American Enterprise Institute

June 2, 2006

[Edited transcript from audio tapes]

8:30 a.m.	Registration and Continental Breakfast
8:55	Welcome:	R. Glenn Hubbard, AEI and Columbia University
9:00		Corporate Income Taxation in a Modern Economy
	Presenter:	Kenneth Judd, Hoover Institute
	Discussants:	Thomas Barthold, Joint Committee on Taxation
		Robert Carroll, Department of the Treasury
	Moderator:	R. Glenn Hubbard, AEI and Columbia University
9:50		The (Compliance) Cost of Taxing Business
	Presenter:	Joel Slemrod, University of Michigan
	Discussants:	Rosanne Altshuler, Rutgers University
		Mark Mazur, Internal Revenue Service
	Moderator:	R. Glenn Hubbard, AEI and Columbia University
10:40	Break
11:00		Developments in the Taxation of Corporate Profit in the OECD Since 1965: Rates, Bases, and Revenues
	Presenter:	Michael Devereux, University of Warwick
	Discussants:	William Gale, Brookings Institution
		Martin Sullivan, Tax Analysts
	Moderator:	R. Glenn Hubbard, AEI and Columbia University
11:50	Luncheon and Keynote Address
	Introduction:	R. Glenn Hubbard, AEI and Columbia University
	Keynote address:	The Honorable Edward Lazear, chairman of the President’s Council of Economic Advisers
1:15		Taxes and Wages
	Presenters:	Kevin A. Hassett, AEI
		Aparna Mathur, AEI
	Discussants:	Jared Bernstein, Economic Policy Institute
		William Randolph, Congressional Budget Office
	Moderator:	R. Glenn Hubbard, AEI and Columbia University
2:05		Corporate Income Taxes and Economic Growth
	Presenter:	Dale Jorgenson, Harvard University
	Discussants:	Jason Cummins, Brevan Howard
		Douglas Holtz-Eakin, Council on Foreign Relations
	Moderator:	Kevin A. Hassett, AEI
2:55	Closing Comments:	Kevin A. Hassett, AEI
3:00	Adjournment

Proceedings:

June 2, 2006

[Panel I – Corporate Income Taxation in a Modern Economy]

 R. Glenn Hubbard:  Good morning everybody.  Welcome, if I could have your attention.  I’m Glenn Hubbard and just wanted to welcome you to today’s conference on the corporate tax and the economy.  I must say to you, my wife has always divided humankind into two groups, economists and real people.  And it is a special treat for me to see 180 economists and/or real people interested in the subject of the corporate tax on a Friday, in the summertime in Washington.  I suspect that the reasons for that are two.  One, there has been an incredible amount of academic work and a rethinking of both the dead-weight loss of the corporate tax and the incidence of the corporate tax over the past decade.  There has also been a sea change, I think, in concerns among business leaders and certainly policy makers about competitiveness issues in the corporate tax and the effect of the corporate tax has on capital markets and labor markets. 

Just as a quick factual matter, the US has a corporate tax rate which is the second highest in the industrial world but has actually quite modest revenue relative to GDP raised from the tax, raising the suspicion of distortions perhaps being larger than the revenue consequences.  Economists, of course, have, for literally a couple of generations, focused on the corporate tax going back to Al Harberger’s seminal work.  But today we brought together a set of new research on a variety of topics in the corporate tax, ranging from compliance cost to revenue effects to effects on wages, effects on economic growth, and effects on risk taking and innovation.  All of these represents new work, and I think important work and I trust that the discussion will be very good. 

I’m welcoming you this morning really in two capacities.  One, on behalf of the Alliance for Competitive Taxation that is described in your materials and has sponsored the academic research you will hear today.  The second is on behalf of the American Enterprise Institute whose facilities we enjoy this morning. 

Without further ado, I want to move to the first, although our papers on corporate income taxation in a modern economy, the presenter will be Ken Judd from the Hoover Institution at Stanford.  Ken is an extremely distinguished public finance scholar and has done some of these most seminal works in capital income taxation and investment.  Commenting on Ken’s paper will be Bob Carroll who is the Deputy Assistant Secretary for Tax Analysis at the Treasury Department and Tom Barthold from the joint committee.  Throughout the day the rules will be the same, about 20 minutes for the presenter, 10 minutes for discussants, the balance of the time for general discussion.  Ken, the floor is yours.

 Kenneth Judd:  Just want to, of course, remind you of what the case against the corporate income tax is.  What are the features of the corporate income tax that have led economists to criticize it so heavily?  Well, starting with Al Harberger back in his papers in the early ‘60s, he emphasized how the corporate income tax misallocate resources across sectors, that the corporate sector pays a higher cost for its capital than the non-corporate sector and, therefore, you are going to have a shifting of capital resources across sectors that just reduces the total productivity of the economy and with relatively modest, if any, revenue benefit. 

Now more recently, a variety of people, Atkinson and Sandmo, Feldstein, Diamond and Mirrless and myself and others, have looked at how capital taxation in general affects economic growth, and Professor Jorgenson’s paper later today will expand on that considerably on [indiscernible] how the corporate income tax discourages growth and reduces productivity over time.  It is a more dynamic analysis.  Now also the other thing, the other criticism of the corporate income tax is that it encourages corporations to shift financing away from equity and towards debt, which has problems because debt financing makes your move more vulnerable to economic risks.  So those roughly summarize the three main criticisms. 

What I have not mentioned here, I should, that the institutional form, it biases the institutional form choice against the corporation, which also may make it inefficient.  So those are the standard kinds of arguments against the corporate income tax. 

Now, what I’m doing here today is bringing some new features into the analysis, let’s say new to the analysis, not new to the economy.  For example, I will be talking about riskiness in the sense of aggregate risks, against stocks versus bonds and people portfolios.  That part of real life is typically missing from discussions of the capital of the corporate income tax.  I’m going to show you what happens when you add that. 

Also, the second focus out of the three will be how the corporate income tax affects pre-existing distortions in the economy.  In particular, distortions that arise because of pricing above marginal cost, and when I say pricing above of marginal cost, I’m not talking about illegal monopolies.  I’m not talking about the companies that have been broken up by anti-trust acts.  I’m talking about companies that have patents and have done research and development and, therefore, must price above the marginal production cost in order to recover their initial fixed costs, and show you what happens in that environment when you start analyzing the impact of the corporate income tax. 

And also, the final piece I’m going to talk about is how the corporate income tax affects the life cycle development of corporations, our businesses I should say. 

And in all of these three points, one common theme here is that I’m taking a more dynamic view of the economy and adding these dynamic elements to the analyses and finding basically that the case against the corporate income tax is even stronger than it has been using the more traditional critiques.  And then, also, I will give you some intuition as to why these new details are really just elaborations of common, well-known basic principles of good taxation.  What are the good principles for good taxation?  What is a corporate income tax?  

In this paper, I focused on an aspect of the corporate income tax as maybe a bit different than the aspects that the other people focus on.  I’m going to focus on the corporate income tax in terms of its role as essentially a tax on the purchase of capital equipment and services by a corporation and they pay a tax on that that a non-corporate entity would not pay.  First of all, I would like to emphasize that you think, well, corporate income tax is not sales tax, it is an income tax.  Well, there is an equivalent.  What is the difference between me buying a machine and then having the government grab 50 percent of the revenues generated by that machine or me buying the machine and at the time I buy the machine, pay the government a 100 percent tax on my initial purchase of it?  There is the equivalence there in terms of every economically relevant feature between taxing me when I buy a machine or grabbing the profits that flow from owning that machine.  And when you see that equivalence, then you start to see why the corporate tax is so bad. 

Now, of course, it is also the case that corporate income tax essentially does tax the owners of capital and affects their savings decisions and investment over time.  I’m not going to focus on that so much. I’m going to focus within business and within sector distortions today.  Also, what I’m going to do is take a partial equilibrium point of view.  I’m going to assume that nothing is going to happen to the required return on investment on the part of investors. 

Now, of course, that is very different than what Al Harberger did in his papers in the early ‘60s, but I would argue that the world was very different in the early ‘60s.  In the early ‘60s, United States was closely approximated by being a closed economy, particularly in terms of capital flows.  Well, that is not the case today.  The United States is a big player but just one big player in the world capital market, and so tax policy that just assumes that all investment comes from internal savings is really, I think, the wrong abstractions.  So I’m going to take the other abstraction and assume that there is an enormous world capital market out there, and that what we do in the corporate income tax side is not going to have a big influence on the world of interest rates and the world-required rate of return on capital. 

