Download How the Tax Reform of 1986 Supercharged the American Economy

H OW THE T AX R EFORM OF 1986
S UPERCHARGED THE A MERICAN
E CONOMY
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.
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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 Did3
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
________________________________________________________________ The Advance Arkansas Institute is a non-­‐profit public policy research organization. Its publications are available at advancearkansas.org For more information, please contact the Institute at (501) 588-­‐4245 or [email protected] ________________________________________________________________ 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
________________________________________________________________ The Advance Arkansas Institute is a non-­‐profit public policy research organization. Its publications are available at advancearkansas.org For more information, please contact the Institute at (501) 588-­‐4245 or [email protected] ________________________________________________________________ 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
________________________________________________________________ The Advance Arkansas Institute is a non-­‐profit public policy research organization. Its publications are available at advancearkansas.org For more information, please contact the Institute at (501) 588-­‐4245 or [email protected] ________________________________________________________________ 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 2013.10
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
________________________________________________________________ The Advance Arkansas Institute is a non-­‐profit public policy research organization. Its publications are available at advancearkansas.org For more information, please contact the Institute at (501) 588-­‐4245 or [email protected] ________________________________________________________________ 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 1986. 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. 41.
2
Ibid, p. 25.
3
“General Explanation of the Tax Reform Act of 1986,” Joint Committee on Taxation, May 4,
1987. http://www.jct.gov/jcs-10-87.pdf
4
Birnbaum and Murray, p. 10.
5
Ibid.
6
Feldstein, Martin, “The tax reform evidence from 1986,” The Wall Street Journal. October 24,
2011. http://www.aei.org/article/economics/fiscal-policy/taxes/the-tax-reform-evidence-from1986/
7
Mitchell, Daniel, “Taxes, Deficits, and Economic Growth,” The Heritage Foundation, May 14,
1996.
8
Tempalski, Jerry, “Revenue Effects of Major Tax Bills,” U.S. Treasury, September 2006.
9
Committee on Finance of the United States Senate, “Tax Reform: Lessons from the Tax
Reform Act of 1986,” September 23, 2010.
10
“The Distribution of Major Tax Expenditures in the Individual Income Tax System,”
Congressional Budget Office, May 29, 2013. http://www.cbo.gov/publication/43768
11
“U.S. Federal Individual Income Tax Rates History, 1862-2013 (Nominal and InflationAdjusted Brackets),” The Tax Foundation, October 17, 2013. http://taxfoundation.org/article/usfederal-individual-income-tax-rates-history-1913-2013-nominal-and-inflation-adjusted-brackets
12
Schuyler, Michael, “The Effects of Terminating Tax Expenditures and Cutting Individual
Income Tax Rates,” The Tax Foundation, September 30, 2013.
http://taxfoundation.org/article/effects-terminating-tax-expenditures-and-cutting-individualincome-tax-rates
________________________________________________________________ The Advance Arkansas Institute is a non-­‐profit public policy research organization. Its publications are available at advancearkansas.org For more information, please contact the Institute at (501) 588-­‐4245 or [email protected] ________________________________________________________________