Back to the Future? Lessons from the Tax Reform Act of 1986

September 28, 2012

This was originally published as an Issue Paper for the Center for the Study of the Presidency & Congress.

Fifteen hundred people gathered on the sunny South Lawn of the White House on the morning of October 22, 1986. Flanked by legislators from both parties, President Reagan picked up a pen and signed the Tax Reform Act into law. Up until that moment, even after the bill passed 292-136 in the House and 74-23 in the Senate, the pundits and lobbyists said it could never happen. This sentiment was captured by the headline in The Washington Post: “The Impossible Became the Inevitable.” The top tax rate of 50% was cut nearly in half, tax brackets were indexed for inflation, many credits and deductions were stamped out, and a sense of fairness and even a bit of simplification returned to the tax code.

As we enter 2013, the prospects for tax reform are again in the headlines. Election year discussions of Warren Buffett’s secretary’s tax rate, Mitt Romney’s ungettable 47 percent of nonpayers, and growing offshore tax avoidance are evidence of growing awareness of the complexity and inequity of the individual income tax. On the corporate tax front, a rate reduction by Japan has left American corporations now paying the highest corporate income tax rate in the industrialized world, while American corporations overseas pay a tax their competitors don’t have to pay and effective tax rates are among the highest.

At the same time, the lobbying power of interests behind the deduction for mortgage interest, the deduction for state and local taxes, the exclusion of employer health care expenses, education credits, and other tax preferences stand strong, convincing Americans that they benefit from more than they actually do from these deductions and credits. Economists nearly uniformly criticize such deductions and credits for their distortions to decision-making and drag on economic growth. Those on the left rightly point out that the deductions and credits primarily benefit high-income taxpayers, reducing their tax bills in some cases below middle-income households. Those on the right rightly point out that lower tax rates without these loopholes would raise as much or even more revenue.

This debate echoes that of thirty years ago, when anyone with investment income who didn’t want to pay taxes could essentially figure out a way not to. Despite (or perhaps because of) a top income tax rate of 70 percent (until 1981) and then 50 percent, taxpayers made great use of tax-free investment shelters. Ski vacations were tax-deductible business seminars, attending baseball games were deductible business meetings, wages somehow became tax-deductible real estate investments, and investments that produced (deductible) losses were valued more than investments that produced (taxable) gains. Public anger rose each year at corporations earning lots but paying nothing and millionaires earning lots and paying nothing, while every new tax law in Congress added more and more credits and deductions. Then, as now, many people said tax reform was a nice idea but less important than the need to reduce the deficit and tackle dozens of other political priorities.

So how did the 1986 tax reform happen? Who made it happen?

President Reagan was of course a key player. This itself was surprising, as he long held the attitude that anything that got money out of Washington and back in taxpayer’s hands was good, whether it be through tax rate reductions or deducting mortgage interest or corporate tax incentives. However, remembering his days as an actor limiting his work to avoid the then 90 percent top tax bracket, Reagan was determined to cut that top tax rate any way he could.

Treasury Secretary Don Regan, craving the spotlight and instructed to put together a plan from Reagan’s 1984 campaign pledge to study tax system reform, put together a small group of tax experts who set out to design a system freed of unjustifiable tax preferences. While Regan’s team gleefully “slayed dragons,” as they put it, they kept a few loopholes for political reasons that remain with us today: mortgage interest, capital gains on home sales, IRAs, and business meals. Everything else went, however, to produce a top tax rate of 35 percent.

Regan’s revolutionary plan likely would have sat gathering dust were it not for the job switch he engineered with White House Chief of Staff Jim Baker for unrelated reasons in January 1985. Regan now marshaled the White House to get behind the plan, while Baker brought his political acumen to getting the plan in front of Congress. Soon, the plan was framed as favored tax breaks for the few versus a fair tax system that applied to everyone. Republicans felt pressure to get behind their party’s President, while Democrats were eager not to be outflanked by Ronald Reagan on making the tax code fairer by eliminating tax breaks for the powerful. (Senator Bill Bradley (D-NJ) especially emphasized this point in his leadership on tax reform.)

