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Chapter 1 Overview and Scope of the Study INTRODUCTION AND ORIGIN OF THE STUDY Legislative Background to the Study In 2008, Congress directed the U.S. Department of the Treasury to work with the National Academies to undertake “a comprehensive review of the In- ternal Revenue Code of 1986 to identify the types of and specific tax provisions that have the largest effects on carbon and other greenhouse gas emissions and to estimate the magnitude of those effects.”1 Congress later appropriated funds so the study could commence in early 2011.2 In considering its task, the committee held discussions with staff of the Department of the Treasury, had an open meeting with the legislative sponsor of the study mandate, Representative Earl Blumenauer (D-OR), and held two pub- lic meetings to hear from interested parties. The committee also considered a suggestion from the staff of the Joint Committee on Taxation (JCT) that the study should “provide scientifically-based information to aid decision makers in the formulation of tax policies aimed at reducing emissions and mitigating cli- mate change … [and] …identify the provisions of the Code that are most likely to have significant effects on carbon emissions” (JCT, 2009). Those discussions led the committee to interpret Congress’s request as in- cluding both provisions intended to affect energy-intensive activities in a nar- row, specific way as well as provisions affecting major sectors of the economy, activities, or large segments of the population. We label the latter set “broad- based provisions” in this report. Moreover, we interpreted the charge to include any tax code provisions that might significantly affect emissions, whether by increasing or decreasing them, that is, whether they increase revenue (as in the 1 Congress made its request as part of the Energy Improvement and Extension Act of 2008 (P.L. 110-343, Sec. 117). 2 2010 Consolidated Appropriations Act (P.L. 110-343, Division B, Title I, Sec. 117). 11

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12 Effects of U.S. Tax Policy on Greenhouse Gas Emissions case of excise taxes) or reduce revenues (as in the case of special deductions, exemptions, and credits that the Office of Management Budget [OMB] and the JCT call tax expenditures). Limitations of the Study The potential scope of the study is enormous because of the size and com- plexity of the Internal Revenue Code (IRC). Difficulties arise as well because it is difficult to gauge the full scope and depth of the mechanisms by which the tax code affects economic activity and greenhouse gas (GHG) emissions. At the same time, there were clear boundaries on Congress’s request. It did not ask the committee to assess the contribution of greenhouse gases to cli- mate change, nor to examine the consequences of global warming, nor to rec- ommend changes in specific provisions of the tax code. Statement of Task The National Academies’ first task in carrying out its congressional man- date was to work with the Treasury Department to draft a statement of work reflecting an understanding of congressional expectations. The committee re- viewed and accepted the following charge: The committee will undertake a consensus study to identify the types of and specific tax provisions that have substantial effects on the emission rates of carbon dioxide and other greenhouse gases, and to the extent pos- sible rank the magnitudes of those effects. The committee will first determine the most appropriate analytical frame- work and methodology to use in examining the effects of the tax code on greenhouse gas emissions. It will consider both provisions that may in- crease emission rates as well as those having the effect of lowering them over specific periods, and both direct (e.g., fuel-related provisions) and in- direct measures (e.g., the home mortgage deduction and the investment tax credit). Studying the tax code’s impact on GHG emissions, the committee will necessarily focus heavily on energy, both the life cycles of different energy sources and their uses in different sectors such as electricity gener- ation, transportation, industrial processes, and consumer uses (including in households). The study may extend to areas beyond energy, such as agri- culture, forestry, urban development, and other land uses which can have significant effects on GHG emissions. The study will not recommend particular new taxes or tax incentives or changes in existing provisions of the tax code but may outline principles and criteria for formulating climate-sensitive tax policy in the future. It may evaluate the efficiency and effectiveness of different tax measures in reducing GHG emissions relative to other policy instruments.