So it is a little bit different emphasis but also it makes a lot of the analyses much simpler because then I do not have to explain very complicated, dynamic, general, liberate [sounds like] models to you, so I think it is the right model, and it is also one that is easy to sort of understand the basic principles.  And it turns out that if you have fixed coefficient technology, if you have no substitution in capital and other inputs, then basically a corporate income tax is the same as taxing the output.  And that was the part of the intuition of Harberger is that a tax on corporations was also basically a tax on the products produced by corporations.  And why is that bad?  Well, the general rule in taxed areas is that you should tax things based on the elasticity of demand for that good.  I mean, of course, assuming that if there is in the long run, if there is elasticity of supply, so it just works on demand.  And so unless you can say that corporations are producing goods that have low elasticity of demand, well then why have a corporate income tax?  The corporate income tax really does not correspond to sensible taxation of goods by the inverse elasticity rule. 

Also, the other thing and that we know from basic economics is, thou shall not tax intermediate goods.  That was a point of Diamond and Mirrless, that if you tax intermediate goods as opposed to final goods, all you are doing is reducing the productivity of the economy.  And that is what the corporate income tax does.  It taxes the production choices of firms and has the impact on the prices that consumers and buyers pay for the products, but it primarily impacts the decisions that producers make in terms of which inputs to use, and that just reduces efficiency of that economy with no real benefit in terms of revenues.  So that is the intuition, the basics, a source of intuition for everything that I’m doing here and underlies a lot of economic analyses. 

Now, the one thing that has always struck me as being odd about the literature on the corporate income tax is that you are talking about corporations and yet, risk is generally not considered a big part of the discussion.  What is a corporation?  A corporation is a business that has publicly traded equity and, as we know, equity prices are highly volatile, there are a lot of risks to it, associated with it, and so it is natural to ask, okay, how does risk enter into this?  Also, what is the motivation for having a corporation?  If you are a businessman and it is just you and your partners and you have some big project in mind that you want to do and you need to raise a lot of capital, and the project that you have is too risky to just go and go to the bank and mortgage your house or get loans, well, then you go to the equity market.

 So the equity market is a place where you spread out idiosyncratic risks of operating a firm.  And then how is that equity priced?  Well, you go back to CAP-M models and risk models basically.  The price of your equity, of your shares, will be related to how much your profits are correlated with general business conditions in the economy that is the CAP-M model of asset pricing.  So when thinking about corporation, you have to think about two kinds of risks.  The motivation for incorporation is often because of high idiosyncratic risk from the firm, but the pricing of the asset is going to be related to its correlation with the aggregate business conditions.

 So what I did, I wrote down the basic standard portfolio model and I said, okay, now let’s look at some risky assets.  By risky, I mean assets that have high aggregate risks.  Some of these are subject to corporate tax and some are not.  And then, I did the standard little marginal excess burden - what is the extra cost to the economy in terms of the efficiency from adding increase in the tax to get an extra dollar of revenue.  So let’s look at the middle line here first, get my phase [sounds like] around the right button here. 

So let’s say that, basically in my model, the assets there is a safe asset bond, which has a one percent safe return.  There is one risky asset or class of assets, tau one, which has moderate risks, and tau two, which has higher risks but appropriately higher mean return.  So all the numbers here were chosen to correspond roughly to US equity returns.  Now, what we find is if all of these assets are subject to the same tax rate, the excess burden of raising taxes in order to get extra dollars is quite modest, like 10 to 11 cents in a dollar.  If you are up to a 20 percent rate, and if everything is taxed to the 40 percent rate, marginal excess burden would be 23 cents in a dollar.  Pretty low numbers in this business. 

But suppose that your safe assets, like think about homeowner occupied housing, is subsidized at a 20 percent rate and then there is bunch of assets that have paid essentially no tax for a variety reasons.  And then there is the risky asset, asset with high aggregate risk is taxed at 40 percent.  Well, then getting an extra dollar on that risky asset cost 17 cents on per dollar of efficiency, but the safe one is actually perverse.  If you raise taxes on that, basically we do set subsidy, not only increase revenue, you increase welfare.  And the reason is that this kind of pattern so distorts portfolio choices that any move towards a more equal treatment of assets is going to result in more economic deficiency and even to the case that we are just raising this tax, raises both revenues and economic welfare. 

So the idea here is that asymmetric treatment of assets in different risk classes will result in large inefficiencies because you are treating similar things in very different ways.  Again, this is very much like the case about intermediate goods.  What are assets?  I mean you got stocks, you have bonds, you have investments, but it is not that you enjoy holding General Motors - well, maybe not pretty good recently - it is not that you enjoy a stock of General Motors or IBM or Google or whatever, you do not have any particular taste for any of those assets. 

What you care about is the money that is going to deliver.  These are all ways of producing cash down the way.  These are just different ways of producing what you care about, money.  So different assets are like different intermediate goods, so any distortion in that choice is going to be highly wasteful and inefficient.  So that is the result.  By the way, as many of you know, calibrating these kinds of models are very difficult because we do not lead those equity premium puzzle but look at variety of numbers.  Basically, these results are very robust. 

Now another thing in this paper is the following:  Markets are not perfectly competitive.  Now, most of the analyses on the corporate income tax assume that all products are sold at marginal cost.  Assume that there is perfect competition in all markets.  And that is, of course, what we always teach in the first economic course and that is, of course, the concern of a lot of literature.  But in the real world, there are a lot of markets where prices are well above marginal costs.  Anytime I buy software and I download it over the Internet, the marginal cost of producing that and selling it to me is basically zero but I end up having to pay them hundreds of dollars for the software.  So price is above marginal cost for many products for good reasons.  They need to recover their fixed costs, which is not because of some illegal monopolization.  So prices above marginal cost for many goods and for very good legitimate business reasons. 

But now look at what happens when you have a tax such as a corporate income tax, which raises the cost of operating such a firm.  So, first, you have market power that produces a mark up of “M.”  So, let’s say marginal cost is “1,” the market power generates an inefficiency, this little [indiscernible] triangle from monopoly, but then now the government comes on and taxes at another tau.  Well, the government walks away with this revenue “r” but now the extra inefficiency is not just a little triangle, not just a little [indiscernible] triangle, it is this triangle plus this box because basically, that tax is on top of another distortion, which also is like a tax, basically the producer taxing the buyer in order to finance some fixed costs. 

So that is the kind of thing that needs to be put also into any analyses of the corporate income tax or any other tax policy, and the antitrust policy is not a legitimate way of dealing with this.  It is not that we are trying to fix the market power here, we are just trying to … given that we have market power, given that we have institutions that have firms pricing above marginal cost, what is rational tax policy?  And, again, I do my little marginal excess burden calculations, and now we find is that the marginal excess burden of taxing capital in a corporation which has market power, that those marginal excess burden numbers are really quite high.  Easily above 50 cents and, in many cases, even well above the dollar and even in this case you get perversed, you get on the right side of the [indiscernible] curb, and that is again you are piling on a corporate income tax piles of distortion on top of existing distortion, and so the efficiency cost is going to be much higher. 

Now why do firms have market power?  Why do we allow this?  Well, we allow this because we give them patents to encourage R&D and innovation, but here again the corporate income tax gets in the way.  The corporate income tax raises the cost of operating your firm, therefore it reduces the incentive to innovate because if you do innovate and succeed, you are not going to get as much benefit from it because the government is going to raise the cost of operation.  And also again, there is another distortion that we know, that even if you innovate and are allowed to charge prices above marginal cost, you rarely, if ever, get the full social benefit of that innovation.  That is the essence of a lot of the work on R & D. 

So there again, R&D decisions typically in corporations will be below the socially efficient level.  And, so then, something like the R&D tax credit comes along, and even if it is fully expensed, the key thing about the R&D tax credit is that the returns to the R&D is greater for society than it is for the firm.  And then I ran a few little numerical examples and found numbers that are strongly supportive of an R&D tax credit.  And again, that reminds me of some work I did years ago on the investment tax credit where in both cases, whether it was an investment tax credit, or bonus depreciation or the R&D tax credit.  What happens is you start with a distorted situation where investment of some sort is too low by having a targeted incentive to increase that investment, you end up with very big bang for the block. 

In all these tax tools, it is the most effective way of reforming, of improving the tax system at little loss, if any, of revenue.  The final little example I have, by the way the paper is just a vignette, a series of vignettes, little examples.  A lot of work needs to be done.  I plan of doing some.  I hope this encourages others also to get into, this into doing this. 

The last, little vignette is trying to encourage you to think about corporations as part of a life cycle of a business.  Corporations are not just born out of nothing.  Basically corporations represent winners.  Steve Jobs was not born as the CEO of Apple.  First, there was a private corporation, a partnership and then when it led to it, incorporate it.  There are thousands of people like that close to where I live in Silicon Valley, very few of them are winners as we, of course, learned the hard way in the late ‘90s to early 2000 period.  So what you have to think about is a dynamic life of a business. 

