COMMITTEE ON WAYS AND MEANS BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois E. CLAY SHAW, Jr., Florida NANCY L. JOHNSON, Connecticut AMO HOUGHTON, New York WALLY HERGER, California JIM MCCRERY, Louisiana DAVE CAMP, Michigan JIM RAMSTAD, Minnesota JIM NUSSLE, Iowa SAM JOHNSON, Texas JENNIFER DUNN, Washington MAC COLLINS, Georgia ROB PORTMAN, Ohio PHIL ENGLISH, Pennsylvania WES WATKINS, Oklahoma J. D. HAYWORTH, Arizona JERRY WELLER, Illinois KENNY C. HULSHOF, Missouri SCOTT MCINNIS, Colorado RON LEWIS, Kentucky MARK FOLEY, Florida KEVIN BRADY, Texas PAUL RYAN, Wisconsin	CHARLES B. RANGEL, New York FORTNEY PETE STARK, California ROBERT T. MATSUI, California WILLIAM J. COYNE, Pennsylvania SANDER M. LEVIN, Michigan BENJAMIN L. CARDIN, Maryland JIM MCDERMOTT, Washington GERALD D. KLECZKA, Wisconsin JOHN LEWIS, Georgia RICHARD E. NEAL, Massachusetts MICHAEL R. MCNULTY, New York WILLIAM J. JEFFERSON, Louisiana JOHN S. TANNER, Tennessee XAVIER BECERRA, California KAREN L. THURMAN, Florida LLOYD DOGGETT, Texas EARL POMEROY, North Dakota
Allison Giles, Chief of Staff Janice Mays, Minority Chief Counsel  SUBCOMMITTEE ON SELECT REVENUE MEASURES JIM MCCRERY, Louisiana, Chairman
J.D. HAYWORTH, Arizona JERRY WELLER, Illinois RON LEWIS, Kentucky MARK FOLEY, Florida KEVIN BRADY, Texas PAUL RYAN, Wisconsin	MICHAEL R. MCNULTY, New York RICHARD E. NEAL, Massachusetts WILLIAM J. JEFFERSON, Louisiana JOHN S. TANNER, Tennessee
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records of the Committee on Ways and Means are also published in electronic form. The printed hearing record remains the official version. Because electronic submissions are used to prepare both printed and electronic versions of the hearing record, the process of converting between various electronic formats may introduce unintentional errors or omissions. Such occurrences are inherent in the current publication process and should diminish as the process is further refined.

Advisory of May 2, 2002, announcing the hearing

Center for Strategic Tax Reform, Ernest S. Christian

Engen, Eric M., American Enterprise Institute

Gale, William G., Brookings Institution

Graetz, Michael J., Yale Law School

Institute for Research on the Economics of Taxation, Stephen J. Entin

Jorgensen, Dale W., Harvard University

SECOND IN SERIES ON THE EXTRATERRITORIAL INCOME REGIME

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

The Subcommittee met, pursuant to notice, at 2:05 p.m., in room 1100 Longworth House Office Building, Hon. Jim McCrery, (Chairman of the Subcommittee) presiding.

[The advisory announcing the hearing follows:]

Chairman MCCRERY. Good afternoon, everyone. If our guests will take their seats, we will begin the hearing.

Welcome, everyone. This afternoon, the Subcommittee on Select Revenue Measures continues its examination of the issues surrounding World Trade Organization's (WTO's) determination that the Extraterritorial Income (ETI) Exclusion Act regime is an export subsidy inconsistent with our international trade obligations. As Members of this Committee know, we are fast approaching the June 17 date on which the WTO arbitration panel will determine the level of authorized sanctions which the European Union may impose to offset the impact of the subsidy provided by the ETI regime. The looming deadline makes it particularly important that we handle this task with both speed and precision.

I was heartened by recent news reports that the European Union understands the difficult challenges we face in untangling the ETI rules and is inclined to withhold imposing sanctions as long as we continue to make meaningful progress toward a legislative solution to this issue. Despite that positive development, though, it would be unwise for their committee or the Congress to pause in our efforts to bring the Tax Code into compliance with our obligations under the WTO.

One month ago the Subcommittee held its first hearing on Foreign Sales Corporation (FSC) ETI. The consensus of all the witnesses, including former Members of this Committee who helped draft those laws, was that the benefits of FSC could not be replicated in a WTO-compliant manner. Simply put, if we are to avoid retaliation from Europe while continuing to help our exporters compete in the global marketplace, we must explore more far-reaching changes to the Tax Code.

Today's hearing continues to search for answers by considering fundamental tax reform proposals or, as Secretary O'Neill was quoted as saying today in the Wall Street Journal, "an overhaul of the tax system."

Fundamental tax reform proposals are generally variations of a consumption tax, such as a retail sales tax, a value added tax (VAT) or a flat tax. On one point, supporters of each of those are correct -- any would be, at least in my opinion, a vast improvement over the current system.

In addition to hearing from advocates of various reform proposals, I am hopeful this session will allow for a give-and-take between the witnesses which we have assembled before us. As one of our Subcommittee Members said to me upon entering the room and surveying the panel, wow, we have got some smart guys here to testify today.

So, as long as we have you here, I hope there is some give-and-take among the witnesses so that will help this Subcommittee better understand the extent of the differences that you have, differences of opinion that you have, and also the areas of common ground which you might share.

In particular, I will be interested to learn more about the contention made by some of the witnesses that the differences between a consumption tax and the current corporate income tax are more a matter of form than substance, and that only a few changes to the current Tax Code would be necessary to make the corporate tax border-adjustable.

As my colleagues know, in prior years, this Committee has held several hearings to better understand this and other issues related to fundamental tax reform. It is my hope that this session will build upon those inquiries. In particular, we will be interested in learning what effect these proposals will have on efforts to promote U.S. exports within the bounds of our international trade obligations.

Before introducing the panel of excellent witnesses today, I will yield to my friend from New York for any comments he may wish to make.

[The opening statement of Chairman McCrery follows:]

Mr. MCNULTY. I thank the Chairman for calling this very important hearing. I thank him for his understanding that I may have to leave to go to the Floor once or twice, because I am involved in one of the issues in the Defense Authorization bill which is currently on the Floor; and in the interest of time, I will just make a very brief opening statement and ask unanimous consent that my entire statement appear in the record.

Chairman MCCRERY. Without objection.

Mr. MCNULTY. Our hearing today will focus on whether fundamental corporate tax reform provides a viable option for replacing the ETI. I look forward to receiving the testimony of experts on proposals for a flat tax, a national retail sales tax, and various European-style value added taxes.

I am deeply grateful to each and every one of the panel members for coming here today and sharing their very valuable time and expertise with the Members of the Committee.

With that, I would like to get right to the panel, Mr. Chairman.

[The opening statement of Mr. McNulty follows:]

Chairman MCCRERY. Thank you, Mr. McNulty. With that, we will certainly turn right to the panel. Our first witness today is Mr. Eric Engen, who is a Resident Scholar with the American Enterprise Institute.

Mr. Engen, your written testimony will be included in its entirety in the record, but we would like for you to orally summarize your testimony in about 5 minutes. Thank you for coming, and you may begin.

STATEMENT OF ERIC M. ENGEN, RESIDENT SCHOLAR, AMERICAN ENTERPRISE INSTITUTE

Mr. ENGEN. Thank you, Mr. Chairman and Members of the Subcommittee. It is a great privilege to have the opportunity to appear before you today. My testimony today provides some broad perspectives on reforms of the corporate tax system and international competitiveness.

The ETI regime exists to help offset some of the efficiency-distorting and anticompetitiveness features of the U.S. corporate income tax. The WTO's decision on the ETI provides an opportunity to rethink the current U.S. corporate income tax structure and consider whether more fundamental tax reform would have an even greater positive effect than the ETI regime on the competitiveness of U.S. businesses.

Economic growth and a higher standard of living in the United States are ultimately achieved by increasing the productivity of U.S. workers. Increased productivity requires saving and investment. It is greater savings and investment and productivity that give businesses improved capabilities to produce goods and services at the relatively lower costs that are demanded in foreign markets.

Businesses must contend not only with making fundamental economic decisions, but also with how to deal with taxes. When compared to our primary economic competitors, such as countries in the Organization of Economic Cooperation and Development (OECD), the United States has a relatively high corporate income tax rate, and unlike most of these competitors, does not provide relief for the double taxation of corporate income.

The U.S. corporate income tax rate is 35 percent, while the average corporate rate for OECD countries is about 30 percent. Moreover, the United States is one of only three of OECD countries that does not have provisions in the Tax Code for some relief from the double taxation of corporate dividends. Coupled with individual income tax rates, the overall marginal tax rate on distributed corporate income in the United States can easily be over 60 percent.

High marginal rates discourage saving and investment in corporate capital and inhibit the competitiveness of U.S. companies in foreign markets.

Some options for corporate income tax reforms are as follows:

First, if the ETI is repealed, then the revenue gain from repeal of the ETI could be used to cut other components of the corporate income tax, such as reducing the corporate alternative minimum tax (AMT). While eliminating or reducing the AMT would be a laudable achievement, it still is only a step in addressing the problem of hefty corporate burdens for U.S. firms relative to their competitors, which initially led to the creation of the ETI.

Second, more fundamental changes that would maintain the basic structure of the corporate income tax system would be to reduce the U.S. corporate tax rate commensurate with the tax rates of competitors and provide relief from the double taxation of dividends.

Both of these changes would increase corporate investment and productivity in the United States and put the taxation of U.S. corporations more on a par with its primary economic competitors, thus increasing the competitiveness of U.S.-based firms and reducing the pressures for an ETI regime. Reducing the U.S. corporate income tax rate from 35 percent to 30 percent, for example, would remove the difference in corporate tax rates between the United States and other OECD countries. Corporate tax rates in OECD countries have decreased, on average, about 11 percentage points over the past 15 years from about 41 percent to almost 30 percent.

In a 1992 report, the U.S. Department of the Treasury recommended that dividend tax relief could best be implemented if a shareholder was allowed to exclude from growth income the dividends received from a corporation, which could be implemented with little structural change to the Tax Code.

Both of these tax changes would likely reduce revenue collected by the Federal Government even if dynamic macro effects were accounted for.

Some additional revenues should be raised, or spending reduced, in order to be budget-neutral. A good general principle for revenue-neutral tax reform is often to broaden the base and lower the rate. This principle suggests that some broadening of the corporate tax base should be considered; on the spending side, government subsidies to corporations could be analyzed.

Third, a much more substantial tax reform would be to completely replace the corporate income tax with a national sales tax, or a VAT.

Replacing the corporate income tax with a consumption tax would remove a large portion of the tax distortion on capital formation in the United States. Moreover, the sales tax or the VAT could be set to be revenue-neutral. However, the incidence of this tax reform would almost certainly be argued by opponents along the lines of it is a tax cut for rich corporations financed by tax hikes on poor consumers, and that argument may very well win the debate.

An alternative that may be more viable would be to fundamentally change the entire tax system. Both the corporate income tax and the personal income tax could be replaced with a flat tax or with a variant of the flat tax, the X tax, that has been proposed by tax economist, David Bradford, of Princeton University. The X tax is a two-component system comprised of a business tax that would replace the corporate income tax and a compensation tax that would replace the individual tax. Businesses would pay tax on -- a flat rate on a base consisting of the receipts from sales less outlays from purchases from other businesses. This part is similar to a VAT and essentially allows complete expensing of all investment.

In addition, business deduct all payments to workers. Workers pay tax on the amount received from businesses, and then total compensation could be taxed with progressive rates, if desired, including allowing an earned income tax credit (EITC) for low-compensation taxpayers. No other income, such as the interest, dividends, rent, or capital gains is included in the compensation tax base; thus, normal returns to capital are not taxed at either the business or individual level.

Although this approach goes well beyond what to do in the near term regarding the ETI regime, this type of fundamental tax reform, in my opinion, holds the most promise for ultimately making U.S. businesses more competitive by putting them in a tax environment that promotes saving and investment and that ultimately leads to higher productivity.

However, one of the potentially toughest issues in fundamental tax reform is the transition from the old tax system to the new system. In particular, there is sort of a "free rider" problem that would tend to rise. Whereas, a majority may agree that the new tax system would be a better overall system, many groups would want to keep their favorite tax preference from the old tax system. However, if most, or all, of these tax preferences in the old income tax system are incorporated into the new consumption-based tax system, then many of the advantages of tax reform become diluted.

Thank you.

[The prepared statement of Mr. Engen follows:]

Chairman MCCRERY. Thank you, Mr. Engen.

Our next witness is Mr. Herman Cain, who has vast experience in the private sector as a Chief Executive Officer and President of corporations; started a consulting business, among other things, in the private sector; and is here today as the spokesman for Americans for Fair Taxation, based in Atlanta, Georgia -- or at least Mr. Cain is based in Atlanta, Georgia.

Mr. CAIN. That is correct, Mr. Chairman.

Chairman MCCRERY. Thank you for coming today, Mr. Cain. Likewise, your full testimony will be entered in the record, and we would ask you to summarize it in about 5 minutes. You may proceed.

STATEMENT OF HERMAN CAIN, CHAIRMAN, GODFATHER'S PIZZA, INC., OMAHA, NEBRASKA; CHIEF EXECUTIVE OFFICE, T.H.E., INC., OMAHA, NEBRASKA; AND MEMBER, AMERICANS FOR FAIR TAXATION, HOUSTON, TEXAS

Mr. CAIN. Thank you, sir. Thank you very much, Mr. Chairman and Members of the Committee.

Nothing would promote the competitiveness of U.S. businesses more than a growing national economy, and since my full testimony has been submitted and already incorporated into the record, there are three key compelling points that I would like to try to make with the Committee.

First, our current Tax Code, which you have heard before, is an 8-million-word mess. It is beyond fundamental or any other kind of reform. The message that I would like to leave on behalf of not only Americans for Fair Taxation, but the many Americans that I talk with throughout my travels is that we should replace the current Tax Code, not try and reform it. That is point number one, to replace it.

I won't belabor all of the things that are wrong with the current Income Tax Code, but simply leave you with a message, which I hope will resonate, and that is, we need to be talking about replacement, because that would resolve all of the border adjustability issues, as well as being able to unleash the full potential of the economic platform in this country.

