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Joint Hearing on Tax Reform and the Tax Treatment of Debt and Equity

July 13, 2011












February 8, 2012

SERIAL 112-14

Printed for the use of the Committee on Ways and Means


DAVE CAMP, Michigan, Chairman

WALLY HERGER, California                         
PAUL RYAN, Wisconsin
DEVIN NUNES, California
JIM GERLACH, Pennsylvania
TOM PRICE, Georgia
RICK BERG, North Dakota
DIANE BLACK, Tennessee
TOM REED, New York

RICHARD E. NEAL, Massachusetts
JOHN B. LARSON, Connecticut
RON KIND, Wisconsin

JON TRAUB, Staff Director
JANICE MAYS, Minority Staff Director

MAX BAUCUS, Montana, Chairman

KENT CONRAD, North Dakota
JOHN F. KERRY, Massachusetts

JON KYL, Arizona
TOM COBURN, Oklahoma
JOHN THUNE, South Dakota
RICHARD BURR, North Carolina

Russell Sullivan, Staff Director
Chris Campbell, Republican Staff Director





Mr. Thomas A. Barthold
Chief of Staff, Joint Committee on Taxation
Testimony A
Testimony B

Dr. Mihir A. Desai
Mizuho Financial Group Professor of Finance, Harvard Business School

The Honorable Pamela F. Olson
Partner, Skadden, Arps, Slate, Meagher & Flom, Former Assistant Secretary of the Treasury for Tax Policy

Mr. Victor Fleischer
Associate Professor of Law, University of Colorado Law School

Dr. Simon Johnson
Ronald A. Kurtz Professor of Entrepreneurship, Massachusetts Institute of Technology Sloan School of Management, former Economic Counsellor and Director of the Research Department at the International Monetary Fund



Wednesday, July 13, 2011
U.S. House of Representatives,
Committee on Ways and Means,
Washington, D.C.


[The  advisory of the hearing follows:]

The joint hearing met, pursuant to call, at 9:07 a.m., in Room HVC210, Capitol Visitors Center, Hon. Dave Camp  [chairman of the House Committee on Ways and Means] presiding.


     *Chairman Camp.  Good morning, and thank you all for joining us this morning.  According to the Congressional Research Service, the last time both the House Ways and Means and the Senate Finance Committees met together for a joint hearing on tax issues was 1940, more than 70 years ago, to discuss a war profits tax.

     And while I have said that I have been looking forward to our two committees working closely together on tax reform, I hope that you all know I didn’t necessarily mean that we would be squeezed in here quite so tightly.  But it is a beautiful new room, and I appreciate the opportunity to be able to use it.

     I want to thank Senator Baucus and his staff, and all of the staffs, for working out the details.  And also, I want to thank my colleagues in both the House and Senate for being here today.  It is a clear illustration of how serious the issue of tax reform is to both of these committees and, of course, to the American economy.

     As former Treasury Secretary James Baker said at the April 6th Joint Tax Committee hearing, “Tax reform has something in it for everybody.”  For an American family, it means greater simplicity, fairness, and predictability, so that families can plan and prosper.  And for employers and their employees, transforming our tax code is critical to making America a more vibrant competitor abroad, and a more attractive place to invest and create the jobs we need here at home.

     However, before we can begin to tackle and craft a plan for comprehensive tax reform, we must take the time to better understand how the current code influences our economy and the decisions made by families and businesses.  The issue of debt and equity, the topics of our hearing today, is among the most complex issues we must grapple with, and among the most important to get right in moving forward.

     Earlier this week, the staff of the Joint Tax Committee issued two reports responding to a request Chairman Baucus and I made, one on household debt, and one on business debt.  The report on household debt examines provisions in current law related to the deduction of interest expenses, including personal interest deductions for mortgage interest, interest on student loans, and investment interest.

     The business debt report focuses more on the tax treatment of debt, relative to equity, and its implication for corporate capital structures.  These are all crucial issues, and I think it is fitting to have both of Congress’s tax‑writing committees here today to receive these reports and hear from our distinguished panel of experts.

     And before I yield to my friend from Montana, I would like to just take a moment to congratulate him on his recent marriage.  And I now recognize Senator Baucus for his opening statement.

     *Chairman Baucus.  Oh, well, thank you very much, Mr. Chairman.  That was something I did not expect.  That is very thoughtful, that is very sensitive, is very nice, and I deeply appreciate it.

     Also, I appreciate our holding a joint hearing.  I think there is an opportunity here for the Ways and Means Committee and the Finance Committee to work together in many areas ‑‑ in this case, with tax reform, both individual and corporate.  We have been working together, we have already set good precedent by working out an agreement with the trade adjustment assistance, you and I and our staffs, and I hope that is good precedent for future cooperation, because both  ‑‑ with us working together, it is clear that we are more likely to get something accomplished than if we don’t.  And I deeply appreciate that.

     The author, Henry Wheeler Shaw, once wrote ‑‑ and I quote him ‑‑ “Debt is like any other trap:  easy enough to get into, but hard enough to get out of.”  We meet together today because we share a common goal.  We believe the tax code should boost American competitiveness, should encourage economic growth and job creation.  It should be fair, simple, efficient, and certain.  And it should also not encourage households or businesses to take on too much debt that they cannot get out of.

     Today we examine the taxation of debt and equity.  Right now we are confronting a massive debt problem due, in part, to 2008 financial crisis.  The year before the crisis, the 5 major investment banks had a leverage ratio of 40 to 1, which means for every $40 in assets, there is only $1 in equity to cover losses.  This raises the question of whether excessive private debt played a major role in creating that meltdown.

     As we work to emerge from that crisis, we seek to understand how our tax code affects private debt, and how does debt affect stability and growth.  Does the code encourage households and businesses to become more leveraged?  Do tax preferences for corporate debt or equity provide incentive for riskier capital structures?  And did the tax code’s treatment of debt contribute to the crisis?

     We clearly did not want to encourage households and business to assume too much. Yet we want to ensure that businesses can borrow at modest rates, because that is an essential step on the road to economic recovery.

     In today’s code it can be hard to tell what is considered borrowing and what is equity investment.  A business can make an infusion of cash that look like either one.  And naturally, some businesses choose to cast their financing in a light that gets the best tax treatment.  But this requires sophisticated tax planning, which not everyone can afford.

     Debt and equity can both be vital tools in today’s economy.  But as we work to inspire growth, we must make sure our code does not encourage businesses and individuals to put themselves in precarious positions.  Tax reform should simplify these issues, make our code fairer.  Americans deserve a tax system they can understand and benefit from, without an extensive tax planner.

     So, let us work together to address these issues, make our code more competitive, more fair.  Let us find creative solutions to our nation’s pressing problems.  Given all the debt discussion, Mr. Chairman, it is my hope that as that proceeds in whatever way it does proceed, that we, in the meanwhile, have extensive hearings on tax reform, individual and corporate, because I think that will provide a good foundation for whatever we do this year or next, or perhaps even in 2013.  But let us work together, have our separate hearings, have joint hearings, but provide a real service to our country.  Thank you.

     *Chairman Camp.  Well, thank you, Chairman Baucus.  And let me now yield to the ranking member of the Ways and Means Committee, Mr. Levin, for his opening statement.

     *Mr. Levin.  Thank you very much.  I think you noticed this is the first time I have been in this room.  There are TV sets here.  I want you to know that they have been, I think, turned off.  I noticed that FOX News, CNN, and ASPN is on these sets.  I am not sure why.  I missed the baseball game last night.  But I think we have turned it off.

     *Chairman Baucus.  Yours isn’t off.

     *Mr. Levin.  No.


     *Mr. Levin.  I pushed it and it says, “U.S. House Guest,  no new messages.”


     *Mr. Levin.  As you mentioned, Mr. Camp, this is the first time since 1940 that there has been this kind of a combined meeting on tax issues.  And, as we know, it is scheduled, and we will discuss certain aspects of the current tax law relating to debt and equity.

     But let me make this comment that I deeply feel.  Because of the uniquely serious challenge facing this nation, action on the debt limit, today would seem most appropriate, if we are gathering to discuss this challenge.  The issue, the debt limit, is squarely within the jurisdiction of our two committees.

     That does not mean that the specific topic before us is unimportant.  Indeed, if we are to seriously address tax reform, issues relating to debt and equity must be considered and, like other significant issues, done so in depth and with open debate.

     As our witnesses’ prepared testimony very much demonstrates, the subject is complex and answers do not always automatically fall into usual ideological frameworks.  But I fear the chances of the discussion at this joint hearing leading to fruitful action have been dimmed immeasurably by the environment created on the overarching action on the debt ceiling.

     Yesterday, Senator McConnell said ‑‑ and I quote ‑‑ “After years of discussions and months of negotiations, I have little question that as long as this President is in the Oval Office, a real solution is probably unattainable.”  In my judgement, this approach politicizes and can poison the well for tax reform in the near future.  It also flies in the face of basic facts.  President Obama inherited a debt that had risen under President Bush from 5.7 trillion to 10 trillion.  And he inherited a record 1.5 trillion deficit that had wiped out the record surplus inherited by President Bush.

     President Obama has said very clearly that we need a balanced framework to reduce the deficit now and in the future, while allowing for needed investments to promote economic growth and job creation.  It is not helpful to walk away from the table.  It is not helpful to insist on an ideological agenda that cannot become law.

     We should hear and review carefully the testimony now to be presented to us by our distinguished ‑‑ and if you have read these documents in advance ‑‑ very knowledgeable witnesses.  But my fear is that any insights that we gain in the process today will be washed away if the debt ceiling is not raised, and we suffer the momentous consequences that would result from destroying the full faith and credit of the United States of America.

     Thank you, Mr. Chairman.

     *Chairman Camp.  Thank you.  I now yield to the ranking member of the Senate Finance Committee, Senator Hatch, for his opening statement.

     *Senator Hatch.  Well, thank you, Chairmen Baucus and Camp, for this historic hearing.  And thank you, Mr. Barthold, and the staff of the Joint Committee on Taxation for producing this important report on the tax treatment of debt and equity, and we appreciate you other witnesses, as well.

     Tax reform should be based on the same three principles that led to the enactment of the Tax Reform Act of 1986:  fairness, simplicity, and economic growth.  I am very much looking forward to hearing what our witnesses have to say on these three principles, as they relate to the tax treatment of debt and equity.

     Allow me to share a few of my initial thoughts, first with respect to individuals, and then with respect to corporations, on the topic of debt and equity.

     On the individual side, we can all agree that savings and investment is a good thing, and that the savings rate in the United States has traditionally been low when compared to many other countries.  But an income tax system, by its nature, discourages savings and investment by taxing the returns to such savings and investment.  This was an observation made by John Stuart Mill over 160 years ago.  Thus, the code encourages consumption, and even “negative savings.”  That is, debt.

     Our tax system encourages the use of debt, rather than equity, in the area of corporate finance, as well as household finance.  If a corporation is in need of additional funds, our tax system encourages the corporation to borrow money, rather than raising funds by issuing stock.  And why?  Because any interest payments on the borrowing are deductible, while any dividends paid on the stock are not deductible.

     In addition, many U.S. multinational corporations are sitting on large piles of cash.  Yet these corporations are borrowing money.  One reason is that their cash is strapped offshore, and the corporations will be subject to a 35 percent U.S. tax on repatriating the cash back to the United States.

     The increased use of debt by both households and corporations makes both more vulnerable to the risks of bankruptcy and other downturns in the economy.

     I would like to thank our witnesses for attending this historic hearing.  Thank our two chairman and all others on this ‑‑ on these two very important committees.  And I look forward to the comments of our witnesses here today on the tax treatment of debt and equity.

     So, again, Chairman Camp and Chairman Baucus, thank you very much for this important hearing that you have called on tax reform.  I appreciate it.

     *Chairman Camp.  Well, thank you, Senator Hatch.  And without objection, any other Member who wishes to have an opening statement included in the formal record may submit one in writing.

     We are fortunate to have a panel of witnesses here this morning with a wealth of experience in private practice, academia, and government.  And let me briefly introduce them.

     First, I would like to welcome Tom Barthold, the chief of staff for the Joint Committee on Taxation.  We thank you and your staff for your efforts in putting together the household and business debt reports for today’s hearing, and we look forward to your presentation.

     Second, we will hear from Pam Olson, who is currently serving as the head of the Washington office tax group of the law firm Skadden, Arps, and has also formerly served as the Assistant Secretary for Tax Policy at the Treasury Department, and has held several positions at the IRS.

     Third, we will hear from Victor Fleischer, who is an associate professor of law at the University of Colorado Law School.  His research is focused on tax planning and the structuring of corporate transactions.

     And fourth, we will hear from Mihir Desai, who is a professor of finance at Harvard Business School, and recently accepted an appointment as a tenured professor of law at Harvard Law School.  He is also a research associate in the National Bureau of Economic Research’s public economics and corporate finance program.

     And finally, we will hear from Simon Johnson, the Ronald A. Kurtz professor of entrepreneurship at the Massachusetts Institute of Technology.  He is also a senior fellow at the Peterson Institute for International Economics in Washington, D.C.  And from March 2007 to August 2008, Mr. Johnson was an economic counselor and director at the research department at the International Monetary Fund.

     Thank you all for being here with us today.  The committee has received each of your written statements, and they will be made part of the formal record.  Each of you will be recognized for five minutes for your oral remarks.

     And, Mr. Barthold, we will begin with you, and you are recognized for five minutes.



     *Mr. Barthold.  Well, thank you very much, Chairman Camp, Chairman Baucus, Mr. Levin, and Senator Hatch, and members of the committees.  It is my pleasure to deliver to the Ways and Means Committee and the Finance Committee two reports requested by the chairmen relating to the tax treatment of the use of debt by households and the use of debt finance, as compared to equity finance, by business.

     Now, the Joint Committee’s staff’s efforts in these reports was to describe what the law is, and what incentives the law might create.  And I will just use my brief time here to highlight a few points.

     First, while, as was noted in some of the opening statements, the recent recession raised valid concerns about leverage in the U.S. economy, it is important to remember that there are many sound economic reasons for both households and businesses to finance with debt.  Debt is not inherently a bad thing.

