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Tax Reform 1986: A Silver
Anniversary, Not a Jubilee
By Michael J. Graetz
Michael J. Graetz is the
Isidor and Seville Sulzbacher Professor of Law, and
Columbia Alumni Professor
of Tax Law, at Columbia
Law School. He is grateful to
the Milton Handler Research Fund at Columbia
Law School for its support
of this article.
Michael J. Graetz
The Tax Reform Act of
1986 was an important achievement, but it has not
proved lasting. Nor did it receive much public
support. Many of its reforms have since been
reversed. What the country needs now is not to
reprise the 1986 act, but to enact a better tax system
— one that is much simpler, fairer, and more
conducive to economic growth in today’s global
economy. The United States can no longer afford to
rely so heavily on income taxes to finance federal
expenditures. We cannot make the progress we
need with just an oil change and lubrication; we
need a major overhaul.
Copyright 2011 Michael J. Graetz.
All rights reserved.
during World War II.1 This legislation clearly was
the crowning domestic achievement of Ronald Reagan’s presidency, and he deserves much credit for
its enactment. Nevertheless, I was surprised when
Reagan described TRA 1986 as ‘‘the best antipoverty measure, the best pro-family measure and
the best job-creation measure ever to come out of
the Congress of the United States.’’ Watching that
tribute to the 1986 act was like watching a Tennessee Williams play: You knew there was something
terribly wrong, but nobody was talking about it. On
its 25th anniversary, it is time to face the truth about
this tax reform.
That this law was such a major event is surely a
testament to the sorry state of the prior law. By the
1980s, the federal income tax had become increasingly criticized as inequitable, economically inefficient, and unnecessarily complex. Until the early
1970s, a plurality of Americans had considered the
federal income tax the most fair of all the major
taxes levied by the various levels of government; by
1979, a plurality rated the income tax as the least
fair.2 Much of the nation’s innovative energies,
entrepreneurial spirit, and marketing imagination
had become concentrated in the creation, production, and selling of tax shelter investments to relatively high-income individuals. Those tax shelters
involved a wide variety of products hardly crucial
to the national economy, including such things as
jojoba beans and chinchilla farms. Inflation also had
Table of Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . 313
An Uneasy Political Marriage . . . . . . . . . . . . . . 314
Revenue and Distributional Neutrality . . . . . . . 315
The Overall Effects of the 1986 Act . . . . . . . . . . 315
The International Economy . . . . . . . . . . . . . . . . 318
Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . 319
Introduction
The Tax Reform Act of 1986 was widely heralded
as the most important tax legislation since the
income tax was converted into a tax on the masses
TAX NOTES, October 17, 2011
1
Much (but not all) of what I say here I have said before,
principally in two of my books, The Decline (and Fall?) of the
Income Tax (1997) and 100 Million Unnecessary Returns: A Simple,
Fair and Competitive Tax Plan for the United States (2008 and 2010);
and also in ‘‘Tax Reform Unraveling,’’ 21 J. Econ. Perspective 69
(2007); in the Dunwody Distinguished Lecture in Law: ‘‘The
Truth About Tax Reform,’’ 40 U. Fla. L. Rev. 617 (1988); and in
recent testimony before the Senate Finance Committee (Doc
2011-4868, 2011 TNT 46-37) and the House Ways and Means
Committee (Doc 2011-16245, 2011 TNT 144-48).
2
The growing antipathy toward the income tax had not gone
unnoticed by the nation’s politicians. Many ‘‘tax reform’’ bills
were introduced in Congress in the early 1980s, most notably
the Fair Tax of Democratic Sen. Bill Bradley and Rep. Richard
Gephardt, and the Fair and Simple Tax (FAST) of Republican
Rep. Jack Kemp and Sen. Robert Kasten. Also, President Reagan
asked Treasury in his 1984 State of the Union address to prepare
a ‘‘plan for action to simplify the entire tax code so all taxpayers,
big and small, are treated more fairly.’’
313
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25 YEARS OF TRA ‘86
COMMENTARY / 25 YEARS OF TRA ’86
An Uneasy Political Marriage
TRA 1986 was the product of an uneasy marriage
of two contrary ideological and political camps. A
number of proposals — principally by academics
but also by some members of Congress — had
urged replacing the income tax with consumption
taxes, but by late 1984 the leading proposals of both
Republicans and Democrats would apply a reduced
and flattened rate structure to a broadened income
tax base, which would include many previously
untaxed items.4
It was surprising when Reagan and key Republican colleagues became leaders of the tax reform
movement. The Democratic Party in its political
platforms had long supported base-broadening income tax reform, even though many Democrats
doubted the wisdom of that position. Republicans,
however, had never been known as great advocates
of broadening the income tax base. Reagan had
3
Adjustments to the rate schedule for inflation were enacted
in 1981, effective in 1985.
