When did you notice corporate tax shelters coming back in a lusty way in the 1990s? What were the first signs of that?

From the time I became deputy secretary in the mid-1990s and started being interested again in matters relating to tax, I would meet people who would express embarrassment about transactions that their law firms had been associated with, or express embarrassment about tax shelters their corporations had been associated with, or even more commonly would complain bitterly about the pressures they were under to be part of tax shelters, with the argument being that everyone does it. Heads of corporations were saying, "My CFOs are saying, 'Everyone else in this industry is doing this. Why can't we do it?'" You had, with tax shelters, the same kind of peer pressure versus "just say no" that you have with substance abuse, and it's not that effective in either case.

So you're hearing from both practitioners in the field and corporate executives.

That's right. … You're seeing anecdotes and you're seeing data. Anecdotes of peer pressure to do things that are questionable. Data -- the corporate profits are going up and corporate tax revenues aren't nearly keeping pace, which suggests that there's more sheltering activity.

You're seeing corporate profits, and they're going somewhere.

Corporate profits are going way up, and corporate taxes, which are supposed to be 33 percent of corporate profits, aren't going up at the same rate. That's got to get you thinking.

I think you said in one speech in 1999, a boom year, corporate tax--

One year, corporate tax receipts went down 2 percent, while corporate profits, as reported, were up something like 20 percent. Now there are a number of factors behind it, involving depreciation, involving options. But we had the economists in the tax analysis section look pretty carefully at it, and there was a big gap. So when you have a gap in the data and you have anecdotes and you [are] talking to the people on the front lines and asking them whether they feel they can control this transaction, you've got to wonder.

We had one other indicator that there was a real problem, which was there were a number of particular transactions that people attempted that people in the IRS or the Treasury heard about, regarded as outrageous, and then issued new rulings to shut them down. But when I asked, "Were you sure you would have heard about it?" -- there was one shelter that shut down that by itself probably was $30 billion, where our people felt that they were lucky to have heard about it. They couldn't be at all sure that there weren't several other shelters out there that were just the same that they just didn't happen to hear about.

So all of this information came together to suggest that there was a serious problem here.

[Did you have any idea how big the problem was?]

We were looking at a big tip of an iceberg. We had some very easy sonar readings from the corporate profits data, suggesting that it was a very big iceberg. … And even apart from the money, the principle that you have to pay your taxes, based on a reasonable calculation of income, reasonably derived, is a principle that is very important to citizenship. It seemed to us that that principle should apply to everyone in our society, and certainly there shouldn't be an exception for the wealthiest individuals and the largest corporations.

Let me just ask you about corporate tax rates. You mentioned corporate taxes not going up as fast or sometimes tending to level, even going down, where corporate profits are going through the roof. What's going on in terms of the corporate tax take, the corporate share of taxes, over a period of time here in American history?

The corporate share of corporate profits in total American income, in the total budget of the government, has trended downwards for a generation. Part of that is understandable -- profits as a share of GNP may have gone down. Part of that is a reflection of the fact that, in an internationally competitive world, it's probably right to have more incentives for corporate investments than we did earlier.

But if you look at the profit figure and you look at the tax collections, there is a discontinuity in that pattern in the 1990s, and that was what was the cause of such concern.

There has been, for quite a long time, a difference between the income that corporations report to Wall Street and the income corporations report to the IRS. What happened to the gap between what corporations report to Wall Street and the IRS in the 1990s? Was there a change?

There's always been a gap, but the gap gapped. There was discontinuity. The income to shareholders went up rapidly. The taxable income reported to the IRS stayed the same, and in some years, actually declined. It was pretty obvious that the reason had to be more shelter[s] and activity of various kinds, and that's part of what has led to our concern.

Similar concerns had to do with transactions that were without economic substance, that led to a misreporting of income, leasing city halls back and forth, things of that kind. Some of it had to do with activities abroad and income that was located abroad, where it wouldn't have to be reported for U.S. tax purposes. Some of it had to do with other kinds of accounting tricks. But what was common to all of this was that the gap grew wider between substantive income, as best we can measure it.

