Do you really want to save the code?

Just two days ago -- at this very conference -- Tax Executives Institute entered the tax reform debate with your letter opposing the "Scrap the Code" movement. Like my young twin daughters when they test the waters in front of our house, so far you are only in up to your ankles, but you are in the water now. I want to welcome you to this tax reform debate.

Unlike Deputy Treasury Secretary Larry Summers who spoke to you yesterday, it is not my purpose to simply bestow congratulations for the wisdom of your position, despite my sympathy with your underlying concerns about the effects of tax law uncertainty on business planning. But we all know that businesses' ability to eliminate political uncertainty, to minimize political risks, is even less than their ability to eliminate economic risks. Moreover, this "Scrap the Code" business in my view is a political side show, more about staking out a political position for Republican or Democratic presidential candidates in 2000 than the future of the tax law. Partisan politics aside, the issue may be generating some tax restructuring momentum; whenever the National Federation of Independent Business sets out to get a million signatures on an issue, it should be taken seriously. The Clinton administration is firmly on the same side of the issue as TEI, and we know from its behavior on last year's debate on IRS restructuring legislation and the proposed shift in the tax law's burden of proof that the Administration will remain with you at least until it spots an unstoppable political train heading in its direction. But whatever the Clinton Administration is doing, TEI should not fall into King Canute's trap and assume that, simply by holding up your hand, you can make a rolling political tide come to a halt. Beware, for I believe we are seeing the beginnings of a rolling political tide.

The presidential campaign of 1996 was an extraordinary event in American tax politics. For the first time this century -- since the enactment of the Sixteenth Amendment in 1913 -- important presidential candidates made serious calls to repeal the income tax. Here, the politicians are following the people. The exit polls favoring a fiat tax showed far more popular approval than was revealed simply by looking at the votes for Steve Forbes, its chief proponent.

In the past 25 years, the income tax has fallen into disrepute and disfavor. The first part of my recent book, The Decline (and Fall?) of the Income Tax, explains why this happened. I will spare you that story here, but the key fact is this: Until 1972, the American people viewed the income tax as the most fair tax in the nation. Since 1980, they have consistently viewed it as the least fair. Do not expect any presidential candidate in the next election to forge a "Save the Code" campaign. Even the strongest proponents of the income tax, people like Dick Gephardt, are calling for a radical restructuring of the income tax.

So the question for you today -- members of TEI -- is where do you go from here? Welcome to the water. You oppose the "Tax Code Termination Act." What do you favor?

Let me begin by asking about the obvious counterpoint to "Scrap the Code" -- namely "Save the Code." Does it make any sense for TEI members to join a "Save the Code" movement? What is the state of this tax code that you don't want terminated? In a recent letter to Treasury you said it is a "labyrinth." You're right! Congress uses the current tax code as my mother employed chicken soup: as a cure-all for any ailment affecting the economy or society, an opportunity to soothe what ails you. If we have a problem of education policy in the United States, education tax credits are the answer. If we have a savings problem, welcome to the Roth IRA. And on and on.

This is not news. The tax code has long been used this way. And Congress often gives the people what it wants. That is why the U.S. tax law today is far more favorable to investments in housing and less favorable to corporate investment than the tax law of the other nations with which we compete in the global marketplace.

In this week's letter, TEI lamented the "folly of making tax policy by sound bite." We don't make tax policy -or any other government policy for that matter -- just by sound bite. We make it by asking the people what they want and then fashioning the sound bites. Tax lawmakers, like all of our elected lawmakers today, cannot get enough of public polls. They want to know what the public thinks, what it wants.

Tax policy is currently driven by public polling data and focus group inquiries. Polling data in 1996 and 1997 revealed that the public's major concerns with the tax system were that it should have greater tax benefits for children, greater tax allowances for education, and more liberal IRA opportunities. In response, the 1997 Tax Act gave us Roth IRAs, HOPE education tax credits, and new tax credits for children. As your reference to sound bites acknowledges, the turn to poll-driven tax policy has changed the language of the tax legislative debate.

For example, the estate tax is now the "death" tax. None of its opponents will say "estate tax" any more. The income tax -- or in some cases the entire tax code -- has become the "IRS tax," not as a way, I assure you, to flatter it.

