HOW THE TAX REFORM OF 1986 SUPERCHARGED THE AMERICAN ECONOMY
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1 HOW THE TAX REFORM OF 1986 SUPERCHARGED THE AMERICAN ECONOMY By Marc Kilmer 12/20/14 In 1986, something remarkable happened: President Ronald Reagan and members of Congress from both parties came together to enact tax reform. Too often in Washington (and in state capitals), reform is simply a label that disguises a giveaway to special interest groups. Not in this case. Instead, this tax legislation actually made the tax code better. It eliminated many loopholes that benefited special-interest groups and lowered tax rates. It was a victory both for those who wanted the tax code to encourage economic growth and for those who wanted the tax code to treat taxpayers more equitably. Today s policymakers at both the state and federal level would do well to look at the example of the 1986 tax reform and enact something similar. Why the 1986 Tax Reform Was Needed In 1984, President Ronald Reagan called for fundamental tax reform during his State of the Union Address: Let us go forward with an historic reform for fairness, simplicity, and incentives for growth. I am asking Secretary Don Regan for a plan for action to simplify the entire tax code so all taxpayers, big and small, are treated more fairly. And I believe such a plan could result in that underground economy being brought into the sunlight of honest tax compliance; and it could make the tax base broader, so personal tax rates could come down, not go up. 1 Prior to 1984, President Reagan had already signed tax reform legislation. Thanks to his efforts, the top marginal tax rate had been reduced from 70% to 50%. This tax cut resulted in more economic growth, and by 1984 the nation was experiencing a booming economy. By reducing the tax penalty to earn more money, the Reagan tax cuts encouraged people to work more and grow the economy. However, President Reagan and many conservatives still thought a top marginal tax rate of 50% was too high. A lower rate would encourage more economic growth by letting Americans keep even more of the money they earn. (continued on other side)
2 Liberals were also making the case for tax reform. Chief among them was then-senator Bill Bradley, Democrat of New Jersey. In 1982, Sen. Bradley introduced legislation that would have closed loopholes and reduced tax rates. In a speech introducing this bill, he said, We should have a tax code in which all citizens with equal incomes are treated essentially the same way. We should have a tax code which allows taxpayers to make their economic decisions on the basis of real value in the marketplace with little, if any, regard for tax implications. 2 The liberal case for tax reform centered on eliminating loopholes. Throughout its existence, the tax code has been repeatedly amended to give breaks to special groups. Politicians rewarded certain economic behavior by removing or reducing taxes on it. As Senator Bradley pointed out, by 1986 many taxpayers made their decisions on the basis of tax implications instead of real value in the marketplace. This created an economy in which taxpayers of similar incomes could be required to pay vastly different amounts in taxes, depending only on the type of economic activity they were engaged in. Some corporations, in fact, paid little or no taxes through a skillful manipulation of the tax code. What the 1986 Tax Reform Did 3 One of the main provisions of the 1986 tax legislation accomplished conservatives goal: it lowered marginal tax rates. The other main provision of the bill accomplished liberals goal: it eliminated some tax loopholes and reduced the effect of others. Tax Rate Reduction This legislation dramatically lowered and simplified individual income tax rates. Prior to the reform, married individuals and heads of households faced 14 tax brackets. Single taxpayers faced 15. The maximum rate was 50%. The 1986 tax reform legislation reduced the number of tax brackets to two: a 15% rate and a 28% rate. It also increased the amount an individual could claim in personal exemptions. The new rates and exemptions were adjusted for inflation. Tax Loophole Elimination and Reduction
3 While the legislation did not touch many popular tax deductions, such as the mortgage interest deduction, it did eliminate other deductions and credits. Among these were deductions for state and local sales tax payments, business meals and travel deductions, entertainment deductions, the political contribution tax credit, and a variety of specialized business tax credits and deductions. The law also tried to put an end to tax shelters that high-income taxpayers had used to shelter their income from taxation. These tax shelters funneled investors money into financial deals that were designed to minimize taxes, not produce the best economic return. As journalists Jeffrey Birnbaum and Alan Murray describe, they caused significant economic distortion: These new tax schemes drastically altered the economics of the real estate business, making it possible for developers to build new office buildings even if the demand for office space was not strong. So-called see-through office buildings structures with few tenants became commonplace in cities like Houston, where the real estate market was driven by the desire for tax-sheltered investments rather than by the need for office space. 4 By attempting (though not wholly succeeding) to curtail these tax shelters, Congress sought to end these types of economically wasteful practices. The Effects of Reform In 1987, the Congressional Joint Committee on Taxation summed up the aims of Congress in enacting this reform legislation: The sharp reductions in individual and corporate tax rates provided by the Act and the elimination of many tax preferences will directly remove or lessen tax considerations in labor, investment, and consumption decisions. The Act enables businesses to compete on a more equal basis, and the business success will be determined more by serving the changing needs of a dynamic economy and less by relying on subsidies provided by the tax code. 5 This is what happened. As economist Martin Feldstein concludes in his analysis of this tax reform legislation, taxpayers responded to lower marginal tax
