The Making of a Miracle
By GEORGE J. CHURCH
They said it couldn't be done . . . couldn't be done . . . couldn't be done. Scrap the gargantuan federal tax code and write a simpler, fairer one? How naive! Drastically reduce top tax rates to their lowest levels in 58 years by throwing out the special breaks and deductions that have accrued over the past four decades? No way! Let the free market determine how people spend and invest their money rather than allow shills for favored industries to use the tax code to tinker with the economy? Get real! Such a drastic overhaul would amount to putting the public interest ahead of special interests -- in this case nearly every interest with enough clout to hire a lobbyist. And everybody knows the political process does not work that way.
Except that once in a great while the process does work that way. Thus it was with tax reform, a political miracle that was brought to the verge of fruition by an amazingly varied group of conservatives and liberals, Republicans and Democrats. Some, like New Jersey Democratic Senator Bill Bradley and New York Republican Congressman Jack Kemp, were longtime crusaders. Others, like Ronald Reagan, who supported a 1981 tax bill that was laden with special breaks, were late converts. But eventually, though the public at times seemed skeptical, most politicians came either to favor the idea or to fear the consequences of opposing it.
And so last week what couldn't be done cleared its last major hurdle. In a series of tense meetings that began Tuesday night and wound up shortly before 5 a.m. Saturday, Senate Finance Committee Chairman Bob Packwood and House Ways and Means Chief Dan Rostenkowski compromised on the last significant differences between the versions passed by the House last December and the Senate in June. Then came a day of nerve-jangling negotiations selling the deal to the other 20 members of the House-Senate conference committee (ten from each chamber). Finally the full committee gave its stamp of approval Saturday night. Though messy details remain to be filled in, and some elements of the compromise may be renegotiated after Congress returns from its three- week recess on Sept. 8, there seems little doubt that both houses will pass a final bill by overwhelming margins, and Reagan will be happy to sign it into law, no doubt with great fanfare.
"A top individual rate of 28% will be one of the lasting legacies of Ronald Reagan's presidency," Treasury Secretary James Baker exulted late last week. "During his time in office, he has brought the top individual rate down from 70%. That is an extraordinary achievement." There was enough credit to go around. Said an exultant Rostenkowski: "The political process works. This tax bill brings a sense of justice to the way we tax income."
Befitting a miracle, the story of tax reform's triumph is a tale of repeated resurrections: almost every week over the past two years somebody has pronounced the idea dead. Indeed, there were many times during its tortured course that the bill really did seem ready for burial. It was repeatedly brought back to life by both Democrats, who control the House, and Republicans, who rule the Senate. Neither party dared to risk resisting an idea that seemed to develop a momentum all its own -- nor to hand the other party a powerful issue in an election year.
The Tax Reform Act of 1986 is one of the few pieces of legislation that can truly be called historic. It will affect nearly every one of the 99.6 million individuals and 3 million corporations that pay federal income taxes, plus some businesses that now pay no tax but will have to start coughing up. It reverses the whole direction that federal taxation has been following for decades: instead of adding exceptions and deductions, it wipes them out by the hundreds; instead of shifting the tax burden from business to individuals, it switches that load the other way. The bill marks a long step toward the reformers' ideal of using the code simply to raise revenue, rather than for social and economic engineering. Altogether, it is easily the most fundamental revision of taxation since World War II.
The bill by 1988 would erase the complex schedule of 15 tax rates on individual incomes, ranging from 11% to 50%, and replace them with just two: 15% and 28%. According to committee estimates, four out of five taxpayers will be eligible for the lower rate. (A complex method of phasing out exemptions and rates will raise to 33% the marginal rate on taxpayers with incomes between $70,000 and $170,000 filing joint returns.) In 1987, a transition year, a schedule of five rates running from 11% to 38.5% will apply. Personal exemptions will be raised from $1,080 on the returns due next April 15 to $1,950 for 1988.
To get these benefits, individuals will have to give up some cherished tax breaks. The bill preserves the most popular: deductions for state and local income taxes and for mortgage interest on first and second homes. But there will be no more deductions for interest on loans to buy cars, boats, clothes and furniture. Nor will there be any for sales taxes. The special deduction for families in which both husband and wife work will be eliminated, along with credits for child-care expenses. For most employees earning more than $40,000, there will be no more $2,000 write-offs for deposits to Individual Retirement Accounts, though the interest earned on past and future IRAs will still be tax exempt. Charitable contributions will be deductible only for those who choose to send in itemized returns (at present they can be written off by users of the short form). Profits on the sale of stocks, bonds, houses and other assets, which have been subject to low capital-gains rates, will be taxed at the same rate as ordinary income: 28% tops. This would be above the effective rate of 20% that prevails now but no higher than the capital-gains rate in force as recently as 1978.