Frankly, there was one other element that now looks to have been of some importance that we didn't focus as much on at the time. Some of the income reported to shareholders wasn't real at the Enrons and WorldComs of this world. That was another part of the gap.

In fact, one of the important directions for policy in this area should be some much greater pressure for the difference between tax income and book income -- between the income you report to Wall Street and the income you report to the IRS. Those numbers should be set by much more common standards. Divergences between those numbers should be much more clearly explained. If we're able to do that, that will have the effect both of discouraging tax avoidance, and of making it more difficult for people to inflate their earnings, because if they do inflate their earnings, they're going to have to give a third of the inflation to the IRS.

Is this just an argument among economists and tax lawyers, or is this something the ordinary taxpayer should care about?

Anyone who cares about the taxes that they pay should care a lot about this issue. I think about what we could do in the tax system with the money we're losing to tax shelters. We could significantly increase the allowance for every child. We could give credits that enabled people to take care of aging relatives. We could provide a significant increase in incentives for people to save for their retirement. We could expand substantially the availability of deductions for tuition. We could use revenue for across-the-board cuts. We could do things that we say as a nation we can't afford, like assuring adequate facilities in elementary schools in our urban areas. We could extend the number of children with health insurance by several million each year.

We can't do all of those things [by shutting down] tax shelters. But if we can do any of those things, it would be something important for American citizens. …

Now what about corporate tax rates? You said that corporate taxes were about 30 percent of the tax bill back in the late 1970s, and in the late 1990s now, it's about 10 percent. That's significant.

There's a lot that's changed. There are lots of arguments you can make about the necessity of corporate tax investments, what's happened in other parts of the tax system. It's important to remember that corporate taxes are ultimately paid by their shareholders.

But I think it's very hard to defend the degree of erosion we've seen in corporate tax collections in the context of the terrific performance of American corporations during the 1990s. I think it's difficult to know what the right norm is. But even a modest reversal in that trend would be tens of billions of dollars a year for the treasury.

Now you're talking about money. When you look at tax shelters, is money the only issue? Is money the only big issue that's at stake here, or is there something more?

It's money, but it's also fundamental fairness. Part of what we do as citizens is vote. Part of what we do as citizens is participate in our large national efforts, whether it's the public schools, or the Social Security system. And part of what we do as citizens is pay our taxes.

You know Justice Holmes famously observed that taxes are what we pay for civilized society. When some of the most powerful and most well-off elements in society decide to withdraw from paying taxes, that is a moral failure. It is a failure of citizenship, and it's something that eats away at our democracy.

Do you worry about the integrity of the tax system -- whether or not people will believe in it, if others are getting away with murder?

I think that because of the things that Charles Rossotti and his team at the IRS have done over the last five years, that those concerns are less pressing today than they were five years ago. But it is crucial that momentum in this area be maintained. That is why we need an aggressive attack on economic transactions without substance. That is why we need an aggressive approach to jurisdictions that seek to promote U.S. tax evasion by offering bank secrecy.

That is why we need to look very hard at the dark side of capital mobility, the whole set of questions around money laundering and tax havens. That is why we need to look at some real outrages -- what one of my colleagues once called economic Benedict Arnolds -- those who renounce their U.S. citizenship in an effort to avoid taxes. …

When we were talking before, you were talking about the tipping point phenomenon. What do you mean, if you can use that term? What were you worried about in terms of the tipping point?

Tipping point was, most people want to obey the law and be good citizens. Most people don't want to be suckers. As long as the vast majority are following the law, most others will follow the law. But if there's too much lawlessness, too much failure to do what's right and everybody's taking advantage of the system, then no one will want to be a sucker. The whole thing will tip, and you'll really do great damage to our tax system and our democracy. It's that kind of tipping -- as people see other people cheating -- that we were worried about.

Now take a look at the situation back then -- 1998, roughly. What kind of shape is the IRS in? You just had these big congressional hearings, 1997, 1998. People have been beating up on the IRS. Is the IRS in good shape to take on this problem of tax shelters?

