[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
THE TAX CODE AND THE NEW ECONOMY
=======================================================================
HEARING
before the
SUBCOMMITTEE ON OVERSIGHT
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 26 AND 28, 2000
__________
Serial 106-79
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
68-411 CC WASHINGTON : 2001
_______________________________________________________________________
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC
20402
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Oversight
AMO HOUGHTON, New York, Chairman
ROB PORTMAN, Ohio WILLIAM J. COYNE, Pennsylvania
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma JIM McDERMOTT, Washington
JERRY WELLER, Illinois JOHN LEWIS, Georgia
KENNY HULSHOF, Missouri RICHARD E. NEAL, Massachusetts
J.D. HAYWORTH, Arizona
SCOTT McINNIS, Colorado
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
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C O N T E N T S
__________
Page
Advisories of September 26 and 28, 2000, announcing the hearing.. 2
WITNESSES
U.S. Department of the Treasury, Joseph M. Mikrut, Tax
Legislative Counsel............................................ 9
______
American Airlines, Inc., Mitchell Salamon........................ 81
American Electronics Association, and Transcrypt International,
Inc., Michael E. Jalbert....................................... 24
Click Bond, Inc., Collie Langworthy Hutter....................... 109
Edison Electric Institute, and DTE Energy Company, Theodore Vogel 51
Electronic Data Systems Corporation, R. Randall Capps............ 100
Hester, J. Joseph, Community College of Allegheny County......... 74
International Furniture Rental Association, Frederick H. von
Unwerth........................................................ 59
IBM Corporation, Linda Evans..................................... 105
Minge, Hon. David, a Representative in Congress from the State of
Minnesota...................................................... 5
National Association of Manufacturers:
Dorothy B. Coleman........................................... 33
Collie Langworthy Hutter..................................... 109
R&D Credit Coalition, and Microsoft Corporation, Bill Sample..... 93
Semiconductor Industry Association, and Advanced Micro Devices,
Clifford Jernigan.............................................. 46
Technology Workforce Coalition, and Prometric, Martin Bean....... 77
Verizon Wireless, and Cellular Telecommunications Industry
Association, Molly Feldman..................................... 36
SUBMISSIONS FOR THE RECORD
American Textile Manufacturers Institute, statement.............. 119
Henry George Foundation of America, Columbia, MD, statement...... 122
International Franchise Association, Brendan J. Flanagan, letter. 123
IPC, Association Connecting Electronics Industries, letter and
attachment..................................................... 124
Tax Council Policy Institute, and PricewaterhouseCoopers LLP,
James R. Shanahan, Jr., joint statement........................ 130
THE TAX CODE AND THE NEW ECONOMY
----------
TUESDAY, SEPTEMBER 26, 2000
House of Representatives,
Committee on Ways and Means,
Subcommittee on Oversight,
Washington, D.C.
The Subcommittee met, pursuant to notice, at 1:04 p.m., in
room 1100, Longworth House Office Building, the Hon. Amo
Houghton (Chairman of the Subcommittee) presiding.
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
September 14, 2000
No. OV-23
Houghton Announces Hearing on
the Tax Code and the New Economy
Congressman Amo Houghton (R-NY), Chairman, Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee will hold a hearing on whether Federal tax laws are
keeping pace with the ``new economy.'' The hearing will take place on
Tuesday, September 26, 2000, beginning at 1:00 p.m., in the main
Committee hearing room, 1100 Longworth House Office Building, and be
continued on Thursday, September 28, 2000, beginning at 11:00 a.m., in
the main Committee hearing room.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only.
Witnesses will include a representative of the U.S. Department of the
Treasury, tax policy experts, and representatives of various sectors of
the economy. However, any individual or organization not scheduled for
an oral appearance may submit a written statement for consideration by
the Committee and for inclusion in the printed record of the hearing.
BACKGROUND:
With the emergence of information-based sectors in the economy,
many observers believe current tax laws improperly measure business
income. The ``new economy'' is based on high-tech equipment, intensive
research and development, and a skilled workforce. Many current tax
rules were written for a predominantly manufacturing economy and may
need to be revised.
The hearing will review the cost recovery rules for physical
capital, which are based on analyses from the 1970s and earlier, and
will receive testimony on the recent Treasury Department Report to the
Congress on Depreciation Recovery Periods and Methods. The hearing will
also review the tax treatment of research and development expenses.
Finally, the hearing will explore how tax law treats the cost of
maintaining a skilled workforce.
In announcing the hearing, Chairman Houghton stated: ``The strength
of the economy may be masking underlying inadequacies in our tax laws.
Rather than waiting for an economic downturn to look at the current
rules, we want to take advantage of the opportunity to ask whether our
tax laws make sense. In an increasingly global economy, it is important
to look at whether our tax rules put us at any competitive
disadvantage.''
FOCUS OF THE HEARING:
The hearing will focus on the tax treatment of physical capital,
such as equipment; intangible capital, such as research and
development, and human capital.
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and Means, U.S. House of Representatives, 1102 Longworth House Office
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noted above.
Chairman Houghton. Ladies and gentlemen, the hearing will
come to order. As most of you know, the American economy is on
a roll, and its success has reached out to many sections of
this country, and much of the strength is attributed to the so-
called new economy. Much of the new economy, of course, is
built on information and technology and relies on a highly
skilled workforce.
Of course, the Nation's economy is made up of more than
high technology. There is still an important role for
manufacturing and trade. But much of the growth in our economy
is in information, in the high-tech sector. Many of our tax
rules predate the new economy. For instance, the cost recovery
rules for capital are based on analyses from the 1970s and
earlier.
Why not leave well enough alone, you might ask? The economy
is strong, but the strength of the economy may be masking
underlying inadequacies in our tax laws. We shouldn't wait for
an economic downturn to take a look at the current laws and the
current rules.
The new economy uses high-tech equipment, so we need to
look at the cost recovery rules for physical capital. It relies
on research and development, so also, we need to take a look at
the tax treatment of intangible capital. Also, it is driven by
a skilled workforce, so we need to look at how our tax laws
treat investment in human capital.
The Treasury Department is going to be reviewing its recent
report to the Congress on depreciation periods and methods this
afternoon, and we will hear from a number of private sector
witnesses on cost recovery. On Thursday, we will hear from
witnesses on how our tax laws treat research and development
and the cost of maintaining a skilled workforce.
Chairman Houghton. I am now pleased to recognize the senior
Democrat on our committee, Mr. Coyne, for an opening statement.
Mr. Coyne. Thank you, Mr. Chairman. As the Chairman pointed
out, the Oversight Subcommittee has scheduled two days of
hearings on the tax code and the new economy. It is clear that
the nature of work has changed in many parts of the U.S.
economy. As smokestack industries have been overtaken by
information-based industries, education has become much more
important to success in our workplaces. Unfortunately, much of
our workforce is not experiencing the economic benefits of or
participating in the current economic boom.
There is, to a large degree, a disconnect between the
skills the business community needs in the workplaces of the
future and the skills many hard-working Americans are trained
to provide. The relationship between the tax laws and the
ability of this country to maintain a skilled workforce is a
timely issue for discussion. All one has to do is look at the
classified employment section of the newspaper to see that the
vast number of workers sought and the technical skills needed
for their jobs.
News reports indicate that currently, there are about
300,000 high-tech job vacancies. Importantly, the number of
high-skilled jobs is increasing at an annual rate of 10
percent, and it is unclear whether these positions can be
filled. We must focus on what can be done in the short and long
term to prepare future generations for our, quote, new economy.
Education and job skills training are critical components of
efforts to succeed. The tax laws are one important and
successful tool for encouraging business innovation and job
training in today's new economic environment.
I welcome all the witnesses that appear before us today and
particularly our colleague, Representative Minge.
Chairman Houghton. Thanks very much, Mr. Coyne.
Mr. Weller, would you like to make an opening statement?
Mr. Weller. Yes; thank you, Mr. Chairman. I would like just
to make a few brief comments. I want to commend you for
conducting these hearings. You know, today, there is over 100
million Americans that are online. In fact, seven Americans go
online for the first time every second. 4.8 million Americans
today are employed in the technology sector, and that is more
than oil, steel and auto industries combined. So there is a
tremendous amount of opportunity.
And, of course, my home State of Illinois ranking fourth in
technology employment, third in technology exports, has seen
wages in the technology sector 59 percent higher than the
traditional old economy. So we know there is a lot of
opportunity for Illinoisans as well as all Americans in the
technology sector to become part of the new economy. But I
think it is important to note that the tax code does have an
impact on the new economy, and that is why today's hearing is
so important. I am proud the House has led the way to, of
course, lower the tax burden on technology; working to repeal
the telecommunications tax on telephone service; to extend for
5 years the Internet tax moratorium and also to move forward
with legislation to block the FCC from imposing new Internet
access fees.
Today's hearing, of course, is on depreciation treatment of
technology, and I think this is an important subject today and
one I look forward to engaging with your witnesses in, Mr.
Chairman. I would like to note that I have introduced
legislation along with Tom Davis, Billy Tauzin and Jennifer
Dunn, legislation that addresses the depreciation treatment of
computers.
You know, today, our tax code says that you have to keep
that office computer on the books for 5 years, but the business
community, you know, which uses computers, whether it is a real
estate office or a local insurance office as well as a major
corporation, they replace them about every 14 months. And, of
course, that just doesn't make sense to carry it on the books
for 5 years if you are only going to use it in the office for
barely a year, and our legislation recognizes that; works to
bring reality, we believe, to the tax treatment for
depreciation for those office computers, because we would allow
you to expense or fully deduct in the year that you purchase
it, the cost of that computer.
We believe that is common sense, and Mr. Chairman, I would
like to work with you as well as the Administration, Treasury
and others to move forward on depreciation reform on the
treatment of computers and other areas of technology.
So I look forward to this hearing, and I thank you for the
opportunity to be part of it.
Chairman Houghton. Thank you very much.
Now, we have many distinguished witnesses, none more so
than the Honorable David Minge, Member of Congress from
Minnesota.
Mr. Minge?
STATEMENT OF HON. DAVID MINGE, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF MINNESOTA
Mr. Minge. Well, thank you very much, Mr. Chairman.
I would like to testify for a couple of minutes about the
Distorting Subsidies Limitation Act. This is H.R. 1060. It is a
bill that I have introduced earlier in this session, and I have
talked to you and a number of our colleagues about one of the
problems that we face in our economy in trying to ensure that
we allocate resources in the most logical fashion possible is
the distortions that occur when the tax code allows and States,
and local units of government take advantage of, one another.
And I have a prepared statement that I have filed with the
committee, and I would like to ask that that be allowed to be
in the record, and I will make some brief oral comments about
this and not stick to that statement.
Chairman Houghton. Absolutely; without objection.
Mr. Minge. Okay; the problem that I have identified and I
have worked with several economists on is the efforts that
States and local units of government make to attract business
from their neighbors. And we're all familiar with the practice.
I worked on economic development in the small rural community
in which I practiced law before I ran for Congress, and I know
that it was a regular issue: how does Minnesota prevent South
Dakota from, so to speak, stealing some of its best employers?
And on the other hand, Minnesota is looking at Connecticut
or California and asking how can we lure those businesses to
Minnesota? What incentives do we have to give? Now, the best
type of competition between the States is to have quality
education systems; to have infrastructure that meets the needs
of the business community; to have tax policies which stimulate
investment. We don't need to be taking billions of dollars of
taxpayer money and providing direct incentives in the form of
buildings or sometimes even cash transfers in order to induce a
business to move from one community to another.
But, in fact, we are. It has been estimated by Professor
Kenneth Thomas of the University of Missouri that more than $15
billion annually of tax money is being spent by State and local
government to induce businesses to move from one location to
another. This is a vast sum. It would educate 3 million
elementary school students for a year; it would hire 300,000
law enforcement officers or construct 6,000 miles of four-lane
highway.
We can't afford as a country to watch this amount of money
being spent unnecessarily and in a way that doesn't make sense
with sound economic policy. This is a situation that cries out
for a response, and indeed, we have been requested by several
State legislators; many economic planners, governors and others
to take action, because what the States have found is that they
can't unilaterally disarm. One State, let's say New York, can't
say we are not going to offer any subsidies to try to prevent
businesses from leaving New York; we will simply have the best
environment possible for businesses in our State.
But then, New Jersey comes along, and it says wouldn't you
like to move the New York Stock Exchange over to Hoboken? Or
wouldn't you like to have your corporate headquarters over in
Jersey City or some other location, or Kvaerner is in
Pennsylvania, and the ship yards in Philadelphia are to be
reconstructed, and I believe there was a $400 million package
that was offered to Kvaerner.
If New York tries to disarm and not use that, but New
Jersey does not, then, the businesses will exploit this
difference. And so, what has been pointed out is that it takes
Congressional action if we are going to deal with this
situation, and this, in a sense, is an unfinished item of
business from the establishment of our Federal union. It was
not adequately dealt with initially by Congress, and it has
lingered, and it has festered.
In my own home State, we have been treated to the spectacle
of professional sports teams imploring the State legislature
and the governor for untold millions of dollars for new
stadiums. Otherwise, the sports team says we have no
alternative but to go to another State which will offer us a
stadium that they have paid for.
Well, this is just one aspect of a problem that I think is
severe, and with a $15 billion a year price tag, it is very
costly to State and local government. The legislation that I
have introduced would address this by first having an excise
tax on the benefits, so that there would be a negative
incentive for businesses to seek this type of assistance. It
would also preclude the use of Federal grant money for that
type of subsidy; and finally, it would make sure that
industrial revenue bonds or enterprise bonds cannot be issued
and have their interest treated as tax free under the Internal
Revenue Code if the proceeds are to be used in this manner.
I must say that I have worked very closely with several
economists on this. The Federal Reserve Bank of Minneapolis has
made this a top priority in terms of economic research and
policy development at that bank, and the chief economist at the
bank has assisted in the preparation of this legislation.
One final comment in this respect: I have held roundtable
discussions with folks on this proposal, and the comment that
came from a businessperson was the biggest problem with your
bill is that the excise tax is not high enough. It ought to be
100 percent. And instead, the tax rate that was chosen is the
corporate tax rate under the Internal Revenue Code.
Well, I would like to thank you very much for the
opportunity to testify about this problem. I think it is
certainly one that our States face as they compete with one
another for high-tech industry, in this new-age economy, and
hopefully, it is something that we can address as we attempt to
address other problems that face our country and face our
economy. Thank you very much.
[The prepared statement follows:]
Statement of Hon. David Minge, a Representative in Congress from the
State of Minnesota
I am pleased by the opportunity to testify before the
subcommittee today on an abuse of the tax code that unwillingly
facilitates the tragic bidding war among communities for
business development. This handicaps our communities from
making adequate investments to prepare them and their citizens
for the economic demands of the new millennium.
States and cities across the country are competing against
one another to lure companies that will provide jobs to local
residents. This has been happening for years, and it probably
always will, given our country's commitment to the free market
economy and rigorous competition. Some localities simply do a
better job of ensuring that their area has an educated
workforce, efficient transportation infrastructure, and is
generally more attractive to employers. That's one of the
tenets of good government--create an environment that promotes
economic growth and jobs.
We all support such competition. But in the last several
years we have seen an increase in competition between the
States based on something other than the quality of the
infrastructure, schools, or available labor force. Local
governments are being forced to spend scarce taxpayer dollars
for incentives to attract specific companies looking for a new
home, or even more discouraging, just to keep a business from
packing up and leaving town.
The problem begins with our tax code. The Federal
Government has attempted to address this situation in the past
by tackling the most offensive abuses. Limits were placed on
the use of tax free municipal bonds to finance projects that
benefit a specific business. Despite the existence of these
limitations, the money generated by ``enterprise'' bonds is
typically a subsidy for a private entity and not recognized as
taxable income.
All told, State and local government across the country
provide more than $15 billion annually in tax rebates and other
subsidies, according to Kenneth Thomas of the University of
Missouri, St.Louis. That price tag is staggering. Those funds
could educate 3 million elementary school students, hire
300,000 police officers or construct 6,000 miles of four-lane
highway.
It gets worse. Some of these distorting subsidies are
financed through Federal tax dollars. The U.S. General
Accounting Office (GAO) reports that Federal block grant funds
are being used not only to create jobs, but subsidize the
movement of jobs from one State to another. Why should the
nation's taxpayers finance these deals that benefit job growth
of one State to the detriment of another?
This practice is wide spread. A 1993 Arizona Department of
Revenue study found that half of the 50 States had recently
enacted financial incentives to induce companies to locate,
stay or expand in the State. Targeted businesses have ranged
from airline maintenance facilities, automobile assembly plants
and professional sports teams to chopstick factories and corn
processing facilities. These deals often range into the
hundreds of millions of dollars.
For example, Pennsylvania, bidding for a Volkswagen factory
in 1978, gave a $71 million incentive package for a factory
that was projected to eventually employ 20,000 workers. The
factory never employed more than 6,000 and was closed within a
decade.
In a 1993 agreement with the State of Alabama, Mercedes
received a sweetheart subsidy package worth $253 million to
build an auto plant in that job-starved State. Each of the
1,500 jobs created cost the State taxpayers $168,000.
Recently, the Marriott Corporation gleaned what is
estimated to be as much as $70 million in subsidies from the
State of Maryland and Montgomery County to expand their
operation. This firm has been headquartered for decades in the
Free State, and has prospered nicely with the help of an
educated and productive workforce. When company executives
threatened to pick up and leave after 44 years in Maryland, and
when they sat down with Virginia officials to discuss
``options,'' Maryland had little choice but pony up with $70
million in tax breaks and road projects or risk seeing Marriott
ride into the sunset.
New York City is in a constant battle with the States of
Connecticut and New Jersey to retain many businesses currently
located within its boundaries. The last year has seen millions
upon millions of dollars showered on such well known financial
and publishing firms as Bloomberg, Bertelsmanns, Time Warner,
the New York Stock Exchange, the New York Board of Trade, CBS,
etc . . . Are these the companies that are truly in the need of
government subsidies?
It is appropriate that I sit before the Subcommittee on
Oversight as oversight of these incentive deals is woefully
inadequate. According to a report by Good Jobs First, most
States lack comprehensive incentive strategies and follow up
audits are rare and of poor quality. Often subsidies are given
to corporations with poor fiscal histories or are not used in
the areas or ways originally intended.
One glaring example is the deal $429 million public subsidy
of the Norwegian ship builder Kvaerner. The purpose of the
subsidy was to entice Kvaerner to build a new ship yard at the
site of the former Philadelphia Naval Shipyard. According to an
August release from the Pennsylvania Auditor General, subsidy
money was squandered on items such as a $2,000 swing set,
basement renovations and other personal items for a Kvaerner
executive. Kvaerner has since pulled out of the ship building
industry.
While spending billions of dollars to retain and attract
businesses, State and local governments struggle to provide
such public goods as schools and libraries, public health and
safety facilities, and the roads, bridges and parks that are
critical to the success of any community. These subsidy deals
have a direct effect on the availability and quality of public
services.
The city of Cleveland, while it struggled to keep the
Cleveland Browns football team from moving to Baltimore,
announced the closing of 11 schools in 1995 for lack of
funding, yet the city offered to spend $175 million of public
money to fix the Browns' stadium to ward off Baltimore's
successful offer to attract the team.
My own State of Minnesota is experiencing a similar
dilemma. There has been a lot of talk in the last couple of
years about the Minnesota Twins being lured away by a publicly
financed stadium in another part of the country. That talk had
quieted but has just recently reappeared on the front pages of
Minnesota newspapers. The Twins have long been pressing the
State and local government for a new sports stadium. It appears
now that the cities of Minneapolis and St. Paul are gearing up
for a bidding war to publicly finance a new stadium to lure the
team. This comes only a few years after the State legislature
and the city of Minneapolis decided against financing a
stadium.
Individual States and local governments are powerless to
put a stop to the practice. Unilateral disarmament in this
bidding war could mean the loss of thousands of jobs to other
jurisdictions. At the same time, businesses cannot be blamed
for wanting to move into a community that offers the best
incentive package. What is clear is that the system itself is
flawed, and that we are due for a tune up.
I have had some personal experience with the issue when I
served on the County Development Commission in my hometown of
Montevideo in western Minnesota. I know from my own work how
frustrating it can be for a smaller community to have to
compete with communities that have deeper pockets or that are
more willing to give breaks or go into debt to win a deal.
We must start considering how to stop the use of tax
subsidies that squander limited public resources and distort
economic decision-making. I am encouraged that nine State
governments, including the Minnesota Legislature, have passed
resolutions urging Congress to find an answer to this lingering
question. I have consulted with the Minnesota Department of
Trade and Economic Development, Mel Burstein and Art Rolnick of
the Minneapolis Federal Reserve Bank, Ohio State Senator
Charles Horn, local economic development planners and many
others to develop legislation and build interest in resolving
this problem.
I have introduced a bill that is intended to end
competition based on public giveaways rather than sound
economic principles. The Distorting Subsidies Limitation Act of
1999 (HR 1060) requires businesses benefitting from special
grants or tax deferrals to be taxed on the value of the
subsidies at the same rates as currently apply to other income
under the Federal corporate tax structure. Let's face it, these
subsidies are income that businesses are milking out of local
government. I think of this proposed tax as a ``sin tax'' meant
to stop an undesirable activity. I also propose an across the
board prohibition on the use of tax-exempt bonds or Federal
resources by States and communities to lure businesses or
prevent them from considering other locations.
Several other members of Congress have put together
legislative proposals in attempt to halt these distorting
subsidies. I salute their efforts, and hope that as concern
about this unwise use of public resources continues to grow, we
in Congress can hammer out a consensus approach. The point is
that Congress is empowered by the Interstate Commerce Clause as
the only entity that can put a stop to the economic war between
the States.
Chairman Houghton. Well, thanks very much, Dave.
Have you got any questions? No, I don't have any questions?
Do you, Jerry? Okay; good; thank you so much, and we expect to
receive your written testimony.
Mr. Minge. Okay.
Chairman Houghton. Thanks very much.
Now, the next witness is Mr. Joseph Mikrut, who is the tax
legislative counsel for the United States Department of the
Treasury. Mr. Mikrut, it's good to have you here.
Mr. MIKRUT. Thank you.
Chairman Houghton. And whenever you're ready, you can begin
your testimony.
STATEMENT OF JOSEPH M. MIKRUT, TAX LEGISLATIVE COUNSEL, U.S.
DEPARTMENT OF THE TREASURY
Mr. Mikrut. Thank you, Mr. Chairman, Mr. Coyne,
distinguished members of the Subcommittee.
I appreciate the opportunity today to discuss with you the
tax rules that relate to investments in human, intangible and
physical capital in the context of the new economy. Over the
last 20 years, the U.S. economy has changed significantly. New
industries have emerged, and the use of technology has
revolutionized production techniques and improved the
efficiency in more traditional industries. These developments
have increased the demand for more highly skilled workers who
are more productive and better able to adapt to the
requirements of new technologies.
In addition, access to computers and the Internet has
increased significantly, creating opportunities to participate
in the new digital economy. In view of these changes, this
hearing appropriately focuses on whether Federal tax rules are
keeping pace with the new economy. The Treasury Department has
previously submitted testimony on the importance of the
Administration's budget initiatives supporting the research
credit; providing educational incentives; bridging the digital
divide and making life-saving vaccines available worldwide.
I will not repeat these discussions this afternoon. Rather,
my comments will focus on the results of the Treasury
Department's recent analysis of current-law cost recovery
provisions. This last July, the Treasury Department issued its
report to the Congress on depreciation recovery periods and
methods. In developing its study, the Treasury Department
solicited and received comments from numerous interested
parties and consulted with the tax writing committee staffs.
The report emphasizes that an analysis of the current U.S.
depreciation system involves several issues, including those
related to proper income measurement, savings and investment
incentives and the administerability of the tax system. The
history of the U.S. tax depreciation system has shown that
provisions intended to achieve certain of these goals; for
example, attempting to measure income accurately by using a
facts and circumstances approach, may clash with other
worthwhile goals; for example, having to have a very
administerable, easy-to-apply system.
Accordingly, the report identifies issues related to the
design of a workable and relatively efficient depreciation
system and reviews options for possible improvements to the
current system with those competing goals in mind. Resolution
of the issue of how well the current recovery periods and
methods reflect the useful lives and economic depreciation
rates would involve detailed empirical studies and years of
analysis. The data required for this analysis would be costly
and difficult to obtain. Thus, the report does not contain any
legislative recommendations concerning specific recovery
periods or methods for any particular piece of property.
Rather, the report is intended to serve as a starting point for
public discussion of possible general improvements to the U.S.
cost recovery system. We look forward to working with the tax
writing committees in this endeavor.
Based on available estimates of economic depreciation, tax
depreciation allowances are more generous at current inflation
rates, on the average, than those implied by economic
depreciation. This conclusion, however, is based on estimates
of economic depreciation that may be somewhat dated. The
relationship between tax and economic depreciation changes with
the rate of inflation, and because current law depreciation
allowances are not indexed for inflation, the current low rates
of inflation reflect the fact that economic depreciation may be
slower than tax depreciation.
In general, current law generally generates relatively low
tax costs for investment in equipment, public utility property
and intangibles and relatively high tax costs for investments
in nonresidential buildings. These differences in tax costs,
standing alone, may distort investment decisions, encouraging
investors to underinvest in projects with relatively high tax
costs.
The report also finds that the current depreciation system
is dated. The asset class lives that serve as the primary basis
for the assignment of recovery periods have remained largely
unchanged since 1981 and are largely based on studies that date
back to the 1960s. Entirely new industries have developed in
the interim, and manufacturing processes in traditional
industries have changed. These developments are not reflected
in the current cost recovery system, which does not provide for
updating depreciation rules to reflect new assets, new
activities and new production technologies.
As a consequence, income may be mismeasured for these
assets relative to the measurement of income generated by
properly classified assets. However, this does not mean that
depreciation allowances for new assets or new industries are
necessarily more mismeasured than other assets.
The replacement of the existing tax depreciation structure
with a system more closely related to economic depreciation is
sometimes advocated as an ideal reform. However, there are
several issues that come about with this reform. One issue is
trying to find the appropriate data in order to reflect proper
economic depreciation. A second reform would involve indexing
for inflation. Current law does not--as I mentioned earlier,
does not index for inflation, while an ideal income tax system
would. Indexing, however raises several concerns, including the
revenue costs, complexity and possible undesirable, tax-
motivated transactions.
In summary, Mr. Chairman, the Treasury Department's recent
depreciation report raises several issues that need to be
addressed in modifying the present cost recovery system and
provides several possible options for modifications in the
system. We intend that the report would serve as a starting
point for public discussion of improvements to the cost
recovery system. We applaud the efforts of Chairman Archer in
commissioning this study and you, Mr. Chairman, in holding this
hearing to further this discussion.
We look forward to working with you and the tax-writing
committees on this matter. I'd like to submit my entire
statement for the record, and I'd be happy to answer any
questions you may have.
[The prepared statement follows:]
Statement of Joseph M. Mikrut, Tax Legislative Counsel, U.S. Department
of the Treasury
Mr. Chairman, Mr. Coyne, and distinguished Members of the
Subcommittee:
Thank you for giving me the opportunity to discuss with you
today the tax rules governing depreciation, research and
experimentation, and workforce training in the context of the
``new economy.'' Over the past 20 years, the U.S. economy has
changed significantly. New industries have emerged, such as
cellular communications and the Internet, and the use of
computers has revolutionized production techniques and improved
efficiency in more traditional industries, such as
manufacturing. In many industries these developments have
increased the demand for more highly-skilled workers who are
more productive and better able to adapt to the requirements of
technological advances. In addition, access to computers and
the Internet has increased significantly, creating
opportunities to participate in the new digital economy.
In view of these economic changes, this hearing
appropriately focuses on whether Federal tax laws are keeping
pace with the new economy.
My comments today will focus on the results of the Treasury
Department's recent analysis of cost recovery provisions in
Report to the Congress on Depreciation Recovery Periods and
Methods. I will also review the tax treatment of research and
experimentation expenses and the tax treatment of the cost of
maintaining a skilled workforce. The Administration recognizes
the importance of the research credit for encouraging
technological development and has supported its extension. The
Administration's FY 2001 Budget includes proposals that would
encourage individuals and businesses to undertake more
education and training. In addition, the Administration
recognizes the need to ensure that residents of inner cities
and less affluent rural communities have full access to the
opportunities that symbolize the promise of the new economy. In
that regard, the Budget includes several proposals that will
help bridge the digital divide.
The Treasury Depreciation Study
The Tax and Trade Relief Extension Act of 1998 directed the
Secretary of the Treasury to conduct a comprehensive study of
the recovery periods and depreciation methods under section 168
of the Internal Revenue Code, and to provide recommendations
for determining those periods and methods in a more rational
manner. The explanation of the directive in the 1998 Act
indicates that the Congress was concerned that the present
depreciation rules may measure income improperly, thereby
creating competitive disadvantages and an inefficient
allocation of investment capital. The Congress believed that
the rules should be examined to determine if improvements could
be made. In developing its study, the Treasury Department
solicited and received comments from numerous interested
parties.
In July, 2000 the Treasury Department issued its Report to
the Congress on Depreciation Recovery Periods and Methods. The
Report emphasizes that an analysis of the current U.S.
depreciation system involves several issues, including those
relating to proper income measurement, savings and investment
incentives, and administrability of the tax system. The history
of the U.S. tax depreciation system has shown that provisions
intended to achieve certain of these goals (for example,
attempting to measure income accurately by basing depreciation
on facts and circumstances) may come at the cost of other
worthwhile goals (for example, reducing compliance and raising
administrative burdens). Accordingly, the Report identifies
issues relating to the design of a workable and relatively
efficient depreciation system, and reviews options for possible
improvements to the current system with these competing goals
in mind.
Resolution of the issue of how well the current recovery
periods and methods reflect useful lives and economic
depreciation rates would involve detailed empirical studies and
years of analysis. The data required for this analysis would be
costly and difficult to obtain. Thus, the Report does not
contain legislative recommendations concerning specific
recovery periods or depreciation methods. Rather, the Report is
intended to serve as a starting point for a public discussion
of possible general improvements to the U.S. cost recovery
system. We look forward to working with the tax-writing
Committees in this important endeavor.
Current Law
The Internal Revenue Code allows, as a current expense, a
depreciation deduction that represents a ``reasonable allowance
for the exhaustion, wear and tear (including a reasonable
allowance for obsolescence)--(1) of property used in a trade or
business, or (2) of property held for the production of
income.'' Since 1981, the depreciation deduction for most
tangible property has been determined under rules specified in
section 168 of the Code. The Modified Accelerated Cost Recovery
System, or MACRS, specified under section 168 applies to most
new investment in tangible property.
MACRS tax depreciation allowances are computed by
determining a recovery period and an applicable recovery method
for each asset. The recovery period establishes the length of
time over which capital costs are to be recovered, while the
recovery method establishes how capital costs are to be
allocated over that time period. All tax depreciation is based
on the original, historical cost of the asset and is not
indexed for inflation.
The tax code assigns equipment (and certain non-building
real property) to one of seven recovery periods that range in
length from three years to 25 years. This assignment typically
is based on the investment's class life. Class lives for most
assets are listed in Rev. Proc. 87-56; others are designated by
statute. Generally, assets with longer class lives are assigned
longer recovery periods.
For equipment, the MACRS recovery period depends either on
the type of asset or the employing industry. Certain assets,
such as computers, office furniture, and cars and trucks are
assigned the same recovery period in all industries. To a large
extent, however, the current depreciation system is industry
based rather than asset based, so that assets are assigned
recovery periods determined by the employing industry.
The applicable method of depreciation depends on the
asset's recovery period. Assets with a recovery period of
three, five, seven or ten years generally use the double
declining balance method. Assets with a fifteen or a twenty-
year recovery period generally use the 150 percent declining
balance method. Assets with a twenty-five year recovery period
use the straight-line method.
Non-residential buildings generally are depreciated over a
39-year recovery period using the straight-line method.
Nonresidential buildings include commercial buildings, such as
office buildings and shopping malls, as well as industrial
buildings such as factories. Residential buildings (e.g.,
apartment complexes) are depreciated over a 27.5-year period
using the straight-line method. The recovery period for
buildings is the same regardless of industry. For tax purposes,
a building includes all of its structural components. The cost
of these components is not recovered separately from the
building; rather these costs are recovered using the life and
method appropriate for the building as a whole.
Principal Issues and Findings
Based on available estimates of economic depreciation, cost
recovery allowances for most assets are more generous at
current inflation rates, on average, than those implied by
economic depreciation. This conclusion, however, is based on
estimates of economic depreciation that may be dated. The
findings are discussed more fully in the Report. The
relationship between tax and economic depreciation changes with
the rate of inflation because current law depreciation
allowances are not indexed for inflation. Furthermore, the
relationship between tax depreciation and economic depreciation
varies substantially among assets. In general, accelerated cost
recovery allowances generate relatively low tax costs for
investments in equipment, public utility property and
intangibles, while decelerated cost recovery allowances
generate high tax costs for investments in other nonresidential
buildings. These differences in tax costs, standing alone, may
distort investment decisions, discouraging investment in
projects with high-tax costs, even though they may earn higher
pre-tax returns.
The current depreciation system is dated. The asset class
lives that serve as the primary basis for the assignment of
recovery periods have remained largely unchanged since 1981,
and most class lives date back at least to 1962. Entirely new
industries have developed in the interim, and manufacturing
processes in traditional industries have changed. These
developments are not reflected in the current cost recovery
system, which does not provide for updating depreciation rules
to reflect new assets, new activities, and new production
technologies. As a consequence, income may be mismeasured for
these assets, relative to the measurement of the income
generated by properly classified assets. However, this does not
mean that depreciation allowances for assets used in newer
industries or for new types of assets in older industries are
necessarily more mismeasured than other assets.
Current class lives have been assigned to property over a
period of decades, under a number of different depreciation
regimes serving dissimilar purposes, and with changed
definitions of class lives. The ambiguous meaning of certain
current class lives contributes to administrative problems and
taxpayer controversies. The current system also makes difficult
the rational inclusion of new assets and activities into the
system, and inhibits rational changes in class lives for
existing categories of investments.
Policy Options
The replacement of the existing tax depreciation structure
with a system more closely related to economic depreciation is
sometimes advocated as the ideal reform. While perhaps
theoretically desirable, such a reform faces serious practical
problems. An approach based on empirical estimates of economic
depreciation is hampered by inexact and dated estimates of
economic depreciation, and by measurement problems that will
plague new estimates. Economic depreciation also requires
indexing allowances for inflation. Indexing raises several
concerns, because it would be complex and may lead to
undesirable tax shelter activity. Another concern is its
revenue cost; indexing could be expensive at high inflation
rates.
Because of other inefficiencies in the tax code, it is
unclear that switching to a system based on economic
depreciation would necessarily improve investment decisions.
Switching to economic depreciation could exacerbate some tax
distortions at the same time that it alleviated others. At
current inflation rates, switching to economic depreciation
would raise the tax cost of most business investment. Thus, it
would reduce overall incentives to save and invest. However,
because current depreciation allowances are not indexed for
inflation, at higher inflation rates switching to economic
depreciation would promote both lower and more uniform taxes on
capital income.
Comprehensively updating and rationalizing the existing
asset classification system would address several income
measurement and administrative problems. For example, it would
allow the proper classification of new assets and assets that
have changed significantly. Comprehensive reform of MACRS
recovery periods and methods would be possible once the class-
life system has been rationalized. These changes might move the
system closer to one based on economic depreciation, or perhaps
provide a more uniform investment incentive. A systematic
overhaul, however, would be an ambitious project. It would
involve a significant (and costly) effort to collect and
analyze data in order to determine the class lives of new and
existing assets and activities. This would place a large burden
on taxpayers required to provide these data. It also may
require granting Treasury the resources and the authority to
change class lives.
Less comprehensive changes could improve the functioning of
the current depreciation system. These changes might address
narrower issues, such as the determination of the appropriate
recovery period for real estate, the possible recognition of
losses on the retirement of building components, or the
reduction of MACRS recovery period cliffs and plateaus. These
and other issues are discussed in more detail in the Report.
For many industries, technological obsolescence may be a
more important factor in determining asset depreciation than
physical wear and tear. The decline in value of certain assets
may be associated with the introduction of newer, more
technologically superior assets that may cause a rapid
disposition of assets of earlier vintage. Moreover, with
increased computerization, technological changes may be
occurring more frequently than in the past. In such
circumstances the determination of appropriate tax depreciation
may raise the concern that current recovery periods do not
adequately reflect the rapid decline in value due to more
frequent replacement or to other factors. In particular, the
development of computers and the integration of computers into
the production process raises the concern that the current
recovery period is too long for computers and for production
equipment that increasingly relies on computer technology.
Current law creates a distinction between stand-alone
computers and computers used as an integrated part of
technology. Stand-alone computers are given a five-year
recovery period. Computers used as an integral part of other
equipment are depreciated on a composite basis as part of the
underlying asset. Consequently, their costs generally are
recovered over 5, 7, 10 or more years.
Some commentators have suggested that, at least in their
initial applications, computers do not generally last for five
years. This suggests rapid obsolescence, which some
commentators use to support their argument that the five-year
recovery period for computers is too long. However, the useful
economic life of a computer does not end with its initial
application. We are aware of no careful empirical study that
clearly substantiates the claim that computers have a
sufficiently short useful economic life to merit a shorter
recovery period.
Some industry representatives also argue that computerized
equipment may be depreciated over too long a recovery period.
Most class lives for equipment pre-date the computer
revolution. Thus, the class lives may fail to reflect the
relatively large cost share currently accounted for by
relatively short-lived computer components. A possible solution
to this problem would be to depreciate assets that encompass
integrated circuits or ``computers'' using the same 5-year
recovery period available to stand-alone computers. While
eliminating the tax distinction between integrated and stand-
alone computers has merit, it also raises two serious concerns.
First, integrated circuits are widely used. Consequently,
depreciating over the same 5-year period all equipment that
contains a computer would effectively restore ACRS in that
virtually all equipment would receive the same (short)
depreciation write-off. Such a depreciation system would not be
neutral if, in fact, the equipment has different economic
lives; it would favor those industries whose equipment lasts
longer than 5 years. Second, restricting the 5-year recovery
period to the cost component represented by computer technology
would raise difficult problems in tax administration.
Separating the cost of the integrated computer from the cost of
remainder of the property would be very difficult.
Another issue arises out of the general difficulty the
current system has in establishing and modifying class lives.
Because establishing and changing class lives and recovery
periods generally requires Congressional action, it has proven
difficult to keep the tax depreciation system current. One
possible solution would give Treasury the authority to
establish and modify class lives. To be effective, Treasury
also would need the additional authority to require taxpayers
to collect, maintain, and submit the data necessary to measure
economic depreciation or useful economic lives. The collection,
maintenance and provision of these data, however, would impose
a heavy cost on taxpayers, and the data's analysis would
require significant Treasury resources. In addition, a
piecemeal approach to modifying class lives may not improve
overall neutrality, because depreciation rules would be
established or modified only for a subset of assets.
Tax Treatment of Research and Experimentation
Technological development is an important component of
economic growth and our ability to compete in the global
marketplace. However, firms may underinvest in research because
it is difficult to capture the full benefits from their
research and to prevent their costly scientific and
technological advances from being copied by competitors.
Because other firms and society at large frequently benefit
from the spillover of research conducted by individual firms,
the private return to research often is lower than the total
return. In this situation, government action can improve the
allocation of resources by increasing research activity.
The tax rules provide a number of incentives for research
and experimentation. To encourage taxpayers to undertake
research, and to simplify the Administration of the tax laws,
special flexible tax accounting rules are provided for
investments in the research and experimentation. This treatment
may be applied to the costs of wages and supplies incurred
directly by a taxpayer, to contract research expenses for
research undertaken on behalf of a taxpayer by another, and to
cost sharing research expenses resulting from technology
sharing arrangements with related foreign parties.
Taxpayers may elect to deduct currently the amount of
research and experimental expenditures incurred in connection
with a trade or business, notwithstanding the general rule that
business expenses to develop or create an asset with a useful
life extending beyond the current year must be capitalized.
Expensing of research and experimentation expenditures provides
a tax incentive for such activities and is simple. To encourage
investments by start-up companies in research, this election to
deduct research expenses may be applied prior to the time a
taxpayer becomes actively engaged in a trade or business. Under
these rules, taxpayers have the option to elect to defer and
amortize research and experimental expenditures over five
years, and this election may be applied for all of a taxpayer's
research expenses or on a project by project basis. Pursuant to
a long-standing revenue procedure, the tax accounting rules
applicable to research and experimental expenditures also
extend to software development costs.
As a further inducement to the conduct of research, a
special five-year depreciation life is provided for tangible
personal property used in connection with research and
experimentation.
The research credit fosters new technology by encouraging
private-sector investment in research that can help improve
U.S. productivity and economic competitiveness. For that
reason, the Administration has supported an extension of the
research credit.
Under present law, the research credit is equal to 20
percent of the amount by which a taxpayer's qualified research
expenditures exceed a base amount. The base amount for the
taxable year is computed by multiplying a taxpayer's ``fixed-
base percentage'' by the average amount of the taxpayer's gross
receipts for the four preceding years. Except in the case of
certain start-up firms, the taxpayer's fixed-base percentage
generally is the ratio of its total qualified research
expenditures for 1984 through 1988 to its gross receipts for
those years. The base amount cannot be less than 50 percent of
the qualified research expenses for the year.
Taxpayers are allowed to elect an alternative research
credit regime. Taxpayers that elect this regime are assigned a
three-tiered fixed base percentage (that is lower than that
under the regular research credit) and a lower credit rate. A
credit rate of 2.65 percent applies to the extent that a
taxpayer's research expenses exceed a base amount computed
using a fixed-base percentage of 1 percent but do not exceed a
base amount computed using a fixed-base percentage of 1.5
percent. A credit rate of 3.2 percent applies to the extent
that a taxpayer's research expenses exceed a base amount
computed using a fixed-base percentage of 1.5 percent but do
not exceed a base amount computed using a fixed-base percentage
of 2.0 percent. A credit rate of 3.75 percent applies to the
extent that a taxpayer's research expenses exceed a base amount
computed using a fixed-base percentage of 2.0 percent.
Qualified research expenditures consist of ``in house''
expenses of the taxpayer for research wages and supplies used
in research, and 65 percent of amounts paid by the taxpayer for
contract research conducted on the taxpayer's behalf (75
percent for amounts paid to research consortia). Certain types
of research are specifically excluded, such as research
conducted outside the United States, research in the social
sciences, arts, or humanities, and research funded by another
person or governmental entity.
A 20-percent research credit also is allowed for corporate
expenditures for basic research conducted by universities and
certain nonprofit scientific research organizations to the
extent that those amounts exceed the greater of two prescribed
floor amounts plus an amount reflecting any decrease in non-
research donations.
The deduction for research expenses is reduced by the
amount of research credit claimed by the taxpayer for the
taxable year. The credit is scheduled to expire on June 30,
2004.
Tax Treatment of the Cost of Maintaining a Skilled Workforce
The skill of America's labor force is crucial to
maintaining the U.S. role in the world economy. Well-educated
workers are essential to an economy experiencing technological
change and facing global competition. Not only are better-
educated workers more productive, they are more adaptable to
the changing demands of new technologies. A highly skilled
labor force makes possible technological change and its spread
throughout the economy. Current tax law encourages employers to
invest in worker training and individuals to invest in their
own skills. Administration proposals would create additional
incentives.
Under present law, employers deduct from current income the
costs of training and educating their workers, whether the
expenses are paid to third-party providers or to the firms' own
employees who provide formal or informal training. Education
and training is deductible either as a necessary business
expense (section 162) if it is related to the employee's
current job position, or as employee compensation if it is
unrelated. Although education and training often contributes to
a worker's human capital and provides both the individual and
the firm a return for years to come, such expenses generally
are deducted currently rather than capitalized and depreciated
over time as the benefit is produced. This expensing of
education and training treats investment in human capital more
generously than most investments in physical capital, which
generally are capitalized and depreciated over time. An
investment in human capital would therefore be more attractive
after-tax than an investment in physical capital which produced
the same pre-tax return.
For workers, employer-provided education and training is
excluded from their taxable income, and is therefore tax-free,
if it maintains or improves their skills for their current
jobs. Even if it does not relate to their current jobs, the
cost of education (but not graduate-level courses) up to $5,250
per year provided by an employer under a section 127 education
plan may be excluded from workers' taxable earnings.
Educational expenses paid by an employer outside of a section
127 plan are included in the employee's gross income if the
education (1) relates to certain minimum educational
requirements, (2) enables the employee to work in a new trade
or business, or (3) is unrelated to the current job altogether.
Section 127, which is scheduled to expire for courses beginning
after December 31, 2001 lowers the cost to the employee of
education and training (relative to paying for it out of after-
tax income) and thereby encourages the worker to undertake more
investment in human capital.
Education and training expenses incurred by a student (or
by a family on his/her behalf) generally are not provided
special tax treatment. However, an employee's education
expenses needed to maintain or improve a skill required for the
taxpayer's current job and not reimbursed by an employer are
deductible to the extent that the expenses, along with other
miscellaneous deductions, exceed two percent of the taxpayer's
adjusted gross income. In addition, individuals may claim a
nonrefundable Hope Scholarship credit of up to $1,500 per
eligible student for qualified tuition and related expenses
incurred during the first two years of post-secondary
education. Finally, taxpayers may claim a nonrefundable
Lifetime Learning credit for post-secondary or graduate
education tuition and related expenses, up to a maximum credit
of $1,000 per family ($2,000 after 2002). These education
credits phase out for certain higher-income taxpayers.