     Now, relative to the growth of the economy, as measured by the gross national product, over the past 25 years non‑financial corporate debt has been largely unchanged, while the debt of the household sector and the debt of the Federal Government have increased by more than 50 percent each.  This is shown in table I of each of the two documents that we prepared.

     In looking at the household debt, the primary source of the growth of household debt is the growth of mortgage debt, and that is documented in figure 3 on page 18 of the household document.  As you know, mortgage interest is favored as an itemized deduction in the Internal Revenue Code.

     Yet over this same 25‑year period where we see this substantial growth in household debt, Congress has generally lowered individual tax rates, which lowers the benefit of that interest deduction, Congress has capped the aggregate amount of acquisition indebtedness that a taxpayer may claim as part of the itemized deduction, and Congress has limited the interest deductibility of home equity debt.  With those factors, it is difficult to conclude that the deductibility of mortgage interest would explain the growth of household debt over that period.

     On the business side, one cannot discuss debt finance without discussing equity finance.  And, as our staff report details, there are tax rules that create incentives to choose debt finance over equity finance.  Most initially, for the issuer, the deductibility of interest expense and, oppositely, the non‑deductibility of dividends, make debt a cheaper source of capital for the business.

     Also, other incentives exist to choose debt finance.  In a partnership, for partners, the inclusion of debt at the partnership level increases the partners’ basis, and increases the limit on the deductibility of partner shares of partnership losses and deductions.  Debt finance of investments can create interest deductions that can shelter other taxable income of the business, and can lead, in some situations, to negative effective tax rates on returns to investment.

     On the other hand, there are also tax rules that favor equity finance.  At the individual level, the individual investor may often prefer equity finance because, under present law, there are low rates of ‑‑ relatively low rates of tax on dividend income, compared to interest income.  And if the investor recognizes a capital gain that results from the retained earnings of the business, that is also taxed at a lower rate than would be interest income.

     For a corporate equity holder, there are low effective tax rates from the dividends received deduction, where a corporation which had lent money would be paying tax on the interest earned at full corporate rates.  For both investors and issuers, equity promotes the possibility of tax‑free mergers, and reorganizations, facilitating fluidity in the business sector.

     Taxpayers have considerable flexibility to design instruments that are characterized as debt or equity under the code.  And it is difficult to create bright‑line rules to distinguish debt from equity.  The courts, through time, have identified multiple indicia of what is debt.  And because of these factors, instruments can be constructed that, as an economic matter, and as our two finance experts can probably explain better than I, that can blend the characteristics of debt and equity.

     In the 1950s, the Congress attempted to define “debt” and “equity” in the Internal Revenue Code, but retreated from that effort.  Treasury has the authority to issue regulations to identify debt and equity, but has never exercised that authority to do so.

     I think those are some broad points that you can draw from our reports.  Thank you for the opportunity to prepare this material for you.  We would be ‑‑ our staff would be happy to provide more detailed work on any questions that might arise in today’s hearing.  And, of course, I am happy to answer any questions that you may have today.

     [The statement of Mr. Barthold follows:  Testimony A   Testimony B ]

     *Chairman Camp.  Thank you, Mr. Barthold.

     Ms. Olson, you are recognized for five minutes.



     *Ms. Olson.  Thank you, Chairman Camp, Chairman Baucus, Senator Hatch, Mr. Levin, distinguished members of the committee.  Thank you for inviting me to testify this morning.

     I am appearing on my own behalf, and not on behalf of any client or other organization.  And the views I express are solely my own, and are based on my experiences in both the private and the public sector.

     My compliments, first, to the chairmen, for your decision to tackle tax reform on a bicameral and bipartisan basis.  The tax code’s treatment of debt and equity is one of many issues that should be considered carefully as Congress considers reform of the tax system.

     It has been observed that the one law Congress cannot repeal is the law of unintended consequences.  Individuals and businesses respond to economic incentives and disincentives, including those provided through the tax laws.  It is important for the tax‑writing committees to be cognizant of the tax system’s incentives and disincentives, particularly with respect to the disparate treatment of debt and equity, so that potential consequences can be factored in as you consider reform of the tax system.

     In its current form, as Mr. Barthold has observed, the Internal Revenue Code provides an incentive for businesses to raise capital through the issuance of debt, rather than equity.  The incentive arises from the interplay of the two features of our tax system that he identified as well, the double taxation of corporate income, and the tax deductibility of interest payments.

     Incurring debt serves as a straightforward means of mitigating the double tax on corporate income.  It is worth noting that the disparate treatment of debt and equity has been the subject of numerous disputes between taxpayers and the Internal Revenue Service that continue today, and that there have been several failed efforts to draw a bright line between the two, both legislatively and administratively.  Treasury and the IRS proposed regulations under Code section 385 back in the 1980s that were subsequently withdrawn.

     The impact of the Internal Revenue Code’s preferential treatment of debt has been a concern for a number of years, and has led to proposals to neutralize or equalize the tax treatment of debt and equity.  The disparate treatment of debt and equity, particularly the double tax on dividends, has also given rise to corporate governance concerns, which affected the Treasury Department’s design of a dividend exclusion proposal that was included in the Bush administration’s fiscal year 2004 budget.

     Prior to 2003, the tax on dividends brought the top tax rate on corporate income distributed as dividends to nearly 60 percent, creating an opportunity for corporate managers to cite the tax inefficiency of dividend payments as a basis for reinvesting corporate profits, rather than distributing them as dividends.

     The payment of dividends is a healthy financial discipline, because it requires free cash flow to fund the payment.  But that discipline was dulled by the tax disincentive to paying dividends.  Prior to 2003, the lower tax rate on capital gains made methods of delivering capital gains to shareholders, such as stock redemption, a more tax‑efficient means of distributing excess cash to shareholders.

     The 2003 dividend exclusion proposal would have brought a measure of transparency to corporate taxes as well, because dividends would only have been excludible, to the extent they were paid out of earnings on which corporate tax had been paid.  The attractiveness of tax‑free dividends was seen as giving corporations an incentive to pay income tax, at least to the extent of dividends expected to be paid to shareholders, and shareholders an interest in the extent to which the corporation had paid tax.  Thus, the proposal could have reduced the value of corporate tax incentives, by preventing the value of those incentives from flowing through to the shareholders.

     There are simpler means of reducing or eliminating the double tax on equity, including the reduced rate Congress ultimately adopted, or making dividends deductible at the corporate level.  A dividends paid deduction would have a significant effect on tax revenues, because it would have the effect of eliminating all tax on dividend income, where the stock is held by a tax‑exempt entity, as is the case with interest income, where the indebtedness is held by a tax‑exempt entity.  Thus, a dividends paid deduction could result in the removal from the U.S. tax base of a significant amount of corporate income.

     As the tax‑writing committees consider tax reform options, one simple means by which to reduce the preference for debt financing is to lower the corporate tax rate.  The preference for debt financing is a result of the ability to deduct interest payments from taxable income, and lowering corporate tax rates would reduce the value of the interest deduction, thus reducing the disparity in the taxation of debt and equity investments.

     Besides reducing the distortion between debt and equity financing, lowering the corporate rate would have the benefit of more closely aligning our rate with rates of other countries, which have fallen in recent years.

     Another reform option would be to integrate the corporate and individual tax systems, along the lines of the Bush administration’s 2004 budget proposal, by eliminating the shareholder level tax on corporate income distributed as dividends.  The dividend exclusion proposal could eliminate the debt financing incentive associated with double taxing the return to corporate equity investment.

     You could also go for full parity between debt and equity, through the adoption of a comprehensive business income tax, which has also been studied by the Treasury Department.

     In considering corporate tax reform, I encourage the committees to make sound policy the primary objective.

     Thank you for the opportunity to testify.  I would be pleased to respond to questions you may have.

     [The statement of Ms. Olson follows:  Testimony ]

     *Chairman Camp.  Thank you very much.

     Mr. Fleischer, you are recognized for five minutes.



     *Mr. Fleischer.  Thank you for inviting me to participate today.  I am an associate professor of law at the University of Colorado, where I teach deals, partnership tax, and tax policy.  My research focuses on how tax shapes the structuring of deals, and so I will focus my testimony from that perspective today.

     The main point that I want to make is that the debt equity distortion is costly on two levels.  The first level of cost is obvious.  Deals are restructured to reduce taxes, which erodes the tax base.  This is the explicit cost of the debt‑equity distortion.

     The second level of cost is implicit.  When a corporation restructures a deal to reduce taxes, the restructuring imposes an implicit cost on the corporations themselves.  It adds complexity to their capital structure, distorts corporate governance, and even changes critical business decisions.

     The debt‑equity distortion imposes an additional implicit cost on the public, in the form of increased systemic risks, taxpayer bailouts, and the like.  It also encourages a lot of wasteful tax planning.  One can think of these implicit costs collectively as the collateral damage of the debt‑equity distortion.

     The best way to reduce this collateral damage is to eliminate the underlying distortion in the tax code.  Legal distinctions in the tax code that have no basis in underlying economics are almost always a bad idea.  The tax lawyers that I know are very, very clever.  If you give them an economic incentive to turn equity into debt, or a corporation into a partnership, or ordinary income into capital gain, they will work tirelessly until you are convinced that a dog is properly treated as a cat for tax purposes.

     With that introduction, I will briefly elaborate on the implicit cost of the debt‑equity distortion.  The first implicit cost is risky managerial behavior.  As firms take on more debt, common stock behaves economically like a risky stock option, giving executives unlimited upside, but limited downside risk.  With enough debt, it even becomes rational for executives to make negative expected value bets with company assets.  The debt holders, not the executives, bear most of the downside risk.

     The second cost is the social cost from increased bankruptcies and systemic risk.  Excessive leverage fuels risky speculation that has repercussions, even for taxpayers that never engage in risky behavior themselves.  The problem is especially acute with banks and other financial institutions, because the externalized social costs are larger than in other sectors.

     The third cost is wasteful tax planning.  In a world without tax distortions, corporations would make financing decisions based on market conditions, not a tax calculation.  Instead, many corporations and financial institutions, in particular, issue new financial products to engage in regulatory arbitrage, exploiting the inconsistencies of two different regulatory regimes.

     In the typical scenario, bank executives want to increase the amount of leverage in the firm to reduce taxes and to supercharge return on equity.  But taking on too much debt runs afoul of banking regulations and the guidelines of credit agencies.

     Platoons of lawyers and investment bankers then create complex new financial products that quality as debt for tax purposes, and equity for financial accounting or credit agency purposes, or as tier one capital for bank regulatory purposes.  These hybrid instruments allow financial institutions to appear safer by appearing to have greater equity capital.  In fact, they mask an increase in debt.  They are dogs that are treated as cats for tax purposes.

     AIG, Lehman Brothers, Bear Stearns, and other failed institutions all had large amounts of these hybrid instruments on their balance sheets before the crash.  These instruments did not perform well in the financial crisis. Because they typically contained ongoing obligations to make cash payments, the instruments were properly perceived by trading counterparties as debt obligations that would not provide a cushion in the way that real equity would.  The resulting loss and instability was borne largely by the public, and not the banks themselves.

     So, what is the bottom line?  The best solution is a broader corporate tax reform effort that would eliminate the debt equity distortion all together.  There are several different ways to do this, including eliminating the deduction for interest, allowing a deduction for corporate equity, or moving to a corporate cash flow or consumption tax system.

     If Congress is interested in moving more immediately on the debt‑equity distortion, my suggestion is to focus on financial institutions.  Financial institutions are where the problem is, they have the most excessive leverage, and the failure of a systemically risky financial institution imposes enormous social costs.

     One approach would be to eliminate the deduction of interest by financial institutions to the extent that debt‑equity ratio exceeds five to one.  The goal of such a limit is not to punish banks, but rather to remove the tax incentive to increase leverage beyond the ratio that would arise in a world without taxes.

     I would be happy to answer any questions you may have, and I thank you for the honor of participating in this hearing.

     [The statement of Mr. Fleischer follows:  Testimony ]

     *Chairman Camp.  Thank you very much, Mr. Fleischer.

     Mr. Desai, you will be recognized for five minutes.



     *Mr. Desai.  Chairman Baucus, Chairman Camp, and members of the committees, it is a pleasure to appear before you today to discuss tax reform and the treatment of debt and equity.  I am a professor of finance at Harvard Business School, professor of law at Harvard Law School, and a research associate of the National Bureau of Economic Research.

     In my comments, I want to describe the fundamental problem raised by the current tax treatment of debt and equity, how changes in the economy and the tax system have raised novel complications to this underlying problem, and outline several alternative solutions.  As an aside, I will comment on the possibility that the tax treatment of debt and equity contributed to the recent financial crisis.

     My written testimony can be summarized in five points.  First, a classical corporate income tax with an entity level and individual level taxation creates the potential for asymmetric treatment of debt and equity income.  This asymmetric treatment can distort financing, organizational form, and investment decisions.

     In the U.S. system, equity income is taxed twice, while debt income is taxed once, though assessing the actual relative tax burdens of equity and debt income is complicated by several factors.  Indeed, the simple narrative that debt is tax favored is not necessarily true, nor is it borne out by recent patterns in the data, as I elaborate on in my recent testimony.  In addition to distorting financing choices, the differential in tax treatment creates a host of opportunities for financial engineers to innovate around that distinction.

     Second, this asymmetric treatment of debt and equity income has been complicated by three significant developments that any reform measure should grapple with.  The first development is the rapid globalization of firms and capital markets.  This development makes the tax treatment of multinational firms and transfer pricing concerns central to the corporate tax, creates situations where investor‑level taxation now often involves foreign investors, and allows the possibility of allocating various headquarter and domicile functions across multiple jurisdictions.

     The second development is that the simple characterization of entity‑level taxation and taxable investors that is customary to use in these discussions does not reflect two very rapid ‑‑ two very important developments:  the rapid rise of pass‑through entities for business income, and the rise of tax‑exempt investors as major players in the capital markets.

     The third development is that corporate tax is now largely for public corporations, where financial reporting incentives compete with tax obligations, and these incentives can compromise tax policy goals.

