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Lack of Reagan Gumption Ensures Top Tax Rate Stays

Apparently what happened in 1986 stays in 1986.

In contemplating the Republican effort to craft a plan to revamp the U.S. tax code, one unmistakable reality comes into focus: The Democrats have won the debate. That became clear with reports that congressional Republicans currently plan to keep the top individual tax rate at 39.6 percent. The significance of this can be understood only through a review of events and developments surrounding tax policy during the Reagan years in the 1980s.

It must be noted, in this context, that the lessons of Reaganism in our own day, some 30 years after he left politics, are limited. We live in a different time, and many of his policies bear little relevance to our own circumstances. His 1988 immigration plan, for example, was a disaster, with its amnesty program that has poisoned the country’s immigration politics ever since. Similarly, his free trade advocacy, while perhaps right for his day, has been superseded by intervening events.

But on tax policy a consensus emerged through nearly seven years of political combat that could have served the country well—had it not been tossed aside by policymakers. Therein lies an object lesson for our own time and for today’s tax reformers.

The tax consensus was produced through a kind of Hegelian process—thesis, antithesis, synthesis. It was a triumph of politics culminating in the famous 1986 tax bill, often cited as a great achievement of political cooperation across partisan aisles.

First, the thesis. Reagan argued forcefully that tax rates were too high. And they were—a top rate of 70 percent on “unearned” income, meaning largely investment income. The top rate on “earned” income, from actual toil, was 50 percent. What’s more, double-digit inflation was pushing Americans into ever higher tax brackets (of which there were many in those days). Thus did the federal government grab more and more money from ordinary Americans without any members of Congress ever having to vote for raising taxes. It was a scandal, and Reagan went after it like an agitated terrier.

The result was the Reagan tax bill of 1981, which among other things reduced individual tax rates by 23 percent over three years. The top rate came down to 50 percent. And tax brackets were indexed for inflation to end the scandal of automatic tax hikes without any congressional assent. It was a signal victory for the new president. A crucial House vote as the debate neared its end was 238-195, with 48 Democrats choosing the GOP option over their own party’s plan. The vote on final passage was 323-107. In the Senate, the final vote was 89-11, which signaled that the new tax thesis for America was lower tax rates. The rates had been too high for too long, the country decided.

But then an antithesis emerged with the biting 1982 recession. It was a planned recession, engineered by Fed chairman Paul Volcker to squeeze soaring inflation out of the economy. But Reagan never attacked Volcker even as his policies devastated Americans, particularly in the Midwest and other Rust Belt regions—home to voters Reagan was trying to win over from the opposition party. He felt—correctly, as it turned out—that eventually his tax cuts would kick in as a non-inflationary economic stimulus. So he suffered through the temporary political consequences in the conviction that eventually it would work.

In the meantime the recession was turning politics on its head, with those errant Democrats who voted for Reagan’s program now turning on him with a vengeance. An economic argument emerged that the tax cuts had contributed to the country’s economic travail by freezing in place massive deficits, forcing governmental borrowing, and thus squeezing out capital from the private economy. Subsequent events exposed this argument as ridiculous, but it didn’t matter. With an off-year election looming, Democrats bludgeoned Reagan.

That led to the second major tax bill in two years. But as Congress grappled with the perceived imperative of dialing back on Reagan’s tax cuts, the president remained steadfast in his defense of his cherished rate reductions. So Congress sought a bipartisan consensus on eliminating many of the tax preferences—loopholes, in the parlance of the day—that riddled the tax code. When the dust settled, the rates remained intact, but many preferences were gone.

And therein emerged the synthesis—lower rates accompanying a simpler, cleaner code with many fewer breaks for special interests cluttering up the country’s tax policy and distorting economic decision-making in ways that retarded economic efficiency.

That was the synthesis that undergirded the famous 1986 bill. It turned out Congress hadn’t really gone after those nettlesome loopholes with anything approaching the aggressiveness that was needed. In fact, they were so cherished by their beneficiaries that it wasn’t clear Congress would actually embrace the synthesis. The House bill, passed in December of 1985, didn’t really go after them with much zeal, with the result that the rates couldn’t come down very much.

But over in the Senate, Senator Bob Packwood of Oregon, Finance Committee chairman, finally busted out of that straitjacket. No, he said, we must really slash away at those loopholes in order to get a truly low individual income tax rate. And he did, with the result that the top rate came down to 28 percent. It was a signal achievement of tax writing—and serves today as a kind of beacon for how Congress should operate.

Some have argued (including myself) that this thesis-antithesis-synthesis process yielded a tax policy so powerful in its economic thrust that it was a major factor in the growth and fiscal surpluses of the Clinton years. A careful study of that era’s economic developments would provide good fodder for this argument.

But the Democrats never bought into it, however bipartisan the congressional votes that generated it. And they had a strong argument—TAX CUTS FOR THE RICH. With Reagan in place, with his soaring communication skills, steadfast conviction, and widespread popularity, that Democratic line didn’t get much traction. Bill Clinton was smart enough to see that: with strong growth driving his own popularity, it was smart politics to keep the synthesis pretty much in place.

But not entirely. Congress would chip away at the synthesis, with Democrats driving the issue but Republicans often avidly joining to assuage special-interest constituents. The result: more and more loopholes and higher and higher rates. The 1986 consensus really didn’t last long at all.

What’s more, Congress abandoned one other fundamental element of the consensus—that Congress should eliminate tax-code disparities that drive taxpayers and investors toward economic actions that distort the economy. Thus the 1986 bill was carefully crafted to eliminate any disparity in individual rates and capital gains rates—to prevent people from gaming the system by converting ordinary income into cap gains. But Reagan’s Republican successor, George Herbert Walker Bush, abandoned this principle within just a few years of the 1986 bill’s passage. That undercut the synthesis—and opened up the code to further tinkering.

And so we ended up with a top rate of nearly 40 percent, which Republicans today are too fearful to take on. The sons of Reagan lack Reagan’s boldness and political influence. Let’s stipulate here that this is not 1981, with a top rate of 70 percent on unearned income and 50 percent on earned income. The tax code isn’t the kind of chessboard it was back in Reagan’s day.

But the top rate is too high. It distorts economic decision-making by creating incentives for people to game the system, which isn’t very difficult to do, given the massive number of preferences and loopholes stashed away in the tax code since that grand but short-lived synthesis that emerged in 1986.

We see now the spectacle of Republicans lacking the resolve to press the issue, to make the case and bring the American people around to the view that prevailed so dramatically in Reagan’s day. The result of that skittishness can be seen in this week’s Wall Street Journal/NBC News survey, which found that only 25 percent view the emerging GOP tax plan as a “good idea,” while 35 percent deem it a bad one. And 40 percent had no opinion or were not sure.

This is a failure of political marketing. The Democrats, meanwhile, have been very effective in marketing their idea that the Republicans are a bunch of oligarchs fixated on helping their fat cat friends through tax policies favoring the rich. You can’t win a debate that way. And you can’t seriously spur the economy with a tax code that encourages massive amounts of distorting economic activity.

Robert W. Merry, longtime Washington, D.C., journalist and publishing executive, is editor of The American Conservative. His next book, President McKinley: Architect of the American Century, is due out from Simon & Schuster in November.



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