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for this period is too small to draw any definitive conclusions about the aggregate importance of this shift.

CONCLUSIONS

The current tax treatment of mergers at both the shareholder and corporate levels encourages merger activity. This conclusion would be different if various changes that have often been suggested were enacted. One, mentioned above, would be the provision of dividend relief from double taxation. A second, justified in the past as a way of reducing the incentive to merge for tax purposes, would be the liberalized transferability of tax benefits through leasing or some other mechanism. It is desirable to have a tax system that is neutral toward mergers, but this may be accomplished either through changes in the treatment of mergers or changes in the treatment of activities that can act as a substitute for mergers. It is by no means clear that the first route is preferable under our current tax system.

The proposal submitted to this committee for changing the tax treatment of mergers would reduce corporate level merger incentives through repeal of the General Utilities doctrine and limitation of the use of previous tax losses of acquired companies. I have indicated reservations about the logic of some of the included provisions and about some of the tax incentives to merge that would remain. It is also important that changes of this nature be coordinated with changes elsewhere in the code that would indirectly influence the incentives to merge. Nonetheless, I view this proposal, if suitably revised, as a step toward reducing the role of the tax code in the merger decision.

STATEMENT OF DONALD W. KIEFER, SPECIALIST IN PUBLIC FINANCE, ECONOMICS DIVISION, CONGRESSIONAL RESEARCH SERVICE, LIBRARY OF CONGRESS, WASHINGTON, DC

Mr. KIEFER. Thank you, Mr. Chairman.

My name is Donald Kiefer. I am a specialist in public finance in the Economics Division of the Congressional Research Service, Library of Congress.

I would like to thank the committee for the invitation to summarize my economic analysis of the proposed revision of subchapter C, and I will submit the full report containing my analysis to the committee.

The final staff report on the Subchapter C Revision Act of 1985 states that one of the goals is that current law should be made more neutral, providing less influence over and less interference with general business dealings. The purpose of my research was to examine the proposal with respect to this goal of achieving greater neutrality within the context of the effects of the overall income tax system on incentives for corporate organization and reorganization.

The overall structure of the U.S. income tax is not neutral with regard to corporate reorganization incentives. The existence of a separate corporate income tax and the resulting double taxation of corporate equity results in a general disincentive to operate a business as a corporation.

The differential tax treatment of debt and equity in the corporate sector creates an incentive for corporations to have higher debt-equity ratios, resulting in substantial leveraging up of corporations in recent years, accomplished to a large extent through merger or acquisition, or, alternatively, financial restructuring in response to an actual or perceived threat of takeover.

The nonrefundability of tax benefits, principally the investment credit and accelerated depreciation, means that business activities which generate large tax benefits or sizeable temporary or periodic losses provide a higher rate of return if their tax benefits can be

used to offset taxable income from other business activities. One way to achieve this is to combine business activities through merger or acquisition.

The lower tax rate on capital gains income of individuals puts pressure on mature firms to continue reinvesting high amounts in the corporation rather than increasing dividends. Acquiring other firms may be perceived as an attractive way of reinvesting earnings in the face of declining internal investment opportunities.

It is not the purpose of the proposed subchapter C revision to eliminate these nonneutralities which result from the structure of the overall income tax system; but these nonneutralities limit the extent to which a revision which focuses exclusively on subchapter C can make the Tax Code more neutral.

The proposed subchapter C revision would, in effect, repeal the general utilities doctrine, thus eliminating the ability to use a reorganization or liquidation to avoid the corporate-level capital gains or ordinary income tax on appreciating assets.

The proposal would also place new limitations on NOL and tax credit carryovers intended to allow approximately the same use of these carryovers as if the acquired corporation had continued to operate. This change would reduce the occurrence of mergers and acquisitions motivated primarily by the value of tax benefit carryovers of the acquired corporation.

The simplification involved in the proposal would also greatly reduce the complexity and cumbersomeness of the tax rules regarding reorganizations and liquidations. On the other hand, some of the reduced influence of the Tax Code on business structure which would result from the subchapter C revision may be partially offset by increased influences elsewhere. As one example, repeal of the general utilities doctrine could cause some appreciating property to be held outside the corporate sector in partnership form, for example, and leased to a corporation rather than having the corporation own the property directly.