The second key point I would like to impress upon you, there is analogous to an old southern saying, "Don't shoot the dog before the hunt is over." The hunt is for a replacement system.

It is real easy for people to find every reason why we should do something. It is real easy for people to identify all of the reasons why a bold move, such as replacing the current system, is too big of a task to take on; and my point, that I want to impress upon you, is, let's not shoot the dog.

If we were able to put a man on the moon, we can find transition rules to move us from an archaic system to a system that would unleash the maximum potential of this economy, and also release the potential for every American to pursue their definition of the American dream.

When President John F. Kennedy said, We will walk on the moon by the end of the decade of the 1960s, he didn't say "maybe." He didn't say, It's a good idea. He said, "We will," and that determination and leadership is what caused the entire country to figure out the steps and the solutions that would get us there.

We need that same type of resolve in order to be able to replace the current income tax structure with the fair tax, which is a national sales consumption tax.

The third point that I would like to leave with you is something that is very disturbing to me personally as a citizen of this country. Many Americans simply do not believe that we will replace the system. They do not believe we can fix this mess. They have simply given up on Congress' ability -- not all, but some Members' ability -- to address the real solution, which is to install a brand-new system.

This is about reinvigorating the belief that our Founding Fathers had. When I tell people that I believe that the fair tax, which is a national sales consumption tax, is the best way to go at this point in terms of eliminating all of the problems that you are dealing with, even with respect to the Subcommittee, they say they don't believe it can be done. I simply remind them, where would we be today if George Washington and our Founding Fathers didn't believe that we could defeat the British? We simply wouldn't be here.

So, in summary, we must replace the current structure with the fair tax; number two, let us not shoot the dog before the hunt is over, we can work out all of the issues relative to how we get there; and number three, let us restore believability on the part of the American people.

Thank you very much.

[The prepared statement of Mr. Cain follows:]

Chairman MCCRERY. Thank you, Mr. Cain.

Our next witness is an old friend who has been kind enough to show me through a few tax problems, tax issues, over the past dozen years or so, 20 years maybe. He has been around a while, and I have a lot of respect for his knowledge of the Tax Code. I don't blame him for all of it, but some of it.

Mr. Christian, you probably should share the blame for it. So I will be interested to hear your comments about how we fix it.

Mr. Christian is the Chief Counsel for the Center for Strategic Tax Reform. Ernie, it is nice to have you with us, and you may proceed.

STATEMENT OF ERNEST S. CHRISTIAN, CHIEF COUNSEL, CENTER FOR STRATEGIC TAX REFORM

Mr. Christian. Thank you, Mr. Chairman. I assure you, I have repented, and I am now on the side of good.

Chairman MCCRERY. Thank you.

Mr. CHRISTIAN. There is another old southern expression that I would submit to my friend, Herman Cain, and that is, "Let's not get the cart before the horse."

Everyone wants an internationally competitive tax system for the United States of America. We need it.

That laudable goal is readily attainable without adopting some radical or experimental new tax system, I respectfully submit. With only two simple amendments, we can convert our existing corporate income tax into what, under WTO, is called an "indirect tax." Devices such as FSC and ETI would then be unnecessary. In a WTO-legal way, we could then fully exclude U.S. export income from U.S. tax, as we ought to do as a matter of policy. That would provide U.S. manufacturers with the option of staying home while exporting American-made products to markets all around the world.

Having done that, we could then take the next important step. We could adopt a territorial tax system that would allow American companies a fair opportunity to directly compete in those foreign markets that cannot be fully served by exports from America alone.

Under WTO, a tax with a tax base equal to value added is an indirect tax, but value added, Mr. Chairman and Members of the Committee, is an accounting concept similar to net income which is the base of our current corporate income tax. Value added as a measurement device has nothing whatsoever to do with taxing consumers or a sales tax or any of the other kinds of things often associated with a VAT.

To convert our corporate net income tax base into a corporate value added tax base, we need to make the interest that corporations pay to their debt holders nondeductible, the same way that dividends paid to equity shareholders are under the current Tax Code already nondeductible. Not deducting interest is not the big deal it might appear. The corporate tax rate would be only 8 to 10 percent after the base is broadened to include full value added, which is an extension of net income.

A Treasury Department study in 1992 by Glenn Hubbard, who is presently the Chairman of the President's Council of Economic Advisers, and my good friend and former Treasury Department colleague, Michael Graetz, sitting to my left, who is a distinguished professor at Yale, pointed out the negative impact on economic growth that results under present law from treating debt capital more favorably than equity capital.

They recommended a comprehensive business income tax in 1992, CBIT as it was called. It allowed no deduction for interest. It equalized the treatment of debt and equity. It is, in fact, the baseline from which we will proceed.

The second amendment is to make wages nondeductible against the 8- to 10-percent corporate tax rate. Before you recoil in horror, remember that employers already pay a 7.65-percent employer payroll tax on wages up to $84,900 per year per employee, the familiar employer FICA tax, Federal Insurance Contributions Act. Thus, wages are already nondeductible under present law against a rate which is almost as high as the 8- to 10-percent corporate rate that we are projecting in this proposal.

In order to avoid double taxation in the wage area, employers would be allowed a credit against the corporate tax for the payroll tax they pay on the same wages. No messing with Social Security whatsoever. Thus, in reality, there would be no major change in the deductibility versus nondeductibility of wages except in the case of the highest paid employees, and even in their case, not very much.

I am not suggesting, Mr. Chairman, that our friends in Brussels will automatically roll over and immediately accept without argument that America's revised corporate tax is an indirect tax under WTO. They won't. They will wiggle and they will squirm. They may even litigate, but I respectfully submit, Mr. Chairman, that they will have a devil of a time saying with any credibility that our tax, which has the same base as their tax, does not qualify simply because we do not engage in the rhetorical charade about VATs.

The Congress, in my opinion, has a golden opportunity before it to act on a bipartisan basis to provide the solution to some long-standing problems. I hope that you and the other Members of Congress will take advantage of that opportunity.

Thank you very much.

[The prepared statement of Mr. Christian follows:]

Chairman MCCRERY. Thank you, Mr. Christian.

Our next witness is also one who is not unfamiliar with the way tax laws are made, and we welcome him to our panel this afternoon. He is Michael Graetz, who is a Professor of Law, as mentioned by Mr. Christian, at a small school in the Northeast, Yale Law School.

Mr. Graetz, we look forward to your testimony, and as with all the other witnesses, your testimony will be included in its entirety. Please summarize in about 5 minutes.

STATEMENT OF MICHAEL J. GRAETZ, PROFESSOR OF LAW, YALE LAW SCHOOL, NEW HAVEN, CONNECTICUT

Mr. GRAETZ. Thank you, Mr. Chairman.

To promote economic growth and enhance Americans' standard of living, the Nation's tax system should be transparent and simple, should minimize economic distortions and taxpayers' compliance costs, and should impose the lowest rates feasible to fund the government's expenditures. The tax system should enhance productivity and should not inhibit savings. The Nation's tax system should also distribute its burdens equitably, and both the tax law and its administration should be regarded by the American people as fair.

By these measures, the American tax system is badly out of whack. We rely too heavily on income taxes and insufficiently on consumption taxes. We could improve our tax system along all of these dimensions by replacing a substantial part of both individual and corporate income taxes with a consumption tax, and by doing so, we could have a tax system the Internal Revenue Service (IRS) could administer.

To get there from here, ideologues on both sides of the political spectrum must compromise. Consumption tax proponents must abandon the fantasy that by enacting a consumption tax, we can completely eliminate the income tax; and income tax adherents must retreat from their stance that any consumption tax necessarily represents an attack on poor and middle-income taxpayers. Retaining and tinkering with the current system offers a poor prescription for either economic progress or tax justice.

Today, Presidents and Congress use the income tax the way my mother used chicken soup, as a magic solution to solve all of the Nation's economic problems. If we have a problem in access to education, child care affordability, health insurance coverage, or financing of long-term care, to name just a few, the answer is a tax credit or deduction. Tax legislation during the 1990s completed the unraveling of the 1986 Tax Reform Act, which had promised, but failed to deliver, a broad-based, low-rate, fair and simple tax.

In 1940, Mr. Chairman, the instructions for the Form 1040 were four pages long. Last year, the booklet was 117 pages long. The Form 1040 for last year had 11 schedules and 20 additional work sheets. As the Congress has introduced new problems into the tax system, old problems have multiplied, and as these hearings suggest, probably the most important relate to the internationalization of the world economy.

Clearly, we need a fundamental reexamination of U.S. income tax policies regarding international income, but more fundamental change is needed. I am a great fan of the current IRS Commissioner Charles Rossotti, but I remain wary when people talk about a customer-friendly IRS. I have often said, I will become a werewolf before I would be a customer of the IRS.

To think that the IRS can become a modern financial services institution without an overhaul of the tax law it administers is to believe that you can turn a Winnebago around without taking it out of the garage. The fundamental problem is that the IRS is being asked to do too much. It cannot do all of the things that Congress is now asking it to do.

The sales tax proponents are right. The majority of American families should not have to file tax returns or deal with the IRS at all. Everyone else proposing tax reform, the flat taxers, the income tax reformers, those who favor progressive consumption taxes, would fail to remove the IRS from the lives of average Americans.

Flat tax advocates trumpet their claim that they would shorten the individual tax return to fit on a postcard, but, given Congress' propensity for enacting tax breaks for this or that, it is foolish to believe that a flat tax would stay flat or simple for very long. The political allure of giving Americans tax breaks for specific expenditures is catnip to both the Congress and the White House. The flat tax's treatment of exports and imports is properly anathema to American businesses.

In contrast, since the reporting of sales taxes would be done by retail businesses and no individual returns would be required, a sales tax would offer genuine and lasting simplification for the American people. The rub, however, is that complete replacement of the income tax with a sales tax would provide a large tax reduction for the country's wealthiest people.

Both the flat tax and the sales tax would shift the Nation's tax burden from high-income people to those with lower income. As the New York Times columnist, William Safire, has said, "Most of us accept as fair this principle: The poor should pay nothing, the middle something, and the rich the highest percentage."

The current income tax is a horrible mess, and in thinking about how we should move forward to a new tax regime, I believe we can profitably learn from the tax policies of our past. We can achieve low rates and a reasonably simple tax system by replacing most of the income tax with a tax on consumption. In the process, we should return the income tax to its pre-World War II status, a low-rate tax on a relatively thin slice of higher-income Americans.

The value added tax is a revenue-producing mainstay in over 120 countries on 5 continents. Sales taxes are far more susceptible to tax evasion than a value added tax. A VAT imposed at about a 12-percent rate could finance an exemption from income tax of families with up to $100,000 of income, and enacting a VAT would allow a vastly simpler income tax at about a 25-percent rate or less to be applied to income over $100,000. This shift in the composition of the Nation's taxes would eliminate more than 85 percent of the American people from the income tax rolls.

This is a practical and workable plan. Low- and middle-income families could be protected from any tax increase through payroll tax offsets. The corporate income tax could also be reduced to 25 percent or less, the same rate that would apply to the income of high-income individuals. This plan is designed to be both revenue-neutral to the Federal Government and distributionally neutral for the American people. It is a practical plan and I urge the Committee to consider it.

Thank you.

[The prepared statement of Mr. Graetz follows:]

Chairman MCCRERY. Thank you, Mr. Graetz.

Our next witness is Mr. Stephen J. Entin, who is President and Executive Director for the Institute for Research on the Economics of Taxation. Mr. Entin, you may proceed.

STATEMENT OF STEPHEN J. ENTIN, PRESIDENT, INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION

Mr. ENTIN. Thank you, Mr. Chairman and Members of the Subcommittee. I am grateful to the Subcommittee for bring renewed attention to the issues of international taxation and competitiveness and for asking me to testify.

The Subcommittee has asked if fundamental tax reform can act as a substitute for ETI in increasing U.S. exports. Such reforms could include a national retail sales tax, a credit invoice VAT, a subtraction method VAT, a business activities tax, a flat tax or a simple cash flow tax on individuals, which I hope you will add to your list.

The simple answer to the Subcommittee's question is that any of the major tax reform proposals would dramatically increase the size of the U.S. capital stock and boost national income by about $4,000 to $6,000 per family. Production for domestic sale would certainly increase. Over time, exports would very probably rise and imports would very probably rise as well.

Manufacturers, whether import competitors or exporters, would certainly benefit. The increased domestic income would be reflected primarily in increased wages and salaries with some lesser gains in domestic capital income as well.

The precise effect on the difference between exports and imports over time is harder to predict. It would depend on whether national saving had risen by more or less than domestic investment in a given year.

All of the major tax reform proposals are territorial in nature. Some of these territorial tax reform proposals are border-adjusted tax (BAT) and some are not. All of the major tax reform proposals eliminate the major biases in the income tax system against saving and investment and produce a tax system that is neutral between income used for consumption and income used for saving and investment. It is this last criterion, neutrality, that would lower the excess tax burden on U.S.-sited capital and would have the biggest impact on business investment, production and employment in the United States and on the resulting trade flows.

The United States is no longer a low-tax country for business. The current tax regime's foreign tax credit is so limited by various divisions, by country and type of income, that it places U.S. businesses at a serious disadvantage to foreign businesses competing in foreign markets. That problem would be solved by a territorial tax system.

Territorial taxation would benefit all U.S. multinational industries and would eliminate the U.S. tax penalties that pressure global countries to incorporate abroad rather than in the United States. It would not, however, specifically benefit the export operations of domestic producers and those who currently benefit from the ETI.

Border adjustability is a different issue. A territorial tax can be border adjusted or not depending where in the production process it is levied. Economists generally believe that after an initial transition, it matters very little whether the tax system is of the border adjusted or nonborder adjusted type. What really matters is whether it treats capital formation and consumption neutrally and taxes them at a low rate.

The income tax treats income used for saving and investment more harshly than income used for consumption, and that is the root of the problem. Income is taxed when earned. If used for consumption, there is generally no further Federal tax, except a few excises. However, income that is saved is subject to several additional taxes on the earnings, including income tax on the interest, dividends and capital gains, to the corporate income tax and to the estate tax.

To correct the bias against saving, either income used for saving must be tax deferred and the earnings and principal taxed when withdrawn for consumption, or the earnings used for saving must be taxed up front and the earnings be left tax exempt.

