Statement of The Honorable Pamela F. Olson, Assistant Secretary for Tax Policy, U.S. Department of the Treasury; accompanied by Gregory F. Jenner, Deputy Assistant Secretary for Tax Policy

Testimony Before the Full Committee
of the House Committee on Ways and Means

February 11, 2004

Mr. Chairman, Congressman Rangel, and distinguished members of the Committee:

Thank you for the opportunity to appear before you today to discuss the tax proposals included in the President’s Fiscal Year 2005 Budget. 

Over the last three years, the President and Congress have responded with courage to the recession and to a number of external crises that put additional, extraordinary, strain on that economy.  The end of the high-tech bubble and its consequences for the stock market, the revelation of years of wrong-doing on the part of certain corporations and their executives, the impact of the September 11attacks, and the uncertainties of the war on terror and the conflicts in Afghanistan and Iraq, are all at the root of the recent economic difficulties.  These events worsened and prolonged the weaknesses in the economy. 

Fiscal policy has played a crucial role in responding to these events.  The tax cuts enacted in 2001 were an important factor in making the downturn one of the shallowest on record.  Together with an expansionary monetary policy embodied in a series of deep interest rate cuts, the tax cuts provided support to a weakening economy at a critical juncture.  The stimulus bill enacted in 2002 provided vital support to the economy in a key area of weakness – corporate investment.  The temporary bonus depreciation provision, for example, provided the needed incentive for new corporate investment at just the right time.  

While the tax cuts of 2001 were essential to keep the recession from deepening, the 2003 tax cut provided the needed lift to allow the nascent recovery to continue and gain strength.  Immediate support to the economy was provided through the acceleration of the lower tax rates, expansion of the child credit, and marriage penalty relief.  Weakness in corporate investment was addressed by reducing the double tax on corporate income through the lower tax rate on dividends and capital gains.  This change lowered the cost of equity capital and provided an important stimulus to corporate investment.  The increase in small business expensing and bonus depreciation provided additional stimulus to corporate investment.

With these vital changes in tax policy, we now have a robust economic recovery with strong economic growth and tightening labor markets that are beginning to put Americans back to work.  Moreover, the tax cuts already enacted will continue to spur economic growth.  The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) will put another $146 billion into the economy this year with $100 billion in the first half of the year. 

But the tax changes enacted over the past three years have done much more than address and respond to the economic difficulties and crises we have faced.  They also laid the ground work for strong economic growth in the future.  The lower tax rates improve incentives.  After-tax rewards from working are now substantially higher.  The taxes paid by entrepreneurs, who tend to pay taxes through the individual income tax, are now lower.  The rewards to their innovation and risk taking are greater.  The cost of equity capital and investing has been reduced.  More risk-taking, investment, and innovation mean higher productivity and greater capital accumulation.  A larger capital stock translates into higher living standards for all in the future. 

Moreover, the tax changes enacted over the past several years have been fair and balanced.  Without the tax cut, the bottom 50 percent of taxpayers would have paid slightly more than 4 percent of individual income taxes.   As shown on the chart below, now they pay even less – 3.6 percent.  In contrast, the top 5 percent of taxpayers pay a larger share – 52.8 percent of individual income taxes rather than 50.2 percent without the tax cuts.  The same is true for the highest income taxpayers – the top 1 percent.

This group now pays 32.3 percent of all individual income taxes, rather than 30.5 percent before the tax cuts were enacted. 

Much remains to be done, however.  Making the tax cuts enacted in 2001 and 2003 permanent, promoting savings, making health care more affordable, reducing the barriers to homeownership, simplifying the tax system, ensuring the integrity of the tax system by preventing abusive transactions, and responding to the WTO decision on the extraterritorial income exclusion (ETI) provisions are all important priorities reflected in the President’s budget proposals.  I will focus on each of these priorities in turn.  

Permanence:  A Stable, Certain Tax Code

The tax reductions made in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and JGTRRA proved essential for promoting economic growth and will help to ensure higher living standards in the future.  If these provisions are allowed to sunset, taxes will increase:  for many individuals after 2004, for many small businesses in 2006; for investors beginning in 2009, and again for most taxpayers beginning in 2011.     

An uncertain tax code imposes real costs on the economy.  Uncertainty makes it difficult for workers and businesses to plan for the future and increases investment risk.  The possibility of higher taxes increases the cost of equity capital to businesses and reduces individuals’ after-tax rewards to working and investing.  A higher cost of equity capital and lower rewards to workers and investors dampen long-run economic growth.   

