Why Reagan's Tax Reform Road Map Won't Work Now
Policy + Politics

Why Reagan's Tax Reform Road Map Won't Work Now

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As politicians and business leaders sound the battle cry to make over the loophole-ridden U.S. tax code, they often point wistfully to the Reagan as the perfect road map. The Tax Reform Act of 1986   achieved many of the goals now being espoused by Republicans and Democrats: It greatly simplified the income tax code, broadened the tax base and eliminated many tax shelters and preferences

The measure was made “revenue neutral” by decreasing individual tax rates and eliminating $30 billion a year in loopholes while increasing corporate taxes. Many of the brackets were consolidated, and the top tax rate was lowered from 50 percent to 28 percent.

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Grover Norquist, president of Americans for Tax Reform, said on Tuesday during a Bloomberg conference in Washington that the 1986 reform legislation “is a good model in a couple of ways,” because it focused on reducing rates with an agreement ahead of time “that it wasn’t going to be a Trojan horse for tax increases.”

Democratic Sen. Ron Wyden of Oregon told The Fiscal Times that the 1986 framework, “where you basically go in there and clean out a significant number of expenditures to hold down rates for everybody and keep progressivity” is the way to go.”
When and whether the White House and Republican and Democratic forces on Capitol Hill will try to rewrite the federal tax code will depend largely on the outcome of the November election, experts agree. If President Obama wins reelection, Democrats retain control of the Senate and Republicans hold onto the House, Republicans may see a virtue in working out a post-election compromise in order to salvage a portion of the Bush-era tax cuts that are scheduled to expire at the end of the year.

If, however, Republican Mitt Romney prevails over Obama and the Republicans win control of both chambers of Congress, there would be little incentive for the Republicans to make a deal with the Democrats before they took control of Congress and the White House in January.

Regardless of the timing, all sides agree a major rewriting of the tax code will call for painful tradeoffs, and likely will require heavy lifting well beyond what the Reagan White House and a politically divided Congress did 26 years ago.

While the 1986 experience inspires some lawmakers, it took two years of hard work and scrutiny before Congress passed and Reagan signed a bill. The bill was premised on an understanding that the legislation would raise roughly the same amount of revenue as under the old laws and would not raise tax rates for any particular income class more than another.

“That agreement at least gave them someplace where they could start,” said Howard Gleckman, a senior fellow at the Urban Institute and author of the TaxVox blog. “Now, there’s no consensus on how much money or if you'll even raise money from tax reform, so until that happens, they’re jammed.”

Today, Democrats and Republicans are sorely divided over whether a tax overhaul should raise revenue at all to help pay down the nation’s $1.3 trillion deficit.  They also are embroiled in a vitriolic debate over the merits of raising taxes on the rich—with President Obama  demanding that the wealthiest Americans pay more in taxes under his  'Buffett Rule’ and Republican House Speaker John Boehner, R-Ohio,  denouncing the concept as “class warfare.” 

There are other big differences that make it difficult to draw a parallel between the 1986 experience and the current mission to try to make the tax code simpler in a way that is acceptable to business executive, consumers and politicians. 

Those include a far different and more complex overseas tax picture today than in the late 1980s, a sharp rise in the number of pass through corporations, a fragile economy, and far more partisanship and political gridlock than existed when Ronald Reagan was president and Democrat Tip O’Neill of Massachusetts was speaker of the House.

"The 1986 Act is often described as the gold standard in tax reform, but the world is a fundamentally different place than in 1986,”said Ed Kleinbard, a tax law professor at the University of Southern California and former chief of staff at the non-partisan Joint Committee on Taxation.” We need more revenues than the 2012 tax rules would generate if extended.”

In essence, the 1986 act shifted some of the tax burden from individuals to corporations.  It nearly halved the top marginal personal income tax rate, moved 5 million low-income Americans off federal income tax rolls, and cut the top corporate tax rate from 46 percent to 34 percent.

Congress offset part of the cost of the tax cuts by eliminating the investment tax credit— one of the largest tax expenditures in the code at the time, which allowed businesses to lop off up to 10 percent of an equipment purchase prices from their tax bills. Lawmakers also lengthened depreciation schedules, by which businesses could recover the cost of their company equipment and property through the tax code.

Tax experts, including Kleinbard, say the 1986 tactic of shifting tax burdens from individuals to corporations is simply not feasible today.  That’s because in 1986 the threat of U.S. businesses moving intellectual property abroad to avoid U.S. taxes was virtually nonexistent due to stricter barriers to international investment and the fact that U.S. corporate tax rates were consistent with other developed nations.  Today, capital is much more mobile, and other developed nations like Canada, the United Kingdom and Japan have lowered their statutory corporate tax rates with the expectation that doing so would attract foreign companies to shift their profits to their jurisdiction.

The top federal corporate tax rate in the U.S. is 35 percent, compared to an average rate of 25.4 percent in 2012 for the 34 developed countries included in the Organization for Economic Cooperation and Development.“So any tax change that would make it more costly or any less advantageous for U.S. businesses to operate domestically—that becomes a real question of competition,” said Joseph Minarik, a former economist for the House Budget Committee and Office of Management and Budget. 

 As for the surge in U.S. companies shifting income to lower tax jurisdictions overseas: “This issue was simply nowhere near as important in 1986 before all of these elaborate tax avoidance structures developed,” said H. David Rosenbloom, director of the International Tax Program at New York University School of Law. “From where I sit, lawmakers are a long way from figuring out what, if anything, to do about it.”

Equally unclear is how lawmakers intend to address the more than 90 percent of U.S. businesses organized as pass-through entities, partnerships, and sole proprietorships. Those structures afford businesses the same liability protection of a corporation, and many of the same tax breaks, but allow profits to flow through to owners and shareholders to be taxed once at the individual rate, escaping corporate taxation. 

According to the Internal Revenue Service, the percentage of U.S. corporations organized as pass-through entities grew from about 24 percent in 1986 up to about 69 percent in 2008, That shift was in part caused by the 1986 tax overhaul’s drastic cut in individual income tax rates, tax experts say.

President Obama and some lawmakers have suggested that a corporate tax overhaul precede an individual tax code overhaul.  In February, Obama proposed cutting the top corporate tax rate to 28 percent from 35 percent by dashing the vast majority of corporate tax preferences from the code.  Under this plan, non-corporate businesses wouldn’t be able to enjoy the tax rate cut C corporations would, but would still lose some of their tax breaks to fund it.

“If you’re going to take away a bunch of business tax incentives, you have to figure out a way to make it tolerable for the people who operate in pass-through form or sole proprietorship.  That’s a real sticking point,” said Clint Stretch, a managing principal at Deloitte Tax LLP.