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October 21, 2011
Tax Reform 1986: A Silver Anniversary, Not a Jubilee

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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.

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.

Table of Contents


An Uneasy Political Marriage

Revenue and Distributional Neutrality

The Overall Effects of the 1986 Act

The International Economy

Looking Ahead


Michael Graetz 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 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 anti-poverty 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 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 rate-reducing 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.

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 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 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.

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.

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 the 1981 legislation and ratifying tax reductions that high-income individuals had managed to achieve through tax shelter investments.

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 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.

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-revenue-raising 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 increases of American workers. Nor have our tax-based 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 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.

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 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, "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 foreign-owned 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 popular 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 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 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 short-term 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 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 high-income 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.


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."

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.

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).

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.

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.

9 Michael J. Graetz, "The Truth About Tax Reform," 40 U. Fla. L. Rev. 617, 635 (1988).

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).

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.

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.


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