The 1986 Tax-Reform Law: Lessons for Today's GOP

The Republican candidates want to overhaul the nation's tax system. What they—and you—need to know first.

The Republican presidential candidates all want to overhaul the nation’s tax system by lowering individual income-tax rates and eliminating preferences such as deductions and credits. This is a good idea. The current tax system is a mess, and it’s tailor-made for people with a knack and capacity for gaming the system. The top marginal rate of 39.1 percent creates an incentive for the wealthy to shelter income, and the tax code gives them ample opportunity to do so. The result is widespread economic decision making that is inefficient and retards savings and investment. So, the argument goes, reduce the rates and eliminate those preferences. Scraping off those barnacles will enable the ship of state to move much more smoothly through the water.

Some of the GOP candidates advocate a single flat rate—9 percent from former businessman Herman Cain; 20 percent from Texas governor Rick Perry; 15 percent from former House speaker Newt Gingrich. Others want a number of rates, but at lower levels—unspecified thus far in the case of former Massachusetts governor Mitt Romney and Minnesota Rep. Michele Bachmann; 8 percent, 14 percent and 23 percent in the case of former Utah governor Jon Huntsman.

In the course of the campaign discussion, frequent reference has been made to the tax overhaul measure enacted by Congress at the urging of President Ronald Reagan in 1986. That is altogether apt, as that was a seminal piece of legislation. But few have looked back on that episode with enough detail to glean lessons for our own time. And there are many.

Reagan pushed the idea during his 1984 reelection campaign, and upon winning he instructed the Treasury Department to fashion a draft proposal. Treasury’s plan called for three brackets—15 percent, 25 percent and 35 percent (compared to 14 brackets and a top rate of 50 percent in the existing law). It sought to align capital-gains taxes with individual rates but to also eliminate a host of individual and corporate tax breaks. It advocated reducing the corporate rate to 33 percent from 46 percent. It also wanted to nearly double the personal exemption to $2,000 and otherwise expand tax preferences for lower-income Americans in ways that eliminated many such people from the tax rolls.

Immediately it was seen as a radical proposal that would create powerful new fault lines in American politics. One business lobbyist, Jack Albertine, told the Wall Street Journal, “This proposal unleashes political crosscurrents all over the place.” Among Republicans, it created a three-way split among supply-side advocates of lower tax rates, business advocates of corporate-tax incentives and fiscal conservatives fixated on balanced budgets. As one prominent supply sider, New York Rep. Jack Kemp, said at the time, “I’m not sure it’s a minus to have business against you.” That was a remarkable statement for a Republican.

But this intraparty feistiness melted after the Democratic House Ways and Means Committee got its hands on the bill. The Democrats kept most individual tax preferences in place while going after business preferences. The top rate went up to 38 percent. The $2,000 personal exemption was cut back. Essentially, committee chairman Dan Rostenkowski took Reagan’s idea and turned it into a Democratic showcase.

House Republicans, now furiously opposed to the very concept, refused to vote for the bill. When it got to the floor, Reagan had to lobby personally to get his party people to buy the argument that it could be cleaned up in the Republican-dominated Senate. He got the bill, but hardly anyone in the GOP liked it, and Democrats remained seriously divided on whether it was a good idea.

When it got to the Senate, Finance Committee chairman Bob Packwood of Oregon could see that he was in a hopeless bind. His mandate was to close enough tax breaks to bring the top individual rate down to 35 percent, but there simply wasn’t enough support for this loophole-closing exercise to get even close to the goal. Soon the committee actually found itself increasing the generosity of various tax breaks under pressure from lawmakers. Rhode Island’s Democratic Sen. John Chafee declared, “We are sliding deeper and deeper into the abyss.”

That’s when Packwood and a top aide, nursing their frustration during a lunch that featured two pitchers of beer, crafted what they called the “radical approach”—going for a top rate of only 28 percent as an incentive to clear away opposition to eliminating tax preferences. As Jeffrey H. Birnbaum and Alan S. Murray later wrote, “Hunched over their sandwiches, they were plotting to take hundreds of billions of dollars out of the pockets of those who had made heavy use of tax loopholes and bestow those billions on everyone who had not.” If rates were that low, they calculated, people wouldn’t care so much about their deductions and credits.

This was remarkable coming from Packwood, who for years had advocated using the tax code to push favored patterns of behavior among Americans and who earlier had suggested accelerated write-off schedules for certain kinds of assets deemed important to the nation. So, for example, telephone communications equipment would be in the special class; telephone switching equipment wouldn’t. Petroleum drilling equipment would be in; computers wouldn’t. Autos used by businesses in favored categories would be in; all other autos wouldn’t. This was precisely the kind of policy making the tax proposal was designed to kill, and now Packwood was opting for an entirely different attitude designed to kill as much of it as possible in order to slash rates.