The Administration's Budget for FY 2001 includes several
proposals to further encourage individuals and employers to
undertake more education and training.
(1) The College Opportunity Tax Cut would expand the
current-law Lifetime Learning credit by increasing the credit
rate (from 20 percent to 28 percent) and by raising the income
range over which the credit would be phased out (by $10,000 for
singles and by $20,000 for joint returns). It would also allow
taxpayers to elect to take an above-the-line deduction for
qualified tuition and expenses in lieu of the Lifetime Learning
credit. By lowering the after-tax cost of post-secondary
education, the College Opportunity Tax Cut would encourage
families and workers to invest in the training and education
they most need to prepare for and keep up with the demands of
the new economy.
(2) The Administration would expand the section 127
exclusion for employer-provided education to include graduate
courses beginning after July 1, 2000 and before January 1,
2002. As the economy becomes more technologically advanced,
cutting-edge skills and information necessary for continued
growth are increasingly disseminated in graduate-level courses.
Graduate education is an important contributor to the human
capital of the labor force. The Administration also wishes to
continue working with Congress to extend section 127 for both
undergraduate and graduate courses beginning after 2001.
(3) The Administration has proposed a tax credit for
employer-provided education programs in workplace literacy and
basic computer skills. This would allow employers who provide
certain workplace literacy, English literacy, basic education
and basic computer training programs to educationally needy
employees to claim a 20-percent credit, up to a maximum of
$1,050 per participating employee per year. With the increasing
technological level of the workplace of the 21st century,
workers with low levels of education will fall farther behind
their more educated co-workers and run greater risks of
unemployment. Lower-skilled workers are less likely to
undertake needed education themselves, and employers may
hesitate to provide general education because the benefits of
basic skills and literacy education are more difficult for
employers to capture than the benefits of job-specific
education. The proposed credit will serve those most in need of
help in getting on the first rung of the technological ladder.
The Administration strongly supports these three proposals
as part of its overall efforts to maintain and enhance the
skill of the workforce. These proposals would encourage
investment in human capital so that workers, wherever they fall
on the education spectrum and wherever they are in their
working years, can obtain and hone the skills necessary for the
economy now and in the future.
Tax Proposals to Bridge the Digital Divide
Access to computers and the Internet and the ability to use
this technology effectively are becoming increasingly important
for full participation in America's economic, political, and
social life. Unfortunately, unequal access to technology by
income, educational level, race, and geography could deepen and
reinforce the divisions that exist within American Society. The
Administration believes that we must make access to computers
and the Internet as universal as the telephone is today -in our
schools, libraries, communities, and homes.
In recognition of the importance of technology in the new
economy, the President's FY 2001 Budget includes a series of
tax incentives to ensure that residents of disadvantaged
communities are able to develop the skills that will be
essential for labor market success in the coming years. This
initiative, to help ``bridge the digital divide,'' consists of
three components. The first initiative, discussed above, is a
credit to employers who provide training in literacy, basic
education, and basic computer skills to educationally
disadvantaged workers.
The second measure, designed to encourage corporate
donations of computer equipment, builds upon and extends a
similar provision of the Taxpayer Relief Act of 1997. Under the
1997 legislation, a taxpayer is allowed an enhanced deduction,
equal to the taxpayer's basis in the donated property plus one-
half of the amount of ordinary income that would have been
realized if the property had been sold. This enhanced
deduction, limited to twice the taxpayer's basis, was made
available to donors for a limited three-year period. Without
this provision, the deduction for charitable contributions of
such property is generally limited to the lesser of the
taxpayer's cost basis or the fair market value. To qualify for
the enhanced deduction, the contribution must be made to an
elementary or secondary school. The Administration proposal
would extend this special treatment through 2004, as well as
expand the provision to apply to contributions of computer
equipment to a public library or community technology center
located in a disadvantaged community.
The third component is a 50 percent tax credit for
corporate sponsorship payments made to a qualified zone
academy, public library, or community technology center located
in an Empowerment Zone or Enterprise Community. The proposed
tax credit would provide a substantial incentive that would
encourage corporations to sponsor such institutions. Up to $16
million in corporate sponsorship payments could be designated
as eligible for the 50 percent credit in each of the existing
31 Empowerment Zones (and each of the 10 additional Empowerment
Zones proposed in the Administration's FY 2001 Budget). In
addition, up to $4 million of sponsorship payments would be
eligible for the credit in each Enterprise Community. This
credit could induce over $1 billion in sponsorship payments to
schools, libraries and technology centers, providing innovative
educational programs to disadvantaged communities.
The proposed initiatives for employer-provided education
programs in workplace literacy and basic computer skills,
corporate sponsorship of qualified zone academies and
technology centers, and corporate donations of computers will
help bridge the digital divide. This proposal will help to
ensure that low-skilled workers receive the training they need
to improve their job skills, and that disadvantaged communities
have access to innovative educational programs and computer
technology.
Conclusion
The Treasury Department's recent depreciation report raised
issues that would need to be addressed in modifying the present
cost recovery system and provided possible options for
modifications in the system. We intended that the report would
serve as a starting point for a public discussion of
improvements to the cost recovery system. We applaud your
efforts, Mr. Chairman, to begin that discussion with this
hearing, and look forward to working with the Congress on this
matter.
The Administration supports the extension of the research
tax credit. The Administration recognizes the importance of
technology to our national ability to compete in the global
marketplace, and the research credit fosters new technology.
The credit provides incentive for private-sector investment in
research and innovation that can help improve U.S. productivity
and economic competitiveness.
The Administration proposals for education and training -
the College Opportunity Tax Cut, the expansion of employer-
provided education assistance to include graduate courses, and
the new tax credit for workplace literacy and basic computer
skills -can help develop the skills necessary for the economy
of the 21st century. The additional proposed initiatives to
address the digital divide -the enhanced deduction for
corporate donations of computers and the credit for corporate
sponsorship payments to qualified zone academies and technology
centers -will help to ensure that low-income communities have
access to innovative educational programs and computer
technology.
This concludes my prepared remarks. I would be pleased to
respond to your questions.
Chairman Houghton. Okay; thanks very much.
You know, you say this is a good starting point. What's a
good ending point?
Mr. Mikrut. Well, I think it depends, Mr. Houghton, on
where you want to go. We have identified in the studies several
current-law anomalies that could be addressed immediately. For
instance, the current system of MACRS has several what are
called ``cliffs'' and ``plateaus,'' where dissimilar assets are
grouped together and get the same depreciation treatment,
whereas, very similar assets are grouped separately and get
very different treatment. That is one issue that could be
addressed immediately.
I think there are several other smaller issues. There are
certain areas where some simplification could be provided by
using general asset accounts. This is an approach that's been
advocated by the AICPA. But most of the complaints that you
hear about the current depreciation system relate to particular
assets. Following the 1986 Act, the Treasury had the authority
to examine and modify class lives to reflect more appropriately
economic depreciation. This authority was taken back in the
1988 Act. Treasury, although it can study depreciation lives,
cannot change the lives. It's now up to the Congress to change
the lives.
I think in order to fully reflect what's happening in the
new economy, one would have to look at all the depreciation
lives, not just those related to the new economy, because new
technologies are applied in old industries.
There are more than 100 class lives, so the task of doing a
top to bottom analysis of the depreciation system is fairly
monumental and would take several years and would involve very
costly data gathering. And so, it is up to the Congress, up to
the tax writing committees, to try to determine exactly what
they want to do. Do they want to have a long-term study that
could resolve some of the controversies throughout the system?
Or would they prefer to focus on the things that come up
immediately with respect to certain assets or--
Chairman Houghton. Long-term is in the eye of the beholder
in this particular age.
One other question, and then, I'll turn it over to Mr.
Coyne. In terms of asset valuation, that there are obviously
differing depreciation schedules in different countries, and
with the internationalization of our businesses, both in
tangible and intangible assets, do you see this coming together
in some sort of a worldwide pattern?
Mr. Mikrut. The question that you ask is one that's asked
frequently, Mr. Houghton, and although it was beyond the scope
of the study, we have looked at where the United States tax
depreciation system ranks with most of our major trading
partners. And what we've found is with respect to equipment, we
provide incentives for saving and investment that are at least
equal to and perhaps greater than many of our trading partners.
Now, it's often difficult to try to isolate one parameter
of a tax system--depreciation--and say, well, this gives one
nation a competitive advantage over another. I think you have
to look at the entire system as a whole, and that complicates
matters. But on a very broad brush analysis, what we've found
is that the depreciation methods and lives that we use and how
we respond to changes in the technology are comparable to many
of our trading partners.
Chairman Houghton. Thank you.
Mr. Coyne?
Mr. Coyne. Thank you, Mr. Chairman.
Mr. Mikrut, the research and development tax credit is
currently on the books for a 5-year period. What would the
Administration's position be relative to advocates for making
that a permanent tax credit?
Mr. Mikrut. The Administration, as you know, Mr. Coyne, has
supported a long-term extension of the credit and has also
supported a permanent extension of the credit. We understand
that the importance of technology to our national ability to
compete in a global economy depends in part upon the research
credit, which fosters, as you know, further new technology. Any
further modification or extension of the credit, I think,
should be taken in the context of any other tax legislation
that comes before the Congress.
Mr. Coyne. I wonder if you could try to explain what your
view of the disconnect between the ability to fill existing
jobs in the economy and the lack of training for personnel who
might want to fill those positions.
Mr. Mikrut. Mr. Coyne, I think this depends on specific
pockets of the economy. Clearly, some portions of the economy
are growing faster than the others. The IT area is growing much
faster than other segments of the economy, and therefore, the
demand for a skilled workforce there is more critical than in
others. And eventually, of course, training and other
investments have to catch up with those demands.
In response, the Administration has proposed in its digital
divide proposal in the budget to provide employers a 20 percent
tax credit to the extent that it provides basic computer skills
and other literacy requirements. We think that those provisions
are important. It supplements the current beneficial treatment
that training receives under current law; that training
expenses, generally, are deducted rather than capitalized.
Mr. Coyne. Thank you.
Chairman Houghton. Mr. Weller?
Mr. Weller. Thank you, Mr. Chairman, and Mr. Mikrut, I
appreciate the time you're taking before our subcommittee
today. In your testimony, you note that you did not submit any
specific recommendations, particularly when it comes to
depreciation treatment and technology, but if I recall
correctly, I voted in the Tax and Trade Relief Extension Act in
1998, over 2 years ago, legislation which directed the
Department of the Treasury to come forward with a study and
recommendations.
Can you tell me why 2 years is not long enough to do the
necessary study to present some recommendations to the
Congress?
Mr. Mikrut. Certainly, Mr. Weller. There are over 100
different assets subject to different depreciation regimes. We
had 18 months to complete the study. The development of those
class lives for the 100 assets takes years of analysis. We did
not necessarily want to be in a position of picking and
choosing winners and losers, saying we will study the proper
class life for this asset and not the proper study for this
other asset.
Mr. Weller. Sure; well, you know, I think we were all a
little disappointed, number one, that it took as long as it
did, because we were expecting it this spring so we could look
at your recommendations and begin this process, and, of course,
we received this report during the August recess. So it makes
it difficult for Congress to move forward during this session
of Congress, so essentially, we're forced to look at it in the
coming Congress, the 107th Congress.
I want to focus on one specific area, depreciation
treatment of technology and first, do you believe that the tax
code and depreciation treatment of assets, particularly as it
comes to technology, do you believe that the current
depreciation treatment of technology has the potential to
stymie innovation and stymie the acquisition of leading-edge
technology to use in the workplace? Do you think the tax code
has an impact on that?
Mr. Mikrut. Certainly, Mr. Weller; as I mentioned in my
opening statement, the extent that tax depreciation is slower
than economic depreciation creates a disincentive to invest in
those technologies. The current tax system, because the lives
and methods are frozen based on industries, essentially, that
were in existence in the 1960's and 1970's may not reflect new
industries that have sprung up.
In addition, the class lives for certain high tech
equipment--computers, semiconductor manufacturing equipment and
such--those lives are set by statute. So even if the Treasury
Department were to come out with a study that would say those
lives should be shorter, present laws wouldn't allow us to
change those lives.
Mr. Weller. Yes; Mr. Mikrut, let's look at something that's
a pretty basic equipment in every office in America today, and
that's the office PC. What's the recovery period for your
desktop PC or my desktop PC if it were owned by private
industry?
Mr. Mikrut. It's 5 years, double-declining balance.
Mr. Weller. Five years? And in your testimony, you stated--
I think it was on page 5--that the Treasury Department was
unaware of any careful empirical study I believe was the quote
there that establishes that computers have a useful life
shorter than 5 years. Can you tell me: has the Treasury
Department undertaken any empirical study itself?
Mr. Mikrut. No, it has not, Mr. Weller.
Mr. Weller. And why not?
Mr. Mikrut. Generally, Mr. Weller, the studies have been
mandated by Congress. Congress has generally directed us by
statute which lives and which pieces of property to study.
Again, in the present study, we have not chosen to pick and
choose amongst different--
Mr. Weller. So you haven't taken any initiative to look
into that.
You know, if the current recovery period is 5 years for the
office PC, and you think about it, 5 years ago, you know, if I
have the 1995 PC on my desk today, how long it would take me to
access the Internet. Well, we made some notes here just kind of
looking back during the last 5 years, development of some of
the technology in the workplace, and if we were forced to keep
that 5-year-old computer, 1995, the current chips in a PC with
an Intel Pentium Pro, an AMD-K5; we've seen three or four
generations of new chips since then.
1995, a good PC had 150 megahertz of memory. Today, 500
megahertz is commonplace. 1995, PCs had a floppy disk. Since
then, we have been through CD-ROM and now DVD. We now have seen
Windows 95, 98 and 2000 applications. We're way behind. The
question I have for you is, you know, if we--your personal
recommendation: do you believe that 5 years is too long for the
office PC for depreciation?
Mr. Mikrut. I think the visceral reaction of everyone whose
looked at this issue is that 5 years is too long for a PC. I
think, unfortunately, we would need authority to collect the
data from taxpayers in order to do a relatively efficient
study. But I think that this is one issue that is clearly worth
looking at. In our budget, we take a similar approach with
respect to high tech in that we would allow expensing for
software.
Mr. Weller. Sure; just a quick followup on that. You know,
when I talk with those who use PCs in the workplace, whether
it's a small business like an insurance agent or a real estate
office or whether it's a sizeable company with several hundred
employees, they tell me that often, they replace these PCs
about every 12 to 14 months, and a number of us are offering
legislation which would allow you to expense the PC, fully
deduct in the year that you purchase it. Do you feel that that
recognizes economic reality?
Mr. Mikrut. Well, unfortunately, as you point out, our
study couldn't tell you if that is economic reality or not,
because although one taxpayer may hold the computer for a year
or less, the computer may have some salvage value when it's
disposed of. So the proper measurement of depreciation would be
what the taxpayer purchased it for versus what the salvage
value is over that period of time. There may be a secondary
market for used computer equipment that would make that
analysis fairly easy to do relative to other types of property.
So this is something that we would like to work with you in
trying to determine.
Mr. Weller. Mr. Chairman, I've run out of time. Thank you,
and I look forward to working with you.
Chairman Houghton. Thanks very much.
Ms. Dunn, we've got about 7 or 8 minutes, and then, we
really ought to go. So, Ms. Dunn?
Ms. Dunn. Mr. Mikrut, those of us who have supported the
R&D tax credits do so because we want to encourage more
research. It's estimated that the high tech sector is
responsible for 30 percent of our economic growth. These are
good, high-paying jobs. I see them in my district near Seattle,
Washington. They have dramatically improved our quality of
life.
It seems that Treasury is attempting to narrow the scope of
the credit and make it much more difficult for businesses to
take advantage of. This is especially true of the, quote,
common knowledge test that you are, the Treasury, is proposing
and that an Oklahoma court recently ruled against. Can you tell
us the justification for deviating from the historic definition
of qualified research by adding this new language?
Mr. Mikrut. I think the common knowledge test, Ms. Dunn, is
trying to attempt to interpret the statute and legislative
history that says that in order to qualify for the credit, the
taxpayer must be attempting to discover something. In trying to
take the theoretical notion of what discovery means, we try to
apply parameters of what's already known, and let's compare
that to what the taxpayer is trying to discover.
We have received several comments on the very issue you
have raised. The regulations that you're pointing to are
proposed regulations; they do not have full force and effect
until they're finalized. We're taking the comments that we've
received very seriously in developing our next set of guidance.
Ms. Dunn. That's very good, because we are very concerned
about this. It's very troublesome for me as I represent
constituencies at home. They are fearful that they would have
to have intimate knowledge of what every other company is
doing, not just in the United States but around the world. So
I'm happy that you're looking at that.
I'd like to ask you well, maybe just one question, wrap it
all into one about the timing on this plan. Can you tell us
whether Treasury is going to finalize the regs this year, and
when would that be? And do you expect that the regulations
would be finalized as-is, or do you expect changes before they
are passed?
Mr. Mikrut. We have had a significant amount of comments on
the regulations. We understand the importance of the
regulations, both to taxpayers and practitioners in trying to
plan exactly how they should conduct their research and exactly
how they would justify the expenditures and the record-keeping.
So we're trying to take all the comments into account.
On the IRS' and Treasury's business plan for this year, it
was envisioned that we try to finalize the regulations this
year. We've made significant progress on several of the
comments, and again, we're still on plan to try to get it done
this year, and I think there will be changes from what you see
in the proposed regulations.
Ms. Dunn. Can you estimate a time, a date, when you expect
them to be finalized?
Mr. Mikrut. I wish I could, Ms. Dunn. It would be a lot
easier for me, too, but I can't at this time.
Ms. Dunn. Thank you.
Thank you, Mr. Chairman.
Chairman Houghton. Okay; thanks, Ms. Dunn.
Mr. Watkins?
Mr. Watkins. I have only a couple of quick questions. I
want to refer to, you know, Mr. Tauzin's letter of July 28
dealing with Section 168. I have been working with a number of
Native Americans who are affected by 168(j) and also the 42(a)
reservations and non-Indian land. We're working to try to get
private sector investments. This expires in 2003. The only
problem is they've run up to a time situation now where the
private sector investors are trying to get plans, trying to get
architectural designs, trying to get an industry ready to go.
They have become reluctant about trying to make the decision to
make the investments, and they feel they are losing the
potential of industry and jobs because of this time shutoff of
2003.
Do you have any plans to ask for some extensions of that
time period? For it to be effective, they're going to have to
have some extension of those years.
Mr. Mikrut. I understand your concern, Mr. Watkins. This is
a similar concern that some have with the R&E credit and any
other investment incentive such that, in order for business to
accurately plan to make investments, they need some lead time
to know what the law is and how long that law will be extended.
The provision that you're pointing to will need a legislative
change. This Administration will not be submitting another
budget, so we won't be able to, in next year's budget, propose
to extend that further than the current sunset date.
Mr. Watkins. Would you be willing to provide a letter at
this time to this Congress to try to have that included in any
type of tax extension for the Native Americans? Because if
we're really sincere about wanting to try to help them attract
private sector jobs, we need to make a move on that, and I
think it would be--submitting a letter, and I'd like to request
it; I'd appreciate the Chairman trying to get maybe a letter,
because we need to move on that. If not, we're just fooling;
we're just speaking with a forked tongue ourselves about trying
to help the Native Americans attract private sector jobs and
build up the private sector economy.
Mr. Mikrut. We appreciate and we understand and support
your goals, Mr. Watkins, and the other question is: will a mere
extension be enough? Or would some other change in the program
be more effective?
Mr. Watkins. Well, this was a 10-year program when it
started, so, you know, if they had another 10 years, it took
them 5 or 6 years to figure out what was happening there, and
then, finally, they've gotten rulings. So they could work to
implement it. Now, the private sector is kind of pulling back.
So we need another 10-year extension on something like this, 5
to 10 years, in order for us to make it effective.
Mr. Mikrut. We understand, Mr. Watkins. And again, the only
issue I was raising is whether--is it merely the passage of
time, or should there be some examination of what is more
effective: the wage credit or the depreciation shorter lives
that really is the engine to attract the jobs that you're
seeking to attract?
Mr. Watkins. I can assure you: I live with Native
Americans, and I was the only non-Native American, non Indian
on a baseball team growing up, and if you've put your feet
under their table like I have and working closely with them,
they need all the help they can get in order to attract jobs
and to be able to build jobs in those areas, and I think that
it would behoove us to try to speak and do what's right.
Mr. Chairman, I hope that we can request and expedite some
kind of extension of 168(j) and 42(a) in order to try to help
the Native Americans.
Chairman Houghton. All right; fine; thank you. If you do
that, it will be very helpful.
So, thank you very much, Mr. Mikrut. We're going to suspend
these hearings for awhile. We have four votes, and I hope Mr.
Jalbert, Coleman and company will understand. We'll be right
back, God and the Speaker willing. Thank you.
[Recess.]
Chairman Houghton. Sorry, everybody, but we're through
voting for awhile, and if we can resume the hearing, I'd like
to introduce Mr. Jalbert, Chairman, President, and Chief
Executive Officer of Transcrypt, International on behalf of the
American Electronics Association; and Dorothy Coleman, Vice-
President of Tax Policy, National Association of Manufacturers;
Molly Feldman, Vice-President of Tax, Verizon Wireless, on
behalf of the Wireless Depreciation Coalition; Clifford
Jernigan, Director of Worldwide Government Affairs, Advanced
Micro Devices; and Theodore Vogel, Vice-President and Tax
Counsel of DTE Energy on behalf of Edison Electric Institute
and Frederick von Unwerth, General Counsel, International
Furniture Rental Association.
So, great to have you here, and Mr. Jalbert, will you
begin?
STATEMENT OF MICHAEL E. JALBERT, CHAIRMAN, PRESIDENT, AND CHIEF
EXECUTIVE OFFICER, TRANSCRYPT INTERNATIONAL, INC., ON BEHALF OF
AMERICAN ELECTRONICS ASSOCIATION
Mr. Jalbert. Good afternoon, Mr. Chairman and members of
the Subcommittee. My name is Mike Jalbert, and I am chairman,
president and CEO of Transcrypt International. My testimony
today is on behalf of the American Electronics Association,
also known as the AEA. There are more than 3,000 high-tech
company members of the AEA, and I thank you for the opportunity
to testify on the tax code and the new economy.
I have prepared this PowerPoint presentation, which you can
see over there on my left, to give a visual demonstration of
the impact the high-tech industry is making on today's economy
and to help explain why our tax code needs to catch up to this
industry.
The growth in high-tech and correspondingly in high-tech
jobs has been nothing less than extraordinary in the 1990s.
High-tech jobs topped 5 million in 1999, adding 1.2 million
jobs in the span of just 6 years. The wages for these jobs are
quite impressive. The wage differential between the private
sector and the so-called high-tech jobs increased from 57
percent in 1990 to 82 percent in 1998. Additionally, the U.S.
Federal Reserve--
Chairman Houghton. Just a minute. Break that down a little
bit. Say that again.
Mr. Jalbert. What I just said, Mr. Chairman, is that the
wage differential between the private sector and the high-tech
jobs increased from 57 percent in 1990--
Chairman Houghton. It was plus 57 percent.
Mr. Jalbert. Plus 57 percent; that's correct; to 82 percent
in 1998.
This growth was taking place all over the United States,
not just in Silicone Valley. For example, my company--
Chairman Houghton. It's Silicon Valley, not Silicone.
Mr. Jalbert. You've got it; Silicon Valley.
[Laughter.]
Mr. Jalbert. For example, my company, Transcrypt
International, a wireless equipment leader in communications
technology, has offices right here in Washington, D.C., but we
have manufacturing facilities and R&D facilities and offices in
Lincoln, Nebraska and Waseca, Minnesota and, not surprisingly,
high-tech is the single largest merchandise exporter in the
United States.
This next slide helps to explain the importance of worker
training tax initiatives. The AEA numbers on high employment
are actually quite conservative. These numbers are very
conservative. In 1999, the number of 5 million high-tech jobs
refers only to jobs with the high-tech industry, not all the
high-tech jobs throughout the entire U.S. economy.
The necessity of high-tech expertise is crossing all
boundaries, and I would suspect that even in your Congressional
offices you have hired employees with high-tech expertise to
help you better communicate over the Web with your constituents
and the larger public. High-tech is everywhere, and the entire
U.S. economy is hiring high-tech. AEA member companies are
finding it increasingly difficult to hire and retain highly
skilled workers.
Permanently extending the Section 127 employer-provided
educational assistance exclusion and expanding it to include
the pursuit of graduate studies will allow high-tech companies
such as mine to address the skilled workforce shortage by
providing training for their own employees.
Turning now to R&D, research and development is a key
ingredient in the new economy, and that fact is repeated
throughout the global marketplace. The R&D tax credit was first
enacted in 1981, and it is no coincidence that industry
replaced the U.S. Government as the primary R&D spender in that
year. High-tech is an R&D-intensive industry, and the R&D
credit provides high-tech and other industries with a critical
tax incentive to maintain and increase their U.S.-based
research and development.
The R&D tax credit is responsible for stimulating U.S.
investment, wage growth, consumption and exports, which all
contribute to a stronger economy and a higher U.S. standard of
living. This credit should be made permanent, and the
regulations governing the credit should be workable.
This final slide clearly demonstrates the U.S. technology
usage rates and growth over just the last few years.
Interestingly, this growth rate pales in comparison with the
growth rate of other countries across the globe. The U.S.
percentage of usage growth is 16 percent for computers, 72
percent for the Internet and 54 percent for cellular phone
usage. This increase in usage demonstrates there is nothing
static about these industries. As the usage rate for high-tech
equipment increases, the industry will continue to grow and
innovate.
Correspondingly, AEA believes that the recovery periods and
depreciation methods under Section 168 should more accurately
reflect what is happening in this new economy. Thank you for
the opportunity to present the Subcommittee with this overview.
I would be happy to answer any questions you may have.
[The prepared statement follows:]
Statement of Michael E. Jalbert, Chairman, President, and Chief
Executive Officer, Transcrypt International, Inc., on behalf of
American Electronics Association
Good afternoon Mr. Chairman and members of the
Subcommittee. My name is Michael E. Jalbert and I am the
Chairman, President and CEO of Transcrypt International, Inc.,
and my testimony today is on behalf of the American Electronics
Association (AEA). Transcrypt International, Inc. designs,
manufactures and markets trunked and conventional radio
systems, stationary land mobile radio transmitters and
receivers, including mobile and portable radios, and
manufactures information security products that prevent the
unauthorized interception of sensitive voice and data
communication. The more than 3,000 high-tech company members of
the AEA and I thank you for the opportunity to testify on the
Tax Code and the New Economy.
I wish to provide the Subcommittee with an important
overview of the New Economy, as much of it is included in the
membership of AEA. I have prepared this power point
presentation to give a visual demonstration of the impact the
high tech industry is making on today's economy and to help
explain why our tax code needs to catch up to this industry.
The statistics presented are collected from the various AEA
Cyber reports, including AEA CyberStates 4.0, AEA CyberNation
2.0, and AEA CyberEducation. More information on these Cyber
reports can be obtained from the AEA homepage at http://
www.aeanet.org
[GRAPHIC] [TIFF OMITTED] T8411.001
The growth in high tech and correspondingly in high tech
jobs has been nothing less than extraordinary in the 1990's.
High tech jobs topped 5 million in 1999, adding 1.2 million
jobs in the span of just six years. The wages for these jobs is
quite impressive--the wage differential between the private
sector and high tech jobs increased from 57 percent in 1990 to
82 percent in 1998. Additionally the U.S. Federal Reserve notes
that 44 percent of GDP growth in recent years is attributable
to high tech. This growth is taking place all over the United
States not just in Silicon Valley. For example, my company,
Transcrypt International, a wireless equipment leader in
communications technology has offices right here in Washington,
D.C. and manufacturing facilities in Lincoln, Nebraska and
Waseca, Minnesota. And not surprisingly, high tech is the
single largest merchandise exporter in the United States.
This quick overview helps to easily explain why the three
topic areas chosen by the Oversight Subcommittee for
examination during the course of this hearing on the Tax Code
and the New Economy are so important: worker training tax
initiatives, the research and development tax credit and its
regulations, and updating the depreciation recovery periods and
methods. As the next slides will demonstrate, AEA specifically
supports updating the tax code address these important issues
in the U.S. economy.
[GRAPHIC] [TIFF OMITTED] T8411.002
Worker Training Tax Initiatives
The AEA numbers on high tech employment are actually quite
conservative. The 1999 number of 5 million high tech jobs
refers only to jobs within the high tech industry, not all of
the high tech jobs throughout the entire U.S. economy. The
necessity of high tech expertise is crossing all boundaries,
and I would suspect that even in your Congressional offices,
you have hired employees with high tech expertise to help you
better communicate over the web with your constituents and the
larger public. High tech is everywhere, and the entire U.S.
economy his hiring high tech.
[GRAPHIC] [TIFF OMITTED] T8411.003
The specific high tech industry product and service
spectrum covers semiconductors and software to computers,
Internet and telecommunications systems and services. AEA
member companies are finding it increasingly difficult to hire
and retain highly skilled workers. AEA's CyberEducation study
found that the number of undergraduates with high-tech degrees
declined 5 percent since 1990. The rapid employment growth
combined with fewer college graduates has resulted in a
shortage of highly skilled workers. Permanently extending the
Section 127 employer-provided educational assistance exclusion
and expanding it to include the pursuit of graduate studies
(H.R. 323) would allow high-tech companies to address the
skilled workforce shortage by providing training for their own
employees.
Research and Development Tax Credit
Research and development is a key ingredient in the New
Economy and that fact is repeated throughout the global
marketplace. The U.S. trails behind other industrialized
nations in its investment in R&D.
[GRAPHIC] [TIFF OMITTED] T8411.004
[GRAPHIC] [TIFF OMITTED] T8411.005
The Research and Experimentation Tax Credit, commonly
referred to as the R&D tax credit was first enacted in the U.S.
in 1981 and it is no coincidence that industry replaced the
U.S. government as the primary R&D spender in that year. This
important tax provision provides for a research credit equal to
20 percent of the amount by which a company's qualified
research expenditures for a taxable year exceeded its base
amount for that year.
[GRAPHIC] [TIFF OMITTED] T8411.006
High-tech is an R&D intensive industry, and the R&D credit
provides high tech and other industries with a critical tax
incentive to maintain and increase their U.S.-based research
and development. The R&D tax credit is responsible for
stimulating U.S. investment, wage growth, consumption and
exports which all contribute to a stronger economy and a higher
U.S. standard of living. The R&D tax credit helps most AEA
member companies (including hardware, software and
manufacturers), regardless of size who undertake research.
Enactment of a permanent R&D tax credit (H.R. 823) will enable
companies to have certainty in their tax planning. AEA strongly
supported the five-year extension of this credit last year, and
urges Congress to permanently extend this credit now.
Additionally, implementation of regulations that accurately
fulfills the congressional intent behind the credit is of
paramount importance. AEA defers to this hearing's R&D panel to
more fully explain the high tech industry's concerns about the
proposed R&D credit regulations. To quickly summarize, AEA
along with others in the R&D industries have filed comments
with Treasury expressing serious concern about the proposed
regulations. Given the strong comments that have been received
by Treasury to these regulations, AEA suggests that at a
minimum Treasury should consider re-proposing these
regulations.
[GRAPHIC] [TIFF OMITTED] T8411.007
U.S. Tax Code Depreciation Recovery Periods and Methods
This final slide clearly demonstrates the U.S. technology
usage rates and growth over just the last few years.
Interestingly, this growth rate pales in comparison with the
growth rate of other countries across the globe. The U.S.
percentage of usage growth -16 percent for computers, 72
percent for the Internet, and 54 percent for cellular phone
usage -demonstrates there is nothing static about these
industries. As the usage rate for high tech equipment
increases, the industry will continue to grow and innovate.
Correspondingly, AEA believes that the recovery periods and
depreciation methods under Section 168 should more accurately
reflect what is happening in this New Economy.
AEA noted with interest the Treasury study that highlighted
the shortcomings of the current system and which concluded that
the current depreciation system is dated. Under this current
regime, only Congress has the authority to change asset class
definitions or class lives, and the introduction of over 50
separate bills in the House and Senate during the 106th
Congress to address this inequity demonstrates how much work is
yet to be done. Rather than commenting on each of these bills,
AEA wishes to state the obvious: that tax certainty and
predictability is of paramount importance. Many subsections of
the high tech industry are considered to be nascent
technologies that do not even have identifiable class lives.
That fact combined with class lives that do not reflect the
useful life of high tech apparatus such as computers, software,
semiconductor manufacturing equipment and printed circuit
boards, is a bad tax combination.
AEA was very interested in Treasury's proposal to establish
temporary asset classes for nascent technologies. As such, the
temporary asset classes would help to provide certainty to
taxpayers for an initial development period, without disturbing
the class lives for existing technologies. AEA agrees with
Treasury that this temporary class designation would provide a
signal that this asset class will be studied before the
expiration date of the temporary asset class. This signal would
be important because often such nascent technologies are too
busy trying to get their technology up and running rather than
worrying about how the tax rules should recognize them.
Similarly, it would avoid placing new assets in an existing
asset class, where they may not belong, and would avoid placing
new assets permanently in a ``default'' class with an arbitrary
class life. AEA concludes its testimony by offering to work
with Treasury and Congress to address these shortcomings in the
tax code.
AEA appreciates the opportunity to present this overview to
you today. I would be happy to answer any questions you may
have. Thank you.
Chairman Houghton. Thank you very much.
What I think we'll do is just go right through the panel
and then take questions afterwards.
All right;--is that okay with everybody?
Okay; Ms. Coleman?
STATEMENT OF DOROTHY B. COLEMAN, VICE PRESIDENT, TAX POLICY,
NATIONAL ASSOCIATION OF MANUFACTURERS
Ms. Coleman.Chairman Houghton and members of the
Subcommittee, thank you for the opportunity to appear before
you today to discuss the tax code and the new economy. My name
is Dorothy Coleman, and I'm pleased to be here today on behalf
of the National Association of Manufacturers. The NAM, 18
million people who make things in America, is the Nation's
largest and oldest multi-industry trade association. The NAM
represents 14,000 member companies, including 10,000 small and
mid-sized manufacturers.
NAM members have long held the belief that the current tax
system is a major obstacle to realizing the full potential of
our economy. We need a new tax system that is simpler and
encourages rather than penalizes work, investment and
entrepreneurial activity, and that is competitive with that of
our foreign trading partners. Specific changes endorsed by the
NAM including savings incentives, a single tax system for
businesses, elimination of the double taxation of corporate
earnings, fair and equitable transition rules, and more rapid
recovery of capital equipment costs.
All businesses, whether considered old or new economy, will
benefit from a pro-growth tax system designed for a 21st
Century economy. In fact, the distinction between the old and
new economies is largely artificial. The term old economy
brings to mind belching smokestacks, blue-collar workers, dirty
factories, bricks and mortar, all aimed at making tangible
things. In contrast, new economy represents high-tech gadgetry,
skilled workers, whistle-clean factories, computers and
microprocessors.
In reality, though, this clear-cut distinction is not an
accurate picture of either the economy or the modern
manufacturing world. The integration of traditional
manufacturing with the technological innovation of the past
decade has transformed our entire economy. This convergence has
been going on for more than a decade and has already created
what we at the NAM call new manufacturing.
A hallmark of our current robust economy is the remarkable
advances in technology that are changing everything about the
way our economy functions. Technology is the single biggest
contributor to economic growth. The fact that manufacturing is
also the single biggest beneficiary of technology underscores
our insistence that the currently fashionable distinction
between the old economy and the new economy is a distinction
without a difference.
Technology has led to a boom in productivity. The rate of
manufacturing productivity growth was nearly 5 percent from
1996 through 1999, double that of the overall business sector,
as it has been since 1992. This strong, steady increase in
productivity has enabled the economy to achieve strong growth
without significant inflation. Over the past 3 years, the U.S.
economy has averaged noninflationary growth of about 4 percent.
We would like to see this economic growth continue; a tax
policy that stops discriminating against capital investment is
essential to continued economic growth.
The pro-growth tax policy we need must encourage businesses
to increase capital formation in the United States. One of the
most effective ways to spur business investment, which, in
turn, will lead to continued technological advances and
productivity growth, is through an enhanced capital cost
recovery system. In particular, the NAM supports moving towards
an accelerated depreciation system that shortens depreciation
lives to one year.
Under this accelerated system, companies could expense
capital equipment in the tax year it was purchased. An integral
part of a system is eliminating the current corporate
alternative minimum tax. By its very nature, the AMT punishes
both individuals and businesses. We commend the Ways and Means
Committee for taking the lead in 1997 to soften the anti-
investment impact of the AMT and provide needed relief to many
companies. Nonetheless, unless the AMT is totally eliminated,
larger deductions for capital investments will push companies
into an AMT situation forcing them to use longer depreciation
periods.
Expensing represents a significant departure from our
current depreciation system. It is imperative that the
transition from the current system to expensing provides fair
and equitable treatment for taxpayers who made business
decisions based on current law. A basic premise of economic
theory is that investment is a positive function of an increase
in demand and a negative function of cost. The cost of capital
to a firm includes three components: the price of capital
goods; the cost of funds to the firm; and the tax treatment of
investment. Expensing lowers the cost of capital and thus leads
to increased investment.
We agree with the Treasury report that the current
depreciation system is dated and that changing the current
system would be a costly and time-consuming undertaking.
Determining class lives alone would consume valuable Treasury
time and resources. In contrast, expensing of capital
investments would be a simple and direct solution.
The goal of a capital recovery system should be to make
capital more available; help American businesses keep pace with
technological change; improve the competitiveness of American
goods in world markets; simplify tax compliance and minimize
the erosive effect of inflation on invested capital. A system
that provides for immediate expensing achieves these goals.
Moreover, workers also benefit from an enhanced capital cost
system. Increased investment raises labor productivity, which
leads to higher wages.
The enhanced capital cost recovery system described here
today doesn't differentiate between old economy and new economy
businesses. It benefits all businesses that invest in capital
goods. On behalf of the NAM, thank you for inviting me here to
discuss this important issue.
[The prepared statement follows:]
Statement of Dorothy B. Coleman, Vice President, Tax Policy, National
Association of Manufacturers
Chairman Houghton and members of the subcommittee, thank
you for the opportunity to appear before you today to discuss
the tax code and the new economy.
My name is Dorothy Coleman, and I am pleased to be here
today to testify on behalf of the National Association of
Manufacturers. The NAM -'18 million people who make things in
America' -is the nation's largest and oldest multi-industry
trade association. The NAM represents 14,000 member companies
(including 10,000 small and mid-sized manufacturers) and 350
member associations serving manufacturers and employees in
every industrial sector and all 50 States. We're headquartered
in Washington, D.C., and we have 10 additional offices across
the country.
NAM members have long held the belief that the current tax
system is a major obstacle to realizing the full potential of
our economy. We need a new tax system that is simpler and
encourages, rather than penalizes, work, investment and
entrepreneurial activity, and that is competitive with the
systems of our foreign trading partners. Specific and systemic
changes endorsed by the NAM include savings incentives; a
single tax system for businesses, with no additional components
like the alternative minimum tax and no net tax increase on
businesses; elimination of the double taxation of corporate
earnings; fair and equitable transition rules and more rapid
recovery of capital equipment costs.
Clearly, all businesses, whether considered ``old'' or
``new'' economy, will benefit from a pro-growth tax system
designed for a 21st century economy. In fact, the distinction
between the ``old'' and ``new'' economies is largely
artificial. The term ``old economy'' brings to mind belching
smokestacks, blue-collar workers, dirty factories, bricks and
mortar -all aimed at making tangible things. In contrast, ``new
economy'' represents high-tech gadgetry, skilled workers,
whistle-clean factories, computers and microprocessors. Its
pace is quick, its productivity is high and its rate of change
is as fast as the Internet.
In reality, though, this clear-cut distinction is not an
accurate picture of either the economy or the modern
manufacturing world. The integration of traditional
manufacturing with the technological innovations of the past
decade has transformed our entire economy. This convergence has
been going on for more than a decade and has already created
what we at the NAM call ``new manufacturing.''
New manufacturing is not just a part of the new economy;
it's one of the reasons we have it in the first place. We would
not have today's new economy, with its seemingly durable high
growth and low inflation, if it weren't for new manufacturing
products (technology), processes (just-in-time inventories, for
example), people (the best workers in the world) and
productivity (made possible by all of the above).
A hallmark of our current robust economy is the remarkable
advances in technology that are changing everything about the
way our economy functions. Technology is the single biggest
contributor to economic growth, and manufacturing is the single
biggest contributor to technology. Based on data from the U.S.
Departments of Commerce and Labor and from the National Science
Foundation, manufacturing accounts for nearly 60 percent of
annual advances in technology. The fact that manufacturing is
also the single biggest beneficiary of technology underscores
our insistence that the currently fashionable distinction
between the old economy and the new economy is a distinction
without a difference.
Technology, in turn, has led to a boom in productivity. The
rate of manufacturing productivity growth was nearly 5 percent
from 1996 through 1999, double that of the overall business
sector, as it has been since at least 1992. This strong, steady
increase in productivity has enabled the economy to achieve
strong growth without significant inflation.
Over the past three years, the U.S. economy has averaged
non-inflationary growth of about 4 percent. We would like to
see this economic growth continue. Needless to say, growth like
that in the next decade cannot be taken for granted. A pro-
growth tax policy that stops discriminating against capital
investment is essential to continued economic growth.
In my remarks today, I'd like to focus on the tax treatment
of physical capital, like plants and equipment. NAM Board
member Collie Hutter, chief operating officer of Click Bond
Inc. in Carson City, Nev., will discuss the tax treatment of
research and development in her testimony before the
subcommittee on September 28.
The pro-growth tax policy we need must encourage businesses
to increase capital formation in the United States. One of the
most effective ways to spur business investment, which in turn
will lead to continued technological advances and productivity
growth, is through an enhanced capital-cost recovery system. In
particular, the NAM supports moving toward an accelerated
depreciation system that shortens depreciation lives to one
year.
Under this accelerated depreciation system, companies could
expense capital equipment in the tax year it was purchased. An
integral part of an accelerated depreciation system is
eliminating the current corporate alternative minimum tax (AMT)
system. By its very nature, the AMT punishes both individuals
and businesses. We commend the House Ways and Means Committee
for taking the lead in 1997 to soften the anti-investment
impact of the AMT. Conforming AMT depreciation periods with
regular corporate tax depreciation periods provided needed
relief to many companies. Nonetheless, unless the AMT is
totally eliminated, the larger deductions for capital
investments under an accelerated depreciation system would push
companies into an AMT situation, forcing them to use longer
depreciation periods.
Fair and workable transition rules also are critical to the
success of an accelerated depreciation system. Expensing
represents a significant departure from our current
depreciation system. It is imperative that the transition from
the current system to a new one provides fair and equitable
treatment for taxpayers who made business decisions based on
current law. In particular, since manufacturing is a capital-
intensive industry, many of our members have sizable amounts of
remaining tax basis that might be lost altogether if expensing
is applied to all capital. While our members support current
expensing, it is important to include transition rules that
allow companies to utilize accrued, but unused, tax attributes.
The positive economic impact of accelerated depreciation is
straightforward. A basic premise of economic theory is that
investment is a positive function of an increase in demand and
a negative function of costs. The cost of capital to a firm
includes three components: the price of capital goods, the cost
of funds to the firm and the tax treatment of investment.
Expensing lowers the cost of capital and thus leads to
increased investment. In this respect, the marginal cost of
capital depends on the depreciation rate applied to new
investments. The depreciation rate applied to old capital does
not change the cost of capital at the margin. However, write-
off of old capital reduces the average corporate tax rate,
leading to higher after-tax profits, larger dividend payouts
and higher stock values.
We agree with the Treasury Department's conclusion in its
``Report to Congress on Depreciation Recovery Periods and
Methods,'' that the current system is dated and that changing
the current system would be a costly and time-consuming
undertaking. Determining class lives alone would consume
valuable Treasury time and resources. In contrast, expensing of
capital investments would be a simple, direct and expeditious
solution.
The goal of a capital recovery system should be to make
capital more available, help American businesses keep pace with
technological change, improve the competitiveness of American
goods in world markets, simplify tax compliance and minimize
the erosive effect of inflation on invested capital. A system
that provides for immediate expensing achieves these goals.
Moreover, workers also benefit from an enhanced capital-cost
recovery system. Increased investment raises labor
productivity, which leads to higher wages.
Higher non-inflationary growth demands higher productivity,
which, in turn, leads to higher compensation. That's a pretty
good formula for success. Federal tax issues that foster this
formula are critical to the continued leadership of the United
States in the international marketplace. The enhanced capital-
cost recovery system described here today doesn't differentiate
between old economy and new economy businesses. It benefits all
businesses that invest in capital goods.
On behalf of the NAM, thank you for inviting me here today
to discuss this important issue.
Chairman Houghton. Thanks very much, Ms. Coleman.
Ms. Feldman?
STATEMENT OF MOLLY FELDMAN, VICE-PRESIDENT OF TAX, VERIZON
WIRELESS, ON BEHALF OF CELLULAR TELECOMMUNICATIONS INDUSTRY
ASSOCIATION
Ms. Feldman. Chairman Houghton and members of the Oversight
Committee, thank you for the opportunity to testify and for
holding these hearings on the tax code and the new economy. My
name is Molly Feldman, and I am Vice-President of Tax at
Verizon Wireless. Verizon Wireless and the Cellular
Telecommunications Industry Association, which represents
nearly 400 companies in all areas of the wireless industry,
seek greater clarity in the depreciation rules governing our
industry.