The IRS was badly bruised at that point. It was badly bruised by a certain amount of internal failings of its management. It was badly bruised by congressional decisions to provide it with inadequate resources. It was badly bruised by the anti-tax climate in the country that had been fomented. That led to all kinds of very unfair attacks on the very good people who worked for the IRS. So it wasn't right to immediately launch a major attack.

Secretary Rubin and I made a judgment when President Clinton's second term began. We recommended to the president that the tradition of having a tax lawyer as head of the IRS be changed, and that we hire an experienced executive who could think about questions of organizational morale, who could think about questions of use of information technology, who could think about these issues in a systematic way. He made such an appointment to Charles Rossotti, who I think everybody agrees did a great job, and began bringing the IRS back to a more healthy situation.

Frankly, there were some issues that were easier than other issues. It was easier to improve the sense of customer service -- people answering the hotlines and the help lines quickly -- than it was to build a cadre of deeply knowledgeable [IRS] officials in very intricate things. …

Rossotti was an interesting choice -- [a] Republican businessman. What was it about Rossotti in particular that attracted you to him, and made you think he'd be a good IRS leader?

He was determined. He was undaunted. He knew about information technology. He knew about organizational culture and he wasn't political. His integrity was above reproach.

And?

He delivered.

So at this point, you're going after tax shelters kind of one by one. I don't know if you can [number] them off, but you've got real estate shelters, you've got life insurance shelters and you've got leasing shelters. They're all over the place. Can the IRS catch up on a case-by-case basis? I mean, you have some victories.

… We did have victories with respect to lease-in, lease-out, with respect to life insurance transactions, with respect to so-called stepped down preferred, a complicated gimmick involving preferred stock dividends.

But we realized that the only way we were going to succeed systematically was to do things that affected the culture. That's why we proposed legislation that would require those who wanted to take aggressive tax positions to flag for the IRS that they were taking aggressive tax position. We proposed regulatory changes that raised the ethical standards for those in accounting and legal professions that wanted to do business with the IRS.

We proposed raising the penalties for those who wrote bogus tax opinions. We proposed codifying a principle that continues to seem compelling to me -- that transactions have to have economic substance, rather than be purely tax-motivated, where you're not allowed to take deductions for them.

A lot of shelters didn't have any economic substance, didn't have business purpose.

That's basically the essence of a tax shelter. People [that] do activities that are best for their businesses and think about the tax consequences if they do it -- that's perfectly legitimate. What's not legitimate is transactions that have as their overwhelming motivation the reduction in reported tax income without changing the underlying substance of business activity. Sure, there are going to be some hard lines to draw there, and people can reasonably argue about the close cases. But there are so many cases that are on the side of essentially no economic substance and pure tax motivation that we thought there was a clear need for changes in the definitional standard.

What happened on Capitol Hill when you sent those proposals out?

There was a certain amount of discussion. The income -- probably even the taxable income -- of many lobbyists was increased. As they scurried and were well paid to fight those proposals, very [little] happened on Capitol Hill. …

What was the chief obstacle? What was the sticking point? What was the obstacle to getting your proposals passed in Congress?

There's a concentrated focused constituency for the tax shelter -- the person who doesn't have to write a check to the government, and the people whose livelihood depend on marketing those tax shelters in the accounting profession in particular. They were a strong constituency for tax shelters.

On the other side, you have a general national interest -- and that's always the challenge in Washington. [A] specific interest that's prepared to invest a lot of money in a particular political issue will often beat the broader national interest, and that was our challenge. …

Are there any particular lobbyists who have influence on the Hill, either because of personal connections, or past work?

In our period, Ken Kies had enormous influence. Ken had been the staff director of the Joint Tax Committee and a most trusted aide of key legislators. He then went to work for one of the accounting firms that was particularly aggressive in marketing tax shelters. He defended all of those tax shelters, and used all his influence to protect those shelters. He was a smart, effective, well-prepared, knowledgeable person on those issues, who had built up an enormous reservoir of loyalty. He was, I'm sure, sincere in his convictions and therefore difficult to contend with. But many of the transactions that were being defended I believe were very expensive; not just to the nation's treasury, but to our reservoir of integrity.