     My third major point is that while excessive leverage is sometimes associated with the tax code because of a presumed debt bias for corporations, concerns over the role of tax policy in fostering the financial crisis appear unfounded.  It is difficult to describe significant roles for tax incentives in the housing market or for financial institutions as primary or secondary actors in the drama of the financial crisis.

     For the non‑financial corporate sector, where the presumed debt bias is thought to exist, the startling fact is how unlevered that sector was, prior to the crisis.  In particular, as Senator Hatch outlined, the rise of cash balances and the decline of net debt is the dominant corporate finance trend of the last decade.

     A brief and remarkable burst in leverage buy‑out activity that is not related to changed ‑‑ to tax incentives is likely responsible for the perception of excessive leverage in the non‑financial sector.  The increased reliance on equity financing also speaks to the potential scope of the current bias towards debt.  In my opinion, the excesses of financial‑sector leverage, which are very important, are best addressed through regulatory approaches, rather than tax instruments.

     Fourth, the corporate tax is ripe for reform for many reasons, but excessive leverage may not rank highly amongst them, in my view.  In my testimony, I highlight three approaches to the debt equity distinctions:  regulatory, structural, and rate solutions all can be deployed to correct perceived concerns regarding the debt equity distinction.  Regulatory approaches which provide arbitrary limits to leverage must be crafted with care, as they can create added complexities with limited payoffs.

     If the stripping of earnings by multinational firms is the concern, then new regulation should be integrated with current policy instruments that already target that problem, such as interest allocation rules and section 163(j).  Indeed, a lowered corporate rate is likely the best antidote to that behavior.

     If firm leverage is the concern, then limits on interest deductibility must consider how highly‑levered industries and organizational forms will be impacted, and the consequent effects on their cost to capital and investment levels.  Given the uncertainty of the current debt bias, such regulations would appear to engender more tax planning than economic benefits.

     Fifth, reforming the corporate tax structurally via comprehensive business income tax can provide a solution‑based symmetric treatment of debt and equity, can undo distortions to organizational form decisions, and provide a first step towards fundamental tax reform.

     A more modest approach to modernizing the corporate tax should couple a rate reduction with a move toward territoriality that is funded by better alignment of book and tax reporting, and by some taxation of non‑C corporation business income.

     As other countries have learned, reducing rates, simplifying international taxation, and broadening the base, are cornerstones of reforms that can improve the lives of American workers and the firms that employ them.  Such reform efforts, rather than regulatory approaches that target excessive leverage, would best advance your admirable agenda of strengthening tax policy and America’s economic future.

     Thank you, and I look forward to any questions you might have.

     [The statement of Mr. Desai follows:  Testimony ]

     *Chairman Camp.  Thank you, Mr. Desai.

     Mr. Johnson, you are recognized for five minutes.



     *Mr. Johnson.  Thank you very much.  I would like to speak about household debt, non‑financial corporate sector debt, and financial sector debt as three separate issues for your consideration.

     However, there is a common problem across all these kinds of debt which is now, I think, apparent to all American homeowners.  If you buy a house that costs $1 million with only $5,000 down ‑‑ so the rest is leverage ‑‑ you are much more at risk when house prices go down than if you had put down $50,000 or $500,000.  You also, of course, get great upside if house prices go up.  You get a better return on your equity.

     And the issue, I think, before us, certainly with regard to the previous financial crisis, and also with regard to what may happen in the future, is to what extent individuals or corporations create a spillover, an externality, a form of system risk when they choose to be over‑leveraged, from a social point of view.

     Now, looking at households, I am afraid ‑‑ I think it is somewhat obvious ‑‑ that the tax code has encouraged households, over a long period of time ‑‑ and it wasn’t the primary instigator of the crisis, but it encourages households to massively over‑leverage, to take on a great deal of risk, which they may or may not fully understand themselves.

     But, in any case, it creates really bad macroeconomic consequences when house prices go down.  I would strongly urge you to consider phasing out the mortgage interest deduction over a long period of time, such as 20 years.  This has been done in other countries.  If handled properly, it would not be disruptive and dangerous.  Obviously, I am not proposing to do it right away.

     On the non‑financial corporate side, I think we don’t have a major problem.  I agree with what the previous witnesses have said, with regard to the attractiveness of making the system more neutral between debt and equity.  And I think there are a number of reforms you could do, either lower the tax of equity or lower the deduction for interest payments, or, even better, move to a new system, a more integrated system for corporate taxation, perhaps also with individual taxation.

     That, I think, is not the pressing number‑one issue, though, with regard to macro risks and financial stability.  Those risks are about the financial sector.  And Senator Baucus said it exactly right at the beginning.  We had financial firms going into the crisis in 2008 with leverage of at least 40 to 1.  And that was not ‑‑ those are not isolated examples.  We have tried for a long time, through regulation, to limit leverage, to have so‑called capital requirements, which have a similar effect to leverage caps, and it hasn’t worked.

     Not only that, but the Basel III attempt to limit leverage, to require more capital, the major international response to the crisis, has also not had a dramatic effect, either now or in terms of what will happen later in the cycle, as firms want to take on more leverage.

     For the financial sector, it is very clear that the top bankers and traders are paid on a return on equity basis.  If they have less equity in the business, and things go well, they get nice compensation.  If things go badly, there is a downside risk.

     But who, I would ask you, bears that downside risk?  It is largely borne by the rest of the economy, by the non‑financial sector, by households, either ‑‑ whether or not you are in favor of bail‑outs, whether or not you think you will get a bail‑out doesn’t matter.  You will get an awful recession, you will get devastating losses.  You get an increase of debt to GDP, if you just want to think in fiscal terms.

     As Mr. Levin pointed out, the debt level has gone up dramatically in the past few years in the United States, mostly because of the recession caused by the excessive leverage in the financial system.  It makes no sense to have a tax code that encourages that leverage, at the same time as we try and pull it back rather ineffectively with regulation.  At a minimum, the tax code should be neutral between debt and equity for financial sector firms.

     I, though, would strongly advise you to follow the lead of some other countries in taxing excessive leverage.  In the UK they now have a tax of 7.5 basis points on what they define as excessive leverage.  That tax, I think, is actually rather low, if you consider that the International Monetary Fund and other organizations assess the value of being too big to fail, the funding advantage you get from being a mega‑bank today ‑‑ not just in the United States; in other countries, as well ‑‑ that funding advantage is 50 basis points, half a percentage point.  We should be taxing away that advantage.

     I would actually suggest going ‑‑ speaking to the points made by Mr. Hatch.  If you want a fair, simple, and pro‑growth system, you should tax excessive leverage in the financial system and use the revenue that generates to reduce corporate taxation for the non‑financial sector, because the non‑financial sector is what really got hit hard.

     That is why the jobs aren’t coming back.

     That is why this has turned out to be such a painful recession.  Thank you.

     [The statement of Mr. Johnson follows:  Testimony ]

     *Chairman Camp.  Well, thank you, Mr. Johnson.  We will now proceed with Member questions for witnesses.  And due to the joint nature of today’s hearing, questioning will alternate between members of the Senate, as recognized by Chairman Baucus, and members of the House, as recognized by myself, for a single round of questioning.

     Senators will be recognized in an order consistent with rules and practices used at Senate Finance Committee hearings.  House members will be recognized in an order consistent with rules and practices used at Ways and Means Committee hearings.

     And each Member will have three minutes to question witnesses.  I realize this is a little shorter than we are used to having in the Ways and Means Committee.  But in order to accommodate everyone, we want to hold to the three minutes for each Member.

     So, with that, let me invite Chairman Baucus to begin the questioning.

     *Chairman Baucus.  Thank you, Mr. Chairman.  I am curious about this question ‑‑ the degree to which financial institution over‑leveraging and the ability of those companies to create an infinite number of financial products to affect their own needs should best be dealt with through the code, or best dealt with, as Mr. Desai said, through the regulatory regime.  Or, is there some combination ‑‑ are there some areas where maybe a tax change to the tax code is better?  There is some general feeling lowering the rate, and trying to flatten the corporate tax code a little bit helps.

     I only have three minutes.  I would like to throw in the implication of pass‑throughs, the rise of pass‑throughs.  What effect does the rise of pass‑throughs have?  I will see a little bit of difference between you, Mr. Johnson, and Mr. Desai and Mr. Fleischer.  But if you could ‑‑ the three of you ‑‑ just briefly comment on that basic question.  Which is more important, and what about pass‑throughs?

     *Mr. Fleischer.  So, on the question of whether we should try and address excessive leverage through the tax code or through regulatory responses, the answer is yes to both.

     On the tax side, I think what is important is to remove the extra incentive to borrow.  I don’t think we should use the tax system to try and solve all of our issues in the bank regulatory area.  The critical thing on the tax side is to try and make it more neutral.

     On pass‑throughs, I think the development of pass‑throughs ‑‑ it used to be that when you think of a partnership, you think of a small business.  Now we see very large companies, including large financial institutions like hedge funds that are organized as partnerships.  To me, that shows they are very sensitive to tax distortions, and will do ‑‑ will go to great lengths to try and avoid the corporate tax.

     *Chairman Baucus.  So what is the solution?

     *Mr. Fleischer.  Well, as I said, I think the short‑term solution, if you want something in the short run, would be to limit or cap the deductibility of interest by financial institutions, based on a leverage ratio.  And I could talk more about comprehensive tax reform, but in the short run ‑‑

     *Chairman Baucus.  Okay, thank you.  Mr. Desai?

     *Mr. Desai.  So, you know, just briefly, to outline what the possibilities are, I think ‑‑ within the tax policy realm I think there are several variants.

     One is what would be called a financial transaction tax, which would be akin to kind of throwing sand in the wheels of financial markets, for the purpose of kind of disrupting excessive levels of transactions.

     The second type would be financial activities taxes, where, you know, broadly, anybody involved in finance has a specific kind of tax.

     One could have a too‑big‑to‑fail kind of tax, which is if your assets are above some threshold level, then you have potentially to pay an extra tax.

     You know, roughly speaking, I think that is the variance that one can have.  And then, of course, one can limit interest deductibility.

     So, you know, I think the first thing to realize is financial institutions are highly specialized.  And understanding them is extremely difficult.  And in situations like that, regulatory apparatuses are best used.  That doesn’t mean that we succeeded in the past, but it also doesn’t mean that we should try a tax instrument in a very complex setting with highly responsive taxpayers and a lot of institutional detail.

     So, that is why I am very skeptical about tax instruments to address financial leverage.  Not because it is not a problem, but because I think there are better ways to do it.  And I understand there has been a failure to do it, but there is little evidence that ‑‑ in my mind ‑‑ that these kinds of taxes are little more than kind of a representation of the vengeance that many of us feel ‑‑

     *Chairman Baucus.  But Mr. Johnson says the financial planners just plan all around any financial regulations that you come up with.  They are so clever ‑‑

     *Mr. Desai.  Well, indeed they are ‑‑

     *Chairman Baucus.  And they are so driven to try to find a product that will yield the greatest return.

     *Mr. Desai.  Indeed they are, and they will do even more so when one tries to think about a tax instrument.  And that just means that we need to strengthen regulatory approaches, where I think that specialized knowledge exists, where we can actually govern them in a much more thoughtful way than through the tax system.

     And finally, I will just say that it is useful to remember that a lot of the leverage was hidden, right?  So let’s think about Lehman Brothers.  I don’t think anybody knew how levered they were.  And that is a part of this crisis, which is there was behavior that was even beyond the realm that you might have imagined.

     *Chairman Baucus.  Mr. Johnson, your thoughts?

     *Mr. Johnson.  Whether you like it or not, Senator, the Code impacts the leverage choice these firms make.  I think we all agree with what the JCT staff has determined, that this is a big bias towards debt, including for the financial sector.

     It makes no sense to have regulation and tax code pointing opposite directions here.  I work a great deal on regulation with regulators, and I am very supportive of what they are trying to do.  But it is not enough.  They are all so constrained, perhaps by their own choice, but they are constrained by international approach to regulation, including Basel III on capital, where the Japanese, the Germans, and the French were the ‑‑ provided the lowest common denominator.  So, why should we regard that as the last word, as the appropriate constraint on the extent ‑‑ excessive leverage?

     I agree with Mr. Fleischer.  There are many appropriate ways to tax excessive leverage, including a version of a thin capitalization tax, which is part of what he discussed.  And the IMF made a very good report to the G‑20 on exactly these issues that I commend to all of you.

     *Chairman Baucus.  Thank you very much.  Appreciate it.  Thank you, Chairman.

     *Chairman Camp.  Well, thank you.  Mr. Desai, you, in your testimony, say that a lower corporate tax would alleviate pressure on the tax bias in favor of debt over equity.  Can you explain how a lower tax rate would address the sort of debt-equity bias that we have heard about?

     *Mr. Desai.  Sure.  And I think Mr. Barthold made reference to this as well, which is the most simple version of this is that that entity‑level taxation is part of the problem.  And so, reducing that rate ends up taking away that distortion, to some degree.

     But it kind of goes further than that, insofar as one of the problems here is not just debt in the aggregate for non‑financial corporations, but the possibility that the corporate tax base is being eroded in the U.S. by earnings stripping, which I think is a widespread concern.  And there, you know, lowering statutory rates is a very valuable thing to do, because it takes out that incentive for relocating profits outside of the United States.

     So, I would say it is at two levels.  It is at one level of the system, which is part of the reason why the system may be tax biased towards debt, is because of the high corporate tax rate, the high deduction.  And once you take that away, you reduce that.  And second, if we think that earnings stripping and reallocations of income, which are legitimate concerns today, given how easy it is to reallocate income, then lowering the rate has the additional salutary effect of taking away that incentive.

     *Chairman Camp.  There seems to be a general consensus that the federal tax code favors debt over equity for C‑corporations and financial firms.  And to the extent that you consider this a problem, is the solution to change the treatment of equity, or the treatment of debt?  And how would any of those changes to the treatment of debt and equity affect taxpayers that take advantage of the current debt bias?

     And if each of you would like to just briefly answer ‑‑ I don’t know if, Mr. Barthold, you really want to address that — but why don’t we start with Ms. Olson and just quickly go down the line?  And I know time is short.

