Unofficial Transcript of W&M Hearing on International Tax Reform Is Available

Good morning. At our recent hearing on Corporate Tax Reform, a number of witnesses testified on the importance of international tax reform. The current U.S. international tax system has been characterized as one that distorts business decisions and inhibits the competitiveness of U.S. businesses abroad.

This hearing will provide us the opportunity to understand how the current U.S. international tax system impacts the competitiveness of U.S. companies operating abroad, and to evaluate how this system can be reformed to enhance our competitiveness abroad and to stimulate job creation at home.

International tax reform will be an important consideration in the full committee's evaluation of the many options to reform the federal tax code. And I want to welcome our visitors and witnesses and look forward to hearing your views on these important issues.

I now recognize the ranking member, Mr. McNulty, of New York for a statement.

MR. McNULTY: Thank you, Mr. Chairman. I also welcome our witnesses, and thank them for their time. Mr. Chairman, in 2002, this subcommittee held a series of hearings specifically on international corporate tax reform. In 2004, the American Jobs Creation Act was enacted into law, and substantially revised our international tax system.

Even with those changes, few believe our international tax rules have been perfected and reach the proper balance.

There is no question that our current international tax structure remains very complex and in need of reform. It is clear that our tax system often carries incentives for U.S. companies to locate or move their operations overseas.

Hopefully our discussion today will focus on realistic options to simplify and restructure our international tax system. Our country's economic growth requires that U.S. companies be competitive both at home and in the expanding markets of the world. I must emphasize that our country continues to face record federal deficits.

The national debt has ballooned to more than $8.3 trillion, and the goal of any future international tax reform measures should not be to merely provide additional corporate tax breaks to U.S. multinationals, nor shall it result in the shifting of U.S. jobs overseas. Our goal must be to modernize our tax system in a way that ensures economic growth in the United States, and provides long- term financial stability for our children and grandchildren.

Thank you, Mr. Chairman. I give back the balance of my time.

MR. CAMP: Thank you very much.

And again I want to welcome our panel. We have with us Dr. Glenn Hubbard, Dean and Russell L. Carson Professor of Finance and Economics at Columbia Business School, New York; Dr. James R. Hines, Professor of Business Economics and Public Policy at the University of Michigan in Ann Arbor; and Dr. Craig Barrett, Chairman of the Board of Intel Corporation in Santa Clara, California.

Each of you have five minutes to summarize your testimony, and after each of you gives your testimony, we'll have a time for questions. And I'll begin with Dr. Hubbard, again welcome, thank you for coming, and you have five minutes.

DR. HUBBARD: Thank you,

Mr. Chairman, and Mr. McNulty. I think that this is an incredibly important subject that you've chosen for this hearing. As a way of putting it in context, I think this subject today touches on the vital issue of competitiveness, and our economy's success absolutely and relative to our trading partners over the past decade has depended on the flexibility and the productivity growth of multinational companies.

I think it's imperative that we not tie the hands behind the back of these successful businesses. For today, I just wanted to make three points. One, that multinationals play a very large role in the American economy. Second, that tax policy toward multinationals matters and reform is needed. And overall corporate tax reform should remain a priority for your consideration.

On the issue of multinationals, recent research among economists suggests that in a highly open economy, highly successful multinationals can boost both brand value of our companies and productivity. This is driven by multinationals who capture for all of us essentially the benefits of globalization.

Interestingly, in thinking about where these multinationals are, most overseas investment by American multinationals is for market access and remains in higher wage, higher tax countries.

On the issue of tax policy, this matters a lot. Empirical work by myself and many other people over many years suggest that the way we tax multinationals importantly affects their investment decision, their location decision, how they finance themselves. Our overall norms that we have traditionally used in this country for judging tax policies toward multinationals strike me as outdated.

They are based on models of perfectly competitive firms, which are not the way multinationals operate. They are based on norms of looking at worldwide well-being, which is not something we do in the rest of policy. In any event, the usual norm of capital export neutrality is not even applied. I think a more contemporary treatment of multinationals would suggest that at a minimum, cash flow taxation -- deferral, in this case -- or an exemption system, territorial tax is far more defensible.

As an economy, we have a strong incentive to get this right to maintain the productivity advantage that we have. Territorial tax proposals in my view deserve very serious considerations and will not affect investment or jobs. The corporate tax though remains the elephant in the room.

This morning's Wall Street Journal referred to the action that's been proposed in Germany for corporate rate cut. The U.S. has the second highest rate in the OECD; the corporate tax familiarly discourages capital formation.

More recent work suggests it actually discourages innovation, risk taking, and in fact wage growth. But importantly, to close with you, fundamental tax reform, whether you chose to examine it as an income tax or a consumption tax, would remove investor level taxes on corporate income.

This necessarily implies a territorial tax.

Almost any version of tax reform gets you there.

Thank you again, Mr. Chairman. I look forward to your questions later.

MR. CAMP: Thank you very much, Dr. Hubbard. Dr. Hines, you have five minutes.

DR. HINES: Thank you, Mr. Chairman, and Mr. McNulty.

There are two primary channels by which residence-based international taxation, as practiced currently by the United States, affects the competitiveness of American business operations. The first channel is that residence taxation creates incentives that distort the behavior of American firms.

The second channel is that residence taxation affects the total tax burdens of companies that are resident in the United States. Both of these channels are important. But they are distinct. U.S. residence-based taxation influences after tax returns by imposing home country taxation that is a function of actions undertaken at home and abroad.

The incentive problem is that the actions that the system encourages are often inconsistent with maximizing investment returns net of foreign taxes, in that what American firms are encouraged instead to do, is to maximize returns net of foreign plus domestic taxes.

Since maximizing returns net of foreign taxes is the essence of competitiveness, these incentives impair the competitiveness of American firms operating abroad. Specifically, the U.S. tax system encourages American firms with deficit foreign tax credits to discount the cost of foreign taxes, since the payment of foreign taxes produces an offsetting foreign tax credit that can be used to reduce U.S. tax liabilities.

For American firms with excess foreign tax credits, the U.S. expense allocation rules discourage profitable investments in the United States that can trigger additional U.S. tax liabilities by reducing the foreign tax credit limit, and may thereby also discourage profitable foreign investments.

In both cases, the system sacrifices the competitiveness of American firms, doing so in pursuit of an unclear objective.

Taxation on the basis of residence not only creates inefficient incentives for American firms with foreign operations, but imposes a pattern on tax liabilities that separately impairs competitiveness.

The most obvious feature of U.S. residence-based taxation is that a firm that is an American resident owes tax to the United States on its worldwide income, whereas a firm that is resident in another country does not. This system effectively imposes what can be a very large tax on U.S. residents, thereby discouraging multinational firms from establishing U.S. residency, and encouraging firms that are already resident to the United States to relocate elsewhere.

The wave of corporate inversions from 1996 to 2002 reflects these incentives, as a number of American firms found it worthwhile to incur the tax and other costs associated with relocating to foreign residence in order to avoid U.S. taxation of their worldwide incomes. The corporate inversion phenomenon is not quantitatively huge in and of itself.

Only 25 large firms inverted, but it's instead a signal of the magnitude of the incentives created by U.S. residence taxation. For every firm that changes its nationality by inverting, there were several others whose U.S. tax liabilities or potential U.S. tax liabilities on foreign income were significant enough to make them contemplate inverting or else never establishing U.S. residency in the first place.

Taxation on the basis of residence makes most sense when residence is an immutable characteristic of a person or a firm. In the global economy, residence is a matter of choice, not only because people and companies can move, but also because the weight of economic activity is itself responsive to tax burdens, even in circumstances in which people in firms never change their tax residences.

If the United States imposes a heavy tax on the foreign incomes of firms resident in the United States, then over time, American firms will not flourish to the same extent as firms resident in other countries. The after-tax incomes of American firms will be depressed by heavy tax burdens, and investors will not commit the funds that they would to an otherwise equivalent firm that was not subject to the same tax burdens.

U.S. adoption of territorial taxation offers the prospect of addressing these problems, providing incentives and tax burdens for global businesses that would enhance the competitiveness of American firms. Even if the goal of the American policy were to enhance world and not U.S. welfare, this is achieved by reducing U.S. taxation of foreign income to bring it better into line with world norms.

One might ask why it matters to the United States, or for that matter the world that companies resident to the United States operate under a tax system that maintains their competitiveness. If the goal of U.S. Policy is to advance the living standards of Americans, then policies should be designed to promote the efficiency of businesses located in the United States.

And this most definitely includes their international competitiveness. In a market system, the wages of American workers are determined by the productivity of labor in the United States. In maximizing the efficiency of business operations, sound policy also maximizes the productivity of American labor and capital.

Since labor represents most of the United States economy, labor receives most of the benefits of productive efficiency in the United States, with these benefits coming in the form of higher compensation and greater employment.