Permanent extension of the tax cuts enacted by the President and the Congress will provide a more certain tax environment for workers and businesses to plan and invest, both reducing complexity and continuing to support a growing economy.  The revenue cost of making the tax cuts permanent ($989 billion) is only a small percentage of the revenue of the federal government over the 10-year budget window.  Moreover, the cost is only a tiny fraction of the United States economy over this same period.

In addition to uncertainty, failure to make the tax cuts permanent will inflict a real blowto the economy.  Allowing the tax cuts to expire amounts to nothing more than a massive tax increase on the vast bulk of individual and business taxpayers.

Towards a Long-Term Solution to the AMT

The expected growth in the individual alternative minimum tax (AMT) is a major problem in the tax code that must be addressed.  The AMT was first enacted in the late 1960s to target a small number of very high income taxpayers who paid little or no tax.  The stage was set for the AMT’s growth when the regular tax was indexed in the early 1980s but the AMT was not.  Other changes throughout the 1980s and 1990s compounded the problem. 

Now the AMT is a tax that is beginning and will continue to affect increasing millions of taxpayers.  It will reach into the ranks of the middle class, potentially denying taxpayers the benefit of many of the deductions, credits and lower tax rates available under the regular tax system.  The AMT also significantly increases the complexity of tax filing for taxpayers subject to the AMT and for millions of additional taxpayers who must complete AMT forms only to determine they are not subject to the AMT.

The AMT’s future growth must be addressed.  The President’s budget extends through 2005 the temporary increase in the AMT exemption amounts and the provision that allows certain personal credits to offset the AMT.  These temporary provisions will keep the number of taxpayers affected by the AMT from rising significantly in the near-term.  More importantly, they will allow the Treasury Department the time necessary to develop a comprehensive set of proposals to deal with the AMT in the long-term.  Because of the revenues involved and the number of taxpayers affected, any long-term solution to the AMT could well require significant changes to the regular income tax.  The Treasury Department looks forward to its task and to working with this Committee to find a long-term solution.

Simpler Savings Options for All

Americans continue to save at a very low rate relative to historical standards and our major trading partners.  The President has put forward in this year’s Budget a modified version of his savings proposal to help address this low rate of saving.  The proposal carefully balances the need for a simpler approach for providing accessible tax-preferred savings options to all Americans and preserving the employer-provided pension system, which has been the foundation for meeting the retirement savings needs for millions.

Saving is made simpler by replacing the existing web of tax-preferred saving options with two new savings vehicles:  Retirement Savings Account (RSAs) and Lifetime Savings Accounts (LSAs).  These savings vehicles allow everyone to contribute regardless of age or income.  The simplicity of these new savings vehicles will help encourage individuals, especially lower income individuals, to save. 

Lower income individuals often do not have the resources to save for the distant future and are unwilling to take the risk of locking up their savings in tightly restricted accounts.  In addition, these individuals tend not to have access to the sophisticated advice needed to navigate the complex, and often conflicting, rules that govern the existing savings vehicles.  LSAs have been designed to make the decision easy: it is a savings vehicle accessible for all, especially low and moderate income individuals.  Any money contributed can be withdrawn at any time without penalty.  Treasury believes that these more relaxed rules will encourage individuals to save who might otherwise not do so in targeted savings plans because of restrictions on and penalties for withdrawals.  As individuals learn to save, and become comfortable doing so, they will do more of it.  The lower $5,000 contribution limit, as compared to the proposal in the FY 2004 Budget, will minimize the effect of these proposals on employer plans. 

The proposal for RSAs would simplify the range of choices for taxpayers saving for retirement.  The proposal takes the easy to understand Roth IRA and makes it available to all.  Any taxpayer can contribute up to the lesser of $5,000 or their earned income.  Unlike current law, however, withdrawals could only be made for retirement, beginning at age 58.  RSAs are the perfect complement to LSAs: targeted, tax-favored savings coupled with savings for any reason.

The proposal for Employer Retirement Savings Accounts (ERSAs) would consolidate six different types of employer contributory plans into a universal account.  The proposal has been modified from the previous FY 2004 Budget proposal to enhance flexibility and encourage small businesses (10 or fewer employees) to fund an ERSA by contributing to a custodial account, which is similar to a current-law IRA.

