness of 
research to changes in taxes and other factors affecting its 
price. To the extent that research activities are responsive to 
the price of research activities, the research and 
experimentation tax credit should increase research activities 
beyond what they otherwise would be. However, the present-law 
treatment of research expenditures does create certain 
complexities and compliance costs.

The scope of present-law tax expenditures on research activities

    The tax expenditure related to the research and 
experimentation tax credit is estimated to be $1.6 billion for 
1998. The related tax expenditure for expensing of research and 
development expenditures is estimated to be $2.6 billion for 
1998 growing to $3.4 billion for 2002. \64\ As noted above, the 
Federal Government also directly subsidizes research 
activities. For example, in fiscal 1997 the National Science 
Foundation made $2.2 billion in grants, subsidies, and 
contributions to research activities and the Department of 
Defense financed $2.1 billion in advanced technology 
development. \65\
---------------------------------------------------------------------------
    \64\ Joint Committee on Taxation, Estimates of Federal Tax 
Expenditures for Fiscal Years 1998-2002 (JCS-22-97), December 15, 1997, 
p.18.
    \65\ Office of Management and Budget, Budget of the United States 
Government, Fiscal Year 1999, Appendix, pp. 996 and 275.
---------------------------------------------------------------------------
    Tables 1 and 2 present data for 1993 on those industries 
that utilized the research tax credit and the distribution of 
the credit claimants by firm size. Three quarters of the 
research tax credits claimed are claimed by taxpayers whose 
primary activity is manufacturing. Nearly two- thirds of the 
credits claimed are claimed by large firms (assets of $500 
million or more). Nevertheless, as Table 2 documents, a large 
number of small firms are engaged in research and are able to 
claim the research tax credit.

 Table 1.--Percentage Distribution of Firms Claiming Research Tax Credit
             and of Amount of Credit Claimed by Sector, 1993            
------------------------------------------------------------------------
                                                    Number of    Credit 
                       Sector                         firms     claimed 
                                                    (percent)  (percent)
------------------------------------------------------------------------
Agriculture, Forestry and Fishing.................      (\1\)      (\1\)
Mining............................................      (\1\)      (\1\)
Construction......................................        0.7        0.4
Manufacturing.....................................       58.0       75.2
Transportation, Communication, and Public                               
 Utilities........................................        1.4        8.1
Wholesale and Retail Trade........................        9.1        2.6
Finance, Insurance, and Real Estate...............        1.5        1.3
Services..........................................       28.3      12.0 
------------------------------------------------------------------------
\1\ Data undisclosed to protect taxpayer confidentiality.               
                                                                        
  Source: Joint Committee on Taxation (JCT) calculations from Internal  
  Revenue Service, Statistics of Income data.                           


 Table 2.--Percentage Distribution of Firms Claiming Research Tax Credit
           and of Amount of Credit Claimed by Firm Size, 1993           
------------------------------------------------------------------------
                                                    Number of    Credit 
               Asset size (dollars)                   firms     claimed 
                                                    (percent)  (percent)
------------------------------------------------------------------------
0.................................................        0.6        0.2
1--100,000........................................       13.4        0.4
100,000--250,000..................................        6.0        0.5
250,000--500,000..................................       10.2        0.9
500,000--1 million................................       14.6        1.4
1 million--10 million.............................       32.7        7.9
10 million--50 million............................       12.2        8.5
50 million--100 million...........................        2.8        4.2
100 million--250 million..........................        2.4        5.0
250 million--500 million..........................        1.4        6.0
500 million and over..............................        3.7      64.9 
------------------------------------------------------------------------
Source: JCT calculations from Internal Revenue Service, Statistics of   
  Income data.                                                          

Incremental tax credits

    For a tax credit to be effective in increasing a taxpayer's 
research expenditures it is not necessary to provide that 
credit for all the taxpayer's research expenditures. By 
limiting the credit to expenditures above a base amount, 
incremental tax credits attempt to target the tax incentives 
where they will have the most effect on taxpayer behavior.
    Suppose, for example, a taxpayer is considering two 
potential research projects: Project A will generate cash flow 
with a present value of $105 and Project B will generate cash 
flow with present value of $95. Suppose that the cost of 
investing in each of these projects is $100. Without any tax 
incentives, the taxpayer will find it profitable to invest in 
Project A and will not invest in Project B.
    Consider now the situation where a 10-percent ``flat 
credit'' applies to all research expenditures incurred. In the 
case of Project A, the credit effectively reduces the cost to 
$90. This increases profitability, but does not change behavior 
with respect to that project, since it would have been 
undertaken in any event. However, because the cost of Project B 
also is reduced to $90, this previously neglected project (with 
a present value of $95) would now be profitable. Thus, the tax 
credit would affect behavior only with respect to this marginal 
project.
    Incremental credits attempt not to reward projects which 
would have been undertaken in any event and to target 
incentives to marginal projects. To the extent this is 
possible, incremental credits have the potential to be far more 
effective per dollar of revenue cost than flat credits in 
inducing taxpayers to increase qualified expenditures. 
66 Unfortunately, it is nearly impossible as a 
practical matter to determine which particular projects would 
be undertaken without a credit and to provide credits only to 
other projects. In practice, almost all incremental credit 
proposals rely on some measure of the taxpayer's previous 
experience as a proxy for a taxpayer's total qualified 
expenditures in the absence of a credit. This is referred to as 
the credit's ``base amount.'' Tax credits are provided only for 
amounts above this base amount.
---------------------------------------------------------------------------
    \66\ In the example above, if an incremental credit were properly 
targeted, the Government could spend the same $20 in credit dollars and 
induce the taxpayer to undertake a marginal project so long as its 
expected cash flow exceeded $80.
---------------------------------------------------------------------------
    Since a taxpayer's calculated base amount is only an 
approximation of what would have been spent in the absence of a 
credit, in practice, the credit may be less effective per 
dollar of revenue cost than it otherwise might be in increasing 
expenditures. If the calculated base amount is too low, the 
credit is awarded to projects that would have been undertaken 
even in the absence of a credit. If, on the other hand, the 
calculated base amount is too high, then there is no incentive 
for projects that actually are on the margin.
    Nevertheless, the incentive effects of incremental credits 
per dollar of revenue loss can be many times larger than those 
of a flat credit. However, in comparing a flat credit to an 
incremental credit, there are other factors that also deserve 
consideration. A flat credit generally has lower administrative 
and compliance costs than does an incremental credit. Probably 
more important, however, is the potential misallocation of 
resources and unfair competition that could result as firms 
with qualified expenditures determined to be above their base 
amount receive credit dollars, while other firms with qualified 
expenditures considered below their base amount receive no 
credit.

The responsiveness of research expenditures to tax incentives

    Like any other commodity, the amount of research 
expenditures that a firm wishes to incur generally is expected 
to respond positively to a reduction in the price paid by the 
firm. Economists often refer to this responsiveness in terms of 
``price elasticity,'' which is measured as the ratio of the 
percentage change in quantity to a percentage change in price. 
For example, if demand for a product increases by five percent 
as a result of a 10-percent decline in price paid by the 
purchaser, that commodity is said to have a price elasticity of 
demand of 0.5.67 One way of reducing the price paid 
by a buyer for a commodity is to grant a tax credit upon 
purchase. A tax credit of 10 percent (if it is refundable or 
immediately usable by the taxpayer against current tax 
liability) is equivalent to a 10-percent price reduction. If 
the commodity granted a 10-percent tax credit has an elasticity 
of 0.5, the amount consumed will increase by five percent. 
Thus, if a flat research tax credit were provided at a 10-
percent rate, and research expenditures had a price elasticity 
of 0.5, the credit would increase aggregate research spending 
by five percent.68
---------------------------------------------------------------------------
    \67\ For simplicity, this analysis assumes that the product in 
question can be supplied at the same cost despite any increase in 
demand (i.e., the supply is perfectly elastic). This assumption may not 
be valid, particularly over short periods of time, and particularly 
when the commodity--such as research scientists and engineers--is in 
short supply.
    \68\ It is important to note that not all research expenditures 
need be subject to a price reduction to have this effect. Only the 
expenditures which would not have been undertaken otherwise--so called 
marginal research expenditures--need be subject to the credit to have a 
positive incentive effect.
---------------------------------------------------------------------------
    Despite the central role of the measurement of the price 
elasticity of research activities, there is little empirical 
evidence on this subject. What evidence exists generally 
indicates that the price elasticity for research is 
substantially less than one. For example, one survey of the 
literature reached the following conclusion:

          In summary, most of the models have estimated long-
        run price elasticities of demand for R&D on the order 
        of -0.2 and -0.5. . . . However, all of the 
        measurements are prone to aggregation problems and 
        measurement errors in explanatory 
        variables.69
---------------------------------------------------------------------------
    \69\ Charles River Associates, An Assessment of Options for 
Restructuring the R&D Tax Credit to Reduce Dilution of its Marginal 
Incentive (final report prepared for the National Science Foundation), 
February, 1985, p. G-14.

    Although most analysts agree that there is substantial 
uncertainty in these estimates, the general consensus when 
assumptions are made with respect to research expenditures is 
that the price elasticity of research is less than 1.0 and may 
be less than 0.5.\70\ Apparently there have been no specific 
studies of the effectiveness of the university basic research 
tax credit.
---------------------------------------------------------------------------
    \70\ In a 1983 study, the Treasury Department used an elasticity of 
.92 as its upper range estimate of the price elasticity of R&D, but 
noted that the author of the unpublished study from which this estimate 
was taken conceded that the estimate might be biased upward. See, 
Department of the Treasury, The Impact of Section 861-8 Regulation on 
Research and Development, p. 23. As stated in the text, although there 
is uncertainty, most analysts believe the elasticity is considerable 
smaller. For example, the General Accounting Office summarizes: ``These 
studies, the best available evidence, indicate that spending on R&E is 
not very responsive to price reductions. Most of the elasticity 
estimates fall in the range of -0.2 and -0.5. . . . Since it is 
commonly recognized that all of the estimates are subject to error, we 
used a range of elasticity estimates to compute a range of estimates of 
the credit's impact.'' See, The Research Tax Credit Has Stimulated Some 
Additional Research Spending (GAO/GGD-89-114), September 1989, p. 23. 
Similarly, Edwin Mansfield concludes: ``While our knowledge of the 
price elasticity of demand for R&D is far from adequate, the best 
available estimates suggest that it is rather low, perhaps about 0.3.'' 
See, ``The R&D Tax Credit and Other Technology Policy Issues,'' 
American Economic Review, Vol. 76, no. 2, May 1986, p. 191. More recent 
empirical analyses have estimated higher elasticity estimates. One 
recent empirical analysis of the research credit has estimated a short-
run price elasticity of 0.8 and a long-run price elasticity of 2.0. The 
author of this study notes that the long-run estimate should be viewed 
with caution for several technical reasons. In addition, the data 
utilized for the study cover the period 1980 through 1991, containing 
only two years under the revised credit structure. This makes it 
empirically difficult to distinguish short-run and long-run effects, 
particularly as it may take firms some time to fully appreciate the 
incentive structure of the revised credit. See, Bronwyn H. Hall, ``R&D 
Tax Policy During the 1980s: Success or Failure?'' in James M. Poterba 
(ed.), Tax Policy and the Economy, 7, pp. 1-35 (Cambridge: The MIT 
Press, 1993). Another recent study examined the post-1986 growth of 
research expenditures by 40 U.S.-based multinationals and found price 
elasticities between 1.2 and 1.8. However, including an additional 76 
firms, that had initially been excluded because they had been involved 
in merger activity, the estimated elasticities fell by half. See, James 
R. Hines, Jr., ``On the Sensitivity of R&D to Delicate Tax Changes: The 
Behavior of U.S. Multinationals in the 1980s'' in Alberto Giovannini, 
R. Glenn Hubbard, and Joel Slemrod (eds.), Studies in International 
Taxation, (Chicago: University of Chicago Press 1993). Also see M. 
Ishaq Nadiri and Theofanis P. Mamuneas, ``R&D Tax Incentives and 
Manufacturing-Sector R&D Expenditures,'' in James M. Poterba, editor, 
Borderline Case: International Tax Policy, Corporate Research and 
Development, and Investment, (Washington, D.C.: National Academy 
Press), 1997. While their study concludes that one dollar of research 
tax credit produces 95 cents of research, they note that time series 
empirical work is clouded by poor measures of the price deflators used 
to convert nominal research expenditures to real expenditures.
---------------------------------------------------------------------------

Other issues related to the research and experimentation credit

    Perhaps the greatest criticism of the research and 
experimentation tax credit among taxpayers regards its 
temporary nature. Research projects frequently span years. If a 
taxpayer considers an incremental research project, the lack of 
certainty regarding the availability of future credits 
increases the financial risk of the expenditure. A credit of 
longer duration may more successfully induce additional 
research than would a temporary credit, even if the temporary 
credit is periodically renewed.
    An incremental credit does not provide an incentive for all 
firms undertaking qualified research expenditures. Many firms 
have current-year qualified expenditures below the base amount. 
These firms receive no tax credit and have an effective rate of 
credit of zero. Although there is no revenue cost associated 
with firms with qualified expenditures below base, there may be 
a distortion in the allocation of resources as a result of 
these uneven incentives.
    If a firm has no current tax liability, or if the firm is 
subject to the alternative minimum tax (AMT) or the general 
business credit limitation, the research credit must be carried 
forward for use against future-year tax liabilities. The 
inability to use a tax credit immediately reduces its value 
according to the length of time between when it actually is 
earned and the time it actually is used to reduce tax 
liability.\71\
---------------------------------------------------------------------------
    \71\ As with any tax credit that is carried forward, its full 
incentive effect could be restored, absent other limitations, by 
allowing the credit to accumulate interest that is paid by the Treasury 
to the taxpayer when the credit ultimately is utilized.
---------------------------------------------------------------------------
    Under present law, firms with research expenditures 
substantially in excess of their base amount may be subject to 
the 50-percent limitation. In general, although these firms 
receive the largest amount of credit when measured as a 
percentage of their total qualified research expenditures, 
their marginal effective rate of credit is exactly one half of 
the statutory credit rate of 20 percent (i.e., firms on the 
base limitation effectively are governed by a 10-percent credit 
rate).
    Although the statutory rate of the research credit is 
currently 20 percent, it is likely that the average marginal 
effective rate may be substantially below 20 percent. 
Reasonable assumptions about the frequency that firms are 
subject to various limitations discussed above yields estimates 
of an average effective rate of credit between 25 and 40 
percent below the statutory rate i.e., between 12 and 15 
percent.\72\
---------------------------------------------------------------------------
    \72\ For a more complete discussion of this point see Joint 
Committee on Taxation, Description and Analysis of Tax Provisions 
Expiring in 1992 (JCS-2-92), January 27, 1992, pp. 65-66.
---------------------------------------------------------------------------
    Since sales growth over a long time frame will rarely track 
research growth, it can be expected that over time each firm's 
base will ``drift'' from the firm's actual current qualified 
research expenditures. Therefore, increasingly over time there 
will be a larger number of firms either substantially above or 
below their calculated base. This could gradually create an 
undesirable situation where many firms receive no credit and 
have no reasonable prospect of ever receiving a credit, while 
other firms receive large credits (despite the 50-percent base 
limitation). Thus, over time, it can be expected that, for 
those firms eligible for the credit, the average marginal 
effective rate of credit will decline while the revenue cost to 
the Federal Government increases.
    Administrative and compliance burdens also result from the 
present-law research tax credit. The General Accounting Office 
(``GAO'') has testified that the research tax credit is 
difficult for the IRS to administer. The GAO reports that the 
IRS view is that it is ``required to make difficult technical 
judgments in audits concerning whether research was directed to 
produce truly innovative products or processes.'' While the IRS 
employs engineers in such audits, the companies engaged in the 
research typically employ personnel with greater technical 
expertise and, as would be expected, personnel with greater 
expertise regarding the intended application of the specific 
research conducted by the company under audit. Such audits 
create a burden for both the IRS and taxpayers. The credit 
generally requires taxpayers to maintain records more detailed 
than those necessary to support the deduction of research 
expenses under section 174.\73\
---------------------------------------------------------------------------
    \73\ Natwar M. Gandhi, Associate Director Tax Policy and 
Administration Issues, General Government Division, U.S. General 
Accounting Office, ``Testimony before the Subcommittee on Taxation and 
Internal Revenue Service Oversight,'' Committee on Finance, United 
States Senate, April 3, 1995.
---------------------------------------------------------------------------

4. Extend the deduction provided for contributions of appreciated stock 
        to private foundations

                              Present Law

    In computing taxable income, a taxpayer who itemizes 
deductions generally is allowed to deduct the fair market value 
of property contributed to a charitable organization.\74\ 
However, in the case of a charitable contribution of short-term 
gain, inventory, or other ordinary income property, the amount 
of the deduction generally is limited to the taxpayer's basis 
in the property. In the case of a charitable contribution of 
tangible personal property, the deduction is limited to the 
taxpayer's basis in such property if the use by the recipient 
charitable organization is unrelated to the organization's tax-
exempt purpose.\75\
---------------------------------------------------------------------------
    \74\ The amount of the deduction allowable for a taxable year with 
respect to a charitable contribution may be reduced depending on the 
type of property contributed, the type of charitable organization to 
which the property is contributed, and the income of the taxpayer 
(secs. 170(b) and 170(e)).
    \75\ As part of the Omnibus Budget Reconciliation Act of 1993, 
Congress eliminated the treatment of contributions of appreciated 
property (real, personal, and intangible) as a tax preference for 
alternative minimum tax (AMT) purposes. Thus, if a taxpayer makes a 
gift to charity of property (other than short-term gain, inventory, or 
other ordinary income property, or gifts to private foundations) that 
is real property, intangible property, or tangible personal property 
the use of which is related to the donee's tax-exempt purpose, the 
taxpayer is allowed to claim the same fair-market-value deduction for 
both regular tax and AMT purposes (subject to present-law percentage 
limitations).
---------------------------------------------------------------------------
    In cases involving contributions to a private foundation 
(other than certain private operating foundations), the amount 
of the deduction is limited to the taxpayer's basis in the 
property. However, under a special rule contained in section 
170(e)(5), taxpayers are allowed a deduction equal to the fair 
market value of ``qualified appreciated stock'' contributed to 
a private foundation prior to June 30, 1998. Qualified 
appreciated stock is defined as publicly traded stock which is 
capital gain property. The fair-market-value deduction for 
qualified appreciated stock donations applies only to the 
extent that total donations made by the donor to private 
foundations of stock in a particular corporation did not exceed 
10 percent of the outstanding stock of that corporation. For 
this purpose, an individual is treated as making all 
contributions that were made by any member of the individual's 
family.

                        Description of Proposal

    The proposal would extend the the special rule contained in 
section 170(e)(5) for one year--for contributions of qualified 
appreciated stock made to private foundations during the period 
July 1, 1998, through June 30, 1999.

                             Effective Date

    The proposal would be effective for contributions of 
qualified appreciated stock to private foundations made during 
the period July 1, 1998, through June 30, 1999.

                              Prior Action

    The special rule contained in section 170(e)(5), which was 
originally enacted in 1984, expired January 1, 1995. The Small 
Business Job Protection Act of 1996 reinstated the rule for 11 
months--for contributions of qualified appreciated stock made 
to private foundations during the period July 1, 1996, through 
May 31, 1997. The Taxpayer Relief Act of 1997 extended the 
special rule for the period June 1, 1997, through June 30, 
1998.

                                Analysis

    Any tax deduction or credit reduces the price of an 
activity that receives the tax incentive. For example, for a 
taxpayer in the 31 percent tax bracket, a $100 cash gift to 
charity reduces the taxpayer's taxable income by $100 and 
thereby reduces tax liability by $31. As a consequence, the 
$100 cash gift to charity reduces the taxpayer's after-tax 
income by only $69. Economists would say that the ``price of 
giving'' $100 cash to charity is $69. With gifts of appreciated 
property, if a fair market value deduction is allowed (while 
the accrued appreciation is not included in income), the price 
of giving $100 worth of appreciated property is as low as 
$40.40.\76\
---------------------------------------------------------------------------
    \76\ This assumes that the taxpayer is in the highest statutory 
rate bracket and the property has a basis of zero and is computed as 
follows: $100 minus $20 (tax avoided from non-recognition of built-in 
capital gain) minus $39.60 (tax saved from deduction for fair market 
value). This ``price of giving'' figure assumes that the taxpayer would 
sell the appreciated property (and pay tax on the built-in gain) in the 
same year of the donation if the property were not given to charity. 
However, a higher ``price of giving'' would be derived if it is assumed 
that, had the taxpayer not donated the property, he would have retained 
the asset until death (and obtained a step-up in basis) or obtained 
benefits of deferral of tax by selling the asset in a later year.
---------------------------------------------------------------------------
    In principle, a lower price of giving should result in more 
charitable giving. The amount of charitable giving that results 
from lowering the price of giving determines the efficiency of 
the tax deductions. If taxpayers do not increase their 
charitable giving significantly in response to a charitable 
contribution deduction, the revenue lost to the government 
because of the tax incentive may exceed the benefits of 
additional contributions that flow to charitable organizations 
as a result of the deduction.
    Economists have not reached a consensus as to whether the 
deduction for charitable donations is efficient in the sense 
that the cost to the government in lost revenue is more than 
offset by additional funds flowing to charitable organizations. 
The economics literature generally does not specifically 
address gifts of appreciated property. Moreover, these studies 
do not include the possibility of the substitutability between 
lifetime giving and gifts made at death. Substantial tax 
savings are available to owners of appreciated property if they 
bequeath such property to qualified charitable organizations. 
Even if the general rule for donating appreciated property 
discourages current giving, such giving may not be lost 
permanently to charitable organizations, but merely may be 
converted into gifts at death. However, if a policy goal is to 
speed the donation of such gifts, there may be additional 
benefits to inducing gifts prior to death.
    The aggregate data on charitable donations also present a 
mixed picture of the effect of tax deductions on gifts of 
appreciated property. Although gifts of appreciated property 
substantially declined after enactment of the Tax Reform Act of 
1986, the total value of gifts to charity has continued to grow 
since that time, despite the fact that the reduction in 
marginal tax rates should have reduced the incentive to give. 
Thus, to the extent that gifts of appreciated property have 
declined, the decline has been largely offset by increases in 
cash gifts.
    There are, however, a number of limitations on charitable 
contributions contained in the Internal Revenue Code. For 
instance, a taxpayer's deduction for a taxable year for gifts 
of appreciated property to public charities cannot exceed 30 
percent of the taxpayer's adjusted gross income (20 percent if 
the donee is a private foundation).
    There is another dimension to efficiency. Receipt of gifts 
of cash by charitable organizations is more efficient, because 
a cash gift permits the donee to avoid the transaction costs 
involved should it wish to convert the appreciated property to 
cash. Moreover, gifts of appreciated property instead of cash 
create administrative costs. Cash donations do not require 
appraisals, generally increase taxpayer compliance, and reduce 
the burden on the IRS of monitoring the accuracy of valuation 
of gifts of appreciated property.

                    F. Miscellaneous Tax Provisions

1. Increase low-income housing tax credit per capita cap

                              Present Law

    A tax credit, claimed over a 10-year period is allowed for 
the cost of rental housing occupied by tenants having incomes 
below specified levels. The credit generally has a present 
value of 70 percent (new construction) or 30 percent (existing 
housing and most housing also receiving other Federal 
subsidies) of qualified costs.
    Generally, the tax credits available for projects in the 
first year of the 10-year period are subject to annual per-
State limitations of $1.25 per capita. Credits that remain 
unallocated by States after prescribed periods are reallocated 
to other States through a ``national pool.'' The $1.25 per 
capita cap was set in 1986 with the inception of the tax 
credit.

                        Description of Proposal

    The $1.25 per capita cap would be increased to $1.75 per 
capita.

                             Effective Date

    The proposal would be effective for calendar years 
beginning after December 31, 1998.

                              Prior Action

    The low-income housing tax credit was enacted as part of 
the Tax Reform Act of 1986. It was extended several times, and 
was made permanent by the Omnibus Budget Reconciliation Act of 
1993. The House version of the Balanced Budget Act of 1995 
would have repealed the low-income housing tax credit after 
1997.

                                Analysis

Demand subsidies versus supply subsidies

    As is the case with direct expenditures, the tax system may 
be used to improve housing opportunities for low-income 
families either by subsidizing rental payments (increasing 
demand) or by subsidizing construction and rehabilitation of 
low-income housing units (increasing supply).
    The provision of Federal Section 8 housing vouchers is an 
example of a demand subsidy. The exclusion of the value of such 
vouchers from taxable income is an example of a demand subsidy 
in the Internal Revenue Code. By subsidizing a portion of rent 
payments, these vouchers may enable beneficiaries to rent more 
or better housing than they might otherwise be able to afford. 
The low-income housing credit is an example of a supply 
subsidy. By offering a subsidy worth 70 percent (in present 
value) of construction costs, the credit is designed to induce 
investors to provide housing to low-income tenants, or a better 
quality of housing, than otherwise would be available.
    A demand subsidy can improve the housing opportunities of a 
low-income family by increasing the family's ability to pay for 
more or higher quality housing. In the short run, an increase 
in the demand for housing, however, may increase rents as 
families bid against one another for available housing. 
Consequently, while a family who receives the subsidy may 
benefit by being able to afford more or better housing, the 
resulting increase in market rents may reduce the well-being of 
other families. In the long run, investors should supply 
additional housing because higher rents increase the income of 
owners of existing rental housing, and therefore may be 
expected to make rental housing a more attractive investment. 
This should ameliorate the short-term increase in market rents 
and expand availability of low-income housing.
    A supply subsidy can improve the housing opportunities of a 
low-income family by increasing the available supply of housing 
from which the family may choose. Generally, a supply subsidy 
increases the investor's return to investment in rental 
housing. An increased after-tax return should induce investors 
to provide more rental housing. As the supply of rental housing 
increases, the market rents investors charge should decline as 
investors compete to attract tenants to their properties. 
Consequently, not only could qualifying low-income families 
benefit from an increased supply of housing, but other renters 
could also benefit. In addition, owners of existing housing may 
experience declines in income or declines in property values as 
rents fall.

Efficiency of demand and supply subsidies

    In principle, demand and supply subsidies of equal size 
should lead to equal changes in improved housing opportunities. 
There is debate as to the accuracy of this theory in practice. 
Some argue that both direct expenditures and tax subsidies for 
rental payments may not increase housing consumption dollar for 
dollar. One study of the Federal Section 8 Existing Housing 
Program suggests that, for every $100 of rent subsidy, a 
typical family increases its expenditure on housing by $22 and 
increases its expenditure on other goods by $78.\77\ While the 
additional $78 spent on other goods certainly benefits the 
family receiving the voucher, the $100 rent subsidy does not 
increase their housing expenditures by $100.
---------------------------------------------------------------------------
    \77\ See, W. Reeder, ``The Benefits and Costs of the Section 8 
Existing Housing Program,'' Journal of Public Economics, 26, 1985.
---------------------------------------------------------------------------
    Also, one study of government-subsidized housing starts 
between 1961 and 1977 suggests that as many as 85 percent of 
the government-subsidized housing starts may have merely 
displaced unsubsidized housing starts.\78\ This figure is based 
on both moderate- and low-income housing starts, and therefore 
may overstate the potential inefficiency of tax subsidies 
solely for low-income housing. Displacement is more likely to 
occur when the subsidy is directed at projects the private 
market would have produced anyway. Thus, if relatively small 
private market activity exists for low-income housing, a supply 
subsidy is more likely to produce a net gain in available low-
income housing units because the subsidy is less likely to 
displace otherwise planned activity.
---------------------------------------------------------------------------
    \78\ M. Murray, ``Subsidized and Unsubsidized Housing Starts: 1961-
1977,'' The Review of Economics and Statistics, 65, November 1983.
---------------------------------------------------------------------------
    The theory of subsidizing demand assumes that, by providing 
low-income families with more spending power, their increase in 
demand for housing will ultimately lead to more or better 
housing being available in the market. However, if the supply 
of housing to these families does not respond to the higher 
market prices that rent subsidies ultimately cause, the result 
will be that all existing housing costs more, the low-income 
tenants will have no better living conditions than before, and 
other tenants will face higher rents.\79\ The benefit of the 
subsidy will accrue primarily to the property owners because of 
the higher rents.
---------------------------------------------------------------------------
    \79\ For example, supply may not respond to price changes if there 
exist construction, zoning, or other restrictions on the creation of 
additional housing units.
---------------------------------------------------------------------------
    Supply subsidy programs can suffer from similar 
inefficiencies. For example, some developers who built low-
income rental units before enactment of the low-income housing 
credit, may now find that the projects qualify for the credit. 
That is, the subsidized project may displace what otherwise 
would have been an unsubsidized project with no net gain in 
number of low-income housing units. If this is the case, the 
tax expenditure of the credit will result in little or no 
benefit except to the extent that the credit's targeting rules 
may force the developer to serve lower-income individuals than 
otherwise would have been the case. In addition, by depressing 
rents the supply subsidy may displace privately supplied 
housing.

Efficiency of tax subsidies

    Some believe that tax-based supply subsidies do not produce 
significant displacement within the low-income housing market 
because low-income housing is unprofitable and the private 
market would not otherwise build new housing for low-income 
individuals. In this view, tax-subsidized low-income housing 
starts would not displace unsubsidized low-income housing 
starts. However, the bulk of the stock of low-income housing 
consists of older, physically depreciated properties which once 
may have served a different clientele. Subsidies to new 
construction could make it no longer economic to convert some 
of these older properties to low-income use, thereby displacing 
potential low-income units.
    The tax subsidy for low-income housing construction also 
could displace construction of other housing. Constructing 
rental housing requires specialized resources. A tax subsidy 
may induce these resources to be devoted to the construction of 
low-income housing rather than other housing. If most of the 
existing low-income housing stock had originally been built to 
serve non-low-income individuals, a tax subsidy to newly 
constructed low-income housing could displace some privately 
supplied low-income housing in the long run.
    Supply subsidies for low-income housing may be subject to 
some additional inefficiencies. Much of the low-income housing 
stock consists of older structures. Subsidies to new 
construction may provide for units with more amenities or units 
of a higher quality than low-income individuals would be 
willing to pay for if given an equivalent amount of funds. That 
is, rather than have $100 spent on a newly constructed 
apartment, a low-income family may prefer to have consumed part 
of that $100 in increased food and clothing. In this sense, the 
supply subsidy may provide an inefficiently large quantity of 
housing services from the point of view of how consumers would 
choose to allocate their resources. However, to the extent that 
maintenance of a certain standard of housing provides benefits 
to the community, the subsidy may enhance efficiency. If the 
supply subsidy involves fixed costs, such as the cost of 
obtaining a credit allocation under the low-income housing 
credit, a bias may be created towards large projects in order 
to amortize the fixed cost across a larger number of units. 
This may create an inefficient bias in favor of large projects. 
On the other hand, the construction and rehabilitation costs 
per unit may be less for large projects than for small 
projects. Lastly, unlike demand subsidies which permit the 
beneficiary to seek housing in any geographic location, supply 
subsidies may lead to housing being located in areas which, for 
example, are farther from places of employment than the 
beneficiary would otherwise choose. In this example, some of 
benefit of the supply subsidy may be dissipated through 
increased transportation cost.

Targeting the benefits of tax subsidies

    A supply subsidy to housing will be spent on housing; 
although, as discussed above, it may not result in a dollar-
for-dollar increase in total housing spending. To insure that 
the housing, once built, serves low-income families, income and 
rent limitations for tenants must be imposed as is the case for 
demand subsidies. While an income limit may be more effective 
in targeting the benefit of the housing to lower income levels 
than would an unrestricted market, it may best serve only those 
families at or near the income limit.
    If, as with the low-income housing credit, rents are 
restricted to a percentage of targeted income, the benefits of 
the subsidy may not accrue equally to all low-income families. 
Those with incomes beneath the target level may pay a greater 
proportion of their income in rent than does a family with a 
greater income. On the other hand, to the extent that any new, 
subsidy-induced housing draws in only the targeted low-income 
families with the highest qualifying incomes it should open 
units in the privately provided low-income housing stock for 
others.
    Even though the subsidy may be directly spent on housing, 
targeting the supply subsidy, unlike a demand subsidy, does not 
necessarily result in targeting the benefit of the subsidy to 
recipient tenants. Not all of the subsidy will result in net 
additions to the housing stock. The principle of a supply 
subsidy is to induce the producer to provide something he or 
she otherwise would not. Thus, to induce the producer to 
provide the benefit of improved housing to low-income families, 
the subsidy must provide benefit to the producer.
    Targeting tax incentives according to income can result in 
creating high implicit marginal tax rates. For example, if rent 
subsidies are limited to families below the poverty line, when 
a family is able to increase its income to the point of 
crossing the poverty threshold the family may lose its rent 
subsidy. The loss of rent subsidy is not unlike a high rate of 
taxation on the family's additional income. The same may occur 
with supply subsidies. With the low-income housing credit, the 
percentage of units serving low-income families is the criteria 
for receiving the credit. Again, the marginal tax rate on a 
dollar of income at the low-income threshold may be very high 
for prospective tenants.

Data relating to the low-income housing credit

    Comprehensive data from tax returns concerning the low-
income housing tax credit currently are unavailable. However, 
Table 3, below, presents data from a survey of State credit 
allocating agencies.

                        Table 3.--Allocation of the Low-Income Housing Credit, 1987-1995                        
----------------------------------------------------------------------------------------------------------------
                                                                                                    Percentage  
                              Years                                  Authority       Allocated       allocated  
                                                                    (millions)      (millions)       (percent)  
----------------------------------------------------------------------------------------------------------------
1987............................................................          $313.1           $62.9            20.1
1988............................................................           311.5           209.8            67.4
1989............................................................           314.2           307.2            97.8
1990............................................................           317.7           206.4            65.0
1991 \1\........................................................           497.3           400.6            80.6
1992 \1\........................................................           476.8           332.7            70.0
1993 \1\........................................................           546.4           322.7            70.0
1994 \1\........................................................           523.7           424.7            77.7
1995 \1\........................................................           432.6           410.9            95.0
----------------------------------------------------------------------------------------------------------------
\1\ Increased authority includes credits unallocated from prior years carried over to the current year.         
                                                                                                                
Source: Survey of State allocating agencies conducted by National Council of State Housing Associations (1996). 

    Table 3 does not reflect actual units of low-income housing 
placed in service, but rather only allocations of the credit to 
proposed projects. Some of these allocations will be carried 
forward to projects placed in service in future years. As such, 
these data do not necessarily reflect the magnitude of the 
Federal tax expenditure from the low-income housing credit. The 
staff of the Joint Committee on Taxation (``Joint Committee 
staff'') estimates that the fiscal year 1998 tax expenditure 
resulting from the low-income credit will total $3.2 
billion.80 This estimate would include revenue lost 
to the Federal Government from buildings placed in service in 
the 10 years prior to 1998. Table 1 shows a high rate of credit 
allocations in recent years.
---------------------------------------------------------------------------
    \80\ Joint Committee on Taxation, Estimates of Federal Tax 
Expenditures for Fiscal Years 1998-2002 (JCS-22-97), December 15, 1997, 
p. 21.
---------------------------------------------------------------------------
    A Department of Housing and Urban Development study has 
attempted to measure the costs and benefits of the low-income 
housing credit compared to that of the Federal Section 8 
housing voucher program.81 This study attempts to 
compare the costs of providing a family with an identical unit 
of housing, using either a voucher or the low-income housing 
credit. The study concludes that on average the low-income 
housing credit provides the same unit of housing as would the 
voucher at two and one half times greater cost than the voucher 
program. However, this study does not attempt to measure the 
effect of the voucher on raising the general level of rents, 
nor the effect of the low-income housing credit on lowering the 
general level of rents. The preceding analysis has suggested 
that both of these effects may be important. In addition, as 
utilization of the credit has risen, the capital raised per 
credit dollar has increased. This, too, would reduce the 
measured cost of providing housing using the low-income credit.
---------------------------------------------------------------------------
    \81\ U.S. Department of Housing and Urban Development, Evaluation 
of the Low-Income Housing Tax Credit: Final Report, February 1991.
---------------------------------------------------------------------------

Increasing State credit allocations

    The dollar value of the State allocation of $1.25 per 
capita was set in the 1986 Act and has not been revised. Low-
income housing advocates observe that because the credit amount 
is not indexed, inflation has reduced its real value since the 
dollar amounts were set in 1986. The Gross Domestic Product 
(``GDP'') price deflator for residential fixed investment 
measures 38.1 percent price inflation between 1986 and the 
third quarter of 1997. Had the per capita credit allocation 
been indexed for inflation, using this index, the value of the 
credit today would be approximately $1.73.82 While 
not indexing for inflation, present law does provide for annual 
adjustments to the State credit allocation authority based on 
current population estimates. Because the need for low- income 
housing can be expected to correlate with population, the 
annual credit limitation already is adjusted to reflect 
changing needs.
---------------------------------------------------------------------------
    \82\ Most Code provisions are indexed to the Consumer Price Index 
(``CPI''). Over this same period, cumulative inflation as measured by 
the CPI was approximately 47 percent. Indexing the $1.25 to the CPI 
would have produced a value of approximately $1.84 today.
---------------------------------------------------------------------------
    The revenue consequences estimated by the Joint Committee 
staff of increasing the per capita limitation understate the 
long-run revenue cost to the Federal Government. This occurs 
because the Joint Committee staff reports revenue effects only 
for the 10-year budget period. Because the credit for a project 
may be claimed for 10 years, only the total revenue loss 
related to those projects placed in service in the first year 
are reflected fully in the Joint Committee staff's 10-year 
estimate. The revenue loss increases geometrically throughout 
the budget period as additional credit authority is granted by 
the States and all projects placed in service after the first 
year of the budget period produce revenue losses in years 
beyond the 10-year budget period.

2. Extend and modify Puerto Rico tax credit

                              Present Law

    The Small Business Job Protection Act of 1996 generally 
repealed the Puerto Rico and possession tax credit. However, 
certain domestic corporations that had active business 
operations in Puerto Rico or another U.S. possession on October 
13, 1995 may continue to claim credits under section 936 or 
section 30A for a ten-year transition period. Such credits 
apply to possession business income, which is derived from the 
active conduct of a trade or business within a U.S. possession 
or from the sale or exchange of substantially all of the assets 
that were used in such a trade or business. In contrast to the 
foreign tax credit, the Puerto Rico and possession tax credit 
is granted whether or not the corporation pays income tax to 
the possession.
    One of two alternative limitations is applicable to the 
amount of the credit attributable to possession business 
income. Under the economic activity limit, the amount of the 
credit with respect to such income cannot exceed the sum of a 
portion of the taxpayer's wage and fringe benefit expenses and 
depreciation allowances (plus, in certain cases, possession 
income taxes); beginning in 2002, the income eligible for the 
credit computed under this limit generally is subject to a cap 
based on the corporation's pre-1996 possession business income. 
Under the alternative limit, the amount of the credit is 
limited to the applicable percentage (40 percent for 1998 and 
thereafter) of the credit that would otherwise be allowable 
with respect to possession business income; beginning in 1998, 
the income eligible for the credit computed under this limit 
generally is subject to a cap based on the corporation's pre-
1996 possession business income. Special rules apply in 
computing the credit with respect to operations in Guam, 
American Samoa, and the Commonwealth of the Northern Mariana 
Islands. The credit is eliminated for taxable years beginning 
after December 31, 2005.

                        Description of Proposal

    The proposal would modify the credit computed under the 
economic activity limit with respect to operations in Puerto 
Rico only. First, the proposal would eliminate the December 31, 
2005 termination date with respect to such credit. Second, the 
proposal would eliminate the income cap with respect to such 
credit. Third, the proposal would eliminate the limitation that 
applies the credit only to certain corporations with pre-
existing operations in Puerto Rico; accordingly, under the 
proposal the credit computed under the economic activity limit 
would beavailable with respect to corporations with new 
operations in Puerto Rico. The proposal would not modify the credit 
computed under the economic activity limit with respect to operations 
in possessions other than Puerto Rico. The proposal also would not 
modify the credit computed under the alternative limit with respect to 
operations in Puerto Rico or other possessions.

                             Effective Date

    The proposal would apply to taxable years beginning after 
December 31, 1998.

                              Prior Action

    The proposal (with an effective date of one year earlier) 
was included in the President's fiscal year 1998 budget 
proposal.

                                Analysis

    When the Puerto Rico and possession tax credit was repealed 
in 1996, the Congress expressed its concern that the tax 
benefits provided by the credit were enjoyed by only the 
relatively small number of U.S. corporations that operate in 
the possessions and that the tax cost of the benefits provided 
to these possessions corporations was borne by all U.S. 
taxpayers. In light of the then current budget constraints, the 
Congress believed that the continuation of the tax exemption 
provided to corporations pursuant to the Puerto Rico and 
possession tax credit was no longer appropriate.
    The proposal to extend and modify the credit computed under 
the economic activity limit is intended to provide an incentive 
for job creation and economic activity in Puerto Rico. In this 
regard, it should be noted that the Puerto Rican government 
itself has enacted a package of incentives effective January 1, 
1998 designed to attract business investment in Puerto Rico. 
This proposal should be analyzed in light of these local 
initiatives which have just gone into force; issues to be 
considered include whether additional federal tax incentives 
are necessary or appropriate and whether the proposed credit 
would interact efficiently with the particular local incentives 
already in place.
    In 1996, the unemployment rate averaged 14 percent in 
Puerto Rico. By comparison, the United States's unemployment 
rate averaged 5.4 percent in 1996 and the State with the 
highest average unemployment rate, New Mexico, averaged 8.1 
percent unemployment. 83 The incomes of individuals 
and families are lower in Puerto Rico than in the United 
States. In the last year for which comparable data are 
available, 1989, the median family income in the United States 
was $35,225 and the median family income in Puerto Rico was 
$9,988. For 1989, the lowest median household income among the 
States was $26,159 in Alabama. 84 In 1996, per 
capita GDP in Puerto Rico was $8,104 while per capita GDP for 
the United States was $28,784. 85 It has been these, 
or comparable, facts that have motivated efforts to encourage 
economic development in Puerto Rico.
---------------------------------------------------------------------------
    \83\ The unemployment rate in the District of Columbia averaged 8.5 
percent in 1996. Source: Bureau of the Census, U.S. Department of 
Commerce, Statistical Abstract of the United States, 1997.
    \84\ Ibid. The data are drawn from the 1990 Census. Comparison of 
the income figures reported for Puerto Rico or the United States to the 
figure for Alabama should be made with some caution as the Alabama 
figure reports household income rather than family income. For 1989, 
median household income in the United States was $35,526 and in Puerto 
Rico median household income was $8,895. U.S. Department of Commerce, 
Bureau of the Census, 1990 Census of Population, Social and Economic 
Characteristics, Puerto Rico, p. 42.
    \85\ Ibid.
---------------------------------------------------------------------------
    The credit computed under the economic activity limit as 
provided in section 30A reduces the Federal income tax burden 
on economic activity located in Puerto Rico. By reducing the 
Federal income tax burden, the credit may make it attractive 
for a business to locate in Puerto Rico, even if the costs of 
operation or transportation to or from the United States would 
otherwise make such an undertaking unprofitable. As such, the 
credit is a deliberate attempt to distort taxpayer behavior. 
Generally, distortions of taxpayer behavior, such as those that 
distort decisions regarding investment, labor choice, or choice 
of business location reduce overall well-being by not putting 
labor and capital resources to their highest and best use. 
However, proponents of the credit argue that such a distortion 
of choice may increase aggregate economic welfare because 
Puerto Rico has so many underutilized resources, as evidenced 
by its chronic high unemployment rate.
    Some also have suggested that the credit may offset 
partially certain other distortions that exist in the Puerto 
Rican economy. For example, some have suggested that the 
application of the Federal minimum wage, which generally has 
been chosen based on the circumstances of the States, to Puerto 
Rico may contribute to Puerto Rico's relatively high 
unemployment rate. Others have suggested that the cost of 
investment funds to Puerto Rican businesses may be higher than 
is dictated by the actual risk of those investments. If this is 
the case, there may be an imperfect capital market. The credit, 
as it applies to wages and capital, may partially offset a 
distortion created by the minimum wage or a capital market 
imperfection.
    The proposal would extend the credit computed under the 
economic activity limit with respect to operations in Puerto 
Rico to new business operations in Puerto Rico, would eliminate 
the present-law cap on the economic activity credit, and would 
make the economic activity credit permanent. The credit 
computed under the economic activity limit is based loosely on 
the value added by a business that occurs within a qualifying 
Puerto Rican facility. That is, the credit is based upon 
compensation paid to employees in Puerto Rico and upon tangible 
personal property located in Puerto Rico. Proponents of the 
credit note that this design does not bias a business's choice 
of production between more labor intensive or more capital 
intensive methods and thus should not promote an inefficient 
use of resources in production. 86 Proponents 
further observe that the economic activity credit under section 
30A is based upon the labor employed in Puerto Rico and the 
equipment located within Puerto Rico which add value to the 
good or service produced, not the cost of raw materials, land, 
intangibles, interest, or other expenses. Thus, they argue that 
the credit directly targets underemployed resources within 
Puerto Rico.
---------------------------------------------------------------------------
    \86\  The income-based credit of prior law was criticized for 
encouraging intangible capital intensive business development rather 
than business development of any type. See the discussion in Department 
of the Treasury, The Operation and Effect of the Possessions 
Corporation System of Taxation, Sixth Report, March 1989.
---------------------------------------------------------------------------
    The economic activity credit only has been available to 
taxpayers since 1994. There have been no studies of its 
efficacy to date. However, the tax credit can never be fully 
efficient. The credit would be available to any business 
locating in Puerto Rico, regardless of whether the business 
would have chosen to locate in Puerto Rico in the absence of 
the credit for other business reasons. Thus, as with most tax 
benefits designed to change economic decisions, in some cases, 
the Federal government will lose revenue even when there has 
been no change in taxpayer behavior.
    Use of a tightly defined tax benefit as a business 
development tool may limit Federal Government funds available 
for other development initiatives that might foster business 
development in Puerto Rico. For example, a lack of 
infrastructure such as roads or waste water treatment 
facilities may forestall certain business investments. It is 
difficult for tax credits to address those sorts of business 
development initiatives. More generally, one might question the 
efficacy of using tax benefits in lieu of direct spending to 
foster economic development. Direct subsidies could be made to 
certain businesses to encourage location in Puerto Rico and the 
subsidies could be tailored to the specific circumstance of the 
business. A tax credit operates as an open-ended entitlement to 
any business that is eligible to claim the credit. On the other 
hand, unlike direct subsidies, under such a credit the marginal 
investment decisions are left to the private sector rather than 
being made by government officials.

3. Specialized small business investment companies

                              Present Law

    Under present law, a taxpayer may elect to roll over 
without payment of tax any capital gain realized upon the sale 
of publicly-traded securities where the taxpayer uses the 
proceeds from the sale to purchase common stock in a 
specialized small business investment company (``SSBIC'') 
within 60 days of the sale of the securities. The maximum 
amount of gain that an individual may roll over under this 
provision for a taxable year is limited to the lesser of (1) 
$50,000 or (2) $500,000 reduced by any gain previously excluded 
under this provision. For corporations, these limits are 
$250,000 and $1 million.
    In addition, under present law, an individual may exclude 
50 percent of the gain 87 from the sale of 
qualifying small business stock held more than five years. An 
SSBIC is automatically deemed to satisfy the active business 
requirement which a corporation must satisfy to qualify their 
stock for the exclusion.
---------------------------------------------------------------------------
    \87\ The portion of the capital gain included in income is subject 
to a maximum regular tax rate of 28 percent, and 42 percent of the 
excluded gain is a minimum tax preference.
---------------------------------------------------------------------------
    For purposes of these provisions, an SSBIC means any 
partnership or corporation that is licensed by the Small 
Business Administration under section 301(d) of the Small 
Business Investment Act of 1958 (as in effect on May 13, 1993). 
SSBICs make long-term loans to, or equity investments in, small 
businesses owned by persons who are socially or economically 
disadvantaged.

                        Description of Proposal

    Under the proposal, the tax-free rollover provision would 
be expanded by (1) extending the 60-day period to 180 days, (2) 
making preferred stock (as well as common stock) in an SSBIC an 
eligible investment, and (3) increasing the lifetime caps to 
$750,000 in the case of an individual and to $2 million in the 
case of a corporation, and repealing the annual caps.
    The proposal also would provide that an SSBIC that is 
organized as a corporation may convert to a partnership without 
imposition of a tax to either the corporation or its 
shareholders, by transferring its assets to a partnership in 
which it holds at least an 80-percent interest and then 
liquidating. The transaction must take place within 180 days of 
enactment of the proposal. The partnership would be liable for 
a tax on any ``built-in'' gain in the assets transferred by the 
corporation at the time of the conversion.
    Finally, the 50-percent exclusion for gain on the sale of 
qualifying small business stock would be increased to 60 
percent where the corporation was an SSBIC (or involving the 
sale in a pass-through entity holding an interest in an SSBIC).

                             Effective Date

    The proposal would be effective for sales after date of 
enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would make investments in SSBICs more 
attractive by providing tax advantages of deferral and lower 
capital gains taxes. Present law, and the proposal, attempt to 
distort taxpayer investment decisions by increasing the net, 
after-tax, return to investments in SSBICs compared to other 
assets. Economists argue that distortions in capital markets 
lead to reduced economic growth. In an efficient capital 
market, market values indicate sectors of the economy where 
investment funds are most needed. Artificially diverting 
investment funds in one direction or another results in certain 
investments that offer a lower rate of return being funded in 
lieu of certain other investments that offer a higher rate of 
return. The net outcome is a reduction in national income below 
that which would otherwise be achieved. Proponents of the 
proposal argue that capital markets are not fully efficient. In 
particular, they argue that a bias exists against funding 
business ventures undertaken by persons who are socially or 
economically disadvantaged.
    Generally, the cost of capital is greater for small 
businesses than for larger businesses. That is, investors 
demand a greater rate of return on their investment in smaller 
businesses than in larger businesses. The higher cost of 
capital may take the form of higher interest rates charged on 
business loans or a larger percentage of equity ownership per 
dollar invested. A higher cost of capital does not imply that 
capital markets are inefficient. The cost of capital reflects 
investors' perceptions of risk and the higher failure rates 
among small business ventures. There has been little study of 
whether the cost of capital to small businesses, regardless of 
the economic or social background of the entrepreneur, is ``too 
high'' when the risk of business failure is taken into account.
    Proponents of the proposal argue that, even if the higher 
cost of capital to such businesses is not the result of 
inefficiency of the capital market, an important social goal 
can be achieved by helping more persons who are socially or 
economically disadvantaged gain entrepreneurial experience. 
Opponents observe that, under present law, that objective is 
addressed by the Small Business Administration's subsidized 
loan program and present-law Code sections 1045 and 1202. They 
note that the proposal would not lower the cost of capital for 
all small businesses or for all small businesses organized by 
persons who are socially or economically disadvantaged, only 
those businesses that receive some of their financing through 
an SSBIC. Other investors do not receive these tax benefits 
even if they make substantial investments in business ventures 
organized by persons who are socially or economically 
disadvantaged. They argue there is a loss of efficiency from 
funneling a tax benefit to entrepreneurs through only one type 
of investment fund pool. In the near term, some of the tax 
benefit may accrue to current owners of SSBICs rather than to 
entrepreneurs as taxpayers seeking to take advantage of the 
proposal bid up the price of shares of existing SSBICs. 
Proponents note that over the longer term, as more funds flow 
into SSBICs and as new SSBICs are formed, there will be a 
larger pool of funds available to qualified entrepreneurs and 
those entrepreneurs will receive the benefits of a lower cost 
of capital.