4
A three-volume document of analysis and income tax
reform proposals was released by Treasury in November 1984,
‘‘Report to the President, Tax Reform for Fairness, Simplicity
and Economic Growth.’’ On May 29, 1985, Reagan submitted his
tax reform proposals to Congress. While differing in some
important respects, those proposals embraced the general principles of a broader-based, flatter-rate income tax that ultimately
were enacted in TRA 1986.
314
described the progressive income tax as having
come ‘‘direct from Karl Marx,’’ who, according to
Reagan, ‘‘designed it as the prime essential of a
socialist state.’’5 Yet, Reagan made tax revision his
highest domestic priority, attempted with many
speeches and trips to foment public support, and,
through personal appeals to members of Congress
at a critical moment, rescued the bill from destruction by House Republicans. In Congress, both Sen.
Robert Packwood, then the Republican chair of the
Senate Finance Committee, and Dan Rostenkowski,
the Democratic chair of the House Ways and Means
Committee, played critical roles in getting tax reform through Congress.
The public, however, never became very interested; no groundswell of support emerged for the
president’s proposals. On June 25, 1986, the day
after the Senate passed the tax reform bill by a 97-3
vote, The New York Times reported the results of a
telephone poll: Less than a third of the American
public believed the Senate bill would either produce a fairer tax system or reduce their taxes. The
great tax-reducing momentum of the late 1970s,
which had inspired California’s Proposition 13 and
similar changes elsewhere reducing state taxes, as
well as the federal tax legislation of 1981, was
absent.
By 1986, reducing the size of government and
deregulating the national economy had become a
priority within the Reagan administration and the
Republican Party. The idea of deregulating the
economy — restricting the government’s role in
influencing economic decision-making in the private sector — argues strongly for broadening the
tax base and lowering tax rates, and the 1986 tax
reform was designed in substantial part to serve
deregulation, a somewhat unconventional tax
policy goal.
What ultimately moved the 1986 tax revision,
then, was an uneasy marriage of two very different
agendas. The conventional tax reformers — who
were interested principally in improving tax equity
by broadening the income tax base so that income
would be taxed similarly regardless of its source —
joined with supply-siders and deregulators who
were interested principally in enacting lower tax
rates ‘‘to get government off the backs’’ of the
American public and American businesses. A massive reduction of tax rates had long been the
5
Ronald Reagan, ‘‘Encroaching Control: Keep Government
Poor and Remain Free,’’ 27 Vital Speeches of the Day 677 (1961),
quoted in Marvin Chirelstein, ‘‘Back From the Dead: President
Reagan Saved the Income Tax,’’ 14 Fla. St. U.L. Rev. 207 (1986).
TAX NOTES, October 17, 2011
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contributed to the unpopularity of the income tax
through ‘‘bracket creep,’’ which had pushed individuals into higher marginal rates each year regardless of whether they had experienced any increase
in their purchasing power.3 By the end of 1986, both
of those problems had been resolved.
TRA 1986 increased the permissible amount of
tax-free income; lowered and flattened income tax
rates; shut down mass-marketed tax shelters for
high-income individuals; curtailed the ability to
shift income to lower-income, lower-rate family
members; and taxed capital gains at the same rate
as ordinary income. By repealing tax benefits for
equipment and real estate, Congress not only financed a reduction in the corporate tax rate (from
46 to 34 percent) but also paid for some of the
individual rate reductions. The corporate changes
also made the income tax considerably more neutral
across industries. Soon thereafter, the law’s ratereducing and base-broadening reforms were mimicked throughout OECD nations.
Today many politicians and pundits are calling
for a reprise. But on its silver anniversary, we must
admit that the changes wrought by the 1986 act
have proved neither revolutionary nor stable.
COMMENTARY / 25 YEARS OF TRA ’86
Revenue and Distributional Neutrality
Even though deficits were becoming a great
concern by the mid-1980s, the linchpin of the 1986
act was revenue neutrality. By insisting on revenue
neutrality, the Reagan administration and the congressional leadership were able to demand that
amendments to the tax bill could be offered only if
any revenue losses were offset by revenue gains.
That procedural use of revenue neutrality changed
the dynamics in the House and Senate taxwriting
committees and on the Senate floor. As one senator
remarked during the Finance Committee’s markup,
an important constituent cooled on an amendment
that would have restored a 100 percent deduction
for business entertainment expenses when that
change was coupled with an increase of one point in
the corporate tax rate. Legislators behaved quite
differently when to pay Peter they had to be explicit
about how they intended to rob Paul.