Fixing the added tax biases against corporate income would require that it not be taxed at both the individual and shareholder level, and there should be no estate and gift tax. If saving is invested directly in physical assets, the correct treatment is immediate expensing of the investment rather than depreciation. The table in my paper shows you the damage that depreciation is doing. Many of the industries hit by the shortfall of depreciation are in import competing and exporting sectors. Most would benefit greatly if we moved toward expensing; they would become more competitive.

Recapping the rules for neutrality: If a tax is imposed at the individual level, saving must be tax deferred. Alternatively, if the saving is taxed, the returns must be left exempt. If the tax is imposed at the business level, investment must be expensed, not depreciated. All the major tax reform plans follow those rules.

A retail sales tax is collected by retailers based on the consumption spending of individuals, which means the tax base is their earnings less their saving.

Value added taxes and the BAT are collected by businesses in increments through the production process, and are based on a business's sales less its investment expenses. This involves expensing, and the tax base equals national income less saving.

An individual cash flow tax is collected from individuals based on their earnings less their saving. A non-corporate business's investment is expensed.

In the flat tax, income from capital would be taxed at the business level before being distributed to the owners or reinvested and, as in a VAT, firms would expense their investment.

Except for a few quirks, all the major reform approaches have the same fundamental tax base, revenues less saving, or revenues less investment. This is the proper definition of net income. These reforms should not be thought of as consumption taxes. They are properly defined income taxes. They all reduce the excess tax burden on investment.

If I had to choose among them, it would be on the basis of transparency, which tax most clearly reveals to taxpayer voters the extent of the government's tax take. That would be the individual cash flow tax.

Thank you.

[The prepared statement of Mr. Entin follows:]

Chairman MCCRERY. Thank you, Mr. Entin.

Our next witness is a gentleman who has been very generous with his time of late with some of us on the Committee on Ways and Means, and we look forward once again to hearing his testimony today. He is William G. Gale who is a Senior Fellow at the Brookings Institution.

Welcome back, Mr. Gale, and please proceed with your oral testimony.

STATEMENT OF WILLIAM G. GALE, SENIOR FELLOW, BROOKINGS INSTITUTION

Mr. GALE. Thank you very much. It's a privilege to be here this afternoon.

So far we have reinvented the Federal tax system about five times in the last 20 minutes. My head is spinning, and I study this stuff all day long. So I'm going to depart from what I planned to say a little bit and try to take a step back and focus on two issues.

One is the specific international tax issues that I think motivated this hearing; and second is, what is the role of fundamental tax reform in addressing those issues? Now, that doesn't help us stop our heads from spinning too much because international taxation is notoriously complicated even for experts, but what I would like to do is focus on the forest rather than the trees here.

There is a single kind of bright line on the international tax issues that has to be focused on amid all the detail and legal and economic discussion, and that is the principle that features of the Tax Code that affect the taxation of offshore income should not be allowed to erode the taxation of domestic income. If you cross that line, then you have created the biggest tax shelter in history. Just as when you put a hole in a dam, you don't just lose the water right in front of the hole, you lose all the water that is near it, the same thing would happen to tax revenues.

So forget about all the gobbledegook and focus on this one issue that whatever happens on the international side should not be allowed to let firms reduce their domestic taxes. I think that's the fundamental issue on the international side.

Having said that, let me turn to export subsidies. The United States subsidizes exports in a couple of ways. I think that the WTO rulings were and are the right ones, that is, our export subsidies violate the WTO regulations, but even ignoring the legal issues, export subsidies are not effective. They are not effective in improving the trade balance. They are not effective in that they pass on some of the subsidies to foreigners, who benefit from lower-priced U.S. exports. They are not effective in that they encourage U.S. firms to choose projects that have low total returns over different projects that have high total returns because of the differential tax treatment.

Most importantly, some of our current export subsidies cross the bright line I mentioned, and they let U.S. firms reduce taxes on their domestic income on the basis of features of their foreign source income. That's a mistake.

So, regardless of what the WTO said, I think it is right that the export incentives should be repealed. Both national welfare and the public fisc would be improved. I say, may it rest in peace, may ETI rest in peace.

The second international issue that has come to attention recently is corporate inversions. Corporate inversions occur when firms move their legal headquarters out of the United States solely for tax purposes. Although inversions are perfectly legal and they make perfect since sense from firms' perspective, they are extraordinarily bad public policy. The reason is that inversions allow firms not only to reduce or eliminate the taxes on their foreign source income, they allow them to reduce or eliminate taxes on their domestic income.

So, once again, inversions cross that bright line, and that is a line where you sort of have to make your last stand. I don't know enough about the legal details to suggest exactly what type of laws should be written to restrict those, but I would argue that that is a high priority for tax policy.

My testimony goes through two reasons why moving to a territorial tax system is not an effective response to the repeal of ETI or an effective response to the increase in inversions. Let me just mention that moving to a territorial system which only taxes U.S. income in response to inversions is basically like saying we are going to reduce the crime rate by making various crimes legal; so you could reduce the crime rate if you make murder legal. That wouldn't reduce murder, but it would reduce the crime rate.

That is the equivalent of going to a territorial system in order to stop inversions. It would no longer be considered an inversion because it would be a perfectly natural part of the Tax Code.

Let me turn to fundamental tax reform. I think the issue here is replacing the corporate income tax with a value added tax, not replacing the whole system with a value added tax because it would not tax exports if we could get WTO to agree on that.

The VAT obviates any potential need for export subsidies. It is my conjecture, though, that the political demand for export subsidies would not disappear. Also, it is important to know that moving to a VAT would not stop the inversion problem, and the reason is, under the value added tax, some firms would see their tax payments skyrocket and the reason is because the VAT tax base is different from the corporate income tax base.

The VAT does not tax profits, and so a company like General Motors, if we move to the flat tax, their tax liabilities would have gone from $110 million in the early 1990s to $2.7 billion; and that is an estimate from Hall and Rabushka, the creators of the flat tax. If you go to a VAT, their tax liability would go up even more because they couldn't deduct wages. So we are talking about some firms having massive increases in tax liabilities, some having massive reductions in tax liabilities. That is the way the VAT is supposed to work relative to the existing system, but firms that have massive increases would still want to invert for the same reason their firms want to invert now.

I would be happy to talk more about the VAT, but my basic point is that neither moving to a territorial system nor fundamental tax reform represents an effective response to the ETI problem or the inversion problem. More direct measures would solve those problems without creating all the side issues that fundamental tax reform raises.

Thank you very much.

[The prepared statement of Mr. Gale follows:]

Chairman MCCRERY. Thank you, Mr. Gale.

Our final witness on the panel today is a respected Professor of Economics at another small school in the Northeast, Harvard.

Mr. Jorgenson, welcome today. We appreciate your taking time out to join us, and we look forward to hearing your oral testimony. You may proceed, sir. Thank you.

STATEMENT OF DALE W. JORGENSEN, FREDERIC EATON ABBE PROFESSOR OF ECONOMICS, HARVARD UNIVERSITY, CAMBRIDGE, MASSACHUSETTS

Mr. JORGENSON. Thank you, Mr. Chairman, distinguished Members of the Committee. It is a very great privilege to participate in these hearings.

I think that you have heard from the other witnesses about the serious deficiencies in our existing tax system. What I would argue is that this is the time for reform, and the argument is going to be based on the fact that the U.S. economy is emerging from a recession at the moment. Maybe we have already emerged.

Investment is still seriously depressed, especially in the corporate sector. Therefore, it is very appropriate for these hearings to focus on the corporations' income tax, as you did in the call for the hearings that are taking place now. Therefore, I am going to propose to focus on tax reform that would have the effect of stimulating investment and thereby accelerating the rate of economic growth to the higher potential that is now evident from our productivity statistics issued only last Monday.

I want to make three points. I want to talk in a little bit more detail about the potential economic impact of tax reform. I think it is very important to try to quantify that, to appreciate the scope of what is under discussion here.

Secondly, I would like to outline a tax reform proposal that focuses on investment and making investment more effective, as well as providing more for more investment.

Then, finally, I would like to refer to the issue of transition rules and simplification, which is also very much on everybody's mind.

What I would like to propose is, in fact, that every dollar of investment should be earning precisely the same rate return before any taxes are levied. That ought to be the fundamental principle, because that is the only way that it is going to be possible to generate the kind of economic growth of which our economy is capable.

The second step in fundamental tax reform is to reduce marginal rates, the rates on the last dollar of income earned, in order to provide the maximum incentives for American workers. My written statement outlines an approach to tax reform that would achieve these two objectives, and it would consist of two parts: a capital income tax rate that equalized before-tax rates of return, and a proportional earnings tax that minimizes the marginal tax rate on earned income.

What kind of effect would this have on our economic growth? Well, for that purpose, I would like to propose a very simple yardstick, and that is the impact on consumer welfare measured in dollars. The reforms I have suggested would have a massive welfare impact amounting to $4.9 trillion. By comparison, U.S. national wealth in the year of the comparison was only $25.4 trillion. So the welfare impact amounts to 19 cents on our national wealth, or 19 cents for every dollar of assets that we hold as a Nation.

How much would the impact be for the kind of value added tax that has been described by other witnesses? The answer is about 40 percent as much. I estimate that would be $2.06 trillion, about 40 percent of the $4.9 trillion that is potential.

In short, the opportunity we face for stimulating investment and bringing our economic growth up to full potential is staggering, and to take advantage of this historic opportunity, I think what we have to do is to reform our taxation of property-type income so as to equalize the burdens. We have to reform our taxation of earned income in order to minimize the marginal rates.

The kind of reform that I have discussed in my written statement, which I hope you have before you, would produce a rate on earned income of only 10.9 percent. For property-type income, the rate would turn out to be something like 30.8 percent, far below the combination of individual and corporate taxation which are now faced by corporate investors. So, the system that I am proposing is one that introduces differential taxation of property-type income and earned income.

This is something that has a great history in U.S. tax law, and precisely this kind of differential taxation existed between 1962 and 1983, for two decades. So, there is a long tradition here to draw on. The definitions of income in the Tax Code would remain unchanged, and the rate structure on property-type income would remain unchanged.

So, this method is based on the idea of reintroducing investment tax credits that would be specific to specific forms of legal organizations. In particular, corporations would receive tax credits of 3.9 cents on the dollar for new investments in equipment and 18.9 cents on the dollar for new investments in structures. Noncorporate businesses would be given a tax credit of 0.5 cent on equipment and 8 cents per dollar on structures. The effect of that is essentially to eliminate, that is to say, abolish the distinction between corporate and noncorporate income so far as the tax structure is concerned.

This would be financed by means of a system of taxation on new investments by the household sector in housing and in equipment, and the rates would be set in such a way as to achieve a revenue-neutral system altogether.

So far as transition rules are concerned, there aren't any. This doesn't require any transition rules. It is a very straightforward system, and there is nothing inconsistent between what I have proposed and any program of tax simplification like the three volume proposal which has been made by the Joint Committee on Taxation.

So, to sum up, the system that I propose is a fundamental reform that deals with the issue that you identified in calling for these hearings, namely, the deficiencies of our current corporate tax system. It is a system that would promote investment, especially in the corporate sector, and it would enhance the competitiveness of American businesses in the global marketplace. This would be a forceful and effective response to the World Trade Organization and will meet the needs of American businesses and consumers in our 21st-century economy.

Thank you.

[The prepared statement of Mr. Jorgenson follows:]

Chairman MCCRERY. Thank you Mr. Jorgenson.

We thank all of you on the panel for providing us with some excellent testimony and some excellent ideas for us to think about.

Now we have the privilege of asking you a few questions regarding your testimony and anything else that the panel of members wishes to inquire about. I would tell the Members of the Subcommittee that if the panel is amenable to staying around, I will allow a second round of questions if anybody wants to stick around for a second round, because this subject matter, as anybody who might be watching on TV has figured out by now, is fairly complex; and if they weren't convinced before Mr. Jorgenson's testimony, they certainly are now. Mr. Jorgenson, if you could hang around for about another 6 months, we could get some excellent feedback from your testimony.

Mr. Gale, I can't help but go back to your analogy about crimes and reducing the crime rate. Some might retort that if the crime were reading any writings of Thomas Paine or reading any writings of Ivy League professors, it might be a good thing to abolish that crime and reduce the crime rate. So keep that in mind.

We are going to have a hearing in June that will specifically include the subject of corporate inversions, so we hope to further explore that issue at that hearing. It is a very important issue for us to learn more about and to explore, and we intend to do that in the June hearing, but I appreciate your remarks today about that.

Mr. Entin, let me start with you, but I want others to comment on this. I have heard in other for a -- some of you comment on this. Generally, the economists and the tax experts that have spoken to Members of the Committee on Ways and Means and in other settings have agreed that border adjustability is not necessarily an advantage, it is not an advantage or a disadvantage in terms of the competitiveness of our domestic corporations.

Do you agree with that, Mr. Entin?

Mr. ENTIN. I do agree with that. Sometimes people do a partial analysis; they take the first step and then they don't allow other things to adjust.

When adjustments are made, border adjustment washes out. The neutral taxes that you see in fundamental tax reform proposals are collected at various points in the production process. Labor and capital come together and produce a product, and the business sells it. The proceeds are paid out to the labor and the capital, and the labor and the capital go off and buy the goods.

A sales tax is imposed at the point of sale, at retail. Products that are sold to exporters don't go through the retail. Thus, they are not taxed. Sold to the domestic person, they are. Imports are taxed when the family takes its income and goes to the retailer and spends it.

In the cash flow tax that I described, individuals take their income, subtract their saving and pay tax on what is left; then they go to the store. Whether they buy an import or an export, there is no tax there. It was collected before they left the house.

If you tax the same tax base before they leave the house or after they get to the store, it is the same tax base. One appears to be border adjustable. One is sort of implicitly border adjustable. There is no difference.

That would be true also for the VAT, which is collected within the firms as their products go up through the production process, or in the sort of Roth-style flat tax approach. All these things wash out.

What the tax reforms do for exporters, I think, is twofold. They take away the extra layer of tax on corporations, many of whom are large exporters and many of whom are import competitors. For corporations and for the small businessman, they also move from depreciation to expensing. These steps lower the cost of capital.