4. Accelerate and expand incentives available to two new empowerment 
        zones

                              Present Law

Designated zones and communities

            Zones and communities designated under OBRA 1993
    Pursuant to the Omnibus Budget Reconciliation Act of 1993 
(``OBRA 1993''), the Secretaries of the Department of Housing 
and Urban Development (HUD) and the Department of Agriculture 
designated a total of nine empowerment zones and 95 enterprise 
communities on December 21, 1994. As required by law, six 
empowerment zones are located in urban areas and three 
empowerment zones are located in rural areas.88 Of 
the enterprise communities, 65 are located in urban areas and 
30 are located in rural areas (sec. 1391). Designated 
empowerment zones and enterprise communities were required to 
satisfy certain eligibility criteria, including specified 
poverty rates and population and geographic size limitations 
(sec. 1392).
---------------------------------------------------------------------------
    \88\ The six designated urban empowerment zones are located in New 
York City, Chicago, Atlanta, Detroit, Baltimore, and Philadelphia-
Camden (New Jersey). The three designated rural empowerment zones are 
located in Kentucky Highlands (Clinton, Jackson, and Wayne counties, 
Kentucky), Mid-Delta Mississippi (Bolivar, Holmes, Humphreys, Leflore 
counties, Mississippi), and Rio Grande Valley Texas (Cameron, Hidalgo, 
Starr, and Willacy counties, Texas).
---------------------------------------------------------------------------
    The following tax incentives are available for certain 
businesses located in empowerment zones: (1) a 20-percent wage 
credit for the first $15,000 of wages paid to a zone resident 
who works in the zone; (2) an additional $20,000 of section 179 
expensing for ``qualified zone property'' placed in service by 
an ``enterprise zone business'' (accordingly, certain 
businesses operating in empowerment zones are allowed up to 
$38,500 of expensing for 1998); (3) special tax-exempt 
financing for certain zone facilities (described in more detail 
below); and (4) the so-called ``brownfields'' tax incentive, 
which allows taxpayers to expense (rather than capitalize) 
certain environmental remediation expenditures.89
---------------------------------------------------------------------------
    \89\ The environmental remediation expenditure must be incurred in 
connection with the abatement or control of hazardous substances at a 
qualified contaminated site, generally meaning any property that (1) is 
held for use in a trade or business, for the production of income, or 
as inventory; (2) is certified by the appropriate State environmental 
agency to be located within a targeted area; and (3) contains (or 
potentially contains) a hazardous substance. Targeted areas include: 
(1) empowerment zones and enterprise communities as designated under 
OBRA 1993 and the 1997 Act (including any supplemental empowerment zone 
designated on December 21, 1994); (2) sites announced before February 
1997, as being an Environmental Protection Agency (EPA) Brownfields 
Pilot; (3) any population census tract with a poverty rate of 20 
percent or more; and (4) certain industrial and commercial areas that 
are adjacent to tracts described in (3) above. The ``brownfields'' 
provision (enacted in the Taxpayer Relief Act of 1997) applies to 
eligible expenditures incurred in taxable years ending after August 5, 
1997, and before January 1, 2001.
    The President's budget proposal would make the brownfields 
incentive permanent (See Part I.B.2.b., above).
---------------------------------------------------------------------------
    The 95 enterprise communities are eligible for the special 
tax-exempt financing benefits and ``brownfields'' tax 
incentive, but not the other tax incentives (i.e., the wage 
credit and additional sec. 179 expensing) available in the 
empowerment zones. In addition to these tax incentives, OBRA 
1993 provided that Federal grants would be made to designated 
empowerment zones and enterprise communities.
    The tax incentives (other than the ``brownfields'' 
incentive) for empowerment zones and enterprise communities 
generally will be available during the period that the 
designation remains in effect, i.e., the 10-year period of 1995 
through 2004.
            Additional zones designated under 1997 Act
    Two additional urban zones with same tax incentives as 
previously designated empowerment zones.--Pursuant to the 
Taxpayer Relief Act of 1997 (``1997 Act''), the Secretary of 
HUD designated two additional empowerment zones located in 
Cleveland and Los Angeles (thereby increasing to eight the 
total number of empowerment zones located in urban areas) with 
respect to which apply the same tax incentives (i.e., the wage 
credit, additional expensing, special tax-exempt financing, and 
brownfields incentive) as are available within the empowerment 
zones authorized by OBRA 1993.90 The two additional 
empowerment zones located in Cleveland and Los Angeles were 
subject to the same eligibility criteria under section 1392 
that applied to the original six urban empowerment 
zones.91
---------------------------------------------------------------------------
    \90\ The wage credit available in the two new urban empowerment 
zones is modified slightly to provide that the credit rate will be 20 
percent for calendar years 2000-2004, 15 percent for calendar year 
2005, 10 percent for calendar year 2006, and 5 percent for calendar 
2007. No wage credit will be available in the two new urban empowerment 
zones after 2007.
    \91\ In order to permit designation of these two additional 
empowerment zones, the 1997 Act increased the aggregate population cap 
applicable to urban empowerment zones from 750,000 to a cap of one 
million aggregate population for the eight urban empowerment zones.
---------------------------------------------------------------------------
    The two additional empowerment zones located in Cleveland 
and Los Angeles were designated by the Secretary of HUD on 
January 31, 1997. However, a special rule provides that the 
designations of these two additional empowerment zones will not 
take effect until January 1, 2000 (and generally will remain in 
effect for 10 years).
    20 additional urban and rural empowerment zones.--The 1997 
Act also authorizes the Secretaries of HUD and Agriculture to 
designate an additional 20 empowerment zones (no more than 15 
in urban areas and no more than five in rural 
areas).92 With respect to these additional 
empowerment zones, the present-law eligibility criteria are 
expanded slightly in comparison to the eligibility criteria 
provided for by OBRA 1993. First, the general square mileage 
limitations (i.e., 20 square miles for urban areas and 1,000 
square miles for rural areas) are expanded to allow the 
empowerment zones to include an additional 2,000 acres. This 
additional acreage, which could be developed for commercial or 
industrial purposes, is not subject to the poverty rate 
criteria and may be divided among up to three noncontiguous 
parcels. In addition, the general requirement that at least 
half of the nominated area consist of census tracts with 
poverty rates of 35 percent or more does not apply to the 20 
additional empowerment zones. However, under present-law 
section 1392(a)(4), at least 90 percent of the census tracts 
within a nominated area must have a poverty rate of 25 percent 
or more, and the remaining census tracts must have a poverty 
rate of 20 percent or more.93 For this purpose, 
census tracts with populations under 2,000 are treated as 
satisfying the 25-percent poverty rate criteria if (1) at least 
75 percent of the tract was zoned for commercial or industrial 
use, and (2) the tract is contiguous to one or more other 
tracts that actually have a poverty rate of 25 percent or 
more.94
---------------------------------------------------------------------------
    \92\ In contrast to OBRA 1993, areas located within Indian 
reservations are eligible for designation as one of the additional 20 
empowerment zones under the 1997 Act.
    \93\ In lieu of the poverty criteria, outmigration may be taken 
into account in designating one rural empowerment zone.
    \94\ A special rule enacted as part of the 1997 Act modifies the 
present-law empowerment zone and enterprise community designation 
criteria so that any zones or communities designated in the future in 
the States of Alaska or Hawaii will not be subject to the general size 
limitations, nor will such zones or communities be subject to the 
general poverty-rate criteria. Instead, nominated areas in either State 
will be eligible for designation as an empowerment zone or enterprise 
community if, for each census tract or block group within such area, at 
least 20 percent of the families have incomes which are 50 percent or 
less of the State-wide median family income. Such zones and communities 
will be subject to the population limitations under present-law section 
1392(a)(1).
---------------------------------------------------------------------------
    Within the 20 additional empowerment zones, qualified 
``enterprise zone businesses'' are eligible to receive up to 
$20,000 of additional section 179 expensing 95 and 
to utilize special tax-exempt financing benefits. The 
``brownfields'' tax incentive (described above) also is 
available within all designated empowerment zones. However, 
businesses within the 20 additional empowerment zones are not 
eligible to receive the present-law wage credit available 
within the 11 other designated empowerment zones (i.e., the 
wage credit is available only within in the nine zones 
designated under OBRA 1993 and the two urban zones designated 
under the 1997 Act that are eligible for the same tax 
incentives as are available in the nine zones designated under 
OBRA 1993).
---------------------------------------------------------------------------
    \95\ However, the additional section 179 expensing is not available 
within the additional 2,000 acres allowed to be included under the 1997 
Act within an empowerment zone.
---------------------------------------------------------------------------
    The 20 additional empowerment zones are required to be 
designated before 1999, and the designations generally will 
remain in effect for 10 years.96
---------------------------------------------------------------------------
    \96\ In addition, the 1997 Act also provides for special tax 
incentives (some of which are modeled after the empowerment zone tax 
incentives) for the District of Columbia.
---------------------------------------------------------------------------

Definition of ``qualified zone property''

    Present-law section 1397C defines ``qualified zone 
property'' as depreciable tangible property (including 
buildings), provided that: (1) the property is acquired by the 
taxpayer (from an unrelated party) after the zone or community 
designation took effect; (2) the original use of the property 
in the zone or community commences with the taxpayer; and (3) 
substantially all of the use of the property is in the zone or 
community and is in the active conduct of a qualified business 
by the taxpayer in the zone or community. In the case of 
property which is substantially renovated by the taxpayer, 
however, the property need not be acquired by the taxpayer 
after zone or community designation or originally used by the 
taxpayer within the zone or community if, during any 24-month 
period after zone or community designation, the additions to 
the taxpayer's basis in the property exceed 100 percent of the 
taxpayer's basis in the property at the beginning of the 
period, or $5,000 (whichever is greater).

Definition of ``enterprise zone business''

    Present-law section 1397B defines the term ``enterprise 
zone business'' as a corporation or partnership (or 
proprietorship) if for the taxable year: (1) every trade or 
business of the corporation or partnership is the active 
conduct of a qualified business within an empowerment zone or 
enterprise community 97; (2) at least 50 percent 
98 of the total gross income is derived from the 
active conduct of a ``qualified business'' within a zone or 
community; (3) a substantial portion of the business's tangible 
property is used within a zone or community; (4) a substantial 
portion of the business's intangible property is used in the 
active conduct of such business; (5) a substantial portion of 
the services performed by employees are performed within a zone 
or community; (6) at least 35 percent of the employees are 
residents of the zone or community; and (7) less than five 
percent of the average of the aggregate unadjusted bases of the 
property owned by the business is attributable to (a) certain 
financial property, or (b) collectibles not held primarily for 
sale to customers in the ordinary course of an active trade or 
business.
---------------------------------------------------------------------------
    \97\ A qualified proprietorship is not required to meet the 
requirement that the sole trade or business of the proprietor is the 
active conduct of a qualified business within the empowerment zone or 
enterprise community.
    \98\ The 1997 Act reduced this threshold from 80 percent (as 
enacted in OBRA 1993) to 50 percent.
---------------------------------------------------------------------------
    A ``qualified business'' is defined as any trade or 
business other than a trade or business that consists 
predominantly of the development or holding of intangibles for 
sale or license.99 In addition, the leasing of real 
property that is located within the empowerment zone or 
community to others is treated as a qualified business only if 
(1) the leased property is not residential property, and (2) at 
least 50 percent of the gross rental income from the real 
property is from enterprise zone businesses.100 The 
rental of tangible personal property to others is not a 
qualified business unless at least 50 percent of the rental of 
such property is by enterprise zone businesses or by residents 
of an empowerment zone or enterprise community.
---------------------------------------------------------------------------
    \99\ Also, a qualified business does not include certain facilities 
described in section 144(c)(6)(B)(e.g., massage parlor, hot tub 
facility, or liquor store) or certain large farms.
    \100\ The 1997 Act provides that the lessor of property may rely on 
a lessee's certification that such lessee is an enterprise zone 
business.
---------------------------------------------------------------------------

Tax-exempt financing rules

    Tax-exempt private activity bonds may be issued to finance 
certain facilities in empowerment zones and enterprise 
communities. These bonds, along with most private activity 
bonds, are subject to an annual private activity bond State 
volume cap equal to $50 per resident of each State, or (if 
greater) $150 million per State. However, a special rule 
(enacted in the 1997 Act) provides that certain ``new 
empowerment zone facility bonds'' issued for qualified 
enterprise zone businesses in the 20 additional empowerment 
zones are not subject to the State private activity bond volume 
caps or the special limits on issue size generally applicable 
to qualified enterprise zone facility bonds under section 
1394(c).101
---------------------------------------------------------------------------
    \101\ The maximum amount of ``new empowerment zone facility bonds'' 
that can be issued is limited to $60 million per rual zone, $130 
million per urban zone with a population of less than 100,000, and $230 
million per urban zone with a population of 100,000 or more. ``New 
empowerment zone facility bonds'' may not be issued with respect to the 
two urban empowerment zones to be designated under the 1997 Act within 
which will apply the same tax incentives as apply to the empowerment 
zones authorized by OBRA 1993.
---------------------------------------------------------------------------
    Qualified enterprise zone facility bonds are bonds 95 
percent or more of the net proceeds of which are used to 
finance (1) ``qualified zone property'' (as defined above 
102) the principal user of which is an ``enterprise 
zone business'' (also defined above 103), or (2) 
functionally related and subordinate land located in the 
empowerment zone or enterprise community.104 These 
bonds may only be issued while an empowerment zone or 
enterprise community designation is in effect.
---------------------------------------------------------------------------
    \102\ A special rule (enacted in the 1997 Act) relaxes the 
rehabilitation requirement for financing existing property with 
qualified enterprise zone facility bonds. In the case of property which 
is substantially renovated by the taxpayer, the property need not be 
acquired by the taxpayer after zone or community designation and need 
not be originally used by the taxpayer within the zone if, during any 
24-month period after zone or community designation, the additions to 
the taxpayer's basis in the property exceed 15 percent of the 
taxpayer's basis at the beginning of the period, or $5,000 (whichever 
is greater).
    \103\ For purposes of the tax-exempt financing rules, an 
``enterprise zone business'' also includes a business located in a zone 
or community which would qualify as an enterprise zone business if it 
were separately incorporated.
    A special rule (enacted in the 1997 Act) waives the requirements of 
an enterprise zone business (other than the requirement that at least 
35 percent of the business' employees be residents of the zone or 
community) for all years after a prescribed testing period equal to the 
first three taxable years after the startup period.
    \104\ A special rule (enacted in the 1997 Act) waives until the end 
of a ``startup period'' the requirement that 95 percent or more of the 
proceeds of bond issue be used by a qualified enterprise zone business. 
With respect to each property, the startup period would end at the 
beginning of the first taxable year beginning more than two years after 
the later of (1) the date of the bond issue financing such property, or 
(2) the date the property was placed in service (but in no event more 
than three years after the date of bond issuance). This waiver is 
available only if, at the beginning of the startup period, there is a 
reasonable expectation that the use by a qualified enterprise zone 
business will be satisfied at the end of the startup period and the 
business makes bona fide efforts to satisfy the enterprise zone 
business definition.
---------------------------------------------------------------------------
    The aggregate face amount of all qualified enterprise zone 
bonds for each qualified enterprise zone business may not 
exceed $3 million per zone or community. In addition, total 
qualified enterprise zone bond financing for each principal 
user of these bonds may not exceed $20 million for all zones 
and communities.

                        Description of Proposal

    The proposal would accelerate from January 1, 2000, to 
January 1, 1999, the effective date for designation of the two 
additional empowerment zones located in Cleveland and Los 
Angeles with respect to which will apply the same tax 
incentives as are available within the nine empowerment zones 
authorized by OBRA 1993. Under the proposal, the wage credit 
would be available in these two empowerment zones for 10 years. 
The credit rate for the wage credit would be 20 percent for 
calendar years 1999-2005, 15 percent for calendar year 2006, 10 
percent for calendar year 2007, and 5 percent for calendar year 
2008.

                             Effective Date

    The proposal would be effective on January 1, 1999.

                              Prior Action

    OBRA 1993 authorized the designation of nine empowerment 
zones and 95 enterprise communities. The Secretaries of HUD and 
the Department of Agriculture designated such empowerment zones 
and enterprise communities on December 21, 1994, and such 
designations generally will remain in effect through December 
31, 2004.
    The 1997 Act authorized the designation of two additional 
empowerment zones, with respect to which will apply the same 
tax incentives as are available within the empowerment zones 
authorized by OBRA 1993. Pursuant to this authorization, areas 
located in Cleveland and Los Angeles were designated as 
empowerment zones on January 31, 1998, but such designations 
will not take effect until January 1, 2000. The 1997 Act also 
authorizes the designation of an additional 20 empowerment 
zones (with different eligibility criteria and tax incentives 
compared to the empowerment zones designated under OBRA 1993). 
These additional 20 empowerment zones have not yet been 
designated.

                                Analysis

    Pursuant to the 1997 Act, areas located in Cleveland and 
Los Angeles have been designated as empowerment zones. With 
respect to these areas, the Administration's proposal would 
permit qualifying businesses to claim wage credits, expense 
additional capital investments under section 179, to benefit 
from special tax-exempt financing, and to expense certain 
environmental remediation expenses for expenses incurred during 
the 10-year period 1999 through 2008, rather than the 10-year 
period 2000 through 2009.105 The proposal does not 
change materially any of the tax benefits (other than adding 
two more years during which the wage credit will be available), 
but rather the time period for which such tax benefits may be 
claimed. However, by changing the time period for which tax 
benefits may be claimed, the value of those benefits may be 
altered for taxpayers in different situations.
---------------------------------------------------------------------------
    \105\ Expensing of qualified environmental remediation expenditures 
within the zones may be claimed only through 2000 under present law. In 
a separate proposal, the President's budget would make permanent the 
expensing of qualified environmental remediation expenditures. (See 
Part I.B.2.b., above.)
---------------------------------------------------------------------------
    The tax benefits for empowerment zones are designed to 
facilitate community economic renewal by encouraging existing 
businesses to remain and expand in the designated empowerment 
zone, by encouraging new businesses to locate within the 
empowerment zone, and by encouraging the employment of zone 
residents within the zone. By accelerating the availability of 
tax benefits, existing businesses located within the 
empowerment zone will be able to claim tax benefits almost 
immediately. The reduction in capital costs or employment costs 
may enable certain existing businesses which might otherwise 
have closed or moved from the zone to remain profitable in 
their current location. Because present law delays the tax 
benefits for Cleveland and Los Angeles, the present value of 
the entire 10-year stream of potential tax benefits is reduced. 
Such a reduction may mean that certain existing businesses will 
find it more profitable to operate elsewhere. Similarly, 
because the empowerment zones located in Cleveland and Los 
Angeles were designated on January 31, 1998, community leaders 
could advertise that Federal tax benefits will be available in 
the future to businesses that relocate to within the zone. 
However, a business that is currently considering a relocation 
would find it less attractive to have to wait until the year 
2000 to claim the promised tax benefits than to be able to 
begin claiming the tax benefits in 1999. By accelerating the 
period during which tax benefits may be claimed, certain 
businesses will find the tax benefits more attractive, and this 
could induce such businesses to remain, locate, or expand 
within the zone.
    On the other hand, by accelerating the period during which 
tax benefits may be claimed, certain businesses may find the 
tax benefits less attractive. Many investment plans, whether 
they be for expansion of an existing business within the zone, 
the relocation of a business to within the zone, or the 
creation of a new business, require substantial lead time 
before investment expenses are incurred or employees are hired. 
For example, commencement of operations for a qualifying 
business may take one year or more between the initial planning 
decisions, the procurement of necessary permits, and the 
placement in service of business property. In such a case, by 
accelerating the period during which a business may claim 
additional expensing under section 179 to the years 1999 
through 2008 rather than the years 2000 through 2009, a 
business considering an investment to commence operations in 
2002 may find that, under the proposal, it may claim additional 
expensing for only seven years, rather than eight years under 
present law. If the subsidy offered by the additional expensing 
under section 179 is critical to the decision to invest in this 
business, the loss of one year's worth of subsidy could affect 
investment decisions. 106 More generally, community 
leaders could find it advantageous to have the lead time 
provided under present law to coordinate State and local 
redevelopment efforts with those that will be forthcoming from 
the private sector in response to future availability of 
Federal tax benefits.
---------------------------------------------------------------------------
    \106\ Because the proposal would add two years during which the 
wage credit would be available within the Cleveland and Los Angeles 
empowerment zones, all businesses that relocate to such zones prior to 
January 1, 2009, would be better off under the proposal than under 
present law with respect to the wage credit, despite the proposed one-
year acceleration of the effective date of the designation of such 
zones.
---------------------------------------------------------------------------

5. Exempt first $2,000 of severance pay from income tax

                              Present Law

    Under present law, severance payments are includible in 
gross income.

                        Description of Proposal

    Under the proposal, up to $2,000 of certain severance 
payments would be excludable from the income of the recipient. 
The exclusion would apply to payments received by an individual 
who was separated from service in connection with a reduction 
in the employer's work force. The exclusion would not be 
available if the individual becomes employed within 6 months of 
the separation from service at a compensation level that is 95 
percent of the compensation the individual received before the 
separation from service. The exclusion would not apply if the 
total severance payments received by the individual exceed 
$125,000.

                             Effective Date

    The proposal would be effective for severance pay received 
in taxable years beginning after December 31, 1998, and before 
January 1, 2004.

                              Prior Action

    No prior action.

                                Analysis

    The proposals lacks specificity in certain respects. For 
example, the proposal does not define a ``reduction in the 
employer's work force.'' Without an adequate definition, almost 
any termination of employment could be construed as in 
connection with a reduction in the employer's work force, 
meaning that up to $2,000 of any payments made upon termination 
of employment would be excludable from income. While the 
proposal was not intended to be interpreted so broadly, 
additional details would be necessary to determine the breadth 
and impact of the proposal. The proposal also does not define 
``severance payments,'' so it is unclear whether the proposal 
is intended to be limited to certain types of payments received 
upon a separation from service, or only some payments. The 
definition is important not only in determining what payments 
qualify for the exclusion, but also in determining whether any 
payments qualify because the $125,000 cap is exceeded.
    It is also not entirely clear from the proposal whether the 
exclusion is a one-time exclusion, an annual exclusion, or 
whether it applies separately to each qualifying separation 
from service of the individual.
    The stated rationale for the proposal is that the tax on 
severance payments places an additional burden on displaced 
workers, especially if the worker is separated from service 
because of a reduction in work force, in which case it may be 
difficult for the worker to find new, comparable employment. 
Some would agree that it is appropriate to provide tax relief 
for individuals in such circumstances. However, others would 
argue that the proposal does not provide relief for all persons 
in similar circumstances. For example, some would argue that 
relief would be even more necessary in cases in which severance 
payments are not provided by the employer, and that a more fair 
approach to providing relief for displaced workers would be to 
provide that some portion of unemployment benefits are 
excludable from income. Others would argue that there is no 
clear rationale for distinguishing separations from service in 
connection with a reduction in the work force from other 
separations--the hardship on the individual may be just as 
great in other circumstances. Some would also argue that the 
proposal is not well-targeted because it provides tax relief 
for individuals who are not in financial distress as a result 
of the separation from service. The limit on the exclusion to 
cases in which the payments are less than $125,000, is one way 
of addressing this concern, as is the restriction that the 
exclusion does not apply if comparable employment is attained 
within 6 months. Other methods would also be possible, but 
would also add complexity to the proposal. The 6-month rule may 
itself add some complexity, because the new employment may 
occur in a tax year other than the one in which the payments 
were received and after the individual's tax return for the 
year of payment had been filed. It is unclear in those cases 
how the individual would correct the error, e.g., would the 
individual file an amended return?

                      G. Simplification Provisions

1. Optional Self-Employment Contribution Act (``SECA'') computations

                              Present Law

    The Self-Employment Contributions Act (``SECA'') imposes 
taxes on net earnings from self-employment to provide social 
security and Medicare coverage to self-employed individuals. 
The maximum amount of earnings subject to the SECA tax is 
coordinated with, and is set at the same level as, the maximum 
level of wages and salaries subject to FICA taxes ($68,400 for 
OASDI taxes in 1998 and indexed annually, and without limit for 
the Hospital Insurance tax). Special rules allow certain self-
employed individuals to continue to maintain social security 
coverage during a period of low income. The method applicable 
to farmers is slightly more favorable than the method 
applicable to other self-employed individuals.
    A farmer may increase his or her self-employment income, 
for purposes of obtaining social security coverage, by 
reporting two-thirds of the first $2,400 of gross income as net 
earnings from self-employment, i.e., the optional amount of net 
earnings from self-employment would not exceed $1,600. There is 
no limit on the number of times a farmer may use this method. 
The optional method for nonfarm income is similar, also 
permitting two-thirds of the first $2,400 of gross income to be 
treated as self-employment income. However, the optional 
nonfarm method may not be used more than five times by any 
individual, and may only be used if the taxpayer had net 
earnings from self-employment of $400 or more in at least two 
of the three years immediately preceding the year in which the 
optional method is elected.
    In general, to receive benefits, including Disability 
Insurance Benefits, under the Social Security Act, a worker 
must have a minimum number of quarters of coverage. A minimum 
amount of wages or self-employment income must be reported to 
obtain a quarter of coverage. A maximum of four quarters of 
coverage may be obtained each year. In 1978, the amount of 
earnings required to obtain a quarter of coverage began 
increasing each year. Starting in 1994, a farmer could obtain 
only two quarters of coverage under the optional method 
applicable to farmers.

                        Description of Proposal

    The proposal would combine the farm and nonfarm optional 
methods into a single combined optional method applicable to 
all self-employed workers under which self-employment income 
for SECA tax purposes would be two-thirds of the first $2,400 
of gross income. A self-employed individual could elect to use 
the optional method an unlimited number of times. If it is 
used, it would have to be applied to all self-employment 
earnings for the year, both farm and nonfarm. As under present 
law, the $2,400 amount would not be increased for inflation.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1998.

                              Prior Action

    The proposal was included in the Administration's 1997 
simplification proposals. 107 A similar proposal was 
also included in the Taxpayer Relief Act of 1997, as passed by 
the House. However, that provision would also have initially 
increased the $2,400 limit to the amount that would provide for 
four quarters of coverage in 1998, and increased the limit 
thereafter as the earnings requirement for quarters of coverage 
increases under the Social Security Act. That provision would 
also have provided that the optional method could not be 
elected retroactively on an amended return.
---------------------------------------------------------------------------
    \107\ See Department of the Treasury, Taxpayer Bill of Rights 3 and 
Tax Simplification Proposals (April 1997).
---------------------------------------------------------------------------

                                Analysis

    Approximately 48,000 taxpayers use one of the optional 
methods. The proposal would simplify SECA calculations for 
those who use the optional method.
    The present-law optional farm method is more advantageous 
than the nonfarm method. The proposal would eliminate 
inequities between the two methods.
    Some argue that the proposal should be expanded to increase 
the $2,400 limit so that the optional method will continue to 
fulfill its original purpose of allowing self-employed 
individuals to earn full quarters of coverage.
    Also, some argue that taxpayers should not be able to make 
an election on a retroactive basis, just as insurance cannot be 
purchased after the occurrence of an insurable event. On the 
other hand, some argue that not permitting the election on an 
amended return may unduly penalize taxpayers who mistakenly do 
not claim the election when they first file their return.

2. Statutory hedging and other rules to ensure business property is 
        treated as ordinary property

                              Present Law

    Capital gain treatment applies to gain on the sale or 
exchange of a capital asset. Capital assets include property 
other than (1) stock in trade or other types of assets 
includible in inventory, (2) property used in a trade or 
business that is real property or property subject to 
depreciation, (3) accounts or notes receivable acquired in the 
ordinary course of a trade or business, or (4) certain 
copyrights (or similar property) and U.S. government 
publications. Gain or loss on such assets generally is treated 
as ordinary, rather than capital, gain or loss. Certain other 
Code sections also treat gains or losses as ordinary, such as 
the gains or losses of a securities or commodities trader or 
dealer that are subject to ``mark-to-market'' accounting (sec. 
475). Other Code sections treat certain assets as giving rise 
to capital gain or loss.
    Under case law in a number of Federal courts prior to 1988, 
business hedges generally were treated as giving rise to 
ordinary, rather than capital, gain or loss. In 1988, the U.S. 
Supreme Court rejected this interpretation in Arkansas Best v. 
Commissioner, 485 U.S. 212 (1988), which, relying on the 
statutory definition of a capital asset described above, held 
that a loss realized on a sale of stock was capital even though 
the stock was purchased for a business, rather than an 
investment, purpose.
    In 1993, the Department of the Treasury issued temporary 
regulations, which were finalized in 1994, that require 
ordinary character treatment for most business hedges and 
provide timing rules requiring that gains or losses on hedging 
transactions be taken into account in a manner that matches the 
income or loss from the hedged item or items. The regulations 
apply to hedges that meet a standard of ``risk reduction'' with 
respect to ordinary property held (or to be held) or certain 
liabilities incurred (or to be incurred) by the taxpayer and 
that meet certain identification and other requirements (Treas. 
reg. sec. 1.1221-2).
    Under the straddle rules, when a taxpayer realizes a loss 
on one offsetting position in actively-traded personal 
property, the taxpayer generally can deduct this loss only to 
the extent the loss exceeds the unrecognized gain in the other 
positions in the straddle (sec. 1092). The straddle rules 
generally do not apply to positions in stock. However, the 
straddle rules apply to straddles where one of the positions is 
stock and at least one of the offsetting positions is either 
(1) an option with respect to such stock or substantially 
identical stock or securities or (2) a position with respect to 
substantially similar or related property (other than stock) as 
defined in Treasury regulations. In addition, the straddle 
rules apply to stock of a corporation formed or availed of to 
take positions in personal property which offset positions 
taken by any shareholder.

                        Description of Proposal

    The proposal would add three categories to the list of 
assets gain or loss on which is treated as ordinary (sec. 
1221). The new categories would be: (1) derivative contracts 
entered into by derivative dealers; (2) supplies of a type 
regularly used by the taxpayer in the provision of services or 
the production of ordinary property; and (3) hedging 
transactions.
    In defining a hedging transaction, the proposal would 
generally codify the approach taken by the Treasury 
regulations, but would modify the rules to some extent. The 
``risk reduction'' standard of the regulations would be 
broadened to one of ``risk management'' with respect to 
ordinary property held (or to be held) or certain liabilities 
incurred (or to be incurred). As under the Treasury 
regulations, the transaction would have to be identified as a 
hedge of specified property. If a transaction was improperly 
identified as a hedging transaction, losses would retain their 
usual character (i.e., usually capital), but gains would be 
ordinary. If a hedging transaction was not identified (and 
there was no reasonable basis for that failure), gains would be 
ordinary but losses would retain their non-hedging character. 
The proposal would provide an exclusive list of assets the 
gains and losses which would receive ordinary character 
treatment; other rationales for ordinary treatment generally 
would not be allowed. The Treasury Department would be given 
authority to apply these rules to related parties.
    As under current Treasury regulations, the proposal would 
require that the timing of income, gain, deduction or loss from 
hedging transactions must reasonably match the income, gain, 
deduction or loss from the items being hedged. In addition, 
under the proposal, taxpayers could, to the extent provided in 
Treasury regulations, elect the application of these timing 
rules for certain transactions that would otherwise be subject 
to loss deferral under the straddle rules. The proposal would 
repeal the exception from the straddle rules for stock. 
Finally, the Treasury Department would be given the authority 
to treat the offsetting positions in a straddle on an 
integrated basis.

                             Effective Date

    The proposal would be generally effective after the date of 
enactment. The identification requirements for hedging 
transactions would be effective 60 days after the date of 
enactment. The Treasury would be given the authority to issue 
regulations applying treatment similar to that provided in the 
proposal to transactions entered into prior to the effective 
date.

                              Prior Action

    A similar proposal was included in the President's tax 
simplification proposals released in April 1997.

                                Analysis

    The proposal's additions to the list of assets that give 
rise to ordinary gain and loss would to some extent be a 
clarification of present law. Hedging transactions have long 
been treated as ordinary under the case law and, more recently, 
under Treasury regulations. Gains on derivative contracts 
referencing interest rates, equity or foreign currencies 
recognized by a dealer in such contracts are treated as 
ordinary under the ``mark-to-market'' rules (sec. 475(c)(2) and 
(d)(3)). One addition the proposal would make to the ordinary 
list would be gains on commodities derivative contracts 
recognized by a dealer in such contracts. Some would argue that 
this addition is justifiable in order to eliminate the 
disparity between commodities derivatives dealers and dealers 
in other derivative contracts, whose gains are treated as 
ordinary as described above. The other addition that the 
proposal would make to the list of ordinary assets is supplies 
used in the provision of services or the production of ordinary 
property. An example would be a sale of excess jet fuel by an 
airline, which is treated as giving rise to capital gain under 
present law. Advocates of this addition would argue that such 
supplies are so closely related to the taxpayer's business that 
ordinary character should apply. Indeed, if the fuel were used 
rather than sold by the airline, it would give rise to an 
ordinary deduction. In addition, hedges of such items generally 
are treated as ordinary in character under present law, giving 
rise to a potential character mismatch, e.g. ordinary gain on 
the hedging transaction with a capital loss on the fuel sale 
that cannot be used to offset it (Treas. reg. sec. 1.1221-
2(c)(5)(ii)). However, opponents would argue that not all 
business-related income is ordinary in character and, thus, 
that the proposal would only create other disparities. For 
example, under present law, a special regime applies to gains 
and losses from property used in a trade or business that is 
either real property or depreciable property held for more than 
one year (sec. 1231). The effect of these rules generally is to 
treat a taxpayer's net amount of gain in any year from these 
items as long-term capital gain, but any net losses as ordinary 
losses.
    The proposal with respect to the definition of hedging 
transactions is largely a codification of the current Treasury 
regulations, with the expansion of the regulations' definition 
of hedging transactions to cover transactions that involve 
``risk management''. As noted above, the Treasury regulations 
were issued in response to the U.S. Supreme Court's decision in 
Arkansas Best, which narrowed the definition of hedging allowed 
by some Federal courts and resulted in confusion in the 
business community as to what types of business hedges would 
receive tax hedging treatment. The regulations adopted a more 
expansive standard than Arkansas Best, with the result that 
more types of business hedging practices can now be treated as 
hedges for character and timing purposes, and the regulations 
have generally been well received by the business community. 
Thus, codifying the regulations would serve to validate the 
Treasury regulations, as well as to assure businesses that the 
current regime for hedges will be available for some time. They 
would also prevent taxpayers from taking aggressive positions 
that transactions that are not described in the proposal 
qualify as hedges.
    The principal change that the proposal would make in the 
hedging definition is the replacement of the regulations' 
requirement that a hedging transaction result in ``risk 
reduction'' with respect to the hedged item with a broader 
``risk management'' standard. This is a change that is arguably 
not within the Treasury's authority to adopt by regulations. 
The parameters of the ``risk management'' standard are not 
clear in the proposal, yielding the possibility that the 
proposal could result in essentially speculative transactions 
obtaining the favorable character and timing benefits of 
hedging transactions. However, advocates of the proposal would 
point to some common types of business hedging transactions 
that arguably do not meet a ``risk reduction'' standard. One 
example frequently cited is a fixed-rate debt instrument hedged 
with a floating rate hedging instrument. A fixed-rate debt 
instrument bears little interest-rate risk, and thus the 
transaction would arguably not meet the ``risk reduction'' 
standard (cf. Treas. reg. sec. 1.1221-2(c)(1)(ii)(B)). However, 
businesses frequently enter into transactions hedging such 
instruments in order to obtain the benefits of floating 
interest rates, and such transactions should meet a ``risk 
management'' standard. There have been also reports of tax 
controversies over the present law ``risk reduction'' standard 
that should be reduced by the proposal. Finally, advocates of 
the proposal would point out that the expansiveness of the 
``risk management'' standard would be limited by identification 
requirement of the present Treasury regulations that would be 
codified by the proposal. Under that requirement, in order to 
obtain hedging character and timing treatment, the taxpayer 
must identify the hedging position in its own records on the 
day that the position is acquired and must identify the 
specific property or liabilities being hedged within 35 days 
thereafter (Treas. reg. sec. 1.1221-2(e)). Despite the 
potential overbreadth of the ``risk management'' standard, 
these identification requirements limit the ability of 
taxpayers to utilize the hedging rules for essentially 
speculative transactions.
    The proposal would generally codify the Treasury 
regulations' timing rules for hedges, with the advantages of 
codification described above, but would also allow taxpayers to 
elect such treatment for non-hedging transactions that are 
subject to the straddle rules. Like any election, this one 
would be made only by taxpayers who predict that it would 
result in a tax savings. Moreover, by adding the election, the 
proposal adds complexity to the already complicated rules for 
timing of straddle income. The proposal is not clear as to the 
priority of the new election and the elections already 
available under the straddle rules (Treas. reg. sec. 1092(b)-3T 
and 4T) and thus may grant multiple elective tax treatments for 
the same transaction. However, advocates of the proposal would 
argue that treatment of some transactions under the straddle 
rules is too severe. For example, a small loss can be deferred 
even where large amounts of gain have been recognized on the 
offsetting position because there is also some unrecognized 
gain. However, opponents of the proposal would argue that such 
problems call for a revision, and hopefully a simplification, 
of the straddle rules, not for a new elective treatment. On the 
other hand, the hedge timing rules, which the proposal would 
allow taxpayers to elect, account for income in an economic 
manner--the timing of gains and losses on the hedging 
transaction must reasonably match those from the items being 
hedged. Advocates of the proposal would also point to the 
identification requirement, which would require taxpayers to 
elect hedge accounting for a transaction at the time it is 
entered into and to follow that treatment whether or not it 
proves advantageous. However, the portion of the proposal that 
would, in addition to the above rules, grant the Treasury 
Department authority to adopt integration treatment for the 
positions of a straddle is unclear in scope and should be 
clarified.
    The repeal of the limited exception from the straddle rules 
for stock is arguably consistent with the policy of those 
rules, which prevent deduction of losses in situations where a 
taxpayer has entered into an offsetting transaction that has 
unrecognized gain, until such time as the gain on the 
offsetting position is recognized. Advocates of the proposal 
would also point out that offsetting stock positions are fully 
subject to the constructive sale rules added by the Taxpayer 
Relief Act of 1997 (sec. 1259), which have more onerous results 
than loss deferral under the straddle rules. However, because 
stock is widely held, the repeal of the stock exception would 
subject many more taxpayers to the complicated straddle rules. 
It must also be pointed out that proposed Treasury regulations 
would severely limit the stock exception even if the proposal 
is not adopted (Prop. Treas. reg. sec. 1.1092(d)-2).
    Finally, the proposal would grant the Treasury Department 
regulatory authority to apply the proposal to transactions 
entered into prior to the date of enactment. It is difficult to 
assess whether it is appropriate to apply rules in a 
retroactive manner without knowing what these rules will be. As 
an alternative, where Congress intends that the provisions of 
the proposal will not change present law, a ``no inference'' 
statement could be made in the legislative history. However, 
this approach would leave ambiguity in the law.

3. Clarify rules relating to certain disclaimers

                              Present Law

    Historically, there must be acceptance of a gift in order 
for the gift to be completed under State law and there is no 
taxable gift for Federal gift tax purposes unless there is a 
completed gift. Most States have rules that provide that, where 
there is a disclaimer of a gift, the property passes to the 
person who would be entitled to the property had the 
disclaiming party died before the purported transfer.
    In the Tax Reform Act of 1976, Congress provided a uniform 
disclaimer rule (sec. 2518) that specified how and when a 
disclaimer must be made in order to be effective for Federal 
transfer tax purposes. Under section 2518, a disclaimer is 
effective for Federal transfer tax purposes if it is an 
irrevocable and unqualified refusal to accept an interest in 
property and certain other requirements are satisfied. One of 
the requirements is that the disclaimer generally must be made 
in writing not later than nine months after the transfer 
creating the interest occurs. In order to be a qualified 
disclaimer, the disclaiming person must not have accepted the 
disclaimed interest or any of its benefits. Section 2518 is not 
currently effective for Federal tax purposes other than 
transfer taxes (e.g., it is not effective for income tax 
purposes).
    In 1981, Congress added a rule to section 2518 that allowed 
certain transfers of property to be treated as a qualified 
disclaimer, even if not a qualified disclaimer under State law. 
In order to qualify, these transfer-type disclaimers must be a 
written transfer of the disclaimant's ``entire interest in the 
property'' to persons who would have received the property had 
there been a valid disclaimer under State law (sec. 
2518(c)(3)). Like other disclaimers, the transfer-type 
disclaimer generally must be made within nine months of the 
transfer creating the interest.

                        Description of Proposal

    The proposal would allow a transfer-type disclaimer of an 
``undivided portion'' of the disclaimant transferor's interest 
in property to qualify under section 2518. Also, the proposal 
would allow a spouse to make a qualified transfer-type 
disclaimer where the disclaimed property is transferred to a 
trust in which the disclaimant spouse has an interest (e.g., a 
credit shelter trust). Further, the proposal would provide that 
a qualified disclaimer for transfer tax purposes under section 
2518 also would be effective for Federal income tax purposes 
(e.g., disclaimers of interests in annuities and income in 
respect of a decedent).

                             Effective Date

    The proposal would apply to disclaimers made after the date 
of enactment.

                              Prior Action

    The proposal was included in the House version of the 
Taxpayer Relief Act of 1997.

                                Analysis

    Under present law, a State-law disclaimer can be a 
qualified disclaimer even (1) where it is only a partial 
disclaimer of the property interest, or (2) where the 
disclaimant spouse retains an interest in the property. In 
contrast, it is currently unclear whether a transfer-type 
disclaimer can qualify under similar circumstances. Thus, in 
order to equalize the treatment of State-law disclaimers and 
transfer-type disclaimers, it may be appropriate to allow a 
transfer-type disclaimer of an undivided portion of property or 
a transfer-type disclaimer where the disclaimant spouse has 
retained an interest in the property to be treated as a 
qualified disclaimer for transfer tax purposes.
    The present-law rules pertaining to qualified disclaimers, 
as set forth in section 2518, are effective for Federal 
transfer tax purposes but not Federal income tax purposes. If a 
disclaimer satisfies the requirements for a qualified 
disclaimer under present law, it may be appropriate to allow 
the disclaimer to be effective for Federal income tax purposes 
as well as Federal transfer tax purposes. It should be noted, 
however, that allowing disclaimers to be effective for Federal 
income tax purposes would override the general assignment of 
income concepts in that area.

4. Simplify the foreign tax credit limitation for dividends from ``10/
        50'' companies

                              Present Law

    U.S. persons may credit foreign taxes against U.S. tax on 
foreign-source income. The amount of foreign tax credits that 
may be claimed in a year is subject to a limitation that 
prevents taxpayers from using foreign tax credits to offset 
U.S. tax on U.S.-source income. Separate limitations are 
applied to specific categories of income.
    Special foreign tax credit limitations apply in the case of 
dividends received from a foreign corporation in which the 
taxpayer owns at least 10 percent of the stock by vote and 
which is not a controlled foreign corporation (a so-called 
``10/50 company'').108 Dividends paid by a 10/50 
company in taxable years beginning before January 1, 2003 are 
subject to a separate foreign tax credit limitation for each 
10/50 company. Dividends paid by a 10/50 company that is not a 
passive foreign investment company in taxable years beginning 
after December 31, 2002, out of earnings and profits 
accumulated in taxable years beginning before January 1, 2003, 
are subject to a single foreign tax credit limitation for all 
10/50 companies (other than passive foreign investment 
companies). Dividends paid by a 10/50 company that is a passive 
foreign investment company out of earnings and profits 
accumulated in taxable years beginning before January 1, 2003 
continue to be subject to a separate foreign tax credit 
limitation for each such 10/50 company. Dividends paid by a 10/
50 company in taxable years beginning after December 31, 2002, 
out of earnings and profits accumulated in taxable years after 
December 31, 2002, are treated as income in a foreign tax 
credit limitation category in proportion to the ratio of the 
earnings and profits attributable to income in such foreign tax 
credit limitation category to the total earnings and profits (a 
so-called ``look-through'' approach). For these purposes, 
distributions are treated as made from the most recently 
accumulated earnings and profits. Regulatory authority is 
granted to provide rules regarding the treatment of 
distributions out of earnings and profits for periods prior to 
the taxpayer's acquisition of such stock.
---------------------------------------------------------------------------
    \108\  A controlled foreign corporation in which the taxpayer owns 
at least 10% of the stock by vote is treated as a 10/50 company with 
respect to any distribution out of earnings and profits for periods 
when it was not a controlled foreign corporation.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would simplify the application of the foreign 
tax credit limitation by applying the look-through approach 
immediately to all dividends paid by a 10/50 company, 
regardless of the year in which the earnings and profits out of 
which the dividend is paid were accumulated. The proposal would 
broaden the regulatory authority to provide rules regarding the 
treatment of distributions out of earnings and profits for 
periods prior to the taxpayer's acquisition of the stock, 
specifically including rules to disregard both pre-acquisition 
earnings and profits and foreign taxes, in appropriate 
circumstances.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1997.

                              Prior Action

    The proposal would modify the effective date of a provision 
included in the Taxpayer Relief Act of 1997 (the ``1997 Act'').

                                Analysis

    The proposal would eliminate the single-basket limitation 
approach for dividends from 10/50 companies, and would 
accelerate the application of the look-through approach for 
dividends from such companies for foreign tax credit limitation 
purposes. It is argued that the current rules for dividends 
from 10/50 companies will result in complexity and compliance 
burdens for taxpayers. For instance, dividends paid by a 10/50 
company in taxable years beginning after December 31, 2002 will 
be subject to the concurrent application of both the single-
basket approach (for pre-2003 earnings and profits) and the 
look-through approach (for post-2002 earnings and profits). In 
light of the delayed effective date for the look-through 
provision included in the 1997 Act, the 1997 Act's application 
of the look-through approach only to post-effective date 
earnings and profits was necessary to avoid affecting the 
timing of distributions before the effective date. The 
provision included in the 1997 Act was aimed at reducing the 
bias against U.S. participation in foreign joint ventures and 
foreign investment by U.S. companies through affiliates that 
are not majority-owned. In this regard, the proposal to 
accelerate the application of the look-through approach would 
be consistent with this objective.
    Under present law, regulatory authority is granted to 
provide rules regarding the treatment of distributions out of 
earnings and profits for periods prior to the taxpayer's 
acquisition of the stock of a 10/50 company. The proposal would 
broaden such regulatory authority to include rules to disregard 
(upon distributions from a 10/50 company) both pre-acquisition 
earnings and profits and foreign taxes, in appropriate 
circumstances. Under such an approach, in appropriate cases, a 
shareholder of a 10/50 company would not be entitled to a 
foreign tax credit with respect to distributions from that 
company out of pre-acquisition earnings and profits, but also 
would not be required to include such distributions in its 
income. Such an approach may provide administrative 
simplification in cases where it would be difficult for a 
minority shareholder to reconstruct the historical records of 
an acquired company. Such an approach also may be appropriate 
in certain cases where a taxpayer enters into transactions 
effectively to ``purchase'' foreign tax credits that can be 
used to reduce the taxpayer's U.S. residual taxes on other 
foreign-source income. However, this concept of disregarding 
earnings and profits and taxes is inconsistent with the general 
treatment of distributions from acquired corporations for 
foreign tax credit purposes.

5. Interest treatment for dividends paid by certain regulated 
        investment companies to foreign persons

                              Present Law

    A regulated investment company (``RIC'') is a domestic 
corporation that, at all times during the taxable year, is 
registered under the Investment Company Act of 1940 as a 
management company or as a unit investment trust, or has 
elected to be treated as a business development company under 
that Act (sec. 851(a)).
    In addition, to qualify as a RIC, a corporation must elect 
such status and must satisfy certain tests (sec. 851(b)). These 
tests include a requirement that the corporation derive at 
least 90 percent of its gross income from dividends, interest, 
payments with respect to certain securities loans, and gains on 
the sale or other disposition of stock or securities or foreign 
currencies or other income derived with respect to its business 
of investment in such stock, securities, or currencies.
    Generally, a RIC pays no income tax because it is permitted 
a deduction for dividends paid to its shareholders in computing 
its taxable income. Dividends paid by a RIC generally are 
includible in income by its shareholders as dividends, but the 
character of certain income items of the RIC may be passed 
through to shareholders receiving the dividend. A RIC generally 
may pass through to its shareholders the character of its long-
term capital gains by designating a dividend it pays as a 
capital gain dividend to the extent that the RIC has net 
capital gain. A RIC generally also can pass through to its 
shareholders the character of its tax-exempt interest from 
State and municipal bonds, but only if, at the close of each 
quarter of its taxable year, at least 50 percent of the value 
of the total assets of the RIC consists of these obligations.
    Under the Code, a 30-percent tax, collected by withholding, 
generally is imposed on the gross amount of certain U.S.-source 
income, such as interest and dividends, of nonresident alien 
individuals and foreign corporations (collectively, ``foreign 
persons''). Dividends paid by a RIC generally are treated as 
dividends for withholding tax purposes, subject to the 
exceptions noted above. This 30-percent withholding tax may be 
reduced or eliminated pursuant to an applicable income tax 
treaty. In the case of dividends on portfolio investments, U.S. 
income tax treaties commonly provide for a withholding tax at a 
rate of at least 15 percent.
    An exception from the U.S. 30-percent withholding tax is 
provided for so-called ``portfolio interest.'' Portfolio 
interest is interest (including original issue discount) which 
would be subject to the U.S. withholding tax but for the fact 
that specified requirements are met with respect to the 
obligation on which the interest is paid and with respect to 
the interest recipient. Pursuant to these requirements, in the 
case of an obligation that is in registered form, the U.S. 
person who otherwise would be required to withhold tax must 
receive a statement that the beneficial owner of the obligation 
is not a United States person. Alternatively, if the obligation 
is not in registered form, it must be ``foreign targeted.'' If 
the obligation is issued by a corporation or a partnership, the 
recipient of the interest must not have 10 percent or more of 
the voting power of the corporation or 10 percent or more of 
the capital or profits interest in the partnership. A corporate 
recipient of the interest must be neither a controlled foreign 
corporation receiving interest from a related person, nor 
(unless the obligor is the United States) a bank receiving the 
interest on an extension of credit made pursuant to a loan 
agreement entered into in the ordinary course of its trade or 
business. Finally, certain contingent interest does not qualify 
as portfolio interest.

                        Description of Proposal

    In the case of a RIC that invests substantially all of its 
assets in certain debt instruments or cash, the proposal would 
treat all dividends paid by the RIC to shareholders who are 
foreign persons as interest that qualifies for the ``portfolio 
interest'' exception from the U.S. withholding tax. Under the 
proposal, the debt instruments taken into account to satisfy 
this ``substantially all'' test generally would be limited to 
debt instruments of U.S. issuers that would themselves qualify 
for the ``portfolio interest'' exception if held by a foreign 
person. However, under the proposal, some amount of foreign 
debt instruments that are free from foreign tax (pursuant to 
the laws of the relevant foreign country) also would be treated 
as debt instruments that count toward the ``substantially all'' 
test.

                             Effective Date

    The proposal would be effective for dividends paid by a RIC 
in taxable years beginning after December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    The major advantage claimed by advocates of the proposal is 
that it would eliminate the disparity in tax treatment between 
debt instruments qualifying for the ``portfolio interest'' 
exception that are held by a foreign person directly and 
similar instruments owned indirectly through a RIC. The 
proposal may encourage investment by foreign persons in U.S. 
debt instruments by making the benefits of the ``portfolio 
interest'' exception available to investors who are willing to 
invest in such instruments only through a diversified fund. 
Expanding demand for U.S. debt instruments could lower 
borrowing costs of issuers. It is argued that U.S. RICs are at 
a competitive disadvantage as compared with foreign mutual 
funds whose home countries do not impose withholding tax on 
dividends attributable to income from debt investments. The 
proposal would ameliorate this disparate treatment between U.S. 
and foreign mutual funds.
    Opponents of the proposal would argue that holding an 
interest in a RIC that holds debt instruments that qualify for 
the ``portfolio interest'' exception is sufficiently different 
from holding such instruments directly that the ``portfolio 
interest'' exception should not apply in the RIC case. A RIC is 
a widely diversified pool of investments, and managers of RICs 
have discretion to acquire and dispose of debt instruments in 
the pool. Moreover, under the proposal, a portion of the RIC's 
assets may be foreign debt instruments, making an investment in 
the RIC less analogous to a direct interest in U.S. debt 
instruments.

                    H. Taxpayers' Rights Provisions

1. Suspend collection by levy during refund suit

                              Present Law

    Levy is the IRS's administrative authority to seize a 
taxpayer's property to pay the taxpayer's tax liability. The 
IRS is entitled to seize a taxpayer's property by levy if the 
Federal tax lien has attached to such property. The Federal tax 
lien arises automatically where (1) a tax assessment has been 
made; (2) the taxpayer has been given notice of the the 
assessment stating the amount and demanding payment; and (3) 
the taxpayer has failed to pay the amount assessed within ten 
days after the notice and demand. The IRS is prohibited from 
making a tax assessment (and thus prohibited from collecting 
payment) with respect to a tax liability while it is being 
contested in Tax Court.109 However, under present 
law, the IRS is permitted to assess and collect tax liabilities 
during the pendency of a refund suit relating to such tax 
liabilities, under the circumstances described below.
---------------------------------------------------------------------------
    \109\  Code section 6213(a).
---------------------------------------------------------------------------
    Generally, full payment of the tax at issue is a 
prerequisite to a refund suit.110 However, if the 
tax is divisible (such as employment taxes or the trust fund 
penalty under Code section 6672), the taxpayer need only pay 
the tax for the applicable period before filing a refund claim. 
Most divisible taxes are not within the Tax Court's 
jurisdiction; accordingly, the taxpayer has no pre- payment 
forum for contesting such taxes. In the case of divisible 
taxes, it is possible that the taxpayer could be properly under 
the refund jurisdiction of the district court or the U.S. Court 
of Federal Claims and still be subject to collection by levy 
with respect to the entire amount of the tax at issue. The 
IRS's policy is generally to exercise forbearance with respect 
to collection while the refund suit is pending, so long as the 
interests of the Government are adequately protected (e.g., by 
the filing of a notice of Federal tax lien) and collection is 
not in jeopardy.111 Any refunds due the taxpayer may 
be credited to the unpaid portion of the liability pending the 
outcome of the suit.
---------------------------------------------------------------------------
    \110\  Flora v. United States, 357 U.S. 63 (1958), aff'd on reh'g, 
362 U.S. 145 (1960).
    \111\  See, e.g., Internal Revenue Manual (``IRM'') 563(13).2 (May 
5, 1993) (setting forth criteria for withholding collection of trust 
fund penalties at the taxpayer's request).
---------------------------------------------------------------------------

                        Description of Proposal

    This proposal would require the IRS to withhold collection 
by levy of liabilities that are the subject of a refund suit 
during the pendency of the litigation. This would only apply 
when refund suits can be brought without the full payment of 
the tax, i.e., in the case of divisible taxes. Collection by 
levy would be withheld unless jeopardy exists or the taxpayer 
waives the suspension of collection in writing. This proposal 
would not affect the IRS's ability to collect other assessments 
that are not the subject of the refund suit, to offset refunds, 
or to file a notice of Federal tax lien. The statute of 
limitations on collection would be stayed for the period during 
which the IRS is prohibited from collecting by levy.

