FROM THE OFFICE OF PUBLIC AFFAIRS

Thank you. It is a pleasure to be here today.

What I would like to do today is briefly reflect on some features of the overall tax system as it currently stands. Then I will move on to discuss corporate tax shelters, and finally some other specific tax issues that arise from the trends shaping the new economy.

I. The American Tax System Today

Over the past few years, the tax system has supported our national economic priorities in many ways. Let me highlight four salient points:

First, the tax burden for the vast majority of Americans is at its lowest in a generation. As a result of a much expanded Earned Income Tax Credit, a Child Tax Credit, targeted education credits, and other tax changes, the federal income plus payroll tax burden is lower for a median income family of four today than at any time in the past 20 years, and their federal income tax burden is the lowest since 1965. For a family of four with half the median income of a family of four, the federal income plus payroll tax burden is lower today than at any time since 1969. And even for a four-person family with twice the median income, the federal income tax burden is lower today than at any time since 1973.

Second, the future tax burden on Americans represented by the national debt has at long last turned downwards. In the same way that a purchase still reduces one's income, whether you pay cash or buy it on a credit card, the contemporaneous tax burden understates the full tax burden during periods of budget deficits, both in terms of the annual interest cost, and the eventual cost of paying off the debt. This is precisely what happened in the 1980s and early 1990s. In 1983, when there was a budget deficit of $208 billion, the average American family was effectively saddled with future income and payroll taxes equal to 35 percent of taxes they actually paid. In 2000, with a budget surplus of $237 billion, we have effectively reduced the future tax burden on American families by nearly 12 percent.

Third, where tax burdens have increased relative to GDP, it is in significant part due to fact that the ability to pay has increased significantly relative to GDP, leaving individuals better off even in the context of higher tax collections. To put this in some perspective, the after-tax income of the wealthiest 1 percent of taxpayers almost doubled between 1990 and 1998, compared to a growth of 54 percent in the after-tax income of the remaining 99 percent of taxpayers. We estimate that over one-third of the increase in individual taxes relative to GDP in recent years has been caused by a growth in capital gains receipts.

Fourth, the tax system is doing more to help promote the values of education, work, and saving. Through targeted tax measures, including the Lifetime Learning and the Hope Scholarship credits, millions more Americans have been given access to higher education. By expanding the Earned Income Tax Credit by more than 10 times over the cost of the program in the mid-1980s, millions more low-income working families have been given a strong incentive to work. And by making it easier for employees to save money through payroll deduction millions of employees are now saving.

It is surely right that we continue to use the tax system to promote out national economic priorities. At the same time, our tax system will increasingly face growing microeconomic challenges that arise from the New Economy.

II. Facing the Challenges that a New Economy Presents

We live in an era of rapid change: financial markets are becoming increasingly sophisticated and efficient at the control and dissemination of risk; economic boundaries are dissolving as globalization grows in intensity; and competitive market systems are increasingly taking hold and spreading around the world.

All these trends are overwhelmingly positive. But at the same time they are creating pressures on our tax system that we need to address: they facilitate more aggressive tax minimization behavior; they challenge the traditional tax rules relating to the source, timing, and character of income from financial products; and they make it easier to re-locate income to offshore domiciles.

In many ways, these phenomena already define an agenda for tax professionals in the years ahead regardless of how the larger questions of tax policy are resolved.

Let me divide my remarks into two parts:

• First, the need to adapt our tax rules and tax administration to accommodate an increasingly sophisticated financial world, most notably by combating abusive tax shelters.
• And second, a brief summary of some of the other key challenges facing our tax system.

The growing sophistication of US and global financial markets is delivering enormous benefits to American individuals and families. By better pricing and spreading of risk these markets are helping to lower the cost of capital and increase the rate of economic growth. At the same time, that greater financial sophistication also creates new opportunities for tax avoidance, and new challenges for tax administration: not least, an ever-increasing variety of abusive corporate tax shelters.

In the early 1980s widespread abuse of our tax system by wealthy individuals undermined our tax base and generated cynicism about the fairness of the tax code. Litigation to pursue abusive shelters also consumed large amounts of IRS time and money. In 1986, Congress responded appropriately by enacting reforms that went a long way to restoring public trust in the integrity of the tax code.