Tax reform was not only revenue neutral but also
roughly distributionally neutral: This tax reform
was not to become an occasion for significantly
shifting the distribution of income tax burdens
among income classes. So distributional neutrality,
along with revenue neutrality, became guiding
principles for the legislation.
6
The divergent effects of the 1986 tax reform on the business
community also played a crucial political role. Some businesses,
such as service and high-technology businesses, enjoyed a
substantial tax reduction, principally because of the lowering of
the top corporate rate from 46 to 34 percent; others faced a
significant tax increase, either because of repeal of special
industry-specific tax breaks or more generally because of the
repeal of the investment tax credit. As a result, the business
community split politically, with some major corporations fighting the tax reform every step of the way, but with others playing
a strong supporting role.
7
The National Commission on Fiscal Responsibility and
Reform, ‘‘The Moment of Truth’’ (Dec. 3, 2010), Doc 2010-25486,
2010 TNT 231-35.
TAX NOTES, October 17, 2011
The Overall Effects of the 1986 Act
By lessening significantly the wide disparities of
prior law in the tax burdens of companies in
different industries, improvements were made in
the allocation of resources and the efficiency of the
use of capital. But this tax act — forged from an
effort to be neutral both in terms of the total federal
revenue and the distribution of the tax burden —
did not have massive economic effects on the
American economy. Subsequent estimates suggested that TRA 1986 spurred perhaps a 1 percent
increase in hours worked — a benefit for sure, but
far from an economic renaissance.
Even the dramatic reduction in the maximum
individual tax rate by the 1986 act to 28 percent did
not have major economic significance. The last time
income tax rates had been that low was the period
1925-1932, when Treasury Secretary Andrew Mellon
succeeded in lowering the top rate from its high of
73 percent in 1921 (when he took office) to 25
percent in 1925. Reagan started three points lower,
at 70 percent in 1981, and ended three points higher,
at 28 percent in 1986. The period of the 25 percent
top rate from 1925 to 1932 was a mixed economic
bag: Our nation’s economy was quite good for a
while, then times became very bad. The next five
decades, from 1932 to 1982, were also a period of
both very good and bad years, even though the top
rate never dropped below 63 percent. And after Bill
Clinton raised the top rate back to around 40
percent in the 1990s, the economy boomed, driven
by a revolution in information technology and the
greater integration of the world economy. Nevertheless, the notion that a very low maximum tax
rate is crucial to the American economy remains an
article of faith in some quarters.
Despite its limited impact on the American
economy, the reduction in the top rate was a significant aspect of TRA 1986. In combination with
the ongoing escalation of payroll tax revenues and
the 1981 reductions of the estate and gift taxes, it
signaled, at least for a time, a decline of progressivity as the guiding principle for fairness in the
distribution of tax burdens in the federal tax system. Reagan and many of his Republican colleagues
had long regarded progressivity as morally wrong,
and Reagan had frequently said that it conflicted
with the proportionality of the Biblical tithe, 10
percent from rich and poor alike.
The 1986 act’s removal of 6 million poverty-level
people from the income tax rolls did increase income tax progressivity at the bottom of the income
scale, and Congress also provided tax reductions to
the middle-income families. By looking to 1985 law
as its guide, however, the distributional neutrality
principle had the effect of blessing both the substantial reduction in progressivity that had occurred in
315
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supply-siders’ dream, and without a substantial
reduction in the tax preference and incentive provisions of the tax code, deregulation of the American
economy would necessarily have remained incomplete.6
That proved a very uneasy marriage. The ink was
hardly dry on TRA 1986 before divorce proceedings
started. And by now the divorce seems final. Thousands of pages of legislation in the years since 1986
have narrowed the income tax base while the top
tax rate has crept upward. Nevertheless, thanks
largely to proposals in December 2010 by President
Obama’s Bowles-Simpson debt reduction commission,7 the call for a replay of a 1986-type reform has
now become a rallying cry for pundits and politicians across the political spectrum.
COMMENTARY / 25 YEARS OF TRA ’86
No issue better reflects the tensions between
traditional tax reformers and supply-siders than
their attitudes toward taxation of capital gains.
Beginning with the Tax Reform Act of 1969, which
eliminated the top 25 percent rate that had previously applied to capital gains, and continuing
through the Tax Reform Act of 1976, tax reform
proponents had succeeded in narrowing the gap
between tax rates on capital gains and ordinary
income. Under TRA 1976, the potential top rate on
capital gains was 49.9 percent, compared with a 50
percent maximum rate on earned income (and a 70
percent top rate on unearned income).