                             Effective Date

    The proposal would be effective for refund suits brought 
with respect to tax years beginning after December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    The decision in a refund suit with respect to divisible 
taxes generally determines the liability for all such tax 
liability of the taxpayer, not merely for the amounts at issue 
in the suit. It may be appropriate that taxpayers who are 
litigating a refund action over divisible taxes should be 
protected from collection of the full assessed amount, until a 
determination of the liability is made, provided that the IRS's 
ultimate ability to collect the amount determined by the court 
to be properly due is preserved.

2. Suspend collection by levy while offer-in-compromise is pending

                              Present Law

    Section 7122 of the Code permits the IRS to compromise a 
taxpayer's tax liability. In general, this occurs when a 
taxpayer submits an offer-in-compromise to the IRS. An offer-
in-compromise is a proposal to settle unpaid tax accounts for 
less than the full amount of the balance due. They may be 
submitted for all types of taxes, as well as interest and 
penalties, arising under the Internal Revenue Code. Pursuant to 
the IRM, collection normally is withheld during the period an 
offer is pending, ``unless it is determined that the offer is a 
delaying tactic and collection is in jeopardy.'' 112
---------------------------------------------------------------------------
    \112\  IRM 57(10)5.1(3) (Sept. 22, 1994).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would prohibit the IRS from collecting a tax 
liability by levy (1) during any period that a taxpayer's 
offer-in-compromise for that liability is being processed, (2) 
during the 30 days following rejection of an offer, and (3) 
during any period in which an appeal of the rejection of an 
offer is being considered. Return of an offer-in-compromise as 
unprocessable would be considered a rejection for this purpose. 
Taxpayers whose offers are either rejected or returned as 
unprocessable and who made good faith revisions of their offers 
and resubmitted them within 30 days of the rejection or return 
would be eligible for a continuous period of relief from 
collection by levy. This prohibition on collection by levy 
would not apply if the IRS determines that collection is in 
jeopardy or that the offer was submitted solely to delay 
collection. The proposal would not require the IRS to stop any 
levy action that was initiated, or withdraw any lien that was 
filed, before the taxpayer submitted an offer in compromise to 
the IRS. The proposal would provide that the statute of 
limitations on collection would be tolled for the period during 
which collection by levy is barred.

                             Effective Date

    The proposal would be effective with respect to taxes 
assessed on or after 60 days after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal may increase taxpayers' perception of fairness 
in the tax system, in that the proposal will generally prohibit 
IRS from utilizing strong collection measures at the same time 
the taxpayer is attempting to resolve the issue with the IRS.

3. Suspend collection to permit resolution of disputes as to liability

                              Present Law

    In general, before assessment of a tax deficiency, the IRS 
must give notice of such deficiency to the taxpayer, which 
provides the taxpayer an opportunity to contest the deficiency 
in Tax Court (secs. 6212 and 6213). The notice of deficiency 
must be mailed to the taxpayer's last known address (sec. 
6212(b)). If the taxpayer fails to file a petition in Tax Court 
within 90 days (150 days if the notice is addressed outside the 
United States), the IRS may then assess the deficiency (sec. 
6213(c)). Once the 90 (or 150) day period has expired, so has 
the taxpayer's only opportunity to seek pre-payment judicial 
determination of the taxpayer's liability. Under present law, 
once a valid assessment is made, the IRS is not required to 
suspend collection if the taxpayer claims not to owe the taxes.
    The taxpayer has one final opportunity to argue doubt as to 
liability. Section 7122 of the Code permits the IRS to 
compromise a taxpayer's tax liability. In general, this occurs 
when a taxpayer submits an offer-in-compromise to the IRS, 
proposing to settle unpaid tax accounts for less than the full 
amount of the assessed balance due.113 The 
regulations provide that doubt as to liability may be grounds 
for the IRS's accepting the taxpayer's offer-in-compromise. The 
Code and regulations do not preclude collection of a tax 
liability while an offer-in-compromise with respect to that 
liability is pending. The regulations provide that collection 
may be deferred while an offer-in-compromise is pending, unless 
the interests of the United States are 
jeopardized.114 The Internal Revenue Manual directs 
employees to advise taxpayers that ``collection normally will 
be withheld unless it is determined that the offer is a 
delaying tactic and collection is in jeopardy.'' 115 
Collection is ordinarily barred, pursuant to the parties'' 
agreement, if an offer-in-compromise is accepted.
---------------------------------------------------------------------------
    \113\  Treas. Reg. sec. 301.7122-1(a).
    \114\  Treas. Reg. sec. 301.7122-1(d)(2).
    \115\  IRM 57(10)5.1(3) (Sept. 22, 1994).
---------------------------------------------------------------------------

                        Description of Proposal

    This proposal would permit an individual taxpayer to 
request that collection be suspended temporarily with regard to 
an income tax liability that is assessed based upon a statutory 
notice of deficiency that the taxpayer failed to receive or to 
which the taxpayer failed to respond. The IRS would suspend 
collection for a 60-day period, during which the taxpayer may 
dispute the merits of the underlying assessment. The 60-day 
period would be extended in appropriate cases where progress is 
being made in resolving the liability. Collection by refund 
offset and jeopardy levies would be exempted. The statute of 
limitations on collection would be stayed while the taxpayer's 
claim is pending. The proposal also would not affect the IRS's 
ability to file a notice of Federal tax lien.

                             Effective Date

    The proposal would be effective for taxes assessed with 
respect to taxable years beginning after December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    This proposal may ease the burden on taxpayers with a 
colorable dispute as to liability who were unable to have a 
hearing in Tax Court because they failed to receive or respond 
to a proper statutory notice of deficiency. Proponents of the 
proposal argue that if such a taxpayer is making a legitimate 
effort to resolve a tax liability through an offer-in-
compromise, and the interests of the United States are 
adequately protected, it would be appropriate to preclude 
enforced collection of the liability. In conjunction with the 
proposal to suspend collection by levy while an offer-in-
compromise is pending, this proposal would restrict IRS 
collection measures while the taxpayer is attempting to resolve 
the issue with the IRS.

4. Require district counsel approval of certain third-party collection 
        activities

                              Present Law

    The Code authorizes the IRS to levy upon all non-exempt 
property and rights to property belonging to the taxpayer (sec. 
6331(a)). In some cases, property belonging to the taxpayer may 
be nominally held in a name other than the taxpayer's. For 
example, if a corporation would be treated as the alter ego of 
an individual taxpayer under common law principles, the IRS may 
treat the corporation's assets as those of the taxpayer and can 
properly take administrative collection action against those 
assets. Similarly, it is sometimes possible to show that 
property held in the name of a third party individual is being 
held in a nominal or representative capacity for a taxpayer 
(such as, for example, in the case of a fraudulent conveyance). 
In such situations, IRS policy is to require written advice by 
District Counsel as to the need for a supplemental assessment, 
a new notice and demand, and the language to be incorporated in 
the notices of lien and levy on such property. However, 
District Counsel approval is not presently required before a 
notice of Federal tax lien can be filed in connection with 
property held by a nominee, transferee, or alter ego of the 
taxpayer, or before the seizure of property to which a Federal 
tax lien attaches but which is presently neither owned by the 
taxpayer nor titled in the name of the taxpayer.

                        Description of Proposal

    The proposal would require IRS District Counsel approval 
before a notice of Federal tax lien can be filed or levy is 
made in connection with property held by a nominee, transferee, 
or alter ego of the taxpayer. District Counsel approval would 
be required before the IRS seizes property encumbered by a 
Federal tax lien if the property is presently neither owned nor 
titled in the name of the taxpayer. The only exception would be 
in jeopardy situations. If District Counsel's approval was not 
obtained, the property-owner would be entitled to obtain 
release of the lien or levy, and, if the IRS failed to make 
such release, to appeal first to the Collections Appeals 
process and then to the U.S. District Court.

                             Effective Date

    The proposal would be effective with respect to taxes 
assessed after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The determination of whether property held in the hands of 
a third party belongs to the taxpayer often involves difficult 
legal issues. It may be argued that District Counsel review of 
these issues before the IRS takes collection action against 
such property will insure that third party property seizures 
are legally sound, thus improving the public's perception of 
the IRS.

5. Require additional approval of levies on certain assets

                              Present Law

    In general, the IRS may collect taxes by levy on the 
property and rights to property of the taxpayer. A number of 
statutory restrictions apply. One of these is that a levy is 
allowed on a taxpayer's principal residence only if a District 
Director or Assistant District Director of the IRS personally 
approve in writing of the levy (except in cases of jeopardy).

                        Description of Proposal

    The proposal would expand these approval requirements to 
also apply to levies on non-governmental pensions and on the 
cash value of life insurance policies. The proposal would also 
provide for administrative and judicial remedies if appropriate 
approval were not obtained.

                             Effective Date

    The proposal would be effective with respect to taxes 
assessed after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Taxpayers may find it beneficial to have these approval 
requirements extended to these additional items, in that doing 
so will help ensure more careful consideration of the 
appropriateness of the levy in the taxpayer's situation.

6. Require district counsel review of jeopardy and termination 
        assessments and jeopardy levies

                              Present Law

    The Code provides special procedures that allow the IRS to 
make jeopardy assessments or termination assessments in certain 
extraordinary circumstances, such as if the taxpayer is leaving 
or removing property from the United States (sec. 6851), or if 
assessment or collection would be jeopardized by delay (secs. 
6861 and 6862). In jeopardy situations, a levy may also be made 
without the 30 days' notice of intent to levy that is 
ordinarily required by section 6331(d)(2). The Code and 
regulations do not presently require District Counsel to review 
jeopardy assessments, termination assessments, or jeopardy 
levies, although the Internal Revenue Manual does require 
District Counsel review before such actions and it is current 
practice to make such a review.116 The IRS bears the 
burden of proof with respect to the reasonableness of a 
jeopardy or termination assessment or a jeopardy levy (sec. 
7429(g)).
---------------------------------------------------------------------------
    \116\  IRM (CCDM) (34)(12)25.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require IRS District Counsel review and 
approval before the IRS could make a jeopardy assessment, a 
termination assessment, or a jeopardy levy. If District 
Counsel's approval was not obtained, the taxpayer would be 
entitled to obtain abatement of the assessment or release of 
the levy, and, if the IRS failed to offer such relief, to 
appeal first to the Collections Appeals process and then to the 
U.S. District Court.

                             Effective Date

    The proposal would be effective with respect to taxes 
assessed after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Seizure of property without the notice periods generally 
required by the Code is a serious matter that should not be 
undertaken without adequate safeguards for the property rights 
of the taxpayer. Determination of whether a jeopardy situation 
exists justifying immediate collection often involves difficult 
legal issues. District Counsel review prior to collection 
action may help protect taxpayers' property rights.

7. Require management approval of sales of perishable goods

                              Present Law

    If the IRS seizes property that (1) is liable to perish, 
(2) is liable to become greatly reduced in price or value by 
keeping, or (3) cannot be kept without great expense, special 
rules apply (sec. 6336). First, the IRS must appraise the value 
of the property. Next, the IRS must give the owner the 
opportunity to pay (or give bond for) the appraised amount. If 
the owner does so, the property must be returned to the owner. 
If the owner does not do so, the IRS conducts a public sale of 
the property as soon as practicable. The IRS Manual (``IRM'') 
117 permits IRS district directors to delegate the 
authority to approve a sale to group managers.
---------------------------------------------------------------------------
    \117\  IRM Part V, chapter 5600, 56(14)5.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require approval by the IRS district 
director or assistant district director before the sale of 
perishable goods. If these provisions are not followed, 
taxpayers could sue for civil damages for unauthorized 
collection actions (sec. 7433). Taxpayers would be permitted to 
waive the requirement of approval.\118\ The proposal would also 
clarify what a perishable good is.\119\
---------------------------------------------------------------------------
    \118\ It is anticipated that owners would consider doing so when 
time is of the essence and an immediate sale was in the owner's best 
interests.
    \119\ The proposal does not specifiy the natue of the 
clarification.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective with respect to taxes 
assessed after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Taxpayers may find it beneficial to have these approval 
requirements applied to sales of perishable goods, in that 
doing so will help ensure more careful consideration of the 
appropriateness of all elements of the sale.

8. Codify certain fair debt collection practices

                              Present Law

    The Fair Debt Collection Practices Act \120\ provides a 
number of rules relating to debt collection practices. Among 
these are restrictions on communication with the consumer, such 
as a general prohibition on telephone calls outside the hours 
of 8:00 a.m. to 9:00 p.m. local time,\121\ and prohibitions on 
harassing or abusing the consumer.\122\ In general, these 
provisions do not apply to the Federal Government.\123\ These 
provisions relating to communication with the consumer and 
prohibiting harassing or abusing the consumer have been applied 
to the IRS through the appropriations process.\124\
---------------------------------------------------------------------------
    \120\ 15 U.S.C. 1692.
    \121\ 15 U.S.C. 1692c.(a).
    \122\ 15 U.S.C. 1692d.
    \123\ 15 U.S.C. 1692a.(6)(c).
    \124\ Section 104 of the Fiscal Year 1998 Treasury Department 
Appropriations Act.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would make the restrictions relating to 
communication with the consumer and the prohibitions on 
harassing or abusing the consumer applicable to the IRS by 
incorporating these provisions into the Internal Revenue Code.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The 1998 Treasury Department Appropriations Act requires 
that the IRS follow these restrictions.

                                Analysis

    Placing these restrictions in the Code may improve the 
general awareness of these restrictions and emphasize their 
importance.

9. Payment of taxes

                              Present Law

    The Code provides that it is lawful for the Secretary to 
accept checks or money orders as payment for taxes, to the 
extent and under the conditions provided in regulations 
prescribed by the Secretary (sec. 6311). Those regulations 
\125\ state that checks or money orders should be made payable 
to the Internal Revenue Service.
---------------------------------------------------------------------------
    \125\ Treas. Reg. Sec. 301.6311-1(a)(1).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require the Secretary or his delegate to 
establish such rules, regulations, and procedures as are 
necessary to allow payment of taxes by check or money order to 
be made payable to the United States Treasury.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The proposal is contained in section 374 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that it is more appropriate that 
checks be made payable to the United States Treasury rather 
than the Internal Revenue Service. They argue that it may 
improve the public's perception of the IRS by raising awareness 
that the IRS is merely the collector of revenue for the Federal 
Government.

10. Procedures relating to extensions of statute of limitations by 
        agreement

                              Present Law

    The statute of limitations within which the IRS may assess 
additional taxes is generally three years from the date a 
return is filed (sec. 6501).\126\ Prior to the expiration of 
the statute of limitations, both the taxpayer and the IRS may 
agree in writing to extend the statute, using Form 872 or 872-
A. An extension may be for either a specified period or an 
indefinite period. The statute of limitations within which a 
tax may be collected after assessment is 10 years after 
assessment (sec. 6502). Prior to the expiration of the statute 
of limitations, both the taxpayer and the IRS may agree in 
writing to extend the statute, using Form 900.
---------------------------------------------------------------------------
    \126\ For this purpose, a return filed before the due date is 
considered to be filed on the due date.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require that, on each occasion on which 
the taxpayer is requested by the IRS to extend the statute of 
limitations, the IRS must notify the taxpayer of the taxpayer's 
right to refuse to extend the statute of limitations or to 
limit the extension to particular issues.

                             Effective Date

    The proposal would apply to requests to extend the statute 
of limitations made after the date of enactment.

                              Prior Action

    The proposal is contained in section 345 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that taxpayers should be fully 
informed of their rights with respect to the statute of 
limitations.

11. Offers-in-compromise

                              Present Law

    Section 7122 of the Code permits the IRS to compromise a 
taxpayer's tax liability. In general, this occurs when a 
taxpayer submits an offer-in-compromise to the IRS. An offer-
in- compromise is a proposal to settle unpaid tax accounts for 
less than the full amount of the assessed balance due. An 
offer-in-compromise may be submitted for all types of taxes, as 
well as interest and penalties, arising under the Internal 
Revenue Code.
    Taxpayers submit an offer-in-compromise on Form 656. There 
are two bases on which an offer can be made. The first is doubt 
as to the liability for the amount owed. The second is doubt as 
to the taxpayer's ability fully to pay the amount owed. An 
application can be made on either or both of these grounds. 
Taxpayers are required to submit background information to the 
IRS substantiating their application. If they are applying on 
the basis of doubt as to the taxpayer's ability fully to pay 
the amount owed, the taxpayer must complete a financial 
disclosure form enumerating assets and liabilities.
    As part of an offer-in-compromise made on the basis of 
doubt as to ability fully to pay, taxpayers must agree to 
comply with all provisions of the Internal Revenue Code 
relating to filing returns and paying taxes for five years from 
the date the IRS accepts the offer. Failure to observe this 
requirement permits the IRS to begin immediate collection 
actions for the original amount of the liability.

                        Description of Proposal

    The proposal would require the IRS to develop and publish 
schedules of national and local allowances designed to provide 
taxpayers entering into an offer-in-compromise with adequate 
means to provide for basic living expenses.

                             Effective Date

    The materials required by this provision would be required 
to be published as soon as practicable, but no later than 180 
days after the date of enactment.

                              Prior Action

    The proposal is contained in section 346 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997. (That 
section of the House bill also contains additional provisions 
relating to offers-in-compromise.)

                                Analysis

    In determining whether there is doubt as to the taxpayer's 
ability fully to pay the amount owed, the proponents believe 
that the Secretary should take into consideration a taxpayer's 
need to provide for the basic living expenses of his or her 
family, based on the cost of living in the taxpayer's locality.

12. Ensure availability of installment agreements

                              Present Law

    Section 6159 of the Code authorizes the IRS to enter into 
written agreements with any taxpayer under which the taxpayer 
is allowed to pay taxes owed, as well as interest and 
penalties, in installment payments if the IRS determines that 
doing so will facilitate collection of the amounts owed. An 
installment agreement does not reduce the amount of taxes, 
interest, or penalties owed; it does, however, provide for a 
longer period during which payments may be made during which 
other IRS enforcement actions (such as levies or seizures) are 
held in abeyance. Many taxpayers can request an installment 
agreement by filing form 9465. This form is relatively simple 
and does not require the submission of detailed financial 
statements. The IRS in most instances readily approves these 
requests if the amounts involved are not large (in general, 
below $10,000) and if the taxpayer has filed tax returns on 
time in the past. Some taxpayers are required to submit 
background information to the IRS substantiating their 
application. If the request for an installment agreement is 
approved by the IRS, a user fee of $43 is charged.\127\ This 
user fee is in addition to the tax, interest, and penalties 
that are owed.
---------------------------------------------------------------------------
    \127\ This user fee is imposed pursuant to 31 U.S.C. 9701. See T.D. 
8589 (February 14, 1995).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require the Secretary to enter an 
installment agreement, at the taxpayer's option, if:
    (1) the liability is $10,000 or less;
    (2) within the previous 5 years, the taxpayer has not 
failed to file or to pay, nor entered an installment agreement 
under this provision;
    (3) if requested by the Secretary, the taxpayer submits 
financial statements that demonstrate an inability to pay the 
tax due in full;
    (4) the installment agreement provides for full payment of 
the liability within 3 years, with installment payments made by 
direct debit of the taxpayer's bank account;
    (5) the taxpayer extends the statute of limitations on 
collection during the term of the agreement; and (6) the 
taxpayer agrees to continue to comply with the tax laws and the 
terms of the agreement for the period (up to 3 years) that the 
agreement is in place.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    Several elements of the proposal essentially codify current 
IRS Manual provisions relating to installment agreements.

                                Analysis

    Taxpayers may consider it helpful to have statutory 
assurance of their right to an installment agreement.

13. Increase superpriority dollar limits

                              Present Law

    The Federal tax lien attaches to all property and rights in 
property of the taxpayer, if the taxpayer fails to pay the 
assessed tax liability after notice and demand (sec. 6321). 
However, the Federal tax lien is not valid as to certain 
``superpriority'' interests as defined in section 6323(b).
    Two of these interests are limited by a specific dollar 
amount. Under section 6323(b)(4), purchasers of personal 
property at a casual sale are presently protected against a 
Federal tax lien attached to such property to the extent the 
sale is for less than $250. Section 6323(b)(7) provides 
protection to mechanic's lienors with respect to the repairs or 
improvements made to owner- occupied personal residences, but 
only to the extent that the contract for repair or improvement 
is for not more than $1,000.
    In addition, a superpriority is granted under section 
6323(b)(10) to banks and building and loan associations which 
make passbook loans to their customers, provided that those 
institutions retain the passbooks in their possession until the 
loan is completely paid off.

                        Description of Proposal

    The proposal would increase the dollar limit in section 
6323(b)(4) for purchasers at a casual sale from $250 to $1,000, 
and it would increase the dollar limit in section 6323(b)(7) 
from $1,000 to $5,000 for mechanics lienors providing home 
improvement work for owner-occupied personal residences. The 
proposal would index these amounts for inflation. The proposal 
also would clarify section 6323(b)(10) to reflect present 
banking practices, where a passbook-type loan may be made even 
though an actual passbook is not used.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The dollar limits on the superpriority amounts have not 
been increased for decades and do not reflect present prices or 
values. Similarly, the passbook loan requirement does not 
reflect present banking practices, in which an actual passbook 
is not used.. If the policy behind the creation of 
superpriority interests is still valid, then increasing the 
limits would be appropriate, as the protection provided by 
present law is not effective because it is so limited.

14. Permit personal delivery of section 6672(b) notices

                              Present Law

    Any person who is required to collect, truthfully account 
for, and pay over any tax imposed by the Internal Revenue Code 
who willfully fails to do so is liable for a penalty equal to 
the amount of the tax (Sec. 6672(a)). Before the IRS may assess 
any such ``100 percent penalty,'' it must mail a written 
preliminary notice informing the person of the proposed penalty 
to that person's last known address. The mailing of such notice 
must precede any notice and demand for payment of the penalty 
by at least 60 days. The statute of limitations shall not 
expire before the date 90 days after the date in which the 
notice was mailed. These restrictions do not apply if the 
Secretary finds the collection of the penalty is in jeopardy.

                        Description of Proposal

    The proposal would permit personal delivery, as an 
alternative to delivery by mail, of a preliminary notice that 
the IRS intends to assess a 100 percent penalty.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The requirement that such preliminary notices be mailed to 
the person's last known address was added in 1996 by the 
Taxpayer Bill of Rights 2 (P.L. 104-168).

                                Analysis

    A penalty under section 6672 may be assessed where a 
``responsible person'' willfully fails to remit Federal income 
tax withholding, social security and health insurance taxes. A 
``responsible person'' includes the employer and certain 
employees of the employer who have control over the use of 
corporate funds. An individual identified by the IRS as a 
responsible person is permitted an administrative appeal on the 
question of responsibility.
    At the time Congress added the requirement that the 
preliminary notice of intention to assess a penalty under 
section 6672 be mailed, it was concerned that some employees 
may not be fully aware of their personal liability under 
section 6672 and believed that the IRS could make additional 
efforts to assist the public in understanding its 
responsibilities.\128\
---------------------------------------------------------------------------
    \128\ See Joint Committee on Taxation, General Explanation of Tax 
Legislation Encated in the 104th Congress (JCS-12-96), December 18, 
1996, pp. 38-39.
---------------------------------------------------------------------------
    The IRS and the Treasury Department have expressed concern 
that the requirement that preliminary notices be mailed leads 
to unnecessary disputes over whether the notice was properly 
addressed or received. The IRS and the Treasury Department have 
also suggested that if the preliminary notice could be 
personally delivered it could afford an additional opportunity 
to resolve disputes in these cases at an earlier stage.
    In requiring the preliminary notice to be mailed, Congress 
insured that the person to whom the notice was addressed would 
have an opportunity to consider the issue of personal liability 
for the penalty before being required to respond. Personal 
delivery should not change this, since the 60-day waiting 
period between the mailing or personal delivery of the notice 
and the assessment of any penalty would continue to apply.

15. Allow taxpayers to quash all third-party summonses

                              Present Law

    When the IRS issues a summons to a ``third-party record 
keeper'' relating to the business transactions or affairs of a 
taxpayer, section 7609 requires that notice of the summons be 
given to the taxpayer within three days by certified or 
registered mail. The taxpayer is thereafter given up to 23 days 
to begin a court proceeding to quash the summons. If the 
taxpayer does so, third-party record keepers are prohibited 
from complying with the summons until the court rules on the 
taxpayer's petition to quash, but the statute of limitations 
for assessment and collection with respect to the taxpayer is 
stayed during the pendency of such a proceeding. Third-party 
record keepers are generally persons who hold financial 
information about the taxpayer, such as banks, brokers, 
attorneys, and accountants.

                        Description of Proposal

    The proposal would generally expand the current ``third-
party record keeper'' procedures to apply to all summonses 
issued to persons other than the taxpayer. Thus, the taxpayer 
whose liability is being investigated would receive notice of 
the summons and would be entitled to bring an action in the 
appropriate U.S. District Court to quash the summons, although 
(as under the current third-party record keeper provision) the 
statute of limitations on assessment and collection would be 
stayed pending the litigation, and certain kinds of summonses 
specified under current law would not be subject to these 
requirements.

                             Effective Date

    The proposal would be effective for summonses served after 
the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    A taxpayer should have notice when the IRS utilizes its 
summons power to gather information in an effort to determine 
the taxpayer's liability. A taxpayer should be able to 
challenge all such efforts where appropriate, and not just 
those situations where the IRS is attempting to recover records 
related to the taxpayer from a specially-defined third party. 
Allowing a taxpayer to challenge all third party summons will 
also eliminate unnecessary disputes between taxpayers, third 
parties and the IRS as to whether a summonsed third party is a 
record keeper.

16. Disclosure of criteria for examination selection

                              Present Law

    The IRS examines Federal tax returns to determine the 
correct liability of taxpayers. The IRS selects returns to be 
audited in a number of ways, such as through a computerized 
classification system (known as the discriminant function 
(``DIF'') system).

                        Description of Proposal

    The proposal would require that IRS add to Publication 1 
(``Your Rights as a Taxpayer'') a statement which sets forth in 
simple and nontechnical terms the criteria and procedures for 
selecting taxpayers for examination. The statement must not 
include any information the disclosure of which would be 
detrimental to law enforcement. The statement must specify the 
general procedures used by the IRS, including whether taxpayers 
are selected for examination on the basis of information in the 
media or from informants. Drafts of the statement or proposed 
revisions to the statement would be required to be submitted to 
the House Committee on Ways and Means, the Senate Committee on 
Finance, and the Joint Committee on Taxation.

                             Effective Date

    The addition to Publication 1 would be required to be made 
not later than 180 days after the date of enactment.

                              Prior Action

    The proposal is contained in section 353 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that it is important that taxpayers 
understand the reasons they may be selected for examination.

17. Threat of audit prohibited to coerce tip reporting alternative 
        commitment agreements

                              Present Law

    Restaurants may enter into Tip Reporting Alternative 
Commitment (``TRAC'') agreements. A restaurant entering into a 
TRAC agreement is obligated to educate its employees on their 
tip reporting obligations, to institute formal tip reporting 
procedures, to fulfill all filing and record keeping 
requirements, and to pay and deposit taxes. In return, the IRS 
agrees to base the restaurant's liability for employment taxes 
solely on reported tips and any unreported tips discovered 
during an IRS audit of an employee.

                        Description of Proposal

    The proposal would require the IRS to instruct its 
employees that they may not threaten to audit any taxpayer in 
an attempt to coerce the taxpayer to enter into a TRAC 
agreement.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The proposal is contained in section 349 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that it is inappropriate for the 
Secretary to use the threat of an IRS audit to induce 
participation in voluntary programs.

18. Permit service of summonses by mail

                              Present Law

    Section 7603 requires that a summons shall be served ``by 
an attested copy delivered in hand to the person to whom it is 
directed or left at his last and usual place of abode.'' By 
contrast, if a third-party recordkeeper summons is served, 
section 7609 permits the IRS to give the taxpayer notice of the 
summons via certified or registered mail. Moreover, Rule 4 of 
the Federal Rules of Civil Procedure permits service of process 
by mail even in summons enforcement proceedings.

                        Description of Proposal

    The proposal would permit the IRS the option to serve all 
summonses in person or by mail.

                             Effective Date

    The provision would be effective for summonses served after 
the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would conform the general service of summons 
procedures to the procedures applicable to third party 
recordkeeper summonses and to the service of process 
requirements of the Federal Rules of Civil Procedure.
    Many IRS summonses are used to obtain financial data from 
large corporate financial institutions, such as banks and 
brokers. Under present law, IRS officials must appear 
personally and serve the summons on an officer of the 
corporation designated to receive service of process. This 
unnecessarily disruptive intrusion could be avoided were the 
mails used as an option.

19. Civil damages for violation of certain bankruptcy procedures

                              Present Law

    A taxpayer may sue the United States for up to $1 million 
of civil damages caused by an officer or employee of the IRS 
who recklessly or intentionally disregards provisions of the 
Internal Revenue Code or Treasury regulations in connection 
with the collection of Federal tax with respect to the 
taxpayer.

                        Description of Proposal

    The proposal would provide for up to $1 million in civil 
damages caused by an officer or employee of the IRS who 
willfully disregards provisions of the Bankruptcy Code relating 
to automatic stays or discharges. No person is entitled to seek 
civil damages in a court of law unless he first exhausts his 
administrative remedies.

                             Effective Date

    The proposal would be effective with respect to actions of 
officers or employees of the IRS occurring after the date of 
enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proponents believe that taxpayers should also be able 
to recover economic damages they incur as a result of a willful 
violation by an officer or employee of the IRS of these 
provisions of the Bankruptcy Code.

20. Increase in size of cases permitted on small case calendar in the 
        Tax Court

                              Present Law

    Taxpayers may choose to contest many tax disputes in the 
Tax Court. Special small case procedures apply to disputes 
involving $10,000 or less, if the taxpayer chooses to utilize 
these procedures (and the Tax Court concurs).

                        Description of Proposal

    The proposal would increase the cap for small case 
treatment from $10,000 to $25,000.

                             Effective Date

    The proposal would apply to proceedings commenced after the 
date of enactment.

                              Prior Action

    The proposal is contained in section 313 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that use of the small case 
procedures should be expanded.

21. Suspension of statute of limitations on filing refund claims during 
        periods of disability

                              Present Law

    In general, a taxpayer must file a refund claim within 
three years of the filing of the return or within two years of 
the payment of the tax, whichever period expires later (if no 
return is filed, the two-year limit applies) (sec. 6511(a)). A 
refund claim that is not filed within these time periods is 
rejected as untimely.
    There is no explicit statutory rule providing for equitable 
tolling of the statute of limitations. Several courts have 
considered whether equitable tolling implicitly exists. The 
First, Third, Fourth, and Eleventh Circuits have rejected 
equitable tolling with respect to tax refund claims. The Ninth 
Circuit has permitted equitable tolling. However, the U.S. 
Supreme Court has reversed the Ninth Circuit in U.S. v. 
Brockamp \129\, holding that Congress did not intend the 
equitable tolling doctrine to apply to the statutory 
limitations of section 6511 on the filing of tax refund claims.
---------------------------------------------------------------------------
    \129\ 117 S. Ct. 849 (1997), reversing 67 F. 3d 260 and 70 F. 3d 
120.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would permit equitable tolling of the statute 
of limitations for refund claims of an individual taxpayer 
during any period of the individual's life in which he or she 
is unable to manage his or her financial affairs by reason of a 
medically determinable physical or mental impairment that can 
be expected to result in death or to last for a continuous 
period of not less than 12 months. Proof of the existence of 
the impairment must be furnished in the form and manner 
required by the Secretary. Tolling would not apply during 
periods in which the taxpayer's spouse or another person is 
authorized to act on the taxpayer's behalf in financial 
matters.

                             Effective Date

    The proposal would apply to taxable years ending after the 
date of enactment.

                              Prior Action

    The proposal (with a different effective date) is contained 
in section 322 of H.R. 2676 (the ``Internal Revenue Service 
Restructuring and Reform Act of 1997''), as passed by the House 
on November 5, 1997.

                                Analysis

    The proponents believe that, in cases of severe disability, 
equitable tolling should be considered in the application of 
the statutory limitations on the filing of tax refund claims.

22. Notice of deficiency to specify deadlines for filing Tax Court 
        petition

                              Present Law

    Taxpayers must file a petition with the Tax Court within 90 
days after the deficiency notice is mailed (150 days if the 
person is outside the United States) (sec. 6213). If the 
petition is not filed within that time period, the Tax Court 
does not have jurisdiction to consider the petition.

                        Description of Proposal

    The proposal would require that the IRS include on each 
deficiency notice the date determined by the IRS as the last 
day on which the taxpayer may file a petition with the Tax 
Court. The last day on which a taxpayer who is outside the 
United States may file a petition with the Tax Court would be 
shown as an alternative. The proposal would provide that a 
petition filed with the Tax Court by this date shall be treated 
as timely filed.

                             Effective Date

    The proposal would apply to notices mailed after December 
31, 1998.

                              Prior Action

    The proposal is contained in section 347 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    Proponents of the proposal believe that taxpayers should 
receive assistance in determining the time period within which 
they must file a petition in the Tax Court and that taxpayers 
should be able to rely on the computation of that period by the 
IRS. Computation of the time period may be difficult for some 
taxpayers and the consequences of missing the filing deadline 
are severe (loss of the ability to litigate in a prepayment 
forum).

23. Allow actions for refund with respect to certain estates which have 
        elected the installment method of payment

                              Present Law

    In general, the U.S. Court of Federal Claims and the U.S. 
district courts have jurisdiction over suits for the refund of 
taxes, as long as full payment of the assessed tax liability 
has been made. Flora v. United States, 357 U.S. 63 (1958), 
aff'd on reh'g, 362 U.S. 145 (1960). Under Code section 6166, 
if certain conditions are met, the executor of a decedent's 
estate may elect to pay the estate tax attributable to certain 
closely-held businesses over a 14-year period. Courts have held 
that U.S. district courts and the U.S. Court of Federal Claims 
do not have jurisdiction over claims for refunds by taxpayers 
deferring estate tax payments pursuant to section 6166 unless 
the entire estate tax liability has been paid (i.e., timely 
payment of the installments due prior to the bringing of an 
action is not sufficient to invoke jurisdiction). See, e.g., 
Rocovich v. United States, 933 F.2d 991 (Fed. Cir. 1991), 
Abruzzo v. United States, 24 Ct. Cl. 668 (1991). A provision in 
the Taxpayer Relief Act of 1997, however, provides limited 
authority to the U.S. Tax Court to provide declaratory 
judgments regarding initial or continuing eligibility for 
deferral under section 6166.

                        Description of Proposal

    The proposal would grant the U.S. Court of Federal Claims 
and the U.S. district courts jurisdiction to determine the 
correct amount of estate tax liability (or refund) in actions 
brought by taxpayers deferring estate tax payments under 
section 6166, as long certain conditions are met. In order to 
qualify for the proposal, the estate must have made an election 
pursuant to section 6166, fully paid each installment of 
principal and/or interest due before the date the suit is filed 
(as long as one or more installments are not yet due), and no 
portion of the payments due may have been accelerated. The 
proposal further would provide that once a final judgment has 
been entered by a district court or the U.S. Court of Federal 
Claims, the IRS would not be permitted to collect any amount 
disallowed by the court, and any amounts paid by the taxpayer 
in excess of the amount the court finds to be currently due and 
payable would be refunded to the taxpayer. Lastly, the proposal 
would provide that the two-year statute of limitations for 
filing a refund action would be suspended during the pendency 
of any action brought by a taxpayer pursuant to section 7479 
for a declaratory judgment as to an estate's eligibility for 
section 6166.

                             Effective Date

    The proposal would be effective for claims for refunds 
filed after the date of enactment.

                              Prior Action

    The proposal is contained in H.R. 2676 (the ``Internal 
Revenue Service Restructuring and Reform Act of 1997''), as 
passed by the House on November 5, 1997.

                                Analysis

    Present-law section 6166 allows taxpayers to defer payment 
of estate taxes attributable to certain closely-held 
businesses, and pay such taxes over a 14-year period. Section 
6166 was enacted to address the liquidity problems of estates 
holding farms and closely held businesses, so that such 
businesses need not be liquidated in order to pay estate taxes. 
Where an installment election has been made under 6166, 
taxpayers may have limited access to judicial review of the 
amount of estate tax liability before the entire estate tax 
liability has been paid. If a dispute arises as to the amount 
of estate taxes due with respect to the closely-held business, 
taxpayers may be required to pay the full amount of estate 
taxes the IRS asserts as being owed for the full 14-year period 
in order to obtain judicial review of the IRS determination, 
which could cause the potential liquidation of the assets and 
frustrate the purpose behind the installment provisions of 
section 6166. In addition, where installment payments are being 
made over a 14-year period, the two-year statute of limitations 
for filing refund claims could operate to bar refunds with 
respect to payments made more than two years prior to the date 
the refund action is filed.
    The proposal is intended to equalize access to the courts 
between taxpayers who are required to pay their full estate tax 
liability at one time with those taxpayers who are deferring 
payments under section 6166, as long as such taxpayers are 
current with respect to their installment payments. To ensure 
that taxpayers deferring payments under 6166 are not provided 
with greater access to the courts than taxpayers who have not 
made such an election, and to ensure that the proposal would 
operate as intended, possible modifications to the 
Administration proposal have been suggested. Under these 
proposed modifications, in order to commence suit: (1) the 
estate must have paid all non-6166-related estate taxes due (in 
addition to any 6166 installments due before the date the suit 
is filed), (2) there must be no suits for declaratory judgment 
pursuant to section 7479 pending, (3) there must be no 
outstanding deficiency notices against the estate, and (4) the 
taxpayer must continue to make any installment payments that 
come due while the lawsuit is pending.

24. Expansion of authority to award costs and certain fees

                              Present Law

    Any person who substantially prevails in any action by or 
against the United States in connection with the determination, 
collection, or refund of any tax, interest, or penalty may be 
awarded reasonable administrative costs incurred before the IRS 
and reasonable litigation costs incurred in connection with any 
court proceeding. In general, only an individual whose net 
worth does not exceed $2 million is eligible for an award, and 
only a corporation or partnership whose net worth does not 
exceed $7 million is eligible for an award.
    Reasonable litigation costs include reasonable fees paid or 
incurred for the services of attorneys, except that the 
attorney's fees will not be reimbursed at a rate in excess of 
$110 per hour (indexed for inflation) unless the court 
determines that a special factor, such as the limited 
availability of qualified attorneys for the proceeding, 
justifies a higher rate. Awards of reasonable litigation costs 
and reasonable administrative costs cannot exceed amounts paid 
or incurred.
    Once a taxpayer has substantially prevailed over the IRS in 
a tax dispute, the IRS has the burden of proof to establish 
that it was substantially justified in maintaining its position 
against the taxpayer. A rebuttable presumption exists that 
provides that the position of the United States is not 
considered to be substantially justified if the IRS did not 
follow in the administrative proceeding (1) its published 
regulations, revenue rulings, revenue procedures, information 
releases, notices, or announcements, or (2) a private letter 
ruling, determination letter, or technical advice memorandum 
issued to the taxpayer.

                        Description of Proposal

    The proposal would permit the award of attorney's fees (in 
amounts up to the statutory limit determined to be appropriate) 
to specified persons who represent for no more than a nominal 
fee a taxpayer who is a prevailing party.

                             Effective Date

    The proposal would apply to costs incurred and services 
performed after the date of enactment.

                              Prior Action

    The proposal is contained in section 311 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997. (That 
section of the House bill also contains additional provisions 
relating to attorney's fees.)

                                Analysis

    The proponents believe that the pro bono publicum 
representation of taxpayers should be encouraged and the value 
of the legal services rendered in these situations should be 
recognized. Where the IRS takes positions that are not 
substantially justified, it should not be relieved of its 
obligation to bear reasonable administrative and litigation 
costs because representation was provided the taxpayer on a pro 
bono basis.

25. Expansion of authority to issue taxpayer assistance orders

                              Present Law

    Taxpayers can request that the Taxpayer Advocate in the 
Internal Revenue Service (``IRS'') issue a taxpayer assistance 
order (``TAO'') if they are suffering or about to suffer a 
significant hardship as a result of the manner in which the 
internal revenue laws are being administered (sec. 7811). A TAO 
may require the IRS to release property of the taxpayer that 
has been levied upon, or to cease any action, take any action 
as permitted by law, or refrain from taking any action with 
respect to the taxpayer.

                        Description of Proposal

    The proposal would provide that in determining whether to 
issue a TAO, the Taxpayer Advocate shall consider, among 
others, the following four factors: (1) whether there is an 
immediate threat of adverse action; (2) whether there has been 
an unreasonable delay in resolving the taxpayer's account 
problems; (3) whether the taxpayer will have to pay significant 
costs (including fees for professional representation) if 
relief is not granted; and (4) whether the taxpayer will suffer 
irreparable injury, or a long-term adverse impact, if relief is 
not granted.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    A substantially similar proposal is contained in section 
342 of H.R. 2676 (the ``Internal Revenue Service Restructuring 
and Reform Act of 1997''), as passed by the House on November 
5, 1997.

                                Analysis

    The proponents believe that these factors should generally 
be considered by the Taxpayer Advocate in determining whether a 
taxpayer assistance order should be issued.

26. Provide new remedy for third parties who claim that the IRS has 
        filed an erroneous lien

                              Present Law

    Prior to 1995, the provisions governing jurisdiction over 
refund suits had generally been interpreted to apply only if an 
action was brought by the taxpayer against whom tax was 
assessed. Remedies for third parties from whom tax was 
collected (rather than assessed) were found in other provisions 
of the Internal Revenue Code. The Supreme Court held in 
Williams v. United States, 115 S.Ct. 1611 (1995), however, that 
a third party who paid another person's tax under protest to 
remove a lien on the third party's property could bring a 
refund suit, because she had no other adequate administrative 
or judicial remedy. In Williams, the IRS had filed a nominee 
lien against property that was owned by the taxpayer's former 
spouse and that was under a contract for sale. In order to 
complete the sale, the former spouse paid the amount of the 
lien under protest, and then sued in district court to recover 
the amount paid. The Supreme Court held that parties who are 
forced to pay another's tax under duress could bring a refund 
suit, because no other judicial remedy was adequate.

                        Description of Proposal

    The proposal would create an administrative procedure 
similar to the wrongful levy remedy for third parties in 
section 7426. Under this procedure, a record owner of property 
against which a Federal tax lien had been filed could obtain a 
certificate of discharge of property from the lien as a matter 
of right. The third party would be required to apply to the 
Secretary of the Treasury for such a certificate and either to 
deposit cash or to furnish a bond sufficient to protect the 
lien interest of the United States. Although the Secretary 
would determine the amount of the bond necessary to protect the 
Government's lien interest, if this procedure was followed the 
Secretary would have no discretion to refuse to issue a 
certificate of discharge, thus curing the defect in this remedy 
that the Supreme Court found in Williams. A certificate of 
discharge of property from a lien issued pursuant to the 
procedure would enable the record owner to sell the property 
free and clear of the Federal tax lien in all circumstances. 
The proposal also would authorize the refund of all or part of 
the amount deposited, plus interest at the same rate that would 
be made on an overpayment of tax by the taxpayer, or the 
release of all or part of the bond, if the Secretary otherwise 
satisfies the tax liability or determines that the United 
States does not have a lien interest or has a lesser lien 
interest than the amount initially determined.
    The proposal would also establish a judicial cause of 
action for third parties challenging a lien that is similar to 
the wrongful levy remedy in section 7426. The period within 
which such an action must be commenced would be a short period 
(120 days) to ensure an early resolution of the parties' 
interests. The statute of limitations on collecting from the 
taxpayer would be stayed while a third party challenged a lien 
in court under these procedures. Upon conclusion of the 
litigation, the IRS would be authorized to apply the deposit or 
bond to the assessed liability and to refund to the third party 
any amount in excess of the liability, plus interest, or to 
release the bond. Actions to quiet title under 28 U.S.C. 
Sec. 2410 would still be available to persons who did not seek 
the expedited review permitted under the new statutory 
procedure.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The Williams decision left many important questions 
unresolved, such as: which class of third parties have 
standing; what administrative procedure is required before 
litigation; the applicable statutes of limitations; the IRS's 
authority to pay interest on such a refund; and how to prevent 
expiration of the collection period on the taxpayer while the 
third party from whom the tax was collected challenges the IRS. 
In order to avoid prolonged uncertainty in this area, it may be 
appropriate to resolve these questions by statute rather than 
through litigation.

27. Allow civil damages for unauthorized collection actions by persons 
        other than the taxpayer

                              Present Law

    A taxpayer may sue the United States for up to $1 million 
of civil damages caused by an officer or employee of the IRS 
who recklessly or intentionally disregards provisions of the 
Internal Revenue Code or Treasury regulations in connection 
with the collection of Federal tax with respect to the 
taxpayer.

                        Description of Proposal

    The proposal would provide that persons other than the 
taxpayer may sue for civil damages for unauthorized collection 
actions.

                             Effective Date

    The proposal would be effective with respect to action of 
officers or employees of the IRS occurring after the date of 
enactment.

                                Analysis

    Proponents argue that anyone should be able to recover 
economic damages they incur as a result of unauthorized 
collection actions.

28. Suspend collection in certain joint liability cases

                              Present Law

    In general, spouses who file a joint tax return are each 
fully responsible for the full tax liability. However, both 
spouses need not join in contesting such liability in the Tax 
Court. Thus, it is possible for one spouse to file a petition 
in Tax Court while the other spouse does not. The IRS may not 
assess the tax liability or take collection action against the 
spouse who has filed the petition in Tax Court, until the Tax 
Court decision is final (sec. 6213(a)). However, there are no 
provisions in the Code or the regulations that prohibit 
administrative collection action against a nonpetitioning 
spouse during the pendency of the Tax Court. In general, the 
IRS is authorized to assess and commence collection action 
against the nonpetitioning spouse after the expiration of the 
90 (or 150) day period in section 6213(c). The IRS's policy is 
generally to forbear from administrative collection until the 
Tax Court renders its decision on the liability.\130\
---------------------------------------------------------------------------
    \130\ IRS Policy Statement P-5-16.
---------------------------------------------------------------------------
    Under certain circumstances, collection action may be 
appropriate even during the pendency of the Tax Court action. 
Collection is appropriate if the amount of the assessment is 
not being contested in the Tax Court, such as when the 
petitioning spouse is seeking relief solely as an innocent 
spouse. Collection may also be appropriate when the interests 
of the IRS are likely to be jeopardized by forbearance, such as 
when the nonpetitioning spouse intends to file a bankruptcy 
petition or leave the United States.

                        Description of Proposal

    When a married couple's joint return is the subject of a 
Tax Court proceeding, the proposal would require the IRS to 
withhold collection by levy against a nonpetitioning spouse 
during the pendency of a Tax Court proceeding involving the 
other spouse. This would treat the nonpetitioning spouse the 
same as the petitioning spouse in most situations. Certain 
exceptions would be provided, including in jeopardy situations, 
when the taxpayer waives this protection (i.e., agrees to the 
collection action), or for some other, limited but automatic 
kinds of collection activity, such as automatic refund offset, 
filing of protective notices of Federal tax lien, or in certain 
other circumstances. The statute of limitations on assessment 
and collection would be stayed for the period during which 
collection is barred. In general, if there is a final decision 
that reduces the proposed assessment against the petitioning 
spouse, the assessment against the nonpetitioning spouse would 
likewise be reduced. The proposal would not affect the IRS's 
ability to collect other liabilities or assessments that are 
not the subject of the Tax Court proceeding.

                             Effective Date

    The proposal would be effective for taxes assessed with 
respect to taxable years beginning after December 31, 1998.

                              Prior Action

    No prior action.

                                Analysis

    A nonpetitioning spouse should generally receive the same 
protection against IRS collection action as the spouse who has 
filed a petition in Tax Court contesting a proposed deficiency. 
The stay of collection protects nonpetitioning taxpayers from 
premature deprivation of their property, before the 
adjudication of the joint and several liability. This proposal 
generally complements the proposal on innocent spouse relief.

29. Explanation of joint and several liability

                              Present Law

    In general, spouses who file a joint tax return are each 
fully responsible for the accuracy of the tax return and for 
the full liability. This is true even though only one spouse 
may have earned the wages or income which is shown on the 
return. This is ``joint and several'' liability. Spouses who 
wish to avoid joint and several liability may file as a married 
person filing separately. Special rules apply in the case of 
innocent spouses pursuant to section 6013(e).

                        Description of Proposal

    The proposal would require that, no later than 180 days 
after the date of enactment, the IRS must establish procedures 
clearly to alert married taxpayers of their joint and several 
liability on all appropriate tax publications and instructions.

                             Effective Date

    The proposal would require that the procedures be 
established as soon as practicable, but no later than 180 days 
after the date of enactment.

                              Prior Action

    The proposal is contained in section 351 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proposal would assist married taxpayers need in clearly 
understanding the legal implications of signing a joint return; 
it is appropriate for the IRS to provide the information 
necessary for that understanding.

30. Innocent spouse relief

                              Present Law

    Spouses who file a joint tax return are each fully 
responsible for the accuracy of the return and for the full tax 
liability. This is true even though only one spouse may have 
earned the wages or income which is shown on the return. This 
is ``joint and several'' liability. A spouse who wishes to 
avoid joint liability may file as a ``married person filing 
separately.'
    Relief from liability for tax, interest and penalties is 
available for ``innocent spouses'' in certain limited 
circumstances. To qualify for such relief, the innocent spouse 
must establish: (1) that a joint return was made; (2) that an 
understatement of tax, which exceeds the greater of $500 or a 
specified percentage of the innocent spouse's adjusted gross 
income for the preadjustment (most recent) year, is 
attributable to a grossly erroneous item 131 of the 
other spouse; (3) that in signing the return, the innocent 
spouse did not know, and had no reason to know, that there was 
an understatement of tax; and (4) that taking into account all 
the facts and circumstances, it is inequitable to hold the 
innocent spouse liable for the deficiency in tax. The specified 
percentage of adjusted gross income is 10 percent if adjusted 
gross income is $20,000 or less. Otherwise, the specified 
percentage is 25 percent.
---------------------------------------------------------------------------
    \131\ Grossly erroneous items include items of gross income that 
are omitted from reported income and claims of deductions, credits, or 
basis in an amount for which there is no basis in fact or lwa (Code 
sec. 6013(e)(2)).
---------------------------------------------------------------------------
    It is unclear under present law whether a court may grant 
partial innocent spouse relief. The Ninth Circuit Court of 
Appeals in Wiksell v. Commissioner 132 has allowed 
partial innocent spouse relief where the spouse did not know, 
and had no reason to know, the magnitude of the understatement 
of tax, even though the spouse knew that the return may have 
included some understatement.
---------------------------------------------------------------------------
    \132\ 90 F.3d 1459 (9th Cir. 1997).
---------------------------------------------------------------------------
    The proper forum for contesting a denial by the Secretary 
of innocent spouse relief is determined by whether an 
underpayment is asserted or the taxpayer is seeking a refund of 
overpaid taxes. Accordingly, the Tax Court may not have 
jurisdiction to review all denials of innocent spouse relief.
    No form is currently provided to assist taxpayers in 
applying for innocent spouse relief.

                        Description of Proposal

    The proposal generally would make innocent spouse status 
easier to obtain. The proposal would eliminate all of the 
understatement thresholds and requires only that the 
understatement of tax be attributable to an erroneous (and not 
just a grossly erroneous) item of the other spouse. The 
proposal would also make parallel the innocent spouse rules 
applicable in community property States and common law States.
    The proposal would provide that the Tax Court has 
jurisdiction to review any denial (or failure to rule) by the 
Secretary regarding an application for innocent spouse relief. 
The Tax Court may order refunds as appropriate where it 
determines the spouse qualifies for relief and an overpayment 
exists as a result of the innocent spouse qualifying for such 
relief. The taxpayer must file his or her petition for review 
with the Tax Court during the 90-day period that begins on the 
earlier of (1) 6 months after the date the taxpayer filed his 
or her claim for innocent spouse relief with the Secretary or 
(2) the date a notice denying innocent spouse relief was mailed 
by the Secretary. Except for termination and jeopardy 
assessments (secs. 6851, 6861), the Secretary would not be 
permitted to levy or proceed in court to collect any tax from a 
taxpayer claiming innocent spouse status with regard to such 
tax until the expiration of the 90-day period in which such 
taxpayer may petition the Tax Court or, if the Tax Court 
considers such petition, before the decision of the Tax Court 
has become final. The running of the statute of limitations 
would be suspended in such situations with respect to the 
spouse claiming innocent spouse status.
    The proposal would also require the Secretary of the 
Treasury to develop a separate form with instructions for 
taxpayers to use in applying for innocent spouse relief within 
180 days from the date of enactment.

