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.
It worked. The final legislation had a top rate of 28 percent for most taxpayers, with capital-gains rates pegged to individual rates. The personal exemption went to $2,000, while the standard deduction went to $5,000 from $3,670. Numerous tax preferences, mostly for business, were curtailed or eliminated.
As Birnbaum and Murray wrote, “To those who had grown accustomed to abusing the tax system and its many chinks and loopholes, it dealt a heavy blow, but to those who paid their taxes each year without taking advantage of the long lists of deductions, exclusions, and credits, the tax plan offered a hefty bonus.” They called the legislation “the rough-hewn triumph of the American democratic system.”
But almost immediately Congress began chipping away at it. Capital-gains taxes were reduced below individual rates, thus setting up a powerful incentive for people to make financial decisions based on tax advantage rather than investment considerations. The rates slowly rose, while new preferences were added. Revenue-raising efforts during the Clinton years invariably went after upper-income Americans while taking more and more citizens off the tax rolls. Though simplified by the 1986 law, the tax code became steadily more complex.
And so we now have today’s mess, which every Republican presidential aspirant has sought to address in one way or another. So what are the lessons of the 1986 experience?
First, tinkering with the current code won’t work. It’s too complex, too much a jumble of competing and interlocking incentives fostering behavior that thwarts smooth economic activity. Rates will have to be reduced substantially while deductions and credits will have to be reduced or eliminated in like manner. Second, a flat tax won’t work. It’s inherently unfair, putting too much of a burden on lower-income Americans. This is particularly true if tax reform is to address a fundamental problem with the current system—the fact that more than half of all tax filers don’t pay any income tax. Among the GOP contenders, only Bachmann has addressed this reality. She says everyone (presumably above the poverty line) should contribute to the common weal through the tax code, even if nominally in the case of low-income Americans. It’s a fair point. It isn’t healthy to have a system that fosters a class of citizens exempt from the most widespread instrument of civic contribution. Everyone should contribute at least a little—and take pride in it as one of the responsibilities that comes with our hallowed system of freedom. But any flat rate that could generate sufficient revenue for the government would necessarily impose rates on the working poor that would be too high.
Further, a truly effective tax system must eliminate disparities in tax rates—between individual levies, for example, and capital-gains taxes—that distort economic decision making. Conservatives don’t like this because in most cases the money that generates capital gains had already been taxed when earned. Thus, they argue, even small capital-gains taxes thwart economic growth. Fair points. But true tax reform must neutralize economic decision making as much as possible.
Finally, no tax-reform effort will ever work unless the country truly gets behind it. The tragedy of 1986 was that lawmakers began chipping away at it even before it had had much of a chance to work. Somehow that congressional penchant for tinkering and intruding into the economy will have to be curbed. Otherwise, the effort will be for naught, as it was the last time. And all the campaign rhetoric on the issue will have been an exercise in futility.
Robert W. Merry is editor of and the author of books on American history and foreign policy.