At first your partnership, you are taxed under the personal tax code, so your deductions are at the personal rate and if you make no money, those losses are rebated to you at the personal rate.  But if you are a winner and you need to go to the corporate form, then what happens?  Then the government grabs money out of the winnings in the form of the corporate tax, and even if you can get a preferential rate on dividends or capital gains, it is still going to be the case that the government basically taxes you more heavily when you win, then allows you to deduct it when you lose. 

Basically, the government has a call option on the winnings.  So it is basically, heads you lose, tails the government wins.  And that feature of the tax code due to the corporate income tax aggravates the similar feature due to progressivity on the personal side because progressivity and personal tax rate also reduces the same bias against riskiness; the corporate income tax aggravates that.  And so, again, when you start thinking about the life cycle of a business operation, we see how the corporate income tax reduces incentives for entrepreneurship and innovation. 

So, basically, the old, bad news is that corporate income tax is bad.  The new bad news is that it is even worse than we thought it was, and it really strengthens all of these examples that I talked about in the paper, really strengthen the case against the corporate income tax.  What we really need, of course, is some fully dynamic and sophisticated model that puts all these things together.  There is no reason to think that the effects are anything but cumulative. 

And this is the kind of work that I hope, I see, for example, there is more activity now in the treasury department, particularly with this proposal to have a division of dynamic analyses.  These are the kinds of elements that should go into those kinds of models and I’m happy to see that the government is more interested and that the Administration is interested in pursuing that.  And when you put these elements into any sort of dynamic analysis, get away from the static focus, put into a dynamic analysis, you see that the case against the corporate income tax is far, far stronger than previous analyses would indicate.

 R. Glenn Hubbard:  Thank you, Ken.  The first discussant is Bob Carroll, speaking of all that activity at the treasury department.  Here he is. 

Robert Carroll:  I thank you very much for the paper on our new division of dynamic analysis, which we have to send up soon.  I also thank Glenn and Ken for the flight here.  I want just to first thank you for the opportunity to talk, discuss the paper.  This is a really good audience.  It is a very important paper. 

First, I want to congratulate Ken on a paper that I thought was extraordinarily well written and very accessible and I think a very important contribution to the policy debate within the beltway.  The paper really builds on research that spans perhaps over a 20-year period, and I think it is very relevant to a number of issues that are under consideration in Washington today, such as you have the dividends and cap gains, the tax relief that was just passed, the state tax repeal that will be under considerations and, of course, the tax form.  As Ken also alluded to, the paper also serves just as something of self-interest.  The paper serves as a road map or a guide for some important next steps in model development not only for treasury but really any policy shop that is working on dynamic analysis. 

I would like to focus my comments on a few points.  One, I just want to summarize kind of the key insights that I see in the paper, talk a little bit about some of the broader application of the paper.  I think the paper is not really a paper so much about the corporate income tax; it is a paper on the tax on capital income and, again, talk about how the paper is relevant to the current tax policy debate and what is the application to tax reform.  A key insight in the paper, that taxes on capital income can be viewed as a tax on intermediate inputs - this is not a new result but it is a result that the paper starts with.  When viewed from the perspective of consumption tax, taxes on intermediate inputs explode over time.  This is simply no different than the tax cascading that occurs in sales, state sales taxes that include intermediate inputs in the tax base or the cascading that occurred in turnover taxes that preceded the European value-added taxes. 

The paper also makes the insight that in the world with imperfect competition, risks and innovation, the economic burden of capital income tax is much larger than perhaps we thought.  And why is this?  Just want to focus on one of the vignettes, consider the case of imperfect competition, where firms exercise market power and earn monopoly rents, the higher prices consumers pay when firms exercise market power and earn monopoly rents can simply be viewed as an additional tax.  Since the dead-weight loss of the taxes related to the square of the tax rate, the world with imperfect competition means that that the distorting effects of the tax on capital income is even greater than under a model with perfect competition that we specifically think about.  How was the paper broader than just the corporate income tax?  Well, the title of the paper, “Corporate Income Taxes in a Modern Economy,” I kind of view as overly modest. 

The paper is really about all capital income taxes, and I think has much broader application.  We have the double tax in corporate profits in the form of the investor level taxes on capital gains and dividends.  Then, of course, we have the state tax, which can be viewed as a third layer of tax and capital income in many instances.  And the paper broadly suggest that the distorting fact of all of these taxes and capital income may be, well, may be larger than generally thought.  But there are features of the corporate income tax in particular that bear special attention and are addressed in the paper.  The diversification of risk through investment in the corporate form is an important characteristic of financing that is dealt within the paper.  The corporate tax serves as a penalty on the spreading of such risk, such investment risks.  More of the liability protection from the corporate form is now more widely available to LLCs [indiscernible] corporations. 

How is the paper relevant to the policy choices currently being debated in the beltway?  Well, as I have already mentioned, Congress has just extended the lower tax rate on dividends in capital gains.  Some of the distortions, like Ken mentioned, with respect to the corporate tax could also be viewed from the perspective of, it is not so much the corporate tax but is actually the double tax on corporate profits that is driving some of the distortions concerning financing, some of the distortions concerning allocated efficiencies between the corporate and non-corporate sector. 

The paper suggests that the benefit of the lower tax rates on dividends and capital gains may be larger than we generally thought and it also, simply because the models that we typically use to consider this had not included perfect competition, risk, and invasion.  Also, it has been reported in the past that the state tax may well be taken up in the near future.  Again, the research suggests that benefits to repeal the state tax and capital formation and economic growth may be larger than a conventional analysis may suggest, simply because a state tax can be viewed as a tax and capital income and as such, a tax in intermediate inputs and quite distortionary. 

And just something I was thinking as Ken was concluding his remarks, one of the perspectives of the life cycle of a firm, where you view a small firm starting in a non-corporate form that happens to succeed grows, acts as additional capital through the equity markets by moving into the corporate form, grows in size, is in a sense penalized for its success by being subject to corporate level tax and the double tax on corporate profits paid out as dividends and gains.  The investors of that successful firm may yet again be penalized when their states that they rise above the level of exemption are yet again taxed.  So it is really not just the corporate level tax that serves as a penalty but it is also the state tax that serves as a penalty on success.  So that is another way in which the paper can really be viewed from a broader perspective. 

What does the paper imply for tax reform?  Well, consider our current income tax.  As we all know, the current income tax is not an income tax at all but a hybrid tax system with elements of both income and consumption taxation.  In fact, roughly about 35 percent of household financial assets receive consumption tax treatment under our so-called current income tax.  This paper suggests that taxing capital income less lightly will produce economic benefits and these benefits, again, may well be larger than we typically thought into the models, not perhaps incorporating features of the importance of imperfect competition, innovation, and risk. 

Of course, it is important to point out when reforming our tax system, there are, of course, other objectives other than economic growth, as the President laid out in the executive order creating the tax panel, but also the objectives of simplicity and fairness.  And I would actually be very interested in other views on how this research, what this research might suggest for government policy shops examining the distributional effects of capital income taxes, a point that Glenn mentioned in his opening remarks.  I think that would be very interesting to get Ken’s insights on that subject. 

And again, the economic gains by dynamic models who use this, the joint committee at CBO and that we are starting to use a treasury, really do need to capture some of these reforms.  So I [indiscernible] these models are being used in the tax reform debate, I think this research is very important.  What does this paper say about some of the choices that we face in considering how to reform our tax systems?  Let's say the choice that maybe an interest in terms of enhancing or encouraging economic growth to reduce the tax in capital income, but there are choices in how we go about that. 

Glenn had mentioned in his opening remarks, for example, that corporate tax revenues has a percentage of… I guess GDP are somewhat lower here, but our statutory rates are fairly high and that may well be suggestive of some distortion or effects associated with the corporate income tax in the US.  It may also be associated with differences in the tax base.  Perhaps, we have some accelerated depreciation that is not available to [indiscernible] and extent by our major trading partners.  So one question I would have, and this is a discussion that has been out there in the tax reform debate, the trade-off between lowering rates and providing additional investments and send those through expensing.  I'm kind of curious what the author might suggest, what this research tells us about in terms of the choice between lowering tax rates and providing expensing for a new investment; two very different approaches for lowering the tax on capital and lowering the tax in the corporate sector.

 The paper suggests an optimal tax framework.  In its suggestion of an optimal tax framework, it might be appropriate to subsidize, and my reading was some might be appropriate to subsidize some forms of capital investment over others.  You mentioned the R&D credit.  Perhaps, we would want to subsidize those who are more closely associated within perfect competition.  So what does this imply for our current system, which allows expensing for most investment and intangibles, but applies the less generous tax appreciation system for investment and physical capital?  Does the paper provide a framework for rationalizing this different treatment? 