We support the premise in the press release announcing the
subcommittee's hearing that the Internal Revenue Code's
depreciation system is very outdated and fails to adequately
address the cost recovery needs of the Nation's new, high-
technology based economy. The wireless telecommunications
industry, like many other high-technology industries, depends
on computer-based technology to facilitate the digitization of
voice, video and data over its new digital networks.
The first steps in the development of the current wireless
system started with the creation of a computer-controlled
network of cells which contained low-powered, computer-based
switching equipment. It was the introduction of the computer to
the system of cell sites that enabled the cellular system to
provide call handoffs as a mobile user passed through its
designated geographic area. Computers are used to provide all
required functions and are predominant in all parts of the
system.
Wireless companies are continuously replacing equipment due
to obsolescence. For example, much of the upgraded digital
wireless equipment that only recently replaced analog equipment
beginning in the mid-1990s is itself expected to be replaced in
a few short years due to the emergence of the next generation
of equipment. The increasing speed with which this is
occurring, just as in the computer industry, has rendered many
billions of dollars worth of equipment obsolete.
The Treasury Department's recently released report to the
Congress on depreciation recovery periods and methods
recognizes that innovation in the information age has created
many new industries that are not clearly addressed by current
depreciation rules. The report points out that the wireless
telecommunications industry was in its infancy when the current
asset classes were defined and that its digital technology does
not fit appropriately into the existing definitions for wired
telephony related classes.
The wireless telecommunications industry is one of the
fastest growing industries in the United States with more than
100 million Americans that currently subscribe to wireless
service. Job growth in the wireless industry supplied just over
4,300 American jobs in 1986. By 1999, over 155,000 jobs were
created, and the industry was responsible for creating another
million jobs in supporting and related industries.
Rapid technological innovation has resulted in an evolving
industry that originally provided voice communications to one
that increasingly works as a network providing computer
functionality. New, third-generation products, sometimes
referred to as 3G, will provide much-improved services to
remote users, including enhanced voice and high-speed data
links to office computers; the ability to send and receive
faxes; high-speed Internet connectivity; video transmission and
videoconferencing.
Wireless companies plan to expand wireless networks into
new markets and rural areas with the goal of uninterrupted
service throughout North America. Continued investment in
network upgrades and expansion will continue to improve local
economies and will permit the increased availability of mobile
data services, providing Internet access to many urban, rural
and suburban communities.
Not only has the increase in wireless subscribership driven
job growth, but it has also increased capital spending. In
1985, total capital spending on wireless telecommunications
equipment amounted to $526 million. By 1999, annual capital
expenditures had exceeded $15 billion. Unfortunately, without
clear depreciation rules which reflect the true useful life of
wireless telecommunications equipment, continued investment
might be limited or deferred.
As you know, the cost of most tangible depreciable property
placed in service after 1986 is recovered using the modified
accelerated cost recovery system. Under this system, assets are
grouped into classes of personal property and real property,
and each class is assigned a recovery period and depreciation
method. The commercial wireless telecommunications industry was
in its infancy in 1986 and 1987 when the depreciation system
was last revised. As a result, the rules which are currently
being applied by the IRS and by the wireless industry were
originally developed without specifically considering the
characteristics of wireless telecommunications equipment.
Both wireless telecommunications companies and the IRS have
expended significant resources over the past few years auditing
and settling disputes involving the depreciation of wireless
telecommunications equipment. Because of the rapid
technological changes, we believe that the maximum recovery
period that should be applied is 5 years. Clearly, the
appropriate class life of cellular telecommunications assets
does not approach 10 years, let alone the 16 to 20 years often
argued by the IRS. As a result of these continuing disputes and
the lack of clear guidance, we believe Congress must clarify
the depreciable life of these assets.
The inappropriate assignment of assets to depreciation
classes with longer recovery periods has a huge impact on the
cost of investment borne by wireless companies. The
misclassification of wireless telecommunications assets imposes
an unfair level of taxation on wireless companies compared to
other companies utilizing assets that have properly defined
class lives. The burden of these unfair taxes is ultimately
borne by the subscribers of wireless telecommunications
service, whose cost of service is higher than it would
otherwise be as well as potential users of wireless systems who
may be precluded from becoming subscribers due to decreased
investment and slower build-out.
Rather than shoe-horn wireless telecommunications equipment
into wire-line telephony classes, as some would do, the better
solution would be to include wireless telecommunications
equipment within the definition of qualified technological
equipment. The code currently defines such equipment to include
any computer or peripheral equipment and any high-technology
telephone station equipment installed on a customer's premises.
Wireless equipment is properly characterized as 5-year,
qualified technological equipment because of the fact that the
predominant components of wireless networks are, in fact,
computers.
A depreciable life of anything greater than 5 years will
penalize this fast-growing industry and limit the capital
available for the continued expansion of an advanced wireless
digital network. Such a network would allow wireless
telecommunications companies to continue to pursue business
objectives which translate into continued job growth,
productivity gains and overall economic expansion.
To ensure depreciation certainty in the future, Congress
should recognize these changes are occurring in the information
age and be prepared to shorten depreciable lives for assets
that are the foundation of the new economy.
We understand that Congressman Phil Crane will be
introducing legislation in the next several days that provides
for this important clarification. We encourage the members of
this committee to join Congressman Crane in addressing this
problem.
In summary, depreciation guidance for the wireless
telecommunications industry is needed to provide clarity and
avoid controversy leading to unnecessary costs to both the
Government and industry. The current depreciation system should
be revised to clarify that all wireless telecommunications
equipment is included in the qualified technological equipment
category.
I'll be pleased to try to answer any questions you may have
regarding my testimony.
[The prepared statement follows:]
Statement of Molly Feldman, Vice President of Tax, Verizon Wireless on
behalf of Cellular Telecommunications Industry Association
Chairman Houghton and Members of the Oversight
Subcommittee, thank you for holding these hearings on the tax
code and the new economy. My name is Molly Feldman and I am
Vice President of Tax at Verizon Wireless. I am appearing
before you today on behalf of a coalition of national and
regional wireless telecommunications companies which have
banded together to seek greater clarity in the depreciation
rules governing our industry. In addition, the Cellular
Telephone Industry Association endorses our recommendation that
depreciable lives for wireless telecommunications equipment
should be clarified to encourage continued investment in the
new economy. We support the premise in the press release
announcing the Subcommittee's hearing that the Internal Revenue
Code's depreciation system is outdated and fails to adequately
address the cost recovery needs of the nation's new high
technology-based economy.
The wireless telecommunications industry provides a
textbook example of the shortcomings of the current tax
depreciation system for emerging high technology industries.
Like so many other high technology industries, the wireless
telecommunications industry depends on computer-based
technology to facilitate the digitization of voice, video and
data over the industry's new digital networks.
The first steps in the development of the current wireless
system started with the creation of a computer-controlled
network of ``cells,'' which contained low-powered computer-
based switching equipment. It was the introduction of a
computer to the system of cell sites that enabled the wireless
system to provide call hand-offs as a mobile user passed
through its designated geographic area, allowing the wireless
system to reuse its limited frequency for another wireless
user. Computers are used to provide all the required functions
and are present in all parts of the system. Without the use of
computers, it is not practical or economical to implement a
wireless system.
The wireless PCS license auctions in 1993 and 1994 created
heightened competition and led to an accelerated change-out of
technology, particularly the conversion from analog to digital
equipment. Wireless companies are continuously replacing
equipment due to functional or technical obsolescence. For
example, much of the upgraded digital wireless equipment that
only recently replaced analog equipment beginning in the mid-
1990s is itself expected to be replaced within the next three
to four years due to the emergence of the next generation of
equipment. The increasing speed with which this phenomenon is
occurring has rendered many billions of dollars worth of
equipment obsolete, as well as shortened both service and
economic lives.
The Treasury Department's recently released ``Report to the
Congress on Depreciation Recovery Periods and Methods'' makes
the point that the rapid pace of innovation in the information
age has created many new industries like the wireless industry
that are not clearly addressed by current depreciation rules.
The report points out that the wireless industry did not exist
when the current assets classes were defined and that its
digital technology does not fit well into the existing
definitions for wired telephony-related classes.\1\
---------------------------------------------------------------------------
\1\ Department of the Treasury, ``Report to Congress on
Depreciation Recovery Periods and Methods,'' July 2000.
The Importance and Growth of the Wireless Telecommunications
---------------------------------------------------------------------------
Industry
The wireless telephone industry has been one of the fastest
growing industries in the United States since the mid-1980s.
The growth in the industry, in terms of subscribership and
capital investment, has taken place at a much faster rate than
predicted in even the most optimistic forecasts. According to
the most recent Cellular Telephone Industry Association (CTIA)
Semiannual Wireless Survey, 86 million Americans subscribed to
wireless service in 1999, and analysts project 175 million
subscribers by 2007.
The growth in wireless subscribers has had a dramatic
effect on the U.S. economy in terms of job creation. The
wireless industry directly supplied 4,334 American jobs in
1986. By 1999, the wireless industry directly supplied over
155,000 jobs and was responsible for creating another million
jobs in industries that support wireless telecommunications.
The wireless industry is part of the high technology community
that is the engine of our economic prosperity, creating new
jobs and new opportunities for all Americans.
The rapid pace of technological innovation that has
characterized the wireless industry in the past will continue
and even increase in the future. The wireless industry is
evolving from an industry that provided primarily voice
communications services to one that increasingly works as a
network providing computer functionality, such as Internet
access. New third-generation (``3G'') products will provide
similar, much improved, services to remote users. Anticipated
uses for new technologies include enhanced voice and high-speed
data links to office computers, the ability to send and receive
faxes, high-speed Internet connectivity, video transmission and
video conferencing.
Wireless companies plan to expand wireless networks into
new markets and rural areas with the goal of uninterrupted
service throughout North America. The current expansion in
networks has distributed the job growth from metropolitan areas
to some of the most rural parts of the country. Continued
investment in network upgrades and expansion will continue to
have a positive effect on local economies throughout the
country. Mobile data services available over the new wireless
digital networks will permit increased expansion of Internet
access into urban, rural and suburban communities,
Not only has the increase in wireless subscribership driven
job growth, but it has also produced a commensurate increase in
capital spending to deploy new technology and expand wireless
networks. In 1985, total capital spending on wireless assets
amounted to $526 million. Annual capital expenditures on
wireless assets exceeded $15 billion in 1999. Capital spending
at the current levels make clear depreciation rules a priority,
but such clarity is exactly what is lacking under our current
depreciation system.
History of the Wireless Telecommunications Industry
Cellular telecommunications technology was first created in
AT&T's laboratories in the 1940s. The technological precursor
of cellular telecommunications was called Mobile Telephone
Service (``MTS'') and consisted of one large broadcasting tower
and a high-powered transmitter which had a range of
approximately 50 miles. In addition to this range restriction,
the system was further limited by the size of the transmitter,
bandwidth constraints and a small user capacity. Another key
limitation was that the MTS could only be used within the
specific geographic location of the tower. The MTS could not
hand off calls to other towers as the user moved outside the
``home'' area. These limitations doomed this technology from
ever becoming commercially feasible.
The first modern cellular system -which the industry now
refers to as ``wireless''--was called Advanced Mobile Phone
Service (``AMPS''). This system was designed to address the
technological limitations posed by MTS. The single base station
in the MTS system was replaced with a computer-controlled
network of ``cells,'' which contained low-powered computer-
based switching equipment. It was the introduction of a
computer to the system of cell sites that enabled the wireless
system to provide call hand-offs as a mobile user passed
through its designated geographic area, allowing the system to
reuse its limited frequency for another wireless user. It
should be clear that computers are used to provide all the
required functions, and that these computers are present in all
parts of the system. Without the use of computers, it is not
practical or economical to implement a wireless system.
As a result of Federal Communications Commission (FCC)
action in 1981 that created a duopoly in 48 Metropolitan
Statistical Areas (MSAs), the first commercially viable AMPS
system was launched in October 1983 in Chicago. Since then, the
wireless industry has grown into a major industry that has
played a significant role in the economic growth in the 1990s.
The FCC auction of 30 MHz Personal Communications Systems (PCS)
licenses during 1993 and 1994, as well as the passage of the
Telecommunications Act of 1996, has significantly increased
investment and competition within the telecommunications
industry. The growth in the wireless industry is due to the
technological advances that have allowed wireless companies to
meet consumer demand and still offer affordable wireless
service to a growing consumer base.
Technological Advances and the Speed of Change
Consumer demand for wireless service has increased at a
phenomenal rate. Although the wireless industry has benefitted
greatly from the strong demand for its products, the industry
has also been forced to aggressively pursue technological
solutions to address bandwidth limitations in order to keep up
with increased competition from new entrants into the wireless
market using the latest digital technologies.
The PCS license auctions in 1993 and 1994 created
heightened competition in the wireless industry. This led to an
accelerated change-out of technology, particularly the
conversion from analog to digital equipment. The increasing
speed with which this phenomenon is occurring has rendered many
billions of dollars worth of equipment obsolete, as well as
shortened both service and economic lives.
Telecommunications technology is progressing at a rate that
has previously only been seen in the personal computer (PC)
industry. Gordon Moore, co-founder and Chairman Emeritus of
Intel Corporation, stated in a speech in 1965, that the pace of
technology change is such that the amount of data storage that
a microchip can hold doubles every year or at least every 18
months. Moore's observation, now known as Moore's Law,
described a trend that has continued and is still remarkably
accurate. It is the basis for many planners' performance
forecasts.
Moore's law is easily applied to changes that have occurred
with wireless telecommunications equipment. The cost of
equipment has remained fairly constant while equipment
capabilities have continued to increase exponentially. The
striking similarity between the PC industry and the wireless
equipment industry is due in large part to the fact that the
major components of a cell site are in fact computers or
peripheral equipment controlled by computers.
Wireless companies are continuously replacing equipment due
to functional or technical obsolescence. For example, much of
the upgraded digital wireless equipment that only recently
replaced analog equipment beginning in the mid-1990s is itself
expected to be replaced within the next three to four years due
to the emergence of the next generation of equipment.
The Future of Wireless Technology
The rapid pace of technological innovation that has
characterized the wireless industry in the past will continue
and even increase in the future. The wireless industry will
evolve from an industry that provides primarily voice
communications services to one that increasingly works as a
network providing computer functionality, such as Internet
access. New third-generation products will provide similar,
much improved, services to remote users. Anticipated uses for
new technologies include enhanced voice and high-speed data
links to office computers, the ability to send and receive
faxes, high-speed Internet connectivity, video transmission and
video conferencing.
In addition, governmental actions may necessitate wireless
carriers to purchase new equipment to meet government mandates.
Currently, the wireless telephone is in the process of
complying with FCC requirements to implement enhanced 911
service. Enhanced 911 (``E911'') service provides emergency
service personnel with the telephone number and location of a
caller reporting the need for emergency services. This
information is used to more rapidly dispatch help and to enable
the emergency personnel to call the user back at the same
number should the call become disconnected.
Both the technological changes taking place in the wireless
industry and new government regulations will require wireless
companies to make substantial capital investments implementing
new technology. These rapidly-approaching events serve to
highlight the critical importance of depreciation rules that
accurately reflect the future state of the industry.
The Components of Wireless Telecommunications Systems
The three primary components of a wireless
telecommunications system--cell sites, mobile switching centers
and handsets--work together as an integrated network to provide
wireless telecommunications services. Each cell site consists
of computer-based assets, which operate as a coordinated unit
that is directly connected to a mobile switching center via a
microwave transmitter or other dedicated transmission facility.
A cell site's computer-based assets are driven by advanced
software programs that encode and decode analog and digital
data through complex algorithms; that monitor and adjust the
power transmission levels of wireless handsets allowing
customers to receive and deliver calls within a particular cell
radius (ensuring quality reception); and that enable call hand-
off as subscribers pass from one cell to the next.
Compared to traditional landline telephone systems, the
functions of wireless telecommunications systems are highly
decentralized--being allocated among the mobile switching
centers and cell sites which comprise these systems. Without
the complex, software-driven functionality of the equipment at
both the cell sites and the mobile switching centers, the
successful coordination of these decentralized functions would
be impossible, as would be wireless telecommunications itself.
Description of a Cell Site
The equipment at a cell site includes computers as well as
equipment that is under the control of computers located at the
cell site itself or at the MSC. A typical cell site is made up
of the following computer base station equipment, which is
integrated to form a single functioning component of the
overall wireless network:
A cell site controller (CSC), which is a
specialized computer that connects calls and maintains call
quality. The CSC controls the computer-based functions of the
cell site. Specifically, the software in the CSC allows the CSC
to communicate with both the cell phone and the MSC, and to
relay and construct the messages that are required to connect
and disconnect calls. Further, the CSC is responsible for
monitoring hand-offs and for relaying signal strength
measurements to the MSC. In addition, the CSC operates together
with the transmitters, receivers and transceivers that modulate
the voice signal into a radio frequency, and vice versa. For
example, when a cell phone makes or receives a call, the CSC
will instruct one of the transceivers to begin transmitting and
will send a digital transmission to the cell phone with
instructions as to the frequency on which the transceiver is
communicating. Because the CSC is a functional extension of the
MSC, any upgrade or change to the MSC will require an upgrade
of the CSC.
Transmitters, receivers, transceivers, antennas
and modems that enable the cell site controller to communicate
with both the MSC and the wireless telephone. The transmitting
and receiving equipment is controlled and operated by software
programs that execute on cell site computers, and these
transform signaling and speech information between the formats
used in the land-line communications facilities and those used
in over the air transmissions between the cell site and the
mobile units.
Power equipment. A variety of power equipment
exists to provide the electrical power necessary to keep the
cell site switching equipment operational under all
circumstances. For example, this equipment is necessary to
convert the external power supply for AC to ``controllable''
DC; to operate the cell site equipment; to monitor and filter
the power level; and, as a secondary function, to ensure that
there is a back-up power supply in the case of a complete
commercial power failure. This power equipment is peripheral
equipment that is essential to the operation of all the cell
site computer-based switching equipment.
An enclosure to protect the electronic equipment
and climate control equipment that enables the equipment to
operate within a controlled temperature and humidity range
In order for a cell site to operate, each component listed
above must be present and in working order.
Changes over Time: Smaller, More Integrated, Similar to
Personal Computers
The cell site has experienced the same technological
advancements in terms of size and integration as most other
technology-based industries. Cell sites are analogous to early
mainframe computers, which often occupied large amounts of
space, sometimes entire rooms within office buildings. Each
successive mainframe required less space, and eventually the
personal computer (PC) was developed. Today's laptop and
palmtop PCs weigh as little as a few pounds, but have
exponentially greater computing capacity than the first room-
sized mainframes.
Early cell sites, while always an integral component of
wireless communications, included an antenna, an enclosure and
computer based switching equipment that required leasing a
separate sizable piece of real estate to assemble the finished
product. As wireless equipment continues to evolve, the size of
cell site equipment is integrated into a smaller package.
Industry experts predict that future cell sites will fit into a
small box and will be placed on utility poles and existing
interstate traffic signs. While functionality and capacity have
increased, Figure 1 shows how the size of the enclosures has
decreased.
[GRAPHIC] [TIFF OMITTED] T8411.008
Cell Site Equipment
Although the next generation of cell site equipment has
been dubbed 3G (for ``third-generation''), there have already
been several waves of wireless technology. Table 1 describes
the major introductions of new cell site equipment that have
occurred since 1983. The first generation of equipment used
with AMPS was introduced for commercial use in 1983. This
analog system was designed to carry one voice channel per 30
kHz bandwidth. The first digital alternative to AMPS was
introduced in 1989. This system, called TDMA (``Time Division
Multiple Access''), allowed more than one user to share the
same voice channel, effectively tripling the number of calls
per bandwidth area.
A different and still more efficient digital encoding
system called CDMA (``Code Division Multiple Access'') was
introduced in 1994. CDMA doubled the carrying capacity of TDMA,
allowing six users to share the same voice channel that
formerly would have been assigned to one analog user. A third
digital standard, GSM, has also been developed. CDMA, TDMA, and
GSM technologies are used for the new all digital cell sites
operating in the PCS bandwidth, which was assigned by auction
in 1993 and 1994. Continual technological advancements such as
CDMA, TDMA, and GSM allow more efficient utilization of
spectrum and reduce the size of cell site enclosures.
Table 1: Major Technological Changes 1984-1998
------------------------------------------------------------------------
Cell Site
Users per 30 Enclosure Year of
Type of Equipment kHz Dimensions Commercial
Bandwidth (feet) Use
------------------------------------------------------------------------
Analog........................ 1 30 1984
50
Digital....................... 3 20 1990
40
Digital....................... 6 10 1996
20
Digital \1\................... 9 34 1998
------------------------------------------------------------------------
Source: Ernst & Young
Overview of Federal Depreciation Rules and Current Treatment of
Wireless Telecommunications Equipment
The cost of most tangible depreciable property placed in
service after 1986 is recovered using the modified accelerated
cost recovery system (MACRS) enacted as part of the Tax Reform
Act of 1986. Under MACRS, assets are grouped into classes of
personal property and real property, and each class is assigned
a recovery period and depreciation method. The applicable
class-life and method used to compute the annual depreciation
allowance varies depending upon the particular asset being
depreciated. An IRS table lists various Asset Classes, along
with their respective class lives and recovery periods.
The commercial wireless industry was in its infancy in 1986
and 1987 when the depreciation system was last revised. As a
result, the rules which are currently being applied by the IRS
and by the wireless industry were originally developed without
specifically considering the characteristics of wireless
telecommunications equipment.
The IRS and the wireless industry have taken different
paths regarding wireless telecommunications equipment \2\
depreciation issues since 1986. The IRS approach has been to
break down cell site equipment into their individual sub-
components and depreciate each based on the functional nature
of the individual sub-component. Wireless companies have taken
the position that the functional nature of the integrated
components should dictate how the assets should be depreciated,
and that the parts of the cell site cannot operate
independently and therefore should be considered an integrated
asset. The differences have resulted in ad hoc, inconsistent,
and costly case-by-case determinations as the issue has arisen
on audit.
---------------------------------------------------------------------------
\2\ See http://www.lucent.com/wirelessnet/products/networks/
cdmahowworks.html for a description of the latest CDMA call densities.
---------------------------------------------------------------------------
The IRS recently provided limited guidance on the
application of Rev. Proc. 87-56 to wireless assets in Technical
Advice Memorandum 98-25-003 (Jan. 30, 1998) (``TAM''). The TAM
asserted that the classes of assets used to provide wireless
telecommunications service are comparable to wireline
telecommunications assets and thus should be assigned to
wireline asset classes. The IRS based this conclusion on the
fact that wireless assets performed switching, transmission,
reception and coordination functions similar to the wireline
assets. The TAM did conclude that mobile switching centers
should be classified in asset class 48.121 (computer-based
telephone central office switching equipment), but it failed to
take a definitive position with respect to the classification
of cell site equipment.
Because the conclusions in the TAM with respect to the
classification of cell site equipment were not definitive, the
TAM provides little practical guidance for IRS auditors or
taxpayers as to the proper classification of cell site
equipment. Because cell site equipment is the backbone that
makes wireless telecommunications possible, the failure to have
clear agreement between the IRS and the industry on the rules
for depreciating this equipment poses substantial difficulties
for the industry.
Significant Increase in the Cost of Capital
As previously noted, the IRS's approach during audits has
been to break cell site equipment down into its sub-components
and propose depreciating each sub-component on its alleged
functional nature, often using a 10-year recovery period (which
equates to a 16 to 20 year class life). The assignment of
assets that are properly five-year property to improper
depreciation classes with longer recovery periods has a large
impact on the cost of investment borne by wireless companies.
Table 2 shows the effect on the hurdle rate of return \3\ and
the effective tax rate of improper assignment of five-year
property to classes with longer recovery periods.\4\ The pre-
tax hurdle rate of return when the assets are properly assigned
is 19.1 percent, while the effective tax rate on the assets is
close to the statutory rate of 35 percent.\5\
---------------------------------------------------------------------------
\3\ The hurdle rate of return is defined to be the pre-tax internal
rate of return a project must exceed before it would be profitable for
a company to undertake it.
\4\ The hurdle rate of return is defined to be the pre-tax internal
rate of return a project must exceed before it would be profitable for
a company to undertake it.
\5\ The calculations assume an inflation rate of 3.3 percent, 100
percent equity financing and a pre-individual income tax discount rate
of 12.2 percent. Economic depreciation is assumed to follow 150 percent
declining balance. The corporation is assumed to be a non-AMT taxpayer
with a 35 percent marginal income tax rate. Depreciation allowances are
computed using the 200 percent declining balance schedule for 5 and 7-
year assessments and the 150 percent declining balance schedule for 10
and 15-year assessments.
---------------------------------------------------------------------------
Table 2: Hurdle Rates of Return and Effective Tax Rates for Cell Site
Equipment
------------------------------------------------------------------------
Hurdle
Assigned Recovery Period Rate of Effective
Return Tax Rate
------------------------------------------------------------------------
5 years........................................... 19.2% 35.0%
7 years........................................... 22.5% 44.4%
10 years.......................................... 26.9% 53.2%
15 years.......................................... 36.2% 64.4%
------------------------------------------------------------------------
Source: Ernst & Young
When the five-year property is not properly assigned, the
hurdle rates of return increase. If the assets are classified
as 15-year property, the hurdle rate of return almost doubles,
rising to 36.2 percent, while effective tax rate rises to over
64 percent. The result of misclassifications is to impose
unfairly high taxes on wireless companies, compared to other
companies utilizing assets that have properly defined class
lives. The burden of these unfair taxes is borne by the users
of wireless service, who pay a hidden tax, and potential users
of wireless systems who do not receive service due to decreased
investment and slower build-out.
One of the guiding principles of MACRS is that the
depreciation tax life of an asset should be shorter than the
actual book life of the asset (i.e., ``accelerated''). The
median five-year recovery period used by companies filing their
tax returns is more consistent with the principles underlying
MACRS as to the rapid obsolescence of wireless equipment. Given
the rapid technological change and advances in the wireless
industry, the median five-year recovery period used by many
companies on their tax returns is the maximum recovery period
that should be applied given the rapid obsolescence of wireless
equipment. Clearly, the appropriate class life of wireless
telecommunication assets does not even approach 10 years, let
alone the 16 years to 20 years used by the IRS.
In addition to imposing higher capital costs, the lack of
clarity in the depreciation rules for cell site equipment
places wireless companies at a significant risk of incurring
penalties and interest as a result of depreciation audit
adjustments. This is particularly troublesome given the
industry's merger and acquisition activity. Acquiring companies
are finding that some acquired companies may have significant
exposure on audit as a result of depreciation elections made in
past years.
Solution -Include Wireless Equipment in Qualified Technological
Equipment
Rather than trying to shoehorn wireless telecommunications
equipment into wireline telephony ``transmission'' or
``distribution'' classes, a better solution would be to include
wireless telecommunications equipment within the definition of
``qualified technological equipment,'' which the Code currently
defines (in section 168(i)(2)) as any computer or peripheral
equipment, any high technology telephone station equipment
installed on a customer's premises, and any high technology
medical equipment. The wireless telecommunications industry
believes that its equipment is properly characterized as
``qualified technological equipment'' because of the fact that
the major components of wireless networks are in fact computers
or peripheral equipment controlled by computers.
Qualified technological equipment has a five-year
depreciable life under the current depreciation system. Given
the rapid technological changes that are expected to continue
in the wireless industry, a depreciable life of anything
greater than five years will penalize this fast growing
industry and limit the capital available for the build out of
an advanced wireless network that will benefit consumers,
businesses and the U.S. economy.
Representative Phil Crane (R-IL) will be introducing
legislation this week to make this important clarification. We
are grateful to Representative Crane for recognizing the need
to address this problem and provide certainty to the wireless
telecommunications industry and its customers.
Summary
Depreciation guidance for the wireless industry is
needed to provide certainty and avoid further controversy
leading to unnecessary costs to both the government and
industry.
The current depreciation system should be revised
to clarify that all wireless telecommunications equipment is
included in the ``qualified technological equipment'' category.
Additionally, Congress should carefully consider the need for
reducing the five-year recovery period to provide proper
recognition of the economic life and resultant class-life for
wireless equipment.
To ensure depreciation certainty in the future, Congress
should recognize the rapid technological change occurring in
the information age and be prepared to shorten depreciable
lives for assets that increasingly have shorter economic useful
lives. Corrective action would assist the IRS in performing
simplified, accurate audits and would greatly reduce the high
compliance costs and excessive capital costs currently borne by
wireless companies. Clarification of the depreciation rules
will allow wireless companies to continue to pursue business
objectives which translate into continued job growth,
productivity gains, and overall economic expansion.
Chairman Houghton. Thanks very much, Ms. Feldman.
Mr. Jernigan?
STATEMENT OF CLIFFORD JERNIGAN, DIRECTOR, WORLDWIDE GOVERNMENT
AFFAIRS, ADVANCED MICRO DEVICES, ON BEHALF OF SEMICONDUCTOR
INDUSTRY ASSOCIATION, SUNNYVALE, CALIFORNIA
Mr. Jernigan. Thank you, Mr. Chairman and members of the
committee. My name is Cliff Jernigan, and I am director of
worldwide government affairs at AMD. I am testifying today on
behalf of the Semiconductor Industry Association, which
represents a $77 billion American semiconductor industry.
It's been 7 years since I last testified before this
committee on depreciation reform. In the meantime, many U.S.
companies in our industry have set up plants overseas at the
expense of American sites, and I think that's unfortunate. This
afternoon, I would like to do three things: first, I would like
to describe our industry and the market in which we compete.
Secondly, I will explain why the current tax depreciation rules
for semiconductor manufacturing equipment are outdated and
discourage investment; and third, I will urge the committee to
support H.R. 1092, the Semiconductor Equipment Investment Act
of 2000, sponsored by Representatives Johnson and Matsui, which
reduces the tax depreciation period for the equipment we use to
make chips from 5 to 3 years.
Let me begin by describing our industry. The semiconductor
industry is now America's largest manufacturing industry in
terms of economic value added, contributing 20 percent more to
the U.S. economy than the next leading industry. We employ
about 280,000 people in high-paying jobs. Parenthetically, our
employment level was about 280,000 people in 1985. Our
employment has remained constant in the United States, but it
has increased overseas, and that's a result of more of our
plants being located overseas.
Driving the growth of the semiconductor industry is the
ever-shrinking transistor, the basic building block of a
semiconductor chip. A decade ago, we were able to integrate
thousands of transistors on a single silicon chip. Today, we
can integrate millions of transistors on a single chip, and
tomorrow, we expect to be able to integrate billions of
transistors on a single chip.
To remain competitive in this rapidly changing environment,
U.S. chipmakers invest 30 cents out of every dollar of sales
into R&D and capital equipment. Unfortunately, the current tax
code fails to recognize the rapid pace of change in our
industry in that it requires an unreasonably long period, 5
years, to recover the cost of our equipment, and I submit
that's one reason many of our companies are being forced to
move overseas.
The useful life of semiconductor manufacturing equipment is
3 years, not 5; probably even less than 3 today. There are
several economic studies cited in my written testimony that
demonstrate this point. Rather than review these studies now,
let me just note what anyone who has shopped for a home
computer already knows--thank you, Congressman Weller--and that
is that every few months, new models are available that are
faster and have more memory for the same price.
This is because the chips in these computers continue to
grow more complex; that is, they perform more functions at
faster and faster speeds. It takes new and more complex
equipment to manufacture each generation of chips, and so, we
have to continually replace our equipment.
The outdated depreciation laws penalize the U.S.
semiconductor industry. Furthermore, they also discourage
investment in the U.S. at a time when other nations are doing
all they can to attract semiconductor industry investment in
plants that cost today between $2 billion to $3 billion each.
Japan, Korea, Taiwan, and many countries in Europe all provide
more favorable depreciation rates, and in some cases, cash
grants or tax holidays to encourage investment.
You may have read yesterday's Wall Street Journal article
about countries trying to entice high-tech companies by
offering significant incentives. I would like to include this
article as part of my written testimony, and I know that you
have a copy now in your possessions.
SIA estimates that an American community seeking to attract
a multibillion dollar chip plant faces a significant handicap
due to the U.S. depreciation laws even before the chipmaker
considers other factors such as workforce and infrastructure
costs. In recognition of these issues, Representatives Nancy
Johnson and Bob Matsui have introduced H.R. 1092 to shorten the
depreciation period for semiconductor manufacturing equipment
to 3 years. There are currently 47 other cosponsors of this
bill, including 10 members of the Ways and Means Committee and
four members of this Subcommittee.
I would like to take this opportunity to thank Chairman
Houghton and Representatives Dunn, Neal and McNulty for
cosponsoring this legislation. I would also like to note that
this issue enjoys bipartisan support and has been endorsed by
both the Republican Main Street Partnership and the Progressive
Policy Institute.
Interestingly, shorter depreciation was part of President
Clinton's platform in 1992, and it was part of Bob Dole's
platform in 1996, but we can't seem to get it done. It is
important for us to move quickly to pass this bill. The
semiconductor industry is undergoing a once-in-a-decade change
in wafer size, moving from manufacturing chips on an eight-inch
diameter wafer to 12-inch wafers. This shift increases the area
of the wafer, allowing manufacturers to produce more chips per
wafer and thereby greatly reducing costs.
But first, this shift will require an investment in plant
and manufacturing equipment probably in the range of $3 billion
to $4 billion. I appreciate the desire of many in Congress to
undertake comprehensive depreciation reform. However, this
could be months if not years. It took 2 years to do the
Treasury study, and we still aren't there yet with solutions.
However, technological change in the new economy moves at
lightning speed, and while a comprehensive reform effort is
underway, 12-inch wafer plants that might have been built in
the U.S. will instead be built overseas.
Therefore, I urge Congress to pass H.R. 1092, not next year
but this year.
In closing, let me leave you with this thought: as you
consider changes to the tax code to reflect the new economy,
remember that the Internet is, in fact, a World Wide Web of
silicon chips. I urge you to shorten the depreciation life for
equipment used to make these chips and that will make the
Internet possible. Thank you for your attention to this issue,
and I look forward to answering any questions you may have.
[The prepared statement follows:]
Statement of Clifford Jernigan, Director, Worldwide Government Affairs,
Advanced Micro Devices, on behalf of Semiconductor Industry
Association, Sunnyvale, California
Thank you Chairman Houghton.
My name is Clifford Jernigan and I am the Director of
Worldwide Government Affairs for AMD. I am testifying today on
behalf of the Semiconductor Industry Association (SIA), which
represents the $77 billion American semiconductor industry. The
SIA is pleased to have this opportunity to testify before the
Oversight Subcommittee of the Committee on Ways and Means on
the need to reform our tax cost recovery rules for the New
Economy.
This afternoon I would like to
1. describe our industry and the market in which we
compete;
2. explain why the current tax depreciation rules for
semiconductor manufacturing equipment are outdated and
discourage investment; and
3. urge the committee's support for the Semiconductor
Equipment Investment Act of 2000, which reduces the tax
depreciation period for semiconductor manufacturing equipment
from five years to three years.
Semiconductors Drive Today's Information Age
The semiconductor industry is now America's largest
manufacturing industry in terms of economic value-added -we
contribute 20 percent more to the U.S. economy than the next
leading industry. The industry employs 284,000 people in the
United States, and these are high paying jobs with wages
significantly above average at every level.
Propelling the growth of the semiconductor industry is the
ever-shrinking transistor--the basic building block of a
semiconductor chip. A decade ago, we integrated thousands of
transistors on a single silicon chip. Today we integrate
millions of transistors on a single silicon chip. The
implications of this technological progress cannot be
overstated. The Internet is, in fact, a world wide web of
silicon chips.
Semiconductor technology advances improve productivity
throughout our economy, leading to the low unemployment and low
inflation we enjoy today. Federal Reserve Chairman Alan
Greenspan, discussing the structural changes behind the current
economic expansion, stated ``. . .the development of the
transistor after World War II appears in retrospect to have
initiated a special wave of creative synergies. It brought us
the microprocessor, the computer, satellites, and the joining
of laser and fiber optic technologies. . . It is the
proliferation of information technology throughout the economy
that makes the current period appear so different from
preceding decades.'' (Remarks before the 92nd Annual Meeting of
the National Governor's Association, July 11, 2000).
The pace of innovation in the semiconductor industry is
among the fastest of any U.S. or worldwide industry. To remain
competitive in this rapidly changing environment, U.S.
chipmakers invested $11 billion in R&D and $17 billion in
capital equipment in 1999. The next generation of fabrication
facilities, those capable of processing 300mm wafers, will cost
between $2-3 billion each. Chip manufacturing equipment will
account for about 85 percent of the cost of these new
facilities.
Competition in this environment is fierce. The U.S. lost
its worldwide market share lead to Japan in 1986, but fought
hard to come back. And comeback we did, increasing from 37
percent global market share a decade ago to 50 percent market
share today.
Since the pace of technological change is extremely rapid
in our industry, SIA member companies spend a greater
percentage of sales on R&D and capital equipment than any other
industry. In fact, over a third of the industry's revenues last
year were plowed back into R&D and capital equipment
investments. Despite this, U.S. semiconductor manufacturers
labor under an inequitable situation. Although the economic
life of semiconductor manufacturing equipment is three years,
the industry is penalized under current tax law, which requires
a five year cost recovery. That is why we are here today.
The Current Depreciation Life is Too Long
There are three commonly cited methods for estimating the
useful life of assets like semiconductor manufacturing
equipment. These three methods are the income approach (which
recognizes a decline in an asset's value based on the asset's
diminishing ability to generate income), the cost approach
(which bases the value of each used asset on the cost of
replacing it with a new asset, but with consideration given for
the reduced remaining service life of the used asset), and the
market approach (which bases relative value on the proceeds of
recent relevant sales of manufacturing equipment as a
percentage of the original cost of each asset). Each of these
three approaches recognizes that the equipment can continue to
be used after technological obsolescence, but only for the
manufacture of older, lower cost, lower value-added products.
The SIA-sponsored American Appraisal Associates study conducted
in 1991 used the market approach, and concluded that the
economic life of semiconductor manufacturing equipment was
about 3.75 years. A 1995 study by Lane Westly used the income
approach and found that semiconductor manufacturing equipment
had a useful life of only 3.27 years. The Lane Westly study
also found that a cost approach provided results consistent
with the income approach. Both studies clearly support the
conclusion that semiconductor manufacturing equipment should be
depreciated over three years rather than five.
There is further evidence suggesting that the pace of
technological obsolescence has quickened since the American
Appraisal and Lane Westly studies. Since 1988, the SIA has been
issuing technology roadmaps to identify and forge a consensus
as to the key challenges to increasing chip productivity, and
to focus research on overcoming those challenges. The roadmap
is developed by semiconductor experts from the U.S., Japan,
Europe, Korea, and Taiwan, and identifies key challenges to
staying on our historical productivity trend. The 1998 roadmap
found that the industry has actually ``skipped'' a year
compared to the roadmap that had originally been projected. For
example, the 1997 roadmap projected that the 1 Gigabit memory
chip would be introduced in 1999 rather than in 2001 as
projected in the prior roadmap. The 1998 roadmap projects the 4
Gigabit will be introduced in 2002, a year earlier than
projected in the 1997 roadmap. (See http://notes.sematech.org/
ntrs/ PublNTRS.nsf for more details on the roadmap).
Technological change not only makes semiconductor
manufacturing equipment obsolete, but it makes the statutory
depreciation class lives obsolete as well.
U.S. Depreciation Laws Penalize U.S. Companies and Discourage
Investment in the U.S.
Other nations are working to encourage investments in
semiconductor production. Japanese law allows for recovery of
up to 88 percent of the cost of chip equipment in the first
year alone; Korea depreciates the equipment over four years
with special benefits that permit additional accelerated
methods or write-downs. Taiwan allows three year straight line
depreciation, but more importantly, also grants tax holidays
that make the depreciation rate a moot point. Singapore also
grants tax holidays for new semiconductor factories. Some
European countries, such as Germany and Italy, have actually
financed a significant part of semiconductor plants through
cash grants and below market interest rates. By contrast,
current U.S. tax law actually discourages investment in U.S.
semiconductor plants.
Current U.S. tax law not only puts our semiconductor makers
at a severe disadvantage with respect to their foreign
competitors, it also makes the U.S. a less attractive
investment location for the new, multibillion dollar
manufacturing facilities the industry will be constructing in
the next few years. SIA estimates that a State in this country
seeking to attract a $2.5 billion chip plant faces a $45
million handicap owing to U.S. cost recovery rules even before
the chip maker considers other factors such as workforce and
infrastructure. (The $45 million represents a Net Present Value
of the imputed interest earned on the difference in the cash
flow resulting from a five year depreciation schedule rather
than three year.) The National Advisory Committee on
Semiconductors, established by Congress in 1988 and composed of
Presidential appointees, found in 1992 that ``Allowing
depreciation of equipment over 3 years -a period closer to the
realistic life for many types of equipment than the current 5
year allowable life -would increase the annual rate of
semiconductor capital investment (in the U.S.) by 11 percent.''
U.S. semiconductor makers seek to have the tax code reflect
the true useful lives of our assets. The disincentive to invest
in the U.S. should be removed.
There is an Urgent Need to Fix the Depreciation Problem
The semiconductor industry is undergoing a once in a decade
change in wafer size, moving from manufacturing chips on 200 mm
(8'') diameter wafers to 300 mm (12'') wafers. This shift
increases the area of the wafer by 2.25 times -from the size of
a salad platter to the size of a medium pizza -allowing
manufacturers to produce more chips per wafer, thereby greatly
reducing costs.
The move to 300mm wafers is but one of the current
technology shifts in the semiconductor industry. Jay Deahna,
Semiconductor Capital Equipment Analyst at Morgan Stanley Dean
Witter, has written that:
``While semiconductor companies bought tools [in 1998] to
maximize the output of their existing fabs this year, next year
new clean rooms will be populated with entirely new sets of
tools, which is positive for equipment company growth. Average
order size should get larger, lead times may stretch, and
pricing may increase. . .
``In the next 5-10 years, we expect more chip manufacturing
changes than the previous forty years. This will be driven by
new materials (copper, low k oxides, 300 mm), equipment
(scanner, electroplating, 300 mm, full-fab automation, PSM
masks), and manufacturing techniques (sub-wavelength
lithography, Damascene). '' [emphasis added. From Jay Deahna,
``Semiconductor Equipment Forecast'' in November 1999
newsletter, ``What's Up From SEMI'']
Recognizing the rapid technological obsolescence in the
semiconductor industry, Representatives Nancy Johnson (R-CT)
and Bob Matsui (D-CA) have introduced The Semiconductor
Equipment Investment Act (H.R. 1092) to shorten the
depreciation period for such equipment to three years. There
are currently 47 other cosponsors on this bill, including ten
members of the Ways and Means Committee and four members of
this subcommittees, including you, Mr. Chairman. Thank you.
I appreciate the desire of many in Congress to establish a
process for comprehensive depreciation reform, including
further studies on specific industries. However, technological
change in the New Economy occurs at lightning speed. The SIA is
concerned that while such a process is underway, 300mm wafer
plants that might have been built in the U.S. will instead be
built overseas. Therefore, we urge the Congress to pass H.R.
1092, the Semiconductor Equipment Investment Act of 2000.
Conclusion
U.S. depreciation schedules should reflect the true
economic life of semiconductor manufacturing equipment. By not
reflecting technological obsolescence, U.S. tax law puts this
dynamic industry at a disadvantage vis-à-vis its foreign
competitors and helps drive investment offshore.
SIA respectfully requests that the Congress:
1. recognize that the economic life of semiconductor
manufacturing equipment is three years, not five; note the
urgency for semiconductor depreciation reform created by
technological shifts such as the move to 300mm wafers; and pass
the Semiconductor Equipment Investment Act of 2000 this year.
Thank you for your attention to this issue.
Chairman Houghton. Thank you very much, Mr. Jernigan.
Mr. Vogel?
STATEMENT OF THEODORE VOGEL, VICE PRESIDENT, TAX COUNSEL, DTE
ENERGY COMPANY, ON BEHALF OF EDISON ELECTRIC INSTITUTE,
DETROIT, MICHIGAN
Mr. Vogel. Good afternoon, Mr. Chairman, Mr. Coyne, members
of the subcommittee. My name is Ted Vogel, and I'm vice-
president and tax counsel for DTE Energy Company, the parent
company of Detroit Edison, which is an electric utility serving
Southeastern Michigan.
I'm currently the chair of the Edison Electric Institute
taxation committee, and I'm testifying here on its behalf. I've
previously filed a written statement with the committee. I'd
like to just highlight some items that are in that statement.
Let me initially note that we are an industry that has most of
its assets classified as 20-year property for Federal tax
purpose--long depreciation lives--and traditionally viewed as
long-lived assets.
There are several major developments that have been going
on in the last few years in our industry that I think you
should be aware of that I think is changing that perception of
our industry and our assets.
First of all, as you are aware, we had a crisis in electric
energy supply this summer. I'll touch on that point. Secondly,
the electric utility industry is being restructured in a way
that has eliminated the traditional vertical monopoly and
replaced it with a competitive marketplace. And thirdly, we're
seeing an increased pace of technological change in the
industry that brings about quicker economic obsolescence of
assets.
In addition, there are some disparities in the existing tax
treatment of our assets that we'd like to call to your
attention. In short, we think the answer is to shorten these
long--very long--depreciable lives. In particular, we're
supporting H.R. 4959, which would shorten depreciable lives of
electric generating equipment from the 15 and 20 year lives
that they have today to 7 years.