This shift in tax legislators' language and tax talk is one that you ignore at your peril. The phrase "gigantic multinational corporation" does not sit well with the phrase "tax cut" or "tax relief." It sounds far more melodious when coupled with words like "loophole closing" or, worse yet, "corporate welfare." Moreover, if he or she needs to pick up some revenue to finance what the public wants, no Congressman -- not even a Texan like Bill Archer -- will want his name attached to the tax break for big oil companies. Congress is every bit as willing to search for villains as to look for friends. The corporate alternative minimum tax you live with today was the result of a search for villains. In 1986 General Electric Corp. wore the blackest of hats, having reported large income to share holders and paid substantial dividends while paying no U.S. income tax. I commend for your reading a 1995 Congressional Budget Office report about federally funded support to business. It identifies more than 60 business tax preferences, with nearly one-quarter of those potential revenue raisers of $1 billion or more annually. And some current budget proposals, such as COLI limitations and changes in annuity accounting, are not even on that list.

This lack of popular support is a genuine political liability for large U.S. corporations. NFIB can wrap itself in Mom and Pop clothing; TEI cannot. But this, too, is not news. After all, the only way the 1986 Tax Reform was able to provide an across-the-board tax cut for Americans in a revenue neutral bill was by increasing corporate taxes.

Let us stop this bleak talk about political liabilities and turn instead to political assets. Even here news is not all good. Probably the greatest political asset of large corporations in today's environment can be found in your ability to finance political action committees, mount sophisticated lobbying campaigns, and create coalitions to warn against dire economic consequences that will accompany adverse tax changes. But there is a great danger in American multinational corporations relying significantly on the corrupt system of campaign financing that we all now endure. Not only do you lose out to middle class tax relief, but you now also seem no match for the grass roots capacity of small business organizations. As Exhibit A, I offer you Chairman Archer's midnight erasures of corporate AMT relief last year in favor of more estate tax relief, which was a priority of the NFIB. Here, large corporations were not clone in by popular demand but rather by the simple exercise of small businesses' greater political clout.

In coping with the current code, the greatest asset of large corporations outside the political process lies in the ability to hire talented people to lead them through the tax law labyrinth. But this, too, is a double-edged sword. Again, Congress has pointed the way. In the 1980s, Congress enacted "safe-harbor leasing," known to the common man as "buy-a-tax-break." This legislation was intended to allow companies not owing any income taxes to capture the business tax breaks of the 1981 legislation. The government could have accomplished this more straight-forwardly simply by writing companies checks for any tax sayings they could not otherwise use. But this would have smacked of"corporate welfare," so Congress's solution was to let those companies that could not use their own tax writeoffs sell their tax reductions to companies that could.

This "rent-a-deduction' scheme was so easy to understand that even cartoonists could capture it. Art Buchwald, the Washington humorist, had a field day describing potential extensions of the idea. And, as described in a National Journal article back in 1981, Buffalo, New York, tax lawyer Diane Bennett suggested two-worker families should be able to "lease" a welfare family to get the tax deductions for their children. My favorite idea was to allow the 99 percent of people whose wealth is too low to pay estate taxes to sell the unused portions of their $600,000 lifetime estate tax exemptions to rich people who could use them. At the top estate tax rate, these exemptions would be worth about $300,000 each. This would end the spectacle of the government having to write checks directly to needy people. The possibilities for "leasing" of tax breaks are unlimited.

In 1986, Congress eliminated safe-harbor leasing. But, by then, corporate attitudes toward the income tax had changed forever. Many corporate managers had come to regard their tax departments as another potential profit center. They could increase their returns to shareholders by producing a better product, by selling more goods or services, or by saving taxes. Often, tax savings was easier.

And Joe Six-Pack's attitude had changed as well. Despite the data showing the amount of taxes being paid by high-income taxpayers, or revealing the relationship of corporate taxes paid to corporate profits, Joe does not believe he gets a fair shake. He believes that people with money and large corporations have tax advisers -- alchemists, perhaps even magicians -- who help arrange their affairs to avoid paying the taxes they should be paying, to avoid their fair share of the tax burden. There are many reasons for this, including the two-tier system of tax enforcement we now have.

Whatever the reasons, this phenomenon not only has diminished popular support for the income tax, but it has also inculcated a culture that threatens income tax compliance. There is much evidence about the declining trend in tax compliance. Lou Harris, for example, has reported shocking attitudes -- especially among the young -- revealing a growing sentiment that there is nothing wrong with tax cheating.

