Thursday, November 30, 2017

T. R. Reid: When Tax Reform in the United States Worked: 1986

T. R. Reid has had a long career as a journalist and author.  One of his best products was a volume titled The Healing of America: A Global Quest for Better, Cheaper, and Fairer Health Care.  This book was published around the time that the program now known as Obamacare was being assembled and passed into law.  It provided an excellent comparison between healthcare systems in other countries and that operating in the United States.  Reid’s message was that we in the US can do a lot better if we would only be willing to learn from others.  He has recently produced another timely book focused this time on the topic of taxation: A Fine Mess: A Global Quest for a Simpler, Fairer, and More Efficient Tax System.  Reid again produces a short, clear, highly readable comparison between the US and other approaches to taxation in use around the world.  Again, the message is that we could learn a lot from others.

Reid states that while the initial passage of the federal income tax occurred in 1913, it was not until 1922 that the law settled into a well-established form.  Over the course of time conditions change and lawmakers feel compelled to “tweak” the tax system and it becomes more complicated and more unwieldy.  By the time of Eisenhower’s administration it was clear that the legislation needed a major rewrite in order to render it more efficient.  That new version was generated in 1954.  As before, this version was subjected to continual modifications as legislators felt a need to accommodate various special interests.  It would be in the 1980s that a sprawling and confusing tax code generated enough disgust to render another rewrite necessary.  This would take place under Ronald Reagan in 1986.  Reid takes note of the fact that major rewrites have occurred every 32 years, making the timing for the next rewrite to be 2018.  How much more timely could an author be?

The path to tax reform in 1986 was not simple, but after several years of arguing back and forth between political partisans, a very simple approach began to be viewed in a positive light by both sides and strong bipartisan support for the new tax code was attained.  The lessons of that period should inform the current deliberations on tax modification, but the attempt to avoid bipartisan support probably means we will not see the needed rewrite on Reid’s 32-year schedule.  Nevertheless, Reid’s perspective is informative.

Reid makes the dubious claim that politics in the Reagan era “was as fractious as it is today.”  At the time of the relevant taxation deliberations we had Republicans in control of the presidency and the Senate while Democrats controlled the House of Representatives.  Reid attributes credit for the needed political momentum to two people.

“These two were strange bedfellows indeed.  One of them, a conservative Republican, was a Wall Street tycoon; the other, a liberal Democrat, was a basketball star.”

The Republican was Donald Regan who accepted the post of secretary of the Treasury under President Reagan.  He was not an ideologue and thought our messy system could be improved by studying what other countries were doing in the taxation arena.  He was particularly interested in what was taking place in New Zealand, a country that was already moving in a direction that seemed appropriate for the US as well.

Essentially all nonpartisan tax experts advise countries to adopt an approach tersely summarized as “broad base, low rates,” or even more simply: BBLR.  The notion is that high taxes affect economic decisions which lead to inefficient economic outcomes.  It is better that decisions be based on their intrinsic properties rather than on tax considerations.  The goal then is to attain the needed funds to run government with the lowest possible rates of taxation.  The way to do this is to broaden the tax base as much as possible.  Every existing special tax deduction or allowance then has the effect of narrowing the base and requiring higher rates.  New Zealand possessed a complex mess for a tax code and decided to apply the BBLR principle in order to fix it.

“It relied primarily for revenue on a personal income tax, and the tax was riddled with exemptions, credits, and giveaways for particular groups and companies.  In short, it was the opposite of BBLR.  All those preferences made for a fairly narrow tax base, which meant that tax rates had to be high to raise the required revenue.  By the early 1980s, the top marginal income tax rate was 66%.”

The tax specialists were tasked with lowering income tax rates by half.  This they accomplished by eliminating essentially all of the special provisions that had been inserted into the previous code and by establishing a national sales tax that has dwelled in the 10-15% range.  This tax was labeled a goods and services tax (GST) but it is equivalent to the value-added taxes (VATs) in place in most nations of the world.

“With that addition, the income tax rates could be cut in half for every tax payer in the nation—with no loss of revenue to the government.”

Reid estimates that a couple in the US with the median income will average paying about 35% of earnings in income taxes and healthcare insurance.  That includes federal, state, local, and payroll taxes (Social Security and Medicare).

