Transcript of Federal Bar Association Conference on the Tax Legislative Process Now Available

The transcript of the Federal Bar Association's 4th Invitational Biennial Conference on the Tax Legislative Process, held November 6 and 7 at the Airlie Conference Center, Airlie, Va., is now available.

Attendees at the conference included many prominent tax policy specialists, such as top congressional staffers, Treasury officials, and leading practitioners, most of whom have also spent time in the public sector.

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                       FEDERAL BAR ASSOCIATION

                      Airlie Conference Center

ATTENDANCE:

                              CONTENTS

AGENDA

Welcome and Overview of Conference Proceedings

Session One: Yesterday's Election: What Happens Now?

What Effect on the Tax Legislative Process?

Moderator: Catherine Porter

PROCEEDINGS

[4:55 p.m.]

[1] MR. ROSENTHAL: Welcome to the conference. We expect this to be a very exciting and illuminating conference.

[2] With me are the Planning Committee members, many of whom you will recognize. In a little bit we will go around the room and introduce ourselves.

[3] Let me give you a few ground rules. Some of you have been to our conference in years past and will appreciate the ground rules. For others the conference procedures are new. In the red book before each of you there is a table of contents, an agenda, propositions for discussion for each of the different sessions, and some background material on some recent rules changes.

[4] With respect to the propositions, we have some formal rules. The making of a proposition does not indicate support for it by the Federal Bar Association or any conferee. So please take that under advisement when you read any particularly stimulating proposition.

[5] We have a moderator for each of the different sessions. The moderator's job is not to give any presentations or to provide any opening comments, but simply to facilitate discussion by the conferees and to keep the discussion moving.

[6] In that regard, to be recognized to speak, we ask that you raise your hand. The moderator will note who has asked to be recognized and will try to follow the order. But there will some jumping around to make sure the discussion flows. The moderator's job will be to try to steer the discussion in a fashion that keeps it moving. Moving where? We are not quite sure. We will find out in the next day and a half.

[7] Transcript of proceedings. We have a transcript being made. Two years ago we had a recording for a transcript that we had hoped to publish. For those of you who wondered what happened to that transcript, it turned out that we are not as good recorders as we are tax lawyers. Consequently, we didn't get anything of much use out of that recording. This year we are fortunate to have the official recorder for the U.S. Tax Court. So we should have a very good transcript.

[8] We plan to publish a transcript so that these proceedings can be viewed more generally by those interested in tax developments. We have a lot of people with very interesting and informative ideas, and we hope to bring those out to the tax community generally. The plan here, for those who are interested, is that this transcript is expected to be turned around in the next two weeks or so. The participants here will have an opportunity to see their remarks and edit them. Edit, but not revamp them. We want to keep the substance the same. For those of you who stammer a lot and use lots of aahs and such, you will have a chance to get rid of those.

[9] We will send the transcripts out and people will return pages for which they participated in parts of discussion and we will put them together. We are hopeful that we can publish this in a publication such as Tax Notes.

[10] Those are our ground rules.

[11] Catherine is going to moderate the first panel. Before we get going, I would like to go around the room with introductions, your name and where you are from. We have a lot of current and former government officials, and it might be helpful to know where they are.

[12] My name is Steve Rosenthal. I'm with KPMG Peat Marwick in Washington. I was at one time a legislation counsel at the Joint Tax Committee, for about six years.

[13] MS. McCLANAHAN: Patti McClanahan, Senate Finance Democratic Committee.

[14] MR. THOMSON: Mike Thomson, Treasury Department.

[15] MR. FERGUSON: Brad Ferguson. I'm a lawyer in Chicago. Years ago I was at the Treasury Department.

[16] MR. TODER: Eric Toder, Treasury Department.

[17] MR. MAZUR: Mark Mazur, National Economic Council.

[18] MR. RICHTER: Norm Richter. I'm right now director of tax planning for a conglomerate in Rhode Island. Before that I was at the Treasury with Glen Kohl and Les Samuels and a lot of people around here, for two years, and before that in the Finance Committee with Jim Gould, for six.

[19] MR. GOULD: I was in the Finance Committee with Norm Richter several years ago. I'm now with Hooper Hooper Owen & me.

[20] [Laughter.]

[21] MR. WEINBERGER: I'm Mark Weinberger. I'm with a small law firm in Washington called Washington Counsel. I used to work for Jack Danforth on the Senate Finance Committee and then I went to work for the Entitlement Tax Reform Commission.

[22] MR. MURRAY: I'm Fred Murray. I am over at the National Foreign Trade Council as their VP for tax policy, and I used to be a legislative counsel over at the IRS.

[23] MR. GIBBS: I'm Larry Gibbs. I'm with Miller & Chevalier in Washington, D.C., and was formerly Commissioner of Internal Revenue.

[24] MR. ALEXANDER: My name is Don Alexander. I'm with Akin Gump. Many years ago I was with the Internal Revenue Service.

[25] MR. KIES: I'm Ken Kies. I guess I'm still with the Joint Committee. My wife is not enthused.

[26] [Laughter.]

[27] MR. WIESNER: Phil Wiesner of Peat Marwick. Many years ago I was with Treasury.

[28] MR. GUTMAN: I'm Hank Gutman with King & Spalding, years ago in the Treasury with Brad, Don, Phil and others, and then chief of staff of the Joint Committee.

[29] MR. TALISMAN: Jon Talisman. I'm with the Democratic staff of the Senate Finance Committee.

[30] MR. KOHL: Glen Kohl, now with the Treasury Department. My wife has more clout.

[31] [Laughter.]

[32] MR. KOHL: I will not be with Treasury shortly.

[33] MR. SAMUELS: Les Samuels with Cleary, Gottlieb, Steen & Hamilton. My wife is enthused.

[34] [Laughter.]

[35] MR. SAMUELS: I was recently at the Treasury Department.

[36] MR. SCHLER: I'm Mike Schler at Cravath, Swaine & Moore. I think I'm one of the few people who has not been in the government.

[37] MR. HARITON: I have also not been in the government. Dave Hariton, Sullivan & Cromwell of New York. I guess this is the New York corner over here.

[38] MR. PAUL: I'm Bill Paul with Covington & Burling, and some years ago I was at Treasury.

[39] MR. GIDEON: I'm Ken Gideon with Wilmer, Cutler & Pickering, and I've been at Treasury and the IRS.

[40] MR. BELAS: Richard Belas at Davis & Harmon. In the great Dole years I was on the Finance Committee staff.

[41] MR. WILKINS: I'm Bill Wilkins with Wilmer, Cutler & Pickering. I was formerly with the Democratic Finance Committee staff.

[42] MR. GRAFMEYER: I'm Rick Grafmeyer with Ernst & Young, and I've been with the Senate Finance Committee staff a couple times.

[43] MS. SMITH: I'm Carolyn Smith with the Joint Tax Committee staff.

[44] MR. BECK: I'm Ed Beck and I have my own law offices in Washington and was formerly with Senator Harry Byrd in the Senate Finance Committee. I don't even think my wife knows I'm here.

[45] [Laughter.]

[46] MR. MULLET: I'm Mark Mullet with Bell Atlantic. I spent about eight years up on the Hill working for a Ways and Means member and most recently with Bill Roth on the Finance Committee.

[47] MS. MATTHEWS: Laurie Matthews, Joint Tax Committee.

[48] MR. COLVIN: John Colvin, U.S. Tax Court.

[49] MS. PORTER: I'm Catherine Porter at Miller & Chevalier, and I worked for Senator Chafee during the Tax Reform Act, and before that with the Ways and Means Oversight Subcommittee for Charlie Rangel.

[50] I would like to note for the record that Don Lubick is also present but is turning off his car lights.

[51] [Laughter.]

[52] MS. PORTER: I want to kick this off and get you all started talking about what has just happened. There are a few questions that are meant to be completely open-ended and thought- provocative on the first page of your red book. That is going to be sort of how the discussion goes for all these sessions. There will be some propositions or some questions. You can take a look at them and see if they prompt you to have any great insights or comments that you would like to make. I have planted some folks out there in the audience who hopefully will start this rolling.

[53] First off, since this on the record, maybe we could around and everybody say who they voted for.

[54] [Laughter.]

[55] MS. PORTER: We had a very heated discussion about the election two years ago. This year I think the results are clearly not as surprising. Nevertheless, we are still facing four more years of a President with a lot of tax ideas on his agenda.

[56] I don't think we have to get into the pros and cons of every one of his proposals, but I would like to hear what you think it's going to be like in the first year of the next Clinton Administration. Is it going to be a big, medium or small tax year? What sort of tax legislation?

[57] Are we going to have an entitlement reform emphasis here? Are we going to have Dole as co-chair of some big commission on entitlement reform?

[58] MR. LUBICK: I think, Catherine, the owner of the other blue Volvo should take care of her problem.

[59] [Laughter.]

[60] MS. PORTER: I have a Blue Volvo, but it is in Washington.

[61] That is where we are going to start. If you're not careful, I might call on you. My proposition is, what are we going to see in the next year?

[62] Nineteen Ninety-three was a pretty big tax year. It was the first year, if I recall correctly, of the last Clinton Administration. We had a huge tax increase which may have affected many of you in this room and many of your clients.

[63] We didn't mention this at the beginning of the session. I see so many familiar faces I assume you know that we are all here representing our own personal views and not that of any particular industry or client. This is a tax discussion involving policy and procedure, not advocacy for any particular group.

[64] Hank?

[65] MR. GUTMAN: I was trying to think about how to frame this issue. If Senator Dole had been elected, one could have looked at his program and said how much does he really care about?

[66] If you took away the 15 percent across the board tax cut and if you took away the repeal of the social security tax increase on upper income social security recipients, the programs do not look a lot different. There is more capital gains relief in the Dole proposal than in Clinton's proposal. Both of them had kids credits. Both of them have a form of estate tax relief. In one case it is an exclusion and in the other case it is an increase in the amount of property that can have deferred estate tax relief. In either case it ends up being essentially a reduction of the rate of tax on preferred assets. They both had IRAs.

[67] Once you took away the big spending issue from the Dole program, his program looks very much like what the President proposes. So I would have been prepared to say, if Republicans and Democrats alike believe in the core issues that are on the spending side in their tax programs, that could give you an outline of what these programs ought to look like in general terms, with the details to be hammered out. Details such as how much capital gains relief we need; details like levels of kids' credit and phasing out.

[68] That to me looked like the tax spending side. I could be fairly comfortable with that. But when I started thinking about the context of a balanced budget, to try to get the budget balanced in 2007, and the issue that I would have been --

[69] MR. KIES: 2002.

[70] MR. GUTMAN: Or 2002. Seven years. I thank you, Ken, for correcting me on that.

[71] MR. BELAS: I always wondered about the revenue estimates in your years on staff.

[72] MR. GUTMAN: In any event, if that is the context, if people are really serious about achieving a balanced budget within that time frame, then I guess the real issue becomes, how do you pay for this?

[73] To me the more interesting issue is not what is going to happen on the spending side. What is going to happen there is going to happen. To me the real focus is, how is this stuff going to be paid for?

[74] There, of course, we have some hints from the President, because there are a number of pay-fors that have been proposed over the last year. We didn't have much of a clue from Senator Dole, but that doesn't seem to be relevant at the moment. What is relevant is when the Administration proposes its spending program on the tax side. How is it going to be paid for? I think that is where some of the discussion ought to go.

[75] MS. PORTER: Thank you very much, Hank. I think what you said is right on point with some of the materials. We don't have that many materials for you to look at, but under the first tab in your book there is a chart of the Clinton and Dole proposals. As you talked about, they are very similar. They are family tax credit, IRA, capital gains, tax incentives, and so on.

[76] Then, right after the blue sheet there is just a listing. I don't think that these revenue estimates are yours, Hank, or yours either, Ken, if I'm not mistaken. There may be CBO and different things in there. But they are Clinton's revenue raisers. I noticed one in particular that seems to be not quite the number that the Joint Committee has mentioned.

[77] MR. KIES: I think they are our numbers. It looks to me like this was taken right off our revenue table.

[78] MS. PORTER: The revenue offsets on page 2, like the sales source rule, should be just $8.4 billion not $16.6 billion.

[79] MR. KIES: There are two pieces to it.

[80] MR. ROSENTHAL: I pulled those materials together, and I believe they originated from materials originally published by the Joint Tax Committee. Nonetheless, I think the point is there are a whole bunch of proposals out there. The question is, how they are going to be treated?

[81] MR. KIES: I would like to put in perspective how Dole's package fit together, because it's directly relevant to how this could be balanced. The Dole economic package got the balance in the year 2002 by doing the following things:

[82] First, it had $158 billion as a Medicare savings number through 2002. The Clinton package was $124 billion. So on the Medicare component they were relatively close together in terms of actual savings, given the overall size of the Medicare program.

[83] The Medicaid number was a little more aggressive, but I think only by maybe $10 billion or $20 billion. I think it was maybe $80 billion. I think the Clinton Administration's was down around $60 billion or something like that.

[84] The welfare number in the Dole package was a little larger than what was actually enacted but not a lot. So that component has already essentially been enacted into law.

[85] The non-defense discretionary savings in the two packages was essentially the same. It's about $370 billion. Many people have said this, so there is nothing unique about it. Many people are skeptical about whether it can be achieved. There is greater skepticism with respect to the way the Clinton package does it, because all the non- defense discretionary savings comes in the last two or three years. In the Dole package, which essentially took the budget resolution from May of this year, it was more of a glidepath. The savings numbers were the same. It's just a larger portion of it in the Clinton package comes in the last three years as compared to the way the budget resolution from May or June did it on more of a glidepath approach.

[86] Both take the fiscal dividend attributable to the balanced budget. At some point we probably are going to have to talk about macroeconomic estimating. The dirty secret essentially, I think, is out now, which is that the CBO did macroeconomic estimating beginning in February of 1995 when they put out Appendix B to the budget documents that said if you get to a balanced budget, we will attribute two developments, a drop in interest rates, and additional enhancement of the GDP growth rate of about one or 2/10 of a percent when you get out a couple years. This translated into $170 billion of fiscal dividend for the period 1996 - 2002.

[87] The rest of what made the Dole package work was another fiscal dividend of $146 billion, which was assumptions by their economists that if you cut taxes in the way in which Dole is proposing, you would get an additional 2/10 of a percent increase in the economic growth rate beginning about two or three years out. The multiplier effect, for anybody that has ever looked at these things, is just staggering given the $7 trillion size of the economy. Once you get out a couple of years it is really producing a lot of real money.

[88] The other advantage Dole had which the Clinton Administration had never seized, for a variety of reasons, was Dole took advantage of the restated baseline of the CBO from August, which has revenues up. That produced many billions of dollars that were not ever taken into account in looking at the Clinton plan.

[89] You then look at the Clinton package. You say, well, Clinton could use that additional money to help pay for his tax cut. The problem that he is going to have relates to a number of the revenue raisers in the complete tax package of the Administration.

[90] There are three components to the tax package that we were scoring when people were asking us to try to compare Dole and Clinton: the March 1996 budget submission; the Princeton University initiative (i.e., the community college credit): and then the proposals released at the Democratic presidential convention. Those three components, when you put them all together and scored them through the year 2002, the net revenue effect was a net loss of $4.9 billion.

[91] Many of the Clinton package revenue raisers in denying the interest deduction for borrowing on corporate owned life insurance were already enacted in the minimum wage bill or the health care bill earlier this year.

[92] Conversely, some of the revenue losing proposals that were in the Clinton proposal, like increased expensing for small business under section 179 have also already been enacted. So there were tradeoffs. The net tradeoffs leave them a little short in terms of the whole plan, but there is offsetting money now that may be available, assuming the baseline doesn't deteriorate.

[93] That is a question that is going to get debated over the next couple of months, because CBO will have to put out a new budget baseline in January. Given the third quarter economic growth rate, and depending on what the fourth quarter economic growth rate is, the enhanced revenues that we saw in the August baseline may no longer be there. So the rosy picture that Dole took advantage of may not exist. If it does, it could represent a source of some potential resources that were not previously available when Clinton put his whole package together. It might make their whole tax package work even if they weren't able to win approval of all the revenue raisers that have been somewhat unpopular.

[94] There are a number of revenue raisers, like reducing dividends received deduction from 70 to 50 percent, changing the NOL carryback period from three years to one year, that haven't sold real well. You may be able to not have to deal with those and still be able to produce a package.

[95] Let me put one last little issue on the table. About $50 billion of the revenue raisers in the Clinton proposal is from an extension of the airline ticket tax. The one thing we have learned about the ticket tax is that the budget assumption that excise taxes always get extended before they expire is regrettably not true.

[96] As a matter of fact, there is a little corollary here. Part of the reason they didn't get extended is that there is a big fight going on between the major airlines and the discount carriers. The majors would like to help the discount carriers out of business. What that suggests is that $50 billion is not as easy money as one might of thought in the past. The component could turn out to be rather controversial.

[97] MR. GRAFMEYER: But, Ken, on the ticket tax, can't they just in the new budget resolution assume that excise taxes, especially that excise tax, expire for scorekeeping purposes? I think that's how they'll do it.

[98] MR. KIES: That is what will happen, and that's why it does score. There was a very tactical reason why it was only extended through December 31, 1996, and that is under the scoring rules it is not presumed to continue, but that's why it does score. The question I'm raising is, will it get extended?

[99] A year ago, or maybe even six months ago, popular wisdom suggested these taxes would be extended. Now it's not so clear. A task force is going to sit up in Ways in Means to look at all the transportation taxes. The ticket tax is one of the major areas, but the various fuels taxes are part of that examination as well.

[100] The Joint Committee will put out in a week or so a whole series of background materials to assist the task force. The task force will meet for the first time the week of the 18th of November. But there is no clear direction as to where it is going. It is by no means a smooth road ahead. That's a big chunk of money that is not as certain as one might have thought six months ago.

[101] The trust fund will run out of money, I believe, in May. So there is an oncoming development that is rather precipitous, or at least will get people's attention. It may lead to just a short-term extension. Who knows. But that is not certain money sitting there. If it were, it would make this picture a little more rosy in terms of the possibility of doing that.

[102] MS. PORTER: Let me ask you all to make certain when you are going to talk that you seek recognition so that we can be sure and say who just spoke so that our recorder knows who is talking.

[103] Ken.

[104] MR. KIES: For very obvious reasons the three major revenue losers in the Clinton package, child credit, enhanced IRAs, and the educational provisions, all sunset at the end of the year 2000. The tactical reason for that approach was when you get to fiscal year 2002, you would have only any revenue effect except they do get a piece of IRAs.

[105] I think when the Congress gets into seriously looking at this, as I think they will, because I assume these things will be in the Administration's budget when it is sent up in February of 1997, politically that will be a troublesome thing. Some will refer to it as the "Mother of All Extenders". It may look a little bit disingenuous to have middle class tax cuts that are only in effect for four years and then setting up an extender that would be very difficult to ever pay for, because it would cost in the neighborhood of $20 billion a year or more to be able to then extend those provisions. That could be a touchy piece of fiction as the whole thing starts to unfold.

[106] MS. PORTER: It sounds kind of depressing.

[107] MR. KIES: I was trying to explain how it could work.

[108] MS. PORTER: It still seems that it is $100 billion just in those three items alone. Then you have to pay for it. It looks as if the tax credit for kids, the tuition tax credit and the IRA expenses all add up to about $100 billion, and that's even if some of them expire before the year 2000. Then if you are trying to raise $100 billion, you end up with $58 billion of that being in the airline ticket tax, and some of the other things also being in the excise taxes, like Superfund or whatever.

[109] I think Hank's question at the beginning about how are you going to pay for it is still the overriding issue. Where is this money going to come from?

[110] Maybe you all don't agree we are going to not have these tax cuts, that you will look at the cost and you will look at what you will need to get them, and we'll discuss them a lot and they won't happen.

[111] MR. ALEXANDER: You could save a lot of money if none of those people otherwise entitled to the deduction for higher education expenses would have B or better averages.

[112] [Laughter.]

[113] MR. ALEXANDER: Do you think that will sell, Ken?

[114] MS. PORTER: Those of you who have been involved with the IRS in tax administration, would you like to comment on the college transcript program of auditing A's, B's, and so forth?

[115] Fred.

[116] MR. GOLDBERG: I like the idea of drug testing better.

[117] MR. ALEXANDER: I was thinking of combining the two, Fred, Automatic drug testing and B average at the same time. How would you make it work, Fred?

[118] MR. GOLDBERG: I don't know. I have not seen too many B's in my life, Don. I'm just not sure.

[119] MS. PORTER: Fred.

[120] MR. MURRAY: The other Fred. Looking at transcripts and drug testing would not be a very pleasant perspective from the IRS side of the ledger, I don't think.

[121] MS. PORTER: Rich.

[122] MR. BELAS: It would be really easy because you would have the most incredible grade inflation we've ever been through in America.

[123] MS. PORTER: I don't want this to get into a debate about the merits of any of the particular proposals. I realize we do have strong differences of opinion on this. Could we talk a little bit more about the mega picture of large tax cuts?

[124] Both Dole and President Clinton have proposed these kinds of tax cuts. So the public is well aware of it. These were debated. This was part of the Contract with America that didn't get enacted. These are things that supposedly all the politicians are going to continue to promise.

[125] Are they going to deliver, and if so, how are they going to pay for it? Or do we feel, having been around this so much and looking at the difficulties of paying for things, they are going to continue to talk and talk and talk and we're just not going to ever see these tax cuts because it's going to be so difficult?

[126] Jon.

[127] MR. TALISMAN: I think you are focusing on the right area, which is the pressure on raising revenue. One thing that hasn't been mentioned is we also have expiring provisions that generally sunset at the end of May, and that package is going to cost a substantial amount of revenue as well.

[128] There is going to be a great deal of pressure on the Finance Committee staff, the Ways and Means Committee staff, the Joint Committee staff and Treasury to come up with revenue raisers that people feel are viable, that are politically palatable, and that will raise the revenue that we need to raise in order to get these initiatives done. To the extent that people believe in a balanced budget, which my boss, Senator Moynihan, does and other members do, if you can't come up with the money in a way that is politically palatable and also works from a tax (or other) policy standpoint, you may have to cut back on the major tax initiatives that are being proposed --the $500 per child tax credit, education initiatives, capital gains cuts and expanded IRAs.

[129] MS. PORTER: We have got a lot of history in this room. Can you all collectively think back about other circumstances? We have been dealing with this budget deficit and pay-fors and all this for an awful long time now, and we always have this problem. You can think of how many times we have just agonized over how are we going to pay for things. How are we going to pay for them? Have we come to the end of the rope now? Have we finally run out of pay-fors?

[130] Jim Gould.

[131] MR. GOULD: We certainly have not run out of pay-fors, but it is going to be interesting. We have got '85, '87, '89 and '90 to look back to as budget negotiations when we had the roles reversed with a Republican White House and for the most part a Democratic Congress. What happened in each of those budgets is essentially most of the tax cuts that were floating around -- and there were lots of tax cuts floating around on each occasion -- the initiatives of members and initiatives of the White House were dropped.

[132] You get down to the same kind of things that we are going to be focusing on presumably in our budget negotiation this time, which is negotiators in a room going down lists of unpalatable options. This time it will be Medicare cuts. Medicaid, social security, cuts in the military, cuts in environment, education, etc. Or tax increases.

[133] You've got this horrible bunch of options to try to deal with to get to a balanced budget. In the past budget battles tax cuts always ended up being a lesser priority. This time tax cuts have been put in play in a way to a greater extent than they were before. It's going to be interesting to see how they come out. You are going to have basically a bunch of people in a room sitting around negotiating, comparing tax cuts and tax increases to pay for them against other ways to get to a balanced budget, none of which will be attractive.

[134] MS. PORTER: Ed.

[135] MR. BECK: First of all, as far as pay-fors, it seems to me you never run out of pay-fors. There is always something somebody can find. It seems to me this situation this year is a little bit different than last Congress. When the Congress came in it was a Republican Congress and they felt like they had a mandate. They had a pretty well set out agenda as to what they wanted to do. I think they are going to be a lot less willing to come forward with proposals this time. In my view, the ball is somewhat in the President's court for him to come out with a set of proposals and struggle with all of the revenue raising options.

[136] The next question, it seems to me, is how will Congress respond to this? Are they going to try to totally rewrite that whole proposal because they think they have got a better idea, say, on capital gains, on estate tax cuts, on IRAs, or are they basically going to try to acquiesce to what the President wants to do and see how that progresses along?

[137] It seems to me that's the real issue. Then the taxes become a sub-issue in the overall budget process and what is going to be done on some of the more important issue, I think, like Medicare, entitlement reform and those types of things.

[138] MS. PORTER: Ken.

[139] MR. KIES: In looking at these numbers, I figured out what this actually is, and it might be useful for people to know. The table that says "President Clinton's Tax Proposals" represents the proposals the President made in March, the Princeton College community college $11,500 tax credit, and then the August 1996 convention proposals with the following modifications: all provisions that were enacted as part of minimum wage or health care in one version or another were deleted. Then the effective date of the child credit, the deduction for higher education and the IRA enhancement was advanced from 1/1/96 to 1/1/97.

[140] We were asked at various points for a variety of alternative analyses of the President's proposal to try to reflect something that might be closer to what one would be dealing with from a reality perspective in 1997. The sunset date is still at the end of 12/31/2000. I'm pretty sure that's what these numbers are.

[141] If you will note, the ten-year net is plus 29.

[142] I would still go back to the point that some of these proposals in terms of revenue-raisers are going to have trouble making it through the process.

[143] Just to underscore my earlier point, my earlier point was you may be able to do the revenue losers without paying for them because of the improvements in the CBO baseline. If the budget deficit projections keep getting any better, it is going to be hard to explain why we just don't go ahead and balance the budget. When you think about where we were a year ago compared to where we are today, it's stunning. While people would like to say it's because Congress and the Administration did various things, the yeoman's work was done by improvements in the CBO baseline, not by any legislative change.

[144] That was my earlier point. It may all fit together in the balanced budget context.

[145] Notwithstanding how ugly the Medicare debate was, I think there is a clear consensus on a bipartisan basis that something has to be done to fix Medicare. I don't think you are going to see people just walk away from the Medicare problem, because it isn't going to fix itself.

[146] MS. PORTER: Could we get some economists that are sitting around the table to talk a little bit about the projected deficit? It was my understanding, and I may well be wrong, that the deficit was projected to start going back up again next year. I don't know how we fit that together with the baseline, but the deficit is going to go up. If you do nothing, what happens?

[147] Eric. I hate to put you on the spot.

[148] MR. TODER: I don't have full knowledge of this. The deficit is projected to go up in the long run. I think what is key to this in terms of how we come out and how CBO comes out is what happens to the projections of the growth of entitlements, particularly Medicare. My information is that those growth rates are slowing down in the projections, which could improve the picture. The deficit will still be going up.

[149] I think also if we are hitting at a 2002 target, the fact that the deficit in the long run is going up doesn't really effect that. If those are the rules we are playing under, that kind of long- run worsening of the budget picture is a reality that will have to be dealt with eventually, but it is not something that necessarily will be dealt with on this cycle.

[150] I guess I would also want to make a comment about processes. It's a very complicated process that we have gotten into and I think it has gotten much more complicated in the last two years because of the agreement by the Administration to balance the budget according the CBO economic assumptions instead of our own, which is partly responsible for the confusion about the trigger-off in Ken's numbers. For example, the reason the middle class tax cut relief numbers are so small is because they are assumed to trigger off. Under our projections they are assumed not to trigger off. Then you would get quite a different bottom line for the net tax change.

[151] It is hard to know exactly how all this is going to play out, but I think we are clearly in a position where the President has pretty strongly committed himself to some of these initiatives, the child credit, the education initiative, and the IRA initiative. It is difficult to imagine how it could be cut out of the budget.

[152] There will be interest in other things, because in some ways I think this is kind of a general issue. Because of spending ceilings and because of the agreement by everybody that there is going to be spending restraint, expenditures will come down. The tax system becomes the vehicle for which all kinds of social policies will have to be funded, and my guess is that there will be pressure and interest in doing more of that. There is clearly going to be some collision when people set goals.

[153] MS. PORTER: Speaking of collisions, do you all see a collision? How do we recognize these conflicting goals about balancing the budget? Maybe these are all colliding trains -- giving everyone tax cuts, having tax reform, (which so far nobody has mentioned)and entitlement reform. These are all things that at a various times pop up as the most popular goal.

[154] Did this election mean anything about the popularity of tax cuts or tax reform or balancing the budget? Did any of these issues win. You had Dole with the tax cut and Perot with the balanced budget, and Clinton won. I am wondering what the priorities are here when you stack those things up. Are we getting a message from constituents that tax cuts are not that important so it won't be hard to cut back on the tax cuts?

[155] MR. KIES: The guy that won has a major tax cut proposal.

[156] MS. McCLANAHAN: It seems to me that both parties have committed themselves. So good idea or bad, they've got to do it. They will have to collude and find a way to do it, whether it's CPI or whether it's fiscal dividends or something else. It is in both of their interests to say "we are following through" because they both went out and said "we really want to do this." There was high visibility about it. They couldn't live it down.

[157] It would be different if there wasn't a vehicle there, but there will be a tax bill because of reauthorization Superfund and the expired airline taxes. If there weren't a vehicle, they could kind of say, well, we just didn't get around to it; we were doing all this other important stuff.

[158] This will be coming up quickly. If they don't do it, they are going to have some explaining to do. I would bet there will be some tax cutting.

[159] MS. PORTER: Ken Gideon and then Norm.

[160] MR. GIDEON: I just have a question. I hear that and I see those campaign promises, but I also see the constituencies of the folks on the congressional side being reasonably immune to revenue as a way of funding that. That says that you would have to fund those cuts out of some sort of spending savings. That seems to be unacceptable to the Administration.

[161] I must say that I for one am fairly skeptical that much of this is going to happen, simply because I really don't see raising some group's taxes as an acceptable alternative, as a way to get there.

[162] MS. PORTER: Norm, you wanted to say something, I thought.

[163] MR. RICHTER: Just something small. I don't quite see how it's such a foregone conclusion that the two parties have to follow through. You say both of them were saying it, but Dole is no longer in the Senate. The person that was saying it is no longer in a position to follow through. There are people left behind who weren't saying it except to support their presidential candidate. I think there is a possibility for tax cuts not to happen. It's all a question of how clearly the blame can be laid at the doorstep of the Republicans.

[164] I guess I am agreeing with Ken with this comment. I have found that it's axiomatic that taxes pay for taxes. Spending cuts don't pay for taxes. So we are looking at this list here.

[165] MS. PORTER: Carolyn.

[166] MS. SMITH: Nobody mentioned fundamental tax reform or restructuring, maybe because that is the least likely thing to happen. First of all, obviously there are going to be some continued discussions about it. Chairman Archer has indicated he's going to continue to have hearings, although go slowly. It seems to me that something so fundamental requires very, very broad support, and President Clinton has made it very clear that he is not interested in tearing up the current tax code, pulling it out by its roots, and putting something else in.

[167] One thing that I think is useful and that may be a good reason to have some of these discussions and hearings continue is that at least, if nothing else, it forces an examination of the current system and looking at what does work, what doesn't work, and whether there are things that need to be changed.

[168] I think there are certainly a lot of areas where perhaps the current code won't work or hasn't kept up with the marketplace or things like that, which could very well be changed, and tax restructuring or tax reform discussions could be useful in pinpointing these areas which might need change in the current code, and which also could be a potential source of revenue raising for some of these other proposals that were discussed.

[169] MS. PORTER: Mark Weinberger.

[170] MR. WEINBERGER: I want to respond to your question about which priorities, the balanced budget, tax cuts or entitlement reform should come first. My view is you can't really separate the three. I think we have to view the proposals to address these issues that were made by both parties through the prism of the legislative process.

[171] My guess is, we will start the whole ball rolling with the President's budget in February. Then the Republican Congress will come back with a budget resolution in April, which will be how it would balance the Federal budget. The tax writing committees are going to go to work in the May-June-July time frame and hammer out the details. The committee chairmen are going to have to prioritize their time between Medicare and taxes and everything else. As we saw last year, taxes were left to the end of the process, in order to see how much money was left to pay for tax cuts after the agreed to spending cuts were identified.