Finally, it seems appropriate to conclude that the proposed subchapter C revision would have relatively limited effects on the overall level of corporate reorganization activity in the economy. This is both because many if not most corporate reorganizations are thought to occur primarily for nontax reasons and because the proposal would not affect some of the important influences of tax policy on corporate reorganizations. Enactment of the proposal, however, might be expected to reduce somewhat the number of mergers or acquisitions motivated largely by the value of tax-benefit carryovers and the number of liquidations, mergers, or acquisitions intended to avoid the corporate-level capital gains or ordinary income tax on appreciated assets. Because of the operation of the recapture rules, this latter effect would occur primarily in the extractive industries, inventory-intensive industries, and industries a substantial part of whose assets consist of intangibles, for example, the insurance industry, and among smaller businesses with appreciating real property.

As one final note, I would also emphasize what Professor Auerbach emphasized, that there is very little empirical evidence in which one can place much confidence on these effects. So these conclusions come largely from examining the nature of the tax

policies themselves and what anecdotal evidence is available from specific merger and acquisition transactions.

Thank you, Mr. Chairman.

Senator CHAFEE. Thank you.

[Mr. Kiefer's written testimony follows:]

STATEMENT OF DR. DONALD W. KIEFER

My name is Donald W. Kiefer.

I am

a specialist in public finance in the economics division of the Congressional Research Service of the Library of Congress. I would like to thank the committee for the invitation to summarize my economic analysis of the proposed revision of subchapter C.

The final staff report on the Subchapter C Revision Act of 1985 states that one of the goals of the proposed revision is that current law should be made more neutral, providing less influence over, and less interference with, general business dealings. 1/ The purpose of my research was to examine the proposal with respect to this goal of achieving greater neutrality. The study

places the analysis of subchapter C and the proposed revision within the context of the effects of the overall income tax system on incentives for corporate

organization and reorganization.

The overall structure of the U.S. income tax is not neutral with regard to corporate reorganization incentives. Given several fundamental characteristics of the tax structure--the separate corporate income tax, the deductibility of interest, nonrefundable tax benefits, the treatment of capital gains and losses, and depreciation which differs from economic depreciation--the tax system will inevitably exert considerable influence on the formation, reorganization, and liquidation of corporations.

The existence of a separate corporate income tax and the resulting double taxation of corporate equity results in a general disincentive to operate a business as a corporation. Because different forms of organization have different tax consequences, the tax code greatly influences the form in which

small businesses are organized.

1/ U.S. Congress. Senate. Committee on Finance. The Subchapter C Revision Act of 1985, A Final Report Prepared by the Staff, 99th Congress, 1st Session, May 1985.

p. 38.

The differential tax treatment of debt and equity in the corporate sector creates an incentive for corporations to have higher debt/equity

ratios.

Because a higher leverage ratio can yield a higher return on equity, a management team that intends to operate a corporation with a higher debt level may be able to purchase the shares of the corporation at a premium over the market price. This pressure has resulted in substantial "leveraging up" of corporations in recent years, accomplished to a large extent through merger or acquisition or financial "restructuring" in response to an actual or perceived threat of takeover.

The nonrefundability of tax benefits (principally the investment credit and accelerated depreciation) means that business activities which generate large tax benefits or sizable temporary or periodic losses provide a higher rate of return if their tax benefits can be used to offset taxable income from other business activities. One way to achieve this is to combine business activities through merger or acquisition.

While this is a non-neutral effect of

tax policy regarding reorganizations, it to some extent offsets another non-neutral effect: nonrefundability can make investments by one company less profitable than investments by another company merely because of a different ability

to absorb tax benefits.

The lower tax rate on capital gains income of individuals puts pressure on mature firms to continue reinvesting high amounts in the corporation rather than increasing dividends. Acquiring other firms may be perceived as an attractive way of reinvesting earnings in the face of declining investment opportunities. Hence, some of the most fundamental structural characteristics of the income tax create incentives for corporate mergers, acquisitions and liquidations.

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