House Ways & Means Committee Chairman Dan Rostenkowski (D-IL) and Senate Finance Committee Chairman Bob Packwood (R-OR) were reluctant heroes, to say the least. Their positions of power came from their past willingness to make the tax code the grab bag of special interests. Rostenkowski pledged his support quickly, determined to get ahead of both the Republicans and Senate Democrats. “[M]ost of us pay taxes with bitterness and frustration,” he told a May 1985 television audience. “The continued escape of privileged groups from taxation violates the fundamental democratic principle of fair treatment for all and undermines public confidence in the tax system.” Rostenkowski urged viewers to send him letters of support for tax reform that he could show his colleagues (“Just address it to ROSTY, Washington, DC. The post office will get it to me.”); 75,000 did.

Rostenkowski’s committee was harder to persuade. Many members cherished individual tax provisions and were buttressed by arguments (and campaign donations) from well-dressed lobbyists. (The hallway outside the Senate Finance Committee was nicknamed “Gucci Gulch.”) New Yorkers fought successfully to keep the deduction for state-local taxes paid, effectively a subsidy for their high state taxes. A number of other tax provisions poured back into the bill, while less politically popular ones (especially oil and gas) were struck. The somewhat disappointing effort even initially died in a House vote in December 1985, before President Reagan personally visited House Republicans to ask for their support and it passed on a repeat vote.

Packwood, who had watched tax reform with indifference, now had the hot potato thrown into his hands. Trying to stop it risked the ire of the President and the label of putting special interests ahead of the national interest, just ahead of his 1986 re-election (including a primary challenge). Packwood took his committee to a retreat in January 1986, and asked each member to list their top priorities for tax breaks to keep. He hoped that everything else could then be jettisoned, and the savings used to lower rates.

Unfortunately, frustration mounted as tax breaks began mounting in the bill beyond the current system. “I discovered that if they have priorities one, two, and three, and you give them one, two, and three, then four, five, and six become their most important priorities,” Packwood lamented to Jeffrey Birnbaum and Alan Murray, authors of Showdown at Gucci Gulch. In April 1986, Packwood canceled markup on the bill after it became clear that every tax credit and deduction had the votes to make it back in. The bill was dead, again.

The phoenix rose again over beers at Irish Times, a bar a short walk from the Capitol. Packwood, always a bit of renegade, had been thinking about the answers he got to a question he had been asking witnesses: at what tax rate would deductions not matter anymore? He had deduced a 25 percent tax rate would be about that level, so he asked his aide to work with the Joint Committee on Taxation to come up with a plan that got rid of everything and set a 25 percent top rate, while keeping it revenue-neutral and distributionally-neutral. His colleagues were initially cautious, and some tax breaks made it back in, but the dramatic plan did what it intended. On May 3, the plan passed the Senate Finance Committee unanimously.

Most lobbyists now cut their losses, determined to get the Senate plan rather than the House plan, and rather than continuing to fight reform. The first key vote on the Senate floor was an amendment to change IRA treatment; Packwood and his allies fought off this effort 51-48 in part by agreeing to allow taxpayers in states with no income tax to deduct sales taxes paid from their federal taxes. Knowing that any change risked unraveling the whole bill, allies stuck together to defeat each amendment and passed the whole thing 97-3 on June 24, 1986. After a summer of conference committee sessions, a determined Packwood, Rostenkowksi, and Baker put together a mutually agreeable package.

It wasn’t perfect. Corporate tax rates went up, large banks lost their bad debt deduction, and the capital gains rate went up sharply. The top rate came down to 28 percent, but surtaxes hiked that to 33 percent for some taxpayers. Some of the more popular deductions stayed, despite their benefits going primarily to high-income taxpayers; however, this is more an issue of unfinished work than a failing. And while tax rates have crept back up and some loopholes have crept back in– it’s a kind of tango that keeps effective tax rates flat and belies any effort to hike tax rates to where they were pre-1986. The effort wasted on tax compliance and tax structuring has been reinvested in more productive avenues, contributing to a lengthy period of sustained economic growth.

A new generation of leaders now runs Washington. While the heroes of 1986 can be lionized, they had the same foibles and interests and partisan squabbles as we have today. (Reagan, Packwood, and Rostenkowski would all soon be embroiled in respective scandals.) The stars aligned for the Tax Reform Act of 1986, although it had to die and be resurrected several times along the way before its triumph. Fairness, complexity, economic growth, and special interests: the issues remain the same and the answers remain the same. The impossible can happen again.

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