[172] I think it's like a house of cards. What will probably happen is they'll look at the spending cuts, and as has always happened in the past, Congress never gets as much on the spending cuts side as it had hoped for.

[173] Since both parties have taken social security and defense expenditures off the table, and since you can't directly cut interest on the debt, over half the budget is out of bounds. Unless you get at least $140 billion in savings from Medicare, there is not a lot of hope for a balanced budget by a date certain, never mind tax cuts.

[174] To summarize, I don't know if you can really separate them out. I think the tax issue is going to come down to how successful the Congress is in dealing with the Medicare issue, and then what other type of savings they can agree to. The residual issue will probably be like it was last year, the tax issue. At that point you are going to have the problem of either having a reduction in the planned tax cuts, or you are going to try, like last year, to find "loopholes" or whatever else to pay for them, and whatever you can't do somehow falls off the table.

[175] When you view it through the legislative process, it's hard to predict now, because you don't know what priorities the committee chairmen are going to give as to when each individual committee is going to work their will. I think it will become evident as the process works itself out. I think if past is prologue, tax cuts will be the residual policy decision.

[176] MS. PORTER: Rich Belas and then Rick Grafmeyer and then Glen Kohl.

[177] MR. BELAS: I think last year's Balanced Budget Act gives you a lot of reasons to believe that in fact you do them all together, as Mark Weinberger said, and that taxes don't have to pay for tax cuts, that in fact you can have a package of spending reduction. You can even have entitlements reform to a certain degree pay for tax cuts as long as the tax cuts are of the type that you can build a bipartisan consensus for.

[178] I think if it hadn't been for externalities, the Balanced Budget Act was really close to getting done. The differences between the President and the Republican Congress really were not that great. You certainly were having spending cuts pay for some of the tax cuts. It was just a question of how much tax cut you were going to have.

[179] So I really don't see it quite as insurmountable as the discussion seems to be going.

[180] MS. PORTER: Rick.

[181] MR. GRAFMEYER: It kills me to say this, but I also agree with Mark and Rich.

[182] MR. WEINBERGER: Maybe I was wrong.

[183] [Laughter.]

[184] MR. GRAFMEYER: They may want to reconsider.

[185] I will look at it from a process standpoint also. Ken mentioned the fact that you have some of these things expiring in May, so there is going to be a big push to do things earlier. I would agree that's true, but I see this working through the process also.

[186] If I had to bet a paycheck now, I would say that the difference between this upcoming process and what has happened in the last couple of years is I think the tax writing committees are going to push to have in the budget resolution one net number that is their target versus a separate spending number and a separate tax number. It gives them the ultimate flexibility. It also allows them to use things like entitlement reform and some other spending changes that they may want to do to offset the tax cuts, to help pay for them.

[187] I do think there is a lot of opposition from the conservative ranks to pay for tax cuts with tax increases regardless of what you call them. I think there is some opposition there. I think that is a problem. So if you have one net number in the budget resolution, it automatically brings them all together.

[188] Then you have to ask yourself, can they really come up with a Medicare number in May or June? I find that hard to believe. Even though when I was around during the budget negotiations, it is true, if that hadn't been entering into an election cycle, we are very close on the entitlement stuff. Very close. It was a matter of degree. How much you would hit hospitals up and stuff like that. It was just a matter of percentages.

[189] I think it also is doable, but I think it happens a little later in the year in one big package, in a budget reconciliation bill, so you have the budget reconciliation protections and everything else and can move this package along, because it will be a big boy if it happens.

[190] MS. PORTER: Glen.

[191] MR. KOHL: Everyone wanted to say the same thing at the same time. I would echo that I think we were closer to having a budget deal last year than people realized. Your chart kind of reveals some of that. Putting aside the 15 percent tax cut, I think once again, and I'm hopeful, that process will continue. In terms of putting people on a glidepath and everything, I do think you can create a budget within a window that balances the budget and has some tax cuts.

[192] MS. PORTER: Carolyn.

[193] MS. SMITH: Just to join in this fray and get a little bit more political, I agree that a lot of these things were very, very close. It seems to me that some of it gets down to more a political question of do the two sides want to come to an agreement or not.

[194] All of us who have worked on the Hill have seen legislation, know that once the decision is made or the end game is clear that, yes, we are going to do this, decisions can be made incredibly quickly. It just depends when you get to the point where both sides want to agree. In the health care bill, at different points in time I was never quite sure what the end game was. Was it to get a bill or not to get a bill? Once you know that there is going to be a bill, decisions can be made quickly.

[195] Last year in the Balanced Budget Act, I think both sides were making political statements and therefore wanted to polarize a little bit. Each side wanted to say, well, this is what we stand for, and the other side was saying, well, we stand for something else. I think the question is, after this round of elections, will the two parties want to work together, and if so, how long will it take? I think there will be political strategizing to determine what should the end game be or if they should agree.

[196] MR. BECK: I guess what you are saying is the end game is not set.

[197] MS. SMITH: Yes. It's not set because it's too soon after the elections. I'm sure all of us were watching various different channels last night carrying all these different commentaries about what people are going to take from this election.

[198] MS. PORTER: Mark.

[199] MR. WEINBERGER: If past is prologue, unless Congress is able to do that in the first year, when we get close to the midterm elections, political will falters. All the major budget reconciliation bills and tax cuts have primarily been in years after the election of a new President or the next term of an existing President. So I think the chances go way down unless they are successful in year one.

[200] MS. PORTER: Bill Wilkins.

[201] MR. WILKINS: I think Carolyn's comment about the end game is a great comment. I would just add that we relearned an old lesson in the Clinton Administration, which we learned in the Reagan Administration too, which is that if there is a stalemate and the threat of train wrecks, government shutdowns, and so forth, it really doesn't matter what the substance is. The President usually comes out looking better than the Congress does. I don't know if the congressional leadership has completely internalized that. I feel like they probably have.

[202] It was true when the Democrats controlled Congress and there was a Republican President, and it was true in the opposite case. It really didn't matter what the substance was. The Congress comes off looking just horrible. It's for a variety of institutional reasons. The congressional people, there are so many of them, they kind of stand around in a big circle shooting at each other. The President does a better job of controlling his message, making it consistent, making it sound better. The public will always tend to side with the President in that circumstance.

[203] In terms of what the two sides should do, there is another conflict, I think the President has a lot more flexibility to get up from the table and walk out of the door than the Congress has.

[204] MS. PORTER: Rich.

[205] MR. BELAS: That was the conventional wisdom, but what happened yesterday is that both the Republicans in the House who were the poster children for shutting down the government got elected and the President got elected. It seems to me that perhaps you can make just as good a case for the voters just saying, yeah, we thought that was fine.

[206] MR. WILKINS: I don't see how you can make that case based on yesterday.

[207] MR. BELAS: Gridlock may be good.

[208] MR. WILKINS: Clinton got the election in his pocket after the government shut down because he was able to define himself by putting the shutdown in contrast to himself. In terms of national politics, it was a tremendous victory for him.

[209] MR. BELAS: It helped him versus Dole, but it didn't help him get a Democratic Congress.

[210] MR. WILKINS: You get a Democratic Congress or a Republican Congress by and large based on how districting works, and what the sympathies are within individual districts. It's true there may be some congressional districts where the members did great by pounding on the table and saying, no deal, no deal, but I think by and large that's not the case. In cases where people perceive their Republican Congressman as being somebody who would rather shut down the government than reach an accommodation with the President, I think that probably tended to hurt those candidates more than it tended to help them.

[211] MS. PORTER: Ken Kies.

[212] MR. KIES: But, Bill, it is kind of hard to ignore the fact that particularly the labor political band was relentless in terms of hammering the point to death that Republicans in Congress were responsible for shutting down the government, and it did not materially affect the mix of the Congress. I'm not sure what it means, but it was not effective as a political message in terms of changing the outcome of the election. We didn't just go through redistricting. I think that's not a legitimate observation. Clearly it didn't work in the congressional elections.

[213] MS. PORTER: Randy Weiss.

[214] MR. WEISS: It's also true that the Republicans decided in the second session to pass legislation that the President could sign. This decision was a big strategic shift on their part. It may well have helped them do as well as they did in the elections.

[215] MS. PORTER: Jim Gould.

[216] MR. GOULD: They spent six months running away from the budget deal, to reinforce Bill's point and to reinforce the Wilkins- Gideon dubiousness.

[217] MR. GIDEON: I won't know if we are going to accept that or not.

[218] [Laughter.]

[219] MR. GOULD: Carolyn's point is absolutely right about what the end game is going to be. Who knows? To think that Clinton is going to be quick to sign on to spending cuts joined with tax cuts after the events of the last two years I think is equally preposterous. At the same time, to think that Republicans are going to be quick to sign on to all these revenue raisers and more to pay for any tax cuts I think is preposterous. That's why you just have to wonder how the deal is going to eventually be put together.

[220] MS. PORTER: Fred.

[221] MR. MURRAY: One of the thoughts coming through a lot of the commentary last night is that the Republican Congress was largely reelected, and in fact most of the freshmen were returned, and given the retirement of many moderates, the new Congress seems to be actually somewhat more to the right than the previous Congress was. The President certainly learned something out of the process this last time about holding his ground in negotiation with this particular Congress.

[222] The point was also made that if we don't get a deal next year, it gets to be much harder as we get closer to the next election cycle. It does cause one to wonder whether or not the sides are any closer together and whether or not it's actually going to be easier next year or may in fact be harder given the fact that some of these folks take very hard line positions.

[223] MS. PORTER: Ken Kies.

[224] MR. KIES: Let me put an end to the rumor that tough legislation doesn't get done in election years.

[225] MR. GOULD: I will second you on that.

[226] MR. BELAS: Third.

[227] MR. KIES: That popular wisdom is so thoroughly trashed with history that I can't imagine people are still saying it.

[228] MR. MURRAY: I withdraw my comment.

[229] [Laughter.]

[230] MR. KIES: Randy's point is what I was going to try to make earlier, and that is that there is a lesson out of what happened this summer, and that is both sides came together and both sides in their respective election efforts claimed credit for it, and both sides deserve some credit for it.

[231] I think this President may surprise people in terms of his willingness to move towards Republicans just like Republicans may surprise people in terms of their willingness to move towards him.

[232] President Clinton today is asking the same question that every second term President asks himself, and that is, how do I make my place in history? If you think of the options, one of them is being the guy that actually got the balanced budget done. He could do it with this Congress, with some modest movement towards them in terms of real tax cuts versus tax cuts that are paid for by tax increases.

[233] In the grand scheme of things, a $50 billion or even $100 billion real tax cut versus everything that has to be done to get to a balanced budget is not a huge swing. It works out to about $20 billion per year. So it's not as out of the question as people might suggest. I think it is out of the question to think that this Congress would pass $100 billion in tax increases to pay for tax cuts. I don't think that is going to happen.

[234] MS. PORTER: Ed.

[235] MR. BECK: Perhaps this is a consensus that is developing, number one, that we are not going to have the shutdown of the government as a way to come up with a tax reduction, but that instead, if it does come about and there is an end game, it will be done in the context of an overall budget process, budget agreement, not as an isolated or separate tax proposal, but it will have to be done in a bigger context and it won't just evolve by itself.

[236] MS. PORTER: I am thinking of winding this first session up. I had one person tell me it was fine to start late, but don't end late. End on time. So we are maybe five minutes over the six o'clock cocktail hour, but many of you may still need to go to your room, call your office, call your family, whatever. We are going to have cocktails and then dinner, and I'm actually not positive where the cocktail hour is.

[237] MR. ROSENTHAL: The Jefferson Room, which is off the right doorway in the back corner, up around there. We will have cocktails from six to seven. To give you a feel for the night's itinerary, a sit- down dinner from seven to nine. Dinner will start at seven o'clock. After that, there is a bar facility and a game room.

[238] MS. PORTER: I hope you will continue some of these conversations this evening. We will be talking about a lot of similar issues.

[239] I notice a huge difference in body language and demeanor. I have not seen Don Lubick smile once and Les has smiled more in this session than I have seen you smile, Les, in the whole time that you were in the Administration. And Don has looked very stressed, I have to say. I don't think it was your car lights.

[240] MR. LUBICK: It was your car lights.

[241] MS. PORTER: I didn't bring my car.

[242] [Laughter.]

[243] [Whereupon at 6:05 p.m. the meeting was recessed, to reconvene at 8:30 a.m., Thursday, November 7, 1996.]

                       FEDERAL BAR ASSOCIATION

                      Airlie Conference Center

ATTENDANCE:

                              CONTENTS

AGENDA

Session Two: Tax legislative process in the last

Moderator: Laurie Matthews

Session Three: Can the tax laws catch up with the

Moderator: Steve Rosenthal

Session Four: Are corporate tax shelters driving tax policy, or vice

Moderator: Mike Thomson

Session Five: Is the tax legislative process ready for the 21st

Moderator: Mark Mullet

PROCEEDINGS

[8:30 a.m.]

[244] MS. MATTHEWS: I want to welcome everybody again this morning. I have a few administrative announcements. Checkout time is noon. So the break after this session would probably be a good time to get your bags. If you want, there is a storage space behind the reception desk where they can keep your bags if you don't have another place, a car or something to put them.

[245] We have a few new participants who have joined us since last night. Perhaps we can ask them to identify themselves and tell us who they are with.

[246] MR. SALMON: John Salmon.

[247] MR. LONGANO: Don Longano.

[248] MR. SHAPIRO: Bob Shapiro.

[249] MS. STECHER: Esta Stecher.

[250] MS. MATTHEWS: Anyone else?

[251] MR. PRATER: Mark Prater.

[252] MS. MATTHEWS: As yesterday, we have a transcription being made. There will be an opportunity to edit remarks, to take out ums and aahs and so forth. We would like everyone who participates to seek recognition before speaking and to identify themselves so that the moderator will have an opportunity to identify the speaker for the reporter.

[253] This morning's session deals with the observation that there were in the last Congress quite a number of changes directed at procedures, some directed at legislative procedures and some directed at the interaction of Congress with administrative procedures.

[254] I will mention some of them. Some of them are listed in your materials at the numbered page 2. And then throw open the forum for discussion as to why people think we have seen this number of changes directed at procedure. Possibly there are different origins for the different changes involved. And what impact it's thought that these changes may have.

[255] Some of the formal changes:

[256] We have line-item veto legislation, which will be effective beginning of next year.

[257] We have regulatory review legislation, which gives Congress an expedited procedure if it wishes to use it to overturn various regulations.

[258] The Unfunded Mandates Reform Act of 1995 involves procedures for enforceable duties. Those have to be reported in committee reports. If the enforceable duties exceed a specified amount of $50 million for intergovernmental duties, they are supposed to be funded or else they are subject to points of order.

[259] There are supermajority requirements of the House rules for income tax increases, and retroactive tax legislation is limited in the rules.

[260] And there are prohibitions on retroactive regulations in the Taxpayer Bill of Rights too.

[261] There also have been some informal rule changes:

[262] A budget reconciliation process involving more than one reconciliation bill, which involves different procedures from other bills.

[263] Requirements for written amendments with statutory language in the committees rather than conceptual amendments, for example, in the House markups.

[264] Some observers have observed changes in committee structure and relationships in the House.

[265] And there have been a number of proposed changes:

[266] Votes on constitutional amendments; also for supermajority requirement.

[267] Also supermajority requirements for retroactive tax increases.

[268] I would like to throw open the topic for discussion as to why people think we have seen these changes and what impact you think they may have. Maybe we should start with some particular changes. How about the line-item veto legislation that we see coming up? How do people think that is going affect their practice or the legislative process?

[269] Rick, you've done some writing on this.

[270] MR. GRAFMEYER: I have thoughts on all these. Obviously it depends what Ken does.

[271] [Laughter.]

[272] MR. GRAFMEYER: I think this last year a lot of procedural things have happened that are really going to change tax legislation. Line- item veto. I guess I'm not of a belief that there will be many provisions that are actually vetoed by a President per se, but I think the concept that committee chairmen have to produce a list come conference report time of all items that are deemed to be special interest -- I think we all know in this room that they are not necessarily special interest, but that is how it is going to be tagged by the press, or whatever -- and to have to produce a list, I think in effect produces a chilling effect that gives chairmen another reason to say why they don't want to do a certain provision. If the chairman doesn't want to do it, the first thing he is going to say is, well, I don't know if this is subject to line-item veto. Just like revenue estimates. They're going to go scurrying off to try to get a determination of whether it is subject to line-item veto or not. Then there will be the normal redrafting and everything else.

[273] From that perspective, I think it's almost a problem for the unwary. Unless people are focused on line-item veto kinds of concepts when you even come forth with a proposal, you are going to have problems.

[274] Reg reform. I don't know if everyone in the room is aware of this. Reg reform already has had a big impact, at least on the Senate perspective where the hospitals were going to get a payment update. It was actually an increase over what they get now, about $200 million beginning October 1.

[275] Doggone it if HCFA didn't get the reg out until September. Because it was a major rule, it wouldn't have taken effect until November 1 under reg reform, and the hospitals would have lost $200 million. So in the Senate they had to go through a process where Senator Lott had to introduce a resolution basically stating that the reg was invalid, and then by unanimous consent the Senate disagreed with that resolution so the reg could come into effect October 1 and the hospitals wouldn't lose $200 million. It's craziness. It's the kind of hoops we jump through for nothing.

[276] I look at reg reform as just another way that Congress is going to try to express their will on the regulatory writers and insert the political process in the reg area.

[277] Then, I guess, unfunded mandates. Anyone can cut me off at anytime.

[278] [Laughter.]

[279] MR. GRAFMEYER: I have no personal beliefs on any of these things.

[280] Unfunded mandates. I don't know if everyone is aware of the fact that CBO has ruled, I think on four different occasions, that the unfunded mandate rule applies to state tax preemptions. So anytime from now on you try to get a state tax preemption in federal law, and I would assume it could apply in ERISA context too, you are subject to unfunded mandate rules. So you have a $100 million limitation. For instance, the pension provision on nonresident pensions, how states can tax those. That would have been subject to the unfunded mandate law if that had been in effect when it was enacted.

[281] That's another little thing that is out there. There are a lot of these little things that are out there.

[282] MS. McCLANAHAN: How does it work with the $100 million? Do you need the 60 votes?

[283] MR. GRAFMEYER: If you exceed the $100 million, then you have to reimburse the states for the loss. I've been involved in something like this.

[284] The goal will be to try to get CBO to estimate it so it's less than $100 million. If it's less than $100 million, it doesn't matter. Once you exceed $100 million, basically you are not going to be able to do the provision, because you are never going to be able to come up with a scheme to reimburse all 50 states for the loss they are incurring. You are just not going to be able to do it.

[285] MS. MATTHEWS: Ken.

[286] MR. GIDEON: Can I just ask a question -- I'm not quite sure to whom, either Glen or maybe Mike -- about how the reg review legislation has simply affected the process of promulgation, and what do you have to do now that you didn't have to do before?

[287] MR. THOMSON: I'll start. It basically slows down the process at a minimum, but only in marginal ways. There is just a little bit more paperwork. There is notification. You have to send the documents up.

[288] Personally, I've assumed on anything we do that is significant the people on the Hill who would care about it are aware of it, without us sending it up there, at least within 24 hours. If it's something significant, they find out about it. Commonly we tell them about it. It's the appropriate thing to do.

[289] This formalizes the process that I think was done on an ad hoc basis but probably reasonably well as far as just a notification. It's always the legislative prerogative, if they disagree with that interpretation of the law that we have come out with, to change it. In that case you have to get into potentially how you pay for it, or whatever else the other requirements would be. I view it as just that's the way it has always been; it just now has a little bit more profile.

[290] MS. McCLANAHAN: Can I ask you a question? In the 1980s OMB actively injected itself into the tax regulatory process. It was an important part of the agenda of the Reagan Administration to reduce paperwork burdens. Is OMB still very active in the process? Do you get the sense that of increasing Hill involvement, of more people injecting themselves into the process?

[291] MR. THOMSON: It has truly been institutionalized. There is a tremendous tradeoff in getting rules out: getting as much guidance out there as possible but not overloading the system with paper, having rules that say it as briefly as you can say it, as concise as you can say it but still being accurate. It's the same tension it has always been, I suppose. But, people are even more keenly aware about minimizing the volume of paper in regs.

[292] I haven't done a scientific study, but by and large I think they are briefer than they were, say, a decade ago or 15 years ago. There is a general desire to have the regulations and the rulings or anything else be shorter and more concise. OMB has a keen awareness of that, but it has been brought down to our level and within the IRS as well to do that on our own. There is not a negotiation process with OMB to say this is what we want do to and they say you have to cut it by a third or anything like that. So there is not a lot of pressure in that way.

[293] The one place I will say it is having an impact, and on balance I suppose it's good but it certainly is perverse on occasion, is where you want to do something that is absolutely helpful to taxpayers; you want to just say here's a safe harbor or here's an election, but to do it in a way that is administrable, that makes sense, you need some sort of paperwork: they need to file an election or they need to document something in a certain way.

[294] Now that is even more bogged down in paperwork, and, in addition, it trips the reg flex requirements -- not necessarily a reg flex analysis but the reg flex requirements. You can either do a full- blown analysis or in some cases have certification. That requires more time and it puts pressure on the question, is it really necessary to do that piece? There is constant pressure on Treasury and IRS to get guidance out. People want more guidance, not less. We want to do the best we can to oblige that.

[295] Now you have this tradeoff of, okay, we've got this big package of rules; it's good guidance, guidance people want and need; we could get it out. And we have got this one other piece that really would be helpful and appropriate, but that is going to take another month or two months.

[296] In the scheme of things that's not forever, but you have that tradeoff much more commonly now, and you try to figure out ways within the boundaries of the rules that is the best way to get this guidance out. So you may end up doing it in a way that doesn't make perfect administrative sense or that is not quite as helpful, or you do it in a way that is most helpful and makes the most sense but takes more time. Those tend to be the tradeoffs.

[297] MS. MATTHEWS: Thank you, Mike and Patti.

[298] Are there other comments on the regulatory process?

[299] Rick.

[300] MR. GRAFMEYER: I guess another question I have on reg review gets into effective dates. Generally, I think it has been stated that most Treasury regs are interpretive in nature and the thought is they are. The same with the revenue rulings and stuff. So don't get into the 60-day requirement where it can't be effective for 60 days.

[301] I see coming down the pike regs that will come out based on, say, this last tax bill, or whatever. I guess I could make a distinction that you may say Treasury regs are interpretive, but I would also say a lot of Treasury regs are also legislative in nature.

[302] I don't know if it's even appropriate to ask for a comment, but I see regs, like on medical savings accounts, where I could easily see Congress step in and say, no, you can't make these effective because we want to review them, because I don't believe your interpretation of medical savings accounts is what Congress' interpretation of medical savings accounts is. I can see a fight over things like that. They would say, we want to review these.

[303] I don't see too many instances of where Congress is going to review regs, but I surely see that coming down the road, something like that.

[304] MR. KOHL: I would echo what Mike said. When we issued guidance before reg review, before The Taxpayer Bill of Rights, we took into account congressional reaction, very light on going retroactive, and those kind of considerations were in effect beforehand. We have paperwork and other issues we have to address, but I think as a psychological matter the decision is let's just keep doing our job as we think it's appropriate, and if Congress wants to step in, so be it.

[305] MS. MATTHEWS: Rich.

[306] MR. BELAS: I have a question on number 4, the supermajority requirements for income tax increases. My recollection is that was income tax rate increases.

[307] MS. McCLANAHAN: It was drafted 100 different ways.

[308] MR. BELAS: But the ultimate version was rate increase.

[309] I have a question. What is a rate increase? Does zero to anything come out to be a rate increase?

[310] MR. KIES: It's a change in section 1 or 11, but not 1(d). There has been a big fight over this. These kind of rule changes inevitably are used to club to death the people that enacted them.

[311] [Laughter.]

[312] MS. PORTER: You can probably edit that comment.

[313] MR. KIES: It was going to be a lot stronger, but it was on the record.

[314] [Laughter.]

[315] MR. KIES: We believe the intent was actual income tax rate increases, not effective rate increases and not other things like that. I think you may well see either a modification of the rule itself or a more comprehensive legislative history, if it is re-upped in the next Congress, to try and completely put to rest any confusion about exactly what it is supposed to apply to.

[316] MR. BELAS: This means that we will never repeal an income tax. We will just zero rate them.

[317] MR. KIES: We won't repeal an income tax?

[318] MR. BELAS: We will just zero rate any tax we don't want temporarily just in case.

[319] MR. KIES: I'm not sure I understand your point.

[320] MR. BELAS: So they can't reimpose it.

[321] MR. KIES: It has implications also for a complete restructuring. If one were to repeal the income tax but enact something in its place, presumably it would have a rate in it. Would that be a rate increase?

[322] MR. BELAS: That was my first question. Can you impose a new tax with a rate in it and have it be a rate increase? The second thing is, if you really want to ensure that you will never have an income tax again, wouldn't you zero rate the income tax rather than repeal it?

[323] MR. KIES: I see.

[324] MS. MATTHEWS: Jon.

[325] MR. TALISMAN: There is one important point. The supermajority requirement under the House rules can be waived by a simple majority.

[326] MS. MATTHEWS: Right. I was about to make that point.

[327] MR. KIES: That's right, and that's effectively what happened. After the initial clubbings, the clubees decided it was better not to be clubbed and they just started waiving the darn thing.

[328] MS. MATTHEWS: Jim Clark.

[329] MR. CLARK: The phrase is "federal income tax rate increase." At the beginning of this past Congress, there was an attempt on the part of a number of Republican Congressmen to try to tie the hands of the Congress in passing tax increases. Your typical Congressman knows what a tax increase is, but when you really start analyzing what a tax increase is, it becomes very problematic as to whether a particular proposal is a tax increase or it isn't. I think all of us realize that.

[330] When the Ways and Means staff started working on this early in the Congress, we tried to come up with something that was as tight as possible, and that's where this phrase "federal income tax rate increase" came from.

[331] Frankly, it apparently wasn't tight enough because we had terrible problems with it over the past two years. For example, as Ken well knows, when we considered the Contract With America in April of 1995, Congressman Moran (D-VA) raised an objection during the consideration of the bill. The bill included a capital gains proposal that provided a 50 percent deduction (or exclusion) and repealed the current law 28 percent cap on capital gains. Congressman Moran argued that our repeal of the maximum 28 percent capital gains rate was a rate increase because we were subjecting capital gains income to the full 39.6 percent rate in theory. Of course, he was ignoring the fact that there was a 50 percent deduction and, therefore, no one would be paying the full 39.6 percent rate.

[332] From a theoretical standpoint, he was making an interesting point. If we then argued that the effective rate really is only 19.8%, we were hung on our own petard because we were arguing effective rates, and we clearly did not intend a "federal income tax rate increase" to be a discussion of effective rates.

[333] We kept running into these kinds of problems throughout the last two years.

[334] MS. McCLANAHAN: Not only that, but my understanding is that for small business stock, you decided to do no more than retain the existing 50 percent deduction so that the treatment of investments would be uniform. That had the effect of taking the effective rate from 14 percent, half of 28 percent, up to half of 39.6, or 19.8 percent, for small business stock. You had said you wanted to count the 50 percent deduction in the one context, but you didn't want to count it in the small business stock context. Logically, if you counted the deduction to assess whether there had been a tax rate increase, your rate really did go up on small business stock.

[335] MR. CLARK: It was quite an evening. Ken, you probably remember it. We were coming up on the end of the 100 days for the Contract With America. Members were about to leave town for the Easter recess, as I recall, and this objection was being raised on the House floor that would have prevented the Congress from achieving their 100- day goal on the Contract With America. It was not a pleasant time.

[336] MS. MATTHEWS: Ken Gideon.

[337] MR. GIDEON: I just want to make sure I understood what was said. Given the delicacy, maybe people can't agree or disagree with this, but I infer from what you said that, for example, an increase in the miscellaneous deduction floor or an increase from 3 to 4, for example, would not be a tax rate increase.

[338] MR. KIES: That is correct.

[339] MR. GRAFMEYER: Correct me, if I'm wrong. The higher case is like Superfund taxes. Didn't we have this debate whether Superfund taxes are a rate increase or not? Let's say the AMT.

[340] MR. KIES: That would be a rate increase. Indeed, reinstating it, since I believe it has expired, would be a rate increase.

[341] MR. GRAFMEYER: Right. That was the issue.

[342] MR. BELAS: So imposing a new income tax is a rate increase.

[343] MR. SALMON: I would like to ask a simple question for the group. If one of the things we are supposed to be talking about is tax policy and the process, given the fact that this has been waived and will be waived virtually every time because no one wants to go through the interpretive gyrations that happened last year, is there some consensus of the group that this rule makes no sense? I hate to ask that question. I'm just curious what people think.

[344] MR. BELAS: John, it depends on your goal.

[345] MR. SALMON: From a substantive standpoint, if you are going to waive it every time you want to waive it and a majority can waive it, which I think Jon pointed out, why go through the conversations we are having here around the table? It doesn't seem to make a lot of substantive sense from a process standpoint.

[346] MS. MATTHEWS: Ken.

[347] MR. KIES: I will disagree with you to this extent. What it is intended to stop it will probably stop. A naked increase in the income tax rate would not ever get the rule waived. If somebody proposed to increase the marginal rate from 39.6 to 45 percent, I don't think you would see the rule waived. The rule gets waived to avoid fights over things that were not intended to be covered but which there is disagreement over whether it is or isn't covered.

[348] MR. SALMON: If the leadership of whatever party is in control of the House of Representatives decided for whatever good policy reason a tax increase should come out and it's going to come out with a majority support of the Ways and Means Committee and the support of the leadership, they are going to waive the rule.

[349] MR. KIES: A House with such an inclination would have repealed the rule before that occurred.

[350] MR. SALMON: You and I aren't differing really. It seems to me a waste of a lot of thought process going on. I don't see the value.

[351] MS. MATTHEWS: Glen Kohl.

[352] MR. KOHL: Two observations on these kind of procedural rules, and I would also throw in the Balanced Budget Amendment. First, before you get to the Balanced Budget Amendment per se, whether it's reg review or these, I think they have the perverse effect of increasing the federal bureaucracy in issuing these kind of rules at a time when you want to strip down. There is much more that we have to do, and I think the Joint Committee's workload has been increased with the line-item veto, with the reg review. It's an interesting turn of events.

[353] Regarding these procedural things, and now I would include the Balanced Budget Act, it reminds me of when I was in law school. Instead of actually getting to doing my work I would clean my desk, or whatever. I used to actually not do a lot of work. Then, when I would get nervous, I would go out and buy another hornbook. I wouldn't open it, but just having one, I knew now I was ready if I ever got down to doing the work. I think they are sideshows and a way of avoiding rolling up the sleeves and going to the main event.

[354] MS. MATTHEWS: Mark Mazur.

[355] MR. MAZUR: It seems like a number of the formal rule changes really increase the cost of legislating, in changes to the Tax Code. Just from an outside observer's point, it is kind of interesting that the legislative body wants to increase the cost of legislating.

[356] MS. MATTHEWS: Ken Kies.

[357] MR. KIES: We are all talking about these rules, particularly things like reg review, from the perspective of tax rules. I have bad news for you. The Congress doesn't generally approach things by thinking about tax first. They think about a lot of other things. While we would like to be exempt from them, generally speaking they don't have our view that we are somehow different from the rest of the regulatory framework of the government. Part of the reason these rules got written is because some agencies do take regulatory action in ways that sometimes looks like it is circumventing what Congress had in mind, and they basically wanted to know when such things were coming out.

[358] To some extent the IRS has done some of that in the form of using coordinated issue papers and other things that are outside the normal regulatory review process. The IRS isn't immune in terms of having engaged in issuing regulatory guidance, which is very important from the standpoint of how audits are conducted, that doesn't follow the normal administrative procedure reviews.

