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October 18, 2006
The Tax Reform Act of 1986: What It Wasn't
Joseph J. Thorndike

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The Tax Reform Act of 1986: What It Wasn't

Joseph J. Thorndike is a contributing editor with Tax Analysts. E-mail: Joe_Thorndike@tax.org.


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We're going to hear a lot today about what the Tax Reform Act of 1986 was all about -- or at least what it was supposed to be about. In an effort to provide some historical context, I'll talk about that, too. But I'd like to start by saying something about what it wasn't.

The 1986 reform was not a watershed in American tax history.

It was certainly a landmark in fiscal policymaking; a milestone of modern politics. It was a key element of the Republican ascendancy of the 1980s. It was, without question, important.

But it was not a watershed. According to the American Heritage dictionary, a watershed is "a critical point that marks a division or a change of course; a turning point." As important as it was, the 1986 reform was not a turning point. It renewed, but did not transform, the American tax regime.

And that's not surprising: It's hard to transform a tax regime. Historian Elliot Brownlee has identified just four watersheds in the history of American taxation: the Civil War, World War I, the Great Depression, and World War II. Each of these crises ushered in a new fiscal regime, a new "system of taxation with its own characteristic tax base, rate structure, administrative apparatus, and social purpose." Tax regimes are durable, moreover, because they are part of their larger economic and political environment. They only change when that environment itself changes.

In other words, tax regimes live and die by necessity, not design. Historically, old ones have disappeared when they failed to meet revenue needs. Sometimes, the tax base has atrophied. Such was the case with the tariff-based regime that arose in the wake of the Civil War, done in by the trade disruptions of World War I.

Other regimes have succumbed to overwhelming revenue demands -- ones that can't be met with existing fiscal tools. It was that sort of crisis that gave rise to our current regime in the months after Pearl Harbor. The World War II tax regime -- marked by a broad-based, progressive personal income tax, a moderate flat-rate tax on corporate profits, and a small but growing wage tax designed to fund social welfare programs -- has proven extremely durable. It has provided the fiscal foundation for a growing federal state for more than half a century.

Part of this durability has derived from tax preferences. Wartime legislation introduced millions of middle class Americans to the income tax; long exempt from this rich man's burden, they faced a new, and quite burdensome, fiscal responsibility.

Congress used preferences to help ease this burden a bit. Even before the war ended, a few lucky taxpayers, most of them businesses, managed to secure preferential treatment. But after the war, such favors went retail. The mortgage interest deduction -- a feature of the tax system since 1913 -- assumed new importance as homeownership soared in the postwar era. Similarly, the tax-free treatment of health benefits found a broad constituency once unions made employer- provided insurance a fixture of the modern labor market.

Tax preferences soon became a functional necessity for the modern tax regime. They gave millions of Americans a vested interest in the tax system, including its imperfections. They also helped ease the bracket creep that marked this tax regime, especially in the late 1960s and early 1970s. Indeed, the appetite for preferences continued to grow. By 1967 the revenue loss from tax preferences equaled 21 percent of total direct expenditures, according to Brownlee; by 1984 the figure had risen to 35 percent.

Preferences, in other words, were getting increasingly expensive. They also contributed to a sense that the income tax was hopelessly complicated -- although, it's worth noting that lawmakers were decrying tax complexity as early as 1916, just three years after the income tax hit the books.

Most important, however, the accretion of incentives vitiated the apparent fairness of the income tax. Many Americans began to suspect that their neighbors were shirking their fair share of the fiscal burden. By the mid-1980s, tales of widespread tax avoidance had combined with complexity worries to set the stage for sweeping reform.

The Tax Reform Act of 1986 made a serious and wholly commendable effort to deal with base erosion and fairness concerns -- and it even made a feint toward simplification. But fundamentally, it marked an effort to renew the existing tax regime, not replace it. And when it comes to tax regimes, renewals -- unlike replacements -- are not particularly durable.

The tax system had problems in the early 1980s, but they did not rise to the level of a structural crisis. If left unchecked, those problems might have produced such a crisis, perhaps even triggering the arrival of a new tax regime. But the 1986 reform had the surprising -- some might say, perverse -- effect of making further tax reform substantially less pressing.