One of the bill's great benefits will be psychological rather than monetary. It will foster a public perception that the tax laws have become fairer by levying approximately the same amount on people with similar incomes. Most significantly, it will wipe out those complex schemes that allow wealthy individuals with wily accountants to claim large paper losses through small cash investments in real estate syndicates and other tax shelters.
At the bottom of the scale, some 6 million people with incomes at or below the poverty line will be freed from paying any income tax at all, doing away with a pernicious unintended consequence of the current law: for the past several years the poor have been sending a growing share of their meager pay to Washington. About 80% of taxpayers will owe less; though many of the reductions will be small, they add up to big money. Collectively, individuals ! over the next five years will keep in their wallets $121.7 billion that they would have to hand over to the Internal Revenue Service under present law.
Business taxes will rise by $120 billion. (One of the principles that tax reformers settled on early was "revenue neutrality," on the theory that a radical rewrite of the tax code would be difficult enough without getting it tangled up in the debate over whether the Government should raise its total tax take in order to reduce deficits.) Although the top tax rate on business profits will drop from 46% to 34%, it will apply to far more corporate income. The investment tax credit on purchases of new machinery and equipment will be killed, and depreciation write-offs will be considerably less generous. Scores of special breaks that benefited such industries as banking and real estate will be wiped out. Those companies that still might get off lightly will be socked with a strict new 21% minimum tax on their profits. Supposedly, this will mean no more cases of giant corporations paying less tax than the people who sweep their office and factory floors pay.
Some business economists are concerned that the bill could lower overall growth by crimping business investment. But the impact will depend largely on factors that are difficult to crank into a computer. Says Ira Shapiro, director of tax policy for the accounting firm Coopers & Lybrand: "The changes are so dramatic that they will alter the way people invest and consume as well as business strategies across the board."
Beryl Sprinkel, chairman of Reagan's Council of Economic Advisers, forecasts that production will grow 10% more over the next five years than it would under the present tax code. One reason: consumers who save on taxes will have more money to spend and invest. A bigger factor is that the bill would remove the distortions that are created by the existing maze of incentives and exemptions. No longer will businessmen waste their ingenuity devising elaborate schemes to turn ordinary income into capital gains. Dollars will flow to the most productive uses rather than being diverted into agricultural enterprises designed to lose money on paper or into half-empty office buildings and shopping malls that offer tax advantages. Says Joseph Minarek of the Urban Institute, a Washington think tank: "What the tax system can really do for growth is just get the hell out of the way."
The bill reverses a trend that has prevailed since the income tax took effect in March 1913 with a top rate of 7% on incomes above $500,000, a stupendous sum in those days. The rates zigzagged up and their calculations were made more complex until, to meet the revenue needs of World War II, the top rate on the highest incomes was a confiscatory 94%. Among those offended: a movie actor named Ronald Reagan who had just begun to earn big bucks. His anger at discovering that he could keep less than a dime of each additional dollar he earned played a part in his postwar conversion from New Deal Democrat to conservative Republican.
The response of many other taxpayers to the high rates was to clamor for relief through exemptions and deductions. Presidents and Congresses obliged, starting a seemingly endless spiral: every break that benefited one group created an alleged inequity that another group could exploit to win favors for itself. But as these goodies removed more and more income from taxation, rates had to be kept high on those luckless -- or politically impotent -- souls whose earnings did not qualify for special treatment.
For more than two decades lonely reformers have waged a futile crusade to change the system. Even before John F. Kennedy appointed him to the Treasury's top tax post in 1961, Harvard Professor Stanley Surrey advocated lower rates, a simpler code and fewer deductions. His advice had little effect. Kennedy did propose rate cuts that were enacted after his assassination, but he also introduced the investment tax credit, on the theory that the tax code should promote industrial modernization, a prime example of manipulating the code for purposes other than raising revenue. George McGovern pledged some tax reforms during his 1972 campaign for the presidency; those promises were buried under Richard Nixon's 49-state landslide. Four years later Jimmy Carter railed at a tax system he called a "disgrace to the human race." Among other things, he cemented the three-martini lunch in American folklore. (By making only 80% of business entertainment deductible, the new bill in effect transforms that fabled meal into a 2.4-martini lunch.) As President, though, Carter never got around to proposing any comprehensive reform. While his tax advisers urged simplification and loophole closing, his energy specialists succeeded in enacting special breaks for energy conservation and development of synthetic fuels.
Meanwhile, galloping inflation overwhelmed the timid rate cuts Congress enacted; it steadily pushed taxpayers into higher brackets even when their earnings rose less than prices. That fanned public perception that the whole system had gone haywire. In 1972 a poll by the Advisory Commission on Intergovernmental Relations found that the public rated the federal income tax the fairest of all taxes. By 1980 respondents rated it the least fair. A revolt of sorts started. By Treasury figures, tax evasion more than doubled, from $42.6 billion in 1976 to $90.5 billion in 1981.