Also, as I mentioned, the R&D [sounds like] credit, the paper argues that a capital subsidy designed to offset the effects of imperfect competition, whereas focus on innovation might be efficiency-enhancing.  The tax could already include in R&D credit, albeit currently elapsed to subsidize a specific set of R&D activities.  But I would just point out for someone who works in a policy arena, from a practical perspective and to what extent do we really have enough information to realistically try to develop a set of optimal tax subsidies for investment that is broadly applied?  The R&D credit is something that appears to have a fair amount of success.  It certainly has its problems, and those sorts of things like problems from a tax administration point of view, let's say in terms of definition, which is how do you define R & E?  How do you draw the lines, the various lines that need to be drawn?  How do you update the base period?  Those are all issues. 

But I think we do need to be wary of a system that has a broad system of many different tax subsidies, kind of following in the [indiscernible] of an optimal tax strategy.  I think that such a system could be the subject of a potential manipulation by the very interest that always attempt to influence and shape the tax code.  That is something I think we need to be careful about.  I think, generally speaking, a more uniform tax treatment that recognizes the economic benefit of lower taxes on capital income where the economic waste from high levels of tax and capital income, there might be a very appropriate approach.

R. Glenn Hubbard:  Okay.  Thanks Bob.  Tom?

Thomas A. Barthold:  Thank you, Glenn.  Let me just say, by the way the introduction on speaking on my own behalf and I'm not representing views of the staff, the joint committee on taxation or any member of Congress.  Unfortunately, I would prefer to be going out alphabetical order because if you read the same paper, you quite often would come up with some of the same comments, and it does appear that Bob and I read the same paper, which is probably a good thing.  So, perhaps, for some of you who did not have an opportunity to read the paper, I'll cast a few of my comments in terms of the broad themes.  And again somewhat like Bob, what is says in terms of the policy prescriptions that you might draw from what Professor Judd with [indiscernible] say general stylized sort of models that do not get into some of the practical aspects that Bob was just starting to suggest might present themselves. 

There are two broad themes to the paper - tax on capital income is bad and tax on corporate capital income is really, really, really bad.  I think that is a fair summary of Professor Judd’s paper.  With regards to the paper - why is the tax on corporate capital income really, really, really bad?  And he lays out, I think, really four basic reasons, one of which is well and long known, and that is productive inefficiency.   Distortion is bad, this is the Harberger result - taxing income from capital investor in one sector and not or differentially taxing it in other sectors leads to productive inefficiency.  Although he identifies and discusses and gives some numerical examples of the potential magnitude of other sources of inefficiency, they probably all are best referred to as productive inefficiency.  But since there are some different themes, let me put some different labels to them.  He discusses risk-bearing and investment and entrepreneurship.  So you might call this a risk inefficiency.  That is sort of a second level of inefficiency that Professor Judd’s paper identifies. 

Then there is monopolistic behavior [indiscernible] market power.  This is really a case of doubling up on distortions.  Does the differential tax then make an existing distortion bigger and how much bigger? 

And then lastly, he talks about innovation.  It is really an issue of inefficiency in promoting growth.  So you might call it growth inefficiency.  And the way this paper addresses that is really to model the innovation effect through looking at potential monopoly games to investors that innovation can create, and I'll come back to that in a second or a couple of minutes. 

What prescriptions would you draw off from the paper and, essentially, does the paper suggest?  Well, one is, number one, eliminate the corporate income tax.  But I think without actually saying it the papers suggests, well, that might not be realistic or at least realistic in the short run.  So if you cannot eliminate corporate income tax, how could you reduce distortions within the tax system that maintain some sort of corporate income tax?  And here, the paper emphasizes really a long-held belief by many tax reformers, to think ahead to tax reform potential, and that is that lower marginal rates are always better than higher marginal rates. 

But what the particular point that the paper emphasizes is that variance ineffective marginal tax rates are bad.  So that leads to sort of a sub-prescription, lower rates or reduced variance?  Well, the reducing variance is actually very easy in the stylistic model of the paper.  I think it is in the second or third section.  The examples presented where we have… I guess it is three different types of capital that are going to be subject to tax. 

One is at the rate tau, the other is at the rate tau plus eta [sounds like], and then tau minus eta and say, “Wow, look at how that variance and rate magnifies the underlying distortion that you get from the straight Harberger-type analysis.”  So if you took all those etas to zero or closer to zero, you get a substantial improvement.  Now that is really easy to accomplish in that stylized model.  You look at those rates, the tau, the tau plus eta, the tau minus eta, make the eta smaller, you are there. 

In terms of the existing corporate income tax or reforming the existing corporate income tax, it is probably a lot more difficult when people, such as Drew Lyon in the old days in some of his work calculated effective marginal tax rates on investment.  And again, remember, the essence of this analysis is that we are looking at the corporate income tax as a tax imposed on the return to equity capital in corporate form, we found a wide variety, a wide variance of effective marginal tax rates and a lot of the report of work and literature.  What leads to that?  Part of it can be the leverage employed and the fact that we permit interest deductions. 

Another very important part is what is the statutorily permitted capital cost recovery compared to economic appreciation?  Well, it is really tough to figure out what economic appreciation is on sort of a real time basis.  We are fairly convinced I think, all professional economists I think are convinced we got it wrong, at least in terms at least of what is in the law, but how wrong?  And so, is it easy to eliminate that variant?  I'm not sure of it is.  [Indiscernible] not having a good answer to that question, I would say then the prescription offered done by the paper would say fall back on low rates - so low rates is going to collapse some of the variants to begin with and get some of the same improvement. 

An interesting thing to think about, I think in that respect is, if you say, “Well, variance in effective marginal rates is bad,” is what do we think of the American Job Creations Act of 2004, which took the corporate income tax essentially, I mean took all [sounds like] tax, but took the corporate income tax and said, “Well, if you do certain sorts of activities called a qualified domestic production activities, that will give a lower effective rate to those activities and not to other activities?”  So I do not think it can plug easily into Professor Judd’s stylized model.  But an interesting question would be we have lowered some of the rates, but we have increased the variants.  So, on net, was that welfare improving or not? 

Another aspect that was emphasized, I mentioned the risk-bearing and entrepreneurship, I'll just very briefly make a couple of remarks here.  Again, the prescription would seem to be low rates.  Part of the problems identified in terms of leading to distortion and risk-bearing and entrepreneurship arise from the asymmetric treatment as characterized by the heads, the government wins; tails, the individual loses.  Of course, we recognize that some of the reasons for the asymmetric treatment are to protect the fisc, the revenue function of the government.  It can be, in fact, quite hard to catch up with fraud in these reported things. 

A number of years ago, this is not in a corporate tax area, but well documented in excise taxation for fuels tax.  It was quite simple to set up a corporation who was supposed to be the taxpayer for motor fuels, and you could claim refunds for some of the fuel’s credits or the like.  But the person who is supposed to pay the tax sometimes would not.  And when you go look for that person, there was a daisy chain of corporations, post-office boxes, and you do not know that the taxes are paid until the money is not received and then you go out and try and find the money.  You try and find the person who is responsible and you are chasing something that does not exist.  And so an important consideration to think of in this context is that, again, the asymmetric treatment is protecting the fisc. 

And so, again, I think that would say that the prescription being offered by the paper here will then be, that low rates would moderate the effect of any asymmetry.  Monopolistic competition or [indiscernible].  Again, this is sort of interesting, I think very interesting within the paper, in part because while the prescription would again be that low rates would be good, here, variants can be good because the variants can offset some of the distorting effects of monopolistic competition.  So there is sort of an interesting trade-off to examine when we look at the idea broached of reduced variance to improve risk-spreading and general productive insufficiency, but then, perhaps, create variants to offset the effective monopolistic competition. 

In the real world, as I think as Bob was pointing out, this could put a lot of pressure on deciding, okay, well, how much monopoly power has this guy got as opposed to that person?  And again, it might be interesting to ask in the Professor’s stylized model in this context, what again do you think of the American Jobs Creation Act of 2004, particularly the rationale behind that act?  Since I'm running out of time, I will not give the history of that.  We will let Glenn do that in question time. 

Let me give a couple of remarks about innovation I noted as did Bob.  This is really sort of an interesting area that the paper suggests for developed… again, the general prescription would be if you have to have a corporate income tax, that low rates would be good.  It also suggests that in a couple of his… he set some examples that he ran that are very robust, that the research and development credits are very good.  Now the way that this comes about is R&D creates some intangible that can be exploited to monopolistic effect, leads to distortion between price and marginal cost. 

But as Bob suggested, gee, there are a lot of things.  It does not have to be a patented widget that gives you that monopoly power in the marketplace and that innovation, that growth that you want to see for about a century.  Coca-Cola has been spending money like crazy creating a brand name, which is considered one of the biggest brands in the entire world and a very effective brand name.  Since that can is… I do not know if anybody is here from soft drink industry, but basically it is filled with water, right?  Water and some sugar, high fructose corn syrup, and yet they charge a lot relative to what you think the marginal cost of water and sweetener would be.  So prices greater than marginal cost, and we know how that brands develop, it is by brand name advertising, so that the analysis that suggests that the stylized model of the paper say that we should also credit spending on brand name advertising, it would seem to be the case.  I'm not sure if we want to carry that or not. 