Indeed, some critics have even suggested that tax reform renewed not just the tax regime, but the seamy political dynamics that sustained it. As economist Milton Friedman has observed, the end result of base broadening reform is just a renewed opportunity for lawmakers to resell old tax preferences.

The 1986 reform is history's best example of intentional -- as distinct from imperative -- tax reform. That's not to diminish its achievements; intentional reform on a grand scale requires more effort and political skill than its imperative counterpart. The policymakers who actually pull it off have accomplished something truly extraordinary.

The 1986 act represents the apotheosis of a certain type of tax reform, summed up by a mantra well known to every tax expert: Broaden the base, lower the rates. Income tax purists had been urging that sort of program since at least the early 1920s, when Thomas Adams, Robert Haig, and Henry Simons more or less created the notion of our modern income tax. But in the postwar era, this reform agenda found its most vigorous advocates in Stanley Surrey and Joe Pechman. For decades, these leading lights of the tax community led an effort to advance horizontal equity and protect the income tax from the depredations of politicians and lobbyists. In 1986 this effort had its greatest success.

But as important as this achievement was -- and it was very important -- it was not durable. Perhaps it was never meant to be. Perhaps tax reform in the Surrey-Pechman model is best regarded as a process, not an event.

But if so, then I think this process may be suspended indefinitely. I don't think the 1986 act is a plausible model for future tax reform. It's hard to believe that conservatives could be lured to the table again by the promise of lower rates. They watched rates creep up in the years after the 1986 legislation, and they understand, all too well, the ephemeral nature of intentional tax reform.

I'm not sure Democrats could be talked into it, either. They've developed a penchant, which they share with GOP colleagues, for using the tax system to serve every interest, meet every goal, and -- if they could -- spend every dollar.

Sure, it was ever thus: Tax expenditures are a grand tradition in American public finance, at least as old as the income tax. But in fact, it was not ever thus. It was once better. Once upon a time, Democrats, at least, could be counted on to defend a few spending priorities -- tuition grants for college, for instance. Now, they couch every progressive goal in the neoconservative rhetoric of "growth" and "opportunity." They use tax incentives to offer symbolic, if often insubstantial, support for their priorities. Democrats may consider this to be good politics, and maybe it is. It seemed to work for Bill Clinton. But this sort of milquetoast liberalism won't do anything good for the tax system.

Ultimately, durable tax reform happens when it must, not when it should. It happens when old taxes just can't keep up anymore -- not with fiscal demands, not with changes in the economy. Sometimes, even good taxes succumb to these changing realities.

Consider, for instance, the general property tax, a levy that states imposed through much of the 19th century. Originally, it was the darling of liberal reformers, who insisted that it would tax people according to their ability to pay. It was imposed on all personal property, not just real estate.

This seemed like a good idea, but it gradually became a sort of cruel joke. Changes in the economy, including the proliferation of financial instruments and other forms of intangible wealth after the Civil War, eviscerated the tax base, especially among the rich. The only people paying tax on all their property were those who didn't have enough to keep much of it in intangible form. That perverse reality produced a backlash, fueling the popularity of nascent income taxes, and opening the door to our modern fiscal state.

We may be approaching that sort of regime-changing, truly transformative fiscal moment -- the moment when existing fiscal tools start to fail. The world is changing, and the tax system may have to change with it.

The most serious threat to the income tax, I suspect, will come from capital income. In theory, at least, we still tax it. But many fans of consumption taxation warn that globalization, and the increasing mobility of capital, will ultimately make capital income untaxable. We'll be left with a de facto, if not a de jure, consumption tax.

Broad-based consumption taxes, defended on their own merits, may have a political future -- although their track record in American political history is not impressive. But consumption taxes that arise through erosion of the ostensible tax base will almost certainly have problems. The only thing Americans like less than taxes, it seems to me, are Potemkin taxes: taxes that claim to do one thing while in fact doing nothing of the sort. The resentment that flows from that sort of fiscal charade may well be a catalyst for lasting reform.