In 1977 the Treasury Department under President
Carter had developed major tax reform proposals
that included a significant cutback on itemized
deductions, a top income tax rate of 50 percent, and
equal taxation of capital gains and ordinary income.
By 1978, however, Congress had become less concerned about the share of taxes paid by high-income
individuals and more concerned about increasing
investment and redressing overtaxation because of
inflation. So the Revenue Act of 1978 lowered the
top capital gains rate to the now magic number of
28 percent. That was done, first, by increasing the
exclusion of capital gains from income from 50 to 60
percent of long-term gains, and second, by changes
in the minimum tax provisions. Subsequently, the
Economic Recovery Tax Act of 1981 lowered the
maximum rate on all ordinary income from 70 to 50
percent, and, as a result, the highest marginal rate
on capital gains became 20 percent.
TRA 1986 eliminated the preferential tax treatment of capital gains, which meant that beginning
in 1988, capital gains, like ordinary income, were
taxed at a top average rate of 28 percent (although
the top marginal rate could have been as high as 33
percent). Congress, however, retained the entire
pre-1986 statutory structure for distinguishing capital gains and losses from ordinary income in order
to limit the use of capital losses against ordinary
income and perhaps also in recognition that the
equal treatment of capital gains and ordinary income would not prove stable. A small wedge reemerged between ordinary income and capital
gains rates in the Omnibus Budget Reconciliation
Act of 1990, and in 2001 capital gains rates once
again became less than half those applicable to
ordinary income. Once the similar treatment of
capital gains and ordinary income was eliminated,
the glue that had kept the top rate on ordinary
income from going higher than 28 percent also
disappeared. Ironically, the supply-side proponents
316
of lower taxes on capital gains paved the political
path to higher top tax rates for ordinary income.
Both the base-broadening provisions and the
lower tax rates of TRA 1986 were widely heralded
as ushering in a new era of income tax fairness. To
be sure, the merits of that legislation were principally its improvements in tax equity, but the
achievements of the 1986 act have been substantially exaggerated.
In addition to ending widespread individual tax
shelters, probably the most significant improvement of tax equity in TRA 1986 was its restructuring
of the taxation of family investment income, including trusts. While the rate schedule changes, including the reduction of the top rate, significantly
decreased the tax savings possible from shifting
income among family members, TRA 1986 also
restricted intrafamily income-shifting opportunities
by eliminating major tax advantages previously
available to trusts and by aggregating the unearned
income of children with the income of their parents
in determining the applicable tax rate. (The 1987
legislation redressed a similar tax advantage by
eliminating graduated tax rates for professional
corporations.)
However, the 1986 legislation left many devices
for tax-free investment income in place; municipal
bonds and life insurance and annuity products are
but three prominent examples. Nor did the 1986 act
address the inequities in the income tax that result
from fringe benefit exemptions; instead, nondiscrimination among employees by employers was
relied on as a guarantee of a modicum of vertical
equity. And deductions for expenses of producing
some business and investment income became subject to a variety of arbitrary disallowances under
TRA 1986, most notably a new floor equal to 2
percent of adjusted gross income. Those provisions
produce unwarranted and inequitable variations in
tax burdens. To take one example, employees with
reimbursed business expenses do better than identically situated employees without those reimbursements. Moreover, the long-standing income tax
disparity between homeowners and renters was
increased by the new interest deductibility rules of
the 1986 act (and modifications in the 1987 act) that,
for example, allow many homeowners, but not
renters, to deduct interest on their purchases of
consumer goods. And the more robust alternative
minimum tax continues to produce different taxes
for people with identical economic incomes and
now has to be patched annually to keep it from
reaching deep into the middle-income earners. Finally, many company-by-company or individual
transition rules gave benefits to one company or
individual while denying them to other taxpayers
in identical circumstances.
TAX NOTES, October 17, 2011
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
the 1981 legislation and ratifying tax reductions that
high-income individuals had managed to achieve
through tax shelter investments.
COMMENTARY / 25 YEARS OF TRA ’86
8
JCT, ‘‘Background Information on Tax Expenditure Analysis
and Historical Survey of Tax Expenditure Estimates,’’ JCX-15-11
(Feb. 28, 2011), Doc 2011-4215, 2011 TNT 40-19.
TAX NOTES, October 17, 2011
creases of American workers. Nor have our taxbased energy tax breaks produced better results.
Nor do tax credits for working parents produce
affordable child care. I could go on and on, but I
shall not.