In the United States, we hit manufacturers harder than the service sectors because manufacturers use more capital. The manufacturers with the longest-lived capital get hit the hardest because depreciation shortchanges longer-lived assets the most; and if there is inflation, it is even worse. So by fixing that element of it, you happen to benefit many of the sectors that have suffered over the years, sectors that have experienced a shift of our resources into other sectors. You are undoing this effect of the bad tax system on manufacturers, and they will grow. There will be some more exports, perhaps, but there will also perhaps be some more imports.

The difference between exports and imports may not be affected very much, but the sectors that you worry about the most and which are complaining the most about import competition are really complaining about the fact that our tax system is hitting them over the head with a two-by-four. Fix that and they won't worry so much about whether their competitors are down the street or over the ocean.

Chairman MCCRERY. Does anyone on the panel think that border adjustability is important for competitiveness?

Mr. GRAETZ. Mr. Chairman --

Chairman MCCRERY. Go ahead, Mr. Graetz, and then I will call on Ernie.

Mr. GRAETZ. I think that it is important. The economic analysis suggests that it doesn't matter whether you apply a consumption-type tax on an origin basis or whether you apply it on a destination basis with border adjustments. The argument is that foreign currency relationships will change to equalize things over time.

The first point I would make is, this is an "over time" story, and the question of how much time is required is not clear.

The second point I would make is, if you take an origin-based tax like the flat tax, it taxes imports only on their U.S. markup, whereas a domestic business is taxed on its full value added, if you will. American business properly is going to say that that system is creating an unfair advantage for imports.

We went through this many times with energy-type taxes. You may remember proposals for energy taxes that were not border adjustable, and the American manufacturers insisted that this put them at a tremendous competitive disadvantage.

I think it is extremely important that you have a tax that does have border adjustments in order to achieve a level playing field quality, and in order not to a rely on the currency adjustments that the economists assure us will take place to protect American businesses. So, it is fundamental issue, and it is not a subsidy.

Border adjustments are not a subsidy for U.S. exports. They just put imports and exports in the same place in terms of what the American consumer pays for them, but I think, in terms of practicality, there is all the difference in the world.

Chairman MCCRERY. Mr. Christian.

Mr. CHRISTIAN. Well, what Mike says is by and large correct. I would further point out that this "over time" theoretical adjustment of exchange rates that he has referred to might be an extremely long period of time. Given that transactions in goods are only a very small portion of the transactions in the current account, they are almost too small to have the effect that economists predict in theory.

The point really is that what we should stop, as a practical real-life matter, penalizing manufacturing in the United States and exporting it to a foreign market. Companies should have the option of staying at home and selling into a foreign market. At the present time we provide an incentive to manufacture abroad and sell abroad. At the present time -- if you do succeed in a foreign market, we penalize you if you bring the money home for reinvestment in the United States of America, whereas, if you can keep it abroad, if you are a large enough company to do so, and reinvest it in someone else's economy, you can defer U.S. tax indefinitely.

Applying little theoretical catechisms to little pieces of the puzzle is wrong. We have to look at the practical picture of what is occurring with respect to U.S. exports. Manufacturing in the United States is in a decline and has been in a decline for a very long period of time.

Mr. CHRISTIAN. It is almost not an issue worth debating. It is like arguing about the last war and the tactics that were employed by generals in the last war. We are in a different situation now.

Chairman MCCRERY. Mr. Cain.

Mr. CAIN. I would just like to add that if we were able to develop the perfect border adjustability formula under the current system, the revenue impact that we are talking about would be minuscule compared to the upside if we put an economic boon in the U.S. economy by changing the entire system. That is one of the points that I wanted to make, because if we go to a national consumption tax, imports and exports get treated the same. The U.S. businesses would applaud that. They know how to compete if there is a level playing field. This is why we are proposing to look at replacing the system such that the temptation to build plants overseas would be gone. There would be an even greater temptation to build plants at home by eliminating that.

Chairman MCCRERY. Before I go to Mr. Neal, Mr. Engen, on a variation of this question, and if you want to comment on that question you may, but is it your opinion that U.S. companies and taxpayers are paying a portion of other country's social welfare costs when value added taxes are imposed on U.S. exports at the border of those other countries?

Mr. ENGEN. I think it depends on what transactions you are looking at specifically. I mean, I think there is a possibility with the way some of the border adjustments work that with some of the payments, those are going into the tax revenues of other countries, and thus of funding whatever they choose to spend on it. I don't necessarily believe that that is an obvious conclusion.

The one thing to comment on from before is, I think I would agree with Mr. Cain to my left, that one of the most important things here is not necessarily the border adjustment, that in the end, that is a relatively small issue, although there are some practical issues in this. In that sense, Mr. Graetz's points that, you know, in the near term and for practical purposes, there are some various issues with the X tax that I was talking about, which is a variant of the flat tax. It can matter in some small ways whether you choose an origin base or a destination base how you do the border adjustments.

I think the main issue is the point brought up is that if we reduce the tax distortion on capital, it is going to make the U.S. economy a much more friendly place for businesses to invest, and it takes away a lot of these other pressures, a lot of the concerns about border adjustment and import -- export subsidies.

Chairman MCCRERY. Thank you. Mr. Neal.

Mr. NEAL. Thank you, Mr. Chairman. Thank you for holding this hearing, and I think these get-togethers are most helpful. Indeed, Chairman Thomas' decision to hold the sessions with the Congressional Research Service also I think have been very, very helpful.

I want to also publicly thank you for agreeing to hold a hearing in early June on the whole issue of corporate inversions.

Stanley Works voted this morning to leave the United States and to reincorporate in Bermuda. That is going to set off a fire storm on both sides of the aisle. A very prominent Republican said to me before the last vote, "You are absolutely right; if this gets to the Floor, I am with you."

I would like to ask first of all, Mr. Gale, and then come back to Mr. Graetz for a second, sometimes it is very hard for all of us to understand what is meant by international competitiveness. Does it mean that tax reductions that are good for some multinational corporations are good for America as a whole?

Mr. GALE. Economists usually like to squirm at the popular definition of competitiveness, which is often defined in terms of the trade balance. Then we get into these arguments about whether border adjusting improves the trade balance, and economists generally think in the long term the answer is no, on the short term generally, I think the answer is no too, but there is room for discussion there, I guess.

Different people define competitiveness in different ways. There is an issue, if it is defined in terms of the trade balance, then border adjustability is just not a big issue. If it is defined in terms of the underlying productivity of American firms, then you have something you can sort of grab on to and talk about how different policies affect productivity. That is a little less of a swishy concept than competitiveness as it usually is applied in the public sector.

Mr. NEAL. Okay. Mr. Graetz, regarding companies that are avoiding U.S. tax by reincorporating with a Bermuda mailbox, would rules to stop this hurt U.S. international competitiveness or speed harmful foreign takeovers of U.S. businesses?

Mr. GRAETZ. Mr. Neal, I don't believe so. I believe the corporate inversion problem does need to be stopped because I think that -- actually, this is one of the places I can actually agree with Bill Gale, which I like to do if I can -- one of the things that is going on in these inversions is an effort to eliminate U.S. tax on U.S. source income. This is not a story that is limited to competitiveness in foreign markets. When some corporations can find it possible and easy to avoid U.S. tax, and others do not, I see no reason to think that this is good for America. Nor do I think it is good for America to have our tax base depend on a mailbox in Bermuda and a meeting in Barbados. I think now you need both. That is Stanley Works' plan, as I understand it; you have to have a mailbox in Bermuda and you have to meet once a year in Barbados, not that that is such a hardship for the companies. I think it is an important problem, and I think it needs prompt attention by the Congress.

Mr. NEAL. Thank you. I want to ask another question if I could, then feel free to expound upon it. Mr. Cain, do you think that we are going to change the Tax Code? You said the American people don't believe we are going to change the Tax Code. Do you think we are going to?

Mr. CAIN. Do I think?

Mr. NEAL. That Congress is going to change substantially the Tax Code? Do you think we are going to a consumption tax or flat tax?

Mr. CAIN. I believe so, because even if we were to pass regulations, or if Congress were to pass regulations to address the issue that you are talking about, it would simply create more complexity, more costs. So we really aren't solving the problem. I firmly believe that the American people have a desire to see some bold action on this thing. So I think that there are a lot of people who believe that it can be done, but doing it to stop that type of thing would just make it more complex.

If I may add one other thing, let me give you the definition of competitiveness that I know most businessmen share, whether it is in the domestic or international. It is a level playing field with the absence of disadvantages and disincentives to do business. That is all American businesses want, whether that is domestic or in the international arena.

Mr. NEAL. I would just close if I could. Back in 1995, the Majority Leader here talked extensively and expansively about changes in the Tax Code. He said, in this Committee, we were going to, I think, pull the Tax Code up by its roots. He said, we were going to drive a stake into its heart. We were moving in the direction of a consumption tax one day and a flat tax the next day. One thing I am curious about, Mr. Cain, is whether you think it is going to happen, because I haven't seen a lot of evidence around here that it is going to happen.

Mr. CAIN. Mr. Neal, I believe it can happen, but more importantly, I believe it must happen. I am familiar with those hearings and those statements because you may recall, I was on the Tax Commission in 1994-1995, but that is part of the problem. We have debated this for a long time, but due to lack of follow-through and leadership, nothing has been done yet.

Mr. NEAL. Thank you very much, Mr. Cain.

Chairman MCCRERY. Thank you, Mr. Neal. Mr. Weller?

Mr. WELLER. Thank you, Mr. Chairman. I commend you for this series of hearings which are very informative as we look at ways of creating economic growth and making or giving the opportunity for American companies to be competitive on the global stage. I recognize we are limited on time, we have a vote here to go to, so I am going to cut to the point here. Over the last several years, it has become very clear that our Tax Code hampers economic growth in the way we depreciate assets or how we recover the cost of assets in our economy. The office computer we carry on the books for 5  years, it has depreciated over 5 years, but on average, business replaces it every 14 months. It just doesn't make sense under our current Tax Code.

My colleague, Mr. English, and I know, Mr. Neal and others, we have all been advocating ideas out of the expense and Technology Reform Act, which will allow you to fully expense computers and telecommunications equipment, wireless, medical technology, security equipment, surveillance equipment, and biometrics and other equipment, that has a very short real life.

Mr. Christian, you in particular have been one who has been very involved and engaged on this issue in cost recovery and depreciation reform. With the Chairman's leadership, we were successful in beginning that process in the economic stimulus plan that the President signed with a 30-percent expensing, or some call bonus depreciation or accelerated depreciation component That is temporary, and we have introduced legislation to make it permanent as the bottom line as we look at depreciation reform. Mr. Christian, I would like to hear from you and others on the panel just what your thoughts are about how expensing in particular how you feel that would impact capital formation, how it would impact economic growth, and also our international competitiveness.

Mr. CHRISTIAN. Mr. Weller, thank you. You and Mr. Neal and Mr. English and others you have taken the leadership role, which has already benefited America. The 30-percent expensing was done in a bipartisan way. I have come here today to propose a bipartisan solution to an international problem involving exports. If you adopted the solution we are talking about and in the same bill went to 100-percent expensing, you would essentially have a neutral tax system for exports from the United States, you would have credited a neutral tax system for capital recovery.

Moving quickly then to the issue of inversions and the international situation which is becoming intense. People are fleeing. Foreign companies are not coming here to make this their headquarters. If we did in one bill what you and Mr. Neal and others under the Chairman's leadership have been trying to do for several years by enacting 100-percent expensing, and if we made the changes to exclude export income from U.S. income tax.

The United States would be the most desirable place in the world for all business, whether American-owned business or foreign-owned business, to conduct world trade throughout the world. Companies that have fled America would want to come home. Those who are thinking about fleeing it would not do so.

There are various kinds of inversions and there are various things about inversions such as earning strippings, that are not good. Mr. Graetz has pointed that out. Those are not small issues, but they are, in a way, tangential issues to what is the larger problem of the cost of capital in the United States and how we treat our exports relative to how other countries treat theirs.

I commend you, Mr. Neal, and others for the progress you have already made on expensing.

Mr. WELLER. Thank you, Mr. Christian. I realize I have run out of time here. I would comment that one thing I would hope that our Subcommittee would look at is how our competitors overseas treat assets when it comes to cost recovery. I have seen information which would suggest that particularly our competition in Asia and Korea and some other countries overseas, that their tax treatment of assets is much more favorable than ours giving their companies a greater advantage when it comes to economic growth.

Thank you, Mr. Chairman.

Chairman MCCRERY. Thank you Mr. Weller. Gentlemen, we have a vote on the House Floor. I am going to recess the Subcommittee for just a few minutes just long enough for us to run over vote and come right back. So the Committee will stand in recess.

[Recess.]

Chairman MCCRERY. The Committee will come to order. I appreciate our panel of witnesses being patient with our duty to vote, and we don't expect another vote for a while. So, we should have sufficient time to finish the questioning. Now I would like to turn to another distinguished Member of the Subcommittee, Mr. Ryan from Wisconsin.

Mr. RYAN. Thank you, Mr. Chairman. Before I ask a couple quick questions, I thought that just for the record there might be some clarifications. It's been said a couple of times that the flat tax is not a consumption tax. That is just not the case. The flat tax is a consumption tax. I just want to make that clear for the record. Also it is a progressive tax. It is a tax because of generous exemptions means that it is effectively a progressive tax. So I just wanted to kind of clear that.

I wanted to nail down this issue of those of you who are for destination principle taxation versus origin principle taxation, different from an economic standpoint, from a competitiveness standpoint on having a territorial origin tax system versus the destination principle system. I would like to continue that road. I saw a couple heads shaking when Mr. Graetz, and I think Mr. Christian, were talking about it.

Steve, let me go to you. I think your head was shaking the most. When we talked about that, and it is the idea that over time, the differences made up and that exchange rates play into it, I would like to see if we can just focus on that discussion right now.

Mr. ENTIN. This is so much easier with a blackboard and maybe about 16 weeks. About the time frame; orders for goods and services change over time, and there is usually a prolonged period waiting for payment. Back in the old days we used to think that exchange rate changes took a long time to work.

The bond market, the stock market, and particularly the foreign exchange market which have gotten so much bigger since the 1930s and 1940s. All of these adjust instantly, unless it is a weekend, and even then there is after-hours trading.

