How to Design Tax Reform: 8 Lessons from 1986

This post originally appeared on Forbes.

Saying that one is for tax reform doesn’t provide much information about what is being sought or how to do it. Potential options extend almost infinitely, as do amendments to any set of options. So how does one both focus and ensure that reform, proposed or enacted, serves the public in a meaningful way? Here I identify eight lessons that were vital to the organization of the Treasury study (“Treasury I”) that led to the Tax Reform Act of 1986, the only comprehensive base-broadening tax reform in the hundred-plus history of the income tax

  1. Know the unique requirements and opportunities of the time. No past reform is repeatable. Today is not yesterday. Society today has new needs, different things to fix, novel opportunities, and changing leadership. The 1986 reform was made possible by many factors, including growing tax shelters that everyone agreed were unfair and inefficient, a President who cared about tax rates more than just about anything else, high levels of productivity as baby boomers moved into their peak earning years, Congressional leaders like Senators Bill Bradley and Jack Kemp who had been promoting tax reform, and budget acts in 1982 and 1984, along with Social Security reform in 1983, that left room for at least a reform that didn’t have to raise revenues.
  2. Don’t try to build up reform out of a stack of wants. The more politicians try to organize reform by supporting a bunch of giveaways, as opposed to allowing tax experts to give them viable options for fixing different parts of the system, the more that they are likely to suggest provisions that don’t add up, are inconsistent, fail to meet stated objectives, can’t be administered, and cause other unintended consequences.
  3. Use principles, not symbols, to drive choices. I’m not so naive as to believe that symbols aren’t important. That’s why every tax bill, no matter how much it deforms, tends to get the label of “reform.” But principles should guide where one is going, and create borders to deter consideration of items that don’t meet any principle well. Tax policy principles center on:  equal justice or equal treatment of equals or “horizontal equity;” efficiency; progressivity (though the degree is open to dispute, the principle is not, since, among other reasons, those with no income can’t pay tax); limits on the disincentives to work, save, or invest that are inherent in any tax; and “administrability,” or avoiding both high enforcement costs and the corruption that rises when cheating can’t be controlled.
  4. Build a baseby focusing on those particular principles, like equal justice, accepted by conservatives, liberals, and independents alike. The main fight between political parties over many decades has been between two principles: progressivity and avoidance of the distortions that higher tax rates create. That still leaves huge amounts of the tax system to be reformed on the basis of concerns that are widely shared. When the roof leaks, families can work together to fix it even if they still are in conflict over whether to spend money on a new bed or sofa.
  5. Always keep in mind the balance sheet within both the tax system and the broader budget. Nothing deters a reform process more than trying to give away money without immediately calculating who will pay the bill—whether through tax increases to offset the tax cuts, spending decreases, or rising debt and interest costs to be paid by future generations.
  6. Engage those health, housing, charity, pension, and other policies that are woven into the tax code. With about one quarter of all federal subsidies lying within the tax rather than expenditure system, these issues are hard to dodge even in modest reforms and impossible to avoid in comprehensive reform. Whether it’s the hundreds of billions of dollars spent on the tax subsidy for employer-provided insurance, or housing tax subsidies that cost more than the budget of the Department of Housing and Urban Development (HUD), tax reform almost inevitably will affect those policies. To the extent that tax subsidies are maintained, they should still be reformed to be more effective in, say, increasing charitable giving or promoting adequate retirement saving.
  7. Gather evidence continually, rather than waiting to provide ex post apologetics for a final proposal. Among the many reasons for success in 1986, Treasury and IRS got very busy gathering evidence on growing problems such as the tax shelters of those days, on who benefited from various provisions, and on what the academic literature said. Some efforts require long-term investments, such as in individual and corporate tax models, and even then one often has to change traditional ways of doing things. Before 1984, tax changes were distributed by adjusted gross income (AGI), which meant that the fictitious negative partnership income of tax shelters was subtracted from AGI in a way that made many rich look poor and tax shelter reform look like an attack on the poor. This had to be amended. Many of these efforts take months or years to develop.
  8. Empower well the plumbers, architects, and engineers—your crew in the Treasury’s Office of Tax Policy and the Congressional Joint Committee on Taxation—if you want a structure that will stand. They often know what pipes can or need to be welded together, but they only do what they are empowered to do in a world where a lot of people make crazy claims. For some reason, smart doctors, lawyers, and entrepreneurs when elected or appointed to political positions think that they have miraculously garnered the talent to weld together the pipes through which explosive gas flows.