Historically, when competing policy ideas aimed
at a common goal emerged in Congress, the leaders
of the taxwriting committees would fashion a compromise provision. Now Congress often compromises by enacting all the ideas, leaving
unsophisticated taxpayers bewildered about how to
cope. For a vivid illustration, consider the income
tax incentives for paying for higher education.
There are eight tax breaks for current-year education expenses: two tax credits, three deductions,
and three exclusions from income. Five other provisions promote savings for college expenses. In
1987 there were only three provisions encouraging
college expenditures or savings. The 1997 act alone
added five provisions that were estimated to cost
$41 billion over five years; together they represented the largest increase in federal funding for
higher education since the GI Bill. Comprehending
the tax savings provided by those provisions, their
various eligibility requirements, how they interact,
and their record-keeping and reporting requirements is mind boggling.
Relying, as we do, on income tax deductions and
credits is about as successful a solution to our
national needs as handing out more gunpowder at
the Alamo. We need to be weaned away from using
tax deductions or credits as a cure-all for our
nation’s ills. But the largest tax expenditures are
very popular with the public. To be sure, they may
be trimmed: a floor on deductions here, a ceiling or
haircut there, but I am convinced that the only path
to real tax reform success is to remove most Americans from the income tax altogether.
There should be no argument that TRA 1986
failed as a simplification measure. Congress lowered rates and broadened the base, but somehow
lost its way to simplification. Compromise is the
root of complexity, and the 1986 act contained an
unending series of political compromises. Quite
often Congress refused either to eliminate or ratify
provisions of dubious merit; instead, it reduced
their benefits or imposed new limitations on their
use. When Congress talks about simplification, taxpayers may well be reminded of Emerson’s comments regarding an acquaintance: ‘‘The louder he
talked of his honor, the faster we counted our
spoons.’’
The 1986 act’s rules on interest deductions could
be awarded the ‘‘foolish complexity’’ prize. Because
money is fungible, it is futile to attempt to trace
317
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Thus, despite claims to the contrary, the 1986 act
did not reflect a coherent or consistent reintroduction of equity into the tax code. One can search long
and hard for a unifying equity theme in the 1986
legislation and, although there are hopeful glimmers here and there, what emerged instead is a
series of complex, unwieldy, and often inequitable
political compromises. Moreover, the 1986 legislation did not induce Congress to forsake the income
tax as a blunt instrument to serve non-revenueraising public policies. Presidents and members of
Congress from both political parties continue to act
as if an income tax credit or deduction is the best
prescription for virtually every economic and social
problem our nation faces. In the process, the IRS is
no longer just a tax collector but now is also the
administrator of many of the nation’s most important spending programs.
To keep track of all the tax benefits, the federal
budget each year contains a list of tax expenditures,
defined as tax credits, deductions, or exclusions that
deviate from a ‘‘normal’’ income tax. The basic idea,
of course, is that many tax benefits are substitutes
for and the equivalent of direct government spending. According to a February 2011 report of the Joint
Committee on Taxation staff, the number of those
tax expenditures has grown substantially since
1986, from 128 to 202. The JCT also points out that
once enacted, no matter how ineffective or distortive, tax expenditures ‘‘tend to stay in place.’’ Their
total cost in lost revenues is estimated to exceed $1
trillion a year.8
Those are not just narrow, special interest tax
loopholes. Indeed, the biggest items are tax breaks
widely available to broad segments of the public.
The largest tax expenditures are popular: tax advantages for health insurance and retirement savings;
deductions for home mortgage interest, state and
local taxes, and charitable contributions; and low or
zero rates on capital gains.
Yet, we know that trying to solve the nation’s
problems through targeted tax breaks typically does
not work. Take health insurance, for example. Our
nation, contrary to others throughout the world, has
long relied on a tax benefit for employers and
employees as its main mechanism for covering
Americans who are neither poor nor aged. What
has been the result? Our healthcare costs are the
highest in the world, and about 50 million Americans are uninsured. Moreover, those costs make
American businesses and products less competitive
in the world economy and gobble up wage in-
COMMENTARY / 25 YEARS OF TRA ’86
The International Economy
Given the internationalization of economic activity during the past 25 years and the increased
competition from abroad, the 1986 act’s reliance on
increased taxation of corporate income is now inapt. We need to attract capital to create better
conditions for American workers and businesses.
To do that, the United States must be an attractive
place for both foreign and domestic investments,
and American companies need to be positioned to
take full advantage of the global market for goods
and services, labor, and capital. But our tax system
9
Michael J. Graetz, ‘‘The Truth About Tax Reform,’’ 40 U. Fla.
L. Rev. 617, 635 (1988).
318
does not advance the well-being of American
workers and businesses; it stifles it.