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Overview and Scope of the Study 13 STUDY CONTEXT: THE NATION’S ENERGY, FISCAL, AND CLIMATE-CHANGE DEBATES We begin with a brief discussion of the context in which the study takes place. The issues addressed in this report lie at the intersection of three major ongoing public policy debates—those concerning national energy policy, fiscal and tax policy, and climate change policy. In each of these areas there are major controversies about the goals of policy, the relative priority of objectives, and the tools or policies that are best suited to attain the objectives. Studying the tax code’s effects on GHG emissions necessarily focuses on energy use, because a preponderance of emissions comes in the form of CO2 released during the combustion of fossil fuels. The United States has struggled with energy policies for four decades, since the oil price shocks and embargo of 1973. With respect to energy policy, some of the major issues are: 1. What are the external costs of energy—that is, what are the costs of en- ergy use that are not reflected in market prices? 2. Should the nation take further steps to reduce the environmental and health damages from energy production and use, and, if so, which are the priority areas for policy? 3. What can be done to moderate the impact of higher energy prices and costs on consumers? 4. To what extent is security of supply a major concern, and in which en- ergy markets? 5. To what extent should environmental policy rely on market-based in- struments (such as pollution prices or taxes), and to what extent should the primary approach be regulatory standards? Tax policy affects the allocation of goods and services, the distribution of income, and the servicing of the public debt. Among the key issues facing the nation here are: 6. How should measures to slow the rise in the federal debt be appor- tioned between tax increases and expenditure reductions? 7. Is there a role for environmental taxes in the mix of revenue increases? 8. Should the government eliminate or expand tax subsidies for fossil fuels and tax subsidies for conservation and renewable energy? 9. Should the government consider the effects on greenhouse gas emis- sions in designing broader tax subsidies, such as tax incentives for in- vestment in machinery or tax subsidies for housing? 10. Is the use of earmarked taxes (such as the use of gasoline taxes to fund the highway trust fund) a sound approach to public finance? 11. To what extent should distribution of income impacts of the tax system be considered in its design or when proposing new tax provisions?

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14 Effects of U.S. Tax Policy on Greenhouse Gas Emissions Finally, the debate about climate-change policy has emerged more recent- ly, but has now joined debates about energy and tax policy on the national stage. Among the important questions here are: 12. What are future trends for climate change as well as the economic, hu- man, and ecological impacts of those? 13. What are the most effective policy instruments to implement climate- change policies? 14. How much should climate-change policy rely on revenue-raising ap- proaches, therefore contributing to deficit or tax reduction, compared to pursuing pure regulatory means? 15. Because climate change is a global problem, what approaches are best suited to implement policy on a multinational scale? The committee summarized its task in the following way: To what extent do provisions of the U.S. federal tax code—with special attention to tax provi- sions focused on the energy sector—contribute in a negative or positive way to slowing the pace of climate change by affecting greenhouse gas emissions? THE LINKAGES BETWEEN TAXES, ECONOMIC ACTIVITY, EMISSIONS, AND CLIMATE CHANGE The issues discussed in this report involve the interaction of the tax code with the economy and the resulting impact upon the emissions of greenhouse gases and on climate change. We begin by discussing the U.S. federal tax sys- tem and particularly those parts that we have studied in this report. We explain how the tax system affects economic activity and thereby affects the emissions of GHGs and other forces that affect the global climate system. Finally, we pro- vide a brief description of the scientific background on the role of emissions and other forces involved in changing climate. Sources and Structure of U.S. Tax Law and Tax Expenditures Sources of U.S. Tax Policy The U.S. tax system arises from several sources of authority. Tax legisla- tion embodied in the Internal Revenue Code (IRC) is the primary source. It out- lines the individual income tax, which is the largest source of federal revenue, along with corporate income tax and excise taxes. Court cases also define im- portant aspects of our tax system.3 Treasury regulations interpreting the IRC and other administrative guidance constitute the balance of tax authority. 3 For example, Eisner v. Macomber, 252 U.S. 189 (1920) and Commissioner v. Glen- shaw Glass, 348 U.S. 426 (1955).