[359] Even in the case of the IRS there were reasons why people wanted to have notice that things were going out. When you think back to the big fight over intangibles, which was a huge fight, it all started from a coordinated issue paper that was undated, which never went through a reg review process, and which ultimately the Congress did in fact essentially legislatively overturn. The IRS is not immune from the kind of concerns that were the overall reasons that this legislation was enacted.

[360] Line-item veto is a very different situation.

[361] MR. KOHL: Can I speak to that point, Ken?

[362] MR. KIES: Sure.

[363] MR. KOHL: Obviously the IRS' record is not perfect. When we spoke to the small business groups and their concerns, I think we would agree that to the outside world the tax rules are the tax rules. A business person doesn't really make that big a distinction whether it's a statute or a reg. I think a lot of the frustration that is directed towards the tax rules that was pinned on the regs was actually a combination of the complexity of the tax rules in both the code and the regs.

[364] This does raise an interesting issue, and I don't know what the answer is. It has to do with these interim forms of guidance. Whether it's PLRs and TAMs and coordinated issue papers, they are in form not final rules; they are in form addressing one particular taxpayer. But the fact of the matter is since FOIA they are very visible; they are discussed in legislative history; they are discussed by courts all the time. You say, yeah, we know we are not allowed to rely on this in precedence, but we note that this PLR did this or that.

[365] I just think another process issue, maybe not for this time because it wasn't teed up, is the growing effect of these non- formal pieces of guidance.

[366] MR. KIES: There is no doubt that sometimes the rules that come out of the IRS are the result of the statute. The coordinated issue paper, which took a position on intangibles, ultimately was overruled by the Supreme Court decision in Newark Morning Ledger. They said it was wrong.

[367] MR. KOHL: You replace a few shingles, you deduct it; you replace a roof, you capitalize it. When do shingles become a roof? The concept of capitalization presents tough issues that arise out of the code. I'm just saying that the tax law is complex, I think we all agree. I think there is frustration with the tax system, and whether it's rules or regs or statutes it's just not as clear.

[368] MS. MATTHEWS: Fred Goldberg.

[369] MR. GOLDBERG: I think there is a different way to think about all of these provisions. By analogy, it has to do with qualitative notions as opposed to quantitative notions. If you look at this stuff, I think there is a clear articulation of priorities and values, things that are important more or important less. For example, the super majority requirement for rate increases. It carries with it a gut level judgment that marginal rates matter a lot. Whatever we are going to do, rates are a first concern; we shouldn't mess with rates.

[370] When you look at reg review, when you look at the provisions on retroactive regulations and retroactive legislation, I think it's far more a qualitative statement that the system has kind of got things out of balance in terms of how it weighs, for example, Mike's comments about length and complexity versus the need for simplicity or basic notions of fair play.

[371] If you just look at these provisions literally, if you parse through them and look for all of the technical problems, and if you just focus on the fact that it's going to cost more to do this or that, I think you lose the import of these rules.

[372] Just as taxpayers are exhorted to follow the spirit of the rules, it seems to me there is a clear statement of spirit to these rules, having to do with notions of burden, complexity, fair treatment of taxpayers.

[373] If you get into the details too quickly, you lose the import of what is trying to be communicated. The risk is if you lose that import, if you don't see what the message is, things are going to get worse and get worse and get worse, until the tax administrators and those who write the rules say, I get the point, these concerns are going to be ground harder and harder in potentially more pernicious kinds of ways.

[374] MS. MATTHEWS: Don Alexander.

[375] MR. ALEXANDER: Going back to a narrower point than the broad point that Fred made, I wonder to what extent Congress wants to manage the IRS and direct the IRS to raise or not raise particular issues on audit. I would be a little concerned about Congress deciding that an ISP paper had to be issued with the same formalities and the same rules as a regulation. Do you really want that, Ken?

[376] MR. KIES: No. That's not what anybody is saying. All this thing does is say tell us when you did it. That's all it says. I think people are making a lot more out of this than there is there.

[377] I certainly would agree with Mike's point that all it does is formalize what was always the case, and that is, if the IRS did something that was boneheaded, eventually the Congress would know and they would react. All this does is speed it up. Maybe people from the IRS and Treasury ought to comment. It may modestly cause IRS and Treasury to think just a little bit more before they take an action that might precipitate a lot of controversy. I think they already thought that way.

[378] But, no, that is not what this is about. All it is, just tell us. That is essentially all that is happening. They send the stuff up and we send it around. Thus far I'm unaware of anything that has come up that has come out of the Service of the Treasury that has created controversy. It's inevitable that there will eventually be one, but I'm not sure that's a lot different from the way the rule was before. So, no.

[379] MS. MATTHEWS: Bill Wilkins.

[380] MR. WILKINS: In response to Fred's comment, I agree that larger policy goals are at stake in writing these rules. However, I think that when people attack a substantive problem with a procedural response, the discussion of the substantive problem quickly devolves into a procedural debate rather than a substantive debate.

[381] The response to Gramm-Rudman was to start talking about deficit reduction in terms of where you could place the dart where it would be closest to the outside edge of the legal target, rather than trying to throw the dart in the middle of the target so you could actually make more progress on the deficit. It became a rules-based, kind of a lawyer-based discussion.

[382] Maybe that's not all bad, but it seems to me that it did degrade the quality of the debate, and it did delay the extent to which deficit reduction gained legitimacy and popularity as a political issue. I would say that if you adopt procedural rules on tax increases, the debate on whether or not there should be a tax increase will be drained of a lot of its substance as people argue about the procedural issue of, well, is this really a tax increase? Like John says, there will be a lot of energy expended on this angels on the head of pin kind of lawyer's argument, and less energy expended on the real merits of the decision that is being made.

[383] MS. MATTHEWS: Brad Ferguson, did you have a comment?

[384] MR. FERGUSON: Later today, when we talk about substance as opposed to process, I think one of the issues that will emerge is the question of the extent to which the tax system is hamstrung by categories. Presented with categories, people will spend a lot of time and effort trying to get into the category or avoid the category, whatever the case may be. The discussion now about tax procedure also involves categorization --the question of a tax change is a rate increase and the question of what's a regulation and what's not a regulation.

[385] My question is whether, in the reg review process, categorization has resulted in any practical effects that people can perceive with respect to the form in which guidance is provided. Do people perceive that there is an effort to avoid a category or move yourself into a category similar to what we see in the private business world with respect to substantive tax rules, or are the effects simply informational, so it's not a big deal anyway?.

[386] MS. MATTHEWS: Mike Thomson.

[387] MR. THOMSON: Let me start by responding in part to your question, Brad, on the regulatory side, or what people from Treasury and IRS loosely call guidance.

[388] By implementing rules that focus on the process, the effects are to shift limited resources. With some downsizing, that magnifies that shift from the substance of the rules to the process or the wrapper around which the rules are delivered.

[389] There is a spectrum of guidance right now from very informal to very formal, a whole wide range, some from the field, some from the national office, some Treasury oriented, and it's appropriate to have that wide stretch, because it's a big system and you need a lot of different things to supply different needs.

[390] I think it has developed very well and I think it's working very well. I think the notification is a good thing. I think we have been responsible in doing that, Treasury and IRS, in alerting people on the Hill about what we perceive as significant measures that we are taking.

[391] I am mindful of Ken's point that these rules weren't about tax, but with tax having probably the largest volume of rules it's hard to exempt them from those rules once you are doing it. I understand that. But when you get into the tax world it shifts resources from focusing on the substance to focusing on the process, and particularly the paperwork reduction analysis and now the reg flex analysis that comes with that. So the net effect has to be to have less guidance.

[392] My own take is perhaps that was not a desire but a cost worth paying to make sure people are really paying attention to the rules and how they are delivering them.

[393] On the other hand, I have to come to the defense of the IRS a little bit when you say that some of this came from IRS taking inappropriate positions. Maybe I am exaggerating your point, Ken, a little bit. I wouldn't cast it quite that way.

[394] There is a lot of uncertainty in the tax law, and as it gets bigger and more complex there is going to be that much more uncertainty. The IRS has to administer it. They have to take positions. I think they take reasonable positions, but tough positions in a lot of cases. They win some of them and they lose some of them. I think this applies to intangibles particularly. It isn't that clear that they were way out of bounds, but we ended up with a resolution that I think is a very reasonable resolution. It made life a lot simpler and had sort of a reasonable balance.

[395] Those things are going to keep coming up forever and ever. I think the IRS should continue to deal with them, with Treasury's input in the ways that they think makes the most sense, but obviously knowing that we don't do it in a vacuum and without people paying attention to it.

[396] I think the combination of those effects are all good with the one residual concern I have, disappointment I have, that we have to spend so much more resources on the paperwork aspects of the rules, which inhibits us getting out guidance that people are constantly clamoring for.

[397] MS. MATTHEWS: Glen.

[398] MR. KOHL: Let me just jump in. These were originally not focused on tax, and then we had to customize it to tax. Early versions would say you have to draft your rule in a way that costs the least amount of taxpayer money, which technically meant you had to draft a reg that gave away the most revenue possible, not necessarily the most reasonable interpretation.

[399] Obviously the provisions had to be adapted: What do you mean? That might be okay for EPA or OSHA, but did that mean in the context of a tax reg? It had to be, well, we're talking about paperwork here. I think they had in their non-tax issues had to be adapted to tax because it was not feasible to exempt them.

[400] MS. MATTHEWS: Larry Gibbs.

[401] MR. GIBBS: The points that are being made are really resonating with me, particularly as the IRS gets injected back into this. Fred's comment about the intent, Bill Wilkins' comment, Don Alexander's comment.

[402] I liken this basically to sort of what we have gone through, say, over the last 20 years with the Freedom of Information Act. If you have been watching that, after tax analysts basically went through initially with certain types of guidance, you now have an allegation out there by tax analysts that after making certain types of guidance public the IRS changed the designations and went right back to what allegedly they were doing before.

[403] I look at all the field service advice that now is public. One of the things I see is that as we take these non-tax rules and try to apply them to the tax area and say to the tax administration, there are really tensions here, field service has a very important function; a lot of these other things have a very important function internally.

[404] It seems to me that one of the things people are saying to the Service is you are so insular, you are so unwilling sometimes to tell us what you are doing or discuss it with us that we basically suspect the worst of you. I wonder if part of what is not happening here is that we are not dealing with sort of root causes in the context of a basic concern about whether you have a tax administration agency that really is leveling and dealing with trying to get to the bottom of what the Congress intends in terms of their basic concerns or just finding ways to circumvent those intentions.

[405] MS. MATTHEWS: Ken.

[406] MR. KIES: I don't think that is what is happening. Les can speak to this. When this thing was going through, the Administration tried very hard to get tax exempted. It wasn't that the Congress thought that the IRS was sneakier than the rest of the agencies. It was that the Congress didn't want to exempt anybody. They couldn't see the world the way we see it. They couldn't accept the proposition that tax is different and therefore should get to live outside of a set of rules that otherwise they thought were appropriate for dealing with the balance between the Congress and the Executive branch.

[407] I never sensed Congress specifically being paranoid about what the IRS was up to. Rather, it was Congress saying, we just don't accept the proposition that you are so different that you should get to live under a different set of rules from what we are otherwise deciding is appropriate for the rest of the Executive branch.

[408] Les, you've had a lot of conversations. We've dealt with the aftermath. We're the cleanup crew, but you were involved in a lot of those discussions. Maybe you could comment on that.

[409] MR. SAMUELS: As these issues kind of evolved they were not originally tax motivated in the sense that they had the tax system in mind as the target for the rule. There is obviously an unhappiness about overregulation, and that kind of swept in all regulations, including tax regulations. Then when you got into a discussion of the tax system, I think there were some who kind of felt that this would be a way of trying to deal with substantive issues that they had a different view than the government on. There is always a little bit of that. You use the process to fight your substantive arguments.

[410] We would ask people to give us some examples of the regulations. The first example was independent contractors. We said, oh, that's interesting, because since 1978 the Internal Revenue Service has been prohibited from issuing any guidance on that topic. That's kind of an example where we had a guidance blackout. The law really hasn't been able to evolve to reflect changing circumstances. There is a long history why that was the case, but that is an example where people have been struggling, and I don't think the situation has improved over the years because of the IRS blackout on giving additional guidance.

[411] I would agree that by and large the tax system wasn't the target, but once the process got going some folks who had particular issues that they were worried about kind of weighed in and figured, well, now there is an opportunity to try to maybe use this a little bit -- there's a little of that -- to try to direct the outcome of some substantive issues.

[412] It was done also at a time when there was a lot of rhetoric about the tax system. So it's hard, I think, for the folks who are interested in this to exempt the tax rules at the same time people are saying the law is too complicated. There is a whole range of rhetoric on the topic.

[413] I think it was hard for folks to come to grips with the proposition that I think most of the people here would recognize, which is that taxpayers and the government kind of want guidance to reduce uncertainty. People want to know what the rules are so they can go ahead with their lives. Maybe they don't like the rules, but at least they know what they are, and they want to get on with their lives. That is kind of a general system that I think most would agree with. You kind of have a collision with that kind of view with the folks who get upset about EPA or OSHA regs, which were kind of the poster children of this issue.

[414] I would also say that we've had in the last couple years the notion that the way to kind of control the tax system is to set some values through the use of procedures. I think when you step back and kind of look at the nature of the system and how complicated it is and how difficult it is from a policy point of view to maybe try to rationalize things, even just at the margins, which I think is the most one could probably do, these type of rules are not going to be a positive force.

[415] When Ken talked about what happens if you change the rules on Pease and PEP, I thought to myself, well, that's kind of interesting. We got the Pease and PEP, I guess in part, because people didn't want a rate increase, and one of the common complaints in terms of the system being too complicated and also a feeling that the government wasn't being honest with taxpayers is Pease and PEP.

[416] If you actually said, well, we've lived with that for a while and we really should try to simplify the system, let's just get rid of it and we'll make an adjustment in the rate, people will basically be where they were after it but they don't have to go through these calculations. The supermajority would prevent you from doing that. You can't put that on the table.

[417] I think obviously anytime you simplify there are a few winners and losers. If you said overall we have a proposal that is going to be as fair as we think we can get it and the way to deal with it is to get rid of some stuff that served a purpose at the time, but now we would like to simplify, well, you're stuck.

[418] I understand the overall let's starve the beast kind of philosophy. Do you need process to do that, or should you just have up and down substantive votes? I think if you are thinking about tax policy, the rules inevitably over a period of time are not going to be a positive force.

[419] MS. MATTHEWS: We have quite a few people who have been seeking recognition. So I am going to call on people in the order in which I happened to see them.

[420] Jon Talisman.

[421] MR. TALISMAN: I was going to shift over to line-item veto. Line-item veto is another instance of where the tax people wanted out of the game. There was this feeling that tax expenditures are like spending items and therefore it wasn't fair to cut us out of the game, but then there was an effort to limit the effect of line-item veto on the tax writing process. So the drafters used these "objective" standards of 100 or less taxpayers being affected or ten or less taxpayers being affected as to what is a targeted tax benefit.

[422] You get several anomalous results with these seemingly objective standards. If you have a tax raising provision that affects 11 people today and you want to carve out all 11 people for transition relief, that's not a targeted tax item because, one, it's a raiser, and two, you've carved out 11, so the transition relief affects 11 people.

[423] However, if you have a tax revenue raiser that affects nine people and you want to carve out all nine people for some transition relief, that's a targeted tax benefit even though it affects all nine people in the class. The tax writers often could find two other people that would take you to 11, and then you are out of the pool again. There are going to be efforts at times, to craft provisions a little broader than you would have crafted them in the first place.

[424] You also have this anomaly that if a provision affects a million people and you carve a very narrow class of a 1,000 people out, that's not a targeted tax benefit, but if you have a provision that only affects 100 people and you carve 90 of them out as a revenue loser, that is a targeted tax benefit.

[425] While I understand the reason the rules were created, going to Fred's comment about the spirit, I think you are going to see very anomalous results in this issue.

[426] One last issue. I think you are going to see a number of constitutional attacks on line-item veto in the future. In fact, the members granted themselves standing to challenge the constitutionality of the line-item veto, there will be some question as to whether that grant of standing is constitutional. But that's another matter for another time.

[427] [Laughter.]

[428] MS. MATTHEWS: Rick Grafmeyer.

[429] MR. GRAFMEYER: Fred mentioned about the spirit, that really there is an underlying message there and you shouldn't look at what the rules are trying to do in unfunded mandates or reg reform because taxes weren't the initial reason.

[430] I would say on line-item veto, yeah, it was intended to go after the Lawrence Welk type situations, the Lawrence Welk home, or whatever. Or museum. But once it became apparent that may apply, I would say there was intended malice to apply it to the tax code by the appropriators and the budget people. It was ugly.

[431] Unlike all these other rules where we talked about the fact, well, we really didn't mean it to apply, I would say line item- veto is a little different. They really intended it to apply and to really cause major problems with the tax writers. It was intended. Then what happened is everyone involved in the tax process started trying to take it back a little bit, to try to bring it back to reality, and you go with the best thing you can get.

[432] The appropriator people, they were adamant. This was supposed to do damage to the system and make it tough for the tax writers to write tax legislation, and I think it worked. Could it lead to gaming and all kind of other issues? Absolutely.

[433] You talk about litigation and things. I'm not so sure for a few years whether we are going to see any litigation that has appropriate standing and/or may have the appropriate facts to actually raise the issue on, that it can get a good hearing on.

[434] The only other comment I am going to make is people talk about the fact of what the intent of these rules is. I look at what the original intent of the Byrd rule was in the Senate and where we are at now, which is a whole different ball game. The people who sat through my Byrd baths, you would go on for days going through provisions. That wasn't the intent of that rule, but I think someone made the comment, maybe Les, that these rules actually drive the substance and have a substantive effect. I guess I am seeing line- item veto walking down that road actually, that it will affect the substance of how provisions are enacted.

[435] MS. MATTHEWS: Don Longano.

[436] MR. LONGANO: I just wanted to pick up on that, Rick, and also I guess respond to Les. It seems to me that for good or for ill these rules are here and they apply to taxes and they are here to stay. It seems to me if we sat here and designed a theoretically pure system going back to where we started, the Congress would write the laws and, of course, Treasury and the IRS would interpret and implement the laws. I think, as Mike pointed out, there is a continuum of advice and interpretation that the Treasury and the IRS engage in. I think that perhaps if we all agreed that anytime theoretically that Congress allocates resources in the interpretation or implementation area, that's a misallocation of resources. Similarly, if the Treasury and the IRS devotes resources and things that are more properly done at the legislative end, again a misallocation of resources.

[437] I think one thing that could be done here that would be helpful, given the constraints of these rules, is if the proper personnel would sit down, not in the heat of battle but perhaps at the beginning of the Congress and kind of have a general persons' agreement as to what on that continuum requires the resources of the Congress to review at the Treasury level and what items at the regulatory arena should more properly be in Congress.

[438] Maybe that sounds a little pollyannaish, but it seems to me if Ken has to deploy personnel to chase down every ISP that comes out of the IRS, that is clearly a misallocation of resources.

[439] MS. MATTHEWS: Ken.

[440] MR. KIES: I agree with that.

[441] [Laughter.]

[442] MR. KIES: On line-item veto, everything Jon said and much more is true about the intricacies of line-item veto and the potential odd consequences. For example, just to give you one that you will probably initially be surprised at but will make sense when you think about it, the work opportunity tax credit will be subject to line- item veto if it is extended for one year, because the definition of what is subject to line item veto is any provision that has a revenue losing effect and affects 100 or fewer taxpayers in any of the first five years. If you extend the work opportunity tax credit for one year, when you get to the fifth year, because of the carryfoward provisions you will have fewer than 100 taxpayers benefiting. So it will be subject to line-item veto. That is sort of an oddball consequence.

[443] The appropriators clearly were in the mood of misery loves company in their fervor to make this thing apply to tax rules, notwithstanding the fact, by the way, that not a single state has a line-item veto provision that does apply to revenue provisions. So we are sort of the test case.

[444] I think the practical effect will be that the provisions that people really had in mind generally won't find their way into the substantive provisions to begin with, because the line-item veto threat or label will be a prophylactic that will stop people from trying to do this stuff.

[445] The sense of what people were really concerned about, everybody kind of has a sense of, you go back to the 1986 Act and look at the transition rules and you will see a lot of things that got done that were probably a little bit on the unsavory side. Those things would all be sitting there for the President to take his pen out and strike them out.

[446] The reason I'm not sure we will get to a constitutional challenge is I'm not sure we will ever get a bill to the President that has a provision designated in it for which he will actually line-item veto. He's not going to line-item veto the work opportunity tax cut even though it may be designated.

[447] What it is going to do is make people maybe a little more careful about what they actually put into the proposed law. It, unfortunately, will invite the clever drafting, because there are clever ways to draft around it. They are not foolproof, but there will be some of that.

[448] By and large, I'm not sure it's going to affect the substantive outcome all that much.

[449] MS. MATTHEWS: Jon.

[450] MR. TALISMAN: Just to get to Ken's point on work opportunity tax credit, depending on how you draft it, the carryover provision can be stricken as opposed to striking the whole provision. If you change it from the targeted jobs tax credit to the work opportunity tax credit and stick in a carryover provision, then it's the carryover provision that is subject to the line-item veto pen as opposed to the whole work opportunity tax credit. However, if you then next year extend it for an additional year, it's the extension that is subject to the line-item veto pen unless you reinstitute it and call it something else. So it's just a drafting issue.

[451] MS. MATTHEWS: Ken Gideon.

[452] MR. GIDEON: I can't envision how one would with any accuracy determine the number of taxpayers affected. Having been involved in efforts where you are looking for trends and trying to find them, you know there must be a few zillion of them out there, but finding them is pretty tough.

[453] MR. KIES: It's the same way we do revenue estimates. We get the dart board out, line it up and fire away.

[454] [Laughter.]

[455] MR. KIES: It's no different than the normal estimating responsibilities we have. It's just going to require an element of precision.

[456] MR. GIDEON: The most difficult area is to get precision.

[457] MR. SAMUELS: There will be an auction for people to step up and say they'll be affected.

[458] [Laughter.]

[459] MR. KIES: It will probably improve our revenue estimating, because we will really find out how many people are being affected by these things.

[460] MR. SAMUELS: But just enough to take you over the threshold.

[461] MR. KIES: I will say this, and I speak for the entire Joint Committee staff. We do not relish this responsibility. We have been through 40 hours of meetings in the last four weeks to come up with our line-item veto pamphlet that we are going to release to the public next Tuesday. It is a nightmare. But it's the law. So we are going to have to deal with it.

[462] MS. MATTHEWS: I'm going to go back and take some people in order.

[463] Mark Weinberger.

[464] MR. WEINBERGER: The good news is if enough time goes by between when you are recognized and you speak, everything is said. So all my brilliant comments were already said.

[465] [Laughter.]

[466] MR. WEINBERGER: The one thing that I think is worth pointing out, is worth talking about, good or bad, right or wrong, is how these things affect tax policy. None of them were originally created with tax policy in mind. If you look at the Regulatory Reform Act that came out of Project Relief from the Republicans to eliminate regulations or the line-item veto, it was basically a budget driven thing. It's not foreign to us. The only thing I would say is that the important thing is how does it affect the tax policy and how does it affect how the administration of tax policy is done.

[467] I agree with Rick's point, which is that early on most of these things will have more of a deterrent effect, and as Mike was saying, an administrative effect, but you can't lose the forest through the trees. I think if you are looking at procedural rules that are put in place and how they will affect tax policy, talking about the line- item veto and talking about congressional review without focusing on PAYGO and the Budget Act is kind of missing the mark.

[468] If you look at what procedural rules have the most profound effect on tax policy, they still, I would think, have to be the PAYGO rules where we obviously have to craft things so that we are revenue neutral in every single year within the 5- and 10-year period, so that we have to craft things so that whatever we do is paid for, so we look for revenue raisers that otherwise might not necessarily come to mind if we were thinking about tax policy first.

[469] The only thing left to raise was the point that, whether these other things have a marginal effect and mostly deterrent, it will have an effect on how tax policy is administered. If you look at the actual substantive tax policy, I think the PAYGO rules and the budget rules, and as Rick said, the Byrd rule and things like that, have to come to the top of the list.

[470] MS. MATTHEWS: Rich Belas and then Fred Murray and then Mike Schler.

[471] MR. GRAFMEYER: If I can interject one interesting point on that. Let me give you an example of the weirdness that is going to go on. If you do a budget bill and you have a tax provision, a small, nothing provision, if it scored a zero, it's subject to the Byrd rule. You don't want it subject to the Byrd rule. So you try to draft it so it loses a little bit of money. Now if you try to draft it to lose a little bit of money, you've got line-item veto problems. There are all kinds of perverse things that are going to go on.

[472] MS. MATTHEWS: Rich.

[473] MR. BELAS: I can understand that the line-item veto rules may very well be goofy in their impact. I think we are overestimating the problems versus what is gained on a couple of the others. For instance, the rule against retroactive legislation.

[474] If you look back to the '86 Act, as Ken was saying, there were some amendments that could be perceived as unsavory. If you look back at it, much of what was considered to be unsavory by the Philadelphia Inquirer and others were attempts to provide as close to a prospective ITC repeal as you could. If they hadn't done a retroactive effective date on the ITC repeal, you could have probably pulled out a substantial percentage of those so-called targeted transition rules. The same point applies, I assume, with passive losses, but I know for sure on the ITC.

[475] So perhaps having the tougher rules on retroactive legislation will help.

[476] Similarly, to go on to Les' point about Pease and PEP, obviously they are probably one of the most embarrassing provisions we have in the individual income tax right now, From my perspective, unless you are a legislator who had stock in the company that owns Turbo Tax, there is no particular reason why you would have done this. It's totally bizarre.

[477] MR. GRAFMEYER: Some great legislators ordered this to be done, I will add.

[478] MR. BELAS: Truth in income tax rates probably would have protected some of the Republicans against some of the efforts in 1993 by the Clinton Administration.

[479] I think we are missing the point of the supermajority. It doesn't mean that you can't do it; it doesn't mean that you can't replace Pease and PEP with higher rates. What it says is you can't do it on a close-call partisan basis. If in fact you can build a consensus that it is better to be honest with the taxpayer, it's better to have a simpler computation in the individual tax return, you can do all these things. It's not a prohibition. It's merely a prohibition against doing something on a close-call partisan basis.

[480] MS. MATTHEWS: Fred Murray.

[481] MR. MURRAY: I just wanted to add a footnote to something Les mentioned when he was discussing the effect of some of these rules. A finding of one of the White House small business conferences was that tax regulation was one of the most significant concerns of the small business community. So we spent a good deal of time over at the Service trying to hold town hall type meetings and trying to investigate that to see what kinds of regulations were really causing these concerns.

[482] In the course of those proceedings we noted that most of what the businessmen wanted to talk about were things like "the guy came out and looked at my return and didn't allow my deduction" or "he didn't particularly like what I was offering in terms of payment terms, so he took my house."

[483] [Laughter.]

[484] MR. MURRAY: When you get into that and sort that through, you find that most of the concerns were really enforcement concerns and had nothing to do with regulations or guidance or ISPs or any of those kinds of things. It was sort of distressing. Then you listened to the representatives of the small business community talk about the worth of reg flex and how it is going to improve the tax process, and it was very difficult to sort of match those two things together, because the people out there who are complaining about tax rules and regulations didn't really understand what tax rules and regulations were all about, I think, in many respects.

[485] MR. KOHL: In addition to Les' one on independent contractor, another one we heard on reg review is, we need this because of what is happening in the home office deduction. Sorry, that was in the Supreme Court, not us. That was my point. People don't like aspects of the tax system, but I don't think in other areas they clearly focus on, oh, it's a reg problem. I think the complaints on the tax system are less reg directed, but that became the fall guy.

[486] MR. WILKINS: If I could follow up on those two comments.

[487] MS. MATTHEWS: Go ahead. Then Fred has something, and then we are going to get to Mike.

[488] MR. WILKINS: The independent contractor and the home office issues are not just jokes about how people don't understand how the system works, and the complaints about collections are not just misperceptions about problems with rules and regulations. They are an expression of problems that people see out there, not with what goes on in Washington, but problems with the bureaucracy. There are some districts that are bad on this and some that are not so bad, but it is bureaucratic behavior and application of rules in ways that may not be supported by the law that is there.

[489] The regulatory flexibility was a response to the bureaucracies going wild. The stories on the IRS bureaucray going wild. I think are stories of what happens in enforcement and in the audit context, rather than the regulatory context. This wasn't the weapon that will kill that problem, but that's not to say it's not a real problem.

[490] MS. MATTHEWS: Fred.

[491] MR. GOLDBERG: I would like to echo what Bill said. I think there is a problem with this discussion, and I certainly hope this discussion is remembered as we go down the road. Glen, I know you didn't mean it this way, but if I'm some guy out there trying to run a business and I hear what you said, what I hear you saying, even though I know it's not what you mean, it's, ha, ha, you guessed wrong. It wasn't the regs that caused your problem. Too bad. Guess again.

[492] I know you didn't mean it that way, but I think in so many of these discussions we lawyer this stuff to death instead of trying to step back and figure out, what are the people saying? What's the real point here? Sure, Treasury can't control what the IRS is doing, but to the extent these kinds of emotive responses are a different message about how the system is working or not working, the real job is to try to understand what that message is and "deal with it", to quote the Mayor.

[493] MR. KOHL: Let me respond to that. I agree with you. My point is that the response of going after reg review was maybe politically very attractive but in fact was not the correct response. I'm not saying there isn't a problem. My point is that the business people don't look at the difference between Congress, Treasury and IRS; it's just the tax system and what it is doing to them.

[494] Fred, you deserve a lot of credit for coming up with the business plan which is a motivation tool to get more regs out, but I will tell you, when you sit with a group of non-tax people at a meeting and you are prepping for this stuff, and you say, practitioners want more tax regs, spontaneous laughter erupts.

[495] You do regs that are sometimes right and are sometimes wrong, but whether you hit the mark or not, my point is the things that have been put in place are not addressing the problem.

[496] I'm not saying there isn't a problem. I'm not trying to be defensive about is there a problem, but I think the message had already been received. We certainly learned from earlier experiences. There is a sensitivity to small business that has been there for a while. This extra bureaucracy that adds more work for the Joint Committee and more work for us does not pass a benefits and burdens test. Will this really solve the problems that the people have or will it just slow down the system and not really solve it? I think net-net it will not solve the problems.

[497] MR. GOLDBERG: It seems to me that we should stop saying, well, they picked the wrong thing and talked about it the wrong way. Instead, we should try to understand what they really meant do, should try to deal with what was really intended, do something to make the system better. To me, that's what the outcome ought to be. It's not enough to say, well, they guessed the wrong one, therefore it was a mistake. I think you need to balance that view against an analysis that says these provisions, however inartful and whatever their limitations, have forced us to think about the issue. If this is how we respond, then these provisions will have gotten us to the right place.

[498] I realize this is not a linear relationship, but I think it's a causal relationship.

[499] MR. SAMUELS: I think that everybody agrees that we have some problems and I think that there is a sensitivity to problems. When you get to proposed solutions that don't address the problems but are presented to the public as solving the problem, that doesn't really help solve the cynicism that people have, one, and two, when you distract people with limited resources having to do new procedures so that they can't really spend the time thinking about the problems, that hasn't helped the system.

[500] I don't think anybody is saying that, yeah, they shot and they missed, and isn't that interesting, and let's kind of laugh about it. I think the problem is that you have limited resources; you have a real problem; and when people kind of get off track and kind of take you on the winding road instead of the straight and narrow, it's bad for the system. It really doesn't help the system at the end of the day.

[501] MS. MATTHEWS: Mike

[502] MR. SCHLER: I'm not trying to change the subject, but back 20 minutes ago when I raised my hand --

[503] [Laughter.]