As to the first point, as you're aware, in the California
market this summer, there were severe electricity supply
crises: San Diego, San Francisco, Silicon Valley, all suffered
brownouts, power spikes and other energy shortages. This was
directly as a result of insufficient generating capacity in
California and an inability to import enough power into the
State. In particular, Silicon Valley firms suffered some
losses. The Hewlett Packard energy manager indicated that if
they lost one day's worth of power, it would amount to $75
million of lost revenue.
California is not alone. We're seeing alarming projections
for much of the country as well in terms of the future growth
of power. In fact, a J.P. Morgan study just released this month
now projects 5 percent or more in annual growth rates. Where is
this growth coming from? It's coming from information
technology, computers, Internet; the growth of our society in
information and in telecommunications, all of it powered by
electricity.
We believe that Congress should act now and should in fact
shorten depreciation lives, and remove the disincentive to
build power plants. Currently, the long depreciation lives for
power plants creates a capital disincentive, and it makes it
harder to attract the needed capital for growth.
The second major development in our industry is the
electrical industry restructuring that's taking place all over
the country. Most States now have moved toward deregulating
their markets. Traditionally, the electrical utility industry
was vertically integrated. You had regional monopolies that
were regulated by the local or State public service
commissions. In fact, the commissions' incentive was to stretch
out depreciation lives as long as possible to keep rates low.
As a result, utilities had no incentives to retire assets early
and upgrade their systems for technological improvements until
they had recovered their costs.
With an open, competitive marketplace, that's no longer the
case. Recovery is no longer based on cost; it's going to be
based on technological innovation.
And that brings me to the third point: technological
innovation is happening in our industry. A generation ago, most
power plant were coal-fired, nuclear-fired, large power plants
that, quite frankly, the technology moved fairly slowly on. If
you built a plant, you knew it could pretty much operate for 40
years with very little change.
In the last decade alone, we've seen an enormous shift as
new generation has moved to gas-fired turbine combined-cycle
operations. These turbines were only 40 to 50 percent efficient
a mere decade ago. Today, they're approaching 70 percent
efficiency. That is driving increased economic obsolescence for
power plants much quicker than we have seen in the past.
Other areas of technological developments are coming fast
down the pike: distributed generation, fuel cells,
microturbines; a lot of developments that I think we're going
to continue to see in the future that will continue to bring
about quicker obsolescence than this industry has experienced
in the past.
Finally, there are some inequities in the current
depreciation system. For example, most of other industries have
much faster depreciation lives than ours. Paper mills, steel
mills, lumber mills, foundries, those types of facilities,
manufacturing plants, have seven-year lives, even though their
assets are very similar to power plants in terms of the overall
useful life of those assets. Chemical plants can be depreciated
in a mere five years.
And again, a lot of that historic disparity came out of the
rate-regulated environment and the monopoly environment that
once existed in our industry. It is now changing.
Other anomalies: a turbine generator owned by a
manufacturer producing power in exactly the same way as one
owned by a utility will receive a shorter depreciation life
under the tax code. A process control computer on, for example,
a cigarette plant will receive a 7-year life, whereas a process
control computer operating a generating plant is given a 20-
year life. So, these kinds of disparities are there in the
code. Some of them are addressed in the Treasury report, and we
appreciate that, and we think those need to be rectified.
In conclusion, we appreciate the Treasury report. There is
some good discussion on page 97 about the challenges facing the
industry, about the changes that are occurring in the industry
and the need to address depreciation rates in the industry, and
we heartily endorse that conclusion. We would like to thank
committee members Thomas, Jefferson and English for their
leadership in sponsoring H.R. 4959.
Thank you for the opportunity to participate.
[The prepared statement follows:]
Statement of Theodore Vogel, Vice President, Tax Counsel, DTE Energy
Company, on behalf of Edison Electric Institute, Detroit, Michigan
My name is Ted Vogel and I am the Vice President and Tax
Counsel for DTE Energy Company, the parent holding company of
Detroit Edison Company. Detroit Edison is an integrated
electric utility serving greater southeastern Michigan with
non-regulated subsidiaries active throughout the United States.
DTE has 2.1 million customers, generates and sells over 50
million MWH of electric energy per year, has approximately
9,000 employees and annual revenues in excess of $4.7 billion.
I am responsible for tax planning and tax compliance for DTE
Energy. I am testifying today on behalf of the Edison Electric
Institute (EEI), specifically the energy supply division of
EEI, the Alliance of Energy Suppliers. Ron Clements, Director
of Governmental Relations at EEI, is accompanying me today.
EEI, through its Alliance of Energy Suppliers, serves the
needs and advances the commercial interests of power producers
and power marketers throughout the United States by advancing
public policy positions that enhance the competitiveness and
effectiveness of the regulated and unregulated producers,
distributors and sellers of electric energy.
THE CRISIS IN ENERGY SUPPLY
The recent headlines that describe the energy supply crisis
in the San Diego region of southern California are a vivid
example of the need to construct additional generation and
transmission capacity in many areas of the United States.
Responding to market demand, almost 52,000 megawatts of
merchant generation--that is, unregulated generating plants
selling energy for resale, not to end-use customers--are
scheduled to come on-line by the end of 2001. This increase in
generating capacity comes far too late, however, to provide
relief from the situation caused by current shortfalls in
generating and transmission capacity.
The San Francisco Bay area also experienced several
blackouts this summer as a result of insufficient generating
capacity in, or availability for import into, the State of
California. Not only was in-state generation in too short of
supply, but, even worse, the California Independent System
Operator, the quasi-public operator of the transmission grid in
California, could not import enough power from neighboring
States to fuel California's high demand for electricity.
Rolling blackouts were instituted in the San Francisco Bay area
on June 14 this summer. Many employees at Silicon Valley
technology companies like Hewlett Packard worked in near
darkness with limited air conditioning. Hewlett Packard's
energy manager told Dow Jones News Service that a blackout in
Silicon Valley would cost companies there as much as $75
million dollars a day in lost revenues.\1\
---------------------------------------------------------------------------
\1\ Dow Jones News Wire, September 20, 2000.
---------------------------------------------------------------------------
The investment firm, J.P. Morgan, reported earlier this
month that U.S. demand for electricity is likely to grow at
more than 5 percent a year, driven largely by the spread of
information technology and telecommunications infrastructure.
Information technology and telecommunications presently account
for 16 percent of U.S. energy consumption, according to the
report.
CONGRESSIONAL ACTION IS NEEDED NOW
Energy shortages have been severe across California, as the
State's expanding economy has out-stripped the construction of
new power plants. To quote President Clinton,\2\ ``The
wholesale price of electricity has risen sharply in California
this summer as a result of tight supplies and growing demand.
---------------------------------------------------------------------------
\2\ Power Marketing Association, Online Daily Power Report, August
23, 2000
---------------------------------------------------------------------------
This is having a particularly heavy impact where the price
hikes are being passed on to consumers, as they are in the San
Diego region.'' The President released $2.6 million in
emergency funds for low-income families to cope with higher
energy costs. He also directed the Small Business
Administration to set up a program for small businesses to
apply for loans to pay their electricity bills. Acknowledging
California's ``power-crunch,'' he renewed his calls to Congress
to take up his Energy Budget initiatives and tax incentives.
The explosive growth in electronic equipment, computers,
telecommunications, and bandwidth content has produced a
dramatic increase in the demand for electricity. All elements
of this new energy intensive information-based economy have two
things in common. All the equipment and content utilized in
this trend incorporate silicon-based microprocessors and
electricity. Everything is plugged in to an electrical outlet.
Personal computers and servers are nothing more than electron
conversion devices that accept kilowatts though a power source
and convert, create, store, and transmit those kilowatts into
digital bits of information. This new information economy is
powered exclusively by electricity. The Internet is becoming
more electricity intensive. Wireless Internet and
telecommunications applications are growing at an even faster
rate than basic Internet growth.
Congress must act now. The most efficient manner for
Congress to act is to legislate incentives to encourage the
construction of new or more efficient electric generation
facilities. The demand for power in this country is staggering
and, with 16 percent of all electric energy being used to
support e-commerce and computers generally, annual growth is
outstripping new capacity by an alarming rate. The inability to
provide sufficient generating capacity will have dire impacts
for virtually all sectors of the country's economy.
IMPACT OF ELECTRICY INDUSTRY RESTRUCTURING
Until the mid-1990's, the investor-owned electric industry
was composed entirely of single State or regional companies
that were closely regulated by the various State public utility
commissions. Companies were vertically integrated: they
generated power, transmitted the power across their regions and
then distributed the power to each customer. The companies
operated as highly regulated monopolies and had an obligation
to serve all customers.
In this regulated market, utilities were given an
opportunity by regulators to recover their investment much
differently than companies that operate in a more competitive
marketplace. A regulated company had little incentive to retire
its assets before the end of their useful life in order to
deploy new technology. To have done so may have resulted in
increased costs to customers that would have been unpalatable
to State commissions and, therefore, not recoverable in rates
paid for regulated services. This regulated status explains, in
part, why electric assets have historically had such long
recovery periods. This no longer is the state of the industry
today.
Nationwide, the structure of the electric industry is
rapidly changing from vertically-integrated, regulated
monopolies to unbundled and fully competitive generation
services. Currently, 24 States and the District of Columbia,
encompassing some 70 percent of the Nation's population, have
either passed electric industry restructuring legislation or
enacted regulatory orders to implement unbundling and
competitive customer choice. In these States, this choice in
electric generating service supplier is either currently
available, awaiting a phase-in implementation or part of a
``big-bang'' implementation in which all customers have the
choice of electric energy supplier all at once. Because of the
introduction of competition, previously applicable rules
regarding the cost recovery of capital simply do not apply any
longer.
There also is no regulatory certainty in a deregulated
electricity market. This is one of the clear contributing
factors at play in the San Diego situation described above.
Uncertainty has stifled the interest of competitive generators
to build new plants. In a regulated environment, predictable
dividend payments to utility investors permitted them the
opportunity to earn a return commensurate with the return they
would earn in industries with similar risk profiles. In a newly
competitive electricity environment, however, investors will
demand a return of, and a higher return on, their investments
over a much shorter period of time to reflect the vastly
increased risks of an unregulated environment. Shorter capital
recovery periods are a key element in attracting these
investors.
The electric industry is one of the most capital-intensive
industries in this country, requiring nearly four dollars in
investment for each dollar of annual revenue. Cost recovery,
including the Federal income tax rules providing for
depreciation and amortization of assets, is of vital
importance. The present 15-20 year depreciation requirement for
generating assets discourages badly needed investment in the
construction of new electric generation facilities and in the
repowering of currently mothballed facilities.
NEW TECHNOLOGY REQUIRES IMPROVED AND ADDITIONAL CAPITAL INVESTMENT
Energy producers must build and maintain state-of-the-art
equipment to accommodate our nation's new technology.
Competitive pressures that arise through the unbundling of
retail electric service requires that all competitors be as
efficient as possible. Because the competitiveness of wholesale
markets is now an established feature of the industry's
business landscape, sales for resale must also be generated as
cost-effectively as possible. The advances in technology
require that all new construction be more efficient in terms of
the engineering measurements than equipment manufactured just a
few years ago. These measurements include capacity factor, heat
rate and availability factor. New combined cycle gas turbine
generators are much more efficient today, resulting in more
rapid obsolescence of older less efficient generating
equipment.
Many of the power plants constructed a generation ago were
coal-fired or nuclear. Power plants being built today are much
more likely to be gas turbine facilities, often operated in a
combined-cycle or as cogeneration facilities that produce steam
for industrial process use as well as electricity. Gas-fired
turbine technology has made stunning advances over the last
decade. These new combined-cycle generators operate at energy
conversion efficiency levels of 70 percent compared to 40-50
percent only a decade ago. Energy conversion efficiency
measures the efficiency with which one type of fuel is
converted to electric energy, which, in turn, is capable of
providing the light, heat or work that consumers expect. As
these advances continue, electric generation equipment suffers
much quicker economic obsolescence than in prior decades when
the current depreciation rates were set.
In addition to new generation facilities, existing electric
generation facilities require massive amounts of investment in
order to retrofit these facilities and bring them into
compliance with environmental regulations. The Clean Air Act
Amendments, new source review, the National Ambient Air Quality
Standards, and the related State implementation plans all
require significant new capital investment in environmental
mitigation technologies in order to improve air quality and
maintain compliance with Federal and State directives. Again,
this advanced technology supports the need for shorter capital
recovery periods.
THE INEQUITIES OF CURRENT DEPRECIATION RULES
The recovery periods permitted under section 168 of the
Internal Revenue Code for assets used to produce and distribute
electricity are much longer than the recovery periods allowed
to other capital intensive industries. As in every other
instance of a heavily regulated industry undergoing
deregulation, new technology is being developed and deployed at
a much more rapid pace and makes obsolete many prior
investments in property, plant and equipment. With most of our
industry's assets placed in the 15-year and 20-year recovery
period, the present cost recovery system unjustly penalizes
investors in electric generation and makes raising necessary
capital much more difficult.
The disparity between electric industry recovery periods
and the recovery periods of other industries is highlighted
upon review of asset class 00.4, Industrial Steam and Electric
Generation and/or Distribution Systems. This asset class
includes equipment identical to that used by the electric
industry except that the energy generated is used in industrial
manufacturing processes instead of being sold to others. This
asset class is given a 15-year life. The same asset in the
hands of an electric company has a 20-year life. No rationale
reasonably supports this distinction.
By contrast to the 15-20 year depreciation lives for
electric generation assets, depreciation lives for other
capital intensive manufacturing processes--such as pulp and
paper mills, steel mills, lumber mills, foundries, automobile
plants and shipbuilding facilities--are depreciable for Federal
income tax purposes over just 7 years. Chemical plants and
facilities for the manufacture of electronic components and
semiconductors can be depreciated over only 5 years. The power
plants that generate electricity have useful lives that are
similar to this production equipment that have recovery periods
in the 7-year range.
Another area of concern are the restrictions contained in
the description of class life 00.12, Information Systems, that
further compounds the disadvantage suffered by investors in
electricity generation, transmission and distribution
facilities. The description excludes computers that are an
integral part of other capital equipment, thus, giving
computers used in a power plant control room a 15 or 20-year
life and a 150 percent declining balance method. A computer
used to run a highly sophisticated nuclear power plant cannot
be expected to be less susceptible to obsolescence than one
used in a cigarette factory, for example, which currently is
recovered within 7 years. The economic life of a process
control computer is not closely related to economic life of the
manufacturing equipment it operates. It belies common sense to
treat a process control computer any differently than a
computer used to administer normal business transactions, yet
these computers perform much more sophisticated ``high
technology'' processes than normal business computer
applications.
Mr. Chairman, to more fully explain the inequities inherent
in current depreciation rates and methods, we have attached a
copy of a letter we submitted to Treasury last November that we
hope can be incorporated into this Subcommittee's formal
record.
CONCLUSIONS AND RECOMMENDATIONS
We applaud this Subcommittee's efforts to take a long
overdue look at the current Federal income taxation system with
respect to capital recovery periods. We agree with the
conclusions of a recent Treasury report and urge you to act on
its findings. The Treasury Report (Report to the Congress on
Depreciation Recovery Periods and Methods) states:
``Electric, gas, water, and telephone utilities were all
generally regulated at the time the current class lives were
established. Under rate of return regulation, utilities were
not theoretically concerned with depreciation and tax expense,
because rate structures were based on cost-plus pricing. A
utility's rate of return on equity was largely independent of
its tax or depreciation expenses. Consequently, for public
utilities, it is unclear that existing class lives truly
represent the actual useful lives of the property involved.
Class lives may be expected to be different in the current
more competitive environment. Producers must maintain state-of-
the-art equipment, which might mean shorter lives and more
rapid depreciation. For example, new generations of combined
cycle gas turbine generators are more efficient today than
previously, leading to a more rapid retirement of such
equipment than would have occurred under regulation.'' [At page
97].
Congressional action is needed to cure the power supply
emergency facing our country. We encourage you to modernize the
tax treatment of new electric generating capacity to reflect
the technical, environmental and economic realities of the
current structure of the electric industry. Doing so would
greatly advance the public interest by insuring against the
dire economic consequences that necessarily accompany
electricity shortfalls. Failing to do so would benefit no one.
In recognition of the need to modernize the capital cost
recovery system for electric generation assets, we wish to
commend Ways and Means Committee members Thomas, Jefferson and
English for their leadership in introducing H.R. 4959 to modify
the depreciation of property used in the generation of
electricity. We believe this is a significant first step in
helping our nation avoid an electric supply crisis which would
harm all segments of our economy.
We would be pleased to provide this Committee with more
information about our industry's views on depreciation rates
and methods for facilities used in the generation, transmission
and distribution of electricity, and how the current system
discourages investment in badly needed new generation capacity
that is necessary to fuel economic growth in this country. We
thank you for the opportunity to participate in this process.
Business Operations Group
November 1, 1999
Department of the Treasury
Office of Tax Analysis
Room 4217, Main Treasury Building
1500 Pennsylvania Avenue, NW
Washington, DC 20220
Re: Notice 99-34; 1999-35 IRB 1; Depreciation Study
Dear Sir or Madam:
The Edison Electric Institute (``EEI'') is pleased to offer the
following comments in response to Notice 99-34; 1999-35 IRB 1 which
requested public comment and recommendations for possible improvements
to the current depreciation system under section 168.
EEI is the association of U.S. investor-owned electric utilities,
their affiliates and associated members worldwide. EEI is serving
approximately 75 percent of the nation's electric customers and
generate approximately three-quarters of all the electricity generated
by all electric utilities in the country.
EEI is concerned that the recovery periods permitted under section
168 for assets used to produce and distribute electricity are much
longer than the recovery periods allowed to other capital intensive
industries. Indeed, this disparity has been present in nearly every
depreciation or cost recovery regime since the 1970's. While there may
have been a justification for this difference a number of years ago,
today we believe that the industry has much more in common with other
capital intensive industries. In the last five years, the electric
industry has begun a transformation from a regional, vertically
integrated, rate regulated business to a national (or international),
industry consisting of three components: generation, transmission and
distribution. Most generation plant investments will be non-regulated.
As in every other instance of a heavily regulated industry undergoing
deregulation, new technology is being developed and deployed at a much
more rapid pace that competes with and makes obsolete many prior
investments in property, plant and equipment. With most of our
industry's assets placed in the 15-year and 20-year recovery period,
the present cost recovery system unjustly penalizes our investors and
makes capital formation much more difficult.
MACRS Cost Recovery Periods
Under section 168, the cost recovery period of assets is generally
determined by reference to the midpoint class life for the asset
guideline class in which such property is classified under Rev. Proc.
83-35, 1983-1 C.B. 745. Section 168 (e)(1) specifies (in relevant part)
that property shall be treated as
10-year property if such property has a class life of 16 through 19
years,
15-year property if such property has a class life of 20 through 24
years, and
20-year property if such property has a class life of 25 or more
years.
Section 168 (b)(1) sets the applicable depreciation method as the
200 percent declining balance method except that section 168 (b)(2)
allows only the 150 percent declining balance method for any 15-year or
20-year property. The application of these rules results in the
following depreciable lives for assets used in the electric industry as
published in Rev. Proc. 87-56:
Hydraulic Production Plants, Steam Production Plants, and
Transmission and Distribution Plant (asset classes 49.11, 49.13, and
49.14 respectively) have 20-year lives,
Nuclear Production Plants and Combustion Turbine Production Plants
(asset classes 49.12 and 49.15) have 15-year lives,
Nuclear Fuel Assemblies (asset class 49.121) have 5-year lives.
Thus, the lion's share of the investment in the electric industry
must be depreciated over 20 years using the 150 percent declining
balance method.
One can scan Rev. Proc. 87-56 and note that very few asset classes
have a 20 year life; aside from electric industry assets there are only
twelve.\1\ Indeed, out of 133 asset classes identified in the Revenue
Procedure only fifteen have even a 15-year life. The only manufacturing
assets included among the fifteen are assets used to manufacture
cement. As a matter of fact, most manufacturing assets have a 7-year
depreciable life and are permitted use of the 200 percent declining
balance method. For example, the following manufacturing categories
have assigned lives that are less than half as long as most electric
industry assets:
---------------------------------------------------------------------------
\9\ They are:
class 01.3 Farm Buildings,
class 40.2 Railroad Structures classified as Public Improvements
Construction,
classes 40.51, 40.53, and 40.54 Railroad Electric Generation
Equipment,
class 48.11 Telephone Central Office Buildings,
class 48.33 TOCSC-Cable and Long-line Systems,
classes 49.21 and 49.221 Gas Utility Distribution and Manufactured
Gas Production Facilities,
class 49.3 Water Utilities,
class 49.4 Central Steam Utility Production and Distribution, and
class 51 Municipal Sewers.
---------------------------------------------------------------------------
7-year cost recovery
Pulp and paper mills, Steel mills, Manufacture of locomotives and
railcars, Lumber mills
Foundries, Auto plants, Ship building
5-year cost recovery
Chemical plants, Manufacture of electronic components and
semiconductors
The disparity between electric industry recovery periods and the
recovery periods of other industries is highlighted upon review of
asset class 00.4 Industrial Steam and Electric Generation and/or
Distribution Systems. This asset class includes equipment identical to
that used by the electric industry except that the energy generated is
used in an industrial manufacturing process instead of being sold to
others. This asset class is given a 15-year life. The same assets in
the hands of an electric company would have a 20-year life.
Another area of concern for our industry are the restrictions
contained in the description of class life 00.12 Information Systems
that further compounds the disadvantage suffered by our investors. The
description excludes computers that are an integral part of other
capital equipment, thus, giving computers used in a power plant control
room a 15 or 20-year life and a 150 percent declining balance method. A
computer used to operate a highly sophisticated nuclear plant cannot be
expected to be less susceptible to obsolescence than one used in a
cigarette factory or a textile mill which currently is recovered within
7 years. The economic life of a process control computer is not closely
related to economic life of the manufacturing equipment it operates. It
belies common sense to treat a process control computer any differently
than a computer used to administer normal business transactions, yet
these computers perform much more sophisticated ``high technology''
processes than normal business computer applications.
The power plants that manufacture electricity have lives that are
similar to the production equipment listed above that have recovery
periods in the 7 year range. The advantageous recovery periods allowed
by Congress were given to encourage modernization of the nation's
industrial base and to improve productivity. As discussed below, the
electric industry is entering a period of great change. It is now
appropriate to reexamine the traditional electric utility recovery
periods and bring them in line with other industries.
The Present and Future State of the Electric Industry
Until the 1990's the investor-owned electric industry was composed
entirely of single State or regional companies that were closely
regulated by the various State public utility commissions. Companies
were vertically integrated in that they generated power, transmitted
the power across their region and then distributed the power to each
customer. The companies operated as monopolies and had an obligation to
serve all customers.
In this sort of market utilities may have had a greater expectation
of recovery of their investment than in a more competitive marketplace.
Furthermore, a regulated company had little incentive to retire its
assets before the end of their technological life in order to deploy
new technology. To have done so might have resulted in increased costs
to customers that would have been unpalatable to State commissions.
This monopoly status may explain why electric assets have historically
had such long recovery periods. Such is not the state of the industry
today.
One by one States are unbundling the electric industry and
introducing competition. Generally, three distinct businesses are
formed: generation, transmission, and distribution. In order to keep
incumbent utilities from enjoying an early market advantage, States are
often structuring market rules such that the incumbent utilities sell
off large numbers of their generation plants. For example, California
utilities sold off half of their fossil fuel plants as part of that
State's restructuring plan. With the proceeds of these sales, many
utilities (or former utilities) are investing in non-regulated
generation plants in other regions of the country. This newly
competitive marketplace is encouraging the introduction of newer
technology. Cleaner burning natural gas plants are being built to
compete with coal fired plants. As many nuclear plants are shut down,
replacement energy is being generated by new, non-regulated plants. In
this marketplace, investors in electric generation have no guarantee of
recovery. As in any other business they will have no control over
other, cheaper sources of supply that will attract away their
customers.
An example of the effect of technological innovation is the rapidly
increasing deployment of combined cycle gas turbine generators.
Combined cycle generators increase efficiency by producing electricity
from otherwise lost waste heat. Today's state-of-the-art combined cycle
generators operate at energy conversion efficiency levels of 70 percent
compared to 40 percent to 50 percent a decade ago. Competitive pressure
is forcing owners of units less than a decade old to make costly
improvements to increase operating efficiency.
In addition to the competitive threats facing the generation
segment of the electric industry, transmission and distribution are
facing competitive threats from gas pipelines and the location of
generation along gas pipelines. Not only is gas a competitive energy
source, but gas pipelines with capacity to serve generating plants can
substitute for portions of transmission lines. Locating new generation
along gas pipelines is, in effect, a mechanism for transporting
electrons by moving gas. Longer term, numerous threats are emerging to
place transmission owner revenues at risk. These include the location
of generation nearer to loads, changes in electricity consumption
patterns, and new technology.
In fact, one rapidly emerging new technology is Distributed
Generation. Distributed Generation refers to electric power produced
using fuel cell technology or on-site small scale generating equipment
that can displace power generated by a central station generating unit.
Because they can be sited on a customer's premise, their widespread use
would effect the economic life of transmission and distribution assets
as well as generating plants.
In EEI's view, the fundamental changes taking place in the electric
industry must be acknowledged and taken into account in the current
cost recovery system. We note that recently many industry groups have
publicly expressed a need for shorter recovery periods. In every case,
these industries already have recovery periods of 5-years, 7-years or
10-years. Although we don't seek to diminish the arguments put forward
by other industries, we do believe that our industry is bearing the
biggest penalty under the present system. The disparity is so great
that we believe that shortening electric industry lives must be acted
upon before adjusting any other industry's lives. We believe the
current system provides incentives that direct capital formation away
from our industry. As a matter of fundamental fairness, the cost
recovery system must take into account marketplace changes that
radically effect the economic useful lives of assets.
We would be pleased to provide you with any other information that
you might find helpful. Please feel free to contact Mr. Cary Flynn of
Duke Energy at 704/382-5918. We would also welcome the opportunity to
meet with you personally to further discuss our views.
Sincerely,
David K. Owens
Executive Vice President
Chairman Houghton. Okay; thanks very much, Mr. Vogel.
Mr. von Unwerth?
STATEMENT OF FREDERICK H. VON UNWERTH, GENERAL COUNSEL,
INTERNATIONAL FURNITURE RENTAL ASSOCIATION
Mr. Von Unwerth. Mr. Chairman, members of the Subcommittee,
I appear here today on behalf of the International Furniture
Rental Association. I am the association's general counsel. I
thank you for this opportunity to say a few words about a
problem for the furniture rental industry that has surfaced
recently with the Internal Revenue Service.
We are a small industry, and I believe the problem is
straightforward, so I won't take much of your time. The
industry I represent is the traditional furniture rental
industry, not to be confused with the rent-to-own industry. The
Congress specifically addressed the depreciation recovery
period for rent-to-own property in the Taxpayer Relief Act of
1997, declaring it 3-year property through an amendment to
Section 168(e) and 168(i).
The members of our industry are in the ``rent-to-rent''
business. It's a service business. We provide short-term
furniture rentals for the convenience of customers temporarily
in need of furniture. All of our members rent furniture for
residential use to both consumers and businesses. Many of them
also rent furniture for office use to individuals and
businesses. Sometimes, it's the same furniture.
It is the rental of furniture for office use that brings us
here today. Now, there has never been any question that the
traditional business of renting furniture falls within Class
57, distributive trades and services, under the MACRS system.
This classification qualifies the furniture held by the rental
company taxpayer as 5-year property under MACRS. Until
recently, there also has been no question that the taxpayer's
rental of furniture to a customer for office use should be no
different for depreciation purposes than his rental of
furniture to a customer for residential use.
In fact, a general information letter from the Service
confirmed that the rental business itself, as a distributive
trade and service business, qualified all the rental inventory
as 5-year property. Both logic and fairness dictate the same
depreciation schedule for the rental company taxpayer whether
the desk, chairs, sofa and end table are rented to the customer
for home use or office use. Of course, there's also the
possibility of a residential customer's rental of furniture for
home office use, of which the rental company may not even be
aware.
To treat these uses differently for depreciation of the
furniture by the rental company would enormously and unfairly
complicate the business of renting furniture. The problem
furniture rental companies now face arises from an IRS
interpretation of a Tax Court opinion in litigation involving
the Norwest banking organization. The Cincinnati office and the
Ohio Appeals Office have interpreted the Norwest opinion to
mean that any general use asset category, such as office
furniture, fixtures and equipment--that's class 00.11--always,
regardless of the circumstances, takes precedence over any
activity category, such as class 57, distributive trades and
services.
The Norwest case had absolutely nothing to do with rental
furniture. It involved a claim by a bank that certain
furnishings were being used in the distributive trade of retail
banking, even though the bank's use of the furnishings was
typical administrative office use. This specious claim was
given short shrift by the Tax Court. The court specifically
noted that there was nothing unique about the bank's use of the
furniture.
The court also made some observations about a revenue
procedure dealing with priorities between asset categories and
activity categories in general. It did not mention the specific
use of office furniture by a furniture rental company as rental
inventory.
Nevertheless, based on the court's general observations in
Norwest, the IRS in Cincinnati has demanded a change in
accounting method by a Cincinnati-based furniture rental
company for the depreciation of its rental office furniture
inventory. The Service is insisting on a 7-year recovery period
based on an asset classification as Office Furniture, Fixtures
and Equipment under Class 00.11.
The Cincinnati IRS position completely ignores the unique
use of office furniture by the taxpayer as rental inventory, in
which it is repeatedly moved in and out of warehouses, trucks,
and customer premises between rentals. Because of the beating
it takes in this unique use, rental office furniture generally
has a rentable life of 3 to 4 years, even though the same
furniture purchased or leased for long-term use by an ordinary
business could last much longer. Thus, a 7-year recovery period
for rental office furniture makes no sense. It is completely at
odds with the goals of Code Section 167(a), which is to provide
a ``reasonable allowance for the exhaustion, wear and tear...of
property used in the [taxpayer's] trade or business.''
To lay to rest this troubling interpretation that now hangs
over the office furniture rental industry, we ask the committee
to clarify the appropriate recovery period through an amendment
to Section 168(e)(3)(A) and 168(i), specifically defining as 5-
year property all office furniture held by a furniture rental
dealer for rental to businesses and individuals under short-
term leases.
Thank you for your time and your consideration. If there
are questions, I will be happy to try and answer them.
[The prepared statement follows:]
Statement of Frederick H. Von Unwerth, General Counsel, International
Furniture Rental Association
Mr. Chairman and Members of the Subcommittee, I appear
today on behalf of the International Furniture Rental
Association. I am the Association's general counsel. I thank
you for the opportunity to say a few words about a problem for
the furniture rental industry that has surfaced recently with
the Internal Revenue Service. We are a small industry, and I
believe the problem is straightforward. So I won't take much of
your time.
The industry I represent is the traditional furniture
rental industry, not to be confused with the rent-to-own
industry. The Congress addressed the depreciation recovery
period for rent-to-own property in the Taxpayer Relief Act of
1997, declaring it 3-year property through an amendment to Code
section 168(e)(3)(A) and 168(i).
The members of our industry are in the ``rent to rent''
business. It is a service business. We provide short term
furniture rentals for the convenience of customers temporarily
in need of furniture.
All of our members rent furniture for residential use to
both consumers and businesses. Many of them also rent furniture
for office use to individuals and businesses. Sometimes, it's
the same furniture. It is the rental of office furniture that
brings us here today.
There has never been any question that the traditional
business of renting furniture falls within Class 57.00,
Distributive Trades and Services, under the MACRS system. This
classification qualifies the furniture held by the rental
company taxpayer as 5-year property under MACRS.
Until recently, there also has been no question that the
taxpayer's rental of furniture to a customer for office use
should be the same for depreciation purposes as its rental of
furniture to a customer for residential use. In fact, a general
information letter from the Service confirmed that the rental
business itself, as a distributive trade and service business,
qualified all the rental inventory as 5-year property.
Both logic and fairness dictate the same depreciation
schedule for the rental company taxpayer whether the desk,
chairs, sofa and end table are rented to the customer for home
use or for office use. Of course, there is also the possibility
of a residential customer's rental of some furniture for home
office use, which may be unknown to the rental company. To
treat these uses differently for depreciation of the furniture
by the rental company would enormously and unfairly complicate
the business of renting furniture.
The problem furniture rental companies now face arises from
an IRS interpretation of a Tax Court opinion in litigation
involving the Norwest banking organization. The Cincinnati
office and the Ohio Appeals Office have interpreted the Norwest
opinion to mean that any ``general use'' asset category, such
as Office Furniture Fixtures and Equipment (Class 00.11),
always, regardless of the circumstances, takes priority over
any ``activity'' category, such as Class 57, Distributive
Trades and Services.
The Norwest case had absolutely nothing to do with rental
furniture. It involved a claim by the bank that certain
furnishings were being used in the distributive trade of retail
banking, even though the bank's use of the furnishings was
typical office use. This specious claim was given short shrift
by the Tax Court. The Court specifically noted that there was
nothing ``unique'' about the bank's use of the furniture. The
Court also made some observations about a Revenue Procedure
dealing with priorities between ``asset'' categories and
``activity'' categories in general. It did not mention the
specific use of office furniture by a furniture rental company
as rental inventory.
Based on the Court's general observations in Norwest, the
IRS in Cincinnati has demanded a change in accounting method by
a Cincinnati-based furniture rental company for the
depreciation of its rental office furniture inventory. The
Service is insisting on a 7-year recovery period based on an
asset classification as Office Furniture, Fixtures and
Equipment under Class 00.11.
The Cincinnati IRS position completely ignores the unique
use of office furniture by the taxpayer as rental inventory, in
which it is repeatedly moved in and out of warehouses, trucks,
and customer premises between rentals. Because of the beating
it takes in this unique use, rental office furniture generally
has a rentable life of 3 to 4 years, even though the same
furniture purchased or leased for long term use by an ordinary
business could last much longer. Thus, a 7-year recovery period
for rental office furniture makes no sense. It is completely at
odds with the goal of Code Section 167(a), which is to provide
a ``reasonable allowance for the exhaustion, wear and tear. .
.of property used in the [taxpayer's] trade or business.''
To lay to rest this troubling interpretation that now hangs
over the office furniture rental industry, we ask the Committee
to clarify the appropriate recovery period through an amendment
to section 168(e)(3)(A) and 168(i), specifically defining as 5-
year property all office furniture held by a furniture rental
dealer for rental to businesses and individuals under short
term leases.
Thank you for your time, and your consideration. If there
are questions, I will be happy to try to answer them.
Chairman Houghton. Thank you very much, Mr. von Unwerth.
Now we will go to questions of the panel. Mr. Coyne?
Mr. Coyne. Thank you, Mr. Chairman.
My question is to Mr. Jernigan. You indicated that over the
last several years your company has been forced to move much of
your operation overseas. What is it either in the tax code or
other regulations that we have here in the country that--why is
it that you find it necessary to do so much business overseas
instead of here in the United States?
Mr. Jernigan. Let me first say that we are still building
in the United States, but we recently completed about a $2
billion facility in Dresden, Germany. Capital recovery is a
major aspect of why we chose to go overseas. The United States
is just not a very good place to invest today.
And, secondly, we couldn't find employees. You are aware of
the H-1B issue. Germany had an abundance of engineers. We have
a very difficult time finding engineers in this country.
Mr. Coyne. Well, relative to the H-1B situation, has your
company or your associations been involved in any attempt to do
more training of U.S. prospective employees for the industry?
Mr. Jernigan. Absolutely. We have training programs,
vocational training programs in our company. We support the
Semiconductor Research Corporation, which puts money into
universities to help train individuals. We spend millions as a
company and an industry to try to train people.
Mr. Coyne. Have you had much success in those efforts?
Mr. Jernigan. Yes.
Mr. Coyne. Or is still one of the driving forces to push
you overseas?
Mr. Jernigan. It is still a prime consideration as to why
we went overseas the last time around.
Mr. Coyne. Even though you have had some success in these
training efforts?
Mr. Jernigan. Yes.
Mr. Coyne. They are just not enough.
Mr. Jernigan. Not enough.
Mr. Coyne. Thank you.
Chairman Houghton. Mr. Weller?
Mr. Weller. Thank you, Mr. Chairman. I think one clear
message I have gotten from this panel is that, of course, our
current tax code is stymieing innovation and advancement of
technology and is actually depressing the opportunity for
higher wages for workers in this country. And that is why I
think your hearings are so very, very important.
I recognize we have got a number of people on the panel
and, of course, a limited amount of time. I just want to direct
my first question, I think, to Ms. Coleman. As you know, of
course, we have worked with your organization on the issue of
depreciation treatment of office computers, as we have with
others that are on this panel. Currently, the office computer,
you carry it on the books for 5 years. Do you feel that that is
an accurate reflection of the life of those office computers?
Ms. Coleman.I certainly think that your legislation to
expense office computers is an excellent first step, and I
think the NAM believes that all business equipment should be
expensed.
Mr. Weller. You indicated you support expensing. You know,
one of the questions I am often asked--and I have been given
the figure of 12 to 14 months is apparently how often that many
businesses replace that computer, the PC that sits on the desk.
Is that an accurate figure?
Ms. Coleman.I am not really in a position to comment on
that right now, but I would be happy to get back to you.
Mr. Weller. Okay. Are there any others on the panel that
can share with us just from their possible, Mr. Jernigan,
maybe? You are in the business.
Mr. Jernigan. I think we are replacing computers in our
company about 2 to 2 and a half years.
Mr. Weller. So that 12 to 14 months may be a little too--
Mr. Jernigan. I don't know the answer.
Mr. Weller. Okay. Anyone else on the panel on that
turnover, on 12 to 14 months?
[No response.]
Mr. Weller. One of the questions that clearly was raised
when Treasury was before us was--you know, they took 2 years to
do their study, which is a long period of time. It is a
lifetime in the time of Congress let alone in the business of
technology where we have seen such rapid changes in the last 2
years, let alone the last 5 or 10. And they indicated that they
had failed to collect any empirical data regarding to when it
comes depreciation treatment of technology.
I was wondering, Do your organizations, have any of you
collected any empirical data that might help us better
understand and better prepare as we work towards depreciation
reform? Any organizations? Mr. Jernigan?
Mr. Jernigan. Yes. The semiconductor industry has done
three studies over the last 15 years in conjunction with people
in the Treasury Department, working with them on the
methodology, et cetera. They are reluctant to still endorse the
studies, but they actually helped to participate in the studies
with the outside consulting firms we used.
The last study we did showed that semiconductor
manufacturing equipment has an economic life of just about 3
years, and that study was done 5 years ago, and I am sure the
life of our equipment is less today.
Mr. Weller. Okay. Tying in with that, Mr. Jernigan--and I
would very much like to see your material as we work on the
depreciation reform.
Mr. Jernigan. We will provide it to you.
Mr. Weller. This is my last question I just want to direct
to you. You mention in your testimony how other countries
provide for depreciation treatment of technology, and, of
course, our chief competitors are in Europe and Japan. Can you
share with us what their depreciation schedules on PCs, for
example?
Mr. Jernigan. In the depreciation area, their lives are
generally equal to better than ours. But then it is in the fine
print that they give you the better incentives. Japan has a 5-
year life, but they give you extra depreciation if you are
located in special zones or if you use the equipment over 24
hours a day. So, in looking at Japan, we have noted that they
offer an 88 percent write-off in the first year and up to 113
percent write-off after 3 years.
Other countries, and our experiences with Germany, will
essentially pay for half the plant. And we know some companies
in our industry where the plant was almost totally paid for,
and that has been the case in Italy. We know that Taiwan is a
major country today. In fact, the Government of Taiwan is
thinking that their plants now will buy more semiconductor
equipment in 2 years' time than in the U.S. In other words,
everyone is going to Taiwan because of all the additional
incentives: short depreciation, cash grants, low interest rate
loans, on and on and on.
I think our Treasury Department was talking about, well, it
looks like there isn't much difference between our country and
other countries. If you look at just the plain depreciation
rules, probably the differences aren't that great. It is in the
other incentives that they offer, which are cash recovery
incentives that oftentimes equate to expensing and sometimes
even expensing plus incentives.
Mr. Weller. That is very helpful. Thank you.
Thank you, Mr. Chairman, for the opportunity to ask
questions.
Chairman Houghton. Thank you.
Mr. Watkins?
Mr. Watkins. Thank you, Mr. Chairman. I, too, would like to
thank you for having these hearings and having this, I think,
very appropriate time to discuss this. The high-tech industry,
we do have a tremendous crisis ahead of us, I think.
Mr. Jernigan, have you looked at Native Americans? We do
have tax incentives, but many companies will not look at Native
Americans, and we do have accelerated depreciation. We have got
some nice tax credits. For instance, in my district I have
surveyed them. I am going through career tech, low-tech stuff,
and there are 8,000 people or more that right now have had some
high-tech. But many industries have not looked at going into
small- town rural America, and I would like to encourage you
not to overlook that, especially with the Native Americans.
Many of them are really highly, well qualified and can do a
great job, but sometimes we are always left out. As I said last
time, don't overlook--do go over rural America going somewhere
else when we do have that need.
I am back here because of that reason. I was a businessman
in small- town rural America and trying to make things work,
and out-migration, the lower unemployment, we have people who
live out there, and one of the biggest problems in high-tech is
needing a stabilized workforce. We have that in rural America.
That is why they are living out in the small- town rural
America because they want to stay there and live there and work
there and raise a family there. All we want to do is have the
opportunity there. And I have been working some pilot areas to
try to get there.
We do have tax incentives there to be able to help us do
some of the things, so I want to encourage you, and I would
welcome any of you to let me visit with you in my office or
your office about that. I am here in this Congress trying to
rebuild the economic livelihood of people who have been left
behind since the Great Depression, let alone just in this time.
You know, history books, we can look back at history books,
and we know the Industrial Revolution was one of the major
launching pads of this great country. But we are living through
two revolutions now, yes, the information technology
revolution, but also globalization. Both those are revolutions
taking place right now in our lifetime, and I would like to
just leave you with the fact that we need to try to make sure
all of America happens to be worthy of these incentives.
I came back also because I wanted to try to help shape a
global competitive economy for the United States. We balanced
the budget, which I think is really important, but a global
competitive economy is one that has got less taxation. We have
got to have less taxation, Mr. Chairman. We have got to be lean
and mean on taxation if we are going to compete in a global
economy. The same way with less regulation--
Chairman Houghton. You can be leaner and I will be meaner.
Mr. Watkins. You will be meaner, yes, sir, Mr. Chairman.
But less regulation and less litigation. In fact, if you look
at it, industry trying to compete around the world today, they
got a 15 percent overburden when you look at the tax, over 15
percent overburden when you look at taxation and the regulation
and the litigation when we start trying to compete with the
world. And I want to try to give you some relief in a lot of
those areas. That is why I am working with my friend Jerry
Weller here on his depreciation bill that we have got to have
to help with the new economy. And I just want to--I guess maybe
I am making more comments than I am asking any questions, but I
am pleading with you not to overlook rural America out in those
areas. I have got 21 counties in Oklahoma, and like I say, none
of them on their own probably can support a major industry, but
when we pull them together in the aggregate, we can provide
tremendous opportunities. And they can do that in Illinois,
they can do that in a lot of other areas around the country.
Have you any industry working with the Native Americans?
Mr. Jernigan. Mr. Watkins, we will invest in any area--it
could be Native Americans or a black community or Asian. That
is not important to our industry. We will go where the jobs are
and where the people are well trained. And I would be very
happy to sit down with you and give you my perspectives of what
Oklahoma will need to do to attract semiconductor jobs.
I know that Oklahoma will attract some major semiconductor
plants. You have a very aggressive economic development
program. You have come very close to attracting some major
plants already, and I would, as I say, be very happy to sit
down and give you my perspective on that. I could be available
this afternoon or--
Mr. Watkins. I will be available right after you get up
from that table.
Mr. Jernigan. Okay, you are on. You have got a date.
Mr. Watkins. Anybody else available?
[Laughter.]
Mr. Watkins. Thank you, Mr. Chairman, very, very much.
Chairman Houghton. Thanks very much, Mr. Watkins.
Mr. Portman?
Mr. PORTMAN. Thank you, Mr. Chairman, and I really
appreciate all the input we are getting from this panel and the
previous panel, and I commend the chairman for holding this
hearing. We probably don't have time this year to legislate in
this area, but now that we do finally have the Treasury report
in hand, we do have some data with which to work. There are no
legislative recommendations, as you know, in the Treasury
report, nor apparently in the earlier testimony from Treasury
did we hear any specific recommendations. So it kind of falls
back on this panel and others in Congress to figure out what
might be the best course to take.
I have heard today a lot of specific concerns, and it seems
to me that to address one area or another might not be the
wisest approach, although there certainly are some areas that
need immediate relief in the high-tech area. But it seems to me
we do need to have a revamping, and it seems to me that it
ought to be something that this committee works on immediately
in the new year.
I have a couple questions for the panel, if I might, and a
couple of specific questions, if I could, Mr. Chairman, for von
Unwerth.
A general question. Should we give Treasury more
discretion--I mean, again, I hear from low-tech to high-tech
companies that the class life or category is inaccurate for
this product or that, that the cost recovery is not appropriate
because of changing conditions, you know, new technologies
among other things, that it is just impossible, frankly, for
Congress to legislate in this area and keep up with it.
The 1986 act gave the Treasury Department more discretion,
as you know, to determine what the appropriate class life was.