If I were to go from a system where we have no border adjustability and then simply impose one, initially I would be saying, "Look, there is a 10-percent drop in the price of exports, a 10-percent tax on imports." But within a matter of a blink of an eye, the exchange rate could go bang, and jump up 10 percent, and the drop in the price of the exports would be undone and the cost of the imports would be driven right back down to where they were a nanosecond ago. That is what we are taught in school.

More to the point, assume that we are at full employment and the Europeans are at full employment (or what passes for it given their huge tax load -- it looks like their unemployment rate is very high, but nobody can afford to hire them so they are stuck). We have low unemployment, or did until a few weeks ago. If we are at full employment and someone comes along and says, "I am going to do something that boosts your exports," that is fine, but what happens next? Instead of selling my product down the street, I am selling it to the guy in Canada. I am still getting paid so I am still going shopping. The guy down the street is still getting paid, and he is still going shopping. If the product I was putting into the domestic market has gone overseas and we all are still going shopping, and we still want to buy just as much stuff, then we are going to have to buy something to fill in the hole left by the exports, and it is going to be an import.

Exports and imports go up at the same time. So, you are going to get the same trade balance, which is governed by whether capital is flowing in or not, but, in fact, the exchange rates adjust and you generally don't get such a big swing in either exports or imports. That is why economists say the adjustment happens quickly and there is not much effect on the pattern of production.

If you want to fix the sectors that are hurting from imports, look and see if our tax system is doing anything particularly brutal to those sectors.

Mr. RYAN. That is the discussion on manufacturing we have been having.

Mr. ENTIN. That is the sector you can help less with depreciation reform, moving to expensing, and perhaps by eliminating or reducing the added layer of corporate taxes, at which point the rest of the concerns about competitiveness pretty much fall into line. I am not saying you shouldn't have a border adjustable tax. It you are going to do a VAT, it's naturally border adjustable. Any retail sales tax is naturally border adjustable, although it is sort of implicit in the way you collect it. If you do a cash flow tax where you collect it before people leave the house, as in the personal side of the old Nunn-Domenici bill, it is not explicitly border adjustable, but people pay the tax and then when they go shopping, it falls equally on what they buy, whether it is domestic or imported. It is implicit. All of these things are. Don't fuss over it so much. Just get rid of the excess tax layers on capital, and make to border adjusted or not, whichever way it naturally turns out to be in the reform you choose, and it is going to take care of it itself.

Mr. RYAN. Mr. Graetz, you are going to answer that, I know, but let me ask you a quick question on top of that because I see the time going. Your proposal, which I just sketched out, you said a 12-percent VAT plus a 25-percent income tax rate on individuals over $100,000 and a corporate rate. I guess it depends on the rate, or if you folded into the tax rate, isn't that effectively a higher tax burden on Subchapter S corporations or the corporate structure? You went through the plan so fast I didn't -- you said it was also not only revenue-neutral, but distribution-neutral? I have never seen anybody accomplish that before when they are proposing tax reform, but could you enlighten me on that as well?

Mr. GRAETZ. I can. I am happy to supplement it for the record, or in other conversations with you, but, yes, the basic plan is to substitute a 12-percent VAT, I think, 12 percent is about right, it may be 13 percent. I may be off a little bit on the number. I am not sure that the 25-percent income tax rate doesn't come down. Those numbers can be adjusted. But the basic point is that for people with under $100,000 of income, you are collecting only a consumption tax and no income tax. That plan can be made distributionally neutral as long as you take care of the low income and moderate income people. The plan is also revenue-neutral because what you are doing is you are using the VAT to fund the exemption of $100,000. That benefits Subchapter S corporations, because they will have a $100,000 exemption on their first $100,000 of income and pay only a 25- or 20-percent rate on their income over that.

The value added tax is like a retail sales tax. I do think people have gotten confused in thinking about the value added tax, even when Bill Gale was talking about the burden on American companies. The difference between a value added tax and retail sales tax is only in the way it is collected. The VAT is collected at all stages of consumption. So, if you want to think about it as a sales tax instead of value added tax, that is fine with me. The only advantage of a value added tax, as far as I am concerned, is that you are collecting it at different stages of production. So, if somebody gets cash at the retail level they don't rip off the whole tax base, they just rip off a little share of the tax base.

So, the VAT is more protected against evasion, but if you want to think about it as a sales tax, I have a 12-percent sales tax, and I have an exemption of $100,000 for Subchapter S businesses. They are much better off than they are under the current system. It is a much lower tax on capital and small businesses than the current system would be.

Mr. RYAN. Origin versus destination.

Mr. GRAETZ. Destination. What I can't imagine, what I cannot imagine in the political context is how you are going to be able to say to General Motors that your tax base is everything you do in the United States, your manufacturing and the markup, but for imported automobiles, it is just the dealer markup.

That is the way the flat tax works, and can you tell them -- which, you know, all the economists agree, and I don't disagree with the economists -- tell them "Well, exchange rates are going to adjust instantaneously and take care of you." Is that going to be your solution? I just don't think it is politically feasible -- it is a political point as much as anything.

I believe that it comes back to what Mr. Cain said about a level playing field. The American businesses that now talk about competitiveness are going to talk about competitiveness in much higher octaves if you tax only dealer markup on imported goods and tax the full value added of products produced in the United States, whether they are consumed here or whether they are consumed abroad.

Mr. RYAN. I see my time is well over. So, I would love to talk to you about that more. Maybe another time.

Chairman MCCRERY. Mr. English.

Mr. ENGLISH. Thank you, Mr. Chairman, and thank you for the opportunity to sit today as part of the Subcommittee. To my untrained mind much of the debate over whether border adjustability makes a difference, particularly the argument that border adjustability does not have a substantial impact on imports and exports, has a little bit of the flavor of Xeno's Paradox. The motion because you are going in a straight line you are always in motion, that Achilles will never catch the tortoise.

I have to believe that there is some distortion involved in imports and exports by having a tax burden placed on exports, that that is a result of the cost of doing business in this country and no comparable tax burden placed on imports. I have to believe that that has -- that makes a difference somewhere. I am struck by something Mr. Entin said that maybe we should be looking at specifically, certain sectors or certain kinds of product lines that might -- where it might be having some kind of an impact.

Mr. Christian, if I could pick you out, since do you believe that border adjustability matters at some level, could you give your view on whether there are certain sections of the economy, manufacturing to be specific, where with a mature industry, a capital intensive industry, relatively low profit margins, that border adjustability could have a significant impact on decisions?

Mr. CHRISTIAN. I don't think there is any question about it, Mr. English. On the outbound side, on the export side, we are making it extraordinarily difficult for manufacturing to exist in the United States. There is this constant pressure to move. I am talking about eliminating that pressure to move. Let people remain in the United States and let companies that have fled come back, let foreigners who wish to come here, trade around the world without paying U.S. income tax on their foreign source income. That is an enormous boon to employment, to business growth, and to economic growth in the United States.

The attenuated counter argument that some people make about exchange rates is 10 or 15 years old as I said earlier, like generals fighting the last war. It is not really the issue today. It is not really the issue, I believe, before the Congress of the United States. It is not really a practical debate. The practical debate is what we can do to eliminate the impediments, the hobbles, if you will, that we have placed on American companies and their ability and their employees' ability to participate in this global economy.

On the in-bound side, the import side, if you will permit me, the Chairman, Mr. McCrery, earlier asked a question about the Europeans who impose an import tax when we sell into their country. Mr. McCrery asked whether by doing so, they were, in effect, forcing us to pay their social welfare costs. My answer to that is yes, there is no question about that.

The so-called origin and destination principle that the VAT advocates like to talk about is actually operating in reverse. The origin of an automobile exported from the United States is the United States. Its destination is Europe. Europe imposes a tax relative to that automobile. The burden of that tax falls back on its origin in the United States. It falls back on the labor and capital in the United States that produced it.

We, in turn, could make a kind of a border adjustment for imports into the United States. There are various ways of doing this. One is to simply redefine what the cost of goods sold is under section 61 definition of gross income as Professor Graetz was referring to in another context earlier. If we had a border adjustment, we would bring foreign labor and capital into the tax base of the United States, not just the distribution markup that Professor Graetz was referring to, but the entire output of labor and capital that is reflected in that commodity, product, or other transaction.

That would be a neutral kind of system that would work greatly to the advantage of the U.S. economy. On the in-bound side, we would want to have some kind of exception for goods on a "short supply" list that are not subject to a competitive international market. As long as there is a competitive market on goods, the burden of the import adjustment would fall on foreign labor and companies.

I don't want to get into it in great detail today because I don't have time, I suppose, but the implicit in this idea of being able to bring foreign labor and capital into the U.S. tax base, much more than we did under section 482 today, is the potential for an enormous shift in the tax burden.

There is the potential for a shift of about $100 billion off of U.S. labor and capital and on to foreign labor and capital. That might be the subject of another hearing. I assure you that is not some pie-in-the-sky idea that I just scribbled down on the back of a yellow pad on the way up here in the car. It is a very important thought that has been given a great deal of analysis and effort over a number of years.

Mr. ENGLISH. I thank you. My time has expired. I want to thank you, Mr. Entin and the entire panel for providing some intellectual heft to this discussion. Thank you, Mr. Chairman for allowing me to inquire.

Chairman MCCRERY. Thank you, Mr. English. Mr. Foley.

Mr. FOLEY. Thank you, Mr. Chairman. Just very quickly, Mr. Christian, you mentioned about the taxation issue relative to corporations, and there have been a flight of companies leaving to go to Bermuda for instance. Could you elaborate again on your response to that?

Mr. CHRISTIAN. Yes, sir, Mr. Foley. There are two or three kinds of situations, and I am not an expert on all the details. Some of them are what are called earnings stripping transactions where you are using devices, shall we say, to strip out of your U.S. company its U.S. income from activities in the United States. You need to do something about that.

I would hate to see you create another destructive Rube Goldberg kind of thing like subpart F. You need to be very careful in addressing the flight of American companies abroad. We are forcing them to do it, really. We ought to deal with the fundamentals here at home and eliminate some needless tax aberrations, if you will, which cause people to want to go abroad. I think we can do that by the kind of proposals that I have sketched out today.

Mr. FOLEY. I missed some of your testimony. That is why I was asking specifically. You are talking about not taxing income that is derived from overseas or --

Mr. CHRISTIAN. Yes, sir. I am talking about not taxing income which is derived from trading with foreigners. Today we have a strange sort of definition in the Tax Code. We define as foreign source income, income that is derived from selling something to a foreigner only when the activity that produces that income has occurred abroad. When the activity that produces income occurs in the United States, we define the income as U.S. source income even though the sale is to a foreigner. I am simply saying if we are talking about foreign trade income, income derived from selling to a foreign purchaser, whether by export or by going there directly, all of that income ought to be foreign source income and exempt from U.S. tax. It is a very fundamental and long-talked about proposition. There is nothing new or shocking about it.

Mr. FOLEY. I know Florida in the 1980s had a rather memorable experience with trying to tax -- it was called at that time a unitary tax that was brought forward by first Senator Bob Graham and then actually applied by Governor Bob Martinez, one Democrat and one Republican. Ultimately we lost a lot of corporations because they said if you were in Florida doing business abroad, you would pay worldwide taxes to Florida for that income. It chased out some giants. We lost IBM. They were ultimately downsizing, but they ultimately left completely virtually the State of Florida and a lot of other corporations. Do you see that as an impediment to corporate strength of America the continuation of those taxes?

Mr. CHRISTIAN. Yes sir. I remember the unitary problem quite well. I spent many years working on it. We used to think in this country that we had a closed economy. Yes, various States had to worry about companies fleeing if they had such a bad tax system that companies wanted to get out, but we always thought that America had a closed economy here. Well, we don't anymore.

Professor Harberger and others have concluded that we really don't and that capital is highly mobile. Capital is the engine that makes it work, that makes the jobs, provides the tools for American workers. It is highly mobile today, and it can flee.

So, why should we create in the United States a hostile tax environment for our own companies and a hostile tax environment for companies who are foreign? I don't think it has escaped the attention of this Committee that before inversion was the problem of the day there was the earlier problem when foreign companies were acquiring U.S. companies wholesale and sort of moving their headquarters abroad. People often wondered why the foreign companies that acquired U.S. companies didn't move their own headquarters here when they were virtually equal in size. Well, I can tell you the reason they don't do that. It is because of the U.S. tax system.

Mr. FOLEY. Probably. DaimlerChrysler is an example. Deutsch Bank buying certain corporations. There are a lot of examples that should be quite frightening, and should be to American enterprise, because it is virtually suggesting they are not welcome here, and you might as well assemble your corporate entities overseas. Bermuda is, right now, an attractive target, and I think that Chairman Johnson is very mindful of that from Connecticut.

We have some exposure and experience in Florida. Tyco bought a company that was headquartered there and but now has moved a lot of their operations, which was ADT and now Tyco what have you. It is troubling because you lose jobs, you lose prestige of having the corporate presence. You lose real estate sales for communities that are dependent, on those large corporate transfers that are, at least when they leave, they flee and take a lot of good business with them. Does anybody else, quickly, I know the Chairman has been very kind.

Mr. CAIN. If I may add, you are absolutely right because there have been a large number of American companies that have been bought by foreign companies because they have certain advantages which basically addresses your point relative to some of the things that we have seen happen. So, I would underscore that just by looking at the companies that have been bought out here now, they are foreign-controlled rather than U.S.-controlled. I would like to point out that if some rules were passed, just to try and discourage companies being able to locate in other countries, we would simply be making the problem worse. We really wouldn't be fixing the problem, because then in the long run, we would have to come back and try to put in another stop gap.

Mr. ENTIN. Mr. Foley, 10 to 30 years ago when our tax rates were relatively low compared to Europe, it was American firms buying European firms. Now their tax rates are lower than ours, and it is their firms buying ours. We need to fix our tax rate.

Mr. FOLEY. Just the other day, Miller Beer announced they may be selling to a foreign source. There are a lot of companies that have long been the flagships of American industries, and all of a sudden, you keep reading in the trade papers the acquisition of another American brand by -- and maybe that is global competitiveness. It seems there is an impediment to them remaining even aggressively buying on the other side of the waters. I would rather our companies be buying them.