[504] MR. SCHLER: -- we were talking about the line item veto. I had a fundamental question that nobody was answering, or maybe it's just obvious to everybody. If you are going to have a line item-veto for revenue provisions, it's not clear to me why you shouldn't have the same thing for all tax expenditure provisions -- as a matter of fact, if you are going to allocate power between Congress and the President to allow the President to veto revenue provisions in bills, it's not clear to me why the same principle shouldn't apply to tax provisions. What is so special about it?

[505] If Congress chooses to spend money by doing something that taxes, why is that any different than spending money any other way? Why are we dealing with this question of whether you have 100 or fewer beneficiaries in some tax provision? That just seems a bizarre distinction to make. Why should that just be for taxes and not for everything else?

[506] MS. MATTHEWS: Fred Murray.

[507] MR. MURRAY: I think Les Samuels made my point more articulately than I could make it. But I think Fred Goldberg is absolutely correct, and I think Bill Wilkins was making the same point. We have some problems that we need to fix in the enforcement area and in the bureaucracy and the way in which we apply the tax laws. But I think Les made the point well that taking resources, particularly at times when we are laying off people in the national office and doing other things because of the resource constraints that we have got, to make people focus on things like reg flex analyses doesn't necessarily fix the problem that needs to be fixed.

[508] MS. MATTHEWS: Ken Kies.

[509] MR. KIES: Part of the answer on the line-item veto is the conception that the biggest concern we saw in making these provisions political attacks was that typically in spending bills you can look at a spending bill and there is authorization of X dollars for X purpose. You can cross that out, and the impact on other spending provisions generally is not that great.

[510] Our big concern on line item-veto was that if you just said to the President you can line-item veto limited tax benefits, there was the great concern that the President could take out a pen, strike out a line, and it would have this interactive effect with other provisions in the Internal Revenue code which there was no way to be able to handle. So at least if we were going to do this, we wanted a procedure where before the bill went to the President it was very clear what could and could not be struck out, and if those things were struck out, they wouldn't have subsidiary consequences.

[511] In order to get to that point, you have to then define statutorily what is subject to line-item veto, and when you start to write those rules, you end up with the anomalous types of situations we have described. So you end up with a set of rules that will occasionally look a little bit odd, but it's unavoidable. I don't see how you can avoid it if you are going to have a system that actually designates in advance.

[512] MR. WILKINS: Why shouldn't the President be able to veto the whole R&D tax credit?

[513] MR. KIES: All I can tell you is that after hours and hours of discussing this, there is no way to replicate what we went through in trying to draft this, but I will tell you it isn't as simple as you are articulating.

[514] MS. MATTHEWS: Carolyn.

[515] MR. KIES: Can I just ask one substantive question? There has been a lot of discussion about regulatory review imposing this horrible burden. What is it? All the thing does is say send the stuff up. Mike, what exactly are you doing now that you didn't do before?

[516] MR. THOMSON: I have been trying to differentiate between simply the regulatory review, and the extension of the regulations to reg flex requirements to interpretive regulations where there is paperwork reduction.

[517] MR. GRAFMEYER: Small business impacts.

[518] MR. THOMSON: With respect to regulatory review, once we worked out exactly what needed to be sent up and what we didn't, it was just a matter of having someone go up to the Hill with it.

[519] MR. KOHL: It is now harder to give small business an election out of a complicated provision than it was before it was passed.

[520] MR. KIES: Now I understand what you are talking about.

[521] MS. MATTHEWS: Carolyn, and then Ed.

[522] MS. SMITH: The appropriations veto is broad. The President could veto appropriation, for example, the appropriation for the Defense Department. If the tax veto authority were to be that broad, theoretically, the way to do it and have it work a little more mechanically, would be the Senate approach. That approach separately involved separately enrolling each bill. You still have a question of, what is a separate bill? There are the interactions that you do have to deal with.

[523] I think this approach is very much a creature of the Senate. It has all of these rules, Byrd rules and things, but everyone agreed it would be an extraordinarily complex procedure to separately enroll major tax bills. How many separate bills would have been involved? Thousands?

[524] MS. MATTHEWS: Ed.

[525] MR. BECK: One comment on what was brought up in the debate about the effect of regulations and small business enforcement and so forth. I think the idea of the reg review, reg flex process is a response of Congress that they want another shot at what the IRS does, but it does seem to me there are some unintended consequences. I don't think you can always assume that all the regulations are bad. The Check with Bob regulation is one that a lot of people really think is a good idea, but it would be a shame to have it come out and then have it bogged down in another area of congressional review and oversight of that particular regulation.

[526] MS. MATTHEWS: Mike Thomson.

[527] MR. THOMSON: I raised my hand in response to Bill Wilkins' point that the concern out there is about the agency being bureaucratic. I think "bureaucratic" is a code word for they didn't buy it; that is, they are just being "bureaucratic" when they don't agree with you. Particularly in the situations we are talking about, independent contractor, home office, capitalization, these age-old but factually intensive situations. The IRS has legitimate interpretative and administrative concerns, and that has to be balanced. We all grapple with those, and I suspect we will keep grappling with them.

[528] I agree that is the heart of the problem, but I wouldn't call it bureaucratic so much as just hard. The law is hard. In an attempt to be fair and administrable, sometimes there are these pressure points that may be intractable. Maybe not. Maybe someone has a solution. We haven't found them. It is the substantive law that is the problem.

[529] I will pick up on Les' point that attempting to go at it through process type things is more a distraction. Yes, let's get at the root of the problem; let's deal with the root of the problem; let's not spend our time off talking about whether or not this particular provision trips this paperwork rule or that reg flex rule or how many small businesses it could affect. That's something we do anyway. We very much keep an eye on how burdensome is this, what are the risks and rewards, what is the investment and the rewards for the government and for the taxpayers. So while it's an important part of the process, it doesn't get to the root of the problem, and we ought to try to do that.

[530] MS. MATTHEWS: Bill.

[531] MR. WILKINS: It's partly that these issues are hard, but it's also partly that there are rogue problems and they are out of control in the field. So it's both.

[532] MR. THOMSON: That is also true, but also not addressable by regulatory reform type processes.

[533] MR. WILKINS: That's true.

[534] MS. MATTHEWS: Ken.

[535] MR. KIES: There has been a reference to the independent contractor issue a couple times. When the Service is losing cases so badly that they are having attorneys fees awarded against them, it is a sign that maybe they are being too aggressive in a particular area. That has happened in a number of cases in the case of the independent contract provisions.

[536] Like it or not, the Service -- and I think it's at the national office level -- they do not like Section 530 of the Revenue Act of 1978. They refuse to apply the provisions. So it isn't just that it's hard law sometimes. They are not applying those provisions.

[537] MR. KOHL: And if Treasury could have issued regs, maybe we have could have controlled the issue.

[538] MR. KIES: I know, but it's IRS policy that is litigating these cases, and when they are losing them so bad they are getting attorneys fees awarded, it's a sign that they are going too far.

[539] MR. KOHL: But Treasury was taken out of game.

[540] MR. KIES: I know that. But that response is exactly what Fred was getting at, which is you are not responding to what the real problem is by just saying, well, we can't issue regulations.

[541] MS. PORTER: So what is the real problem? Are we talking tax reform of substantive law? Are we talking of reforming the IRS or restructuring it? What is the problem?

[542] MR. KIES: The truth of the matter is that the difference between an independent contractor and an employee today is rather modest other than being subject to withholding. I'm not trying to say that's a small item. These big fights which went back into the 1970s were at a time when there were significant tax differences, and today it's basically a compliance issue. The Service hasn't caught up with that and they are relentless in this particular area, and they are losing left and right.

[543] MR. BELAS: Ken, are you suggesting that Taxpayer Bill of Rights 5 is going to replace attorneys fees with capital punishment?

[544] [Laughter.]

[545] MS. MATTHEWS: Catherine.

[546] MS. PORTER: I won't talk too much because I talked a lot last night. It seems to me we keep going back and forth. People say, well, everybody knows what the problem is and these procedural rules didn't address the problem but the spirit of the rules did sort of point to a problem. I'm just wondering if we have any consensus at all on what the problem is. I'm not talking about just independent contractors right now. I am talking about a much bigger, more philosophical issue of do we have any agreement on what the problem is.

[547] There is a message here that Fred and Bill and all have talked about in these procedural rules, that somehow the procedural rules may have missed addressing the problem. There has been a nodding of heads by everyone at the table indicating that there is a problem.

[548] Does anyone want to specify exactly what it is?

[549] MS. MATTHEWS: Don Alexander.

[550] MR. ALEXANDER: I'm totally confused at this point. We were talking about the problem of the rogue agent. I agree with Bill Wilkins that there are some. I think that's an IRS management problem and I think on the whole IRS does a pretty good job despite the fact that some people complain like hell. Some of the complaints are legitimate. Bill, many of them, as you must know, are not.

[551] As Ken correctly points out, the problem is a compliance problem. IRS has as one of its duties to try to make the tax law work. Independent contractors, I think we all agree -- I hope we do at this particular session -- don't comply as much with their tax obligations as people who are subject to withholding. So IRS does have a problem.

[552] Section 530 of the 1978 Act prevented the issuance of regulations. I agree with Glen Kohl. I wish that that had not been done, and I think we would have more uniform rules and better rules. The problem with the rogue agent is not going to disappear in an organization as large as IRS, but some sensible regulations would help to control it.

[553] Finally, in answer to a point about IRS being subject to attorneys fees, and under this wonderful new rule they are going to have the burden of proof, I don't know if it's going to change anything. I think we decided yesterday it wasn't. I do want to mention, if we are talking about cases, that the Microsoft case seems to go in a slightly different direction.

[554] MS. MATTHEWS: We are at the end of our time. There are three more people who would like to speak, and I am going to call on them, and hopefully we can wrap up.

[555] Mark Weinberger.

[556] MR. WEINBERGER: I think Mike Thomson and Les' point about process doesn't fix substance is absolutely right. I think people would agree with that. But none of the rules we are talking about, whether it be line-item veto, whether it be congressional review of regulations, or whether it be PAYGO rules, were aimed at fixing tax substance. They were all aimed to fix other bigger and different problems and as a result have an effect on tax policy.

[557] I don't think we can say that process doesn't have a role in tax policy. Obviously it is not the sort of causal relationship we would like from a tax practitioner's perspective, but these issues don't really go to the substance of tax policy.

[558] None of these rules we have been talking about were aimed directly at tax policy. I would say the issue of the deficit, the issue of whether the government has too much role in individual's lives are other bigger issues that are being addressed in a different context, and that's the substance these rules were really aimed at.

[559] MS. MATTHEWS: Norm.

[560] MR. RICHTER: I just want to make the perhaps obvious observation that just because there is noise and there is backlash against the tax system doesn't mean necessarily that there is a problem, to go to Catherine's point. There is going to be natural resentment of revenue collection functions in every society that has to collect revenues to fund public services.

[561] There is an irreducible amount of noise and backlash you are going to get in every system, it seems to me, and that is going to always be compounded -- this goes to Mike's point -- by the fact that laws are built out of words that try to put boxes around the infinite variety of facts and circumstances that are out there. So you are always going to have places where taxpayers are going to resent the way in which their particular facts got forced into this little box that the law has put together. That is where Fred Murray's point comes in. You actually talk to people about what their problem is, and it's the fact that "he didn't let me have my deduction" and "he made me pay my taxes."

[562] MS. MATTHEWS: Mark.

[563] MR. MULLET: This is just a short comment. Now that Ken is gone, this is great timing on this thing.

[564] [Laughter.]

[565] MR. MULLET: I would love to be a fly on the wall in Ken's office so I could watch the taxpayer gymnastics as taxpayers go in to argue that this really doesn't cost any money, so it's a technical correction, but on the other hand, it's not subject to the Byrd rule because it really does cost a dollar or two, but yet it really affects more than the seven taxpayers you thought it did; it affects 11, or it affects 101; but that doesn't cost any money either as we increase the number of taxpayers.

[566] MR. GRAFMEYER: We are just saying that to get around this other stupid rule.

[567] MR. MULLET: Because we are trying to get around this other rule.

[568] So you have got at least four rules there that people are going to go and talk to Ken about, and they completely conflict with one another. It's just going to make for wonderful fun in the Joint Tax Committee.

[569] MR. BELAS: That's what we mean by dynamic scoring.

[570] [Laughter.]

[571] MS. MATTHEWS: I see we haven't solved the independent contractor issue, but we have had a lively discussion. Our hope is our procedures have contributed to some substantive exploration of these procedural problems. Thank you all.

[572] [Recess.]

[573] MR. ROSENTHAL: We are ready to start. The propositions for the next session can be found on page 4 of your materials. This session is entitled Can the Tax Laws Catch up with the Financial Markets?

[574] This session presents a mix of both process and substance as we go forward. What I have in mind for our discussion this morning is to focus first on the question of whether or not a problem exists, and if there is a problem, is there a solution? Finally, at the tail end of our discussion, I would like to talk a little bit about how solutions to dealing with financial markets might be created.

[575] This particular problem within the context of the tax law should be viewed as a specific example of the broader problem of the tax laws trying to tackle technical areas. The point of this discussion is to focus on process and substance generally and not to focus on any specific proposals that have been introduced by either the Administration or in Congress. The intent is to use this particular area of the tax law, which has received an awful lot of attention recently, to think about the ways in which the tax process works and the way that tax rules operate.

[576] Let me start first with the question of, is there a problem with the financial markets and the tax law? I think many have observed that the financial markets in recent years have evolved very quickly and have grown increasingly sophisticated. In addition, the current tax rules, which in many respects date back to 1913, might not be equipped to deal with some of the financial products and some of the transactions we see today.

[577] Let's focus first on whether or not that observation is correct and what the problems might be in the existing income tax laws and then think about ways that those problems might be addressed.

[578] Mike, can you describe generally, in terms of the current income tax rules and financial transactions, are there problems that people are bumping into?

[579] If anybody else has some other views as well, we would like to hear about the particular types of problems that you might see with an increasingly complicated and sophisticated environment bumping into very old tax rules.

[580] MR. SCHLER: I think the basic problem is that a financial product is just a bunch of cash flows, money going this way or that way between two parties. Depending on what you call it, there are just totally different rules to the extent there are any rules at all. Everything is in boxes. In about a minute I came up with five boxes. If something is treated for tax purposes as contingent debt, there is one set of rules. If you call it a notional principal contract, there is another set of rules under 446. If you call it a series of options, you are under another set of rules for options. If you call it a prepaid forward, another set. If you call it preferred stock or any kind of stock, it's a different set of rules, the 305 type rules. But the same set of cash flows can be any of these things.

[581] Just as a footnote, you can do almost anything with preferred stock these days. You can have preferred stock payable in cash equal to an ounce of gold. Or you can call it a prepaid forward contract. So for any set of cash flows you can try to fit into a box. Even worse, you run the risk that the IRS will come in and say the box you thought it was in is really the wrong box, and you get a totally different set of rules.

[582] There are some rules that make sense. The contingent debt rules, the regs which just came out, give you an economically correct result. If you have a notional principal contract, you would basically get an economically correct result. Then you have rules like the option rules where it's a totally different set of rules.

[583] Eventually the goal might be to reconcile all these different rules so that you just look at cash flows. That will mean some substantial revisions to the existing rules. If you are going to treat equity products like debt, you have really got a substantial revision of 305 you have to do. You have to substantially change the rules for options if you are going to treat somebody paying an option premium the same as if they bought a contingent debt, and it has effects on things like convertible debt, which has elements of being contingent debt. It's also treated totally different than contingent debt.

[584] I think that is what the basic problems are. You can create a bunch of cash flows, which is what you economically want to do. Ultimately you want these cash flows. You can call it anything you want and you try to put it into a box, but depending on which box you are in, you get totally different treatment in many cases.

[585] One of the big problems is uncertainty, not knowing which box you are in. This is economically inefficient and results in extremely complicated prospectuses, telling people, well, we're calling it this and we think it's this but maybe it's that. The consequences if it's this is these five pages; if it's that, it's those five pages. We are sorry we can't tell you what the right answer is, but there is no authority.

[586] That's really what the problem is, I think.

[587] MR. ROSENTHAL: David.

[588] MR. HARITON: My problem is I don't really know what Mike means by the economically correct result. The problem with this question, whether the tax law can keep pace with innovation on Wall Street, is it implies that it's a practical problem: Can we just as a matter of tax pyrotechnics keep pace with all these new transactions that they are coming out with?

[589] What I think Mike is driving at is the idea that maybe you could reach a point where you will be providing effectively for the same tax treatment written into the treatment of a broad range of financial instruments and transactions and it wouldn't matter whether it was called an option or a forward or a swap or whatever.

[590] When you step back and think about it, you realize that there is no such thing as the consistent tax treatment of economically equivalent transactions in our system. You start with a system where we all know that holding appreciated property is economically equivalent to selling that property and buying it back again. Then you're short against the box here. You are caught up in this conversation about why a particular taxpayer should be treated as having sold property because he's entered into a transaction that is economically equivalent to selling the property. You lose your footing, because it all has no meaning.

[591] We have been caught up lately in this discussion of whether or not the Treasury should be accruing interest income as prepaid forward contract. When you actually sit down and think about it, you realize that there are two economically equivalent transactions with radically different tax treatments.

[592] In case 1, A invests $100 in debt for three years, earns $15 of interest income, and also enters into a three-year forward contract to buy a share of growth stock growing $15 in three years.

[593] In case 2, the guy simply invests in a share of growth stock and holds it for three years.

[594] In case 1, you get $15 in income accrual; in case 2 you get no income accrual.

[595] Now, here you are, in front of the Treasury asking, well, how should Treasury treat a guy who gives $100 to a company today and gets back one share of stock in three years? Should he be treated like the first guy, who gets $15 of income accrual, or should he be treated like the second guy, who gets no income accrual?

[596] There are no answers, because you are not debating about how you arrive at consistent tax treatment of economically equivalent transactions. You are debating about how to enforce the non- equivalence of transactions and when and where you want to have the non-equivalence and what you want to be non-equivalent with.

[597] Debt/equity is the biggest obvious case there, because we really don't know. We are asking ourselves, well, are these guys disguising debt as equity or are these guys disguising equity as debt?

[598] We really don't ourselves know what the distinction between equity and debt is. We really can't see any economic difference between preferred stock and debt to begin with. I think until we answer some very basic tax philosophical questions about what sort of inconsistencies in treatment we would want to have, we are not going to be able to answer the practical question about how to keep pace each year with all the innovation.

[599] MR. ROSENTHAL: Rick Reinhold.

[600] MR. REINHOLD: The tax laws reflect 19th century property concepts for the most part in assuming that people own assets and owning an asset has a consequence, and a liability is a certain thing and a debt obligation is a certain thing. There has been a lot of change in the financial marketplace so that you can own some rights to an asset, not all, and the tax law has more or less played this catch-up game that says, well, if you eliminate the risk of holding this assets, or whatever, then we are going to deny a certain tax treatment. There has been a cat and mouse game among practitioners and the government to try to sort out the proper tax treatment under given transaction formats. The financial engineers probably have a consistent upper hand.

[601] I think Michael is right in the sense that whether you describe a given asset as the ownership of the asset or as a forward contract or an option or a swap is a matter of economic indifference. Yet as long as there is going to be a different tax regime applicable to each, you will have consistent elections against the revenue. Especially in the case of financial product when you have got so many players in the marketplace that are not subject to tax, whether they are farmers or pension plans or other kinds of entities, loss entities on the other side, the government has got to lose that game almost consistently.

[602] I think without stepping back and saying what kind of tax treatment do we really want for people that experience cash flows of this nature, it is a game the government cannot win.

[603] The difficulty, however, is once you start disaggregating a share of General Motors stock into a series of cash flows, you then have to explain to the guy on the street who still has a 19th century concept of property and thinks tax laws more or less follow that view. So then you are driven to a two-tier tax system, which is not particularly attractive and probably leaves open a lot of opportunities for gaming, it seems to me.

[604] MR. ROSENTHAL: Brad.

[605] MR. FERGUSON: If the goal is to try to treat equivalent transactions in the same way, what most people latch on to is the concept of risk or lack of risk, certainty or lack of certainty, That is really what most of the debt equivalence analysis involves. In the financial world, risk can be anywhere along a spectrum, from virtually no risk in the case of a short-term government obligation, to a lot of risk in the case of a forward contract. If we only have two or three cubbyholes and the cubbyholes are specifically defined, the financial engineers can vary the risk of a particular instrument to fall outside the cubbyhole or inside the cubbyhole. That's a losing proposition for the fisc.

[606] What is the solution?

[607] One solution is to eliminate the significance of the cubbyholes, to do away with debt-equity distinctions and with realization requirements, or maybe not to tax returns on investment at all.

[608] Another solution is to fuzz up the borders, so people don't know whether they are inside the cubbyhole or outside the cubbyhole. But, then people complain about uncertainty.

[609] I think ultimately you are faced with some of these very basic questions that you've posed here. Can we really have an administrable system where we don't integrate corporate and shareholder taxes or we do not mark everything to market?

[610] MR. ROSENTHAL: Let's think a little bit about the solution. I think it's clear from our comments already that the financial markets and the tax laws present an awful lot of anomalies. David has suggested that we need a tax philosophy. Both Brad and Rick have described how the fisc is a systematic loser in a world in which cubbyholes can be either fit or not fit at the discretion of taxpayers, say.

[611] Given these anomalies, let's turn for a moment then to thinking about whether in fact new rules can be developed to address these financial markets. There is a series of things to think about here, whether the income tax system works, is how to put new rules in place, is how to get the IRS to be able to examine and audit whatever rules we put in place. Let's go to those questions for a moment.

[612] Tim.

[613] MR. HANFORD: I have a couple of comments on this. As I listened to David talk about the question of taxing economically equivalent transactions the same way and trying to identify what is economically equivalent, there is an underlying sense we have that sometimes the question should be measured: Are the distinctions created solely for tax reasons? Would a transaction be done this way for non- tax reasons? We suspect that in some cases it wouldn't be. So I guess we are trying to identify transactions that are new solely for tax reasons and address them.

[614] When we have our fundamental tax reform hearings next year, I think I am going to make David one of our lead witnesses for why we should do away with the income tax, because there are no answers to this question.

[615] We at the staff try a small step to understand some of these new financial products. We believed that before you could write proper tax rules to address some of them you had to know how they worked. So we thought that the people who created them should at least explain them to the IRS and to the Congress. We proposed corporate tax shelter reporting in any case where some new product or scheme was created that the creator thought should be kept confidential because once revealed it might not exist very long. We will probably continue to discuss that as a concept for dealing with some of the innovation.

[616] MR. ROSENTHAL: David.

[617] MR. HARITON: We can't even understand the transactions. When you say, Tim, that you want to know what the taxpayer would have otherwise done or did the taxpayer do something differently in order to achieve a tax result, I honestly don't understand what you mean. I tried to grapple with it. Take the case, as I mentioned a moment ago, where A give B $100 and B gives A a share of stock at the end of three years. Assuming that that achieves the particular result that is beneficial, like no accrual of interest, what do you think the taxpayer would have done otherwise but for taxes? What transaction are you now going to analogize this to that you think is the right answer as opposed to the wrong answer?

[618] MR. HANFORD: I guess I'm not sure how the taxpayer got into the second transaction, who suggested it, and why it was done.

[619] MR. HARITON: Les, why don't you comment.

[620] MR. SAMUELS: I want to step back and make some general observations. Obviously the financial markets evolve to a particular place in time, but if you kind of step back and look at the process over time, when the derivatives market started in earnest with interest rate swaps and those kinds of exchanges, people who started to do those transactions at the very beginning, it wasn't like the tax law was trying to catch up with financial instruments. The question was, what are the tax consequences?

[621] People designed those transactions, having been involved in the first ones, to meet client and investor needs. One of the things that one learns in participating in this market is you can design the most interesting financial product, but if there aren't investors who are interested in buying it, it really isn't all that interesting. I've seen people designing some very interesting products and no one wants to buy them. It's a little like proposing a new tax incentive and it turns out the people who were the intended beneficiaries don't really get very interested in it.

[622] But it does happen that there is kind of an investor base and also an issuer base that does look at economics of a lot of these transactions. While we are looking, the discussion comes very quickly to a smaller segment of the market that might have more tax innovation associated with it, but when you look at a lot of what is going on out there, the economics are driving the transactions. If you see how the law has evolved, it has evolved both at a legislative level and a guidance level. Mark to market for financial institutions was a change that affected an important part of the economy, and for them they are marking to market.

[623] While there are obviously a lot of other investors, like tax exempt investors and taxable investors, you have kind of addressed part of the market, but some other issues obviously are left on the table. You have got the hedging rules. There was a great deal of concern about how some of these transactions would fare under kind of the Arkansas Best case. There was a lot of controversy and discussion about kind of what the rules ought to be, and ultimately administrative guidance was given to solve a lot of those problems.

[624] You've had the contingent debt rules that have developed. Maybe we can agree or disagree with the rules, but I think there is a relatively coherent set of rules that tell people what the results are. Yes, it didn't cover everything, and when the regs came out, as I recall, in the preamble it says the government is continuing to look at some of the cubbyholes that Mike mentions.

[625] I view this as kind of an ongoing process, that from time to time you are going to see some transactions that are troublesome and you might want to think about a legislative response. Someone mentioned short against the box. That's not new. That is older than anyone here, I think.

[626] MR. ALEXANDER: No.

[627] [Laughter.]

[628] MR. SAMUELS: Don, I was looking at you, and I think it's older.

[629] MR. ALEXANDER: I remember its inception.

[630] [Laughter.]

[631] MR. SAMUELS: That's not a new financial innovation. That one has been around for a long time, and people, for a variety of reasons, hadn't addressed it legislatively until recently.

[632] I kind of view this as an evolution. You will see the tax law kind of responding in steps both to perceived problems where people are engaging in some segments of the market in transactions that you feel are basically tax driven and where the economics and the tax seem to be separated in terms of their treatment in a significant way.

[633] Then you will have other parts of the market where people are saying, listen, we are just trying to tell you what the rules are, because we think notional principle contracts are something that ought to be allowed. We are not trying to stop them. We want people to know what the rules are and we don't want people to game us too much. So there was kind of an evolution of the rules on notional principle contracts.

[634] I think you have to step back and kind of look at the evolution of this. We are at a particular place and time and there are some interesting transactions and there is a lot of intellectual horsepower that is being put into these transactions. That's why maybe it has a little higher visibility now, but I think it's important when you think about it to take a perspective and see how the market has developed and why it is a particular place.

[635] MR. ROSENTHAL: Ken Gideon.

[636] MR. GIDEON: The fundamental problems in this area are not new. They are the problems of the income tax. I would be interested in some of the people who work regularly in this area really picking up on something that Rick said of how much of this problem is a problem of the mismatch of a tax exempt entity, be it foreign or formally tax exempt in the United States vis-a-vis someone who is taxable and what that arbitrage is doing as opposed to a situation in which if you have two fully taxable taxpayers how much you care about some of these issues in terms of if somebody is paying, what the problem might be.

[637] Finally, just the observation that one of the difficulties of the income tax that is observable wherever you see it is that anytime it has to value something without a clear market standard available to it has to infer a value before there is a market demonstration of value. That's very tough, and tends, with the best intentions of those who draft, to get it wrong a lot.

[638] MR. ROSENTHAL: Ed.

[639] MR. KLEINBARD: Obviously Ken is right. Why is there preferred stock and subordinated debt in this world? Do they exist for complex commercial reasons? No. They exist as a practical matter in the world because they are devices by which buyers and sellers, issuers and investors can decide how best to deploy their capital or hire that capital in the most efficient manner. The capital markets are very efficient.

[640] I would say to Tim that this conversation about financial products is largely a conversation about capital markets. These are public deals, and I think that tax shelter issues are best reserved for the afternoon.

[641] The capital markets are extremely efficient. I don't know that that is a problem at all. It certainly isn't a problem that has anything to do with financial products.

[642] The fact is it seems to me that this conversation suffers from a kind of disjointedness because it confuses two really separate issues.

[643] One is the sort of wistful view that it would be great if we had a unified field theory of all financial products in which everything is nice and tidy and all comparable cash flows are taxed comparably. Sure that would be nice. Dull, but nice. But it isn't going to happen.

[644] I can think of four reasons that are so ingrained in our model that we call the tax system that it will never in our lifetime change. One is what David referred to, the fundamental dislocations that follow from a realization-based system.

[645] Another is the notion of capital gains as opposed to ordinary income. Of course financial products are designed to maximize capital gains to investors who care about capital gains and not to do so for investors who don't care about capital gains. Of course that's what efficient markets do. That shouldn't surprise anybody. It's not the fault of financial products that there is a distinction between capital gains and ordinary income that cannot be described to any intelligent outsiders to the system in any way that has the least bit of logic behind it.

[646] A third reason is the distinction we draw between debt and equity. We have subordinated debt and preferred stock. The completely binary tax consequences, that the flow from those two characterizations have nothing to do with anything other than tax. You just recognized that. That has been true even longer than Don has been practicing.

[647] MR. ALEXANDER: That's true.

[648] [Laughter.]

[649] MR. KLEINBARD: Finally, Rick is absolutely right about tax exempt and taxable investors.

[650] So we have four fundamental reasons why the quest for a unified field theory of taxation of financial products is doomed to failure. Of course that's true.

[651] I thought the purpose of this conversation was perhaps a little bit more modest issue, which is, what do we do when the financial markets innovate, innovate, innovate? How have we responded to those issues? As to this issue -- I think, and this would not have been true a few years ago, we can say in large measure the answer has been yes.

[652] In fact, a lot of energy was put in by a lot of people around this table and elsewhere in developing timing rules for swaps, in developing hedging rules, in developing timing consistency principles, in developing source rules for derivative product, in developing the mark to market rules for securities dealers.

[653] I would say as a p.s. that I don't think there is a significant securities dealer subject to mark to market today who doesn't go to bed every night thanking God for mark-to-market. It is the best thing that ever happened to the industry in terms of being able to accurately predict and deal with the tax consequences of economic transactions in a rational way.

[654] We could break early for lunch --

[655] [Laughter.]

[656] MR. KLEINBARD: There are some places where there are problems. Michael and David both referred to the taxation of prepaid forwards. Nobody knows the answer. In fact, I know the answer. It's just that I haven't done a good enough job convincing everyone else.

[657] [Laughter.]

[658] MR. KLEINBARD: The IRS has the regulatory authority to deal with that. Treasury and the Service have the 7872 authority to deal with the taxation of prepaid forwards and elongated options. It's a pity they haven't done it yet. They have the authority to do so.

[659] Contingent debt regs. We can argue about them. I don't think they are perfect. Others do.

[660] Where are the problems today? The problems today, I think, are first in the taxation of these little odds and ends like prepaid forwards you need to get straightened out, and that could happen in three months with some regulations; the taxation of the financial institutions who are the large players in the market of financial products. The capital markets are not dominated by Ma & Pa Kettle; they are dominated by large financial institutions, and not enough work has gone into thinking about how some of them, like insurance companies and hedge funds, are taxed.

[661] Finally, starting next to think not about the old issues or about the unified field theory, but about some of the problems that people are now looking at, like electronic commerce. Those are where the issues are.

[662] I think, frankly, if you look back over the last ten years, the sum and substance of it is we've had a great deal of success in terms of rules that sophisticated New York lawyers and sophisticated Washington tax writers can understand. There is a larger question about whether people in the field can deal with them. I think we ought to get back to that. But frankly, the last ten years has been a story of success in the marketplace, and I don't think the fact that there are differences between tax exempt and taxable investors is one that ought to be laid at the feet of the capital markets.

[663] MR. ROSENTHAL: Rich Belas, did you want to jump in?

[664] MR. BELAS: I suppose I am going to have to wait for the transcript, but I think Ed Kleinbard probably covered most of what I was going to say.

[665] I think as long as we can't make up our mind as a tax system about what accounting rule we are going to apply we will have confusion. Are we going to do this on a taxpayer by taxpayer basis? Are we going to have accrual versus cash basis taxpayers, or are we going to apply the accounting rules on a transaction by transaction basis and have taxpayers be accrual for one purpose and cash for another purpose? As long as we have preferential rates for different types of income, I don't see any realistic possibility that we are ever going to be able to come up with an answer for new financial products, new types of cash flows, as they come up. I think going back 15 or 20 years to the debt equity regs gives you absolutely no reason for hope.