Our system of taxing international business income is truly archaic. The structure for taxing
international business income came into the tax law
in 1918 and 1921.10 It was substantially modified in
1962 and again in 1986, and there has been much
tinkering since then, but we are in a very different
world economy today. Corporations and other
owners of large amounts of capital now move
money quickly and easily around the world, making it much more difficult for any nation — including the United States — to tax their income.
How to tax multinational business enterprises
has long been controversial. Recent disputes over
the Obama administration’s international tax proposals — for example, regarding the cross-crediting
of foreign taxes, the treatment of domestic expenditures that help produce foreign income, the treatment of intangible assets, and transfer pricing,
alongside the recent trend of countries with foreign
tax credit systems to move to international business
tax regimes that exempt foreign dividends — amply
illustrate differences in policy preferences. The
thrust of TRA 1986 was to limit the ability of U.S.
companies to offset U.S. taxes on unrelated income
and to restrict some deductions for companies that
invest abroad. Elsewhere around the world, however, nations have subsequently embraced lower
corporate income tax rates, both to attract investments and to reduce the temptations of their domestic companies to shift income abroad through
intercompany pricing or other techniques.
Difficulties in taxing international income are
fundamental. As I have observed elsewhere, the
basic building blocks of international income taxation — the concepts of residence and source — are
now foundations built on quicksand.11 They may
have drawn reasonable lines when they first became the basis for international income taxation
early in the 20th century, but in today’s global
economy, with all of its technology and innovative
financial transactions, both corporate residence and
the source of income and deductions are easily
manipulated. Businesses now not only have the
ability to elect whether to be taxed as corporations,
they also can elect where to be taxed. If you ask a law
student in an international tax class where to incorporate a new business enterprise and he answers,
10
See Graetz and Michael M. O’Hear, ‘‘The ‘Original Intent’
of U.S. International Taxation,’’ 46 Duke L. J. 1021 (1997).
11
See Graetz, ‘‘The David R. Tillinghast Lecture, Taxing
International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies,’’ 54 Tax L. Rev. 261, 320 (2001);
and Graetz, ‘‘A Multilateral Solution for the Income Tax Treatment of Interest Expense,’’ 62 Bull. Int’l Tax 486 (Nov. 2008).
TAX NOTES, October 17, 2011
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borrowed funds to particular uses. Futility, however, is no bar to legislation; TRA 1986 distinguished at least 17 different categories of interest.
Home mortgage interest was a political untouchable, while credit card interest was not, but that was
and remains no adequate reason to enact tax rules
of awesome complexity that have served principally to inspire large portions of the American
public to reconsolidate their consumer, educational,
and other debts into home equity loans. In 1988 I
observed, ‘‘Hard times now may put not only
people’s credit ratings, but also their homes, at
risk.’’9 Unfortunately, we have now seen that happen.
The complexity of the 1986 act, coupled with its
failure to adopt and maintain a coherent vision of
equity, made it unstable. Even if it would, Congress
could not resort to principle as a basis for resisting
change.
Since 1986, Congress has amended the code
annually, adding many thousands of pages of new
legislation. In retrospect, the inherent weaknesses of
TRA 1986 have become easy to identify. First, despite the tremendous leadership and ingenuity of
Reagan, along with that of the chairs of the House
Ways and Means and Senate Finance committees,
the fragile political coalition that enacted the law
left in place many ongoing complexities, inequities,
and inefficiencies. Second, the 1986 act had little
public support even when it was passed. Third, and
most importantly, TRA 1986 was based on retaining
and strengthening the income tax itself, rather than
heeding the calls of many economists and politicians to replace all or a large part of it with some
form of consumption tax on purchases of goods and
services. So, on the silver anniversary of the 1986
reform, the income tax continues to be what it has
long been — a source for contests among different
groups with different interests for the privilege of
paying less taxes.
COMMENTARY / 25 YEARS OF TRA ’86
TAX NOTES, October 17, 2011
lar with the public despite the virtually unanimous
view among tax policy analysts that the corporate
tax is a bad tax economically. People tend to believe
that taxes remitted by corporations, especially large
multinational companies, are paid by someone else.
The question of who actually bears the economic
burden of corporate income taxes has long tormented public finance economists. Three candidates come instantly to the fore: people who own
the companies, people who work for the companies, and people who buy the companies’ products.
Because the tax may affect wages, prices, or returns
to capital, economists believe that workers, consumers, or owners of capital generally may bear the
economic costs of the tax. For many years the
conventional wisdom among economists was that
the tax principally reduced returns to capital, at
least in the short run, and thus the tax was considered to be progressive, even if economically distortional. Government distributional tables often
allocate the corporate tax burden to owners of
capital. Even so, ultimately, any reduction in capital
because of the tax might result in lower wages, so in
the long run, workers may pay.