                             Effective Date

    The proposal would be effective for understatements with 
respect to taxable years beginning after the date of enactment. 
An innocent spouse seeking relief under this proposal must 
claim innocent spouse status with regard to any assessment not 
later than two years after the date of such assessment.

                              Prior Action

    A similar proposal is contained in section 321 of H.R. 2676 
(the ``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents are concerned that the innocent spouse 
provisions of present law are inadequate. The proponents 
believe it is inappropriate to limit innocent spouse relief 
only to the most egregious cases where the understatement is 
large and the tax position taken is grossly erroneous. The 
proponents also believe that all taxpayers should have access 
to the Tax Court in resolving disputes concerning their status 
as an innocent spouse. Finally, the proponents believe that 
taxpayers need to be better informed of their right to apply 
for innocent spouse relief in appropriate cases and that the 
IRS is the best source of that information.

31. Elimination of interest differential on overlapping periods of 
        interest on income tax overpayments and underpayments

                              Present Law

    A taxpayer that underpays its taxes is required to pay 
interest on the underpayment at a rate equal to the Federal 
short-term interest rate plus three percentage points. A 
special ``hot interest'' rate equal to the Federal short-term 
interest rate plus five percentage points applies in the case 
of certain large corporate underpayments.
    A taxpayer that overpays its taxes receives interest on the 
overpayment at a rate equal to the Federal short-term interest 
rate plus two percentage points. In the case of corporate 
overpayments in excess of $10,000, this is reduced to the 
Federal short-term interest rate plus one-half of a percentage 
point.
    If a taxpayer has an underpayment of tax from one year and 
an overpayment of tax from a different year that are 
outstanding at the same time, the IRS will typically offset the 
overpayment against the underpayment and apply the appropriate 
interest to the resulting net underpayment or overpayment. 
However, if either the underpayment or overpayment have been 
satisfied, the IRS will not typically offset the two amounts, 
but rather will assess or credit interest on the full 
underpayment or overpayment at the underpayment or overpayment 
rate. This has the effect of assessing the underpayment at the 
higher underpayment rate and crediting the overpayment at the 
lower overpayment rate. This results in the taxpayer being 
assessed a net interest charge, even if the amounts of the 
overpayment and underpayment are the same.
    The Secretary has the authority to credit the amount of any 
overpayment against any liability under the Code (sec. 6402). 
Congress has previously directed the Internal Revenue Service 
to consider procedures for ``netting'' overpayments and 
underpayments and, to the extent a portion of tax due is 
satisfied by a credit of an overpayment, not impose interest. 
133
---------------------------------------------------------------------------
    \133\ Pursuant to TBOR2 (1996), the Secretary conducted a study of 
the manner in which the IRS has implemented the netting of interest on 
overpaymetns and underpayments and the policy and administrative 
implications of global netting. The legislative history to the General 
Agreement on Trade and Tariffs (GATT) (1994) stated that the Secretary 
should implement the most comprehensive crediting procedures that are 
consistent with sound administrative practice, and should do so as 
rapidly as is practicable. A similar statment was included in the 
Conference Report to the Omnibus Budget Reconciliation Act of 1990.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would establish a net interest rate of zero on 
equivalent amounts of overpayment and underpayment of income 
tax that exist for any period, provided that the taxpayer 
reasonably identifies and establishes an appropriate situation 
for netting before the statute of limitations for filing a 
claim for refund for any of the periods involved has expired. 
Each overpayment and underpayment is to be considered only once 
in determining whether equivalent amounts of overpayment and 
underpayment exist. The special rules that increase the 
interest rate paid on large corporate underpayments and 
decrease the interest rate received on corporate underpayments 
in excess of $10,000 would not prevent the application of the 
net zero rate. The proposal would apply to income taxes.

                             Effective Date

    The proposal would apply prospectively, to periods of 
overlapping mutual indebtedness that occur after the date of 
enactment.

                              Prior Action

    A similar proposal is contained in section 331 of H.R. 2676 
(the ``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that taxpayers should be charged 
interest only on the amount they actually owe, taking into 
account overpayments and underpayments from all open years.

32. Archive of records of the IRS

                              Present Law

    The IRS is obligated to transfer agency records to the 
National Archives and Records Administration (``NARA'') for 
retention or disposal. The IRS is also obligated to protect 
confidential taxpayer records from disclosure. These two 
obligations have created conflict between NARA and the IRS. 
Under present law, the IRS determines whether records contain 
taxpayer information. Once the IRS has made that determination, 
NARA is not permitted to examine those records. NARA has 
expressed concern that the IRS may be using the disclosure 
prohibition to improperly conceal agency records with 
historical significance.

IRS obligation to archive records

    The IRS, like all other Federal agencies, must create, 
maintain, and preserve agency records in accordance with 
section 3101 of title 44 of the United States Code. NARA is the 
Government agency responsible for overseeing the management of 
the records of the Federal government.134 Federal 
agencies are required to deposit significant and historical 
records with NARA.135 The head of each Federal 
agency must also establish safeguards against the removal or 
loss of records.136
---------------------------------------------------------------------------
    \134\ 44 U.S.C. sec. 2904
    \135\ 5 U.S.C. sec. 552a(b)(6),
    \136\ 44 U.S.C. sec. 3105.
---------------------------------------------------------------------------

Authority of NARA

    NARA is authorized, under the Federal Records Act, to 
establish standards for the selective retention of records of 
continuing value.137 NARA has the statutory 
authority to inspect records management practices of Federal 
agencies and to make recommendations for 
improvement.138 The head of each Federal agency must 
submit to NARA a list of records to be destroyed and a schedule 
for such destruction.139 NARA examines the list to 
determine if any of the records on the list have sufficient 
administrative, legal research, or other value to warrant their 
continued preservation. In many cases, the description of the 
record on the list is sufficient for NARA to make the 
determination. For example, NARA does not need to inspect 
Presidential tax returns to determine that they have historical 
value and should be retained. In some cases, NARA may find it 
helpful to examine a particular record. NARA has general 
authority to inspect records solely for the purpose of making 
recommendations for the improvement of records management 
practices.140 However, tax returns and return 
information can only be disclosed under the authority provided 
in section 6103 of the Internal Revenue Code. There is no 
exception to the disclosure prohibition for records management 
inspection by NARA.141
---------------------------------------------------------------------------
    \137\ 44 U.S.C. sec. 2905.
    \138\ 44 U.S.C. sec. 2904(c)(7).
    \139\ 44 U.S.C. sec. 3303.
    \140\ 44 U.S.C. 2906.
    \141\ American Friends Service Committee v. Webster, 720 F.wd 29 
(D.C. Cir. 1983).
---------------------------------------------------------------------------
    NARA is also responsible for the custody, use and 
withdrawal of records transferred to it.142 
Statutory provisions that restrict public access to the records 
in the hands of the agency from which the records were 
transferred also apply to NARA. Thus, if a confidential record, 
such as a Presidential tax return, is transferred to NARA for 
archival storage, NARA is not permitted to disclose it. In 
general, the application of such restrictions to records in the 
hands of NARA expire after the records have been in existence 
for 30 years.143 The issue of whether the specific 
disclosure prohibition of section 6103 takes precedence over 
the general 30-year expiration of restrictions generally 
applicable to records in the hands of NARA has not been 
addressed by a court, but an informal advisory opinion from the 
Office of Legal Counsel of the Attorney General concluded that 
the 30-year expiration provision would not reach records 
subject to section 6103.144
---------------------------------------------------------------------------
    \142\ 44 U.S.C. sec. 2108.
    \143\ 44 U.S.C. sec. 2108.
    \144\ Department of Justice, Office of Legal Counsel, Memorandum to 
Richard K. Willard, Assistant Attorney General (Civil Division) 
(February 27, 1986).
---------------------------------------------------------------------------

Confidentiality requirements

    The IRS must preserve the confidentiality of taxpayer 
information contained in Federal income tax returns. Such 
information may not be disclosed except as authorized under 
Code section 6103. Section 6103 was substantially revised in 
1976 to address Congress' concern that tax information was 
being used by Federal agencies in pursuit of objectives 
unrelated to administration and enforcement of the tax laws. 
Congress believed that the wide-spread use of tax information 
by agencies other than the IRS could adversely affect the 
willingness of taxpayers to comply voluntarily with the tax 
laws and could undermine the country's self-assessment tax 
system.145 Section 6103 does not authorize the 
disclosure of confidential return information to NARA.
---------------------------------------------------------------------------
    \145\ S. Rept. 94-938, p. 317 (1976).
---------------------------------------------------------------------------
    Section 6103 restricts the disclosure of returns and return 
information only. Return means any tax or information return, 
declaration of estimated tax, or claim for refund, including 
schedules and attachments thereto, filed with the IRS. Return 
information includes the taxpayer's name; nature and source or 
amount of income; and whether the taxpayer's return is under 
investigation. Section 6103(b)(2) provides that ``nothing in 
any other provision of law shall be construed to require the 
disclosure of standards used or to be used for the selection of 
returns for examination, or data used or to be used for 
determining such standards, if the Secretary determines that 
such disclosure will seriously impair assessment, collection, 
or enforcement under the internal revenue laws.'' Section 6103 
does not restrict the disclosure of other records required to 
be maintained by the IRS, such as records documenting agency 
policy, programs and activities, and agency histories. Such 
records are required to be made available to the public under 
the Freedom of Information Act (``FOIA'').146
---------------------------------------------------------------------------
    \146\ FOIA does not require disclosure of records of information 
that would frustrate law enforcement efforts. 5 U.S.C. sec. 552(b)(7).
---------------------------------------------------------------------------
    The Internal Revenue Code prohibits disclosure of tax 
returns and return information, except to the extent 
specifically authorized by the Internal Revenue Code (sec. 
6103). Unauthorized disclosure is a felony punishable by a fine 
not exceeding $5,000 or imprisonment of not more than five 
years, or both (sec. 7213). An action for civil damages also 
may be brought for unauthorized disclosure (sec. 7431).

                        Description of Proposal

    The proposal would provide an exception to the disclosure 
rules to require IRS to disclose IRS records to officers or 
employees of NARA, upon written request from the Archivist, for 
purposes of the appraisal of such records for destruction or 
retention. The present-law prohibitions on and penalties for 
disclosure of tax information would generally apply to NARA.

                             Effective Date

    The proposal would be effective for requests made by the 
Archivist after the date of enactment.

                              Prior Action

    The proposal is contained in section 373 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proponents believe that it is appropriate to permit 
disclosure to NARA for purposes of scheduling records for 
destruction or retention, while at the same time preserving the 
confidentiality of taxpayer information in those documents.

33. Clarification of authority of Secretary relating to the making of 
        elections

                              Present Law

    Except as otherwise provided, elections provided by the 
Code are to be made in such manner as the Secretary shall by 
regulations or forms prescribe.

                        Description of Proposal

    The proposal would clarify that, except as otherwise 
provided, the Secretary may prescribe the manner of making of 
any election by any reasonable means.

                             Effective Date

    The proposal would be effective as of the date of 
enactment.

                              Prior Action

    The proposal is contained in section 375 of H.R. 2676 (the 
``Internal Revenue Service Restructuring and Reform Act of 
1997''), as passed by the House on November 5, 1997.

                                Analysis

    The proposal would eliminate any confusion over the type of 
guidance in which the Secretary may prescribe the manner of 
making any election.

34. Grant IRS broad authority to enter into cooperative agreements with 
        State tax authorities

                              Present Law

    The IRS is generally not authorized to provide services to 
non-Federal agencies even if the cost is reimbursed (62 Comp. 
Gen. 323,335 (1983)).
    Most taxpayers reside in States with an income tax and, 
therefore, must file both Federal and State income tax returns 
each year. Each return is separately prepared, with the State 
return often requiring information taken directly from the 
Federal return.

                        Description of Proposal

    The proposal would provide that the IRS is authorized to 
enter into cooperative agreements with State tax authorities to 
enhance joint tax administration. These agreements may include 
(1) joint filing of Federal and State income tax returns, (2) 
joint processing of these returns, and (3) joint collection of 
taxes (other than Federal income taxes).

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The proposal was included in the Tax Simplification and 
Technical Corrections Act of 1993 (H.R. 3419), as passed by the 
House in 1994, but was not enacted.

                                Analysis

    Permitting the IRS to enter into agreements that are 
designed to promote efficiency through joint tax administration 
programs with States could reduce the burden on taxpayers 
because much of the same information could be used by both 
Governments.
    For example, the burden on taxpayers could be significantly 
reduced through joint electronic filing of tax returns, whereby 
a taxpayer electronically transmits both Federal and State 
returns to one location. Joint Federal and State electronic 
filing could simplify and shorten return preparation time for 
taxpayers. Also, State governments could benefit from reduced 
processing costs, while the IRS could benefit from the 
potential increase in taxpayers who would elect to file 
electronically because they would be able to fulfill both their 
Federal and State obligations simultaneously.

35. Low-income taxpayer clinics

                              Present Law

    There are no provisions in present law providing for 
assistance to clinics that assist low- income taxpayers.

                        Description of Proposal

    The proposal would authorize the Legal Services Corporation 
to make matching grants for the development, expansion, or 
continuation of certain low-income taxpayer clinics. Eligible 
clinics would be those that charge no more than a nominal fee 
to either represent low-income taxpayers in controversies with 
the IRS or provide tax information to individuals for whom 
English is a second language. The term ``clinic'' would include 
(1) a clinical program at an accredited law school in which 
students represent low-income taxpayers, and (2) an 
organization exempt from tax under Code section 501(c) which 
either represents low-income taxpayers or provides referral to 
qualified representatives.
    A clinic would be treated as representing low-income 
taxpayers if at least 90 percent of the taxpayers represented 
by the clinic have incomes which do not exceed 250 percent of 
the poverty level and amounts in controversy of $25,000 or 
less.
    The aggregate amount of grants to be awarded each year 
would be limited to $3,000,000. No taxpayer clinic could 
receive more than $100,000 per year. The clinic must provide 
matching funds on a dollar-for-dollar basis. Matching funds may 
include the allocable portion of both the salary (including 
fringe benefits) of individuals performing services for the 
clinic and clinic equipment costs, but not general 
institutional overhead.
    The following criteria would be required to be considered 
in making awards: (1) number of taxpayers served by the clinic, 
including the number of taxpayers in the geographical area for 
whom English is a second language; (2) the existence of other 
taxpayer clinics serving the same population; (3) the quality 
of the program; and (4) alternative funding sources available 
to the clinic.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    A substantially similar proposal is contained in section 
361 of H.R. 2676 (the ``Internal Revenue Service Restructuring 
and Reform Act of 1997''), as passed by the House on November 
5, 1997.

                                Analysis

    The proponents believe that the provision of tax services 
by accredited nominal fee clinics to low-income individuals and 
those for whom English is a second language will improve 
compliance with the Federal tax laws and should be encouraged.

36. Disclosure of field service advice

                              Present Law

    Field service advice memoranda are documents prepared by 
IRS national office attorneys for use by IRS district counsel 
attorneys. Because field service advice memoranda apply legal 
principles to the facts of a particular case, they generally 
contain confidential taxpayer information. In Tax Analysts v. 
IRS,147 the court held that the Freedom of 
Information Act requires field service advice memoranda issued 
by the National Office of the Chief Counsel of the Internal 
Revenue Service to field personnel to be open to public 
inspection. Section 6103 of the Code prohibits the disclosure 
of tax return information. Statutory procedures do not 
currently exist for insuring taxpayer privacy while allowing 
the public inspection of field service advice memoranda.
---------------------------------------------------------------------------
    \147\ 117 F.3d 607 (D.C. Cir. 1997).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would provide that field service advice 
memoranda are return information in their entirety, which would 
prohibit their disclosure. The proposal would also provide a 
structured mechanism 148 for public inspection of 
field service advice memoranda, subject to a redaction process 
similar to that applicable to written determinations under 
section 6110. This would permit the taxpayer whose liability is 
the subject of the field service advice memorandum to 
participate in the process of assessing what information should 
not be disclosed.
---------------------------------------------------------------------------
    \148\ Details concerning the operation of this mechanism are not 
specified.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective on the date of enactment. 
It would also apply to those memoranda that were the subject of 
the lawsuit on a specifically scheduled basis.

                              Prior Action

    No prior action.

                                Analysis

    Some might view the proposal as providing an appropriate 
resolution to issues currently outstanding in the litigation 
over disclosure of these memoranda. Others might view the 
proposal as providing a result that is more restrictive (in 
terms of providing disclosure) than the result reached in the 
litigation.

                   II. PROVISIONS INCREASING REVENUE

                        A. Accounting Provisions

1. Repeal lower of cost or market inventory accounting method

                              Present Law

    A taxpayer that sells goods in the active conduct of its 
trade or business generally must maintain inventory records in 
order to determine the cost of goods it sold during the taxable 
period. Cost of goods sold generally is determined by adding 
the taxpayer's inventory at the beginning of the period to 
purchases made during the period and subtracting from that sum 
the taxpayer's inventory at the end of the period.
    Because of the difficulty of accounting for inventory on an 
item-by-item basis, taxpayers often use conventions that assume 
certain item or cost flows. Among these conventions are the 
``first-in-first-out'' (``FIFO'') method which assumes that the 
items in ending inventory are those most recently acquired by 
the taxpayer, and the ``last-in-first-out'' (``LIFO'') method 
which assumes that the items in ending inventory are those 
earliest acquired by the taxpayer.
    Treasury regulations provide that taxpayers that maintain 
inventories under the FIFO method may determine the value of 
ending inventory under a (1) cost method or (2) ``lower of cost 
or market'' (``LCM'') method (Treas. reg. sec. 1.471-2(c)). 
Under the LCM method, the value of ending inventory is written 
down if its market value is less than its cost. Similarly, 
under the subnormal goods method, any goods that are unsalable 
at normal prices or unusable in the normal way because of 
damage, imperfections, shop wear, changes of style, odd or 
broken lots, or other similar causes, may be written down to 
net selling price. The subnormal goods method may be used in 
conjunction with either the cost method or LCM.
    Retail merchants may use the ``retail method'' in valuing 
ending inventory. Under the retail method, the total of the 
retail selling prices of goods on hand at year end is reduced 
to approximate cost by deducting an amount that represents the 
gross profit embedded in the retail prices. The amount of the 
reduction generally is determined by multiplying the retail 
price of goods available at yearend by a fraction, the 
numerator of which is the cost of goods available for sale 
during the year and the denominator of which is the total 
retail selling prices of the goods available for sale during 
the year, with adjustments for mark-ups and mark-downs (Treas. 
reg. sec. 1.471-8(a)). Under certain conditions, a taxpayer 
using the FIFO method may determine the approximate cost or 
market of inventory by not taking into account retail price 
mark-downs for the goods available for sale during the year, 
even though such mark-downs are reflected in the retail selling 
prices of the goods of goods on hand at year end (Treas. reg. 
sec. 1.471-8(d)). As a result, such taxpayer may write down the 
value of inventory below both its cost and its market value.

                        Description of Proposal

    The proposal would repeal the LCM method and the subnormal 
goods method. Appropriate wash-sale rules would be provided. 
The proposal would not apply to taxpayers with average annual 
gross receipts over a three-year period of $5 million or less.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment. Any section 481(a) adjustment 
required to be taken into account pursuant to the change of 
method of accounting under the proposal would be taken into 
account ratably over a four taxable year period beginning with 
the first taxable year the taxpayer is required to change its 
method of accounting.

                              Prior Action

    The proposal is substantially similar to a provision that 
had been reported favorably by the Senate Committee on Finance 
in conjunction with the passage of the General Agreement on 
Tariffs and Trade, but was not included in the final 
legislation as passed by the Congress in 1994. The proposal is 
identical to a provision contained in the President's budget 
proposals for fiscal years 1997 and 1998.

                                Analysis

    Under present law, income or loss generally is not 
recognized until it is realized. In the case of a taxpayer that 
sells goods, income or loss generally is realized and 
recognized when the goods are sold or exchanged. The LCM and 
subnormal goods inventory methods of present law represent 
exceptions to the realization principle by allowing the 
recognition of losses without a sale or exchange. In addition, 
these methods are one-sided in that they allow the recognition 
of losses, but not gains, even if the items of inventory 
recover their value in a subsequent year.
    In general, the LCM and subnormal goods inventory methods 
have been long-accepted as generally accepted accounting 
principles (``GAAP'') applicable to the preparation of 
financial statements and have been allowed by Treasury 
regulations for tax purposes since 1918. However, the mechanics 
of the tax rules differ from the mechanics of the financial 
accounting rules. Moreover, the conservatism principle of GAAP 
requires the application of the LCM and subnormal goods methods 
so that the balance sheets of dealers in goods are not 
overstated relative to realizable values. There is no analog to 
the conservatism principle under the Federal income tax.
    The repeal of the LCM method may cause some taxpayers to 
change their methods of accounting for inventory to the LIFO 
method. The LIFO method generally is considered to be a more 
complicated method of accounting than is the FIFO method and 
often results in less taxable income. Despite this potential 
tax saving, many taxpayers are deterred from using the LIFO 
method because of the present-law requirement that the LIFO 
method must also be used for financial statement purposes, thus 
reducing financial accounting income.
2. Repeal non-accrual experience method of accounting

                              Present Law

    An accrual method taxpayer generally must recognize income 
when all events have occurred that fix the right to its receipt 
and its amount can be determined with reasonable accuracy. An 
accrual method taxpayer may deduct the amount of any receivable 
that was previously included in income if the receivable 
becomes worthless during the year.
    Accrual method service providers are provided an exception 
to these general rules. Under the exception, a taxpayer using 
an accrual method with respect to amounts to be received for 
the performance of services is not required to accrue any 
portion of such amounts which (on the basis of experience) will 
not be collected (``non-accrual experience method''). This 
exception applies as long as the taxpayer does not charge 
interest or a penalty for failure to timely pay on such 
amounts.

                        Description of Proposal

    Under the proposal, the non-accrual experience method would 
be repealed.

                             Effective Date

    The proposal generally would be effective for taxable years 
ending after the date of enactment. Any required section 481(a) 
adjustment would be taken into account ratably over a four-year 
period.

                              Prior Action

    The non-accrual experience method of accounting was enacted 
by the Tax Reform Act of 1986, which repealed the bad debt 
reserve method of accounting and required certain taxpayers to 
use an accrual method of accounting.

                                Analysis

    The principal argument made for repeal of the non-accrual 
experience method is that it allows accrual method service 
providers the equivalent of a bad debt reserve, which is not 
available to other accrual method taxpayers. Opponents of the 
use of bad debt reserves argue that such reserves allow 
deductions for bad debts to be taken prior to the time they 
actually occur. The more favorable regime for service debts 
under the non-accrual experience method has also given rise to 
controversies over what constitutes a service (as opposed, for 
example, to selling property or issuing a loan).
    On the other hand, the non-accrual experience method allows 
an accrual method service provider to avoid the recognition of 
income that, on the basis of experience, it expects it will 
never collect. This moderates the disparity in treatment 
between accrual method service providers and service providers 
using the cash method of accounting, who generally are not 
required to recognize income from the performance of services 
prior to receipt of payment. Most large entities in other lines 
of business are required to use the accrual method of 
accounting, either because their inventories are a material 
income producing factor or they are corporations with gross 
receipts in excess of $5,000,000. Service providers, however, 
are frequently organized as partnerships of individuals or as 
qualified personal service corporations, eligible to use the 
cash method of accounting. It may be appropriate to continue to 
allow accrual basis service providers the use of the non-
accrual experience method to avoid the disparity of treatment 
between accrual and cash method competitors that could 
otherwise result.
    While the non-accrual experience method does provide a 
benefit that is not available to accrual basis sellers of 
goods, this difference may be appropriate. Sellers of goods may 
be able to mitigate their bad debt losses by recovering the 
goods themselves. This option is not available to service 
providers.
3. Make certain trade receivables ineligible for mark-to-market 
        treatment

                              Present Law

    In general, dealers in securities are required to use a 
mark-to-market method of accounting for securities (sec. 475). 
Exceptions to the mark-to-market rule are provided for 
securities held for investment, certain debt instruments and 
obligations to acquire debt instruments and certain securities 
that hedge securities. A dealer in securities is a taxpayer who 
regularly purchases securities from or sells securities to 
customers in the ordinary course of a trade or business, or who 
regularly offers to enter into, assume, offset, assign, or 
otherwise terminate positions in certain types of securities 
with customers in the ordinary course of a trade or business. A 
security includes (1) a share of stock, (2) an interest in a 
widely held or publicly traded partnership or trust, (3) an 
evidence of indebtedness, (4) an interest rate, currency, or 
equity notional principal contract, (5) an evidence of an 
interest in, or derivative financial instrument in, any of the 
foregoing securities, or any currency, including any option, 
forward contract, short position, or similar financial 
instrument in such a security or currency, or (6) a position 
that is an identified hedge with respect to any of the 
foregoing securities.
    Treasury regulations provide that if a taxpayer would be a 
dealer in securities only because of its purchases and sales of 
debt instruments that, at the time of purchase or sale, are 
customer paper with respect to either the taxpayer or a 
corporation that is a member of the same consolidated group, 
the taxpayer will not normally be treated as a dealer in 
securities. However, the regulations allow such a taxpayer to 
elect out of this exception to dealer status (the ``Customer 
paper election'').\149\ For this purpose, a debt instrument is 
customer paper with respect to a person if: (1) the person's 
principal activity is selling nonfinancial goods or providing 
nonfinancial services; (2) the debt instrument was issued by 
the purchaser of the goods or services at the time of the 
purchase of those goods and services in order to finance the 
purchase; and (3) at all times since the debt instrument was 
issued, it has been held either by the person selling those 
goods or services or by a corporation that is a member of the 
same consolidated group as that person.
---------------------------------------------------------------------------
    \149\ Treas. reg. sec. 1.475(c)-1(b), issued Decenber 23, 1996.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would provide that certain trade receivables 
would not be eligible for mark-to-market treatment, whether the 
taxpayer is a securities dealer required to use mark-to-market 
treatment or elects such treatment under the Treasury 
regulation. The trade receivables that would be excluded would 
include non-interest bearing receivables, and account, note and 
trade receivables unrelated to an active business of a 
securities dealer. The proposal would specify that no inference 
is intended as to the treatment of such receivables under 
present law and would also grant the Treasury regulatory 
authority to carry out the purposes of the proposal.

                             Effective Date

    The proposal generally would be effective for taxable years 
ending after the date of enactment.

                              Prior Action

    The mark-to-market method of section 475 was enacted by the 
Omnibus Budget Reconciliation Act of 1993.

                                Analysis

    Advocates of the proposal to exclude certain receivables 
from ``mark-to-market'' treatment would argue that it is 
necessary to prevent what is in effect a deduction for bad debt 
reserves, through the deduction of losses in value of the 
taxpayer's receivables and that Congress did not intend mark-
to-market treatment to reintroduce a bad debt reserve 
deduction. However, it is not clear that a mark-to-market 
method is equivalent to a bad debt reserve method. A bad debt 
reserve method generally attempts to measure the extent to 
which a creditor will or will not collect the face amount of 
its accounts receivable.\150\ Such collections often are 
primarily dependent upon the creditworthiness of the debtors. A 
mark-to-market method of accounting attempts to measure the 
fair market value of a creditor's accounts receivable. Such 
value is dependent upon a number of factors, including the 
creditworthiness of the debtors, the interest rate and other 
terms borne by the receivables, and the marketability of the 
receivables.
---------------------------------------------------------------------------
    \150\ Under some bad debt reserve methods, this amount may be 
determined by reference to the taxpayer's bad debt experience in 
previous years.
---------------------------------------------------------------------------
    As a demonstration of the differences between a mark-to-
market method and a bad debt reserve method, consider the 
following two examples. Assume a taxpayer sells goods, on 
credit, during the taxable year to a variety of debtors, some 
of whom are of risky creditworthiness. In order to compensate 
for these potential bad debts, the accounts receivable bear a 
relatively high rate of interest. Under a mark-to-market 
method, this pool of accounts receivable could be valued at or 
near their face values, resulting in little or no deductible 
loss (the fact that some receivables will not be collected is 
offset by the fact that others will generate above-market 
interest returns). Under a bad debt reserve method, the 
taxpayer generally would be allowed a deduction to reflect the 
fact that a portion of its accounts receivable will not be 
paid. In this example, a bad debt reserve method would result 
in a larger deduction during the taxable year than a mark-to-
market method. Consider another example. Assume a taxpayer 
sells goods, on credit, to the Federal Government during the 
taxable year and that these accounts receivable do not bear 
interest. Under a ``mark-to-market'' method, this pool of 
accounts receivable would be valued below their face values, 
resulting in a deductible loss (the present value of even the 
most secure non-interest bearing loan is less than its face 
value). Under a bad debt reserve method, the taxpayer generally 
would not be allowed a deduction because the likelihood of its 
accounts receivable not being paid is, at best, remote. In this 
example, a mark-to-market method would result in a larger 
deduction during the taxable year than a bad debt reserve 
method.
    Mark-to-market treatment to allow deductions with respect 
to receivables has probably been facilitated by the ``customer 
paper election'' provided by the recent Treasury regulations. 
Thus, opponents of the proposal might argue that a regulatory 
rather than a legislative solution is appropriate. However, 
even without the customer paper election, taxpayers that 
regularly acquire receivables in transactions with customers 
may argue that they are entitled to mark-to-market treatment 
under present law. The proposal adds simplification in that 
certain non-traded receivables will not have to be valued. The 
major argument against the exception of certain receivables 
from the mark-to-market regime is that mark-to-market always 
provides a more accurate reflection of the income derived from 
an asset, even if it produces losses. On the other hand, 
Congress, in 1993, applied the mark-to-market method to a 
discrete class of taxpayers and financial instruments 
(securities of security dealers); thus, it is appropriate to 
further clarify the limits of the application of the method by 
explicitly excluding certain accounts receivable.

                 B. Financial Products and Institutions

1. Defer interest deduction on certain convertible debt

                              Present Law

    If a financial instrument qualifies as a debt instrument, 
the issuer of the instrument may deduct stated interest as it 
economically accrues. In addition, if the instrument is issued 
at a discount, the issuer may deduct original issue discount 
(``OID'') as it economically accrues, even though the OID may 
not be paid until the instrument matures. The holder of a debt 
instrument includes stated interest under its regular method of 
accounting and OID as it economically accrues.
    In the case of a debt instrument that is convertible into 
the stock of the issuer or a related party, an issuer generally 
may deduct accrued interest and OID up until the time of the 
conversion, even if the accrued interest and OID is never paid 
because the instrument is converted.

                        Description of Proposal

    The proposal would defer interest deductions for accrued 
stated interest and OID on convertible debt until such time as 
the interest is paid. For this purpose, payment would not 
include: (1) the conversion of the debt into equity of the 
issuer or a related person (as determined under secs. 267(b) 
and 707(b)) or (2) the payment of cash or other property in an 
amount that is determined by reference to the value of such 
equity. Convertible debt would include debt: (1) exchangeable 
for the stock of the issuer or a related party, (2) with cash-
settlement conversion features, or (3) issued with warrants (or 
similar instruments) as part of an investment unit in which the 
debt instrument may be used to satisfy the exercise price of 
the warrant. Convertible debt would not include debt that is 
``convertible'' solely because a fixed payment of principal or 
interest could be converted by the holder into equity of the 
issuer or a related party having a value equal to the amount of 
such principal or interest. Holders of convertible debt would 
continue to include the interest on such instruments in gross 
income as under present law.

                             Effective Date

    The proposal would be effective for convertible debt issued 
on or after the date of first committee action.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal.

                                Analysis

    The manner in which the proposal would operate may be 
illustrated in one context by examining its effect upon the tax 
treatment of instruments commonly known as liquid yield option 
notes (``LYONs'').\151\ A LYON generally is an instrument that 
is issued at a discount and is convertible into a fixed number 
of shares of the issuer, regardless of the amount of original 
issue discount (``OID'') accrued as of the date of conversion. 
The conversion option usually is in the hands of the holder, 
although a LYON may be structured to allow the issuer to ``cash 
out'' the instrument at certain fixed dates for its issue price 
plus accrued OID. If the LYON is not converted into equity at 
maturity, the holder receives the stated redemption price at 
maturity (i.e., the issue price plus accrued OID). A LYON is 
convertible into a fixed number of shares of issuer stock 
regardless of the amount of accrued OID and does not provide 
interim interest payments to holders. Thus, a LYON could be 
viewed as providing the holder both a discount debt instrument 
and an option to purchase stock at a price equal to the 
maturity value of the debt. If the stock has risen in value 
from the date of issuance to the maturity date to an amount 
that is greater than the stated redemption price at maturity of 
the OID debt, the holder will exercise the option to acquire 
stock by surrendering the debt. If the stock has not 
sufficiently risen in value, the holder will cash in the debt 
and let the option lapse.
---------------------------------------------------------------------------
    \151\ Other convertible debt instruments may have features similar 
to LYONs and may be issued or traded under different names or acronyms. 
The reference to ``LYONs'' in this discussion is intended to be a 
reference to any other similar instruments.
---------------------------------------------------------------------------
    As a simplified example, assume ABC Co. issues a LYON that 
will mature in five years. The LYON provides that, at maturity, 
the holder has the option of receiving $100 cash or one share 
of ABC Co. stock. The LYONs are issued for $70 per instrument 
at time that the ABC Co. stock is trading for less than $70 a 
share. Thus, at the end of five years, the holder of the LYON 
has the following choices: (1) if ABC Co. stock is trading at 
less than $100 a share, the holder will take the $100 cash, but 
(2) if ABC Co. stock is trading at more than $100 a share, the 
holder will take the stock. Because the holder is guaranteed to 
receive at least $100 in value at maturity, present law allows 
the issuer (and requires the holder) to accrue $30 of OID as 
interest over the five-year term of the instrument.
    The structure of LYONs raises several tax issues. The first 
is whether the conversion feature of a LYON is sufficiently 
equity-like to characterize the LYON as equity instead of debt. 
Under present law, issuers of LYONS deduct (and the holders 
include in income) the amount of OID as interest as it accrues. 
A second issue is whether it is appropriate to accrue OID on an 
instrument when it is unclear whether such instrument 
(including the accrued OID) will be paid in cash or property 
other than stock. The proposal provides answers to these two 
issues by applying a ``wait and see'' approach, that is, OID on 
a LYON is not deductible unless and until the amount of OID is 
paid in cash. In this way, the proposal defers the 
determination of whether a LYON is debt or equity until 
maturity. This approach is consistent with present-law section 
163(e)(5) that provides that a portion of the OID of applicable 
high-yield debt instruments is not deductible until paid.
    Opponents of the proposal would argue that the 
determination of whether an instrument is debt or equity should 
be made at its issuance and, at issuance, a LYON has more debt-
like features than equity-like features. They would further 
point out that the holder of a LYON is guaranteed to receive at 
maturity at least the amount of the OID and that present law 
properly allows issuers to accrue such amount over time. 
Opponents of the proposal also would argue that under present 
law, taxpayers are allowed deductions when stock is issued for 
deductible expenses (or taxpayers can issue stock to the public 
and use the cash to pay deductible expenses) and that the 
issuance of stock for accrued interest is no different. They 
further claim that issuers can achieve results that are similar 
(or better) than the present law treatment of a LYON by issuing 
callable OID indebtedness and options or warrants as separate 
instruments and that the tax law should not discourage the 
efficient combination of the two types of instruments. However, 
if the two instruments truly trade separately, it is not clear 
that they are economically equivalent to a LYON. Finally, 
opponents would argue that it is unfair and contrary to the 
present-law OID rules to require holders of LYONS to accrue OID 
in income while deferring or denying related OID deductions to 
issuers. Again, under present law, holders of applicable high-
yield debt instruments are required to include OID in income as 
it accrues, while OID deductions of issuers of such instruments 
are deferred or denied.

2. Disallowance of interest on indebtedness allocable to tax-exempt 
        obligations of all financial intermediaries

                              Present Law

In general

    Present law disallows a deduction for interest on 
indebtedness incurred or continued to purchase or carry 
obligations the interest on which is not subject to tax (tax-
exempt obligations) (sec. 265). This rule applies to tax-exempt 
obligations held by individual and corporate taxpayers. The 
rule also applies to certain cases in which a taxpayer incurs 
or continues indebtedness and a related person acquires or 
holds tax-exempt obligations. \152\
---------------------------------------------------------------------------
    \152\ Section 7701(f) (as enacted in the Deficit Reduction Act of 
1984 (sec. 53(c) of Public Law 98-369)) provides that the Treasury 
Secretary shall prescribe such regulations as may be necessary or 
appropriate to prevent the avoidance of any income tax rules which deal 
with linking of borrowing to investment or diminish risk through the 
use of related persons, pass-through entities, or other intermediaries.
---------------------------------------------------------------------------

Application to non-financial corporations

    In Rev. Proc. 72-18, 1972-1 C.B. 740, the IRS provided 
guidelines for application of the disallowance provision to 
individuals, dealers in tax-exempt obligations, other business 
enterprises, and banks in certain situations. Under Rev. Proc. 
72-18, a deduction is disallowed only when indebtedness is 
incurred or continued for the purpose of purchasing or carrying 
tax-exempt obligations.
    This purpose may be established either by direct or 
circumstantial evidence. Direct evidence of a purpose to 
purchase or carry tax-exempt obligations exists when the 
proceeds of indebtedness are directly traceable to the purchase 
of tax-exempt obligations or when such obligations are used as 
collateral for indebtedness. In the absence of direct evidence, 
a deduction is disallowed only if the totality of facts and 
circumstances establishes a sufficiently direct relationship 
between the borrowing and the investment in tax-exempt 
obligations.
    Two-percent de minimis exception.--In the case of an 
individual, interest on indebtedness which is not directly 
traceable to tax-exempt obligations is not disallowed if during 
the taxable year the average adjusted basis of the tax-exempt 
obligations does not exceed 2 percent of the average adjusted 
basis of the individual's portfolio investments and trade or 
business assets. In the case of a corporation other than a 
financial institution or a dealer in tax-exempt obligations, 
interest on indebtedness which is not directly traceable to 
tax-exempt obligations is not disallowed if during the taxable 
year the average adjusted basis of the tax-exempt obligations 
does not exceed 2 percent of the average adjusted basis of all 
assets held in the active conduct of the trade or business. 
These safe harbors are inapplicable to financial institutions 
and dealers in tax-exempt obligations.
    Interest on installment sales to State and local 
governments.--If a taxpayer sells property to a State or local 
government in exchange for an installment obligation, interest 
on the obligation may be exempt from tax. Present law has been 
interpreted to not disallow interest on a taxpayer's 
indebtedness if the taxpayer acquires nonsaleable tax-exempt 
obligations in the ordinary course of business in payment for 
services performed for, or goods supplied to, State or local 
governments.\153\
---------------------------------------------------------------------------
    \153\ R.B. George Machinery Co., 26 B.T.A. 594 (1932) acq. C.B. XI-
2, 4; Rev. Proc. 72-18, as modified by Rev. Proc. 87-53, 1987-2 C.B. 
669.
---------------------------------------------------------------------------

Application to financial institutions

    In the case of a financial institution, the allocation of 
the interest expense of the financial institution (which is not 
otherwise allocable to tax-exempt obligations) is based on the 
ratio of the average adjusted basis of the tax-exempt 
obligations acquired after August 7, 1986, to the average 
adjusted basis of all assets of the taxpayer (Code sec. 265). 
For this purpose, a financial institution is (1) a person who 
accepts deposits from the public in the ordinary course of the 
taxpayer's business that is subject to Federal or State 
supervision as a financial institution or (2) a foreign 
corporation which has a banking business in the United States. 
In the case of an obligation of an issuer which reasonably 
anticipates to issue not more than $10 million of tax- exempt 
obligations (other than certain private activity bonds) within 
a calendar year (hereinafter the ``small issuer exception''), 
only 20 percent of the interest allocable to such tax-exempt 
obligations is disallowed (Code sec. 291(a)(3)).

Treatment of securities dealers

    A pro rata disallowance rule, similar to the rule 
applicable to financial institutions, applies to dealers in 
tax-exempt obligations, but there is no small issuer exception, 
and the 2-percent de minimis exception does not apply (Rev. 
Proc. 72-18). Securities dealers are allowed, however, to 
exclude from the pro rata disallowance rule interest on 
borrowings that they can prove by tracing were incurred or 
continued for a purpose other than purchasing or carrying tax-
exempt obligations.

Treatment of insurance companies

    Present law provides that a life insurance company's 
deduction for additions to reserves is reduced by a portion of 
the company's income that is not subject to current tax 
(generally, tax-exempt interest, deductible intercorporate 
dividends, and the increase in certain insurance policy cash 
values) (secs. 807 and 812). The portion by which the life 
insurance company's reserve deduction is reduced is related to 
its earnings rate. Similarly, in the case of property and 
casualty insurance companies, the deduction for losses incurred 
is reduced by a percentage (15 percent) of (1) the insurer's 
tax-exempt interest, (2) the deductible portion of dividends 
received (with special rules for dividends from affiliates), 
and (3) the increase for the taxable year in the cash value of 
life insurance, endowment or annuity contracts (sec. 
832(b)(5)(B)). If the amount of this reduction exceeds the 
amount otherwise deductible as losses incurred, the excess is 
includible in the property and casualty insurer's income.

                        Description of Proposal

    The Administration proposal would extend to all persons 
engaged in the active conduct of banking, financing, or similar 
business (such as securities dealers and other financial 
intermediaries) the rule that applies to financial institutions 
that disallows interest deductions of a taxpayer (that are not 
otherwise disallowed as allocable under present law to tax-
exempt obligations) in the same proportion as the average basis 
of its tax-exempt obligations bears to the average basis of all 
of the taxpayer's assets. The proposal would not extend the $10 
million small-issuer exception to taxpayers which are not 
financial institutions. The proposal would not apply to 
insurance companies.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after date of enactment with respect to obligations acquired on 
or after the date of committee action.

                              Prior Action

    Section 10116 of the Omnibus Budget Reconciliation Act of 
1987 as reported by the House Committee on the Budget would 
have disallowed a deduction for interest on indebtedness 
allocable to tax-exempt installment obligations. In addition, 
that section would have reduced the non-statutory two-percent 
de minimis test to the lesser of $1 million or two-percent of 
the taxpayer's adjusted basis of all of the taxpayer's assets. 
That bill passed the House, but the provision disallowing a 
deduction for interest allocable to tax-exempt obligations was 
subsequently deleted in conference.
    The Administration made similar proposals in 1995 and 1997 
except that the proposed extension of the interest disallowance 
rule would have applied to all corporations, not just financial 
intermediaries. In addition the prior proposal would not have 
applied to nonsaleable tax-exempt debt acquired by a 
corporation in the ordinary course of business in payment for 
goods or services sold to a State or local government. Like the 
present proposal, the prior proposal would not have applied to 
an insurance company. Finally, the prior proposal would have 
applied the interest disallowance provision to all related 
persons (within the meaning of sec. 267(f)).

                                Analysis

Premise of proposal

    Taxpayers generally are allowed to deduct the amount of 
interest expense paid or accrued within the taxable year (Code 
sec. 163(a)). However, present law disallows the deduction of 
interest expense on indebtedness incurred to purchase or carry 
tax-exempt obligations (Code sec. 265(a)(2)). The purpose of 
this disallowance rule is to prevent the tax arbitrage that 
would otherwise occur if taxpayers could borrow money and 
deduct any resulting interest expense while excluding from 
gross income interest income on State or local obligations 
financed with that borrowing. If unrestricted, tax arbitrage 
could create an unlimited transfer of funds from the Treasury 
to State and local treasuries. Moreover, the transfer of funds 
generally is inefficient in that the Federal tax revenue lost 
generally exceeds the arbitrage profit earned by State and 
local governments.
    Present law provides more favorable rules on the 
disallowance of interest expense or reserve deductions 
allocable to tax-exempt bonds to certain types of financial 
intermediaries (e.g., property and casualty insurance and 
finance companies) than other types of financial intermediaries 
with whom they compete (e.g., banks). If one accepts the 
premise that all money is fungible and that debt of the 
taxpayer finances its proportionate share of all of the 
taxpayer's assets including tax-exempt bonds, a proportional 
disallowance rule theoretically should apply to all taxpayers. 
The Administration proposal to apply a proportional 
disallowance rule to all financial intermediaries is based on 
the notion that similar taxpayers should be taxed similarly. 
While uniform treatment may not be appropriate among all 
taxpayers, there arguably should be uniform treatment among 
taxpayers that compete against each other.

Scope of proposal

    The scope of the proposal is not entirely clear since it 
applies to persons in the active conduct of businesses 
``similar'' to ``banking'', ``financing,'' ``securities 
dealers'' and ``other financial intermediaries.'' For example, 
is a retailer who sells appliances or furniture on an 
installment method in a financing business and, therefore, 
subject to the proposed rule? Is any retailer who issues its 
own credit card (e.g., Sears, Macy's, J.C. Penney's, Firestone, 
etc.) subject to the proposed rule?

Effect of proposal

    The primary effect of the proposal would be to disallow the 
2-percent de minimis exception and the installment sale 
exception to taxpayers covered by the proposal.
    Repeal of 2-percent de minimis exception.--The 
Administration proposal to adopt a pro rata rule would repeal 
the 2-percent de minimis exception for those taxpayers covered 
by the proposal. Some proponents of the Administration proposal 
accept the premise that money is fungible and, accordingly, 
would disallow interest deductions on a pro rata basis (e.g., 
in the same proportion as the taxpayer's average basis in its 
tax-exempt obligations bears to the average basis of its total 
assets). These proponents argue that the proposed pro rata 
allocation of indebtedness among assets (in the manner 
prescribed for financial institutions) has the additional 
administrative benefit, for taxpayers that own more tax-exempt 
bonds than the 2 percent de minimis amount, of avoiding the 
difficult and often subjective inquiry of when indebtedness is 
incurred or continued to purchase or carry tax-exempt 
obligations.
    Opponents of the Administration proposal argue that the 
proposal would have the effect of raising the financing costs 
for State or local governments. Opponents also note that the de 
minimis exception avoids the complexity of complying with the 
proposed pro rata rule. Lastly, opponents note that there is no 
policy justification for repealing the de minimis exception for 
financial intermediaries, but not individuals.
    Repeal of the installment sale exception.--The 
Administration proposal to adopt a pro rata rule also would 
repeal the installment sales exception for those taxpayers 
covered by the proposal. Opponents of the proposal believe that 
the present exception for debt arising from installment sales 
to State and local governments should be retained because such 
debt often is incurred by governments for acquisition of 
property that could not easily be financed through debt issued 
in the public debt markets because of the size of the 
government or the asset acquisition.
    The exemption from the pro rata rule for insurance 
companies is justified on the grounds that present law already 
adjusts the deduction for additions to an insurance company's 
reserves for its tax-exempt income.

                      C. Corporate Tax Provisions

1. Eliminate dividends-received deduction for certain preferred stock

                              Present Law

    A corporate taxpayer is entitled to a deduction of 70 
percent of the dividends it receives from a domestic 
corporation. The percentage deduction is generally increased to 
80 percent if the taxpayer owns at least 20 percent (by vote 
and value) of the stock of the dividend-paying corporation, and 
to 100 percent for ``qualifying dividends,'' which generally 
are from members of the same affiliated group as the taxpayer.
    The dividends-received deduction is disallowed if the 
taxpayer has held the stock for 45 days or less during the 90-
day period beginning on the date that is 45 days before the 
date on which such share becomes ex-dividend with respect to 
such dividend. In the case of certain preferred stock, the 
dividends received deduction is disallowed if the taxpayer has 
held the stock for 90 days or less during the 180-day period 
beginning on the date which is 90 days before the date on which 
such share becomes ex-dividend with respect to such dividend. 
The holding period generally does not include any period during 
which the taxpayer has a right or obligation to sell the stock, 
or is otherwise protected from the risk of loss otherwise 
inherent in the ownership of an equity interest. If an 
instrument was treated as stock for tax purposes, but provided 
for payment of a fixed amount on a specified maturity date and 
afforded holders the rights of creditors to enforce such 
payment, the Internal Revenue Service has ruled that no 
dividends-received deduction would be allowed for distributions 
on the instrument.154
---------------------------------------------------------------------------
    \154\ See Rev. Rul. 94-28, 1994-1 C.B. 86.
---------------------------------------------------------------------------
    The Taxpayer Relief Act of 1997 amended sections 351, 354, 
355, 356 and 1036 to treat ``nonqualified preferred stock'' as 
boot in corporate transactions, subject to certain exceptions. 
Nonqualified preferred stock is defined in section 351(g) as 
preferred stock that does not participate (through a conversion 
privilege or otherwise) in corporate growth to any significant 
extent, if (1) the holder has the right to require the issuer 
or a related person to redeem or purchase the stock, (2) the 
issuer or a related person is required to redeem or purchase 
the stock, (3) the issuer or a related person has the right to 
redeem or purchase the stock and, as of the issue date, it is 
more likely than not that such right will be exercised, or (4) 
the dividend rate on the stock varies in whole or in part 
(directly or indirectly) with reference to interest rates, 
commodity prices, or similar indices, regardless of whether 
such varying rate is provided as an express term of the stock 
(as in the case of adjustable rate stock) or as a practical 
result of other aspects of the stock (as in the case of auction 
rate stock). For this purpose, clauses (1), (2), and (3) apply 
if the right or obligation may be exercised within 20 years of 
the issue date and is not subject to a contingency which, as of 
the issue date, makes remote the likelihood of the redemption 
or purchase.

                        Description of Proposal

    Except in the case of ``qualifying dividends,'' the 
dividends-received deduction would be eliminated for dividends 
on nonqualified preferred stock (as defined in section 351(g)).
    No inference regarding the present-law tax treatment of the 
above-described stock is intended by this proposal.

                             Effective Date

    The proposal would apply to stock issued after the date of 
enactment.

                              Prior Action

    A substantially similar proposal was included in the 
President's fiscal year 1998 budget proposal.

                                Analysis

    This proposal extends the denial of the dividends-received 
deduction to preferred stock that is treated as taxable 
consideration (or ``boot'') in certain otherwise non-taxable 
corporate reorganizations and restructurings.
    It is arguable that stock with the particular 
characteristics identified in the proposal is sufficiently free 
from risk and from participation in corporate growth that it 
should be treated as debt for certain purposes, including 
denial of the dividends received deduction. Many of the types 
of stock described in the proposal are traditionally marketed 
to corporate investors (or can be tailored or designed for 
corporate investors) to take advantage of the dividends 
received deduction. As one example, a corporation may structure 
a disposition of a subsidiary taking back this type of 
preferred stock. The transferor might transform what may be 
essentially sales proceeds into deductible dividends, based on 
the future earnings of the former subsidiary corporation after 
principal ownership has been transferred to others. Features 
such as puts and calls effectively determine the period within 
which total payment is expected to occur.
    Similarly, so called ``auction rate'' preferred stock has a 
mechanism to reset the dividend rate on the stock so that it 
tracks changes in interest rates over the term of the 
instrument, thus diminishing any risk that the ``principal'' 
amount of the stock would change if interest rates changed. 
Although it is theoretically possible (and it has sometimes 
occurred) that an auction will ``fail'' (i.e., that a dividend 
rate will not be achieved in the auction that maintains the 
full value of principal of the investment), this has occurred 
extremely rarely in actual practice. Investors may view such 
stock as similar to a floating rate debt instrument.
    In addition to section 351(g) which treats the type of 
stock addressed here as ``boot'' for purposes of certain 
otherwise tax-free transactions, the Code in various places 
treats certain non-participating preferred stock differently 
from other stock. For example, ceterain preferred stock that 
does not participate to any significant extent in corporate 
growth does not count as stock ownership in determining whether 
two corporations are sufficiently related to file consolidated 
returns; also such stock does not count in determining whether 
there has been a change of ownership that would trigger the 
loss limitation rules of Code section 382.
    On the other hand, some argue that a relatively low level 
of risk and participation in growth, or expectation of 
termination of the instrument at a particular time, should not 
be factors governing the availability of the dividends received 
deduction. Furthermore, it is argued that if this type of 
instrument is viewed as sufficiently debt-like, then it should 
be classified as debt for all tax purposes, rather than merely 
subjected to several detrimental non-stock consequences.