In essence, we gave them discretion to, therefore, change what
some cost recoveries were and change the taxes that you pay.
We kind of pulled that authority back to Congress, partly
in response, I understand, to constituent concerns. I wasn't
here then. It was slightly before my time. But I wonder if I
could get the panelists who were in the business at that time
and dealing with Treasury or those who have looked back on that
period to give us some input as to whether we should give
Treasury more discretion in that area. Does that make sense?
Ms. Coleman, do you have a thought on that?
Ms. Coleman.Well, I have to admit, I wasn't involved in the
issue at that time. Certainly, I think--
Mr. Portman. You and I were both in high school at the
time.
Ms. Coleman.I wish.
I think the time that it took to do just this study that
they released in July, points to how time-consuming it would be
to update the current system.
Mr. Portman. It took 2 years, and there are no
recommendations.
Ms. Coleman.Pardon me?
Mr. Portman. I am just agreeing with you.
Ms. Coleman.We support moving to an expensing system, which
would be a lot more straightforward and certainly easier to
administer and develop.
Mr. Portman. And with an expensing system, you wouldn't
have to worry about making some of these decisions, changing
classifications. You would have immediate expensing. And you
talked about a transition to that. How about, though, others of
you who, if we were to stay with a depreciation system, would
it make sense to give Treasury more discretion? Mr. Jernigan?
Mr. Jernigan. I think it definitely would. I think you need
to give Treasury broad guidelines that are intuitively correct.
As Congressman Weller said, he can't believe that a computer
has a 5-year class life, and we all know that maybe it should
be 2 years or 1 and a half years. So I think you need to give
Treasury a mandate and strong guidance that you have got to be
realistic, also.
We don't always have that data out there, or it is very
expensive to collect that data. In our industry, the
semiconductor industry, we have done three studies, and the
studies are very time-consuming, they are very expensive. You
have to hire outside people. And then when you turn over the
study to the Treasury, it just gets lost. And industries don't
have the manpower and the time and the money to do all these
studies.
So broad guidelines to Treasury encouraging them to be more
realistic and intuitive in what they are doing I think would be
very useful.
Mr. Portman. Including maybe mandated reviews or sunsetting
or different classifications or class lives to force them to
take a look at the reports or the data that you would submit.
How about any other comments on that, is anybody fearful of
giving Treasury that kind of discretion? Mr. Vogel?
Mr. Vogel. Well, as I think you are aware, Treasury has had
a lot of authority over the years, and that is where the
guidelines that we currently live with today came out of in the
early 1960s. And what I think we see is that it is a slow,
ponderous process. It is heavily fact-driven. The Treasury
report itself that recently came out, really weighed lots of
different directions that they could go in terms of deciding
how should the assets be depreciated, over what life, and what
kind of results are we trying to achieve.
To some extent, what happened in 1981 was a superb
development in that what happened was we set aside the notion
of sort of trying to carefully tweak the depreciation to match
what lives are being experienced and called it something
different, called it ``accelerated capital cost recovery.'' And
the concept was that we are getting away from this traditional
notion of how long these assets live and recognizing that what
we have got really going on is the need to recovery your
capital and recover it in a timely manner and recover it on a
real dollar value basis so that the effects of inflation do not
destroy the capital base of the country.
And that is the system we are on today, and I think
Congress took the lead in enacting that kind of system. So I
think it would be risking longer periods of stagnation if it
were put back into a merely administrative process. I think
that is why we have suggested that, you know, the only way to
timely address the changing nature of our industry is for
Congress to act.
Mr. Portman. You mentioned inflation. Another idea going
beyond cost recovery is to actually index depreciation
schedules to inflation. With low inflation, I assume your cost
recovery has been relatively good, although relative to other
countries, Mr. Jernigan, it doesn't make any difference because
I don't think any other of our major competitors handle
inflation any differently than we do. Although with low
inflation, maybe that is not as big a concern today with you.
One idea would be that Congress could mandate that at a
minimum. There is an expense to that, of course.
Mr. Vogel. I think Treasury's report discussed some of the
problems of identifying one area for inflation adjustment.
Mr. Portman. Well, I appreciate again the input, and I
thank the chairman for taking on this issue. He is a brave
soul, mean, lean, and courageous.
I have one other question, if I could, Mr. Chairman, with
regard to the final testimony we heard today with regard to the
rental furniture.
You said in your comment, Mr. von Unwerth, that the
rentable life of this equipment is 3 to 4 years, which is
inconsistent, it seems to me, with what you are calling for,
which is to simply go back to a clarification that the five-
year recovery period is proper. Why wouldn't you ask for three
to four years rather than sticking with the five years or
clarifying the five years?
Mr. Von Unwerth. Well, you make a very good point. Thank
you, Mr. Portman. We are sort of right on the cusp of a class
life. We are about four years, three to four years, and the
class life difference between three and five-year property is
right at that. The breakpoint is between four and five -four
years and under for three-year propoerty, five to nine years
for five-year property. The next breakpoint, for seven-year
property is 10 years and up. We know we shouldn't be there.
Mr. Portman. Yes. And you have got an IRS ruling, you said,
out of my hometown IRS office, Cincinnati, Ohio, for 7.
Mr. Von Unwerth. They have insisted on a change of
accounting method to go to 7 years for one of the national
office furniture rental companies that is headquartered in
Cincinnati. That makes no sense. Everybody else is doing 5 and
always has. We do think there is a case to be made for 3, but
we are not here asking for that. All we are seeking at this
point is simply a clarification that 5 is the fair and proper
interpretation.
Mr. Portman. Three years is what the rent-to-own industry
has now?
Mr. Von Unwerth. That is what the rent-to-own industry has.
Yes, that is correct.
Mr. Portman. Okay. But you are just asking for a
clarification that the 5-year recovery period is proper.
Mr. Von Unwerth. That is correct.
Mr. Portman. Under the current system. And when you say
short-term leases, what are you talking about?
Mr. Von Unwerth. One year or less. They are typically in
the industry one year or less. The legislation we propose would
define short -term as one year or less and would define a
qualified dealer as one who leases primarily pursuant to short-
term leases. We are not talking about anything like a finance
lease here. This is rental.
Mr. Portman. And the revenue differential between 5 and 7
years' recovery would be what for rental?
Mr. Von Unwerth. About a million and a half a year, maybe 2
million. That is based on an assumption of 75 to 100 million of
property annually placed in service by the entire industry.
Mr. Portman. That is all?
Mr. Von Unwerth. As I said, this is a very small industry.
Mr. Portman. Okay. Thank you very much. I appreciate your
testimony, and I thank all of you for helping us out. Maybe we
will see you again next year.
Thank you, Mr. Chairman.
Chairman Houghton. Thank you very much, Mr. Portman. I have
just got a couple of questions to wind this thing up. First of
all, Mr. Jernigan, you know, when Brazil or Japan or Germany
are giving these terrific incentives, I don't think that really
gets into depreciation. I mean, that is an outright incentive,
and I don't think that this particular panel can handle this
particular--that is another issue, important as it might be.
Also, Mr. Jalbert, you talked about R&D tax credits. The
same thing, I think it is very important, that we ought to do
it, but I don't think we can handle that.
I think the thing that I am interested in is almost a
redefinition of Section 167. Rather than the wear and tear and
the obsolescence, you have other factors you are talking about.
In sort of simple language, it is a Moore's Law of every
industry. And so the question is more than wear and tear, it is
competition, it is rejuvenation, it is inflation.
I could make a strong case, I think, for the iron and steel
industry, that they should have the special accelerated
depreciation because they are so much in the doldrums, as
contrasted to the wireless industry, because you have been able
to do particularly well.
However, when you take a look at the pressure from abroad
and the incentives which are given there on depreciation
itself, it makes it very, very difficult.
So I wonder how we sort this thing out and help the
Treasury redefine that Section 167. Maybe you have some ideas.
Mr. Jernigan. Do you want me to start?
Chairman Houghton. Sure.
Mr. Jernigan. Okay. Well, as I have said, the U.S.
semiconductor industry has submitted three studies to Treasury
which I think are quite compelling and were done under the
auspices and guidance of Treasury. I think that would be a good
starting place. The last study we showed was 3 years. I think
Treasury ought to recommend to the Congress that we have a 3-
year life and Congress ought to act on it expeditiously as
opposed to waiting for comprehensive reform, which may be two
or three more generations of semiconductor plants.
Chairman Houghton. Have you seen the report to Congress on
depreciation recovery from the Treasury?
Mr. Jernigan. I have only read it once through because it
was about 130 pages, but I have seen it. The July study.
Chairman Houghton. Yes.
Mr. Jernigan. Yes. It doesn't address the issues very
adequately for us. It is more of--
Chairman Houghton. Well, look, this panel is trying to get
at the issue. We are trying to find a resolution to this rather
than just hearing things. And if you have some specific ideas
which should be added to this, then we can pass it along or you
can pass it along to Treasury, we would like to see them.
Mr. Jernigan. We will do that, sir.
Chairman Houghton. We would like to see something done.
Okay. Now, Mr. Vogel or Ms. Feldman, any other suggestions we
have here? Because we would like to move the ball forward here.
Clearly, we are in an entirely different age now in terms of
the depreciation schedules, and we would like to have some
specific, very simple, one or two suggestions that the Treasury
ought to use. But you have got to understand that there is a
precedent to be set. When you do it for one industry, you have
got to do it in some sense for another.
Any other suggestions? How about you, Mr. Jalbert?
Mr. Jalbert. I come here as a representative of the AEA,
but I am also a businessman. And what I see is practicality,
and I look at our book accounting versus our tax accounting,
and I will take the example of the computer.
We know our computers won't last more than 2, 2 and a half
years, yet we depreciate them over 5. And that is just an
example of how we are behind the times. And we have a company
that has--we are in rural America. We are in Waseca, Minnesota,
and in Lincoln, Nebraska. And when you think about that, we are
a high-tech company and we have over 100 engineers. Yet we have
openings for 20, and that is because of qualifications and that
is because of training.
So we have to do training in our own company. We are not a
big company. We are between 55 and 60 million. But we spend 1
percent of our revenue on training, and that is something that
we would like to continue, especially for graduate work. So we
look at graduate work and the tax incentives there. We look at
depreciation and the opportunities there. And then finally, if
you take a look at R&D credit, we are an industry that is
driven by R&D. We are $55 to $60 million company, and we spend
$6 to $7 million a year just on R&D. So the tax code has to be
in tune with what is going on today.
So the practicality for me as a businessman is we need to
make some of these things permanent, we need to continue other
things, and we need to re-examine how we do depreciation.
Chairman Houghton. Any other comments, Ms. Coleman, Ms.
Feldman?
Ms. Feldman. Yes. With the rapid advances in technology,
especially in the last 10 to 20 years, we would suggest instead
of revamping everything we would suggest starting with some of
the industries that have started up, like the wireless
industry, in the more recent years that aren't specifically
mentioned in the revenue procedure. It just raises questions by
the IRS as to what our class lives are and what our recovery
periods are. We think we know what they are, but it is a
continuing audit issue amongst our companies that has not been
resolved. To address industries such as ours that have the
newer technologies might be a good starting point.
Chairman Houghton. Ms. Coleman?
Ms. Coleman.I think once again moving towards expensing
would resolve a lot of these issues.
Chairman Houghton. You would like to expense everything.
Ms. Coleman.Pardon me?
Chairman Houghton. You would like to expense everything.
Ms. Coleman.Yes, I would. But being a broad-based trade
group, I think one problem that we have is that some assets
that have longer class lives are at a disadvantage vis-a-vis
assets with a shorter asset life, which could distort
investment decisions. And I think an expensing system would
eliminate a lot of those problems.
Chairman Houghton. All right. Fine. Anybody else, Mr.
Vogel, Mr. von Unwerth? No comments? All right.
Well, thanks very much. I certainly appreciate it. Any
other suggestions you have for us to mull over, please send
them in to us.
The hearing is adjourned.
[Whereupon, at 3:31 p.m., the hearing was adjourned, to
reconvene at 11 a.m., Thursday, September 28, 2000.]
THE TAX CODE AND THE NEW ECONOMY
----------
THURSDAY, SEPTEMBER 28, 2000
House of Representatives,
Committee on Ways and Means,
Subcommittee on Oversight,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:00 a.m., in
Room 1100 Longworth House Office Building, Hon. Amo Houghton
(Chairman of the Subcommittee) presiding.
Chairman Houghton. I don't mean to scare everybody, but I
hope the meeting can come to order. We are appreciative of all
of you being here, particularly our panel, and we are going to
continue the hearing on the tax code and the new economy. As
many of you know--I don't know whether you gentlemen were
here--but our focus was on depreciation. Today we are going to
hear from you and others on how our tax laws treat research and
development and the cost of maintaining a skilled workforce. So
what I would like to do is turn this over now to our senior
Democrat on the subcommittee, Mr. Coyne, to introduce the first
witness.
Mr. Coyne. Well, thank you, Mr. Chairman, and as you note,
today is the second of the Oversight Subcommittee's hearings to
discuss the new economy and whether the tax laws are current in
today's times. I want to thank Chairman Houghton for scheduling
these important hearings and also I want to personally welcome
Mr. Joseph Hester from Pittsburgh, Pennsylvania, who is Vice
President of Administrative Services at Allegheny Community
College and will be our first witness on this first panel.
I look forward to his insights and views on the importance
of developing and coordinating students' educational studies
with the workforce skills needed by the business community
today and to the testimony of the other witnesses, both on the
first and second panels.
Thank you, Mr. Chairman.
Chairman Houghton. Thanks very much, Mr. Coyne. Mr. Weller,
would you like to make an opening statement?
Mr. Weller. Well, thank you, Mr. Chairman, and again I want
to commend you for what I believe are very, very important
hearings regarding the impact of Federal tax policy on
technology. Clearly what was stated on Tuesday was that our
outdated tax code stymies innovation and it is blocking and
depressing job opportunities and wages for workers. So, clearly
I think these hearings are extremely important and I look
forward to discussing with our panel today a couple of
initiatives that I feel are extremely important and address the
issue of employer-provided computers and Internet access, as
well as the need to provide tax incentives for skills training
in the workforce.
So, thank you, Mr. Chairman, for the opportunity to
participate and thank you for putting together these panels.
Chairman Houghton. Not a bit. Thanks very much, Mr. Weller.
Now, Mr. Hester, would you begin with your testimony?
STATEMENT OF J. JOSEPH HESTER, VICE PRESIDENT, ADMINISTRATIVE
SERVICES, COMMUNITY COLLEGE OF ALLEGHENY COUNTY, PITTSBURGH,
PENNSYLVANIA
Mr. Hester. Thank you, Mr. Chairman and members of the
committee. My name is Joe Hester and I am here representing the
Community College of Allegheny County. I certainly appreciate
the opportunity to come and speak to you briefly about the
Community College of Allegheny County in western Pennsylvania
and its workforce needs. There is one thing that is clear to us
in western Pennsylvania and I suspect this is true around the
rest of the country as well: Today we have more good jobs
available than we have people that have the skills and training
and preparation to fill those jobs.
Our problem is not one of people not having jobs. They have
jobs, but they also have the aptitude to have better jobs if
they had the skills and training that they need and there are
good jobs available for them. Enticing them into the training
program and giving them that opportunity is the problem that we
face. The Community College of Allegheny County has been
involved in a significant way in trying to bridge the gap
between job demands and the available pool of skilled workers.
We have programs in place. We have good programs in place
that could provide those skills. The problem is in attracting
folks out of the working world and into those training programs
to acquire those skills. What I am talking about is people who
can work at the production level in businesses in western
Pennsylvania. We have institutions in western Pennsylvania that
do a good job of producing plenty of senior engineers and
managers to get organizations started and opening them up to
the public, but we do not have an adequate supply of folks that
are prepared to work at the production level.
We have a workforce that could accommodate those
requirements if they had the necessary training. We think that
there are a number of options that are available to encourage
folks to come into our training programs. A prominent one of
those that I would like to suggest to you is encouragement of
apprenticeship programs where people are encouraged to go to
work for organizations and their organizations then provide
them with the opportunity to go and get instruction in
technical fields while they are learning also on the job.
Such programs would allow people the opportunity then to
learn on the job and to fill those jobs without walking away
from gainful employment that puts food on the table for their
families. Section 127 of the Tax Code already provides some
incentives to businesses to pay for ongoing training for their
existing employees and we think that is a very positive
provision. We would like to see it made a permanent provision
rather than being continually sunset-reviewed.
I would like to offer a program that we are familiar with
from Iowa that might be a model that would be useful in
encouraging businesses to become more involved in providing
this kind of opportunity to their employees. In that program,
the community colleges in Iowa are allowed to sell bonds which
they then use to finance programs for new and expanding
businesses. The taxes paid by those employees in those new and
expanded businesses then are funneled back to the community
colleges for a period to pay off those bonds.
The Iowa experience has been very positive in the use of
this kind of vehicle and it is one that I would recommend to
the committee for consideration. With respect to existing tax
law, the Hope Scholarship program is a very positive force in
allowing folks to access the educational programs and advance
their skills, but it only covers tuition and fees. It does not
address the living needs of folks that go to community
colleges, who are normally older than the traditional college
student, who have families to support and who cannot afford to
walk away from a job that puts bread on the table.
If the provision of the Hope scholarship and similar kinds
of programs were extended to cover these kinds of other
expenses, we think that would be a positive support for
community college operations.
Chairman Houghton. Is that it?
Mr. Hester. That is essentially it for me, sir. Thank you
for the opportunity.
[The prepared statement follows:]
Statement of J. Joseph Hester, Vice President, Administrative Services,
Community College of Allegheny County, Pittsburgh, Pennsylvania
Mr. Chairman and Members of the Subcommittee:
Good morning. My name is Joe Hester and I am Vice President
for Administrative Services of the Community College of
Allegheny County (CCAC), located in Southwest Pennsylvania. I
am pleased to be here to speak with you today.
In Southwest Pennsylvania, as elsewhere, there are today
more good jobs available than there are qualified applicants to
fill them. This is particularly true at the production level
for many organizations attempting to expand delivery of their
products or services to expanding markets of opportunity.
Community colleges have as a significant part of their
common mission the provision of assistance to their community's
labor pool in acquiring the necessary knowledge and skills to
fill these good jobs. If we fail in this endeavor, many good
jobs in our communities will go elsewhere.
The Community College of Allegheny County devotes
considerable energy and effort to assisting the match between
available jobs and labor market skills. We offer a wide range
of programs that address the needs that we know about in our
market area. We work closely with business, industry and labor
organizations in the area to identify existing and emerging
requirements. We know, nonetheless, that there are many
individuals in the area who could benefit substantially from
participation in our programs but who fail to do so due to some
set of reasons unique to their individual circumstances. At the
same time, the needs of business go unmet.
There are a number of issues that we would encourage you to
consider in your review of the tax code.
Technology Needs
Community colleges have long been leaders in the use of
technology, both for distance learning and in the classroom.
However, community colleges remain challenged by the ever-
increasing pace of technological development because of the
drain it puts on resources. As technology develops at a faster
pace, so do the demands of financing it.
We urge Congress to develop creative ways of using the tax
code to help underwrite technology on our campuses. The needs
are enormous and growing. Perhaps a credit could be established
to businesses that provide to campuses badly needed
instrumentation, computers and software, and help with
infrastructure needs.
Another approach might be to give states greater incentives
to make technology available on community college campuses.
Faculty Needs
Another pressing need at our institutions is faculty adept
in high-tech areas, particularly those in the area of
information technology. The fundamental economic reality today
is that most community colleges simply cannot afford to compete
in the market for individuals accomplished in IT fields.
Consequently, a tax credit is needed to encourage companies
with employees who can teach in the high-tech areas, and the
natural sciences, to lend them out to institutions of higher
education. Some businesses are already doing this, but a
financial incentive would stimulate greater activity and
benefit all parties over the long run.
Skilled Workers
Community colleges embrace the goal of working closely with
business to train workers for the new economy. One pressing
need remains identifying entry-level workers who have the
literacy and quantitative skills, and a strong orientation to
the world of work, to make them productive employees. To help
companies develop skilled workers, the federal government
should approve a corporate tax credit to encourage
participation in early formal training or apprenticeship
programs. Apprenticeships are beneficial to worker and employer
alike, but they are extremely costly and easily eschewed in a
competitive business environment. The government needs to do
more to tangibly encourage them. To help incumbent workers
update their skills throughout their careers, a long-time
priority for CCAC and most community colleges, the federal
government should provide employers a corporate tax credit of
$2,500 per employee per year to cover the cost of formal
training for front-line, hourly wage workers in technical
fields.
President Clinton's ``College Opportunity Tax Cut'' (COTC)
Although the tax code is not generally an effective
mechanism for helping financially disadvantaged students make
the leap to college, it can, when used creatively, provide
meaningful access. However, we have deep concerns regarding the
President's $30 billion ``College Opportunity'' tax plan. While
the plan provides some benefit to community college students
wanting to enhance their job-related skills, its basic
structure precludes it from being of any assistance to needy
credit students attending community colleges. There are two
reasons for this:
As with the Hope Scholarship and Lifetime Learning
Tax Credits, the President's proposal is non-refundable and
therefore does not reach low-income students with the greatest
financial need. We acknowledge the extreme difficulties faced
by middle and upper middle-income families facing expensive
tuition bills for higher education. Nevertheless, it is poor
public policy to address this need to the exclusion of the most
economically disadvantaged group of college students.
As with the Hope and the Lifetime Learning
credits, the newly proposed benefit applies only to tuition and
fees and does not cover books or living expenses. These costs
are often as severe an impediment to college attendance as
tuition and fees, and their exclusion from the credit makes it
fundamentally flawed.
The Hope and Lifetime Learning credits have made attending
the first two years of college more affordable for many, but,
contrary to what the Administration has asserted, they have
hardly made the first two years of college affordable for all.
There is still tremendous unmet financial need for many
community college students. The Hope and Lifetime Learning
credits only cover expenses for tuition and fees and are not
available to the neediest students. If Congress acts on the
President's new proposal, more must be done to help these
deserving students.
Section 127 of the Internal Revenue Code
Community colleges and their students strongly support
making Section 127 of the Internal Revenue Code permanent. This
provision has been remarkably successful in helping individuals
gain access to the education and training so critically
important to remaining marketable in today's rapidly changing
economy. As this Committee knows, Section 127 allows employees
to receive up to $5,250 annually of tax-free employer-provided
educational assistance. It is effectively targeted because
businesses have a strong self-interest in making sure that the
education and training benefits they provide will actually
result in more productive employees. Section 127 benefits are
used at all types of institutions of higher education.
Since its creation, Section 127 has always been subject to
a sunset provision. It is hard to explain why this should be
the case, since the provision has strong bi-partisan, bi-
cameral support. Section 127 should be made permanent.
On behalf of the Community College of Allegheny County, I'd
like to thank you for the opportunity to appear here today.
Chairman Houghton. Well, thank you very much. We will have
questions and you can come back and make any other statements
you would like.
I would like to move next to an individual, Mr. Bean.
Thanks very much for coming.
STATEMENT OF MARTIN BEAN, PRESIDENT, PROMETRIC, BALTIMORE,
MARYLAND, ON BEHALF OF TECHNOLOGY WORKFORCE COALITION,
ARLINGTON, VIRGINIA
Mr. Bean. Mr. Chairman and distinguished representatives,
my name is Martin Bean and I am President of Prometric, Inc., a
Thomson Learning company. Prometric is the global leader in the
delivery of computer-based testing services for academic and
corporate assessment. And more importantly for today, we are
the leader in the delivery of IT certification tests where
every year we deliver over three-and-a-half million exams. But
perhaps more importantly we touched just about every IT
professional in the world seeking to be certified in our
industry.
I am here today to speak on behalf of Prometric, but also
the Technology Workforce Coalition, or TWC. TWC was formed to
address the IT skilled worker shortage, a critical problem in
every sector of our economy. Nearly 270,000 unfilled positions
were identified in last fall's workforce study, ``The Crisis in
IT Service and Support.'' The survey of 878 chief information
officers and other IT executives found that nearly 10 percent
of IT service and support professional positions are unfilled
in America today. As a result, the U.S. economy loses more than
$100 billion in spending each year on salaries and training.
The Technology Workforce Coalition advocates Federal-and State-
level solutions to address the shortage, including IT training
tax credits, H1B visas, temporary visas, K-12 curriculum
changes and teacher training incentives.
While TWC supports a multifaceted approach, it believes
that IT training credits and tax credits would have the
greatest impact on the shortage. One of the biggest barriers to
IT training is the cost. Small businesses and individuals often
cannot afford the cost of training and, more importantly in the
IT industry, continuous retraining. IT training tax credits are
market-driven, prudent, cost-effective and user-friendly. For
that reason, nine members of the U.S. House of Representatives,
led by Representatives Jerry Weller and Jim Moran, and we thank
them for that, introduced bipartisan legislation, H.R. 5004,
the Technology Education and Training Act, on July 27, 2000.
TWC strongly believes that the provisions of H.R. 5004
represent the best opportunity defined by the medium-and long-
term solution to the IT worker shortage. The IT training tax
credit was included on the list of recommendations by the 21st
Century Workforce Commission. As this session of Congress comes
to a close, it would be a strong signal to American workers
that Congress cares about the biggest obstacle to a rewarding
IT career, namely getting access to the necessary training and
certification that opens the door to the new economy.
Federal legislators also play a key role in determining a
critical but small supply of IT workers that get into the U.S.
through the INS H1B temporary visa program. In fact, I used the
INS visa program to come over to the United States from
Australia. But although H1B workers fill a critical role in the
IT workforce, the proposed increase in visas will not come
close to filling over 850,000 available positions in United
States of America today. Therefore, while it is extremely
important that we increase access to foreign IT skilled
workers, we must also focus on training more IT workers here in
the United States. In doing so, we will silence critics who
claim the IT industry and Congress is more interested in
importing temporary foreign workers than it is in training U.S.
workers.
If business is changing substantially, and it is, shouldn't
we also view training in a new way? TWC believes the training
program must result in certification. IT certification provides
an independent assessment of the worker skills and helps
determine whether they are qualified for the requirements of
the job. Further, it helps ensure that the Government
investment in training results in the skills truly being
obtained.
We understand that time is short here at the end of the
106th Congress, but by linking the IT training tax credit to
the H1B visa legislation, Congress can pass two measures that
will significantly reduce the IT worker shortage, implement two
recommendations of the congressionally-created 21st Century
Workforce Commission, silence critics who claim Congress is
only focusing on foreign workers and encourage more IT training
for American workers.
TWC believes that there will be a substantial return on
investment on the IT training tax credit. U.S. productivity
would improve and the Government would quickly recover the cost
of the credits through new corporate sales and personal income
tax revenue by filling hundreds of thousands of available jobs.
In 2020, we will look back at this period and recognize that
either America maintained or lost its position as the global
leader due to its ability to increase the IT workforce.
The initiatives I have mentioned today are a win-win for
all involved as we prepare for the workforce challenges of the
21st century and strive to maintain America's global IT
leadership. We thank you, Mr. Chairman, for the opportunity to
testify at this hearing.
[The prepared statement follows:]
Statement of Martin Bean, President, Prometric, Baltimore, Maryland, on
behalf of Technology Workforce Coalition, Arlington, Virginia
Mr. Chairman and distinguished representatives, my name is
Martin Bean. I am the president of Prometric, a global leader
in the delivery of computer-based testing and assessment
services for academic and corporate assessment, and information
technology (IT) industry certification. Prometric is a division
of Thomson Learning, which is among the largest providers of
lifelong learning. To give you an idea of the scope of our
business, which is based in Baltimore, Maryland, Prometric has
contracts to deliver over 2,400 different tests, through a
network of over 3500 computer-based testing services centers,
in 128 countries. We operate 10 call centers in 9 countries
that handled over 7.5 million calls in 1999, operated in 25
different languages, and handled over 33 different currencies.
In short, we touch nearly every IT professional in the world
that wants to be certified for an IT career.
I am here today to testify on behalf of Prometric and the
Technology Workforce Coalition (TWC), which was formed to
address the IT skilled worker shortage. The coalition is made
up of many IT associations including the Computing Technology
Industry Association (CompTIA), Information Technology Training
Association (ITTA), Association for Competitive Technology,
Association for Online Professionals, American Society for
Training & Development, Information Technology Association of
America (ITAA), Software and Information Industry Association,
Society for Information Management, and over 500 small and
large companies. Large company members of TWC include my
company as well as Compaq, Computer Associates, EDS, Ernst &
Young, Gateway, Global Knowledge Network, Inacom, Intel,
Lucent, MicroAge, Microsoft, Motorola, New Horizons, Novell,
Productivity Point Int'l, and Texas Instruments. TWC also has
hundreds of small company members from all across America.
As you are well aware, the demand for IT skilled workers
has caused a major shortage and is a critical problem for large
and small companies in every sector. This April, ITAA released
a study showing that over 850,000 of the 1.6 million new IT
jobs needed in America over the next year can't be filled.
Nearly 270,000 unfilled positions were identified in last
fall's ``Workforce Study: The Crisis in IT Service and
Support.'' Commissioned by CompTIA, the Workforce Study is
significant in that it focuses specifically on IT service and
support positions. These workers are responsible for the
installation, maintenance and repair of computer hardware,
software, and local area networks, creating websites, as well
as the help desk support that are critical to customer service
operations. It is the point of entry into a bright future as
part of the IT workforce, including thousands of minority and
disadvantaged students, and displaced workers. The survey of
878 Chief Information Officers and other IT executives found
that nearly 10% of IT service and support positions are
unfilled. As a result, the U.S. economy loses more than $100
billion in spending each year on salaries and training.
By 2002, the U.S. Department of Labor estimates that over
half of U.S. workers will require some type of IT skills
training. What was once only a worker shortage for IT companies
has spread to the IT-enabled companies (banking, insurance,
etc.) throughout the entire economy. According to the Bureau of
Labor Statistics, more than 20 separate non-IT industries have
workforces comprised of between 4% and 12% of IT workers. In
fact, in your own offices you can see the substantial changes
IT has had on your constituent activities. For better and at
times for worse, your staff receives hundreds of emails a day.
Depending on the issue or public interest, the number of emails
can jump to tens of thousands per office per week. What is
today a significant challenge for corporate human resource
departments will soon be a crisis for the public sector since
they are not able to offer the compensation packages that are
attracting high tech professionals to careers in the private
sector. To be blunt, how will state and local governments
across America attract the IT workforce they need if the public
and private sectors do not aggressively begin implementing
solutions to the overall IT worker shortage?
The Technology Workforce Coalition advocates federal and
state level solutions to address the shortage including IT
training tax credits, H-1B temporary visas, K-12 curriculum
changes, and teacher training incentives. While TWC supports a
multi-faceted approach, it believes that IT training tax
credits would have the greatest impact on the shortage. One of
the biggest barriers to IT training is the cost. Small
businesses and individuals often cannot afford the cost of the
training and continuous retraining. IT training tax credits are
market-driven, prudent, cost-effective, and user-friendly tool
that will simultaneously help large segments of America's
workforce including high school students not going to college,
displaced workers, those caught in the digital divide, and
people feeling trapped in Old Economy jobs.
For that reason, nine members of the U.S. House of
Representatives, led by Representatives Jerry Weller and Jim
Moran, introduced bipartisan legislation, H.R. 5004, the
Technology Education and Training Act (TETA), on July 27, 2000.
H.R. 5004 would offer businesses and individuals in the United
States the incentives to seek education and training in IT
industries. TWC strongly believes that the provisions of H.R.
5004 represent the best opportunity to find both a medium and
long-term solution to the IT worker shortage and ultimately
provide U.S. citizens with high paying jobs here at home.
The coalition thanks Representatives Weller and Moran, and
the other legislators, for introducing a bill that could have
the greatest impact on the biggest challenge for today's
business leaders--hiring, training, and retaining IT workers.
TETA provides a $1,500 tax credit for information technology
(IT) training expenses. The tax credit would be available to
both individuals and businesses. The allowed credit would be
$2,000 for businesses or individuals in enterprise zones,
empowerment zones, and other qualified areas. The training
program must result in certification. This helps ensure that
the government investment in training has an independent
assessment built in to verify that the skills are attained.
The IT training tax credit was included on the list of
recommendations by the 21st Century Workforce Commission. The
commission was created by the Workforce Investment Act (WIA) to
study and recommend solutions to the critical IT worker
shortage facing America. As this session of Congress comes to a
close, it would be a strong signal to America's workers that
Congress cares about the biggest obstacle to a rewarding IT
career--getting access to the necessary training and
certification that opens the door to the New Economy.
Federal legislators also play a key role in determining a
critical but small supply of IT workers that enter the U.S.
through the INS H-1B Temporary Visa program. H-1B workers fill
high-end IT positions when American workers are not available.
In fact, I used an INS visa program to come over to the United
States. I serve as an example of the typical foreign worker
that is given the opportunity to participate in the greatest
economy the world has ever seen. America is the land of hopes
and dreams to millions of people across the globe. After
getting a chance to work in America, highly educated H-1Bs
often move into positions where they are responsible for
hundreds of workers or in my case, get the chance to run an
entire company. America also benefits tremendously by
attracting the best minds throughout the globe that are given
the opportunity to taste the American dream, flourish in its
system, and create opportunities for thousands of American
workers. From the immigrants fleeing tyranny over the last 200
years to the foreign skilled IT workers seeking a seat in the
lead engine of the New Economy, America continues to offer
hope, riches, and a chance for every person willing to work
hard to achieve their American dream.
Several legislative proposals have been put forward
recently that would increase the number of H-1B visas. In 2020,
we will look back at this period and recognize that America
either maintained or lost its position as the global IT leader
due to its ability to increase its IT workforce. By attracting
the best minds from other countries and improving our domestic
education and training programs at all levels, America can win
the IT talent competition.
But although H-1B workers fill a critical role in the IT
workforce, the proposed increase in H-1B visas will not come
close to filling over 850,000 available positions. In fact, for
the next 10 years, over 80% of the IT workforce must come from
the existing labor pool, which calls substantially for a strong
investment in re-training American workers. Therefore, while it
is extremely important that we work to increase access to
foreign IT skilled workers by increasing the cap on H-1B visas,
we must also focus on training more IT workers here in the
United States. We can also silence critics who claim the IT
industry and Congress is more interested in importing temporary
foreign H-1B workers than it is in training U.S. workers.
Passing H.R. 5004 will enable Congress to silence H-1B critics
by simultaneously taking steps to increase the training of U.S.
workers.
Tax credits are an efficient way to deliver incentives to
small businesses, which typically are unable to afford the high
costs of IT training and lack the manpower to keep up with the
paperwork required to qualify for other programs. The tax
credit would be increased to $2,000 for all companies operating
in enterprise or empowerment zones, and for companies with
fewer than 200 employees. Since those receiving training will
find jobs waiting for them when they finish their training, the
country will immediately begin recouping its investment in the
form of additional personal and corporate income taxes that
would otherwise not be generated.
One of the most important aspects to our new economy is how
rapidly business practices and the IT skills required for
workers change. IT training tax credits let business leaders
dictate who, what, and where to train. Congressman Jim Moran
represents the 8th district of Virginia. He sums up the problem
at the federal job training level quite well. ``Unfortunately,
some federal job training programs are training workers how to
use an abacus. They just aren't prepared to train the workforce
of today or tomorrow.''
IT is changing every business sector and the terminology
that details our work (i.e., 24x7, bandwidth, and e-anything).
In fact, Intel's Chairman Emeritus Andy Grove stated recently
that, ``Within the next 5 years, every business will be an E-
business or be Out-of-Business.'' If business is changing
substantially, shouldn't we also view training in a new way?
Business leaders are very skeptical regarding the reliability
of IT workers that say they have received training, but are not
certified. An independent assessment of the workers skills best
determines whether they are qualified for the requirements of
the job. Another consideration is that students seeking IT
careers have often been misled into believing that by just
taking an IT course they are guaranteed to get a job. Many
business organizations are calling for wide scale use of IT
certifications to provide fundamental skill assessments that
will benefit both the employer and the worker.
Another unfortunate result of the IT worker shortage is
that human resource managers are now looking at high schools
and colleges as high tech recruiting centers. That would be
great if these recruiters were focusing only on the students,
but the IT worker shortage is so critical that teachers are
getting great offers to make the school to work transition
America doesn't want. We should not blame teachers. They get
offers to double their salary, use the latest hardware and
software, and have the opportunity to earn substantial stock
options and bonuses. If America is to obtain the long-term
return from its investment in school systems that will be
required in the New Economy, then principals and politicians
must realize--especially in a strong economy--that schools are
competing with start-ups and established companies for workers
with IT skills. The only way to reduce the demand on
transitioning teachers to IT workers is to increase the number
of IT trained workers.
By implementing these solutions to the critical IT skilled
worker shortage, America will stimulate employment of new and
displaced workers into high-paying IT careers, fill critical
and growing IT labor shortages across all industries, and
strengthen the U.S. economy by enhancing productivity and
increasing exports. The initiatives I have mentioned today are
a win-win for all involved as we prepare for the workforce
challenges of the 21st century and strive to maintain America's
global IT leadership.
We understand that time is short here at the end of the
106th Congress. But by linking the IT training tax credit to
the H-1B visa legislation, Congress can pass two measures that
will significantly reduce the IT worker shortage, implement two
recommendations of the congressionally created 21st Century
Workforce Commission, silence critics who claim Congress is
only focusing on foreign workers, and encourage more IT
training for American workers. TWC believes that there will be
a substantial ROI on the IT training tax credit. U.S.
productivity would improve and the government would quickly
recover the cost of the credits through new corporate, sales,
and personal income tax revenue by filling hundreds of
thousands of available jobs.
We thank you Mr. Chairman for the opportunity to testify at
this hearing. TWC would be happy to provide you with any
further information you desire about federal and state efforts
to address the IT skilled worker shortage. We encourage all
interested parties to visit our Web site,
www.techcoalition.org, to see detailed information about the
shortage and how they can join the grassroots effort to help
implement the solutions discussed today.
Chairman Houghton. Thank you very much, Mr. Bean.
Mr. Salamon?
STATEMENT OF MITCHELL SALAMON, SENIOR TAX COUNSEL, AMERICAN
AIRLINES, INC., FORT WORTH, TEXAS
Mr. Salamon. Thank you, Mr. Chairman. Good morning, Mr.
Chairman and members of the subcommittee. My name is Mitchell
Salamon, and I am Senior Tax Counsel with American Airlines in
Fort Worth, Texas. American Airlines appreciates the
opportunity to address the important role of Federal tax law in
the new economy. Specifically, we want to tell you about an
exciting new program we are implementing to help our employees
bridge the digital divide. And most importantly, we are here to
urge you to pass H.R. 4274, which will greatly enhances this
process. I would like to take this opportunity to thank Mr.
Weller and Mr. Lewis for their leadership in this area.
Earlier this year, American Airlines and American Eagle
joined the ranks of Ford Motor Company, Delta Air Lines and
Intel by announcing that we would implement an employer-
subsidized, home computer initiative for our workforce. Under
our program, American will subsidize employee purchases of
basic home computers with unlimited Internet access. We
anticipate spending over $45 million over the next three years
to put home computers into the hands of every employee who
chooses to participate.
American's home computer program is an employee-empowerment
initiative that also makes business sense. Computer skills are
an essential component of almost every function within the
airline industry. American Airlines and American Eagle operate
and maintain 970 aircraft serving 243 cities with 4,100 daily
departures throughout the world. Today I am delighted to have
with me Crew Chief Thomas Thompson, representing our workforce.
In light of the scope and complexity of our industry, you
can see that a technically-skilled workforce is vitally
important to our success. As you might expect, we rely heavily
on advanced technology to run sophisticated reservation, flight
and revenue management and maintenance systems, which are
continuously modified and upgraded. Obviously, a workforce
skilled in tomorrow's technology will contribute greatly to
American's primary goal of delivering the highest quality
customer service.
In addition to supplying the hardware, American is
developing an Internet portal which will provide an
unprecedented opportunity to facilitate effective and timely
communication between the company and its employees on issues
ranging from company and industry news, corporate policies,
surveys, safety issues, online training, scheduling flight crew
assignments, accessing human resource and benefit information,
and leveraging emerging e-business opportunities that are
currently under development by the company.
This year American Airlines also created and introduced
Flagship University, a virtual institution and library that
employees can access through the portal. Flagship University
will deliver employee development programs on topics such as
airport customer service, handling of dangerous goods, airport
security, flight service, environmental issues, work balance
issues, substance abuse and leadership issues that we hope will
instill knowledge, skills and the attitudes necessary to
maximize the long-term potential of our employees.
So far, employee feedback has been overwhelmingly
enthusiastic and enrollment is high. Participating employees
pay American $12 per month for three years, but may upgrade and
obtain options directly through the vendor at their own
expense. Many employees have acknowledged that they would not
be able to purchase a computer without the benefit of the
program. Our employees are seizing this opportunity to enhance
and develop their computer literacy and, consequently, they
will be prepared for work assignments and new positions that
will continue to evolve with the progression of the information
age.
However, without a clarification of the tax laws, the
potential for adverse tax consequences in this instance will be
a significant impediment to implementing workforce initiatives
that help close the digital divide. The current tax rules are
unclear whether employer-subsidized home computers will be
characterized by the IRS as taxable compensation to employees.
The potential tax burden will most certainly reduce the number
of employees taking advantage of this opportunity and other
employers for making similar investments in their workforce.
For this reason, we believe it is critical that Congress
adopt H.R. 4274, the Digital Divide Access to Technology Act,
the DATA Act, introduced by Congressmen Weller and Lewis. This
legislation will clarify that employers can provide subsidized
computers and Internet access to their employees as a non-
taxable fringe benefit, which will further motivate the
business community to bridge the technology gap that currently
exists.
Mr. Chairman, thank you for the opportunity to speak before
the subcommittee today and I will do my best to answer any
questions that you or other members may have.
[The prepared statement follows:]
Statement of Mitchell Salamon, Senior Tax Counsel, American Airlines,
Inc., Fort Worth, Texas
Mr. Chairman and members of the Subcommittee, American
Airlines appreciates the opportunity to address the important
role of Federal tax law in the ``new economy.'' Specifically,
we want to tell you about an exciting new program we are
implementing to help our employees bridge the digital divide.
And most importantly, we are here to urge you to pass H.R.
4274, which will greatly enhance this process.
Earlier this year, American Airlines and American Eagle
joined the ranks of Ford Motor Company, Delta Airlines and
Intel by announcing that we would implement an employer-
subsidized home computer initiative for our workforce. Under
our program, American will subsidize employee purchases of
basic home computers with unlimited internet access. We
anticipate spending over $45 million over the next three years
to put home computers into the hands of every employee that
chooses to participate.
American's home computer program is an employee empowerment
initiative that also makes business sense. Computer skills are
an essential component of almost every function within the
airline industry. American Airlines and American Eagle operate
and maintain 970 aircraft serving 243 cities with 4,100 daily
departures throughout the world. Together, we employ over
110,000 people. In light of the scope and complexity of our
industry, you can see that a technically skilled workforce is
vitally important to our success. As you might expect, we rely
heavily on advanced technology to run sophisticated
reservation, flight and revenue management and maintenance
systems, which are continuously modified and upgraded.
Obviously, a workforce skilled in tomorrow's technology will
contribute greatly to American's primary goal of delivering the
highest quality customer service.
In addition to supplying the hardware, American is
developing an intranet portal, which will provide an
unprecedented opportunity to facilitate effective and timely
communication between the company and its employees on issues
ranging from company and industry news, corporate policies,
surveys, safety issues, on-line training, scheduling flight
crew assignments, accessing human resource and benefit
information, and leveraging emerging e-business opportunities
currently under development.
This year American Airlines also created and introduced
Flagship University, a virtual institution and library that
employees can access through the portal. Flagship University
will deliver employee development programs on topics such as
airport customer service, handling of dangerous goods, airport
security, flight service, environmental issues, work/life
balance, substance abuse, and leadership issues that will
instill knowledge, skills and attitudes necessary to maximize
the long-term potential of our employees.
So far, employee feedback has been overwhelmingly
enthusiastic and enrollment is high. Participating employees
pay American $12 per month for 3 years and may upgrade and
obtain options directly through the vendor for an additional
fee. Many employees have acknowledged that they would not be
able to purchase a computer without the benefit of the program.
Our employees are seizing this opportunity to enhance and
develop their computer literacy, and consequently, they will be
prepared for work assignments and new positions that will
continue to evolve with the progression of the information age.
However, without a clarification of the tax laws, the
potential for adverse tax consequences will be a significant
impediment to implementing workforce initiatives that help
close the digital divide. The current tax rules are unclear
whether employer-subsidized home computers will be
characterized by the IRS as taxable compensation to employees.
The potential tax burden will most certainly reduce the number
of employees taking advantage of this opportunity and other
employers from making similar investments in their workforces.
For this reason, we believe that it is critical that
Congress adopt H.R. 4274, the Digital Divide Access to
Technology Act (DATA Act) introduced by Congressmen Weller and
Lewis. This legislation will clarify that employers can provide
subsidized computers and internet access to their employee as a
non-taxable fringe benefit, which will further motivate the
business community to bridge the technology gap that currently
exists.
Chairman Houghton. Thanks, Mr. Salamon. I would like to
turn the proceedings over to Mr. Coyne for some questions.
Mr. Coyne. Thank you, Mr. Chairman. Mr. Bean, you indicated
that we have to train more IT workers here in this country as
opposed to reaching overseas, not that we are going to refrain
from doing that, but we must begin here at home. I would like
to know what level of achievement educationally must a
candidate for this training have already achieved.
Mr. Bean. Do you mean what level of education prior to
entering the industry?