As the economy has become more open internationally, a number of recent economic studies have
concluded that the corporate income tax is less
likely borne by capital generally, but rather — at
least in some substantial part — by workers in the
form of lower wages. Owners of capital today can
move their money anywhere in the world, but
workers and consumers are less mobile.
All the uncertainty in the economics profession
contributes to the public view that someone else
pays the tax. And it is child’s play to characterize
large corporations, especially large multinational
corporations, as villains. That is probably why the
public seems to like a tax that economists hate. But
high tax rates on corporate income in today’s global
economy are a bad way either to achieve economic
growth or to obtain and maintain progressivity in
the distribution of the tax burden. (Indeed, simply
shifting the tax burden from corporations to shareholders and bondholders could increase progressivity.)
Looking Ahead
I now regard the 1986 act as a promise failed.
Nevertheless, many people continue to believe that
the best path for tax reform is simply to improve the
income tax. Politicians and pundits from all political quarters are now calling for a base-broadening,
rate-reducing income tax reform that reprises the
1986 reform. They seem to agree that the best course
is to repeal tax breaks — the so-called tax expenditures — and lower income tax rates, as TRA 1986
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‘‘the United States,’’ the student probably deserves
a failing grade. Technological advances allow vast
sums of capital and the ownership of valuable
intellectual property to be moved around the world
with the click of a mouse, and financial innovations
facilitate tax planning opportunities. The interdependence of the world economy makes trying to
impose high income tax rates on multinational
corporations counterproductive. Deductions flock
to high-tax-rate countries, and income flocks to
those with low rates. There is only so much the
United States can do unilaterally to address that
problem.
I have come to believe that absent broad international agreement and cooperation to forgo tax competition to attract capital — a transformation that is
certainly not on the horizon — a low statutory
corporate tax rate is essential. This year we will
have the highest statutory corporate tax rate in the
developed world.
Many economists and government officials tell
us to ignore the statutory tax rate, that we should
look instead at the lower ‘‘effective’’ tax rates. But,
of course, average tax rates are meaningless when
one is being asked about where to borrow or invest
the next dollars. And the more relevant ‘‘marginal
effective tax rates’’ are subject to debate and often
difficult to calculate. Corporations respond to their
knowledge that we tax corporate income at a 35
percent rate, while another country imposes tax at a
much lower rate, say 15 to 20 percent. They do not
need a computer to tell them where to locate their
deductions and where to locate their income.
Foreign-owned multinationals understand that as
well as U.S. companies.
To be sure, businesses often shift their income
and deductions around the world without necessarily also shifting their employees or real investments
in plant and equipment. But not always. Other
governments may require that real economic activity actually take place there. In those cases, and
whenever business activity is located abroad for
business rather than tax reasons, there may be
incentives for companies to shift their foreign income to even lower tax countries — to so-called tax
havens. Complicating matters further, it may well
be in the U.S. national interest for U.S. corporations
to engage in tax planning strategies that reduce
their foreign income taxes and increase their cash
flow. But when those strategies are turned on the
U.S. tax system by either domestic or foreignowned enterprises, our fisc and our economy suffer.
If the substantive difficulties of designing sound
corporate income tax policies for today’s global
economy were not hard enough, taking political
considerations into account makes the task positively herculean. Corporate income taxes are popu-
COMMENTARY / 25 YEARS OF TRA ’86
output similar to other nations. The big difference is
that we are the only OECD country without a
national-level tax on sales of goods and services.
Reforming the income tax will do nothing to change
that fundamental economic disadvantage. After the
Second World War, when the United States had
virtually all the money there was, even a horrible
tax system — with rates up to 91 percent — could
not impede our success in the world economy. This
century we can no longer afford to so hobble
ourselves.
We need to restructure our tax system if we want
to succeed in today’s global economy. It is quite
practical to combine a tax on sales of goods and
services with an income tax on high-income people
that is at least as progressive as current law and also
raises at least as much revenue. Enacting a 12.5
percent tax on sales of goods and services could
fund a $100,000 exemption from the income tax,
removing 150 million Americans from the income
tax rolls. Making that system revenue neutral, with
a distribution of the tax burden similar to that of
current law, could be accomplished with an income
tax rate of 16 percent on incomes between $100,000
and $200,000, and 25 or 26 percent on incomes
exceeding $200,000; a 15 percent corporate tax rate;
and a debit card exempting from the consumption
tax a specified amount of purchases and payroll tax
offsets to protect low- and moderate-income families from a tax increase.13 Small businesses with up
to $500,000 or less of sales could be exempted from
having to collect the consumption tax.