A third proposal would credit Individual Development Accounts (IDAs) to encourage and assist lower-income individuals save.  This proposal would provide dollar-for-dollar matching contributions of up to $500 targeted to lower income individuals.  Matching contributions would be supported by a 100 percent credit to sponsoring financial institutions.

Together, these proposals further promote an ownership society by removing barriers to savings, reducing complexity, and improving fairness by providing the benefits of tax preferred savings to everyone, regardless of financial sophistication or capacity to save for the very long-term. 

Reducing Barriers to Homeownership

A significant barrier to homeownership continues to be the supply of affordable housing for lower income individuals.  To address that need, the President has proposed a $2.4 billion ($16 billion over 10 years), 5-year Single-Family Affordable Housing Tax Credit of up to 50 percent of the project costs of rehabilitation and construction of affordable homes, provided they are offered to homebuyers with incomes of not more than 80 percent of area median income.  The tax credit would eventually result in an additional 200,000 affordable single-family homes becoming available through construction or rehabilitation.

Affordable Health Care is a Priority

Expanding access to health insurance remains an important goal of the President and is reflected by his continued commitment in this area.  The lack of access to affordable health insurance is a complex problem that requires a comprehensive approach focusing on different segments of the uninsured with policies tailored to meet their needs.  There is no one size fits all solution; a policy that excels in one dimension may do poorly in others.  The high and rising cost of health insurance is a key factor that limits access.  Policies that help control costs will make insurance more affordable through lower premiums.

Health Savings Accounts (HSAs), enacted as part of the recently-passed Medicare Reform legislation, are a significant step towards promoting cost consciousness through greater reliance on individual choice and high deductible plans.  HSAs, now part of current law, are complemented by a new proposal in the President’s Budget for an above-the-line deduction for premiums to purchase the high deductible health plans (HDHP) necessary in order to have an HSA.  The proposal generally helps level the playing field for a segment of the population that does not have employer-sponsored coverage. 

The proposal for a refundable, advanceable health insurance tax credit would help make insurance more affordable for lower income individuals.  The credit amount under the proposal would vary with family size, mirroring the relationship of actual health insurance premiums.  The credit is targeted to low-income individuals and families, who are the least likely to have employer-based health insurance, resulting in the efficient use of the subsidy.  Together, these policies promote affordability and access, and help encourage greater cost consciousness by giving individuals a greater stake in their health care choices.

Protecting Defined Benefit Plans and Promoting Fair Treatment for Older Workers in Conversions to Cash Balance Plans

The President’s budget reflects the importance of preserving defined benefit pension plans and the benefits they provide to workers and their families.  In addition to the proposal to fix the flawed interest rate used to determine the amount of contributions a plan sponsor must make to its defined benefit plan, the budget contains three interrelated proposals that recognize the importance of cash balance plans in providing retirement security to millions of Americans. The first proposal would ensure that companies converting from a traditional defined benefit plan to a cash balance pension include a fair transition for older workers.  A five-year hold harmless provision would be required in a cash balance conversion, so that workers would continue to earn benefits under the greater of the prior plan formula or the cash balance formula for five years after the conversion.  The second proposal would clarify that cash balance plans do not violate the age-discrimination rules that apply to pension plans as long as they treat older workers at least as well as younger workers.  This would remove uncertainty created by inconsistent federal court decisions and would ensure the future of cash balance plans.  The final proposal would eliminate the “whipsaw” effect, which acts as an effective cap on the interest credits that cash balance plans can provide to workers.  This would permit companies to give higher interest credits, allowing larger retirement accumulations for workers.

Simplification of an Overly Complex Tax Code

In a sophisticated economy, a tax code with complex provisions may be unavoidable.  It is the price we pay to ensure fairness, to limit government interference with personal and business decisions, and to prevent abuse.  On the other hand, unnecessary complexity imposes tremendous burdens on honest taxpayers simply doing their best to comply with the law.  The present tax system imposes compliance costs on taxpayers estimated to range from $70 billion to $100 billion per year from the individual income tax alone.   Compliance costs also are onerous for business taxpayers, especially small businesses, while the typical Fortune 500 company spends almost $4 million a year on tax matters.