[666] MR. ROSENTHAL: David.

[667] MR. HARITON: I might take what Ed said a step further by saying that I am not persuaded that a unified field theory would be either dull or nice.

[668] [Laughter.]

[669] MR. HARITON: If you just think about a swap, for example, since you raised it, suppose we had bilateral exchanges of cash flows between two taxpayers and we discovered that A was paying a lot of money to B. Is it because A was a loser and is suffering losses, or is it because this was an intended investment made by A and B, and if it's the latter, then don't we have to be accruing interest under a unified field theory? It's a nightmare of absolute complexity.

[670] I agree that where we have come in the last ten years to sort of a growing relative piece in different cubbyholes is for now best augmented by some of the integration rules that are developing in the code.

[671] I think this speaks to something that Tim raised a little earlier, that the biggest concern about inconsistency is the taxpayer's ability to game against the system by choosing the form of the transaction. The response is, of course, presumably that the best tool that you could give the Commissioner to defend herself against that would be the right to forcibly integrate the transactions into something else which does not have a particular tax benefit. We see that coming in all over the code, in 1275, in 1221, in 446, in 988. In fact, in the cases where for some reason the IRS has denied the taxpayer the right to integrate, in effect it shot itself in the foot by denying itself the right to force integration and giving the taxpayer the opportunity to game the system.

[672] MR. ROSENTHAL: Mike.

[673] MR. SCHLER: I think there are probably three fundamental issues. One is debt/equity, for which the Service has had great authority since '69 and tried and failed several times. One is realization, which is the short against the box issue. The third is the rate at which you accrue income.

[674] In the accrual of income, there really is a lot of perfectly legal gaming between taxable and tax exempt people. Anytime you can fit something into a cubbyhole where both sides aren't treated economically correctly, whether it is reporting income too fast or too slow, there are obvious opportunities for gaming, because you always have issuers who can't use deductions and holders who aren't taxed. It's just like a windfall from the government. Whether it's undue acceleration of income or undue deferral of income, you always have people taking advantage of that.

[675] It seems to me the ultimate goal should be -- this is getting to the unified field theory -- you want to have something like a super 446; everybody should be accruing income and deduction on an economically correct basis. It's like an overriding principle. The contingent debt regs more or less reach that result when they apply, and the notional principal contract regs reach that result. The notional principal contract regs are written in very general ways, and so you end up there.

[676] There are a lot of other cubbyholes that don't have that result: options; prepaid forwards.

[677] It seems to me the goal in the long run should be to get everything on some kind of economically correct accrual. On an ongoing basis the OID concept makes the most sense and avoids the most gaming of the system, I think.

[678] MR. ROSENTHAL: Rick.

[679] MR. REINHOLD: I hear this discussion about the progress that we have made. It seems to me it might be interesting to go back and look at how equity swaps fared in that process.

[680] I think Les is absolutely right that swaps started out for reasons having nothing to do with taxes and had a lot of tax lawyers scratching their heads for a while to figure out what these things were. Guidance has since come out, and by and large it's pretty thoughtful guidance.

[681] But equity swaps may be a little different in the sense that, for any of who don't know, it's simply a situation where you enter into a contract and you give up the cash flows associated with a share of stock and get back for it a set of cash flows that approximates a debt return, or something like that. You could sign an equity swap instead of selling your appreciated General Motors stock and get a debt return and simply avoid the capital gain tax.

[682] I guess one of the early pieces of guidance said that if you are a foreigner and you hold an equity swap on General Motors stock, that's foreign source income and there is no withholding tax. Obviously a foreigner who thinks about his alternatives decides that an equity swap is better. The Treasury has pointed out in the preambles of all of the swap regs that they think that's an avoidance opportunity and they are going to fix it soon.

[683] Then I guess the further realization is that the equity swap does permit maybe more of a deferral of capital gains taxes than seems appropriate, and therefore the short against the box rules would get it, and presumably those will be enacted at some point.

[684] I guess the adviser's next turn is to then figure out how much risk you can retain and dodge the short against the box rule. I think people were pretty comfortable that if you kept maybe 10 percent on the upside or downside that was probably enough for that set of rules.

[685] That's not a defect of those rules necessarily. I think what it does point out is that the economic marketplace is very efficient, but taxes are part of the economic marketplace. If people sign a set of contract rights that allow them to postpone tax indefinitely or avoid tax altogether in the case of an equity swap because of the section 1014 adjustment to basis on death, that's a pretty good deal.

[686] You are going to have the situation where products that I continue to think really represent the carving up of risks and other attributes of ownership in a way that is really inconsistent with the 19th century concept of asset ownership are going to continually defeat the operation of the rules unless the rules take them on their own term.

[687] MR. ROSENTHAL: Fred.

[688] MR. GOLDBERG: Having not understood any of this, I'm going to talk about two different subjects. I am trying to keep of words like "government's a loser," "gaming," "take advantage," "dodge." These words come up a lot in talking about this issue. In some people's minds three words carry a judgment about "good" and "bad" behavior.

[689] I guess to the extent that a judgment being passed, and it's a negative judgment, I would take exception. What we're seeing is a natural response of the marketplace. To the extent you attempt to put value judgments on this behavior, I think that is wrong.

[690] Beyond that, these judgements carry with them certain dangers that people should be careful about, because what it does is it leads you down a road of asking the kinds of questions that Tim was asking: Why did you do it? Who suggested it? How did you feel about it? Which was more important?

[691] I think that is not a good road to go down, one, because I don't think it's a road that can be administered. Secondly, I don't think it's a good road to go down because the same people who have been described today as overreaching and abusive in the independent contract role, or what have you, are going to be the same folks administering these rules. In a world where the IRS is trying to do a Rorschach test to figure out your motive, or taxpayers who thought it up on their own, and taxpayers who had it suggested to them get different tax treatment - - this is not where I think you ought to be driving the system.

[692] The third goes back to our discussion before the break. Imagine a guy from outer space here listening to this conference. What he heard was no outrage or discomfort or judgments applied to efforts to find an 11th taxpayer or to find the 101st taxpayer, or to provide positions by way of industry specialist papers instead of by way of regulations.

[693] It's clear that we are perfectly comfortable in our world saying, well, we can find that 11th taxpayer so that same rule doesn't apply, or we can find our 101st taxpayer so that some other rule doesn't apply, or we can couch the guidance in a different form so it's not subject to reg flex.

[694] Taxpayers who engage in "gaming the system" or taking advantage or dodging or putting it in the right cubbyhole because they get a good answer out of that cubbyhole -- I think that's exactly the same behavior. Moral judgements are a dead-end road to go down.

[695] I think you need to go back to the kinds of questions that Dave, Mike, and Rick are asking: What kind of answers do we want here and what are the norms? Is our norm certainty? Is our norm maximize the revenue? What is our objective? Stay away from "good guy/bad guy".

[696] MR. ROSENTHAL: If I can follow up for a moment on Fred's first two points, which go to the judgments underlying a tax solution. More specifically, let's focus on the question of how should staff be considering these types of questions.

[697] I think one problem that you see often, especially in the financial markets area but also in other technical areas of the tax law, is a general discomfort by the staff that things are going on that they don't quite understand and some concern that things are so complex out there that the IRS cannot audit and examine these issues.

[698] I've heard Ed say, well, the staff sort of got it right in the last ten years in addressing a lot of questions, but these questions continue to come up. Let's just talk for a moment about how the staff and the IRS is to tackle these issues.

[699] For instance, in the last Small Business Tax Bill the effective date of the FASIT tax legislation was delayed, motivated principally, as I could best determine, by the fact the staff wasn't quite sure what they were doing in this complex technical area. That's one approach to passing legislation.

[700] Jim, how does the staff deal with very technical areas of law, very difficult spots to try to sort out? Where do you go for guidance? What's the best way to approach these kinds of problems? How do you think about the IRS down the road? Do you have any ideas on that?

[701] MR. CLARK: First of all, we are sometimes concerned that we are not hearing about the sophisticated transactions that are out there in the marketplace. I think this is one of the things that Tim was alluding to earlier, the fact that a lot of these transactions that are being sold in the marketplace are subject to confidentiality agreements. There is some suspicion on our staff that the financial products which are marketed subject to confidentiality agreements may be the more aggressive transactions in play.

[702] MR. RICHTER: Jim, if I might interject, those kind of confidentiality agreements are, to my understanding, directed not so much at protecting from you finding out as from their competitors finding out. The investment banks protect themselves against each other. That is what I perceive to be the driver of those agreements. Not to say that it doesn't have the effect you are talking about.

[703] MR. CLARK: Right.

[704] MS. STECHER: Also, I would point out that most of the transactions that we are discussing here are in the public markets. They are not subject to confidentiality agreements. The transactions which are, as Ed said, are really more the topic of this afternoon. The transactions that we are discussing here are transactions for which you can get prospectuses from the SEC.

[705] MR. ROSENTHAL: Esta, you've been on the industry side when legislation was being developed. You've come in and tried to convince the staff of the direction and clarity of industry's position. How does the process work from your perspective, and how should the process be working?

[706] MS. STECHER: I think the staff underestimates the willingness of the private sector to help and looks at the private sector with a little bit more suspicion than is justified, particularly with respect to complicated financial transactions, or, the tax treatment of financial institutions. There are a number of people in the private sector who would be willing in good faith to assist the staff.

[707] MR. CLARK: Let me give you an example. Although it may be slightly off topic. We still have practitioners telling us that we got it wrong on corporate owned life insurance, which I frankly don't understand at all. I view COLI as a blatant hole in the tax system that desperately needed to be closed, should have been closed years ago, and would have but for the fact that there was a lot of congressional opposition to closing it. You have life insurance salesmen in every district who talk to their Congressman. It was only after the marketing of that product got totally out of hand that the Congress was able to close that loophole.

[708] MR. ROSENTHAL: Jim, is your point that it's difficult for the staff to tell when the outsiders are bringing forward objective information or when that information might be slanted towards their constituents or clients? Is that the issue here?

[709] MR. CLARK: It's sometimes difficult, yes.

[710] MR. KLEINBARD: But surely that's not a very good example of a confidential arrangement.

[711] MR. CLARK: No.

[712] MR. KLEINBARD: Confidentiality is completely beside the point in this conversation. The fact is, if you get a subscription to Investment Dealer Digest, a subscription to Euromoney, a subscription to the Wall Street Journal and a subscription to Corporate Financing Week, you'll know everything that is going on in the world of financial products. You don't need to be a rocket scientist. I have my graduate degree in medieval history. It doesn't require a lot of mathematics to do it. It just requires reading the Wall Street Journal, because Wall Street in the end has two reasons it always makes these transactions transparent. First, when they are public transactions they have to be disclosed. The Washington Post told you about Estee Lauder if you didn't want to read the fine print in the prospectus.

[713] Second, as they say on Wall Street, when the puck goes in the net a lot of sticks go in the air, and Wall Street can't help --

[714] [Laughter.]

[715] MR. KLEINBARD: People can't help but tell the press about the wonderful new accomplishments that are done. So there is a tremendous transparency of what ultimately is happening in the financial products arena. It's just not an issue.

[716] MR. ROSENTHAL: Mark Prater.

[717] MR. PRATER: Going to this business that Brad raised about normative judgments and things like that, we're always under pressure when one of these transactions bubbles up and the press reports it. There are members who will target trying to do something about a transaction. So we are a lot of times caught in a vice, because we see a piece of it; we see an example of a product the industry has come out with, and it is something that creates a visceral reaction and political pressure to do something about it.

[718] At the same time, we also realize, partly from meeting with industry folks, that there is more to it than that and we may end up doing some damage in some cases. Being legislation is a very time driven, sometimes a very short time frame situation, we try to do the best we can with the constraints that are thrown on us in terms of dealing with a legislative angle.

[719] Financial products are an area that we continue to struggle with, at least from a congressional standpoint.

[720] MR. ROSENTHAL: Fred Goldberg.

[721] MR. GOLDBERG: The focus here is on the legislative side in dealing with these transactions. I agree with Ed's assessment, and I think to some extent Rick's assessment, that by and large a lot of these issues have been dealt with quite effectively over the last ten or 15 years. I think there are instances where it has happened legislatively. I think there are instances, probably the majority of instances, where it has happened through the administrative process.

[722] If you are looking for things to think about in dealing with these transactions, on the one hand you have a perception that the community is not forthcoming.

[723] But, there is another perception to keep in mind. On the administrative side, if you are forthcoming, there is a risk of waiting two to three years to get an answer. Ed's point about the hockey sticks. One person says I can come forward, play it straight and try to get guidance and I'm looking at three years. Somebody else says, well, I can get my opinion and do it in three months. There is something wrong with the process right now.

[724] If you could find administrative mechanisms that would afford potential issuers with clear answers in 30 to 60 days, you might find you would see an awful lot more coming forth.

[725] MR. ROSENTHAL: Catherine.

[726] MS. PORTER: I had a question. I'm not an expert in financial markets. A lot of these concepts seem so similar. Are the products themselves so different from everything else that we deal with in the tax system?

[727] You've been talking about what is a loophole and what is an incentive. If the taxpayer is doing something whether it's COLI or whether it's those old deals in which the Navy leased those ships -- that was ages ago -- taxpayers are always doing things that comply with the letter of the law. Are they to be vilified in the press or otherwise because they pushed to the edge of what was permissable under the law?

[728] MR. BELAS: Because they didn't maximize their tax liability.

[729] MS. PORTER: You have the dilemma of legislating retroactively to catch them or prospectively to be "fair." So you have got these same tensions.

[730] I am just wondering. For those of you who are in this arena, those New York lawyers, is this that different from other areas? Are the New York lawyers so much smarter and the capital markets, so much quicker and faster and complicated that this one the taxpayer will always win? Whereas in the other areas, with Navy leasing, or COLI or some other idea, the government and the legislative process somehow can catch up.

[731] MR. ROSENTHAL: Let me turn to Brad. Can you answer that? Earlier you talked about the special problems that are presented with financial markets and taxing financial markets. Is something special going on?

[732] MR. FERGUSON: I think in part it's a result of the fact that financial products have the ultimate in intangibility and the ultimate in mutability. You are dealing in a world where creative people have a fertile field in which to work.

[733] Normative judgments are probably inappropriate, but I think the question of purpose really does have a place. Maybe not in the courts, but certainly in the process of trying to draft legislation and trying to draft regulations.

[734] A threefold question is, what are the parties trying to do? Are they doing the transactions solely because there is some tax benefit, or are they trying to accomplish a pretax business purpose, such as raising money? If they are trying to raise money, then tax considerations should be allowed to play a role in determing how best to raise it.

[735] There are some very fundamental questions about purpose. Maybe you don't put somebody on the witness stand and ask him what his subjective intent is, but I think business purpose is important in this area and in others. We deal with business purpose all the time. We may not like the test in all these areas, but we always ask ourselves in a deal: what's happening and why is it happening? What do people really have in mind here?

[736] MR. ROSENTHAL: Carolyn, can you answer this question?

[737] MS. SMITH: It seems to me that from the taxpayer perspective you certainly have a right to structure your transactions to produce the least tax liability. If the perceived problem is tax motivated transactions perhaps the real problem is that the tax system itself is not neutral with respect to transactions.

[738] Maybe we should be looking at the tax system itself. The economists will say in the context of overall tax reform that you should have a neutral tax system so that it doesn't interfere with transactions. I don't know if you can get to that result. There are a lot of issues there. It seems to me that that maybe is where the purpose should be.

[739] When we say we don't want transactions done for tax motivated reasons we are really questioning our tax system, because in all areas -- going back to the independent contractor discussion earlier -- you get different tax results by doing things in different ways.

[740] I want to comment on Ed's comment about how you have to look at the entities themselves and the financial institutions. In the tax reform and restructuring debate, how to tax financial institutions is one of the big imponderables and unanswerable questions that nobody else has really been able to figure out how to do. So I don't know if we can answer these things.

[741] MR. RICHTER: Neutrality is something I've never been able to understand. The only way the tax system can be neutral is if there is a zero tax rate.

[742] MS. SMITH: I didn't say I had an answer.

[743] MR. RICHTER: I guess I never think of that as a helpful guide to determining what's bad and what's good.

[744] MR. ROSENTHAL: Eric.

[745] MR. TODER: Obviously we have a realization-based income tax that can't be neutral. I think the issue really is one of elasticity and how similar, what are the costs of arranging transactions that cross the line. If people can do them at very low transactions cost in mass market, then you really have to stop them because it erodes the base.

[746] I take it that there will always be some people that are well advised and want to put things in the right cubbyhole and will be able to do it and get away with not paying the tax.

[747] MR. ROSENTHAL: David.

[748] MR. HARITON: I think Mark's comments and all the comments that followed are speaking about an institutional role question, which is whether the Treasury Department should sort of be standing in the middle of the fray, as it were, in a world in which new transactions are being developed all the time and people are actively trying to figure out what their tax consequences are most of the time, as Les was saying, not necessarily with a view to any tax- driven transaction but just what are the consequences.

[749] Normally, and I think this might have been more the case ten years ago, you would have expected the audit process to make sure that people were minding their P's and Q's to some extent. More recently you have the Treasury sort of in the middle being blown about by the winds of the press, being blown about possibly even by the winds of various taxpayers and bankers. You may have the odd situation of the Treasury actually becoming a pawn in the process of market development. One guy has got one product and somebody else has got another product and somebody is going to run down there and blow up the product.

[750] [Laughter.]

[751] MR. GRAFMEYER: Is this a great country or what?

[752] [Laughter.]

[753] MR. ROSENTHAL: Mike Schler.

[754] MR. SCHLER: No matter what you think about the purpose test generally, I'm not sure it really means a whole lot in this context. There is some economic reason for wanting to buy a bunch of cash flows, and you can call it this or you can call it that, but there is no purpose for calling it anything. It's just a bunch of cash flows. The question is how that should be taxed.

[755] Somebody mentioned foreigners buying equity swaps. If a foreigner buys an equity swap on IBM stock instead of IBM stock itself, which is a more normal transaction, and the only reason for that is to avoid dividend withholding tax would you say, well, you will withhold on the swap because the purpose was to avoid the dividend withholding tax?

[756] You just need a rule to deal with these things and not worry about why people are doing them. I think that's a hopeless endeavor when it's purely arbitrary what you call something.

[757] MR. GOLDBERG: I think purpose is an important inquiry at the policy level, the legislative level. It helps you identify things that are so far at the end of a spectrum that the economics perhaps are completely out of proportion to the taxes.

[758] I agree with Carolyn's point. It tells you there is something important going on in the system. You look at where people are engaging in arbitrage transactions to decide whether you care or not, and, if you do care, what you should do about it. That happens in the guidance process and the legislative process.

[759] To have that same focus in the trenches, with the agents and the individual taxpayers trying to unscramble how did somebody feel about something, that's where I get off the boat on purpose. I don't think it's going to work. You will not get anything like evenhanded administration of the law. You will not get anything like the certainty we require in the capital markets.

[760] MR. ROSENTHAL: Glen Kohl.

[761] MR. KOHL: We are slipping a little bit into this afternoon. Actually, Fred and I agree more than it is going to end up appearing in this transcript. I think you have to take purpose on a case-by- case basis. I will try not to talk about tax shelters and other things that happen this afternoon, but a lot of times it depends what the alternative is.

[762] I think one of the most popular regs that you proposed, Fred, and we finalized, was the 382 option regs which replaced a complicated, detailed set of rules with triggering exercises of options, with basically a rule that said nothing other than we'll only trigger an option if its principal purpose was to avoid 382. In that context, we had the ABA, Chicago bar and other groups saying, "please, finalize that as quickly as possible. We love that reg."

[763] I think there are times when purpose is appropriate and there are times when purpose is inappropriate, and you have to look at the context and what are the alternatives to decide when it's appropriate and when it's not appropriate.

[764] MR. ROSENTHAL: Could we follow up that point for a little bit, which is, how are you going to structure a solution? This is an interesting time for Fred to leave.

[765] [Laughter.]

[766] MR. ROSENTHAL: Because I know under his tenure there was a lot of attention to the notion.

[767] MR. GOLDBERG: The IRS Restructuring Commission is meeting.

[768] MR. ROSENTHAL: In thinking about solutions to the problems that popped up, the sense I have from this discussion is that anomalies exist and will be addressed during the course of the legislative system. The issue then becomes, how should they be addressed?

[769] Glen described what appears to be a more ad hoc approach than the approach that Fred was framing. As I understood it, Fred was framing the notion that you devise a philosophy, a principle, and then try to stick to it. Glen generally agreed with that but then focused perhaps more on the specific transaction at hand, a more ad hoc approach. The issue then is how do you want to start looking at these kinds of questions?

[770] And going further, perhaps into this next question, 6, what do you think about it in terms of structuring rules? Should they be vague and risk the uncertainty and the screaming that Brad described earlier, or should they be clear and perhaps risk the opportunities to continue to move transactions around cubbyholes?

[771] I wonder, Ed, if you have thought about the types of approaches to these kinds of problems.

[772] MR. KLEINBARD: I think the purpose point does segue very nicely into this, because in the end, using purpose as a touchstone in this area, when you talk about products, doesn't give you any useful information: Why did you issue that subordinated debt? Did you do it just to get the interest deduction? Well, of course, that's why I did it.

[773] It doesn't answer anything. The markets are efficient; there is no extra cost to issuing subordinated debt as opposed to preferred stock; we gain nothing by looking at purpose in this area.

[774] I tend to believe that because of the four fundamental structural incongruities identified earlier we are always going to have to work with an ad hoc kind of a force of attraction kind of analysis.

[775] Following up Rick's very useful example about equity swaps, Treasury has authority to deal with that case. Treasury has four- year- old proposed regulations. The problem could be solved tomorrow if they wanted to. That's a perfect example.

[776] Should we treat equity swaps that a foreigner does with respect to U.S. equity more like just a contract right which we source to residents, or should we treat it more like an investment in the underlying equity? Neither is necessarily wrong. We'll just make a decision. Bang! That one is more like an equity. We don't want foreigners to invest in U.S. equities indirectly. It's better for the capital markets for them to invest directly. Why should we give this business to derivative dealers? Let's bring that money into the markets themselves rather than do it indirectly.

[777] I think each case is going to be a relatively ad hoc decision of the nature of which the rival answers have a stronger magnetic pull. I don't in general like antiabuse rules and vague advice, because the capital markets are efficient and it introduces a lot of sand in the wheels in ways I don't like, and because I believe that antiabuse rules only work if you have as your premise the notion that there will be effective and vigorous litigation that follows and we will have cases and interesting cases, intelligently decided cases, hard fought litigations that lead to good case law which people can then use as a touchstone.

[778] The fact is, in my view from the outside, if there is a real shortcoming in the entire process, the tax policy, tax administration today, it's in the litigation process. I think it was a Fourth Circuit case (Halle v. Commissoner) the other day saying that if you have a contract to buy real estate and you delay the closing on the real estate and the buyer pays more to the seller because the closing has been delayed, that's a deductible interest expense. That case is a disgrace to the tax system. How can we be talking about exotica of tax policy when somebody can't figure that one out?

[779] Antiabuse to me implies vigorous and useful litigation, and I think that is where the system has fallen down.

[780] MR. ROSENTHAL: On this antiabuse issue, perhaps Glen Kohl might address this. I wondered if there has been some thought given to the general approach of when antiabuse rules are used and not used in the Administration, and whether you had any thoughts or comments on that particular issue.

[781] MR. KOHL: I can, but I am just wondering if that is this afternoon's session.

[782] MR. ROSENTHAL: You can hold off until then if you like. That will save some materials for the afternoon.

[783] Mike, did you want to go on?

[784] MR. SCHLER: I think somebody said it depends what you mean by antiabuse rule. If it is objecting to an antiabuse rule because it looks at the purpose of the taxpayer entering into the transaction, I think certainly in this area (although maybe not other areas) that objection makes a lot of sense. It's crazy to have that kind of rule. If for an antiabuse rule you mean a rule that says no matter what you do the result has to clearly reflect income as an overriding principle, that makes sense and will stop a lot of the more abusive type transactions.

[785] It seems to me that kind of thing makes a lot of sense, and it's very hard to object to that. It may create some uncertainty, because there is always a question whether the result you get is too good to be true and whether this applies, but it seems to me that is a perfectly good backstop. In theory, I guess the Treasury has authority under 446 to do something like that, but I'm sure that would be one of these regs Congress would be reviewing. So legislation may make more sense for that kind of thing.

[786] MR. ROSENTHAL: Laurie.

[787] MS. MATTHEWS: This comment may also relate to this afternoon, but following up on Ed's observation about the equity swap and possibly treating the foreign investor as if he had an equity instrument, a stock instrument, raises a question of nomenclature about antiabuse and an approach question, which is, is it appropriate for the tax system to look at situations where there is an arbitrage potential, people are being treated differently, and the government and taxpayers experience very different results, and to be selective, and to say, as some recent legislative proposals have said, that it's not necessarily a two-way street and that all transactions are not treated exactly the same in all situations, but we'll look at where the possible drain may be? Is that something that people think is a fair approach given the problems that exist? Or is that something that people think in itself will turn to further gaming? I don't want to use that pejorative term, but further problems in terms of the outcomes.

[788] MR. KLEINBARD: This is a perfect example. In the domestic context, if you do an equity swap or a stock loan, it's not a dividend. If you do it in the international context, the proposed regs would say it is a dividend. So you are producing a different result, depending on the context.

[789] MR. ROSENTHAL: David.

[790] MR. HARITON: That's problematic in the sense that there are no inbound investments for the foreigner in the swap, which gives you a treaty problem, gives you technical problems. What you were saying earlier suggested choices, random rules, whatever you would like revenue-wise, for examination: What was really your purpose in doing that transaction?

[791] Of course there is a middle ground which Michael is suggesting, which is what is really going on as a matter of substance underlying the transaction, but can we have some sort of substantive standards to complement our specific rules to help us get to the tax treatment?

[792] Under those sorts of substantive standards you actually have a problem, for example, imposing a withholding tax on equity swap payments when there is absolutely no inbound net investment into the United States.

[793] MR. ROSENTHAL: Bill.

[794] MR. WILKINS: It's hard for me to see that there is no inbound investment into the United States because the counter party in that swap is going to hedge his position somehow. You can look at the counter party in the swap as a conduit. It's not a conduit under normal conduit principles, but it's close enough to a conduit that I don't have a problem with writing a reg that imputes the existence of a conduit relationship and a deemed inbound investment because you have a U.S. counter party that is not subject to withholding that is investing in the stock for the foreign investor.

[795] MR. HARITON: That's a technical point.

[796] MR. WILKINS: I was trying to make a nontechnical point. I'm trying to make a policy point in terms of choosing what your withholding rule says.

[797] MR. HARITON: All I meant by inbound investment is that in the same way that an interest rate swap is not the same as a loan so that you couldn't impose withholding tax on the outbound payments on the swap because there is no investment, likewise an equity swap is not an equity investment, so that you don't have quite the same authority to impose withholding tax. That's not a conduit issue at all. If IBM itself made a derivative payment but you had no net investment in IBM, I think you have a problem imposing an outbound withholding tax.

[798] MR. ROSENTHAL: Ken Gideon.

[799] MR. GIDEON: I think this problem is generic. I don't know whether it belongs more in the afternoon session or in this one. One of the problems with purpose tests is that they are not very predictable. While some people think that uncertainty is a virtue in this world because it supposedly inhibits things, at some point uncertainty becomes completely unworkable for the system.

[800] To illustrate that this is not a new problem, if you look at tax shelter litigation in the early 1980s, the initial round of decisions were "I know it when I see it. That's bad." And then put some people away. There was not really much of anything to tell you what the difference between case A and case B was other than maybe you could look at which judges were there and you could kind of predict based on who your decider was what the outcome would be.

[801] That was an untenable situation, and it evolved. I think it almost always has to evolve in that situation, because you have to be able to tell people better than that what will be the standard used to judge their case. So what you saw was the emergence of the prudent abandonment rules and a whole series of doctrines where people began to rationalize which ones worked and which ones didn't. Some of the computer cases that began to say, okay, this is enough, this isn't. I'm not saying that they are precise.

[802] I guess the point is that purpose alone is simply not a basis for making these decisions. You may very well have an articulated rule that says these are our general standards and then down at the end, and by the way, if you do something that's really stupid but technically right, we're still going to try to get you. That's not a great surprise.

[803] MR. ROSENTHAL: I would like to break this session a little early and follow up on Ken's points in the next corporate tax shelter discussion, because that seems like a natural thing to do.

[804] Are there any other comments on this specific topic now? We will go into more of these general questions shortly. Any remaining comments?

[805] Brad.

[806] MR. FERGUSON: Very briefly, on the purpose point. I agree that purpose should not be the determining factor in very many cases in court. My basic point is that, at least in the legislative context and in the administrative context, if a particular transaction would not exist but for the tax system, that is something you should be more worried about than a transaction that exists in a certain form because of a particular tax rule. Such a distinction may not separate many goats from the sheep, but the goats that it separates are important goats.

[807] MR. ROSENTHAL: Les.

[808] MR. SAMUELS: I really want to follow up on a point that Carolyn Smith made. We have been talking about some difficult issues, debt equity and realization. To the extent that someone says, well, I want to get myself out of these difficult issues by abandoning the tax system, starting over with a consumption tax, I think that the application of consumption taxes to financial services businesses probably make this discussion look fairly tame. There is no nirvana and you are going to trade one set of problems for another. No matter what tax system you have, given the innovations in the capital markets and the globalization of the capital markets, you will have continuing vexing issues that people have to come to terms with on a reasonable basis.

[809] MR. ROSENTHAL: With that, we will break for lunch. We will come back at 1:30 for the next session on corporate tax shelters.

[810] [Whereupon at 12:05 p.m. the meeting was recessed for lunch, to reconvene at 1:30 p.m. this same day.]

[811] AFTERNOON SESSION [1:35 p.m.]

[812] MR. THOMSON: This afternoon's subject we obviously touched on, if not trampled on, a good bit this morning in the context of financial products. But this is a different segment that to some extent might or might not overlap with financial products, dealing with the perception of the problem of an increased level of corporate tax shelter activity and the relationship of that with the tax process.

[813] I like Brad Ferguson's metaphor that we ended with this morning of trying to find the goats. We are now searching for the goats among the sheep and seeing if we can separate out the goats from the sheep.

[814] I do want to say at the outset, just to be clear, that the questions I will pose and the propositions I will submit are intended to invoke thought and discussion. You should not infer that the questions or propositions necessarily reflect the views of the Treasury Department, or even myself for that matter; it's only intended to spur debate.

[815] To some extent this morning, the question was submerged in the discussion, and some discussions around lunch verified for me that it might be useful to have a bit of a definition of what it is we are talking about, more of a definition than goats.

[816] I don't want to have a precise definition, but just to try to keep the discussion focused on the category that we want to talk about. It is along the lines of, as I had in the questions that we posed, tax strategies that are designed to generate substantial tax benefits without much regard for the economics of the transaction. I emphasize "much" because everyone knows you have to have a business purpose, some economics, but there has always been a large degree of how much.

[817] Another way people talk about it is the reverse-engineered tax deal. You are not interested in doing a deal; you are not interested in raising equity or entering into a partnership, or whatever the transaction may be; this is just a forum for generating tax benefits. When you draw a circle around the totality of the transaction, you've got very substantial tax benefits and very insubstantial economics viewed as a totality from the outset.

[818] To the extent the discussion gets there, in deciding how you address it we may touch on how might you define tax shelter for some or all of these purposes. It may be appropriate in that part of the discussion. For now I just wanted to try to capture the notion of it without having to be overly precise about it.

[819] I think the right place to start, comparable to where Steve started the discussion on financial products, is, is there a problem?

[820] There is a perception certainly within the government, and I think by many outside the government from discussions we've had, that there is indeed a problem, that there are enough goats out there that we need to be troubled by it and we need to certainly have our eye on trying to minimize the level of pure tax shelter activity that is out there.

