“The nine most terrifying words in the English language are: ‘I’m from the government, and I’m here to help.’” When Ronald Reagan unleashed this historic line in 1986, he apparently forgot about tax shelters. In the early 1980s, tax shelters were so popular that the government would soon be cutting more checks to companies than collecting them. From 1981 to 1983, 128 out of 250 major American corporations had zero or negative taxes in at least one of the three years. In total, they collected $5.7 billion in tax benefits on profits of $57.1 billion. When media outlets tried to shame General Electric for taking home a check for $283 million, it insisted that it was just following the law. “When a company responds to [federal] incentives, I don’t think they ought to be castigated,” said John McCoy, manager of tax accounting for GE. “They ought to be applauded for carrying out the will of Congress.” The sad part is, he wasn’t wrong: the Reagan administration shot itself in the foot by doling out a massive goody bag of tax breaks to (nearly) everyone just four years earlier. Faced with the legacy of creating the biggest peacetime budget deficits ever known, President Reagan finally called for reform. This week, in celebration of national Tax Day (as typically scheduled), we take a look back at the most significant tax reform of the past century — the Tax Reform Act of 1986 — a piece of legislation which spawned a global copycat movement and is still regarded as the gold standard (despite our many deviations from it) for the modern fiscal state.
The Era of Regressive Taxation
For the first century and a half of its existence, the U.S. federal government supported itself almost exclusively through high tariffs, sales taxes, and by selling off large tracts of public land. The income tax first made an appearance during the Civil War — initially imposed at a rate of 3% on all citizens who earned more than $800 a year — but was quickly abolished for another half century. Still, taxes seemed pervasive, especially to the poor. Popular commodities like sugar, rum, and tobacco were heavily taxed, draining the pockets of the average worker. Many state residents were compelled to keep an exhaustive list of personal items — including animals, watches, jewelry, household furniture, library books, etc. — to satisfy property tax requirements. Mark Twain attracted a mass following simply by complaining about taxes. “We’ve got so much taxation,” said Twain in a 1906 speech on morals, “I don’t know of a single foreign product that enters this country untaxed except the answer to prayer.”
William Jennings Bryan — the O.G. social justice warrior — took up the crusade of income taxes in 1894, objecting to regressive tariffs and excise taxes on behalf of the poor. “If taxation is a badge of freedom,” stormed Bryan during a House debate, “let me assure my friend that the poor people of this country are covered all over with the insignia of freedom.” But the Supreme Court trampled his dreams of a progressive income tax in 1895 and wasn’t challenged again until the passage of the 16th amendment in 1913. Once the U.S. entangled itself in two world wars, it gave up any pretense of getting by on prairie auctions or tobacco sales and fully embraced the income tax. By the end of World War II (which was so expensive that the top marginal rate briefly reached 94 percent), 90 percent of the labor force submitted tax returns, with 60 percent paying federal income taxes. Taxes continued to climb for the next two decades, but nobody objected very loudly because personal incomes climbed still faster. That all changed in the 1970s, when a trifecta of inflation, oil prices, and Vietnam first made tax reform a riveting political talking point again.
Everything’s Gone but the Grin
From 1950 to 1980, the will of Congress slowly eroded the tax base (despite climbing rates) through a thickening web of tax expenditures and loopholes. Take the case of the depletion allowance: oil drillers once enjoyed an exclusive tax break known as the depletion allowance to account for their wells depleting over time. Other industries soon demanded the same, and by the mid 1980s everyone from cement companies to Christmas tree farms to cattle growers had obtained one. A cottage industry of tax-shelter experts soon lent itself to the cause. Popular vacation spots such as Vail, Colorado started hosting “investment seminars” at ski resorts. “After a long day on the slopes, skiers could drop by the seminars, fix a cocktail, and watch a videotape telling them how to make tax-shelter investments,” writes historian and Wall Street Journal editor, Alan Murray. “They could then deduct the trip as an investment expense. The average taxpayer was, in effect, subsidizing ski trips for investors who wanted to learn more about escaping taxes!” By 1984, even Trappist monks were in the know about special favors. “We’d like to have it,” said Father John Baptist of the Trappist Abbey, in reference to the lucrative investment credit. “Because everyone else has it.”
In just three decades, corporate contributions to government revenues dropped from 25% in the 1950s to a hair over 6% in 1983. “It’s like Alice’s Cheshire Cat,” remarked Van Doom Ooms, chief economist for the House Budget Committee. “Everything’s gone but the grin.” The individual income tax didn’t prove much more lucrative. Without tax reform, the Joint Committee on Taxation concluded that by 1987, tax expenditures would cost the government $450 billion a year in lost revenue — more than the entire amount raised by individual income taxes. To exacerbate the situation, mass inflation ensured that more people below the poverty line were being taxed than ever before. Meanwhile, thanks to those educational ski resorts, about thirty thousand taxpayers with earnings exceeding $250,000 (including 3 thousand millionaires) paid less than 5% of their income in taxes.