2. Repeal tax-free conversion of larger C corporations to S 
        corporations

                              Present Law

    The income of a corporation described in subchapter C of 
the Internal Revenue Code (a ``C corporation'') is subject to 
corporate-level tax when the income is earned and individual-
level tax when the income is distributed. The income of a 
corporation described in subchapter S of the Internal Revenue 
Code (an ``S corporation'') generally is subject to individual-
level, but not corporate-level, tax when the income is earned. 
The income of an S corporation generally is not subject to tax 
when it is distributed to the shareholders. The tax treatment 
of an S corporation is similar to the treatment of a 
partnership or sole proprietorship.
    The liquidation of a subchapter C corporation generally is 
a taxable event to both the corporation and its shareholders. 
Corporate gain is measured by the difference between the fair 
market values and the adjusted bases of the corporation's 
assets. The shareholder gain is measured by the difference 
between the value of the assets distributed and the 
shareholder's adjusted basis in his or her stock. The 
conversion of a C corporation into a partnership or sole 
proprietorship is treated as the liquidation of the 
corporation.
    The conversion from C to S corporation status (or the 
merger of a C corporation into an S corporation) generally is 
not a taxable event to either the corporation or its 
shareholders.
    Present law provides rules designed to limit the potential 
for C corporations to avoid the recognition of corporate-level 
gain on shifting appreciated assets by converting to S 
corporation status prior to the recognition of such gains. 
Specifically, an S corporation is subject to a tax computed by 
applying the highest marginal corporate tax rate to the lesser 
of (1) the S corporation's recognized built-in gain or (2) the 
amount that would be taxable income if such corporation was not 
an S corporation (sec. 1374). For this purpose, a recognized 
built-in gain generally is any gain the S corporation 
recognizes from the disposition of any asset within a 10-year 
recognition period after the conversion from C corporation 
status, or any income that is properly taken into account 
during the recognition period that is attributable to prior 
periods. However, a gain is not a recognized built-in gain if 
the taxpayer can establish that the asset was not held by the 
corporation on the date of conversion or to the extent the gain 
exceeds the amount of gain that would have been recognized on 
such date. In addition, the cumulative amount of recognized 
built-in gain that an S corporation must take into account may 
not exceed the amount by which the fair market value of the 
corporation's assets exceeds the aggregated adjusted basis of 
such assets on the date of conversion from C corporation 
status. Finally, net operating loss or tax credit carryovers 
from years in which the corporation was a C corporation may 
reduce or eliminate the tax on recognized built-in gain.
    The amount of built-in gain that is subject to corporate-
level tax also flows through to the shareholders of the S 
corporation as an item of income subject to individual-level 
tax. The amount of tax paid by the S corporation on built-in 
gain flows through to the shareholders as an item of loss that 
is deductible against such built-in gain income on the 
individual level.

                        Description of Proposal

    The proposal would repeal section 1374 for large S 
corporations. A C-to-S corporation conversion (whether by a C 
corporation electing S corporation status or by a C corporation 
merging into an S corporation) would be treated as a 
liquidation of the C corporation followed by a contribution of 
the assets to an S corporation by the recipient shareholders. 
Thus, the proposal would require immediate gain recognition by 
both the corporation (with respect to its appreciated assets) 
and its shareholders (with respect to their stock) upon the 
conversion to S corporation status.
    For this purpose, a large S corporation is one with a value 
of more than $5 million at the time of conversion. The value of 
the corporation would be the fair market value of all the stock 
of the corporation on the date of conversion.
    In addition, the Internal Revenue Service would revise 
Notice 88-19 155 to conform to the proposed 
amendment to section 1374, with an effective date similar to 
the statutory proposal. As a result, the conversion of a large 
C corporation to a regulated investment company (``RIC'') or a 
real estate investment trust (``REIT'') would result in 
immediate recognition by the C corporation of the net built-in 
gain in its assets.
---------------------------------------------------------------------------
    \155\ Notice 88-19, 1988-1 C.B. 486, allows C corporations that 
become RICs or REITs to be subject to rules similar to those of section 
1374, rather than being subject to the rules applicable to complete 
liquidations.
---------------------------------------------------------------------------

                             Effective Date

    The proposal generally would be effective for subchapter S 
elections that become effective for taxable years beginning 
after January 1, 1999. Thus, C corporations would continue to 
be permitted to elect S corporation status effective for 
taxable years beginning in 1998 or on January 1, 1999. The 
proposal would apply to acquisitions (e.g., the merger of a C 
corporation into an existing S corporation) after December 31, 
1998.

                              Prior Action

    Similar proposals were included in the President's budget 
proposals for the fiscal years 1997 and 1998.

                                Analysis

    The conversion of a C corporation to an S corporation may 
be viewed as the constructive liquidation of the C corporation 
because the corporation has changed from taxable status to 
passthrough status. The proposal would conform the tax 
treatment of such constructive liquidation to the tax treatment 
of an actual liquidation. Thus, the proposal would conform the 
treatment of the conversion from C corporation status to 
passthrough entity status where the passthrough entity is an S 
corporation with the present-law treatment where the 
passthrough entity is a partnership or a sole proprietorship.
    The proposal would eliminate some of the complexity of 
subchapter S under present law.156 The rules that 
trace C corporation built-in gain and C corporation earnings 
and profits generally would become unnecessary. In addition, 
the rules imposing corporate tax and the possible loss of S 
corporation status after the conversion due to excessive 
passive income also could be eliminated. However, these complex 
rules would continue to apply to small converting C 
corporations and it could be argued that these businesses are 
the least able to handle complexity.
---------------------------------------------------------------------------
    \156\ A similar proposal was included in a letter to House Ways and 
Means Chairman Dan Rostenkowski from Ronald A. Pearlman, Chief of Staff 
of the Joint Committee on Taxation, recommending several simplification 
proposals. See, Committee on Ways and Means, Written Proposals on Tax 
Simplification, (WMCP 101-27), May 25, 1990, p 24.
---------------------------------------------------------------------------
    The proposal would create some complexity, as it would 
require the valuation of C corporation stock to determine if 
the $5 million threshold has been exceeded and C corporation 
assets for purposes of determining the amount of gain on the 
constructive liquidation. However, valuations theoretically are 
required under present law because of the need to determine 
whether corporate tax may be due under the built-in gain 
tracing rules; it is possible that taxpayers may not perform 
the valuations for all assets in all cases, particularly if 
they believe that there is no aggregate net built-in gain, or 
if there is a possibility that built-in gain assets may not be 
disposed of within the present-law tracing period. It should be 
noted that the $5 million threshold creates a ``cliff'' where 
corporations valued at $5 million or less are not subject to 
tax while corporations valued at greater than $5 million would 
be subject to full taxation. It appears that rules would be 
required to address step transactions designed to avoid the 
proposal (e.g., where a series of C corporations, each under 
the $5 million cap, merge into an S corporation; or where a 
large C corporation divides into multiple entities so that some 
or all of the entities are under the $5 million cap). Another 
issue under the proposal is whether the stock of the 
corporation is to be valued immediately before the conversion 
(i.e., as C corporation stock subject to two levels of tax) or 
immediately after the conversion (i.e., as S corporation stock, 
subject to one level of tax).
    The proposal would create significant shareholder and 
corporate liquidity concerns for large C corporations planning 
on converting to S corporation status. Current businesses that 
organized as C corporations may have done so in anticipation of 
converting at a relatively low tax cost in the future. Not 
applying the proposal until taxable years beginning after 
January 1, 1999, addresses some, but not all, of these 
concerns.
    Finally, the proposal raises significant policy issues 
regarding the integrity of the separate corporation tax as 
opposed to integrating the corporate and individual tax 
regimes. More acutely, the proposal raises issues regarding the 
need for the continued existence of subchapter S in light of 
other developments. Recent IRS rulings with respect to the 
various State limited liability companies and the ``check-the-
box'' Treasury regulations 157 have significantly 
expanded the availability of pass-through tax treatment for 
entities that accord their investors limited legal liability. 
These developments, coupled with the restrictive rules of 
subchapter S,158 have decreased the desirability of 
the subchapter S election for newly-formed entities. This 
proposal would decrease the desirability of the subchapter S 
election for existing C corporations. Thus, if the proposal 
were enacted, the primary application of subchapter S would be 
limited to existing S corporations and small converting 
corporations. At that point, one may question whether it is 
desirable to have a whole separate passthrough regime in the 
Code that pertains to a limited number of taxpayers. Any repeal 
of subchapter S would require rules providing for the treatment 
of existing S corporations.159
---------------------------------------------------------------------------
    \157\ Treas. reg. secs. 301.7701-1, -2, and -3, issued in final 
form on December 17, 1996.
    \158\ For example, only domestic corporations with simple capital 
and limited ownership structures may elect to be S corporations.
    \159\ See, for example, the letter of July 25, 1995, from Leslie B. 
Samuels, Assistant Treasury Secretary (Tax Policy) to Senator Orrin 
Hatch, suggesting possible legislative proposals to allow S 
corporations to elect partnership status or to apply the check-the-box 
regulations to S corporations.
---------------------------------------------------------------------------

3. Restrict special net operating loss carryback rules for specified 
        liability losses

                              Present Law

    Under present law, that portion of a net operating loss 
that qualifies as a ``specified liability loss'' may be carried 
back 10 years rather than being limited to the general two-year 
carryback period. A specified liability loss includes amounts 
allowable as a deduction with respect to product liability, and 
also certain liabilities that arise under Federal or State law 
or out of any tort of the taxpayer. In the case of a liability 
arising out of a Federal or State law, the act (or failure to 
act) giving rise to the liability must occur at least 3 years 
before the beginning of the taxable year. In the case of a 
liability arising out of a tort, the liability must arise out 
of a series of actions (or failures to act) over an extended 
period of time a substantial portion of which occurred at least 
3 years before the beginning of the taxable year. A specified 
liability loss cannot exceed the amount of the net operating 
loss, and is only available to taxpayers that used an accrual 
method throughout the period that the acts (or failures to act) 
giving rise to the liability occurred.

                        Description of Proposal

    Under the proposal, specified liability losses would be 
defined and limited to include (in addition to product 
liability losses) only amounts allowable as a deduction that 
are attributable to a liability that arises under Federal or 
State law for reclamation of land, decommissioning of a nuclear 
power plant (or any unit thereof), dismantlement of an offshore 
oil drilling platform, remediation of environmental 
contamination, or payments arising under a workers' 
compensation statute, if the act (or failure to act) giving 
rise to such liability occurs at least 3 years before the 
beginning of the taxable year. No inference regarding the 
interpretation of the specified liability loss carryback rules 
under current law would be intended by this proposal.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    A taxpayer is required to determine and report the taxable 
income recognized in each taxable year, regardless of whether 
the taxable year matches the natural business cycle of the 
taxpayer or whether transactions have occurred which span 
several years. This is known as the ``annual accounting 
concept.'' Thus, deductions claimed in the current taxable year 
may relate to, and be properly matched with, income reported in 
a different taxable year. In recognition of the restrictions of 
the annual accounting concept, present law allows taxpayers 
with net operating losses to carry such losses back to the 
preceding two taxable years or carried forward to the 
succeeding 20 years. In addition, present law allows a 10-year 
carryback of that portion of a net operating loss that relates 
to certain specified liabilities to the extent these 
liabilities arose as a result of acts or failures to act that 
occurred more than three years ago.
    The proper interpretation of the specified liability loss 
provisions has been the subject of controversy. Although the 
legislative history suggests that these specified liability 
loss rules were provided to apply to certain liabilities for 
which a deduction is deferred as a result of the economic 
performance rules of section 461(h),160 many 
taxpayers have not limited their claimed specified liability 
losses to such deductions. In addition, many taxpayers have 
interpreted the 3-year requirement and the requirement that the 
liability arises out of a Federal or State law in a broad 
manner and the IRS has announced that it will contest many such 
claims. (See, e.g., Notice 97-36, 1997-26 I.R.B. 6, June 1, 
1997.) For example, taxpayers have claimed that accounting fees 
paid for annual compliance with SEC and ERISA auditing and 
reporting requirements can be carried back 10 years as 
specified liability losses on the ground that the taxpayer 
first became subject to the laws imposing such reporting 
requirements more than 3 years prior to the year of the current 
annual expenditures. Taxpayers have also asserted that 
accounting fees paid in connection with an IRS audit can be 
carried back 10 years as specified liability losses. In a 
recent decision, Sealy Corp. v. Commissioner, 107 T.C. 177 
(1996), the Tax Court upheld the IRS position rejecting a 10-
year carryback for such claims; however the court did not 
specify the boundaries of the 10-year carryback provision. It 
is also possible that taxpayers may continue to take and 
litigate positions such as those in the Sealy Corp. case even 
on similar facts, seeking to obtain other interpretations in 
other courts.
---------------------------------------------------------------------------
    \160\ H. Rept. 98-861, 98th Cong., 2d Sess. 871 (1984).
---------------------------------------------------------------------------
    The proposal would lessen similar controversies by 
providing a definitive list of items for which the 10-year 
carryback is available. It may be argued that the proposal may 
result in a mismatch between income and expense to the extent a 
currently deductible liability relates to previously recognized 
income and the liability is not listed under the proposal. 
However, proponents of the proposal argue that section 172(f) 
was originally intended as a relief provision narrowly targeted 
to certain liabilities for which a deduction is deferred as a 
result of the economic performance rules of section 461(h), and 
that narrowing the provision to a limited class of liabilities 
does not frustrate the original Congressional intent.

4. Clarify definition of ``subject to'' liabilities under section 
        357(c)

                              Present Law

    Present law provides that the transferor of property 
recognizes no gain or loss if the property is exchanged solely 
for qualified stock in a controlled corporation (sec. 351). 
Code section 357(c) provides that the transferor generally 
recognizes gain to the extent that the sum of the liabilities 
assumed by the controlled corporation and the liabilities to 
which the transferred property is subject exceeds the 
transferor's basis in the transferred property. If the 
transferred property is ``subject to'' a liability, Treasury 
regulations have indicated that the amount of the liability is 
included in the calculation regardless of whether the 
underlying liability is assumed by the controlled corporation. 
Treas. Reg. sec. 1.357-2(a).
    The gain recognition rule of section 357(c) is applied 
separately to each transferor in a section 351 exchange.
    The basis of the property in the hands of the controlled 
corporation equals the transferor's basis in such property, 
increased by the amount of gain recognized by the transferor, 
including section 357(c) gain.
    Section 357(c) also applies to reorganizations described in 
section 368(a)(1)(D).

                        Description of Proposal

    The proposal would eliminate any distinction between the 
assumption of the liability and the acquisition of an asset 
subject to a liability. Instead, the extent to which a 
liability (including a nonrecourse liability) would be treated 
as assumed for Federal income tax purposes in connection with a 
transfer of property would be determined on the basis of all 
the facts and circumstances. Thus, for example, a transferee 
would not be treated as assuming a liability if the transferor 
indemnifies the transferee against the possibility of 
foreclosure. Similarly, the fact that a lender retains a 
security interest in property securing a recourse liability 
would not cause the transferee to be treated as assuming the 
liability if the transferor remains solely liable on the 
indebtedness without a right of contribution against the 
transferee. In general, if nonrecourse indebtedness is secured 
by more than one asset, and any assets securing the 
indebtedness are transferred subject to the indebtedness 
without any indemnity agreements, then for all Federal income 
tax purposes the transferee would be treated as assuming an 
allocable portion of the liability based upon the relative fair 
market values (determined without regard to section 7701(g)) of 
the assets securing the liability. The proposal would authorize 
the Secretary of the Treasury to issue regulations to carry out 
the purposes of this proposal, including anti-abuse rules.
    No inference regarding the tax treatment under current law 
would be intended by this proposal.

                             Effective Date

    The proposal would apply to transfers after the date of 
first committee action.

                              Prior Action

    No prior action

                                Analysis

    In general, a taxpayer recognizes income when he or she is 
relieved of a liability. Thus, if a taxpayer transfers an asset 
to a corporation, and the corporation assumes a liability of 
the taxpayer in an amount greater than the taxpayer's basis in 
the asset, present law treats the taxpayer as having sold the 
asset for an amount equal to the relieved liability. Similar 
rules apply if an asset is transferred subject to a liability.
    Present law does not clearly define what ``transferred 
subject to a liability'' means. If the transferor has cross-
collateralized a liability with several assets, it has been 
asserted that each of those assets is literally ``subject to'' 
the entire amount of the liability, even where the transferor 
has not been relieved of the liability. A number of cases have 
applied section 357(c) in a manner or with language suggesting 
that it is not necessary to consider whether, as a practical 
matter, the transferor has been relieved of the transferred 
liability. For example in Rosen v. Commissioner,\161\ the Tax 
Court stated that ``. . . there is no requirement in section 
357(c)(1) that the transferor be relieved of liability. 
Similarly, in Owen v. Commissioner,162 the Ninth 
Circuit Court of Appeals rejected a claim by the taxpayers that 
the concept of assets ``subject to'' liabilities only applies 
to non-recourse liabilities, and stated that continuing 
personal liability for the loans secured by the transferred 
equipment was irrelevant.
---------------------------------------------------------------------------
    \161\ 62 T.C. 11, 19 (1974), affd. without published opinion 515 
F.2d 507 (3d Cir. 1975).
    \162\ 881 F.2d 832 (9th Cir. 1989).
---------------------------------------------------------------------------
    In Lessinger v. Commissioner,163 on the other 
hand, the Second Circuit Court of Appeals construed the 
language of section 357(c) to avoid imposing gain recognition 
on the taxpayer where the taxpayer contributed his own 
promissory note in the amount of the excess of the transferred 
liabilities over the basis of the transferred assets.
---------------------------------------------------------------------------
    \163\ 872 F.2d 519 (2d Cir. 1989).
---------------------------------------------------------------------------
    As a result of this uncertainty in present law, some 
taxpayers may be reluctant to engage in legitimate transactions 
or may restructure them, while others may attempt to structure 
transactions to take advantage of different interpretations.
    For example, a taxpayer who has cross-collateralized a 
liability with assets that the taxpayer now, for valid business 
reasons, wants to contribute to one or more corporations, may 
structure the transaction in a manner seeking to take the 
position that some case law supports non-recognition, or may 
contribute additional assets with basis sufficient to avoid 
gain recognition under any of the case law, or may seek to 
obtain a release of the transferred assets from the lender. It 
may be difficult or expensive for a taxpayer to obtain such a 
release.
    On the other hand, taxpayers not concerned about current 
gain recognition (for example, due to losses, credits or status 
as a non-taxable entity) may attempt to structure transactions 
to take advantage of different interpretations. For example, 
assume that transferor A has borrowed $100,000 on a recourse 
basis, secured by two assets. A transfers one asset with a 
basis of $20,000 and a fair market value of $50,000 to a 
controlled domestic corporation, X. Under the literal language 
of section 357(c), it may be argued that A would recognize 
$80,000 of gain on the transfer, and X would hold the asset at 
a basis of $100,000 (A's original basis of $20,000 plus $80,000 
recognized gain). If A is a foreign person or a tax-exempt 
entity or in the position to use expiring loss or credit 
carryovers to offset the gain, X can obtain a stepped-up basis 
in the asset without a tax cost to A. X can benefit from this 
stepped-up basis by increased depreciation deductions or 
reduced gain on the future sale of the asset.
    The proposal is intended to ensure that 357(c) will operate 
in a manner that reflects the economics of the transaction. 
While it may be argued that factual uncertainty will remain 
because this approach involves a facts and circumstances test, 
it can also be argued that the proposal will increase the legal 
certainty and reduce the potential for results that do not 
conform to the economic reality of the extent of actual relief 
from liability (if any) that has occurred in a transfer.

                        D. Insurance Provisions

1. Increase proration percentage for property and casualty insurance 
        companies

                              Present Law

    The taxable income of a property and casualty insurance 
company is determined as the sum of its underwriting income and 
investment income (as well as gains and other income items), 
reduced by allowable deductions. Underwriting income means 
premiums earned during the taxable year less losses incurred 
and expenses incurred. In calculating its reserve for losses 
incurred, a property and casualty insurance company must reduce 
the amount of losses incurred by 15 percent of (1) the 
insurer's tax-exempt interest, (2) the deductible portion of 
dividends received (with special rules for dividends from 
affiliates), and (3) the increase for the taxable year in the 
cash value of life insurance, endowment or annuity contracts.
    This 15-percent proration requirement was enacted in 1986. 
The reason the provision was adopted was Congress' belief that 
``it is not appropriate to fund loss reserves on a fully 
deductible basis out of income which may be, in whole or in 
part, exempt from tax. The amount of the reserves that is 
deductible should be reduced by a portion of such tax-exempt 
income to reflect the fact that reserves are generally funded 
in part from tax-exempt interest or from wholly or partially 
deductible dividends.'' \164\ In 1997, the provision was 
modified to take into account the increase for a taxable year 
in the cash value of certain insurance contracts.\165\
---------------------------------------------------------------------------
    \164\ H. Rept. 99-426, Report of the Committee on Ways and Means on 
H.R. 3838, The Tax Reform Act of 1985 (99th Cong., 1st Sess.,), 670.
    \165\ P.L. 105-34, The Taxpayer Relief Act of 1997, section 1084.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would increase the proration percentage 
applicable to a property and casualty insurance company from 15 
percent to 30 percent.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment with respect to investments 
acquired on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    The proposal relates to the effect of the 15 percent 
proration percentage of present law on the funding of 
deductible loss reserves by means of income that may be, in 
whole or in part, exempt from tax. In 1996, property and 
casualty insurers held between 13 and 14 percent of all tax-
exempt debt outstanding,\166\ and about 21 percent of these 
companies' financial assets were invested in tax-exempt 
debt.\167\ Proponents of the proposal interpret this as 
evidence that property and casualty insurers continue to find 
tax-exempt debt more profitable than otherwise comparable 
taxable debt. A taxpayer generally is likely to buy a tax-
exempt security rather than an otherwise equivalent taxable 
security if the interest rate paid on the tax-exempt security 
is greater than the after-tax yield from the taxable 
security.\168\ The 15-percent proration requirement of present 
law has the effect of imposing tax on interest paid by a tax-
exempt bond at an effective marginal tax rate equal to 15 
percent of the taxpayer's statutory marginal tax rate. 
Proponents of the proposal argue that the 15 percent rate could 
be increased to a rate that reduces but does not eliminate the 
use of tax-preferred income to fund deductible reserves.\169\
---------------------------------------------------------------------------
    \166\ Federal Reserve Board, Flow of Funds Accounts, Flows and 
Outstandings, second quarter 1997.
    \167\ Ibid.
    \168\ Mathematically, it is more profitable to hold a tax-exempt 
security paying an interest rate, rte, than a taxable 
security of comparable risk and maturity paying an interest rate, r, if

          rte>r(1-t),

    where t is the taxpayer's marginal tax rate.
    \169\ By reducing the deduction for increases in reserves by 15 
percent of the taxpayer's tax-exempt interest earnings, the taxpayer's 
taxable income is increased by 15 percent of the taxpayer's tax-exempt 
interest earnings. Thus, the 15-percent proration requirement has the 
effect of imposing tax on the interest paid by a tax-exempt bond at an 
effective marginal tax rate equal to (.15)t, where t is the 
taxpayer's marginal tax rate. One effect of creating an effective tax 
on the interest earned from a tax-exempt bond is that a property and 
casualty insurer would only find holding the tax-exempt bond more 
profitable than holding an otherwise comparable taxable bond when 
rte(1-(.15)t)>r(1-t). This is equivalent to:

          rte>r{(1-t)/(1-(.15)t)}.

    If the statutory marginal tax rate of the property and casualty 
insurer were 35 percent, then it would be profitable to purchase tax-
exempt debt in lieu of taxable debt when rte>(.686)r. Under 
the proposal, it would be profitable to purchase tax-exempt debt in 
lieu of taxable debt when rte>(.726)r.
    Because the tax-exempt debt offers yields less than that of 
otherwise comparable taxable debt, some analysts maintain that a holder 
of tax-exempt debt already pays an ``implicit tax'' by accepting a 
lower, albeit tax free, yield. This implicit tax can be measured as the 
yield spread between the tax-exempt debt and the otherwise comparable 
taxable security. In this sense the taxpayer's true effective marginal 
tax rate to holding tax-exempt debt would be the implicit tax rate plus 
(.15)t. However, in considering the ``implicit'' tax, one must 
recognize that this implicit tax is not paid to the Federal Government, 
but rather is received by the issuer of the tax-exempt debt in the form 
of a lower borrowing cost.
---------------------------------------------------------------------------
    It is also argued that banks and life insurance companies 
(which also maintain reserves, increases in which are 
deductible for Federal income tax purposes), are subject to 
more effective proration rules that generally prevent them from 
funding reserve deductions with tax-preferred income. Present 
law may promote unequal treatment of competitors in the 
financial service sectors and the proposal would reduce any 
such unequal treatment, it is argued.
    Critics of the proposal could respond that property and 
casualty insurance may be a sufficiently different business 
from that of other financial service providers that the 
disparate treatment of tax-exempt securities across the 
financial services industry does not create any unfair 
competitive advantage for one sector over another. The proposal 
alternatively could be criticized because it would still 
provide property and casualty insurers with more favorable 
proration rules than currently apply to banks and life 
insurance companies.
    Critics of the proposal note that by reducing the effective 
yield received by property and casualty insurers on their 
holdings of tax-exempt debt, the proposal can reduce the demand 
for tax-exempt bonds by this industry. As noted above, property 
and casualty insurers are large holders of tax-exempt bonds. A 
reduction in demand for these securities by the property and 
casualty insurers may lead to an increase in borrowing costs 
for State and local governments. Even a small increase in the 
interest cost to tax-exempt finance could create a substantial 
increase in the aggregate financial cost of debt-financed 
public works projects to State and local governments.
    On the other hand, it could be said that the proration rate 
under the proposal is low enough so that there would be no such 
reduction in demand. Depending on yield spreads between tax-
exempt and taxable securities, a modest increase in the 
proration percentage may only reduce the profit of the property 
and casualty insurers without changing the underlying advantage 
those taxpayers find in holding tax-exempt rather than taxable 
debt.
    More broadly, it is said that the present tax rules provide 
an inefficient subsidy for borrowing by State and local 
governments. The interest rate subsidy provided to State and 
local governments by the ability to issue tax-exempt bonds 
cannot efficiently pass the full value of the revenue lost to 
the Federal Government to the issuer. The Federal income tax 
has graduated marginal tax rates. Thus, $100 of interest income 
forgone by a taxpayer in the 31-percent bracket costs the 
Federal Government $31, while the same amount of interest 
income forgone by a taxpayer in the 28-percent bracket costs 
the Federal Government $28. Consequently, if a taxpayer in the 
28-percent bracket finds it profitable to hold a tax-exempt 
security, a taxpayer in the 31-percent bracket will find it 
even more profitable.\170\ This conclusion implies that the 
Federal Government loses more in revenue than an issuer of tax-
exempt debt gains in reduced interest payments, illustrating 
the inefficiency of this subsidy.
---------------------------------------------------------------------------
    \170\ As explained above, a taxpayer generally finds it more 
profitable to buy a tax-exempt security rather than an otherwise 
equivalent taxable security if the interest rate paid by the tax-exempt 
security, rte, is greater than the after-tax yield from the 
taxable security, r(1-t), where t is the taxpayer's marginal tax rate 
and r is the yield on the taxable security.
---------------------------------------------------------------------------

2. Capitalization of net premiums for credit life insurance contracts

                              Present Law

    Insurance companies are required to capitalize policy 
acquisition expenses and amortize them on a straight-line 
basis, generally over a period of 120 months \171\ beginning 
with the first month in the second half of the taxable year. 
Policy acquisition expenses required to be capitalized and 
amortized are determined, for any taxable year, for each 
category of specified insurance contracts, as a percentage of 
the net premiums for the taxable year on specified insurance 
contracts in that category. The percentages for each of the 
categories are as follows:
---------------------------------------------------------------------------
    \171\ A special rule permits a 60-month amortization period for 
certain small companies.

------------------------------------------------------------------------
                                                                 Percent
------------------------------------------------------------------------
  Annuities....................................................     1.75
  Group life...................................................     2.05
  Other life (including noncancellable or guaranteed renewable          
   accident and health)........................................     7.70
------------------------------------------------------------------------

    Group credit life insurance policy acquisition expenses 
fall within the ``group life'' category,\172\ even though the 
actual expenses are substantially higher than 2.05 percent of 
net premiums for the contracts.
---------------------------------------------------------------------------
    \172\ See Recommendations of the Committee on Finance for purposes 
of the Reconciliation Bill provided for in H. Con. Res. 310 (101st 
Cong., 2d Sess.) (``Finance Committee Report''), 136 Cong. Rec. S 15693 
(Oct. 18. 1990).
---------------------------------------------------------------------------
    Regulatory authority is provided to the Treasury Department 
to provide a separate category for a type of insurance 
contract, with a separate percentage applicable to the 
category, under certain circumstances. The authority may be 
exercised if the Treasury Department determines that the 
deferral of policy acquisition expenses for the type of 
contract which would otherwise result under the provision is 
substantially greater than the deferral of acquisition expenses 
that would have resulted if actual acquisition expenses 
(including indirect expenses) and the actual useful life of the 
contract had been used. In making this determination, Congress 
intended that the amount of a reserve for a contract not be 
taken into account.\173\ If the authority is exercised, the 
Treasury Department is required to adjust the percentage that 
would otherwise have applied to the category that included the 
type of contract, so that the exercise of the authority does 
not result in a decrease in the amount of revenue received by 
reason of the amortization provision for any fiscal year.
---------------------------------------------------------------------------
    \173\ See H. Rept. 101-964, Conference Report to accompany H.R. 
5835, Omnibus Budget Reconciliation Act of 1990 (101st Cong., 2d 
Sess.), 1066, 1070.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require insurance companies to 
capitalize and amortize 7.7 percent of net premiums for the 
taxable year with respect to all credit life insurance (whether 
or not it is group credit life insurance), not 2.05 percent.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The provision requiring insurance companies to capitalize 
and amortize policy acquisition expenses was enacted in 1990 to 
correct prior-law mismeasurement of the income of insurance 
companies. Policy acquisition expenses arise in connection with 
acquiring a stream of premium and investment income that is 
earned over a period well beyond the year the expenses are 
incurred. It is a well-established principle of the tax law 
that costs of acquiring an asset with a useful life beyond the 
taxable year are amortized over the life of the asset. Congress 
adopted a ``proxy'' approach designed to approximate the 
expenses for each year that are attributable to new and renewed 
insurance contracts in each of several broad categories of 
business. While this approach does not measure actual 
acquisition expenses, Congress believed that the advantage of 
adopting a theoretically correct approach was outweighed by the 
administrative simplicity of the proxy approach.\174\
---------------------------------------------------------------------------
    \174\ Finance Committee Report, supra, at S 15961.
---------------------------------------------------------------------------
    It could be argued that Congress specifically intended 
group credit life insurance to come within the ``group life'' 
category, and that therefore it would not be appropriate to 
change the amortization percentage applicable to it. Similarly, 
it could be argued that because Congress believed that the 
levels of amortizable amounts would in most cases, understate 
actual acquisition expenses,\175\ it is not now necessary to 
revise the percentage applicable to credit life insurance.
---------------------------------------------------------------------------
    \175\ Ibid.
---------------------------------------------------------------------------
    On the other hand, the level of actual policy acquisition 
expenses for credit life insurance is substantially higher than 
either 2.05 percent or 7.7 percent. Because the actual expenses 
are relatively high, it can be argued that it is more accurate 
to place credit life insurance in the highest-percentage 
category, even though such insurance may be group insurance. It 
is also argued that Congress may not have been aware, at the 
time group credit life insurance was included in the ``group 
life'' category, that policy acquisition expenses for credit 
life insurance were ordinarily rather high.
    It also could be argued that even though credit life 
insurance has relatively high actual acquisition expenses, the 
contracts tend to have a relatively short duration and 
therefore the present value of the deduction for these expenses 
is lower than if the contracts remained in effect for a long 
period. Therefore, it is argued, the contracts should remain in 
the 2.05 percent category. On the other hand, the present value 
of the deduction for acquisition expenses is actually higher 
than even the highest percentage category, advocates for the 
proposal argue. Further, they argue, credit life insurance is 
often reinsured with small companies eligible for the more 
favorable 60-month amortization period, and consequently the 
present value of the deduction for acquisition expenses in such 
a case is greater.
    The Treasury Department has regulatory authority to create 
an additional category of contract (provided it adjusts the 
category from which the contract was drawn so that there is no 
decrease in revenue from the provision), as noted above. Some 
may argue that this may suggest that legislation might not be 
required to change the capitalization percentage applicable to 
credit life insurance. On the other hand, it could be said that 
determining the proper percentage for the new category of 
contract and making the correct adjustment to its former 
category might be viewed as a judgment that is best left to 
Congress. Some might argue that the requirement that 
adjustments to the categories be balanced by an offsetting 
adjustment indicates that Congress viewed unfavorably any 
administrative change to the categories, making legislation the 
preferred means for any change to the categories.

3. Modify company-owned life insurance (COLI) limitations

                              Present Law

Exclusion of inside buildup and amounts received by reason of death

    No Federal income tax generally is imposed on a 
policyholder with respect to the earnings under a life 
insurance contract (``inside buildup'').\176\ Further, an 
exclusion from Federal income tax is provided for amounts 
received under a life insurance contract paid by reason of the 
death of the insured (sec. 101(a)).
---------------------------------------------------------------------------
    \176\ This favorable tax treatment is available only if the 
policyholder has an insurable interest in the insured when the contract 
is issued and if the life insurance contract meets certain requirements 
designed to limit the investment character of the contract (sec. 7702). 
Distributions from a life insurance contract (other than a modified 
endowment contract) that are made prior to the death of the insured 
generally are includable in income, to the extent that the amounts 
distributed exceed the taxpayer's investment in the contract; such 
distributions generally are treated first as a tax-free recovery of the 
investment in the contract, and then as income (sec. 72(e)). In the 
case of a modified endowment contract, however, in general, 
distributions are treated as income first, loans are treated as 
distributions (i.e., income rather than basis recovery first), and an 
additional 10 percent tax is imposed on the income portion of 
distributions made before age 59\1/2\ and in certain other 
circumstances (secs. 72(e) and (v)). A modified endowment contract is a 
life insurance contract that does not meet a statutory ``7-pay'' test, 
i.e., generally is funded more rapidly than 7 annual level premiums 
(sec. 7702A). Certain amounts received under a life insurance contract 
on the life of a terminally or chronically ill individual, and certain 
amounts paid for the sale or assignment to a viatical settlement 
provider of a life insurance contract on the life of a terminally ill 
or chronically ill individual, are treated as excludable as if paid by 
reason of the death of the insured (sec. 101(g)).
---------------------------------------------------------------------------

Interest deduction disallowance

    Generally, no deduction is allowed for interest paid or 
accrued on any indebtedness with respect to one or more life 
insurance contracts or annuity or endowment contracts owned by 
the taxpayer covering any individual (the ``COLI'' rules).
    An exception to this interest disallowance rule is provided 
for interest on indebtedness with respect to life insurance 
policies covering up to 20 key persons. A key person is an 
individual who is either an officer or a 20-percent owner of 
the taxpayer. The number of individuals that can be treated as 
key persons may not exceed the greater of (1) 5 individuals, or 
(2) the lesser of 5 percent of the total number of officers and 
employees of the taxpayer, or 20 individuals. For determining 
who is a 20-percent owner, all members of a controlled group 
are treated as one taxpayer. Interest paid or accrued on debt 
with respect to a contract covering a key person is deductible 
only to the extent the rate of interest does not exceed Moody's 
Corporate Bond Yield Average--Monthly Average Corporates for 
each month beginning after December 31, 1995, that interest is 
paid or accrued.
    This rule was enacted in 1996.

Pro rata disallowance of interest on debt to fund life insurance

    In addition, in the case of a taxpayer other than a natural 
person, no deduction is allowed for the portion of the 
taxpayer's interest expense that is allocable to unborrowed 
policy cash surrender values with respect to any life insurance 
policy or annuity or endowment contract issued after June 8, 
1997. Interest expense is allocable to unborrowed policy cash 
values based on the ratio of (1) the taxpayer's average 
unborrowed policy cash values of life insurance policies, and 
annuity and endowment contracts, issued after June 8, 1997, to 
(2) the sum of (a) in the case of assets that are life 
insurance policies or annuity or endowment contracts, the 
average unborrowed policy cash values, and (b) in the case of 
other assets, the average adjusted bases for all such other 
assets of the taxpayer.
    An exception is provided for any policy or contract 
177 owned by an entity engaged in a trade or 
business, which covers one individual who (at the time first 
insured under the policy or contract ) is (1) a 20-percent 
owner of the entity, or (2) an individual (who is not a 20-
percent owner) who is an officer, director or employee of the 
trade or business. The exception for 20- percent owners also 
applies in the case of a joint-life policy or contract under 
which the sole insureds are a 20-percent owner and the spouse 
of the 20-percent owner. A joint-life contract under which the 
sole insureds are a 20-percent owner and his or her spouse is 
the only type of policy or contract with more than one insured 
that comes within the exception. Any policy or contract that is 
not subject to the pro rata interest disallowance rule by 
reason of this exception (for 20-percent owners, their spouses, 
employees, officers and directors), or by reason of the 
exception for an annuity contract to which section 72(u) 
applies, is not taken into account in applying the ratio to 
determine the portion of the taxpayer's interest expense that 
is allocable to unborrowed policy cash values.
---------------------------------------------------------------------------
    \177\ It was intended that if coverage for each insured individual 
under a master contract is treated as a separate contract for purposes 
of sections 817(h), 7702, and 7702A of the Code, then coverage for each 
such insured individual is treated as a separate contract, for purposes 
of the exception to the pro rata interest disallowance rule for a 
policy or contract covering an individual who is a 20-percent owner, 
employee, officer or director of the trade or business as the time 
first covered. A master contract does not include any contract if the 
contract (or any insurance coverage provided under the contract) is a 
group life insurance contract within the meaning of Code section 
848(e)(2). No inference was intended that coverage provided under a 
master contract, for each such insured individual, is not treated as a 
separate contract for each such individual for other purposes under 
present law. A technical correction may be needed so that the statute 
reflects this intent. See Title VI of H.R. 2676, the Tax Technical 
Corrections Act of 1997, as passed by the House on November 5, 1997.
---------------------------------------------------------------------------
    This rule was enacted in 1997.

                        Description of Proposal

    The proposal would eliminate the exception under the pro 
rata disallowance rule for employees, officers and directors. 
The exception for 20-percent owners would be retained, however.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is directed to an aspect of the issue 
addressed by Congress in 1996 and 1997: the issue of borrowing 
against life insurance contracts to achieve tax arbitrage. 
Businesses that own life insurance on employees and borrow from 
a third-party lender or from the public may still be able to 
achieve tax arbitrage by deducting interest that funds the tax-
free inside buildup on the life insurance (or the tax-deferred 
inside buildup of annuity and endowment contracts). This 
continued opportunity for tax arbitrage results from the 
exception under the pro rata interest deduction limitation for 
insurance covering employees and others, it is argued. 
Businesses have been able to substitute third-party debt for 
debt that would have been subject to the 1996 Act limitations 
on interest deductibility with respect to insurance on 
employees. This tax arbitrage opportunity may be utilized by 
financial intermediation businesses, which may have a 
relatively large amount of debt in the ordinary course of 
business. Thus, it is argued, the exception should be repealed.
    It can be argued, however, that retaining an exception from 
the pro rata interest disallowance rule for employees, 
officers, and directors is important for small businesses. 
Small businesses might argue that they need access to cash, in 
particular the cash value of life insurance on key employees, 
and that it would be inappropriate to reduce the tax subsidy 
stemming from the exception in their case. They might also 
argue that the proposal should be more targeted, perhaps to 
financial intermediaries or to large employers, or should 
provide for a narrower employee exception structured like the 
20-key-person exception under the 1996 legislation, so as to 
address the tax arbitrage concern without negatively impacting 
their cash needs. On the other hand, it could be countered that 
in most cases the cash needs of small businesses have already 
been addressed by the proposal's continuation of the exception 
for 20-percent owners. In addition, it can be argued that 
insuring the lives of key employees can be accomplished by 
purchasing term life insurance, which is not affected by the 
proposal, and that cash needs can be addressed without the 
purchase of cash value life insurance.
    Opponents might also argue that the proposed effective date 
may be too harsh. The proposal would limit the deduction for 
interest even in the case of insurance contracts that were 
purchased before the effective date, with no explicit phase-in 
rule. By contrast, the 1996 COLI limitations provided a phase-
in rule, and the 1997 COLI limitations generally applied only 
to contracts issued after the effective date. On the other 
hand, it could be argued that purchasers of COLI that would be 
impacted by the proposal were aware of Congress' concern about 
tax arbitrage through leveraging life insurance because of the 
1996 and 1997 legislative activity in the area. It could be 
said that recent COLI purchasers in particular assumed the risk 
of further Congressional action on leveraged life insurance 
products, as well as those whose contractual arrangements 
include provisions to ``unwind'' the transaction in the event 
unfavorable tax rules are enacted. Further, arguably the 
effective date for the proposal merely puts COLI purchasers 
with non-traceable third party debt in the same position they 
would have been in had they been subject to the phase-in rules 
under the 1996 legislation, which is fully phased in by 1999.

4. Modify reserve rules for annuity contracts

                              Present Law

    A life insurance company is subject to tax on its life 
insurance company taxable income (LICTI) (sec. 801). LICTI is 
life insurance gross income reduced by life insurance 
deductions. For this purpose, a life insurance company includes 
in gross income any net decrease in reserves, and deducts a net 
increase in reserves.
    A decrease in reserves arises if (1) the opening balance 
for reserve items exceeds (2) the closing balance for the 
reserve items (reduced by certain adjustments). An increase in 
reserves arises if (1) the closing balance for reserve items 
(reduced by certain adjustments) exceeds (2) the opening 
balance for the reserve items.
    In determining reserves, a life insurance company takes 
into account the life insurance reserves (among other items). 
Life insurance reserves for any contract are the greater of the 
net surrender value of the contract or the reserve determined 
using the tax reserve method, but in no event may the reserve 
for any contract at any time exceed the amount set forth in the 
annual statement (sec. 807). No additional reserve deduction is 
allowed for deficiency reserves (sec. 807(c)(3)(C)).
    In the case of an annuity contract, the tax reserve method 
means the Commissioners' Annuities Reserve Valuation Method 
prescribed by the National Association of Insurance 
Commissioners (NAIC) 178 which is in effect on the 
date of the issuance of the contract (CARVM) (sec. 
807(d)(3)(B)(ii)).
---------------------------------------------------------------------------
    \178\ In general, the NAIC promulgates guidelines relating to 
accounting for insurance products for purposes of the insurer's annual 
statement, which generally is filed with the State in which the insurer 
is subject to State regulation.
---------------------------------------------------------------------------
    Present law provides for a 10-year spread of the reserve 
amount that arises in the event of a change in the basis for 
determining reserves (807(f)).
    On June 11, 1997, the NAIC Life Insurance (A) Committee 
adopted Actuarial Guideline XXXIII Determining CARVM Reserves 
for Annuity Contracts with Elective Benefits (NAIC Guideline 
33).
    NAIC Guideline 33 states that industry practices and 
methods of reserving under CARVM for some annuity contracts 
have not been found to be consistent, ranging from relatively 
low reserves based on cash surrender value to higher reserves 
representing the greatest actuarial present value of future 
benefits under the contract. NAIC Guideline 33 provides 
generally that the ultimate policy reserve must be sufficient 
to fund the greatest present value of all potential benefits, 
both guaranteed elective and non-elective benefits under the 
contract.
    NAIC Guideline 33 states that it is effective on December 
31, 1998, affecting all contracts issued on or after January 1, 
1981. The NAIC Guideline also states that its purpose is ``to 
codify the basic interpretation of CARVM and does not 
constitute a change of method or basis from any previously used 
method . . .'' (NAIC Guideline at page 3).
    In 1997, the NAIC also adopted Actuarial Guideline XXXIV, 
Variable Annuity Minimum Guaranteed Death Benefit Reserves 
(NAIC Guideline 34), interpreting the standards for the 
valuation of reserves for ``minimum guaranteed death benefits'' 
provided in variable annuity contracts. NAIC Guideline 34 
requires that reserves for these benefits be determined 
assuming an immediate drop in the values of the assets 
supporting the variable annuity contract, followed by a 
subsequent recovery at a net assumed return until the maturity 
of the contract. NAIC Guideline 34 also provides mortality 
tables that assume increased longevity of individuals, to be 
used in determining reserves for contracts with these benefits. 
NAIC Guideline 34 states that it is effective for all contracts 
issued on or after January 1, 1981.

                        Description of Proposal

    Under the proposal, reserves for any annuity contract with 
a cash surrender value would equal the lesser of the CARVM 
reserve for the contract or the contract's adjusted account 
value. The proposal would retain the rule of present law that 
in no event may the reserve for any contract at any time exceed 
the amount set forth in the annual statement.
    For purposes of the proposal, the adjusted account value 
for a contract would equal the net cash surrender value for the 
contract, plus a percentage of the net surrender value for the 
contract. The percentage would be 5.5 percent in the taxable 
year in which the contract is issued, 5.0 percent in the second 
year, 4.0 in the third year, 3.0 in the fourth year, 2.5 
percent in the fifth year, 1.5 percent in the sixth year, 0.5 
percent in the seventh year, and 0 percent in the eighth and 
all succeeding years.

                             Effective Date

    The proposal would be effective for taxable years ending on 
or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    In general, an important purpose of ``statutory 
accounting,'' the method of accounting used by insurers in 
reporting to State insurance regulators, is to maintain the 
solvency of insurers so that they have the funds to pay future 
benefits under insurance contracts. This method has been 
characterized as conservative, generally taking account of 
deductions and losses relatively early and taking income items 
into account relatively late. If an important goal of an income 
tax system is the accurate measurement of income, the 
accounting method used for tax purposes should be less 
conservative than a method whose goal is company solvency. 
Acceleration of losses and deductions (including reserve 
deductions) that may be appropriate for regulatory purposes 
results in understatement of income for tax purposes, it is 
argued.
    Although present-law tax rules for life insurance companies 
are based in part on ``statutory accounting'' methods that the 
companies utilize under non-tax regulation, the rationale for 
this may be in part that the advantage of increased accuracy in 
measuring income is outweighed by the advantage of 
administrative convenience for insurers. However, it is argued, 
when the disparity between a normative tax accounting method 
and ``statutory accounting'' rules becomes too great, accuracy 
dictates a divergence from the statutory accounting rule 
theretofore in use for tax purposes. For example, in 1987 
Congress modified the interest rate to be used by life 
insurance companies in computing reserves so as to take into 
account the greater of the applicable Federal interest rate or 
the prevailing State assumed rate. At that time, Congress 
stated that ``the interest rate applied by State insurance 
regulators may not reflect current market trends, and is likely 
to be selected with a view towards maintaining insurance 
company solvency (a regulatory goal) rather than accurately 
measuring income of the company (a tax goal).'' 179
---------------------------------------------------------------------------
    \179\ H. Rept. 100-391, Report of the Committee on the Budget, 
House of Representatives, to accompany H.R. 3545, The Omnibus Budget 
Reconciliation Act of 1987 (100th Cong., 1st Sess.), 1106.
---------------------------------------------------------------------------
    The effective date of the proposal could be criticized as 
needlessly broad, in that the proposal applies to reserves for 
all contracts, whenever issued, starting in taxable years after 
enactment. Application to previously issued contracts arguably 
may not be needed, because the scope of the application of NAIC 
Guidelines 33 and 34 for tax purposes is not clear. For 
example, although NAIC Guidelines 33 and 34 say that they apply 
to contracts issued on or after January 1, 1981, perhaps this 
retroactivity applies for State regulatory purposes but not for 
Federal tax purposes, because the tax law utilizes the CARVM in 
effect when the contract is issued. Further, although NAIC 
Guideline 33 states that it is not a change in basis for 
determining reserves, that assertion is not necessarily 
controlling for purposes of the Federal tax law. If NAIC 
Guidelines 33 and 34 were to apply to any company that was 
using cash surrender value reserves or otherwise computing 
reserves less conservatively that would be required under the 
Guidelines, it could be said that the company would have to 
spread the change in reserves over a 10-year period under the 
present-law rule of section 807(f). In addition, to the extent 
that the Guidelines would require companies to maintain 
deficiency reserves, they are not deductible under present law. 
Additional issues may also arise as to the extent to which NAIC 
Guidelines 33 and 34 apply for tax purposes.

5. Tax certain exchanges of insurance contracts and reallocations of 
        assets within variable insurance contracts

                              Present Law

    Gain or loss realized from the sale or other disposition of 
property generally is subject to tax under present law. The 
gain from a sale or other disposition of property is the excess 
of the amount realized on the disposition over the adjusted 
basis of the property. The loss from a sale or other 
disposition of property is the excess of the adjusted basis 
(for determining loss) over the amount realized (sec. 1001).
    Gain or loss realized on some transactions is accorded non-
recognition treatment under special rules. A special rule 
resembling other nontaxable exchange rules for like-kind 
property was enacted in 1954. This rule provides that no gain 
or loss is recognized on the exchange of certain insurance 
contracts for other insurance contracts. No gain or loss 
generally is recognized on the exchange of: (1) a life 
insurance contract for a life insurance, endowment or annuity 
contract; (2) an endowment contract for an endowment contract 
(provided regular payments begin no later than under the 
exchanged contract) or an annuity contract; or (3) an annuity 
contract for an annuity contract (sec. 1035).
    Additional special rules apply to variable life insurance 
and variable annuity contracts (sec. 817). A variable life 
insurance contract generally is a life insurance contract under 
which the amount of the death benefit (or the period of 
coverage) is adjusted on the basis of the investment return and 
the market value of the segregated asset account maintained 
with respect to the contract. A variable annuity contract 
generally is an annuity contract under which the amounts paid 
in, or the amount paid out, reflect the investment return and 
the market value of the segregated asset account maintained 
with respect to the contract. In order for a variable life 
insurance or annuity contract to meet the definition of a life 
insurance contract (including an annuity contract), and to be 
eligible for favorable tax rules on distributions under the 
contract, for any calendar quarter period, the segregated asset 
account with respect to the contract generally must be 
adequately diversified (sec. 817(h)).179a
---------------------------------------------------------------------------
    \179a\ In addition, the policyholder may not exercise excessive 
control over the investments. See Rev. Rul. 81-225, 1981-2 C.B. 12; 
Christofferson v. U.S., 749 F.2d 651 (8th Cir. 1984), cert. denied, 473 
U.S. 905 (1985); Rev. Rul. 82-54, 1982-1 C.B. 11.
---------------------------------------------------------------------------
    The segregated asset accounts for a variable contract may 
be invested in a variety of investment funds. A variable life 
insurance or variable annuity contract often gives the holder 
the option to reallocate assets under the contract among these 
investment choices, and the practice has developed that no 
current taxation is imposed if no distribution is made under 
the contract at the time. In addition, a variable life 
insurance contract or variable annuity contract may be 
exchanged for another contract, as described above, without 
current taxation. Under these special rules, the holder of a 
variable life insurance or annuity contract may be able to 
dispose of one or more investment properties and re-invest in 
different investment properties without current taxation of the 
gain or loss realized on the disposition.
    A variable life insurance contract otherwise has the same 
tax treatment to the holder as a life insurance contract that 
is not variable. Generally, an exclusion from Federal income 
tax is provided for amounts received under a life insurance 
contract paid by reason of the death of the insured (sec. 
101(a)). Further, no Federal income tax generally is imposed on 
a policyholder with respect to the earnings under a life 
insurance contract (``inside buildup''). Distributions from a 
life insurance contract (other than a modified endowment 
contract) that are made prior to the death of the insured 
generally are includible in income only to the extent that the 
amounts distributed exceed the taxpayer's investment in the 
contract. Such distributions generally are treated first as a 
tax-free recovery of the investment in the contract, and then 
as income (sec. 72(e)). Present law provides a definition of 
life insurance designed to limit the investment orientation of 
the contract (sec. 7702). However, no dollar limit is imposed 
on the amount that may be paid into a life insurance contract 
for Federal income tax purposes.
    Similarly, a deferred annuity that is a variable contract 
otherwise has the same tax treatment to the holder as a 
deferred annuity that is not variable. Generally, no Federal 
income tax is imposed on a deferred annuity contract holder who 
is a natural person with respect to the earnings on the 
contract (inside buildup) in the absence of a distribution 
under the contract. Annuity distributions generally are treated 
as partially excludable under an ``exclusion ratio'' (the ratio 
of the investment in the contract to the expected return under 
the contract as of that date) (sec. 72(b)). Other distributions 
(which for this purpose include loans) are treated as income 
first, then as a tax-free return of the investment on the 
contract (sec. 72(e)). An additional 10 percent tax is imposed 
on the income portion of distributions made before age 59-1/2, 
and in certain other circumstances (sec. 72(q)). An annuity 
contract must provide for certain required distributions where 
the holder dies before the entire interest in the contract has 
been distributed (sec. 72(s)). No dollar limit is imposed on 
the amount that may be paid into an annuity contract (that is 
not a pension plan contract) for Federal income tax purposes.

                        Description of Proposal

    Under the proposal, tax-free treatment for an exchange of 
any life insurance, endowment or annuity contract for any 
variable contract would be repealed. Further, tax-free 
treatment for an exchange for any variable contract for any 
life insurance, endowment, or annuity contract would be 
repealed. The proposal also provides that each reallocation of 
assets among investment options within a variable annuity 
contract (such as a separate account mutual fund) or to the 
insurance company's general account under the terms of a 
variable contract would be treated as an exchange to which tax-
free treatment does not apply.