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Overview and Scope of the Study 15 U.S. Tax Policy Structure, Function, and the Concept of Tax Expenditures The main function of the tax system is to raise revenues to finance gov- ernment operations and transfers. The choice of the level and structure of taxes also affects the stability of the economy, the distribution of household income, and medium- and long-term economic growth. Congress uses the tax system to promote social and economic goals through special tax reductions for some ac- tivities (called tax expenditures because they substitute for direct spending pro- grams) and revenue-raising or excise taxes on other activities. The key focus of this study is the last of these functions: how selected provisions of the tax code affect greenhouse gas emissions. While very few, if any, provisions in the tax code were explicitly, or as a matter of priority, de- signed to affect emissions, all provisions have at least an indirect impact. This study focuses on provisions meant to encourage or discourage activities that affect GHG emissions directly, especially energy-related activities, but also ex- amines broad-based provisions that may have an indirect effect. While the code primarily uses excise taxes as a means of discouraging se- lected activities (such as those imposed on the sale of highway motor fuels), tax rules can provide special tax benefits in a number of ways. For instance, the income from the activity may be excluded in whole or in part from taxable in- come, or tax may be imposed on the income at a preferential rate (i.e., a lower rate than for other income). Other provisions allow firms to deduct the capital costs of engaging in an activity in a single tax year instead of requiring the costs to be capitalized and recovered over the expected lifetime of the asset. Alterna- tively, the cost recovery deductions may be allowed on an accelerated schedule in comparison to the rate at which the asset declines in value. The code also pro- vides tax credits for specific activities. Tax provisions granting special treatment to certain activities are substitutes for direct government expenditure of funds to support those activities. Hence, such provisions are often called tax expendi- tures. The Congressional Budget Act of 1974 directed the newly established Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) to publish annual lists of tax expenditures and estimates of their revenue cost.4 The publication of an annual tax expenditure report for the U.S. Congress is now undertaken by the JCT. The Treasury creates an alternative set of calcula- tions with a slightly different methodology, published annually as part of the President’s budget documents prepared by OMB. Tax expenditures have contin- ued to grow over the period since they were first tabulated. The JCT estimates 4 Congressional Budget and Impoundment Control Act of 1974 [P. L. 93-344, Sec. 3(3)].

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16 Effects of U.S. Tax Policy on Greenhouse Gas Emissions that tax expenditures grew from roughly $380 billion in 1974 to $1,100 billion for fiscal year 2011.5 Methodology of Calculation of Tax Expenditures The Joint Committee on Taxation identifies tax expenditures as departures from a normative tax system and uses a specific method to compute expendi- tures.6 Under the JCT staff methodology, the normal structure of the individual income tax includes the following major components: one personal exemption for each taxpayer and one for each dependent, the standard deduction, the exist- ing tax rate schedule, and deductions for investment and employee business ex- penses. Most other tax benefits to individual taxpayers are classified as excep- tions to normal income tax law. Some scholars have criticized the JCT’s methodology, because it com- pares the tax system actually in place against a hypothetical and subjectively determined tax system (a “normal” tax system) that has never existed. (JCT, 2008). We still used JCT’s expenditure estimates in conjunction with estimates prepared by Treasury Department staff as an aid in deciding which IRC provi- sions to study for several reasons. JCT regularly computes and updates estimates and publishes details of its computational methodology. JCT’s estimates are widely accepted, including by Congress, and rarely differ to any great extent from the other widely available set of estimates produced by the Treasury De- partment. Further, the consulting firms that carried out the modeling work regu- larly employ JCT estimates when analyzing policies. Understanding the Link Between Taxation and GHG Emissions Understanding the mechanism by which the tax code affects greenhouse gas emissions is central to the analysis and findings of this report. This mecha- nism operates primarily through the way taxes affect the prices of goods and inputs. 5 The committee encourages readers to bear in mind that the Joint Committee on Taxa- tion warns that because of the nature of expenditure estimates there is limited value in using total expenditure estimates for any year. All figures are in 2012 dollars. Summation and conversion to 2012 dollars performed by National Research Council staff. Sources: The Staffs of the Treasury Department and Joint Committee on Internal Rev- enue Taxation. Estimates of Federal Tax Expenditures. JCS-11-75. July 8, 1975; Staff of the Joint Committee on Taxation. Estimates of Federal Tax Expenditures for Fiscal Years 2011-2015. JCS-1-12. January 17, 2012. 6 A detailed explanation of JCT’s methodology is contained in the annual tax expendi- ture report. See JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2011-2015 (January 17, 2012). The definition of normal income is from the JCT’s report for 2013.