Another thing I was thinking, which I thought was sort of interesting in some respect and just pick on another big national and international brand, they say in the old saw [??] in retailing is that the three most important things in retailing are location, location, location.  I have read a couple of papers that have suggested that part of McDonalds’ dominance, besides a nice brand name for which we will give them a credit for spending on brand name advertising in the stylized model, is that they have been very effective in picking locations and actually using locations to foreclose entry by other competitors.  So what the stylized model also suggests is that there should be an equivalent credit given for spending on rents to create the local monopolies, which is sort of a guts [sounds like] of one-year-old textbook monopolistic competition models. 

Now to return actually to a little theme of Bob’s, and then I'll close since I have eaten up more than the required time, it is in thinking about the research credit.  Again, there are difficulties in going from sort of stylized model to actual application as Bob handed.  In the paper, the paper says,  “Well, think of spending being proportional to m2 or m2 is the percentage in cost reduction that we are able to achieve.”  And so, it is really easy in the model to target a credit against this proportionality factor K that is multiplied by m2 and this cost [indiscernible].  That can be pretty tough to figure out what the K times m2 is and would we make the same claim about the gains of productive efficiency if we do not get it right with the underlying thought that variance in tax rates is generally a bad thing. 

As an example, some people have suggested to me that the following would qualify under Section 41, the research credit, which is currently expired but under that framework.  Consider a farmer, a dairy farmer up in Vermont and he is going to run a herd of 200 dairy cows and he is wondering, well, if I vary the feed and I have brand A, and then I have another brand, brand B, it is different.  And if I do some other things in terms of when it is administered, when I milk them, how I heat or do not heat the dairy barns, I take my 200 head and I have 101 barn, and I set up the other 100 in the other barn and I run this experiment to see which gives me better milk output.  Some people, in fact, I think a couple of them are sitting out in the audience, has suggested that all the expenses for the labor, the feed, purchase of the cows would be eligible for the current research credit. 

I do not think that is the notion in the stylized model that Professor Judd has in line when he is talking K times m2.  I think he has got a concept of sort of the incremental expense in terms of the research, and I'm really not quite sure how to break that out in the dairy example.  But let me again, as Bob had said, very interesting paper and outlines and number of interesting points to think about in terms of taxation of capital income, and in particular, in terms of thinking of how tax applies to incorporate capital income.

R. Glenn Hubbard:  Thanks, Tom.  Before we take questions, can you have a brief response perhaps to the discussants or would you prefer…?

Kenneth Judd:  Well, yes, I think in order to keep the backlog from growing too much out.  I'll reply to some of the main points.  On distribution, I stayed away from distribution and distribution of concerns in this paper [indiscernible] that takes you down another road.  I have looked at distribution of concerns in the case of the ITC, for example, and what I found there is that the investment tax credit, suppose you had capitalism workers survey a very clean but stark division of society. 

And what I found is that, for example, the investment tax credit would often be pareto improving even if the workers had to pay for the ITC themselves.  And the reason was that capitalists benefit obviously from the ITC because it reduces their cost of building up their businesses, but also workers benefit from the ITC because it increases the capital liberation and increases wages productivity and they benefit.  So what I found in that case is that if you look at reducing rates, that is reducing the corporate tax rate, reducing the personal tax rate on capital versus something like the ITC, the ITC will have much less severe of any distributional problems.  Whereas reducing rates are going to… there you are going to have a real big distributional problem because when you reduce the rate on capital income, reduce the corporate income tax rate, reduce the capital gains tax rate, there is a benefit in terms of future [indiscernible] future investment, but there is this windfall loss of revenue and gain to the owners of capital that make the distributional consequences less palatable or less likely to be pareto improving. 

So now, taking that logic towards the R&D tax credit, since it is focused on increasing a particular kind of investment and it is not going to generate windfall gains to as much for existing owners of capital or businesses, then I suspect that the distributional concerns are very much less for things like the R&D tax credit or investment tax credits or whatever than for general rate cuts.  So now, I sort of get a question of how do I feel about general rate cuts versus these other tools, and that is where the distributional concerns become very important when you make those comparisons. 

In the paper, I put in this little exercise about the optimal tax rate on capital.  And, of course there, the result is that the more market power a firm has, the more the subsidy should be.  That is not to advocate that the treasury department should go out and measure price cost margins and give proportional subsidy.  The incentives are odd. 

It is also a case with depreciation.  It is like you go to a firm and you ask, “Okay, you have this machine.  How long is it going to last?”  “Oh, it is going to fall apart in a year.”  Therefore, it should be completely expensed.  No, of course no one is going to tell customers that the machines are going to fall apart in a year.  But on depreciation, we seem to avoid…  I'm sure there are still problems, but the Treasury department has professionals that try to evaluate exactly what the economic life is of various classes of equipment. 

Now, I do not think that is a sensible way to proceed for mark-up, trying to go out and say, “Okay, Intel has 100 percent markup on its chips and Microsoft has 200 percent markup on its software versus the marginal cost of shipping a box with Windows.”  Now, that kind of thing is no way would I navigate that.  That is completely impractical.  The point here is this and this gets back to the mean variants, also intuition:  It is nice to have this view of what an ideal tax system looks like because it tells you how far away you are from this ideal even if it is impractical to enforce and also gives you some idea as to what direction to move. 

So in terms of rates, what you want to do is move towards the ideal.  And the way to think about the variance example is that you do not want to have extra variance around an ideal.  So that is where variance is bad.  If the ideal thing is to tax everything equally, you do not want to have variance around that.  But if a tax rate on everything is up here but then the optimal one on each piece is down here, well then move towards the optimum for some of them may increase variance, but it is also making things better because you are moving towards the optimum.  So that is whether this business about mean in variance comes into play.  And so for the IND tax credit, for example, trying to calibrate the exact optimum R&D tax credit for various industries, that is not possible. 

And so my approach to all of these things is to look at a wide range of parameter values throughout the critical elasticity and cost of R&D and see if there is some minimal level of R&D tax credit that is good in all cases.  And that may sound impossible to find but typically in these kinds of models, I'm able to look at a wide variation of examples and come up and pay to say that at least the five percent R&D tax credit or something is good for everybody, and so we do not have to get into the business of fine-tuning for exactly what the R&D production function is.  So that is sort of my approach about this. 

I completely agree we are trying to fine-tune the tax system to the exact amount of market power in a different sector and the R&D tax production [indiscernible].  That is impossible and we will completely be [indiscernible] by special [audio cuts off].

R. Glenn Hubbard:  I think we have time for a couple of questions and then let Ken, if you want to call on people as you see fit, have questions for Ken or anyone on the panel.

Steven:  Steven [indiscernible].  You mentioned the distributional consequences in lowering the corporate tax.  We are referring to the weight [sounds like], the joint tax committee and other measured distribution, court of the conventions, or are you suggesting that there would be, in fact, more of a tax increase on labor than their wages would go up if we were eliminated at the corporate tax?  [indiscernible name] had papers recently suggesting that getting rid of the taxing, a tax on capital with raised wages be enough to make it better for workers even if they had to pick up the tax.  So we are talking about the artificial way of measure, the burdens or the real or actual burdens, and is it the only things, like the ITC, that they will benefit labor in that?

Kenneth Judd:  Actually, about 20 years ago I had a paper, which showed a very general case, much more general than the [indiscernible] that we are talking about.  That if workers sat down and they wrote the tax code, then they would want to phase out all taxation of capital in the long run.  So in the long run, it is of note, even if they can tax the capital income and put it near [sounds like] pocket, the impact on wages is so great that, no, they do not want to do that.  So in the long run, this taxation of capital income in uniform, corporate or whatever is bad for everybody.  Now the exact details of what is in the tax community, I'm [indiscernible] too. 

Also, most of these distributional analyses are very static, and everything I'm talking about is dynamic.  I mean, if you do a static analysis of an ITC, it does not look good because all these money goes to these corporations, and in the short run, it is not going to have much impact on wages.  So everything I'm talking about is really a dynamic analysis, which often completely overturns the static analysis.  But again, this is just why we need to have to embrace a professional analysis, [indiscernible] division of dynamic analysis where we can talk about these issues dynamically, but also on sort of a nonpartisan, professional manner.  But everything I say, once you switch from static to dynamic, a lot of things get flipped. 

Also, by the way, I want to point out that in some sense, a flat tax on [indiscernible] that gets us, all right?  Because if you went to a flat tax for [indiscernible], for example, all existing depreciational credits are wiped out, so you do not have as big a windfall game to the owners of capital.  So that is a feature of all risks of flat tax that some do not like.  But it is a good feature from my point of view.