Gearing up for a new consumption tax might
take businesses and the IRS up to two years after
Congress enacts the law. Experience elsewhere
shows that during that interval, Americans would
accelerate their purchases on large ticket items such
as cars and major appliances, providing a shortterm boost to our economy.
Over the longer term, tax reform would make the
United States a much more favorable place for
savings, investment, and economic growth. Most
Americans would owe no tax at all on their savings,
and everyone would face lower taxes on savings
and investments. Most Americans would never
again have to deal with the IRS. This tax reform also
would make the United States a much more attractive place for corporate investments. And it fits well
12
To take only two examples, Finance Committee member
Ron Wyden, D-Ore., and the sponsor of a far-reaching income
tax reform bill, says that it’s time to give the income tax a ‘‘good
cleansing.’’ Editorial, The Wall Street Journal, Feb. 17, 2006.
George Shultz, Reagan’s secretary of state, describes the 1986 act
as the ‘‘unsung hero’’ of ‘‘good economic times’’ and says that
‘‘it’s time to clean house again.’’ Andrew Frye, ‘‘Shultz Says It’s
Time to ‘Clean House Again’ With U.S. Tax Code,’’ Bloomberg,
Sept. 18, 2011.
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13
These numbers are preliminary estimates from the Tax
Policy Center, which, under a contract with Pew Charitable
Trusts, is in the process of estimating the revenue and distributional consequences of my tax reform plan and has given me
permission to describe their preliminary results. These estimates
are for 2015. The Tax Policy Center, under this contract, is now
working on a paper that will provide more detailed final results.
TAX NOTES, October 17, 2011
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did.12 While income tax reform would surely improve current law, it would not, in my view, go far
enough. Changes in the past 25 years make this a
dead end.
As we now know, it does not take long after a
good cleansing of the income tax for the law to get
dirty again. Even those who applauded the 1986 act
as a wildly successful tax reform must concede that
the legislation was not stable. Many of its reforms
have been reversed: Its broad base and low rates
have been transformed into a narrower base with
higher rates. How can anyone remain optimistic
about fixing the income tax without radical surgery?
Today’s tax reform challenge is daunting: to
reduce deficits and debt in the long run, but also to
promote our nation’s economic growth. The fundamental problem is that in today’s international
economy, the United States can no longer afford to
rely so heavily on income taxation to finance federal
expenditures.
First, there is relatively little low-hanging income
tax reform fruit. The top 10 tax expenditures total
more than $1 trillion of lost revenue. But, as I have
said, those are not narrow, special interest benefits.
They are popular tax advantages for things such as
retirement savings, employer-provided health insurance, home ownership, charitable giving, having
children, and a tax credit for parents who are
working at low-wage jobs. Neither party will gain
any political advantage from repealing those.
Second, TRA 1986 funded an overall tax cut for
individuals by increasing taxes on corporations.
That is not practical today. After the 1986 reform,
the United States had the lowest corporate tax rate
among the developed nations. Now our corporate
income tax rate is the highest. Raising the corporate
income tax may be popular politically, but it is
economic folly. The United States will not flourish
by continuing to encourage businesses to borrow
here and invest elsewhere.
What our nation needs is a new and better tax
system, one that is far simpler, fair, and more
conducive to economic growth. Compared with the
rest of the world, the United States is a low-tax
country, but we are not a low-income-tax country.
Our income tax takes a share of our economic
COMMENTARY / 25 YEARS OF TRA ’86
TAX NOTES, October 17, 2011
(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
with international tax and trade agreements. This
system would solve the problems caused by international tax planning by multinational corporations, and, consistent with our obligations under
trade treaties, it would tax imports and exempt
exports, yield hundreds of billions of dollars for the
treasury from sales of products made abroad. By
returning the income tax to its pre-World War II role
as a relatively small tax on a thin slice of highincome Americans, it would eliminate the temptation for Congress to use tax breaks as if they are
solutions to America’s social and economic problems. We have tried that, and it doesn’t work.
The 1986 tax reform gave our income tax a good
cleansing, but its ink had hardly dried before Congress started adding new tax breaks and raising
rates. A replay is simply inadequate now to address
our current economic and fiscal challenges. A dramatic reform that uses a goods and services tax to
reduce our nation’s reliance on income taxation
could redeem the failed promise of TRA 1986. This
time we need a major overhaul of our nation’s tax
system, not just another oil change and lubrication.
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