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December 14, 2010
Historical Perspective: Why Liberals Should Like Tax Reform
Joseph J. Thorndike

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The smart money bets against tax reform -- always and everywhere. But every once in a while -- usually a long while -- the smart money is wrong. In recent weeks, we've seen a few stray signals that this particular while may be almost over.

American political leaders are nearing that proverbial spot between a rock and a hard place. The rock, in this case, is our looming debt crisis. (Although words like "looming" conveniently obscure the timing of that crisis, which might unfold in a week or a decade.) The hard place -- which lawmakers are highly skilled at avoiding -- is genuine austerity.

So far, politicians have been able to wiggle out of that tight spot using a combination of empty rhetoric and legislative inertia. They complain loud and long about the unsustainable course of federal fiscal policy but then legislate like it doesn't exist. If the resulting cognitive dissonance ever gets to them, they certainly don't show it. Apparently, partisan scapegoating is a pretty good palliative.

End of Inertia

There are signs, however, that inertia may be losing its grip on the policy process. President Obama's National Commission on Fiscal Responsibility and Reform managed to muddle party lines on spending cuts and tax reductions, if only slightly and temporarily. Rising interest in fiscal reform is evident across the political spectrum. If experts from the Center on Budget and Policy Priorities and the American Enterprise Institute both can find nice things to say about the Bowles-Simpson commission (even while trashing many of its suggestions), then maybe there's cause for hope.

Still, many liberals remain suspicious of calls for retrenchment. Not unreasonably, they see the issue as a stalking-horse for conservative efforts to shrink the size of government.

But debt worries are real, as many liberal groups recognize. In particular, the CBPP has been a leader on the left when it comes to debt control. Other liberal groups have also tried to ensure that progressive voices are not absent from the most important policy debate of the coming decade. (Consider, for example, the recent report on debt control from Our Fiscal Security, a joint project of Demos, the Economic Policy Institute, and the Century Foundation.)

One thing that almost all debt control plans have in common is some sort of "tax reform." But the meaning of that feel-good term varies dramatically depending on who's doing the talking. For most conservatives, tax reform means rate reduction and pretty much nothing else. For liberals, reform usually means the opposite -- an increase in statutory and effective rates, especially at the top of the income scale. Sometimes liberals also support a particular type of base broadening, in the form of repealing the preference for capital gains.

Neither the conservative nor the liberal version of tax reform bears much resemblance to the historical meaning of the term. For the past 75 years or so, tax reform has been defined by a tradeoff: broaden the tax base and lower rates. That version of tax reform derives from an intellectual tradition with roots in the New Deal, and perhaps even earlier. It found its truest real-world expression in the political anomaly known as the Tax Reform Act of 1986.

Improbable but Possible

The 1986 version of tax reform is technocratic, developed by tax academics and professionals, not politicians. And in some respects it's politically hopeless. Tax preferences make the world go round, or at least the tax world. Trying to eliminate them is a fool's errand.

Except when it isn't. In 1986 the stars aligned and champions of classic tax reform found an opening for their agenda. Leveraging popular outrage over "loopholes," the reformers of 1986 defied the iron rules of lawmaking and influence peddling. It was truly remarkable, a once-in-a-generation achievement.

Well, the tax reform generation is still alive and kicking, at least in academia and various think tanks. But it has largely disappeared from the House and Senate. A new generation holds the reins of power, and it might be time for another run at the tax reform windmill.

If only the liberals would agree.

The tax elements of the Bowles-Simpson plan bear a strong family resemblance to classic tax reform. Unlike the 1986 version, the Bowles-Simpson plan is not revenue neutral. But it does embody the fundamental trade: sacrificing tax preferences for the sake of lower rates.

Indeed, many liberal critics have suggested that it takes the classic tradeoff too far. Too much of the revenue derived from a broader base is slated for rate cuts, they complain. More of the money should be used for debt control or vital spending programs. Fair enough. It's reasonable to quibble with the allocation of new revenues. But it's not reasonable to question the need for lower rates in general. They are a crucial part of the tax reform bargain.

