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TAX FOUNDATION SPECIAL

February 1995 BRIEF The of Section 1071: The FCC Certificate Program House Ways & Means Committee Testimony

By JD. Foster The following testimony was presente d so that you, the policy makers, may make in- Executive Director and by Dr. Foster before the House Ways & formed decisions . Chief Economist Means Committee on January 27, 1995. I appreciate the opportunity to appear be- Tax Foundation fore you today to discuss Section 1071 of th e Madam Chairwoman and Members of th e Internal Revenue Code which allows the Fed- Committee, my name is J .D. Foster and I a m eral Communications Commission (FCC) to the Executive Director and Chief Economist o f grant tax relief with respect to the sales of ra- the Tax Foundation . The Tax Foundation is a dio, television, and other properties under cer- nonprofit, nonpartisan research and publi c tain circumstances. This demonstrates, I think, education organization that has been monitor- that even at a time when such fiscally colossal ing at all levels of government issues like a balanced budget amendment an d since 1937 . I would like to emphasize to the the "Contract with America" dominate our at- Committee that the Tax Foundation is not a tention, there remain many important issue s "grass-roots" organization, a association , that should not be neglected, even though or a lobbying organization . We do not take they may never appear above the fold on th e positions on specific legislation or legislativ e morning paper. I commend the Committee fo r taking the time to address this issue . I will restrict my remarks to the economi c aspects of this issue and leave the debate abou t Even at a time when such fiscally colossal the social and communications policy to oth- ers more familiar with those aspects . It is no t issues like a balanced budget amendment my purpose today to argue in favor of o r "Contract with America" dominate against the program, or for or against an y and the changes in the program, but rather to present our attention, there remain many important its underlying economics as best as I have issues that should not be neglected, even been able to determine them . though they may never appear above the The FCC Tax Certificate fold on the morning paper. Program Under Section 1071, the FCC has the au- thority to grant a tax certificate to the forme r owners of certain broadcast facilities when th e proposals. Our goal is to explain as precisely sale or exchange of those facilities is certifie d and clearly as we can the current state of fisca l by the FCC "to be necessary or appropriate t o policy and the consequences of particular leg- effectuate a change in a policy of, or the adop- islation in the light of specific tax principles tion of a new policy by, the Commission with 2

respect to the ownership and control of radi o they work with improve (a fisherman generally broadcasting stations. .." Since 1978, the FC C will catch more fish with a net than with a has used this provision as a tool for its an- single line, for example), so one consequence nounced policy of promoting minority owner - of this tax is that wages in these states are de- ship of broadcast facilities . The tax certificate pressed relative to what they would otherwis e gives the taxpayer the right to elect to treat th e be. sale or exchange as an involuntary conversio n The federal tax system is replete with non - under Code Section 1033 . The tax benefit gen- neutralities, almost all of which result in les s erally is to allow the former owner to defer the output, fewer jobs, and lower wages . Some of realization of gain on the sale or ex - these, such as the heavy tax burden on saving , change of the if the proceeds from th e are very broad in application and carry steep sale are used to purchase similar property. To price tags. Others are much narrower, such as the extent the taxpayer does not utilize the in - the FCC tax certificates which are the subjec t voluntary conversion rules, the capital gain re- of this hearing . sulting from the sale or exchange of the asset It is important to note that there are occa- shall nevertheless not be recognized, if the tax - sions when the tax code is non-neutral by de- payer so elects, because the taxpayer may re- sign. In many instances, the underlying policy duce the basis for determining gain or loss on is an attempt to address an economic external- sale or exchange of property if the property ity through the tax code . An externality arise s would qualify for depreciation under I .R.C. when the individuals involved in an activity are Section 167 . unable to enjoy all the economic benefits or d o not bear all the economic costs of an activity . Tax Neutrality An example of the former would be a software manufacturer whose products are pirated ; an When it was founded some 58 years ago example of the latter would be a restaurant the Tax Foundation established six Principle s which has a band that plays music so loud tha t of Taxation to guide its analysis . One of these it drives away customers from the restaurant principles was that the tax code should not be next door. used to micro-manage the economy . That is , The Research and Experimentation Tax the tax code should be as neutral as possible Credit exemplifies a tax provision enacted i n with respect to economic decision making . recognition of a positive externality . Even Tax neutrality is important because whe n with patent and copyright protection, many of distort how resources are employed, the the economic benefits that follow from R & E net result is almost always a lowering of activity cannot be captured through product wages, fewer jobs, and lost output. Thus, a sales or pricing by the doing the non-neutral tax removes resources from the work. As a result, a lower level of R & E activ- private sector in two ways: through the collec- ity is performed than would be socially desir- tion of the tax itself and through the incom e able. This is an externality which the tax lost because of the misallocation of re- credit seeks to offset . sources—what is called the deadweight loss . There are also many examples of taxes im- Border tariffs offer a classic example of th e posed to address negative externalities . One deadweight loss from taxation . Tariffs are ex- such is the gasoline which attempts t o ternal taxes and, as such, distort the prices of force the users of gasoline to pay for the foreign relative to domesti c amount of the resource they consume through goods and services, thereby distorting the allo- the product's price, but also for the economic cation of domestic resources like capital an d cost of the pollution that is thereby generate d labor. The history of modern trade policy is a through the gasoline excise . nearly continuous effort to reduce tariffs be- To summarize, through its non-neutralitie s cause to do so results in an expansion of trad e the current tax code severely distorts the allo- and an expansion of national output through cation of national resources, thereby reducing the more productive use of resources . output, wages, and employment . While mos t Another example of a non-neutral tax an d of the non-neutral provisions in the tax cod e its deadweight loss involves the taxation o f are the by-products of other policy choices (a capital . Some states, for example, impose a desire for a system, the choic e specific tax on plant and equipment locate d of income as a tax basis, and so forth), som e within the state. These taxes on real capital re- are deliberate attempts to use the tax code to duce the amount of capital employed . Conse- capture economic externalities. Good tax quently, the workers in those states have les s policy should seek to eliminate the former an d capital with which to work . We know that to target the latter most carefully . workers are generally paid more as the tools