Viewed through a modern lens, residence-based taxation as practiced by the United States appears very curious in that it serves neither the interest of the United States, nor the interest of the world as a whole.

Thank you.

MR. CAMP: All right. Thank you very much, Dr. Hines.

Dr. Barrett.

DR. BARRETT: Chairman Camp, members of the subcommittee; thank you for this opportunity. My name is Craig Barrett.

I am chairman of Intel, and just to give you a few pertinent facts about Intel: We are the world's largest semiconductor company. Revenues last year were approximately $38 billion -- 80-plus percent of that revenue came from outside of the United States. We are mainly an export-oriented company.

We spend over $5 billion a year in research and development. Last year, we spent nearly $6 billion on capital investment for manufacturing. There has been a lot of discussion recently about competitiveness, and our company and others have spoken on this topic.

Competitiveness, in my definition, is really the ability to have a highly educated workforce, the investment in research and development to generate ideas for the next generation of products, and the role of the government in establishing an environment for investment in innovation or for investment.

With regard to my own company and my own industry, it's not really an issue of whether tax policy will cause us to invest or not invest in R&D and capital. We will invest. The only question is where we will invest and where the jobs will be created by our investment. I'd like to address briefly two topics: One, investment in manufacturing, the sort of manufacturing facilities that we have which are very capital-intensive, they are roughly $3 billion facilities. They are probably the poster child for the sort of manufacturing the United States should have. They're capital- intensive, they are high-tech, they have a highly educative workforce, they have immense value add and they are profitable.

The other area that I would like to address is research and development. We currently do most of our research and development in the United States, but there are forces tending to pull that away to other countries. Let me address the manufacturing issue first, and the impact of tax policy.

The $3 billion facilities that we have, if you do a net present value or net present cost of those facilities over a 10-year period, and you compare them to being located in the United States or being located in certain foreign environments where tax policies differ, you see that the range in net present value is approximately a billion dollars plus or minus a few hundred million over a 10-year period.

So roughly a $100 million penalty to put those facilities in the United States because of our tax policy. That $100 million a year deficit or penalty comes about from our high corporate tax rate. We're, as mentioned earlier, the highest in the OECD -- it's the lack of investment tax credits, and the lack of what I would call competitive depreciation schedules for our facilities.

Interestingly, labor plays a very, very small role in that penalty, and cost of materials and capital are about the same everywhere in the world. So the billion dollar over 10-year penalty, roughly 70 percent of it is tax-related, 20 percent is investment credit or investment incentive-related, roughly 90 percent of it is tax-related.

To briefly compare that to a few other countries and their attitudes. In Malaysia, for example, a similar investment to the one that might happen in the United States would give a 10-year tax holiday, that is 10 years of 0 percent tax, accelerated depreciation schedules and a depreciation schedule of roughly well over 100 percent of the actual capital cost.

In Israel, you would see a 20 percent capital grant, basically a 10 percent corporate tax rate. In Ireland, you'd see a 10 percent tax rate. You'd see a 20 percent R&D tax credit, and the list would go on and on. Other countries are using their tax base as an incentive to promote investment in their countries; whereas the United States is not.

The solution to this I think is complicated, obviously, but it embodies corporate tax rates, it embodies depreciation schedules; it involves investment tax credit.

As my first CFO that I worked with at Intel told me: "A buck is a buck no matter how it gets to the bottom line." And not being a tax expert, I can't tell you exactly how to get that dollar to the bottom line, but getting it there is incredibly important.

Just a few comments on R&D tax credit. The R&D tax credit in the United States started in 1981. It has not been uniformly applied during that period. There have been lapses in it. The fact that it gets approved for short periods of time, when our horizon for R&D spending is much longer than the approval periods for that R&D tax credit, make it less of an incentive in the United States than it could be. A brief example, in conclusion: France, which is not known for its progressive tax policy in promoting investments, has a 50 percent incremental R&D tax credit, which applies not only to salaries, but also to capital investments in R&D.

Thank you for the chance to testify. I look forward to questions.

MR. CAMP: Thank you very much. I want to thank all of the panel members for being here. Dr. Barrett, the question I wanted to ask you was, how does the U.S. international tax system impact business investment decisions, but after hearing your testimony, I think I should ask you how do other countries' tax systems affect or impact business investment decisions? But I guess in deciding to locate a facility, what are the considerations that are most important to you?

DR. BARRETT: Historically, the considerations were the ability to do business; that is, the presence of the infrastructure. And this is infrastructure -- everything from transportation to power to educated work force, so the physical infrastructure. And over the last 10 or 20 years, that limited the choices basically to countries in Western Europe and Japan and the United States, the only countries with really significant infrastructure.

More recently we've seen a dramatic switch, as more and more countries come online with strong educational infrastructure and also physical infrastructure, so Asia now is perhaps the most competitive environment.

If you look at the sort of facilities I was describing, about 70 percent of all facilities currently under construction are in Asia.

They are not -- and I don't mean Japan, I mean Asia proper. So increasingly, it's a very, very competitive environment.

And increasingly, those countries are using their tax policy and their other government investment policies to promote investment, to promote high-paying jobs, and looking at that as an investment for the future.

And we've seen Western Europe, Japan, and the United States more or less hold firm, with a few exceptions, on relatively high corporate tax rate, lack of investment tax credits, and lack of competitive depreciation schedules. Ireland might be the Western European exception when, approximately 15 years ago they changed their corporate tax rate from 40 percent to its current 12-1/2 percent.

And you've seen what happened in Ireland in terms of investment and growth of their economy as they went from the bottom of the EU in 1989 to currently the highest per capita income in the EU, driven primarily by strong educational infrastructure, but more importantly by a very low corporate tax rate.

MR. CAMP: Thank you.

Dr. Hubbard, this lower corporate tax rate, what effect -- I mean, obviously, recent studies in the U.S. have shown that we have one of the highest rates, as several of you have testified, comparing us to our trading partners. What effect does our U.S. tax rate have on the competitiveness of U.S. Firms operating abroad?

DR. HUBBARD: Well, the U.S. tax rate affects U.S. firms in really two ways.

At home, it certainly affects investment decisions. In terms of their operation abroad, it affects their overall tax burden.

The corporate tax also affects workers in our economy, whether it's from overseas operations or domestic operations, because much of the burden of the corporate tax is actually borne by workers. So a rate cut would be good for labor.

MR. CAMP: And Dr. Hines, we've had a lot of discussions over time about whether we should replace our worldwide U.S. taxation system with a territorial system, and if we did convert to a territorial tax system, again, on U.S. companies operating abroad, what effect would that have on their competitiveness?

DR. HINES: Adoption of territorial taxation would immediately make U.S. firms more competitive in foreign markets, and make them more efficient in the United States as well. The reason is that the current system in which the United States is such an outlier compared to other countries -- other rich countries and other countries that aren't rich -- leads to an outcome where American firms don't have the -- the tax system gives the American firms the wrong incentives to organize their production around the world.

If we were to adopt a territorial system and thereby become like most of the countries in the world, we would go back to having a tax system that doesn't distort ownership of assets the way that the current system does. And once you don't distort the ownership of assets, you will make business more productive, and that includes more productivity in the United States.

So I agree with Dr. Hubbard that the main impact actually of that system would be to rationalize production, and thereby increase the productivity of labor and other factors in the United States.

MR. CAMP: Are there any incremental steps that you would suggest in the event that a comprehensive addressing of the issue is not done?

DR. HINES: You mean it won't be done? Just in case it isn't, then they are partial steps. There are big steps in that direction. France exempts 95 percent of foreign source dividends. But there's nothing magic about the number 95.

So for the calendar year 2005, of course the United States exempted 85 percent of foreign source dividends from taxation, but that was just a purely temporary adjustment --

MR. CAMP: Right.

DR. HINES: Which is different than what we are talking about now. But one could choose a number that's -- well, currently the number is zero. And you could exempt 50 percent or more.

MR. CAMP: So you think the exemption of foreign source dividends would be one area that we've done in the past, at least partially, and for a short period of time, it would be something that we could do as an incremental step.

DR. HINES: Yes. The concept being not as a temporary gesture at this time, but instead permanent. Absolutely.

MR. CAMP: All right. Thank you.

Mr. McNulty may inquire.

MR. McNULTY: Thank you Mr. Chairman. Since I came here in the late '80s, I've been increasingly concerned about the increasing federal budget deficits and the growing national debt, which I mentioned in my opening statement is now in excess of $8.3 trillion.

And as someone who has four children and five grandchildren, I worry about that more and more with each passing day, and I was just wondering if you could state for the committee how you believe your proposals today would positively impact that situation or the bottom line, as you would have it, for the United States of America?

DR. HUBBARD: If I could begin Mr. McNulty, the U.S. fiscal picture over the medium-to-long run is almost entirely a story about our entitlement programs, and in fact, the implicit debt in those programs is far larger than the numbers that you mentioned, an order of magnitude perhaps.

