Segment 1 Of 2 Next Hearing Segment(2)
SPEAKERS CONTENTS INSERTS Tables
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41–197 CC
1998
REVENUE RAISING PROVISIONS IN THE ADMINISTRATION'S FISCAL YEAR 1998 BUDGET PROPOSAL
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
MARCH 12, 1997
Serial 105–8
Printed for the use of the Committee on Ways and Means
COMMITTEE ON WAYS AND MEANS
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BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois
BILL THOMAS, California
E. CLAY SHAW, Jr., Florida
NANCY L. JOHNSON, Connecticut
JIM BUNNING, Kentucky
AMO HOUGHTON, New York
WALLY HERGER, California
JIM McCRERY, Louisiana
DAVE CAMP, Michigan
JIM RAMSTAD, Minnesota
JIM NUSSLE, Iowa
SAM JOHNSON, Texas
JENNIFER DUNN, Washington
MAC COLLINS, Georgia
ROB PORTMAN, Ohio
PHILIP S. ENGLISH, Pennsylvania
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
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CHARLES B. RANGEL, New York
FORTNEY PETE STARK, California
ROBERT T. MATSUI, California
BARBARA B. KENNELLY, Connecticut
WILLIAM J. COYNE, Pennsylvania
SANDER M. LEVIN, Michigan
BENJAMIN L. CARDIN, Maryland
JIM McDERMOTT, Washington
GERALD D. KLECZKA, Wisconsin
JOHN LEWIS, Georgia
RICHARD E. NEAL, Massachusetts
MICHAEL R. McNULTY, New York
WILLIAM J. JEFFERSON, Louisiana
JOHN S. TANNER, Tennessee
XAVIER BECERRA, California
KAREN L. THURMAN, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records of the Committee on Ways and Means are published in electronic form. The printed hearing record remains the official version. Because electronic submissions are used to prepare both printed and electronic versions of the hearing record, the process of converting between various electronic formats may introduce unintentional errors or omissions. Such occurrences are inherent in the current publication process and should diminish as the process is further refined. The electronic version of the hearing record does not include materials which were not submitted in an electronic format. These materials are kept on file in the official Committee records.
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C O N T E N T S
Advisory of February 25, 1997, announcing the hearing
WITNESSES
Amacher, Richard C., Belk Stores Services, Inc., and National Retail Federation
American Automobile Manufacturers Association, C. Ellen MacNeil
American Bankers Association, Richard A. Hayes
American Petroleum Institute, Paul Sullivan
Applied Materials, Inc., and Export Source Coalition, William C. Barrett
Belk Stores Services, Inc., Richard C. Amacher
Caterpillar, Inc., Douglas R. Oberhelman
Crumrine, Donald F., Flaherty & Crumrine, Inc
Export Source Coalition:
William C. Barrett
Gary C. Hufbauer
Douglas R. Oberhelman
Exxon Corp., Paul Sullivan
Flaherty & Crumrine, Inc., Donald F. Crumrine
Goldberg, Hon. Fred T., Jr., Skadden, Arps, Slate, Meagher & Flom LLP
Gordon, Robert N., Twenty-First Securities Corp., and Securities Industry Association
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Hayes, Richard A., Wells Fargo & Co., and American Bankers Association
Hufbauer, Gary C., Institute for International Economics, and Export Source Coalition
Hyde, Arthur D., Salomon Brothers, Inc., and PSA The Bond Market Trade Association
Institute for International Economics, Gary C. Hufbauer
MacNeil, C. Ellen, Arthur Andersen LLP, and American Automobile Manufacturers Association
National Retail Federation, Richard C. Amacher
Oberhelman, Douglas R., Caterpillar, Inc., and Export Source Coalition
Parks, Linda, James, Parks, Tschopp & Whitcomb, P.A.
PSA The Bond Market Trade Association, and Salomon Brothers, Inc., Arthur D. Hyde
Securities Industry Association, Robert N. Gordon
Solid Waste Association of North America, Bernard J. Zahren
Sullivan, Paul, Exxon Corp., and American Petroleum Institute
Twenty-First Securities Corp., Robert N. Gordon
Zahren Alternative Power Corp., and Solid Waste Association of North America, Bernard J. Zahren
Wells Fargo & Co., Richard A. Hayes
SUBMISSIONS FOR THE RECORD
Ad Hoc Coalition of Utilities for Capital Formation, statement
Ad Hoc Coalition on Intermarket Coordination, statement
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Alliance of American Insurers, statement
America's Community Bankers, statements and letter-..L 134, 258
American Electronics Association, Peter Levy, statement
American Financial Services Association, statements and attachment
American Land Title Association, statement
Bank of America, et al., John E. Chapoton, and Thomas A. Stout, Jr., joint statement
Bear, Stearns & Co. Inc., New York, NY, statement
Boudrias, Claude P., Chemical Manufacturers Association, Arlington, VA, statement
Bunning, Hon. Jim, a Representative in Congress from the State of Kentucky, joint letter (see listing under Hon. Phil English)
Business Roundtable, statement
Caterpillar, Inc., statement
Chapoton, John E., and Thomas A. Stout, Jr., Bank of America, et al., joint statement
Chemical Manufacturers Association, Arlington, VA, Claude P. Boudrias, statement
Christensen, Hon. Jon, a Representative in Congress from the State of Nebraska, joint letter (see listing under Hon. Phil English)
Coalition on Credit Card Interest, statement
Cooper, Milton, National Association of Real Estate Investment Trusts, and Kimco Realty Corp., New Hyde Park, NY, statement
Coopers & Lybrand L.L.P., letter and attachment
Covol Technologies, Inc., Lehi, UT, Asael T. Sorensen, Jr., statement
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Doherty, John J., New York City Department of Sanitation, statement
Dunn, Hon. Jennifer, a Representative in Congress from the State of Washington, joint letter (see listing under Hon. Phil English)
Edison Electric Institute, statement
English, Hon. Phil, a Representative in Congress from the State of Pennsylvania; Hon. Jon Christensen, a Representative in Congress from the State of Nebraska; Hon. Jim McCrery, a Representative in Congress from the State of Louisiana; Hon. Amo Houghton, a Representative in Congress from the State of New York; Hon. Jim Bunning, a Representative in Congress from the State of Kentucky; Hon. E. Clay Shaw, Jr., a Representative in Congress from the State of Florida; Hon. Wes Watkins, a Representative in Congress from the State of Oklahoma; Hon. Sam Johnson, a Representative in Congress from the State of Texas; Hon. John Ensign, a Representative in Congress from the State of Nevada; Hon Jerry Weller, a Representative in Congress from the State of Illinois; Hon. Jennifer Dunn, a Representative in Congress from the State of Washington; and Hon. J.D. Hayworth, a Representative in Congress from the State of Arizona, joint letter
ENSERCH Corp., Dallas, TX, statement
Ensign, Hon. John, a Representative in Congress from the State of Nevada, joint letter (see listing under Hon. Phil English)
Financial Executives Institute, statement
Financial Services Council, statement
Gateway 2000, David McKittrick, statement
General Motors Corp., statement
Government Finance Officers Association, et al., statement
Griffin, W.M., Texas Utilities Co., statement
Hartford Steam Boiler Inspection and Insurance Co., Hartford, CT, James C. Rowan, Jr., letter
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Hayworth, Hon. J.D., a Representative in Congress from the State of Arizona, joint letter (See listing under Hon. Phil English)
Houghton, Hon. Amo, a Representative in Congress from the State of New York, joint letter (see listing under Hon. Phil English)
Independent Bankers Association of America, joint statement (see listing under New York Clearing House Association)
Inland Steel Co., East Chicago, IN, joint statement (see listing under Sun Coal and Coke Co.)
International Mass Retail Association, Arlington, VA, Robert J. Verdisco, statement and attachment
Interstate Natural Gas Association of America, statement
Investment Company Institute, statement
Johnson, Hon. Sam, a Representative in Congress from the State of Texas, joint letter (see listing under Hon. Phil English)
Kimco Realty Corp., New Hyde Park, NY, Milton Cooper, statement
Levy, Peter, American Electronics Association, and Raychem Corp., statement
Mahar, Declan, Fairfield, CT, letter
McCrery, Hon. Jim, a Representative in Congress from the State of Louisiana, joint letter (see listing under Hon. Phil English)
McKittrick, David, Gateway 2000, statement
Merrill Lynch & Co., Inc., statement
Monsanto Co., statement
Murray, Fred F., National Foreign Trade Council, Inc., statement
National Apartment Association, and National Multi Housing Council, joint statement
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National Association of Manufacturers, statement
National Association of Real Estate Investment Trusts, Milton Cooper, statement
National Foreign Trade Council, Inc., Fred F. Murray, statement
National Mining Association, statement
National Multi Housing Council, and National Apartment Association, joint statement
New York City Department of Sanitation, John J. Doherty, statement
New York Clearing House Association, New York, NY; Independent Bankers Association of America; Securities Industry Association; and America's Community Bankers, joint statement
Northern Indiana Public Service, Merrillville, IN, joint statement (see listing under Sun Coal and Coke Co.)
Pace Carbon Fuels, L.L.C., Fairfax, VA, James R. Treptow, letter
Ramstad, Hon. Jim, a Representative in Congress from the State of Minneapolis, statement
Raychem Corp., Peter Levy, statement
Rowan, James C., Jr., Hartford Steam Boiler Inspection and Insurance Co., Hartford, CT, letter
Securities Industry Association, joint statement (see listing under New York Clearing House Association)
Shaw, Hon. E. Clay, Jr., a Representative in Congress from the State of Florida, joint letter (see listing under Hon. Phil English)
Sorensen, Asael T., Jr., Covol Technologies, Inc., Lehi, UT, statement
Stout, Thomas A., Jr., and John E. Chapoton, Bank of America, et al., joint statement
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Sun Coal and Coke Co., Philadelphia, PA; Inland Steel Co., East Chicago, IN; and Northern Indiana Public Service, Merrillville, IN, joint statement
Tax Council, statement
Texas Utilities Co., W.M. Griffin, statement
Treptow, James R., Pace Carbon Fuels, L.L.C., Fairfax, VA, letter
United States Council for International Business, New York, NY, statement
United States Telephone Association, statement
Valero Energy Corp., San Antonio, TX, statement
Verdisco, Robert J., International Mass Retail Association, Arlington, VA, statement and attachment
Washington Counsel, P.C., statements
Watkins, Hon. Wes, a Representative in Congress from the State of Oklahoma, joint letter (see listing under Hon. Phil English)
Weller, Hon. Jerry, a Representative in Congress from the State of Illinois, joint letter (see listing under Hon. Phil English)
REVENUE RAISING PROVISIONS IN THE ADMINISTRATION'S FISCAL YEAR 1998 BUDGET PROPOSAL
WEDNESDAY, MARCH 12, 1997
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:03 a.m., in room 1100, Longworth House Office Building, Hon. Bill Archer (Chairman of the Committee) presiding.