[821] What I would like to start the discussion with is, do people accept that? Is that well accepted? Do people challenge it?

[822] As a follow-on, I would be interested in people's perception of whether or not today it is comparable to where it has been in the past, say ten years ago or 20 years ago, or has it changed in any dramatic way?

[823] I think one hallmark, in my view, of these arrangements is they rely very heavily on the form of the transaction and with less emphasis on the substance of the arrangement. We have all had these various articulations of substance over form doctrines, step transactions and such that have been around forever, and part of the question is, is that analysis different than it has been in the past?

[824] Mr. Schler.

[825] MR. SCHLER: When we were working on the New York State Bar report a few years ago on the partnership antiabuse reg, which is about a 50- or 60-page report, pretty much every sentence was heavily debated except the one sentence that said there is a lot of this activity going on. Nobody even questioned that.

[826] There is no question a lot of it is going on. If you were to ask me if there is more than in prior years, I think my impression is there probably is. The market for tax advantaged products has grown and there is competition among investment banks, accountants and lawyers to provide those products to companies, because they are very profitable products. You get a lot of bright people thinking about these things and they come up with ways of structuring transactions. You have some that probably work and some that probably don't work, but there is certainly a lot more brainpower being devoted to it these days.

[827] Do people worry less about business purpose these days than they used to? I think they probably do worry less. I think partly because there is probably more of a perception that things will not be picked up on audit, so you just do more and take your chances.

[828] I think the whole tax world is probably getting more aggressive generally and people are more likely to take their chances. Even if a few things are picked up, you end up no worse than if you haven't done it at all unless there are penalties, and in practice you don't worry that much about penalties. So I think it's the lack of a downside to some extent. There is less chance of being picked up on audit and just more competition to provide these products.

[829] MR. THOMSON: Bill Wilkins.

[830] MR. WILKINS: Just to keep the historical perspective, what we are talking about today is a lot different than what we used to talk about with tax shelters before the '86 Act and the passive loss rules. Then there was an issue of protecting the wage-driven part of the tax base, which is a huge part of the tax base relative, for example, to the corporate tax base.

[831] In addition, although there is getting to be more of a perception problem with shelters today, it doesn't approach what the perception problem was with shelters when they were mass marketed individual shelters. Then you had everybody talking at the barbecue about how they weren't paying tax on their salary because of what they had bought down at Merrill Lynch.

[832] That was more of a civic problem, I think, than we face today. This is more confined to a different group of taxpayers. It's less visible. I don't know how that informs the debate or the discussion of a solution if there is a perceived problem, but it is a different problem than what we used to talk about.

[833] MR. THOMSON: Phil Wiesner.

[834] MR. WIESNER: First off, I don't like the use of the words "tax shelter" because I think those are politically charged words. I rather view these as transactions that have tax advantages to them.

[835] It's certainly true that a number of corporate clients are coming out of the alternative minimum tax and looking for ways to reduce their effective tax rate, but it by no means can go to the level of the '80s problem, as Bill said, on the individual side, for a couple reasons.

[836] First, tax savings are important, but a lot of what is driving it is book income. In order for the accounting side to book the benefit it needs a very high level of comfort, a level of comfort that definitely was not there from a tax opinion point of view on the individual side.

[837] Second, in order to book the income tax benefit you need, more than a more likely than not, tax opinion. You need basically a "should" type opinion. That definitely is a sea change difference from the individual tax shelters of the '80s.

[838] I think there are forces at work that will make this market. The market will be there. There is money to be made in some of these creative structures, but they can't possibly rise to the same level of problem that the individual shelters did.

[839] MR. THOMSON: Ken Kies.

[840] MR. KIES: Let me take a slightly contrary view and use COLI as a recent example of where activity not only rose to that level but even greater. Take Wal-Mart as the poster child. When you have a company wiring a billion dollars of premium in the morning and then borrowing it back by wire in the afternoon and instantly creating with each year another $35 million of perpetual tax savings, that's a problem.

[841] As best I can tell, very few of the companies that had these rather large COLI programs had opinions. But clearly the accountants were blessing them in terms of the consequences. I think we were looking at a potential for a substantial erosion of the entire corporate tax base if something hadn't been done.

[842] It sprung up in about a three-year period. Even though it was a post-86 Act phenomena, the real aggressive growth occurred all in the past three or four years. And the numbers were stunning. If you had 50,000 covered lives, the net after tax cash flow, net-net after ten years was approximately $370 million, and after 20 years was $1.2 billion. Those are pretty real numbers.

[843] I don't know where the next COLI is. If somebody around here can tell us, it would be kind of handy next year.

[844] [Laughter.]

[845] MR. KIES: I know it's out there somewhere. We just don't know where it is. The only limiting factor, as best I can tell, was that it didn't work if you were in the AMT. Otherwise it was spectacular. Like I said, I don't know where the next one is. Maybe there won't be a next one.

[846] MR. THOMSON: Don Longano.

[847] MR. LONGANO: As most of you know, I've only been in private practice for two years, so I lack historical perspective. I would note one thing, which I think is an issue here. I'm not saying it's a problem or whatever.

[848] I think many corporate tax departments find themselves under a considerable amount of pressure to add value to the company. I wish I was in practice ten years ago and I could let you know if I sensed a change. I don't think corporate tax departments generally get points for filing an accurate return or no typos. Most tax departments report not through the general counsel of the company but through the CFO.

[849] Again, I'm not saying it's good or ill, but I think it's good to note that the professionals here in the corporate area are under some amount of pressure, and that may show through on some of the planning that you see.

[850] MR. THOMSON: Dave Hariton.

[851] MR. HARITON: In that context, I'm having a little trouble with the sheep and goats question, the wheat and chaff question that was raised. Is the problem just that people are spending more time thinking about their taxes, or is it a question of are the deals too aggressive?

[852] A corporation has a capital loss that is about to expire, and so they purposely, for the sole reason of tax sell assets and lease them back. Is that the sort of problem that we are talking about?

[853] MR. KIES: COLI was definitely a goat.

[854] [Laughter.]

[855] MR. KIES: If you want a bright line, that's it.

[856] MR. THOMSON: Let me try to keep it as focused as we can. As a general matter, I would like to focus on the true goats like COLI, the completely tax engineered, just voila you've got tax benefits.

[857] MR. SCHLER: COLI is not the best example of that.

[858] MR. WIESNER: It's sort of like COLI becomes the scapegoat, and the question is, what other scapegoats are there? There are degrees of getting from goat to sheep. That's the issue. At what point do you cross the line?

[859] You compare today to ten years ago. Let's compare it to 12 years ago where you had a 10 percent investment tax credit, 5-year ACRS, and most companies were reducing their effective tax rate to zero or less very legitimately with the investment tax credit and depreciation in transactions. The 1986 Act did away with the investment tax credit. Now we have other structures marketed by our investment banking friends or privately thought up and marketed to clients individually that run the spectrum of using partnership rules, corporate rules, you name it rules. Everyone is legitimately using the rules. I say legitimately. They are following the rules literally. Then I think your issue is, at what point do you violate the intent of those rules?

[860] Your response to it has been the partnership antiabuse rules. I can live with those rules because I view them like the difference between a root canal with novocaine versus a root canal without novocaine. There are worse things that could have been done than the partnership antiabuse rules, like extending the passive loss rules to corporations.

[861] MR. KOHL: We'll take our support wherever we can find it.

[862] [Laughter.]

[863] MR. WIESNER: I would like some other reactions, but certainly the partnership antiabuse rule hasn't stopped the truly legitimate partnership transactions and it hasn't stopped most of what I would say may be close to the edge in terms of aggressive tax advantage transactions. But, it has definitely stopped the junk that is on the market.

[864] What it has also done is increased the number of tax opinions that have been issued in these transactions for penalty protection. So they now have another 20 pages describing the partnership antiabuse rules and the fact that it's more likely than not that this transaction doesn't violate the partnership antiabuse rules.

[865] So I think we have adjusted to the response and can live with the response, but I think the response has been positive in terms of the types of transactions that are on the marketplace. I would be interested in other views on that.

[866] MR. THOMSON: Mr. Alexander.

[867] MR. ALEXANDER: Positive in what respect? Positive in creation of more transactions?

[868] MR. WIESNER: Driving out the junk.

[869] MR. ALEXANDER: I'm not totally sure the junk has been driven out. I don't really think that's what we are talking about. Nor are we talking about COLI, because we have solved the COLI problem. I don't know about the rest of you, but I see an awful lot of junk. Is the situation the same as it was ten years ago? No. The individual tax shelters have pretty well disappeared. Are corporate shelters a real problem? I think they are. Should the Treasury be concerned about this? I think it should.

[870] MR. THOMSON: Randy Weiss.

[871] MR. WEISS: I want to emphasize a point that Phil made. In the last five or ten years the corporate tax base has been tightened up. It was a lot easier before the 1986 Act to reduce taxes without having to engage in anything very exotic, and there was less demand for mass marketed products like COLI, because the number of corporations interested was a lot lower.

[872] Partly what has happened, I think, is that more and more corporations do have substantial tax bases. They have used up their NOLs. There is more of a market for this stuff.

[873] In addition, a lot of the specific ideas that I've heard about have been responses to legislative tightening of the rules. For example, when General Utilities was repealed, Taxpayers tried hard to get around the change. The volume of corporate base broadening provisions has gone up a lot since the early 1980s, and that has spawned continuing attempts to get around these provisions.

[874] Yes, I think, there has been much more attempt to look at these rules and try to stretch them, but it's not surprising.

[875] MR. THOMSON: Norm Richter.

[876] MR. RICHTER: I can't shed any light on whether the volume has increased or not for somewhat the same reason as Don, which is that I don't have enough time. It has only been a couple of years since I've been a tax director of a corporation. But I can confuse the goats and sheep a little more by telling you a little bit about the experience I have as a tax director.

[877] I get pitched weekly from the various investment banks with proposals for structures that are usually extremely complex, that are intended to generate the voila tax benefit result that you are talking about. Usually it gets pitched at the CFO level and it gets pushed down by him with a little cover note that I have to pay attention to that says, "Norm, this sounds great. Does this work?" Or "Shouldn't we do this?"

[878] Of course, then I have to make sure I understand it thoroughly enough to explain to him why it is something that we shouldn't do. It's not that I come at it with that attitude, but generally I know I'm pretty much going to reach that conclusion in most cases, and so far that is what I have done.

[879] I think the tendency on the part of tax directors generally is to avoid these things if at all possible, because the risk all rests with them if it doesn't work. As Don observed, the performance of tax departments, tax functions inside of corporations is very hard to measure. As a result, really what gets measured are mistakes and exposures. So there is a risk avoidance tendency that you see developing. That's a tangent.

[880] Really I wanted to just observe that my own experience is of the things being pitched to me, and that may just be a function of the perception of what my company is interested in or should be interested in now. The bulk of the products, the shelters, if you will, are actually designed to take advantage not of the U.S. tax system but of a foreign tax system. They are exploiting usually advantages from hybrid instruments and hybrid entities in the different characterizations in the foreign country and in the U.S.

[881] You have situations where both countries are getting the treatment that their rules say they should have. Each country is arguably whole, but there is income falling in the middle that is getting taxed nowhere in the world system. Should we care about that? Is that a goat? Is that something that U.S. policymakers should care about? Should we be the policemen for the proposition that every dollar of income in the worldwide system should be subject to at least one level of tax somewhere?

[882] Some of the things offend me from an academic perspective. An example that I can put forward just to focus this a little bit is I was startled to see a transaction that seems to work where a loan is put into a UK sub and that loan is through a series of entities bought back by the owner of the sub, although it is done in a way that is absolutely invisible to Inland Revenue in the UK. So the result is you have debt still in existence in the UK chugging away, producing interest deductions, but you don't have any more debt anywhere in the system.

[883] There is nothing happening on the U.S. side, but it just so happens it's because the foreign countries in very many cases respect form a lot more than the U.S. system does. So you've got the disconnect usually because of that. They will respect debt if it says debt, and that's the end of the analysis.

[884] MR. THOMSON: Brad Ferguson.

[885] MR. FERGUSON: I will refer to the '70s and '80s. In the corporate area, we had the investment credit and 5-year write-offs. Corporate taxpayers were sacrificing pretax return. There was a pricing adjustment that was factored into the marketplace, and on a net-after tax basis, corporations weren't getting away with anything.

[886] In the case of individual shelters, as bad as some of them were, a great many provided not a particularly good return after tax because the tax shelterers were sacrificing pretax return.

[887] I am wondering whether we should try to distinguish between those types of deals for which there is a free ride, in the sense that you are not sacrificing a pretax return in order to get a tax benefit, and those deals where there is such a sacrifice.

[888] I perceive that, in many instances, the corporate tax shelters of the '90s are ones that do not involve any sacrifice of pretax return. To me, at least on a gut level, that seems worse, but maybe it's not something around which you can establish principles.

[889] MR. THOMSON: Ed Kleinbard.

[890] MR. KLEINBARD: It doesn't follow directly from what Brad was saying. I think there were a couple of important thoughts that started to emerge and I wanted to follow up on that.

[891] Just for the record, on Wall Street there is no such thing as a corporate tax shelter. We call them structured transactions.

[892] I sense in the last ten years or so a difference in attitude in corporate America. Obviously I don't have Norm's perspective of sitting there getting besieged all day long, but I am a regular besieger. I think there is a difference. It's an interesting evolution, because in fact corporate tax departments tend to be very conservative in their orientation, for obvious reasons. As Norm has said, if you get something wrong, people know it; if you get something right, people say, well, of course, we were always entitled to it.

[893] Similarly, because the marketplace tends to focus on GAAP earnings, the real issue tends to be not how much cash did you save today, but what is your effective rate for financial accounting purposes. A tremendous amount of what goes on is really driven not by cash savings but by managing the financial presentation of the tax liability, which is much more important, because that drives the price of somebody's stock. So the question you get is, why does so and so have a 32 percent effective rate and we have a 47 percent effective rate? Not, why did so and so write out this size check to the IRS?

[894] Notwithstanding all of that, there does seem to be more interest in the area. I think there are two reasons I can identify for that, and I'm not sure either of them necessarily should be laid at the feet of Wall Street or a new attitude in corporate America.

[895] The first is, again I continue to believe that a point that is underappreciated is the apparent collapse of the ability to successfully litigate a tax case. The Mobil Esmark case was an extremely disappointing case to all of us who didn't represent any of the principals in that case. In fact that was what you would have thought was the step transaction was all about. When the taxpayer won that case it began a process in which it became harder and harder to use traditional substance over form step transaction notions as a reason not to agree with a particular transaction.

[896] So effective litigation is in large measure an explanation, and a return to a real focus on litigation is to my way of thinking the most effective solution to the overall issue.

[897] The second reason is an incredible surge in new rules that are perceived as always well intentioned but when applied to all sorts of real cases, because of the haste in which things are done, because of the absence of regulatory guidance, sometimes because of just not adequate understanding of the complexity of the business environment, end up producing results that are clearly perceived to be unfair.

[898] Then one has to in effect go out and find a structured transaction to solve the apparent unfairness. That's one of the two reasons why you see so much of this activity in the international arena, because you have so many rules. You say, how the hell did that income end up in that basket? Why is that tax trapped over there? I really paid this foreign tax. Why can't I get a credit for it? Do you have a solution for it? That's the kind of dialogue that goes on.

[899] In my experience, the vast bulk of the discussions that go on, just as Norm was saying, is in the international arena. We should all be very proud that a leading export industry of the United States is exporting ten-year-old tax ideas from the United States and imposing them on foreign jurisdictions.

[900] [Laughter.]

[901] MR. KLEINBARD: It's a major export industry. It brings back a lot of revenue and therefore tax base to the United States.

[902] The other side of it is the U.S. tax system as it applies to the international arena. I think that a lot of tax departments, notwithstanding their conservative bias, are interested in pursuing transactions because they perceive the rules themselves to be complex, arbitrary and unfair as they apply in the international context.

[903] MR. BELAS: And you can't get it fixed by legislation.

[904] MR. KLEINBARD: Nothing can be fixed. Just like Arkansas Best couldn't be fixed. Yes, it's a terrible problem. Gee, it's unfair. Nothing we can do about it. Isn't that a pity? That case, I think, had more to do with souring corporate America's feelings about the tax process than about anything else I could think of.

[905] MR. THOMSON: Mike Schler.

[906] MR. SCHLER: I think Ed is right about Mobil Esmark. If you can get cases like that, it's sort of hard to argue against the validity of some of these proposed transactions. In fact, if the Service loses another pending form/substance case new in the tax court, that will be the end. That will be a sign you can do anything you want and you can litigate and probably win, whether it's because the Service doesn't litigate well or just because that's the way the courts are coming out on the substantive issues.

[907] Ed pointed out that one reason is that taxpayers think some of the complexity is unfair and so they are trying to overcome it. That may be to some extent, but I think, if anything, the complexity has a different effect. There are just so many more rules and the more detailed the rules are, the easier it is to get around them. A general rule is hard to get around because, number one, you don't know when you've gotten around it, and number two, there is nothing to get around. It's just a general rule about step transactions or something.

[908] The more specific the rule the easier it is to avoid. You know exactly where the lines are and it's much easier to manipulate the system if there are a lot more rules. A detailed rule is going to have holes.

[909] One other thing. Norm has mentioned hybrids. In general it's probably right that there is no U.S. tax policy reason to object if some income is not taxed from a U.S. point of view, just because the income isn't being taxed anywhere else. Why should we care? The one exception to that would be if you are relying on a treaty benefit. The whole purpose of the treaty is to avoid double tax and treaties really are not designed to convert a single tax into no tax at all. So there might be different issues when there is a treaty involved.

[910] MR. THOMSON: Mike and Ed have both entered into the part of the discussion about what might we do about it, what are the root causes of this problem? I am certainly hearing a lot of agreement that there is a significant problem out there, and you have touched on some of the causes of it, the increased volume of new legislation and rules and the complexity of those rules.

[911] Mike, you touched on the tradeoffs. Let's talk about that.

[912] In the context of where we do have this problem there is a big picture of who has what role. Ed, you focused on litigation. I hear you saying ultimately it all comes down to who prevails in court in some of the key cases.

[913] MR. KLEINBARD: It all comes down winning cases.

[914] MR. THOMSON: So if the IRS can't adequately pursue and win some of these key cases, I would surmise you would say it doesn't matter what rule you write.

[915] MR. KLEINBARD: Yes. The alternatives, the idea that people should send in all their confidential proposals to Washington. The facts of the Colgate case are known. The fact that thousands or ten of thousands of things pour into Washington doesn't change anything other than create a large repository where somebody has to file them, but it doesn't necessarily result in any litigation result. More perniciously, I think, it changes the way people behave on the outside and turns commercial dialogue into something that will make Kabuki theater seem like a night at the Improv where people rehearse and speak in a way that they know they are on the record.

[916] MR. THOMSON: Let's focus on the litigation aspect. If that is where the rubber meets the road, are there suggestions? If the perception is the IRS has lost and may continue to lose some of these key cases, what can be done about that? What should be done about that?

[917] Ken Kies.

[918] MR. KIES: I will give you one radical solution. The reason they are losing is because they are outmanned and outgunned. One solution is to -- this will never happen -- have the Service contract out and put the same kind of resources on the government side that the taxpayers are putting on the taxpayer side. Until you do that they are going to continue to lose those kind of cases.

[919] MR. RICHTER: Are they anymore outgunned and outmanned today than they were 25 years ago?

[920] MR. KIES: They are, because the world is more complex and the number of great minds that are thinking faster than the government side are more than there were ten or 20 years ago, I think.

[921] Look at the captive insurance cases. The Service was miserable in those cases. They kept using the same expert, some guy from Pennsylvania who the Tax Court repeatedly kept saying didn't know what he was talking about, and they would repeatedly bring the same guy back.

[922] [Laughter.]

[923] MR. KIES: They must have got a deal on him. Perhaps they paid him for three cases at the outset. They had to use him. It was a disaster.

[924] MR. ALEXANDER: They had to use the low bidder. They don't have to do that anymore. That helped to solve that problem. I agree with you. They are outmanned.

[925] MR. GIDEON: I think this problem is difficult. There are governmental solutions. I don't know whether they are ever likely to be implemented. If you look at, for example, how the Federal Reserve is compensated, if you look at how some of the other specialized agencies where the government has recognized that frankly it needs to pay more so that it has the same caliber players that the people on the other side have, that might be an intelligent solution. I believe that the number of important tax cases every year is not a huge number. So it's not that you are going to have to have a gazillion of these lawyers. You just need a critical cadre that can do it.

[926] I think the other problem for the Service is it is so hard to keep these people once you have them. I think the Service succeeds in hiring a lot of bright and talented lawyers. The difficulty is that when they really get to be bright and talented and know what they are doing they are not going to be working for the Service anymore. That has been kind of the perpetual problem of kind of staying up with this.

[927] I would like to enter something of a note of doubt about all these proceedings in terms of whether this problem is as serious as we may be saying. I tend to look at the results of the score sheet. Corporate tax receipts have been rising steadily in recent history. We do not seem to be losing appreciable segments of revenue. Maybe there is an argument that we are not getting as much of it as a percentage as we used to get, but I'm not sure I've seen any evidence that suggests that.

[928] And I don't mean to say that the government shouldn't be vigilant about this. I think you always have to police the boundaries.

[929] Leaving aside the foreign transactions where I think the world is just different, but looking at kind of purely domestic operations, I'd have to say that one of the open questions is whether people really are succeeding in eliminating their tax liability in any meaningful sense.

[930] I think there is a need for managing it for a lot of the reasons that have been suggested, that basically trying to create that kind of earnings flow that is going to look good for purposes of earnings per share is very important, and everybody knows that. If you are the fisc and you are kind of patient or you are sitting back there and you don't in the long run really care whether you get it this year or next year as long as you are reasonably sure that you are going to get it -- you might care if you are not going to get it for 20 years. If that's the kind of problem that we have, maybe we ought not to be worrying about it quite so much.

[931] I'd be interested in the perception of the people who really see a lot of this, as to whether stepping back a step in terms of government accounts are people really succeeding in making liability disappear or are they simply moving it around in ways that are advantageous in terms of their financial reporting.

[932] MR. THOMSON: Rick Reinhold.

[933] MR. REINHOLD: I think I agree with both Ken and Ed Kleinbard to some extent. The developments in the foreign tax area have prompted people to devote a lot of energy to planning. You see a lot of different transactions. Whether it's shoving debt offshore or restructuring foreign operations, it's really just a desire to get some sort of normative taxation so you don't find yourself losing money in the United States and paying a ton of taxes offshore. I suppose from a U.S. perspective that's avoidance.

[934] I think they are transactions that have an economic basis. I'm not quite sure whether they should be classified as tax shelters or not. I think my instincts are that they shouldn't. Ken would not be terribly concerned about those, I don't think. Maybe I am going beyond what he said. Whereas a transaction like a lease strip which is pretty transparent and pretty flagrant, I think stands on a different footing.

[935] MR. THOMSON: Dave Hariton.

[936] MR. HARITON: I was struck on the litigation point, which is we mostly lay the trouble at the door of resources. I just wanted to ask if you think the IRS has made some bad tactical decisions about what to litigate. All these resources were devoted to the Fannie Mae case a few years back, which, to me at least, encouraged taxpayers to take the attitude, well, if this is what you are going to expect, you might as well put your hands into the cookie jar, because you can't expect fairness out of the other side.

[937] MR. THOMSON: Glen Kohl.

[938] MR. KOHL: I would like to ask a question not so much in terms of how much it's out there, but just comments I have heard when I've been in the government, and tell me if people think this is true: "Glen, no one ever asked me if anything works anymore. It's just, "Will I get penalties?" And the whole exercise is to get into a position such that, worst-case scenario, realistically you just got a loan from the government and that we have a system in which many people are not really trying to get the right answer, but just, can I operate above substantial authority and have no harm, no foul?

[939] I am just curious if that is what the private practitioners see going on in terms of how people are doing things.

[940] I see Rick nodding his head.

[941] MR. REINHOLD: I think to some extent that's true. You can judge for yourself by comparing the sort of columns that appear in the tax press about the issues that practitioners worry about on the one hand versus the issues that get litigated on the other. The Service doesn't raise interesting questions; it doesn't raise difficult questions; they tend to audit things that can be photocopied, like T&E.

[942] [Laughter.]

[943] MR. REINHOLD: I think there is a huge disconnect between things that practitioners worry about and the things that get audited.

[944] MR. GIBBS: With respect to that question and also a comment about the attorneys, my perception is that the real problem is not so much at the attorney level as it is at the ability of the Internal Revenue Service to adequately audit and find the issues and problems and develop them even with legal help in a way to maximize the ability to win them in the courthouse.

[945] It's interesting, because I think there is a tie here to some extent between this issue and the tax shelter issue previously. When the tax shelter issue started coming out, the IRS had no problems in winning the cases. So to some extent there is some kind of a difference between the tax shelters of the individuals some ten or 20 years ago and what we are seeing now.

[946] I think part of it is the complexity of the returns, and I frankly think some of it is the inadequacies of the audit and examination capability, and I would say that that is particularly true in the international area with the general overall quality of the international examiners.

[947] MR. THOMSON: Mr. Gibbs, what would you say would be the prospects of improving that and how would you improve that?

[948] MR. GIBBS: I think there are a lot of reasons and causes for it, which we will probably get to in the next segment. I don't know about hiring private sector folks. It may help in certain areas and in certain cases. I do agree with Ken that I don't think you need to put them all on all of the cases.

[949] One of the things that I see my clients constantly frustrated over is that the issues that are being raised and being developed by the Internal Revenue Service are being treated like tax shelters and they are not even close. I think it leads to some cynicism when all of them know that they have got tax shelters there that perhaps should be raised and they are not even being tackled.

[950] MR. THOMSON: John Salmon.

[951] MR. SALMON: We are talking about sort of reacting to the law and working with issues. Isn't there another side of this?

[952] I just put it out as a question because I don't know the answer.

[953] Doesn't the government have to be careful?

[954] Checking the box is one example.

[955] Are we giving people more tools to play with?

[956] I know people are talking about giving it simplicity because people are going to get there anyway, but the impression I get is we are going way beyond the point of where they have got to get anyway.

[957] Another part of this issue is, are we throwing fuel on the fire with some situations like that to very creative people when you allow them to sort of carefully design their form or whatever different form they happen to be in? Is the government adding to the problem, I guess is my question, with proposals such as that?

[958] The difference is some things you can probably get to today, but when you go to this type of proposal you can go way beyond what people would even try to do. That's the impression I am getting, but I think there are a lot of people in this room who are probably closer to it from a practitioner standpoint than I. Is the government adding to the problem?

[959] MR. THOMSON: Any reactions to that?

[960] Mike Schler.

[961] MR. SCHLER: On check the box, I think you pretty much could do everything before. This may facilitate it. On the other hand, even if check the box was withdrawn tomorrow, the proposal made people think about the issue and realize all the things you'll be able to do more simply. So I think now they would just do it the longer way because it's something that a lot of bright people have started focusing on regardless of what eventually happens.

[962] I think in the end it's not going to make a whole lot of difference. There will be marginal cases, but I've never heard of a deal that otherwise worked but the one problem was you couldn't arrange to have the entity to be a partnership. That just is unheard of.

[963] Mostly it's international type issues, trying to get both benefits. There is a proposed reg on trying to deal with treaties by looking at how the foreign law treats an entity, not how the U.S. treats an entity. This is very controversial, but if it's adopted it will eliminate some of the double benefits.

[964] Just one more thing on litigation. The Service could hire ten bright litigators who could do a couple of cases a year. I think that would help. It's certainly necessary not to have these cases that the government should win but they are losing, but it is by no means sufficient because of the audit problem. I don't know how you solve the audit problem unless you somehow find a way to encourage taxpayers not to do the transactions in the first place. Not necessarily by registration or something. That's a separate issue. It seems to me somehow you need some statutory support (such as an overriding clear reflection of income rule) either substantively or procedurally rather than relying on the audits. I think relying on audits is hopeless.

[965] MR. THOMSON: Rich Belas.

[966] MR. BELAS: Two things I wanted to say. On the litigation issue, it may very well be that there aren't enough competent government lawyers in these cases. I wouldn't disagree with that. On the other hand, I think probably one of the big problems is a management problem, that they are not held to the same standards as any private company would hold its lawyers in making the determination on whether they are going to litigate. The cost-benefit analysis seems to be really totally lacking at the government level when they beat their heads against the wall on issues they are going to lose every single time and they keep on doing it time after time rather than focusing on the issues that probably would have greater significance to the government.

[967] The second one is that I don't think we have really adequately analyzed what the motivation is. Is it that there is just such cynicism in the corporate tax community that there is no reason why you should pay taxes if you don't have to? I think what Norm was suggesting is that is probably not the case.

[968] Or are there really some structural problems in the tax laws that you can't fix, that you can't any longer expect to enact reform bills, whether it's the Houghton-Levin bill or parts of Houghton- Levin international tax bill or other reform bills that just seem to die because there is no revenue gained by doing anything with them?

[969] MR. THOMSON: Tim Hanford.

[970] MR. HANFORD: I want to react to something that Larry said, that part of the problem is the audits, that the IRS simply can't find these transactions. I think that's right. Even the ones that they do find they don't necessarily find them on a timely basis, and as Ken said, are wholly developed almost overnight, maybe within one IRS audit cycle. It's interesting to ask how you can give the IRS the tools to find some of these to discourage them early on.

[971] MR. GIBBS: I think far more significant than the Colgate case is how the Colgate case was located. I will simply say to the folks sitting in this room that if you will think about it, the decision in Merrill Lynch with respect to the summons is a lot more significant in terms of its use in Tiffany Fine Arts.

[972] I think all of us would be somewhat uncomfortable if IRS started showing up in our offices saying that they wanted to take a look at the income that we had earned from financial products that we had sold and asking us for the same kind of information that was served in the subpoena to Merrill Lynch. I've got a sneaking suspicion that would have a severe impact. I don't know what all the ramifications are.

[973] Basically what happened was IRS in the Merrill Lynch case came in to Merrill Lynch and said, we want to take a look facially at your income that you are earning from selling these financial products, and we want to know who you are selling them to. The case was defended on the basis that if you want to do that, it's a John Doe summons, and you have to go through John Doe procedures. The Merrill Lynch case says, no, even if it's just a facial, we want to take a look at the Merrill Lynch income. That's okay. And you can get the names of the investors.

[974] When the Service realizes the implication of that and is willing to apply that on a broader basis, I suspect it has pretty good implications in terms of how you find investors.

[975] MR. ALEXANDER: I want to follow up on that, if I can, and ask Mike Schler. Given what Larry just said, you might have a somewhat higher opinion of the examination process as a way to try to make the tax system work. I've got a follow-up question after you answer that one.

[976] MR. SCHLER: I suppose that's a possibility, but if that becomes common, by the time the IRS gets around to subpoenaing Merrill Lynch, there will be no documents left for them to subpoena. They just won't keep the records. I don't know of any legal requirement to keep the records.

[977] MR. ALEXANDER: Having worked for the Nixon Administration, I'm not sure that shredding is a solution.

[978] MR. SCHLER: You can't shred after you get the subpoena.

[979] MR. ALEXANDER: My further question is, if the examination process, in your judgment, doesn't work, what tool, if at all, do you have in the tax administration system to try to make our tax system work?

[980] MR. SCHLER: You mean administratively?

[981] MR. ALEXANDER: Yes. Are we going to have a truly voluntary tax system where only those who want to pay do? If the examination process doesn't work to make our system a viable one, then what substitute, if any, is there?

[982] MR. SCHLER: Maybe there is none, but the question is, do you make it work either administratively or by legislation?

[983] MR. ALEXANDER: Legislation won't work if there is no way of enforcing the legislation.

[984] MR. THOMSON: Let's explore some of that. One way of getting at the problem is the old-fashioned way of auditing and trailing and setting it up and litigating. The sense I'm getting is that's an important facet and ultimately that's the litmus test, perhaps.