Today, we are facing a similar problem: the proliferation of abusive corporate tax shelters. Since 1990, in real terms, the gap between book income and taxable income has more than doubled to over $90 billion and is now wider than any time since the mid-1980s. Although some of this gap can be attributed to the use of legitimate tax incentives, there is no doubt that there has been a striking growth in abusive tax shelters.

Let me be clear: every taxpayer has a right to minimize his or her tax burden by legitimate means. However, we can and must draw the line at tax engineered transactions that have no goal other than to reduce a taxpayer's tax liabilities and, in doing so, undermine the integrity of the tax system. We well remember the words of Learned Hand: "There is nothing sinister in arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; for nobody owes any public duty to pay more than the law demands; to demand more in the name of morals is mere cant."

We must however draw the line at the pursuit of engineered transactions that are devoid of economic substance. As the American Bar Association, the Joint Committee on Taxation and other professional bodies have attested, these transactions have no goal other than to reduce a corporation's tax liabilities and, in doing so, undermine the integrity of the tax system.

Consider:

• Shelters reduce the corporate tax base and thus raise the burden on other taxpayers.
• Shelters create an atmosphere of cynicism among legitimate taxpayers that could damage the credibility of our voluntary tax system. Law-abiding companies feel obliged to follow the lead of competitors who abuse the tax code.
• Shelters complicate the tax code by forcing legislators to take remedial action. In the past few years alone, nearly 30 narrow statutory provisions have been adopted in response to abuses further complicating the tax code.
• And shelters divert resources from productive investment. As a former tax official now head of a well known law firm said: "You can't underestimate how many of America's greatest minds are being devoted to what economists would all say is totally useless economic activity."

The Treasury, the IRS, and Congress have taken aggressive action to curb visible shelters. But tax shelters are like icebergs: only a small proportion is visible. We can and must do more. Last February, I spoke to the Federal Bar Association about Treasury's growing concern with the proliferation of abusive shelters. Since that time:

• First, we have increased the ability of the IRS to tackle abusive shelters, by issuing new regulations that require corporate taxpayers to disclose more information to the IRS. The IRS has also set up an Office of Tax Shelter Analysis, which will provide a consistent national approach to addressing shelter transactions. These steps have already improved our ability to detect and close down new shelters. Indeed, later today or tomorrow the IRS will be issuing a notice to close down a shelter transaction involving stock compensation arrangements that that generates artificial losses. More notices will be forthcoming in the near future.
• Second, we are improving guidelines for tax practitioners. Before the end of this year, Treasury and the IRS will issue proposed regulations to revise Circular 230, which sets standards for professionals practicing before the IRS. The dilemmas of this area have been exemplified by the recent remark of a tax practitioner, that "writing tax opinions is a choice between eating and sleeping. I like to eat." We would prefer that he get some rest. That is why we are revising Circular 230 so that we can modernize opinion standards for the kinds of tax shelters prevalent today.
• Third, we continue to pursue legislation that will strengthen our ability to combat tax shelters. In the FY 2000 and FY 2001 Budgets, this Administration made important proposals to inhibit the growth of tax shelters. We welcome the draft bill released by the Senate Finance Committee last month and we hope to make progress towards enacting effective tax shelter legislation in the months ahead.

Combating abusive tax shelters is perhaps the biggest challenge facing our tax administration system today. But the increasing sophistication of our financial system is also creating new challenges for the appropriate and consistent tax treatment of financial instruments.

Many of the instruments traded on today's markets may not fit comfortably into the framework of traditional tax rules. Yet targeted rules designed to address the latest fad in financial instruments soon become outdated and create a system of ad hoc rules that can complicate the law and create new loopholes.

This has brought calls from many tax professionals and academics for a thorough review of the current taxation of financial instruments. In principle, we would support such a review. But of course, it will be crucial that such a review be even-handed with respect to similarly situated financial products and taxpayers, and that any new rules that result have minimal disruptive effect on the markets.

III. Meeting the Tax Challenges of a Rapidly Changing World

In a world where cyber-transactions are growing at a rapid pace, tax administrations also face the challenge of adapting existing tax systems to a more cyber-based world. At the same time, in a fast-integrating global economy, we have to work ever harder to ensure that the otherwise positive forces of global capital mobility do not undermine our national interests by facilitating increased tax evasion or abusive tax avoidance. And running through all of these is the challenge of maintaining an effective tax administration.