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[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
CONTACT: (202) 225–1721
IMMEDIATE RELEASE
February 25, 1997
No. FC–4
Archer Announces Hearing on
Revenue Raising Provisions
in the Administration's
Fiscal Year 1998 Budget Proposal
Congressman Bill Archer (R–TX), Chairman of the Committee on Ways and Means, today announced that the Committee will hold a hearing on revenue raising provisions in the Administration's fiscal year 1998 budget proposal. The hearing will take place on Wednesday, March 12, 1997, in the main Committee hearing room, 1100 Longworth House Office Building, beginning at 10:00 a.m. Oral testimony at the hearing will be heard from public witnesses.
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BACKGROUND:
The Administration's fiscal year 1998 budget proposal contains approximately $78 billion in revenue increases, according to Administration estimates. These provisions have not yet been estimated by the Joint Committee on Taxation.
In announcing the hearing, Chairman Archer stated: ''As part of his fiscal year 1998 budget, the President has sent to Congress a number of proposals which would increase Federal tax revenues. The Administration believes that many of these proposals will eliminate 'unwarranted tax benefits.' As the Ways and Means Committee and the Congress demonstrated during the 104th Congress, we will not permit anachronistic and unwarranted tax provisions to remain in the law. However, commentators have suggested that many of the proposals submitted by the Administration are simply tax increases by another name. The Ways and Means Committee will study carefully the revenue raising proposals submitted by the Clinton Administration in order to determine which are firmly grounded in tax policy.
I am pleased that the Administration has for the most part heeded the announcement Senator Roth and I issued last year regarding effective dates for its revenue proposals. However, I am concerned that several of the new proposals from the Administration still have retroactive effective dates or retroactive impact. I want to learn more about potential effective dates for the proposals as well as the rationale for those dates.''
FOCUS OF THE HEARING:
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The focus of the hearing will be the revenue raising provisions of the Administration's budget proposal for fiscal year 1998, other than the aviation, oil spill, Superfund, and Leaking Underground Storage Tank excise taxes and the corporate environmental tax extension proposals which will be considered later this year.
DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:
Requests to be heard at the hearing must be made by telephone to Traci Altman or Bradley Schreiber at (202) 225–1721 no later than the close of business, Tuesday, March 4, 1997. The telephone request should be followed by a formal written request to A.L. Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. The staff of the Committee will notify by telephone those scheduled to appear as soon as possible after the filing deadline. Any questions concerning a scheduled appearance should be directed to the Committee staff at (202) 225–1721.
In view of the limited time available to hear witnesses, the Committee may not be able to accommodate all requests to be heard. Those persons and organizations not scheduled for an oral appearance are encouraged to submit written statements for the record of the hearing. All persons requesting to be heard, whether they are scheduled for oral testimony or not, will be notified as soon as possible after the filing deadline.
Witnesses scheduled to present oral testimony are required to summarize briefly their written statements in no more than five minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full written statement of each witness will be included in the printed record, in accordance with House Rules.
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In order to assure the most productive use of the limited amount of time available to question witnesses, all witnesses scheduled to appear before the Committee are required to submit 300 copies of their prepared statement and a 3.5-inch diskette in WordPerfect or ASCII format, for review by Members prior to the hearing. Testimony should arrive at the Committee office, room 1102 Longworth House Office Building, no later than Monday, March 10, 1997. Failure to do so may result in the witness being denied the opportunity to testify in person.
WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:
Any person or organization wishing to submit a written statement for the printed record of the hearing should submit at least six (6) copies of their statement and a 3.5-inch diskette in WordPerfect or ASCII format, with their address and date of hearing noted, by the close of business, Wednesday, March 26, 1997, to A.L. Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. If those filing written statements wish to have their statements distributed to the press and interested public at the hearing, they may deliver 200 additional copies for this purpose to the Committee office, room 1102 Longworth House Office Building, at least one hour before the hearing begins.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a witness, any written statement or exhibit submitted for the printed record or any written comments in response to a request for written comments must conform to the guidelines listed below. Any statement or exhibit not in compliance with these guidelines will not be printed, but will be maintained in the Committee files for review and use by the Committee.
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1. All statements and any accompanying exhibits for printing must be typed in single space on legal-size paper and may not exceed a total of 10 pages including attachments. At the same time written statements are submitted to the Committee, witnesses are now requested to submit their statements on a 3.5-inch diskette in WordPerfect or ASCII format.
2. Copies of whole documents submitted as exhibit material will not be accepted for printing. Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material not meeting these specifications will be maintained in the Committee files for review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a statement for the record of a public hearing, or submitting written comments in response to a published request for comments by the Committee, must include on his statement or submission a list of all clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the name, full address, a telephone number where the witness or the designated representative may be reached and a topical outline or summary of the comments and recommendations in the full statement. This supplemental sheet will not be included in the printed record.
The above restrictions and limitations apply only to material being submitted for printing. Statements and exhibits or supplementary material submitted solely for distribution to the Members, the press and the public during the course of a public hearing may be submitted in other forms.
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Note: All Committee advisories and news releases are available on the World Wide Web at 'HTTP://WWW.HOUSE.GOV/WAYS_MEANS/'.
The Committee seeks to make its facilities accessible to persons with disabilities. If you are in need of special accommodations, please call 202–225–1721 or 202–225–1904 TTD/TTY in advance of the event (four business days notice is requested). Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above.
—————
Chairman ARCHER. The Committee will come to order. The Chair would observe this is the quietest milling around he can remember in many, many years.
Today's hearing has been called to discuss the revenue raising provisions contained in the President's budget. When the President proposed his budget, I said that if it was, indeed, in balance and if it provided tax relief for the American people, then I would consider it live on arrival. One of the purposes of our hearings has been to determine whether the President's budget is alive and kicking or just barely breathing.
Before I indicate which condition has been met, we must never yield from our dedication to reach a bipartisan agreement on balancing the budget while providing permanent tax relief to the American people. Whatever shortcomings I or any other Member find in the President's proposals, we must not let them stop us from working together in good faith and with a firm dedication to completing our work.
The American people elected a Democrat President and a Republican Congress and they expect us to work together. While this budget may be flawed, I believe we can and we must constructively move forward to get our jobs done. That is why my regrettable conclusion is that this budget is just barely breathing.
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It has a $69 billion deficit in the year 2002. It raises taxes. It increases welfare spending by $21 billion. The deficit goes up from now through the year 2000, while 98 percent of the spending reductions come in the final 2 years, after the President has left office.
Its tax cuts are temporary while its tax hikes are permanent. The budget contains 42 separate revenue raisers adding up to $73.3 billion in higher taxes over 5 years and $150.6 billion over 10 years.
Three of these provisions are particularly noteworthy. They threaten worker's salaries by hiking the payroll tax. They raise taxes on 10 million middle-income investors, and possibly 15 million middle-income investors, and they penalize companies that create export jobs.
I am talking about the extension of the FUTA tax, the average cost basis proposal for taxing investors and the export source rule. I believe there is bipartisan opposition to these proposals that is widely shared on this Committee.
Just as I did last year, I am prepared to take action to modernize the Tax Code by reforming or eliminating anachronistic provisions, but I intend to protect the taxpayers from provisions that increase the taxes on hard-working Americans, threaten their salaries or cost them jobs, especially high-paying, good, export-related jobs.
I hope the President will agree to modify his budget so it is balanced and that he will do so without raising taxes or increasing welfare spending. If he does, he will aid our efforts to reach agreement on a budget resolution that can be supported by Republicans, Democrats, and the White House.
In all cases, we must move forward and I hope we can do so together. That is why we must fulfill our responsibility to have a budget resolution on the floor in May.
I, again, extend an open hand to the President: Give us a budget that is in balance, while providing permanent tax relief, and we will reach an overwhelmingly bipartisan agreement on a budget resolution.
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That is the best way for us to work together to complete the job the American people sent us here to do. And I yield to Mr. Rangel, the Ranking Minority Member of the Committee, for any statement he would like to make.
Mr. RANGEL. Thank you my friend, Mr. Chairman.
I assume everybody that will be testifying today would want to balance the budget and cut taxes, and that is good. That is the political thing for us to do. But somehow the last time we thought this way, 90 percent of the revenue that was raised was raised from programs that affect the poor. I would like to turn that around.
If we are really going to reduce taxes and balance the budget, we all ought to share in that effort. But, no matter how many books have been written on it, no one has said it better than Senator Russell Long when he said, ''Don't tax me, don't tax thee, tax the person behind the tree.''
So, we are going to see today who is behind the tree. I know it is not going to be any of the witnesses before us today. I also appreciate the fact that my Chairman wants to protect those high-paying jobs. We need those people out there.
So, since all revenue increases are difficult, I personally do not see how, in good conscience, we can talk about a tax cut. We all know the entire country really enjoys a tax cut. But we need to reduce our deficit. These were the things economists have been talking about, Greenspan says that deficit reduction is important to return the economy to one that is evergrowing and prosperous. It is just the Republican type of thinking that we should not be paying more than we get in.
But if you are going to reduce what we bring in, then we are going to have a problem in deciding where we are going to raise the revenue.
Mr. Chairman, it just seems to me that if we do not like what the President has sent to us in terms of a budget, and I am not in love with it myself, what we ought to do is come up with another plan. But if all we are going to do is to tell the President of the United States to keep preparing budgets until we feel he has done it right, then we may have a longer haul than the Members of this Committee want.
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It would help me a great deal if the witnesses today would volunteer whether they want a tax cut and a balanced budget. If each of you will let me know how you feel about tax cuts now, I will not have to ask you separately. It will make it a lot easier for us to understand each other. If everyone says they want a big tax cut—that we give this money back to the American people—but they still want to hold on to their incentives—which others, of course, will call welfare and loopholes but for purposes of fairness we will call it incentives—then it will be hard to accomplish our deficit reduction goals. If you are not behind the tree to be taxed, who is?
Thank you, Mr. Chairman.