                             Effective Date

    The proposal would apply to contracts issued after the date 
of first committee action. Reallocation of assets after that 
date under the terms of an existing variable contract that was 
issued on or before that date would not be subject to the 
proposal. However, in the case of a material change to a 
contract originally issued before the date of first committee 
action, the contract would be treated as a new contract. Thus, 
the proposal would apply to any exchange of the new contract 
for another contract at any time after the material change. In 
addition, the proposal would apply to any reallocation of 
assets under the new contract at any time after the material 
change.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is based on the premise that reallocations of 
assets within variable contracts, as well as exchanges of the 
contracts themselves, are sufficiently similar to exchanges of 
investment assets that ordinarily are subject to current 
taxation, that these exchanges should be subject to current 
taxation as well. If a taxpayer invests in a mutual fund, or a 
particular stock or bond, for example, and then disposes of the 
fund, the stock or the bond, gain or loss is recognized. If 
fairness dictates that similarly situated taxpayers should be 
subject to similar tax treatment, then wrapping the investment 
in a variable life insurance or annuity contract should not 
produce different tax results. Congress gave credence to this 
view in an analogous situation when it modified the tax 
treatment of ``swap funds'' in the Taxpayer Relief Act of 1997. 
In that Act, Congress limited the ability of taxpayers to 
contribute certain types of investment assets to a pool of 
other investment assets and diversify or otherwise change the 
nature of its investments without recognition of gain or loss 
on the transaction. By analogy, it can be argued that 
reallocation of assets within a variable contract and exchanges 
of variable contracts represent transactions that are more 
properly treated as taxable exchanges.
    Opponents argue that variable life insurance and variable 
annuity contracts, while not strictly pension or retirement 
vehicles, serve an important function in encouraging savings by 
individuals. They assert that the tax benefits of tax-free 
reallocations of assets and exchanges of the contracts should 
be retained in order to continue this incentive. On the other 
hand, it could be argued that Congress has already provided 
targeted incentives for retirement savings in the form of tax-
favored treatment for qualified pension plans, section 401(k) 
plans, SIMPLE plans, and a variety of individual retirement 
account (``IRA'') provisions. In addition, it is argued that 
these provisions are subject to dollar caps, as well as other 
restrictions, whereas contributions and benefits under life 
insurance and annuity contracts generally are not. It is argued 
that additional tax incentives for savings should be 
deliberated by Congress rather than evolving through the 
modification of insurance products, the tax treatment of which 
was determined long before variable contracts were introduced 
in the marketplace. Further, as a savings incentive, tax-
favored treatment for variable life insurance and variable 
annuity contracts is arguably extremely inefficient, because of 
the relatively high fees and transaction costs of such vehicles 
compared to purchases of mutual funds or other securities.
    Opponents of the proposal also argue that, perhaps 
unintentionally, the proposal destroys the market for variable 
life insurance and annuity contracts, because individuals will 
no longer choose to purchase them if the holder may not select 
at will from an array of investment options depending on 
current market conditions. It can be countered that limiting 
tax-free exchanges and reallocations of assets within variable 
contracts still leaves such contracts more tax-favored than 
non-insurance vehicles such as mutual funds or direct ownership 
of stocks, securities or bonds. The proposal, it is argued, 
would not eliminate the tax deferral or the favorable tax 
treatment on annuity distributions under the exclusion ratio. 
Also, the proposal would not eliminate the tax- favored 
treatment of distributions, such as partial surrenders, under 
life insurance contracts generally as tax-free return of the 
investment in the contract first. Nor would the proposal 
eliminate the opportunity to withdraw the cash surrender value 
as a loan, and then receive the balance tax-free as a death 
benefit. It is also argued that the proposal would not affect 
the market for variable life insurance and annuity contracts in 
which the purchaser expects to buy and hold for the long term 
without changing the type of investment.

6. Computation of ``investment in the contract'' for mortality and 
        expense charges on certain insurance contracts

                              Present Law

    An exclusion from Federal income tax is provided for 
amounts received under a life insurance contract paid by reason 
of the death of the insured (sec. 101(a)). Further, no Federal 
income tax generally is imposed on a policyholder with respect 
to the earnings under a life insurance contract (``inside 
buildup'').
    This favorable tax treatment is available only if the 
policyholder has an insurable interest in the insured when the 
contract is issued and if the life insurance contract meets 
certain requirements designed to limit the investment character 
of the contract (sec. 7702). Among other requirements, 
mortality charges must be reasonable mortality charges which 
meet the requirements (if any) prescribed in Treasury 
regulations and which (except as provided in regulations) do 
not exceed the mortality charges specified in the prevailing 
commissioners' standard tables as of the time the contract is 
issued. Similarly, expense charges must be reasonable and must 
be charges which (on the basis of the company's experience, if 
any, with respect to similar contracts) are reasonably expected 
to be actually paid.
    Distributions from a life insurance contract (other than a 
modified endowment contract) that are made prior to the death 
of the insured generally are includible in income, to the 
extent that the amounts distributed exceed the taxpayer's 
investment in the contract. Such distributions generally are 
treated first as a tax-free recovery of the investment in the 
contract, and then as income (sec. 72(e)).
    In the case of a modified endowment contract, however, in 
general, distributions are treated as income first, loans are 
treated as distributions (i.e., income rather than basis 
recovery first), and an additional 10-percent tax is imposed on 
the income portion of distributions made before age 59\1/2\ and 
in certain other circumstances (secs. 72(e) and (v)). A 
modified endowment contract is a life insurance contract that 
does not meet a statutory ``7-pay'' test, i.e., generally is 
funded more rapidly than 7 annual level premiums (sec. 7702A). 
The requirements that mortality and expense charges be 
reasonable also apply to modified endowment contracts.
    Generally, no Federal income tax is imposed on a deferred 
annuity contract holder who is a natural person with respect to 
the earnings on the contract (inside buildup) in the absence of 
a distribution under the contract. Annuity distributions 
generally are treated as partially excludable under an 
``exclusion ratio'' (the ratio of the investment in the 
contract to the expected return under the contract as of that 
date) (sec. 72(b)). Other distributions (which for this purpose 
include loans) are treated as income first, then as a tax-free 
return of the investment on the contract (sec. 72(e)). An 
additional 10-percent tax is imposed on the income portion of 
distributions made before age 59\1/2\, and in certain other 
circumstances (sec. 72(q)). An annuity contract must provide 
for certain required distributions where the holder dies before 
the entire interest in the contract has been distributed (sec. 
72(s)).
    Investment in the contract means the aggregate amount of 
premiums or other consideration paid for the contract to date 
reduced by the aggregate amount received under the contract 
that was excludable from income (sec. 72(e)(6)), for purposes 
of the distribution rules. These rules do not provide that the 
investment in the contract is reduced by the portion of the 
premium paid that is used to pay mortality charges or expense 
charges. These charges can include the cost of term insurance 
protection for the current period, or, in the case of a 
deferred annuity contract, the cost of a payout option such the 
right to purchase a life annuity at guaranteed rates.

                        Description of Proposal

    The proposal would modify the definition of investment in 
the contract for purposes of the distribution rules with 
respect to life insurance and annuity contracts.
    For a life insurance contract, investment in the contract 
(as defined under present law) would be reduced by the 
mortality charges that are taken into account for purposes of 
Code section 7702. Investment in the contract would also be 
reduced by appropriate expense charges, to the extent provided 
in regulations (or other guidance promulgated by the Treasury 
Department).
    For an annuity contract (other than an immediate annuity 
described in section 72(u)(4)), the investment in the contract 
(as defined under present law) would be reduced by the 
contract's assumed mortality and expense charges. These assumed 
charges would be defined as the contract's average cash value 
during the year multiplied by 1.25 percent. In the event that 
the contract holder used accumulated funds in the contract to 
exercise a particular payout option such as the right to 
purchase a life annuity at guaranteed rates, then the assumed 
mortality and expense charges associated with that option would 
be added to the investment in the contract at that time.

                             Effective Date

    The proposal would be effective for contracts issued after 
the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is based on the premise of tax policy that 
amounts paid for current expenses should not be included in the 
basis of an asset. A life insurance contract that has a cash 
value can be viewed as divisible into two portions: a portion 
providing current term insurance protection and a cash value 
portion. The cost of the term insurance portion represents a 
current expense for a benefit--insurance protection--that does 
not last beyond the term. The cash value portion, by contrast, 
has continued value. Thus, because investment in the contract 
is equivalent to the basis for the contract (for purposes of 
section 72), the investment in the contract for a life 
insurance or annuity contract should not include amounts that 
represent current expenses, such as mortality charges for term 
insurance coverage for the current period and associated 
expense charges. It is also argued that the investment in the 
contract should not include the cost of any payout options that 
are still contingent and have not been exercised by the holder.
    If investment in the contract is overstated by including 
the amount of current mortality and associated expenses, then 
the amount of any distribution from a life insurance or annuity 
contract that is taxable is measurably understated. This 
understatement of income would arise whether the contract is a 
modified endowment contract, with respect to which income is 
taxed before return of basis, or is a life insurance contract 
eligible for the more favorable distribution rules permitting 
recoupment of basis before the income is taxed, or is an 
annuity contract subject to the income- first rule on non-
annuity distributions.
    On the other hand, it could be argued that the proposal, 
while increasing the accuracy of the tax law, also increases 
its complexity by requiring an additional calculation with 
respect to distributions from life insurance or annuity 
contracts. Nevertheless, insurance companies already keep track 
of prior distributions for purposes of computing the investment 
in the contract, as well as mortality and expense charges, and 
frequently provide this information to policyholders on an 
annual basis, so it could be argued that there is not a 
significant additional record-keeping or reporting burden. It 
could also be argued that the incremental improvement in 
accuracy of the tax rules does not outweigh the disadvantage of 
disrupting present practices and present-law tax treatment for 
the numerous contracts that would be affected by the proposal.

                   E. Estate and Gift Tax Provisions

1. Eliminate non-business valuation discounts

                              Present Law

    Generally, for Federal transfer tax purposes, the value of 
property is its fair market value, i.e., the price at which the 
property would change hands between a willing buyer and a 
willing seller, neither being under any compulsion to buy or 
sell and both having reasonable knowledge of relevant facts. In 
valuing a fractional interest in a non-publicly traded entity, 
taxpayers routinely claim discounts for factors such as 
minority ownership or lack of marketability. The concept of 
such valuation discounts is based upon the principle that a 
willing buyer would not pay a willing seller a proportionate 
share of the value of the entire business when purchasing a 
minority interest in a non-publicly traded business, because 
the buyer may not have the power to manage or control the 
operations of the business, and may not be able to readily sell 
his or her interest.
    In the family estate planning area, a common planning 
technique is for an individual to contribute marketable assets 
to a family limited partnership or limited liability company 
and make gifts of minority interests in the entity to other 
family members. In valuing such gifts for transfer tax 
purposes, taxpayers often claim large discounts on the 
valuation of these gifts.

                        Description of Proposal

    The proposal would eliminate valuation discounts except as 
they apply to active businesses. Interests in entities would be 
required to be valued for transfer tax purposes at a 
proportional share of the net asset value of the entity to the 
extent that the entity holds readily marketable assets 
(including cash, cash equivalents, foreign currency, publicly 
traded securities, real property, annuities, royalty-producing 
assets, non-income producing property such as art or 
collectibles, commodities, options and swaps) at the time of 
the gift or death. To the extent the entity conducts an active 
business, the reasonable working capital needs of the business 
would be treated as part of the active business (i.e., not 
subject to the limits on valuation discounts). No inference is 
intended as to the propriety of these discounts under present 
law.

                             Effective Date

    The proposal would be effective for transfers made after 
the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    It is well established that discounts may be appropriate in 
valuing minority interests in business entities. See, e.g., 
Estate of Andrews, 79 T.C. 938 (1982). Generally, these 
discounts take the form of minority discounts and lack of 
marketability discounts. A minority discount reflects a 
decreased value due to the fact that a minority shareholder (or 
partner) may have little ability to control or participate in 
the management of the business, or to compel liquidation of the 
business or payment of distributions. The IRS has stated that 
minority discounts even may be appropriate in cases where the 
transferred interest, when aggregated with interests held by 
family members, is part of a controlling interest. See Rev. 
Rul. 93-12, 1993-1 C.B. 202. In addition to minority discounts, 
an additional valuation discount due to lack of marketability 
also may be available to reflect the fact that there is no 
ready market for interests in a closely-held entity. It is not 
unusual for taxpayers to claim combined discounts of 30 to 50 
percent, although taxpayers have claimed discounts of as much 
as 60 or 70 percent in some cases. See, e.g., Estate of 
Barudin, T.C. Memo. 1996-395 (taxpayer claimed a combined 
discount of 67.5 percent; the Tax Court allowed 45 percent). 
The appropriate level of discount for any particular business 
interest often is the subject of litigation.
    The Administration proposal raises two separate issues 
relevant to the valuation of assets and the administration of 
the estate tax: the appropriateness of minority discounts and 
the liquidity of assets. The issue of minority discounts 
relates to circumstances where the value of a fractional 
holding of an asset may not equal the proportionate market 
value of the entire holding. Analysts generally believe that 
minority discounts result from the ability of the controlling 
owner to dictate the course of future investment, business 
strategy, or timing of liquidation of the asset. Not being able 
to make such decisions generally makes a minority claim on the 
asset less valuable.\180\ The extent of any minority discount 
depends upon the facts and circumstances related to the asset.
---------------------------------------------------------------------------
    \180\ Using the same reasoning, it can be argued that individuals 
may be willing to pay more than the proportionate market value of the 
entire holding in order to have control (i.e., ``control premiums'').
---------------------------------------------------------------------------
    An asset's liquidity is its ability to be readily converted 
to cash. The issue of liquidity of assets relates to 
identifying those assets which are readily tradeable and, 
therefore, for which market values are readily ascertainable 
without great expense to the asset's owner. While generally 
people view passive assets such as stocks and bonds as liquid 
assets, not all passive assets are equally liquid, and some 
passive assets may be less liquid than active assets. For 
example, specialty brokers may be able to more readily generate 
offers to purchase a radio station in a major metropolitan 
area, than would a financial broker who attempts to generate 
offers for the purchase of a bond issued by a small rural 
school district.
    Although the practice of claiming valuation discounts has 
been accepted in valuing active businesses, proponents of the 
Administration proposal maintain that it is less clear whether 
such discounts are appropriate for entities holding marketable 
assets. For example, if an individual contributes his or her 
stock portfolio to an entity and transfers interests in the 
entity to his or her children, it is questionable that the 
stock portfolio is somehow worth less to the family, simply 
because its ownership is dispersed among several individuals. 
In such circumstances, where the underlying assets remain 
readily marketable, proponents may argue that issues of control 
are much less important than in the context of making decisions 
to manage the operations of an ongoing active business. That 
is, the proposal would deem there to be no minority or other 
discount in the case of a family enterprise that holds 
marketable assets.
    Opponents of this approach note that it is inconsistent 
with observed market outcomes to claim that a minority discount 
cannot exist when the assets in question are liquid. For 
example, assume a taxpayer holds a one-third share in a 
portfolio of New York Stock Exchange stocks and that her 
brother holds the two-third's share. In this circumstance, the 
brother would be able to dictate the course of future 
investment, investment strategy, and timing of liquidation of 
the portfolio. Some may argue that such a circumstance could 
reasonably give rise to a minority discount on the value of the 
taxpayer's one-third holding even though the underlying assets 
are liquid.
    In determining how much of a minority discount might be 
appropriate with respect to entities holding liquid assets, it 
may be helpful to consider the value placed on closed-end 
mutual funds. Closed-end mutual funds are traded regularly on 
the open market and, among funds that invest in domestic 
assets, are almost always traded at a discount from the net 
asset value of the underlying assets. The discounts observed in 
the marketplace generally are smaller than those often claimed 
as minority discounts in valuing transfers of business 
interests for estate and gift tax purposes. For example, over 
the past six months the discount from net asset value of the 
Herzfeld Closed-End Average has ranged between 12 percent and 4 
percent of net asset value.\181\ On the other hand, closed-end 
mutual funds also may be valued at a premium. While this is 
observed infrequently with closed-end mutual funds that invest 
in domestic equities, it may make it difficult to arrive at any 
generalized conclusions as to the proper valuation of interests 
in such entities.
---------------------------------------------------------------------------
    \181\ The Herzfeld Closed-End Average measures 16 equally-weighted 
closed-end funds that invest principally in equities of U.S. 
corporations. Barron's Market Week, February 9, 1998, p. 89. As an 
average, the Herzfeld Closed-End Average does not reflect the range of 
discounts or premiums that may be observed on individual funds.
---------------------------------------------------------------------------
    The Administration proposal states that valuation discounts 
would be denied with respect to entities holding ``readily 
marketable assets.'' It is unclear, however, whether the 
proposal is actually limited to ``readily marketable assets'' 
as that term is commonly understood. The examples listed in the 
proposal (i.e., cash, cash equivalents, foreign currency, 
publicly traded securities, real property, annuities, royalty-
producing assets, non-income producing property such as art or 
collectibles, commodities, options and swaps) indicate that the 
proposal would apply to most passive assets. However, as noted 
above, passive assets are not automatically liquid. The 
liquidity of markets is a qualitative concept. While the market 
for Treasury securities generally is conceded to be the most 
liquid market in the world, there are not generally accepted 
ways to measure the relative liquidity of the market for U.S. 
Treasury securities to that of pork bellies, to that for 
Picassos, to that for real estate in New York city. Observers 
note that Picassos are not sold daily and an effort to quickly 
convert a Picasso to cash may result in the painting being sold 
at a discount to its ``market value.''
    To the extent that the Administration proposal is meant to 
cover assets such as real estate and art that may not actually 
be readily marketable, the arguments that valuation discounts 
are inappropriate may not be as applicable.\182\ If the 
proposal does not include a ``bright line'' definition of those 
assets to be denied valuation discounts, the proposal could 
lead to increased taxpayer litigation regarding the standard of 
``readily marketable assets.'
---------------------------------------------------------------------------
    \182\ For example, the Tax Court recently accepted a taxpayer's 
expert's valuation allowing a 44 percent combined discount with respect 
to the transfer of an undivided one-half interest in timberland, based 
on the taxpayer's lack of control and the marketing time and real 
estate commission cost involved in selling real property in that 
particular market, where the Commissioner's expert admitted that an 
undivided one-half interest in real property has a limited market and 
that a fractional interest may be discounted, but introduced no 
testimony or other evidence to rebut taxpayer's expert's testimony as 
to the appropriate level of discount. Estate of Williams, T.C. Memo. 
1998-59.
---------------------------------------------------------------------------

2. Gifts of ``present interests'' in a trust (repeal the ``Crummey'' 
        case rule)

                              Present Law

    Under present law, the first $10,000 \183\ of gifts of 
present interest are excluded from Federal gift tax. Several 
courts have held that a donee's power to withdraw annual 
additions to the trust during the year in question gave that 
donee a present interest in the additions. These withdrawal 
powers often are referred to as ``Crummey powers.'' See, e.g., 
D. Clifford Crummey v. Commissioner, 397 F. 2d 82 (9th Cir. 
1968). This result has been upheld even where the donee is a 
minor or lacks knowledge of his right of withdrawal.
---------------------------------------------------------------------------
    \183\ The Taxpayer Relief Act of 1997 provided that this amount 
will be increased (i.e., indexed) in $1,000 increments for inflation 
occurring after 1997.
---------------------------------------------------------------------------
    In the Crummey case, the holder of the withdrawal power was 
the ultimate beneficiary of the trust. In more recent cases, 
such as Estate of Cristofani v. Commissioner, 97 T.C. 74 
(1991), and Estate of Kohlsaat v. Commissioner, 73 T.C.M. 2732 
(1997), the trust agreement was drafted to give withdrawal 
rights to individuals who did not have substantial economic 
interests in the trust.
    Premiums paid by an insured person for a life insurance 
policy are considered a taxable gift to the beneficiaries of 
the policy if (1) the policy proceeds are payable to 
beneficiaries other than the insured's estate, (2) the insured 
retains no power to receive the economic benefits in himself or 
his estate, (3) the insured retains no power to change the 
beneficiaries or their proportionate benefit, and (4) the 
insured retained no reversionary interest in the insured or his 
estate. Treas. Reg. sec. 25.2511-1(h)(8). The transfer of cash 
to an insurance trust is a future interest where the cash is 
used to pay premiums on an insurance policy and the income from 
the insurance proceeds after the death of the insured is to be 
paid to the trust's beneficiary for life. Treas. Reg. sec. 
25.2503-3(c), Example (2).

                        Description of Proposal

    The proposal would overrule the Crummey decision by 
amending section 2503(b) to apply only to outright gifts of 
present interests. Gifts to minors under a uniform act would be 
deemed to be outright gifts.

                             Effective Date

    The proposal would be effective for gifts completed after 
December 31, 1998.

                                Analysis

    Opponents of the Administration proposal argue that the 
principles of the Crummey decision are longstanding. Taxpayers 
have made use of Crummey powers to minimize gift taxes with 
respect to certain transfers in trust for at least 30 years. On 
the other hand, the Administration argues that use of the 
Crummey power often is a legal fiction since, typically by 
understanding or expectation, it is extremely rare for a 
Crummey power to be exercised. The Administration believes that 
the continued existence and expansion of the Crummey decision 
undermines the statutory requirement that only a gift of a 
present interest is eligible for the $10,000 annual gift tax 
exclusion.
    The legislative history of the annual exclusion indicates 
that its size was established to exempt numerous small gifts 
and larger wedding and Christmas gifts. That legislative 
history \184\ also supports the view that the disallowance of 
the annual exclusion for future interests was necessary because 
of the need to determine the identity of the donee and the 
amount of the gift. Opponents of the Treasury proposal argue 
that, in many cases, the existence of a Crummey power does not 
make the identity of the donee, or the value of the transfer, 
unclear and, therefore, use of Crummey powers is consistent 
with the annual exclusion.
---------------------------------------------------------------------------
    \184\ The Finance Committee report for the Revenue Act of 1932 
(Committee Report No. 665 (72d Congress 1st Session)) states as 
follows: ``Such exemption, on the one hand, is to obviate the necessity 
of keeping account of and reporting numerous small gifts, and, on the 
other, to fix the amount sufficiently large to cover in most cases 
wedding and Christmas gifts and occasional gifts of relatively small 
amounts. The exemption does not apply with respect to a gift to any 
donee to whom is given a future interest. The term ``future interest in 
property'' refers to any interest or estate, whether vested or 
contingent, limited to commence in possession or enjoyment at a future 
date. The exemption being available only in so far as the donees are 
ascertainable, the denial of the exemption in the case of future 
interests is dictated by the apprehended difficulty, in many instances, 
of determining the number of eventual donees and the value of their 
respective gifts.'' page 41. Identical language is contained in page 29 
of Report of the Committee on Ways and Means (Report Number 708, 72d 
Cong., 1st Session)
---------------------------------------------------------------------------
    Proponents of the Treasury proposal argue that application 
of the Crummey rule to situations where the withdrawal rights 
have been given to individuals who do not have substantial 
economic interests in a trust may be more troubling because it 
potentially permits an unlimited gift tax exemption through 
multiple withdrawal rights given to multiple individuals while 
only the intended donee or donees have substantial economic 
interests in that trust. In any event, the Treasury proposal 
would overrule all uses of Crummey powers, not just these 
situations.
    Crummey powers frequently are used in conjunction with a 
trust whose principal asset is a life insurance policy (called 
an ``insurance trust''). These trusts typically first begin 
making income payments after the death of the insured from the 
insurance proceeds so that interests in such a trust are future 
interests. Crummey powers are used so that cash contributions 
to the trust by the insured to be used to pay premiums on the 
insurance policy will qualify for the annual exclusion. The 
proposal's repeal of the Crummey rule would cause such cash 
contributions to cease to qualify for the annual exclusion, 
resulting in use of the insured's unified credit or payment of 
gift tax. If limitations are adopted on the use of Crummey 
powers, transitional relief may be appropriate in situations 
where the insurance policy is a whole life policy, especially 
where the policy has been irrevocably transferred to the trust 
and the insured individual is no longer insurable.

3. Eliminate gift tax exemption for personal residence trusts

                              Present Law

    Section 2702 sets forth special valuation rules for 
circumstances in which an individual sets up a trust, retaining 
a partial interest in the trust and transferring other 
interests in the trust to family members. In general, if an 
interest in a trust is retained by a grantor when other 
interests are transferred to family members, the retained 
interest is valued at zero for gift tax purposes unless it is a 
qualified annuity interest (a ``GRAT''), unitrust interest (a 
``GRUT''), or a remainder interest after a GRAT or a GRUT. A 
special exception under section 2702(a)(3)(A)(ii) provides that 
the special valuation rules do not apply in the case of 
personal residence trusts. In general, a personal residence 
trust is a trust ``all the property in which consists of a 
residence to be used as a personal residence by persons holding 
term interests in such trust.'

                        Description of Proposal

    The proposal would repeal the personal residence exception 
of section 2702(a)(3)(A)(ii). If a residence is used to fund a 
GRAT or a GRUT, the trust would be required to pay out the 
required annuity or unitrust amount; otherwise the grantor's 
retained interest would be valued at zero for gift tax 
purposes.

                             Effective Date

    The proposal would be effective for transfers in trust 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The present-law rules pertaining to personal residence 
trusts were enacted by Congress in 1990 as a specific statutory 
exception to the general rules of section 2702. Personal 
residence trusts are commonly used as a tax planning device to 
reduce transfer taxes by allowing an individual's home (or 
vacation home) to be transferred to his or her heirs at 
significant tax savings. For example, an individual may 
transfer his primary residence to a trust which provides that 
the grantor may continue to live in the house for fifteen 
years, at which time the trust assets (i.e., the home) will be 
transferred to his children. The grantor may retain a 
reversionary interest in the property (i.e., provide that if 
the grantor does not survive the trust term, the property would 
revert to his estate).\185\ The trust agreement may further 
provide that the grantor may continue to live in the home after 
the fifteen-year period as long as he makes rental payments to 
his children at fair market value. If the requirements for a 
personal residence trust are satisfied, the transfer is treated 
as a gift of the contingent remainder interest, which generally 
has a relatively small value as compared to the full fair 
market value of the residence.
---------------------------------------------------------------------------
    \185\ Reversionary interests commonly are retained so that, if the 
grantor dies before the end of the trust term, the property may be left 
to the grantor's spouse, thus qualifying for the marital deduction. 
Retention of a reversionary interest also has the effect of reducing 
the amount of the taxable gift.
---------------------------------------------------------------------------
    The gift tax is imposed on the fair market value of the 
property transferred. In the case of a transfer such as the one 
described above, the value of the gift would be determined by 
taking the fair market value of the entire property, and 
subtracting from it the actuarially determined value of the 
grantor's retained income interest and the actuarially 
determined value of any contingent reversionary interest 
retained by the grantor. The actuarially determined value of 
any annuity, interest for life or a term of years, or any 
remainder or reversionary interest is based upon tables set 
forth by the IRS under section 7520. These tables set forth 
valuation rates for each type of interest (e.g., annuity, life 
interest, remainder interest) based upon applicable interest 
rates and the length of the term.
    There are several advantages and disadvantages to the use 
of personal residence trusts. First, such trusts allow an 
individual to transfer his home to his heirs at a significantly 
reduced value for gift tax purposes. In addition, any future 
appreciation in the house is not subject to transfer taxes, as 
long as the grantor survives the trust term.\186\ Lastly, if 
the grantor continues to live in the home after the trust term 
has expired, the required rental payments to his heirs will 
reduce the size of his estate (and thus his estate taxes) even 
further. On the other hand, when a personal residence trust is 
utilized, the heirs receive a carryover basis in the residence 
rather than having the basis stepped up to its full fair market 
value on the date of death, as would be the case if the grantor 
held the property until death and transferred it outright to 
the heirs at that time. This disadvantage may be alleviated 
somewhat, however, by the provision in the Taxpayer Relief Act 
of 1997 that potentially exempts up to $500,000 of capital gain 
from tax when the home is sold, if the heirs meet the ownership 
and residence requirements of that provision.
---------------------------------------------------------------------------
    \186\ If the grantor dies during the trust term, the full fair 
market value of the house at the date of death will be brought back 
into his estate under section 2036, regardless of whether the grantor 
has retained a reversionary interest in the property. However, the 
estate will receive credit for any gift taxes paid (or use of the 
unified credit) with respect to the initial transfer to the personal 
residence trust.
---------------------------------------------------------------------------
    The valuation rules of section 2702 are patterned after the 
rules set forth in section 2055 for determining whether a 
charitable deduction is allowed for split interests in property 
where an interest is given to charity. When Congress enacted 
section 2055 in 1969, there were concerns that it would be 
inappropriate to give a charitable deduction except in cases 
where there was some assurance that the interest given to 
charity could be properly valued. Types of interests for which 
a deduction was allowed included annuities and unitrusts. 
Generally, an annuity pays a fixed amount each year while a 
unitrust pays out a certain fraction of the value of the trust 
annually. Thus, a charitable deduction is allowed in cases 
where, for example, an annuity is paid to charity with the 
remainder going to an individual, or an annuity is paid to an 
individual with the remainder going to charity, or a unitrust 
pays out to charity annually with the remainder going to an 
individual, or a unitrust pays out to an individual annually 
with the remainder going to charity. In addition, a charitable 
deduction is allowed for the contribution of a remainder 
interest in a personal residence or farm under an exception 
provided in section 170(f)(3)(B)(i). These same basic rules 
were adopted in valuing non-charitable gifts for purposes of 
section 2702.
    Proponents of the Administration proposal argue that the 
use value of the residence retained by the grantor is a poor 
substitute for an annuity or unitrust interest, and that the 
actuarial tables overstate the value of the grantor's retained 
interest in the house. These conclusions are based in part on 
the fact that in a personal residence trust situation, the 
grantor ordinarily remains responsible for the insurance, 
maintenance and property taxes on the residence, and thus the 
true rental value of the house should be less than the fair 
market rent. Such proponents also argue that by completely 
exempting personal residence trusts from the requirements of 
section 2702, personal residence trusts are accorded even more 
beneficial treatment than are GRATs, GRUTs, or remainder 
interests after a GRAT or a GRUT, because under those 
arrangements, it is not possible to reduce the value of the 
gift by retaining a contingent reversionary interest.
    The Administration proposal does not question whether a 
remainder interest in a personal residence can be appropriately 
valued for purposes of determining the amount of a charitable 
contribution, in that no modification of section 2055 is 
proposed. It is unclear how the same basic valuation rules 
could produce an acceptable result where a remainder interest 
is going to charity, yet an unacceptable result where the 
remainder interest is being transferred to private parties.

4. Include qualified terminable interest property (``QTIP'') trust 
        assets in surviving spouse's estate

                              Present Law

    For estate and gift tax purposes, a marital deduction is 
allowed for qualified terminable interest property (QTIP). Such 
property generally is included in the surviving spouse's gross 
estate. The surviving spouse's estate is entitled to recover 
the portion of the estate tax attributable to such inclusion 
from the person receiving the property, unless the spouse 
directs otherwise by will (sec. 2207A). A marital deduction is 
allowed for QTIP passing to a qualifying trust for a spouse 
either by gift or by bequest. Under section 2044, the value of 
the recipient spouse's estate includes the value of any such 
property in which the decedent had a qualifying income interest 
for life and a deduction was allowed under the gift or estate 
tax.

                        Description of Proposal

    The proposal would provide that if a marital deduction is 
allowed with respect to qualified terminable interest property 
(QTIP), inclusion is required in the beneficiary spouse's 
estate.

                             Effective Date

    The proposal would be effective for decedents (i.e., 
surviving spouses) dying after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Both the gift tax and the estate tax allow an unlimited 
deduction for certain amounts transferred from one spouse to 
another spouse who is a citizen of the United States.\187\ 
Under both the gift and estate tax marital deduction, 
deductions are not allowed for so-called ``terminable 
interests''. Terminable interests generally are created where 
an interest in property passes to the spouse and another 
interest in the same property passes from the donor or decedent 
to some other person for less than full and adequate 
consideration. For example, an income interest to the spouse 
generally would not qualify for the marital deduction where the 
remainder interest is transferred to a third party. Special 
rules permit a marital deduction where the surviving spouse has 
an income interest if that spouse has a testamentary power of 
appointment or the remainder passes to the estate of that 
surviving spouse.
---------------------------------------------------------------------------
    \187\ In addition, a marital deduction is allowed for both gift and 
estate tax purposes for transfers to spouses who are not citizens of 
the United States if the transfer is to a qualified domestic trust 
(QDOT). A qualified domestic trust is a trust which has at least one 
trustee that is a U.S. citizen or a domestic corporation and no 
distributions of corpus can be made without withholding from those 
distributions.
---------------------------------------------------------------------------
    An exception to the terminable interest rule was provided 
when the unlimited marital deduction was provided in 1981. 
Under this exception, a marital deduction is allowed for a 
transfer to a trust of ``qualified terminable interest 
property'' (called ``QTIP'') in which the spouse only has an 
income interest, as long as the transferor elects to include 
the trust in the spouse's gross estate for Federal estate tax 
purposes and subjects to gift tax the property in the QTIP if 
the spouse disposes of the income interest.
    The purpose and effect of the terminable interest and 
qualified terminable interest rules is to permit deferral of 
taxation on amounts transferred to spouses that are not 
consumed before the death of the second spouse, not to provide 
an exemption from estate and gift tax. In some cases, the 
estate of the first spouse to die has claimed a marital 
deduction as a QTIP and then, after the statute of limitations 
for assessing tax on the first estate has elapsed, the estate 
of the second spouse to die argues against inclusion in that 
second estate due to a technical flaw in the QTIP eligibility 
or election in the first estate. Under the proposal, the estate 
of the second spouse to die would be required to include 
property with respect to which the estate of the first spouse 
to die claimed a marital deduction even if there was a 
technical flaw in the QTIP eligibility or election in the first 
estate.

                       F. Foreign Tax Provisions

1. Replace sales source rules with activity-based rule

                              Present Law

    U.S. persons are subject to U.S. tax on their worldwide 
income. Foreign taxes may be credited against U.S. tax on 
foreign-source income of the taxpayer. For purposes of 
computing the foreign tax credit, the taxpayer's income from 
U.S. sources and from foreign sources must be determined.
    Income from the sale or exchange of inventory property that 
is produced (in whole or in part) within the United States and 
sold or exchanged outside the United States, or produced (in 
whole or in part) outside the United States and sold or 
exchanged within the United States, is treated as partly from 
U.S. sources and partly from foreign sources. Treasury 
regulations provide that 50 percent of such income is treated 
as attributable to production activities and 50 percent is 
treated as attributable to sales activities. Alternatively, the 
taxpayer may elect to determine the portion of such income that 
is attributable to production activities based upon an 
available independent factory price (i.e., the price at which 
the taxpayer makes a sale to a wholly independent distributor 
in a transaction that reasonably reflects the income earned 
from the production activity). With advance permission of the 
Internal Revenue Service, the taxpayer instead may elect to 
determine the portion of its income attributable to production 
activities and the portion attributable to sales activities 
based upon its books and records.
    The portion of the income that is considered attributable 
to production activities generally is sourced based on the 
location of the production assets. The portion of the income 
that is considered attributable to sales activities generally 
is sourced where the sale occurs. Treasury regulations provide 
that the place of sale will be presumed to be the United States 
if the property is wholly produced in the United States and is 
sold for use, consumption, or disposition in the United States.
    Specific rules apply for purposes of determining the source 
of income from the sale of products derived from natural 
resources within the United States and sold outside the United 
States or derived from natural resources outside the United 
States and sold within the United States.

                        Description of Proposal

    Under the proposal, income from the sale or exchange of 
inventory property that is produced in the United States and 
sold or exchanged abroad, or produced abroad and sold or 
exchanged in the United States, would be apportioned between 
production activities and sales activities based on actual 
economic activity. The proposal would not modify the rules 
regarding the source of income derived from natural resources.

                             Effective Date

    The proposal would apply to taxable years beginning after 
the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal.

                                Analysis

    The 50/50 source rule of present law may be viewed as 
drawing an arbitrary line in determining the portion of income 
that is treated as attributable to production activities and 
the portion that is treated as attributable to sales 
activities. The proposal could be viewed as making this 
determination more closely reflect the economic components of 
the export sale. Some further argue that the present-law rule 
provides a tax benefit only to U.S. exporters that also have 
operations in high-tax foreign countries. In many cases, the 
income from a taxpayer's export sales is not subject to tax in 
the foreign jurisdiction and therefore does not give rise to 
foreign tax credits. The present-law treatment of 50 percent of 
the income from a taxpayer's export sales of property it 
manufactured in the United States as foreign-source income 
therefore has the effect of allowing the taxpayer to use excess 
foreign tax credits, if any, that arise with respect to other 
operations. It is argued that the proposal would prevent what 
might be viewed as the inappropriate use of such excess foreign 
tax credits.
    Others argue that the export benefit provided by the 50/50 
source rule of present law is important to the U.S. economy and 
should be retained. It is further argued that the rule is 
needed to counter-balance various present-law restrictions on 
the foreign tax credit that can operate to deny the taxpayer a 
credit for foreign taxes paid with respect to foreign 
operations, thereby causing the taxpayer to be subject to 
double tax on such income. Moreover, the 50/50 source rule of 
present law can be viewed as having the advantage of 
administrative simplicity; the proposal to apportion income 
between the taxpayer's production activities and its sales 
activities based on actual economic activity has the potential 
to raise complex factual issues similar to those raised under 
the section 482 transfer pricing rules that apply in the case 
of transactions between related parties.

2. Modify rules relating to foreign oil and gas extraction income

                              Present Law

    U.S. persons are subject to U.S. income tax on their 
worldwide income. A credit against U.S. tax on foreign-source 
income is allowed for foreign taxes paid or accrued (or deemed 
paid). The foreign tax credit is available only for foreign 
income, war profits, and excess profits taxes and for certain 
taxes imposed in lieu of such taxes. Other foreign levies 
generally are treated as deductible expenses only. Treasury 
regulations provide detailed rules for determining whether a 
foreign levy is a creditable income tax. A levy generally is a 
tax if it is a compulsory payment under the authority of a 
foreign country to levy taxes and is not compensation for a 
specific economic benefit provided by a foreign country. A 
taxpayer that is subject to a foreign levy and that also 
receives a specific economic benefit from such country is 
considered a ``dual-capacity taxpayer.'' Treasury regulations 
provide that the portion of a foreign levy paid by a dual-
capacity taxpayer that is considered a tax is determined based 
on all the facts and circumstances. Alternatively, under a safe 
harbor provided in the regulations, the portion of a foreign 
levy paid by a dual-capacity taxpayer that is considered a tax 
is determined based on the foreign country's generally 
applicable tax or, if the foreign country has no general tax, 
the U.S. tax (Treas. Reg. sec. 1.901-2A(e)).
    The amount of foreign tax credits that a taxpayer may claim 
in a year is subject to a limitation that prevents taxpayers 
from using foreign tax credits to offset U.S. tax on U.S.-
source income. The foreign tax credit limitation is calculated 
separately for specific categories of income. The amount of 
creditable taxes paid or accrued (or deemed paid) in any 
taxable year which exceeds the foreign tax credit limitation is 
permitted to be carried back two years and carried forward five 
years. Under a special limitation, taxes on foreign oil and gas 
extraction income are creditable only to the extent that they 
do not exceed a specified amount (e.g., 35 percent of such 
income in the case of a corporation). For this purpose, foreign 
oil and gas extraction income is income derived from foreign 
sources from the extraction of minerals from oil or gas wells 
or the sale or exchange of assets used by the taxpayer in such 
extraction. A taxpayer must have excess limitation under the 
special rules applicable to foreign extraction taxes and excess 
limitation under the general foreign tax credit provisions in 
order to utilize excess foreign oil and gas extraction taxes in 
a carryback or carryforward year. A recapture rule applicable 
to foreign oil and gas extraction losses treats income that 
otherwise would be foreign oil and gas extraction income as 
foreign-source income that is not considered oil and gas 
extraction income; the taxes on such income retain their 
character as foreign oil and gas extraction taxes and continue 
to be subject to the special limitation imposed on such taxes.

                        Description of Proposal

    The proposal would deny the foreign tax credit with respect 
to all amounts paid or accrued (or deemed paid) to any foreign 
country by a dual-capacity taxpayer if the country does not 
impose a generally applicable income tax. A dual-capacity 
taxpayer would be a person that is subject to a foreign levy 
and also receives (or will receive) directly or indirectly a 
specific economic benefit from such foreign country. A 
generally applicable income tax would be an income tax that is 
imposed on income derived from business activities conducted 
within that country, provided that the tax has substantial 
application (by its terms and in practice) to persons who are 
not dual-capacity taxpayers and to persons who are citizens or 
residents of the foreign country. If the foreign country 
imposes a generally applicable income tax, the foreign tax 
credit available to a dual-capacity taxpayer would not exceed 
the amount of tax that is paid pursuant to the generally 
applicable income tax or that would be paid if the generally 
applicable income tax were applicable to the dual-capacity 
taxpayer. Amounts for which the foreign tax credit is denied 
could constitute deductible expenses. The proposal would not 
apply to the extent contrary to any treaty obligation of the 
United States.
    The proposal would replace the special limitation rules 
applicable to foreign oil and gas extraction income with a 
separate foreign tax credit limitation under section 904(d) 
with respect to foreign oil and gas income. For this purpose, 
foreign oil and gas income would include foreign oil and gas 
extraction income and foreign oil related income. Foreign oil 
related income is income derived from foreign sources from the 
processing of minerals extracted from oil or gas wells into 
their primary products, the transportation, distribution or 
sale of such minerals or primary products, the disposition of 
assets used by the taxpayer in one of the foregoing businesses, 
or the performance of any other related service. The proposal 
would repeal both the special carryover rules applicable to 
excess foreign oil and gas extraction taxes and the recapture 
rule for foreign oil and gas extraction losses.

                             Effective Date

    The proposal with respect to the treatment of dual-capacity 
taxpayers would apply to foreign taxes paid or accrued in 
taxable years beginning after the date of enactment. The 
proposal with respect to the foreign tax credit limitation 
generally would apply to taxable years beginning after the date 
of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal. The proposal in the fiscal year 1998 
budget proposal also included an additional modification with 
respect to the treatment of foreign oil and gas income under 
subpart F of the Code which is not included in this proposal.

                                Analysis

    The proposal with respect to the treatment of dual-capacity 
taxpayers addresses the distinction between creditable taxes 
and non-creditable payments for a specific economic benefit. 
The proposal would modify rules currently provided under the 
Treasury regulations and would deny a foreign tax credit for 
amounts paid by a dual-capacity taxpayer to any foreign country 
that does not have a tax that satisfies the definition of a 
generally applicable income tax. Thus, neither the present-law 
facts and circumstances test nor the present-law safe harbor 
based on the U.S. tax rate would apply in determining whether 
any portion of a foreign levy constitutes a tax.
    Proponents of the proposal argue that the safe harbor of 
the present regulations allows taxpayers to claim foreign tax 
credits for payments that are more appropriately characterized 
as royalty expenses. Opponents of the proposal argue that the 
mere fact that a foreign country does not impose a tax that 
qualifies under the specific definition of a generally 
applicable income tax should not cause all payments to such 
country by a dual-capacity taxpayer to be treated as royalties 
rather than taxes. Moreover, applying such a rule to dual-
capacity taxpayers could disadvantage them relative to other 
persons that are subject to a levy in a country that does not 
impose a tax that satisfies the specific definition of a 
generally applicable income tax but that do not also receive a 
specific economic benefit from such country (e.g., a taxpayer 
that is not in a natural resources business); a taxpayer that 
is not a dual-capacity taxpayer would not be subject to this 
disallowance rule and therefore could continue to claim foreign 
tax credits for payments to a foreign country that does not 
impose a generally applicable income tax. In addition, issues 
necessarily would continue to arise in determining whether a 
taxpayer is a dual-capacity taxpayer and whether a foreign 
country has a generally applicable income tax.
    Under the proposal, a separate foreign tax credit 
limitation (or ``basket'') would apply to foreign oil and gas 
income, which would include both foreign oil and gas extraction 
income and foreign oil related income. In addition, the 
present-law special limitation for extraction taxes would be 
eliminated. The proposed single basket rule may provide some 
simplification by eliminating issues that arise under present 
law in distinguishing between income that qualifies as 
extraction income and income that qualifies as oil related 
income. The proposal also would have the effect of allowing the 
foreign taxes on extraction income, which may be imposed at 
relatively high rates, to be used to offset the U.S. tax on 
foreign oil related income, which may be subject to lower-rate 
foreign taxes.

3. Apply ``80/20'' company rules on a group-wide basis

                              Present Law

    In general, U.S.-source interest and dividends paid to 
nonresident alien individuals and foreign corporations 
(``foreign persons'') that are not effectively connected with a 
U.S. trade or business are subject to a U.S. withholding tax on 
the gross amount of such income at a rate of 30 percent (secs. 
871(a) and 881(a)). The 30-percent withholding tax may be 
reduced or eliminated pursuant to an income tax treaty between 
the United States and the foreign country where the foreign 
person is resident. Furthermore, an exemption from this 
withholding tax is provided for certain items of U.S.-source 
interest income (e.g., portfolio interest). The United States 
generally does not impose withholding tax on foreign-source 
interest and dividend payments.
    Interest and dividend income generally is sourced in the 
country of incorporation of the payor. Thus, interest or 
dividends paid by a U.S. corporation to foreign persons 
generally are subject to U.S. withholding tax. However, if a 
U.S. corporation meets an 80-percent active foreign business 
income test (the ``80/20 test''), all or a portion of any 
interest or dividends paid by that corporation (a so-called 
``80/20 company'') effectively is exempt from U.S. withholding 
tax. In general, a U.S. corporation meets the 80/20 test if at 
least 80 percent of the gross income of the corporation during 
a specified testing period is derived from foreign sources and 
is attributable to the active conduct of a trade or business in 
a foreign country (or a U.S. possession) by the corporation or 
a 50-percent owned subsidiary of the corporation. The testing 
period generally is the three-year period preceding the year in 
which the interest or dividend is paid.
    Interest paid by an 80/20 company is treated as foreign-
source income (and, therefore, exempt from the 30-percent 
withholding tax) if paid to unrelated parties. Interest paid by 
an80/20 company to related parties is treated as having a 
prorated source based on the source of the income of such company 
during the three-year testing period (a so-called ``look-through'' 
approach). Dividends paid by an 80/20 company are treated as wholly or 
partially exempt from U.S. withholding tax under a similar look-through 
approach based on the source of the income of such company during the 
three-year testing period.

                        Description of Proposal

    The proposal would apply the 80/20 test on a group-wide 
basis. Therefore, members of a group would be required to 
aggregate their gross income for purposes of applying the 80/20 
test.

                             Effective Date

    The proposal would apply to interest or dividends paid or 
accrued more than 30 days after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The 80/20 test generally is applied based on the gross 
income of a ``tested'' U.S. corporation (i.e., the corporation 
paying the interest or dividend) during a three-year lookback 
period. In some cases this three-year lookback period may be 
subject to manipulation and can result in the improper 
avoidance of U.S. withholding tax with respect to certain 
distributions attributable to the U.S.-source earnings of a 
U.S. subsidiary of the payor corporation. For instance, 
dividends paid by a ``tested'' U.S. corporation attributable to 
the U.S.-source earnings of a U.S. subsidiary of such 
corporation can be timed in such a manner that the earnings are 
not included in the three-year lookback period. Some assert 
that such a dividend timing strategy is not unlike other 
dividend timing strategies (or so-called ``rhythm methods''), 
such as those previously used to maximize section 902 foreign 
tax credits prior to the adoption in 1986 of the pooling 
concept for a foreign subsidiary's earnings and profits and 
taxes.
    The proposal would apply the 80/20 test on a group-wide 
basis. As a result, members of a group would be required to 
aggregate their gross income for purposes of the 80/20 test. It 
is not clear how a ``group'' should be defined for these 
purposes. One approach may be to use an affiliated group 
concept under principles similar to section 1504. Under such an 
approach, the U.S.-source earnings of a wholly-owned U.S. 
subsidiary of the payor corporation would be considered in 
determining whether payments from the payor corporation (or 
from other group members) qualify for the 80/20 company rules. 
However, such an approach may be viewed as being overly broad, 
and may serve to disqualify from the 80/20 company rules 
payments from group members which in fact are attributable to 
foreign-source earnings. For instance, interest payments from a 
group member to unrelated parties that are attributable to 
foreign-source earnings of such group member may not qualify 
for the 80/20 company rules if the 80/20 test is applied on 
such a group basis. It is argued that the degree to which 
earnings of group members would be tainted under such an 
approach can be reduced by more narrowly defining the group. 
For instance, the group could be defined to include only the 
tested U.S. corporation and certain subsidiaries owned by it. 
On the other hand, some may argue that a group approach by its 
nature may not be sufficiently targeted to the specific timing 
issues raised by the three-year lookback rule.
    The proposal also may affect U.S. income tax treaties that 
contain provisions that incorporate the 80/20 test (e.g., the 
U.S.-UK income tax treaty which provides that the reduced rates 
of tax on dividends, interest and royalties do not apply to 
certain 80/20 companies); the interaction of this proposal with 
the affected treaties would require further clarification.

4. Prescribe regulations regarding foreign built-in losses

                              Present Law

    U.S. persons are subject to U.S. tax on their worldwide 
income. Foreign persons are subject to U.S. tax, calculated in 
the same manner and at the same graduated rates as the U.S. tax 
on U.S. persons, on income that is effectively connected with 
the conduct of a U.S. trade or business. Foreign persons also 
are subject to a U.S. 30-percent withholding tax on the gross 
amount of certain U.S.-source income that is not effectively 
connected with a U.S. trade or business.
    Various rules are aimed at preventing U.S. taxpayers from 
transferring appreciated property outside the U.S. taxing 
jurisdiction to escape U.S. tax on the built-in gain with 
respect to such property. Section 367(a) limits the application 
of nonrecognition provisions to corporate reorganizations 
involving transfers to foreign corporations. In addition, under 
section 864(c)(7), the gain with respect to property that was 
used in connection with a U.S. trade or business may be 
considered to be effectively connected with a U.S. trade or 
business, and therefore subject to U.S. tax, even though the 
property is no longer so used at the time of its disposition. 
Moreover, section 877 includes rules to limit the ability of 
former U.S. citizens to avoid U.S. tax on appreciated property.
    The Code does not include analogous provisions specifically 
aimed at preventing taxpayers from transferring property with 
built-in losses into the U.S. taxing jurisdiction. Such losses 
could be used to offset income or gain that otherwise would be 
subject to U.S. tax.

                        Description of Proposal

    Under the proposal, the Secretary of the Treasury would be 
directed to prescribe regulations to determine the basis of 
assets held directly or indirectly by a non-U.S. person and the 
amount of built-in deductions with respect to a non-U.S. person 
or an entity held directly or indirectly by a non-U.S. person 
as may be necessary or appropriate to prevent the avoidance of 
tax. No inference would be intended regarding the treatment 
under present law of transactions involving losses arising 
outside the U.S. taxing jurisdiction.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to address both transactions in 
which taxpayers acquire built-in losses arising outside the 
U.S. taxing jurisdiction and transactions in which related 
income and loss are generated but the income arises outside the 
U.S. taxing jurisdiction. Such losses could be used to reduce 
U.S. tax both by U.S. persons and by foreign persons with 
operations in the United States. The Administration is 
concerned that existing regulatory authority may not provide 
the Secretary of the Treasury with sufficient flexibility to 
address potential abuses in a comprehensive manner. However, 
granting broad regulatory authority to address the use of 
built-in foreign losses, without further enumerating the scope 
of such authority, may be criticized as creating uncertainty 
and providing insufficient guidance to taxpayers making 
business decisions. On the other hand, an alternative approach 
of requiring basis adjustments in all such cases would provide 
greater certainty but could be criticized as inflexible and 
unduly harsh. Additional consideration should be given to 
identifying the specific circumstances where basis adjustments 
may or may not be appropriate.