Mr. CAIN. It is the tax on the income and the labor that is causing that. You would see a flip-flop if American companies didn't have that penalty on their corporate profits and that penalty on labor. More U.S. companies could buy more foreign companies.

Mr. FOLEY. I wish Mr. Crane was here. He would applaud this, because he has long advocated the abolition of corporate income taxes since it is double taxation. Thank you, Mr. Chairman for your indulgence.

Chairman MCCRERY. Thank you, Mr. Foley. All good questions. I saw Mr. Entin nodding as Mr. Cain was making his point that if we went to a consumption tax, and I assume you would say do away with the corporate income tax all together, that that would solve the problem of American companies being bought by foreign companies. Did you mean to nod?

Mr. ENTIN. Yes.

Chairman MCCRERY. Why is that? Why would -- also I think in your testimony, Mr. Entin, you said that if we were to go to a consumption tax, that the U.S. national income would rise as a result of that. Would you get into both of those questions a little bit?

Mr. ENTIN. I am tempted next time to write shorter testimony. The current broad based income tax raises its revenue with heavier taxes on income that is saved and invested than on income used for consumption, because capital is very sensitive to taxation, and because capital has to shrink a great deal to drive its returns up by enough to pay the higher tax, the current tax system shrinks the capital stock a great deal. That reduces productivity, which reduces wages and employment. If we had a tax that was less punitive on capital and brought the tax on income that is saved down to match the tax on income that is used for consumption, we would have a much larger capital stock, higher productivity and much higher wages. That is the connection, because capital so sensitive to tax and because it is being mistreated under current law.

The major tax reform plans are often called consumption taxes. Mr. Christian makes a point a lot, and it is a very good one: we really shouldn't think of the consumed income tax or the VAT or the national retail sales tax as consumption taxes. Goods and services don't pay taxes. People pay taxes. If you remember that income is a net concept, revenue minus the cost of earning the revenue, then you can start thinking of saving as a cost of earning interest. You have to buy the bond to earn the interest. You have to buy the stock to earn the dividend. You have to buy the machine to earn the return.

The correct tax treatment, then, is to look at net income, which is revenue minus the saving, or revenue minus is the expense investment. We should be giving all saving the treatment we give the regular deductible IRA, individual retirement account, or a Roth-style treatment, which is the same thing in present value. We should be expensing plant equipment, not depreciating it. Income is really that net concept. Then we see that the things we are calling consumed income taxes are really income taxes where income is correctly viewed as net income, and saving is recognized as a cost of earning income. Don't think of them as goods and services taxes. These are income taxes where income is properly defined, and if you went to a properly defined income tax, you would have a much higher capital stock and a much higher level of output and income.

Chairman MCCRERY. I believe in your testimony you also concluded that going to a consumption tax would make U.S. businesses more competitive; is that right?

Mr. ENTIN. It would make all businesses more productive. Of course, if we were more productive and sold more goods abroad, we would earn more foreign exchange and buy more imports, too, but we would certainly be a more productive economy. So, the competition is not really between the U.S. firm and the foreign firm, or the United States and a foreign government, it is between from the bad current tax system that is shooting us in the foot and a good alternative tax system that wouldn't shoot us in the foot.

Chairman MCCRERY. Is our goal to raise our national income? Does that trump everything else, or are there considerations of job creation and the type of jobs that we have?

Mr. ENTIN. In shooting ourselves in the foot, we are shooting ourselves in the manufacturing foot twice and the other foot once. We would have higher income and a bigger manufacturing sector. So if you fix this, you happen to be also helping the manufacturing sector which is suffering from underdepreciation.

Chairman MCCRERY. So, if we go to a consumption tax, we not only raise our national income, but we increase the number of manufacturing jobs in this country?

Mr. ENTIN. Probably.

Mr. CAIN. Yes, sir. If I could comment on it, it starts with supercharging the economy at a growth rate much higher than we anticipate at the present time with the current tax system. So, if the gross domestic product (GDP) is growing at 5 percent instead of a paltry 1 percent or 1½ percent -- and Mr. Jorgenson has actually done some research on that -- consumer prices go down to help offset the fact that you have a national consumption tax.

One other point I wanted to make very quickly is that in the United States -- if we change to a consumption tax, they would be forced to reexamine their tax structures, which would create a ripple effect around the world because of all the new companies that are going to want to come here. This is because of the -- increased competitiveness of businesses operating here. So, fixing the real problem has far-reaching impacts not only relevant to the issues of border adjustability and relative to some of the other issues you are dealing with, but also in terms of keeping this country as the leader economically with respect to building on its economic platform.

Mr. GALE. Could I add a comment there? You asked about the effects of consumption taxes on national income or on economic growth. There is a range of estimates. The most well-known academically refereed estimates are by Alan, Averbach, and a team of coauthors in an article that came out in the American Economic Review a couple of years ago. That paper suggests that, using a very sophisticated model, that after 15 years if you introduced a realistic flat tax -- that is, one that had transition relief -- the economy would be about 1.5 percent larger than it otherwise would be. That is after 15 years. That is for a well-designed flat tax that did not have, for example, deductions for health insurance, deductions for State and local taxes, firm deductions for payroll taxes. It had no EITC, no child credit, no education credit, et cetera. If you think that for political reasons those things would creep back into a flat tax, the growth effect would go to zero really fast.

So, the results that everyone is talking about, about how going to a consumption tax would raise national income, that is true if we go to a pure or very broad-based consumption tax. If we go to a consumption tax that looks like European consumption taxes, for example -- and there is no reason to think that we are going to be purer about this than the Europeans will be -- if we go to a consumption tax like theirs, there is no reason to think that there is going to be very big growth effects at all.

The one thing we do know is that we will redistribute tax burdens, and normally we think of some -- at least along some dimensions of trade-offs between equity and efficiency. So, you should not think that moving to a consumption tax basically solves the growth equation or is an unambiguously positive growth effect. It is quite possible, and I would venture it is probable, that if we designed the consumption tax, it would be pockmarked, so full of holes that the rate would have to be so high that the growth effect would be zero or negative.

Chairman MCCRERY. Mr. Jorgenson, did you have a comment on that?

Mr. JORGENSON. Yes. I wanted to make a point again that I suggested in my earlier testimony. I think that if you think in terms of the potential impact of tax reform, the consumption tax achieves about 40 percent of that potential, and that is essentially with the most optimistic assumptions. I am overlooking all of the issues that Bill Gale just raised.

Another issue is why don't we have a consumption tax? As you remember, Chairman Archer held hearings for many years which many of us participated in. There is lots and lots of testimony about all the plans that have been discussed here about a consumption tax. The reason is because the tax rates are staggering.

For example, if you have a progressive national retail sales tax -- this is what Archer originally was interested in -- the marginal tax rate, the tax that you would have to collect on every dollar at the retail level -- just imagine this -- is 40 cents. That is what we are talking about. So, it is not a very practical idea. I think that is what led to the neglect of consumption tax reform when this issue was very thoroughly discussed by the Committee on Ways and Means in the middle 1990s.

I think you have really put your finger on the issue here. The issue here is not how to benefit the corporations which have been up to this point benefiting from the export subsidies that have now been struck down by the World Trade Organization, the issue here is how to enhance the productivity of the U.S. economy. We have an extremely productive economy. Since 1995 our economy has been growing at more than 4 percent a year. If you look at the way that productivity is behaving in the current recession, it is running at about 1.1 percent above what it has in previous recessions throughout the whole postwar period. We are in a new economy. What do we need to do to deal with the issues of a new economy? We need to focus on investment and how to stimulate investment, and that, it seems to me, is where the attention should be directed rather than toward a consumption tax.

Chairman MCCRERY. Yes, Mr. Entin.

Mr. ENTIN. The Joint Committee on Taxation had a panel about 4 years ago, and they are going to revive this for some future work, which looked an a number of models and how they would model going to fundamental tax reform. The models showed great differences in the amount of growth that you would get out of tax reform, according to whether the models assumed that there was a free flow of capital and goods, including manufactured goods and investment goods, across borders, or whether the economy was closed to such flows. In the closed economy models, which relied entirely on increasing U.S. saving to fund the additional capital and assumed very low rates of elasticity of domestic saving, it took forever to get to the higher growth levels, and those models showed very small growth numbers. The open economies showed growth in the 6- to 15-percent range, and I took a 10-percent estimate in my paper.

Since the opening of the capital markets in the last two decades, we really cannot look at closed models as being realistic. I once debated someone from a major econometric modeling company who was worried about the effect that the flat tax would have on mortgage interest and have values. I said, "We are going to get a lot of growth." He said, "You will never get enough saving to fund it." He said that foreigners are already lending us $100 billion a year -- this was way back in the 1980s -- and we cannot expect them to go to $200 billion a year. I said, "You know those capital flow figures that you just quoted? Those are net figures." At the time, there were about $300 billion of investment going out and about $400 billion coming in to the United States each year. It was $700 billion to play with, not $100 billion, and all we had to do was stop lending abroad. He turned beet red. He remembered after I said it that the net capital inflow number was, in fact, a net figure.

When we lowered the inflation rate in the early 1980s and prospectively enacted some accelerated depreciation which was later repealed, businesses started thinking that it was a good idea to invest in the United States instead of in Brazil and Argentina and all around the world. Between 1982 and 1984, the United States lending abroad from the banking system fell by over 85 percent, from about $120 billion annually to less than $20 billion. There was very little increase in the inflow from Europe. Essentially it was our own savings staying home. As for physical capital investment, if you run into problems in the machine tool industry and they can only ramp up output 25 percent, you can buy more machine tools from Europe, and you can add very quickly to the domestic capital stock. You can get the growth quickly, and it can be a big change. Always use an open model, because the world is open.

Mr. GALE. Can I respond to that, just one more comment? If you have an open economy model, as Steve mentioned, you will definitely get more GDP growth; that is, gross domestic product. You will get more capital coming in if you move to a reform like that. What you won't necessarily get more of is more national income, more gross national product (GNP), and if you want to look at the future welfare of Americans, you need to look at the national income numbers. Money that comes in has to be paid back. So it increases our GDP, but it is essentially a mortgage against the GDP. So once we pay that back, we are not anywhere near as better off as the GDP figures themselves would suggest, and when you want to look at the future welfare of American citizens, you want to focus mainly on GNP or national income rather than on national product.

Mr. ENTIN. If I borrow $100 to put a machine in my shop, and I have had to borrow it from a foreigner, then the interest is going to go to the foreigner. If I borrow it from my brother-in-law, the interest is going to my brother-in-law. Either way, I get to work with that machine and my employees get to work with that machine and 75 percent of the economy is wages. So our workers get to benefit from the machine, regardless of who paid for it and who gets the interest or the dividend.

Mr. CAIN. Mr.  Chairman, if I can just add one comment.

Chairman MCCRERY. I think I agree with Mr. Entin. It is not that I disagree with Mr. Gale. It just seems to me -- and I am not an economist, thank goodness, but it just seems to me that, Mr. Gale, your argument is up here floating around in the ether, when Mr. Entin's is right on the ground in terms of jobs and job creation.

Mr. GALE. Oh, I agree that his is on the ground. The issue is that if you -- in Steve's example, when you pay your brother-in-law back, that dollar is still in the economy. Okay. When you pay the foreigner, it is out. It is gone. So there is a distinction between how much we produce -- how much is produced in the United States. That is GDP, and that would go up substantially, as Steve mentioned. How much of that is ours.

Chairman MCCRERY. But isn't that --

Mr. GALE. That is national income.

Chairman MCCRERY. If GDP goes up, isn't that good?

Mr. GALE. Of course. Other things equal, yes. My point is that GNP, national income, is the measure of economic welfare. The wealth of Americans depends on the national income, not on national product. This is Econ 1 stuff, but there is a difference between producing in the United States and having the proceeds of that output go to Americans, and that is the fundamental issue here.

Chairman MCCRERY. I appreciate your treating us like we are in Econ 101, because we are not economists, and we need to learn. So, I do appreciate your taking the time to try to explain, but surely you are not saying that there is no relationship between GDP growth and GNP growth or national income?

Mr. GALE. No, I don't think I said that. I said that GDP growth that is financed by capital inflows has to be paid back via capital outflows in the future, and sort of the question is are you -- if you --

Chairman MCCRERY. Let me just interject, but if that capital inflow continues and so we continue to create jobs and increase productivity, what difference does it make if for a temporary period of time it goes back overseas? If it is --

Mr. GALE. If we can create a system where we have continual capital inflows, then you have solved all of our problems. Normally people have to pay back their capital inflows, and that is the nature of borrowing is you have to pay it back, but I agree, if we --

Chairman MCCRERY. You are paying back the capital and the interest. I mean, as long as they are willing to continue to finance growth here in the United States, that is a good thing, I think.

Mr. GALE. That is a good thing, except that then we also have to pay it back. I am just saying we don't get the entire proceeds of capital borrowed from abroad.

Chairman MCCRERY. I agree, we don't get the entire proceeds, but in a global economy, it just seems to me that we can no longer think or expect to be self-contained and to have just a circular flow of capital here in the United States.

Mr. GALE. No one is suggesting that. All I am suggesting is that when we talk about big output effects or potentially big output effects of tax reform, that that does not necessarily translate into big national income effects. That is the only point I was trying to make.

Mr. CAIN. Mr. Chairman, I am not an economist either. Let me give an example that I can relate to as a businessman. The advantage of having a very vibrant gross domestic product, as you have pointed out, is that it would create more jobs. Unemployment would go down. We would be able to employ those people that want to be employed, et cetera, but one of the things that it would allow people to do by taking the tax off of income and putting it on consumption is that it would not penalize people's sweat equity. I am looking at it more from a standpoint that if someone chooses to work a little harder or extra, they won't be penalized when they are trying to increase their individual income. So from that perspective, that is the importance of having a very vibrant GDP. Quite frankly, I don't worry as much about national income as the ability of individuals to increase their own income with their own sweat equity.

Chairman MCCRERY. Mr. Engen.

Mr. ENGEN. If I could just wade in carefully. As an economist on a couple of things here, one, I was on the Joint Committee on Taxation modeling group that was brought up here, and one of the things that I want to point out was in that looking at the number of different models that -- looking at the effects of flat taxes, all of them were positive in terms of their growth effects. There was a range, but they were all positive. Some were at a lower end, and some were unbelievably high.