[985] Then another question is, assuming you are uncomfortable being able to do that well or well enough, what other ways can you do it? Are there ways to head these off at the pass, so to speak?

[986] People have touched on a couple of things I would like to have some discussion about. Mike Schler mentioned the tradeoff of more generalized rules, purpose based or principle based rules, something of that nature, solely or in conjunction as a backstop to some more precise rules.

[987] The other thing that people have touched on is the penalty and disclosure system, if I can call it that, and whether it can be modified. Do people have suggestions about how that can be improved?

[988] Glen Kohl.

[989] MR. KOHL: This is to people who have heard any one of my last three speeches. They have heard some of this. But I will limit the stories about my kids.

[990] One of the things that I have observed is that it is impossible to craft the perfect set of rules. That is what we learned when we tried, and the more rules there are the more ways there are around it.

[991] In terms of guidance, we talked a little about antiabuse rules. I would lump with antiabuse rules existing doctrines like business purpose and clear reflection and things like that. One of the things I've discovered is that you can have precise rules which give you bright lines but then don't work in all situations.

[992] For people who have heard this the third time I apologize, but something as simple as the speed limit. The speed limit is 55. You can tell when this speech started. But in fact we see that even that bright line doesn't work when there is a snowstorm and you really shouldn't be able to go that fast, or you have a pregnant wife in the car and you should be able to go faster, or, as I've said, it's three in the morning and Bruce Springsteen is on the radio. Even in that case it doesn't quite work, something as simple as that. I would submit that the reckless driving statutes are the antiabuse rules to the speed limit when you literally comply with the speed limit but still are not driving safely.

[993] You see it in the NBA in the salary cap and the games that are around that. I can tell these stories about dealing with my kids and the way they interpret things. The problem of establishing a perfect regime is intractable. While people say bright lines have this advantage and general rules have this advantage, it's ultimately a question of balance and of degree.

[994] I think Montana just went to any reasonable speed and got rid of the speed limit. Again, when are you being unreasonable is kind of facts and circumstances test and lacks a bright line. On the other hand, it adequately addresses the situations where the speed limit doesn't work.

[995] What has heartened me is what everyone has said, that the key issue is systemically the government has to win some cases so there creates an environment in terms of what is going to happen.

[996] I think ultimately tax lawyers have a self-assessment system. My sense of things now is that in many transactions there are debates between tax lawyers, some saying this works and others saying, no, it doesn't work. Ultimately, the issue is, will the government back the latter group up?

[997] As I've said to people, we got a lot of thanks from people when we said lease strips don't work and we're going to issue a reg saying they don't, but also saying, and we don't think they work under current law. More than one person said, I'm glad you said that, because otherwise I just get known as someone who doesn't get in on the good stuff. I think the Ford Motor case was an example of that, and I think the case that has been discussed. A lot of people said, no, it doesn't work, and other people said yes.

[998] These cases I view as less the government versus the particular taxpayer but rather more as weighing in on the larger question of is it in the tax lawyer's interest to say "no, let's go slow here, that approach pushes it too far." Ultimately if they are not supported, then the rational decision for them is to be more aggressive. It's like waiting on line and everyone else is cutting in and you're just sitting there waiting. Ultimately the line will break down.

[999] It exists in life. In a basketball game, if the ref doesn't call penalties, then the one schmuck that is not fouling people is going to say, well, I'm going to get my shots in too. I think ultimately it's going to be played out in the court cases and the guidance process. We do not always wait for the courts because cases take so many years to play out that it's just not timely enough.

[1000] MR. KIES: Is the moral of that don't play basketball on a highway in Montana?

[1001] [Laughter.]

[1002] MR. KOHL: I'm glad you found some theme to that.

[1003] MS. PORTER: The ultimate general rule would be you just pay your fair share of tax and you decide what's fair. I take that to the nth degree. I don't mean that you shouldn't have general rules. I think many people think that goes to the heart of the matter. Mike Schler was saying that it was harder to get around a general rule. But suppose we did just say everybody pay their "fair share." What's fair?

[1004] MR. THOMSON: One of the things Glen touched on was the role of the Administration, Treasury and IRS in writing rules about this notion. The concepts that we are dealing with or the underpinning of the words of the statutes are these judicially created doctrines of substance over form.

[1005] Does anyone have any comment on the appropriateness of Treasury and IRS, in regulations, for example, being the strongest form, putting these concepts within the rules? Do they think that's appropriate? Do they think that does anything?

[1006] Mike Schler.

[1007] MR. SCHLER: There are different kinds of regs. There are legislative regs where they certainly have the power. I think there are two issues. The first question is, do you look at the purpose of the taxpayer. The second is, do you look and see if what the taxpayer is doing is consistent with the purpose of the statute, regardless of the purpose of the taxpayer?

[1008] I think looking at the purpose of the taxpayer may be okay, in some situations, but it's much more a questionable kind of thing. If the system works right, you would just look at the transaction and see if the tax results were consistent with the purpose of the statute. Whether that is authorized in a reg, if it's an interpretive reg rather than a legislative reg may depend on the particular case, but often it will be. I think in many cases it would make more sense to have legislation along those lines.

[1009] MR. THOMSON: Bob Shapiro, I didn't see you at the beginning. Do you want to make a comment?

[1010] MR. SHAPIRO: My comment doesn't relate to the question you asked. Let me just make a couple observations.

[1011] I just made a major crossover in my career as a tax practitioner in Washington. Having spent 15 years in government, I have just started my 16th year in private practice.

[1012] My government years with the Joint Committee on Taxation spanned 10 major tax bills, including two tax reform bills in 1969 and 1976. Throughout this period, the Joint Tax staff was directed to find new ways of raising revenues, and also to identify "loopholes" and "abuses" and to shut down tax shelters. The pressure to find additional revenues has increased significantly since my term in government because of the budget deficits in the 1980's. Thus, developing "revenue raising options," "revenue enhancements," and "accelerated compliance measures" has become a major role for Congressional and Treasury tax staffs.

[1013] This constant drive to find revenues to help reduce the Federal deficit in budget legislation as well as to offset the costs of tax- cut measures has reached beyond eliminating what all would agree are abusive transactions or unintended results of statutory language. Instead, the revenue-production frenzy has spilled over to affect what businesses see as ordinary and legitimate costs of doing business. Also, businesses react strongly to use of the term "corporate welfare" as a cover for squeezing more tax revenues out of the corporate sector.

[1014] Businesses are frustrated with the complexity of the tax law, particularly where very detailed legislative and regulatory rules are drafted to try to stop any possible transaction that might be deemed "abusive." This is certainly not intended to endorse corporate tax abuses by any sense - there are many CEOs, CFOs, and tax directors who support the goal of eliminating abuses. But now many deductions or credits provided by statute to businesses are being viewed by some as possible "corporate welfare."

[1015] In response to the continuing pressure for tax dollars, and frustrated by the complexities of tax law, corporations put pressure on tax practitioners to reduce their effective tax rates. The CEO may hear something about a new tax planning opportunity, or be approached by investment bankers with the latest innovation said to save taxes. This creates pressure down the line to the tax director and then to the company's tax consultants to find creative ways to interpret the tax laws. At the same time, the IRS is left with strident criticism mainly for implementing the continuing stream of tax laws passed by Congress.

[1016] I'm suggesting that we need to step back and examine whether the pressure for revenues and sloganeering about "corporate welfare" has led to undue complexity, frustration for businesses, and searches for more ways around the intricate web of tax rules. Let's examine whether we can attack abuses without so ensnarling the tax system that it threatens to break down.

[1017] MR. THOMSON: Phil Wiesner.

[1018] MR. WIESNER: I think some of what I was going to say was included in Bobby's remarks, but it was getting back to Mike's comments. My thought on this may be viewed as radical, but I think we don't need more legislation to deal with this problem. I think the tax community, the tax professionals have come to grips begrudgingly with the partnership antiabuse rules. They are there. Accept them. They are at least very general and very easy to understand.

[1019] MR. KOHL: Keep talking.

[1020] [Laughter.]

[1021] MR. WIESNER: But they are. We don't need to further complexify partnership subchapter K and the corporate subchapter rules, which is what happens every time you try to deal with a particular abusive problem or what's perceived to be an abuse. We create more problems.

[1022] Third, let the tax professionals do the job they are supposed to do, that is, the tax lawyers and tax accountants, in terms of policing the deals.

[1023] Fourth, let the marketplace operate the way it is operating, which is the good deals are driving out the bad deals. We are anecdotally seeing that the CFOs and the VPs of tax are taking a much harder look at these transactions than the individuals ever did back in the 1980s.

[1024] I think this is something which over time is going to work out best for all, and if we try to legislate whatever it is, another forest will die in the name of corporate tax shelters.

[1025] MR. MULLET: I'm sorry to butt in, but how else would you have dealt with the DuPont-Seagrams case if you didn't do it legislatively?

[1026] MR. WIESNER: I'm not familiar with those facts, but Colgate- Palmolive, those types of transactions, assuming they lack business purpose and don't have economic substance, if the IRS is doing its job in terms of audit, coordinated audits and raising those issues in court, then let the chips fall where they may in court on those issues. It's not something I think can ever be resolved legislatively nor should the burden be placed on the tax professionals to attach a statement to the tax return that's another five pages long detailing every deal that the client may have considered in the past year.

[1027] MR. THOMSON: Rick Reinhold.

[1028] MR. REINHOLD: I had a fairly narrow point about antiabuse rules and regulations. It goes back to a question you asked a few minutes ago. It seems to me those rules are appropriate and extremely effective where the principle that they apply can be readily articulated and understood from the regulation. I think an example is the 752 debt allocation regs. What those regs are trying to achieve is quite clear and the antiabuse rule is, I think, going to be quite effective in policing the operation of those rules.

[1029] As a point of contrast, the deferred intercompany transaction rules come to mind and the antiabuse rule down at the end that says that if you figure out a way to do something that is inconsistent with the principles of these regs, you lose. I guess the concept is fine, except you can't figure out what the principle is in those regulations. They are so complicated and lots of different people have different views on every transaction you can imagine except the ones that are listed in the examples.

[1030] If the rules can be stated simply, then an antiabuse rule make sense, but if it is going to be broad and amorphous, it has little or no value, it seems to me.

[1031] MR. THOMSON: Glen.

[1032] MR. KOHL: I just wanted to shift to the one process point. It kinds of picks up on what Larry Gibbs said and what was said about policing transactions. The registration of confidential corporate tax shelter provision, which was in the BBA, we picked up, and it is in the Administration budget.

[1033] One of the reasons why it's there, when you talk about finding out about transactions and information, we received a letter saying don't give general rules; go after transactions.

[1034] I think what you said is right about finding out about these transactions. I understand every rule has to be crafted and correct, but what we are hearing is something that I think has really a negative impact on the tax community. Ed talked about the hockey pucks going up, but the fact is --

[1035] MR. KLEINBARD: Hockey sticks.

[1036] [Laughter.]

[1037] MR. KOHL: I stick to basketball. Puck is too small. For me to keep my eye on the ball it has to be a very big ball.

[1038] Just the stories you hear from advisers of not being allowed to consult even on an anonymous basis with IRS people, something that used to be common, calling someone up, P owns X, and it is going to form S-1, and that people can't do that.

[1039] We've heard stories of there being approved lists of counsel that the potential company can use and not being able to consult with their own counsel. Then in cases where there are situations where under the shroud of confidentiality agreements not being able to maybe -- well, let's go check with another lawyer, or this or that.

[1040] I was surprised how well received that provision was at the ABA in New Orleans last January in terms of lawyers around the country who felt that they were just getting pushed around when they were saying, no, this didn't work, and really not being able to go anywhere. I had one person that came up after we issued the reverse MIPS notice that said, thank you, Glen. I was getting in dutch with my clients. You really helped me out.

[1041] I've always thought the tax community was very special in how people talked and dealt with issues. The chill in the process that prevents the kind of discussion at seminars and things like that and after we shut down some things -- Glen, I can't blame you for shutting down that. We knew about it. Why didn't it ever come out in seminars? Well, we couldn't talk about it. Confidentiality agreements.

[1042] I'm going to stop.

[1043] MR. THOMSON: Dave Hariton.

[1044] MR. HARITON: I think the antiabuse rules are a terrific accomplishment of the Administration's first four years. A day doesn't go by without my telling somebody that they can't do that because of the swap antiabuse rule, the OID antiabuse rule, or whatever.

[1045] Having said that, it tremendously arms, in theory at least, the audit staff. Maybe you can lead an auditor to water but you can't make the auditor drink. I don't think the solution is for the Treasury Department to go into the policing business. Frankly, the Department just doesn't have the manpower to do that. How many auditors does it take to audit the transactions that go on in the United States?

[1046] What you ultimately have is a very skewed and one-sided picture and a bunch of debates. If some transaction is written up in the press, then it's going to get a whole lot of attention and whole lot of hearings until something else gets written up in the press. You are not forming any coherent solution to the problems that have been discussed over the last hour. The antiabuse rules are, I think, a path towards a coherent solution.

[1047] MR. THOMSON: Ed Kleinbard.

[1048] MR. KLEINBARD: Glen suggested that there are investment banks that go around and --

[1049] MR. KOHL: I never said that.

[1050] [Laughter.]

[1051] MR. KLEINBARD: That go around with a precooked opinion that says we don't want you to go talk to your lawyers; you hire this law firm or we don't do the deal; we won't show the rest of the deal unless you agree to hire the law firm we've selected for you, or one of three law firms we've selected for you, and you can't talk to anyone else. And so on.

[1052] Glen is correct that that happens. It is contemptible, and in my view is a clear ethical issue. It has nothing to do with the Congress of the United States and it has a great deal to do with the self- policing mechanism of the bar associations of the various states in which that happens. It is a malicious interference with the relationship between lawyer and client.

[1053] And, interestingly, in every case, if you have a client that in fact is serious about its own tax analysis and they tell the investment bank in question to take a hike, we'd like to look at your product and we'll hire whomever we please, in every case I'm aware of the investment bank folds: Okay. We have a choice, revenue or no revenue.

[1054] [Laughter.]

[1055] MR. KLEINBARD: In the end, the investment bank folds. There is an issue, but it is an ethical issue and it should be dealt with and it is a disgrace that the bar associations have not yet dealt with it in the correct forum.

[1056] They say, well, you know, these things take a long time to come out, and the litigation we've talked a lot about isn't always successful. Wouldn't litigation be easier if we had a road map as to how to set up the litigation, by having all this information available through the registration process?

[1057] I think it is frankly naive to think the registration process is going to do that. In pretrial discovery there are two possibilities. Either you try to give nothing in discovery or you drown them in discovery. So what's going to happen in this process is that the registration process will lead to tons of material flowing in. Those tons of materials will by and large be useless material.

[1058] Those materials in turn will create a more adversarial process than we have.

[1059] First, it will take a lot of time to do.

[1060] Second, it will create an inference. The agent will come in and say, you filed tax shelter registration materials in respect to this transaction. Therefore, I will disallow it. Well, don't you want to learn about it? No, I don't have to learn. It has been filed. Therefore, it must be something that should be disallowed.

[1061] I think in the end what people would like is a system in which it was possible to get firm answers more quickly and more effectively rather than a system in which you just have an adversarial process with no real meaningful discussion or resolution of the issues.

[1062] Look at it today. You cannot get a private letter ruling on any issue worth asking. The only way in which you can get a private letter ruling is on something which is so obvious that you are embarrassed to even ask for it. Then it takes a year. The Service and Treasury have gone out of the business of issuing revenue rulings on any facts that are favorable to a taxpayer, because it's a one-way street. It kind of misses the point, I think.

[1063] If you want to have a system that works, you've got to give useful guidance, and you have to have the effective litigation. Obviously you have to have the effective audit process, but creating a more confrontational, more adversarial system is precisely backwards to this process.

[1064] If you want to bring corporate America back into the fold, you do it, following Glen's analogies, by demonstrating that you are the stern but loving parent, and you do that by dealing with unfairnesses, by solving unfairnesses when they hurt a taxpayer, and by punishing the hell out of them when they transgress. It's not that hard. It doesn't require an atmosphere of more confrontation; it requires an atmosphere in which legal issues can be resolved through private letter rulings, and factual issues get resolved through quality litigation.

[1065] MR. KOHL: And is another possible response to the legislation the reverse? That would achieve a result that you would agree with, that people will stop the practices that bring them into the registration process, and it could be that they end up getting none?

[1066] MR. KLEINBARD: That's what I meant before when I said about the Kabuki theater. Everything would be extremely stylized. People will say this is not controversial, this is not confidential, you can show it to everyone you want.

[1067] [Laughter.]

[1068] MR. KLEINBARD: That's exactly what will happen in some cases.

[1069] MR. KOHL: If that's all that happened, then obviously not, but to the extent there are submissions but now people can do the kind of things you agree are so-called "despicable" -- that was his word, right?

[1070] MR. KLEINBARD: If I didn't say it, I meant to.

[1071] MR. KOHL: You could take the view that even if not a single document was filed the provision would be a success because it would have achieved the solution to the shrouding.

[1072] MR. THOMSON: Let's get some other views. Mr. Kies and then Mr. Hanford.

[1073] MR. KIES: I would say relative to people not being able to get any useful rulings that I'm not sure Viacom would view the 355 ruling that they got as useless.

[1074] MR. KLEINBARD: The rest of us do.

[1075] [Laughter.]

[1076] MR. KIES: You're not on that list.

[1077] [Laughter.]

[1078] MR. KIES: Just a couple comments. First, there have been a number of comments that corporate revenues are up so there is really not a problem here. I would just suggest I'm not so sure that the evidence is that clear on that point. Corporate revenues currently are way, way, way below what was projected after the 1986 Act, number one.

[1079] Number two, there were hearings in Senate Finance in the late 1980's or early 1990's to try and look at what is going on there. There were some relatively unsatisfactory explanations, although some of it was more movement to Sub S and unincorporated form in response to the repeal of The General Utilities doctrine, but the actual level of corporate receipts I'm not sure tells us that there is nothing to worry about. I think the evidence is a little mixed there.

[1080] The next point is that I think we are kidding ourselves if we believe that the problems that are the topic of this session will never have to be addressed through legislation. The system is dynamic, the economy is dynamic, the people that advise are innovative.

[1081] Short against the box, yes. It has been there for years, but until people saw the Estee Lauder transaction in all its glory I'm not sure people really understood how well it worked.

[1082] I will give you an example of something that you are going to hear about next year, and that's the Indian gambling thing. There was a provision in the Balanced Budget Act that would have made Indian gambling taxable. We estimated it over six years raising $370 million. We asked for a GAO report and it came back and said that the annual net revenues are $1.5 billion. There is something going on there. There is a substantial growth industry. One might wonder, why is it tax exempt?

[1083] Section 1071 is another example. It got repealed at the beginning of the 104th Congress. When people actually got into section 1071 and found out the kind of deals that were going on they were kind of amazed that the thing worked the way it did. The statute itself was stunning in the sense that it gave to the FCC the decision to write tax law. Just in reading it it's amazing to see what the thing said.

[1084] I think it's inevitable that from to time there is going to be a need for legislative solutions. I think the IRS and Treasury should maybe spend more time, not less, working with Capitol Hill to try and identify areas where maybe there is a need to do this kind of thing.

[1085] MS. PORTER: Maybe that goes to the home analogy. The parents are squabbling and so they are not effectively disciplining the children.

[1086] [Laughter.]

[1087] MR. THOMSON: Tim.

[1088] MR. HANFORD: I want to respond to something Ed said about the effectiveness of potential tax shelter registration, that in those cases where there is actually registration the threat that the tax system might be buried with disclosures rather than get useful disclosures. My recollection is that the proposal says that you need to supply any document that was used in marketing the arrangement. In theory, that means we would also get the executive summary that was actually used.

[1089] MS. STECHER: If you get every spinoff in America as well as the deals that you are looking for, it doesn't seem to me that this information will be terribly useful to whatever poor soul is going through every executive summary.

[1090] I would like to follow up on one thing that Ed said. In my experience, most taxpayers would like to do deals that work. It is not their goal to do deals that do not have substantial authority and then pray that their auditor doesn't find it or negotiate to settle on audit. They would like to know that the transaction works.

[1091] I think one of the great failings of the tax system today is the private letter ruling process; it is impossible to get guidance on a timely basis. We see a lot of taxpayers who would happily go to the Internal Revenue Service and ask for certainty. Overseas they do ask for example, Inland Revenue. You can get much quicker turnaround time and much quicker answers, though potentially disparate treatment, because the inspectors for Inland Revenue have vastly more discretion than a case manager on audit.

[1092] I think that taxpayers would take advantage of this opportunity. This would give you much greater insight into the kinds of transactions that were going on in America today and I think much greater control over whether or not taxpayers go forward with what you consider to be abusive.

[1093] MR. KOHL: I agree with you. That's what I was saying this morning. I think one of the problems is private letter rulings, notwithstanding the code that says they are not precedent, have become meaningful guidance. So they are not just a question on a particular transaction, but they are substantial authority and they are cited by cases.

[1094] The concept of a quick ruling, maybe it will be right, maybe it will be wrong, but where one person takes a crack and gives an answer would be better and you could get answers and you could get certainty. The problem is these rulings, like it or not, are published and effectively become policy rulings. I think that is part of the reason why it's harder to get them, because they are not really anymore just one piece of guidance for one particular taxpayer.

[1095] MR. THOMSON: I don't see the connection between the private ruling process and getting at tax shelters. My assumption is those transactions that we are most skeptical of are not the likely candidates to come in for a private ruling.

[1096] MS. STECHER: In your definition of goat, I think that's probably right, but in the wide range between goat and sheep, just to stick with the analogy here, I think there are lots of transactions that people would be happy to come in and talk to the Service about in advance if they thought that there was any hope of getting guidance in less than a year.

[1097] MR. THOMSON: I'm inclined to try to wrap up this session here and let people stretch their legs before we move to the next topic. Would anybody like to make a concluding statement?

[1098] [No response.]

[1099] MR. THOMSON: Let's come back in about 15 minutes.

[1100] [Recess.]

[1101] MS. PORTER: Before we begin on the substantive part of the program, I just wanted to take a minute to thank Steve Rosenthal. Steve has been in charge of this conference and has gone to great lengths to make certain that it went smoothly and well.

[1102] On behalf of the Federal Bar Association and for all of us who participated, I want to thank you, Steve. It has been the best one that I have attended. Part of it is the selection of who you have gotten here and your diligence in trying to have each panel focused and different.

[1103] Steve has spent an enormous amount of time working on the program.

[1104] And also the court reporter I want to thank. Not only thank the court reporter for coming, but thank Steve for making certain that we had one. In times past that has been a little bit of a weak spot, because we have sort of tried to do it ourselves and it has not always turned out well. So we are very pleased, and I just want to thank you, Steve, before everybody drifts off.

[1105] [Applause.]

[1106] MR. ROSENTHAL: Thank you for your participation. I agree with Catherine that this last day has been phenomenally successful. On behalf of the Planning Committee and the Federal Bar Association, we appreciate the participation of all of you, the extra efforts that people from New York and elsewhere have gone to be here and to help us think about these issues and bring illuminating views to us and, with luck, the rest of the tax community once we have a transcript published.

[1107] I was going to add this as a wrap-up, but now is as good a time as any. You will receive one last piece of correspondence. For those of you who have talked at any point, the expectation is that you will get copies of the pages for which you appear in the transcript of these proceedings. We expect that to be in three weeks time or so. I will ask a relatively quick turnaround, within a couple of weeks for any editing of remarks. Again, try to be true to the actual remarks, but our expectation is to try to have this published at least in electronic form somewhere before Congress returns in January.

[1108] Nonetheless, that's where we are. Thanks for your participation and I look forward to our last session.

[1109] MR. MULLET: I want to thank you, Steve. I think you have done a terrific job. I know everyone on the Planning Committee particularly appreciates all those lunches you bought us, and we look forward to it again next time.

[1110] The last topic raises the question, is the tax legislative process ready for the 21st Century?

[1111] What really got this issue started or what was in our minds was taking a look at all of the crises, all of the problems that are facing us going into the next century. They are very well documented. From Medicare to Medicaid to social security, there are a number of problems facing us that are coming up in the country. The questions that have come up have revolved around whether Congress is going to be able and willing to face these problems and respond to them.

[1112] I might start off with a question to the general group. Just a show of hands, no names. How many people here think that something as dramatic as the 1986 Tax Act could take place within the 105th Congress? Could this session of Congress do something as dramatic as the 1986 Tax Act?

[1113] [No response.]

[1114] MR. MULLET: Nobody. Ken is gone. I know Ken would have raised his hand.

[1115] I think this is a clear case of how dramatic the problems are. Mike is absolutely right. The '86 Act isn't nearly as dramatic as solving some of the problems that are facing us in the next century or dealing with some of the tax reform proposals that are out there now. I think that is really what got us started on this topic.

[1116] I am going to start by asking Mark Weinberger, since we was in charge of the Entitlement Commission and probably has more background than anybody here, to comment on whether the tax system can achieve these objectives that are listed at the top of the page here and whether the system is capable of getting anything done. He was on the commission which made a report. And whether there will be anything that results from that report or not.

[1117] MR. WEINBERGER: Mark, what you are talking about is beyond just tax. You are talking about some of the major problems that we are going to have to face as a country, and the effect the Federal Budget process will play in addressing them. As we talked about earlier, many of the budget rules have a significant effect on tax policy.

[1118] Can we do something like the '86 Act now? One of the biggest impediments, I think, is the PAYGO rules. We didn't have those type of rules back in '86. They came in 1990. When you think about trying to make a tax bill the size of the '86 Act work on a year-by-year basis, how are you going to do transition rules?

[1119] As many of us know, a large reason that we were able to do the '86 Act was through some transition rules that helped corporate America to buy into it, which lost revenue in the short term and in order to increase revenue over the long term. You can't do that under the current budget rules.

[1120] In addition, you have in the Senate, as you well know, under the PAYGO rules a 60-vote requirement. So if you are going to have any type of violation of the PAYGO rules, you now have to have 60 votes in the Senate to get around it. That means any large tax bill would have to have strong bipartisan support. It couldn't be something that is a 51-member vote.

[1121] I think those type of procedural rules should make something like the '86 Act a lot more difficult.

[1122] Going to your bigger question, I think the whole focus of Congress is obviously on annual deficits and a 5-year or 7-year budget window. So it makes it very difficult to deal with the long- term problems that are systemic due to the demographic changes we are facing.

[1123] You mentioned a commission. We probably will have a commission next year, and it will probably look at Medicare. That's what all the politicians are talking about. But when you look at Medicare, as Ken Kies said earlier, the Republicans and Democrats aren't very far apart. You've got $168 billion on the Republican side and $124 billion that the President put on the table. Primarily all of those savings are aimed at provider cuts and reimbursement taxes. They don't deal with the long-term systemic and demographic problem.

[1124] If you are talking about getting a balanced budget by year 2002, it's not necessarily consistent with looking at fixing the overall scheme of our long-term problems.

[1125] The last point that I would like to make is that budget rules have another kind of effect which is an anomaly. When we talked about Medicare, for example, because that's the most popular one from the last debate, we talked about the Republican plan or the Democratic plan. We are either going to cut Medicare or we're going to slow the growth of Medicare, whatever it may be. People think of that as a major cut.

[1126] What we don't realize is that Medicare is growing so fast, along with social security, that while we may be slowing down the baseline, they are still growing at a rate such that they are crowding out our ability to spend money on anything else, like education and all the other programs on the discretionary side of the budget. We don't have a way in our current budget process to look at those type of issues.

[1127] I think it's going to be very difficult to address long- term problems under our current budget rules.

[1128] MR. MULLET: John.

[1129] MR. SALMON: Mark, we can focus on the process, we can focus on the budget rules and the PAYGO rules and this and that, but I think the fundamental reason you can't do what was done in '85 and '86, which I think was about as significant a change as you could get -- maybe not as significant as some people have thrown on the table, but in terms of mainstream proposals I think it was very significant -- it's not the process and the budget rules that will slow us down; it's sort of the political will to find consensus. You can always waive a rule. Jon's comment earlier this morning: Any rule can be waived in the House and the Senate functions by unanimous consent. It's the lack of sort of political consensus to try to find the common ground, to try to find the middle that is going to impede serious progress here.

[1130] I don't want to take anything away from the budget rules, but I think the bigger point when it comes to tax policy is the lack of political consensus, the lack of interest in trying to find the middle. That's not an issue for this conference, but I think it's a far bigger issue than all the process rules that we can talk about.

[1131] MR. MULLET: Ed.

[1132] MR. BECK: I would just like to concur with what John is saying. I think the real problem is the political consensus to find a way to address the problems. I think everybody knows that entitlements are eating us alive, but there has to be a series of things that fall into place before the Congress can operate.

[1133] You asked Ken if the congressional committees are capable of achieving these goals. I think they definitely are, but they are not capable of doing it unless there is a consensus among the committees. Maybe the consensus building process is to have an outside commission which makes the recommendations. Maybe part of the way you build a consensus is to throw it to a commission and say it's an up-or-down vote, much like the base closings, or some way where we do fast track in the trade area.

[1134] That's the way you might develop some mechanisms outside of the committees, but the committees themselves can do the job. The technical rules can be overcome once the political consensus comes into play.

[1135] MR. MULLET: I saw Rick's hand go up first, and then Mark.

[1136] MR. GRAFMEYER: If I sound like Bobby Byrd, just shoot me now. I'll obviously have to edit that out.

[1137] [Laughter.]

[1138] MR. SALMON: We'll repeat it and put it back in. "Rick, you shouldn't have said that about Bobby Byrd."

[1139] [Laughter.]

[1140] MR. GRAFMEYER: I disagree with all this kind of stuff. If you look historically, the Senate has always been a place where there has been comity and people try to reach a consensus and get along. I would say it's true what John said. For quite a few years that has not been the case. But the way to solve those problems isn't base closing kind of commissions and entitlement commissions, because that goes against the whole idea of why the Senate was set up the way it was.

[1141] Heaven forbid I agree with some of the commentators from the other side of the aisle where I used to work, but I think some of the comments are totally correct. When you start doing everything through reconciliation process and you start calling everything a reconciliation bill and through procedural rules or anything else just try to do basically exactly like, I'll say, the House does, which is a totally jam-down kind of way to do legislation, I think it defeats the purpose of how the government is supposed to work, especially from a Senate perspective.

[1142] I will agree with John that it's the political will of members, but bottom line is if they don't have the political will, that means the people aren't speaking loud enough and hard enough on these kinds of issues, or the members aren't hearing it. So the way to change it is not to do a base closing thing so that a very small majority gets their way but to actually allow the rules to work. If that means we don't have legislation for five or ten years, then that's life in the big city.

[1143] I'm sort of a believer in let's keep it sort of the way it is and not do these base closing kind of concepts for big problems.

[1144] MR. MULLET: Mark.

[1145] MR. PRATER: I agree with what Rick said. I want to point out a couple specific examples that we dealt with in a staff session. One was Senator McCain's Corporate Subsidies Commission.

[1146] First of all, it didn't really define very well what this stuff was, so-called corporate welfare. So it left within this commission, which had no members that were directly elected, no one really accountable politically to anyone, a lot of power to go after the tax code and substitute its judgment for the members of the tax writing committees.

[1147] All of the Finance Committee members signed a letter, from the chairman and ranking member on down, saying basically don't vote this bill. One of the things is that tax writing committees have done a lot of heavy lifting over the years. Like it or not, they did it. COLI was not easy to do. There are other things that have been dealt with by the tax writing committees.

[1148] I think the mechanism is there. It goes to John's basic point, which is you have to have some kind of a consensus, and that consensus has to be so deep that it has to come up through the membership of the committees. If it's not there, it's not there.

[1149] The other thing that I would comment on is I think what is left in terms of the tax base, there are things that are so fundamental. When you look at what are called tax expenditures -- I don't necessarily fully agree with that term -- but when you look at what you would have to do to the tax base to bring rates down, you're talking about things that affect a lot of taxpayers. You're talking about itemized deductions; you're talking about deferral for pension benefits; you're talking about tax free treatment on employer provided health care. These are things that are embedded in our culture, in a sense.