5. Prescribe regulations regarding use of hybrids

                              Present Law

    Because of differences in U.S. and foreign tax laws, it is 
possible for a taxpayer to enter into transactions that are 
treated in one manner for U.S. tax purposes and in another 
manner for foreign tax purposes. These transactions are 
referred to as hybrid transactions. A hybrid transaction may 
involve the use of a hybrid entity that is treated as a 
corporation for purposes of the tax law of one jurisdiction but 
is treated as a branch or partnership for purposes of the tax 
law of another jurisdiction. Alternatively, a hybrid 
transaction also may involve the use of hybrid securities, such 
as a security that is treated as debt or a royalty right in one 
jurisdiction but is treated as an equity interest in another 
jurisdiction. Moreover, a hybrid transaction may involve 
another type of hybrid structure, including a transaction 
involving a repurchase agreement arrangement that is 
characterized as a loan in one jurisdiction but is 
characterized as a non-taxable exchange in another 
jurisdiction.
    Section 894(c), enacted with the Taxpayer Relief Act of 
1997, was aimed at addressing the potential tax-avoidance 
opportunity available for foreign persons that invest in the 
United States through hybrid entities. Section 894(c) limits 
the availability of a reduced rate of withholding tax pursuant 
to an income tax treaty in order to prevent tax avoidance. 
Under section 894(c), a foreign person is not entitled to a 
reduced rate of withholding tax under a treaty with a foreign 
country on an item of income derived through an entity that is 
treated as a partnership (or is otherwise treated as fiscally 
transparent) for U.S. tax purposes if (1) such item is not 
treated for purposes of the taxation laws of such foreign 
country as an item of income of such person, (2) the foreign 
country does not impose tax on an actual distribution of such 
item of income from such entity to such person, and (3) the 
treaty itself does not contain a provision addressing the 
applicability of the treaty in the case of income derived 
through a partnership or other fiscally transparent entity. In 
addition, the Secretary of the Treasury is authorized to 
prescribe regulations to determine, in situations other than 
the situation specifically described in the statutory 
provision, the extent to which a taxpayer shall not be entitled 
to benefits under an income tax treaty of the United States 
with respect to any payment received by, or income attributable 
to activities of, an entity that is treated as a partnership 
for U.S. federal income tax purposes (or is otherwise treated 
as fiscally transparent for such purposes) but is treated as 
fiscally non-transparent for purposes of the tax laws of the 
jurisdiction of residence of the taxpayer.
    Section 894(c) addresses a potential tax-avoidance 
opportunity for Canadian corporations with U.S. subsidiaries 
that arises because of the interaction between the U.S. tax 
law, the Canadian tax law, and the income tax treaty between 
the United States and Canada. Through the use of a U.S. limited 
liability company, which is treated as a partnership (or 
otherwise fiscally transparent) for U.S. tax purposes but as a 
corporation for Canadian tax purposes, a payment of interest 
(which is deductible for U.S. tax purposes) may be converted 
into a dividend (which is excludable for Canadian tax 
purposes). Accordingly, interest paid by a U.S. subsidiary 
through a U.S. limited liability company to a Canadian parent 
corporation would be deducted by the U.S. subsidiary for U.S. 
tax purposes and would be excluded by the Canadian parent 
corporation for Canadian tax purposes; the only tax on such 
interest would be a U.S. withholding tax, which could have been 
imposed at a reduced rate of 10 percent (rather than the full 
statutory rate of 30 percent) pursuant to the income tax treaty 
between the United States and Canada. Under section 894(c), 
withholding tax is imposed at the full statutory rate of 30 
percent in such case.
    Notice 98-5, issued on December 23, 1997, addresses among 
other things, the treatment of certain hybrid structures under 
the foreign tax credit provisions of the Code. The Notice 
states that the Treasury Department and the Internal Revenue 
Service have concluded that the use of certain hybrid 
structures creates the potential for foreign tax credit abuse. 
The hybrid structures identified in Notice 98-5 include 
transactions that result in the effective duplication of tax 
benefits through the use of structures designed to exploit 
inconsistencies between U.S. and foreign tax laws (e.g., an 
arrangement that generates foreign taxes for which a credit is 
given in both the United States and a foreign country for the 
same taxes). The Notice states that it is intended that 
regulations will be issued to disallow foreign tax credits for 
such arrangements in cases where the reasonably expected 
economic profit from the transaction is insubstantial compared 
to the value of the foreign tax credits expected to be obtained 
as a result of the arrangement. In addition, the Notice states 
that Treasury and the Internal Revenue Service are considering 
various approaches to address structures, such as hybrid entity 
structures, intended to create a significant mismatch between 
the time foreign taxes are paid or accrued and the time the 
foreign-source income giving rise to the relevant foreign tax 
liability is recognized for U.S. tax purposes; such approaches 
may include either deferring the foreign tax credits until the 
taxpayer recognizes the income, or accelerating the income 
recognition to the time when the credits are allowed. The 
Notice further states that it is intended that regulations will 
apply with respect to hybrid arrangements resulting in the 
effective duplication of tax benefits for foreign taxes paid or 
accrued on or after December 23, 1997 and, in the case of other 
hybrid entity structures, no earlier than the date proposed 
regulations are issued.
    Notice 98-11, issued on January 16, 1998, addresses the 
treatment of hybrid branches under the provisions of subpart F 
of the Code. The Notice states that the Treasury Department and 
the Internal Revenue Service have concluded that the use of 
certain hybrid branch arrangements is contrary to the policy 
and rules of subpart F. The hybrid branch arrangements 
identified in Notice 98-11 are structures that are 
characterized for U.S. tax purposes as part of a controlled 
foreign corporation (a ``CFC'') but are characterized for 
purposes of the tax law of the country in which the CFC is 
incorporated as a separate entity. The Notice states that it is 
intended that regulations will be issued to prevent the use of 
hybrid branch arrangements to reduce foreign tax while avoiding 
the corresponding creation of subpart F income; such 
regulations will provide that the branch and the CFC will be 
treated as separate corporations for purposes of subpart F. The 
Notice further states that it is intended that such regulations 
will apply to hybrid branch arrangements entered into or 
substantially modified on or after January 16, 1998 and, in the 
case of arrangements entered into before such date, to all 
payments or other transfers made or accrued after June 30, 
1998. The Notice also states that similar issues raised under 
subpart F by certain partnership or trust arrangements will be 
addressed in separate regulations projects.

                        Description of Proposal

    Under the proposal, the Secretary of the Treasury would be 
directed to prescribe regulations clarifying the tax 
consequences of hybrid transactions. Such regulations would set 
forth the appropriate tax results with respect to hybrid 
transactions in which the intended results are inconsistent 
with the purposes of U.S. tax law or U.S. income tax treaties. 
The regulations also would provide that the intended results 
will be respected in the case of hybrid transactions in which 
the results are not inconsistent with the purposes of U.S. tax 
law or treaties. In this regard, the regulations would not deny 
the intended tax results solely because the hybrid transaction 
involves the inconsistent treatment of entities, items, or 
transactions.

                             Effective Date

    The proposal would be effective as of the date of 
enactment.

                              Prior Action

    No prior action.

                                Analysis

    The Administration's description of the proposal provides 
several examples of specific circumstances where the proposed 
regulatory authority may be used. One example involves the use 
of hybrid securities to generate interest deductions in the 
United States that are viewed as incompatible with the purposes 
of a U.S. income treaty. Another example is the use of hybrid 
securities that generate original issue discount deductions in 
a foreign jurisdiction without corresponding income inclusions 
in the United States. A third example involves the use of 
hybrid transactions to generate inappropriate foreign tax 
credit benefits. However, the proposed regulatory authority is 
not limited to these examples.
    General principles of income taxation include the principle 
of equitable taxation and the principle of efficient taxation. 
Some analysts suggest that, in certain cases, hybrid 
transactions may compromise both the equity and the efficiency 
of the U.S. income tax. Equity requires that similarly situated 
taxpayers be treated similarly. The proposal suggests that in 
certain circumstances hybrid securities may be used to generate 
interest deductions in the United States that generally could 
not be claimed by otherwise similar businesses that have not 
issued such hybrid securities. In such a circumstance, the net 
capital costs of one business might be higher than those of 
another because the second business's use of hybrid securities 
permits it a tax deduction not available to the first business. 
Such an outcome could put the first business at a competitive 
disadvantage in the prices it can charge for its product. To 
the extent that the only difference between the two businesses 
is the hybrid structure, an inequity may be created by the 
income tax that would not exist in the market in the absence of 
the tax.
    Such disparate treatment of different hybrid structures 
also might produce market inefficiencies. For example, if 
certain businesses or industries are able to use hybrid 
structures to reduce their income tax burden compared to that 
of other businesses or industries, their after-tax rate of 
return will increase. In the capital market, increases in rates 
of return act as signals to investors as to where more 
investment funds are needed. Investors may respond by making 
more investment funds available to these businesses or 
industries and less to other businesses or industries. To the 
extent changed rates of return are a consequence of the income 
tax and not of underlying market conditions, investor decisions 
will be distorted. Too little investment monies may go to some 
businesses and too much to others. A misallocation of 
investment monies can dampen future economic growth.
    Hybrid structures might create a further form of 
inefficiency in investment. Such structures might increase the 
after-foreign-tax earnings of foreign subsidiaries. Because 
active foreign subsidiaries are permitted to defer U.S. income 
tax on their net foreign earnings, hybrid structures might 
create an inefficient incentive for domestic businesses to 
locate certain facilities abroad.
    Hybrid structures may induce a third type of inefficiency 
as well. Creation of hybrid entities or hybrid securities 
requires real resources, the time and effort of many 
individuals, and other such costs. These resources represent 
funds spent to reduce tax liability rather than funds spent to 
produce more goods or services for sale to the public.
    It may be the case that certain hybrid transactions are 
purely a matter of form over substance. On the other hand, 
other hybrid transactions may have business purposes in 
addition to whatever ancillary tax saving they produce. The 
development of such transactions reflects the growing financial 
sophistication of world capital markets and the desire to 
spread risk efficiently. The ability to divide business claims 
more finely than in the old simple distinctions of ``bond'' or 
``stock'' generally has improved the efficiency of the 
financial markets, allocated risk more efficiently to those 
better able to bear risk and, thereby, has reduced the cost of 
capital, making possible more investment and greater future 
economic growth potential. Moreover, hybrid transactions are 
not inherently inequitable. Any business may choose to organize 
itself to take advantage of the benefits of these structures. 
New innovations in business, be it in management structure or 
financial structure, often create an advantage for the 
innovator, but such outcomes are not inherently unfair.
    The use of hybrid transactions to circumvent provisions of 
the U.S. tax law is potentially troublesome. Moreover, the 
availability of these transactions may have been exacerbated by 
the so-called ``check-the-box'' entity classification 
regulations issued in 1996. However, given the numerous types 
of hybrid transactions, a broad grant of regulatory authority 
to specify the tax consequences of hybrid transactions in 
general may not be the most appropriate solution. Granting 
broad authority, without further enumerating the reach of the 
authority, could create an environment of uncertainty that has 
the potential for stifling legitimate business transactions. In 
addressing the issues raised by hybrid transactions, additional 
consideration should be given to identifying both the specific 
circumstances where a hybrid transaction is inconsistent with 
the purposes of the U.S. tax law and the appropriate tax 
treatment of such transactions. Finally, it should be noted 
that the Treasury Department and the Internal Revenue Service 
have announced their intention to issue regulations addressing 
the treatment of hybrid branches under the subpart F provisions 
(Notice 98-11); it is not entirely clear how this proposal for 
regulatory authority may interact with that regulation project.

6. Modify foreign office material participation exception applicable to 
        certain inventory sales

                              Present Law

    Foreign persons are subject to U.S. tax on income that is 
effectively connected with the conduct of a U.S. trade or 
business; the U.S. tax on such income is calculated in the same 
manner and at the same graduated rates as the tax on U.S. 
persons (secs. 871(b) and 882). Detailed rules apply for 
purposes of determining whether income is treated as 
effectively connected with a U.S. trade or business (sec. 
864(c)). Under these rules, foreign-source income is treated as 
effectively connected with a U.S. trade or business only in 
limited circumstances (sec. 864(c)(4)).
    Income derived from the sale of personal property other 
than inventory property generally is sourced based on the 
residence of the seller (sec. 865(a)). Income derived from the 
sale of inventory property generally is sourced where the sale 
occurs (i.e., where title to the property passes from the 
seller to the buyer) (secs. 865(b) and 861(a)(6)). However, a 
special rule applies in the case of certain sales by foreign 
persons. If a foreign person maintains an office or other fixed 
place of business in the United States, income from a sale of 
personal property (including inventory property) attributable 
to such office or place of business is sourced in the United 
States (sec. 865(e)(2)(A)). This special rule does not apply, 
however, in the case of inventory property that is sold by the 
foreign person for use, disposition or consumption outside the 
United States if an office or other fixed place of business of 
such person outside the United States materially participated 
in the sale (sec. 865(e)(2)(B)). Accordingly, income from the 
sale by a foreign person of inventory property attributable to 
an office or other fixed place of business of such foreign 
person in the United States is sourced based on where the sale 
occurs, provided that the inventory property is sold for use 
outside the United States and a foreign office or other fixed 
place of business of such person materially participated in the 
sale. Income that is sourced outside the United States under 
this rule is not treated as effectively connected with a U.S. 
trade or business.

                        Description of Proposal

    Under the proposal, the foreign office material 
participation rule would apply only if an income tax equal to 
at least 10 percent of the income from the sale actually is 
paid to a foreign country with respect to such income. 
Accordingly, income from the sale by a foreign person of 
inventory property attributable to an office or other fixed 
place of business of such person in the United States would be 
sourced in the United States if an income tax of at least 10 
percent of the income from the sale is not paid to a foreign 
country. Income sourced in the United States under this 
proposal would be treated as effectively connected with a U.S. 
trade or business conducted by the foreign person.

                             Effective Date

    The proposal would be effective for transactions occurring 
on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Under present law, a foreign person that maintains an 
office in the United States is not subject to U.S. tax on 
income derived from sales of inventory property attributable to 
such office provided that the property is sold for use outside 
the United States and a foreign office materially participated 
in the sale. The foreign person is not subject to U.S. tax on 
such income even if no foreign country imposes tax on the 
income. The proposal would modify this material participation 
rule so that it would apply only if an income tax of at least 
10 percent is paid to a foreign country with respect to such 
income.
    The proposal reflects the view that the United States 
should not cede its jurisdiction to tax income from sales of 
inventory property attributable to an office in the United 
States unless the income from such sale is subject to foreign 
tax at some minimal level. Under present law, a similar rule 
applies in the case of certain sales by a U.S. person of 
personal property (other than inventory property) attributable 
to an office or other fixed place of business outside the 
United States; such income is sourced outside the United 
States, but only if a foreign income tax of at least 10 percent 
is paid with respect to such income.

7. Modify controlled foreign corporation exemption from U.S. tax on 
        transportation income

                              Present Law

    The United States generally imposes a 4-percent tax on the 
U.S.-source gross transportation income of foreign persons that 
is not effectively connected with the foreign person's conduct 
of a U.S. trade or business (sec. 887). Foreign persons 
generally are subject to U.S. tax at regular graduated rates on 
net income, including transportation income, that is 
effectively connected with a U.S. trade or business (secs. 
871(b) and 882).
    Transportation income is any income derived from, or in 
connection with, the use (or hiring or leasing for use) of a 
vessel or aircraft (or a container used in connection 
therewith) or the performance of services directly related to 
such use (sec. 863(c)(3)). Income attributable to 
transportation that begins and ends in the United States is 
treated as derived from sources in the United States (sec. 
863(c)(1)). Transportation income attributable to 
transportation that either begins or ends (but not both) in the 
United States is treated as derived 50 percent from U.S. 
sources and 50 percent from foreign sources (sec. 863(c)(2)). 
U.S.-source transportation income is treated as effectively 
connected with a foreign person's conduct of a U.S. trade or 
business only if the foreign person has a fixed place of 
business in the United States that is involved in the earning 
of such income and substantially all of such income of the 
foreign person is attributable to regularly scheduled 
transportation (sec. 887(b)(4)).
    An exemption from U.S. tax is provided for income derived 
by a nonresident alien individual or foreign corporation from 
the international operation of a ship or aircraft, provided 
that the foreign country in which such individual is resident 
or such corporation is organized grants an equivalent exemption 
to individual residents of the United States or corporations 
organized in the United States (secs. 872(b)(1) and (2) and 
883(a)(1) and (2)). In the case of a foreign corporation, this 
exemption does not apply if 50 percent or more of the stock of 
the foreign corporation by value is owned by individuals who 
are not residents of a country that provides such an exemption 
unless the foreign corporation satisfies one of two alternative 
tests (sec. 883(c)). Under these alternative tests, the 
exemption applies to a foreign corporation without regard to 
the residence of the corporation's shareholders either if the 
foreign corporation is a controlled foreign corporation (a 
``CFC'') or if the stock of the corporation is primarily and 
regularly traded on an established securities market in the 
United States or in a foreign country that provides an 
equivalent exemption. Accordingly, the exemption for 
transportation income applies to any CFC formed in a country 
that provides an equivalent exemption, regardless of whether 
the owners of the stock of the CFC are residents of such a 
country.
    A foreign corporation is a CFC if U.S. persons own more 
than 50 percent of the corporation's stock (measured by vote or 
by value), taking into account only those U.S. persons that own 
at least 10 percent of the stock (measured by vote only) (secs. 
957 and 951(b)). For this purpose, a U.S. partnership is 
considered a U.S. person (secs. 957(c) and 7701(a)(30)). The 
U.S. 10-percent shareholders of a CFC are required to include 
in income currently for U.S. tax purposes their pro rata shares 
of certain income of the CFC and their pro rata shares of the 
CFC's earnings invested in U.S. property (sec. 951).

                        Description of Proposal

    The proposal would modify the provision under which a CFC 
organized in a country that provides an equivalent exemption is 
eligible for the exemption from U.S. tax for transportation 
income without regard to the residence of the shareholders of 
the CFC. Under the proposal, a CFC would qualify for this 
exemption only if the CFC is more than 50-percent owned by U.S. 
shareholders that are individuals or corporations. A CFC that 
does not satisfy this test would be eligible for the exemption 
for transportation income only if it satisfies either the 
requirement as to the residence of its shareholders or the 
public trading test of present law.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to prevent the use of the CFC test 
by foreign persons that are not residents of a country that 
grants an equivalent exemption to obtain the benefit of the 
exemption from U.S. tax for transportation income. Under 
present law, if 50 percent or more of the stock of a foreign 
corporation is owned by individuals who are residents of 
countries that do not provide an equivalent exemption, such 
foreign corporation generally is not eligible for the exemption 
from U.S. tax for transportation income (even though the 
corporation is itself organized in an equivalent exemption 
country). However, if such persons hold the stock of the 
foreign corporation through a U.S. partnership, the corporation 
will constitute a CFC and therefore under present law will 
qualify for the exemption. The proposal would prevent this 
result and would permit CFCs to qualify for the exemption from 
U.S. tax for transportation income only if U.S. persons subject 
to U.S. tax (i.e., individuals or corporations) own more than 
50 percent of the stock of the CFC.
    The proposal could give rise to double taxation in certain 
circumstances. The U.S. 10-percent shareholders of a CFC are 
required to include in income currently their pro rata shares 
of certain income of the CFC, including certain shipping 
income. Under the proposal, a CFC that does not satisfy the 
ownership requirements set forth in the proposal would not be 
eligible for an exemption from the U.S. 4-percent tax on 
transportation income. Thus, income of such a CFC would be 
subject to the U.S. 4-percent tax at the CFC-level and also 
could be includible in the incomes, and therefore subject to 
U.S. tax, of any U.S. 10-percent shareholders. It should be 
noted that the same potential for double taxation could occur 
under present law in the case of a CFC organized in a foreign 
country that does not grant an equivalent exemption.

                      G. Administrative Provisions

1. Increased information reporting penalties

                              Present Law

    Any person who fails to file a correct information return 
with the IRS on or before the prescribed filing date is subject 
to a penalty that varies based on when, if at all, the correct 
information return is filed. If a person files a correct 
information return after the prescribed filing date but on or 
before the date that is 30 days after the prescribed filing 
date, the penalty is $15 per return, with a maximum penalty of 
$75,000 per calendar year. If a person files a correct 
information return after the date that is 30 days after the 
prescribed filing date but on or before August 1 of that year, 
the penalty is $30 per return, with a maximum penalty of 
$150,000 per calendar year. If a correct information return is 
not filed on or before August 1, the amount of the penalty is 
$50 per return, with a maximum penalty of $250,000 per calendar 
year.
    There is a special rule for de minimis failures to include 
the required, correct information. This exception applies to 
incorrect information returns that are corrected on or before 
August 1. Under the exception, if an information return is 
originally filed without all the required information or with 
incorrect information and the return is corrected on or before 
August 1, then the original return is treated as having been 
filed with all of the correct required information. The number 
of information returns that may qualify for this exception for 
any calendar year is limited to the greater of (1) 10 returns 
or (2) one-half of one percent of the total number of 
information returns that are required to be filed by the person 
during the calendar year.
    In addition, there are special, lower maximum levels for 
this penalty for small businesses. For this purpose, a small 
business is any person having average annual gross receipts for 
the most recent three taxable years ending before the calendar 
year that do not exceed $5 million. The maximum penalties for 
small businesses are: $25,000 (instead of $75,000) if the 
failures are corrected on or before 30 days after the 
prescribed filing date; $50,000 (instead of $150,000) if the 
failures are corrected on or before August 1; and $100,000 
(instead of $250,000) if the failures are not corrected on or 
before August 1.
    If a failure to file a correct information return with the 
IRS is due to intentional disregard of the filing requirement, 
the penalty for each such failure is generally increased to the 
greater of $100 or ten percent of the amount required to be 
reported correctly, with no limitation on the maximum penalty 
per calendar year (sec. 6721(e)). The increase in the penalty 
applies regardless of whether a corrected information return is 
filed, the failure is de minimis, or the person subject to the 
penalty is a small business.

                        Description of Proposal

    The proposal would increase the penalty for failure to file 
information returns correctly on or before August 1 from $50 
for each return to the greater of $50 or 5 percent of the 
amount required to be reported correctly but not so reported. 
The $250,000 maximum penalty for failure to file correct 
information returns during any calendar year ($100,000 with 
respect to small businesses) would continue to apply under the 
proposal.
    The proposal also would provide for an exception to this 
increase where substantial compliance has occurred. The 
proposal would provide that this exception would apply with 
respect to a calendar year if the aggregate amount that is 
timely and correctly reported for that calendar year is at 
least 97 percent of the aggregate amount required to be 
reported under that section of the Code for that calendar year. 
If this exception applies, the present-law penalty of $50 for 
each return would continue to apply.
    The proposal would not affect the following provisions of 
present law: (1) the reduction in the $50 penalty where 
correction is made within a specified period; (2) the exception 
for de minimis failures; (3) the lower limitations for persons 
with gross receipts of not more than $5,000,000; (4) the 
increase in the penalty in cases of intentional disregard of 
the filing requirement; (5) the penalty for failure to furnish 
correct payee statements under section 6722; (6) the penalty 
for failure to comply with other information reporting 
requirements under section 6723; and (7) the reasonable cause 
and other special rules under section 6724.

                             Effective Date

    The proposal would apply to information returns the due 
date for which (without regard to extensions) is more than 90 
days after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal.

                                Analysis

    Some of the information returns subject to this proposed 
increased penalty report amounts that are income, such as 
interest and dividends. Other information returns subject to 
this proposed increased penalty report amounts that are gross 
proceeds. 188 Imposing the penalty as a percentage 
of the amount required to be reported might be viewed as 
disproportionately affecting businesses that file information 
returns reporting gross proceeds.
---------------------------------------------------------------------------
    \188\ Gross proceeds reports are useful to indicate that a 
potentially income-producing event has occurred, even though the amount 
reported on the information return bears no necessary relationship to 
the amount of income utlimately reported on the income tax return.
---------------------------------------------------------------------------

2. Modify the substantial understatement penalty for large corporations

                              Present Law

    A 20-percent penalty applies to any portion of an 
underpayment of income tax required to be shown on a return 
that is attributable to a substantial understatement of income 
tax. For this purpose, an understatement is considered 
``substantial'' if it exceeds the greater of (1) 10 percent of 
the tax required to be shown on the return, and (2) $5,000 
($10,000 in the case of a corporation other than an S 
corporation or a personal holding company). Generally, the 
amount of an ``understatement'' of income tax is the excess of 
the tax required to be shown on the return, over the tax shown 
on the return (reduced by any rebates of tax). The substantial 
understatement penalty does not apply if there was a reasonable 
cause for the understatement and the taxpayer acted in good 
faith with respect to the understatement (the ``reasonable 
cause exception''). The determination as to whether the 
taxpayer acted with reasonable cause and in good faith is made 
on a case-by-case basis, taking into account all pertinent 
facts and circumstances.

                        Description of Proposal

    The proposal would treat a corporation's deficiency of more 
than $10 million as substantial for purposes of the substantial 
understatement penalty, regardless of whether it exceeds 10 
percent of the taxpayer's total tax liability.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal.

                                Analysis

    Opponents might argue that altering the present-law penalty 
to make it apply automatically to large corporations might be 
viewed as violating the policy basis for this penalty, which is 
to punish an understatement that is substantial or material in 
the context of the taxpayer's own tax return. Proponents might 
respond that a deficiency of more that $10 million is material 
in and of itself, regardless of the proportion it represents of 
that taxpayer's total tax return.

3. Repeal exemption for withholding on gambling winnings from bingo and 
        keno in excess of $5,000

                              Present Law

    In general, proceeds from a wagering transaction are 
subject to withholding at a rate of 28 percent if the proceeds 
exceed $5,000 and are at least 300 times as large as the amount 
wagered. The proceeds from a wagering transaction are 
determined by subtracting the amount wagered from the amount 
received. Any non-monetary proceeds that are received are taken 
into account at fair market value.
    In the case of sweepstakes, wagering pools, or lotteries, 
proceeds from a wager are subject to withholding at a rate of 
28 percent if the proceeds exceed $5,000, regardless of the 
odds of the wager.
    No withholding tax is imposed on winnings from bingo or 
keno.

                        Description of Proposal

    The proposal would impose withholding on proceeds from 
bingo or keno wagering transactions at a rate of 28 percent if 
such proceeds exceed $5,000, regardless of the odds of the 
wager.

                             Effective Date

    The proposal would be effective for payments made after the 
beginning of the first month that begins at least 10 days after 
the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 budget proposal.

                                Analysis

    It is generally believed that imposing withholding on 
winnings from bingo and keno will improve tax compliance and 
enforcement.

4. Modify the deposit requirement for Federal unemployment (``FUTA'') 
        taxes

                              Present Law

    If an employer's liability for Federal unemployment 
(``FUTA'') taxes is over $100 for any quarter, it must be 
deposited by the last day of the first month after the end of 
the quarter. Smaller amounts are subject to less frequent 
deposit rules.

                        Description of Proposal

    The proposal would require an employer to pay Federal and 
State unemployment taxes on a monthly basis in a given year if 
the employer's FUTA tax liability in the prior year was $1,100 
or more. The deposit with respect to wages paid during a month 
would be required to be made by the last day of the following 
month. A safe harbor would be provided for the required 
deposits for the first two months of each calendar quarter. For 
the first month in each quarter, the payment would be required 
to be the lesser of 30 percent of the actual FUTA liability for 
the quarter or 90 percent of the actual FUTA liability for the 
month. The cumulative deposits paid in the first two months of 
each quarter would be required to be the lesser of 60 percent 
of the actual FUTA liability for the quarter or 90 percent of 
the actual FUTA liability for the two months. The employer 
would be required to pay the balance of the actual FUTA 
liability for each quarter by the last day of the month 
following the quarter. States would be required to establish a 
monthly deposit mechanism but would be permitted to adopt a 
similar safe harbor mechanism for paying State unemployment 
taxes.

                             Effective Date

    The proposal would be effective for months beginning after 
December 31, 2003.

                              Prior Action

    A substantially similar proposal was included in the 
President's fiscal year 1998 budget proposal.

                                Analysis

    Proponents of the proposal argue that the new deposit 
requirements will: (1) provide a regular inflow of money to 
State funds to offset the regular payment of benefits; and (2) 
reduce losses to the Federal unemployment trust funds caused by 
employer delinquencies. Opponents respond that the State trust 
funds already have sufficient funds for the payment of benefits 
and find no evidence that more frequent deposits reduce 
employer delinquencies. Further, opponents contend that the 
proposal's administrative burden significantly outweighs its 
benefits.

5. Clarify and expand mathematical error procedures

                              Present Law

Taxpayer identification numbers (``TIN''s)

    The Internal Revenue Service (``IRS'') may deny a personal 
exemption for a taxpayer, the taxpayer's spouse or the 
taxpayer's dependents if the taxpayer fails to provide a 
correct TIN for each person for whom the taxpayer claims an 
exemption. This TIN requirement also indirectly effects other 
tax benefits currently conditioned on a taxpayer being able to 
claim a personal exemption for a dependent (e.g., head-of-
household filing status and the dependent care credit). Other 
tax benefits, including the adoption credit, the child tax 
credit, the Hope Scholarship credit and Lifetime Learning 
credit, and the earned income credit also have TIN 
requirements. For most individuals, their TIN is their Social 
Security Number (``SSN''). The mathematical and clerical error 
procedure currently applies to the omission of a correct TIN 
for purposes of personal exemptions and all of the credits 
listed above except for the adoption credit.

Mathematical or clerical errors

    The IRS may summarily assess additional tax due as a result 
of a mathematical or clerical error without sending the 
taxpayer a notice of deficiency and giving the taxpayer an 
opportunity to petition the Tax Court. Where the IRS uses the 
summary assessment procedure for mathematical or clerical 
errors, the taxpayer must be given an explanation of the 
asserted error and a period of 60 days to request that the IRS 
abate its assessment. The IRS may not proceed to collect the 
amount of the assessment until the taxpayer has agreed to it or 
has allowed the 60-day period for objecting to expire. If the 
taxpayer files a request for abatement of the assessment 
specified in the notice, the IRS must abate the assessment. Any 
reassessment of the abated amount is subject to the ordinary 
deficiency procedures. The request for abatement of the 
assessment is the only procedure a taxpayer may use prior to 
paying the assessed amount in order to contest an assessment 
arising out of a mathematical or clerical error. Once the 
assessment is satisfied, however, the taxpayer may file a claim 
for refund if he or she believes the assessment was made in 
error.

                        Description of Proposal

    The proposal would provide in the application of the 
mathematical and clerical error procedure that a correct TIN is 
a TIN that was assigned by the Social Security Administration 
(or in certain limited cases, the IRS) to the individual 
identified on the return. For this purpose the IRS would be 
authorized to determine that the individual identified on the 
tax return corresponds in every aspect (including, name, age, 
date of birth, and SSN) to the individual to whom the TIN is 
issued. The IRS would be authorized to use the mathematical and 
clerical error procedure to deny eligibility for the dependent 
care tax credit, the child tax credit, and the earned income 
credit even though a correct TIN has been supplied if the IRS 
determines that the statutory age restrictions for eligibility 
for any of the respective credits is not satisfied (e.g., the 
TIN issued for the child claimed as the basis of the child tax 
credit identifies the child as over the age of 17 at the end of 
the taxable year).

                             Effective Date

    The proposal would be effective for taxable years ending 
after the date of enactment.

                              Prior Action

    The Small Business Job Protection Act of 1996 extended the 
mathematical and clerical error procedure to the omission of a 
correct TIN for personal exemptions and therefore indirectly to 
other tax benefits which are currently conditioned on the 
taxpayer being able to claim a personal exemption for a 
dependent (e.g., head-of-household status and the dependent 
care tax credit). The Taxpayer Relief Act of 1997 extended the 
mathematical and clerical error procedure to the omission of a 
correct TIN for the child tax credit and the Hope Scholarship 
credit and Lifetime Learning tax credits.

                                Analysis

    One argument in favor of the proposal is that treating age 
discrepancies as evidence of an incorrect TIN and applying the 
mathematical and clerical error procedure will increase 
compliance with the Internal Revenue Code. Also, in the case of 
the refundable earned income credit, the proposals will reduce 
the amount of erroneously large refunds in excess of tax 
liability sent to taxpayers and ease the IRS burden in trying 
to recoup the erroneous portion of the refund from lower-income 
taxpayers. One response to the proposal is that the IRS already 
has general regulatory authority to implement it. Others 
question whether the IRS has the ability to apply these new 
proposals without incorrectly denying tax benefits to some 
taxpayers.

               H. Real Estate Investment Trust Provisions

1. Freeze grandfathered status of stapled or paired-share REITs

                              Present Law

In general

    A real estate investment trust (``REIT'') is an entity that 
receives most of its income from passive real estate related 
investments and that essentially receives pass-through 
treatment for income that is distributed to shareholders. If an 
electing entity meets the qualifications for REIT status, the 
portion of its income that is distributed to the investors each 
year generally is taxed to the investors without being 
subjected to a tax at the REIT level. If an entity qualifies as 
a REIT by satisfying the various requirements described below, 
the entity is taxable as a corporation on its real estate 
investment trust taxable income (``REITTI'') and on certain 
other amounts. REITTI is the taxable income of the REIT with 
certain adjustments, the most significant of which is a 
deduction for dividends paid. The allowance of this deduction 
is the mechanism by which the REIT becomes a pass-through 
entity for Federal income tax purposes.
    In general, a REIT must derive its income from passive 
sources and not engage in any active trade or business. 
Accordingly, in addition to the tax on its REITTI, a 100-
percent tax is imposed on the net income of a REIT from 
``prohibited transactions'' (sec. 857(b)(6)). A prohibited 
transaction is the sale or other disposition of property held 
for sale in the ordinary course of a trade or business other 
than certain foreclosure property.

Requirements for REIT status

    A REIT must satisfy a number of tests on a year-by-year 
basis that relate to the entity's: (1) organizational 
structure; (2) source of income; (3) nature of assets; and (4) 
distribution of income. These tests are intended to allow pass-
through treatment only if there really is a pooling of 
investment arrangement, if the entity's investments are 
basically in real estate assets, and if its income is passive 
income from real estate investment, as contrasted with income 
from the operation of a business involving real estate. In 
addition, substantially all of the entity's income must be 
passed through to its shareholders on a current basis.
    Under the organizational structure tests, a REIT must be 
for its entire taxable year a corporation or an unincorporated 
trust or association that would be taxable as a domestic 
corporation but for the REIT provisions, and must be managed by 
one or more trustees (sec. 856(a)). The beneficial ownership of 
the entity must be evidenced by transferable shares or 
certificates of ownership. Except for the first taxable year 
for which an entity elects to be a REIT, the beneficial 
ownership of the entity must be held by 100 or more persons.
    Under the source-of-income tests, at least 95 percent of 
its gross income generally must be derived from rents, 
dividends, interest and certain other passive sources. In 
addition, at least 75 percent of its income generally must be 
from real estate sources, including rents from real property.
    For purposes of these tests, rents from real property 
generally include charges for services customarily rendered in 
connection with the rental of real property, whether or not 
such charges are separately stated. Services provided to 
tenants are regarded as customary if, in the geographic market 
within which the building is located, tenants in buildings that 
are of a similar class (for example, luxury apartment 
buildings) are customarily provided with the service. Where a 
REIT furnishes non-customary services to tenants, amounts 
received generally are not treated as qualifying rents unless 
the services are furnished through an independent contractor 
(sec. 856(d)(2)(C)). In general, an independent contractor is a 
person who does not own more than a 35-percent interest in the 
REIT (sec. 856(d)(3)(A)), and in which no more than a 35-
percent interest is held by persons with a 35-percent or 
greater interest in the REIT (sec. 856(d)(3)(B)).
    The requirements relating to the nature of the REIT's 
assets includes a rule mandating that, at the close of each 
quarter of its taxable year, at least 75 percent of the value 
of the entity's assets be invested in real estate assets, cash 
and cash items, and government securities (sec. 856(c)(5)(A)).
    The income distribution requirement provides generally that 
at least 95 percent of a REIT's income (with certain minor 
exceptions) must be distributed to shareholders as dividends 
(sec. 857(a)).

Stapled REITs

    In a stapled REIT structure, both the shares of a REIT and 
a C corporation may be traded, often including public trading, 
but are subject to a provision that they may not be sold 
separately. Thus, the REIT and the C corporation have identical 
ownership at all times.
    In 1984, Congress became concerned that the net effect of a 
separate treatment of an active business stapled to a REIT is 
to eliminate the corporate tax on an active business. 
Accordingly, Congress adopted Code section 269B in the Deficit 
Reduction Act of 1984 (the ``1984 Act''). The provision 
relevant to REITs requires that in applying the tests for REIT 
status, all stapled entities are treated as one entity (sec. 
269B(a)(3)). This provision generally was effective upon 
enactment. However, the 1984 Act included grandfather rules, 
one of which provided that certain stapled REITs were not 
subject to the new provision (sec. 136(a)(2) of the 1984 Act). 
The rule provided that the new provision did not apply to a 
REIT that was a part of a group of stapled entities if the 
group of entities was stapled on June 30, 1983, and included a 
REIT on that date.

                        Description of Proposal

    The proposal would limit the tax benefits of the existing 
stapled REITs that qualify under the 1984 Act's grandfather 
rules. Under the proposal, the general rules treating the REIT 
and the stapled C corporation as a single entity for purposes 
of the REIT qualification tests (sec. 269B) would be applied to 
properties acquired by grandfathered entities on or after the 
effective date and activities or services relating to such 
properties performed on or after the effective date.

                             Effective Date

    The proposal would be effective as of the date of first 
committee action.

                              Prior Action

    No prior action.

                                Analysis

    In a stapled REIT structure, the shares of a REIT are 
stapled to a C corporation that operates an active business. 
The REIT holds real estate assets used in the C corporation's 
business, which it rents to the C corporation. The goal of a 
stapled REIT structure is to achieve a single level of tax on 
the part of a corporation's income that is attributable to the 
return on its real estate assets, often where that corporation 
is publicly-traded. A corporation operating a business cannot 
itself meet the requirements for REIT status, especially the 
rule that at least 95 percent of a REIT's gross income must be 
from real property rents and other passive sources (sec. 
856(c)(2)). A publicly-traded corporation generally cannot 
qualify for pass-through treatment as a partnership (sec. 
7704). Thus, absent a stapled REIT or similar structure, all of 
the income of a publicly-traded corporation is subject to both 
income tax at the corporate level and tax at the shareholder 
level when dividends or liquidation proceeds are paid.
    For stapled REITs that are grandfathered under the 1984 
Act, the structure allows an amount of the C corporation's 
income equal to the rent paid to the REIT for assets used in 
the C corporation's business to be excluded from corporate-
level taxation. The C corporation claims a deduction for the 
rent paid. Although the rental income is taxed to the REIT's 
shareholders, who also are the C corporation's shareholders, 
the corporate tax on this income has been eliminated.
    The 1984 Act generally prevents these benefits by treating 
the REIT and the stapled C corporation as one entity for 
purposes of the tests for REIT qualification. In many 
situations, combining the activities of the C corporation and 
the REIT would cause all income attributable to a property to 
be treated as other than rents from real property. This could 
cause a violation of the 95-percent gross-income test, 
resulting in disqualification of the REIT. Thus, the REIT would 
be treated as a C corporation.
    A small number of stapled REITs which are still in 
existence are excepted from the 1984 Act's changes under the 
grandfather rule. These entities thus continue to derive the 
benefits of the stapled REIT structure that the 1984 Act rules 
generally prevent. Recently, some of these grandfathered 
stapled REITs have engaged in acquisitions of real estate 
assets worth billions of dollars. 189 Moreover, some 
of the grandfathered REITs have been acquired by new owners who 
have changed their lines of business and vastly increased their 
assets. 190
---------------------------------------------------------------------------
    \189\ ``Hiltons They Aren't; 2 Guys In a Hurry,'' The New York 
Times, September 7, 1997, sec. 3, p. 1.
    \190\ ``Pavlovian Capitalists; Stapled REITs,'' The Wall Street 
Journal, April 17, 1997, p. C1.
---------------------------------------------------------------------------
    It can be argued that this grandfather rule, like similar 
transition rules, was probably provided with the intent of 
preventing the application of the new rules to some entities 
already in existence, the owners of which had made large 
investments based on the assumption that the tax benefits of 
the structure would continue to be available. However, it can 
be argued that Congress did not intend that the grandfathered 
REITs would engage in large-scale acquisitions of assets or 
that new owners would acquire the grandfathered REITs in order 
to utilize their grandfathered status for different businesses. 
Furthermore, the ability of the current grandfathered REITs to 
utilize the benefits of their grandfathered status for new 
asset acquisitions raises concerns of competitiveness. Because 
other publicly traded entities that engage in businesses 
involving real estate are taxed as corporations and, thus, are 
subject to two levels of tax, they probably must charge higher 
prices in order to obtain a comparable economic rate of after-
tax return on their assets.
    Particular aspects of the proposal may be criticized. For 
example, it may be considered unfair to apply the proposal to 
all new properties acquired by grandfathered entities. In 
addition, it is not clear what constitutes a ``property'' for 
purposes of the proposal. A new parking lot added to an 
existing structure would constitute separate property for some 
tax purposes (e.g., the depreciation rules). If the concept of 
a new property under the proposal is this expansive, the 
required allocations of income and activities could be onerous. 
Further, the application of the general rules for stapled REITs 
(i.e., combining the REIT and the stapled C corporation for 
purposes of the REIT qualification tests) only to specific 
properties of grandfathered REITs could be viewed as overly 
complicated or unfair. The proposal's approach appears to 
require a tracing of income to the business conducted by the C 
corporation with each new property acquired by the REIT. For 
example, such tracing would be required to apply the 95-percent 
gross income test to the combined entities. On the other hand, 
any complexity arising the proposal is limited to a small 
number of taxpayers who derive a benefit not available to other 
taxpayers.
    Finally, it is unclear whether the proposal would apply to 
properties acquired by the REIT prior to the effective date but 
leased to the C corporation thereafter.

2. Restrict impermissible businesses indirectly conducted by REITs

                              Present Law

    In general, a real estate investment trust (``REIT'') is an 
entity that receives most of its income from passive real 
estate related investments and that receives pass-through 
treatment for income that is distributed to shareholders. If an 
electing entity meets the qualifications for REIT status, the 
portion of its income that is distributed to the investors each 
year generally is taxed to the investors without being 
subjected to tax at the REIT level.
    A REIT must satisfy a number of tests on a year-by-year 
basis that relate to the entity's: (1) organizational 
structure; (2) source of income; (3) nature of assets; and (4) 
distribution of income.
    To satisfy the REIT asset requirements, at the close of 
each quarter of its taxable year, an entity must have at least 
75 percent of the value of its assets invested in real estate 
assets, cash and cash items, and government securities (sec. 
856(c)(5)(A)). Moreover, not more than 25 percent of the value 
of the REIT's assets can be invested in securities (other than 
government securities and other securities described in the 
preceding sentence). The securities of any one issuer may not 
comprise more than five percent of the value of a REIT's 
assets.
    Finally, the REIT may not own more than 10 percent of the 
outstanding securities of any one issuer, determined by voting 
power (sec. 856(c)(4)(B)).
    A REIT is permitted to have a wholly-owned subsidiary 
subject to certain restrictions. A REIT's subsidiary is treated 
as one with the REIT (sec. 856(i)).

                        Description of Proposal

    The proposal would prohibit a REIT from holding more than 
10 percent of the outstanding stock of any one issuer, 
determined by either vote or value.

                             Effective Date

    The proposal would be effective with respect to stock 
acquired on or after the date of first committee action. Stock 
acquired before such date would become subject to the proposal 
when the corporation in which stock is owned engages in a trade 
or business in which it does not engage on the date of first 
committee action or if the corporation acquires substantial new 
assets on or after such date.

                              Prior Action

    No prior action.

                                Analysis

    The 10-percent limitation on a REIT's ownership of the 
stock of any one issuer arguably is consistent with several 
other requirements for REIT status that prevent the REIT from 
engaging in an active business, as opposed to passive real 
estate investments. If a REIT owns a majority or even a 
substantial minority position in a corporation that engages in 
an active business, the REIT could in effect conduct an active 
business indirectly through such corporation, although the REIT 
would be prohibited from conducting such a business directly.
    The present-law rule that a REIT may not own more than 10 
percent of the voting securities of any one issuer could be 
viewed as insufficient to prevent a REIT from having a 
substantial interest in an active trade or business. Because 
only voting securities are counted, a REIT can own a large 
interest in the value and income of a corporation, provided the 
REIT has a 10-percent-or-less voting interest. Apparently, some 
REITs may have acquired large interests in the income and value 
of corporations conducting real estate development or 
management businesses, which the REIT could not conduct itself, 
by using preferred stock structures that do not violate the 
more-than-10-percent voting securities test. In some instances, 
the employees and officers of the corporation owned also may be 
employees and officers of the REIT. By comparison, other tax 
rules that depend on ownership of a threshold level of stock 
have adopted a test based on percentage of vote or value 
similar to that of the proposal (e.g., secs. 355(d)(4) and 
sec.957(a)).
    Opponents of the proposal would argue that it adds 
complexity and in some cases would cause unfair results. 
Because the proposal would prevent a REIT from having a 
greater-than-10-percent stock interest by vote or value, it 
would be possible that a REIT investing primarily in preferred 
stock of a corporation would not violate this test at the time 
the stock was acquired, but subsequently would violate it due 
to a decline in the corporation's value. Additional complexity 
would arise from the requirement of monitoring the value of 
shares.

3. Modify treatment of closely held REITs

                              Present Law

    In general, a real estate investment trust (``REIT'') is an 
entity that receives most of its income from passive real 
estate related investments and that receives pass-through 
treatment for income that is distributed to shareholders. If an 
electing entity meets the qualifications for REIT status, the 
portion of its income that is distributed to the investors each 
year generally is taxed to the investors without being 
subjected to tax at the REIT level.
    A REIT must satisfy a number of tests on a year-by-year 
basis that relate to the entity's: (1) organizational 
structure; (2) source of income; (3) nature of assets; and (4) 
distribution of income.
    Under the organizational structure test, except for the 
first taxable year for which an entity elects to be a REIT, the 
beneficial ownership of the entity must be held by 100 or more 
persons. Generally, no more than 50 percent of the value of the 
REIT's stock can be owned by five or fewer individuals during 
the last half of the taxable year. Certain attribution rules 
apply in making this determination.

                        Description of Proposal

    The proposal would impose as an additional requirement for 
REIT qualification that no person can own stock of a REIT 
possessing more than 50 percent of the combined voting power of 
all classes of voting stock or more than 50 percent of the 
total value of shares of all classes of stock. For purposes of 
determining a person's stock ownership, rules similar to 
attribution rules for REIT qualification under present law 
would apply (sec. 856(d)(5)).

                             Effective Date

    The proposal would be effective for entities electing REIT 
status for taxable years beginning on or after the date of 
first committee action.

                              Prior Action

    No prior action.

                                Analysis

    REITs allow individual investors to obtain a single level 
of tax on passive real estate investments, often in publicly-
traded entities. Present law requires that ownership interests 
must be held by at least 100 persons and that 5 or fewer 
individuals cannot own more than 50 percent of the value of the 
REIT. These ownership requirements indicate that Congress 
intended that REIT benefits not be available to closely-held 
entities. A REIT held largely by a single corporation does not 
meet this objective of Congress.
    It is clear that, under present law, it is unnecessary for 
a corporation to establish a separate real estate entity as a 
REIT in order to insure that there is a single corporate level 
tax. If the separate entity is a corporation, the dividends-
received deduction and the benefits of consolidation can 
eliminate a second corporate tax. If the separate entity is a 
non-publicly-traded partnership or limited liability company, 
only one level of tax is imposed. The REIT rules were enacted 
earlier than most of the rules for other pass-through regimes 
and lack some of the more sophisticated rules of such regimes 
aimed at preventing unwarranted shareholder benefits. For 
example, the REIT rules contain no provisions to prevent REIT 
shareholders from structuring their interests in order to 
divide the income from the REIT's assets among themselves in a 
tax-motivated manner (cf. secs. 704(b) and (c) and 
1361(b)(1)(D)). Consequently, where REIT status is elected by 
an entity with a substantial corporate shareholder, a principal 
reason may be to take advantage of deficiencies in the REIT 
rules that have been the basis for several recently reported 
tax-motivated transactions.
    Congress may have believed that improper use of the REIT 
rules was limited by the restrictions on REIT ownership. The 
100-or-more shareholder requirement, and the rule that no more 
than 50 percent of the value of the REIT's stock can be owned 
by five or fewer individuals, generally require that REIT stock 
be widely held, with the result that it is less likely that 
shareholders will be able to agree on a structure designed to 
yield tax benefits for certain shareholders. However, present 
law does not contain a provision prohibiting ownership of large 
amounts of a REIT's stock by one or a few corporations.
    Several recent transactions have utilized REITs to obtain 
tax benefits for large corporate shareholders. In such 
transactions, the requirement that the REIT have 100 or more 
shareholders often may be met by having related persons (such 
as employees of the majority holder) acquire small amounts of 
stock. The most well-known of these has been the so-called 
``step-down preferred'' transaction. In such a transaction, the 
REIT issues a class of preferred stock that pays 
disproportionately high dividends in the REIT's early years and 
``steps down'' to disproportionately low dividends in later 
years. Such stock may be sold to a tax-exempt entity. One or 
more corporate shareholders hold the REIT's common stock and 
are in effect compensated for the preferred's dividend rights 
in the early years by the right to higher payments on, or 
liquidation proceeds with respect to, the common stock after 
the preferred dividends ``step down.'' These corporate 
shareholders generally fund the high dividends paid to the 
preferred shareholders by making deductible rent payments to 
the REIT for real property it leases to the corporate 
shareholders. 191
---------------------------------------------------------------------------
    \191\ Cf. IRS Notice 97-21, 1997-11 I.R.B. 9, which denies the 
benefits of a step-down preferred transaction based on a conduit 
analysis.
---------------------------------------------------------------------------
    By preventing a shareholder from owning a greater-than-50-
percent interest in the REIT, the proposal would substantially 
reduce the ability of a single shareholder or a small group of 
shareholders to utilize a REIT to achieve tax benefits based on 
their individual tax situations. However, the proposal may not 
prevent such structures entirely. For example, it still might 
be possible under the proposal for three corporations to 
acquire nearly all of the REIT's shares (with additional small 
shareholders to meet the 100-shareholder test).
    Opponents of the provision would argue that it adds 
complexity and in some cases would prevent legitimate business 
transactions. Because the proposal would prevent one 
shareholder from having a greater-than-50-percent interest by 
vote or value, it would be possible that a shareholder who 
initially did not violate this test subsequently may violate it 
due to a decline in the REIT's value. Under the proposal, the 
REIT apparently would become disqualified at such time. 
Similarly, the proposal could prevent a REIT's organizers from 
having a single large investor for a temporary period, such as 
in preparation for a public offering of the REIT's shares. 
Finally, the proposal may be criticized for adding complexity 
to the already complex REIT rules. For example, individual 
shareholders apparently would be subject to the proposal even 
though they also are subject to the present-law rule preventing 
five or fewer shareholders from owning 50 percent or more of a 
REIT's shares by value.

             I. Earned Income Credit Compliance Provisions

1. Simplification of foster child definition under the earned income 
        credit

                              Present law

    For purposes of the earned income credit (``EIC'), 
qualifying children may include foster children who reside with 
the taxpayer for a full year, if the taxpayer ``cares for the 
foster children as the taxpayer's own children.'' (Code sec. 
32(c)(3)(B)(iii)(I)). All EIC qualifying children (including 
foster children) must either be under the age of 19 (24 if a 
full-time student) or permanently and totally disabled. There 
is no requirement that the foster child either be (1) placed in 
the household by a foster care agency or (2) a relative of the 
taxpayer.

                        Description of Proposal

    For purposes of the EIC, a foster child would be defined as 
a child who (1) is cared for by the taxpayer as if he or she 
were the taxpayer's own child, and (2) either is the taxpayer's 
niece, nephew, or sibling or was placed in the taxpayer's home 
by an agency of a State or one of its political subdivisions or 
by a tax-exempt child placement agency licensed by a State.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1998.

                              Prior Action

    A substantially similar proposal was included in a list of 
eight proposals to reduce errors on tax returns with respect to 
the EIC released by the Department of the Treasury on April 23, 
1997. 192
---------------------------------------------------------------------------
    \192\ A further discussion of these proposals can be found in the 
Joint Committee on Taxation document, Description of the 
Administration's Proposals Relating to the Earned Income Credit (JCX-
14-97), May 7, 1997.
---------------------------------------------------------------------------

                                Analysis

    Some advocates of this proposal contend that the element of 
present law which requires that a foster child be cared for by 
the taxpayer as the taxpayer's own child is open to intentional 
noncompliance by some taxpayers. They continue that the 
vagueness of this element of present law also creates a 
compliance burden on the IRS as well as the taxpayer. They 
believe that this proposal would: (1) reduce potential abuse by 
tax cheats; (2) prevent unintentional errors by confused 
taxpayers; and (3) provide better guidance to the IRS when 
investigating questionable EIC claims.
    Opponents respond that there are legitimate family living 
arrangements (e.g., care for a godchild) where a taxpayer 
deserves the EIC because the taxpayer is caring for the foster 
child even though that child meets neither the proposed 
familial relationship with the taxpayer, nor was formally 
placed with the taxpayer by an agency of the State or a tax-
exempt child placement agency licensed by the State. Further, 
they contend that this proposal does not reduce any ambiguity 
found in present law. Since the EIC requirement that the foster 
child be cared for by the taxpayer as the taxpayer's own child 
is retained for all foster children, both the IRS and taxpayers 
with foster children will still be required to interpret its 
meaning.

2. Clarify the operation of the earned income credit where more than 
        one taxpayer satisfies the requirements with respect to the 
        same child

                              Present law

In general

    In order to claim the earned income credit (``EIC'), an 
individual must be an eligible individual. To be an eligible 
individual, an individual must either have a qualifying child 
or meet other requirements. In order to claim the EIC without a 
qualifying child, an individual must not be a dependent and 
must be over age 24 and under age 65.