For large companies, the focus on achieving tax savings coupled with new competition to give business tax planning advice has had a major impact on the way the tax law is written and, as you well know, on the way it is administered. First, there has been a dramatic shift in the sources for obtaining outside tax advice, especially with investment bankers entering the fray. With lawyers, accountants, and investment bankers all competing to offer creative tax savings ideas to corporate executives -- not just the corporation's tax executives -- the standards of conduct of tax practice are now up for grabs. No single body of state or federal law governs the professional conduct of these advisers, nor is there any uniform standard of professional ethics or conduct. Given the competitive forces at play, these tax advisers seem to be quite willing to write unqualified opinions that turn on literal and technical interpretations of the tax law, which more conservative judgment might regard as susceptible to attack either by the IRS administratively or in the courts. Corporate tax practice today seems in many ways reminiscent of the tax shelter days of the late 1970s and 1980s, when tax lawyers became sellers of insurance against tax fraud penalties.

I am reminded of the time when I was sitting in a Scottsdale, Arizona, bar at an ABA meeting in the late 1970s, just after the then-Assistant Attorney General for Taxation, Cart Ferguson, delivered a hard-hitting speech on the ethics of tax practice. One of the lawyers came to the next table and reported to his wife his impression of what Ferguson had said: "He said if you do a deal that's really just a sham, you are getting pretty close to the line."

Because of the inability of Congress to respond quickly to what it might deem inappropriate tax planning, the IRS is left with inadequate statutory guidance. The congressional tendency has been to delegate more power to the IRS and to introduce new penalties into the law as a way to change the odds of the tax planning lottery. The IRS is now empowered to assign penalties for substantial understatements of tax, for overvaluations, for getting intercompany prices wrong, and most recently for failing to register corporate tax shelters.

Power increasingly devolves to the IRS. While I am a great fan of Charles Rosotti and his efforts to reorganize the IRS, I am wary when people talk about a customer-friendly IRS. I will become a werewolf before I change from a taxpayer into a "customer" of the IRS. Tears will always fill my eyes when someone says, "I'm from the IRS, and I'm here to help you." When politicians claim they are making the IRS user-friendly, I am reminded of Emerson's comment about an acquaintance: "The louder he talked of his honor, the faster we counted our spoons."

The hallmark of tax administration today is anti-abuse notices, regulations, and litigation. It is not difficult to trace a path from relatively narrowly-targeted anti-abuse rules, such as those contained in the SWAPs regulations, to the partnership anti-abuse rules, to Notice 98-5, and now to Notice 98-11 and its regulations. There is no shortage of litigation where technical statutory arguments can lose to more general concerns about tax abuse. The Ford Motor Company and ACM Partnership cases offer recent examples. In some circumstances -- notably in connection with financial instruments and some international transactions -- the IRS has very few options. Taxpayers have far greater ability now than they have had in the past to take advantage of distinctions between debt and equity, between ownership and options, between fixed and contingent returns, and even between branches and subsidiaries.

If you "save the Code," this then is what you will have preserved. Financial and business arrangements have become so complex in the current regime -- particularly with regard to international arrangements -- that neither the IRS nor Congress can write laws to deal with them. New provisions will sometimes produce opportunities, as the extension of "check-the-box' regulations to international organizations has demonstrated. Whether one shares TEI's view that this was a "bold" step, or the view of its critics that it was simply reckless, it has become clear in recent months that neither the Treasury nor the IRS had fully thought through the consequences. Notice 98-11 offers more than ample evidence that when a misstep is perceived, it will be followed by a quick turnaround. Notice 98-11 advances a fundamental emphasis on capital export neutrality that is inconsistent with the multiple purposes of the international income tax provisions. If taken seriously as stated, this view threatens not only deferral of foreign income in the context of hybrid entities, but could be used to attack deferral everywhere it exists. This principle also would, on its own terms, undermine cross-crediting between low-tax and high-tax foreign countries. With Notice 98-11 and its regulations, Treasury has attacked reductions of foreign taxes in a manner that will shift assets from U.S. multinationals to foreign treasuries in a way that seems quite uncertain in its impact on the U.S. Treasury.

Notwithstanding the mistakes and the missteps, power will be increasingly devolved to the IRS under the current income tax. Even if not by enactment of the President's current budget requests, and perhaps not in today's anti-IRS political environment, but inevitably nonetheless. If not by Congress explicitly, then in the courts by extensions of the so-called Chevron doctrine, which accords great deference to IRS regulations.

As you well know, turning the IRS around is like reversing the direction of a Winnebago in a garage. But the unhappy truth is this: we will never truly reform the IRS if we do not overhaul the tax law. The IRS is broken because its task is to administer an unadministerable tax law. If Congress is really serious about evicting the IRS from the lives of Americans and their corporations, it must place rewriting the tax law at the top of its agenda.