Enter Ronald Reagan, voicing his rage against the tax system during the 1980 campaign. But the new President at first wanted not to reform but simply to slash. In the process, however, he unintentionally helped boost the case for reform. When he sent his three-year, 25%-rate-cut plan to Congress in 1981, the Administration got trapped in a bidding war with Democrats led by, among others, Rostenkowski. So many breaks for business were loaded into the bill that it became a monstrosity. To take the worst example, real estate profited so enormously that a 1983 Treasury study concluded that the industry as a whole not only was paying no tax but was actually being subsidized by Washington to the tune of $15 billion a year.
The momentum for reform began to grow. Senator Bradley, who never got over his astonishment that as a basketball star for the New York Knicks he had been a "depreciable asset" to the team's owners, went shopping for a House partner interested in reform. In the spring of 1982 he and Richard Gephardt of Missouri proposed a code with low rates and few deductions. New York Congressman Kemp, a prime architect of the 1981 tax cuts, later teamed up with Wisconsin Senator Robert Kasten to write a Republican bill that embodied many of the same principles. But none of these legislators had the clout to get action. That could be done only by the President, and Reagan was uninterested.
His attitude began to change at the end of 1982. Advisers were pressing him to agree to a tax increase to reduce what was already looming as a menacing deficit. To Reagan that was heresy. But he had to say something in his 1983 State of the Union address. During a round of golf in Palm Springs, Calif., while the President was on vacation, Secretary of State George Shultz, a trained economist, mentioned academic studies about the advantages of a flat tax (that is, everybody paying the same rate). Reagan, ever on the alert for a plausible way to cut tax rates further, inserted in his State of the Union , speech a 37-word passage pledging to "study ways to simplify the tax code and make it more fair for all Americans." For a year nothing much happened. But as the time came to prepare his 1984 State of the Union address, which would set the themes for his re-election campaign, Reagan was searching for something positive to say about tax policy. His advisers settled on a strengthened pitch for tax reform. Says Richard Darman, then on the White House staff: "It was a classic offensive issue. We would emphasize fairness, lower rates and simplicity." The White House was careful to avoid specifics, lest it offend voters who might lose tax breaks. Instead, the President announced that he was ordering Donald Regan, then Secretary of the Treasury, to prepare recommendations that would be released after the election. That directive was widely derided as a transparent ploy, but it worked, thanks partly to some unwitting assistance from Democratic Nominee Walter Mondale. Bradley and Gephardt had visited Mondale to plead that he adopt tax reform as a major issue, but the nominee declined, preferring to plump for a tax increase that turned out to be about as popular as, well, a tax increase.
Regan had little idea about what kind of reform the President had in mind. (No surprise; Reagan didn't either.) The Secretary turned the matter over to Treasury's tax specialists, who produced a set of recommendations that came to be known as Treasury I. They would have raised taxes on business far more than anyone in the Administration wanted. The President said only that he would "need time to study the entire document." Cynics concluded that the Administration lacked interest. Tax reform, for the first time but certainly not the last, was declared dead.
But it was not. Citizens for Tax Justice, a labor-backed group, had just released a list of 128 major corporations that had recently paid no taxes at all, fanning public indignation. The White House was searching for a bold domestic initiative to begin Reagan's second term. Tax reform won partly by default. The President's political advisers thought it might become the "realigning issue" that would give the Republicans a permanent majority in the country by proving to voters that the G.O.P. was for the common man. (So many Democrats eventually shaped the bill that this idea has disappeared.)
When Regan became White House chief of staff in early 1985, the new team of James Baker and his top assistant, Darman, took over at Treasury and set about producing revised recommendations. Their report, Treasury II, issued in May last year, restored many tax benefits for business. Reagan, ever the salesman who has to sell himself first, had become a zealot for his new cause. He plugged Treasury II in a major TV address ("America, go for it!"), followed by a series of barnstorming speeches around the country.The President derided the complexity of the present tax code by frequently reeling off this incomprehensible last sentence of section 509(a): "For purposes of paragraph (3), an organization described in paragraph (2) shall be deemed to include an organization described in section 501(c)(4), (5), or (6), which would be described in paragraph (2) if it were an organization described in section 501(c)(3)."