Mr. Coyne. Yes. Right.
Mr. Bean. Thank you. One of the interesting things about
our industry is that it is extremely egalitarian. The
technology changes at such a rapid pace that it has more to do
with a person's willingness and aptitude to embrace the
technology and learn how to use it than it does to actually
have to have reached any particular formal status in our
education process.
Many of the certification programs that we sponsor,
programs such as CompTia's A-Plus program are specifically
designed to take entry-level workers who often have very
limited formal education and allow them to take advantage of
the new economy by giving them the just-in-time, industry
level, pragmatic training that they need to actually be very
relevant to our economy, to actually be able to implement the
technology that is out there.
So, in short an answer to your question is that more than
just about any other industry, IT technology relies more on the
inherent skills, aptitude and desire of the individual than any
formal level of qualification earned.
Mr. Coyne. Thank you. Mr. Hester, why aren't enough of our
students being trained to fill the positions that are now being
offered to H1B candidates?
Mr. Hester. Representative Coyne, I think there are a
number of reasons why they are not. One is that those folks who
have the aptitude and the abilities necessary to acquire these
skills are, in today's robust economy, earning a living
someplace else and they are not prepared to come out of that,
to come into a training program like Community College of
Allegheny County operates in order to acquire those skills at
the loss of their ability to put food on the table.
One of the ways that we try to address that is to work with
businesses to have a cooperative arrangement with them--that
they bring folks that have these kinds of aptitudes, aptitudes
that we have tested for, into their businesses and begin to
work and work with us to provide technical training for them,
to update their skills while they also learn on the job. This
is an expensive proposition for businesses to engage in and we
have not developed a tremendous amount of capacity through
that, but that is one of the reasons why we have not been able
to fill these needs, because we cannot attract people with the
necessary aptitude out of already-paying jobs.
The second is we have difficulty in attracting the
necessary instructional faculty in these areas. These folks are
very expensive nowadays. Those that already have the ability to
work in this marketplace are drawing a very high salary and our
salary limitations, to some extent, prevent us from attracting
them into our educational environment to teach. Something that
would be helpful to us is any kind of mechanism that would make
it more attractive for businesses to place their employees on
loan to us for a period of time, to allow us to train--work in
partnership with them to train those necessary production level
workers within the salary structure we have to live with.
Mr. Coyne. Thank you very much. Thank you, Mr. Chairman.
Chairman Houghton. Thank you, Mr. Coyne. Mr. Weller?
Mr. Weller. Well, thank you, Mr. Chairman. I think this
first panel has been very, very helpful as we talk about the
important role of education and skills training in technology.
I think one thing I have certainly seen, since this is the
second part of a two-day set of hearings, is how the Tax Code
has an impact particularly on global competitiveness as we
compete with our Asian and European competitors to attract
technology jobs. Clearly, the Tax Code, as well as our
investment in education, is going to make a big difference.
It is interesting when we talk about statistics a lot and
there are almost 5 million Americans today employed in the
technology sector. Technology-sector wages are about 70 percent
higher than the traditional private sector jobs, so there is a
lot of opportunity. But at the same time, even though there is
a tremendous number of Americans employed in technology, we are
having a hard time filling all the positions.
Mr. Bean, you noted in your testimony, referring to a study
that was done this past year, that almost one out of 10, 10
percent of IT worker positions, are unfilled. Currently, almost
270,000 jobs, right now, are unfilled and it certainly has a
big impact on our economy with the loss of productivity and
creativity, as well as worker productivity. That same study, I
believe you noted, indicated that next year we are going to
need 1.6 million new workers and that, unless we adjust this
worker shortage, that half of those jobs will go unfilled.
Obviously, the H1B visa issue, and of course I am a supporter
and co-sponsor of David Dreier's bill, is a short-term
solution.
But I believe I know, as you do, Mr. Bean, that the long-
term solution is investment in skills training and education. I
wanted to ask you, Mr. Bean, why is the skills investment so
important as we look at global competitiveness? You indicated
your company does certification not only in the United States,
but in Asia and Europe as well, so you are dealing with our
competitors. But from an American standpoint, from our own
parochial interest, why is skills investment so important?
Mr. Bean. Thank you. I think it was best summed up by
Chairman Greenspan in his Humphrey Hawkins testimony, where he
really described what is fueling our economy today, that this
IT revolution is what is fueling it largely. When we look at
the magnitude, as you just summed us for us then, Congressman,
of the shortage that faces us, I do not believe there is any
other single threat to our competitors on the global stage as
big as our shortage of IT workers. This industry, as you know,
is summed up in this hearing and in setting this hearing up,
used to largely be about the hardware and software in the IT
industry. But the global stage has shifted.
The hardware and software now is nowhere near as important
as what I talk about as the brainware in our industry--that
those economies that are going to do best in their ability to
compete on the global stage are not those that have the
economic wherewithal to invest in the hardware and software, as
much as those that have their people skilled and educated, to
be able to translate that at an individual level to an enduring
competitive advantage, but on the global stage, for America,
into an enduring competitive advantage.
The workforce shortage that we have in the IT industry is
not an American phenomenon, it is a global phenomenon. My fear
for America is that unless we take steps right now to put the
training where we need it, to skill the American workers, to
help the private sector embrace the technology fairly rapidly,
due to the rate of change of technology, we are going to slip
behind in our ability to remain the leader in the IT industry,
something that we should all be very proud of and we should not
let slip away, because as Chairman Greenspan said, that is what
is fueling our economy today; that is what will fuel our
economy going forward and the greatest asset we have in
remaining competitive on a global stage is our investment in
our people to embrace that technology.
Mr. Weller. Well, you testified in support of our
bipartisan legislation, the Technology Education Training Act,
which provides a tax incentive to attract investment in skills
training and investment in people.
Mr. Bean. Yes.
Mr. Weller. Why do you believe a tax incentive is the best
way to encourage this type of investment in skills training and
solve this problem?
Mr. Bean. I think it is because it puts the private sector
in a position to be able to embrace the training that they need
to remain competitive. It is extremely pragmatic. It is going
to allow them to, as they have done a pretty good job of in the
past, adopt those types of education and training programs that
they need to remain competitive.
The rate of change in technology is such, as was, I
thought, very well summed up by my colleague to my right, such
that you have got to do something different. Formal academic
institutions cannot keep pace with technology that changes on
average every six months. It also gives the private sector the
opportunity, though, to reach out to those workers that, quite
frankly, want their piece of the new economy.
You know, if you think about workers needing to cross the
digital divide, as is characterized by all of us in the various
pieces of legislation before us, their ability to be able to
cross that digital divide is largely a function of our ability
to give them the necessary training that they need to be
relevant inside the organizations that they work for, both in
the public and the private sector.
I believe that the implementation of a tax credit will give
us and give our economy the ability to put the training spend
(sic.) where it will do the most for our competitiveness on a
global level.
Mr. Weller. Thank you, Mr. Bean. I see, Mr. Chairman, that
my time has expired. I do have some questions for Mr. Salamon.
If there is a second round of questions, I would like to ask
Mr. Salamon questions after my colleagues complete their first
round of questioning.
Chairman Houghton. All right. Why don't I cut in here and
then maybe Ms. Dunn would like to ask a question and then we
will go around for a second round. The concept of tax credits
is a dicey one for us because we keep loading up tax credit.
The President says that we should not use tax credits and then
all of a sudden we have 28 or 30 or 40 or 50 suggestions as far
as tax credits and it really complicates the code.
I can understand, and this is to all of you really, the use
of tax credits where the incentive is absolutely essential. For
example, I think, Mr. Hester, you said something about front-
line hourly wage workers in the technical field. I think that
is probably a pretty good idea. I am just talking for myself.
When it comes to middle-or upper-management, clearly the
success of most of these companies in the information
technology area is that they have training programs themselves.
They just bite the bullet and they do it, but it doesn't
get all the way down. So, the question is how far should those
tax credits go in the organization? Maybe, Mr. Hester, you
would like to answer it, and Mr. Bean, and also Mr. Salamon,
just as far as you are concerned, I would like to find out
really sort of what percentage of the people you think would be
using these computers, and also would they be used for business
as well as home use. So, why don't we start with you, Mr.
Hester?
Mr. Hester. It is difficult for me to speak to the general
question of how far up in the organization--that is the way I
would put it--these kinds of tax credits should extend. Clearly
from our perspective, from the community college perspective,
where we are involved in and engaged in trying to fill the
production-floor level kinds of jobs that are most needed by
all kinds of industries and where the real shortage of
personnel exists, it is in attracting those folks into those
training programs, whether they are inside a corporation or in
our institutions exclusively, that we think a tax credit would
be very beneficial.
Again, there are other incentives that are very attractive
on a normal kind of personal level for individuals and
businesses at higher levels of employment to work on
maintaining and sustaining their skills, but the problem of
filling available jobs at the production floor level is one
that we are all struggling with and that requires getting folks
into the human capital development pool, out of the working
environment, and we think a tax credit would be very positive
for them. And certainly, if it didn't extend any farther, we
would certainly hope you would consider that.
Chairman Houghton. So, the question is to take the front-
line workers, to get them there and then to keep them there?
Mr. Bean?
Mr. Bean. I think the question is best answered at two
levels. I think in addition to looking at how far down in an
organization this tax credit should apply to training, but also
across the industry sectors in terms of the size of the
companies. By 2002, the U.S. Department of Labor estimates that
over half of U.S. workers will require some type of IT skills
training. I actually believe that that is a conservative
estimate. I think that it will be more than half.
If you think about that, that means the answer to your
question, Congressman, is that just about every level in the
organization should be able to take advantage of IT training.
The reasons for that are many. If we look at the rate of change
inside all organizations, not just the IT sector but any
company that seeks to embrace technology to remain competitive,
and what we have seen over recent years with the proliferation
of the Internet through organizations and the ability for every
worker to tap into the information they need to do their job, I
think the answer is that every worker of the future needs to be
able to take advantage of IT training to remain individually
competitive, but also competitive in the economy.
Chairman Houghton. No, I agree. It is just that the
question is how far down does the Government get into the
process?
Mr. Bean. Sorry. How far down does the Government get into
the process of the tax credit? I think that the more flexible
that we can be in actually allowing organizations to make the
decisions of what IT training they need to be competitive is
the right answer to that question. I think the more broad-
ranging we can be with the tax credit to allow the money to be
put where it is going to be of greatest advantage is where we
need to head.
Chairman Houghton. Thanks very much. Mr. Salamon?
Mr. Salamon. Thank you, Mr. Chairman. In response to your
question, so far we have distributed about 40 percent of the
enrollment kits to our workforce. So, in essence, 40 percent of
the workforce now has the ability to enroll in the program.
Sign-ups at this point have been about 70-to-80 percent and we
contemplate that upwards of 90 percent of eligible participants
are going to take advantage of this program. It has been met
with a lot of enthusiasm.
These computers will be used at home. They will be used
outside the workplace. From our standpoint, clearly there is
going to be some personal benefit here, but the compelling
business motivations for us to do this clearly outweigh any
personal benefit that employees might have.
Chairman Houghton. They would probably be used at home and
not in the business place.
Mr. Salamon. Not in the business place itself.
Chairman Houghton. Thanks very much. Ms. Dunn, would you
like to ask questions?
Ms. Dunn. Thank you very much, Mr. Chairman.
Mr. Bean, you talked about the certification process. Could
you explain the certification process to us? If you are
certified in one State, are you automatically certified in
another State?
Mr. Bean. Thank you for the question. Yes, the
certification process is actually one of the truly portable
qualifications in the world, in the IT industry, which is what
we are speaking about specifically today. The test that
somebody would pass in my State of Maryland versus the test
that somebody would pass in California, because it is all
delivered via a computer, is exactly the same. And so the
qualification itself is not only transportable across States,
but also national frontiers, as well.
Ms. Dunn. Would you just run through what it involves?
Mr. Bean. Sure. The process is largely the combination of
learning and then testing, the certification really being the
outcome of the learning. The way an individual can learn to be
qualified to take an IT certification is very laissez-faire.
You can learn either through self-study on the job, by
attending formal classroom training, attending Web-based online
learning and the certification exam itself, which takes place
in a secure testing center on a computer terminal that asks you
a series of questions that are simulation-based, multiple-
choice, true-false, scenario-driven, are then the final outcome
on which the certification is granted by either the industry
association such as CompTia, or for that matter vendors such as
Microsoft, Novell, Computer Associates, et cetera.
Ms. Dunn. Also, Mr. Bean, could you tell us, is the worker
training credit in place of Section 127 or is that in addition
to Section 127?
Mr. Bean. Thank you. Sorry for having to check. It is in
addition, ma'am.
Ms. Dunn. Thank you very much.
Chairman Houghton. Mr. Weller?
Mr. Weller. Thank you, Mr. Chairman. Thank you for the
courtesy or the opportunity to do a second round of
questioning. I would like to direct a few questions to you, Mr.
Salamon. There are always interesting statistics. You have 100
million Americans today that are online. Seven million
Americans go online for the first time every second and so
there is a tremendous opportunity for working Americans to gain
information and participate in the new economy in many ways.
But if you look at other statistics you note that
households with incomes of 75,000 or more are 20 times more
likely to have a computer or Internet access at home. Educators
tell me they notice the difference in the classroom between
kids who have a computer and Internet access at home and those
who do not and the ability of children to do their homework and
schoolwork and do work on a school paper. And that is why I
really want to salute American Airlines, as well as Ford, Intel
and Delta Airlines, for stepping forward in providing computers
and Internet access is a solution to that challenge. That is
600,000 families as a result of your company and three others.
I know with Ford Motor Company, almost 5,000 families in my
district will benefit from what Ford Motor Company is doing.
But, as a result of your initiative, everyone from the laborer,
the assembly-line worker, the baggage handler, the flight
attendant, all the way up through management, their children
will now have computers and Internet access at home to do their
homework, and that is why I want to thank you for your
company's leadership in doing this.
I also want to thank you for bringing one of your fine
workers with you, Tom Thompson, who I understand is employed
out at Dulles airport. You do a great job. I have flown in and
out of there on American Airlines and appreciate the good work
you do as an example of an employee that would benefit. It is
my understanding that unless our legislation is passed and
signed into law, the IRS could impose a tax on workers for
receiving employer-provided computers and Internet access.
Our estimates from our staff analysis would estimate that a
worker making about $27,000 a year would pay about $200 in
taxes if they choose to accept these computers and Internet
access. And, for a worker making 27,000, 200 bucks is a lot of
money. It is real money for working people. Mr. Salamon, let me
just ask a few basic questions of you. Tell me how many
American Airlines employees have actually received computers as
a result of your initiative. I know you have indicated you are
going through the sign-up process. Are they actually receiving
computers and Internet access in their home at this time?
Mr. Salamon. Many of the employees that have signed up
receive it within the same week. Forty percent of the workforce
now has the forms to sign up and it is going like gangbusters.
There is a six-month window really to sign up, but the reaction
up front has just been tremendous. The phones are ringing off
the hook.
Mr. Weller. So, there is a lot of enthusiasm. Because of
this tax issue, I know I had spoken with one of your other
employees and they said there is a little bit of buzz among the
employees. They had heard the Department of Treasury, the IRS,
may tax their computer benefits. Have you had concerns
expressed to you by employees?
Mr. Salamon. Yes, sir. In our focus groups, that was a
concern that was discussed right up front as we mentioned the
possibility of a tax on distributing the computers, and the
indications from them were that they would have to take that
into account in whether or not this was something they want to
participate in or whether they really could afford to.
Mr. Weller. Have employees expressed hesitancy, been
hesitant about accepting these computers because a worker
making $27,000 would have to pay $200 in taxes? Have some said
they would probably not accept it because of that concern for
the taxes?
Mr. Salamon. In our original focus groups, that was a
concern.
Mr. Weller. Have you had other companies that have
expressed interest in providing this type of benefit to their
employees? Have they consulted with you about potentially doing
this and expressing concern regarding this potential tax
consequence?
Mr. Salamon. Yes, Mr. Weller, aside from the companies that
you mentioned, we have been contacted by three or four
companies that are exploring this as a possibility and also are
concerned about the tax issue and wanted to consult with us on
where we were on the tax issue.
Mr. Weller. Of course, one of the initiatives when
Representative Lewis and I joined together to offer this
bipartisan legislation to clarify the tax treatment of
employer-provided computers and Internet access--of course, we
would like to see it treated the same as an employer
contribution to a pension benefit or an employer contribution
to a health care benefit. And we believe it is good policy to
eliminate the digital divide and, of course, because of your
company's leadership and the others that are moving forward on
this, we now have an opportunity essentially for universal
access for every working American that is employed by American
Airlines or other companies, to have access to the Internet
and, of course, the opportunity that it provides.
From an, essentially, if I can use the term, quality-
control standpoint, what type of conditions do you have for the
employees on their ability to use these computers to ensure the
computer stays in the home and doesn't wander off, if the
employee is terminated or decides to leave their position? What
types of controls do you have?
Mr. Salamon. The way we are implementing our program, and
each program obviously is going to be different, but the way
American's program works is the computers are theirs. There is
a significant co-payment that they are making in their
participation in the program. The computers are theirs. We
anticipate that they are going to make good use of the
computers. There will be some personal use. Clearly there is
going to be business use that is going to benefit both them and
us in the long run.
In terms of other controls, we have the policies in place
about responsible behavior with computers, but there is no
monitoring going on. We have a lot of trust in the workforce.
This is an initiative of faith that really is for their benefit
in the long run and we trust that they will use it
appropriately.
Mr. Weller. Just a final quick question. Would these
employees be able to use these computers obviously to access
their employee benefits, see where their pension is or if they
have questions regarding their health benefits? Is that the
type of use that they could use them for?
Mr. Salamon. That is absolutely part of the game plan. They
will have a whole host of information available right through
our Internet site. They will be able to customize their own
personal Internet site for workforce information that is
particularly relevant to them and they will have continuous
access and it will be a great way for us to communicate back
and forth very effectively.
Mr. Weller. Thank you, Mr. Salamon, and thank you for
bringing Tom Thompson, one of your workers from Dulles airport
with you today, too, as well. But thank you for your time in
participating. Mr. Chairman, thank you.
Chairman Houghton. Thank you very much. Ms. Dunn?
Ms. Dunn. I think we have got an outstanding panel here and
I want to take advantage of your creativity by asking you a
question that is very basic to a lot of us in the Congress now.
In the last couple days, we have read about the number of
teachers that are going to be retiring over the next few years
and, at the same time, we have read a lot about baby boomers
with technology backgrounds who are thinking about taking early
retirement to do something else. I am a former IBM systems
engineer. What kind of tax incentives and educational
incentives would you like to see or would be effective in
recruiting people with technology backgrounds to go into
teaching so that they can truly develop a group of young
educated people who will be able to have good technology skills
as they graduate from high school college? Any thoughts?
Chairman Houghton. Don't all speak at once.
Mr. Bean. It is a very good question, and obviously the
teacher shortage is, from an educational perspective and as a
parent, is going to be a significant challenge for all of us on
a global stage when we just talk about broad learning
competitiveness, as well. As I sit here as somebody like you,
who came up through the IT education industry, in the IT
industry, I think what would take for me to be up to go back
and do that--I think the types of incentives that are going to
be important is firstly a recognition, as it was summed up
before, that when you look at the delta that exists between
what is paid to our teachers in the IT arena to actually impart
those skills versus what is earned in the private sector, I
think there is going to have to be something done for teachers
just to stay in place. For those that aren't looking to leave
their particular profession, what are we going to do for them
to actually stay in place as teachers rather than to be poached
by HR managers looking to fill their depleted ranks inside
corporate America, as well? So, in terms of tapping into the
creativity today, I would say we need to first of all address
the incentives for the teachers to stay put, and I hate to say
it, but I can only think that thing has to start with economic
incentives, given the disparity that exists between what IT
teachers are paid versus what they can earn in the private
sector by moving into system engineer-type roles.
Secondly, to attract those people back into teaching, which
I think is something that many of them would be extremely
interested in doing, what we need to take a look at is to make
sure that our taxation system does not unduly penalize them for
wanting to impart those skills to young people or people of all
levels. So, instead of necessarily putting incentives in place,
let's revisit our taxation system to make sure that if you or I
sought at our point of retirement, which these days can be in
our early 40s in the IT industry, that we are not penalized for
wanting to go back into the school system and actually give of
our expertise to young people so that they can move forward.
Chairman Houghton. All right. Fine. Well, gentlemen, thanks
very much. You have been very, very helpful. I would like to
call the second panel. Bill Sample, Chairman of the R&D Credit
Coalition, Redmond, Washington, Senior Director of Domestic
Taxes and Tax Affairs for Microsoft; and Mr. Randall Capps,
Corporate Tax Director and General Counsel, Electronic Data
Systems Corporation; Linda Evans, Program Director of Taxes and
Finance, Governmental Programs, IBM; and Collie Hutter, Chief
Operating Officer of Click Bond, Inc., of Carson City, Nevada.
Well, thank you very much for being with us. Mr. Sample,
would you begin your testimony?
STATEMENT OF BILL SAMPLE, CHAIRMAN, R&D CREDIT COALITION,
REDMOND, WASHINGTON, AND SENIOR DIRECTOR, DOMESTIC TAXES AND
TAX AFFAIRS, MICROSOFT CORPORATION
Mr. Sample. Thank you, Mr. Chairman. Mr. Chairman and
members of the subcommittee, my name is Bill Sample, Chairman
of the R&D Credit Coalition and Senior Director of Domestic Tax
and Tax Affairs at Microsoft. I am here today on behalf of the
R&D Credit Coalition, which represents 87 professional and
trade associations and more than 1,000 U.S. companies. We thank
you for focusing on the tax treatment of R&D as part of your
hearings on the Tax Code and the new economy and applaud the
members of this committee for their continued commitment to a
permanent R&D tax credit.
As Chairman Houghton stated when announcing this hearing,
the new economy is based on high-tech equipment, intensive
research and development and a skilled workforce. The R&D tax
credit, according to many Government and private-sector
experts, as listed in my written testimony, is a proven,
effective means of encouraging increased R&D activity in the
United States, which in turn will help provide technology
improvements to benefit the economy.
I have spent the last 10 years working in the software
industry and strongly believe in the economic and social
benefits that result from high-risk investments in technology
research. The last 10 years have also been very good for the
U.S. economy and the products of technology research have
helped create the budget surplus that is currently paying down
the national debt. Technology-driven increases in productivity
have also created more jobs for U.S. workers. Business Week
recently reported on a NABE survey of economists that lowered
the estimated maximum sustainable unemployment rate that would
not fuel inflation from six percent down to four-and-a-half \1/
2\ percent. That 1.5 percent represents a significant increase
in available jobs. The R&D credit encourages companies to hire
more high-skilled, high-paid workers to fill those jobs.
I would like to underscore the ripple effects of the
economic success created by technology research on a more
individual level. Whether it is the $18 million donated by
Microsoft employees to the United Way in 1999, the software and
hardware donated to schools and non-profits by our employees
and our business partners, the educational software my two
children use at home and at school or the e-mail and Internet
technology that enables my wife to be den mother for my six-
year-old son's Tiger Cub Troop, the economic and social
benefits of technology are helping many people improve their
lives. These stories are repeated over and over again in the
1,000 companies that make up the R&D Credit Coalition.
This committee plays a critical role in overseeing that the
U.S. Treasury and Internal Revenue Service properly administers
the law consistent with congressional intent. As the person
responsible for much of Microsoft's tax compliance, I can tell
you that regulations and other administrative guidance often
have more impact on our tax liability than the statutory
language.
In recent years, the U.S. Treasury and IRS have
administered the R&D credit rules in such a way as to attempt
to significantly reduce the scope of research activities
eligible for the R&D credit. Despite clear guidance provided by
Congress and the committee report language accompanying the
1998 and 1999 extensions of the R&D credit and separate letters
from committee members to Treasury, the IRS continues to apply
the discovery test, common-knowledge test and process-of-
experimentation requirements of its proposed regulations
defining eligible research pursuant to IRC Section 41(d) in its
examination of taxpayers.
Recently, a court admonished the IRS for taking positions
that were clearly unsupported by the law. In Tax and Accounting
Software Corporation versus the United States, the court
rejected the IRS-proposed discovery and common-knowledge tests.
The court held the IRS's, and I quote, ``Construction of the
statutory language would be a strained and improper reading
without any support in the legislative history to back it up,
and further the IRS is completely missing the fact that
Congress intended to encourage commercial research through the
enactment of the R&D credit.''
With respect to the process of experimentation requirements
in the proposed regulations, the Tax Court found that, and I
quote, ``The highly-structured definition of research which is
proffered by the IRS in its regulations makes it virtually
impossible for commercial research to qualify through the
Section 41 credit, which was clearly not the intention of
Congress.
In conclusion, we should seize on the opportunity we have
to take at least one critical positive step towards a 21st-
century Tax Code. Make the R&D credit permanent. Thank you and
I am happy to take questions.
[The prepared statement follows:]
Statement of Bill Sample, Chairman, R&D Credit Coalition, Redmond,
Washington, and Senior Director, Domestic Taxes and Tax Affairs,
Microsoft Corporation
Mr. Chairman and members of the subcommittee, my name is
Bill Sample, Chairman of the R&D Credit Coalition and Senior
Director of Domestic Taxes & Tax Affairs at Microsoft. I am
here today on behalf of The R&D Credit Coalition, which
represents 87 professional and trade associations and more than
1,000 U.S. companies. We thank you for focusing on the tax
treatment of research and development as part of your hearings
on the tax code and the new economy and applaud the members of
this subcommittee and the full Ways and Means Committee for
their continued commitment to a permanent R&D tax credit. Last
year as part of the Tax and Trade Extension Act of 1999, this
important tax credit was extended for five years, through June
30, 2004, and a modest increase in the Alternative Incremental
Research Credit was adopted. We look forward to working with
you to finish the job and make the R&D credit permanent.
This testimony will focus on: (1) the importance of making
the R&D credit permanent; and (2) the need to address growing
controversies in the administration of the R&D credit caused by
positions taken by the Department of the Treasury and the IRS
in examination, litigation, and the proposed R&D regulations.
As the Committee members consider how well the tax code is
``keeping pace'' with the new economy we urge you to encourage
tax policies that will fuel the U.S. economy, keeping American
companies and their workers prosperous and competitive in the
changing global marketplace. Without a growing economy,
Americans' standard of living, and our ability to support the
needs of our aging population, will be in jeopardy. Faced with
a static or decreasing workforce as U.S. demographics shift,
U.S. lawmakers must focus on encouraging technology development
to increase productivity, enabling a smaller workforce to
support a growing population of retirees.
As Chairman Houghton stated when announcing this hearing,
``the 'new economy' is based on high-tech equipment, intensive
research and development, and a skilled workforce.'' We could
not agree more. Increased technology development will help to
ensure sustained economic growth and the prosperous environment
needed to continue to improve our standard of living for
current and future generations of Americans. U.S. tax law
should promote technology development in the U.S., and the most
effective way to do that is through a permanent R&D tax credit.
The R&D tax credit, according to many government and
private sector experts, is a proven, effective means of
encouraging increased research and development activity in the
United States, which in turn will help provide the technology
improvements to benefit the economy.
In 1998, Coopers & Lybrand (now PricewaterhouseCoopers), an
accounting firm, completed a study, Economic Benefits of the
R&D Tax Credit, (January, 1998) that dramatically illustrates
the significant economic benefits provided by the credit.
According to the study, making the R&D credit permanent would
stimulate substantial amounts of additional R&D in the U.S.,
increase national productivity and economic growth almost
immediately, and provide U.S. workers with higher wages and
after-tax income.
There is a significant body of other evidence produced by
the General Accounting Office, Bureau of Labor Statistics,
National Bureau of Economic Research, and others, that likewise
conclude that this credit represents a very sound investment in
U.S. economic growth. As we enter the 21 st century with a
projected budget surplus and continued economic promise, now is
the time to make a long-term commitment to U.S. research and
development and to make the R&D credit permanent.
I. The R&D Credit
A. Background
As an incentive for companies to increase their U.S. R&D
activities, Congress first enacted the R&D credit in 1981. The
credit as originally passed was scheduled to expire at the end
of 1985. Recognizing the importance and effectiveness of the
provisions, Congress decided to extend it and continued to
extend it on at least nine subsequent occasions. In addition,
the credit's focus has been sharpened by limiting both
qualifying activities and eligible expenditures. With each
extension, the Congress indicated its strong bipartisan support
for the R&D credit.
In 1986, the credit lapsed, but was retroactively extended
and the rate cut from 25 percent to 20 percent. In 1988, the
credit was extended for one year, but its effectiveness was
reduced by decreasing the deduction for R&D expenditures by 50%
of the credit. In 1989, Congress extended the credit for
another year, again reduced the effectiveness of the credit by
decreasing the deduction for R&D expenditures by a full 100% of
the credit, and made changes that were intended to increase the
incentive effect for established as well as start-up companies.
In the 1990 Budget Reconciliation Act, the credit was extended
again for 15 months through the end of 1991. The Tax Extension
Act of 1991 extended the credit again, through June 30, 1992.
In OBRA 1993, the credit was retroactively extended through
June 30, 1995.
In 1996, as part of the Small Business Job Protection Act
of 1996, the credit was extended for eleven months, through May
31, 1997, but was not extended to provide continuity over the
period July 1, 1995 to June 30, 1996. This one-year period,
July 1, 1995 to June 30, 1996, was the first gap in the
credit's availability since its enactment in 1981.
In 1996, the elective Alternative Incremental Research
Credit (``AIRC'') was added to the credit, increasing its
flexibility and making the credit available to R&D intensive
industries that could not qualify for the credit under the
regular criteria. The AIRC adds flexibility to the credit to
address changes in business models and R&D spending patterns
that are a normal part of a company's life cycle.
The Congress next approved a thirteen-month extension of
the R&D credit that was enacted into law as part of the
Taxpayer Relief Act of 1997. The credit was made available for
expenditures incurred from June 1, 1997 through June 30, 1998,
with no gap between this and the previous extension. In the Tax
and Trade Extension Act of 1998, the Congress approved a one-
year extension of the credit, until June 30, 1999. In 1999, the
credit was extended until June 30, 2004, and a modest increase
in the AIRC rates was adopted that will bring the AIRC's
incentive effect more into line with the incentive provided by
the regular credit to other research-intensive companies.
According to the Tax Reform Act of 1986, the R&D credit was
originally limited to a five-year term in order ``to enable the
Congress to evaluate the operation of the credit.'' While it is
understandable that the Congress in 1981 would want to adopt
this new credit on a trial basis, the credit has long since
proven over the 19 years of its existence to be an excellent
investment of government resources to provide an effective
incentive for companies to increase their U.S.-based R&D.
Recently released corporate data show significant increases in
total qualified research eligible for the credit. The credit is
working, and we should underscore its effectiveness by making
it permanent.
The historical pattern of temporarily extending the credit,
combined with the first gap in the credit's availability,
reduces the incentive effect of the credit. The U.S. research
community needs a stable, consistent R&D credit in order to
maximize its incentive value and its contribution to the
nation's economic growth and sustain the basis for ongoing
technology competitiveness in the global arena. While a five
year extension of the credit is helpful, Congress should make
the R&D credit permanent.
B. The Importance of an R&D Credit
1. Productivity Growth
It is well recognized that ``[m]uch of the growth in
national productivity ultimately derives from research and
development conducted in private industry.'' See, Office of
Technology Assessment (1995). Sixty-six to eighty percent of
productivity growth since the Great Depression is attributable
to such innovation. In an industrialized society R&D is the
primary force driving technological innovation. Moreover, since
companies cannot capture fully the rewards of their innovations
(because they cannot control the indirect benefits of their
technology on the economy), the rate of return to society from
innovation is twice that which accrues to the individual
company.
Economists and technicians who have studied the issue agree
that the government should intervene to increase R&D
investment. In a study conducted by the Tax Policy Economics
Group of Coopers & Lybrand (now PricewaterhouseCoopers), it was
found that ``. . .absent the R&D credit, the marketplace, which
normally dictates the correct allocation of resources among
different economic activities, would fail to capture the
extensive spillover benefits of R&D spending that raise
productivity, lower prices, and improve international trade for
all sectors of the economy.'' Stimulating private sector R&D to
drive national productivity growth is particularly critical in
light of the decline in government funded R&D over the years.
2. Global Competitiveness
Private sector U.S.--based R&D is critical to the
technological innovation and productivity advances that will
maintain U.S. leadership in the world marketplace. Since 1981,
when the credit was first adopted, there have been dramatic
gains from R&D spending. Unfortunately, our nation's private
sector investment in R&D (as a percentage of GDP) lags far
below many of our major foreign competitors. For example, U.S.
firms spend (as a percentage of GDP) only one-third as much as
their German counterparts on R&D, and only about two-thirds as
much as Japanese firms. This trend must not be allowed to
continue if our nation is to remain competitive in the world
marketplace.
Foreign governments are competing aggressively for U.S.
research investments by offering substantial tax and other
financial incentives. Even without these tax incentives, the
cost of performing R&D in many foreign jurisdictions is lower
than the cost to perform equivalent R&D in the U.S. According
to an OECD survey, the U.S. R&D tax credit as a percentage of
industry-funded R&D was third lowest among nine countries
analyzed. In order for U.S. businesses to remain competitive in
this global environment, the R&D credit must remain in place on
a permanent basis.
3. Reduced Cost of Capital
The R&D credit reduces the cost of capital for businesses
that increase their R&D spending. This results in more capital
being available for innovative ventures that would otherwise
not be undertaken because of risks involved with the project.
When the cost of R&D is reduced, the private sector is likely
to perform more of it. In most situations, the greater the
scope of R&D activities, or risk, the greater the potential for
return to investors, employees and society at large. By
lowering the economic risk to companies seeking to initiate new
research, the R&D credit will potentially lead to enhanced
productivity and overall economic growth.
4. Cost Effective Tool to Encourage Economic Growth
A number of economic studies \1\ of the credit have found
that a one-dollar reduction in the after-tax price of R&D
stimulates approximately one dollar of additional private R&D
spending in the short-run, and about two dollars of additional
R&D in the long run. The Coopers & Lybrand study estimated that
a permanent extension of the R&D credit would create nearly $58
billion of economic growth over the 1998-2010 period, including
$33 billion of additional domestic consumption and $12 billion
of additional business investment. These benefits stem from
substantial productivity increases that could add more than $13
billion per year of increased productive capacity to the U.S.
economy. Accordingly, studies confirm that one of the most cost
effective tools of encouraging economic growth would be the
enactment of a permanent R&D credit.
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\1\ These include the Coopers & Lybrand 1998 study, the KPMG Peat
Marwick 1994 study, and the article by B. Hall entitled: ``R&D Tax
Policy in the 1980s: Success or Failure?'' Tax Policy and the Economy
(1993).
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5. Job Creation
Dollars spent on R&D are primarily spent on salaries for
engineers, researchers and technicians. When taken to market as
new products, incentives that support R&D translate to salaries
for employees in manufacturing, administration and sales. Of
exceptional importance to many members of the R&D Credit
Coalition, R&D success also means salaries to the people in our
distribution channels who bring our products to our customers
as well as service providers and developers of complementary
products. And, our customers ultimately drive the entire
process by the value they place on the benefits from advances
in technology (benefits that often translate into improving
their ability to compete and lower prices for consumers). By
making other industries more competitive, research within one
industry contributes to preserving and creating jobs across the
entire U.S. economy. The R&D credit and investment in R&D is
ultimately an investment in people, their education, their
jobs, their economic security, and their standard of living.
The R&D credit is available to all qualifying taxpayers
Any taxpayer that increases their U.S. R&D spending and
meets the technical requirements provided in the law can
qualify for the credit. By utilizing the R&D credit, businesses
of all sizes, and in all industries, can best determine what
types of products and technology to invest in so that they can
ensure their competitiveness in the world marketplace. As such,
the R&D credit is a meaningful, market-driven tool to encourage
private sector investment in research and development
expenditures in the U.S. that should be made permanent.
II. The R&D Credit should be made permanent
In order to achieve the maximum incentive effect, the R&D
credit should be made permanent. As recently recognized by the
Joint Committee on Taxation, ``[i]f a taxpayer considers an
incremental research project, the lack of certainty regarding
the availability of future credits increases the financial risk
of the expenditure.'' See, Description of Revenue Provisions in
the President's Fiscal Year 2000 Budget Proposal (JCS-1-99).
Research projects cannot be turned off and on like a light
switch and generally represent multi-year commitments; if
corporate managers are going to take the benefits of the R&D
credit into account in planning future research projects, they
need to know that the credit will be available to their
companies for the years in which the research is to be
performed. Research projects have long horizons and extended
gestation periods. Furthermore, firms generally face longer
lags in adjusting their R&D investments compared, for example,
to adjusting their investments in physical capital.
In the normal course of business operations, R&D
investments take time and planning. Businesses must search for,
hire, and train scientists, engineers and support staff, and in
many cases invest in new physical plants and equipment. There
is little doubt that some of the incentive effect of the credit
has been lost over the past nineteen years as a result of the
constant uncertainty over the continued availability of the
credit. This must be corrected so that the full potential of
its incentive effect can be felt across all sectors of our
economy.
In order to provide for the maximum potential for increased
R&D activity, and for the government to maximize its return on
tax dollars invested in the credit, the practice of
periodically extending the credit for short periods, and then
allowing it to lapse, must be eliminated, and the R&D credit
must be made permanent.
III. Problems with the proposed R&D regulations and growing
controversies in the Administration of the R&D Credit
The economic benefits of permanently extending the R&D
credit will be significantly reduced, however, if the credit is
administered by the government in a manner contrary to the
intent of Congress. Improper implementation and administration
of the law could reduce the credit eligibility of legitimate
research activities. Despite the broad support for this tax
incentive, and additional guidance by the Congress on the
proper administration of the credit (e.g., legislative history
and letters), there remain significant problems with the manner
in which the IRS administers the law and interprets the
application of R&D credit eligibility rules to corporate
research activities. Many of these problems are the direct
result of positions taken by the Administration in regulations
interpreting the R&D tax credit under Internal Revenue Code
section 41 (``the proposed R&D regulations'') \2\ and in tax
examinations and litigation.
---------------------------------------------------------------------------
\2\ Prop. Regs. Sections 1.41-1 to 1.41-8, Vol. 63 Fed. Reg. No.
231, 63 FR 66503.
---------------------------------------------------------------------------
The growing controversy created by the proposed R&D
regulations has been well known for some time. These
regulations attempt to significantly reduce the scope of
``qualified research'' through the use of a discovery test that
turns in part, on a proposed ``common knowledge'' test. Over
four dozen witnesses representing a broad cross-section of
businesses and industry raised significant concerns about these
proposed regulations in oral and written testimony before the
Department of the Treasury and IRS. The public hearing on the
proposed regulations was attended by over 100 practitioners and
corporate taxpayers. Nearly every witness who testified argued
for significant changes to the proposed rules, including the
elimination of the proposed ``common knowledge'' test. Many
felt that left unchanged, the proposed ``common knowledge''
test could cause increased administrative burden and
complexity, result in questionable tax increases by eliminating
the credit eligibility of many legitimate research projects,
and violate Congressional intent for the application of the R&D
credit.
As evidenced by the volume and scope of these public
comments, the proposed R&D regulations are extremely
controversial and have caused great uncertainty for taxpayers
and the IRS in the examination process. In addition, recent IRS
National Office guidance in the form of a Coordinated Issue
Paper (``CIP'') relies on concepts from the proposed R&D
regulations to support its analysis and holdings. See,
Coordinated Issue All Industries Research Tax Credit--Qualified
Research (Release Date: August 30, 1999). The CIP incorporates
the ``common knowledge'' test proposed in the regulations
almost verbatim and cites it as authority. Even though the
regulations are proposed and recognized as controversial, the
IRS is currently applying the principles of these proposed
regulations to deny credit eligibility.
These problems have also been recognized by the Chairman
and other Members of this Committee. As recently as last month,
Chairman Bill Archer and Representatives Nancy Johnson and
Robert Matsui wrote to Treasury Secretary Summers expressing
their concern regarding the administrability of the R&D credit
by both the government and taxpayers. In their letter of August
17, 2000, these Members expressed concern about allegations
that during the comment period on the proposed R&D regulations,
``IRS agents are misapplying the proposed regulations and
misinterpreting the clear statutory intent of the definition of
qualified research.'' They went on to emphasize that any final
regulations should be consistent with Congressional intent.
In a separate letter dated August 21, 2000, Representatives
Johnson and Matsui wrote to Secretary Summers reiterating their
concerns by stating the following:
``This reliance by the IRS on proposed rules, which are
subject to further administrative actions, evidences a
disregard for the administrative rulemaking process and
inappropriate tax administration of the statutory provisions of
section 41. These actions also reflect the fact that there may
not be a full appreciation within the IRS, in both the National
and field offices, of the level of concern surrounding the
proposed rules from both a policy and practical perspective.
The problems and controversy surrounding the use of a
discovery test that incorporates a ``common knowledge'' test is
the result of positions taken by the Department of the Treasury
and the IRS in examination, litigation, and the proposed R&D
regulations. These problems and controversy are unnecessary,
since the test contained in the proposed R&D regulations was
never contemplated nor endorsed by Congress as part of the R&D
tax credit.
In fact, as part of the conference report to the Ticket to
Work and Work Incentives Improvement Act of 1999 (Pub. L. 106-
170), Congress urged you ``to consider carefully the comments
[you] have received regarding the proposed regulations relating
to . . . the definition of qualified research under section
41(d), particularly regarding the 'common knowledge' test.''
\3\
---------------------------------------------------------------------------
\3\ Ticket to Work and Work Incentives Improvement Act of 1999,
Conf. Rpt. 106-478, page 132 (Nov. 17, 1999).
---------------------------------------------------------------------------
At the time, Congress also reaffirmed ``that qualified
research is research undertaken for the purpose of discovering
new information which is technological in nature;'' and that
``new information is information that is new to the taxpayer,
is not freely available to the general public, and otherwise
satisfies the requirements of section 41.'' \4\
---------------------------------------------------------------------------
\4\ Id.
---------------------------------------------------------------------------
We understand that public comments on the proposed R&D
regulations are now being carefully reviewed by your staff and
we are encouraged by such actions. At the same time, we remain
concerned that during this comment period, IRS agents are
misapplying the regulations and/or misinterpreting the clear
statutory intent of the definition of ``qualified research.''
Given the unique nature of these proposed R&D regulations,
the genuine controversy reflected in public comments on the
issue of the discovery and ``common knowledge'' tests, and the
problems they are causing in the tax examination and audit
process, we urge that at the very least the final R&D
regulations do not contain a ``common knowledge'' test or any
other rules inconsistent with the Congressional intent as
espoused most recently in the legislative history to the Ticket
to Work and Work Incentives Improvement Act of 1999. We also
urge the Department of the Treasury and the IRS to allow a
further public comment period on changes they may be
considering on any controversial aspect of the regulations
before the regulations are finalized.
Left unchanged and outstanding, any rules that incorporate
the ``common knowledge'' test contained in the proposed
regulations will cause more confusion, controversy and
administrative burdens, without furthering the underlying
legislative intent of the R&D tax credit. We believe such
results will harm rather than help the current Administration's
efforts to encourage R&D investments and to support the R&D tax
credit.'' See, Letter From Representatives Johnson and Matsui
to Secretary Summers (dated August 21, 2000)
The R&D Coalition strongly endorses these statements and
encourages this committee to pursue any actions available to
work with the Department of the Treasury and the IRS to resolve
these problems with the proposed R&D regulations.
The proposed R&D regulations also go beyond legislative
intent in their proposed definition of ``process of
experimentation,'' and implication of an additional record
keeping requirement in order to qualify for the credit. The
proposed regulations take an inappropriate academic view in
defining the phrase ``process of experimentation'' and add
requirements not present in the underlying statute. In
addition, the proposed regulations appear to add a new
substantiation requirement (in the form of a rule that seems to
require contemporaneous recording of the results of
experiments) into the basic definition of qualified research.
Both positions are inconsistent with and beyond the legislative
history underlying the R&D credit.
Recently, a court admonished the use by the IRS of
positions that were clearly unsupported by the law. In Tax and
Accounting Software Corp. v. U.S., N.D. Okla. (July 31, 2000),
the court rejected the IRS's proposed ``discovery'' test and
the opinions of the courts in Norwest Corporation and
Subsidiaries v. Commissioner of Internal Revenue, 110 T.C. 454
(1998) and United Stationers, Inc. v. United States, 982 F.
Supp. 1279 (N.D. Ill. 1997), affirmed 163 F.3d 440 (7th Cir.
1998) that relied on a ``discovery test'' to qualify for the
R&D credit. The court held that ``that construction of the
statutory language would be a strained and improper reading
without any support in the legislative history to back it up.''
Tax and Accounting Software Corp. v. U.S., Order (p. 9).
The court went on to find that ``there is no support'' in
the statute or legislative history for the position contained
in the proposed R&D regulations that requires ``obtaining
knowledge that exceeds, expands, or refines the common
knowledge of skilled professionals in the particular field of
technology or science.'' It further said that ``the IRS is
completely missing the fact that Congress intended to encourage
commercial research'' through the enactment of the R&D credit.
Id. at p.14.
Importantly, the court concluded by stating that ``[T]he
highly structured definition of research which is proffered by
the IRS in its regulations makes it virtually impossible for
commercial research to qualify for the section 41 credit, which
was clearly not the intention of Congress. Id. at p. 14
(emphasis added).