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Overview and Scope of the Study 17 The Three Routes from Taxes to Emissions This study investigates the three major kinds of tax provisions. One set is excise tax provisions that apply to energy goods and services. Firms will pass on the cost of the excise taxes to consumers, raising the prices consumers pay. Thus, excise taxes on energy tend to increase the prices consumers pay, thereby decreasing consumption of energy. Less consumption generally means fewer GHG emissions, while more consumption would mean increased emissions. A second set of tax expenditures affects inputs into the production process. For example, the oil depletion allowance is a tax expenditure that reduces the costs of producing petroleum and thereby encourages domestic oil production. If the increased production lowers world oil prices, consumption of oil and associated GHG emissions will increase. Similarly, tax provisions that encourage firms to increase the amount of electricity produced from renewables, such as wind power, should decrease GHG emissions, as those sources either displace fossil-fuel- generating capacity or avert construction of new fossil-fuel-generating capacity. A final set of tax provisions, which we call “broad-based provisions” in this study, presents greater challenges. These include those that favor employer- provided health care, the deduction for home mortgage interest, and accelerated depreciation. The mortgage interest deduction, for example, lowers the cost of owner-occupied housing. This will increase housing consumption compared to consumption of other goods and services. If the increased emissions associated with housing are greater than the reduction in emissions from the goods dis- placed by the increased housing, then overall emissions would increase. Similar- ly, if increased housing consumption displaces more GHG-intense consumption, then these expenditures would lower overall emissions. Figure 1-1 provides a schematic of how taxes affect GHG emissions. It shows that CO2 and other GHGs are the outcome of a complex set of factors, of which tax provisions are just one. General Equilibrium Considerations One further issue must be considered in analyzing the effects of tax provi- sions. This is the “general equilibrium” impacts of tax changes. The idea is that we need to account for the fact that industries and households cannot be consid- ered in isolation. When a tax provision affects one industry, it will also have effects on others. For example, suppose that increasing the gasoline tax lowers the quantity of gasoline consumed, thereby changing GHG emissions from gasoline use. But the changes do not stop with the gasoline market. If the dollar value of gasoline

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18 Effects of U.S. Tax Policy on Greenhouse Gas Emissions Input prices (wages, interest rates, …) Prices of goods, services, and inputs Market infrastructure: Quantities of Markets for inputs and Regulations, goods, services, outputs mandates, … and inputs Tax provisions (gasoline tax, oil depletion CO2 and other allowance, production greenhouse gas credits,…) emissions FIGURE 1-1 Schematic representation of how taxes affect GHG emissions through the market. expenditures goes down, that will free up income for spending in other sectors. There will be secondary effects on output of goods and services in other sectors, depending on the impact on real wages, relative prices, and other factors. So we also need to consider the GHG emissions that arise from these ripple effects outside the gasoline sector. These ripple effects are called the “general equilibri- um effects” of changing taxes. Following this example further, perhaps people decide to fly rather than to drive (assuming the tax increase excludes aviation fuel). But air travel has rela- tively high GHG emissions as well, so there would be some offset to the reduc- tion in the emissions from the gasoline sector by increases in GHG emissions in the airline sector. A complete analysis would incorporate all the sectors. The analysis should ideally also include effects in the rest of the world, since climate change is a global phenomenon, and because GHG emissions anywhere—not just in the United States—will affect future climate change. In other words, gen- eral equilibrium principles mean that a proper analysis must account for each sector in the entire economy, and in some cases the global impacts, in order to obtain a reliable estimate of GHG impacts. Global focus of the impacts A final reminder is that the focus of this study is ultimately on the global totals for consumption, production, and greenhouse gas emissions. While the charge was to examine the U.S. tax code, the impacts of the code are not limited to the U.S. borders. The U.S. tax system affects foreign as well as domestic pro-