“In New Zealand, in contrast, the median wage earner pays about 17.5% in income tax.  But that one payment also covers his old-age pension (there’s no separate tax for Social Security), plus free healthcare for life (there’s no separate tax for healthcare), plus free education through college graduation (there’s no separate tax for schools).  So the average New Zealander’s wages are taxed at less than half the rate of the average American’s.  And yet New Zealand provides more government services than the United States—with half the tax rate.  That’s the beauty of BBLR.”

One must remember that New Zealand’s consumption tax (value-added tax) is also much more efficient at collecting funds than the array of state and local sales taxes that are so easy to cheat on, and we waste much more money than anyone else on healthcare.  But yes, there are things to be learned from other countries.

The driver for tax reform from the liberal side was Bill Bradley, a basketball all-American at Princeton and a Rhodes Scholar who followed that up with a career as a star player for the New York Knicks of the NBA.  Bradley’s interest in federal taxes is said to have arisen when he learned that as a player he was considered a “depreciable asset” by his employers.  He entered the Senate representing New Jersey in 1978 and began focusing on the issue of taxation.  His goal was to apply the principles of BBLR in order to be able to lower tax rates.

“’The trade-off between loophole elimination and a lower top rate became obvious,’ Bradley wrote later; ‘the lower the rate, the more loopholes had to be closed to pay for it.’  Bradley stuck to the mantra of ‘broad base, low rates’ for years, telling anybody who would listen that a significant cut in tax rates would win the votes needed to broaden the base.  ‘The key to reform was to focus on the attractiveness of low rates, not on the pain of limiting deductions.”

When Regan, his successor at Treasury, James Baker, and Bradley brought a credible proposal to President Reagan in 1984 to significantly cut tax rates he bought into the idea.  Legislation would eventually pass in 1986 after much political haggling.

The tax legislation passed in 1986 is startling in the changes that were approved.  The fact that it could actually be passed by a bipartisan vote is astonishing given today’s environment.

“The 1986 law, generally recognized as ‘the most significant reform in the history of the income tax,’ reduced the top marginal rate for individual taxpayers from 50% to 28%—the biggest reduction of any tax bill before or since.  It did that by eliminating a broad range of ‘tax shelter’ breaks available only to the rich.  It cut back the deduction for mortgage interest and completely eliminated the deduction for interest on consumer loans, like auto loans and credit cards.  It eliminated the deduction for state and local sales taxes.  It limited deductions for charitable contributions, IRA deposits, medical bills, and other personal expenses.  It set the tax rate on capital gains—that is profit on stocks, real estate deals, and so on—at the same level as the top income tax rate, so that financiers could no longer cut their tax bill by defining all their pay as capital gains.”

“The new law produced significant tax cuts for low-income and median-income Americans and provided tax savings for the rich as well.  But somebody had to pay for all that lost revenue, and the burden was shifted largely to corporations.  Although the bill cut the basic corporate tax rate, from 48% to 34%, it took away so many of industry’s cherished credits, deductions, and depletion allowances that corporate taxes increased by some $120 billion over five years.”

It may be difficult to believe now, but at one time the United States was the shining example of how to produce tax policy.

“This stunning and unexpected tax reform, particularly coming out of a politically polarized Washington, D.C., drew attention, and prompted action, around the world.  When little New Zealand transformed its tax code, the other wealthy nations found it interesting; when the mighty United States did the same thing, the rest of the world found it imperative, on political and fiscal grounds, to do the same.  In short order, Britain, Ireland, Canada, the Netherlands, and other democracies dramatically lowered their tax rates by broadening the tax base.  The OECD called this wave of tax reduction a ‘global revolution,’ and the United States lit the spark.”

But politicians do what politicians do and “money doesn’t talk, it swears,” so over the years, even New Zealand’s tax code became cluttered with exceptions and had to be rewritten in 2010.  Our politicians have also been busy.  Corporate taxes produce ever less in relative revenue and the demand is to cut that revenue even further.  Mechanisms for tax avoidance inexorably grow causing the government to either raise rates or borrow money to keep the ship of state afloat.

“After proudly patting itself on the back because of the 1986 reform, Congress in the next three decades made more than thirty thousand changes to the 1986 code.  Most of them ran counter to the ethos of BBLR.  Virtually all of them made the tax code more complicated—including that bizarre ‘anti-complexity clause,’ Section 7803(c)(2)(B)(ii)(IX).”

It is hard to believe that only three decades ago Congress was capable of acting on such a major bill.  Reid may see his 32-year prophecy come to pass, but it is unlikely that the result will be viewed as a worthwhile accomplishment by the American people—let alone by the rest of the world.

The interested reader might find the following articles informative:

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