SPECIAL 3 BRIEF

The Taxation of Capital Gains can distort the allocation o f capital by shifting capital to tax-favored uses . In general and in most cases, the taxatio n In general, such a targeted tax benefit woul d of capital gains is highly distortionary . Except generally only be warranted on purely eco - in instances in which the capital gain arises di- nomic grounds if it were used to offset som e rectly as a result of reinvesting income, such as externality as discussed above . corporate retained earnings, the capital gains To the extent the FCC tax certificate pro - tax is a levy on capital and not on the incom e gram is attempts to capture an externality, an d accruing to capital. As a on capital , in this regard is similar to attempts to addres s the capital gains tax reduces the incentives to other externalities such as polluting emissions, save and invest . Therefore, broad-based reduc - it must be recognized that the program seek s tions in the tax improve the neutrality of th e to address a social condition and not an eco- tax code. nomic externality, in which case economic ar- The capital gains tax can be reduced i n guments do not apply . Increasing minority ownership of broadcast facilities is social policy and not a response to an economic ex- ternality . Lacking any externality aspects , The FCC tax certificate progra m therefore, the FCC tax certificate program rep - resents an instance of micro-management of reflects three policy decisions: to the economy which cannot be supported o n the basis of the need to offset an anomalou s increase the number of minority owne d economic condition . broadcast facilities, to compensate th e former owners of the facility for th e Property Rights and the Cer- tificate Program loss of control of their property when Property rights are the very backbone o f the sale was made involuntarily, and to our economic system . Much of our judicial system exists to protect from subsidize the purchase of broadcast confiscation or loss of through the ac- facilities through the shared tax tions of either individuals or governmental en- tities. Whenever an individual believes his or benefits granted by the tax certificates. her private property can be taken without du e process and just compensation, their eco- nomic energy and vitality diminishes . The FCC tax certificate program is in- tended, in part, to diversify ownership of broadcast facilities to encourage greater minor- three ways : by reducing the which i s ity control . To the extent this governmen t applied to taxable gains, by reducing th e policy goal results in the involuntary sale b y amount of a taxable gain that is subject to tax private individuals of broadcast facilities to an y (either through a percentage exclusion, by in- other party, even if at a fair-market price, som e dexing the basis for inflation, or by a simple in - form of compensation is appropriate. Thus, in crease in the basis), or by allowing the tax- any case where the FCC requires that a privat e payer to defer the recognition of the capita l individual or group sell a broadcast facility, fo r gain. Deferral arises most notably when hom e whatever reason, to another individual o r owners sell one home and buy another , group, and the transfer is truly involuntary , though it also arises in private saving arrange- then the tax benefits conferred by the FCC ta x ments such as Individual Retirement Accounts . certificate program could be considered an ap- The deferral of tax is one of the tax benefit s propriate form of compensation . conferred on qualifying sales of broadcast sta- tions. A step-up in basis, which occurs in th e Sharing The Benefit tax code most notably in levying the estat e tax, is a second tax benefit recipients of FCC The tax benefits are conferred on the tax certificates enjoy . former owners of broadcast facilities by th e Targeted reductions in the capital gain s FCC tax certificate in the sense that the ta x tax on the one hand improve the neutrality of benefits are theirs to claim . In the market- the tax system by reducing the distortion place, since both the buyer and the seller are against saving and investing . On the other aware of the possible tax benefit, the value o f hand, however, targeted reductions in the the benefit will be considered by both parties SPECIAL BRIEF

