THE MECHANICS OF THE TAX REFORM TRIUMPH OF 1986: A ROADMAP TO PROSPERITY

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1 THE MECHANICS OF THE TAX REFORM TRIUMPH OF 1986: A ROADMAP TO PROSPERITY By Marc Kilmer 12/09/14 In 1986, Democrats in Congress worked with a Republican president to do something remarkable: pass comprehensive tax reform that lowered the people s tax rates while discarding a variety of special-interest giveaways. This triumph of sound public policy over parochial politics was a singular achievement in the history of tax reform. Before 1986, changes to the tax code generally involved carving out tax breaks for politically favored activities. Post-1986 tax changes have followed this same pattern of special interest giveaways. Legislative history illustrates that it is far more likely that a group enjoying a concentrated benefit (such as a tax break) will often prevail, even if that benefit imposes costs on the wider public. In 1986, however, we saw the opposite: the public benefited from lower tax rates while many special interest groups saw their narrowly-crafted exemptions and credits eliminated. An ideal tax system would have low rates, a broad taxpaying base, and an absence of favors for particular industries or activities through tax deductions or credits. Arkansas is far from having such a tax code. Looking to the lessons of the 1986 federal tax reform, however, we can discover the practical steps state lawmakers should take in order to move towards this system. This involves tax reform with low rates, shared sacrifice and shared benefits, and strong bipartisan leadership. Low Tax Rates If you benefit from a deduction that lowers your income tax payment, why would you ever support its elimination? As lawmakers found in 1986, the key is to lower the top marginal tax rate significantly so that it will be in your interest to do so. While the U.S. income tax began with a 7% top tax rate in 1913, this low rate did not last long. In 1918, the top rate went up to 77%. By 1944, it had risen all the way to 94%. While various tax bills had reduced rates throughout the decades between 1944 and 1986, that year s top tax rate of 50% was still very high. 1 (continued on other side)

2 Even though this top rate nominally applied to incomes over $169,000, the tax code was honeycombed with numerous deductions and credits which allowed many people to pay far less than the top rate. These tax exemptions were a way to lessen the impact of high tax rates on many Americans. As tax rates went up, interest groups hired lobbyists to get special preferences in the tax code for themselves. By 1986, there were tax exemptions, deductions, or credits for a variety of industries, from real estate developers to oil and natural gas companies to timber companies. Many business expenses, even questionable ones such as expensive dinners or sports tickets, were also deductible. As a result of creative use of these preferences, some companies paid little or no taxes at the time. This was obviously a great deal for these companies, and they fought the tax proposals coming out of the White House and Congress to end or curtail their tax breaks. But not all companies had this view. As journalists Jeffrey Birnbaum and Alan Murray explain, there were business leaders who recognized the benefits reform could bring: Many companies, particularly those that paid high tax rates and made only modest use of investment incentives, favored eliminating tax preferences in return for lower rates. A small group of others thought tax reform would be good for their customers and encourage sales. 2 Whenever lawmakers target a tax break for elimination, those who benefit from it will fiercely defend it. The key to the 1986 tax reform was to pair tax preference elimination with something that would be strongly supported tax rate reduction. Those who wanted tax rate reduction knew the only way to get it would be to support the elimination of tax breaks. Birnbaum and Murray describe how Senator Bob Packwood, Chairman of the Senate Finance Committee, used the prospect of a low top tax rate (his proposal was 25%) to leverage support for tax break elimination: The 25-percent plan s central attraction was the low top rate. It was so low that the [Senate Finance Committee] members began to focus on its attractiveness rather than on the pain that their constituencies would feel from the elimination of tax preferences. 3