That said, the point that Bill brought up in that, well, if you do enough in terms of adding in other components, you can erode the growth effects back to zero or close to zero is true, and that was the final point I made in my testimony. Essentially what you are doing is you are then -- you are saying we are going to switch to, say, a flat tax or another type of consumption tax, but then you are building in all of the features of the income tax that we are having problems now. So that is a key feature.

I mean, Bill's point is one that should be definitely heeded, that an important part of getting the positive growth effects from a flat tax, just for example, is that you cannot let all of these other exceptions come in as people want to keep their favorite tax preference from the old system and put it in the new system.

The second thing is that just it is the case that if we have the increased capital financed by domestic saving, then yes, all of the proceeds from that output, both that go to labor and that go to capital, stay in the United States. If that capital does come from outside of the United States, yeah, you do have to make payments back on that, but in all likelihood, the labor that that foreign investment in the United States is hiring is U.S. labor, and that is still kept in the States.

So there is -- there can be a discrepancy on that, and, yes, it is more beneficial if U.S. capital formation is financed by U.S. saving -- or it can be, but there is still a return to labor.

Chairman MCCRERY. One more comment, and then I would like to --

Mr. JORGENSON. I just want to make a comment about transition rules. I think that Bill has made a very important point that Eric is agreeing with. Let us think of what these transition rules amount to. Are you saying that after you change to a consumption tax, you are going to take away all of the depreciation allowances you promised all of those investors who have in good faith bought equipment and built factories and commercial buildings and so on, with the expectation they are going to be able to make deductions? I don't think so. Are you going to say that every corporation that has issued a bond is not going to be able to deduct the interest payments that it was contemplating when it issued that security? I don't think so, and if you simply go down the list -- I have just mentioned the two most prominent examples. These are not airy-fairy examples. This is something that is the heart and soul of tax policy. You are going to end up, as Bill said, undermining most of the benefits that are associated with the switchover.

So you might say, should we give up, do we have to abandon the effort? Should we just say, well, we have had these hearings; can't do it. I mean, it is just impossible.

Chairman MCCRERY. That is what we have done so far.

Mr. JORGENSON. The answer is that we start from the income tax. That is the key idea. Forget about the idea of a consumption tax. It just isn't going to happen. An income tax that focuses on investment is feasible. It is something that doesn't require any transition rules. Why? Because it leaves all of the provisions of the income tax in place, and I am referring to the depreciation provisions, the tax deductibility of interest and all of the things that fill 110 volumes of the Internal Revenue Code.

Now, how do we fix this? What we do is simply take a step that will make sure that every asset in the economy earns the same rate of return before taxes. In order to do that, all we need to do is to change the method by which we carry out our capital cost recovery. In the system that prevailed before January 1, 1987, when the investment tax credit was abolished, we had a two-pronged approach to that. We had capital consumption allowances and we had the investment tax credit. My proposal is to simply reinstitute the investment tax credit, but in a way that would achieve the goal.

What is the goal again? The goal is trying to equalize the rate of return before taxes on all assets, and that doesn't require any transition rules. It starts with new assets. It doesn't affect any existing assets. All existing assets would be treated in exactly the same way, and existing liabilities. If you take a bond, for example, tax deductibility of bond interest would continue. Capital consumption on allowances on all of the existing assets would continue, but this would superimpose on it a system of tax credits that would eliminate the corporate tax. If you don't call that a tax reform, I don't know what it is.

Mr. GRAETZ. Mr.  Chairman, can I make one point?

Chairman MCCRERY. Sure.

Mr. GRAETZ. This  transition problem, I think, is a very important problem --

Chairman MCCRERY. Yeah, and I was going to get into that.

Mr. GRAETZ. When people are talking about an entire replacement of the system we now have with some form of consumption tax, among the reasons to try and do the kind of hybrid approach that I have been pushing here, is that you get the advantage of low rates. You shift the burden to consumption substantially, but you are retaining a corporate tax at a 20- or 25-percent rate, which makes the United States very attractive, both as a headquarters and as a source of investment. You have taken away some of the advantage of those depreciation and interest deductions, they were going to get against the 35-percent rate. Now they are only going to get those deductions against a 20-percent rate, but nobody can complain about that, because you have kept the tax in place, and you have lowered the rate. This is not the kind of transition relief Congress has ever felt necessary to give, in effect to say, you have really got to get the benefit of your depreciation against a higher rate when we are lowering corporate rates. We don't do that.

So, my plan gets some of the advantages of Dale's ideas, but it is not the kind of radical change that either the proponents of going fully to a consumption tax are arguing for or the proponents of going to a full investment relief for new capital are arguing for. My plan really is a compromise. I just want to emphasize that fact. It avoids many of the problems, including the transition problems of the total restructuring of the system of the sort this Committee has been talking about so far. I really urge you to start thinking about this in a broader way, and not to think that you are going to replace the entire income tax with a sales tax. If you replace it for 85 percent of Americans and they don't have to file tax returns, that would be a major improvement in the lives of the American people. And it would whittle the IRS down to a size that would enable it to do what it might be able to do. So, this plan is a major step in the direction that people have been advocating, but it doesn't cause the kind of problems that have been discussed so far here today.

Chairman MCCRERY. Well, let me try to pose some problems with your approach. Your approach -- I think you have just stated clearly the advantage to your approach, which is that you avoid a lot of the transition problems associated with a complete overhaul to a sales tax or VAT or anything else, and those problems are substantial, in my view. There are a number of conservatives who would say to you, my goodness, you are going to create another tax -- you are not going to do away with any tax. You are going to keep an income tax. You are going to keep all of the State sales taxes and everything, and then you are going to add a new tax, a VAT or, you know, some kind of consumption tax on top of that. My goodness, the Congress would have all kinds of opportunities to increase taxes on the American people. They could do a little bit here, a little bit there, and tweak it here and there, and you just really increase the opportunity for more of our national income to go to the Federal Government in the form of revenues. Isn't that a legitimate concern?

Mr. GRAETZ. Well, I think it is always appropriate to be concerned about Congress increasing taxes and how they might do that.

Chairman MCCRERY. But haven't you increased their opportunity --

Mr. GRAETZ. I don't think this proposal increases the opportunities in the following sense, Mr. Chairman. I cannot imagine a Congressman standing up on the Floor of either the House or the Senate and suggesting that you lower the $100,000 exemption from the income tax. It took the Second World War for the income tax that we had from the beginning of the century until the Second World War to become a tax on the masses, and it would take that kind of catastrophe to bring that 85 percent of Americans back in. So that is the first point. The second --

Chairman MCCRERY. That underscoring the flip side danger, which is that you have such a small amount of the American public paying income taxes, that it is much easier for a politician to say, why do I care about that 15 percent? It is the other 85 percent that is going to elect me. I can increase the taxes, which is my only pool of income tax revenues. I can just easily -- politically easily increase their taxes.

Mr. GRAETZ. Let me make two comments about that. One is, it is easy under the current system.

Chairman MCCRERY. It is getting easier, I know.

Mr. GRAETZ. It is easy under the current system. That is exactly what Bill Clinton did in 1993. He said, let's take the top rate, which was 31 percent, and let's move it up to 40 percent and not bother with anybody below that level. If you have a majority in the Congress, that can be done.

The answer to that, I think is -- and this is a reform that the House voted, and appropriately so in my view, is to put in a supermajority rule that says that you cannot raise rates, you cannot raise tax rates as part of this plan without having a 60 percent vote in both the House and the Senate. That would --

Chairman MCCRERY. That would overcome a lot of objections, but I am not sure we can --

Mr. GRAETZ. I think that the problem is, Mr. Chairman, that when you think, well, we are going to raise those rates -- remember the goal here. The rate we are talking about is a much lower tax rate than we now face. That is, we would have lowered the rate on marginal investments, on marginal income, on all of these people by dividing the tax base up so that we are not relying entirely on an income tax to finance our government. No other country does that.

If you look at the chart at the end of my testimony and you look at how the U.S. taxes consumption compared to how everybody else in the industrial world does, we have given up an important tool. We have given up the consumption tax tool. The advantage to us is that we have lower taxes compared to GDP than our trading partners. We have said we are not going to have lower tax rates. We can let other countries have lower tax rates, because we have given up the tool of a tax on consumption which could ease the burden on capital and production in the United States. I think that in terms of long-run health of the economy and long-run marginal tax rates, this program would be lower. I am just as conservative as you are on the thought that -- let's not make this an occasion for bringing more money into Washington. I understand that objection and I sympathize with it entirely, but I don't think that that is a good reason, frankly, to give up the tool of taxing consumption in a greater way and easing the burden of taxes on production and investment.

Chairman MCCRERY. Mr. Engen, do you agree with that? Would you like to see us create a consumption tax and keep the income tax?

Mr. ENGEN. I have sort of struggled over this particular issue, and indeed it was one of the things I mulled over quite a bit as I was writing my testimony for this. On the one hand -- I guess I am going to be an economist here; do the one-hand, two-hand thing. I do have sympathy with I think the point of view that you are bringing up. When I look at countries that do have this extra tax lever to the greater degree, they are ones in Europe, and they have an overall tax burden on the economy as a whole that is higher.

On the other hand, I think that the type of proposal that Mr. Graetz is putting forth is a nice medium ground, in between some of the various proposals that are out there, and as long as you could implement these restrictions on raising taxes in the future, then it would be okay. I guess I am not quite as convinced that you could implement those, but of course, I am an economist and not a politician, so I have less of a view on that. I think it is a reasonable concern.

Chairman MCCRERY. Thanks for clearing that up. I don't mean to belittle what you just said. You are right. Mr. Graetz certainly, I think, has a proposal that is worth looking at, and it may be the only -- well, not the only, but it may be one of a very few realistic proposals that we could possibly enact. It does scare me and a lot of others, I think, as well as you, that we are creating another opportunity for tax increases.

Mr. Gale.

Mr. GALE. Thanks. Just real quickly, I have read literally every word of Mike's book and wrote a 35-page review of it for a legal journal, which was a huge mistake. I want to say two things. One is, it is one of the few serious large-scale proposals out there. The flat tax X tax is another, and something like broad-based income tax reform is the third. So, I think it is a very serious proposal. I don't want to sound like a broken record here, but the thing to remember is that the rates that were quoted depend on having a very broad base. Mike is right that, pre-World War II, we had an income tax that was only on high-income people. On the other hand, we have had a mortgage interest deduction since 1913. We have had a State and local tax deduction since sometime in the teens, I think in 1913. We have had a charitable deduction since the teens. We have had a health insurance adjustment since way back before 1920. So when you start adding those in, they take out big chunks of the income of people that have income above $75,000 or $100,000, and the rates have to go up.

Similarly with the VAT. If you exempt things the way the European countries have exempted in a VAT, the rates go way up. So, I congratulate Mike on putting forward a doable, cohesive, coherent proposal, but I just want to caution that all of these rate estimates depend on how broad the base is. As soon as we start introducing these subsidies, the rates go through the ceiling.

Chairman MCCRERY. You have made that point several times, and it has sunk in, even into this country lawyer.

Mr. GRAETZ. One point with which I certainly agree. The VAT base needs to be very broad in order to get the kind of rate I am talking about, but I think it is realistically broad. I have looked at this deal pretty carefully. The income tax on people above the $100,000 floor does not eliminate the deduction for charitable contributions or home mortgage interest, as one might believe. You can still, based on information I have, get to the right rates, but this is an important question as to whether the rates are realistic or not. I would only hope that we would be sitting in this room.

Chairman MCCRERY. Trying to set the rate.

Mr. GRAETZ. Trying to set the rate and making sure the rates are low enough.

Chairman MCCRERY. Right. Mr. Entin, do you want to jump in on this?

Mr. ENTIN. I think I am of the view -- my boss who was a tax expert in town for many years, Norman Ture, kept drumming into my head that taxes needed to be transparent and visible to the electorate, otherwise people would think someone else was paying them. They would vote for people who were promising more government than they would vote for if they knew that they were paying it. So, I favor broadly-based taxes without a lot of people dropped off the rolls, and I don't particularly care for taxes hidden at the business level, when in fact it is the workers and the consumers and the shareholders who are paying the taxes. I do worry that we would get a runaway tax situation if we left too many people off the income tax.

The other thing I worry about are those distribution tables which will guide you in picking one plan over another simply because the initial incidence at the time is imposed will look better or worse. Not one of your burden tables is correct. Not one of them is close to being correct. When you put taxes, for example, on upper-income doctors or impose huge malpractice premiums on them, what do you think happens to the quantity of those doctors? People retire early. They don't enter the profession. The number of doctors shrinks. They don't employ as many nurses or other workers in the offices. They don't produce as much health care for the people, and the providers who remain can charge a higher price so that they can pay their malpractice insurance and their higher income taxes. It is the consumers who end up paying the higher premiums and taxes through their insurance company.

The same thing is true for income taxes. A lot of people who have been pushed into the upper brackets go to their corporations and say, "If you want my skills, you are going to have to pay my tax bill." Then it shows up in the price of the product.

Taxes never stay where you think you are putting them. The payroll tax partly falls on capital, because it shrinks the labor supply. Capital taxes partially fall on the workforce because it shrinks the capital stock. Upper income taxes fall on lower-income people. Lower income taxes to some extent fall on the upper-income people. Please don't let those silly burden tables take you away from a good tax plan and push you toward a bad one.

Chairman MCCRERY. Easier said than done.

Let me try to conclude, getting not back to, because all of this has a relation to the subject of the hearing -- or the series of hearings, which is the ETI, and what do we do about losing the ETI, which I think everyone that has talked to the Committee has said you are going to lose the ETI eventually. You are going to have to do something with it, or the Europeans will retaliate. They have shown some forbearance. They think that we are, in good faith, searching for a solution to the problem, and so they are not retaliating now, and no indication that they will in the next couple of months or so. Eventually we are going to have to find a replacement or a substitute, something, or we are going to have to decide -- and this is the question I want to put to you -- we are going to have to decide that the economic value to the country is not sufficient to justify risking a trade relationship, and instead of trying to replicate or trying to take care of those specific companies, that group of companies that were benefited by the ETI, we take that income, and we spread it throughout corporate America, or whatever, in the form of lower rates or more expensing.