So I return to my original question. Members of TEI: Where do you want to go from here? What are the alternatives?

The most prominent proposals for replacing the current income tax are the fiat tax and national sales tax. Both possess weaknesses that are fatal. As advanced by House Republican Dick Armey, a fiat tax with few deductions would stay neither pure nor fiat for long. The political allure of tax breaks for "targeted" expenditures or investments would be too seductive for Congress and the White House to resist. Moreover, a complete replacement of the income tax with either the fiat tax or a national sales tax would provide a major tax reduction for the country's wealthiest citizens -- those who need it least.

Of special concern to TEI members will be the treatment by the fiat tax - currently the most popular alternative proposal -- of imports and exports. Compared to the consumption taxes prevalent throughout the world, a fiat tax treats imports and exports quite differently. Typically, sales or value-added taxes impose tax only on consumption that occurs within the country. Goods produced in the country but exported for consumption elsewhere are not taxed, while imports are subject to the value-added or sales tax.

In contrast, under the flat tax, this system is not available. Instead, imports would not be taxed but exports would. Thus, if Ford sold cars made in the United States to be used in the United States, their full retail sales value would be included in the fiat-tax base. Likewise, if Ford, or any other U.S. automobile manufacturer sold cars made in the United States to a foreign dealer for use abroad, the manufacturer's sales price of each car would be subject to the U.S. fiat tax. But a U.S. dealer in foreign cars would be taxed only on the excess of that dealer's total receipts from its sales over the costs of the cars from the foreign manufacturer. As a result, the costs of manufacturing cars abroad would not be included in the U.S. fiat-tax base; only the foreign car dealer's markup would be subject to U.S. taxation. Indeed, as currently structured, the fiat tax may create incentives for car manufacturers headquartered in Japan or Germany, for example, to cease policies of making cars for U.S. use in U.S. plants and instead return to their prior policy of exporting automobiles to the United States. The economists assure us that any disadvantage to U.S. businesses from an "origin-based" consumption tax like the flat tax will be rectified by adjustments in currency exchange rates, but I would be surprised if U.S. multinationals share this indifference about whether a U.S. consumption tax is border-adjustable.

To be sure, if the American people are presented a choice among a national sales tax, a flat tax, or the status quo, they may well respond "none of the above." In my book, I make clear that a better option is available. Enacting a 10- to 15-percent value-added tax, as exists throughout Europe and elsewhere, would finance an income tax exemption of $75,000 to $100,000 and eliminate 100 million of the 115 million tax returns filed each year. The income tax that survived could be cut to a 20- to 25percent top rate and would return to its pre-World War II status as a relatively minor feature of the tax system. The vast majority of Americans would have no contact at all with the IRS. Such a VAT should also whittle the corporate income tax down to a 20- to 25-percent rate and eliminate the complex rules for taxing corporate income earned abroad. The U.S. would then be the most attractive nation for corporate investment in the world. Skeptics may fear that we will end up with the worst of both taxes, but if a supermajority vote were required to lower the $100,000 income tax exemption or to raise either VAT or income tax rates, America could have a tax system it could live with for the next century.

Beyond accomplishing true IRS reform, this proposal would produce a fair, simple, and efficient tax system that the American people deserve. In the final analysis, it would succeed in transforming April 15, as Billy Tauzin is so fond of saying, into just another spring day.

So how do we move forward? You members of TEI are, of course, basically right. Railing against the tax code and bashing the IRS only offer opportunities to score partisan points. But achieving tax reform requires building political bridges, not blasting partisan chasms. Your mission -individually or collectively -- should you accept it, is to help innoculate the American people against the snake-oil salesmen and to help our leaders find a way to forge a bipartisan solution, a solution that fulfills this organization's longstanding commitment to "a tax system that works" for the century ahead. Given your knowledge, your expertise, and the central economic role of the companies for which you work, you can and should play a key role in shaping the nation's tax future. Come on in, the water's fine.

MICHAEL J. GRAETZ is the Justus S. Hotchkiss Professor of Law at Yale Law School. He formerly served as both Deputy Assistant Secretary for Tax Policy and Special Counsel to the Secretary at, the Treasury Department during the Bush Administration. He is the author of numerous law review articles and co-author of Federal Income Taxation: Principles and Policies. His most recent book, entitled The Decline (and Fall?) of the Income Tax, wets published in 1997. This article is adapted from Mr. Graetz's remarks to Tax Executives Institute's 1998 Midyear Conferences.