Chairman ARCHER. We are pleased to have a panel of extremely competent witnesses this morning and our real purpose this morning is to evaluate the President's tax proposals that are in his budget.
Each of you is qualified to do that in perhaps a little different way. We are delighted to have you with us and Mr. Hayes, would you commence.
Let me say that the ground rules—probably most of you know this—but the ground rules in the Committee are that we would like for you to keep your oral testimony within 5 minutes if at all possible. Your entire written statement without objection will be included in the record. And if you, at the beginning, will identify yourself and whom you represent or with what organization you have a role, before commencing your testimony, we would appreciate that.
[The opening statement of Mr. Ramstad follows:]
INSERT OFFSET FOLIO 13 HERE
[The official Committee record contains additional material here.]
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Chairman ARCHER. Mr. Hayes, would you commence.
STATEMENT OF RICHARD A. HAYES, SENIOR VICE PRESIDENT, CORPORATE TAX DEPARTMENT, WELLS FARGO & CO., LOS ANGELES, CALIFORNIA; AND CHAIRMAN, TAXATION COMMITTEE, AMERICAN BANKERS ASSOCIATION
Mr. HAYES. Thank you, Mr. Chairman.
Mr. Chairman and Members of the Committee, I am Dick Hayes, senior vice president of Wells Fargo & Co. I am pleased to appear before you to present ABA, the American Bankers Association's, views on the revenue raising provisions of the administration's fiscal year 1998 budget proposal.
At the outset, I would like to commend you, Mr. Chairman, for holding these hearings. We are also particularly appreciative of your efforts with respect to expanding IRAs, cutting capital gains, and reforming the death tax. We agree the benefits to be gained from these proposals would be severely hampered by the budget's revenue raising provisions that I will discuss today. I will summarize a few of the issues raised in my written testimony and ask that both be included in the official record.
The provisions we find offensive share certain common characteristics. They are actually across-the-board corporate tax increases or significant tax policy changes rather than loophole closers. They are targeted at current provisions which are not, in fact, abusive and they will cause harm to the corporate community and its stockholders. We believe that the better course would be to equalize the business playingfield by closing genuine loopholes.
For example, limiting the proliferation of multiple common bond credit unions that have expanded their membership and customer base far beyond the parameters of their original common bond is a sorely needed loophole closer which we would respectfully offer for your consideration.
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The examples of the proposed provisions to which ABA strongly objects include the following proposed changes: Information reporting penalties, NOL, net operating losses, and S corporation rules.
Dealing first with the information reporting penalties, the information reporting penalty change will not improve compliance. Penalties typically are intended to discourage bad behavior and encourage good behavior, not to serve as revenue raisers.
The banking industry prepares and files information returns annually in good faith for the benefit of the IRS. We take particular umbrage with the suggestion that this proposal reduces corporate welfare or closes a corporate loophole in that it presumes noncompliance, a conclusion for which there is no substantiating evidence.
Second, in connection with NOL, the net operating loss carrybacks, limiting the NOL carryback to 1 year would add further distortion to the reporting of income in cyclical businesses since business cycles do not necessarily conform to the beginning and end of a 12-month taxable year.
The provision also effectively tilts the scale to the benefit of IRS which will receive a time value of money benefit.
Additionally, reducing the NOL carryback period could have an adverse impact on a bank's regulatory capital. For regulatory capital purposes, the value of the carryback would be reduced to the amount of taxes paid in the 1 year prior to the NOL.
The decrease in NOL value would not be compensated by an increase carryforward period because bank regulatory agencies have a capital limitation on deferred tax assets such as carryforwards that are dependent upon future taxable income. This significant tax policy change is unwarranted and should not be a part of the budget legislation.
Next, the repeal of code section 1374. As you know, the 104th Congress recently allowed banks and thrifts to elect S corporation status, a change for which we are greatly appreciative. However, the repeal of code section 1374 or so-called large S corporations, would make the cost of conversion to S corporation status prohibitively expensive for the majority of eligible banks and thrifts.
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This proposal would accelerate net unrealized built-in gains and create a corporate shareholder level tax with respect thereto. It may effectively close the window of opportunity for banks and thrifts to elect S corporation status and it is particularly unfair since these institutions never had the opportunity to elect S corporation status when they commenced business.
Additionally, there is a need for a technical correction with respect to qualified subchapter S subsidiaries that would allow electing parents to treat banks and thrifts as a qualified subchapter S subsidiary without changing its status under the particular rules that affect banks.
In conclusion, I appreciate this opportunity to present the ABA's views and I would be pleased to answer any questions you may have.
Thank you very much.
[The prepared statement follows:]
Statement of Richard A. Hayes, Senior Vice President, Corporate Tax Department, Wells Fargo & Co., Los Angeles, California; and Chairman, Taxation Committee, American Bankers Association
Mr. Chairman and members of the Committee, I am Dick Hayes, Senior Vice President, Corporate Tax Department, Wells Fargo & Co. As chairman of the Taxation Committee of the American Bankers Association (ABA), I am pleased to appear before you today to present the views of the ABA on the revenue raising provisions of the Administration's fiscal year 1998 budget proposal.
The ABA brings together all elements of the banking community to best represent the interests of this rapidly changing industry. Its membership—which includes community, regional, and money center banks and holding companies, as well as savings associations, trust companies, and savings banks—makes ABA the largest banking trade association in the country.
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The Administration's 1998 budget proposal contains several significant proposals about which we are deeply concerned. Although we support legislative efforts to curtail tax abusive transactions, certain of the corporate reform proposals have been inaccurately and pejoratively categorized as ''corporate welfare'' and ''loophole closers.'' Some of the revenue-raising proposals are actually across-the-board corporate tax increases rather than ''loophole closers.'' Others involve reductions on tax expenditures that were enacted to achieve a specific social or economic policy objective. In this connection, many of the Administration's corporate revenue raising proposals would be more properly addressed under the rubric of overall tax reform and should not be included in this budget legislation.
We strongly object to the use of the term ''corporate welfare.'' The term ''welfare'' is generally used to describe governmental assistance given to needy individuals during a difficult period in their lives. It connotes receiving ''something in exchange for nothing.'' The corporate tax law does not contain any analogous provisions. Corporate tax incentives are generally intended to induce or support specific taxpayer actions that achieve specified social and economic policy goals. Accordingly, the term corporate welfare is, at best, misleading. A ''loophole'' is generally considered to mean a hidden flaw in the tax law the exploitation of which does not reflect the intent of Congress. While we generally support the closing of loophole transactions, many of the Administration's proposals would, in effect, penalize the legitimate business activities of corporations for no other reason than to raise needed revenue.
In this regard, the current corporate reform debate seems to disregard the fact that the corporate income tax is ultimately paid by individuals. It also disregards the vital role played by corporations in our domestic economy. According to New York Stock Exchange statistics, a great many taxpayers have linked their economic futures to that of corporate America. More than one American in three owns stock, much of it through mutual funds and retirement accounts. Corporate America employs directly over 20 million taxpayers (more than one fifth of all domestic wage and salary workers). Thus, indeed, a hit to corporations will ultimately be felt by individual taxpayers. Given the technological innovations of today's competitive market place, this is not the time for Congress to further disadvantage domestic business entities by curtailing much needed corporate tax incentives. Rather, Congress could better equalize the business playing field by closing genuine loopholes. For example, credit unions that have expanded their membership/customer base far beyond the parameters of their original common bond continue to be exempt from taxation and compete, unfairly, with commercial banks and thrifts. Limiting the proliferation of multiple common bond credit unions is a sorely needed loophole closer, which we would respectfully offer for your consideration.
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We support the proposals to expand the availability of Individual Retirement Accounts, and to reduce the taxation of capital gains and estates involving closely held business. However, the Administration's revenue raising proposals will inhibit job creation, inequitably penalize business and lessen the overall economic stimulative impact of the budget proposal. In my statement today, I will discuss the proposals that we find most troubling.
Revenue Raising Proposals
Increased Information Reporting Penalties
The Administration proposes to raise the penalties, under section 6721, for failure to file correct information returns from the current $50 per return, not to exceed $250,000 during any calendar year, to the greater of $50 per return or 5 percent of the total amount required to be reported. The ABA strongly opposes the Administration's proposal.
The banking industry prepares and files information returns to report items such as employee wages, dividends, and interest (on Forms W–2, 1099–INT, –DIV, –B, –S, and –MISC) annually in, good faith, for the sole benefit of the IRS. The Administration reasons that the current penalty provisions may not be sufficient to encourage timely and accurate reporting. We disagree. Information reporting penalties were raised to the current levels as part of the Omnibus Budget Reconciliation Act of 1989, P.L. 101–239. The suggestion that this proposal reduces ''corporate welfare'' or closes a ''corporate loophole'' presumes that, irrespective of the legislative actions of the one hundred first Congress, corporations continue to be noncompliant, a conclusion for which there is no substantiating evidence.
Further, penalties typically are intended to discourage ''bad'' behavior and encourage ''good'' behavior, not to serve as revenue raisers. Let's presume that the new penalty levels achieve the Administration's goal of decreasing the number of taxpayers that incur penalties. In the next budget, will we have another proposed increase in the penalties in order to maintain the revenue flow? Certainly, the proposed increase in penalty is unnecessary and would not make sound tax policy.
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Modify Net Operating Loss (NOL) Carry-Back and Carry-Forward Rules
The ABA opposes the Administration's proposal to limit carry-backs of net operating losses (NOLs) to one year and extend carry-forwards to twenty years. Current law permits NOLs to be carried back three years and carried forward fifteen years to correct income distortions resulting from losses reported at the end of the taxable year. In many instances, NOLs result from general business cycles. This is particularly true for the banking industry, whose performance, over time, tends to mirror the financial ups and downs of its customers. Business cycles often last longer than twelve months and do not necessarily conform to the beginning and end of a taxable year. Accordingly, a one-year carry-back limitation would further distort and prevent accurate reporting of income for the combined period and of the current and previous taxable years.
In its explanation of the reason for change, the Administration cites the increased complexity and administrative burden associated with carry-backs vis-a-vis carry-forwards. This rationale is inconsistent with sound tax policy and is not an adequate justification for so significantly limiting the NOL carry-back period. The notion of a carry-back has always had a quasi-equitable component to it—i.e., it allows a taxpayer, struggling with a financial downturn, to receive a cash infusion from the refund of previously paid taxes. The proposed one-year carry-back effectively tilts the scale to the benefit of the IRS, which will receive a time value of money benefit. Refunds would be paid at some point in the future rather than currently.
Additionally, reducing the NOL carry-back period could have an adverse impact on a bank's regulatory capital. The value of the carry-back for regulatory capital purposes would be limited to the amount of taxes paid in the year prior to the operating loss rather than the total amount of taxes paid in the three previous years.
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Increasing the life of a net operating loss carry-forward from fifteen to twenty years is not likely to compensate for this immediate reduction in the value of net operating loss carry-backs. Current regulations cap the amount of net operating loss carryforwards that can be included in regulatory capital to the lesser of the amount that can be realized within one year or 10% of Tier 1 capital.
Bank regulatory agencies have a capital limitation on deferred tax assets (such as net operating loss carry-forwards) that are dependent on future taxable income. The capital limitation does not apply to net operating loss carry-backs because they are not dependent on future taxable income. The amount of deferred tax assets that are dependent on future taxable income (such as net operating loss carry-forwards) that can be included as regulatory capital is the lesser of:
• The amount of deferred tax assets that the institution expects to realize within one year based on its projection of taxable income, or
• 10% of Tier 1 capital, net of goodwill and intangible assets other than mortgage servicing rights and purchased credit card relationships.
Accordingly, we suggest that this proposal not be included in the budget package.
Modify Foreign Tax Credit (FTC) Carryover Rules
The ABA opposes the Administration's proposal to limit carry-backs of foreign tax credits (FTCs) to one year and extend carry-forwards to seven years. The proposed FTC carryover limitation would further distort and prevent the accurate reporting of income for previous years. The Administration's explanation for the proposed limitation on FTC carry-backs cites increased complexity and administrative burden associated with carry-backs as opposed to carryforwards. The Administration's rationale is inconsistent with sound tax policy and is not an adequate justification for so significantly limiting the FTC carry-back period. For the reasons set out above, there is little, if any, justification for making such a significant tax policy change. We suggest that this proposal not be included in the budget package.
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Repeal Section 1374 for Large Corporations
The ABA opposes the proposal to repeal Internal Revenue Code section 1374 for large S corporations. The proposal would accelerate net unrealized built-in gains (BIG) and create a corporate level tax on BIG assets while also creating a shareholder level tax with respect to their stock. The BIG tax would apply to gains attributable to assets held at the time of conversion, negative adjustments due to accounting method change, intangibles such as core deposits and excess servicing rights and recapture of the bad debt reserve.
Financial institutions were permitted to elect S corporation status for the first time pursuant to the provisions of the Small Business Jobs Act. Effectively, this proposal would shut the window of opportunity for those financial institutions to elect S corporation status by making the cost of conversion prohibitively expensive for the majority of eligible banks. We believe such a change would be contrary to Congressional intent.
Additionally, we note that technical correction legislation is necessary with respect to the treatment of nonfinancial institution S corporations that hold S bank or thrift corporation subsidiaries. Under current law, an S corporation is allowed to own a and elect S corporation status for a ''qualified subchapter S subsidiary'' (QSSS). If a nonfinancial institution parent corporation elects to treat a bank or thrift subsidiary as a QSSS, the QSSS is not treated as a separate corporation and all the assets, liabilities, and items of income, deduction, loss and credit of the subsidiary are treated as the attributes of the nonfinancial institution parent corporation. A technical correction is necessary to allow Treasury regulations to provide that an election to treat a bank subsidiary as a QSSS would not change the status of either the nonfinancial institution parent or the subsidiary for purposes of selected provisions of the Internal Revenue Code applicable to banks and thrifts (such as sections 265(b) interest expense disallowance; 582(c) bad debts and 6050P returns relating to cancellation of indebtedness).
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With respect to thrifts, Section 593(e), as amended by the Small Business Job Protection Act of 1996, provides that distributions by a thrift to its shareholders are taken first out of earnings and profits (E&P) then out of the frozen base year reserves. Moreover, when a C corporation becomes an S corporation, it retains its accumulated C corporation E&P; however, it does not accumulate any additional E&P while it remains an S corporation. According to recent IRS pronouncements, failure to have C corporation E&P may trigger unintended reserve recapture under section 593(e). In order to make subchapter S benefits available to all eligible thrifts, S corporation earnings should be counted as E&P for section 593(e) purposes. We would urge that such technical corrections legislation be included in the instant tax legislation.
Limit Dividends Received Deduction
The ABA strongly opposes the Administration's proposals to reduce the dividends-received deduction (from 70 percent to 50 percent for corporations owning less than 20 percent of the stock of a U.S. corporation), modify the holding period requirement, and to deny the deduction on limited term preferred stock. In explaining the proposed changes, the Administration states, inter alia, that the 70 percent deduction is too generous; that the holding period requirement does not assure that the owner of stock bears sufficient risk of loss; and that the current rules for the deduction are too complex. We disagree. The ABA, along with other members of the financial services community, has steadfastly opposed limitation of the dividends received deduction.
The dividends-received deduction mitigates multiple level taxation of earnings from one corporation paid to another. Originally ''corporations were not taxed on dividends received from other corporations in order to prevent multiple taxation of corporate earnings as the earnings passed from one corporation to another possibly within the same chain of ownership.''(see footnote 1) The deduction was first cut back (to 85%) in an attempt to simplify corporate structures and to discourage the use of multiple entities for tax avoidance. However, the deduction remained at 85 percent until 1986, when it was reduced to 80 percent. It was further scaled back in 1987 to 70 percent. In several years since, the deduction has been on the ''usual list of suspects'' almost anytime revenue is needed. Currently, the dividends received deduction is a necessary tool in maintaining corporate viability rather than an implement of tax avoidance. The dividends received deduction does not constitute ''corporate welfare'', nor should it be considered a ''corporate loophole.'' Cutting back the deduction from 70 percent to 50 percent would not only be a tax increase but, in effect, a move closer to imposing a full triple tax on profitable banks and thrifts.
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The Administration has a separate proposal that would deny the interest deduction for certain debt instruments and reclassify certain other debt instruments, because such instruments have ''substantial equity features.'' If the Administration is successful in curtailing the dividends-received deduction to 50 percent (and perhaps even further in the future), we wonder whether such reductions put even greater pressure on issuers to avoid equity instruments and structure debt instruments to achieve their corporate goals?
Reducing the dividends received deduction, as proposed, would also disrupt the preferred stock market with resulting harm to investors, such as IRAs, pensions funds and corporations. The holding period changes would create uncertainty for preferred stock investors as to the availability of the deduction, discourage market-driven hedging practices, and impose significant compliance costs on companies with large portfolios. It would also further erode U.S. competitiveness. We do not believe that tax policy should sacrifice equity in order to achieve simplicity. We strongly urge that this proposal not be included in the 1998 budget package.
Basis of Substantially Identical Securities Determined on an Average Basis
The ABA opposes the Administration's proposal to require taxpayers to determine their basis in substantially identical securities using the average of all of their holdings in securities. We also oppose the proposal to require that taxpayers use a first-in, first-out method for purposes of determining whether gain or loss on the sale of a security is long or short term. These proposals would unnecessarily create additional and complex recordkeeping burdens. Taxpayers would be required to maintain two sets of records for each investment: one for average cost (which must be adjusted at the time of each purchase) and another for acquisition dates (which must be adjusted at the time of each purchase or sale). The burden would be further complicated for taxpayers who maintain computerized records. Programming, in and of itself, in order to establish, maintain and adjust two sets of records at the time of each transaction, would be substantial. We oppose the significant imposition of costs and compliance burdens associated with the proposal to change the timing aspects of reporting gain or loss from the sale of stock or securities. This proposal is not targeted toward abuse, but is a significant tax policy change with respect to the timing of reporting gain or loss from the sale of stock and is inappropriate for inclusion in the budget.
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Require Reasonable Payment Assumptions for Interest Accruals on Certain Debt Instruments
ABA opposes the proposal to require prepayment assumptions for interest accruals that would cause credit card issuers to pay tax on grace period interest before having a fixed right to the income. The proposal would require issuers to include in currently taxable income an estimate of the amount of grace period interest that will accrue in the future. This estimate would be based on the credit card issuer's assumptions of the likelihood that its credit card customers will not pay their entire balance before the end of the applicable grace period. This proposal effectively repeals the longstanding and long accepted ''all events'' standard in this area. It is not a ''loophole closer'' nor does it constitute ''corporate welfare.'' Moreover, this proposal can only be viewed as a tax increase and an arbitrary departure from well established tax policy.
Other Issues
The Administration's proposal contains a number of other provisions to which we object as being harmful to banks and thrifts, as listed below.
• Extend section 265 pro rata disallowance of tax-exempt interest expense to all corporations;
• Registration of confidential tax shelters;
• Deny the interest deduction on certain debt instruments; and
• Defer the deduction on certain convertible debt.
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Conclusion
I appreciate having this opportunity present ABA's views on the revenue raising provisions contained in the President's fiscal year 1998 budget proposal. We look forward to working with you in the future on these most important matters. I would be pleased to answer any questions you may have.
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Chairman ARCHER. Thank you, Mr. Hayes.
Our next witness is Arthur Hyde. If you would identify yourself, you may proceed.
STATEMENT OF ARTHUR D. HYDE, MANAGING DIRECTOR AND HEAD, CORPORATE DEBT, SALOMON BROTHERS, INC., NEW YORK, NEW YORK; AND CHAIRMAN, CORPORATE BOND DIVISION, PSA THE BOND MARKET TRADE ASSOCIATION
Mr. HYDE. Thank you, Chairman Archer, Mr. Rangel, and good morning. My name is Arthur Hyde, and I am managing director of Salomon Brothers, Inc., in charge of corporate debt. I am also chairman of the corporate bond committee of PSA. I am pleased to be here to present PSA's views on some of the revenue raising tax proposals in the Clinton administration's fiscal year 1998 budget.
My specific focus is those proposals which affect corporate and municipal bonds. I begin by stating that PSA strongly disagrees that the debt instruments I will discuss today are being issued by corporations in order to exploit tax loopholes. These securities provide issuers with efficient and flexible capital raising alternatives to finance investment. They have been embraced by investors small and large and fill important gaps in their portfolios.
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Moreover, the PSA questions whether these proposals will generate the revenues projected by the administration. And it is clear to us that on the margin they will inhibit capital formation.
Chairman ARCHER. Mr. Hyde, there are some of us up here who have gotten along in life and whose ears are not quite as good as others, and a comment or two that you have made cannot be totally understood. So, if you could move the mike just a little bit closer to you, that would be great. We will put that time back on your record that I have taken away from you.
Mr. HYDE. Thank you.
Chairman ARCHER. Thank you.
Mr. HYDE. One administration proposal would prohibit corporations from issuing debt with maturities longer than 40 years. The administration has drawn an arbitrary line as to the maximum maturity of a debt instrument with no apparent justification.
Under the proposal, a 40-year bond would qualify for an interest expense deduction but a 41-year bond would not. With all due respect to the U.S. Treasury, debt does not magically turn into equity after 40 years. Maturity should not be a decisive factor. Debt holders are creditors, and stockholders are owners. Interest is a business expense, and dividends are paid out of profits. Nonpayment of interest is an event of default, nonpayment of dividends is not. Creditors can force issuers into bankruptcy, preferred stockholders cannot. Creditors' claims in bankruptcy are senior to equity holders.
Debt instruments with very long maturities have provided certain borrowers, including domestic and foreign corporations, with secure, low-cost, long-term capital. Why frustrate that process?
Prohibiting U.S. corporations from deducting payments on long-term debt would cutoff domestic companies from this important source of funding, while allowing foreign corporations a competitive advantage as they tap U.S. investor's funds.
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Another administration proposal would effectively prohibit corporations from issuing fixed-rate capital securities with maturities longer than 15 years. Fixed-rate capital securities have all the characteristics of debt. Perhaps most important, they are regarded as debt in the way they are priced and traded.
The administration argues that fixed-rate capital securities, longer than 15 years, are more like equity than debt due to their accounting treatment. PSA disagrees. The market disagrees.
By any reasonable definition of debt, they qualify. Moreover, they provide low-cost, long-term capital for corporations and added flexibility under times of stress which strengthens U.S. corporations' capital base.
It is for this very reason that the Federal Reserve made the conscious decision last fall to let banks issue these securities. Since then, over $25 billion has been issued and our financial system is all the stronger for it.
The administration has also proposed reducing DRD, the dividends received deduction, to 50 percent from 70 percent and eliminating it altogether for certain preferred stock. Reducing the DRD would exacerbate one of the most egregious problems in our tax system, the multiple taxation of corporate earnings.
It would represent a direct tax increase, not just on corporations that hold preferred stock and qualify for the DRD, but also on corporations that issue DRD-eligible preferred stock.
Another administration proposal would force corporations that issue convertible debt with OID, original issue discount, to defer their OID deduction until the interest was actually paid in cash. However, investors would still be required to recognize and pay taxes on their accrual of OID.
This proposal violates the basic tenet of tax symmetry, that a deduction by one taxpayer be offset by a recognition of income by another.
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Finally, the administration has proposed denying a portion of interest expense deduction for corporations that earn tax-exempt interest on municipal securities. Although nominally a tax increase on corporations, those who would lose the most under the proposal would be State and local governments and their citizens who issued tax-exempt securities to finance investments and manage cash flow. They would face significant increases in capital costs.
PSA fully supports a balanced budget. We believe strongly, however, that tax increases which would raise capital financing costs and discourage new investment are inconsistent with the goals of a balanced budget. We also question whether the proposals would raise the amount of revenue which has been estimated. It is certain the proposals would result in decreased issuer flexibility, higher issuer financing costs, reduced investment alternatives for investors, and place U.S. corporations at a competitive disadvantage relative to foreign corporations.
Again, thank you for the opportunity to be here.
[The prepared statement follows:]
Statement of Arthur D. Hyde, Chairman, Corporate Bond Division, PSA The Bond Market Trade Association
Thank you, Chairman Archer, and good morning. My name is Arthur Hyde and I am a Managing Director and Head of Corporate Debt at Salomon Brothers Inc. I am also the Chairman of the Corporate Bond Division of PSA The Bond Market Trade Association and it is in that capacity that I appear today. I am pleased to be here to present PSA's views on some of the revenue-raising tax proposals in the Clinton administration's fiscal year 1998 budget. PSA represents securities firms and banks that underwrite, trade and sell debt securities, both domestically and internationally. Our membership includes most major dealers in corporate and municipal bonds.
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PSA's members help provide capital financing for corporations and state and local governments throughout the nation. We take a very active interest in issues that affect the cost of capital for issuers of debt instruments. We firmly believe that investment in capital assets, both public and private, in addition to creating jobs, is one of the most important factors that determines productivity. Improved productivity, in turn, is the means by which the standard of living for all Americans improves. We are, therefore, extremely supportive of fiscal policies that raise the levels of savings and investment. For this reason, PSA has long been a vocal advocate of a balanced federal budget. Eliminating the deficit is the most direct way to raise savings rates. Taking the federal government out of the competition for a limited pool of funds available for investment will lower the cost of capital for other borrowers and will result in higher levels of private-sector and state and local capital spending. Indeed, one of the most important reasons for balancing the federal budget is the positive effect on savings and investment.
We are dismayed, therefore, that the administration's plan to balance the budget is based in part on proposed tax increases which would raise the cost of capital for corporations and state and local governments and discourage capital investment. We strongly disagree with the administration's characterization of instruments affected by its proposals although they have been couched as cuts in ''unwarranted corporate tax subsidies'' and as ways to close ''tax loopholes.''(see footnote 2) The proposals which we oppose are really nothing more than tax increases. Moreover, the revenue-raising proposals they are targeted at capital investment, an activity which we feel the tax code should encourage. We feel as you do, Chairman Archer that the tax code ought to foster economic growth. We agree with recent statements you have made that ''raising taxes on job makers, risk takers and investors''(see footnote 3) is the wrong way to balance the budget. We therefore appreciate the opportunity to express our firm opposition to proposed tax increases in the president's budget which would increase the cost of capital for corporations and state and local governments, discourage capital investment and job creation, and otherwise weaken the overall economy.
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There is a number of proposals in the Administrations FY 1998 budget released on February 6, 1997, which would have negative effects on the capital markets and savings and investment.
My statement this morning will focus on the following proposals in the administration's FY 1998 budget released on February 6, 1997:
• Deny interest deduction on certain debt instruments;
• Reduce dividends-received deduction to 50 percent and eliminate dividends-received deduction for certain preferred stock;
• Defer original issue discount deduction on convertible debt; and
• Extend pro rata disallowance of tax-exempt interest expense to all corporations.;
• Defer original issue discount deduction on convertible debt; and
• Require reasonable payment assumptions for interest accruals on certain debt instruments.
The staff of the Joint Committee on Taxation has estimated that together, these proposals represent a tax increase on capital investment of over $4 billion over the period 1997–2002, and over $9 billion over the period 1997–2007.(see footnote 4)
When they were originally released in December 1995, the above provisions were proposed with an immediate effective date.(see footnote 5) The result was considerable uncertainty and confusion among capital markets participants. Transactions that were on the verge of execution were suspended. The trading and issuance of certain financial instruments was virtually halted. It took the March 29, 1996 joint statement by Chairman Archer and Senate Finance Committee Chairman Bill Roth on the future effective dates of the pending proposals to put to rest the market's concerns over when the administration's tax proposals would be applied if they were enacted.(see footnote 6) PSA is grateful to you, Chairman Archer, and to Chairman Roth for this clarification. We are also pleased that in its current budget proposal, the administration generally proposed effective dates of ''first committee action'' or final enactment with regard to the above proposals. However, we remain steadfastly opposed to the substance of the proposals on their substance. In addition, even the more sensible effective dates proposed by the administration this year raise significant questions regarding the effect that the proposals would have on the value of certain outstanding financial instruments, especially preferred stock, if the tax treatment of their future payments was changed adversely.
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In our written statement to the Ways and Means Committee last year,(see footnote 7) we outlined some of the political opposition to the administration's tax proposals that had arisen since their release in December 1995. Since our statement last year, that political opposition has intensified. Indeed, we are aware of no public expression of support for the proposals by any member of Congress in the 15 months since their original release apart from members of the administration. PSA has compiled a collection of statements by numerous members of Congress and market participants opposing the above proposals which outlines the scope and breadth of opposition. We will be happy to make this compilation available to Committee members and staff.
The Characterization of Debt and Equity
Three of the administration's proposals outlined above relate to the taxation of financing instruments issued by corporations. Corporations have available to them two ways to finance capital investment: equity and debt. In general, because they are business expenses, payments or accruals on debt are characterized as interest and are deductible for corporate taxpayers. Payments on equity instruments are characterized as dividends and generally are not deductible. The non-deductibility of dividends on equity capital, discussed further below, results in the multiple taxation of corporate earnings, which in turn makes the after-tax cost of equity capital much higher than it would otherwise be. Because of the multiple taxation of corporate earnings corporate interest expense deduction, debt is a favored form of capital under our system of corporate income taxation not from any justifiable policy consideration, but simply as a historical anomaly. For this reason, tax considerations play a role in a corporation's choice of financing mechanism. However, the decision to raise capital in the first place is not tax-motivated. Corporations issue securities and raise capital, debt or equity, because the expected returns on the assets financed from the proceeds of the securities is attractive. The deductibility of payments or accruals on debt capital securities, therefore, can not be reasonably characterized as a tax loophole or benefit.
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The administration's proposals related to corporate financing instruments reflect a fundamentally new approach to the characterization for tax purposes of corporate debt and equity, an approach which is a radical departure from accepted tax policy and which would entail negative consequences for corporate investment in capital assets. Indeed, the administration's proposals represent a significant departure from existing Internal Revenue Service (IRS) rules and practices regarding the classification of debt and equity. Currently, in distinguishing between the two, the IRS considers the following eight factors:(see footnote 8)
• whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future;
• whether holders of the instruments possess the right to enforce the payment of principal and interest;
• whether the rights of the holders of the instruments are subordinate to rights of general creditors;
• whether the instruments give the holders the right to participate in the management of the issuer;
• whether the issuer is thinly capitalized;
• whether there is identity between holders of the instruments and stockholders of the issuer; the label placed upon the instruments by the parties; and
• whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency, or financial accounting purposes.
According to the IRS, ''no particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity. The weight given to any factor depends upon all the facts and circumstances and the overall effect of an instrument's debt and equity features must be taken into account.'' As discussed below, however, the administration's proposals would impose new, arbitrary criteria which would supersede a more reasonable ''facts-and-circumstances'' evaluation of particular financing instruments.
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Although we do not necessarily disagree with a ''facts-and-circumstances'' approach to distinguishing between debt and equity, the existing guidelines leave unanswered questions regarding the tax status of particular financial instruments and products. Even more important, the guidelines fail to recognize some fundamental differences in the nature of the income derived from debt and equity instruments and place undue emphasis on accounting factors in distinguishing between the two. PSA believes that there are several general, guiding principles that should apply in defining debt and equity for tax purposes. Before addressing the administration's proposals specifically, a discussion of these principles would be useful.
Single Taxation of Corporate Earnings
The problem of double and triple taxation of corporate profits under prevailing tax law is a fundamental concern for PSA under prevailing tax law. Because corporate equity is not afforded the same tax treatment as debt, corporations' earnings are often taxed multiple times. If a corporation holds stock in another corporation, it is taxed on the dividends paid on that stock to the extent that the dividends do not qualify for the dividends-received deduction (DRD). It is also, of course, taxed on its earnings from all other sources. If the corporation pays dividends to a tax-paying investor, that investor pays taxes on the dividends. To the extent that accumulated, unpaid earnings are represented in the appreciated price of a stock, those earnings are taxed as capital gains when shares are sold by a taxable investor. If the stock is part of an estate, the holdings are taxed when the estate is distributed. The effect of these multiple levels of taxation is to raise financing costs for corporations, reducing incentives for capital formation, and creating serious concerns about global competitiveness.
Ultimately, the solution to the problem of multiple taxation of corporate earnings short of moving to an entirely new system of taxation, such as a consumption tax is to integrate fully the corporate and individual tax systems. Many of the proposals for corporate tax integration which have been circulated in recent years suggest either abolishing the corporate income tax altogether and taxing all corporate earnings at the level of investors, or exempting investment earnings from taxation at the individual level and fully subjecting all corporate earnings, whether paid as interest or dividends, to the corporate income tax.(see footnote 9) PSA would fully support further study and consideration of the issue of corporate tax integration with the goal of amending the federal tax code to ensure that corporate earnings are not taxed more than once. Ultimately, we would favor a tax system without arbitrary distinctions between debt and equity and where financing decisions were made solely on the basis of the lowest cost source of capital. In the end, these issues would be more appropriately considered in the context of a fundamental review of the entire tax system. Short of fully integrating the individual and corporate tax systems, however, we firmly believe that in cases where a reasonable question exists as to the characterization of an instrument as debt or equity, tax law should err on the side of favor treatment as debt so as to minimize the problem of multiple taxation.
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The Nature of Equity Investment
Equity and debt investments are fundamentally different in an important sense. An investor typically buys an equity instrument as a way to participate directly in the long-term growth of the issuing corporation. Such is the case with common stock. Debt investments do not afford this benefit to holders. In buying a debt instrument, an investor is purchasing an income stream or interest accrual, not a participation in the success or failure of a company. It is true that a debt investor can benefit from a corporation's strong performance if a corporation's financial condition improved enough so that its credit rating were upgraded, for example or can be hurt by a corporation's poor performance if a corporation were downgraded or the company went bankrupt. However, the potential risks and rewards of a corporate debt investment related to the performance of a company usually represent only a very small aspect of an investor's total return on his or her investment.
Ultimately, the characterization of an instrument as equity or debt should rest on whether by buying the instrument in question, an investor is purchasing a direct participation in the long-term growth of the issuing corporation, or a stream of cash flows based on an agreed upon rate. A reasonable test to distinguish debt and equity might include the following questions:
• Does the instrument have a fixed maturity?
• Does the holder receive or accrue periodic income at an agreed-upon rate?
• Does the instrument offer the holder the opportunity to participate in the growth or decline of the company during the period in which payments are made or accrued?
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• Can the obligations of the issuer be enforced? Can a default force the issuer into bankruptcy or, ultimately, liquidation?
For most financial instruments, the distinction between debt and equity is obvious. Common stock clearly is equity. Senior and subordinated corporate bonds clearly are debt. Traditional preferred stock, since it represents an interest in a stream of fixed dividend payments, also would fall under the definition of debt. Fixed-rate capital securities(see footnote 10) also represent interests in fixed streams of payments, and therefore would be debt.
Accounting Treatment and Tax Policy
How a financing instrument is treated under accounting rules should play no role in determining its tax treatment. Distinguishing between debt and equity for accounting purposes serves a goal fundamentally different from that for tax purposes. The characterization of financial instruments under accounting rules is based on an issuer's payment obligations and an investor's rights in bankruptcy. The rules also provide common definitions and conventions so that the accounting statements of one company are easily comparable to those of another. The distinction under the tax code exists so that similar types of income are afforded similar tax treatment. There is no reason to expect that the treatment of a given financial instrument under the tax code should necessarily mirror its treatment under generally accepted accounting principles (GAAP) or under the information disclosure requirements of securities statutes and regulations.
Indeed, relying on accounting rules as the basis for how a particular instrument is taxed would effectively grant tax policy authority to the Financial Accounting Standards Board and the Securities and Exchange Commission (SEC). With all due respect to these two highly regarded organizations, PSA firmly believes that tax policy authority should rest with Congress and, to the extent such authority is granted in law, the Treasury Department. The designation of certain hybrid financial instruments as non-debt liabilities in SEC filings, for example, relates to accounting concerns with respect to their status in bankruptcy, not to the nature of the income or other benefits received by the holder or to the obligations of the issuer.
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Deny Interest Deduction on Certain Debt Securities
The administration's budget plan contains a proposal to deny corporate interest expense deductions for debt with a maturity longer than 40 years and instruments with maturities longer than 15 years not characterized as debt in an issuer's SEC filings. This proposal appears to be aimed at eliminating the interest deductibility of innovative new financial instruments, such as fixed-rate capital securities. These instruments are issued by a wide variety of companies, including banks, utilities, insurance companies, media and telecommunications companies, energy companies and manufacturers. They are bought by both institutional and retail investors. In 1996, U.S. corporations raised over $3224 billion of investment capital through the sale of these instruments. Since 19931, corporations have issued over $62388 billion of fixed-rate capital securities.
Fixed-rate capital securities are popular among corporations because by providing a long-term, fixed-rate source of capital that is junior to all other debt but senior to all equity, they fill an important void in a corporation's capital structure. Traditional preferred stock, for a variety of reasons, is an expensive and relatively unattractive source of capital for most corporations. Alternatively, by relying too much on senior and even subordinated debt, corporations run the risk of becoming ''over-leveraged.'' Fixed-rate capital securities can fill an important gap in many corporations' balance sheets. Most forms of fixed-rate capital securities offer corporate issuers the added feature of the deferability of interest payments. In most cases an issuer can, if necessary, defer payments on fixed-rate capital securities for up to five consecutive years. The deferral entails several requirements. A corporation must first stop paying dividends on all common and preferred stock. During the deferral period, interest continues to accrue and is treated under current tax rules for tax purposes as original-issue discount. At the end of five years, if the issuer is still unable to make payments to fixed-rate capital securities investors, its obligations are fully enforceable. Nevertheless, the ability to defer payments in a time of stress is attractive and gives corporations a great deal of financial flexibility. Conceivably, for example, it could prevent a corporation from taking more drastic cost-cutting actions during a downturn, such as lay-offs or plant closings.
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The administration has proposed essentially to prohibit companies from issuing fixed-rate capital securities longer than 15 years apparently on grounds that ''they have substantial equity features (including many non-tax benefits of equity).''(see footnote 11) The administration has characterized this proposal as a way to curb transactions which have ''exploited'' regulatory ambiguity. However, there is no evidence that corporations have in any way attempted to skirt existing distinctions between debt and equity or have otherwise engaged in abusive activity. Indeed, it is only because of a favorable IRS ruling several years ago that fixed-rate capital securities with deductible payments are now able to be issued. The IRS had the opportunity then to take a more aggressive position on the question of interest expense deductibility and chose not to. PSA disagrees with the administration that the current tax treatment of these instruments needs to be changed. Even if the current tax status of these instruments were under debate, fixed-rate capital securities can in no way be reasonably characterized as abusive. Issuers are able to deduct interest payments on fixed-rate capital securities FRCS because these instruments are virtually identical to other forms of corporate debt with regard to payment characteristics and the legal and financial obligations assumed by issuers.
A careful analysis of the affected instruments reveals that they possess the critical attributes of debt. Indeed, Treasury's proposal does not rely on any of these attributes to curtail the interest deductibility of these instruments. Rather, Treasury has focused on the fact that fixed-rate capital securities are not typically shown as debt on a company's balance sheet. The reality is, balance-sheet treatment of these instruments has never before been relevant to their tax treatment and whether they are identified as debt obligations for tax purposes.
Fixed-rate capital securities issued through a trust are a case in point. A company utilizing these instruments issues debt obligations to a trust which, in turn, issues trust securities to investors. The transaction is structured in this way because securities issued through a trust are viewed more favorably by a nationally recognized credit rating agency to improve the attractiveness of the securities to the public. Because these debt obligations are issued through a trust, they are not shown on an issuer's consolidated balance sheet as debt, although the footnotes to the issuer's balance sheet disclose that the sole asset of the trust is the junior, subordinated debt of the issuer status of the obligations as indebtedness is clearly disclosed in a footnote to the company's balance sheet. It should also be noted that fixed-rate capital securities are not characterized as equity on an issuer's balance sheet.
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The balance-sheet characterization of fixed-rate capital securities as non-debt liabilities does not alter the conclusion that the underlying debt securities possess all the critical attributes of debt. This is clearly illustrated by the facts that:
• Investors in these instruments are the legal owners of an undivided interest in the underlying debt obligations, and they enjoy all the creditor legal rights and economic benefits as if they had purchased the debt obligations directly from the issuer, rather than certificates from the trust. In addition, holders of these instruments do not enjoy any participation in an issuing corporation's growth, as do holders of common stock.
• Issuers of these securities despite their ability to extend an interest payment period for up to five years have an absolute obligation to pay interest and principal at maturity. In the case of a default, investors can enforce the obligations of an issuer. Ultimately, the issuer could be forced into bankruptcy or liquidation.
• Holders of fixed-rate capital securities are higher in seniority the ''pecking order'' of payments in the case of bankruptcy than any equity investors.
Contrary to Treasury's revenue projections, this proposal would likely fail to raise revenue. Issuers that are affected by the proposed legislation would either choose to issue hybrid preferred securities with a maturity of 15 years or less, or they would maintain the 15-plus-year maturity of the instruments and issue them directly to investors, rather than through a partnership or trust, albeit at a potentially higher overall cost of capital. In only very few cases limited to commercial banks due to unique regulatory capital rules would an issuer substitute its hybrid financing with equity. In cases where a higher financing cost makes an investment project unfeasible, an issuer would simply not undertake the transaction at all. In any case, Treasury's proposal will ultimately fail to reduce substantially the amount of interest issuers deduct, and it will therefore be unlikely to raise significant tax revenue.
The administration's proposal would also affect corporate debt instruments with maturities longer than 40 years. Here, the administration's distinction between debt and equity is completely arbitrary and capricious. Under the proposal, two otherwise identical debt securities, one with a maturity of 40 years and the other with a maturity of 41 years, would be treated in entirely different ways.
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In the past two years, corporations have taken to issuing debt with very long maturities, sometimes as long as 100 years. The reasons involve the unique market conditions which have prevailed in recent months that have made the transactions attractive to both issuers and investors. Because they can borrow for 100 years at interest rates only slightly higher than, say, 30-year financing, corporations are able to take advantage of stable and long-term financing sources. Domestic corporations are not the only borrowers who have discovered this means of financing. Foreign corporations and governments have also issued 100-years bonds in the U.S. market over the past two years. Since 1990, corporations have raised approximately $8 billion in capital through the sale of 50- to 100-year debt securities. Relative to the corporate bond market overall corporations issued nearly $449 billion in debt securities in 1996 alone instruments with very long maturities represent only a very small portion of total corporate debt financing. However, the instruments provide an attractive, alternative financing source for certain companies.
The administration has offered no explanation as to its choice of 40 years as the criterion for debt. It has also not explained why maturity alone should characterize an instrument as debt or equity when it otherwise has all the characteristics of debt. Any distinction based solely on one factor the maturity of an instrument ignores long-standing definitions and conventions regarding what constitutes debt financing. The administration's proposal would prevent corporations from accessing an efficient source of financing. Foreign corporations, which generally are not burdened by such arbitrary tax policy distinctions as those represented in the president's budget, would still have access to this source of long-term capital and hence would enjoy an advantage over domestic companies. In addition, the administration's proposals would deny debt treatment for certain instruments without fully re-characterizing them as equity so that they would qualify for the dividends-received deduction. These instruments would, in effect, be subject to the worst tax aspects of both debt and equity.
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The administration has proposed capricious, arbitrary distinctions as to what qualifies as debt financing eligible for interest-expense deduction. In addition, the administration's proposals would deny debt treatment for certain instruments without fully re-characterizing them as equity so that they would qualify for the dividends-received deduction. These instruments would, in effect, be subject to the worst tax aspects of both debt and equity.
The definition of equity should rest on more than the criteria proposed by the administration. It should defensible grounds by encompassing only securities whose returns are directly related to the long-term growth of the issuing corporation, such as common stock. Neither long-dated corporate bonds nor fixed-rate capital securities afford this benefit to holders. In both cases, the holder is buying an income stream, not an equity participation.
Reduce Dividends-Received Deduction to 50 Percent and Eliminate Dividends-Received Deduction for Certain Preferred Stock
Under current law, corporate taxpayers that earn dividends on investments in other corporations are permitted a tax deduction equal to at least 70 percent of those earnings. The deduction is designed to mitigate the negative economic effects associated with multiple taxation of corporate earnings. The administration has proposed reducing the minimum dividends-received deduction (DRD) to 50 percent, which would increase the taxation of corporate earnings and discourage capital investment. A companion proposal to eliminate the DRD altogether for preferred stock with certain characteristics would also entail harmful effects.
A generous DRD is important because it reduces the effects of multiple taxation of corporate earnings. As discussed earlier, when dividends are paid to a taxable person or entity, those funds are taxed twice, once at the corporate level and once at the level of the taxpayer to whom the dividends are paid. These multiple levels of taxation raise financing costs for corporations, create global competitiveness problems, and generally reduce incentives for capital formation. The DRD was specifically designed to reduce the burden of one layer of taxation by making dividends largely non-taxable to the corporate owner.
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The administration has argued only that the current 70-percent DRD is ''too generous.''(see footnote 12) It has provided little additional justification for a proposal which would magnify the problem of multiple taxation of corporate earnings and raise the cost of capital investment for U.S. corporations. It has also argued that certain preferred stock, such as variable-rate and auction-set preferred, ''is economically more like debt than stock.''(see footnote 13) However, the administration has not proposed that such instruments be formally characterized as debt eligible for interest payment and accrual deductions. As with the previous proposal to deny an interest deduction for certain debt instruments, the administration has sought to characterize certain preferred stock in such a way as to maximize tax revenue; it would be ineligible for both the DRD and the interest expense deduction.
Scaling back the DRD would exacerbate the effects of multiple taxation. The change would be tantamount to a tax increase on corporate earnings since the minimum deduction available to certain investors would fall. This tax increase would flow directly to issuers of stock, especially preferred stock, who would face higher borrowing costs as investors demanded higher pre-tax yields. Preferred stock is an especially important source of capital for certain corporations and industries, such as commercial banks and utility companies. In response, corporations would tend to cut capital expenditures, reduce working capital, move capital raising and employment overseas, and otherwise slow growth-oriented investment. Amplifying the competitive disadvantages of multiple taxation of American corporate earnings would be the fact that many of our largest economic competitors have already adopted tax systems under which inter-corporate dividends are largely or completely untaxed. Eliminating the DRD altogether for preferred stock with certain characteristics would cut U.S. corporations off from an efficient source of financing. The administration's DRD proposal would thus have a wide range of unintended consequences that would harm the national economy.
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The administration's proposal to reduce the DRD to 50 percent would be effective for ''dividends paid or accrued more than 30 days after the date of enactment.''(see footnote 14) While the proposed effective date can not strictly be characterized as retroactive, it would apply to a large volume of outstanding instruments and would have some very negative consequences for investors and issuers. The proposal would be applied to instruments which were issued and purchased under an assumption of a 70-percent DRD. Reducing the DRD to 50 percent would substantially erode the after-tax value to investors of future payments on these instruments. If a holder sold its investment in the secondary market, its price would reflect the lower, less attractive DRD. In these cases, investors would effectively bear the additional tax liability. A large volume of recently issued outstanding preferred stock was originally sold with ''gross-up'' provisions which essentially require issuers to compensate investors for the additional tax liability associated with adverse changes to the DRD. In these cases, issuers would directly bear the burden of the tax increase. In both cases, taxpayers who made decisions based on prevailing tax policy would be harmed by an adverse change. When the DRD was lowered in previous years, the legislation contained ''grandfather'' provisions to protect issuers and investors who would have been harmed by the change. While we remain steadfastly opposed to the proposal to reduce the DRD to 50 percent, we feel strongly that at the very least it should apply only to stock issued after the date of enactment.
Defer Original Issue Discount on Convertible Debt
The administration has proposed to change the tax treatment of original issue discount (OID) on convertible debt securities. OID occurs when the stated coupon of a debt instrument is below the yield demanded by investors. The most common case is a zero-coupon bond, where all the interest income earned by investors is in the form of accrued OID. Under current law, corporations that issue debt with OID may deduct the interest accrual while bonds are outstanding. In addition, taxable OID investors must recognize the accrual of OID as interest income. Under the administration's proposal, for OID instruments which are convertible to stock, issuers would be required to defer their deduction for accrued OID until payment was made to investors in cash. For convertible OID debt where the conversion option is exercised and the debt is paid in stock, issuers would lose the accrued OID deduction altogether. Investors would still be required to recognize the accrual of OID on convertible debt as interest income, regardless of whether issuers took deductions.
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The administration's proposal is objectionable on several grounds. First, convertible zero-coupon debt has efficiently provided corporations with billions of dollars in capital financing. The change the administration proposes would significantly raise the cost of issuing convertible zero-coupon bonds, and in doing so would discourage corporate capital investment. Second, the administration's presumptions for the proposal are flawed. The administration has argued that ''the issuance of convertible debt with OID is viewed by market participants as a de facto purchase of equity.''(see footnote 15) However, performance does not bear out this claim. In fact, of the convertible zero-coupon debt retired since 1985, approximately 70 percent has been retired in cash, and only 30 percent has been converted to stock. Indeed, the market treats convertible zero-coupon bonds more as debt than as equity.
Third, and perhaps most important, the administration's proposal violates the basic tenet of tax symmetry, the notion that the recognition of income by one party should be associated with a deduction by a counterparty. This fundamental principle exists to help ensure that income is taxed only once. Under the proposal, investors would be taxed fully on the accrual of OID on convertible zero-coupon debt, but issuers' deductions would be deferred or denied. The proposal would compound problems associated with the multiple taxation of investment income, thereby raising the cost of corporate capital.
Because the proposal would exacerbate problems of multiple taxation of corporate income and because it would raise the cost of corporate capital investment, PSA urges the rejection of the administration's proposal.
Extend Pro Rata Disallowance of Tax-Exempt Interest Expense to All Corporations
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Another proposed tax increase in the administration's budget, while it would nominally apply to corporations, would in reality be borne by state and local governments in the form of higher financing costs. Rather than closing a ''tax loophole'' for corporations, the proposal would make it more expensive for state and local governments to finance vital public services.
Under current law, investors, including corporations, are not permitted to deduct the interest expense associated with borrowing to finance purchases of tax-exempt securities. Financial institutions that earn non-qualified tax-exempt interest are automatically disallowed a portion of their interest expense deduction in proportion to the ratio of municipal bond holdings to total assets. Non-bank corporations that earn tax-exempt interest, in order to avoid a loss of interest-expense deduction, must demonstrate that they did not borrow to finance their purchases. Under an IRS procedure in place since 1972, as long as a corporation's tax-exempt bond portfolio does not exceed two percent of its total assets, the IRS does not attempt to determine whether the corporation borrowed to finance its municipal bond holdings.(see footnote 16) This is the so-called ''two-percent de minimis rule.'' The administration's proposal would effectively repeal this ''safe harbor'' and automatically deny corporations that earn tax-exempt interest a pro rata portion of their interest expense deduction. The proposal effectively exempts insurance companies from its proposed new treatment.
The administration's proposal would raise the costs of borrowing for state and local governments, and would make it more expensive to finance new investment. The Treasury Department argues that the proposal would not significantly affect municipal borrowing rates. In a letter sent last year, Treasury Secretary Rubin argues that ''eliminating the 2 percent de minimis rule will not materially affect the costs of borrowing for State and local governments'' because non-financial corporations hold only about 5 percent of outstanding tax-exempt bonds.''(see footnote 17) In other words, the administration argues, the departure of non-financial corporations will at worst have only a minimal influence on total municipal market conditions. While it is true that non-financial corporations account for a small percentage of total municipal securities outstanding, the administration's argument fails to recognize the absolutely vital role they play in important market segments: short-term municipal notes and certain variable-rate securities, state and local government housing and student loan bonds, and municipal leasing transactions. The effects of the administration's proposal would be most felt by state and local governments in these three areas.
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Short-Term Municipal Note Market
State and local governments issue short-term securities to finance a variety of programs and services. The most common use of short-term financing is to fund mismatches between revenues and expenditures. States and localities may incur expenditures before they receive tax and other revenues. Through short-term borrowing, state and local governments can finance temporary cash-flow shortfalls. States and localities also issue longer term bonds that are designed to behave like short-term instruments in order to appeal to certain investors and to take advantage of prevailing market conditions. These longer term ''variable rate demand notes'' (VRDNs) are issued to finance a variety of public investment projects.
Non-financial corporations are major purchasers of short-term municipal notes and VRDNs. Corporations buy short-term municipals as a cash management vehicle. In doing so, corporations finance their municipal investments from surplus cash and working capital accounts, not from the proceeds of borrowing. Corporate investment in the municipal market is almost never tied to corporate borrowing in any way. By participating actively in the short-term market, corporations help to keep municipal borrowing rates incredibly stable. Currently, short-term municipal borrowing rates are approximately 65.5 percent of comparable taxable rates. This ratio has remained virtually constant in recent years, due largely to participation in this market by corporations. The ratio of longer term municipal borrowing rates to taxable rates is much more volatile, ranging in recent years from 75 to 90 percent, since corporations do not actively participate in the market for longer dated municipal bonds. The administration's proposal would effectively discourage virtually all corporate investment in the municipal market. In doing so, the proposal would significantly raise the cost of short-term borrowing for state and local governments and would make short-term municipal rates more volatile relative to taxable rates. We agree with you, Chairman Archer, that the administration's proposal ''would plainly have a negative impact on State and local governments that rely upon tax-exempt debt.''(see footnote 18) We also appreciate your commitment to ''resist attempts to include this provision in any balanced budget agreement.''(see footnote 19) Numerous others in Congress have expressed similar sentiments, including over one-third of the Senate in the 104th Congress,(see footnote 20) and we are encouraged by these expressions of opposition to this short-sighted proposal.
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The administration has argued that the law as presently written permits non-financial corporate taxpayers ''to reduce their tax liabilities inappropriately through double Federal tax benefits of interest expense deductions and tax-exempt interest income.''(see footnote 21) Implicit in the administration's argument is the assumption that corporations have deliberately engaged in arbitrage practices by borrowing in the short-term market and investing in tax-exempt obligations. However, there is no evidence to suggest that corporations are engaging in abusive, arbitrage-motivated transactions. Holdings of municipal bonds have averaged only 0.47 percent of the financial assets and 0.15 percent of the total assets of non-financial corporations since 1987,(see footnote 22) a level that has remained fairly consistent. Moreover, given that the top corporate income tax rate is 35 percent and the short-term tax-exempt/taxable yield ratio hovers around 65.5 percent, the level of after-tax return available to corporations in the municipal market simply does not justify arbitrage transactions.
The Treasury has also argued that ''the treatment of financial institutions and dealers should be applicable to all corporations, without regard to the type of business activity the corporation conducts.''(see footnote 23) In reality, the proposal would result in grossly unfair treatment for a large number of corporations which, under current law, may legitimately invest in the tax-exempt bond market by clearly showing they did not borrow to do so. It would do this through a provision that would extend the pro rata disallowance of interest expense on a combined basis to ''affiliated companies'' that file consolidated returns and by eliminating the present-law analysis of the intent of the corporation.
Non-financial corporations currently purchase a substantial portion of newly issued short-term state and local securities. They are, in effect, buyers of last resort that prevent excessive interest rate volatility. In their absence, short-term, tax-exempt rates would likely rise in times when other short-term investors are net sellers. Non-financial corporations would not be major buyers of short-term municipals in the future under the proposal, with the result being higher, more volatile state and local borrowing rates.
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Housing and Student Loan Bonds
The housing and student loan sectors of the municipal market would also be negatively affected by the administration's proposal. State and local governments issue bonds to finance home mortgage loans for low- and moderate-income families as well as loans for low-income, multi-family rental projects. Both these programs provide limited, targeted, below-market financing for housing. Over the past several decades, state and local housing bonds have provided tens of billions of dollars in rental housing for low-income families and have made home ownership available to families who may not have been able to finance a home through any other source. Student loan bonds are issued to finance below-market loans to college students who may not otherwise be able to obtain tuition financing.
Together, Fannie Mae, Freddie Mac, Sallie Mae and other government-sponsored corporations and agencies hold about $8.6 billion of outstanding municipals. These entities invest primarily in state and local housing bonds (Fannie Mae and Freddie Mac) and student loan bonds (Sallie Mae). Indeed, it is a condition in Fannie Mae's and Freddie Mac's statutory charters that they help support the market for low- and middle-income housing, and investing in state and local housing bonds is one of the ways in which these agencies carry out that obligation. Under the administration's proposal, these organizations would simply stop buying municipals. State and local housing and student loan agencies would become almost completely dependent on individual investors, acting directly or through mutual funds. Individuals tend to be more volatile and less consistent sources of demand. Higher financing costs in these sectors ultimately mean less financing of low- and moderate-income single family and multi-family housing and less student loan financing. a result, the cost of mortgage financing provided through state and local governments would increase substantially.
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Municipal Leasing Transactions
The proposal would also have profound effects on municipal leasing. States and localities routinely lease assets and equipment, such as school buses, police cars, and computers. If the administration's proposal were adopted, equipment lessors estimate that their cost of financing for state and local governments would increase dramatically. After originating municipal lease transactions, most lessors generally sell their financing contracts to private funding sources to generate the capital they need to continue to operate their business. Those who invest in tax-exempt leasing include corporations, commercial banks and investment banks. Individuals and mutual funds, through certificates of participation, also purchase tax-exempt leases. Although the administration's proposal would not apply ''to certain non-salable tax-exempt bonds acquired by a corporation in the ordinary course of business in payment for goods and services sold to a state or local government,'' this intended relief is illusory. The vast majority of equipment manufacturers who sell to state and local governments prefer not to hold municipal leases because they do not want to tie up their capital. These companies generally sell their financing contracts to third party investors. The administration's proposal would discourage vendor financing of capital equipment leased to states and localities. As a direct result, the cost of new capital investment by state and local governments would rise substantially. Require reasonable payment assumptions for interest accruals on certain debt instruments
This proposal would require investors in certain asset-backed securities (ABS) to use ''reasonable payment assumptions'' in determining their annual accrual of original-issue discount. ABS are important because they permit banks and other issuers to manage their balance sheets by selling otherwise illiquid assets efficiently. This proposal represents a tax increase on (ABS) investors because in most cases it would accelerate their recognition of OID income. Investors would likely pass this additional tax onto issuers in the form of higher rates of return. The proposal would apply to already outstanding ABS, thereby subjecting these investors to more onerous tax treatment after their investment decision, similarly to the proposal to reduce the DRD.
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Summary
Again, we appreciate the opportunity to comment on the tax proposals contained in the administration's FY 1998 budget proposal. Although we strongly oppose many of the administration's proposals on the grounds that they would discourage capital formation and public and private investment, we welcome the Ways and Means Committee's attention to these important issues, and we look forward to working with members and staff of the committee as your work on the budget progresses.
PSA is truly encouraged that a balanced federal budget may finally be at hand. We support eliminating the deficit because it we believe that capital investment creates jobs and is vital for a stronger economy. A balanced budget will foster greater levels of savings and investment, which in turn will result in higher productivity and better living standards. We are deeply troubled, however, that the administration has proposed increased taxes on capital investment as part of its balanced budget plan. PSA believes that policy-makers at all levels should be looking for ways to encourage greater savings and investment, not discourage it by making it more expensive for corporations and state and local governments to raise capital. We strongly urge the Committee in its deliberations on the administration's budget to oppose all proposals that would increase the cost of capital investment.
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Chairman ARCHER. Thank you, Mr. Hyde.
Our next witness is very familiar to Members of the Committee, but I will let you identify your background and what you are currently doing, Fred Goldberg.
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STATEMENT OF HON. FRED T. GOLDBERG, JR., PARTNER, SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP; AND FORMER COMMISSIONER, INTERNAL REVENUE SERVICE, AND FORMER ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY
Mr. GOLDBERG. Thank you, Mr. Chairman.
My name is Fred Goldberg, and I am here in my individual capacity. I served at one point as the IRS Commissioner; at another point as the Assistant Secretary for Tax Policy, and I am now in private practice.
I do want to note that a number of clients that I represent have an interest in these proposals; that many of the clients of the firm I am with are affected by these proposals, but I am here today in my individual capacity.
It is a pleasure to appear before you today, and it has been several years since I last testified before this Committee and, Mr. Chairman, I must say I am pleased to note you have changed seats since I was last here.
I will limit my remarks today to summarizing why I believe most of the administration's proposals should be rejected.
However, I request that my entire statement be entered into the record, and I do note that my statement does identify several areas where legislation would be warranted.
The administration's proposals are not loophole closers. They are not a tax on corporate welfare. I implore you and your colleagues to get past these labels. These proposals are tax increases on real people and real businesses. They are tax increases that will discourage savings and investment, they are tax increases that will undermine our economy's ability to respond to competitive pressures and to restructure key industries to create jobs and meet the needs of customers. They also represent major changes in long-established tax policy.
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The proposals suffer from four fundamental defects. First, as I note in my written statement, the administration proposals represent ad hoc, unwarranted, and sometimes astonishing changes in basic tax policy. I believe they are unprincipled in the truest sense of the word.
To prove this point, ask yourself the following questions: Is there a unifying theme to these proposals? Can you take the rationale for one proposal and apply it consistently to other proposals? Should tax consequences be determined solely by financial accounting and nontax regulatory rules, but only when it raises revenue? Should instruments be classified as debt or equity based on how they are ''viewed,'' but only when it raises r