Let me discuss each of these in turn:

The challenges of e-commerce are many and complex: from the application of traditional rules for determining source of income and jurisdiction, to the risk that sophisticated Internet encryption methods that are developed to maintain commercial secrecy also be used to hide information from the authorities.

Like the cyber-world itself, the search for the solution to these challenges is still in its infancy. But we have worked to establish one guiding principle. This is that our global tax administration system should provide an environment in which e-commerce can flourish, but it cannot permit the Internet to undermine the system of revenue collection upon which our public services depend.

This basic principle has guided us in working with both our OECD and non-OECD partners, in consultation with the private sector, to build an international consensus on the framework underlying any taxation of e-commerce, clearly any such consensus must be based on two pillars:

• First, that tax rules and tax administration should be neutral and non-discriminatory between Internet and non-Internet transactions.
• Second, international cooperation should aim to prevent double taxation or unintentional non-taxation of e-commerce, while maintaining the fiscal sovereignty of participating countries. A key element of this effort must be to minimize opportunities for arbitrage across borders.

As I said, this is very much a beginning, not an end. But it is an important start.

In a world where capital can silently traverse the globe at the touch of a button, tax evasion and tax avoidance schemes can be undertaken just as quickly and just as quietly. So, just as we must ensure that e-commerce does not give rise to distortions in our national tax administrations, so we need to foster a climate of cooperation among nations to ensure that the growth of tax evasion is avoided.

Let me highlight two areas where we have taken recent steps to further these important goals:

• First, in June the OECD published a report of its work on harmful tax competition. While the two lists included in the report have drawn widespread attention, the real story from the OECD's work is the commitment of OECD members and six non-OECD members to cooperate with each other and eliminate those aspects of their own tax frameworks that facilitate avoidance or international tax arbitrage. Ultimately, this cooperation will provide new tools that will allow tax administrators to discover and fully evaluate transactions that may be abusive.
• Second, at a national level, we recently issued regulations imposing special, and more rigorous, requirements on banks based in tax havens. These requirements are designed to ensure that such banks have access to - and can provide information regarding - the beneficial owners of interest income.

Once again, none of us can look at the challenges to tax administrators that are posed by global integration -- whether it is the question of multi-national transfer pricing or the appropriate response to tax havens -- and say that our existing tools for fashioning are up to the job. But in recent years we have taken important first steps toward ensuring that these challenges can be met without eroding our tax base or preventing the full benefits of capital mobility from being realized.

The common thread linking all of these challenges is the need to ensure an effective tax administration. That is why it is critical that we continue to push forward with the modernization and re-organization of the IRS so that it can adapt to the challenges of a rapidly changing world.

In its new mission statement the IRS pledged to focus on two core priorities: "Providing America's taxpayers with top quality service by helping them understand and meet their tax responsibilities, and applying the tax law with integrity and fairness to all."

In following through on this pledge, the IRS has been able to take advantage of new technology to provide a genuinely user-friendly and efficient service. For example:

• In FY2000 electronic tax filing hit a new record with more than 35 million taxpayers filing electronically - a 20 percent increase over last year. Over the same period, the number of taxpayers filing self-prepared tax returns from their home computers grew by 44 percent to 7.6 million.
• The number of recorded hits on the IRS website rose by 15 percent to over 791 million in the tax year that ended in May. This makes the IRS website one of the most frequently visited on the Internet.

Clearly, we have much more to accomplish. I believe that under the leadership of Commissioner Charles Rossotti, the IRS will continue to build effective reforms around the needs and interests of ordinary and law-abiding taxpayers.

IV. Conclusion

Let me conclude where I began. It is critical that we think about the challenges facing our tax system in the years ahead. Such an exercise provides us with a valuable opportunity to think about what it means to manage our finances in a fiscally responsible way that serves us all. As Justice Holmes said: "Taxes are the price we pay for civilized society." It is also an opportunity to confront the microeconomic challenges posed by the New Economy. Working together, I know that we can meet these challenges without in any way compromising our commitment to fiscal discipline. Thank you.