Lessons of 1986

Some liberal activists, however, are inclined to disagree. Robert Borosage, a leading voice among liberal/progressive activists, has voiced caution about the entire notion of classic tax reform. In a piece for The Huffington Post, he recalled a bygone era:

    In the mid-1980s, under Ronald Reagan, civic-minded Senator Bill Bradley joined with reformers to fashion a similar deal [to current plans for tax reform] -- lower rates, eliminate egregious tax loopholes and deductions, in a revenue-neutral fashion. The establishment rallied; the bill passed.

All's good, right? Well, not so much. According to Borosage, the deal evaporated before the ink was even dry. Preferences were eliminated by the law, but the lobbyists behind them were not. And those lobbyists went to work immediately. "The loopholes, tax expenditures, various dodges returned," Borosage wrote. "Now the tax code is so riddled with them that beltway pundits can call for playing the same game once more." Meanwhile, he said, "the lower rates stayed largely in place."

On one level, of course, Borosage is right. The preferences did return. Indeed, the preference for capital gains was hardly gone from the lawbooks before it came roaring back in the 1990s. But Borosage is wrong when he suggests that rates stayed low. Consider the top marginal rate (not the only important one, I know, but still an important marker of rate progressivity, especially for liberals interested in redistributive taxation). From a low of 28 percent established in TRA 1986, the top rate moved to 31 percent in 1991 and 39.6 percent in 1993. Even after the 2001 tax cuts, it stood at 35 percent -- nothing like the pre-reform rates of 50 percent, 60 percent, or even higher, but still well above the 1986 low.

Indeed, rising rates are the reason so many of today's conservatives are suspicious of tax reform. If Borosage distrusts classic reform because loopholes have a tendency to reappear, then conservatives dislike it because rates have a way of creeping up.

Broadly speaking, both liberals and conservatives seem angry that tax reform didn't last. But all lawmaking is ephemeral, especially when it comes to taxes. The dynamics of democracy do not lend themselves to statutory stability.

Milton Friedman made that point in particularly cynical fashion. He argued that tax reform is really designed to keep lawmakers in office and lobbyists in clover. By wiping the slate clean every once in a while, reform ensures that lawmakers can resell tax preferences to those who have lost them. By the same token, it guarantees that lobbyists will stay fully employed as they work to recover lost ground. Good news all around -- except for the rest of us. (See Milton Friedman, "Tax Reform Lets Politicians Look for New Donors," The Wall Street Journal, July 7, 1986, at 12.)

I'm not quite as cynical as Friedman, but he has a point. Tax reform is not an event but a process. You don't have to like that fact to accept its empirical validity. Tax reform is a lot like cleaning out your garage. Just because you cleaned it last week, do you really expect that it will never need cleaning again?

If you think of tax reform in terms of process rather than permanence, then it doesn't seem nearly so disappointing. For liberals, especially, it can be an eye-opening shift in perspective. Tax reform is a way to extend the life of a tax regime and ensure its vitality. And in the future, this country will need a very vital tax system.

In 1986 broadening the base and lowering rates helped breathe new life into a struggling tax regime. It helped restore public faith in a revenue system beset by special interests and cluttered with perks and preferences. It also ensured that the system would continue to raise adequate revenue. Piecemeal erosion of the tax base raised questions about the system's long-run viability.

For liberals, the reinvigoration of the tax base was crucial. Not only did it protect the existing flow of revenue, but it made future tax increases more effective. Economist Joseph Pechman underscored that point in 1989 when lawmakers were struggling to close a widening budget deficit. Given the new, broader base that emerged from the 1986 reform, Pechman predicted that even modest rate increases would produce considerable revenue. His prediction was borne out by the rate increases of the 1990s.

If taxes are going to play a big part in solving our long-term budget woes, then attention to the tax base is vital. If nothing else, it will help ensure that future (inevitable) tax increases are as efficient as possible. If lower rates are the price of base broadening, then liberals should swallow hard and accept that political (and economic) reality.

For the foreseeable future, adequacy should be the liberal priority when it comes to taxes. Not even progressivity comes close as a liberal goal. Indeed, progressive taxation -- especially when reduced to arguments over top-end rates -- can be an obstacle to progressive government. If liberals want to protect the vital social programs of the past -- and make room for those of the future -- then they need to make sure we have money to pay for them. How we raise that money is less important than simply having it in the first place.