A Formula for Tax Reform
The Tax Reform Act of 1986 was championed by one of the most improbable pairings seen yet in political history: liberal Bill Bradley, a former NBA basketball star turned “policy-wonk,” and conservative Donald Regan, former chairman & CEO of Merrill Lynch, who abandoned a dazzling career on Wall Street to become President Reagan’s secretary of the Treasury. Bradley’s interest in tax reform stemmed from his experience on the Knicks, where his status as one of the league’s best-paid rookies earned him the nickname “Dollar Bill.” During his first contract negotiations, a tax attorney asked him: “How much do you want to pay in taxes?” Bradley was appalled. He learned that he could distort his income through any number of creative categories: as property, as a long-term consulting contract, as an employer-paid life insurance and pension plan, or as a payment to his own “Dollar Bill” corporation. Most disturbing of all? The Knicks themselves were allowed to write off Bradley as a “depreciable asset” to account for his slowdown with age. “I [was] a loophole for the New York Knicks,” Bradley realized. Regan, despite reaching the upper echelons of Wall Street, retained an anti-establishment streak from his Irish working-class background. He took a scorched-earth approach to tax deductions and described the existing tax code as “incomprehensible in its details and shady in its exceptions.” Regan relished the idea of taking down the “Gucci boys” — wealthy lobbyists who paced the halls of Congress in burnished leather slippers. One day he walked in on his Treasury team agonizing over which of the many cherished tax preferences to scrap. Regan said to them: “This is the day we do away with Santa Claus.”
Together, the two of them approached President Reagan with a plan to cut the top rate to 30% or lower by sticking to Bradley’s mantra of “broad base, low rates” (BBLR). Even though the plan would temporarily raise corporate taxes — blasphemous territory for a man who once contemplated eliminating them entirely — President Reagan was seduced by the idea of lower individual tax rates across the board. Scarred by high taxes as a young B-list actor, Reagan remembered rationing the number of films he made per year so as to avoid the top federal rate of 90%. “Why should I have done a third picture, even if it was Gone with the Wind?” said Reagan. “What good would it have done me?” The plan would lower all tax rates by going after nearly every one of the Gucci Boys’ sacred cows. Deductions for auto loans and credit cards? Gone. Deductions for state and local taxes? Gone. Deductions for charity, mortgage interest, and IRA deposits? Severely curtailed. It even set the tax rate on capital gains to the same level as the top income tax. “The trade-off between loophole elimination and a lower top rate became obvious,” wrote Bradley afterwards. “The key to reform was to focus on the attractiveness of the low rates, not on the pain of limiting deductions.”
The Legacy of BBLR
In short order, Reagan’s tax bill was lauded as the most significant tax reform in the history of the income tax. It reduced the top marginal rate for individual taxpayers from 50% to 28% — the most dramatic cut ever accomplished by a tax bill — and established a simple, two-tier tax system that put an end to unchecked deductions. Even the corporate tax rate plummeted from 48% to 34% (but they still paid $120 billion more over five years). The rest of the world took note: Britain, Ireland, Canada, and the Netherlands quickly adopted similar formulas to dramatically lower their tax rates. Today, the BBLR model is seen as the gold standard for tax regimes by the OECD. One of its perennial bestsellers (imagine!) is a 160-page guidebook called Choosing a Broad Base-Low-Rate Approach to Taxation. But the good times didn’t last long. The mortgage interest deduction — long derided as “the perfect break for bobos in paradise” — made a swift comeback, followed by capital gains, electric vehicles, depletion allowances, student loan interest deductions, new child-care credits, etc. By the end of the 1990s, the top marginal rate had climbed back to 39.6%, where it sat until the Trump Administration reinstated some level of reform in 2017. “The U.S. tax code is a mockery of the BBLR principle,” wrote investigative reporter T.R. Reid in 2018. “It is stuffed to the root with loopholes that narrow the tax base and thus force tax rates higher.”
The U.S. is unlikely to ever return to a strict BBLR model because it increasingly relies on tax credits and deductions to support the “hidden” welfare state. Tax expenditures are a pivotal tool used by both parties to provide housing, health, retirement, and income support policies. They are now estimated to account for 40% of the welfare state. At the end of the day, Americans would rather subsidize housing through tax breaks than directly issue someone a benefit check. Meanwhile, the U.S. now lags the rest of the world when it comes to tax innovation. Whereas most developed countries now support individual, rather than joint, filing, the U.S. clings to its joint-filer status, a World War II relic that continues to punish many working married women by taxing the second income at a much higher rate.
And while the vast majority of the world has adopted some form of a value-added consumption tax (VAT), the U.S. remains devoted to the income tax. “The VAT makes so much economic sense that even the U.S. Congress will eventually recognize its value,” says the UCLA Law School professor Eric Zolt, who has helped design tax codes for about forty countries. “Mark my words,” Zolt says forcefully, “the United States will have a VAT within five years. Of course,” the professor concedes, “I’ve been saying that for the last twenty years.” Progressive or not, one of the income tax’s greatest flaws is its high visibility, a trait that will always make it susceptible to games of political whack-a-mole. We are witnessing this in real-time, as the Biden administration attempts to reverse some of Trump administration’s corporate tax cuts with the pending American Jobs Plan.
On the flip side, it seems unlikely that a pro-tax movement will ever gain much popular support. Because when it comes to taxes, most people still follow the motto: “Don’t tax you, don’t tax me, tax that fellow behind the tree!”
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