R. Glenn Hubbard:  We have time for another question if somebody has it?

Male Voice:  Actually, for all of you, but Bob in particular.  You mentioned proprietors and [indiscernible] in this analysis.  And of course, I mean, in effect, that is kind of a way out.  Have any of you looked at this particularly for innovation, et cetera, use of that form and whether we are already seeing this problem solved to some degree via that route?

Thomas Barthold:  Yes, that is exactly the point I was trying to make is that as LLCs, as an escort [??] become more widely available, there are more shareholders.  As corporations, there are more shareholders than perhaps 10 or 15 years ago.  They can access the capital markets more easily than it used to 10 or 15 years ago.  I think that kind of cuts any other directions to some extent.

Kenneth Judd:  Also, I would say that one reason why I did not… I mean your comments about all these criticisms could be extended to capital taxation in general are quite correct.  But in this paper, I did not want to get into these issues about how much is owned by pension funds, how much is outside the reach of the personal tax rates.  So, in that respect, the results are relatively conservative.  They are underestimates of the true effects when you add in these other features, and that is one reason I did not get into those kinds of issues. 

But you are absolutely right, that there is even more distortions that could be added into the analysis, such as state sales taxation of equipment and the personal taxation of capital income.  When you start adding all these things together, this form of taxation becomes … is clearly we are shooting ourselves in the foot.  I mean it is clear when you put these things together.

R. Glenn Hubbard:  I'm going to have to wind up to just keep roughly on schedule, and I will give a last word here if you would like?

Kenneth Judd:  Well, I think the discussions for the comments are quite on target and exactly the concerns are natural, and implementing these ideas in the fullest extent is impractical.  No question.  By the way, though my father being a dairy farmer would [indiscernible] like to have this R&D.  But what I think is clear from this analysis is that we can find steps in the right direction that do not require an enormous amount of detailed information about individual businesses or R&D, that the principles of productive efficiency are very strong, and that we can at least make some steps in the right direction without getting involved down in a lot of the serious… [indiscernible] [End of Panel I]

[Panel II - The (Compliance) Cost of Taxing Business]

R. Glenn Hubbard:  Okay, thank you very much Ken, Tom, and Bob.  We are going to move right on to the next panel, which takes up a different subject, that of compliance cost.  A lot of the popular interest in tax reform of all types has stemmed from people’s concern about simplicity, one of the features Bob Carroll raised in his remarks.  And any look at the actual cost of compliance centers pretty quickly on the biggest cost being in some elements in the corporate income tax. 

So Joel Slemrod will be presenting the paper today from the University of Michigan Business School.  Joel has done enormous amounts of work over many years in public economics, but, in particular, is one of the country’s leading experts on formally measuring compliance costs that he will talk about today, and also through the lens of how we should think about various tax reform proposals.  We have two discussants as well:  Rosanne Altshuler, who is a professor of economics at Rutgers, and most recently was one of the shepherds of the tax reform panel, and will bring that perspective.  And Mark Mazur is from the IRS, who is the director of research statistics and analysis, and a long-time thinker in this area. 

So Joel, whenever you are set up there, the floor is yours.

Joel P. Slemrod:  Well, thanks Glenn.  Thanks for inviting me.  It is a pleasure to be with this group.  I want to say a special hi to those people who are seeing me on the screen.  Makes me nostalgic for the old Tiger Stadium - we got some locals, I could tell – where if you got the wrong ticket, there were structurally necessary columns between you and the playing field.  We have a new ballpark, and that is no longer a problem.  Ken, in the first session, has been talking about one of the costs of the corporate income tax, which is a distortion of economic activity. 

Now for something completely different.  Another cost of the corporate income tax, actually of any tax at all, is the resource cost of collecting the taxes.  The resource cost has two components:  administrative cost, that is, the resources of the IRS and state tax authority, their budgets.  And the second aspect is the compliance cost, that is, the cost immediately borne by the taxpayers themselves and third parties in the tax collection process, by which I mean withholding agents.  And I think it is clear the big picture is that the research of the last two decades has convinced us that the compliance costs, in general, dominate the administrative costs, and for the income tax, on the order of 10 to 20 times as large. 

So my presentation today is about that aspect, the compliance cost of taxing business, and I’m going to adjust four aspects of business compliance costs.  First, their magnitude; second, the nature and determinants of these costs; third, the policy implications of business compliance costs; and four, the effect of various tax reforms on the magnitude, nature and determinants of compliance cost.  Those of you who have taken a peek will know that the paper I prepared for this conference contains … this is sort of like what Tom said about the corporate tax when he said it was really, really, really bad.  The paper contains much, much, much, much more detail about number two than I will talk about this morning.  And it also addresses the likely compliance cost of alternative tax systems, which I will touch on, but not discuss, in much detail today. 

First, the magnitude:  The paper has a table, which tries to summarize what I think we know about the compliance cost of the corporate income tax, in particular the federal corporation income tax.  How do we know these numbers?  Well, the answer is from asking corporations.  These are numbers based on surveys done over the last 15 years.  The first two rows are surveys done of, basically, the 1,300 largest companies in America, and the third row is about the second tier, which I’ll call medium-sized businesses, which are defined as approximately those firms that are smaller than the biggest 1,300, but have at least $5 million in assets. 

As I said, this table summarizes what we think we know about the magnitude.  For the biggest corporations, these top 1,300, per-firm compliance costs come to about slightly less than $2 million per firm.  All of these numbers are in 2005 dollars, so if you multiply those by the 1,300 in the group, the total compliance cost of the biggest companies is bigger than $2 billion a year.  One way to put these costs in perspective is to look at them as a fraction of the federal corporation income tax they pay, and that was done for the 1992 study, and the answer is about 2.7 percent of revenue.  And so one perspective is, since all taxes have administrative and compliance cost, one might want to think about the relative cost of raising money in one way versus another.  And it turns out that that 2.7 percent is actually almost certainly small relative to most other ways of raising revenue, and the bottom-line reason for that are the economies of scale from taxing big entities that already have sophisticated financial systems. 

The bottom row is about the medium-sized businesses, and there are a lot more than 1,300 of those, and they are very diverse.  If you look at the average per firm, it is about $100,000 per firm.  But, as I said, there are a lot more than them, so if you multiply that average by the number of firms in this sector, you get a total compliance cost of $23-24 billion, again, in 2005 dollars. 

So to compare the compliance cost of taxing this sector versus the compliance cost of taxing the biggest corporations, it would be nice if there were a percentage number in the lower right hand corner.  There is not, and I can tell you why.  If you just look at the ratio of these costs to the corporate tax paid by these groups, the answer would be in the low 20s.  Twenty percent of revenue is compliance cost, which is much, much higher than for the big companies, and probably twice as high as for the individual income tax.  But it is not listed here because it is a misleading number, because a lot of these companies are pass-through entities.  And so, to put in the denominator just the corporate income tax over-state what the ratio of compliance cost is to revenue.  So if you did that right, and I did not have access to the data to do it right, the answer would be less than 20 percent, but almost certainly more than 2.7 percent in the upper right hand corner.  So that is a brief overview of the magnitude of compliance costs. 

What about the nature and determinants of compliance costs?  These numbers all come from the surveys that I mentioned.  So here are some interesting facts about the compliance costs of corporation income tax.  About two-thirds, slightly less than two-thirds of these costs of corporations go for internal personnel costs.  That figure is a little bit higher for the biggest companies, compared to the medium-sized companies.  About a sixth of the cost is for internal costs, but for non-personnel expenses, such as computers and copy machines, software, et cetera.  The fraction of the compliance cost that is paid for outside assistance, so outside the tax department and outside the data gathering parts of the corporation, not in the tax department, is higher for medium-sized firms.  They are more heavily dependent on outside assistance, and for the big firms, approximately a quarter of these compliance costs for the medium-sized firms go to outside assistance versus a bit less than 20 percent for the biggest firms. 

About a quarter of the compliance costs of the big business is due to state tax requirements and 30 percent for medium-sized businesses.  This is a tough number to get right.  We just ask the companies straight out, but obviously a lot of the calculations that have to be done in order to comply with corporate income tax overlap for federal and the state government.  So one should not put too much faith in exactly what this number means.  One ubiquitous finding in this literature is the regressivity of compliance costs. 

Now, regressivity in this context means something different than what it usually means.  Usually regressivity is about a tax burden on individuals relative to their income or other measure of well-being, so regressivity in a tax system usually means that for higher income people, the fraction of their income that is a tax burden is lower for higher income people.  Here, regressivity means, for bigger businesses, the ratio of compliance cost to some measure of size is lower.  And that is a ubiquitous finding in the business compliance cost literature.  There are economies of scale relative to compliance cost, so costs are certainly higher for bigger businesses. 