The question is how we meet our obligations. We have to have the most efficient possible tax system to do this, and the sorts of changes that are being talked about to make firms more productive I think will go in the right direction. We can't meet those obligations down the road by raising taxes on capital. We would be killing ourselves to do that. So I think you've mentioned probably the big question, and I think it is another big reason for favoring tax reform along the lines that's been discussed this morning.

DR. HINES: I share your concern with the deficit. I think it's not a sound way to run economic policy to have huge debts and persistent government deficits, and it's simply a matter that the United States has to pay its bills and the United States will pay its bills. The question is how we are going to do that and whether we'll do it in a sensible manner or in a less sensible manner.

You are much better positioned to be able to pay your bills if you have an efficient tax system. And the reason is that you'll collect money more effectively and you'll have a stronger economy to tax, so the more efficient you can set up the system, the easier it will be to pay your bills.

Now of course, this isn't going to be the whole solution, because in order for the country to pay its bills, we are going to have to either cut spending or raise taxes.

I mean, those are the only two things you can do when you have a deficit, but in the process of doing that -- I beg your pardon?

MR. McNULTY: Or grow the economy.

DR. HINES: Yes.

MR. McNULTY: The same could happen as a result of tax reforms.

DR. HINES: Absolutely. If you can grow the economy, that is a way of collecting more taxes, because they happen automatically. But all of those things are going to happen most easily if you have an efficient system, and what we are describing this morning I think is that the current system is not efficient from the standpoint of taxing American multinational firms.

DR. BARRETT: I only have four grandkids that I am worried about. And the oldest one is a sophomore, going to junior at Stanford, so she is getting perilously close to the work environment. This is a conundrum, but as far as the head of a major corporation is concerned in the U.S, my company, for example, could be very successful if it never hired another person in the United States.

Most of our business is done out of the U.S. As a U.S. citizen, that's not an acceptable solution to me. And so I'd like to see the U.S. to be as competitive as possible. Using tax policy to in fact promote investment and to promote the creation of high-paying jobs I think is the most critical thing that the government can do.

And as I look around the world at these other countries that we are involved with who have progressive tax policies who promote investment, they see a net positive flow into their treasury.

Ireland is perhaps the classic example, where, with a low- corporate tax rate, they did not rob the treasury in Ireland; they in fact created the most prosperous, most dynamic economy in Western Europe, and created the growth of their economy and the growth of opportunity for their citizens.

So my comments are all targeted towards opportunity for citizens in the United States by a tax policy which promotes investment in the United States and creation of jobs in the United States. The current policy, with the numbers that I have mentioned, are in fact exactly the opposite.

They are promoting companies of the sort that Intel is one of, to invest in R&D, and to invest in manufacturing facilities out of the United States.

That can't possibly be good for the budget deficit, but more importantly, it can't possibly be good for our children or grandchildren.

Thank you.

MR. CAMP: Mr. Chocola may inquire.

MR. CHOCOLA: Thank you, Mr. Chairman, thank you all for being here this morning. Dr. Hubbard, I appreciate your comments about the unfunded liabilities we face, which I think GAO puts at least $46 trillion today. We could have a long hearing just on that, but I guess my first question would be for you, Dr. Hubbard, but all of you are more than welcome to respond. If the U.S. ended our tax deferral on overseas income, you think the result would be more or less companies investing in the United States? DR. HUBBARD: I think if the U.S. repealed deferrals, if that is your question, we would be raising tax on capital in the United States. It would become less attractive for American companies, and by weakening the economy, less attractive for companies generally.

MR. CHOCOLA: Dr. Hines, do you have any comments?

DR. HINES: Yes, I think there would be less investment in the United States. Repealing deferral has a superficial appeal because it seems that you would remove the tax liability associated with repatriation, and therefore trigger flows of funds from abroad to the United States.

And so at first blush, it is easy to think of repealing deferral as a gesture that would create more investment funds for the United States. However, in the medium run after maybe a couple of months of that, repealing deferral would make the United States even more unusual compared to all other countries that are capital exporters.

We would become unique, and unique in the sense of imposing such a heavy tax on outbound investment in the United States -- what that would do is weaken American companies, first of all, and secondly, make it much less attractive for foreigners to invest in the United States, which is another source of job creation and investment.

So repealing deferral is not a gesture that one would want to undertake if you are trying to encourage investment in the U.S., even though, as I say, it does have this apparent appeal.

MR. CHOCOLA: Thank you.

Dr. Barrett, I think Intel took advantage of the temporary low rates of repatriating earnings?

DR. BARRETT: We did indeed. To the best of my knowledge, that temporary repealing rates brought about $300 billion back to the U.S. Intel contributed about $6 billion to that repatriation. $3 billion of that went to build a new facility, which is under construction in Arizona at this point in time.

But in response to your question, I would reiterate that over 80 percent of our business is export business. Our competitors are international competitors. If you repeal the deferral tax on foreign income, it would make Intel and companies like Intel less competitive in the international marketplace and our competitors would prosper, we would decline.

MR. CHOCOLA: Yesterday, I had a group of steel workers in my office, and we had a spirited discussion about global trade issues. I used to run a public company much smaller than Intel, but we had some of the same issues. We had to make decisions on where we invested, not always on tax policy, but on market forces, obviously.

Dr. Hubbard, you said in your written testimony that although firms take the cost of production of their affiliates into account, there is little reason to believe that increased investment abroad necessarily implies less economic activity at home.

Would you like to explain or expand on that?

DR. HUBBARD: Sure. There is often a common view that if a multinational invests abroad, that just displaces whatever it would have done in the U.S. In fact, most of multinational investment abroad has to do with market access, accessing lower costs of production as well. So the capital abroad and the capital in the U.S. for many industries are complements.

Certainly multinational employment abroad can tend to raise high-wage employment here in the United States, so this is something that isn't a matter of just theory, there have been a number of empirical studies by Martin Feldstein and others that suggest this very strong complementarity, despite the facial appearance.

MR. CHOCOLA: Dr. Barrett, in your written testimony you talked about, I think you said you -- paraphrasing, you agree not giving companies incentives to engage in behavior that they were going to engage in anyway, it's just a question of where they're going to engage in their behavior.

In the earlier hearing, we had -- people said don't give us tax incentives; give us a low rate. Has there been any research done on what an optimal rate would be here for the corporate income tax in United States to make us as competitive as possible, to be revenue appropriate? Has there been any studies of that?

DR. BARRETT: I don't have an absolute number; I can only point you to countries that are aggressively attracting investment in the sort of innovative investment that we would like to have more of in the United States. And they are usually either tax holidays or tax rates in the 10 percent range, so the 0 to 10 percent range compared to the U.S. 35 percent from a federal standpoint, and not adding state and other taxes on top of that. I certainly would not argue with a 10 percent corporate tax rate in the United States.

MR. CHOCOLA: Do either of you have any -- are aware of any research done?

DR. HUBBARD: The optimal task --

MR. CAMP: The gentleman's time has expired, so if you would just answer briefly, I would appreciate it.

DR. HUBBARD: The optimal tax on capital is zero, Congressman, but I think more interestingly, the recent work suggests that a revenue maximizing corporate rate would only be in the mid-20s for the U.S.

MR. CHOCOLA: Thank you.

MR. CAMP: Thank you, the gentleman from Texas, Mr. Doggett, may inquire.

MR. DOGGETT: Thank you,

Mr. Chairman. Just picking up on Dr. Hubbard's comment.

Dr. Hines, isn't that optimum tax rate of zero what you're advocating for all foreign source income?

DR. HINES: No, because foreign source income is taxed by foreign governments where it's earned.

MR. DOGGETT: I'm talking about U.S. tax rates should be zero on foreign source income.

DR. HINES: Yes, that's right.

MR. DOGGETT: Dr. Hubbard, do you agree with that, that the --

DR. HUBBARD: Absolutely.

MR. DOGGETT: What we should do is apply the optimum zero rate on all foreign source income of U.S. companies as far as the U.S. tax system is concerned.

DR. HUBBARD: Yes, sir.

MR. DOGGETT: Dr. Barrett, is that your position also?

DR. BARRETT: My position is merely that the U.S should have a competitive policy on tax such that it doesn't inhibit companies like Intel from investing in the United States as well as investing in foreign countries.

MR. DOGGETT: Going right to that point then, if we make the rate zero on all foreign source income, don't we need to at the same time to lower toward zero the rate on corporate income in this country in order to avoid an incentive for people to do all their investment where they pay no taxes, no U.S. taxes at all?

DR. HUBBARD: Not quite, Congressman. The argument for this zero tax on foreign source income is simply that that's in the interest of the United States because of the well-being of multinationals and the effect that has on wages and capital formation in the United States. There's a separate and bigger question that I mentioned in my opening remarks about the corporate tax generally, and yes, we should be lowering the corporate tax rate, but those are two different questions.

MR. DOGGETT: Dr. Barrett has told us that there are countries like Malaysia that practically pay Intel to come. They're not paying any tax perhaps at least for some period of tax holiday, and are being given various and other incentives to be there due to the lack of the competition between the states and localities here to attract an Intel.

So if -- there is no U.S. tax and in some cases for extended periods of tax holidays, there is no foreign tax there, if the U.S. corporate tax stays even in the 20s and there is no tax that you face to build a new plant in Malaysia or some other country, unless you lower the U.S. tax significantly, there will be a strong incentive to export jobs and plant and equipment abroad, won't it?

DR. HUBBARD: I'd be careful about generalizing that example, Congressman, because the bulk of multinational investment really is from market access -- tends not to be in the Malaysia's of the world, but the high-tax, high-wage countries.

DR. HINES: If the question is what effect would that have on business activity in the United States and employment in the United States, the way to -- exempting foreign income from taxation, there is a lot of theory and a lot of evidence now, it's just -- that would improve business activity and increase employment in the United States.

And it seems paradoxical, but the way that it works is, foreign governments have the opportunity to tax businesses located wherever they are and they can choose to tax it or not at whatever rate they want. And of course, some of them offer very low tax rates.

MR. DOGGETT: Not to cut you too short, but let me ask what I think is the converse of the question I posed, and that is, if the right for building a new plant and equipment is effectively 35 percent in Maryland and zero in Malaysia under your plan, you don't think we need to make any adjustments in the rate for the domestic income generation just because it's zero abroad?

DR. HINES: Not on that basis.

That's a separate question.

MR. DOGGETT: Then let me ask you, as we move under your recommendations to a zero tax rate on foreign source income -- we've heard comments from Dr. Barrett that we need to make adjustments, which I agree with, and depreciation schedules for -- certainly people who are in semiconductor and other kinds of new information technology production, that we need to have more dependable research and development tax credit all -- all those things of course take money from the treasury, as would a zero tax rate on foreign source income.

How do you each of you propose that we make up that revenue, or do you believe that the answer, as I thought Dr. Hubbard was saying, is that the deficit is all about entitlements, which is another way of saying make it up by changes in Medicare and Social Security?

DR. HUBBARD: Well, to answer your question, Congressman, we actually don't raise that much revenue directly from the taxation of foreign source income, we just have a lot of distortions. And this is one that's not that costly to fix. It is expensive to cut the domestic corporate rate, and that should be part of an exercise of overall tax reform where I think most economists would recommend what you call the base.

MR. DOGGETT: Since my time is up, do either of you have any specific places that you would generate more revenue in order to compensate for any changes in the level of corporate taxation at home or abroad that you recommend?

DR. HUBBARD: In general, you should broaden the corporate tax base and focus on bringing down corporate rates.

DR. HINES: You might want to think about a value added tax.

MR. CAMP: All right. Thank you.

DR. BARRETT: I was going to suggest that other countries look at this as opposed to taxation, as to creating opportunity in creating jobs, which then create a tax base of their own. When we look at different states in the U.S. where corporate tax rate is not an issue, but it's local taxes, every analysis that has been done shows that creating the local jobs more than accommodates the decrease in property tax rates or whatever incentives states can provide. So when I travel around the world, I see countries investing for the future by creating jobs and creating the tax base, and not worrying about taxing the corporation that creates the jobs.

MR. CAMP: Thank you. I want to thank the panel members for your excellent testimony and the time for being here. Thank you very, very much.

Our second panel I would ask to come forward is composed of Michael J. Graetz, who is Hotchkiss Professor of Law at Yale Law School in New Haven, Connecticut; Paul Oosterhuis, who is a partner in Skadden Arps; and Stephen Shay, who is a partner in Ropes & Gray. Thank you all for being here.

You each have five minutes to summarize your testimony. Your written statements, we have and will be made a full part of the record.

We'll begin with Mr. Oosterhuis.

Thank you for being here.

MR. OOSTERHUIS: Thank you. It's my pleasure to be here. I actually got my start as a tax lawyer on the joint committee staff back in 1973, and spent a wonderful 5-1/2 years working on international tax rules back then.

MR. CAMP: Welcome back.

MR. OOSTERHUIS: Thank you. Since then, I've been working in private practice advising U.S.-based and foreign-based multinationals on the subject that we're talking about today, so I am going to speak to you from the perspective of a practitioner.

I would like to focus my attention on territorial proposals like that that Jim Hines and Glenn Hubbard discussed on the prior panel. The first thing to make sure everybody understands is that a territorial system, a territorial exemption system as it has been proposed recently would raise revenues not lose revenues.

And that's important for you to understand, because it's important to understand why it might do that. And when you're think about it, understand whether the implications of those revenue- raising aspects of it cause you problems in deciding whether that's a good way, good direction that we should move in or not. Moving from our current deferral in foreign tax credit system to a territorial system raises revenues essentially for three reasons.

The first: In our foreign tax credit system as it exists today, companies can use foreign taxes that they pay to high-tax governments and use those credits to reduce their U.S. tax on other items of income that are not heavily taxed. And that first of all applies to exports; because the way our rules are going back to the 1986 Act, we allow some portion of export income to be foreign source income whether or not the company has any presence abroad.

If a company has substantial high-taxed earnings in foreign countries and exports, they can reduce their rate of tax on exports by using those credits against their export income. When you go to a territorial exemption system, those credits go away because the income is exempt, so you don't have any foreign tax credit. And therefore, for some companies, that's going to raise the taxes on their export transactions. You need to understand that, you need to evaluate whether that's a good idea or whether there is serious issues involved in that.

Second, companies that have high tax foreign earnings can use those high foreign taxes to reduce the U.S. tax on their royalty income, given the way our rules work today. And that's royalties principally from technology, it's also royalties from trademarks and consumer and marketing intangibles, but principally royalties from technology development activities that occur in the United States.

So if you go to a territorial system, you are increasing the taxation of those technology companies that rely on high taxes in various foreign countries to reduce the tax on their royalties from their own foreign affiliate. You need to worry about that. You need to think about that. You also I think need to think about that in the context of what you are doing with the R&D tax credit, because one solution there may be to use some of the money that territorial would raise to expand or make permanent the R&D tax credit.

But they will have that impact if you move to a territorial exemption system.

The third is that because in a territorial exemption system you are exempting foreign dividends, most people think there are some expenses that also need to be disallowed, because they are expenses that relate to the generation of exempt income. In our foreign tax credit world, we don't need to do that.

We just treat those expenses as being foreign source expenses, and then you get a foreign tax credit on your net foreign source income, your foreign income net of those expenses.

But in a territorial system, the logical analog is to say we will disallow those expenses as deductions within the United States. That can have a very negative impact on the location of jobs in the United States, to the extent the expenses of paying those people, for example, are disallowed as the deduction.

R&D is one -- in the joint committee proposal for territorial that came out a little over a year ago, they proposed that some R&D expenses might be disallowed; personally I think that's wrong, it's a technical matter and I think it would be bad as a policy matter.

Second, G&A expenses is a big category. Those are headquarters type of expenses of people who are managing the international business of U.S. multinationals. There is an argument that some of those expenses should be disallowed.

But I think that would be something you ought to seriously consider if you're going to think seriously about territorial as to whether that would be wise or not. So those are some of the issues that you need to think about as you think about moving to a territorial system.

On balance, there is a lot to be said for it, as Mr. Hubbard and Mr. Hines indicated in the prior panel, but there are some problems with it. It does raise revenue if it's done in a certain way rather than lose revenue. So you need to very careful as you analyze the process.

MR. CAMP: Thank you very much, Professor Graetz.

MR. GRAETZ: Thank you, Mr. Chairman, Mr. McNulty and members of the committee. I want to begin where the last panel left off, which is with the notion that it is no longer possible, given the integration of the world economy, to think about domestic tax reform and international tax reform as if they are two different subjects.

Corporate income tax in the United States affects not only the competitiveness of U.S. companies abroad, but also the attractiveness of the United States as a place for investment of both domestic and foreign capital.

When John Castellani, the President of the Business Roundtable testified before this subcommittee a month ago, he made the point that the U.S. corporate tax rate was the most important issue facing American companies, and I agree with him.

In my view, the most important corporate change that the Congress could make, both to stimulate our own domestic economy and to increase the competitiveness of U.S. companies throughout the world, would be to lower our corporate tax rate substantially. A 25 percent rate would put us in line with where the OECD countries are in now, but I really think our goal should be lower than that. We should try and get the corporate rate down to 15 percent, the rate that's now applicable to capital gains and dividends.

It would be good for the U.S. economy, it would allow much simplification of the international tax rules; it would diminish the payoffs from corporate tax shelters and inter-company transfer pricing, and it would be good for America. The $64 question I think is the one that Congressman Doggett put earlier, which is given the financial shape of the U.S. Treasury, how do we replace the revenues that that would cost, and given the fact that corporate tax receipts were about $300 billion last year, cutting the rate would be expensive.

My answer to that is that we really ought to take seriously enacting a value added tax or a similar tax on goods and services. If we enacted a tax, for example, at a 10 to 14 percent rate, that would allow us to pay for the corporate rate reduction, it would allow us to eliminate 150 million Americans from paying taxes; it would allow us to get our individual tax rate down in the neighborhood of 20 and 25 percent; and it would keep the distribution of the tax burden about where it is today.

Compared to other OECD nations, the U.S. is a low-tax country, but it's not a low income tax country. And so when people like the earlier panel talk about countries like Singapore and Ireland, they talk about the low income tax rates, but all of those countries make up the revenue by taxing consumption typically in the form of a value added tax.

So that kind of basic tax reform would enhance our nation's economic growth, dramatically simplify our tax system and maintain roughly the same distribution of burdens as we now have.

The second point I want to make is that any domestic tax reform that we're going to undertake must fit well with international tax practices. While I found much to admire in the report of the President's panel on tax reform, their alternative to the income tax, what they call a growth and investment tax, is completely out of sync with international practices, and as they recognize, would require a complete renegotiation of all of our income tax treaties and the GATT.

You know, the idea that we're going to get a tax reform not only through this Congress and signed by the President, but also through the World Trade Organization seems to me hopelessly optimistic. I don't mean to suggest that we can't make incremental improvements of the sort that we've been talking about earlier to our international tax system without fundamental tax reform.

My point is that the benefits to the U.S. economy would be quite small compared to the benefits of a fundamental restructuring of the U.S. tax reform. The third point I want to make, and this one seems obvious, but apparently, it's not, even if you just read today's joint committee pamphlet, is that in evaluating either domestic or U.S. tax or international tax reforms, the goal ought to be what is in the best interest, the long-term well-being of the American people?

That's the goal that we apply everywhere else in domestic and international policy, and we ought to apply it to international tax reform as well. And the joint committee pamphlet today describes that as a minority view, so I think it's worth reconsidering. On the question of territoriality, in the few seconds remaining to me, let me just say one thing: I believe the reason to go to territoriality instead of what we now have, which can be done on a revenue-neutral basis, as Paul has just suggested, is that it eliminates the barrier to repatriation of earnings to the United States.

And the current system now makes that expensive, or requires huge amounts of tax planning in order to make that possible.

And as we've seen with the Homeland Investment Act and the temporary exclusion of dividends, there is a major amount of earnings of U.S. companies that get trapped abroad that might profitably be reinvested in the United States if we did not have a residual tax on repatriations.

And I think that's the reason to do it. That would lower the cost of capital to U.S. businesses and improve our situation.

Thank you, Mr. Chairman.

MR. CAMP: Thank you, Professor Graetz. Mr. Shay.

MR. SHAY: Thank you, Mr. Chairman.

Our international tax rules are only one element of our overall system for tax and business income, and as has been said by others on this panel, the broader system design issues are more significant than the choice of whether you tax foreign income at a full rate or with exemption. I agree that the primary focus of U.S. income tax policy should be how to raise revenue in a manner that improves the lives and living standards of our citizens and our residents.

The manner in which we apply our rules should be guided by our traditional tax policy criteria of fairness, efficiency, and administrability. There is, I guess it's fair to say, a lack of consensus among economists regarding what promotes efficiency in an open global economy. I would prefer taking a common sense practical approach, which is that you reduce incentives to shift economic activity in response to differences in effective tax rates.

Under our current international tax rules, foreign income generally is treated more favorably than domestic income. Income earned through a foreign corporation may be deferred from U.S. tax without regard to whether it is subject to a foreign tax.

Taxpayers that operate in high tax foreign jurisdictions can use excess foreign tax credits against other low foreign taxed income, which provides an incentive to earn low foreign tax income.

Income from export sales is treated as foreign source income for our foreign tax credit limitation purposes, though most countries, almost no country in the world will tax that at the other end, and yet it is allowed to be offset by excess foreign tax credits. Cross- crediting effectively allows the burdens of other countries' high foreign taxes to be offset against the U.S. tax, and yet the 2004 Act, referred to as the Reform Act, expanded the scope for cross- crediting.

Our current international tax rules distort economic decisions, create incentives to structure business activity in a manner that takes advantage of lower, reduced foreign effective tax rates. And the most disturbing aspect of them in my view is to undermine the confidence of U.S. citizens and residents that the American tax system is fair.

I didn't say at the outset that I am an international tax practitioner and I have been doing it for 25 years. The President -- let's turn to possible reforms.

We've been speaking about exemption. The President's Advisory Panel on Tax Reform's simplified income tax proposal would exempt foreign business income as part of its reform plan. The proposal would not require any minimum level of foreign tax, or even a subject to tax requirement, which is commonly found in other territorial systems, as a condition for the exemption.

I would contrast this with the proposal made in 1993 by the outgoing Treasury Department of the first Bush administration. Under the President's Advisory Panel's exemption proposal, any kind of non- separable income that can earned at a lower rate outside the United States would benefit from exemption and the amounts could be repatriated. That would expand the scope of people who would be interested in creating a foreign operation, in my experience.

Today, a client comes asking if they can do that, I say if you can't reinvest your money usefully outside the United States, deferral is not for you. Exemption would expand that.

I must skip over some other technical problems with those rules, but expense allocation is by far the most important, and the rules in there have defects that need to be addressed.

Based on the foregoing, I do not believe that the benefits among exemption system, even if redesigned, are likely to be superior to a reform that is based on full taxation of foreign income with an appropriately limited foreign tax credit.

One approach would be to tax United States shareholders and U.S.-controlled foreign corporations currently on their share of the income. There would be a number of technical changes that would be necessary to make this workable, but these rules have a history of use since 1962, and could be implemented without substantial redesign.

The current foreign tax credit mechanism should be improved by repeal of the sales source rule and other rationalization of source rules that today permit foreign taxes to offset U.S. tax and U.S. economic activity. Full taxation of foreign income would eliminate the locking effect of a separate tax on repatriation of earnings, as would an exemption system. They're the same in that regard, but in addition, it would reduce the scope of transfer pricing shifting that is induced by effective tax rate differentials.

Finally, full current taxation of foreign income is a fairer system. U.S. persons will be taxed in their income more equally and the advantage would not fall to those who operate principally outside the United States. I respectfully encourage the subcommittee to consider international reform proposals that would take in this broader perspective. These have been characterized so far today as a minority view on fairness and a superficial view on full taxation, but I beg to differ with my colleague, Dr. Hubbard. Thank you.

MR. CAMP: Thank you. I appreciate all of your testimonies. Thank you for coming before the subcommittee. I think the main thing that we're trying to get at is this dramatically changing world that we're in, and the fact that other countries are changing their tax systems, and I guess I would like to, if you could, each of you summarize briefly, what best could we do immediately to address our international competitiveness and our ability to continue to have U.S. companies compete abroad?

MR. OOSTERHUIS: I would say considering a territorial exemption system would be the best thing you could do. I don't think it would take that long to put together a package. But you do need to consider some of things I talked about earlier in terms of its impact on technology companies and on exporters, but assuming you put together an appropriate package, you may well be able to improve the competitiveness of U.S companies.

And I agree with Michael. The extent of the deferred earnings today -- I mean our current system with deferral doesn't discourage people from investing abroad in my experience. My experience may be a little different than Steve's in practice, but companies do invest abroad taking full advantage of the fact that you don't currently tax their earnings even if they are not taxed abroad.

And so moving to an exemption system with territorial isn't in my judgment going to significantly increase the incentives to move investment from the United States to abroad; rather, what it's going to do is what Michael was saying, which is free up those monies abroad to be invested efficiently rather than distorted.

There was a survey that Marty Sullivan did for Tax Notes. It indicated the amount of deferred income by 38 major multinationals in 1997 was $9 billion, by 2003 it was $46 billion a year. I would imagine by now it's substantially higher than that. That's a lot of distortion. That's the reason why HIA was an important priority of the 2004 Congress and it will come back again in the few years if you don't think about territory.

MR. CAMP: All right. Professor Graetz.

MR. GRAETZ: Well, on a purely incremental basis, I want to agree with Paul that I think that one should take seriously the idea of eliminating the barrier to repatriations by going to some form of territorial system. But as I said, I really think that the -- that to be serious about this competitiveness of our economy, what we really need to do is find a way to get our rates down and move to a consumption tax.

And that's not an incremental change, but it's I think where we need to go.

MR. CAMP: Thank you. And Mr. Shay.

MR. SHAY: Mr. Chairman, I was at the Treasury Department and was international tax counsel in 1986. My views haven't changed. Some people say that's a problem, but I think we should broaden the base, lower rates, and not treat income differently.

Thank you.

MR. CAMP: Mr. McNulty, you may inquire.

MR. McNULTY: Thank you, Mr. Chairman. Some of you heard the question that I posed to the first panel, and I think Professor Graetz said it better than I could, and that was that whatever we do with regard to tax policy ought to be based upon what is in the best interests of the American people.

Certainly, hundreds of billions of dollars in deficits every year and an exploding national debt that has exceeded $8.3 trillion is not in the best interest of the people of the United States of America.

And so my question would be, how are the proposals which you are making today make that situation better?

MR. GRAETZ: Mr. McNulty, if I could start, I think that the tax reform ought to be proceeding on at least a revenue-neutral basis in a way that will increase economic growth, and therefore will in fact increase revenues. And so I think that to the extent that we can move away from relying on corporate taxes, relying as heavily as we do on income taxes, taking advantage of our status as a low-tax nation and taxing more consumption and less income, but doing it in a way that is consistent with international practices rather than trying to invent some new tax, as the President's panel did, taking American exceptionalism as the norm seems to me the wrong way to go.

So I think what we ought to do is really look at a country like Ireland's tax system, where they have substantial value added taxes, which could help close the deficit and at the same time be used to reduce income taxes on companies and eliminate income taxes on most Americans, a vast majority of Americans. But I think that in our current fiscal situation, and looking as you and Dr. Hubbard did forward to an aging society and the demands that for retirement income, long-term care, and health insurance, we're going to have to think seriously about a restructuring of our tax system. And I know that it's a difficult thing to do, but I really think that's where we have to go.

MR. OOSTERHUIS: I couldn't agree more. Relying heavily on the income tax in a global economy is a very difficult thing to do. There is just too many ways that income and activity can be moved to maximize competitiveness, and it's necessary that companies do that. Their foreign competitors are doing that. And so the more you put the revenue pressure on solely on the income tax, the more pressure you put on trying to capture that revenue with proposals like Steve's to tax our multinationals on their global income, even though foreign countries don't do that with their multinationals.

The way to take the pressure off that is to get the rates down, and the way to get the rates down is to move to some sort of consumption tax to make up the difference.

MR. SHAY: It seems to me clear that there is an advantage to achieving lower income tax rates, but the only way I see you get there consistent with the direction of your question is you broaden the base. And in the event that you do not find additional sources of revenue in the value added tax, if you're going to put the kind of reliance we do on the income tax, there is going to be a greater, not lesser, premium on not having holes in the bathtub.

What I do for a living is plan to take advantage of effective tax rate differences, and you can see the fruits of that, not from me, but from a whole category of people in the financial footnotes of companies, and if you had public, the non-public companies, they do that by organizing themselves to take advantage of tax rate differences.

So it just seems to me common sense that you want to move in a direction that is going to reduce those, and full taxation of foreign income moves in that direction. Now, it is different from other countries, and so if you're going to do that, I do think you need to try to broaden the base and lower the tax rate, and if you can keep it within range of other countries, that is where we want to be, and I think it's where we have to be.

MR. McNULTY: Thank you all. Thank you, Mr. Chairman.

MR. CAMP: Thank you.

Mr. Chocola may inquire.

MR. CHOCOLA: Thank you, Mr. Chairman, and thank you all for being here. Been a lot of talk today about moving from a worldwide to a territorial system.

Mr. Linder is not here, unfortunately, but as you know, he likes a fair tax, and I think it's great in theory, but there seems to be a lot of transitional issues we'd have to work through. What kind of transitional issues would there be from going from a worldwide to a territorial system that would be beneficial, or non-beneficial?

MR. GRAETZ: Well, the key question is whether you would apply an exemption for dividends back to the United States, with respect to earnings that have been accumulated under current law, or whether you would limit the dividend exclusion to earnings after the date of the enactment.

Now, I would argue that one should apply it to all dividends, and if that creates too big a hole, then exempt only a percentage of the payments, rather than trying to trace whether dividends are out of post-enactment or pre-enactment earnings, which are simply going to create opportunities for planning, and complexities, and undermine what I believe is the major goal of going to a territorial system, which is to allow the tax-free movement of capital that's now trapped off-shore back to the United States.

MR. OOSTERHUIS: If I could add two other transitional issues. One is there are companies that have excess foreign tax credits which would lose their value once you move to a territorial system, in all likelihood. And I think you need to provide some transitional measure for them to obtain value from those foreign tax credits during a transition period, or else you unfairly in effect tax companies who have just happened to be in a circumstance where they have excess credits in the years leading up to the switch. The other are companies who've had losses in the United States and have what we call overall foreign losses, which normally would be recaptured out of this exempt income in the future.

A lot of those losses are there because of our over-reaching interest allocation rules that you addressed prospectively in -- starting in 2009, I believe, in the 2004 Act, but that still apply, and so requiring recaptured effect, as a result of those over- reaching roles is something I think you ought to also address transitionally.

MR. CHOCOLA: We haven't had a lot of discussion this morning about a value added tax. Would you guys like to discuss how that would impact competitiveness of the U.S. companies, especially a border adjustable value added tax?

MR. GRAETZ: I'll begin. I've been advocating a value added tax for a number of years now as a way to reduce income taxes in the United States. I know that my economist friends on the prior panel would tell you that border adjustability doesn't matter, because currency rates will adjust I think instantaneously is their position, so that it doesn't matter whether you tax production here or consumption here.

I really disagree with that.

Border adjustability is the rule throughout the world, with one or two very small exceptions in some of the former Soviet states. And I think, as I've said earlier, what we ought to be seeking to do is to get a tax system that meshes well with other tax systems, and that if you have to distort either consumption or the place of production, which is the choice between having border adjustability or not, all of the evidence I've seen suggests that you're much safer in distorting consumption rather than distorting location of production and keeping these questions of competitiveness going.

So in my view, I think we ought to move to a tax which is border adjustable. And just to complete the point, that means, under the current WTO, that a standard credit method value added tax will work.

Mr. Linder's national sales tax will work on that ground, whatever its other problems might or might not be. And so I think border adjustability is the way to go, and a tax that's sometimes known as the "X-tax," sometimes known as the "flat tax," sometimes known in the President's panel as the "growth and investment tax," which gives a deduction for wages, is not allowed to be border adjustable under our current trade agreements. And so I think those are not terribly practical ideas.

MR. CHOCOLA: Anybody else would like to?

Thank you, Mr. Chairman.

MR. CAMP: Thank you. The gentleman from Texas, Mr. Doggett, may inquire.

MR. DOGGETT: Thank you, Mr. Chairman. Professor, do you believe that it's possible or wise to eliminate all U.S. taxes on corporate foreign source income without substantially reducing the corporate tax on domestic corporate income?

MR. GRAETZ: Well, I don't. I think the way you put the question, I do not think that would be wise. That's why I'm arguing that we ought to do is lower the corporate tax rate generally.

MR. DOGGETT: Right.

MR. GRAETZ: I do want to come back to Paul's earlier point, which is that moving to an exemption system, as compared to our current system where we defer earnings abroad and give tax credits, is not a system that lowers the overall rate of tax. It's done in a revenue-neutral way, would not lower the overall rate of tax on foreign earnings, it would keep it the same.

It changes to a large extent some of the rules about how and who would pay those taxes, but it would not lower those taxes. By talking about an exemption system compared to a current system, we're not necessarily talking about a reduction of tax on foreign earnings abroad, we're talking about a different system that would raise roughly the same amount of revenue, at least that's what Paul and I have been talking about.

MR. DOGGETT: And to have revenue-neutrality on the corporate tax changes you would make at home and abroad, you recommend a value added tax?

MR. GRAETZ: I do. And I would like to say that I think that the value added tax not only allows you to do tremendous good in terms of our international competitiveness, in terms of our domestic investment and investment abroad, but it also allows you to eliminate from the tax rolls 150 million people at a reasonable rate, at a rate that -- I have a chart at the end of my paper that shows you that the rate would be no higher than that around the rest of the world.

So it creates a huge amount of revenue to be used to lower income taxes on individuals as well as on corporations.

MR. DOGGETT: Mr. Shay, lower rates was one of three things that you talked about as objectives, but you also said that if rates are to be lowered, we need to broaden the base, and we need to not treat different kinds of income differently. What steps would you take to broaden the base, and to assure that different types of income are not treated differently?

MR. SHAY: Well, the focus of this hearing has been on foreign income, and so the proposal I would make in that context is to include foreign income currently with a foreign tax credit. But then after foreign tax credit -- taking into account the effective rate would be -- the objective is to keep the effective rates the same, to minimize tax-motivated decision-making on that.

MR. DOGGETT: And you discussed cross-crediting, do you feel the way the laws on tax credits currently are written, that they're too generous?

MR. SHAY: I think the most problematic aspect of our current foreign tax credit rules are source rules that effectively treat as though they're foreign income income that is never going to taxed by a foreign jurisdiction. Therefore, you aren't really serving the purpose of the foreign tax credit, which is to avoid or relieve double taxation, but what you're doing in essence is allowing high foreign taxes to offset what should be viewed as U.S. tax base. So yes, that would be a reform.

MR. DOGGETT: Like me, you've heard five witnesses say that the only way we can be competitive is to eliminate taxes on foreign source income, and I note in passing that the Congressional Budget Office has found that the effective corporate tax rate, we're about at the median of the G-7 versus the statutory rate on something like equity-financed investments and machinery.

How do you believe, Mr. Shay, we can have taxation of foreign source income and still be competitive?

MR. SHAY: Well, I think that we're using a very narrow definition of "competitive," and that is, what is the tax on a multinational or a taxpayer who has international income? I really think that earlier in this hearing, we've had a more appropriate and broader view.

What is going to make us competitive is as a country, it's not what the particular tax rate is. We are not Ireland. We have to educate our people, we have a retirement crisis. That retirement crisis, by the way, is shared in Europe. And it troubles me a little bit to not look out ahead, and see -- they have already maxed out on value added tax. Where is their future revenue going to come from? It is going to come from the income tax. Or it's going to come from somewhere.

So the notion that this is all static, and that we should not be building a system for the future that is stable, that can sustain if necessary higher rates, strikes me as risky.

MR. CAMP: Thank you. The gentleman's time has expired. The gentleman from Florida, Mr. Foley, may inquire.

MR. FOLEY: Thank you. I'd like you to expound on that thought because it seems like we frustrate both the American economy and the consumer with our tax policies. It's confusing, complicated, getting ready to adjust rates on estate taxes, capital gains taxes, incentives for various activities, and when I look at what Mr. Linder is proposing, which really becomes a consumption tax, it seems to me those who want to spend more pay more.

There is an embedded cost I would assume in this Blackberry when you purchase, isn't there, on the price tag, a tax consequence? So given that fact, a consumption tax, give me an idea what you think would be the most logical progression from the complication we have today, to a tax that not only frees the economy but increases competitiveness.

MR. SHAY: I think you broaden the base in as many ways as you can -- it may be heresy, but it's not clear to me why we need to have a differential tax rate on capital gains -- it's not clear to me why we need to have favorable tax of foreign income. If you eliminate -- we have major tax expenditures that have been viewed as sacred cows. As long as they are there, we are going to have difficulty achieving the objectives you need, but to be competitive, we need to broaden the base, lower rates.

If we need to go to value added tax, the one thing the panel needs to recognize is that value added tax is a tax on consumption. It is a tax on consumers. It is possible to make it progressive. There are not great models for doing that. And so we need to think about how we integrate that, and how we integrate it with the state retail sales taxes.

It's not clear to me it is efficient to have a retail sales tax of the state, and a Federal value added tax. I think there would be pressure to try and integrate those, and there should be if we go in that direction. But the core decision that I think Michael is alluding is we have to decide what is the balance? Europe has achieved the balance of a much higher value added taxation in relation to income taxation. We have the other end of that balance. If we're going to shift that, we need to understand that that reduces our ability to achieve progressive objectives, and that we need to incorporate that into our overall thinking.

So in addition -- as I say in my testimony, there is tension between fairness, which is what progressivity is aimed at, efficiency, which would imply broadening and possibly increasing the ratio of consumption taxation, income taxation; and administrability. And I think there's a way to meld all those but it involves difficult choices, and I don't see the difficult choice being made with respect to foreign income. I don't think exemption is the best way to get there. Sorry.

MR. FOLEY: Your thoughts on it?

MR. GRAETZ: Well, I really am interested in Steve's comments, because he says that he was there in 1986. I guess everybody has claimed their prior experience.

I was at the Treasury in 1992, '90 to '92, and in '69 to '72, so I was there twice. But the world has changed since 1986, and in 1986, international transactions were less than 10 percent of the global economy.

Today, they're more than a quarter of the global economy, and we really do have to change our thinking, and I think we have to change it in fundamental ways. And I think that moving toward a sales tax, tax on consumption, which is what a value added tax is -- all it is, there's a lot of misunderstanding about it, people think it's French; in fact it was invented by Thomas Sewell Adams in 1929, in the United States, in New Haven, Connecticut, I might add.

But it's a U.S. idea, and all it is is a sales tax with withholding. And instead of relying on the retailer to pay the whole amount, we require the wholesaler to withhold some of that sales tax and the manufacturer to withhold some of it, but it's not a multiple tax on different levels, so I think that's what we ought to be thinking about.

MR. FOLEY: But it also seems like you capture more of the economy, because right now the underground economy is never captured. If they don't pay income taxes, or capital gains taxes, then they're not going to be paying any tax; whereas consumption does in fact capture every level of the economy.

MR. GRAETZ: I think there are many advantages to it. The advantage of compliance, of relying on more than one tax, that is, the ability to collect at low rates on multiple tax bases, is a great advantage in terms of making sure that you collect the tax. And the more eggs you put in one basket in this economy, the less you're going to collect.

MR. CAMP: Thank you. The gentlewoman from Pennsylvania, Ms. Hart, may inquire.

MS. HART: Thank you, Mr. Chairman.

I want to follow-up on some of Mr. Chocola's line of questioning. As he was asking his question, I was reading my notes from a meeting that we had back home.

I am from Pittsburgh, and I had the opportunity to meet with a number of the sort of senior tax people in my larger manufacturing companies about this issue, and they sent me out of the room with a whole lot of questions and some suggestions, and one was that they all announced to me that they do prefer the territorial tax structure because they do want to be able to make their decisions about where they locate their manufacturing facilities based on what's better for their company and what's better for their customers.

In some cases, they're going to want to locate a manufacturing facility in the Far East because that's where their customers are. But in a significant number of the cases, they would prefer to locate their facilities here in the United States.

But when they look at their balance sheet, it's not making a lot of sense to them.

And now what I'd like you to do for me, and I'm not sure if any of you are very heavily schooled in the difference as far as the tax decisions for a manufacturer, I expect that you are, I would guess, especially Mr. --

MR. OOSTERHUIS:

How do you do?

MS. HART:

Mr. Oosterhuis; is that right?

MR. OOSTERHUIS: Oosterhuis.

MS. HART: Oosterhuis; that's close. I want to start with you.

MR. OOSTERHUIS: Sure.

MS. HART: Can you help me, as far as the analysis of a territorial tax, if that's going to make a big difference as far as some of the decisions these folks will make. They tell me that it will. What's your experience?

MR. OOSTERHUIS: To be honest, my experience is that it will make a marginal difference, not a big difference, because today, manufacturing income, if you have a plant -- whether it's in Germany, or Singapore or Ireland -- the income from that is not subject to current U.S. tax. It's only subject to U.S. tax if you bring those earnings back to the United States in the form of a dividend. For most of the --

MS. HART: Before you go on, I'm presuming that they're going to want to repatriate.

MR. OOSTERHUIS: Right. Well, that's where the nub is, because for years, the inability to bring money back was not a problem for most multinationals. The amount of income relative to the growth outside the United States was modest, and so the funds could be re- invested. What has happened over the past ten years is the amount of earnings that companies have from their facilities outside the United States has grown very substantially, and that puts a lot more pressure on the utilization of those funds; and therefore, a lot more pressure on being able to bring those funds back to use them efficiently in the United States.

And so I do think that is one of the main reasons why we should consider territorial -- not that it will necessarily lead people in the future to make decisions to invest abroad that they otherwise wouldn't have made, but rather that it will free them up with respect to their existing investments to utilize the funds most efficiently, which may actually discourage them from investing the newest plant abroad and build it back in the United States, because they can get the money back here to build it.

MS. HART: And that's obviously what a lot of them express as far as a concern. Mr. Shay?

MR. SHAY: The companies are going to want the flexibility that territoriality offers. That just makes sense. If implicit in your question was what would increase the likelihood that they would invest in the United States, it presumably would be greater depreciation -- exactly what Mr. Barrett was saying earlier. More benefits for investment in United States? Well, then how do you fund those benefits? And do you fund them by exempting foreign income? I mean, there's a circle here that needs to be completed, and part of the premise that I have is, I -- look, I think the companies are a very important productive part of our economy; they are my clients.

But the perspective that you have to have is what's in the best interests of the United States, and what is going to maximize economic activity here in relation to the world? That's the question. And the question is does exemption get you there? MS. HART: Thank you.

Did you have a comment?

MR. GRAETZ: I would just like to comment on something that Mr. Shay has said earlier that's relative to these questions, and that is the suggestion that we would somehow be better off by taxing all foreign income currently. If you go back, we never taxed foreign active business income currently in the United States, nor has any other OECD country ever taxed all foreign income currently when it's active business income.

And the idea that if in 1918, when the foreign tax credit came into the Code we had taxed income currently, that looking backwards we'd be better off if we had not had all the U.S. investments abroad that we've had during the interval just seems incorrect to me. And it seems to me that one has to be careful when one talks about base broadening not to talk about base broadening in a way that will make things worse in terms of the economic benefits to the U.S. people.

MS. HART: I see my time has expired. Thank you, Mr. Chairman.

MR. CAMP: Thank you very much.

The gentleman from Illinois, Mr. Weller, may inquire.

MR. WELLER: Thank you, Mr. Chairman, and I commend you for conducting this hearing today, and I'm sorry I missed part of it. But I'd like to ask our panelists here: The folks I represent back home, they look at the tax code, they think it's complicated. They all hear the stories about jobs going offshore, they believe that the tax code has something to do with it, and as many business decisionmakers have shared with me, the tax code does influence business decision-making particularly in the area of investment.

And one of the areas they raise, of course, is how we depreciate assets. You know, as we look at the capital purchases and how they impact investment in the United States, 96 percent of the globe's population is outside of our borders, 4 percent is inside our borders, and obviously we want to produce products over here in the United States and sell them outside our own territories and serve that market.

I was wondering, can each of you share your perspective on how our current corporate tax code as we treat capital assets from the standpoint of depreciation, how you believe that affects business decision-making on investing in -- particularly in production for manufacturing, and other capabilities to serve the international market producing the product here, how that behavior is influenced.

Mr. Oosterhuis, you want to go first?

MR. OOSTERHUIS: I'll go first.

It's very dependent on which kind of industry, which kind of company you are talking about. The semi-conductor manufacturers that Mr. Barrett represents are very capital-intensive in physical assets, tangible property assets, and so for them, depreciation is very important in their location decisions. I have no doubt about that.

There are other industries, the software industry, for example, where there are a lot of high-paying jobs, but where depreciation is not particularly relevant at all because other than the computers that their employees use, their tangible assets are not that substantial. Most of their investments are intangible development costs, software development-type activities.

And there, our rules are consistent with international norms; we allow a deduction for it. So I think you're absolutely right that focusing on our depreciation rules can be very important to selected sectors of the economy, but to industries like pharmaceuticals and software, it's not all that important.

MR. WELLER: How about those who make cars and bulldozers, and --

MR. OOSTERHUIS: Certainly for cars and bulldozers, it would be, sure.

Absolutely.

MR. GRAETZ: While I don't disagree with anything Paul has said, I just want to make one additional observation. And that is, throughout the history of United States, going back actually to the Depression, we've changed depreciation law to stimulate investment, and had investment tax credits to stimulate investment in 1954, 1962, 1971, and on and on, we can go through a list.

And the best evidence that I've seen is that those changes have affected mostly the timing of investment rather than the overall level of investment. And to my mind, there is a trade-off -- we saw it in the '86 Act, we've seen it over a long period of time between whether you have low rates and relatively higher depreciation, or whether you have a faster depreciation and higher tax rates.

And I think in the current economy, we really ought to focus on getting the rates down, and then the depreciation allowances won't matter nearly so much as they do with high rates -- rather than singling out, as this earlier conversation suggests, those capital- intensive industries for a tax break, rather than spreading the tax break more evenly throughout the economy through low rates.

MR. WELLER: Was part of the reason though if people move the timing of their purchase or they fast-forward it, is it because those -- well, there was bonus depreciation that was on the Bush tax cut, or some of the various investment tax credits was because of the temporary nature of that; had they been permanent provisions of the tax code, would the behavior have been different?

MR. GRAETZ: Well, Mr. Weller, as you know well, the fat lady never sings in tax policy. And I don't know what the meaning of "permanent" is in tax policy. We have tax legislation constantly. The investment tax credit is a great example. It was put in on a permanent basis, and it was repealed permanently, then it was put back in. And then it was taken back off.

And so I think that companies are well aware, especially in a climate like the current fiscal climate, where we really do have to believe that we're going to be looking for revenues ahead, that a depreciation break today may well be gone tomorrow even if it is labeled "permanent."

MR. WELLER: Mr. Shay?

MR. CAMP: If you could answer briefly, because his time has expired.

MR. SHAY: The whole thrust of the '86 Act was to try and equalize the taxation of capital, non-capital-intensive businesses by pushing rates down. That is the advantage. And depreciation always turns.

That's why once it's gone, you're paying full tax on it, so lower tax rates tends to be a better long-term answer.

MR. CAMP: Thank you. The gentlewoman from Ohio, Ms. Tubbs Jones, may inquire.

MS. TUBBS JONES: Thank you, Mr. Chairman. Gentlemen, good morning. I'm going to start with Mr. Shay.

Mr. Shay, you were talking about the '86 tax changes. If you had a looking glass, looking forward, what would you have done differently, what would you have suggested that we would have done differently with regard to that?

MR. SHAY: Well, to some extent, tried to have preserved it better. It's really been largely eroded since then. And maybe this isn't fully responsive to your question, but I think every time we --

MS. TUBBS JONES: My feelings won't be hurt. It's happened more often --

MR. SHAY: But I think every time we've tried to put in benefits and provisions, whether it is capital gains preferences, whether it is to accelerate depreciation, it's the government trying to guess right. And I think the whole thrust of the approach I would propose is, let's try and get as close to economic depreciation, as broad a base as we can, lower tax rates, and not have the government policy be the one that's dictating where the investment is made.

And I beg to differ slightly with my colleague, Professor Graetz. The U.S. financial industry was subject to full current taxation from 1986 to 1997. They persuaded this Congress to change that with the advent of the active finance exception, the sub-part (f). I'm not aware that there is a really strong data that they became a second-rate citizen during that period.

MS. TUBBS JONES: What else would you suggest that we do immediately? It's still your time.

MR. SHAY: I think actually I would just stop, because --

MS. TUBBS JONES: He's so stunned I've given him this much time. He's lost for words. I'm kidding. Go ahead.

MR. SHAY: No, no. I think, I've really made -- that's my response.

MS. TUBBS JONES: In the state of Ohio since 2001, we lost 186,000 jobs. In the city of Cleveland alone, we lost 60,000 jobs. I'm going to come off to you for more, Mr. Shay, and Professor Graetz. What would you suggest we might do in terms of taxing authority to help return some of those jobs to the United States, because of course most of them went overseas somewhere, lower labor rates, et cetera, et cetera, et cetera?

MR. GRAETZ: Well, it is true that we do lose some jobs to overseas competition, especially where lower --

MS. TUBBS JONES: Some jobs, Professor Graetz? Oh, no.

MR. GRAETZ: Well, the best evidence of overseas investment that I've seen is that in the aggregate, overseas investment increases U.S. jobs because it creates jobs at home in order to supply the growth abroad. But I understand what you're saying about Ohio, and I think it's an important question, and it's certainly true that it's very important for certain localities, and I would say that I think that the best thing we could do is to try and get the rates on investment in Ohio down.

And one way to do that is to lower our corporate tax rates, and our tax rates on capital investments. And the difficulty, which is the difficulty we keep bumping back into, is that we're going to have to tax something else if we're not going to tax that kind of income, unless we believe that the economic growth will be enough to pay for it, which I'm skeptical of. And so I think that this relates to your earlier question to Mr. Shay.

I think the big difference looking backwards 20 years, is that in 1986, we decided to continue the sole reliance of the United States federal government on income taxes rather than consumption taxes. We broadened the base and we lowered the rates, and what happened in the 20 years since is that the rates have gone up and the base has gotten narrower.

And that will happen again. And I think we just have to spread out our way of raising taxes, and include a consumption tax in the mix.

MS. TUBBS JONES: Well, you won't accuse Democrats of raising taxes and doubling taxes in order to reach this outcome that you're proposing.

MR. GRAETZ: I have to say I think there are occasions in which taxes have to be raised. I'm not a person that's ever accused anybody of anything.

MS. TUBBS JONES: Say it again so my colleagues on the other side could hear that --

MR. GRAETZ: But I think it's --

MS. TUBBS JONES: There are occasions when --

MR. GRAETZ: There are occasions when taxes need to go up. I'm clear about that. I think there are those occasions, but the question is, in order to raise the revenue that you need to finance the government you're going to have, how can you do that in a way that is fair and most conducive to economic growth and less burdensome?

And there, I think we are in the wrong place in relying as heavily as we do on the income tax, and on taxes on capital investments, both domestically and throughout the world.

MS. TUBBS JONES: Thank you, Mr. Chairman.

MR. CAMP: All right, thank you.

And I want to thank this Panel for your testimony, and appreciate the members for attending this hearing.

At this time, the Select Revenue Measures subcommittee is adjourned.

(Whereupon, at approximately 11:41 a.m. the HEARING was adjourned.)