[1150] Going the next step from the '86 Act, whatever step that is, to the extent that you are retaining the income tax base -- Mr. Archer, that's not the direction he wants to go -- but if you go that direction or some analog to it, you really have to deal with some very fundamental questions, and that is not something that I think you could do in a year or maybe even two years.

[1151] MR. MULLET: I saw Larry, then Mark's, then Don's hand go up. Larry.

[1152] MR. GIBBS: I came wondering whether we would get to this issue. I have been saying publicly that I thought this was the biggest issue that certainly our tax system faces but also our nation.

[1153] Catherine and I had the experience after the Entitlements Commission report -- I assume everyone here has read the report; it's not long, if you haven't. In the speeches I give I keep showing the information where people can get it. I really didn't realize what it was when it was done -- with Fred and Mark and Hal Gann and Brad Aldonis in our firm. We gave about three sessions where we invited first the attorneys and then we invited the attorneys to bring friends and parents and so forth.

[1154] From that experience, my reaction is that it's not a question of really finding consensus. My reaction is that the politicians are telling us the truth. It is the third rail, and if we are looking to our politicians to do this, I think we are looking in the wrong place. I think you've got to get beyond the politicians. There is so much mis- and disinformation outside that until the public understands what it means to them individually and what we are talking about, I despair that you really have a political process that can deal with the issues, as big as they are.

[1155] I don't know how you do that. It's going to take courage; it's going to take leadership; it's going to take organization. And I don't think it's just the Congress that says not on my watch. I've gone to my corporate clients and explained to them. I thought the selling thing to them was, "Who do you think is really going to pay the tax cost of this when it comes?" It's not on their watch. "I'm not going to be here."

[1156] Entitlements were one-third of our federal budget 25 years ago. Today they are two-thirds of our entire federal budget. That's in 25 years, and it's not going to take 25 years for the thing to be to the point where if we don't start addressing it it's going to be a serious problem.

[1157] My point is that we and others have got to find some way to get the leadership in the country beyond just the Congress to start focusing on this issue, because I don't think our politicians can do it alone.

[1158] MR. MULLET: Mark Weinberger, I think you can probably tell us when entitlements take up the whole budget.

[1159] MR. WEINBERGER: In 2013 entitlements and interest on the debt will consume all Federal revenue. By the year 2025 four federal programs will consume all of our current revenue base of 19 percent of the economy, which is pretty much at an all-time high. Those programs are social security, Medicare, Medicaid, and federal retirement programs. Anything else would require a tax increase. These are just automatic pilot spending.

[1160] MR. RICHTER: And interest on the debt, too, right?

[1161] MR. WEINBERGER: That doesn't include interest on the debt.

[1162] MR. RICHTER: And that's automatic pilot spending.

[1163] MR. WEINBERGER: Right.

[1164] Public education is the linchpin to success.

[1165] To draw on the relationship between this issue and tax policy, for those who think we won't have a consumption tax in this country at any point because it's too hard to get to, if you think of just the bare demographic facts, you might begin to question your assumption. Back in 1950 we had eight people in the work force for everyone over 65. Today we have about five. In about five or ten years we are going to have three, and by the year 2020 there will only be two people in the work force -- less than two actually. About 1.8. How are we going to get the money to support all these elderly Americans?

[1166] MS. McCLANAHAN: Immigrants.

[1167] MR. WEINBERGER: Right.

[1168] It is impossible to think that we can have a growing economy and get the revenue amount from payroll and income taxes alone. That's too high a tax productivity. For those who think a consumption tax is never going to come, I think the demographics, if you really studied them, would lead you to believe differently. The question, of course, is when and how.

[1169] One last point. The legislative process is not going to be determinative of when we get to these issues. However, I think the current committee structure and jurisdictions create barriers. We rely on the Finance and Ways and Means Committee to deal with all of social security, all of Medicare, all of Medicaid -- well, I guess not all. In the House you have some other Committees with jurisdiction. And, the tax law changes. It's hard for these members to focus on all of these issues at one time. It makes the legislative process a key indication of how fast this thing could possibly move.

[1170] So then you look to the commissions. A commission is a very dubious way to deal with this problem. The people who are appointed to commissions are usually people who have vested interests and usually people come with a pretty good idea of the group of people they want to protect.

[1171] It's not the best way to reach consensus. These aren't people who necessarily have worked on these issues for years through the committee structure and have all the information available. Commissions usually last only a year. It's not a long time to build the dynamic where people could actually negotiate and get things done. A commission will work when you come to a crisis situation, like in 1983 with Social Security and you need cover to do what you already knew you had to do. They work best when you want a rubber stamp a concept to give people some political courage.

[1172] Maybe a commission can work at that point, but to come up with a well thought out consensus on all these various difficult issues, a commission is a very difficult place, I think, in which to do it.

[1173] MR. MULLET: Don Longano.

[1174] MR. LONGANO: Let me make a collective comment playing off what everyone has been saying. I think one reason why no one raised their hand when asked if significant reform could happen during the next Congress is because, as we all know, it takes a lot of alignment of the planets and the stars to do significant reform. Someone was talking about bottom up, top down. It has to really be everything. It has to be the President down; it has to be the Congress, every Congress person up; it has to be public opinion, whether it's negatively created, which is what happened in '86, or possibly positive opinion and let's correct the obsolete code that we have and move into our new technological world. You need basically ever facet to be in order to allow the politics to be there to do significant reform.

[1175] You can kind of guesstimate: Can it be 2001? Will it have to be 2005? On and on. I think our challenge here is we as tax professionals can sort of foster the discussion by talking about obsolete portions of the tax code, but we can't control the alignment in global terms.

[1176] Our responsibility is, I think, to spend this time when it is not going to happen debating and coming up with some ideas or potentially a consensus of what should be done when the spark is there. In that regard, I commend Chairman Archer for indicating that he is going to continue his hearings on reform even though we know that it is not going to roll through to enactment in the next Congress.

[1177] Our challenge is to pay attention to those and not walk away. Of course, it's always easier to be busy with the item of the moment. I do agree with Mark Weinberger. At some point in time the alignment will be there, and if we don't have some really good ideas about how to make the system work on a technical basis, then it will be shame on us.

[1178] MR. MULLET: Jon Talisman and then Randy Weiss and John Salmon.

[1179] MR. TALISMAN: I think there are a couple issues here that are being mixed. The question is, are we raising the same amount of revenue by switching systems or are we raising additional revenue by adding systems? In other words, do you have an add-on value-added tax to raise the additional revenue needed to pay for entitlements and defense spending and the like that you may not be able to afford in the future?

[1180] If you are talking about substituting a known for an unknown, I think that is unlikely to occur in this Congress and maybe any Congress. There is an inherent fear: we know we can raise a sufficient amount of revenue with an income tax. If we switch to a value-added tax with transition rules, regardless of whether they are subject to the PAYGO rules or not, in the near term you are going to lose revenue generally. As a result, we are going to find slippage and we are going to be further behind the eightball rather than further ahead when we institute a value-added tax or another type of consumption tax in exchange for the income tax.

[1181] If, as Mark suggested, you are talking about whether a value- added tax would be useful as a way of getting to the people who arguably are outside the income tax base because of the demographic switch, I think that's a useful dialogue, but then again another way of getting at that problem is to focus on entitlements, and that's a dialogue we need to have hand in hand with that. As Senator Moynihan has suggested, we should be rethinking our use of CPI as a cost of living index. It is not a true cost of living index and its use in statutes is forcing these entitlement spending up by a dynamic that is overstated.

[1182] Finally, we can talk about an optimal consumption tax system, but that seems to me impractical. When we get done designing it, it probably won't be an optimal tax system, through transition rules, through various special interests, through things that we need to do with respect to encouraging retirement savings. We will have to take a look at the fully-developed consumption tax, with all these types of exceptions before we know whether we can really raise the same amount of money as an income tax. So when you say an optimal tax system, I'm not even sure that's on the table.

[1183] MR. MULLET: Randy.

[1184] MR. WEISS: There seems to be an unspoken assumption in the discussion about these long-run spending and budget problems that these have to be dealt with in one fell swoop sometime in the next two, three, or five years. I disagree with that assumption. These issues can be dealt with over a long period of time and in an incremental fashion.

[1185] The proposition that is being asked is, if Congress functions the way it has historically, could these problems ultimately be dealt with in a reasonable manner? Historically either a crisis in a trust fund like social security in 1983 or general concern about budget deficits has been what has driven a lot of spending cuts and tax increases.

[1186] The Medicare trust fund is going to run out of money in a few years. Presumably that will be an opportunity to have something like the 1983 Social Security Act that could address the short-run problem and also at least address some long-run problems.

[1187] With regard to the other issues about growth of entitlements, I don't see why those can't simply be dealt with in the same kind of incremental process that we have seen for the last 15 years. Presumably, we will have a balanced budget target each year and each year we will look at spending, including Medicare and Medicaid, which have been cut routinely throughout the last 15 years, and just make another little cut.

[1188] Apart from just a process question of whether the budget process can work the way it has, the long-run projections that are part of the discussion are so speculative that it would be not very prudent to make drastic and radical decisions based solely on somebody's guess as to what is going to happen 50 years from now.

[1189] MR. THOMSON: John Salmon.

[1190] MR. SALMON: Just to finish the thought that you started, what is different from '85 and '86 in doing significant tax reform. We talked about political will to do it among politicians. This goes back to Catherine's point earlier. I think this conference is a good way of sort of keeping communication going. Treasury and the Hill need to work together. That was a big thing that went on in '85 and '86. You may have had a President of one party and at least the House controlled by another party, but you had a tremendous amount of cooperation between the Treasury tax professionals and the Hill tax professionals. When you don't have that, you don't even have the communication working, you can't grapple with a lot of the questions we have talked about today.

[1191] I think it's important that the professionals, while they may work for politicians, whether they be on one end or the other of Pennsylvania Avenue, have to keep the communication going and the contact there.

[1192] You can go all the way back to the Nixon days where people sort of had maybe different political agendas but there were tremendous working relationships between Treasury, IRS and the Hill. When congress has been successful in moving strong legislation it is when that communication system is working. I think it has broken down. In the last couple of years it hasn't been great.

[1193] I'm sorry some people aren't here now to talk about it, but I think that is an important thing where we can collectively make a difference. We can't move all the politicians to get all the planets in alignment, as Don wanted, but I think we can improve the quality of the communication in the tax process.

[1194] MR. MULLET: I think that is really what I was trying to get to with question three. I've said for a long time that I can't think of any dramatic tax reform that hasn't been pushed down from the Executive branch coming out of Treasury and then pushed on to Congress and Congress being willing to take it up, which I think is basically what you are saying, John. Is that the proper role for the Executive branch and the Legislative branch and does it necessarily have to go that way? With Chairman Archer pushing for tax reform, it seems to be reversing itself as to whether the Executive branch will latch onto it or not.

[1195] Fred Murray and then Don Alexander.

[1196] MR. MURRAY: I have one observation, I guess in reaction to Randy's comment a minute ago about incremental reforms. I guess I'm somewhat more skeptical about whether or not incremental reforms can work at the order of magnitude that we will need. Certainly some of them can be, but just looking at the Medicare debates of the last few years and what both parties have tried to do and how each party has excoriated the other party in the process leads me back to the comment that John was making and others have made. Trying to find a better basis for dialogue and trying to find a way to find some sort of solution that both parties can buy into at a somewhat similar time may make more sense because the problems are of such a significant magnitude that I'm not sure that incremental reforms, particularly if they come late in the day near a crisis, are going to be as effective as they may have been in the past.

[1197] I would like to introduce a somewhat different topic by going back to a comment that Rick made earlier, and that Mark was making, on the effect of the budget rules on the process. We seem to be forcing ourselves into a process now where every tax bill forced into a reconciliation bill at some point.

[1198] The Small Business Act was kind of a recent exception, but you can argue about exactly how it was constructed, and whether or not it really meets certain needs that we have got.

[1199] I guess a need that I have in mind is we've got technical corrections and simplifications that have been out there in some cases for as much as five years or longer now that we can't find a home for. We can't get them into a bill; we can't get them acted upon.

[1200] There are other provisions that I think a lot of people are interested in, and the mechanism as they currently exist with the PAYGO rules make it very difficult to consider some of these things in a more academic environment, in an environment that used to exist where we had hearings and had the ability to consider tax policy changes on the basis of the tax policy involved in the particular provision.

[1201] I just wonder if anybody has got some comments on where we can go to try to fix the system in that regard.

[1202] MR. THOMSON: Mark, do you want to comment on that?

[1203] MR. PRATER: We did a package of technical corrections.

[1204] MR. MURRAY: That's true. We did, but there are lots of other things that have been out there on the plate for a good long time.

[1205] MR. PRATER: I agree with you, Fred. There is some frustration with those things sitting out there for a long period of time, and reconciliation is a bar to doing those things.

[1206] I think one of the good things about the '96 legislation is that we are able to do a lot of ventures without the constraints of reconciliation. I think most of the stuff in the small business bill and the health care bill were consensus items. Long-term care and things like that have been kicking around for several years.

[1207] For me it was kind of pleasant to wrap them up.

[1208] MR. MURRAY: The small business bill was sort of an exception to my complaint but also it was a limited exception. I think probably lots of people in this room have various provisions that they have been interested in that go all the way back to the Rostenkowski simplification and technical correction bills and beyond that.

[1209] It does seem that with the PAYGO rules and having to find a revenue raiser that exactly offsets whatever it is you want to talk about, that we have forced ourselves, it seems to me at least, into a process where we forego sound tax policy in many respects in order to satisfy some of these other also very important considerations. I just wonder what we are doing to the system in the process. There is no effective outlet for a lot of these pressures.

[1210] MR. MULLET: Don, then Norm.

[1211] MR. ALEXANDER: We have been talking about the process and the problems in meeting revenue demands created by entitlements, particularly social security and Medicare. I guess we touched on some of the substantive elements only when Jon mentioned that you should look at the CPI, which I think is a very healthy thing to do.

[1212] As the only other elder American or greedy geezer in the group - - Don Lubick has departed.

[1213] [Laughter.]

[1214] MR. ALEXANDER: I just want to mention that I am in mild disagreement with Mark's statement that we would have 1.8 working Americans for each elderly person. I'm not totally sure that being an elderly person is inconsistent with being a working American. I wonder whether in addition to reforming the CPI, which would be a strong move in the right direction, we might also take a look at the idea of retiring people at 65. You could straighten that out in two ways. One, you could maybe kill them all at 75, which some might not want to have done to them, or two, you could suggest that they work until 67, or longer which would go a long way towards solving the problems I think you mentioned, wouldn't it?

[1215] MR. GRAFMEYER: We tried that last year, Don, and it went down.

[1216] MR. WEINBERGER: Can I respond to that even out of order? I think that is an excellent point. I certainly didn't mean to suggest that if you were over 65 you're not working. That's when the benefits kick in currently, obviously. That's what I was referring to.

[1217] You are absolutely right. Back in 1935 when social security was created and the eligibility age was 65 the average person only lived to 61. Today basically the average person lives to 76 and by the year 2020 it's projected to be closer to 80. So people are collecting benefits for a larger portion of their lives. It is scheduled to go up to 67 over the long term, and most of the proposals do in fact suggest that you should increase that to a higher level. So I think that's a good point.

[1218] MR. MULLET: Norm.

[1219] MR. RICHTER: I just wanted to second Randy's point and say not only is incremental reform in this direction, moving to a consumption-based tax or some other kind of tax, advisable, but it is also inevitable. If there is anything that observing the political system that we have has taught me is that our electorate just does not like radical change. Everybody can cite examples of that. We tend to see things proceed incrementally.

[1220] I guess I just wanted to note that most other countries that do have tax systems are dual systems. They have income tax systems and they have consumption tax systems operating side by side. We're relatively unusual in the emphasis we put on an income tax system.

[1221] What I think you really ought to be looking for at some point is watching for that little consumption tax that is somewhere in the system, that it somehow can grow. That's the way it's bound to happen, in my view.

[1222] Without meaning to comment on the pros and cons of the tax I'm about to refer to, but the opportunity to get part of the way there or get that process started was lost in 1993 when the energy tax didn't happen. The energy tax would have been 20 cents on the dollar spent in the United States subject to tax in a consumption tax form, and that could have created the machinery and started the process to migrate over to that other system.

[1223] MR. MULLET: I guess with me that raises the question of whether or not in this country that means increasing our tax load from roughly 20 percent of GDP to something more than that and whether in fact we really want to look more like Europe than we do now. I always think of Senator Packwood, because that was something he often repeated in the Finance Committee. He didn't answer that question. He just always raised it: Do we really want to look more like Europe or not? I guess that's a fundamental question.

[1224] MR. RICHTER: Looking like Europe, I think in the sense he was using it, and you probably are too, you mean aggregate tax burden as a percent of GDP.

[1225] MR. MULLET: Right.

[1226] MR. RICHTER: Japan has a tax burden as a percent of GDP very similar to ours and yet they have a consumption tax as well as an income tax. There is no reason why the mix can't come out to the same amount of revenue. It's not implicit in that that you increase the tax burden in the aggregate.

[1227] MR. MULLET: Correct me if I'm wrong, Mark, but I think he also figured in some state and local effect in there. I don't exactly remember what the numbers worked out to. Maybe our economists have a better idea.

[1228] MR. PRATER: He looked at total spending as a percent of GDP and total taxes and what his trend lines showed was the state and local part. The federal part on the revenue side stayed pretty flat; the state and local part went up; and the federal spending went up. So we had a deficit developing at the federal level because the revenue base was staying fairly constant.

[1229] MR. GRAFMEYER: The concept is an invalid comparison of European countries doing what we do. Going back to the Packwood example, in the health hearings, when we talk about it, the concept is people want the American level of services that they get under Medicare and Medicaid but they want it at the European cost and system, and it just doesn't work that way, because they are getting Cadillac services and they aren't paying as much as they do, because overseas they just don't have the service availability that we do. It's a quid pro quo kind of thing and it just doesn't work. You can't have both. But people don't want to give up what they have and they don't want to pay more taxes.

[1230] MR. MULLET: Mark Weinberger, then Larry, then Brad and Glen. Did you already finish?

[1231] MR. WEINBERGER: I wanted to say in response to Randy's comment earlier that, you're right, we don't really need to act in the next three, four, five years, as you suggest that people might have indicated we needed to, but I think that, quite frankly, is part of the problem. 2002 will be the easiest year in our lifetimes to balance the federal budget.

[1232] As we look at whether it's tax reform, social security reform, Medicare reform, whatever it is, they are so important in people's lives you have to have a sustainable and lengthy transition period. In '83 we had a 75-year transition period for the changes in social security. As we move to 2008, when the baby boomers start to retire, you lose the ability to have a significant transition period and you have to act and options start dropping off the table.

[1233] Even if you don't agree with the long-term findings, as you are suggesting, the range of options suggest a trend that politicians need to focus on. When I go back to the process that I mentioned earlier, the problem is we focus on 2002, which is a noble cause to balance the budget by that date, but it pushes off our ability to think about the longer term problems because we are focusing on dealing with 2002, and that is why we are looking at discretionary spending cuts and things like that as opposed to dealing with these issues that require, in my opinion at least, a transition period because they are so important and so big and require much bigger fixes than you would need to get to balance by 2002.

[1234] We don't need to fix all the problems today. You're right. But I think that is part of the problem, that because we don't need to do it today we don't do it at all -- risking the ability to implement solutions that become more difficult to do over time.

[1235] MR. WEISS: I didn't mean to suggest that there aren't some changes that don't require transition. Indeed, the crisis of the Medicare trust fund, which will seem to happen soon, will provide an opportunity for that.

[1236] I was just saying that there are also a lot of very short- run changes that don't require any transition. If you added them all up over the past 15 years, it's a substantial amount of money, and I would guess there will continue to be those as well.

[1237] MR. MULLET: On that point, one of the questions I might raise is, to meet this so-called optimal tax system fairness -- Dr. Kotlikoff has done a lot of generational accounting -- can we do that waiting until the crisis is closer to us and still have a fair system or not?

[1238] I've got Larry next.

[1239] MR. GIBBS: I would urge the Federal Bar Association to present a program for the folks that would like to attend in this group. I think this would be a great group to get it started. But let the folks that served on the commission make the presentation to you. I was very skeptical when I went in, and I went back twice after I saw it the first time because I couldn't believe what I was seeing.

[1240] If I sound like I'm saying we have got to solve it in four years, that's not what I'm saying. What struck me is that not everybody is playing from the same database, I don't believe. There has been no dissent to the commission's finding. I think there was one person who didn't agree with the report. The economist community has had a chance to take a look at it. But there is no consensus as to the solutions.

[1241] When you see what the problems are and you are looking at the time frames, it's not a 50-year issue before the issues that we are facing that we can't deal with in this country become really severe issues. It's not what we are dealing with 50 years from now; it's what we can't even deal with today. We have got to get to a point where we can deal with them within the next ten years or 15 years.

[1242] My reaction is that I think it would be very helpful if we could all start from kind of the same base at least with respect to the work that has been done, to go from there in terms of how to discuss solutions, because, Don, there really are a lot of moving parts. It's not a simple solution of do this or do that or do one, two, three things. As a result, until you understand the problem, the solution looks awfully complicated.

[1243] MR. MULLET: Brad.

[1244] MR. FERGUSON: Just a brief observation. Most of us who are tax lawyers in private practice -- and perhaps those of us who are lawyers in government as well -- are accustomed to dealing with small gauge problems. They may mean a lot to particular taxpayers or industries and they may be hard to solve, but they are limited problems: How do you deal with financial products? How do you deal with corporate tax shelters? What have you. The process is geared to deal with small gauge problems.

[1245] To the extent we are talking about any kind of a budget crisis, a demographic crisis, that is in a different dimension. I can't think about these problems in conventional tax lawyer terms because the problems force me to think of taxes as a way of raising money for the government. Those broad issues of public policy are extraordinarily important, and we need to try to find some way to use our skills -- as tax lawyers, tax economists, accountants, whatever - - to think about those problems constructively. It is not easily done.

[1246] MR. MULLET: Collette.

[1247] MS. GOODMAN: First of all, Larry, we did a Federal Bar program on the Entitlements Commission report. Mark was there and Catherine ran it.

[1248] I think your point still is well taken as far as education of everyone on the issue. I don't know what the percentage is, but I would suspect a large percent of the public still believes that social security is money they put away into the system 20 or 30 years ago and they are just getting back that money that has been saved for them all along. They should understand better today how it works.

[1249] In terms of the incremental approach, it doesn't take into account this problem that we are just going to move inexorably toward having all of the money that is raised going to spending for these entitlements and nothing left for discretionary spending or even defense spending. Contrast that with the fact that we could do things now to change the situation dramatically in the future.

[1250] Despite all the hand wringing, I don't think it's actually that difficult a problem. It's our generation. We've got a President who is our generation, and it's a question of do we take less or do our children pay more?

[1251] We should certainly do the CPI. I think increasing retirement age in the future, maybe that's the problem with these people who say I don't want it done on my watch. Let's say the retirement age is going to go up to 70 15 years from now. That gives our generation time to adapt to that. I really think the answer is to take less. I don't even think it's that difficult. We should be willing to face up to it.

[1252] MR. MULLET: The program that Collette is talking about was put on by a couple members of the Social Security Advisory Commission, which hasn't yet issued their report.

[1253] MS. GOODMAN: No. This was something the Federal Bar Tax Section did right after the Entitlements Commission report came out, up on the Hill. That was one program.

[1254] MS. PORTER: It was several years ago. It was right after the commission report came out. The commission report came out in January of 1995, and we did a program in January of 1995. Fred Goldberg came. It was wonderful. It was very well attended and was done on Capitol Hill.

[1255] I was next in line to actually say something here, because this is an issue that I think is extremely important to the nation and one that we as tax lawyers ought to feel a special responsibility for, because it is going to involve some increase in taxes to solve. I think the education component is just endless and it's endlessly important.

[1256] What Collette said is absolutely correct. The electorate is totally uninformed by and large about how the system works and therefore you are not going to be able to call upon them to make the sacrifices or to accept the solution, because they have no clue as to what the real problem is. I think gradually some of them are understanding this, especially those in our generation, because they are beginning to see what it's going to mean to them and their children.

[1257] I disagree just slightly with Collette in that I think we also have to call upon the existing beneficiaries, not just the middle generation here, to help solve the problem. I think you have got to have a dialogue going among these generations to come up with a solution.

[1258] MS. GOODMAN: I think there seems to be an assumption that this is not going to touch the people who are currently receiving social security. I think you could do the CPI.

[1259] MS. PORTER: You are beginning to see some debate about it. There is some education, but it is going to have to be ongoing for quite a long time. I know Mark Weinberger has participated in lots of educational programs. I assume that you will continue this crusade.

[1260] MR. WEINBERGER: Going back to process, which is where we started, most of the members of Congress, because it's automatic spending, they don't focus on that until they realize how it crowds out the ability to spend in other things that are important, like President Clinton's education proposals and technology and infrastructure and R&D. Unless you raise taxes, you can't afford to pay for the growing automatic teller spending and these discretionary accounts. That is going to force the process to think about this at some time in the near future and I think probably within the next five years.

[1261] MR. THOMSON: Mark Mazur.

[1262] MR. MAZUR: Collette's point is not really that inconsistent with what Randy was saying about incremental reform. Incremental reform now is not inconsistent with taking longer term and larger steps. If you take incremental steps now they grow exponentially over time quite often. In some sense that makes compound interest your friend in trying to solve these budget problems.

[1263] It's useful to note that if you can take some incremental steps early on, you can build a political consensus and take bigger steps later, which gets back to a point John was making about trying to develop a political consensus on a bipartisan basis. If you want to develop some trust among the people who are working on these issues, it's probably a good way to start, with some small steps where you can actually get accomplishment, get them done and then move on to bigger and harder stuff.

[1264] MS. GOODMAN: I guess it's a question of what we are defining as incremental. Is it incremental, meaning dealing with issues, or is it doing something small now but which will have a bigger effect later on?

[1265] MR. MAZUR: I guess I would view incremental as something Mark was talking about, the President's Medicare proposals. That would probably be perceived as an incremental step.

[1266] MR. WEINBERGER: It's incremental, not inconsistent. What happens is, as you well know, Congress will do this. Then they will claim that they put the problem off for ten years. Then they won't address this for another ten years.

[1267] MR. MAZUR: That would be a problem.

[1268] MR. WEINBERGER: Yes, and that will probably be what happens if they do something like this, because that's what usually happens.

[1269] MR. MULLET: It sounds to me that people are more concerned about the entitlements issue and how to deal with the tax problems from that than they are about tax reform. Does anybody here think that Congress ought to take on tax reform before they deal with the entitlement issues and how to reform, say, social security, Medicare, et cetera?

[1270] Eric.

[1271] MR. TODER: Let me make a couple of comments. I think on tax reform that it's often talked about in these very large terms about replacing the whole system with a consumption tax. I don't believe that's likely to happen and I don't believe it's desirable to spend political energy on it, given the entitlement problems.

[1272] When we think about tax reform we shouldn't be so much thinking about that or even another '86, which I think is also unlikely. Not for process reasons. I think it's unlikely because of what happened in '86, that '86 really picked off a lot of the prime base broadeners and the ones that are left are just much more difficult to do. It's not clear that society is kind of burning to have the mortgage interest deduction or charitable contributions deduction eliminated. Those are the kinds of places where there is big money.

[1273] I don't think we should forego doing tax reforms of things like international tax rules or AMT or a whole host of things that have been talked about by some people at this conference, and also the individual AMT.

[1274] We really do need to focus energy on improving the workings of the existing system, and I don't think that that needs to be extensive.

[1275] MR. MULLET: Fred.

[1276] MR. MURRAY: I would just like to amplify what Eric said and what I tried to say earlier but not too well. I wasn't trying to limit my remark to technical corrections, but I think simplification and reform on a more modest scale is also precluded by our existing system as it is currently in place. I think that is something where we could devote some energy perhaps and at some point in time figure out how to make some of these more modest changes in the system.

[1277] MR. MULLET: Is that a function of the budget process that we have now or is that a function of the will of the politicians to address the issue?

[1278] MR. MURRAY: I think it's partly both. Again, I think some of the changes that were made in the small business bill were very helpful, but I also think that most of the focus of the debate in the political sense is on whether we have capital gains or don't have capital gains or whether we have certain types of tuition credits or whether certain types of tuition is deductible. Major political themes, but some of these other things are just as important and don't find their way into the political process, or at least they are crowded out by the political process.

[1279] I do think that the budget rules do have a severe impact on being able to effectuate what I would call good tax policy, things that we need to change for good reasons that are unrelated to the larger problem of the deficit.

[1280] MR. MULLET: Eric.

[1281] MR. TODER: Actually, I would like to say something first about the budget rules, saying that in all awareness of all the game playing that goes along the margins with it, a lot of which I have to deal with on a day-to-day basis and some of which I proactively do myself.

[1282] Leaving all that aside, I think it has had a very positive effect in crowding out and restricting bad tax policy, because I think people are always going to give away things. It may be imperfect, but it's really the only discipline we have. I guess that's my contrary view.

[1283] MR. MURRAY: I agree with you. But it takes the good and the bad at the same time. That would be my view.

[1284] MR. MULLET: The last question on the list here was whether bipartisan tax reform could work or whether the two parties are too far apart. I think that also goes for entitlement reform. All of the budget process rules are easy to get by if you get bipartisan support for anything, but we don't seem to have had it, at least in the last four years when you look at the major tax legislation that has come out. So I might ask the staff from the committees whether or not they think that this next session of Congress would be more likely to work in a bipartisan fashion. Since we are one day after the elections here, if you can give any kind of horoscope on that.

[1285] MR. PRATER: That's always my hope. When we work on a bipartisan basis, I think we produce better legislation. I think the more people that are involved on both sides of the aisle in the committee process, the better the product. In terms of trying to take care of the issues that are out there, if you have a more inclusive process you have a way of kind of resolving a lot of things and there is a lot less tension with the subsequent legislation. So it's all around a better way to go.

[1286] I'm hopeful. I think we've got a good track record from this last year. I think there are some good achievements in the bill that we have produced in the past.

[1287] I think tax reform is something -- the issues there are so fundamental. I think even consensus within each of the parties at this point is real tough, let alone trying to get both parties to agree on the details.

[1288] There seems to be a bipartisan consensus that savings is an issue and that we would agree we can have savings incentives and things that get more Americans into the savings mode, whether it be through the pension system, qualified plans, et cetera, or through other measures. In terms of radical overhaul, there are still some serious differences.

[1289] I tend to think that tax reform won't happen unless it's bipartisan. So we've got a ways to go. We plan to have hearings and go through a lot of the issues just as Ways and Means does. I think it's good for the members and good for the community to keep the issues alive and out there for comment.

[1290] MR. MULLET: Jon or Jim. Not to put you on the spot.

[1291] MR. CLARK: At the beginning of the current Congress, we began work in the House on the Contract with America. In a very real sense, The Republicans had their agenda which they were moving forward admittedly on a rather partisan basis. I think this approach has certainly changed in the past year and will change even further, I believe, in this next Congress. The margin has narrowed between House Republicans and House Democrats. There is going to be a greater need in the coming Congress to work closely together to achieve anything.

[1292] On the topic of fundamental tax reform, the Ways and Means Committee will continue with hearings next year. Chairman Archer views the current hearings as an educational process. Fundamental tax reform will not happen overnight. To move from one tax system to another is a Herculean effort and there is a necessary educational process that must take place over some length of time.

[1293] I think it's fair to say that we are not going to get fundamental tax reform next year but hopefully we will continue to lay the groundwork for fundamental changes at some point in the future.

[1294] MR. MULLET: Does anybody else have any comments?

[1295] [No response.]

[1296] MR. MULLET: I think this concludes the program. We are even a little bit early. I hope everyone has a good trip back, and thank you for coming.

[1297] [Whereupon at 4:35 p.m. the meeting was adjourned.]