in establishing the sales price . For example, matter the FCC tax certificate program be - suppose the value of a broadcast facility in th e comes indistinguishable from farm subsidies or absence of capital gains tax deferral is $50 mil- merchant shipping subsidies, except that th e lion, and that the value of the deferral to the beneficiary group is determined by racia l seller is deemed to be $ 5 million . The final rather than by industrial classification . There are many federal programs which ul- timately have a significant rent-seeking quality . (Rent seeking is the economic expression fo r There is no economic justification for the actions of any individual or group that seeks special benefits from a governmental en- such a subsidy program which, like all tity). Strictly speaking, whether a particular subsidize or penalize group should be granted special benefits a mat- attempts to ter of social policy, rather than economi c particular economic activities, distorts policy, and to this extent outside the purview of economic analysis . the allocation of precious resources. Common sense provides a simple test , however, of the extent to which a program ha s a significant rent-bestowing character . This test is unnecessary in most cases since, like sales price could fall, therefore, anywhere be- farm subsidies, it is easy enough to determine tween $45 million, in which case the buye r who the rent seekers are, namely the farmers . gets the full benefit of the deferral, or $50 mil - In the case of the FCC tax certificate program , lion in which case the seller gets the full ben- however, the existence and definition of the efit. The of the benefit enjoyed by th e rent-seekers is less clear and so the test is mor e seller and the buyer will vary case-by-case, but , helpful. it is likely that in nearly every case both th e The simple rent-seeking test is this : Who buyer and the seller will enjoy some portion o f favors the program and do they receive a finan- the tax deferral benefit. cial benefit from the program? In the case of Therefore, the argument that the FCC tax the FCC tax certificates, this hearing and th e certificate is just compensation for the involun- testimony given may offer the clearest evi- tary nature of the sale or exchange, to the ex- dence of who may be rent-seeking, a matter I tent it was in fact involuntary, supports th e will leave to the Committee to decide . program only to the extent the entire benefi t of the tax is conferred on the sellers of the Conclusion broadcast facilities since it is their loss of the The FCC tax certificate program to expan d control of the asset which has given rise to th e minority ownership of broadcast facilities re- need for the benefit. However, since in mos t flects three policy decisions . The first is to in- markets it is not possible to guarantee the en - crease the number of minority owned broad- tire amount of the tax benefit will be retaine d cast facilities and, as such, is almost entirely a by the former owner, the tax benefit loses its social policy . The second policy is to compen- character of compensation for involuntary con- sate the former owners of the facility for th e version and becomes a simple subsidy to the loss of control of their property when the sale The Tax Foundation, a new owners. was made involuntarily . This compensation nonprofit, nonpartisan arises, however, only to the extent that the research and public Rent-Seeking and the FCC Tax purchase price of the facility is not reduced to education organization, reflect a sharing of the tax benefit between has been monitoring tax Certificate purchaser and seller. and fiscal activities at all The foregoing discussion leads to the con- The third policy reflected by the program levels of government since clusion that the FCC tax certificate program is to subsidize the purchase of broadcast facili- 1937. can only be justified on economic grounds in ties through the shared tax benefits granted b y those cases in which the sale of the broadcast the tax certificates . There is no economic jus- Editor & Communication s facility is truly involuntary and in which the en - tification for such a subsidy program which , Directo r tire tax benefit is enjoyed by the seller of the like all attempts to subsidize or penalize par- Stephen Gol d facility. In the absence of any other economic ticular economic activities, distorts the alloca- rationale, the tax certificate program become s tion of precious resources . Therefore, the sub- Tax Foundatio n the equivalent of any number of subsidy pro - sidy, too, must be regarded purely as a social 1250 H Street, N .W . grams designed to benefit some special inter- policy decision . Suite 750 est. In other words, except under the narro w Washington, D .C . 2000 5 conditions described above (involuntary con - (202) 783-2760 version and seller beneficiary), as an economi c