Qualifying child

    A qualifying child must meet a relationship test, an age 
test, an identification test, and a residence test. Under the 
relationship and age tests, an individual is eligible for the 
EIC with respect to another person only if that other person: 
(1) is a son, daughter, or adopted child (or a descendent of a 
son, daughter, or adopted child); a stepson or stepdaughter; or 
a foster child of the taxpayer (a foster child is defined as a 
person whom the individual cares for as the individual's child; 
it is not necessary to have a placement through a foster care 
agency 193); and (2) is under the age of 19 at the 
close of the taxable year (or is under the age of 24 at the end 
of the taxable year and was a full-time student during the 
taxable year), or is permanently and totally disabled. Also, if 
the qualifying child is married at the close of the year, the 
individual may claim the EIC for that child only if the 
individual may also claim that child as a dependent.
---------------------------------------------------------------------------
    \193\ See discussion in Part II.I.1., above, of this pamphlet 
relating to the President's proposal to simplify the foster child 
definition under the earned income credit.
---------------------------------------------------------------------------
    To satisfy the identification test, an individual must 
include on their tax return the name, age, and taxpayer 
identification number (``TIN'') of each qualifying child.
    The residence test requires that a qualifying child must 
have the same principal place of abode as the taxpayer for more 
than one-half of the taxable year (for the entire taxable year 
in the case of a foster child), and that this principal place 
of abode must be located in the United States. For purposes of 
determining whether a qualifying child meets the residence 
test, the principal place of abode shall be treated as in the 
United States for any period during which a member of the Armed 
Forces is stationed outside the United States while serving on 
extended active duty.

Tie-breaker rule

    If more than one taxpayer would be treated as an eligible 
individual with respect to the same qualifying child for a 
taxable year only the individual with the highest modified 
adjusted gross income (``modified AGI'') is treated as an 
eligible individual with respect to that child. For these 
purposes, modified AGI means AGI with certain losses 
disregarded and the addition of two items of nontaxable income. 
The losses disregarded are: (1) net capital losses (if greater 
than zero); (2) net losses from trusts and estates; (3) net 
losses from nonbusiness rents and royalties; and (4) 75 percent 
of the net losses from businesses, computed separately with 
respect to sole proprietorships (other than in farming), sole 
proprietorships in farming, and other businesses. The two items 
of nontaxable income added to AGI to determine modified AGI 
are: (1) tax-exempt interest; and (2) non-taxable distributions 
from pensions, annuities, and individual retirement accounts 
(but only if not rolled over into similar vehicles during the 
applicable rollover period).
    Historically, the Internal Revenue Service (``IRS'') has 
interpreted this tie-breaker rule to deny the EIC to other 
taxpayers meeting the definition of eligible individual 
regardless of whether the taxpayer with the highest modified 
AGI had claimed the EIC with respect to the child on the 
taxpayer's tax return. The Tax Court in Lestrange v. 
Commissioner, T.C.M. 1997-428 (1997) held that the tie-breaker 
rule does not apply to deny the EIC to a taxpayer unless 
another taxpayer actually claimed the EIC with respect to the 
child on the taxpayer's return. The Tax Court decision hinged 
on the determination that the child was not a qualifying child 
with respect to the taxpayer with the highest modified AGI 
because the identification test was not met by that taxpayer 
with respect to the child. Under this view, because the 
taxpayer with the highest modified AGI did not satisfy the 
qualifying child requirement, there was not more than one 
eligible individual and the tie-breaker rule did not apply.

                        Description of Proposal

    The proposal clarifies that the identification requirement 
is a requirement for claiming the EIC, rather than an element 
of the definition of ``qualifying child''. Thus, the tie-
breaker rule would apply where more than one individual 
otherwise could claim the same child as a qualifying child on 
their respective tax returns, regardless of whether the child 
is listed on any tax return. A similar change would be made to 
the definition of ``eligible individual''. No inference is 
intended as to the operation of the tie-breaker rule under 
present law.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                                Analysis

    Proponents of the clarification believe that it is 
necessary to provide the EIC efficiently and appropriately. 
They argue that the present-law rules including the residency 
test are simpler and more verifiable that the old support test. 
194 They continue that the tie-breaker is necessary 
in all cases where more than one taxpayer could claim the same 
qualifying child, to ensure that only needy taxpayers receive 
the EIC. For example, a taxpayer with a qualifying child should 
not qualify for the EIC if that taxpayer is sharing a household 
with the taxpayer's own higher-income parent. To allow these 
taxpayers to essentially elect out of the tie-breaker rule by 
failing to claim the child on the return of the higher-income 
parent would undermine Congressional intent with regards to the 
EIC.
---------------------------------------------------------------------------
    \194\ The Omnibus Budget Reconciliation Act of 1990 replaced the 
old EIC requirement that the taxpayer be eligible to claim a dependency 
exemption with the present-law rules. Generally, the dependency 
exemption requirement was not satisfied unless the taxpayer could 
establish that the taxpayer had provided over one-half of the cost of 
maintaining the household which included the child for the year.
---------------------------------------------------------------------------

                  J. Other Revenue-Increase Provisions

1. Repeal percentage depletion for non-fuel minerals mined on Federal 
        and formerly Federal lands

                              Present Law

    Taxpayers are allowed to deduct a reasonable allowance for 
depletion relating to the acquisition and certain related costs 
of mines or other hard mineral deposits. The depletion 
deduction for any taxable year is calculated under either the 
cost depletion method or the percentage depletion method, 
whichever results in the greater allowance for depletion for 
the year.
    Under the cost depletion method, the taxpayer deducts that 
portion of the adjusted basis of the property which is equal to 
the ratio of the units sold from that property during the 
taxable year, to the estimated total units remaining at the 
beginning of that year.
    Under the percentage depletion method, a deduction is 
allowed in each taxable year for a statutory percentage of the 
taxpayer's gross income from the property. The statutory 
percentage for gold, silver, copper, and iron ore is 15 
percent; the statutory percentage for uranium, lead, tin, 
nickel, tungsten, zinc, and most other hard rock minerals is 22 
percent. The percentage depletion deduction for these minerals 
may not exceed 50 percent of the net income from the property 
for the taxable year (computed without allowance for 
depletion). Percentage depletion is not limited to the 
taxpayer's basis in the property; thus, the aggregate amount of 
percentage depletion deductions claimed may exceed the amount 
expended by the taxpayer to acquire and develop the property.
    The Mining Law of 1872 permits U.S. citizens and businesses 
to freely prospect for hard rock minerals on Federal lands, and 
allows them to mine the land if an economically recoverable 
deposit is found. No Federal rents or royalties are imposed 
upon the sale of the extracted minerals. A prospecting entity 
may establish a claim to an area that it believes may contain a 
mineral deposit of value and preserve its right to that claim 
by paying an annual holding fee of $100 per claim. Once a 
claimed mineral deposit is determined to be economically 
recoverable, and at least $500 of development work has been 
performed, the claim holder may apply for a ``patent'' to 
obtain title to the surface and mineral rights. If approved, 
the claimant can obtain full title to the land for $2.50 or 
$5.00 per acre.

                        Description of Proposal

    The proposal would repeal the present-law percentage 
depletion provisions for non-fuel minerals extracted from any 
land where title to the land or the right to extract minerals 
from such land was originally obtained pursuant to the 
provisions of the Mining Law of 1872.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1997 and 1998 budget proposals.

                                Analysis

    The percentage depletion provisions generally can be viewed 
as providing an incentive for mineral production. The Mining 
Act of 1872 also provides incentives for mineral production by 
allowing claimants to acquire mining rights on Federal lands 
for less than fair market value. In cases where a taxpayer has 
obtained mining rights relatively inexpensively under the 
provisions of the Mining Act of 1872, it can be argued that 
such taxpayers should not be entitled to the additional 
benefits of the percentage depletion provisions. However, the 
Administration proposal would appear to repeal the percentage 
depletion provisions not only for taxpayers who acquired their 
mining rights directly from the Federal Government under the 
Mining Act of 1872, but also for those taxpayers who purchased 
such rights from a third party who had obtained the rights 
under the Mining Act of 1872. In cases where mining rights have 
been transferred to an unrelated party for full value since 
being acquired from the Federal Government (and before the 
effective date), there is little rationale for denying the 
benefits of the percentage depletion provisions to the taxpayer 
currently mining the property on the basis that the original 
purchaser obtained benefits under the Mining Act of 
1872.195
---------------------------------------------------------------------------
    \195\ The Administration has indicated that it may consider a 
transition rule that would address this issue.
---------------------------------------------------------------------------

2. Modify depreciation method for tax-exempt use property

                              Present Law

    Taxpayers are allowed to recover the cost of property used 
in a trade or business through annual depreciation deductions. 
The depreciation deductions for most tangible property are 
determined under the modified Accelerated Cost Recovery System 
(``MACRS'') of section 168.196
---------------------------------------------------------------------------
    \196\ The Tax Reform Act of 1986 installed MACRS as the successor 
system to the Accelerated Cost Recovery System (``ACRS''). ACRS 
generally provided more generous depreciation allowances than MACRS for 
property placed in service after 1980 and before 1987.
---------------------------------------------------------------------------
    Under MACRS, depreciation for tangible personal property is 
determined using accelerated methods over specified recovery 
periods that are generally shorter than the class lives of the 
property. Depreciation for real property is determined using 
the straight-line method over 27.5 years (for residential real 
property) or 39 years (for nonresidential real property). The 
class life of real property generally is 40 years, whether or 
not the property is residential.
    Accelerated depreciation under MACRS generally is 
unavailable for property that is (1) used predominantly outside 
the United States, (2) financed with tax-exempt bonds, or (3) 
leased to a tax-exempt entity (``tax-exempt use property''). 
For this purpose, a tax-exempt entity means (1) the United 
States, any State or political subdivision thereof, any 
possession of the United States, or any agency or 
instrumentality of any of the foregoing, (2) any organization 
exempt from tax (other than farmer's cooperatives), and (3) any 
foreign person or entity. Tax-exempt use property generally is 
depreciated using the straight-line method over a period equal 
to the greater of (1) the property's class life, or (2) 125 
percent of the lease term. 197 Property used 
predominantly outside the United States or financed with tax-
exempt bonds generally is depreciated using the straight-line 
method over the property's class life.
---------------------------------------------------------------------------
    \197\Special exemptions are provide for certain real property, 
qualified technological equipment, and property subject to a short-term 
lease.
---------------------------------------------------------------------------
    The class lives of property are periods that had been 
developed by the Treasury Department for purposes of computing 
depreciation allowances under prior law. Prior to the enactment 
of section 168 in 1981, depreciation deductions generally were 
determined based on the taxpayers' estimates of the useful 
lives of its depreciable property. Such a ``facts and 
circumstances'' system often led to disputes between taxpayers 
and the IRS as to the proper period over which depreciation 
should be computed. Class lives for different types of property 
were developed to give taxpayers safe harbors over which to 
depreciate such property.

                        Description of Proposal

    Tax-exempt use property would be depreciated using the 
straight-line method over a period equal to 150 percent of the 
class life of the property. The proposal would not affect the 
depreciation of property other than tax-exempt use property.

                             Effective Date

    The proposal would be effective for property placed in 
service after December 31, 1998. The proposal would also be 
effective for property that first becomes tax-exempt use 
property after December 31, 1998, or becomes subject to a new 
lease after that date.

                              Prior Action

    No prior action.

                                Analysis

    Theoretically, depreciation deductions for property would 
be most accurately determined by ``economic depreciation.'' 
Under economic depreciation, property is valued and ``marked-to 
market'' on an annual basis and any decrease in value from one 
year to the next is allowed as a depreciation deduction. 
Economic depreciation generally is conceded to be difficult to 
administer due to the case-by-case, annual valuations of each 
property that would be required. Because of these 
administrative difficulties and in order to provide an 
incentive to invest in tangible property, depreciation 
deductions generally have been determined under ACRS and MACRS 
since 1981. Depreciation allowances under ACRS and MACRS are 
determined pursuant to statutorily mandated schedules that 
often are more generous than the depreciation allowances 
determined under economic depreciation.
    The purpose of the special depreciation rules for tax-
exempt use property is to prevent the benefits of accelerated 
depreciation from accruing to users of property who do not pay 
U.S. income taxes. However, to the extent the class life of a 
leased asset is shorter than the economic useful life of the 
asset, and because taxpayers have control over the term of a 
lease, current law may continue to provide depreciation that is 
too rapid compared to economic depreciation. In such cases, the 
class lives of all property, including tax-exempt use property 
should be extended.
    There is no empirical evidence that suggests that the class 
lives of all property, or tax- exempt-use property, is too 
short. The Treasury Department's Office of Tax Analysis has, 
from time-to-time, issued reports on the useful lives of 
specific types of property. 198 Some of these 
studies have suggested that the present-law class lives are too 
short for some types of property, and too long for other types 
of property. Pursuant to a provision in the Omnibus Budget 
Reconciliation Act of 1988, the Treasury Department may not 
change the class lives of property. Such authority had been 
granted by the Tax Reform Act of 1986.
---------------------------------------------------------------------------
    \198\ See, Department of the Treasury, Report to Congress on the 
Depreciation of Clothing Held for Rental, July 1989; Department of the 
Treasury, Report to Congress on the Depreciation of Fruit and Nut 
Trees, March 1990; Department of the Treasury, Report to Congress on 
the Depreciation of Scientific Instruments, March 1990; Department of 
the Treasury, Report to Congress on the Depreciation of Horses, March 
1990; Department of the Treasury, Report to Congress on the 
Depreciation of Business-Use Passenger Cars, April 1991; and Department 
of the Treasury, Report to Congress on the Depreciation of Business-Use 
Light Trucks, September 1991.
---------------------------------------------------------------------------

3. Impose excise tax on purchase of structured settlements

                              Present Law

    Present law provides tax-favored treatment for structured 
settlement arrangements for the payment of damages on account 
of personal injury or sickness.
    Under present law, an exclusion from gross income is 
provided for amounts received for agreeing to a qualified 
assignment to the extent that the amount received does not 
exceed the aggregate cost of any qualified funding asset (sec. 
130). A qualified assignment means any assignment of a 
liability to make periodic payments as damages (whether by suit 
or agreement) on account of a personal injury or sickness (in a 
case involving physical injury or physical sickness), provided 
the liability is assumed from a person who is a party to the 
suit or agreement, and the terms of the assignment satisfy 
certain requirements. Generally, these requirements are that 
(1) the periodic payments are fixed as to amount and time; (2) 
the payments cannot be accelerated, deferred, increased, or 
decreased by the recipient; (3) the assignee's obligation is no 
greater than that of the assignor; and (4) the payments are 
excludable by the recipient under section 104(a)(2) as damages 
on account of personal injuries or sickness.
    A qualified funding asset means an annuity contract issued 
by an insurance company licensed in the U.S., or any obligation 
of the United States, provided the annuity contract or 
obligation meets statutory requirements. An annuity that is a 
qualified funding asset is not subject to the rule requiring 
current inclusion of the income on the contract which generally 
applies to annuity contract holders that are not natural 
persons (e.g., corporations) (sec. 72(u)(3)(C)). In addition, 
when the payments on the annuity are received by the structured 
settlement company and included in income, the company 
generally may deduct the corresponding payments to the injured 
person, who, in turn, excludes the payments from his or her 
income (sec. 104). Thus, neither the amount received for 
agreeing to the qualified assignment of the liability to pay 
damages, nor the income on the annuity that funds the liability 
to pay damages, generally is subject to tax.
    Present law provides that the payments to the injured 
person under the qualified assignment cannot be accelerated, 
deferred, increased, or decreased by the recipient. Consistent 
with these requirements, it is understood that contracts under 
structured settlement arrangements generally contain anti-
assignment clauses. It is understood, however, that injured 
persons may nonetheless be willing to accept discounted lump 
sum payments from certain ``factoring'' companies in exchange 
for their payment streams. The tax effect on the parties of 
these transactions may not be completely clear under present 
law.

                        Description of Proposal

    The proposal would impose an excise tax on any person 
acquiring a payment stream under a structured settlement 
arrangement. The amount of the excise tax would be 20 percent 
of the consideration for acquiring the payment stream. The 
excise tax would not be imposed if the acquisition were 
pursuant to a court order finding that the extraordinary and 
unanticipated needs of the original recipient of the payment 
stream render the acquisition desirable.

                             Effective Date

    The proposal would be effective for acquisitions occurring 
after the date of enactment. No inference would be intended as 
the contractual validity of the acquisition transaction or its 
effect on the tax treatment of any party other than the 
acquiror.

                              Prior Action

    No prior action.

                                Analysis

    The proposal responds to the social policy concern that 
injured persons may not be adequately protected financially in 
transactions in which a long-term payment stream is exchanged 
for a lump sum. Transfer of the payment stream under a 
structured settlement arrangement arguably subverts the purpose 
of the structured settlement provisions of the Code to promote 
periodic payments for injured persons. The potential for deep 
discounting of the value of the payment stream may financially 
disadvantage injured persons that the provision was designed, 
in part, to protect.
    It could be argued that imposing a tax on the acquisition 
of the payment stream would only worsen the risk that the 
injured person would receive an excessively discounted value 
for the payment stream. It is possible that the acquiror may 
reduce the consideration even further by the amount of the 
excise tax. It can be argued that sellers may not accept such a 
deep discount in many cases, however. One possible response to 
the concern relating to excessively discounted payments might 
be to raise the excise tax to a level that is certain to stop 
the transfers (perhaps 100 percent), or to modify the present-
law rules to impose a different penalty on transfer of the 
payment stream, such as a rule of current inclusion of the 
amount the structured settlement company originally received 
for agreeing to the qualified assignment.
    It could also be argued that it is not the function of the 
tax law to prevent injured persons or their legal 
representatives from transferring rights to payment. Arguably, 
consumer protection and similar regulation is more properly the 
role of the States than of the Federal government. On the other 
hand, the tax law already provides an incentive for structured 
settlement arrangements, and if practices have evolved that are 
inconsistent with its purpose, addressing them should be viewed 
as proper.

4. Reinstate Oil Spill Liability Trust Fund excise tax

                              Present Law

    A 5-cents-per-barrel excise tax was imposed before January 
1, 1995. Revenues from this tax were deposited in the Oil Spill 
Liability Trust Fund. The tax did not apply during any calendar 
quarter when the Treasury Department determined that the 
unobligated balance in this Trust Fund exceeded $1 billion.

                        Description of Proposal

    The proposal would reinstate the Oil Spill Liability Trust 
Fund tax during the period after the date of the proposal's 
enactment and before October 1, 2008. The proposal also would 
increase the $1 billion limit on the unobligated balance in 
this Oil Spill Liability Trust Fund to $5 billion.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The President's fiscal year 1998 budget proposal included a 
similar provision.

                                Analysis

    Some view the Oil Spill Liability Trust Fund excise tax as 
a tax on oil producers and consumers to fund an insurance pool 
against potential environmental risks that arise from the 
transport of petroleum. In this view, the tax is an insurance 
premium in a mandated scheme of risk pooling. While the first 
liability for damage from an oil spill remains with the owner 
of oil, the tax funds a trust fund that may be drawn upon to 
meet unrecovered claims that may arise from an oil spill either 
upon the high seas or from ruptured domestic pipelines. The tax 
and the Trust Fund represent a social insurance scheme with 
risks spread across all consumers of petroleum. The analogy to 
insurance is imperfect, however. The tax assessed reflects an 
imperfect pricing of risks. For example, the prior-law Oil 
Spill Liability Trust Fund tax was imposed at the same rate 
regardless of whether the importer employed more difficult to 
rupture double-hulled or single-hulled tankers.
    Proponents of reimposing the Oil Spill Liability Trust Fund 
excise tax suggest that the revenues would provide a cushion 
for future Trust Fund program activities. However, the 
Congressional authorizing committees have not notified the tax-
writing committees of either a shortfall in the amounts 
required for currently authorized expenditures or of plans to 
expand or extend those authorizations. Opponents of reimposing 
the taxes suggest that this action should be undertaken only in 
combination with such authorizing legislation.

                 III. OTHER MEASURES AFFECTING RECEIPTS

A. Reinstate Superfund Excise Taxes and Corporate Environmental Income 
                                  Tax

                              Present Law

    Before January 1, 1996, four taxes were imposed to fund the 
Hazardous Substance Superfund Trust Fund (``Superfund'') 
program:
          (1) An excise tax on petroleum and imported refined 
        products;
          (2) An excise tax on certain hazardous chemicals, 
        imposed at rates that varied from $0.22 to $4.87 per 
        ton;
          (3) An excise tax on imported substances made with 
        the chemicals subject to the tax in (2), above; and
          (4) An income tax on corporations calculated using 
        the alternative minimum tax rules.

                        Description of Proposal

    The proposal would reinstate the three Superfund excise 
taxes during the period after the date of the proposal's 
enactment and before October 1, 2008. The corporate 
environmental income tax would be reinstated for taxable years 
beginning after December 31, 1997, and before January 1, 2009.
    Revenues from reinstatement of these taxes would be 
deposited in the Superfund Trust Fund.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The President's fiscal year 1998 budget proposal included a 
similar provision.

                                Analysis

    The Superfund Trust Fund provides for certain environmental 
remediation expenses. The prior-law taxes were imposed on 
petroleum products, chemical products, and more generally on 
large businesses. Thus, the taxes were imposed on those 
taxpayers who generally were believed to represent the parties 
liable for past environmental damage rather than on taxpayers 
perceived to benefit from the expenditure program. Depending on 
their incidence, these taxes may inexactly recoup damages from 
parties held responsible for past environmental damage. For 
example, the burden may fall on the current owners of 
enterprises rather than those who were the owners at the time 
the damage occurred. On the other hand, to the extent that 
taxable products continue to create environmental harm, the 
taxes may discourage overuse of such products.
    Proponents of reimposing the Superfund excise taxes suggest 
that the revenues can provide a cushion for ongoing Superfund 
program costs, and that reimposition of these taxes is a 
necessary complement to reauthorization and possible 
modification of the Superfund program. Opponents suggest that 
the taxes should be reimposed only as part of pending program 
reform legislation. These persons suggest, in particular, that 
proposals to address issues associated with so-called 
``retroactive liability'' may require budgetary offsets which 
could be provided by reimposing the Superfund taxes as a 
component of such authorizing legislation.

  B. Extend Excise Taxes on Gasoline, Diesel Fuel, and Special Motor 
                                 Fuels

                              Present Law

Overview
    The current highway transportation excise taxes consist of:
          (1) taxes on gasoline, diesel fuel, kerosene, and 
        special motor fuels;
          (2) a retail sales tax imposed on trucks and trailers 
        having gross vehicle weights in excess of prescribed 
        thresholds;
          (3) a tax on manufacturers of tires designed for use 
        on heavy highway vehicles; and
          (4) an annual use tax imposed on trucks and tractors 
        having taxable gross weights in excess of prescribed 
        thresholds.
    Special motor fuels include liquefied natural gas (``LNG'), 
benzol, naphtha, liquefied petroleum gas (e.g., propane), 
natural gasoline, and any other liquid (e.g., ethanol and 
methanol) other than gasoline or diesel fuel. Compressed 
natural gas (``CNG'') also is subject to tax as a special motor 
fuel.
    With the exception of 4.3 cents per gallon of the motor 
fuels excise tax rates, these taxes are scheduled to expire 
after September 30, 1999.
Highway motor fuels taxes
    The current highway motor fuels excise tax rates are shown 
in Table 4.

Table 4.--Federal Highway Trust Fund Motor Fuels Excise Tax Rates, as of
                           October 1, 1997\1\                           
                    [Rates shown in cents per gallon]                   
------------------------------------------------------------------------
                                                               Tax rate 
                        Highway fuel                             \2\    
------------------------------------------------------------------------
Gasoline\3\................................................         18.3
Diesel fuel \4\............................................         24.3
Special motor fuels generally..............................     \5\ 18.3
CNG........................................................      \6\ 4.3
------------------------------------------------------------------------
\1\ The rates shown include the 4.3-cents-per-gallon tax rate which is  
  transferred to the Highway Fund effective on October 1, 1997.         
\2\ Effective on October 1, 1997, an additional 0.1-cent-per-gallon rate
  was imposed on these motor fuels to finance the Leaking Underground   
  Storage Tank Trust Fund.                                              
\3\ Gasoline used in motorboats and in certain off-highway recreational 
  vehicles and small engines is subject to tax in the same manner and at
  the same rates as gasoline used in highway vehicles. 6.8 cents per    
  gallon of the revenues from the tax on gasoline used in these uses is 
  retained in the General Fund; the remaining 11.5 cents per gallon is  
  deposited in the Aquatic Resources Trust Fund (motorboat and small    
  engine gasoline), the Land and Water Conservation Fund ($1 million of 
  motorboat gasoline tax revenues), and the National Recreational Trails
  Trust Fund (the ``Trails Trust Fund'') (off-highway recreational      
  vehicles). Transfers to these Trust Funds are scheduled to terminate  
  after September 30, 1998. Transfers to the Trails Trust Fund are      
  contingent on appropriations occurring from that Trust Fund; to date, 
  no appropriations have been enacted. Of the 6.8-cents-per-gallon tax, 
  2.5 cents per gallon is scheduled to expire after September 30, 1999. 
  The remaining 4.3-cents-per-gallon rate is permanent.                 
\4\ Kerosene is taxed at the same rate as diesel fuel.                  
\5\ The rate is 13.6 cents per gallon for propane, 11.9 cents per gallon
  for liquefied natural gas, and 11.3 cents per gallon for methanol fuel
  from natural gas, in each case based on the relative energy           
  equivalence of the fuel to gasoline.                                  
\6\ The statutory rate is 48.54 cents per thousand cubic feet (``MCF'). 

    Present law includes numerous exemptions (including partial 
exemptions for specified uses of taxable fuels or for specified 
fuels) typically for governments or for uses not involving use 
of the highway system. Because the gasoline and diesel fuel 
taxes generally are imposed before the end use of the fuel is 
known, many of these exemptions are realized through refunds to 
end users of tax paid by a party that processed the fuel 
earlier in the distribution chain. These exempt uses and fuels 
include:
          (1) Use in State and local government and nonprofit 
        educational organization vehicles;
          (2) Use in buses engaged in transporting students and 
        employees of schools;
          (3) Use in private local mass transit buses having a 
        seating capacity of at least 20 adults (not including 
        the driver) when the buses operate under contract with 
        (or are subsidized by) a State or local governmental 
        unit;
          (4) Use in private intercity buses serving the 
        general public along scheduled routes (totally exempt 
        from the gasoline tax and exempt from 17 cents per 
        gallon of the diesel tax); and
          (5) Use in off-highway uses such as farming.
    LNG, propane, CNG, and methanol derived from natural gas 
are subject to reduced tax rates based on the energy 
equivalence of these fuels to gasoline.
    Ethanol and methanol derived from renewable sources (e.g., 
biomass) are eligible for income tax benefits (the ``alcohol 
fuels credit'') equal to 54 cents per gallon (ethanol) and 60 
cents per gallon (methanol). 199 In addition, small 
ethanol producers are eligible for a separate 10-cents-per-
gallon credit. 200 The 54-cents-per-gallon ethanol 
and 60-cents-per-gallon renewable source methanol tax credits 
may be claimed through reduced excise taxes paid on gasoline 
and special motor fuels as well as through credits against 
income tax. 201
---------------------------------------------------------------------------
    \199\ The alcohol fuels credit is scheduled to expire after 
December 31, 2000, or earlier, if the Highway Fund excise taxes 
actually expire before that date.
    \200\ The small ethanol producer credit is available on up to 15 
million gallons of ethanol produced by persons whose annual production 
capacity does not exceed 30 million gallons.
    \201\ Authority to claim the ethanol and renewable source methanol 
tax benefits through excise tax reductions is scheduled to expire after 
September 30, 2000 (or earlier, if the underlying excise taxes actually 
expire before September 30, 2000).
---------------------------------------------------------------------------

Non-fuel Highway Fund excise taxes

    In addition to the highway motor fuels excise tax revenues, 
the Highway Fund receives revenues produced by three excise 
taxes imposed exclusively on heavy highway vehicles or tires. 
These taxes are:
          (1) A 12-percent excise tax imposed on the first 
        retail sale of highway vehicles, tractors, and trailers 
        (generally, trucks having a gross vehicle weight in 
        excess of 33,000 pounds and trailers having such a 
        weight in excess of 26,000 pounds);
          (2) An excise tax imposed at graduated rates on 
        highway tires weighing more than 40 pounds; and
          (3) An annual use tax imposed on highway vehicles 
        having a taxable gross weight of 55,000 pounds or more. 
        (The maximum rate for this tax is $550 per year, 
        imposed on vehicles having a taxable gross weight over 
        75,000 pounds.)

                        Description of Proposal

    The proposal would extend the excise taxes on nonaviation 
gasoline, diesel fuel (including kerosene), and special motor 
fuels that currently are scheduled to expire after September 
30, 1999. (The currently scheduled, March 31, 2005, expiration 
date for the Leaking Underground Storage Tank Trust Fund rate 
would be retained.)

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    In a separate 1997 proposal, the Administration proposed 
extending all of the highway excise taxes through September 30, 
2005, a part of legislation to extend Highway Trust Fund 
expenditure authorizations.

                                Analysis

    The current structure of highway transportation excise 
taxes relies heavily on a 1982 DOT cost allocation study. 
202 Average cost allocation is offered as an 
equitable way to recover the costs incurred in provision of 
highway services. One result of 1982 excise tax changes is that 
users of the freight shipping services of heavy trucks bear a 
heavier tax than do users of passenger automobiles. The higher 
tax rates for trucks (fuel and non-fuel taxes) were imposed in 
an attempt to reflect the greater road damages from trucks and 
heavy trucks in particular. The structure of these taxes 
demonstrates compromises reached to accommodate 
administrability of the tax system to the desire to recover 
costs equitably. Administrative costs could have been minimized 
by relying solely on the fuels excise taxes, but the three 
additional excise taxes permit policymakers to distinguish 
between heavy cross-country vehicles that burn diesel fuel and 
smaller, lighter local delivery vehicles that also burn diesel 
fuel. Given this apparent goal, the annual use tax reflects 
further compromise with the goal of administrability. The 
annual use tax is the same dollar amount whether the truck 
drives 5,001 miles or 100,000 miles in the year. Collecting a 
tax based on actual miles driven (e.g., a ``weight-distance'' 
tax) would be more precise, but more difficult to administer.
---------------------------------------------------------------------------
    \202\ Department of Transportation, Federal Highway Administration, 
Final Report on the Federal Highway Cost Allocation Study, Report of 
the Secretary of Transportation to the United States Congress Pursuant 
to Public Law 95-599, Surface Transportation Assistance Act of 1978 
(May 1982).
---------------------------------------------------------------------------
    Highway Trust Fund taxes are like ``prices'' that highway 
users must pay to use the roadways. To promote economic 
efficiency, prices should equal society's marginal, or 
incremental, cost of providing the service. The extent to which 
the current highway transportation excise taxes promote the 
efficient use of highway system depends upon the extent to 
which these taxes approximate the incremental cost of the 
Government's provision of the highway services. 203 
In the presence of economies of scale, taxes that reflect 
average costs may move the tax (price) further away from 
marginal costs, thereby decreasing efficiency. Because these 
taxes are set at average rates to apply nationally, the taxes 
can never be fully efficient. It is more costly to build and 
maintain roads in some geographic locations than in others. For 
example, it is less expensive to build highways across flat 
rural areas than through mountains or in urban areas. 
Similarly, the tax and expenditure policy is unlikely to follow 
cost or tax burdens imposed exactly. The excise taxes generally 
apply to all motor fuel purchased, while the expenditures 
(benefits) are provided only to the users of certain highways. 
Any change in the taxes assessed on different highway users may 
be expected to change the pattern of use of the highways by the 
different users.
---------------------------------------------------------------------------
    \203\ For a more complete discussion of the issues of efficiency 
and equity related to highway taxes see, Joint Committee on Taxation, 
Present Law and Background on Transportation Excise Taxes and Trust 
Fund Expenditure Programs (JCS-10-96), November 14, 1996.
---------------------------------------------------------------------------
    A majority of the revenues from the highway excise taxes is 
dedicated to the Highway Trust Fund. Part of the fuels tax 
revenues finance programs of the Aquatic Resources Trust Fund, 
the Land and Water Conservation Fund, and the National 
Recreational Trails Trust Fund. Extension of all of the fuels 
tax rates and non-fuels highway taxes is necessary as part of 
reauthorization of these programs.
    The President's budget proposal addresses only extension of 
the fuels taxes. In general, under the Budget Enforcement Act, 
excise taxes dedicated to trust funds are assumed by the 
Congressional Budget Office to be permanent, despite any 
statutory expiration dates. A small portion (2.5 cents per 
gallon) of the expiring taxes on gasoline blended with ethanol 
and on gasoline used in motorboats is retained in the General 
Fund. It is understood that the budget proposal addresses only 
the fuels taxes because the Office of Management and Budget 
economic forecast does not assume these General Fund components 
of the fuels tax rates to be permanent. During any period when 
the fuels taxes are imposed, the Congressional Budget Office 
forecast assumes the entire tax rate (as opposed to just the 
11.5-cents-per-gallon Trust Fund component) to be permanent. 
Thus, for purposes of Congressional budget scorekeeping, this 
proposal has no revenue effect.

  C. Convert Airport and Airway Trust Fund Excise Taxes to Cost-Based 
     User Fees to Pay for Federal Aviation Administration Services

                              Present Law

Airport and Airway Trust Fund excise taxes with scheduled expiration 
        dates

    Excise taxes are imposed on commercial and noncommercial 
\204\ aviation to finance programs administered through the 
Airport and Airway Trust Fund (the ``Airport Trust Fund''). 
These excise taxes were modified and extended (through 
September 30, 2007) by the Taxpayer Relief Act of 1997 (the 
``1997 Act''). The following describes the current aviation 
excise taxes.
---------------------------------------------------------------------------
    \204\ Noncommercial aviation is defined to include transportation 
that does not involve the carrying of passengers or freight ``for 
hire'' (e.g., corporate aircraft transporting corporate employees).
---------------------------------------------------------------------------
            Commercial air passenger transportation
    Commercial passenger air transportation generally is 
subject to one of two taxes. First, domestic air passenger 
transportation is subject to a tax equal to the total of 7.5 
percent of the gross amount paid by the passenger for the 
transportation plus a $3 per flight segment tax.\205\ These tax 
rates currently are being phased-in, as follows:
---------------------------------------------------------------------------
    \205\ A flight segment is transportation involving a single take-
off and a single landing.
---------------------------------------------------------------------------
          October 1, 1997-September 30, 1998: 9 percent of the 
        fare, plus $1 per domestic flight segment;
          October 1, 1998-September 30, 1999: 8 percent of the 
        fare, plus $2 per domestic flight segment; and
          October 1, 1999-December 31, 1999: 7.5 percent of the 
        fare, plus $2.25 per domestic flight segment.
    After December 31, 1999, the ad valorem rate will remain at 
7.5 percent. The domestic flight segment component of the tax 
will increase to $2.50 (January 1, 2000-December 31, 2000), to 
$2.75 (January 1, 2001-December 31, 2001), and to $3 (January 
1, 2002-December 31, 2002). On January 1, 2003, and on each 
January 1 thereafter, the fixed dollar amount per flight 
segment will be indexed annually for inflation occurring after 
2001.
    Second, commercial air passengers arriving in the United 
States from another country or departing the United States for 
another country are subject to a $12 tax per arrival or 
departure.
    Further. amounts paid to air carriers (in cash or in kind) 
for the right to award or otherwise distribute free or reduced-
rate air transportation are treated as amounts paid for taxable 
air transportation, subject to a 7.5-percent ad valorem rate. 
This tax applies to payments, whether made within the United 
States or elsewhere, if the rights to transportation for which 
payments are made can be used in whole or in part for 
transportation that, if purchased directly, would be subject to 
either the domestic or international passenger taxes, described 
above.
            Commercial air cargo transportation
    Commercial transportation of cargo by air is subject to a 
6.25-percent excise tax.
            Noncommercial aviation
    Noncommercial aviation is subject to taxes on fuels 
consumed. Aviation gasoline is taxed at 15 cents per gallon and 
aviation jet fuel is taxed at 17.5 cents per gallon.

Permanent aviation fuels excise tax

    In addition to the taxes described above, aviation gasoline 
and jet fuel is subject to a permanent 4.3-cents-per-gallon 
excise tax rate. Receipts from this tax (since October 1, 
1997), like the taxes with scheduled expiration dates, are 
deposited in the Airport Trust Fund.

                        Description of Proposal

    The proposal states that legislation to phase out aviation 
excise taxes and to replace those taxes with cost-based user 
fees will be proposed at a later date. (The budget proposal, as 
transmitted, addresses only those taxes that currently are 
scheduled to expire after September 30, 2007.) Under the 
proposal, the aviation excise taxes would be phased out over 
the period fiscal year 1999 through fiscal year 2003 (with the 
first reduction on October 1, 1999, and full phase-out on 
October 1, 2002). Other details of the proposal have not been 
specified.

                              Prior Action

    The proposal is similar to a proposal contained in the 
President's fiscal year 1998 budget, for which details were not 
submitted to the Congress. The structure and level of aviation 
taxes to support the Federal Aviation Administration (the 
``FAA'') was addressed in the Taxpayer Relief Act of 1997. That 
Act enacted the current excise tax structure, provided that the 
taxes with scheduled expiration dates would be imposed through 
September 30, 2007, and transferred receipts from the permanent 
4.3-cents-per-gallon aviation fuels tax (previously retained in 
the General Fund) to the Airport Trust Fund.

                                Analysis

    Because details of the proposal have not been transmitted 
to the Congress, it is not possible to comment on specifics; 
however, several general issues regarding substitution of user 
fees for excise taxes which were raised before the Congress 
during consideration of the 1997 Act may be noted.\206\
---------------------------------------------------------------------------
    \206\ For a more discussion of these issues, see, Joint Committee 
on Taxation, Present Law and Background Information on Federal 
Transportation Excise Taxes and Trust Fund Expenditure Programs (JCS-
10-96), November 14, 1996.
---------------------------------------------------------------------------

Budget Act scorekeeping

    The current excise taxes imposed to finance FAA activities 
are classified as Federal revenues, with gross receipts from 
the taxes being deposited in the Airport Trust Fund. Because of 
interactions with the Federal income tax, net revenues to the 
Federal Government is less than the gross receipts from these 
taxes (i.e., ``net revenues'' equal approximately 75 percent of 
gross excises taxes). Spending from the Airport Trust Fund is 
classified as discretionary domestic spending, subject to 
aggregate annual appropriation limits (``caps'') that apply to 
this spending as well as other types of discretionary domestic 
spending. These caps most recently were set as part of the 1997 
balanced budget agreement. Because spending from the Airport 
Trust Fund is subject to the discretionary domestic spending 
caps, deposit of amounts in excess of net revenues from these 
taxes in the Airport Trust Fund does not impact Federal budget 
scorekeeping.
    Proponents of changing FAA financing to user fees typically 
argue that current spending levels are too low because of the 
discretionary spending caps. These persons suggest that, if the 
FAA were permitted to impose cost-based user fees, it could 
spend the entire amount collected outside of the regular 
budgetary process. However, if FAA financing and spending were 
restructured using user fees and expenditures not requiring 
appropriation, the discretionary domestic spending caps 
established by the 1997 balanced budget agreement would have to 
be reduced to prevent increases in other programs that might 
produce deficit spending. Further, if the user fees were 
classified as Federal revenues and the FAA were allowed to 
spend more than the net revenues produced (as opposed to the 
gross receipts), from a budgetary standpoint, the agency would 
be engaged in deficit spending.
    Under the current financing and spending structure, Airport 
Trust Fund spending levels may be less than net excise tax 
revenues. Any excess net revenues received are included in 
calculations of the Federal deficit or surplus under the Budget 
Enforcement Act. If the excise taxes were repealed, and were 
not replaced by similarly treated revenue sources equal at 
least to the excess of collections over expenditures, Federal 
deficit or surplus calculations would be affected.

Tax vs. fee

    Proponents of cost-based user fees suggest that the FAA, 
not the Congress, should establish and collect appropriate fees 
for the services it provides. These persons suggest that 
imposition of fees by the FAA would enable that agency to 
operate in a more businesslike manner. However, others point 
out that care must be taken to ensure that any FAA-imposed fees 
are not legally ``taxes'' because the taxing power cannot 
constitutionally be delegated by the Congress.\207\ In general, 
a true user fee (which an Executive agency may be authorized to 
levy) may be imposed only on the class that directly avails 
itself of a governmental program and may be used solely to 
finance that program rather than to finance the costs of 
Government generally. The amount of the fee charged to any 
payor generally may not exceed the costs of providing the 
services with respect to which the fee is charged. Fees are not 
imposed on the general public; there must be a reasonable 
connection between the payors of the fee and the agency or 
function receiving the fee. Those paying a fee must have the 
choice of not utilizing the governmental service or avoiding 
the regulated activity and thereby avoiding the charge. If the 
FAA were authorized to establish and collect cost-based user 
fees, the fees would have to satisfy these criteria to avoid 
being subject to challenge as unconstitutional delegations of 
the taxing power. When the Congress modified and extended the 
aviation excise taxes in 1997, the FAA was reported to have no 
comprehensive cost accounting system upon which it could base 
such fees. Further, over 50 percent of FAA costs were 
identified in the then most recently conducted cost allocation 
study as ``common'' costs to many sectors, requiring allocation 
rules. Such allocation rules may be viewed by some as imprecise 
and subject to challenge.\208\
---------------------------------------------------------------------------
    \207\ Article I, Section 8 of the U.S. Constitution includes the 
enumerated powers of Congress the ``. . . Power To lay and collect 
Taxes, Duties, Imposts, and Excises. . . .''
    \208\ See, e.g., Asiana Airlines v. Federal Aviation 
Administration, No. 97-135 (D.C. Cir., January 30, 1998), holding that 
certain international overflight fees imposed by the FAA based on this 
cost allocation study violated a statutory requirement that the fees be 
cost-based.
---------------------------------------------------------------------------

Cost allocation and Airport and Airway Trust fund excise tax efficiency

    Setting taxes or fees on the basis of cost allocation 
generally is an attempt to have the tax or fee reflect the 
average cost of providing the service. Many view such pricing 
as an equitable manner to recover costs. However, cost 
allocation as a basis of air transportation excise tax design 
may create an economically inefficient tax structure. The 
provision of transportation services often requires substantial 
capital investments. Fixed costs tend to be large compared with 
marginal costs. For example, the construction of a bridge 
across the Mississippi River requires a substantial fixed 
capital investment. The additional resource costs (wear and 
tear) imposed by one additional automobile on an uncongested 
bridge, once the bridge has been built, is quite small in 
comparison. This means that the provision of many 
transportation services is often characterized by ``economies 
of scale.'' Provision of a good or service is said to be 
characterized by economies of scale when the average cost of 
providing the good or service exceeds the marginal cost of 
providing that good or service. When this occurs, the average 
cost of providing the good or service is falling with each 
additional unit of the good or service provided. Economists 
proffer setting prices or taxes equal to marginal cost to 
obtain economically efficient outcomes. However, in the 
presence of substantial economies of scale, the marginal cost 
is less than the average cost of providing the transportation 
service and the revenues collected from equating taxes to 
marginal costs would not cover the full expenditure required to 
provide the service. That is, provision of the service may 
require a subsidy beyond the revenues provided by the 
economically efficient tax.\209\
---------------------------------------------------------------------------
    \209\ Some argue that the presence of economies of scale justify 
Government involvement in certain infrastructure investments. They 
argue that when the economies of scale are great, the potential for 
cost recovery and profit from market prices may be insufficient for 
private providers to undertake the investment, even though provision of 
the service would create marginal benefits that exceed marginal costs.
---------------------------------------------------------------------------
    Cost allocation would set the price or taxes for air 
transportation services at rates equal to the average cost of 
services. In the presence of substantial economics of scale, 
average cost pricing implies that consumers are being charged 
prices in excess of marginal resource costs and that less than 
the economically efficient level of transportation services are 
provided. Indeed, an expansion of services would lead to a 
decline in the average cost of the service to each user. If 
each user could be charged that lower average price, the price 
paid would still exceed the marginal cost of the provision of 
the service, all costs would be recovered and net economic 
well-being (efficiency) would increase. Thus, the principle of 
cost allocation involves a trade-off between economic 
efficiency and cost recovery.\210\
---------------------------------------------------------------------------
    \210\ For a discussion of ways of decreasing the inefficiencies 
that arise from diverging from marginal cost pricing while raising 
revenue to cover substantial fixed costs, see Congressional Budget 
Office, Paying for Highways, Airways and Waterways: How Can Users Be 
Charged? May 1992.
---------------------------------------------------------------------------

Congressional oversight

    The current financing and Airport Trust Fund spending 
process involves oversight of at least four Congressional 
committees in each House of Congress. Taxes are imposed and 
dedicated to the Airport Trust Fund by the tax-writing 
committees. Overall expenditure levels for domestic spending 
are set by the budget committees. Specific expenditure purposes 
are authorized by the House Committee on Transportation and 
Infrastructure and the Senate Committee on Commerce, Science 
and Transportation. Finally, expenditures are appropriated by 
the appropriations committees of each House. Proponents of 
changing FAA financing and spending authority as proposed by 
the Administration suggest that such extensive Congressional 
oversight is unnecessary. At a minimum, the Administration's 
proposal could eliminate the oversight roles of the tax-writing 
and appropriations committees. Others suggest that the 
involvement of multiple Congressional committees promotes 
better prioritization of actual FAA spending needs within the 
framework of the overall system of Federal revenues and outlays 
and a more efficient use of FAA resources.

                         D. Tobacco Legislation

                       Present Law and Background

    There are no special rules limiting the liability of 
manufacturers and sellers of tobacco products. Although the 
tobacco industry has agreed to certain voluntary limitations on 
its ability to advertise products, the constitutionality of 
mandatory limitations has not been established.
    A number of States have brought suit against the 
manufacturers of tobacco products. These suits generally allege 
that the tobacco companies were negligent in that they failed 
to exercise reasonable care in the design, manufacture and 
marketing of cigarettes and other tobacco products. These suits 
further allege that the tobacco companies sold dangerous and 
defective products, suppressed technologies that could have 
resulted in safer products, and engaged in false advertising, 
deceit and fraud. Some of these suits also allege violations of 
the Federal Racketeer Influenced and Corrupt Organizations Act 
(RICO), Federal anti-trust statutes, and other Federal and 
State laws.
    The States' suits generally have sought compensation for 
the costs attributable to smoking that the litigant States have 
incurred through the Medicaid Program, the State's employee 
retirement program, the State's employee health insurance 
program, and through charity care. These suits generally also 
have sought injunctive relief that would prohibit certain types 
of marketing of tobacco products, particularly cigarettes and 
smokeless tobacco.
    Settlements have been filed in three states: Florida; 
Mississippi; and Texas.\211\ These settlements provide for the 
payment of substantial monetary damages to the States and 
require the tobacco companies to fund certain anti-smoking 
initiatives and change their marketing practices. The terms of 
these settlements may be modified if a proposed nationwide 
resolution \212\ advanced by certain tobacco companies and 
certain States is enacted.
---------------------------------------------------------------------------
    \211\ Settlements have been approved by the courts in Florida and 
Mississippi, approval is pending in Texas.
    \212\ The proposed resolution is memorialized in a document marked 
``for settlement discussion purposes only'' and dated June 20, 1997.
---------------------------------------------------------------------------
    The proposed nationwide resolution provides for the payment 
by the tobacco companies to the various States and the Federal 
Government of a lump sum payment of $10 billion and base 
payments with a face value totaling $358.5 billion over 25 
years. The actual amount that would be paid under the proposed 
nationwide resolution could be more or less, depending upon 
certain factors. In addition, the proposed nationwide 
resolution would place significant restrictions on the 
marketing and advertising of tobacco products, clarify the 
scope of FDA authority over tobacco, and establish nationwide 
standards for second-hand smoke.
    The proposed nationwide resolution is contingent on the 
enactment of Federal legislation that would limit the potential 
civil liability of the tobacco companies to private individuals 
for the tobacco companies'' past and future conduct. Such 
legislation would cap the amount the tobacco companies could be 
required to pay as damages in any year, prohibit class action 
suits, make certain evidence inadmissible and (with regard to 
past conduct of the tobacco companies only) prohibit punitive 
damages.
    Several bills have been introduced in the 105th Congress 
that follow the terms of the proposed nationwide resolution 
with certain changes. In addition, other legislation has been 
introduced in the 105th Congress that would increase the excise 
tax on tobacco products.

                        Description of Proposal

    The President's budget for fiscal year 1999 does not 
include a specific proposal related to the treatment of tobacco 
products or the proposed settlement. However, the budget does 
include ``receipts from tobacco legislation'' of $9.795 billion 
in fiscal year 1999, $11.787 billion in 2000, $13.283 billion 
in 2001, $14.544 billion in 2002, and $16.085 billion in 2003, 
for a five-year total of $65.494 billion.

                              Prior Action

    Excise taxes on tobacco products were last increased in the 
Balanced Budget Act of 1997.

                  E. Other Provisions Affect Receipts

    Certain of the outlay proposals contained in the 
President's budget result in changes in receipts. These 
provisions are as follows:

1. Expand use of Federal highway monies to include use for certain 
        ``creative financing'' projects and for State infrastructure 
        bank programs

    Interest on State and local government bonds is tax-exempt 
if the bonds are used to finance activities carried out and 
paid for by these governments. Governmentally owned and 
maintained highways, transit systems, and rail systems are 
eligible for this financing. Interest on bonds issued to 
finance activities of private businesses (``private activity 
bonds'') is taxable unless a specific exception is included in 
the Code. The private business activities for which tax-exempt 
bond financing is available do not include privately owned and/
or operated highways (e.g., private toll roads). Tax-exempt 
private activity bonds may be issued, subject to certain 
limits, to finance mass transit and high-speed intercity rail 
facilities (other than rolling stock).
    The proposal would authorize the use of Federal highway 
monies to provide credit enhancement to certain highway 
projects, such as toll roads, transit, and high-speed intercity 
rail facilities. The credit enhancement could be provided 
through direct loans, letters of credit, or loan guarantees, 
each of which could be used to leverage issuance of larger 
amounts of tax-exempt bonds. The proposal further would 
authorize the use of Federal highway monies for funding of 
State infrastructure banks. These banks would serve as 
revolving pools of funds for financing of transportation 
projects (including leveraged financing and credit 
enhancement).
    The direct effect of the proposal would be to increase 
issuance of long-term tax-exempt bonds by expanding the revenue 
sources available to repay (or secure repayment of) 
transportation debt.

2. Allow Federal housing funds to be used to leverage tax-exempt bond 
        financed low-income housing credit projects

    Present law provides an income tax credit for low-income 
rental housing. In general, the credit is paid over 10 years 
and is equal to 70 percent of the basis of newly constructed 
low-income housing units. The credit percentage is reduce to 30 
percent in the case of existing housing and of housing that 
receives other Federal subsidies, including tax-exempt bond 
financing. In general, each State annually may allocate credits 
equal $1.25 per resident of the State. Credits for low-income 
housing projects financed with the proceeds of tax-exempt State 
or local government bonds are not subject to this volume limit.
    Tax-exempt bonds may be issued to finance activities that 
are carried out by and paid for by States and local 
governments. Interest on bonds issued by these governments to 
finance activities of private businesses (``private activity 
bonds'') is taxable unless a specific exception is included in 
the Code. One such exception allows issuance of tax-exempt 
private activity bonds to finance low-income rental housing, 
defined in generally the same manner as under the low-income 
housing credit provision. Issuance of most tax-exempt private 
activity bonds is subject to annual State volume limits of $50 
per resident ($150 million, if greater).
    The proposal would allow Federal housing monies to be used 
to establish State revolving funds to be used to provide 
additional security for repayment of tax-exempt debt.\213\
---------------------------------------------------------------------------
    \213\ The President's budget proposal includes an unrelated 
proposal to increase the State low-income housing credit limit. (See, 
discussion in Part I.F.1., above.)
---------------------------------------------------------------------------
    The proposal can be expected to result in increased 
issuance of tax-exempt bonds and in increased utilization of 
low-income housing income tax credits, which would be available 
without regard to the low-income housing credit volume limit.

3. Employer buy-in (COBRA continuation coverage) for certain retirees

    Under the proposal, the termination of retiree health 
benefits for retirees age 55 to 64 and their dependents would 
become a COBRA qualifying event. Affected retirees would be 
eligible to enroll in the health plan of their former employer, 
and would be required to pay a premium no greater than 125 
percent of the average premium for active employees of the 
former employer. The affected retirees would remain eligible 
for the COBRA continuation coverage until they reach age 65. 
This proposal would have no effect on Federal outlays, because 
the cost would be paid by the private sector. However, in many 
cases the cost of providing the COBRA coverage would exceed 125 
percent of the premium for active employees. The additional 
costs would be borne by the former employers providing the 
coverage, resulting in a reduction in taxable income. Thus the 
proposal would result in an indirect reduction in Federal tax 
revenues.

4. Consumer bill of rights and responsibilities

    The proposal would require that private health plans 
implement a series of consumer protection initiatives, 
including enhanced information disclosure, an expansion of the 
grievance and appeal process, and enhanced access to specialty 
care. These consumer protection initiatives will result in a 
small increase in health care costs, and in particular, a small 
increase in average premiums for employer-sponsored health 
plans. This will result in an increase in employee compensation 
paid in nontaxable form, which will result in an indirect 
decline in Federal tax revenues.