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Overview and Scope of the Study 19 duction and consumption. Some provisions directly affect foreign economic activity through impacts on prices, exports, imports, or financial markets. Others have influences because the markets – such as petroleum or grains – are global in nature, so changes in domestic supply or demand spill over to other countries. Still others affect trade flows through tariffs and quotas. Some of the models used by the committee contain a full set of global linkages, and others are lim- ited to U.S. production and consumption. While our analyses do not include every provision that affects global economic activity, the aim of the present re- port is to assess the impacts of the main provisions of the tax code that affect global greenhouse gas emissions. The Link from Emissions to Climate Change Although this report focuses primarily on the impact of the tax system on emissions of CO2 and other greenhouse gases, Congress’s ultimate concern in requesting this study is not with these gases per se, but with their impact on earth systems such as climate and also the health of oceans and biological sys- tems. We conclude this chapter with a brief synopsis of the link from emissions to climate change and other earth systems to provide readers with a context for the discussion of the relationship between tax policy and GHG emissions. This discussion is based on the findings of many earlier peer-reviewed studies by the National Research Council, the United Nations Intergovernmental Panel on Climate Change, and a large body of research from scientific and academic in- stitutions around the world. Each major study has concluded human-caused cli- mate change is a real phenomenon well established by current knowledge about earth sciences.7 Scientists have established with high reliability that the basic aspects of global warming are taking place. We know from direct measurements of tem- perature that Earth’s global mean surface air temperature has increased over the past century (IPCC, 2007). We know from direct measurements of atmospheric gases that greenhouse gas concentrations have also increased, and that this in- crease has been due primarily to emissions from human activities (IPCC, 2007). And we know that the observed global warming is consistent with the observed increase in greenhouse gas concentrations, but not with the background noise in the climate system, nor with changes in natural phenomena that can change Earth’s climate, such as solar output, volcanoes, and Earth’s orbital variations (IPCC, 2007; and Santer et al., 2013). While all measurements have some uncer- tainty, each of the above conclusions is an established scientific fact. 7 See National Research Council, 1979, 1983, 1992, 2002, 2010, and 2011 for some of the most important NRC reports. Other important surveys are the Intergovernmental Panel on Climate Change, 1990, 1996, 2002, and 2007.

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20 Effects of U.S. Tax Policy on Greenhouse Gas Emissions Greenhouse Gases and Earth’s Energy Balance Greenhouse gases are necessary for life as we know it on Earth. Indeed, if Earth had no atmosphere to absorb a portion of the energy radiated out due to the heating of the Earth’s surface, the surface temperature would be approxi- mately -18°C (Kasting and Catling, 2003), well below the freezing point of wa- ter. However, Earth’s surface receives energy input not only in the form of short-wave radiation from the Sun but also in the form of long-wave radiation that is radiated from the atmosphere back down to Earth’s surface. Calculating the energy balance for Earth with this atmospheric “greenhouse effect” shows that greenhouse gases are responsible for elevating and maintaining Earth’s sur- face temperature from well below the freezing point of water to the mild and habitable global mean surface temperature of approximately 15°C that is ob- served at present (Kasting and Catling, 2003). The potency of these greenhouse gases arises from the fact that they are essentially transparent to short-wave radiation but absorb a substantial fraction of long-wave radiation. As a result, short-wave radiation emitted from the Sun passes through these gases, while long-wave radiation emitted from Earth’s sur- face is partially absorbed, providing additional energy input to Earth’s surface. Thus, although greenhouse gases are present only in trace amounts in the atmos- phere, they have a substantial influence on Earth’s surface temperature. Observed Changes in Greenhouse Gas Concentrations Greenhouse gases include water vapor, carbon dioxide, methane, nitrous oxide, and fluorinated gases such as the hydrofluorocarbons that are used as refrigerants in appliances such as refrigerators or air conditioners. While some greenhouse gases have natural sources, many greenhouse gases are also emitted by human activities, including carbon dioxide emissions from combustion of fossil fuels, nitrous oxide emissions from agricultural fertilizer use, and methane emissions from leaks in natural gas pipelines. Analysis of the atmospheric chem- istry of gases indicates that the atmospheric concentration of many greenhouse gases has been increasing since the start of the industrial revolution (around 1750), and that human activities are primarily responsible for that increase (IPCC, 2007). The U.S. Environmental Protection Agency tracks emissions from differ- ent sources in the United States and reports them annually in its Greenhouse Gases Inventory (EPA 2010). These are combined using a formula for “carbon dioxide equivalence,” which estimates each compound’s effect on the Earth’s energy balance over a 100-year period. In 2010, U.S. greenhouse gas emissions were 84 percent carbon dioxide, 10 percent methane, 4 percent nitrous oxide, and 2 percent fluorinated gases using this CO2-equivalent. For 2010, 34 percent were from electricity production, of which 70 percent is supplied by fossil fuels; 27 percent from transportation, of which 90 percent is supplied by petroleum-