But costs, as a fraction of size, whether size is measured by assets or employment or sales or whatever, are lower for big businesses.  To give you a sense of that magnitude, other things equal, a business that is one percent larger will have half a percent more in compliance cost.  So you can see that that means that the ratio of cost to size is falling by about half a percent for each percent increase in assets. 

Sector also matters.  An example of that is that these findings show consistently that, other things equal, businesses in the wholesale or retail trade sector have lower costs, and the mining and oil and gas sector have higher costs.  Not surprisingly, a larger number of active entities [indiscernible] associated with higher compliance costs.  Firms subject to the alternative minimum tax, other things equal, have significantly higher compliance cost.  I’m sure that is no surprise to the people in the business here.  Having ongoing litigation is associated with higher costs. 

And another clear finding is that foreign activity matters.  So, for the biggest companies, many of which, but not all of which, are substantially multinational, about 40 percent of the total compliance costs of federal taxes can be associated with their foreign source income, 40 percent.  Now if you compare that to how foreign they are, or were in this case, since this survey is a few years old, the 40 percent number is noticeably higher than their fraction of foreign activity, which was about 20 to 25 percent in this period.  So, although 20 to 25 percent of their foreign activity is foreign, about 40 percent of the compliance costs are associated with their foreign source activity.  If you try to calculate a ratio of compliance costs to tax collected from the attempt to tax foreign source income, you get a very, very big number.  But that also can be used in misleading ways, because one reason, arguably, that the US taxes worldwide income is not in order to raise revenue on that foreign source income but to protect the revenue base of the domestic income from income shifting and other possibilities.  So to calculate a ratio here is not straightforward. 

Okay, policy implications of compliance costs.  With some exceptions, but as a general rule, compliance costs represent costs to society, in the same way that to the extent that a tax system distorts activity, causes us to use our resources in an inefficient manner, that is a cost to society, so are compliance costs.  The same would be true of administrative costs, of course.  The personnel, the computers, the copiers, the paper clips that are used for tax compliance could be used more productively if compliance costs were lower. 

There are a few caveats that have to be made to this conclusion.  One is that these compliance cost estimates do not distinguish between involuntary costs that must be expended to comply with the law, and discretionary costs that are incurred to avoid taxes.  Let me be more straightforward about the latter components.  Some of these millions of dollars that big companies spend on tax matters are done completely voluntarily for tax planning and tax minimization purposes, to the extent that these tax planning lowers the company’s tax liability. 

And there is research that suggests that these investments actually produce a good rate of return, private rate of return, to the extent that… this is true the costs to society are larger than the net private costs incurred by the businesses.  So, just take the tax planning part of the Tax Department.  That might be a profit center.  It might be profitable for the company, but from society’s point of view, the tax savings to the company are just a transfer from all other taxpayers to that company, but the costs expended are a true resource cost. 

Who bears the burden of these compliance costs?  Well, compliance costs, by definition, are, in the first order, paid by the businesses.  But we economists know that that is not a satisfactory answer to this question of who bears the burden of the compliance cost.  In the same way, we know that just looking at which corporations remit corporation tax is not a satisfactory answer to who bears the burden of the corporation income tax.  We have already heard this morning claims that the corporation income tax burden is really borne by workers. 

The way we come to such conclusions is by thinking carefully about models of tax incidents, while we need to apply the same sort of reasoning to answer the question who bears the burden of the compliance costs of the tax system.  It is not a satisfactory answer, from an economics point of view, to say it is borne by the corporations.  We need to trace the incidents to individuals in their role as customers or shareholders, workers of the corporation, and the like. 

How would we do that?  Well, just as is true to tracing the incidents of corporation tax payments, the key to understanding the burden of the compliance cost is to understand what determines these compliance costs.  And I have already mentioned that these compliance costs depend on factors, such as size, sector, degree of multi-nationality of the corporate activities, to the extent that, say, for example, compliance costs are higher in one sector versus another, this is an inefficiency because it causes resources to move away from the high compliance cost sectors.  Whether, in fact, the sector bears a higher burden, or the individuals associated with that sector bear a high burden, depend on whether these costs mimic the true cost of enforcing taxes. 

So, the right way to think about this is, if it is true that, in fact, it is less costly to collect revenue from businesses in the retail and wholesale sector than it is from, say, the oil and gas sector, then both the incidence and efficiency consequences of this system are quite different.  The efficiency consequences may be benign if, in fact, it is more difficult to actually collect taxes from the oil and gas sector.  The compliance cost may then appropriately reflect the true cost of raising revenue from that sector. 

I mentioned that the paper talks more about the effect of tax reform on compliance cost, and I will have time to go through today.  So, let me just talk about, briefly, what I think about these questions.  First of all, on these surveys, we have asked representatives of the businesses to assess what they think would be those changes in the tax system, which would provide the biggest savings in compliance cost.  Based on these survey responses, the number one answer we get that comes to the highest estimate of compliance cost savings would be to conform the tax and financial statement definition of income.

 Now, on that basis, I’m not here to advocate doing such, but I thought you might be interested to know what businesses themselves say with [indiscernible] to the biggest compliance cost savings.  The second biggest cost saving they mentioned is to establish complete uniformity among state rules for taxing corporate income, and establishing uniformity between the state rules and the federal government rules.  If you ask these businesses what they think about the potential compliance cost savings are of the sorts of fundamental tax reforms that we have been talking about for a couple of decades.  In this room and other places in this city and in the country, we find that the respondents expressed considerable skepticism about whether fundamental tax reform would deliver considerable, or even positive, savings in compliance costs. 

And, by fundamental tax reform, now I have in mind something like a value-added tax or a Hall-Rabushka flat tax.  And the most often mentioned concern has to do with the transition period, that in the transition, the system would get that much more complex.  Now, of course, it depends on how the transition is handled.  I can imagine cold-turkey transitions, where the cost would not be that great.  I can also imagine very, very, very ugly transition periods, for which the compliance costs would be high. 

Another interesting thing you learn when reading the answers to these sorts of questions on the survey is that sometimes people who are filling out the survey have difficulty distinguishing between the implications for compliance cost and the implications for the bottom-line tax payments of the corporation.  And some people certainly have a visceral understanding that some of these changes would vastly increase the tax liability of their particular corporations.  And again, economists know that there is a very big difference between how a particular tax reform would affect the amount of dollars the company has to remit to the IRS, and its implications for the ultimate bottom line of the corporation. 

Now, based on other information and other analyses, including experience in other countries, either a value-added tax or a flat tax could, in principle, provide substantial reductions in compliance cost.  But, from actual experience, we know that value-added taxes, in practice, do not generate noticeably lower cost to revenue ratios than the income taxes the same countries levy.  For example, if you look at what is known about the UK, their estimated cost-to-revenue ratio of their value-added tax is in the same ballpark as the cost-to-revenue ratio of their income tax.  Other types of consumption taxes such as the retail sales tax or a personal consumption tax have daunting administrative and compliance problems that I do not have time to go into today. 

So, having received the zero time notice from Glenn, it is lucky that I’m on my conclusions.  Compliance costs certainly represent resources that, under other circumstances, in particular, a simpler tax system, could have been used to add to the productive capacity of the country.  There is often, maybe almost always, but not always, a trade-off that must be made between these and other goals, and the simplicity as measured by the compliance costs.  But not always.  There are certainly ways to make a tax system simpler and lower compliance cost without endangering the other objectives of the tax system.  We know that the simplest tax system is not necessarily the best.  But neither is all of the complexity in the current system necessarily serving a useful purpose.  All taxes have compliance costs. 

I want to close, really close, by saying that…  I’ll give you some food for thought.  There has been some debate recently about whether the IRS should delegate to private collection agencies some of the duties that the IRS has been handling now.  I want to put that discussion in a larger context, and say that in a very important sense, the US tax system is already largely privatized.  Why?  Because businesses remit over 80 percent of taxes at all levels, including their withholding payments, and they are central to the backbone of the enforcement mechanism of the US tax system by providing the tax authorities with information reports.  The compliance costs dwarf the administrative costs, and certainly tax policy needs to address these costs even if they do not show up in government budgets.

R. Glenn Hubbard:  Great.  Thank you, Joel.  Our first discussant is Rosanne Altshuler.

Rosanne Altshuler:  Thank you.  And thank you, Glenn, for inviting me to participate in this conference.  I always like talking about corporate tax, business taxation, and it is always incredible how many people show up for something like this.  I always enjoy reading and thinking about Joel’s work.  He is a real pioneer in the area of tax compliance, and he has done a very comprehensive review in this paper.  If anything, it is too comprehensive, in the sense that there is almost too much information, especially pertaining to the evidence from survey studies, to synthesize and digest.  It really is overwhelming, but very useful. 