Despite these obvious controversies with the regulations
and the unsupported positions taken by the IRS in the proposed
R&D regulations, in examination and in litigation, there is no
indication that changes are being instituted to correct these
glaring problems. We therefore, encourage you and this
committee to take all actions necessary to ensure that the R&D
credit incentive, which is so valuable to our national economy,
is not undermined by the regulators that implement this law.
IV. Conclusion
There is a unique opportunity in this time of economic
prosperity to take a thoughtful look at whether our tax laws
are a help or hindrance to sustained growth and the
competitiveness of U.S. businesses. We should seize on the
opportunity we have to take at least one critical positive step
toward a 21st century tax code--make the R&D Credit permanent.
Private sector R&D in the U.S. stimulates investment in
innovative products and processes that greatly contribute to
overall economic growth, increased productivity, new and better
U.S. jobs, and higher standards of living in the United States.
Moreover, by creating an environment favorable to private
sector R&D investment in the U.S., jobs will remain in the
United States. Investment in R&D is an investment in people. A
permanent R&D credit is essential for the United States economy
in order for its industries to compete globally, as
international competitors have chosen to offer direct financial
subsidies and reduced capital cost incentives to ``key''
industries.
Finally, in order to ensure that these objectives are met,
the R&D credit laws must be administered and regulated in a
manner consistent with Congressional intent and not in a manner
that undermines the national goals of this well-supported
public policy.
Thank you, and I am happy to take any questions.
Chairman Houghton. Thanks very much. Mr. Capps.
STATEMENT OF R. RANDALL CAPPS, CORPORATE TAX DIRECTOR, AND
GENERAL TAX COUNSEL, ELECTRONIC DATA SYSTEMS CORPORATION,
PLANO, TEXAS
Mr. Capps. Good morning, Mr. Chairman and members of the
committee. My name is Randy Capps and I am Tax Director for
Electronic Data Systems Corporation. I would like to thank you
for this opportunity to speak with you about the research and
experimentation tax credit. EDS has been a leader in the
information technology services industry for more than 35
years. Our leadership depends on continuous reinvention of our
products and our services. Our 120,000 employees deliver
management consulting and electronic business solutions to more
than 9,000 business and Government clients in over 50
countries.
Each year, we spend more than $1.7 billion on a wide range
of research and development. EDS researchers have, for example,
developed programs that help health insurers control costs. We
developed a manufacturing system, using a computer language
tailored for the semiconductor industry, that guided silicon
wafers from one production location to another. We are focusing
today on development of programs to guard against cyber-
terrorism in the digital economy.
My industry was born out of high-cost, high-risk research.
It is driven by the creativity of thousands of innovative
corporations. The R&D yields products and services that are
improving lives and generating productivity increases
throughout the economy.
Since the R&D credit was enacted in 1981, it has been
extended 10 times. With each extension, Congress indicated
strong bipartisan support. Last year, Congress extended the
credit for five years. Earlier this year, the Senate voted 98-
to-one in favor of an amendment to the estate tax bill that
would have made the credit permanent. All amendments were
stripped from the final bill, but the bipartisan support was a
strong indicator of the importance of the credit to members
from all parts of the country.
So, why is the credit so important? First, it offsets the
tendency for underinvestment in R&D. The single-biggest factor
driving productivity growth is innovation. However, companies
cannot profit from the indirect benefits of the technology to
the economy. As a result, the rate of return of R&D to society
is twice that which accrues to an individual company.
The second reason why it is so important: The credit helps
U.S. business remain competitive in world markets. Foreign
governments are competing aggressively for research investments
by offering substantial tax and other financial incentives.
Companies that do research in the United States are at a
disadvantage when competing with foreign-based multinationals
that have lower research costs.
Third, R&D spending is very responsive to the credit.
Economic studies of the credit have found a one-dollar
reduction in the after-tax cost of R&D stimulates approximately
one dollar of additional private R&D spending in the short run
and about two dollars of additional R&D spending in the long
run.
Most important, research and development is about jobs and
it is about people. Investment in R&D is ultimately an
investment in people, their education, their jobs, their
economic security and their standard of living.
Dollars spent on R&D are primarily spent on salaries for
engineers, researchers and technicians. At EDS, more than 90
percent of the expenses qualifying for the R&D credit go to
salaries for U.S. employees who are directly involved in
research. When R&D results in new products and services, the
incentives that support R&D translate into salaries of
employees in production, administration and sales. By making
other industries more competitive, research in one industry
contributes to the creation of jobs across the entire economy.
Research projects cannot be turned on and off like a light
switch. The most important thing that you as leaders in the tax
legislative process can do to promote sustained investment in
long-term research is to make the credit permanent. House
Speaker Dennis Hastert, Minority Leader Dick Gephardt, Senate
Majority Leader Trent Lott, Minority Leader Tom Daschle, Vice
President Al Gore and Texas Governor George Bush have all
endorsed the permanent R&D credit.
This week's issue of Time magazine includes a story
entitled ``Hooray for R&D: It is Time to Make a Popular and
Effective Tax Credit Permanent.'' That is exactly what I am
asking you to do. Thank you and I would be happy to answer any
questions you may have.
[The prepared statement follows:]
Statement of R. Randall Capps, Corporate Tax Director, and General Tax
Counsel, Electronic Data Systems Corporation, Plano, Texas
Good morning. Mr. Chairman and members of the committee. My
name is Randy Capps, and I am Corporate Tax Director for
Electronic Data Systems. I would like to thank you for the
opportunity to speak with you about the research and
experimentation tax credit and to thank you and all the members
of the subcommittee who have supported the credit over the
years.
EDS has been a leader in the global information technology
services industry for more than 35 years. Our 120,000 employees
deliver management consulting and electronic business solutions
to more than 9,000 business and government clients in
approximately 50 countries. EDS reported revenues of $18.5
billion in 1999. EDS spends more than $1.7 billion on research
and development every year.
For example, EDS researchers have developed programs that
help health insurers to control costs and a manufacturing
system, using a computer language tailored for the
semiconductor industry, to guide silicon wafers from one
production station to another. Today, a major focus is to
develop programs to guard against cyber terrorism in the
digital economy.
The information technology services industry was born out
of basic research and is driven by the applied research of
hundreds of innovative corporations. This corporate R&D
produces a growing range of products and services that are
generating productivity increases throughout the economy. The
technological revolution that is occurring in my industry is
replicated in many others. These industries are reinventing
themselves and in the process are creating a broad range of
high-paid, high-skilled jobs in the United States.
R&D is the primary source of technological innovation.
According to the U.S. Office of Technology Policy,
technological innovation has accounted for up to half of U.S.
economic growth during the past five decades.
I. R&D Credit Legislative History
The R&D credit was enacted in 1981 to provide an incentive
for companies to increase their U.S. R&D activities. As
originally passed, the R&D credit was to expire at the end of
1985. Recognizing the importance and effectiveness of the
provisions, Congress decided to extend it. In fact, since 1981
the credit has been extended ten times. In addition, the
credit's focus has been sharpened by limiting qualifying
activities and eligible expenditures. With each extension,
Congress indicated its strong bipartisan support for the R&D
credit. Most recently, Congress approved a five-year extension
of the credit, until June 30, 2004.
This year, the Senate voted 98 to 1 in favor of an
amendment that would have added a permanent R&D tax credit to
the estate tax bill. For reasons unrelated to the credit, all
amendments were stripped from the bill. However, I believe this
vote was a strong indication that members of Congress recognize
the contribution of the credit to economic growth.
In 1996, the elective Alternative Incremental Research
Credit (``AIRC'') was added to the credit, increasing its
flexibility and making the credit available to R&D intensive
industries which could not qualify for the credit under the
regular criteria. The AIRC adds flexibility to the credit to
address changes in business models and R&D spending patterns
which are a normal part of a company's life cycle.
According to the conference report of the Tax Reform Act of
1986, the R&D credit was originally limited to a five-year term
in order ``to enable the Congress to evaluate the operation of
the credit.'' It is understandable that Congress in 1981 would
want to adopt this new credit on a trial basis. The credit has
long since proven to be an excellent, highly leveraged
investment of government resources to provide an effective
incentive for companies to increase their U.S.--based R&D.
The historical pattern of temporarily extending the credit
reduces the incentive effect of the credit. The U.S. research
community needs a stable, consistent R&D credit in order to
maximize its incentive value and its contribution to the
nation's economic growth.
II. Why do we Need an R&D Credit?
A. The credit offsets the tendency for under investment in R&D
The single biggest factor driving productivity growth is
innovation. As stated by the Office of Technology Assessment in
1995: ``Much of the growth in national productivity ultimately
derives from research and development conducted in private
industry.'' Sixty-six to 80 percent of productivity growth
since the Great Depression is attributable to innovation. In an
industrialized society, R&D is the primary means by which
technological innovation is generated.
Companies cannot capture fully the rewards of their
innovations because they cannot control the indirect benefits
of their technology on the economy. As a result, the rate of
return to society from innovation is twice that which accrues
to the individual company. This situation is aggravated by the
high risk associated with R&D expenditures. As many as 80
percent of such projects are believed to be economic failures.
Therefore, economists and technicians who have studied the
issue are nearly unanimous that the government should intervene
to increase R&D investment. A recent study, conducted by the
Tax Policy Economics Group of Coopers & Lybrand, now part of
PriceWaterhouseCoopers, concluded that ``. . .absent the R&D
credit, the marketplace, which normally dictates the correct
allocation of resources among different economic activities,
would fail to capture the extensive spillover benefits of R&D
spending that raise productivity, lower prices, and improve
international trade for all sectors of the economy.''
Stimulating private sector R&D is particularly critical in
light of the decline in government funded R&D over the years.
Direct government R&D funding has declined from 57 percent to
36 percent of total R&D spending in the U.S. from 1970 to 1994.
Over this same period, the private sector has become the
dominant source of R&D funding, increasing from 40 percent to
60 percent.
B. The credit helps U.S. business remain competitive in a world
marketplace
The R&D credit has played a significant role in placing
American businesses ahead of their international competition in
developing and marketing new products. It has assisted in the
development of new and innovative products; providing
technological advancement, more and better U.S. jobs, and
increased domestic productivity and economic growth. This is
increasingly true in our knowledge and information-driven world
marketplace.
Research and development must meet the pace of competition.
In many instances, the life cycle of new products is
continually shrinking. As a result, the pressure of getting new
products to market is intense. Without robust R&D incentives
encouraging these efforts, the ability to compete in world
markets is diminished.
Continued private sector R&D is critical to the
technological innovation and productivity advances that will
maintain U.S. leadership in the world marketplace. Since 1981,
when the credit was first adopted, there have been dramatic
gains in R&D spending. Unfortunately, our nation's private
sector investment in R&D (as a percentage of GDP) lags far
below many of our major foreign competitors. For example, U.S.
firms spend (as a percentage of GDP) only one-third as much as
their German counterparts on R&D, and only about two-thirds as
much as Japanese firms. This trend must not be allowed to
continue if our nation is to remain competitive in the world
marketplace.
Moreover, we can no longer assume that American companies
will automatically choose to site their R&D functions in the
United States. Foreign governments are competing aggressively
for U.S. research investments by offering substantial tax and
other financial incentives. Even without these tax incentives,
the cost of performing R&D in many foreign jurisdictions is
lower than the cost to perform equivalent R&D in the U.S.
An OECD survey of 16 member countries found that 13 offer
R&D tax incentives. Of the 16 OECD nations surveyed, 12 provide
an R&D tax credit or allow a deduction for more than 100
percent of R&D expenses. Six OECD nations provide accelerated
depreciation for R&D capital. According to the OECD survey, the
U.S. R&D tax credit as a percentage of industry-funded R&D was
third lowest among nine countries analyzed.
In July of this year, the UK government revised its R&D tax
rules to provide increased incentives for small and medium size
companies. Stephen Beyers, UK secretary of state for trade and
industry, said of the change: ``I want the UK to be the most
attractive location for companies to conduct R&D.''
Making the U.S. R&D tax credit permanent would markedly
improve U.S. competitiveness in world markets. The 1998 Coopers
& Lybrand study found that, with a permanent credit, annual
exports of goods manufactured here would increase by more than
$6 billion, and imports of good manufactured elsewhere would
decrease by nearly $3 billion. Congress and the Administration
must make a strong and permanent commitment to attracting and
retaining R&D investment in the United States. The best way to
do that is to permanently extend the R&D credit.
C. The credit provides a targeted incentive for additional R&D
investment, increasing the amount of capital available for
innovative and risky ventures
The R&D credit reduces the cost of capital for businesses
that increase their R&D spending, thus increasing capital
available for risky research ventures.
Products resulting from R&D must be evaluated for their
financial viability. Market factors are providing increasing
incentives for controlling the costs of business, including
R&D. Based on the cost of R&D, the threshold for acceptable
risk either rises or falls. When the cost of R&D is reduced,
the private sector is likely to perform more of it. In most
situations, the greater the scope of R&D activities, or risk,
the greater the potential for return to investors, employees
and society at large.
The R&D credit is a vital tool to keep U.S. industry
competitive because it frees-up capital to invest in leading
edge technology and innovation. It makes available additional
financial resources to companies seeking to accelerate research
efforts. It lowers the economic risk to companies seeking to
initiate new research, which will potentially lead to enhanced
productivity and overall economic growth.
D. Private industrial R&D spending is very responsive to the
R&D credit, making the credit a cost effective tool to
encourage economic growth
Economic studies of the credit, including the Coopers &
Lybrand 1998 study, the KPMG Peat Marwick 1994 study, and the
article by B. Hall entitled: ``R&D Tax Policy in the 1980s:
Success or Failure?'' Tax Policy and the Economy (1993), have
found that a one-dollar reduction in the after-tax price of R&D
stimulates approximately one dollar of additional private R&D
spending in the short-run, and about two dollars of additional
R&D in the long run. The Coopers & Lybrand study predicts that
a permanent R&D credit would lead U.S. companies to spend $41
billion more (1998 dollars) on R&D for the period 1998-2010
than they would in the absence of the credit. This increase in
private U.S. R&D spending, the 1998 study found, would produce
substantial and tangible benefits to the U.S. economy.
Coopers & Lybrand estimated that this permanent extension
would create nearly $58 billion of economic growth over the
same 1998-2010 period, including $33 billion of additional
domestic consumption and $12 billion of additional business
investment. These benefits, the 1998 study found, stemmed from
substantial productivity increases that could add more than $13
billion per year of increased productive capacity to the U.S.
economy. Enacting a permanent R&D credit would lead U.S.
companies to perform significantly more R&D, substantially
increase U.S. workers' productivity, and dramatically grow the
domestic economy.
E. Research and Development is About Jobs and People
Investment in R&D is ultimately an investment in people,
their education, their jobs, their economic security, and their
standard of living. Dollars spent on R&D are primarily spent on
salaries for engineers, researchers and technicians.
When R&D results in new products and services, the
incentives that support R&D translate into salaries of
employees in manufacturing, administration and sales.
Successful R&D also means salaries to people in the
distribution channels who bring new products to customers,
service providers and developers of complementary products.
Finally, customers benefit from advances in technology that
improve their productivity and ability to compete. By making
other industries more competitive, research within one industry
contributes to preserving and creating jobs across the entire
economy.
At EDS more than 90 percent of expenses qualifying for the
R&D credit go to salaries for employees directly involved in
research. These are high-skill, high-wage jobs that employ U.S.
workers. Investment in R&D, in people working to develop new
ideas, is one of the most effective strategies for U.S.
economic growth and competitive vitality. Indeed, the 1998
Coopers & Lybrand study shows improved worker productivity
throughout the economy with the resulting wage gains going to
hi-tech and low-tech workers alike. U.S. workers' personal
income over the 1998-2010 period, the 1998 study predicts,
would increase by more than $61 billion if the credit were
permanently extended.
F. The R&D credit is a market driven incentive
The R&D credit is a meaningful, market-driven tool to
encourage private sector investment in research and development
expenditures. Any taxpayer that increases their R&D spending
and meets the technical requirements provided in the law can
qualify for the credit. Instead of relying on government-
directed and controlled R&D spending, businesses of all sizes,
and in all industries, can determine what types of products and
technology to invest in so that they can ensure their
competitiveness in the world marketplace.
III. The R&D Credit should be made Permanent to have Maximum Incentive
Effect
As the Joint Committee on Taxation pointed out in the Description
of Revenue Provisions in the President's Fiscal Year 2000 Budget
Proposal (JCS-1-99), ``If a taxpayer considers an incremental research
project, the lack of certainty regarding the availability of future
credits increases the financial risk of the expenditure.'' Research
projects cannot be turned off and on like a light switch. If corporate
managers are going to take the benefits of the R&D credit into account
in planning future research projects, they need to know that the credit
will be available to their companies for the years in which the
research is to be performed. Research projects have long horizons and
extended gestation periods. Furthermore, firms generally face longer
lags in adjusting their R&D investments compared, for example, to
adjusting their investments in physical capital.
In order to increase their R&D efforts, businesses must search for,
hire, and train scientists, engineers and support staff. They must
often invest in new physical plants and equipment. There is little
doubt that a portion of the incentive effect of the credit has been
lost over the past 17 years as a result of the constant uncertainty
over the continued availability of the credit.
If the credit is to provide its maximum potential for increased R&D
activity, the practice of periodically extending the credit for short
periods and then allowing it to lapse, must be eliminated, and the
credit must be made permanent. Only then will the full potential of its
incentive effect be felt across all the sectors of our economy. No one
has said this more forcefully than Federal Reserve Chairman Alan
Greenspan who testified at last year's high technology summit. Chairman
Greenspan was emphatic in his conclusion that, if there is a credit, it
should be permanent.
House Speaker Dennis Hastert, House Minority Leader Richard
Gephard, Senate Majority Leader Trent Lott, Senate Minority Leader Tom
Daschle, Vice President Al Gore, and Texas Governor George Bush have
endorsed a permanent R&D credit.
IV. Conclusion
Making the R&D credit permanent promotes the long-term
economic interests of the United States. It will eliminate the
uncertainty over the credit's future and enable businesses to
make better long-term decisions regarding investments in
research. Private sector R&D leads to innovative products and
processes that contribute to economic growth, increased
productivity, new and better U.S. jobs, and higher standards of
living for all Americans. By creating an environment favorable
to private sector R&D investment, a permanent credit will make
it easier for U.S. companies to compete effectively in the
global economy and help to ensure the growth of high-skill jobs
in the United States.
EDS strongly supports the permanent extension of the R&D
credit. Last year's enactment of a five-year extension provided
the business community with its first opportunity to consider
the benefits of a long term extension when calculating the
costs of long-term, high cost research projects. Unfortunately,
the lack of permanence means that the uncertainty of making
such calculations increases every year.
The U.S. economy is experiencing remarkable economic
growth. Much of this growth reflects R&D investments that were
made years ago. The time has come to invest in the future. I
urge you to include a permanent R&D credit in the first
available vehicle.
Chairman Houghton. Thanks very much, Mr. Capps.
Ms. Evans, we are going to have to break pretty soon, but
please go ahead with your testimony and we will suspend and
then we will come right back.
STATEMENT OF LINDA EVANS, PROGRAM DIRECTOR, TAXES AND FINANCE,
GOVERNMENTAL PROGRAMS, IBM
Ms. Evans. Mr. Chairman, members of the subcommittee, on
behalf of IBM, I thank you for the opportunity to share our
views on the R&D credit. My name is Linda Evans, Program
Director, Finance and Tax Policy, with IBM Governmental
Programs. As a key player in the information technology
industry, or IT, IBM strives to lead in the creation,
development and manufacturing of the industry's most advanced
information technologies, which includes computer systems,
software, networking systems, storage devices and
microelectronics.
We also have a worldwide network of services solution teams
that translate these advanced technologies into value for
private-and public-sector customers. Without question, the key
to IBM's success is its record of innovation, which is made
possible by R&D. The R&D credit and the alternative incremental
research credit, or the AIRC, are useful tools to facilitate
business research investment and I will speak more about that
in a minute.
I would like to first say a few words about the power of
the IT industry and how it brings value to the economy and
society. I think it fair to say that the IT industry has had a
significant impact on the growth of the United States economy
and, according to studies by the Department of Commerce, while
IT growth accounts for a relatively small share of the
economy's total output, about 8.3 percent in 2000, that growth
has contributed nearly one-third of real U.S. economic growth
between 1995 and 1999.
Productivity is a measure of economic health and as you
know Federal Reserve Board Chairman Alan Greenspan has said on
more than one occasion that information technologies have had a
positive effect on productivity growth. Further, according to
the Department of Commerce, IT and electronic commerce, which
are part and parcel of the new economy, will drive economic
growth for years to come. Now, how is this phenomenal growth
sustained?
The relentless drive of IT, which fuels productivity and
brings us societal benefits, relies heavily on R&D, which is
the lifeblood of innovation. The IT industry must innovate to
survive. What role does the credit play in all of this? With
the R&D credit, the Government is supporting the view that R&D
is essential for innovation and economic growth. Last year's
five-year extension of the credit and the improvement of the
AIRC provides some of the predictability that industry has
sought over nine years of annual renewals.
A permanent credit, of course, will provide even greater
certainty for companies that are planning long-term research
investments and we thank you for last year's extension. A
testament to the value of R&D and innovation for IBM is the
fact that for the seventh year in a row, the company has earned
more U.S. patents than any other company in the world. In fact,
in 1999, IBM earned 2,756 patents, which was 900 more than the
next company. IBM continues to seek ways to make computer
technology work faster and more effectively.
This includes breakthrough chip-making processes to produce
the next generation of computer chips, which are the brains of
computers, and progress in storage density to make products for
increasingly mobile workers in the new economy who will need
the convenience, portability and greater computing power. The
computing power, software developments and simulation
capabilities of IBM's technology are bringing better
understanding and faster solutions to the world's scientific,
medical and environmental problems.
For example, a big challenge for IBM is to simulate the
folding of a complex protein, and for that IBM will build a
supercomputer called Blue Gene, whose power will be needed to
unlock the code of some 3 billion chemical structures.
Chairman Houghton. Could I interrupt a minute? Listen, I am
terribly sorry, but since I am the only one here and I have got
to go and vote, could we suspend the proceedings and I will
rush over and I will come right back and I will wait for the
finish of your testimony. And then we can move to Ms. Hutter;
okay?
Ms. Evans. Certainly.
Chairman Houghton. Thanks very much.
[Recess.]
Chairman Houghton. Well, again, thanks for bearing with us.
Let's continue. Ms. Evans, right in mid-sentence?
Ms. Evans. Thank you, Mr. Chairman. The computing power,
software advancements and simulation capabilities of IBM's
technology are bringing better understanding and faster
solutions to the world's scientific, medical and environmental
problems. For example, a big challenge for IBM is to simulate
the folding of a complex protein, and for that the company will
build a supercomputer called Blue Gene, whose power will be
needed to unlock the code of some three billion chemical
structures.
And there is Deep Thunder, IBM's weather-modeling
visualization system that will more accurately predict local
weather patterns and violent weather phenomena such as
thunderstorms and wind shear. IBM uses its IT to leverage the
power of the Internet to help businesses of all sizes expand
their reach in electronic commerce. In the area of education,
improving K-12 and lifelong learning are important national
concerns and IBM's strong historical commitment to improving
schools leads us to develop technologies and expertise for
teaching methods, including Internet-based methods that will
facilitate and improve the way kids learn and the way teachers
teach.
In conclusion, today you will have heard from my colleagues
and myself about some of the ways our companies innovate. You
will have learned that innovation is a central focus of the IT
industry and that research and development fuels innovation.
The research credit remains an important tool in creating a
positive environment for this to continue.
Thank you very much.
[The prepared statement follows:]
Statement of Linda Evans, Program Director, Taxes and Finance,
Governmental Programs, IBM
Mr. Chairman, Members of the committee, on behalf of IBM, I
thank you for the opportunity to share our views on the
importance of research and development in the context of the
new economy and the role of the federal R&D credit. I am Linda
Evans, Program Director Taxes & Finance for IBM Governmental
Programs here in Washington D.C. Over the next few minutes, I
will briefly touch on the impact of the Information Technology
industry or (IT) in the emerging ``new economy'' and the
critical role of R&D--the lifeblood for innovation and driver
of the IT industry. I will then give some examples of IBM's
technological and developmental innovations that benefit the
lives of all Americans.
As a key player in the IT industry, IBM strives to lead in
the creation, development and manufacture of the IT industry's
most advanced information technologies, including computer
systems, software, networking systems, storage devices and
microelectronics. IBM also has a worldwide network of solutions
and services teams that translate these advanced technologies
into value for its private and public sector customers.
Key to IBM's success is its record of innovation which is
made possible by investment in research and development. The
federal R&D credit and its complement Alternative Incremental
Research Credit or (AIRC), have proven to be a cost-effective
means to increasing business research investment. I'll speak
more about this in a minute.
The Power of the IT sector
I think it fair to say that the high-technology sector and
in particular, the information technology industry, has had a
significant impact on the growth of the U.S. economy. According
to a 1998 Department of Commerce study on ``The Emerging
Digital Economy,'' the information technology (IT) industry has
been growing at more than double the rate of the overall
economy and it now constitutes 8.2% of GDP. The Commerce paper
also found that IT has driven over one-quarter total real
economic growth on average over each of the last five years.
According to the Department of Commerce, business spending
on IT in 1996 rose to 45 percent of total business investment
as compared to only 3 percent of total business investment in
the 1960s. Companies in the U.S. are now looking more and more
to IT to increase productivity. Federal Reserve Board Chairman
Alan Greenspan has said more than once that information
technologies have had a positive effect on productivity growth
in the U.S. In the area of employment, the Department of
Commerce found that in 1996, 7.4 million people worked in the
IT sector and IT-related jobs throughout the United States.
The Department of Commerce study further concludes that IT
and electronic commerce which are part and parcel of the
emerging digital economy, will drive economic growth for years
to come. According to one estimate, in the U.S., some $2.7
trillion of business will be conducted on-line by 2004. On a
worldwide basis it is said that this figure could hit some $7.3
trillion in the same year. What is emerging is the rise of a
new economy, and a new global medium, the Internet, that will
perhaps be the single most important driver of business,
economic and social change in the 21st century.
Research and Development: Lifeblood of Innovation
To fuel continuing economic growth, productivity and bring
other societal benefits, the high-technology sector and IT rely
heavily on research and development. The highly-competitive IT
industry must innovate to survive, and it must innovate
quickly. You may have heard of the legendary Moore's Law named
for Intel cofounder Gordon Moore which holds that the price/
performance of the integrated circuits etched onto silicon
chips (microchips) processing capacity doubles every 18 months.
Federal R&D Credit
With the enactment of the federal R&D credit in 1981, the
government is supporting the view that research and development
is essential for innovation and continued economic growth. The
credit is a recognition of the positive role of government in
facilitating a cost-effective way to increase business research
investment. In 1999 the ``Taxpayer Refund Relief Act'' extended
the credit for five years providing some of the predictability
that industry has sought over nine years of annual renewals.
For high-tech and IT companies, this is important because they
generally budget R&D over five-to-ten year planning cycles.
Also last year, the credit was strengthened by improvement in
the Alternative Incremental Research Credit or the AIRC. The
AIRC was created in 1996 for use by companies that could not
benefit from the regular credit. Last year's changes to the
AIRC have made it available to a greater number and variety of
companies. For IBM, last year's extension and modification of
the R&D credit and the AIRC have created a more positive
environment.
IBM Innovation
A testament to the value of R&D to IBM is the fact that for
the seventh year in a row, the company earned more U.S. patents
than any other company in the world. In 1999, IBM earned 2,756
patents--900 more than the second-place company. In fact, over
the decade from 1990 to 1999, IBM was awarded more patents than
any other company, leading to a host of new products and
services. The heart of IT is indeed innovation and for IBM it
embraces processing, speed, storage and connectivity.
IBM continues to seek ways to make computer technologies
work faster and more effectively. This includes breakthrough
chip-making processes that involve new materials to produce the
next-generation of computer chips, the brains of computers. IBM
has also led in the storage density area, by announcing in
April of this year the densest drives ever for notebook
computers. The drives have 15 times the capacity of the typical
notebook drive and can hold the equivalent of a mile-high stack
of documents or 49 music CDs. The drive spins at about 5,400
rotations per minute, faster than most notebook drives and more
like a desktop PC drive. As workers become increasingly mobile
in the new economy, they'll need the convenience of portability
and the computing power of a desktop workstation.
Solving Problems with IBM products and services
``Deep computing'' refers to the application of raw
computing power, advanced software and sophisticated
algorithms, and it is being used to analyze and solve
increasingly complex environmental problems. For example IBM
RS/6000 SP technology which also powers the supercomputers of
the Lawrence Livermore facilities, is being used by the U.S.
National Center for Atmospheric Research to calculate how
thousands of variables interact. Such variables as ocean
temperature, precipitation and ozone depletion can be analyzed
and configured to better predict long-term climate change.
The products and services generated by innovations in the
IT industry embrace many facets of every day life in this
country and in the world. In the interest of time, I will
describe just a few of the areas of IBM's involvement:
Life Sciences and Health Care
Many of you may recall Gary Kasparov playing chess against
the powerful Deep Blue IBM computer. Today, IBM is
participating in the next Grand Challenge, to simulate the
folding of a complex protein. For this big initiative, IBM will
build a supercomputer called ``Blue Gene'' whose power will be
needed to unlock the code of some three billion chemical
structures.
Electronic Commerce and E-business
Estimating the number of current Internet users is not at
all exact as there are a multitude of surveys, but according to
one estimate, there are over 350 million users today and with
so many new users getting on line each day, there will soon be
over 500 million users. The Internet bridges geographic
boundaries and IBM directs its (IT) in ways that leverage the
power of the Internet to help small, medium and large
businesses expand their global reach. The prospect of
connecting a multitude of information systems and reaching
whole new sets of users including employees, customers,
suppliers and business partners, has given rise to what IBM
refers to as ``e-business.'' This is a strategic priority for
IBM and it refers to the broader, more powerful aspects of what
is evolving: Now entities of all sizes in all industries, both
private and public sector can redefine what they do and
reinvent who they are. E-business applications and technology
can transform internal operations including how products get
developed, how work gets done and even how employees share
ideas.
In the Area of Environmental Sciences
IBM researchers have developed a weather modeling and
visualization system to improve local weather forecasts and to
more accurately predict local patterns as well as violent
weather phenomena such as thunderstorms and wind shear. IBM's
system called Deep Thunder provides local scale information and
precision that can also be important in potential applications
such as aviation, travel, agriculture and construction, where
weather is an important factor in making decisions. The
computing power, software advancements and simulation
capabilities of IBM's technology are bringing better
understanding and faster solutions to the world's scientific,
medical and environmental problems.
In the Area of Education
Improving K-12 and lifelong learning are important national
concerns. Education is vital to a thriving economy and this is
no less true for a new information-based economy. IBM has a
strong history of, and commitment to, improving schools. The
company works to provide technology and expertise to bring new
teaching methods including IT and Internet-based methods that
will facilitate and improve the way kids learn, and the way
teachers teach. Through such technologies as data warehousing,
knowledge management and distance learning, these programs
extend and improve the availability and quality of education.
Of course, a comprehensive discussion of education and its
challenges goes well beyond computers in the classroom, and
that discussion is outside the scope of our task here today.
Conclusion
Well today, you will have heard from my colleagues and me
about some of the ways our companies strive to innovate. You
will have learned that innovation is a central focus of the IT
industry and that we must innovate to survive. Research and
Development fuels innovation and the federal research credit is
an important tool in creating a positive environment for
innovation.
Chairman Houghton. Thanks very much.
Ms. Hutter?
STATEMENT OF COLLIE LANGWORTHY HUTTER, CHIEF OPERATING OFFICER,
CLICK BOND, INC., CARSON CITY, NEVADA, AND MEMBER, BOARD OF
DIRECTORS, NATIONAL ASSOCIATION OF MANUFACTURERS
Ms. Hutter. Thank you, Chairman Houghton and members of the
subcommittee for the opportunity to testify regarding the tax
treatment of R&D. I am Collie Hutter, Chief Operating Officer
and owner of a small 75-employee manufacturing company called
Click Bond, Inc. We are located in Carson City, Nevada. As an
owner of a company engaged both in performing R&D and applying
the technological advances derived from R&D, I strongly
advocate that the R&D tax credit be made permanent.
By way of background, my undergraduate degrees is in
physics from Carnegie Mellon University and I earned an MBA at
the Wharton School of the University of Pennsylvania. Currently
I am on the board of directors of the National Association of
Manufacturers. I will share with you how R&D, applied in my own
business, has produced technological advances that have kept my
company growing.
Since 1969, I have been a business owner of first a
research and development company and now a manufacturing
company that engages in considerable R&D. Click Bond designs
and develops and manufactures fasteners, screws and nuts for
the aerospace defense market. All of our fasteners are designed
to be adhesively bonded for surface mounting. Click Bond's
customers are primarily the aircraft manufacturers. We
transformed from a pure R&D company to a manufacturing company
in 1987 by default.
At that time, we were unable to license the Click Bond
technology to another manufacturer as we had been able to do
with the other products we had developed. Since we strongly
believed in this particular product line, we went into the
manufacturing business ourselves. I suppose it might be said
that my company moved backwards from being a new economy
company, one based on high-tech equipment, intensive research
and development and a skilled workforce, to an old economy
company that employs less-skilled people. That is not true.
Our skilled scientists and engineers are still doing their
innovative work, but are more focused on one type of product.
We like to think that we expanded our horizons by converging a
traditional manufacturing company with technology to become a
new manufacturer in the new economy. My company has benefited
from the R&D tax credit in three ways: One, through direct use;
number two, from the flow-down from our suppliers who utilize
the tax credit; and indirectly through the high-tech products
developed in use with the credit.
The direct benefit is that a number of years ago I was able
to use the credit and it was a sufficient amount of money for
our company to apply for an additional patent. The major
benefit we have is the flow-down benefit. The Click Bond
fastening systems are possible because chemical companies, many
of which use the R&D credit, have developed the high-strength,
fuel-resistant, high-temperature epoxy and acrylic-modified
adhesives that are used to bond our fasteners to the aircraft
and other surfaces. These same chemical companies also
developed and brought to market the high-strength plastics from
which we make our fixtures that hold our fasteners in place.
The credit encourages them to continue and to expand their
research into new products. An indirect benefit we have of the
research and development is that Click Bond uses the products
developed and brought to the market by the new economy. These
new-economy products provide the tools to control my
manufacturing process, design my parts and increase the
efficiency of my operation. For example, we use electronic
micrometers that feed information directly to computers for
statistical process control. Parts that flow in and out of our
stock rooms are controlled by bar-coded bins. A materials
resource planning program that runs on a Windows platform
controls the movement of work-in-process through our factory.
Many of our incoming orders are received via electronic
data interchange. Our high-speed Internet access via T1 lines
and Cisco routers was installed so we can efficiently purchase
supplies over the Internet. Our lathes and mills have computer
controls. You see, new-economy products support many aspects of
my traditional manufacturing operation. High-tech and modern
manufacturing are the same thing. Manufacturing today is, by
definition, high-tech and the engine of the new economy.
Currently it is fashionable to say that there is a
distinction between the old and new economy. This distinction
is without a difference. It is a false dichotomy. My company is
a good example of this. Today manufacturers have many things to
think about in addition to just getting their product out the
door: EPA, OSHA, State regulations, personnel regulations,
health insurance, to name a few. Large companies have the
resources to employ experts in these areas, while small
companies typically rely on the owner, like myself, to be the
expert.
A permanent R&D credit would reduce the number of variables
we have to contend with in our long-range planning. Every R&D
dollar spent is potentially at risk. The insurance that the R&D
tax credit is there reduces the perceptible risk. It would be
positive to know that the credit will be there when the R&D is
complete. A permanent credit would be a powerful tool to fuel
more R&D in our new economy. Not only my company, but also the
many other companies large and small that are constantly
juggling their limited supply of capital between intangible and
tangible products would benefit from the permanent credit.
Again, thank you for your indulgence of time. I will be
happy to answer any questions.
[The prepared statement follows:]
Statement of Collie Langworthy Hutter, Chief Operating Officer, Click
Bond, Inc., Carson City, Nevada, and Member, Board of Directors,
National Association of Manufacturers
Thank you Chairman Houghton and members of this
subcommittee for the opportunity to testify regarding the tax
treatment of research and development (R&D) expenses at this
hearing on the federal tax code and the ``new economy.'' I am
Collie Hutter, Chief Operating Officer and owner of a small,
75-employee manufacturing company, Click Bond, Inc, in Carson
City, Nevada.
As the owner of a company engaged both in performing R&D
and applying the technological advances derived from R&D, I
strongly advocate that the Research and Experimentation tax
credit, commonly referred to as the R&D tax credit, be made
permanent. Thank you in particular to those congressional tax-
writing committee members here today--which is many of you--who
have supported the R&D tax credit, including most recently a
multi-year extension. Specifically, I will comment on how R&D
applied in my own business have produced technological advances
that have kept my company growing.
By way of background, my undergraduate degree is in Physics
from Carnegie Mellon University and I earned an MBA at the
Wharton School at the University of Pennsylvania. Currently, I
am on the Board of Directors of the National Association of
Manufacturers.
Since 1969, I have been a business owner, along with my
husband and brother-in-law, of first a research and development
(R&D) company and now a manufacturing company that engages in
considerable R&D. Click Bond designs, develops, manufactures
and markets fasteners, screws and nuts for the aerospace/
defense market and other producers of end products that are
made of composite materials. All of our fasteners are designed
to be adhesively bonded for surface mounting. Click Bond is a
wholly owned subsidiary of our R&D company, Physical Systems,
Inc.
Physical Systems holds approximately 20 U.S. patents on
products that were successfully brought to the marketplace. The
engineers and scientists at Physical Systems developed all the
products covered by these patents. Ten of these patents cover
the Click Bond product lines.
We transitioned from a pure R&D company to a manufacturing
company in 1987 by default. At that time, we were unable to
license the Click Bond technology to a manufacturer, as we had
been able to do with our other products. Since we strongly
believed in the product concept, we went into the marketing and
manufacturing business ourselves.
I suppose it might be said that my company moved backwards
from being a new economy company, one based on ``high tech
equipment, intensive research and development, and a skilled
workforce,'' to an ``old economy'' company that employs less
skilled people. That simply is not true. My company would not
have grown without using the technology developed in just the
past decade. Our skilled scientists and engineers still are
doing their innovative work, but are more focused on one type
of product. We like to think that we expanded our horizons by
converging a traditional manufacturing company with technology
to become a ``new manufacturer'' in the new economy. Further,
our workforce grew from seven to 75.
Click Bond's customers are primarily aircraft manufacturers
such as Boeing Commercial and Military, Lockheed Martin,
Northrop Grumman, Airbus, British Aerospace, Bombardier and
their suppliers. Twenty percent of our business is derived from
exports and another 20 percent comes from domestic commercial
customers such as boat builders, the automotive industry and
the amusement park industry.
Over the years, my company has benefited from the R&D tax
in the following three ways: 1) through direct use of the
credit; 2) from the flow-down benefits from our suppliers who
use the credit; and 3) indirectly, through the hi-tech
products, developed because of the tax credit, that are used in
our manufacturing process and product innovations.
1) The Direct Benefit:
My company took advantage of the R&D tax credit in
initially developing the Click Bond product line. Although the
credit was of a small monetary value, it was sufficient to
allow us that one additional patent application. In one 12
month period, we applied for and received three U.S. patents on
our Click Bond product line. For a small, new company to enter
a highly competitive market such as fasteners, it was of
immeasurable benefit for us to have good patent protection for
our innovative products.
2) The Flow-Down Benefit:
Many large U.S.-based chemical companies take advantage of
the R&D tax credit. The credit encourages them to continue and
expand their research into new products. The Click Bond
fastening systems are possible because these chemical companies
developed the high strength, fuel resistant, high temperature
epoxy and acrylic modified epoxy adhesives used to bond our
fasteners to aircraft and other surfaces. These chemical
companies also developed and brought to market the high
strength plastics from which we make our fixtures that hold our
fasteners in place while the adhesive sets. A small company
such as Click Bond rarely performs primary materials research.
Instead, we typically incorporate the materials and processes
developed by the larger companies into our innovation programs.
Also, we do intensive research into new materials being
introduced to the market--especially those trends we see the
primary research following. We will often develop products that
need a material or process that has yet to be brought to the
market, and we will have to wait to complete our development
until the product is available on an economic scale.
3) Indirect Benefit:
Click Bond is an excellent example of the integration of
traditional manufacturing with the technological innovations of
the past decade that have transformed our economy into what is
now commonly referred to as the new economy. Manufacturing
today by its very definition is high tech and the engine of the
new economy. My company is a case in point.
Click Bond uses the products developed and brought to
market by the new economy. These new economy products provide
the tools to control my manufacturing process, design my parts,
and increase the efficiency of my operation. We have more than
35 computers for 75 employees. Also, we have electronic
micrometers that feed information directly to computers for
statistical process control. Parts flow in-and-out of our
stockrooms and are controlled by bar coded bins. A Material
Resource Planning program that runs on a Windows platform
controls the movement of work-in-process through our factory.
Many of our incoming orders are received via Electronic Data
Interchange. Our high speed Internet access via T1 lines and
Cisco routers was installed so we can efficiently purchase
supplies over the Internet. We are preparing to purchase
materials for production over the Internet, too. Our lathes and
mill are computer controlled.
As you can see, new economy products support every aspect
of my traditional manufacturing operation. High tech and modern
manufacturing are the same thing. Currently fashionable is a
distinction between the old economy and the new economy. This
distinction is without a difference; it is a false dichotomy.
Small companies are often the first to introduce a new
material--or a new use for a material--because we can produce
economically on the small scale required by a new product
introduction. In the aircraft business, a product may be sold
in small quantities for years before the market demands
production on a scale that makes economic sense. An example of
this is the all-composite screw that is essentially a screw
made of reinforced plastic. These fasteners save weight, resist
corrosion and do not conduct electricity. In short, they are
excellent airplane parts.
A number of companies have been looking at making various
types of composite fasteners. A large company, spurred on in
part by the R&D credit, started research into a composite
screw. The company was able to get very close to a finished
product, but determined that it could not economically justify
production on the relatively small scale that would be required
during what was proving to be a very lengthy introductory
period. Click Bond was able to buy the project for cash and
future royalties. We are working hard to improve the product
through additional R&D, but also we have put their original
product in production in our plant, where we can more easily
justify the small production quantities.
Based on my experience, I believe that the R&D tax credit
is serving its intended purpose as an incentive to spur R&D
that would not otherwise be performed. I applaud Congress for
approving a multi-year extension of the credit last year, but I
cannot overstate how the incentive value of the R&D credit
would be enhanced exponentially if the credit were permanent. A
permanent credit would be a powerful tool to fuel more R&D in
our new economy.
Today, manufacturers have many things to think about, in
addition to just getting their product out the door. EPA, OSHA,
EEOC, state regulations and the many rules and regulations
relating to personnel, health insurance costs, to name a few.
Large companies have the resources to employ experts in these
areas while small companies typically rely on the owner to be
the expert. A permanent R&D credit would reduce the number of
variables we have to contend with in our long-range planning.
Every R&D dollar spent is potentially at risk. The assurance
that the R&D tax credit is there reduces the perceptible risk.
It would be a positive to know that the credit will be there
when the research is done.
As a member of the small business community, it is a
privilege to testify here today. If the R&D tax credit were
permanent--which it should be--the credit's incentive value
would be significantly enhanced for my company as well as many
others. Not only my company, but also the many other companies,
large and small, that are constantly juggling their limited
supply of capital between intangible and tangible projects,
would benefit from a permanent credit. My fellow NAM Board
member Murray Gerber was quoted in Time last week (September
25), citing another spillover benefit from the R&D tax credit.
While he did not use the R&D credit himself, he doubts he would
have received R&D contracts from his primary customer if that
company did not use the credit. This is just another example of
the spillover benefits from the R&D credit.
In closing, I strongly urge you to make permanent the R&D
tax credit. A permanent credit will encourage manufacturers,
large and small, to continue performing the vital R&D that is
necessary for creating the jobs of tomorrow and expanding upon
our current economic prosperity. Again, thank you for the
invitation to testify at this hearing. I will be happy to
answer any questions you may have.
Chairman Houghton. Well, thanks very much, Ms. Hutter. I
have got a couple of questions, but the question I have got is
a personal one. Why did you ever think of leaving the
Northeast?
Ms. Hutter. I married somebody from California.
Chairman Houghton. But ended up in Nevada?
Ms. Hutter. And ended up in Nevada.
[Laughter.]
Chairman Houghton. And you went to Carnegie Mellon; is that
right?
Ms. Hutter. Yes, I went to Carnegie Mellon.
Chairman Houghton. I see. Great. Wonderful. I don't know
how Mr. Weller feels about this, but I know we have talked up
here about the R&D tax credit and making it permanent. I think
we all agree it is a good idea. The question is as we move into
this new age of industrialization or information technology,
what are those things which really should be covered by the R&D
tax credit? It is a vast area. I mean, it goes from original
research right down to quality control.
Do you think that is right? Have we got the formula right
for you all?
Ms. Hutter. It is not my total area of expertise. I think
the broader we can define it, if it is pure R&D, it really is
going to eliminate many of the smaller companies, would be my
feeling, because my company does do pure R&D, but I think--
Chairman Houghton. More product and process work?
Ms. Hutter. Right.
Chairman Houghton. I see. But that would not apply to IBM
necessarily; would it, Ms. Evans, when you are talking about
the number of patents which you have applied for and been
accepted, that is far beyond just the process and product work?