The next key player was Ways and Means Committee Chairman Rostenkowski, a street-savvy product of Mayor Richard Daley's Chicago Democratic machine, which was never known for its affinity for reform movements. Rostenkowski became the first example of what wags were to christen the "dead-cat syndrome"; none of the major actors could afford politically to have tax reform die on their doorstep. Like several other proponents of reform, Rostenkowski may have been moved by personal considerations too. Kemp and Gephardt are running for their parties' 1988 presidential nominations, and Bradley may try later. Rostenkowski's ambition is to become Speaker of the House, and to do so he needed to show he could adroitly manage a major issue. The chairman at first, however, could not get his committee to budge. Gephardt, a committee member, relates what happened next: "Danny called the members in, sat them down one by one and said, 'This is it. Tax reform is going to go down, and we're going to be blamed for it.' " The Ways and Means Committee eventually produced a bill that contained four individual income-tax rates, ranging as high as 38%; retained many exemptions and deductions for individuals; and would raise business taxes, by some estimates, on the order of $160 billion over five years. On the House floor a solid phalanx of Republicans combined with a faction of Southern Democrats to defeat the bill on a procedural motion, and tax reform once again seemed dead.
It was revived by desperate measures. Bradley emphasized to Democratic waverers in the House the bill's prospective benefits to the poor. Reagan visited Capitol Hill to voice an odd-sounding plea: he would veto the bill in that form, but House Republicans should vote for it anyway to give the Republican Senate a chance to rewrite the legislation. It passed the House just before Christmas on a voice vote.
On to the Senate Finance Committee, whose new chairman, Bob Packwood of Oregon, had declared only months before that he liked the tax code the "way it is." Packwood allowed his committee to reinstate so many tax breaks that at one point last spring the Senators were giving away $2 billion a day. The giveaways could not be reconciled with lower rates, and the resulting hash seemed unlikely even to get to the Senate floor. But Packwood could not afford to fail on the first major test of his committee leadership. Musing over a pitcher of beer at lunch with a top aide, he suddenly declared that perhaps the Finance Committee should throw out all the work it had done and start from scratch with a radically simpler bill. He called the committee into closed sessions, violating Senate rules. The 20 members voted unanimously for a bill with the two low rates of 15% and 27%. Most deductions and tax breaks were tossed out, and an estimated $96 billion of the tax burden over five years was shifted from individuals to business.
By the time the bill hit the Senate floor, its momentum had become irresistible. Even major elements of the business community had come around. Corporations do not benefit uniformly from the many deductions and special rules in current law; for example, one study showed that the effective tax rate on major oil companies is only 8.2%, while wholesalers pay 35.5%. High- tax companies joined with corporate giants like General Motors and IBM, which hoped for a boost to the economy, to create the Tax Reform Action Coalition. When the final vote by the full Senate came in June, the bill passed by an overpowering 97 to 3.
This made the "conference of the century," as some observers dubbed the House-Senate meeting to resolve differences between the two bills, seem like the prelude to a foregone conclusion. There was even a deadline of sorts. The 22 conferees began their meetings in July under an agreement that they would try to finish by Aug. 15. They were afraid that if they did not have a deal by then, the whole bill would be picked apart by a swarm of lobbyists who would descend on Senators and Representatives back home during the three-week recess.
But the conferees repeatedly got hung up, mostly on what Rostenkowski / defined simply as the question of "who benefits and who pays." Many of the legislators had pet industries whose breaks they fought bitterly to protect. One example: Gephardt, of all people, supported Republican Senator John Danforth in arguing for continued special treatment of the profits of defense contractors (some of the biggest are based in their home state, Missouri).
The conference frequently proceeded in the manner of a labor negotiation. The delegates from each chamber would caucus separately and come back with a new offer to be presented to the other side. The House gave in early to the Senate's two tax rates. That left the biggest question: How large should the increase in business taxes be? After a supposedly climactic session last Tuesday turned into a shouting match, the weary conferees agreed to let Packwood and Rostenkowski try to break the impasse. The two met on and off--at times with a few aides, at times alone--well into the night. By Thursday evening, according to Packwood, they were within two hours of a deal that would cut individual taxes and raise business levies by $124 billion. Then the phone rang.
The caller was David Brockway, staff chief of the Joint Committee on Taxation, relaying bad news: the numbers would not balance. If new projections of slower growth in the economy were correct, the tax increase on business would be only $114 billion, and the cut for individuals would be $131 billion, leaving a $17 billion gap. Packwood and Rostenkowski quickly agreed on how to raise $7 billion, but deadlocked on the remaining $10 billion. "It's a blow to us to have been so close and yet so far," said Rostenkowski as they broke late Thursday night. "He and I almost cried," Packwood reported at a press conference Friday morning. Nonetheless, the two chairmen began meeting yet again, with Packwood vowing that they would stay in session however long an agreement might take.
In that session the two agreed, among other things, on a return to $120 billion in the tax load that would be shifted to business and a slight increase, to 28%, in the top tax rate on individuals. When they emerged from their meeting room shortly before dawn for a stroll around the Capitol's darkened Statuary Hall, