ILLUSTRATION 2 Assumptions: (a) Selling price of oil at the wellhead (b) Value of oil reserves sold in the ground (d) Capital gain tax rate $26 per bbl. $8 or $12 per bbl.* 35% 17.5% * Market prices for oil reserves sold in the ground have ranged from $8 12 per barrel in typical transactions in recent years. Mr. GUARINI. Mr. Pickle. Mr. PICKLE. I am particularly glad to have my friend, Mr. Durand, here, accompanied by Julian Martin. Although there is an apparent built-in prejudice about high profiteering in the oil and gas industry, in the last year or two, you have very serious problems. It doesn't take much to put this industry in great difficulty. I noticed in the morning paper that crude oil from Mexico is going to come in at about $1 less per barrel. That may sound good until we get some more foreign oil at a cheaper price. It also means, great difficulty for those oil and gas producing areas which then will have less market for their product. There are many businesses that will be hurt all over the country if oil gets down to $24, $23 a barrel. It is not going to just affect the oil and gas industry. It is going to break a lot of businesses, including banks. We will have problems, if we take after this industry now, because we think we ought to raise a dollar. We better think in terms of national energy policy and try to hold the line on what would be worthwhile productivity. Mr. GUARINI. Thank you, Mr. Pickle. The Chair and the committee want to thank all of you for having given us your thinking and advice and counsel, and we appreciate your being here, and we want to thank you. We will adjourn until tomorrow morning at 9. The tax hearing will continue on the 20th. Thank you. [Whereupon, at 4:35 p.m., the hearing was adjourned, to reconvene at 9 a.m., Thursday, June 20, 1985.] COMPREHENSIVE TAX REFORM THURSDAY, JUNE 20, 1985 HOUSE OF REPRESENTATIVES, COMMITTEE ON WAYS AND MEANS, Washington, DC. The committee met, pursuant to other business, at 3:30 p.m., in room 1100, Longworth House Office Building, Hon. Barbara B. Kennelly presiding. TOPIC: EVALUATION OF ALTERNATIVE PROPOSALS Mrs. KENNELLY. The Chair will now call as a panel Paul McDaniel, professor of law, Boston College School of Law; Harvey Galper, senior fellow, the Brookings Institution; Isabel Sawhill, senior fellow, the Urban Institute; Marshall E. Blume, professor of finance, the Wharton School, University of Pennsylvania; and Hugh Calkins, Esq., Jones, Day, Reavis & Pogue, Cleveland, OH. Mrs. Sawhill, and gentlemen, thank you so much for coming today, and particularly thank you for waiting so long. We are sorry it took longer than we had anticipated. We welcome to the committee a group of five tax experts who will share with us their reaction to the President's tax reform proposal. Each of these witnesses will be examining the President's proposal from a different perspective, but I believe they are aware of the major concerns of this committee. Does the proposal treat the middle-income taxpayer fairly? What are the longrun revenue consequences? Would there by any significant effect on economic growth and international competitiveness? Can any significant simplification be achieved? The committee will also be interested in any suggestions for modifications or improvements to the President's proposal. We are particularly concerned about the extent to which opportunities for tax avoidance would still exist through tax shelter arrangements or other devices. Mr. Galper, would you please begin? STATEMENT OF HARVEY GALPER, SENIOR FELLOW, THE Mr. GALPER. Yes; thank you very much. Madam Chairman and members of this committee, it is a pleasure to be here to discuss how to improve our current tax system. I will devote my time to tax shelters and tax arbitrage. I will try to summarize my statement and request it be included in the record in full. (2403) Mrs. KENNELLY. It will be. Mr. GALPER. Thank you. I will not, however, consider here illegal or abusive tax shelters that disguise fraudulent activity with the form and trappings of legitimate businesses and investments. Rather, I am concerned about the entirely legal ways in which the tax system can be manipulated to generate substantial aftertax returns from an investment with a low or even negative beforetax payoff. My position on these matters is very clear. Virtually all tax shelter opportunities arise from the failure to measure and to tax income properly. Any policy that fails to deal with this fundamental cause of tax shelters is inevitably an imperfect and patchwork response. It may be cosmetically appealing to enact devices such as minimum taxes: Few people will be seen to escape tax entirely. But if the fundamentals are not dealt with, the result will be complexity, inconsistency, and still plenty of avenues to game the system. In a word, I am a purist with respect to income measurement rules. I arrived at this position not because I am preoccupied with symmetry or aesthetics, but because the failure to get the rules right will always get us into trouble. This is my one and only message today. All that follows is an elaboration of this issue. What are inconsistent measurement rules? Inconsistent or inaccurate measurement rules arise when the economic return from an investment is not fully taxed; or the cost of an investment is incorrectly calculated; or some combination of the two. The purest example of a tax shelter or tax arbitrage occurs when individuals borrow funds to put into an individual retirement account. Such a transaction involves no saving by the individual, no investment, and no risk. Yet the tax system provides a very nice return generated solely by inconsistent tax rules: The interest on borrowed funds is fully deductible, but the interest return in the IRA is tax exempt. Thus, an individual in the 50-percent bracket who can borrow and lend at 12 percent, can realize a 6-percent net return on the funds deposited in the IRA purely by paper transactions. The after-tax cost of the borrowed funds is 6 percent; the after-tax return on the IRA is 12 percent, and the net return is 6 percent. IRA's are now limited in amount so that the annual gain to the taxpayer is limited. The principle, however, is abundantly clear and, unless checked, the abuse is easily expanded. Furthermore, over time, the $4,000 limit for a two-earner couple can add up. Even ignoring interest compounding, 15 years of $4,000 deposits per year equals $60,000. Six percent of this amount is $3,600 per year of after-tax income, a fine return for doing nothing but taking money from one pocket to put in the other. Most tax shelters require some investment to yield a tax-preferred return. But the forms in which tax-preferred returns are available are also enormously varied, ranging from tax-exempt bonds to assets yielding lightly taxed capital gains, to assets with accelerated depreciation, to the owner-occupied home where the return is tax exempt because it is a return inkind rather than in cash. In each case, the failure to tax the income in full provides the seeds of a tax shelter. At this point, some definition of what we mean by tax shelters may be useful. At the broadest level, a tax shelter is an investment that yields a higher after-tax return than is available on fully taxed assets with the same before-tax return. Any of the tax preferences just noted would qualify, for they all serve to increase aftertax returns. The popular view, that tax shelters arise only from such preferences as accelerated depreciation or expensing of intangible drilling costs, deductions that can be used to offset other taxable income, is unduly narrow. These deductions are qualitatively the same as any other tax preferences. The same degree of preferential taxation, and the same results, follows from tax-exempt bonds or capital gains. And, in combination with borrowing and the deductibility of interest, any tax preference can generate losses to shelter or offset other taxable income. The key point is that such losses are artificial accounting losses, not real economic losses. Real losses reduce real income and provide no shelter benefits. HOW DO FAULTY INCOME MEASUREMENT RULES CREATE TAX SHELTERS The process by which inaccurate tax rules create tax shelters is fascinating and depressing. The first step in the process is the fact that, regardless of the kind of tax-preferred asset created, the tax preferences are worth more to those in high tax brackets than those in low tax brackets. Naturally, therefore, tax-preferred investments are particularly sought after by high bracket taxpayers. The interaction of a graduated structure of marginal tax rates with a variety of tax-preferred assets thus channels assets yielding the greatest tax preferences to high bracket taxpayers, while low bracket investors, including zero-taxed pension funds and endowments, will tend to hold fully taxed assets. Thus, there will be a general sorting out process, whereby people and institutions will tend to hold those assets that make economic sense to them given their tax bracket. In fact, assets do not have to be tax-preferred to create tax shelters. Super-taxed assets or assets on which the yield is taxed at greater than ordinary rates, also contribute to the tax shelter process. What are super-taxed assets and how do they cause tax shelters? The most important categories of super-taxed assets are ordinary bonds, mortgages, and loans on which the full nominal interest rate is subject to tax, even though part of the return is just compensation for inflation. The taxation of both real and inflationary returns means that the tax rate on real income is higher than the statutory rate. The combination of preferentially taxed and super-taxed assets causes returns on the former to fall and those on the latter to rise. The tax system, thus, greatly distorts the returns that can be earned on various forms of investment. Following the earlier logic, bonds and other super-taxed securities will be held by low bracket individuals or tax-exempt institutions such as pension funds, for whom the extra taxation matters very little and is more than offset by the higher return. Also, such securities will |