3 In the end, many business groups opposed the 1986 tax reform. To them, it was more important to preserve their preferences than to see lower tax rates. But enough groups saw the larger benefits of this tradeoff and decided it was in their interest to support it. They could only do this because it lowered the top tax rate dramatically, from 50% to 28%. A reform bill that would have lowered the top rate by a smaller amount would not have garnered this type of support. In short: the key to eliminating tax breaks is to offer much lower tax rates in return. Shared Sacrifice, Shared Benefits In the 1986 tax reform, many industries took a hit when their tax preferences were curtailed or eliminated. Many of these industries had strong champions in Congress. These members of Congress had spent their careers fighting to create or preserve these tax breaks. These senators and representatives were not going to let their favored tax preferences be eliminated if other members tax breaks were left intact. This was shown during the Senate Finance Committee markup of the legislation. After the House of Representatives passed tax reform legislation, it almost came undone in the Senate s tax committee. The key moment came when Chairman Packwood supported a senator s attempt to preferential tax treatment for municipal bonds. As soon as senators saw that this tax break was being restored, they pushed for their own pet priorities to be saved, too. Birnbaum and Murray describe what happened next: The trend of giveaways, once begun, could not be slowed. Each day, the committee not only failed to eliminate or curtail tax breaks, but they approved new breaks that were more generous than existing law. It was the kind of special-interest spectacle for which the Finance Committee was well known. The bill was supposed to be the most ambitious piece of tax-reform legislation since the inception of the modern income tax, but instead of taking away tax benefits, the committee spent two straight weeks adding them back at a terrifying pace. 4 What finally stopped the tax reform plan from unraveling was Sen. Packwood s plan to eliminate tax breaks in return for cutting the top tax rate in

4 half. With this low rate, Packwood believed that people would stop caring so passionately about their deductions or credits. 5 As we saw above, this is exactly what happened. To make a broad generalization, lawmakers were willing to do the right thing if they saw that everyone would be sacrificing something. While the 1986 tax reform did leave many tax preferences intact, it did spread the pain around enough to attract bipartisan support for the bill. It also ensured that everyone would benefit through lower tax rates. Strong Bipartisan Leadership Strong, bipartisan support for tax reform was an essential key to making the 1986 legislation a reality. Without key lawmakers pushing for a major overhaul, the parochial interests of legislators would have quickly sunk this landmark bill. Although the idea of eliminating reductions in order to lower and simplify tax rates was one that had been discussed since at least the early 1980s, President Reagan gave the initial push to the bill that eventually resulted. In his 1984 State of the Union Address, he said: Let us go forward with an historic reform for fairness, simplicity, and incentives for growth. I am asking [Treasury] 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. 6 When the Treasury officials sent a plan to Capitol Hill, they had to win over Chairman Dan Rostenkowski of the House Ways and Means Committee. Rep. Rostenkowski embraced the tax plan, and maneuvered it through the House of Representatives in the face of often strong opposition. His counterpart in the Senate, Bob Packwood, became a true believer in tax reform after some initial skepticism. These two men often rescued tax reform after their committee members tried their best to derail it. Without sustained effort on their parts, specialinterest groups would have succeeded in defeating this bill.

5 The motives of Rep. Rostenkowski and Sen. Packwood were mixed. However, both desired to be known as public servants who put aside narrow interests in order to serve the greater good through tax reform. President Reagan, along with true believers in tax reform such as Senator Bill Bradley, had created an atmosphere that was amenable to this brand of tax reform. For instance, when congressional committees voted to restore tax preferences, the media portrayed members of Congress as tools of special interest groups. That outside pressure helped ensure that this legislation survived a Congress that had often been hostile to genuine tax reform. Conclusion While subsequent years have seen the undoing of many aspects of the 1986 tax reform, its example continues to inspire reformers at the state and national level. Evidence indicates that the reforms of 1986 gave workers an incentive to work more hours and thus earn more money for their families. It also resulted in a significant increase in federal revenue. Those results show the benefits that lawmakers who pursue similar reform can expect. Looking at how Congress and the President largely defied special interest groups to enact sensible tax reform in 1986 can give us insights into how today s reformers can do the same. Setting low rates to offset the pain caused by removing tax preferences, sharing the costs and benefits among a wide group, and having committed leaders willing to champion reform are all necessary. Tax reform succeeded in 1986 because these things were present. Tax reform can do so again today. Marc Kilmer is an analyst with the Advance Arkansas Institute. 1 U.S. Federal Individual Income Tax Rates History, , The Tax Foundation, October 17, Birnbaum, Jeffrey and Alan Murray, Showdown at Gucci Gulf: Lawmakers, Lobbyists, and the Unlikely Triumph of Tax Reform, Random House, p Ibid, p Ibid, p Ibid, p Ibid, p. 41.

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