You said several times that there were transactions that were sort of hard to draw a line, but there are some that are clearly across the line. Is there a smell taste test for shelters? Are there common elements that you can see? …

Anything they're uncomfortable describing in full to the IRS, that you'll never share with competitors, is presumptively a problem. Anything that is marketed by somebody who's going to get a fee that's going to be higher if it's not audited than if it is, is presumptively a problem. Anything that involves transactions that have nothing to do with your underlying business is something that has to be looked at very hard. Those three -- lack of connection to your business, compensation arrangement for the promoter that's based on tax success, and a reluctance to disclose are all indicators of areas where you need to look very hard.

… Everywhere we go and talk to Europeans, some council members, treasurers of cities, city officials say they are bound by their [leasing] contract not to reveal the identity of the American investor. Is that a warning sign?

Absolutely. Whenever there is a failure to disclose and a desire for secrecy, you have a presumptive problem. There are enormous privacy issues with respect to what people should have to make public on their financial reports. The issues in privacy with respect to your tax return do not strike me as compelling issues. They are there for a reason, and they're supported for a reason, and that reason is the desire to knock out proper enforcement against the transactions.

What is the situation today? Do we still have this problem of tax shelters or do you think five years of effort by the IRS have cured the problem?

My guess is that there are still tens of billions of dollars left on the table each year because of the failure to enforce effectively. That failure to enforce effectively derives in part from the fact that we don't have the laws that require reporting. We don't have the laws that set a clear standard with respect to shelter activity. We don't have the commitment in the executive branch in a national cooperation with respect to tax havens that encourage shelter. We don't have adequate resources dedicated to enforcement. And we have not removed the fundamental conflicts of interest in the accounting profession that does tax preparation work that lead to so many of these tax shelters.

So are you saying that the incentives -- for example, the fees that people can make are so high in the accounting profession -- there are so many advantages to helping somebody with tax shelters that the risk of being caught in the penalties if you are caught is simply outweighed by the upside of making money?

I'm saying two things. First, the audit lottery is a good bet for the accounting firms and their clients. If it's not audited, you win. If it is audited, you're not that much worse off than you would have been if you had simply not attempted the shelter, and you probably won't be audited.

Second, the accounting firms are responsible for reporting and measuring income of major corporations. It is human nature that, if the referee wants to sell you something, you think very hard about buying it. That conflict of interest which has now been closed with respect to consulting services is still very present with respect to tax shelters. …

Do we hold the professions accountable for what some people would call the decline in ethics in the professions?

I'm not sure. The term profession means a group of people who adhere to norms of expertise and ethics. Some of what has gone on in the tax area should not be dignified with the term profession. There is much that we can hold members of the accounting and legal professions accountable for. There have been many instances in which the reasonable ethic norms of those professions have been abandoned.

Certainly it was my effort, when I was at the Treasury, to call on the leaders of those professions to reassert ethical norms. I think it's fair to say that there were some substantial concerns, some significant efforts -- that's certainly not completely successful in the legal profession. I have not seen a similar response in the accounting profession.

You made a major speech [in 1999]. What's the importance of the speech and the timing of the speech? What were you trying to do at the time you made that speech?

I was trying to get people's attention. I was hoping that Congress would pass legislation that the administration had proposed during the election year. I didn't expect the Congress would pass that legislation, but I was certainly hoping that the issue would get substantially more attention. I hoped frankly that, as Ken Galbraith said, conscience is the knowledge that someone is watching. I hoped that by making it clear that the Treasury Department was very focused on this issue to deter some of the greatest abuses.

Do you think that happened? Do you think that simply by raising the visibility of this, that it actually helped deter [anything]?

Based on what I heard and what our people who were close to the front lines on this heard, I think the speech and the attention the issue got had some positive benefit. But we've got a long way to go.