4 rates and fewer loopholes by increasing their income. This is especially pronounced for higher-income taxpayers: Taxpayers who faced a marginal tax rate of 50% in 1985 had a marginal tax rate of just 28% after 1986, implying that their marginal net-of-tax share rose to 72% from 50%, an increase of 44%. For this group, the average taxable income rose between 1985 and 1988 by 45%, suggesting that each 1% rise in the marginal net-of-tax rate led to about a 1% rise in taxable income. 6 Multiple researchers have found that marginal tax rate cuts, including those made in the 1986 tax reform, result in more hours worked or a higher work effort. 7 In other words, people work, save, and invest more when they are allowed to keep more of their own money. These activities grow the economy and create jobs. The evidence from the 1986 tax reform shows that lowering tax rates and eliminating loopholes does indeed stimulate new economic activity. Furthermore, not only did the tax reforms of 1986 increase economic activity, they also produced more revenue for the federal government. According to U.S. Treasury figures, the 1986 tax reform legislation produced an additional $18.6 billion in revenue in its first year of enactment. That s an increase of 2.3% in federal receipts due to this legislation. 8 Why We Need Reform Today Looking back nearly 30 years after this tax reform, the triumph of sensible tax policy over special interest politics was brief. A variety of tax legislation signed into law by both Republican and Democratic presidents has restored various loopholes, created new ones, and raised tax rates. The tax code today bears little resemblance to the tax code that resulted from the 1986 legislation. During a 2010 Senate Finance Committee hearing, Committee Chairman Max Baucus noted that since 1986, Congress has made more than 15,000 changes to the code. He also pointed out that Once again, just as in the 1980s, many can largely avoid paying taxes if they know how to manipulate the code. A long list of deductions, credits, and exclusions is available to help avoid taxation. 9 According to the Congressional Budget Office (CBO), over 200 of these deductions, credits, and exclusions can be termed tax expenditures. These are
5 provisions in the tax code that resemble federal spending by providing financial assistance to specific activities, entities, or groups of people. Tax expenditures, like traditional forms of federal spending, contribute to the federal budget deficit; influence how people work, save, and invest; and affect the distribution of income. Of these more than 200 tax expenditures, 10 are so large that they totaled 5.7% of Gross Domestic Product (GDP) in Along with introducing new tax deductions, credits, and exclusions, lawmakers have also raised marginal tax rates. Five years after the 1986 tax reform, President H. W. Bush and Congress introduced a 31% tax rate. In 1993, President Clinton and Congress imposed two higher tax rates: 36% and 39.6%. President George W. Bush and Congress temporarily lowered the highest tax rate to 35%, but also introduced a new tax rate at the lowest income level. With the expiration of the Bush tax cuts, the highest rate returned to 39.6%, and there are now 7 different tax rates. 11 Tax reform that would reduce the largest tax reductions and credits in exchange for lower income tax rates could cause a significant change to our tax code. In one scenario modeled by the Tax Foundation, such a plan could result in a reduction in individual income tax rates of one-third. This scenario also predicted that the GDP would grow by $10 billion. The Tax Foundation concluded, Pruning back tax expenditures could if done wisely pay for spectacular reductions in income tax rates and fuel economic growth. 12 While the need for tax reform at the federal level is clear, the need for similar reform at the state level is just as urgent. While the Arkansas state tax code does not have the reach of the federal tax code, it does have some of the same problems. By lowering marginal tax rates, consolidating the state s income tax brackets, and reducing the number of tax loopholes and expenditures, Arkansas lawmakers could duplicate the positive effects America saw from the 1986 tax reforms. As the nation s experience with that tax reform showed, the state s economy would grow after the enactment of this type of tax reform. Conclusion The 1986 tax reform legislation was not perfect. But it was remarkable for many reasons. It united both liberal and conservative notions of tax reform in ways that both advanced tax fairness as well as economic growth. It was bipartisan legislation, proposed by a Republican White House but largely pushed through
6 Congress by Democrats. It overcame the strong opposition of special interest groups which had spent decades convincing lawmakers to overload the tax code with giveaways for their narrow constituencies. In the end, this legislation reformed the tax code in ways that caused greater economic growth. Unfortunately, this success did not last long. The tax code today needs the type of revisions we last saw in The Arkansas tax code could also benefit from similar revisions. As the aftermath of the 1986 tax reform shows, this would be the most effective way for lawmakers at either the state or federal level to grow our economy. Marc Kilmer is an analyst with the Advance Arkansas Institute. 1 Birnbaum, Jeffrey and Alan Murray, Showdown at Gucci Gulf: Lawmakers, Lobbyists, and the Unlikely Triumph of Tax Reform, Random House, p Ibid, p General Explanation of the Tax Reform Act of 1986, Joint Committee on Taxation, May 4, Birnbaum and Murray, p Ibid. 6 Feldstein, Martin, The tax reform evidence from 1986, The Wall Street Journal. October 24, / 7 Mitchell, Daniel, Taxes, Deficits, and Economic Growth, The Heritage Foundation, May 14, Tempalski, Jerry, Revenue Effects of Major Tax Bills, U.S. Treasury, September Committee on Finance of the United States Senate, Tax Reform: Lessons from the Tax Reform Act of 1986, September 23, The Distribution of Major Tax Expenditures in the Individual Income Tax System, Congressional Budget Office, May 29, U.S. Federal Individual Income Tax Rates History, (Nominal and Inflation- Adjusted Brackets), The Tax Foundation, October 17, Schuyler, Michael, The Effects of Terminating Tax Expenditures and Cutting Individual Income Tax Rates, The Tax Foundation, September 30,
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