So I suppose -- I would want to ask you to give me your thoughts on that generally and mix into that more on the subject of today's hearing. Even though we all agree our current tax system is convoluted and complex and burdensome in terms of the compliance costs, all those bad things, still in all, don't we have as a Nation generally have a tax burden that is competitive, so to speak, if not advantageous in terms of our trading partners around the world? I mean, if you look at the total tax burden in any European country, it is probably going to be higher than the total tax burden here in the United States.

So what should this Committee do in terms of trying to fix ETI in the context of our entire tax burden here? Ernie?

Mr. CHRISTIAN. Mr. Chairman, I think that the ETI is gone, it is lost. I think we should move on beyond that. I think that I would, of course, stick with the suggestion I made about the easy way to fix it; and that is, adjust our base a little bit in the corporate tax and exclude exports.

We need to be practical about what can happen and what can't happen. I have concentrated here today on something I think is a very practical, doable solution to the problem that you identify. I have probably worked for 20 years on various different fundamental tax reform proposals. I suspect I have perhaps spent as many hours on that as anybody at this table. I have concluded that fundamental tax reform, as such, is simply too big, is too hard. It is a symphony with too many notes to be played in this body.

We need to concentrate on the things that are good components of fundamental tax reform, that we can do and that solve real problems. One of the impediments to that is trying to do too much, and another one is simply terminology. We here today use the word "consumption tax" to refer to two different things and in two different ways. Realistically, the only consumption tax being talked about is Mr. Cain's retail sales tax and Mike Graetz's particular version of the European credit invoice VAT, which is a sales tax. That is a tax on consumers.

Economists, including many here today, have on the other hand been referring to -- as a "consumption tax" -- an income tax amended in only one respect. That is, it expenses capital equipment. So, I would hope that rather than becoming embroiled in this morass of calling an income tax with expensing a consumption tax, and confusing ourselves and everybody else, we would talk about our income tax with all its warts and about how we can fix it on the international side, on the investment side, and in other ways that represent longstanding, familiar amendments that can be enacted into law. We cannot tear the whole thing out by its roots, as the former Chairman used to say, and start over and rebuild it on some other grounds, like a sales tax or something like that. It is basically in my opinion contrary to the American tradition and ethic of taxation at the Federal level.

So, we need to operate in that tradition, that ethic, and I think by deftly doing it, we can find our way through this process and end up with the components, the economic components, that are actually the substance of all of the tax reform proposals that everybody has been talking about for years: not double-taxing investment, not double-taxing personal saving, a genuinely workable, competitive, international tax system with an expert exclusion, and, if we wish, bringing foreigners into the U.S. tax base by means of an import adjustment or a cost-of-goods-sold adjustment.

When stated in those ways, those are imminently doable things for the most part. It doesn't scare anybody. It is not too hard, and we can do it. When we got to the last page and turned it over, we would have accomplished the economic substance involved in all of the tax reform proposals, including the four or five I have drafted over the years, and Professor Graetz's and others, is my answer.

Mr. GRAETZ. Mr. Chairman, I do want to point out that -- and I am a person who was involved in the creation, along with Glen Hubbard and others, of the Comprehensive Business Income Tax (CBIT) bit proposal that is the basis for Ernie Christian's testimony -- I believe that the CBIT tax, which is a single business tax without a deduction for interest or dividends, and no taxation of interest or dividends at the individual level, is a better tax system than the one we now have and would be a great improvement.

On the other hand, I also want to say, having managed to get that proposal out the door of the Treasury Department after a lot of conversations with a lot of people, that denying the corporate interest deduction is not a small step as it has just been painted. It is really quite a large step.

So, I think the question of what is realistic and what is not realistic in this environment is one that the Congress is going to have to come to grips with. Ultimately I believe, with the help of the President of the United States -- I think that the one lesson of the 1986 act that was well learned is that when a President of the United States makes a tax change of some major sort a key issue -- fundamental reform can happen. And in the absence of that kind of Presidential leadership, it is not likely to happen. The 1986 act, whatever you think about it, would never have been passed if Ronald Reagan hadn't come to the Congress the way he did in 1995 and 1986 and made it a key issue.

I have been around tax legislation with Ernie for 30 years, and we have been around different tables doing this sort of thing for a long time. I remain much more optimistic than he does about what Congress can do. I am actually with Herman Cain in his optimism. I think that the tax system that we have and that we are relying on, that this income tax and tinkering with depreciation and tinkering with investment tax credits in order to try and make us more competitive, is a road to disaster. I think it has proved to be a dead end. We can go on for another 5 or 10 years continuing to prove it to be a dead end.

It wouldn't shock me if this kind of change doesn't happen overnight, but I think that the optimism that Mr. Cain has suggested is the right way to think about this. I do think we have to be realistic about what we can do. I don't believe we can take a system that we have relied for the 20th century as heavily -- not entirely until the Second World War, because we had tariffs as our consumption tax -- but as heavily as we have relied on the income tax, and say we are going to throw that tax away and that we are now going to go to a consumption tax system all in one step. I just don't see it happening, and I don't see it happening largely because of the distributional question. I think I have been in print more critical of distribution tables than anyone at this table. I have called them paint-by-numbers tax law making and all sorts of other ugly names. The truth of the matter is that there are serious questions about what happens to the distribution of the tax burden and who we shift it to by moving completely from an income tax to a consumption tax. We would shift the tax burden down the income scale in ways that I think are going to be ultimately unacceptable if we replace the income tax in full, and that is why I think looking for some middle ground is important.

I do not think it is worth this Committee's time and effort to jeopardize our trade relationships by looking for some new export subsidy. I was at the Treasury Department, I guess Ernie was, too, when we did the DISC, Domestic International Sales Corporation. Then we did the FSC, and then we did the ETI, and each time the WTO has said no-go. I believe that if you think seriously about consumption taxes, it is very important to think about ones that will get through the WTO, because we have committed ourselves to this international trade relationship, and I think properly so. I think it is not clear that a subtraction method value added tax will get through WTO if challenged. Japan currently has such a tax. It has not been challenged. Their economy has been in very bad shape and nobody wants to challenge them. If the United States went to such a tax, I am not at all sure it wouldn't be challenged. Whether it would succeed or not, I don't know. It should succeed.

The indirect/direct distinction -- the distinction between taxing transactions as Mr. Cain's tax and mine do, or taxing entities as Mr. Christian's and Mr. Entin's and others do -- is not a substantive distinction. The WTO has an indirect/direct distinction that it may well stick to, no matter how archaic, particularly if it gives it a lever vis-B-vis the United States on trade issues, which is what has happened in the recent round here.

I would give up on the ETI. I think the question is where can the revenue best be spent, and that is the question that this Committee ought to turn to and address. There are lots of possibilities, but I would hope that we would move in directions that keep this fundamental tax reform issue on the agenda as you have tried to do in these hearings.

Chairman MCCRERY. We will go to Bill and then Mr. Jorgenson.

Mr. JORGENSON. All right. Thanks. This has been a very fun and illuminating hearing. I just want to say a couple of things. One is, as I mentioned earlier, I think we should let ETI die a peaceful death. I would consider the revenues gained sort of money that could be used anywhere you want to. Cut the corporate tax rate. You know, pay down the public debt. Whatever. I don't see any obligation to put it back into an export subsidy, and I want to emphasize from a macroeconomic viewpoint, they don't do any good, although they may benefit the bottom lines of several major corporations.

On the broader picture, there are a number of well-conceived tax reforms that would be unambiguous improvements over our existing system. I mentioned the -- Mike's proposal, a flat tax, slash, X tax proposal or broad-based income reform. The problem with all of those and the things that I worry about is they only exist on paper, and in order to get them to exist in the real world, they have to go through the political process. They have to be inured against attack by aggressive tax attorneys and accountants and tax planners, and they have to transition from the existing system.

So, there are basically two problems. One is, how do you get to any of these systems? That is the transition problem. Second is, how do you stay there? I think basically you have to repeal politics, repeal the politics of tax policy in order to stay there. I don't know how you do that, because the complications that exist in our income tax, you know, weren't there at the beginning, but they grew in; not because anyone wanted to make it more complicated, but because it was a natural response of the political system.

So, I am not at all opposed at the principle level to broad-based tax reform, but I don't know how we get there, and I am worried that if we do that and then the political process takes over, we end up with a situation where we have done a huge amount of work to change the entire tax system. The one thing we know, we would do is redistribute tax burdens away from the wealthiest households, and we would probably end up with a system that probably isn't a whole lot better than what we have. I don't think it is worth taking the leap in order to do that unless we have some assurances.

I hear this man on the Moon comment all the time that Mr. Cain raised. That is, if we could put a man on the Moon, why can't we do this? It is a darn good question, and the answer is, putting a man on the Moon is a technological problem that could be solved with everyone working together. Tax policy is not a problem where everyone works for the same goals. People have diametrically opposite goals, and half of the Congress feels like they have made their day when they have subverted the will of the other half. In a situation like that, you can't make unambiguous progress. So, I am very concerned about what you might call the political economy of tax reform, although I think if you put several economists and lawyers in the room and let us design a system that would be set forever, we could come up with pretty close to the same system.

Mr. JORGENSON. Could I chime in at this point?

Chairman MCCRERY. Yes sir.

Mr. JORGENSON. I just wanted to agree with the general sentiment around the table that ETI is gone, and I don't think it should be greatly limited. I am glad you are having hearings about this and so on, but it is something that has disappeared and is probably better forgotten.

In terms of the issue that you have raised in these hearings, though, about where do we go from here, I think Bill has put it very well, and that is that basically you can try to retread the footsteps of predecessors who have focused on so-called fundamental tax reform -- I am thinking in terms of these -- the value-added tax or the flat tax or a national retail sales tax. We have already done that several times, and it always leads to the same conclusion, which Bill, I think has summarized for us very adequately.

So, I think that what I would recommend is the following and that is that we try to amend the existing income tax system. I think that is the direction for reform. It can be done in such a way that we would achieve the objectives that you and your colleagues have emphasized repeatedly in your questions.

What you are really concerned about, it seems to me, is to deal with the inequity in our tax system that arises from the differential treatment of corporate-source income. Corporate-source income, whether it is derived domestically or abroad, is double tax. That is what we have heard over and over again from this panel and which you raise this question over and over again in your questions. How do you deal with that? You have a system of taxation in which effectively you treat corporate-source income symmetrically with other kinds of income. Now, you might say, wouldn't it be better to have a hybrid system? That is what Michael Graetz has been raising throughout these hearings. I am going to tell you, and I think everybody here would agree with that, our current system is a hybrid system. What do I mean by that? Pension funds are consumption taxes. The way that we think about a 401(k), for example, is that we exempt the investment and we charge tax on the consumption when the benefits are finally paid during retirement. That is a growing part of our tax structure. The way that taxation of owner-occupied housing is structured under our system, it is effectively a consumption tax. So we have a hybrid system. The issue is how can we use this existing hybrid system in order to achieve the goals that you have identified? Namely, to deal with the problems in the corporate sector. That is the issue which I think you can address using the scheme that I have placed before you.

Mr. CAIN. Mr. Chairman -- and I will be brief.

Chairman MCCRERY. Thank you, Mr. Jorgenson. Mr. Cain.

Mr. CAIN. I have much more confidence in Congress' ability to make a bold move and get through the political barriers that will be needed to solve the long-term problem. Some suggestions have been made for the short-term issue that you deal with relative to the WTO, and I respect those suggestions, but the success of American businesses, the success of this country, starts with believing that you can do something. As long as we continue to believe that we can't change it in a big way and that our elected representatives will never take the big steps to change it dramatically, we have defeated ourselves. We will continue to have hearings and debates over who gets to get a cookie out of the cookie jar this time, driven only by more and more complexity and more and more debate.

So, I would encourage you, Mr. Chairman, and your colleagues, to begin to believe that, yes, we can make dramatic changes to the Tax Code.

Chairman MCCRERY. Thank you, Mr. Cain.

Mr. Engen, do you want to have some last shots here, or have you had enough?

Mr. ENGEN. I guess the one thing I would add is that it would seem to me if -- Bill's point is a good one. We have gotten to the point where we are with the Tax Code now because of the system we have and all of us that operate within it. It doesn't necessarily seem to me that we should then be more optimistic that we are necessarily going to change the current system, say, an income tax in a more beneficial way, than we should be more optimistic that we could change to a system, say, like the X tax or Mr. Graetz's tax.

You know, my view is it would seem like the probability of going in any of those different directions -- they are somewhat simpler -- that there is no reason to believe that it would be easier to amend the income tax in a way that is more beneficial. So in that sense, I would say that that is where the focus should be, even though in any direction it is going to be difficult, that those steps are well worth being taken.

I would like to say, yeah, I think the ETI should go. Those foreign subsidies I think don't have a place. There are some small things that can be done with the revenue from that, but the type of fundamental changes we are talking about here, whether it is broad-based income tax reform, whether it is an X tax, whether it is Mr. Graetz's hybrid, that is going to take a lot more effort for sure, but it is well worth it.

Chairman MCCRERY. Mr. Entin.

Mr. ENTIN. If you can do a fundamental reform, that would be wonderful. Many things fit together better if you are changing everything in a consistent manner than if you are trying to do it reform piecemeal. If you can't do a major reform, and you have only a few billion dollars, Ernie Christian suggested a gradual move toward expensing at the business level or a lower-corporate rate, and to improve gradually the tax treatment of saving. Go far enough down that road and you will get to reform eventually. I will second his remarks on that.

Chairman MCCRERY. Thank you. I want to thank all of you for staying with us for 3 hours this afternoon. This is, as Mr. Gale said, a very interesting subject. To sum all this, it was illuminating in some respects, so I do appreciate the expertise that you bring with you, and your enthusiasm, Mr. Cain. We in Congress, sometimes I think, do get somewhat jaded and lose sight of the goals we had when we came here. So maybe after the elections, if the President does what Secretary O'Neill said yesterday he was going to do, which is promote fundamental tax reform, an overhaul of the tax system, maybe we can be rejuvenated here at the legislative level and move forward.

So, we will certainly consider your thoughts and ideas, and I am sure talk with all of you again before we proceed with such an undertaking. Thank you very much, and the hearing is adjourned.

[Whereupon, at 5:00 p.m., the hearing was adjourned.]