For these reasons, it is crucial that we continue efforts to simplify the tax laws.  The 2005 Budget includes several new simplification proposals.  All of these proposals address complexities borne by individuals and families.  They do not represent an exhaustive list; instead, they serve as examples of the many steps that can and should be taken to make the tax code easier to understand and comply with.   The Treasury Department looks forward to working with this Committee to identify other areas where significant improvements can and should be made.

Stopping Abusive Transactions

Voluntary compliance with the tax laws is undermined when taxpayers use abusive transactions to avoid paying the taxes they rightfully owe.  For the past three years, the Administration has acted aggressively to restore confidence in the tax system by halting the promotion of abusive transactions and bringing taxpayers back into compliance with the tax laws.  The President’s Budget builds on these efforts and information gathered through IRS compliance programs.  The new legislative proposals close loopholes and target identified abusive transactions and practices.  As other abusive transactions are identified, the IRS will challenge the transactions in audits, and the Treasury Department and the IRS will work with Congress to enact any legislation necessary to address such transactions.

One proposal deserves particular mention.  The Administration has proposed to limit certain types of abusive leasing transactions, known as SILOs.  These arrangements are entered into with tax-indifferent parties, such as foreign governments, domestic municipalities, and tax-exempt organizations.  They purport to be leasing transactions but, in substance, provide no financing to the tax-indifferent party aside from a fee. These arrangements have no meaningful financial or economic utility other than the transfer of tax benefits to a U.S. taxpayer (by means of a purported “sale” of property) in exchange for the payment of an accommodation fee to the tax-indifferent party. 

Although Treasury has been aware of SILOS for some time, the extent of the problem has only recently come to light.  Our data indicates that as much as $750 billion dollars of SILOs have been done in just the last four years.  We have every reason to believe that, left unchecked, this trend will continue and grow.  Because these transactions essentially involve no risk to either party, and require very little in the way of actual cash investment, corporations seeking to reduce their U.S. tax liability will face no economic bar to seeking out these arrangements on an increasing basis.

SILOs represent a threat to the viability of the corporate tax base.  They present a ready-made tool for self-help tax relief for large corporations and consortiums of smaller ones.  Indeed, the magnitude of SILO transactions is such that the Treasury Department had to re-estimate and reduce its baseline estimate of corporate tax receipts over the ten-year budget window.  It is essential that Congress deal with this issue.  Otherwise, any corporation with the wherewithal to do so could plan itself out of the corporate income tax.  The American citizenry rightfully expect their government to ensure that all taxpayers pay the taxes they owe, unreduced by artificial transactions.  Congress should act promptly to ensure that SILOs are not permitted to continue.

At the same time, in addressing the SILO problem, it is not our goal to interfere with garden variety leasing transactions that have been entered into for many years and that involve legitimate financing or refinancing of assets.  The detailed SILO proposal in the President’s budget permits legitimate lease transactions to continue.  We look forward to working with this Committee to ensure that legislation is enacted that leaves legitimate transactions unscathed while preventing abusive lease transactions from going forward. 

Responding to WTO Decisions on ETI Provisions

The Extraterritorial Income (“ETI”) provisions of our tax law, like the prior-law foreign sales corporation provisions, have been found to be inconsistent with World Trade Organization (WTO) rules.  The WTO has authorized the imposition of trade sanctions against U.S. exports up to the level of $4 billion per year, and the European Union has adopted a plan providing for sanctions to be phased in beginning next month if the ETI provisions remain in the law.

Honoring our WTO obligations requires repeal of the ETI provisions.  At the same time, meaningful changes to our tax law are required to preserve and enhance the competitiveness of U.S. businesses operating in the global marketplace.  Thus, the necessary repeal of the ETI provisions should be coupled with other tax changes that promote the competitiveness of American manufacturers and other job-creating sectors of the U.S. economy.  Tax law changes that would provide a benefit to these vital contributors to the U.S. economy include across-the-board corporate tax rate reduction, expansion and permanence of the research credit, improvements in depreciation rules, extension of NOL carryback rules, AMT reform, business tax simplification, and rationalization of the international tax rules.  The Administration intends to continue to work with this Committee and the Congress on prompt enactment of legislation that brings our tax law into compliance with WTO rules and makes changes to the tax law to enhance the global competitiveness of American businesses and the workers they employ. 

Conclusion

Thank you again, Mr. Chairman and members of the Committee, for the opportunity to appear before you today.  We look forward to working together with this Committee and others in the Congress to promote tax policies that continue to provide a sound foundation for economic growth.