The Road to Tax Reform – It May Be Long, But It’s Been Done Before

Mac O’Brien contributed to this post

The Tax Reform Act of 1986 is still heralded today as a legislative landmark, not only for what it accomplished, but also for how it became law. In his article entitled “How Tax Reform Came About,” Dr. Joseph J. Minarik explains how the Tax Reform Act of 1986 evolved over time as it made its way through the legislative meat grinder.

Comprehensive tax reform was first set into motion by the public’s negative reaction to the Economic Recovery Tax Act of 1981, which many viewed as biased in favor of the nation’s corporations and wealthiest taxpayers. In 1983, Senator Bill Bradley (D-NJ) and Representative Dick Gephardt (D-MO) coauthored the first ever comprehensive tax reform proposal set forth by members of Congress. While some had previously discussed closing a few unjustifiable tax loopholes in exchange for lowering tax rates, each of those proposals lost more revenue from its rate cuts than it gained from loophole closings. Bradley and Gephardt, on the other hand, explicitly stated all of the tax expenditures and loopholes that would be eliminated or curtailed – including some popular deductions and exemptions in the real estate industry – to pay for their plan’s proposed rate reductions. For the most part, Bradley-Gephardt received positive feedback due to its fairness (as it eliminated inequities among taxpayers of similar incomes), its reduced rates on productive economic activities, and its reversal of many of the unpopular and egregious corporate tax loopholes that had emerged in the Economic Recovery Tax Act of 1981.

The year after Bradley-Gephardt was introduced, presidential politics entered the picture. Fearful that the Democratic nominee would rely on the popular Bradley-Gephardt bill in the campaign cycle, President Reagan countered by using his 1984 State of the Union address to publicly direct his Treasury Secretary to compile a list of recommendations for comprehensive tax reform by December of that year. Additionally, Senators Jack Kemp (R-NY) and Robert Kasten (R-WI) announced that they too would introduce a comprehensive tax reform plan, dubbed the “Republican Bradley-Gephardt.” The significance of supply-side conservatives – like Kemp and Reagan – acknowledging the necessity of comprehensive tax reform brought the issue to the forefront.

The recommendations contained in Treasury’s report (deemed “Treasury I”) were more complex than the Bradley-Gephardt bill, but echoed many of the same findings. Treasury I proposed three individual rate brackets – 15, 25, and 35 percent – and a corporate tax rate of 33 percent. (By comparison, the tax code at the time contained 14 individual tax rate brackets, the highest of which was 50 percent, and the statutory corporate tax rate was 50 percent, as well). By closing a variety of tax expenditures and loopholes for corporations, even with a lower tax rate of 33 percent, Treasury I proposed a $25 billion-per-year increase in revenue from corporate income taxes to finance a $25 billion-per-year cut in individual income taxes. This approach appealed to Reagan because it addressed his main concern: keeping the top individual tax rate low. Reagan felt that he could justify the closing of tax expenditures and a $25 billion-per-year increase in revenue from corporate taxes by asserting that he cut the maximum individual income tax rate in half (from the 70-percent top marginal rate that was in place when he came into office).

The tax reform debate trudged through campaign season and Reagan ultimately won reelection. The following year, his administration released Treasury II, which made some tweaks to the original proposal. Although Treasury II signified the president’s continued commitment to comprehensive tax reform, the proposal was short on revenue, unlike Treasury I. The new plan made fresh concessions to certain vested interests that limited the curtailment of preferences for capital gains, charitable donations, depreciation, and others, but correspondingly resulted in a loss of revenue.

This posed a fresh hurdle to comprehensive tax reform, as the Democratic-controlled House demanded that reform be revenue neutral. The House Ways and Means Committee chose to proceed with the bill only after much persuasion from its chairman, Dan Rostenkowski (D-IL), and Senator Bradley. The Committee’s final product was tougher on corporate deductions and loopholes than Treasury II and also contained slightly less aggressive rate reductions. The corporate tax rate in the bill was set at 36 percent, and a fourth income-tax bracket (at 38 percent) for the wealthiest Americans was added to the Treasury proposal. In finalizing this revenue-neutral plan, however, Rostenkowski resorted to working in caucus with members of his own party, leaving Republicans out of the drafting process.

Although in the minority, House Republicans found enough Democrats who opposed the bill to procedurally kill it before it reached the House floor. Before that occurred, however, Reagan intervened. While the president assured Republicans in the House that he would veto the bill if it reached his desk unchanged, he urged them to pass the piece of legislation so that the Republican majority in the Senate could make adjustments to the bill that adhered to the desires of the party.

Despite initial signs of trouble in the Senate, tax reform picked up steam when Senate Finance Committee Chairman Robert Packwood (R-OR) proposed that the Committee create a tax reform bill “from scratch.” The bill started as revenue-neutral with no tax expenditures and a baseline of low tax rates. Whenever Committee members wanted to add deductions, or any other type of preference, to the bill, staff would calculate how tax rates had to be adjusted in order to maintain revenue neutrality, creating tradeoffs between loopholes and low marginal rates through trial and error. In the end, the Committee’s bill established two tax brackets – one at 15 percent and the other at 27 percent – through unprecedented elimination and curtailment of exemptions, deductions, and loopholes. The low maximum rate satisfied President Reagan and many other conservatives in the Senate, while Democrats approved of the shift in revenue from individual taxes to corporate taxes. When the bill came to the floor, it passed the Senate by a resounding vote of 97-3.

But the battle was not quite yet won. In the House/Senate conference, the two parties clashed over the new corporate tax rate, stalling the bill and leaving it on the brink of destruction. At the eleventh hour, however, Senator Bradley proposed a formulation that satisfied the Democratic House’s demand for middle-class tax relief without taxing corporations to an extent that would push Senate Republicans away from the table.

The compromise bill ultimately passed both bodies of Congress with relative ease. While comprehensive tax reform’s loophole closures certainly created some enemies, the annual tax burden transfer of $25 billion from individuals to corporations generally made the bill popular with the American public. Further, by reducing tax expenditures and creating a more-level playing field for all corporations, the corporate tax rate had actually been lowered (even as corporate tax revenues increased by $25 billion).

Yet, in retrospect, the most-important takeaways from the Tax Reform Act of 1986 may be the herculean bipartisan effort that was required from Congress and the administration, and the low-tech, commonsense economic approach paired with the comprehensive nature of the policy itself. Perhaps the process for tax reform today should be based on the lessons learned from over a quarter-century ago.

Dr. Minarik served as a member of the Bipartisan Policy Center’s Domenici-Rivlin Debt Reduction Task Force and is the senior vice president and director of research for the Committee of Economic Development.