What do I want to do in my comments?  First, I want to quickly summarize what I think some of the important take-away points are from Joel’s paper.  And my focus is going to be on how the evidence in the paper can be used to provide guidance of reform of the current system of taxing business.  And I also want to provide some background on the sources of compliance cost in our current code.  And I think it makes sense to add this material to Joel’s talk and to our session. 

An important source, and maybe the main source of business compliance cost, is complexity.  I think we all know that, and I think the right approach is to try to understand where the complexity comes from.  And the surveys are helpful here.  And then once we understand where the complexity comes from, try to work out the benefits and costs of simplification.  This is an exercise that the President’s Advisory Panel on Federal Tax Reform engaged in.  And, as a result, I think the panel put forward some innovative and promising ideas to simplify business and individual taxation, and, as a result, lower compliance costs. 

I want to briefly hit on a few of the panel recommendations for business and where they came from.  I, of course, would have liked to see even more analysis of the recommendations in Joel’s paper, but I very much appreciate the discussion that he included.  Joel has reminded us today, and also through his work on compliance over the years, that there are trade-offs to simplicity.  In his presentation to the President’s panel, he stressed, and again today, nothing simplifies the tax system without also affecting equity and efficiency.  Joel already discussed this, but I want to repeat it. 

A side question that we need to ask is whether simplicity must involve a trade-off with efficiency.  Must we pick one over the other?  And I think that, in many cases, especially, I found, in business tax, in business compliance, they are complements.  I found more in my work on the panel that there were trade-offs between simplicity and efficiency on the individual side, more so than business.  So this is a good thing.  And, although it is probably beyond the scope of the paper, I would have liked to have seen more discussion of this issue in the paper, and maybe we can discuss this in the question and answer session. 

I also want to stress how little we know, and I think Joel’s paper brings this out, how little we know about comparative compliance, and how important this is for a reform.  In particular, this was a real problem when it came to evaluating an add-on VAT on the panel.  There was concern that adding a European VAT to the current system would impose a very big burden on business, and maybe it would.  But we did not really have good information on how large that burden would be.  What percentage of large corporations are already dealing with the VAT?  I mean, I think they all are.  We are the only country, well, over 135 countries have a VAT and I defy you to name more than 135 countries.  We are the only OACD country that does not. 

So how burdensome would it be to apply that same tax to US cash flows of these businesses?  I do not know.  What about small businesses?  How similar is the burden to the retail sales tax they are already paying?  How does the extra burden of an add-on VAT compare with the benefits of radically lower rates on individual and business income that adding a VAT would allow us to have?  These are all unanswered questions that, I think, we need more work on, and Joel should get busy on this.  I think Joel’s paper fairly clearly, and maybe this is unfair, but fairly clearly says that there is a lot more to be done on this, quote-unquote, comparative tax reform. 

A big open question is, how does a consumption tax compare to an income tax, in terms of compliance costs?  So, what are the takeaways from Joel’s paper?  Just really quickly, federal tax code is a major source of compliance burden.  What does that tell us?  I’m not sure.  Should we be looking at these dates for guidance?  I do not know.  Compliance costs have increased in the 1990s.  Why?  I mean I can guess but again, I’d like to know a little bit more.  A significant portion of total compliance cost of federal taxes is due to the taxing of foreign source income.  In a sense, this tells us that we should be focusing in on international, which is something that we did on the panel.  If we could simplify the treatment of cross-border income, this would have an outsized impact on overall compliance costs because they have… multi-nationality has an outsized impact on compliance costs. 

Tax planning is an important component of compliance burden.  I think that is really important.  Where does tax planning come from?  What features of the tax code induce tax planning?  Cleaning the tax code of features that lend themselves to tax planning could significantly lower compliance costs for larger firms and for medium-sized firms.  As far as incremental reforms are concerned, one takeaway that I got from the paper is the corporate AMT.  That is easy, it has just got to go.  In terms of compliance, and I think that is another one where efficiency would probably be improved. 

As Joel already said, large businesses are skeptical about reform.  One of the things that lead to the skepticism is the uncertainty about what is going to happen to international transactions and financial operations.  This uncertainty is one of the uncertainties that make it difficult to do comparative tax compliance analysis.  If we want to compare a consumption tax to an income tax, we have to know how that consumption tax is going to work.  We gave some guidance and some outlines in the panel report about how are growth and investment tax that get with work.  But we did not give all the details, and without the details, you really cannot say anything about compliance costs. 

Again, Joel divided his paper into large businesses, medium-sized businesses, and small businesses.  I was very interested to see that tax planning is also important for medium-sized businesses, so, again, that suggests to me that we need to think seriously about the features in the tax code that lead to tax planning.  And, again, the federal tax code is a major source of compliance spending.  The sources of complexity, a high percentage of the medium-sized businesses cited depreciation rules, and this was an area that we tackled, thanks to the Treasury Department, guidance from the Treasury Department, I think.  There is simplification to be done on depreciation, and the Treasury has ideas that we used in our report. 

Next, comes the AMT.  R&D credit rules, interestingly enough, were a source of complexity that was written in.  Then, in terms of takeaways for small businesses, we do not know much. I think Joel did not even have a chance to talk about that.  So the questions that came to my mind from reading the paper are two big ones:  Can we do better?  And I think that the answer is yes. 

Doug Shackleford, an academic accountant at UNC, challenged the panel in his testimony in Tampa, before the panel.  And again, I’m going to return to tax planning.  He said an indication that tax reform succeeds will be a reduction in the need for tax planners.  And the key to reducing the need for tax accountants – sorry everyone, but I think you are safe – but the key to reducing the need for tax accountants and lawyers is the elimination of differences in tax rates.  Whenever you tax the same income differently, you provide an opportunity for a planner to reduce taxes, and this is a nice link to the session that we had this morning. 

We currently tax the same income differently at different times.  An example is the current repatriation holiday.  We tax the same income differently in different places, an example of the sourcing rules and in the international arena.  We tax the same income differently in different organizational forms, and we tax the same income differently if it is generated in different processes.  A recent example is the lower tax rates for domestic manufacturing.  And these types of differences provide tax planners with endless opportunities to shift wealth from the treasury to taxpayers for a fee, complicate the system and increase compliance cost.  So, again, I would like to see more kind of focus in this discussion on the sources of compliance cost. 

So you have to step back and say, with all of these different tax rates for the same type of income, are the benefits worth the costs?  So that is one big question that, I think, we need to talk about.  And the other big question where we really do not have the answers is, should we abandon the income tax?  What about cash flow tax?  Is it a better construct?  Is it a better construct for businesses?  Should we throw away the Hague-Simons accretion to wealth principle?  Again, we need a whole paper on this issue and we need, as I said before, to know about how international and financial transactions would be treated.  And this is why the surveys show such skepticism, is because we do not know. 

An important point that Joel makes is that, when we start talking about a cash flow tax, consumption taxes, whatever, you see a lot of taxes that we economists say are economically equivalent.  They are not equivalent from an administrative viewpoint. 

I guess I’m almost out of time.  Just to hit on what the panel recommended, just a couple of things.  The panel recommended leveling the playing field between different types of business entities.  All large business entities with receipts greater than $10 million would be taxed at the business level.  Both of the panel options would reduce the differences in the combined individual and corporate tax on dividends and the interest on corporate debt.  So the single rate business-level tax that would be paid by all large business entities, combined with the proposal in the report to eliminate the tax and domestic earnings of large business entities, would provide a more even treatment of financing and lower the tax burden on business investment.  We clean the tax base.  Special provisions are a major source of complexity that even comes through in the surveys.  Even the businesses cited the R&D credit as a source of compliance.  So both of the panel’s options would provide a broad tax place that is free of special breaks, targeted to specific individuals and business activities, and, as a result, there is just no reason for the corporate AMT. 

Finally, small business, we could do a whole session on this, greatly simplified record-keeping, expanding of expensing, simplified inventory accounting, and, even for medium and large businesses, there would be simplified depreciation.  So I enjoyed reading the paper.  I learned a lot from the surveys.  I think we need to look more carefully again at the sources of complexity.  Whether simplification can decrease tax-induced distortions and kind of give us a double dividend, I guess, more focus on cash flow taxation and the potential for simplification.  I walked away personally not so… it was not clear to me that what we were doing on cash flow taxation was going to be much simpler in the end and what about an add-on VAT?  What would be the compliance cost?  So thank you.

R. Glenn Hubbard:  Thank you, Rosanne.  Mark?

Mark Mazur:  Thanks, Glenn.  Before we get started, I just wanted to issue the usual disclaimers that are in line with Tom Barthold.  These are my views, not necessarily the views of the Internal Revenue Service nor the Treasury Department.  I also wanted to note that, with Joel on the projection screen down there on the side of the stage, I think it is appropriate because Joel, you really are like one of the rock stars of tax policy.  So it is good to see being treated, feted [sounds like] that way.  Okay. 

First