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Overview and Scope of the Study 21 based fuels; 21 percent from industry, including both energy consumption and industrial chemical reactions; 11 percent from commercial and residential activi- ties such as building heating and cooling; and 7 percent from agriculture, includ- ing methane from livestock and nitrous oxide from fertilizer application and other practices. In addition, land use and forestry, which can act as a source or sink of CO2, has been a net sink in the United States, offsetting about 15 percent of U.S. emissions in 2010. Given these contributions, the committee must con- sider a suite of different gases, not just CO2, and different economic activities in order to meet its charge. Global Warming: Observed Changes in Earth’s Surface Temperature and Potential Impacts of Continued Global Warming Scientists have reconstructed measures of the global mean surface temper- ature based on instrumental records. Global mean surface temperatures have increased over the past century by about 0.8°C, most rapidly over the past four decades (IPCC, 2007). Independent analysis by several research groups from multiple countries reveals very similar calculations of global-scale temperature change over the past century (IPCC, 2007). Earth’s climate has changed dramatically over geological history (IPCC, 2007), and an important question involves the role of human factors in recent warming. Climate scientists estimate the impacts of greenhouse gases on past and future climates using computerized numerical climate models. These have been developed over more than a half-century using well-established physical laws, such as the laws of conservation of momentum, mass, and energy, as well as based on detailed representations of the Earth’s geography. Climate models have been validated by comparing model calculations with the observed climate record. Thus, scientists can use the models to make hypotheses about the strength of background noise in the climate system, as well as how climate re- sponds to changes in factors such as increased concentrations of greenhouse gases, volcanic eruptions, and the strength of solar output. Comparisons of mod- el calculations and historical data indicate that the observed magnitude and pat- tern of warming in the atmosphere and ocean are not consistent with the back- ground noise in the climate system, nor with observed changes in solar output or volcanic eruptions, but are consistent with measured anthropogenic increases in atmospheric greenhouse gas concentrations (IPCC, 2007; and Santer et al., 2013). Although the cause of recent and rapid climate change cannot be directly observed, the many published studies of detection and attribution show that hu- man activities are the predominant reason for observed global warming, and for a number of related observed climate changes. Model calculations consistently show that further increases in global greenhouse gas concentrations are virtually certain to cause further global warming. Model experiments also show that re- gional climates are highly likely to change in response to this global warming.

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22 Effects of U.S. Tax Policy on Greenhouse Gas Emissions Most model runs indicate that a future with higher greenhouse gas concentra- tions will be one with more energy in the atmosphere, likely leading to changes in regional climates, increasing occurrence of extreme hot events, increasing intensity of precipitation, increasing lengths of dry spells, and decreasing snow- pack (IPCC, 2012 and IPCC, 2007). THE CLIMATE CONTEXT OF THE COMMITTEE’S CHARGE The robust scientific understanding of the connection between greenhouse gas emissions, global warming, and regional climate change provides the broad context for the committee’s charge. The contribution of increasing atmospheric concentration of greenhouse gases to Earth’s changing climate is well under- stood, as is the connection between a changing global climate and many of the changes in regional climate, including changes in the frequency and magnitude of extreme weather events. The well-established climate changes that have al- ready occurred—and those that are likely to occur in the future should green- house gas concentrations continue to rise—motivated the congressional direc- tion to undertake this study, and thereby provide the context in which the committee has executed its charge.