     *Ms. Olson.  I think you can go either direction.  I mean I think right now we have a little bit too much of a bias towards debt and against equity.  And so I think you can go in either direction.  You could go in the direction of reducing the double tax on corporate income, or you could go in the direction of some restrictions on interest.

     I think if you go in the direction of some restrictions on interest, you need to first think about significantly reducing the corporate rate, and you need to think about transition, because there are capital structures in place that would be significantly affected by that kind of a change.

     *Chairman Camp.  All right.  Mr. Fleischer?

     *Mr. Fleischer.  I largely agree with that.  My preference would be to limit the ‑‑ on the interest side, to limit interest deductions.  And the big benefit there is that you could reduce corporate tax rates, which reduces all sorts of distortions and incentives to tax planning.  Thank you.

     *Mr. Desai.  Just briefly I would say that, you know, I think this is an opportunity that one shouldn’t squander, and there is the possibility of more comprehensive approaches.  Mr. Rangel has put forward things, other folks have put forward things, and I think that is a very useful opportunity.

     So, to try to fix this on the margin is not as advisable as something like the comprehensive business income tax, which I think would be very useful.

     *Chairman Camp.  Thank you.  Mr. Johnson?

     *Mr. Johnson.  My suggestion for the non‑financial sector is to have an allowance for corporate equity, where you are allowed to deduct some of the dividends payments, based on an assessment of what is the normal rate of return on capital.

     But for the financial sector, I think you have to go further.  For the financial sector, I am proposing that you tax excessive leverage, because that is what generates the big negative ‑‑ now, it is a form of pollution, a very bad form of pollution that doesn’t hit you ever year.  But every 5 to 10 years you are going to have some very nasty consequence to this.  And you should take that revenue and use that as general revenue, and use that to reduce tax rates on other parts of the economy.  Because it is those parts of the economy that are going to be hit very hard when the banks go bad again.

     *Chairman Camp.  All right, thank you.  Chairman Baucus?

     *Chairman Baucus.  Thank you.  We will experiment with this new regime here.  Under Senate rules, we go according to a first come first served, early bird system.  And the earliest bird that arrived from the Senate was Senator Hatch.  You are next.

     *Senator Hatch.  Well, thank you.  Thank you, Mr. Chairman, and both of you.

     Professor Desai, this is a question for you.  And I would like it also to be answered by Ms. Olson and Mr. Barthold, if they could weigh in briefly on this question, as well.

     Professor Desai, in your written testimony you said that “the current corporate tax system has the worst of all worlds:  high statutory rates and low average rates.”  Could you please explain that a little bit more?

     For instance, if ‑‑ say the average rate is 17.5 percent, and say that the statutory rate is 35 percent, and the ratio of average rate to statutory rate would be 1 to 2, as I see it.  Do you think there is some ideal ratio ‑‑ one to one, maybe?  Or would it actually be ideal to have a statutory rate somewhat lower than the average rate, if that could be accomplished?

     And if you would, go weigh in on that and then, after that, Ms. Olson and Mr. Barthold.

     *Mr. Desai.  So, I guess what I was trying to get at there is a few things.  The first is the statutory rate is high.  And by “high,” I mean by global standards the statutory rate is high.

     When I said it was the worst of all worlds, if one is going to have a high statutory rate, one would like lots of revenue, presumably, or at least there would be some benefit that would come from that.  And we are living in a world where we are not getting that.

     So, we have highly responsive taxpayers, we have very high statutory rates, which, on the margin, is distorting incentives, as we know marginal rates will do.  And we are not collecting very much.

     So, the promise of tax reform, of course, that other countries have embarked on and that I hope you embark on, is lower rates, broader base, and bringing together statutory and average rates in a way that is much more consistent with economic efficiency and, I should mention, is also more consistent with political viability.  The corporate tax is now viewed ‑‑ I think widely by the American people ‑‑ as something that is not paid at all.  And it discredits the overall tax system and, I think, has a wide series of repercussions.  So, bringing those two back in line is, I think, a very worthy goal.

     *Senator Hatch.  Thank you.  Ms. Olson?

     *Ms. Olson. I agree with Mr. Desai’s comments.  I do think that it would be much better if we had a lower statutory rate, and if we did some things to broaden the base, which would have the effect of increasing the effective rate, or bringing the effective tax rate closer to the statutory rate.

     The differences now, I think, of the ways in which the tax code directs resources, as opposed to resources being directed on the basis of what produces the best pre‑tax return.  And we will maximize national income, and therefore, economic growth, if we remove some of those distortions.

     *Mr. Barthold.  Senator Hatch, I will probably just re‑emphasize a point that Mihir Desai made.  When we are looking at the statutory rate, we are usually thinking of it as the marginal tax rate that applies, and economists emphasize the importance of marginal tax rates.  Because, at the margin, that influences the next investment that will be made, or the next financing choice that will be made.

     And so, high marginal tax rates tend to distort choice.  They could promote more debt than equity.  They could promote tax shelter behavior.  They can reduce incentives to invest, which reduces incentives for future growth.  And so, that is why economists generally are always in favor of lower marginal tax rates.  As to an optimal ratio of marginal to average, remember that average also reflects a number of other policy concerns that Members may have in the design of the tax code.  And so, the optimality of that is your decision.

     *Senator Hatch.  Well, thank you.  My time is up, Mr. Chairman.

     *Chairman Camp.  Mr. Levin is recognized for three minutes.

     *Mr. Levin.  Thank you, Mr. Chairman.  Now, this has been, I think, interesting and, I hope, helpful.  I do think that the complexities emphasize that as we approach these issues we kind of need to leave ideology at the door, and try to dig into these issues.

     In a sense, it is easy to say lower the rates and broaden the base.  The problem is when we start talking about how you broaden the base.  And that is not at all easy.  We have held hearings, for example, on transfer pricing.  And it is not easy.  We have held hearings on tax havens.  And there is often disagreement about that.

     By the way, let me just say quickly on the mortgage interest deduction ‑‑ some of you have mentioned it ‑‑ I just urge that we be careful about our proposals.  That ‑‑ because that is one way to kind of lower the rate, but the impact, when you look at the distributional analysis of mortgage interest, it has been very much a middle‑income tax provision.  And I think most of us have to ask where we would be if it hadn’t been in existence the last 40 years.  And there are some problems of excess, but I think we have to be careful about not throwing out the baby with the bath water.

     So let me, on corporate, ask each of you just directly  ‑‑ some of you have already expressed yourselves ‑‑ do each of you favor taxation of excessive leverage in the corporate sector?  Yes or no, or however you would like to modify that.

     Ms. Olson, let’s start with you.  I won’t ask Mr. Barthold.

     *Ms. Olson.  I would go in the direction of eliminating some of the bias between debt and equity.  I don’t think I would think that it would be a great idea to tax excessive leverage, because I am not sure how we would define it, or how we would apply it.  I had some experience with section 163(j) proposals when I was at the Treasury Department. We made an effort to try to cap interest deductions, and it didn’t turn out very well.

     *Mr. Levin.  All right.  Mr. Fleischer, there are just 20 seconds left, I see here.

     *Mr. Fleischer.  I favor removing the tax incentives to be excessively levered.  Going beyond that, you have to proceed carefully.  If you want to impose a kind of penalty tax on excessive leverage, I might support that.  But you would have to be careful in the design.

     *Mr. Levin.  Mr. Desai?

     *Mr. Desai.  No on very targeted things towards excessive leverage.

     And on your point about revenue, you are absolutely right on broadening the base.  There are two solutions in my testimony.  One is the non‑corporate business income, which has grown enormously, and then the second is the gap between book and tax income, which also, I think, can generate some revenue.

     *Mr. Levin.  Mr. Johnson, I think you have already spoken, so ‑‑

     *Mr. Johnson.  But if I could just add, the tax on excessive leverage is where European Union is heading, including the UK.  London is our major competitor, vis a vis New York.  So we are behind the curve on taxing excessive leverage, compared to major comparative countries.

     *Mr. Levin.  Thank you.  Thank you, Mr. Chairman.

     *Chairman Baucus.  Okay.  Next is Senator Wyden.

     *Senator Wyden.  Thank you, Mr. Chairman.  And, Chairman Baucus and Chairman Camp, let me thank you both for your bipartisan leadership in putting together this important hearing.

     I believe that tax reform is now the major unused tool in the economic recovery toolshed.  The Federal Reserve has cut interest rates repeatedly.  The Economic Recovery Act was passed.  Numerous initiatives are in place to help hard‑hit homeowners.  But bipartisan tax reform is now sitting, in effect ready, in the economic recovery toolshed.  And I hope, as we consider this, we know that a variety of factors go into job creation, but the last time there was bipartisan tax reform, our country created 6.3 million new jobs in the 2 years after it was passed.

     Now, on the debt equity issue specifically, Mr. Barthold, a question for you.  Senator Coats of Indiana and I put in, as part of our broad tax reform, an idea that suggests that one way to make the tax code less tilted towards debt finance is to disallow a portion of the deduction for interest cost that is attributable to inflation.  That would make the interest on debt a bit less deductible and, in turn, would make equity finance a bit more attractive.

     Now, you all scored that, as part of our proposal, as raising $163 billion over 10 years.  My question is ‑‑ and see if we can put this into English ‑‑ Mr. Barthold, wouldn’t that mean that if you had broad tax reform, and you had that one feature in it, that means you would have that substantial sum ‑‑ $163 billion ‑‑ so you could cut rates for middle class folks, focus on creating jobs in our country, pay down the deficit?  Isn’t that what that score really means?

     *Mr. Barthold.  Senator Wyden, yes, sir.  I mean our estimate was you had a proposal that would limit interest deductibility, and you chose to do that by measuring the inflation component annually.

     As we noted in our report, there is a substantial amount of interest expense claimed annually by business.  And so, a reduction in the deductibility of that is a substantial base‑broadener, given the existing ‑‑ the rest of the Internal Revenue Code.

     *Senator Wyden.  Thank you, and thank you for your professionalism always, for all the Members on both sides of the aisle.

     Question for you, Mr. Fleischer, and we appreciate your involvement in this, as well.  Jane Gravelle, of the Congressional Research Service, has found that in recent years, over the life of a loan, about half the value of the interest deduction is now inflation.  Isn’t that another argument for limiting the deduction to its non‑inflation component?

     *Mr. Fleischer.  I think it is.  I think there are different ways to limit interest deductibility, and I think you want to think about inflation as one possibility.  My own personal opinion would be for something closer to comprehensive business income tax, which I think would actually be simpler, along those lines.  But yes, you are right.

     *Senator Wyden.  Thank you, Mr. Chairman.  My time is up.

     *Chairman Camp.  Thank you.  Mr. Herger is recognized for three minutes.

     *Mr. Herger.  Thank you, Mr. Chairman.  Several of you mentioned in your testimony that the tax code’s bias towards debt investment may encourage some businesses to take on an excessively risky amount of debt, increasing the risk of bankruptcy and the associated cost to society.  Among the most serious of these consequences is a loss of jobs, resulting from major bankruptcies.

     Since one of the most important issues facing Congress is the urgent need to create jobs, could you ‑‑ maybe beginning with you, Mr. Fleischer ‑‑ comment on whether reforming the tax treatment of debt and equity might help to create a better foundation for stable job growth?

     *Mr. Fleischer.  I do think it would, and I think you will probably find some unanimity from the panel.  The more simple, efficient, fair our corporate tax system is, the easier it is for businesses to make planning decisions, including hiring workers, going forward.

     *Mr. Herger.  Thank you.  Mr. Desai?

     *Mr. Desai.  So, just two quick thoughts.  You know, the first is, as I mentioned in my written testimony, it is remarkable that we have not had more corporate bankruptcies, given the nature of the credit crisis.  And I think that is because the non‑financial corporate sector is under‑levered, relative to historic standards, and we should be happy and grateful for that nice outcome.

     Would it have a salutary effect for kind of ‑‑ if we kind of made debt not deductible?  The one thing one has to keep in mind is that the cost of capital would rise, as a consequence of that.

     So, some of the social spillover effects of bankruptcies that you are worried about would certainly be a benefit.  The cost of capital would likely rise, as a consequence of that.  And that would have some potentially offsetting effects, as well.  So, I am not so sure it is quite easily a job‑winner.

     *Mr. Herger.  Mr. Johnson?

     *Mr. Johnson.  As long as we are putting this in the context of medium‑term fiscal consolidation ‑‑ so, over a 5 to 10‑year horizon, until the financial markets believe you have credible plans for bringing down the deficit, controlling the deficit, and preferably bringing down the debt, then yes, I think that there is ample scope for measures that would encourage short‑term job creation.

     But I would strongly caution against focusing only on that.  Experience in Europe, including in the last days and weeks, tells you that countries that previously thought that they had an impeccable credit rating can come under market pressure much more quickly.  So, please, whatever you do, put it in the framework of medium‑term, credible, committed fiscal consolidation.

     *Mr. Herger.  Ms. Olson?

     *Ms. Olson.  I think there is definitely some value in doing whatever we can to make the tax system more rational.  And something along the lines of what you are talking about might well move in that direction.

     *Mr. Herger.  Thank you.  Thank you, Mr. Chairman.

     *Chairman Baucus.  Okay.  Next is Senator Stabenow.

     *Senator Stabenow.  Thank you very much, Mr. Chairman.  And, first, a thank you to you and to Chairman Camp for doing what I hope will become more than just one meeting.  I think this is really important to do, and congratulations.

     As we talk about all of this ‑‑ and we clearly are having important hearings and discussions on tax reform, which clearly needs to happen ‑‑ and we look at how we need to create tax fairness for small businesses, as well as large, multinational businesses, how do we create incentives for investments in American jobs, and in this global economy, and how do we create incentives for American families to be able to plan themselves and achieve important goals for their families like home ownership which has, of course, been under attack, given what has happened with the fact that the majority of families think they were saving through equity in their home, and then we’ve seen what is happening in the housing market, and so on.  And so, it has been very difficult, I think, obviously, for families, on a number of fronts.