Ms. Evans. Right. If I had to decide how much of the R&D--
about 15-to-20 percent of our R&D is basic and exploratory, and
a lot of that is on the margin, sort of high-risk research and
development. The others are project-driven, and the thing about
the IT sector is that it is a highly-competitive one. You have
to innovate and innovate quickly. You may have heard the
expression of Moore's law, that the power of processing
capability doubles every 18 months. Well, there are even new
measures in the new economy referring to the ``network
effects,'' because now everything is connected with computers
and communication devices, so the speed is rather quick.
So we have exploratory research, as well as project-
developed research; and the bulk of the R&D goes towards
project research. I would say, of that, 50 percent is hardware,
and the other half is in software development.
Chairman Houghton. Well, you know, as you look out at the
United States and the world economy, clearly we have got assets
and we have got liabilities. One liability we have is wages. I
mean, we just cannot compete with Sri Lanka or Indonesia or
things like that. So, we have got to have new products; we have
got to have new science; we have got to have new things coming
along. So, the question of the R&D tax credit is, is it geared
toward those new things rather than just sort of sustaining
some sort of quasi-technical work which is done in firms? Maybe
Mr. Capps or Mr. Sample would have comments about that.
Mr. Capps. Yes, I think it is. Again, it is intentionally
designed broadly, but what it results in is improvements in
products, processes and capabilities across all industries,
which ends up translating into productivity increases. I know
that in the information technology industry, what IBM does,
what EDS does, what Microsoft does, is to create the ability to
use information and leverage off information in ways that were
not possible 10 years ago.
One person can do more than what one person could do back
then; we are increasingly seeing that trend and have seen it
help keep inflation down.
Chairman Houghton. Can I just interrupt a minute? I agree
with you, and you are expressing it much better than I, but I
think the question I have is if you look over the next hill and
see the science evolving as it is now, and you see the
tremendous international competitive forces, is the Government
and university and business community there--are we doing the
right things for one another?
We cannot create jobs, obviously; but we can create an
atmosphere where those jobs are stimulated. The question is if
you look at the R&D tax credit, is it really pointed towards
those things which would create the new rather than just
sustain something which has already been developed?
Mr. Sample. Mr. Chairman, I think the R&D credit does a
great job of focusing companies on technical innovations and
creating more high-skilled jobs to enable our workers to
compete with some of the other economies you have mentioned
that are more competitive on a basic wage rate. It does that in
a couple of ways. First, the research has to be in the
technology area in order to qualify for the credit.
Second, the research--
Chairman Houghton. Research has to be in the technology
area? Research has to be in the research area.
Mr. Sample. But only in technology. It has got to be
basically the physical sciences, and computer sciences. So, it
has basically got to be physics, biology, chemistry or computer
sciences. For example, social research, as important as that
might be, does not qualify for the credit.
Chairman Houghton. No, I understand.
Mr. Sample. Second, in order to be eligible for the credit,
the particular development project has to involve a process of
experimentation, which means that companies have to try to do
something with the research project that they currently do not
know how to do. A significant element of the project has to
involve trying to do things through a trial-and-error process
that they do not know how to do. And, lastly, only a very
narrow range of expenditures qualify for the credit. Primarily
it is salaries and wages paid to people performing direct R&D
activities.
So, the credit focuses companies on doing technology
research to learn things that they currently do not know how to
do, and the only way they can continue to qualify for the
credit is to increase their qualifying expenditures, which are,
I think as a general matter for the R&D Credit Coalition
companies, over 75 percent of the expenditures are for
additional salaries and wages, and in my company it is over 90
percent.
Chairman Houghton. Good. Thanks very much.
Mr. Coyne?
Mr. Coyne. Thank you, Mr. Chairman. I would like to ask the
panelists if the nature of your R&D at your companies is
affected by the fact that you are on a four-year leash as it
relates to R&D, as opposed to if it were permanent? Would the
nature of your R&D change? Would it be different?
Mr. Sample. Well, I do not think the nature of the R&D
would change in that in order to have a successful R&D project,
you are going to have to commit to making a long-term multi-
year investment in product development. The impact of making
the credit permanent would basically increase the incentive
that is provided by the R&D credit for companies to do even
more R&D than they are doing now.
Mr. Coyne. Does anyone else want to comment?
Mr. Capps. It affects your ability to model a benefit
currently for more than four years, next year for more than
three years. At EDS, most of our research projects are multi-
year projects, so that becomes an issue. You cannot outlook the
full benefits, so you are not getting the full bang for the
buck.
Mr. Coyne. Did you want to comment?
[No response.]
Mr. Coyne. Okay. I wonder if you could comment on how real
or unreal is the problem we hear so much about, businesses not
being able to find and hire trained workers to do the necessary
work that the corporations have to do?
Mr. Capps. Yes, I think it is a very real issue. I think we
are already seeing that and experiencing it in the information
technology industry. I don't know what the exact numbers are,
but I have heard we have over one million unfilled positions as
I am speaking to you. Those are good positions, high-skill,
high-paid positions and there are not the people to fill them.
They are projecting that number is on the order of
magnitude of four million unfilled positions by 2004. So, it is
a real issue. It is an immediate issue. We are facing that
today.
Mr. Coyne. How about IBM and Microsoft and Mrs. Hutter's
company?
Ms. Evans. We are experiencing the same thing; and clearly
in the area of science and engineering, it has not been really
as great a focus in this country, certainly at the K-12 level.
We are finding a shortage of people in those skills in this
country and we have had to use the H1B visa program to fill
those jobs. I also don't know the numbers, but it is very real
in the IT sector where the skills required are increasing
exponentially as the technology changes. So, it is a problem.
Ms. Hutter. I just want to follow-up that that is a
problem, even though the level that we are working on obviously
is much different. Even in our small company, we have three
vacancies in our engineering department--and also the caliber
of engineers--maybe an example of my getting old, but some of
these young people coming out of the schools, they know an
awful lot about computers, but they don't know what they are
looking at on the screen. They have never actually gone out and
had to make something, and that is one problem that we are
seeing.
Mr. Sample. It is probably one of the most important issues
facing our company as we look to how we are going to continue
to succeed and grow. I think we ended our last fiscal year with
over 4,000 unfilled permanent full-time positions, and I think
we are going to plan to hire another 4,000-plus this year. I do
not know where we will be able to find them. The increase in
the high-tech economy in the Puget Sound area, as well as in
the Nation as a whole, means we are competing now with
RealNetworks, with Amazon, a lot of high-tech companies, and we
just can't find the people to fill the jobs.
Mr. Coyne. Does this extend to the floor workers, people
working on the floors of the factories, or is it just the
engineers and high-tech and computer science engineers and
technicians?
Mr. Sample. Well, in our company, very few of our employees
are involved in the operation side. Most are development, sales
and marketing, technical jobs. It extends across the board,
though.
Mr. Capps. Yes, I think the numbers I was throwing out are
more for the skilled workers that have a higher level of
education and training, but I think we are starting to see
strains on even the lower end of the workforce. And so it is a
broader issue, I think. It goes deeper.
Ms. Evans. I would agree with my colleagues. The upper end
is probably where the greatest shortage is, but it is starting
to be apparent at the lower levels, too, of lower-skilled
people in our industry.
Mr. Coyne. Thank you.
Chairman Houghton. Ms. Dunn?
Ms. Dunn. Thank you, Mr. Chairman. It has been a
fascinating panel. It is interesting as we reach out--I don't
see what is wrong with moving to the West, Mr. Chairman. I
think moving to the West is a good thing. There is a lot of
appeal in beautiful States like Nevada and Washington.
Chairman Houghton. Well, you are outvoted two-to-one.
[Laughter.]
Ms. Dunn. I will bring my support troops. I want to
especially welcome Mr. Bill Sample of Microsoft, who, in my
neck of the woods, certainly has done as much as any company in
the Nation, I am sure in the world, to educate people on a
variety of tax issues and tax-related issues, taxation on the
Internet, this issue we are talking about today, R&D credits,
which I have never found anybody who doesn't agree that we
should have permanent R&D credits. This is just a monolithic
movement over the last few years and a frustration when we
couldn't get it made permanent last year. We could get it to at
least cover the next five years.
So, it is something that I know is very important and you
have a great support group here in the Congress, if we can make
sure we find the money to fund it. I wanted to just ask a very
practical question that would help me to imagine the practical
effects of the unpredictability if the R&D credit is not made
permanent. In the last few years, it has been for fewer than
five years. In some cases, I think we have gone past the
deadline and we have had to do a catch-up R&D. What actions do
your companies take in order to deal with this unpredictability
and what kind of costs do you incur? What can we use in talking
about this issue that is real-life, from the front lines, to
help us bring on the folks who don't understand the value of
the R&D tax credit?
Mr. Sample. Thank you. Well, as I said, our R&D projects
are planned years in advance and at a minimum we spend probably
three-to-five years on a particular product. Windows 2000,
which we released last fall, began development in the mid
1980s. So, every year, when we go through our budget cycle, we
have to make commitments to projects which our level of effort
we know is going to have to be maintained years into the
future.
In the 1980s, I think the financial people in our industry
were more willing to rely on extensions of the R&D credits when
looking out over two, three, four-year time horizons. But, in
1995, the credit lapsed and it was not extended until the
following year and there was a twelve-month gap where there was
no credit. After that twelve-month gap, I don't know any tax
professional that would recommend to their CFO to count on the
credit beyond the extension period, 1995 to 1996--there was a
twelve-month gap. And, so, I think it is more critical now
after the 1995-to-1996 gap than it ever has been to make the
credit permanent.
Ms. Dunn. Does anybody else wish to comment on the cost to
your company or your business plan as you see that there is
some unpredictability?
Mr. Capps. I think our experience at EDS has been similar
to what Bill described at Microsoft. Before we had the gap, I
was predicting with more confidence that the credit would be
extended and recommending that our people recognize that and
take that into account. But, since that, I would discount that
a certain amount and it just hasn't carried the same weight
that it would if it was permanent.
Ms. Evans. In the case of IBM, certainly long-term planning
is critical and we would experience the same thing. So, to the
extent that you have a sufficient horizon for these projects,
some of which I talked about earlier, tapping some major
medical and environmental issues, it is difficult for you to be
able to plan and predict when you have these long-term
projects. So, it is a problem for us.
Ms. Hutter. I think a pervasive argument, even in the small
companies, is that R&D is inherently risky and you are now
having an additional risk of a credit that you are counting on
that is supposed to be your incentive is also a risk--in other
words, it is just a multiplier. And I think for us it is just
you can't count on it, and that makes another uncertainty,
which tends to take money away from that type of work.
Ms. Dunn. Let me just ask one brief question, Mr. Chairman.
The R&D can only be applied to research and development done in
the United States. How extensive is that credit? Are you
finding your companies are restricting R&D to the United States
because the credit means enough to you or are you going
overseas?
Mr. Sample. Well, every year over the past several years,
we have been increasing our R&D spending in the U.S. by
probably three-quarters-to-a-billion dollars a year and
probably adding several thousand R&D heads a year. So, every
year the management at Microsoft has to decide where to make
that incremental investment and other jurisdictions compete for
our R&D investment. And one of the ways they compete is by
making it cost-attractive in a variety of ways, including
offering tax incentives.
Our management is keenly aware that the R&D credit can
reduce the cost of our doing research in the United States by
about five-to-six-and-a-half percent on qualifying
expenditures. I can tell you that is a big enough number to get
the attention of our senior management all the way to the top.
There is really only one tax issue I get e-mails from our
chairman about, making sure it is still around, and that is the
R&D credit.
Mr. Capps. At EDS, the majority of our research is done in
the U.S. We have had some intense pockets of research outside
the U.S. We acquired a company a number of years ago that had a
research group in England, and we have continued that. We did
some research through a joint venture up in Canada. Both those
jurisdictions had incentives for research that were attractive.
As we go forward--we are in a very competitive global
environment-- all these things come into play and you look at
the cost of a labor force, the tax regime. All those things
work into the model as far as where are you going to put
various operations and where are you going to grow. So far we
have been fortunate in being able to maintain the bulk of our
R&D here, but that is a growing issue. A lot of countries offer
very attractive financial and tax incentives to locate research
there.
I think the OECD recently did a study looking at nine
countries, and saw the U.S. as third from the bottom as far as
the relative incentives that it was providing.
Ms. Evans. I wouldn't say we do R&D in this country because
of the credit, because 85 percent of our research and
development is done in the United States and that is the legacy
of our starting off in New York with the Watson Laboratory,
which is the main laboratory, and it cooperates with our
laboratory in Almaden, California, and then there are other
labs around the country.
But over 85 percent of our research and development is done
in this country and the fact that the credit does benefit U.S.
research is helpful, but it is not a reason that we do it here
in this country.
Chairman Houghton. Just one final question. IBM has a large
research laboratory in Switzerland. Do you get tax credits in
Switzerland for R&D?
Ms. Evans. I do not know the answer to that. I can find
that out.
Chairman Houghton. It is not important. Well, look, thank
you very much. I certainly appreciate it. The meeting is
adjourned.
[Whereupon, at 11:44 a.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of American Textile Manufacturers Institute
The American Textile Manufacturers Institute (ATMI)
welcomes the opportunity to include the following comments in
the record of the September 26, 2000 hearing held before the
House Ways and Means Subcommittee on Oversight with respect to
the tax code and the new economy. ATMI will focus its comments
on the Treasury Department's analysis of cost recovery
provisions in its recent Report to Congress on Depreciation
Recovery Periods and Methods (``Report on Depreciation'').
ATMI is the national trade association for the U.S. textile
industry. The ATMI Tax Committee, which developed the
information and proposals contained in these comments, consists
of several dozen tax executives from various ATMI member
companies of all sizes.
Since the American textile industry is a capital intensive
industry, ATMI has historically taken a great interest in tax
depreciation policy. For example, ATMI worked closely with
Treasury representatives in the early 1960's in the development
of the Rev. Proc. 62-21, 1962-2 CB 418, which established the
Class Life System, and then in the late 1960's and early 1970's
with Congress and the Treasury in the enactment and
implementation of the Asset Depreciation Range System (ADR) for
assets placed in service after December 31, 1970. We also have
taken an interest in the enactment and implementation of both
the Accelerated Cost Recovery System (ACRS) and the Modified
Accelerated Cost Recovery System (MACRS).
We are pleased that Congress is again studying the recovery
periods and depreciation methods under Section 168 of the
Internal Revenue Code. As you are undoubtedly aware, there has
been no change in class lives since 1981, and further, there
has been no significant change in depreciation policy by
Congress since MACRS was established in 1986.
Upon review of the Treasury Department's Report on
Depreciation, we cannot help but conclude that the time-
consuming and expensive studies proposed by the Treasury
Department may not be necessary at all in connection with your
efforts to improve upon the nation's system of recovery periods
and depreciation methods under section 168. ATMI submits that
Congress could more efficiently promote the creation of capital
in the United States by implementing some or all of the
proposals detailed below without the necessity of engaging in
the lengthy and expensive studies suggested by the Treasury
Department.
The Importance of Tax Depreciation Policy to the Textile
Industry
As noted above, the American textile industry is a capital
intensive industry and as a consequence capital recovery
depreciation policies are of paramount interest to it. We
currently spend over $2 billion annually in capital investment
in order to modernize our plant and equipment, which is
absolutely essential for our companies to remain competitive in
the global economy.
In addition, there are two other factors regarding the
textile industry that we believe should be given consideration
by Congress in connection with any modification of Section 168.
The first of these two factors is that special attention
should be given to aiding struggling industries, particularly
those industries such as steel and textiles (which are so
critical to our national defense and to our overall economy)
that must compete with surging imports from countries that
provide a much more supportive environment to their industries.
The textile industry averaged only 2.28% profit on sales
and 3.34% profit on assets over the period from 1987 through
1995. This compares to an average of 4.10% profit on sales and
an average 4.52% profit on assets over the same period for all
manufacturing companies (including textile companies). For the
most recent years, the profitability of the American textile
industry has fallen even further behind the average as shown by
the following schedule:
U.S. Textile Industry All U.S. Manufacturers
Return on Sales Return on Assets Return on Sales Return on Assets
1996 2.6% 3.8% 6.1% 6.5%
1997 2.8% 4.0% 6.3% 6.6%
1998 3.2% 4.3% 6.0% 6.0%
1999 1.3% 1.6% 6.2% 6.1%
Much of this poor performance of the American textile
industry in even boom times is attributable to the rapid
acceleration of imports. The following table tracks the growth
in textile and apparel imports (measured in square meter
equivalents --SME) to record levels for each year during the
period of 1989 through 1998:
Growth of U.S. Textile and Apparel Imports, 1989-1998
------------------------------------------------------------------------
Imports (sme in Change from prior
Year billions) year
------------------------------------------------------------------------
1989............................ 12.144 +13.01%
1990............................ 12.195 +0.42%
1991............................ 12.800 +4.96%
1992............................ 14.521 +13.45%
1993............................ 15.846 +9.12%
1994............................ 17.286 +9.09%
1995............................ 18.308 +5.91%
1996............................ 19.063 +4.12%
1997............................ 22.895 +20.10%
1998............................ 25.945 +13.32%
1999............................ 28.615 +10.29%
------------------------------------------------------------------------
The plight of the textile industry can be demonstrated by
many other objective measurements. Textile employment has been
declining for many years and declined at rates that exceeded
productivity growth in each of the years 1993 through 1998.
Plant closings are now a common occurrence in the American
textile industry. Yet another objective measurement is the
precipitous decline in the market value of shares of most
publicly traded American textile companies in the face of a
roaring bull market.
The second factor is the normal wear and strain placed on
textile machinery by the long and continuous hours of operation
of most textile machinery. When business conditions permit,
textile machinery is operated continuously 24 hours a day,
seven days a week (minus normal downtime for routine
maintenance). This, of course, can shorten the life of this
machinery.
We submit that these factors support one or more of the
proposals outlined below as being particularly important for
the textile industry. However, we understand that any
legislation may not be industry specific and we submit these
proposals for general consideration as well as for targeted
relief for struggling industries such as the American textile
industry.
Depreciation Proposals of ATMI
The goals of our proposals are to allow more rapid recovery
of the costs of machinery, equipment and buildings, to further
simplify tax depreciation procedures, and to aid struggling
American industries so that they can better compete against
imports that have become even more damaging, especially because
of surges from Asian countries whose currencies have devalued
over the past several years. To accomplish these goals, we
propose the following modifications in MACRS (and to the extent
relevant in ACRS):
1. Replace the 200 percent declining balance method with a
300 percent declining balance method as the general applicable
depreciation method under Section 168(b). This proposal
recognizes that depreciable lives have not been reconsidered in
many years and that technological advances have greatly
accelerated during this period, rendering much of the old
technology obsolete. It permits this adjustment to be made
without the delay, expense and complications that would result
in undertaking an industry by industry, machine by machine
study. If not adopted generally, we propose this change for
capital intensive industries that are facing increasingly
intense competition from foreign companies that enjoy more
favorable tax regimes.
2. Allow a certain percentage of the cost of depreciable
property to be expensed in the year in which such depreciable
property is placed in service. The portion not expensed would
then be depreciated in accordance with Section 168, or
preferably depreciated under Sec. 168 as modified by our first
proposal. This proposal is a simplified approach to account for
the inflation factor in replacing depreciable property and to
reflect accelerating obsolescence and increased use of such
property. As in the case of other of our proposals, if not
adopted generally, this proposal should be targeted to
distressed industries. We proposed that the percentage expensed
be at least 20%.
3. The establishment of a deductible repair allowance that
would permit the taxpayer a deduction for actual repair
expenditures not to exceed 20% of the unadjusted cost basis of
property in each applicable recovery period category (see Sec.
168(c)). One of the most common items of controversy in the
audit of tax returns of manufacturing companies is whether
expenditures made with respect to machinery, equipment and
buildings are ordinary repairs and maintenance expenses that
are deductible under Sec. 162, or are capital improvements that
must be capitalized under Sec. 263. Under the ADR system, an
annual asset guideline repair allowance percentage was provided
and, if the taxpayer elected, expenditures that might otherwise
be classified as Sec. 162 or Sec. 263 expenditures could be
deducted to the extent of the applicable percentage. See Rev.
Proc. 77-10, 1977-1 CB 548 (the repair allowance percentage for
textile machinery was in four main categories: 22.2-16%, 22.3-
15%, 22.4-7% and 22.5-15%). Unfortunately, this statutory
repair allowance percentage was not continued under ACRS or
MACRS and, consequentially, the old item by item audit disputes
resumed and, if anything, has been accentuated by Indopco, Inc.
v. Commissioner, 112 S. Ct. 1039 (1992). See Rev. Rul. 94-12,
1994 -1 CB 565.
In fact, the failure of ACRS and MACRS to provide a repair
allowance procedure seems incongruous in view of the fact that
these systems address all of the other items that had been
sources of dispute and conflict under general depreciation
methods ( e.g., lives, rate of depreciation, method of
depreciation, salvage and time of placement in service).
We recommend a 20% allowance because it is somewhat higher
than the percentage allowance under ADR (see Rev. Proc. 77-10,
supra), which proved to be inadequate in practical experience
in our industry.
4. With respect to buildings, we propose that capital
improvements to buildings be depreciable over a period of years
that is no longer than the remaining depreciable life of the
building. Under this proposal, in the typical situation when a
capital improvement is made to a building (e.g., replacement of
a roof) a taxpayer would have the option of adding such
improvement costs to the adjusted basis of the building so that
it would be depreciable over the remaining life of the
building.
5. While we have no precise proposal, we recommend that
Congress reconsider and shorten the lives of buildings used in
manufacturing.
6. We recommend that consideration be given to providing
shorter lives for used property.
7. Under all circumstances and in all events, we propose
that the alternative minimum tax, if not entirely repealed, be
modified to eliminate depreciation as an adjustment in
computing AMT income ( i.e., repeal Sec. 56(a)(1)) and also in
calculating the adjustments for corporations based on adjusted
current earnings under Sec. 56(g). These AMT provisions greatly
complicate the preparation of corporate returns even where no
AMT is due. They require that the taxpayer maintain an
additional and separate depreciation system. Where these
adjustments do cause AMT liability, the result is to undermine
the policy of Sec. 168. We believe that allowing AMT to
undermine Sec. 168 is bad tax policy. We urge Congress to
eliminate (or modify) depreciation as an adjustment in
computing AMT. (We recognize that these AMT proposals raise
issues regarding adjustments under Sec. 481 and/or in modifying
Sec. 53 credits.)
8. Finally, we recommend that Congress authorize the
Treasury Department to enter into depreciation agreements with
any industry. This could allow an industry to perform
depreciation analysis using a reasonable method of estimation.
If this study followed specific procedures and those procedures
were reviewed by Treasury, then the assets' class lives could
be changed administratively. This method could be implemented
by an ``Advance Depreciation Agreement,'' on a basis similar to
advance pricing agreements under Sec. 482.
We look forward to working with you to address any
technical points concerning any of our proposals.
Conclusion
We commend Congress for undertaking this needed
comprehensive study of the recovery periods and depreciation
methods under Sec. 168. We would welcome the opportunity to
meet with Committee Members and staff, both to discuss our
proposals and also to learn from you of other proposals being
considered in order that we might have an opportunity to
comment.
Statement of Henry George Foundation of America, Columbia, Maryland
A National Tax Can PROMOTE Economic Growth & Jobs
THE PROBLEM--The electorate is enamored of government
programs despite the taxes needed to finance them. That can
only be changed if the government can come up with a revenue
tax that actually promotes economic growth and jobs.
THE SOLUTION -Fortunately, there is such a tax. We can
start funding the government with a tax on land values. If that
tax is increased, land values will not be decreased. A tax on
land values would then replace national taxes on production.
THE MORAL ASPECT--Workers and businessmen are entitled to
all they produce; if you produce something, it's yours. Then
there's nothing left for the landowner to justifiably own. No
human being ever produced the land. If landowners (or
slaveowners) get something for not producing, then workers and
businessmen get less than what they produced. Landowning can no
more be justified than slaveowning. Tax the one, abolish the
other.
ECONOMIC BENEFITS--When we tax production, we have less
production. When we tax land values (or the annual imputed and
actually-collected land rent) then land-sites must be more
efficiently used (which by itself also means more production).
So--tax land values, not things produced. If this is done,
we'll have economic growth and more jobs, and yet the
government can gets the revenue it needs. As a bonus, most
voters would get tax reductions (since they own little valuable
land).
EMPIRICAL SUPPORT--All 17 studies of the twenty
jurisdictions which have already adopted the two-rate tax show
that spurts in new construction and renovation follow two-rate
adoption within three years, and these two-rate jurisdictions
have always out-constructed and out-renovated their nearby
comparable one-rate neighbors. All independent studies by
university researchers fully corroborate these 17 studies.
IMPLEMENTATION--In the first year, each state should levy a
surtax of 3% of its assessed land value and remit the revenue
thus collected to the national government, who will then use
the revenue to replace a particular tax on production which it
is already levying, such as part of the income tax. The U.S.
Congress used this type of revenue tax four times in the past--
in 1798, 1813, 1815 and 1861; the Constitution allows it. It
can also establish a Federal Equalization Board.
Tax Land Value Not Production Tax Land Value Not Production
Tax Land Value Not Pro
International Franchise Association
Washington, DC
October 6, 2000
The Honorable Amo Houghton
Chairman, House Ways and Means Oversight Subcommittee
1136 Longworth House Office Building
Washington, DC 20515
Dear Chairman Houghton:
The House Ways and Means Oversight Subcommittee recently held a
hearing to review the Treasury Department Report to Congress on
Depreciation Recovery Periods and Methods. Although the International
Franchise Association (IFA) was unable to provide testimony at the
hearing, I would like to submit our comments for the record.
IFA believes that the Treasury Report substantiates our belief that
depreciation schedules in general need to be modernized, and we are
encouraged by some of the findings in the study including: . . . that
``the current depreciation system is dated''. . . that ``the asset
class lives that serve as the primary basis for the assignment of
recovery periods have remained largely unchanged since 1981''. . . and
that ``entirely new industries have developed in the interim.'' We
believe that these points speak directly to the need to address
depreciation schedules for franchised real property.
The International Franchise Association (IFA) serves as the voice
of franchising both domestically and internationally. We represent both
franchisors and franchisees and our membership includes more than 800
franchise concepts in 75 different industries--from quick service
restaurants to lawn care, to maid service and photo development.
Franchising, as a concept, ties the spirit and ingenuity of local small
businessmen and women to the advantages of a national brand name,
accessible investment capital and an established marketing platform.
When depreciation schedules were last updated about 20 years ago,
franchising was certainly a viable business concept, however it was not
the economic engine that it is today. Today, franchising accounts for
$1 trillion in U.S. retail sales and more than 8 million jobs. Today's
business climate now has more than 75 different industries that utilize
the franchise business format. By shortening the depreciation schedules
for franchises, Congress would not only allow the tax code to recognize
this leading segment of our economy, but also to better reflect the
true economic life of franchise assets.
Current law requires franchisees to depreciate their real property
over a 39-year period. However, the typical franchise agreement between
a franchisor and franchisee specifies ownership for only a 15 or 20-
year period. (In some cases, the contracts are renewed, but only under
terms that are then current.) These contracts also frequently require
franchisees to undergo expensive refurbishments every 5 to 7 years.
Under current law, these very common redecorations and upgrades must
also be depreciated over a 39-year period. Also, improvements to
leaseholds, which typically have a length of 7 to 10 years, also must
be depreciated over a 39-year period.
On behalf of our more than 30,000 member franchise outlets across
the country, we urge Congress to take the necessary steps to modernize
franchised real property depreciation schedules.
We urge Congress and we thank you for holding your Oversight
Subcommittee hearing on this important issue.
Sincerely,
Brendan J. Flanagan
Director of Government Relations
Study on the Effects of Depreciation on the PWB and Electronics
Assembly Industries
Executive Summary
Printed wiring boards (PWBs) and printed wiring assemblies
(PWAs) form the foundation for virtually all electronic systems
in the world. They are the backbone of all computer and
electronic products. Not only are they essential to all
electronic products, they are vital to the changing technology
in the automotive, communications, consumer products, computer,
government and military, industrial and medical markets.
The United States is struggling to remain a global leader
in the face of strong international competition. In 1984, the
United States owned 40 percent of the world market. Since that
time, however, U.S. share of the world market has eroded. By
1999 the United States held only a 26-percent share, with Japan
in the lead at 29 percent. Other Asian producers, with Taiwan
moving up very quickly, accounted for 23 percent of world
production. Absent any policy or overall economic change, this
downward trend is likely to continue.
Another area where the U.S. industry lags behind its
foreign competitors is cost recovery. Most foreign competitors
recover a greater percent of asset costs in the first year,
thus placing U.S. companies at a competitive disadvantage. As
electronic equipment becomes more technologically advanced and
the pace of technological innovation quickens, additional
investment becomes necessary. This new investment is relatively
more costly to U.S. companies than to offshore competitors.
The Congress modified depreciable service lives many times
since the early 1950s. The last modification, however, was
nearly 15 years ago. In fact, many service lives have remained
unchanged for more than 20 years. In the PWB and PWA
industries, the past 20 years have been characterized by
sweeping technological, organizational and competitive changes.
Previous Congressional intent indicated a need to keep
depreciation policies consistent with economic pressures.
Clearly, depreciation policy has not kept pace with the
technological change and economic pressures facing the PWB and
PWA industries.
The current proposal to reduce from five to three years the
service lives of equipment in the PWB and PWA industries would
provide this necessary and overdue change.
Industry Overview
Electronic interconnects form the foundation for virtually
all electronic systems in the world. They are the backbone of
all computer and electronic products. Printed wiring boards
(PWBs) and printed wiring assemblies (PWAs) connect and house
other electronic components, integrating the entire circuitry
of all electronic products. Without electronic interconnects,
these products would not function.
PWBs and PWAs are essential to not only all electronic
products, but are also vital to innovative technology in the
automotive, communications, consumer products, computer,
government and military, industrial, and medical markets.
To the average consumer, the words ``electronics industry''
conjure an image of large corporate businesses, such as
Hewlett-Packard, AT&T, IBM and others. These large firms, known
as original equipment manufacturers (OEMs), produce the
finished electronic product. OEMs are, however, only one
portion of the electronics industry. The electronic
interconnect industry, comprised of both the PWB and PWA
sectors, supplies products and services critical to OEMs. PWB
and PWA growth depends, therefore, upon OEM growth.
As OEM firms experienced rapid growth in the 1980s, they
began to rely more heavily on the PWB/PWA sectors for inputs to
their manufacturing processes. Emerging product shortages from
abroad and rising production costs domestically reinforced this
trend. This drove OEMs to shift portions of their fixed and
operating costs to other firms. PWB/PWA firms became cost-
effective suppliers of quality interconnect products, helping
to alleviate product shortages prevalent in the electronics
food chain. Over time, PWB/PWA firms expanded their production
processes to include product testing, design, and development,
further elevating their importance to the electronics industry
as a whole.
Today, the PWB/PWA sectors remain a vital part of the
electronics industry. With advances in technology occurring
rapidly in other industries, the demand for high-density
electronic interconnects is ever increasing. Industries such as
the automotive, computer, telecommuni-cations, consumer,
medical, and aerospace industries have introduced more
electronic equip-ment and components in their products and,
consequently, have high demand for interconnect products. While
news of brisk product demand is a favorable condition facing
PWB/PWA manufacturers, they face significant economic pressures
that hamper their ability to meet such demand.
International Markets
The U.S. printed wiring board industry remains a global
leader, despite facing strong international competition. In
1984, U.S. industry owned 40 percent of the world's PWB
market.\1\ Since that time, however, the U.S. market has
experienced a steady decline in world market share as a result
of growing international competition.
---------------------------------------------------------------------------
\1\ Interconnection Technology Research Institute, Technology
Issues facing the Industry, October 1999.
---------------------------------------------------------------------------
In 1999 Japan was estimated to have 29 percent of the world
market for rigid printed wiring boards, with the United States
next at 26 percent. Other Asian producers came in at 23
percent, with Europe (14 percent) and all others (8 percent)
accounting for the rest. Taiwan has greatly expanded its PWB/
PWA capacity and is challenging U.S. industry for market
leadership.
Japan's dominance is attributable to lower costs in labor,
raw materials, environmental protection and safety compliance.
In addition, the U.S. industry lags behind Japan in the use of
automated process improvement techniques and in some technology
areas including design-tool development, implementation, and
usage.\2\
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\2\ USITC, Advice Concerning the Proposed Modification of Duties on
Certain Information Technology Products and Distilled Spirits, Report
to the President on Investigation No. 332-380, Publication 3031, April
1997.
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Another area where the U.S. industry lags behind its
foreign competitors is in the tax treatment of capital goods.
Foreign countries, Japan most noticeably, are able to recover a
higher (up to 80) percent of capital costs in the first year of
service.\3\
---------------------------------------------------------------------------
\3\ Data reflected in this graph do not account for differences in
the overall tax regime of the country. However, for supporting evidence
of international comparisons see ``Report of the Technical Committee on
Business Taxation,'' Ministry of Finance, Canada, 1998.
[GRAPHIC] [TIFF OMITTED] T8411.009
As the graph indicates, major foreign competitors recover a
greater percent of asset acquisition costs in the first year,
thus placing U.S. firms at a disadvantage relative to those
competitors. Discrepancies in the cost structure of foreign
business and the associated tax treatment raise issues of
international competitiveness. To the extent that these
differences arise from domestic policies that the federal
government can modify to enhance U.S. competitiveness,
businesses are concerned with these differences. In response to
these concerns, legislative changes focused on leveling the
playing field have been the subject of numerous domestic trade
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and tax proposals.
Domestic Markets
U.S. companies producing PWBs and PWAs had shipments of
$9.6 billion and $25.6 billion, respectively, in 1997.\4\
According to the 1997 Economic Census, employment in the PWB,
PWA and supporting industries is approximately 250,000.\5\
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\4\ Data from US Department of Commerce, Economic Survey,
Manufacturing Industry Series, EC97M-3344G; EC97M-3344H(revised); and
EC97M-3344B; 1997.
\5\ Ibid., Includes the related interconnect industry (NAICS
334417; EC97M-3344G; 1997.
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The 1997 Economic Census Survey of Manufacturing reports
657 and 1,315 companies involved in the manufacture of PWBs and
PWAs, respectively. These figures are consistent with Market
Research division of the IPC (Association Connecting
Electronics Industries). Based on extensive membership surveys
and statistical analysis, the IPC reports that the industry is
comprised of mostly small businesses, with approximately 90
percent having shipments of less than $10 million each in
1998.\6\
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\6\ IPC Study of Financial Benchmarks for 1997 and IPC Assembly
Market Research Council, The 1998 Market for Electronics Manufacturing
Services Providers/Contract Assembly Companies.
[GRAPHIC] [TIFF OMITTED] T8411.010
The industry's preponderance of small firms is a result of
a larger trend in the electronics industry. As larger
corporations returned to their ``core competencies,'' they
began contracting out to smaller firms to produce inputs
formerly produced in-house.\7\ As large firms began downsizing
and eliminating certain in-house production, small firms
emerged to fill that production void. As a result, the
importance of small firms to the economy has grown over time.
In addition to supplying important inputs to the electronics
production process, small firms became important to such issues
as job creation and economic expansion.
---------------------------------------------------------------------------
\7\ Harrison, B., Lean and Mean, New York: Basic Books, 1994.
---------------------------------------------------------------------------
Nationally, firms with fewer than 100 workers employ as
many firms with 500 or more workers. Within the PWB and PWA
industries, small firms make important contributions to
employment, with heaviest concentration in small and mid-sized
firms. The graph distributes employment by firm size for the
PWB and PWA industries. As shown, the PWB and PWA industries
reflect the national trend in employment and job creation.
Importance of Capital Cost Recovery
One area that affects the firm's ability to compete is the
investment in new capital and the means of recovering capital
costs. Since the markets for electronic interconnects are
characterized by a high degree of competition both
internationally as well as domestically, cost recovery becomes
a very important variable in the firm's competitive equation.
For tax purposes, capital cost recovery typically means
recovering the cost of capital over a useful service life.
However, the present cost recovery system, the Modified
Accelerated Cost Recovery System (MACRS), has very loose ties
to a useful service life. In creating that system, the Congress
intended to improve competitiveness through its tax legislative
changes:
``An efficient capital cost recovery system is essential to
maintaining U.S. economic growth. As the world economies become
increasingly competitive, it is most important that investment
in our capital stock be determined by market forces rather than
by tax considerations...output attainable from our capital
resources was reduced because too much investment occurred in
tax-favored sectors and too little investment occurred in
sectors that were more productive but which were tax-
disadvantaged. The nation's output can be increased simply by a
reallocation of investment, without requiring additional
saving.'' \8\
---------------------------------------------------------------------------
\8\ Joint Committee on Taxation, General Explanation of the Tax
Reform Act of 1986, May 4, 1987.
---------------------------------------------------------------------------
Despite Congressional intent to help U.S. firms remain
competitive, the MACRS has remained essentially unchanged since
it became law in 1986. Unfortunately, the decades since the
1980's were periods of dramatic growth and change in
international and domestic markets.
One such change is the rate of change in technological
advances. Clearly, with such dynamic changes in technology,
competitive firms may face limitations with an essentially
static cost recovery system. One example of this technological
change is that of electronic assembly equipment and devices.
The following time line demonstrates the pace at which change
occurred in this industry.
Progression of Electronics Assembly Equipment \9\
Technological advance has occurred at steady pace. These
advances had their costs, however, as demonstrated by the price
of new equipment. Since the early 1970s, the price of this
equipment increased from $70,000 to $500,000. This price change
represents a 700-percent increase.
---------------------------------------------------------------------------
\9\ Data provided by IPC.
[GRAPHIC] [TIFF OMITTED] T8411.011
While the price increase is quite dramatic, an even more
dramatic trend occurred in the productivity of the machinery.
``Pick-and-place'' equipment began placing components at a rate
of 1,900 per hour. Current technology can place components at a
rate of 50,000 per hour. This change in technology represents a
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2,600-percent increase.
Economic versus Tax Depreciation
Since the 1980s, tax legislation has attempted to conform
tax depreciation with that of economic depreciation. The move
toward shorter service lives and accelerated methods has, for
the most part, created a correspondence between the two
patterns. Because tax depreciation is a financial concept and
economic depreciation is a physical value concept, however, the
correspondence is not always consistent.
Numerous factors influence the correspondence between
economic decline and tax depreciation. Such factors include
inflation, interest rates, tax rates and other tax parameters,
and technological change.
When inflation levels are sufficiently high, these levels
erode the value of the depreciation deduction. High levels of
inflation also increase the cost of borrowing by increasing
interest rates. High interest rates slow investment by adding
additional borrowing costs to the purchase price.
Tax rates, in particular, slow investment by reducing
available funds. As tax rates increase, investment typically
decreases. In other words, as payments to the federal
government increase, fewer funds remain to invest in capital
stock.\10\
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\10\ The effect of other tax parameters, such parameters as carry
over rules, may affect the amount of available funds for investment as
well. However, the direction and the magnitude of the effect depend
upon the particular provision. Generally, such provisions as credits
increase available funds and such provisions as limited deductions
reduce available funds.
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Technological change lowers the economic value of assets.
As technological change occurs more rapidly, existing capital
is not as valuable as the newer, more advanced capital asset.
Consequently, technological change, while offering advances for
the production process, imposes the need for continued
investment. The previous example of the pick-and-place
equipment demonstrates this point. Since the early 1970s,
technological change enables such equipment to place 2,600
percent more components per hour. Existing pick-and-place
equipment is clearly less efficient and valuable than the
newer, faster equipment.
The influence of the economic variables is easily
quantified. Technological change, however, is not. As described
above, economic depreciation is measured using prices in the
used equipment market. Typically, used asset prices reflect the
change in value associated with changes in innovation. Yet,
there are several reasons why this measure of economic
depreciation will not adequately measure the influence of
technology on capital goods.
In some industries, technological change in new equipment
embodies a greater degree of precision. The old and new
equipment create products that are not substitutes for one
another. In the case of printed wiring boards, the circuit
board with finer circuitry will have different capabilities
(generally better) than those with wider circuits.
This type of technological change is not as easily
quantified in the used-asset price, because the used-asset
price reflects the value of producing different output. The
market, in fact, may exist for the older machine. Consumers may
still demand the product from the older asset. Consequently,
there may still be a market for the older asset and the used-
asset price reflects this value.
This is a common situation in many manufacturing
industries. The actual production process may remain virtually
unchanged. However, refinements in the finished output continue
at a rapid pace, creating a need for new investment. If
businesses are unable to keep pace with this level of change,
they will be less competitive in both the domestic and
international markets.
View of Tax Service Lives
From the outset in 1913, income tax legislation has
recognized capital cost recovery as a cost of doing business.
The Congress modified depreciable service lives many times
since then (e.g., Bulletin F in 1933 and 1945, Revenue
Procedure 62-21, and others), particularly from the 1950s to
the 1970s. Unfortunately, the last modification was nearly 15
years ago with the appearance of the Modified Accelerated Cost
Recovery System (MACRS). Even so, many service lives have
remained unchanged for more than 20 years. In the PWB and PWA
industries, the past 20 years represent the most dramatic
technological change in their market. Previous Congressional
intent indicated a need to keep depreciation policies
consistent with economic pressures. Clearly, depreciation
policy has not kept pace with the technological change and
economic pressures facing the PWB and PWA industries. The
current proposal to reduce from five to three years the service
lives of equipment in the PWB and PWA industries would provide
this necessary and overdue change.
Reducing Service Lives
Generally, reducing service lives of depreciable assets
results in a revenue loss in federal tax receipts. The revenue
loss results from the timing difference of the two patterns of
depreciation deductions.
In a static world with a constant level of investment, the
revenue loss is a result of shifting from later periods to
earlier periods the depreciation deduction. This timing change
often is referred to as a speed-up or an acceleration of the
deduction. No additional deductions are provided with this
change.
The benefits of this acceleration of deductions are similar
to receiving payments over time. If promised payment of $100,
and given the option of two payment periods, which payment
period would prove more attractive, three or five years? In
either case, the total payments remain the same. Most would
agree that, given the time value of money, sooner is preferable
to later. This is precisely the situation with depreciation
deductions. The deduction represents a net payment to the
business.\11\ The greater the deduction in the early years, the
more funds available to operate and expand business.
---------------------------------------------------------------------------
11 The increased deduction represents a decrease in tax liability,
which suggests the owner pays himself rather than paying taxes.
---------------------------------------------------------------------------
Summary
Electronic interconnects form the foundation for virtually
all electronic systems in the world. They are the backbone of
all computer and electronic products. Not only are they
essential to all electronic products, they are vital to the
changing technology in the automotive, communications, consumer
products, computer, government and military, industrial and
medical markets.
SPAN The United States remains a global leader despite
facing strong international competition. In 1984, U.S.
companies owned 40 percent of the world market. Since that
time, however, the U.S. share of the world market has eroded.
In 1996, Japan and the United States each were estimated to
have 27 percent of the world market.
Another area where U.S. industry lags behind its foreign
competitors is cost recovery. Many countries permit their
domestic electronic interconnect companies to recover a greater
percent of asset costs in the first year. This places U.S.
firms at competitive disadvantage relative to their
international competitors, given the rate of technological
change in this industry. As electronic equipment becomes more
technologically advanced, additional investment becomes
necessary. This new investment is relatively more costly to
U.S. firms.
The Congress modified depreciable service lives many times
since the early 1950s. However, the last modification was
nearly 15 years ago and many service lives have remained
unchanged for more than 20 years. In the PWB and PWA
industries, the past two decades include the most dramatic
technological change in their market. Previous Congressional
intent indicated a need to keep depreciation policies
consistent with economic pressures. Clearly, depreciation
policy has not kept pact with the technological change and
economic pressures facing the PWB and PWA industries.
The current proposal to reduce from five to three years the
service lives of equipment in the PWB and PWA industries would
provide this necessary and overdue change.
Statement of James R. Shanahan, Jr., Partner, PricewaterhouseCoopers
LLP, on behalf of Tax Council Policy Institute
Mr. Chairman, Members of the committee, on behalf of the
Tax Council Policy Institute, I thank you for the opportunity
to share our views on the importance of research and
development in the context of the new economy and the role of
the federal R&D credit. I am Jim Shanahan, a partner with
PricewaterhouseCoopers LLP. I respectfully submit this
statement on behalf of the Tax Council Policy Institute (TCPI).
The TCPI is a 501(c)(3) research and educational
organization affiliated with The Tax Council. Its primary
purpose is to bring about a better understanding of significant
federal tax policies that impact our national economy through
careful study, thoughtful evaluation and open discussion. The
TCPI thanks you for focusing on the tax treatment of research
and development as part of your hearings on the tax code and
the new economy.
Consistent with its mission, the TCPI this coming year will
be focusing on the R&D tax credit. On February 15-16, 2001, the
TCPI will be hosting a Symposium on the ``R&D Tax Credit in the
New Economy.'' I will serve as one of the program managers for
this event. We believe that in choosing the R&D Tax Credit as
next year's topic (following this year's very successful
INDOPCO Symposium), the TCPI has underscored the importance of
the R&D credit to the new economy.
As we formulate the program agenda, we foresee speakers
from accounting and law firms, academia, Congressional staffs,
Treasury, and the IRS sharing their knowledge, expertise, and
experience. We hope that the Symposium will facilitate an open
discussion forum, highlight the importance of an R&D credit
incentive in today's economy, and supply a common ground from
which the operation of the R&D tax credit can be analyzed. In
general, we intend for the event to provoke thoughts on how the
credit can operate and be administered in an efficient, fair,
and effective way.
-