Want to predict the probability of reform? Simply go through the list and ask yourself the extent to which those in charge at any stage understand and have a plan for dealing with these types of issues.

 


The Trump Administration Dilemma on Tax Reform

This post originally appeared on TaxVox.

Q: Since the modern federal income tax was created in 1913, how often has Congress enacted a revenue-neutral income tax reform that significantly expanded the tax base and lowered rates??

A: One. In 1986.

It is no wonder that the Trump administration—like others before it—is struggling with broad and systemic tax reform. To better understand why, think of tax legislation in three distinct flavors: tax cuts, tax increases, and revenue-neutral changes.

Most income tax bills cut taxes. The reason is obvious. Elected officials like to give something to voters rather than take something away from them.

Since the large tax increases required to finance World War II, most revenue bills reduced taxes, particularly in the period up through 1981. Significant reductions in defense spending as a share of the economy, along with inflationary increases in incomes that pushed people to pay higher individual income tax rates, made legislated tax cuts possible during what I call the Era of Easy Finance.

In a few cases, Congress did raise income taxes. Tax historians Joseph Thorndike and Elliott Brownlee have shown that almost all major income tax increases came about as a result of war. Others, generally raising annual revenues by well less than 1 percent of GDP, have been enacted, for instance, as part of several deficit reduction agreements between 1982 and 1997.

Broad-based and systemic income tax reform that keeps revenues roughly the same as current law requires a tremendous amount of work, largely because it means broadening the tax base by identifying which popular tax subsidies, now costing more than $1 trillion annually, should be targeted for elimination.

Less broad-based but still systemic reforms are also possible. Outstanding modern examples are the codification effort of 1954 and the 1969 reform best known for addressing tax issues surrounding foundations and charities.

As economic coordinator of the Treasury’s 1984 study that led to the Tax Reform Act of 1986, I remember how difficult it was for Treasury and Joint Committee on Taxation staffs to draft legislation and to estimate cost and distributional effects for those proposals. Increasing taxes on some to pay for tax cuts for others requires tax writers to agree on principles to guide and justify their actions. The political aspects of tax reform, building a political coalition to push to see these principles enacted, are even more difficult than the technical concerns.

Tax reform of the revenue-neutral variety is much harder than merely cutting taxes. To cut taxes, lawmakers simply tally a set of wants, perhaps pare them down to fit within a specified amount, and leave the financing bill for current tax cuts to future generations of unidentified taxpayers.

Finally, the design of any systemic reform must acknowledge the economic and political environment of its time. The 1986 Act, for instance, took advantage of bipartisan concerns over tax shelters, President Reagan’s focus on high tax rates, Democrats’ objections to the rising income taxation of the poor, and social conservatives’ efforts to reverse the rising burden being placed on families with children. Deficits were perceived to be a problem, though a smaller one than today in part because Congress had raised taxes and cut spending in the 1982 and 1984 budget agreements and in the Social Security Act of 1983.

President Trump and his team have promised to cut tax rates for all businesses and for the middle class, while not increasing the deficit. They can’t get there by taxing the poor. Even if they assume greater economic growth, it’s not going to be enough to pay for the historically large tax cut provisions. So what’s left?

Some seem to want simply to throw in the towel on revenue neutral tax reform and just cut taxes instead. But $1.3 trillion in additional spending is already built in for 2026 (largely due to rising interest costs and increased spending on Social Security, Medicare, and Medicaid). This is far more than the $850 billion in additional taxes projected to be collected for that year due to a growing economy. How will Congress and the president cover that existing shortfall, even before they think of more tax cuts?

That’s the box the Administration is in. And it is why tax reform is no easier than health care reform. Avoiding big new revenue losses requires systemic reform, such as increasing taxes on individuals to offset business tax cuts. Or engaging in true budget reform that includes scaling back on popular programs. Those are the requirements of our time, like them or not, and while briefly they might be ignored politically, over the longer run they can’t be dodged as a matter of either economics or arithmetic.