     But there is another area in the code where we encourage people to save, and that is through the Pension Protection Act of 2006.  And I am wondering, Dr. Desai, if you might respond to the fact that Congress has allowed firms to auto‑enroll employees into 401(k) plans, but allowing employees to then opt out if they desire.  And the goal was to encourage savings.

     However, the Wall Street Journal reported earlier this week that while more people were now contributing to 401(k) plans, many of them are making contributions that are actually less than what they otherwise would be with the typical 3 percent default.

     So, I am wondering if you have suggestions or if any of you have suggestions on how we can improve this provision to encourage greater savings as we focus on pensions, which are another important part of, you know, economic security for families.

     *Mr. Desai.  So, Senator Stabenow, I think you are absolutely right to turn the discussion toward savings, in some sense, that is underneath it all, one of the most important metrics that we can measure our success by, especially given the history of the American citizen over the last several decades as being a “dis‑saver”.

     So ‑‑ and you are also right to kind of put your finger on pensions, which are an important piece of the savings picture.

     So, just briefly, I think, you know, one of the revolutions in economics in the last decade or two decades has been about behavioral biases.  And so, when you force people or rather, when you give them default options that allow them to save easily, that is an incredibly powerful device, it turns out.

     So, I think, in the design of pensions, and in the design of legislation around pensions, paying attention to default provisions, and paying attention to making it extremely easy for a person to save, is a very important part of this.

     Of course, one would be remiss without mentioning the broader point, which is the distortion to saving in the tax code that is primary is the nature of the income tax.  And the opportunity for fundamental tax reform provides you an even bigger lever on that than would be otherwise available.

     *Senator Stabenow.  Thank you very much.  Thank you, Mr. Chairman.

     *Chairman Camp.  Thank you.  Mr. Rangel is recognized for three minutes.

     *Mr. Rangel.  Thank you, Chairman Camp and Chairman Baucus.  I don’t remember the meeting in 1940, but ‑‑


     *Mr. Rangel.  But I certainly do welcome this meeting.  Not only do we have Democrats and Republicans looking civil and acting civil, but we have the House and Senate coming together.  And even though they are close by physically, people don’t recognize how seldom we have a chance to see each other.

     This panel is extraordinary.  And I think all of us, especially our chair, is excited about the possibility of tax reform.  And it takes this type of cooperation in order for us to move forward.  And it takes a better understanding of equity and debt in order to develop a system that is fair and equitable.

     Having said that, there is a big elephant in this room, and it is called debt ceiling.  And until we get that out of the way, it will be impossible for us to, in a bipartisan way, deal with this very serious problem that everyone admits is really dampening our economic growth, by not having a fairer system with lower corporate rates and closing loopholes.

     Having said that, I wonder, Mr. Chairman, whether I would be out of order if I took advantage of the minds of our great panel here to ask them, is there anyone here that sees any connection at all in terms of increasing the debt ceiling, as we have 17 times to make certain that our great nation pays our debt, and the solution to the budget problem that we have which, of course, involves revenue and cut‑back in spending?

     As economists and people who understand these serious problems, is there anyone here that sees where there is any connection between dealing with reduction of our debt and authorizing the President to increase the debt ceiling?  And if you do, I wish you could share it with me in 30 seconds.

     Having seen no response ‑‑

     *Ms. Olson.  Mr. Rangel, I hope that the cooperation you are seeing here today sets the stage for the debt ceiling negotiations.

     *Mr. Rangel.  But you don’t see any connection between increasing the debt ceiling with the President and dealing with our serious problem with the national debt, do you?

     *Ms. Olson.  They are all important steps towards getting ‑‑

     *Mr. Rangel.  I know that.  God knows every day it is important.  But really, as a professional that has worked with the Internal Revenue and served presidents in the past, do you see a connection between the two, except politics, which is not really why you are here?

     *Ms. Olson.  I think there are important policies that have to be addressed.  You have got to address them on the spending side, and you have got to address them on the revenue side.  It is very important for us to get our fiscal house in order across the board.

     *Mr. Rangel.  So you do believe that we can hold the question of debt and spending and revenues with denying the President the opportunity to pay our debts internationally?  You do see a connection?  What Administration did you serve under?

     *Ms. Olson.  President Bush.

     *Mr. Rangel.  Oh, okay.  I have completed my questions, thank you.

     *Chairman Camp.  Thank you, Mr. Rangel.

     *Chairman Baucus.  Okay.  And I will recognize Senator Nelson from Florida.

     *Senator Nelson.  I am afraid we are going to fritter away this opportunity to get tax reform done in this debt ceiling.  But if we had our d’ruthers, the Senate Budget Committee has come out and said you could do a $4 trillion package and 2 trillion of revenues could come from just eliminating 17 percent of the tax expenditures over the next decade, which amount to $14 trillion.

     So, if you were to whack 17 percent of those tax expenditures, where would you go first?

     *Mr. Fleischer.  So I will start.  I have written and testified previously about some loopholes, some of which might be characterized as tax expenditures.  The carried interest loophole is the one where I have testified before, and that is converting ‑‑ when fund managers convert their labor income into capital gain.

     There are other examples, including the ‑‑ some of the treatment of the hybrid instruments that I talked about before that banks use to exploit the debt equity distinction.  So I do think there is some low‑hanging fruit in order to generate significant revenue.

     *Mr. Desai.  So just briefly I would say, you know, in general, in these discussions I am always loathe to characterize anything as a loophole, because that makes it sound like it is easy to get rid of.  And I think tax administrators know that there is no free money hanging around here and we can just snap our fingers and close something and it will work.

     What is at play, of course, are serious policy choices.  And if you want to look at the expenditure side, the tax expenditure side ‑‑ you know, I haven’t looked at this in the last week or two, but my understanding, as I recall, is that the big numbers are going to be on owner‑occupied housing, which is the mortgage interest deduction, and it is going to be on the preference for employer‑provided health insurance.

     And as, you know, people have written about, those are both significant sources of revenue.  I think the distortion on health care choice that’s created because the employer deduction on health insurance is significant, that would be a place to look.  And, you know, of course, housing is hugely important.  But you know, that ‑‑ I don’t think it has to do with leverage in the financial crisis.  But the preference for owner‑occupied housing is another place to look, where you can get the kind of money that you are talking about.

     *Mr. Johnson.  Excessive leverage in the financial sector.  You could be steeply progressive on this.  It is the very biggest banks with their huge debts that pose a disproportionate risk to the system.

     And this is an obvious thing to go after.  It is completely consistent with the broader assessment from the right and from the left, with regard to the fact that too‑big‑to‑fail has become a massive government subsidy operation.  And while we have tried to deal with that in various ways, nobody is impressed.  Standard & Poor’s just ruled yesterday that they think the government would still have to come and support major financial institutions if they fail.  That is a systemic risk.  That is pollution.  That is a negative externality you should be taxing on.

     *Chairman Camp.  Mr. Johnson is recognized.

     *Mr. Johnson of Texas.  Thank you, Mr. Chairman.  Ms. Olson, in your testimony you talk about reform alternatives that you believe could address this bias in the tax code.  One of the reform proposals you mention is the lower corporate tax rate.  In your view, what should that rate be?  And how far would that proposal go toward addressing a bias?

     *Ms. Olson.  Mr. Johnson, I think that ‑‑ I am not sure what the optimal corporate rate is.  But I think one of the things we have to look at is what the rate has fallen to in other countries around the globe that are major trading partners.  And that would suggest that a rate of somewhere around 25 percent would be about the top rate.  Now, that would include the state and local rate, which adds about four or five points to the overall rate.  So you’ve got to take that into account, as well.

     I think that companies use leverage for a lot of reasons besides the interest deduction.  In fact, lots of times companies find that equity capital is less expensive than debt even taking into account the deduction of interest and the non‑deductibility of dividends.

     So, I think that bringing the corporate rate down would go a long ways towards eliminating the bias that currently exists.

     *Mr. Johnson of Texas.  Well, we also eliminate the taxation of dividends as a measure of improving the system?

     *Ms. Olson.  I think that there has to be a connection between the two.  And so, to the extent that you have got a high corporate rate, you need a lower rate on dividends, and vice versa.  If you bring down the corporate rate, you don’t need, perhaps, to reduce the rate on dividends quite as much.

     But if you have too high a rate of tax on dividends, you will give companies a disincentive to pay dividends, and that has been a problem for us ‑‑

     *Mr. Johnson of Texas.  Yes, that is kind of double taxation, isn’t it?

     *Ms. Olson.  Yes.

     *Mr. Johnson of Texas.  Okay.  Mr. Barthold, the mortgage interest deduction, did it have a role to play in the tax underwriting standards? Should we do something about that?  Could you elaborate on what tax incentives could reduce the cost of renting, as well?

     *Mr. Barthold.  The code currently provides several benefits for rental housing, to try and increase the supply of rental housing and reduce rents to moderate to low‑income individuals.  There are provisions in section 42 to provide the low‑income housing tax credit to expand the supply of rental housing to qualifying lower‑income families.

     Similarly, under section 142 of the code, states may issue tax‑exempt bonds to help finance at lower cost multifamily housing, again, targeted at lower income.  So there are provisions in the Internal Revenue Code to help benefit the rental market.

     But I don’t think I am fully addressing your question, sir.

     *Mr. Johnson of Texas.  Well, I have kind of run out of time, so ‑‑

     *Mr. Barthold.  Well, the chairman may ‑‑ since I misspent it, maybe the chairman will grant an extra 30 seconds?


     *Mr. Johnson of Texas.  Thank you, Mr. Chairman.

     *Chairman Baucus.  Mr. Chairman, we have some votes that are going to start in the Senate fairly quickly.  There are no more senators at this moment.  I think Senator Carper is on his way.  I suggest that you continue on your side.  So ‑‑ well, just continue on your side.  When the vote does occur, the Senate will cross that bridge when we get there.  And when Senator Carper comes, we can address him, too.

     Is he here?  Senator Carper?  No, he is not here yet.  Why don’t you go ahead?

     *Chairman Camp.  All right, thank you.  Mr. Neal is recognized.

     *Mr. Neal.  Thank you, Mr. Chairman.  And actually, in the House we have done a pretty good job this year at the Ways and Means Committee of conducting a lot of hearings, in an effort to examine how we might revamp the code.  But I think that it is also important to acknowledge today that, unless the presidential candidates next year take up the issue in earnest, it is going to be very hard for us, even having accumulated a great deal of evidence as to how the code might be altered, to, in fact, make it happen.

     And I think insisting that after we come up with competing products, perhaps, or even one product, that the presidential candidates address the extensive hearings and evidence that we have assembled ‑‑ now, Mr. Barthold has heard this question before, but I want to go back to it because of the hearings that the Select Revenue Subcommittee held last year.

     One of the witnesses testified at that hearing that foreign‑owned multinationals in the United States have a competitive advantage over U.S.‑based corporations, with respect to certain U.S. investments.  The witness stated, further, that the tax advantage afforded to inbound investors arises because of their ability to erode the U.S. tax base through base erosion payments, such as earnings or interest‑stripping payments.

     Maybe we might hear from Professors Fleischer or Desai as to what your thoughts are on whether foreign‑owned U.S. subsidiary corporations engaged in earnings strippings on their debt‑financed U.S. investments have a competitive advantage over U.S.‑owned corporations.  And should some of the tax rules related to debt financing rules be modified in order to prevent this competitive disadvantage for U.S.‑owned corporations?

     *Mr. Fleischer.  I am going to defer to Professor Desai on that.

     *Mr. Desai.  So I think there are a few things to say.  The first is it is striking that the profitability of foreign multinationals in the U.S. is low, relative to American firms.  And one explanation for that is, in fact, lots of earnings stripping by these foreign firms out of the U.S. base.  There are alternative explanations, which is it is hard to make money in America versus American multinational firms.

     But if, in fact, base erosion is the problem, then you have to ask the question, are they able to do something that American firms aren’t able to do?  And at first approximation, I would have thought that they are subject to the same regulations and the same rules that American multinational firms are.

     So I understand the source of the concern, which is very low profitability of foreign firms in the U.S.  And I understand the possibility that part of what is going on here is they are stripping all their earnings out.  What I am less convinced of is the degree to which that represents earnings stripping or something else.  And given that they face the same rules, it is a puzzle why they would be more capable, in some sense, than American firms.

     *Mr. Neal.  Professor Fleischer?

     *Mr. Fleischer.  Well, just to add that there is two ways to look at that.  One ‑‑

     *Mr. Neal.  Yes, there generally is, in tax policy.

     *Mr. Fleischer.  Yes.  I think Mihir is right.  On the other hand, it also just shows that American multinationals are also very good at moving profits offshore through things like transfer pricing.

     *Mr. Neal.  Okay.

     *Chairman Camp.  Thank you, Mr. Neal.

     *Mr. Neal.  Thank you, Mr. Chairman.

     *Chairman Camp.  Mr. Tiberi is recognized.

     *Mr. Tiberi.  Thank you, Chairman Camp and Chairman Baucus, for holding this hearing today.  Great panel of witnesses, as well.

     I first want to associate myself with the remarks by Mr. Levin with respect to the home mortgage interest deduction, and kind of piggyback on something that Mr. Johnson had said.

     In addition, on the rental side, Mr. Barthold, you have rental owners that have the ability to not only take advantage of the mortgage interest deduction, but a series of other deductions that, in theory, would reduce, if taken away, their ability to keep rents lower, meaning if, through the tax code, you took away deductions from rental housing owners, they would have to increase the rent.  That is not a question, just a comment.

     The question I have is more on the business side to all of you.  Joint Tax actually came out with a report that stated that the debt to equity issue concerning the Tax Code’s preferential treatment for financing with debt doesn’t really apply to owners of businesses that are pass‑through entities.

     As we have heard on this committee, more than half of American businesses are set up as pass‑through entities.  The Administration has suggested switching, or changing the way that pass‑through entities are taxed to the corporate side, tax them as C‑corps, instead.  Wouldn’t that have a negative effect on those pass‑through entities today, and continue to exacerbate the debt‑to‑equity issue through the tax code? Starting with Joint Tax.

     *Mr. Barthold.  Well, thank you, Mr. Tiberi.  I think the main point that you are raising is that the corporate income tax itself, at its simplest level, is a tax on the return of income to the equity owners.

     *Mr. Tiberi.  Right.

     *Mr. Barthold.  And it is an extra tax.  We have noted on the panel the double taxation.

     So, if you were to make, by whatever criteria, entities that are currently pass‑through entities subject to a second level of tax, and the tax were just on the return‑to‑equity owners, it would increase the relative burden on equity returns, and so would favor debt financing by those entities, just as we argued is the case for a C‑corporation.

     *Mr. Tiberi.  That is exactly my question.  Ms. Olson?

     *Ms. Olson.  Yes.  I agree with that, and I think it would be better to move in the opposite direction of integrating the corporate system with the individual system, rather than to push pass‑throughs into the corporate system.

     *Mr. Tiberi.  Thank you.

     *Mr. Fleischer.  So I do want to note there are distortions from debt versus equity in the pass‑through context.  In a lot of partnerships they are very flexible vehicles, from a structuring perspective.  And the interest deductions that you can generate by financing with debt, those deductions can be moved around to a large extent to one partner or another, depending on which partner has the higher tax rate.  So it doesn’t always match up with the underlying economics.

     So, you know, my preference here would be to move towards a system where pass‑throughs and ‑‑ where ‑‑ I should say what are currently pass‑throughs and what are currently C‑corps are treated the same.  I think doing that, it removes the penalty of operating in C‑corp form, which, from an economic perspective, doesn’t make much sense to me.

     *Mr. Tiberi.  All right, thanks.

     *Chairman Camp.  Thank you.  Thank you, Mr. Tiberi.

     *Mr. Tiberi.  Thank you.

     *Chairman Camp.  Mr. Thompson is recognized for three minutes.

     *Mr. Thompson.  Thank you, Mr. Chairman.  Thanks for holding the hearing.  And thanks to all of you for being here.

     There has been ‑‑ a number of you have mentioned that ‑‑ the need to do the tax reform, and the whole idea of lowering the rate and broadening the base, which, I assume, suggests that you believe we should pay for any tax reform that we do.  It should be revenue neutral, is that a good assumption?  Start with Ms. Olson.

     *Ms. Olson.  I think it is important for the country to size its budget so that there is a better match‑up between revenues and spending.  But I think that we have made an awful lot of decisions throughout our recent history on the basis of our revenue constraints, and that has led to some bad policy.

     *Mr. Fleischer.  So ‑‑

     *Mr. Thompson.  Revenue‑neutral tax reform?

     *Mr. Fleischer.  Yes, revenue‑neutral is ‑‑

     *Mr. Thompson.  If we ‑‑ because of the time, if you could, just tell me if revenue‑neutral tax reform is the way we should be going.

     *Mr. Fleischer.  I think it is the right starting point.

     *Mr. Thompson.  Thank you.  The rest of you?

     *Mr. Desai.  Yes.  Yes.

     *Mr. Johnson.  I think that is a minimum, Mr. Thompson, revenue neutrality.  However, if you were taking on broader tax reform, including a switch away from an income tax towards a VAT‑type system, then you have the option of being either revenue neutral, or raising significant revenue in a way that is not distorting, and doesn’t hurt savings, doesn’t hurt investment.

     *Mr. Thompson.  Thank you.  I just want to point out that on lowering the rate and broadening the base on the corporate stuff, if you do away with all the tax expenditures, it only gets you to about 28 percent, not the 25.

     Ms. Olson, what I have been hearing most about here recently ‑‑ and it deals with this debt ceiling debate, and I am hearing from people all over my district.  Yesterday, 100‑percent Vietnam ‑‑ a disabled Vietnam veteran who says if he doesn’t get his Social Security check he is living in his car.  Farm credit folks were in yesterday, and they finance everything from grapes to rice to pears to walnuts in my district.  And they tell me that it is going to be devastating for agriculture, and that we ‑‑ it will take years, decades, to recover from the loss of not doing the debt ceiling.

     Can you tell us how and what the priority would be for paying our debts, if we don’t pass the debt ceiling?

     *Ms. Olson.  I am afraid that that is not within my area of expertise.

     *Mr. Thompson.  So it would be ‑‑ from your experience at Treasury?

     *Ms. Olson.  No, my experience at Treasury was all on the tax collection side, as opposed to paying out.

     *Mr. Thompson.  Okay, thank you.  Can anyone tell us what the fiscal impact would be if the debt ceiling is not raised?  How many years would it take for us to recover from the hit, even if it is just a few days or a week or a month without raising the debt ceiling?  I understand that this is  a fiscal consequence that will haunt us forever.  Mr. Johnson?

     *Mr. Johnson.  Mr. Thompson, we don’t know, exactly.  We have never done it.  We shouldn’t do it.  I hope we don’t do it.  It would be very bad for the economy, particularly at this point in time, for all the reasons that you have enumerated.

     *Chairman Camp.  All right.  Thank you very much.  Dr. Boustany is recognized.  And because of the discrepancy in the number of Members, I will be recognizing two Republicans for one Democrat at this point.  So, Dr. Boustany?

     *Dr. Boustany.  Thank you, Mr. Chairman.  Let me first express my support for moving forward with fundamental tax reform, rather than trying to do this piecemeal with tax policy changes, because of the distortions that we will create if we try to do that.

     Ms. Olson, in your testimony you mention the adjustments to the deductibility of interest expense would need to be considered in connection with any further moves toward expensing capital investments.  And clearly, in recent years we have seen a number of efforts and laws enacted to spur economic activity by increasing accelerated depreciation provisions and moving toward more generous expensing for certain types of assets.

     And at the same time, we have interest remaining as a deductible expense.  So talk a little bit about the distortions that could be created.  Could we, in effect, see negative effective tax rates and other types of distortions?  I would like all of you to comment on that.  Thank you.

     *Ms. Olson.  Yes.  The short answer to your question is yes, we would see negative tax rates.  You know, I think it is sort of one thing to do it on a temporary basis, where you are trying to spur some investment, accelerate some investment.  It probably doesn’t have the same impact.  But certainly, if you are going to do expensing on a long‑term basis as part of fundamental tax reform, then you do need to look at interest expense.

     *Mr. Fleischer.  I agree.  Any time that you are allowing borrowing to invest in an investment that is going to throw off tax‑exempt income, you have created an opportunity and an incentive to engage in tax arbitrage.  And as I said in my testimony, tax lawyers are very clever.  And once they spot these opportunities, they are going to try and design structures to take the fullest advantage.

     *Mr. Desai.  I would echo what has been said.  It is exactly the reason why one should move not towards incremental efforts, but to think about this in a systematic way, precisely so we avoid these kinds of situations, where you can easily end up with negative effective tax rates.

     *Mr. Johnson.  I agree also.

     *Dr. Boustany.  Thank you.  I yield back, Mr. Chairman.

     *Chairman Camp.  Mr. Buchanan is recognized.

     *Mr. Buchanan.  Thank you, Mr. Chairman, for the opportunity today.  And I want to thank all the panelists, as well.

     Let me just ask you.  We are talking about the debt ceiling, getting people back to work.  In the environment we find ourselves in today, do you think that raising taxes on individuals or small businesses makes sense, in terms of what is going on today?  Do any of you feel that that makes some sense as a policy decision, here in Washington?  Ms. Olson, I will start with you.

     *Ms. Olson.  Well, certainly on a near‑term basis, I think we need to be very careful with anything we do that would raise taxes.  I think one of the most important things we can do for the country is to get things set so that, for the long term, we know where we are going to stand.  Because I think what we learned in 2001 was that it was the permanent changes that had the most impact.

     *Mr. Buchanan.  Yes.  Mr. Desai, because I’m short on time.

     *Mr. Desai.  Just briefly, I ‑‑

     *Mr. Buchanan.  I am talking about individuals and small businesses.  Does it make any sense in the near future to raise taxes on individuals or small businesses?

     *Mr. Desai.  To the degree that we want to take a shot at actually fixing our structural problems, then we are going to have to raise taxes on someone.

     *Mr. Buchanan.  Okay.

     *Mr. Desai.  At some point.  Clearly, there are short‑run consequences of doing it right now.

     *Mr. Buchanan.  Now, let me go to the other issue that we are talking about, debt and equity.  And I have had the good fortune to have been in business for 30 years, and have been involved in a lot of leverage transactions.

     But you look at the 1980s, what happened?  I remember the “predators balls” ‑‑ that happened with Milken and all those in the 1980s, and we ended up- in 1990, 1991- with S&L bank crises.  Now we move forward, we find ourselves in this scenario, of having a lot of leverage.

     But at the end of the day, what I find, if you don’t have viable financial institutions, is that you put everything at risk.  And what is happening ‑‑ at least in Florida; I am sure around the country is that a lot of these banks that are leveraged 10 to 1, because they have been taking such a hit to their equity, they have had to shrink all the banks.

     So, not only do you affect the companies that are trying to create jobs, but you affect a lot of good companies, where they come in, they scoop all their equity.  And that is why it is so critical, in my experience, that you have sound financial institutions.  And if you go back 100 years, we get in this trap every 10 or 15 years.

     So, Mr. Johnson, do you agree that we have to take a look at the viability, long‑term, of financial institutions, as it relates to small businesses especially?  It is nice to talk about equity, but it is hard to get equity for small business.  And those are job creators.

     *Mr. Johnson.  Absolutely, Mr. Buchanan.  If you go back to when we had a real free market system around finance in this country, more than 100 years ago, before deposit insurance, before the Federal Reserve was created, banks at that time routinely had 30 percent equity.  No risk adjustment in that calculation.  Thirty percent equity, relative to their total assets.  And they had big buffers against losses.  And when you had a downturn, they didn’t have to cancel all their other loans, all their good loans.  They didn’t squeeze out the small businesses.

     We cannot go back to a system without deposit insurance, unfortunately.  We have to recognize that regulation has encouraged and allowed banks to have too little capital for too long.  If we are going to have big shocks in our economy, going forward, you need to be discouraging debt and encouraging equity in the heart of the financial ‑‑ including big banks and small community banks.

     *Chairman Camp.  Thank you, Mr. Buchanan. Mr. Larsen is recognized for three minutes.

     *Mr. Larsen.  Thank you, Chairman Camp and Chairman Baucus, for being a part of this historic hearing.  And this comes at a historic time for the nation.

     I would like to know the opinion ‑‑ we have received letters from more than 400 CEOs about the pending potential of default on the ‑‑ our ‑‑ the nation’s debt.  The CEOs, in their letter, outline ‑‑ they say that even a technical ‑‑ technical ‑‑ default in this case would have catastrophic events.  In 1979 this happened, even under the well intentions of Congress.  It was late, resulting in interest rates that plagued the country for the next 10 years.

     Given what is happening around the globe as we speak, what ‑‑ Moody’s downgrading of Ireland again today ‑‑ what is your advice to the Congress in terms of acting, given the deadlines that Treasury Secretary Geithner has outlined?

     *Mr. Johnson.  My advice, sir, would be simple, the same advice as Christine Legarde, the new director of the IMF, has given to the United States, which is you need to extend the debt ceiling.  You cannot play games with something this serious.  World financial markets are much more fragile than you might like to believe.

     *Mr. Larsen.  Mr. Desai?

     *Mr. Desai.  I would echo that.  I think what is worth considering is exactly why.  And one piece of that is the technical default, which is, you know, people may stop receiving their payments, which is extremely problematic.

     But it can also become a broader manifestation of a system that appears broken to the rest of the world.  And that is where we run into really significant problems.  So, I am less ‑‑ you know, have less of a position on exactly how we fix that, but I think it is very important that this particular deadline is not ignored, and taken ‑‑

     *Mr. Larsen.  With regard to the deadline, if I might just follow up quickly here, before the others respond, is this not the equivalent of knowing about Lehman Brothers?  With all the other nations that we see in jeopardy, and knowing what we know, isn’t it essential that we act now?

     *Mr. Desai.  It is essential that we act now.  I would caution us to use parallels to private sector actors, only because the government is very special.  And ‑‑

     *Mr. Larsen.  Point well taken.

     *Mr. Desai.  And ‑‑ but I take your point that it is a very serious issue.

     *Mr. Johnson.  I would use the Lehman example.  Frankly, the situation in Europe right now is very bad.  It is getting worse.  The eurozone does not have control over the situation in Italy, in Spain, much more broadly.  It is absolutely essential that the United States remain a beacon of safety and clarity to international investors.  Otherwise, there will be consequences for all of us around the world.

     *Mr. Larsen.  Would you say what is at stake is the United States’s reputation as a governing entity, both globally and domestically?

     *Mr. Johnson.  Yes.

     *Chairman Camp.  Thank you very much.  Mr. Smith is recognized.

     *Mr. Smith.  Thank you, Chairman Camp, Chairman Baucus, for holding this hearing today.  We have heard a little bit about home mortgages and home ownership being a priority in our society, and certainly in the tax code.  Could you, starting with Mr. Fleischer, reflect on the effectiveness of the mortgage interest deduction?  How effective has that been, and are there any alternatives that you might propose?

     *Mr. Fleischer.  Well, I think it has had an impact in putting more people into houses.  And, from that perspective, that is good.  But if you were to take a step back, and try and think about designing housing policy, it is hard to conceive that using an interest deduction, a mortgage interest deduction, would be the right way to accomplish that goal, particularly one that is not capped at a certain number.

     So, for example, allowing it at all on second homes or on super‑expensive homes doesn’t make a whole lot of sense to me, if the goal is to get lower‑class and middle‑class people into houses.

     *Mr. Smith.  And would you propose an alternative in our public policy, in terms of encouraging home ownership?

     *Mr. Fleischer.  Sure.  I mean I think in the short run, limiting the mortgage interest deduction would be beneficial in the short run.  In terms of what the other policy goals are, I guess I am not quite sure what you are getting at.

     I think we do have a lot of people in houses, probably more than we need to, in fact.  There are people that do move around a lot, and would benefit from some sort of equivalent subsidy to renters.

     *Mr. Smith.  Okay.  Mr. Desai?

     *Mr. Desai.  You know, so briefly I would just say that there is a bit of a puzzle which is, given how large this preference is, it has not been easy to find evidence of its effects on behavior.  So it is a very large preference.

     And then, the question we have to ask ‑‑ is maybe we like it, and we have to ask why we like it.  And I can think of three reasons we like it.  You know, one is we like it because home ownership is good.  It creates good citizens, it creates good people.  And that is just what we believe.  The second is that we believe the construction sector is very important.  And we think that, in a cyclical recovery, it is potentially something that you want spur.  And finally, maybe you think that it is just a vehicle for savings, and you want to preference it that way.

     I think it is important to kind of nail down which of those we really believe.  We have had very high levels of home ownership.  And it is not clear that more home ownership is good.  We should understand that there are chunks of the population for which renting is a really good thing to do.

     *Mr. Smith.  Okay.  Mr. Johnson?

     *Mr. Johnson.  We are not directly encouraging home ownership.  We are encouraging leverage as part of home ownership.  So we are encouraging households to take on these very large debt burdens.  And there are absolutely other ways to encourage home ‑‑ if you want to do it revenue‑neutral, we could reduce the mortgage interest deduction and find other ways to encourage people to buy first homes, for example, if that is what you wanted to do, if the goal was home ownership.

     I think you should be very clear.  We encourage households to take on and believe in an enormous amount of leverage.  And I think, frankly, many of them didn’t understand the risks, the downside risks, that they now see in many parts of the country.

     *Mr. Smith.  Okay, thank you.  I yield back.

     *Chairman Baucus.  I will now recognize Senator Carper.

     *Senator Carper.  Hi, everybody.  Up here, on the right.

     *Chairman Baucus.  I see you down there.

     *Senator Carper.  Pretty big room, isn’t it?  This is bigger than the Senate, I think.  Glad I found it.  It is nice to be here with the chairman of the Ways and Means Committee.  How are things in Detroit?  Those Tigers are in first place in the American League Central, as we go to the all‑star break.  That was good to see, and to see another guy from Michigan, Carl Edwards’s big brother.  Sandy, nice to ‑‑ very nice to be with you.

     To our witnesses, thanks very much for joining us in what is really a unique setting.  And it is kind of fun to do this.

     One of the main reasons that tax reform has again become necessary is the proliferation of new tax breaks that we add to the tax code, it seems like, every year, as well as some of the increased use of the existing tax expenditures by taxpayers.  I am told if you add up the cost of these tax expenditures, the total comes over the next 10 years to something like $15 trillion over the next decade.  It is more than the Federal Government will spend on Social Security or, I believe, on national defense.  No small amount of money.

     Some of these tax incentives are for individuals.  Some are for corporations.  And some are pretty good policy.  Others, less so.  Many ‑‑ I guess it probably just depends on where you sit, as to whether or not they make good policy sense.  But many tax preferences are inefficiently designed.  Some lose more revenue than is necessary and don’t deliver benefits to the taxpayers who, arguably, need them the most.

     And with those thoughts in mind, tax treatment of debt versus equity is certainly something that needs to be examined and, I think, closely.  One of the keys to tax reform in 1986, when I served in the House with some of these fellows here ‑‑ including this fellow from Massachusetts, to my right ‑‑ one of the keys to reforms that we adopted in 1986 was that Congress, working with the Reagan administration, partially cleaned up at least some of the tax preferences, in exchange for lower rates.

     I would just like to ask each of our witnesses to take a couple of seconds and directly and frankly tell our committees which one policy change ‑‑ one policy change ‑‑ would do more than any other that you can think of to reduce the bias in favor of debt in the current tax code.

     Let me say that again.  Just take a couple of seconds and just tell our committees which one policy change do you think would do more than anything else you can think of to reduce the bias in favor of debt in our current tax code.  Thanks.

     *Ms. Olson.  Greater integration of the corporate and individual tax systems.

     *Senator Carper.  Say that one more time.

     *Ms. Olson.  Greater integration of the corporation and individual tax systems.

     *Senator Carper.  All right.  Thank you.

     *Mr. Fleischer.  I agree.  I think equalizing the treatment of debt and equity.

     But I will take just a second to add that, you know, 1986 is kind of like the Holy Grail in the tax academy.  It was an amazing achievement that broadened the base and lowered the rates.  And one of the keys to that was sort of not focusing only on one thing at a time, but focusing on the system as a whole, and tackling a lot of different tax expenditures at the same time.  I think that that was part of the magic of that reform.

     *Senator Carper.  All right, thank you.

     *Mr. Desai.  One version of the integration proposal would be the comprehensive business income tax, which ‑‑

     *Senator Carper.  I am sorry, were you saying ‑‑

     *Mr. Desai.  One version of the integration effort would be the comprehensive business income tax, and I think that is a very worthwhile way to go.

     *Senator Carper.  All right, thank you.

     *Mr. Johnson.  I suggest that you tax excessive leverage in the financial sector, and use the proceeds of that to introduce some deductibility for dividends, therefore equalizing the treatment of debt and equity.

     *Senator Carper.  All right.  That is an interesting idea.  Thank you.  Anybody else?

     [No response.]

     *Senator Carper.  All right.  Do ‑‑ is my time expired?  Let me just ask our chairs.

     *Chairman Camp.  It has.

     *Senator Carper.  Yes?  Okay.  Well, it was great.  It was great while it lasted.


     *Senator Carper.  And it was great to see all of you.  Thank you for those simple, direct answers.

     *Chairman Camp.  Thank you very much, Senator Carper.  Ms. Jenkins is recognized.

     *Ms. Jenkins.  Thank you, Mr. Chairman, and thank you for holding this hearing.  Thank you all for being here.

     In general, since 1945, household debt has steadily increased.  There has been some decrease in the combined mortgage and consumer debt for households.  But the total combined debt for 2010 is approximately 120 percent of disposable income.  In particular, debt has rapidly increased since tax reform back in 1986, which eliminated the deduction for interest on personal credit.

     So, my questions for the panel are, is this level of debt sustainable?  Why has household debt increased when no deduction is available for interest on personal credit?  And what is the appropriate private debt ratio for households, and how long do you think it will take for us to achieve that?  Tom, do you want to start?

     *Mr. Barthold.  Well, thank you, Ms. Jenkins.  You recited the statistics that we provided to the Members, which I think is ‑‑ a first point shows that there is not an obvious link between our tax policy related to household debt and what has been going on in the household market.

     Also, though, do remember that it is a reasonable and sound economic matter for households to incur debt.  It can be a matter of when you are young and you are starting out, you purchase a home.  So you carry a large debt load, which you gradually pay down, as you pay down the mortgage.  You may borrow to purchase automobiles or to furnish the home to buy other durable goods.  It is part of what ‑‑ you know, we use the jargon in the pamphlet that the economists like, of the life cycle theory of consumption.

     So, what that doesn’t answer is why has the overall debt load on households increased.  And I don’t have a good take on that.  I will defer to my other panelists.

     *Ms. Jenkins.  Ms. Olson?

     *Ms. Olson.  I think I should defer to the economists down at the end of the ‑‑

     *Ms. Jenkins.  Okay.

     *Mr. Fleischer.  I will just add one factor to the mix here, which is that ‑‑ which is the housing bubble.  So, as real estate prices were going up, people were able to increase household debt with larger and larger mortgages to finance current consumption.  I think with the housing bubble burst, I think we are observing people de‑leveraging in significant ways.

     *Ms. Jenkins.  Okay.  Mr. Desai?

     *Mr. Desai.  Well, two things.  You know, the first is I think you are right to put your finger on what is a long‑term process of leverage, and what is going to be a long‑term process of de‑leverage, as we move forward.  The reasons for it can be cultural, and they can be economic.

     And I think one thing to highlight here, of course, in the context of the tax code, is the absence of a consumption tax, or a value‑added tax, or the ‑‑ alternatively, the presence of an income tax which disfavors saving is a piece of that puzzle.  How much of it is, it is hard to say.  But certainly, if we think about the things that are within our domain and our ability to control, it is yet another reason to really think hard about whether the income tax we have now is the right one.

     *Chairman Camp.  Thank you.  Mr. Marchant is recognized.

     *Mr. Marchant.  Thank you, Mr. Chairman.  Is it fair to say that the main takeaway from this hearing could be that a way to bring the equity and debt issue into focus is to devalue the value of the debt deduction in the code by simplifying the code and lowering the rate, and making that debt deduction less valuable?

     Also, Mr. ‑‑ I don’t know if Mr. Fleischer or Desai — but I think one of you said that there were some hybrid debt instruments that were distorting the system.  Could you identify what those hybrid debt instruments are?

     *Mr. Fleischer.  Sure.  On the first question, the goal is neutrality between debt and equity, broadly speaking.  And so you can either do that by limiting interest deductibility, or what you called lowering the value of that interest deduction, or you could do it by allowing a deduction for corporate equity.  So, looking at the amount of equity that a firm has, and allowing them an imputed deduction.  Either of those approaches would achieve tax neutrality.

     So, some of the hybrid instruments, I am thinking of things ‑‑ they all have trade names that the investment banks come up with, but I am thinking of things like ‑‑ Feline Prides was one of the first, and these are instruments that are part debt and part equity.  And what they do is they get the ‑‑ on the balance sheet, or for bank regulatory purposes, they look like they are equity, but they are deductible.  So at one time these were referred to on Wall Street as tax‑deductible preferred stock.

     But, of course, it is not preferred stock.  There is ongoing obligations that the banks have to make to pay to the people who buy these securities.  And so, in the financial crisis, those ‑‑ they cannot skip those payments, like you could with ‑‑ on stock.  So that added to the crisis.

     *Mr. Marchant.  Could you limit the tax preference on those specific instruments without ‑‑ or would that just ‑‑

     *Mr. Fleischer.  Well, it is hard, because all you are doing, then, is kind of moving the line.  So there ‑‑ you can move the line a little bit, but you are going to see a lot of activity, then, that just shifts to wherever you have moved the line.  Again, tax neutrality would be the better solution.

     *Mr. Marchant.  Okay.

     *Mr. Fleischer.  And, failing that, a tax on excess leverage that reduces the value of the interest deduction, I think, would be a very good short‑term solution.

     *Mr. Marchant.  Okay.  Mr. Desai?

     *Mr. Desai.  I would just underscore Vic’s point about the futility of line‑drawing in the context of managers and financial engineers, who can capitalize on that kind of line drawing.

     *Mr. Marchant.  Okay.

     *Chairman Camp.  All right, thank you.  Mr. Becerra is recognized.

     *Mr. Becerra.  Thank you all for your testimony.  And in the three minutes that I have, let me see if I can focus a bit.

     I know we have been talking quite a bit about the treatment of debt and equity for corporations, how we move forward with the tax code that tries to reform our system of taxation, and make us more competitive.  But I think most eyes that are focused on the Congress today, and on Washington, D.C., are still worried about the debt issues that confront us right now.

     Mr. Barthold, perhaps you can give me an answer to this question.  Does increasing the debt ceiling have anything to do with reducing future spending by the Federal Government?

     *Mr. Barthold.  Well, Mr. Becerra, I am not an expert on the overall fiscal position of the United States.  The Members of Congress vote on outlays and vote on revenues.

     *Mr. Becerra.  But in terms of future spending, spending next year, spending in 10 years, if we vote in Congress to increase the debt ceiling limit today, or before August the 2nd, does that have anything to do with what we will spend directly in 2020?

     *Mr. Barthold.  Well, sir, as a simple statutory matter, the two issues are separate.

     *Mr. Becerra.  Okay.  And I know you have had a chance to speak a bit about this, and I know with the short amount of time ‑‑ let me ask Mr. Johnson a question.

     Should revenues be part of the debt limit discussion, as we start to discuss how we move forward in dealing with our deficits and our national debt?  If you want to have an approach that resolves this issue of our national debt, should revenues be part of that conversation?

     *Mr. Johnson.  In any situation where a fiscal adjustment is required, such as in the United States today, I would suggest that you look at both revenue and expenditures.  So, yes, I would definitely include revenues in the discussion.

     *Mr. Becerra.  And if we are able to resolve these large deficits and this large national debt in a way that is comprehensive, long‑term, does that help the private sector, our companies that are trying to do business both here, domestically, or abroad?

     *Mr. Johnson.  Of course.  The best thing you could do for the economic recovery at this point is to have a medium‑term fiscal framework that is completely credible, people understand that the debt is on a sustainable trajectory.  That will bring down long‑term interest rates.  That will encourage investment.  That will boost job growth.

     *Mr. Becerra.  In the alternative, if we take the country to the brink and say August the 2nd we don’t have any solution or resolution to the debt ceiling issue, what happens in the eyes of the business community?

     *Mr. Johnson.  We don’t know what happens, but we don’t want to find out.  Other countries that have tried to play these kinds of games with the financial markets usually end up being burned.  The limited experience we had in the 1970s with the so‑called technical default was it had an impact on base interest rates for a prolonged period of time.  Why would you want to take that risk?

     *Chairman Camp.  Thank you.  Mr. Berg is recognized.

     *Mr. Berg.  Mr. Chairman, thank you.  You know, obviously, I have been sitting here listening to a lot of analogies.  One of the analogies is between personal household debt and the Federal Government debt.

     And to me, maybe I look at it too simplistically.  I think there is an analogy.  People loaded up on residential debt because they need money.  Inflation was driving values up, and people were able to make that leveraged investment and get a higher return.  I think our U.S. debt has soared out of control because it has been too easy to simply borrow the money and not make some of the difficult decisions that need to be made.

     I truly think that if we don’t take this issue seriously, and we don’t look long‑term and have a serious how rebalance and get our country back on track, I think the private sector and financial markets will say, “Hey, Washington still does not get it.  They are just going along.”

     You know, the fundamental question that we have got here, I think is, what is the impact of interest deductions?  And, obviously, as we looked at this trend over the last 20‑plus years, it hasn’t had that big an impact. Although, in my sense of things, it is changing business decisions.

     So, I have two questions.  One question, are we clear that the deduction on interest is really not the right incentive, as we move forward?  And if it were a revenue‑neutral situation, what would you do with those tax dollars in another way?  Would you just reduce, for example, the corporate rate?  Would you eliminate the interest deduction and focus on the corporate rate?  Or, what would you do with those dollars?

     So ‑‑ you look deep in thought, Tom, so we should start with you.

     *Mr. Barthold.  Well, I think you have asked the broad question of how to undertake major tax reform.  I mean you could undertake a tax reform, and maintain deductibility of interest.  You could undertake tax reform.  You could create new preferences for equity.  You could, as Ms. Olson has suggested, and Mihir Desai, integrate corporate tax with the individual tax, and change overall incentives.  But that is  ‑‑ I mean, I assume that is part of the purpose of this hearing.

     *Mr. Berg.  Well, maybe I asked too many questions.  The first question is, should we keep the interest deduction, in your opinion on this panel?

     And if we didn’t have an interest deduction, would you be here advocating that we put one in?

     *Mr. Barthold.  Well, you know, sir, that I don’t advocate before the committees, I work for the committees.  So I will defer to my colleagues on the panel.

     *Ms. Olson.  There are certainly good arguments for limiting the interest deduction.  But you can’t, in my view, limit the interest deductions without taking into account a lot of ripple effects.  I think that the interest deduction affects financing decisions.  I don’t think it dictates them.  I think we make a mistake any time we think that the tax rules are the things that ultimately decide what people do.  They have an impact on them.

     And if we are going to limit interest deductions, then we have got to do it on a comprehensive basis. We ought to take a comprehensive look, and we have got to think about transition.  Things like the comprehensive business income tax set up a system that is more like the treatment of equity.  So you wouldn’t have a deduction for interest on the business side, but on the recipient side, it wouldn’t be taxable income.  So you shift things around, much along the lines of the way consumption taxes operate.

     *Chairman Camp.  All right, thank you.  Mr. Kind is recognized.

     *Mr. Kind.  Thank you, Mr. Chairman.  I want to thank our panelists today, an excellent panel.  And, Mr. Chairman, I want to thank you and Chairman Baucus for this format.  I think this is very helpful.  I think it makes sense for us to, hopefully in the future, have more joint hearings like this, so that we can better coordinate the action in the House and the Senate, especially over something as important and crucial as comprehensive tax reform.

     Mr. Johnson, let me start with you.  I mean you have been an advocate for some time about taxing excessive leverage right now.  But you had admitted earlier in your testimony in the Lehman case, and coming out of the financial crisis, that it was often difficult to be able to identify what excessive leverage looked like at the time.

     Have we made improvements, in regards to ‑‑ with the passage of Dodd‑Frank or other steps coming out of the financial crisis ‑‑ of having a better ability of identifying excessive leverage when it existed, as opposed to a retrospective look‑back, and then identifying it?

     *Mr. Johnson.  It was Mr. Desai who made the point about Lehman’s leverage.

     Look, the New York Fed and the SEC were living at Lehman for the last six months.  I think they knew what the leverage was, and I am sure they could have told you what the excessive leverage was, if that was the framework.  But, more broadly, taking on the ‑‑ I think the spirit of your question, which is do we understand the risks that arise from this kind of leverage, do we know the damage that can be done, do we know who will be impacted, all the small businesses and small community banks will be devastated next time there is a big problem.

     Or, if Italy were to run into serious debt problems today, no, we don’t know.  The Financial Stability Oversight Council, which was created for this purpose, as far as we can see from the outside, does not have a determination on this in any precise manner.  These risks are huge, and they impact the rest of the economy.  And they come directly and immediately from excessive leverage, particularly in our biggest financial institutions.

     *Mr. Kind.  Well, let me ask the rest of the panel, maybe starting with you, Ms. Olson, that, obviously, there are capital structures that are in place right now, based on the current tax code as it exists.  And we really haven’t gotten into the transition period that we should be considering, when making these type of changes.  But what type of time period do you think we should realistically be looking at, as far as a transition pace of tax reform?

     *Ms. Olson.  Well, that will be determined, at least in part, by the kind of change that you make, and how ‑‑ whether it is very incremental, or whether it is much more comprehensive.

     But even incremental change, I think, needs some transition period of, say, 5 years, 10 years ‑‑

     *Mr. Kind.  Well, just the issue that we have been dealing with mainly today on debt, and the incentives for increased debt in the tax code today.

     *Ms. Olson.  Again, I think it would depend on how radical you want to be in making changes.  If the changes are incremental, then they could be phased in more quickly.  But if they are more radical changes, then you would need a very long period of time to adjust.

     *Mr. Kind.  Mr. Fleischer, you have an opinion?

     *Mr. Fleischer.  I want to go back to the point on excessive leverage.

     *Mr. Kind.  All right.

     *Mr. Fleischer.  It is very difficult to determine even how much leverage there is, especially once you start thinking about the embedded leverage in derivatives, and the use of off‑balance‑sheet entities.

     But the point that I would make is you don’t have to get it exactly right to make things better.  Right now, the tax system is tilted in the wrong direction.  And so, any move towards neutrality is likely to make things much better, rather than worse.

     *Mr. Kind.  Sure.  Mr. Desai?

     *Chairman Camp.  Quickly, please.

     *Mr. Desai.  Again, I would echo Pam’s comments, that the scope of the transition has to mirror the scope of the change.  So you can imagine a narrow change that ‑‑ which I would not support ‑‑ but which could be done quickly, or you can imagine a broader change, which has to embrace the ‑‑

     *Chairman Camp.  thank you.

     *Mr. Kind.  Thank you.

     *Chairman Camp.  Mr. Reed is recognized.

     *Mr. Reed.  Thank you very much, Mr. Chairman.  I guess I am the newest member to the committee, so I get the last question.

     I have really enjoyed the testimony ‑‑ and I find it very informative ‑‑ from the panel today.  And I do want to focus on just a very limited area, if we could.

     One thing I hear, as I go through my district, from a lot of younger folks is that the college tuition that they are facing- and the loan and the debt associated with that tuition burden- is going through the roof.

     I would be interested in anyone from the panel offering their insight as to whether the subsidies that we provide through the tax code with the student loan deduction, what impact, if any, do you see them having in regards to tuition growth that has clearly been demonstrated over the past few years?

     *Mr. Johnson.  I think you are raising a very important issue, Mr. Reed, and one that doesn’t get enough attention.  Obviously, the issue is what kind of education are you getting for the money that you are paying, and questions are increasingly being raised about some parts of the education sector.

     And there are rules in place, as you know.  If a sufficiently high proportion of graduates default on a loan, then that institution is no longer able to get these kinds of loans for its applicants.  But these rules seem not to be particularly effective right now.

     And perhaps we should consider, on a revenue‑neutral basis, shifting away from this loan structure towards an alternative way of financing.  For example, through using some form of grants that are based on ‑‑ also on assessing people’s means to pay for themselves.

     *Mr. Reed.  Any other comments from any of the panelist?  Because I am really interested in seeing is the tax code itself, by allowing the deduction for student loan interest, encouraging higher tuition costs because of the inflationary impact of that policy?  Does anyone have any counterpoints, or any other information on that?

     *Mr. Barthold.  Mr. Reed, some people have raised that possibility, that the incidence ‑‑ some of the benefit of the numerous provisions that we have enacted to benefit education may redound to the providers of education.  But the economic evidence to this point couldn’t be described as anything more than mixed.

     *Mr. Reed.  Okay.

     *Mr. Desai.  I would just echo that, and not just because I am in the higher education business.  But it has been very difficult to find this out.  And, in part, it has to do with the fact that pricing in higher education is a very curious practice.  And part of what we have seen is increased list prices, and then lots of discounting with fellowships.  So there is a whole market structure there, which is complicated.

     I just want to echo Simon’s point, though.  A big part of this concern may be about the heterogeneity in the educational sector today, which didn’t exist 20 years ago, where you have various different providers providing different kinds of quality.  And that is worth looking at.

     *Mr. Reed.  Thank you.  My time has expired.

     *Chairman Camp.  Thank you.  Mr. Crowley is recognized.

     *Mr. Crowley.  Timing is everything.  I am the last man on the totem pole.  But thank you, Mr. Chairman.  I appreciate you holding this hearing, this historic joint hearing between the House and the Senate on a very important issue of debt in the tax code.

     More pressingly, I think, as has been expressed by many of my colleagues, we should be talking about the overall issue of debt.

     In three weeks, the U.S. will hit the so‑called debt limit, which is like maxing out on a credit card.  But while an individual with a credit card can stop paying ‑‑ making future payments with the card once they hit their limit, the same can’t be said for the U.S. Government.

     The spending debt will be financed by debt limit increase ‑‑ paying for past obligations, not future spending.  For example, we just can’t stop paying out Social Security.  We just can’t stop paying out veterans compensation and pensions.  We just can’t stop paying out military pay and benefits to our troops at war.

     But if we do not increase the debt limit, that is exactly what will happen.  Funds that were promised ‑‑ and, in terms of Social Security, funds that were [sic] even the government’s money, but the people’s own money ‑‑ will not be paid, because we won’t have the funds to do so.  Could you imagine if Social Security checks bounced?  It is a real possibility, if Congress continues to play games on the budget, and if they continue, as the Senate Republican leader said yesterday, refuse to work with President Obama on the pressing problems of this country.

     The number one job of this Congress should be to create jobs and get our fiscal house in order, not to play politics and bow to special interest groups.  That is why I salute President Obama for continually extending his hand in cooperation and negotiation to work with Congress to ensure we can meet our obligations of paying out Social Security on August 3rd, while also working for long‑term debt reduction for our children and our great‑grandchildren.

     But any debt reduction plan will require a shared sacrifice.  Seniors on Social Security, veterans who rely on their VA pensions, and the troops in battle should not have to lose their rightful benefits, while others do not meet that same sacrifice.  And I will oppose a plan that does not involve shared sacrifice, but makes seniors and veterans and military families pay the bills created after a decade of fiscal irresponsibility.

     It is amazing that we have people in this room who supported trillions in tax cuts and two unpaid‑for wars, but now say it is up to veterans and the seniors and the troops to sacrifice a bit more so millionaires don’t have to.  This President is trying to work out returning our country to a policy of fiscal discipline last seen when President Bill Clinton was in the office, while ensuring we promote economic growth and stability.  And I urge all of us to focus on this critical mission, and to stop playing politics and the blame game.

     And with that, I yield back the balance of my time, Mr. Chairman.

     *Chairman Camp.  All right.  Mr. Paulsen is recognized for three minutes.

     *Mr. Paulsen.  Thank you, Mr. Chairman.  And I also want to compliment you for holding the hearing with the Senate, and for laying the foundation for what we heard from some of our colleagues and Senator Wyden, in particular, about this being an important foundation for tax reform for economic growth.  And I think we have heard from our panelists the negative implications of the preference for debt financing, and ideas for equalizing the treatment between debt and equity.

     And I guess I just want to go back to the design of what the tax system should look like- what the tax code should look like, what tax reform should look like- if we are going to promote economic growth, if we are going to promote jobs.  I mean that should be our number one goal here, I think.  Because, obviously, issues like spending and debt are a big issue.  But we have to increase economic growth.

     When you only have 18,000 jobs coming out in the last jobs report, that is pretty embarrassing.  It is embarrassing, when you think we have got more college graduates probably in Minnesota than we have jobs coming out nationally.

     So, knowing that that’s the case, we want a tax code that is going to promote work, savings, and investment.  What should be the focus on that, in the context of debt and equity?  Ms. Olson?

     *Ms. Olson.  Well, I think there is a lot of economic literature that supports the notion of moving in the direction of a consumption tax.  And there are lots of ways to get there.  Something like a comprehensive business income tax would be one thing that Congress might look at to move in that direction.

     *Mr. Paulsen.  Yes.  Mr. Fleischer, anything to add?

     *Mr. Fleischer.  I largely agree with that.  I mean I think the basic principles of what we are aiming for I think a lot of us agree on, that broad‑based lower rates are the place to start.  And to try and reduce the distortions in the code that lead not only to a reduction in tax revenue, but an incentive to engage in wasteful tax planning, that from a long‑term, economic perspective, it is not encouraging long‑term growth.

     Right.  And we have had a lot of, I think, comments from the panelists about lowering the rate, broadening the base. And in the context of helping small businesses, too, please share if there is any thoughts on that, because that is a driver of the economy, is the small business economy.

     *Mr. Desai.  Right, absolutely.  And I think the remarkable thing, of course, is the level of consensus on what, you know, tabula rasa, if we started the world, what a good tax code would look like.  And there is a remarkable level of consensus on that, which is some notion of a consumption tax base, coupled with progressivity that can be achieved in a variety of ways.

     So, in some sense, that is not the hard part.  The hard part is, you know, where you said ‑‑ you know, I think sitting where we sit, I think there is wide consensus about what the code should look like.  But getting there is the harder part.

     *Mr. Paulsen.  And, Mr. Johnson, before my time runs out?

     *Mr. Johnson.  I think you should focus on moving towards a value‑added tax system.  And you can make that as progressive or as not progressive as you want, and you can generate the same revenue or less revenue or more revenue.  There is a variety of VAT systems around the world.

     The U.S. system, taxing income, is always going to get in the way of your goals.  You want to promote work, savings, and investment.  Well, anything that is primarily ‑‑ or as much income tax‑based in our system is not going to do that.  And I think I would echo ‑‑ or encourage you to look at the specific proposals put forward by my colleagues here, and look at other proposals ‑‑ for example, that the IMF has available ‑‑ in terms of how countries can move and transition smoothly to a VAT system.

     *Chairman Camp.  All right, thank you.

     *Mr. Paulsen.  Thank you, Mr. Chairman.

     *Chairman Camp.  I want to thank our panelists this morning, all of you, for being here and for participating in the hearing.  I also want to thank Chairman Baucus and the Senate Finance Committee, as well as their staff, for making this joint hearing possible.

     This hearing is now adjourned.

     [Whereupon, at 11:23 a.m., the committees were adjourned.]


Mr. Thomas A. Barthold
Dr. Mihir A. Desai


Sen. Olympia J. Snowe


National Association of Home Builders
The Center for Fiscal Equity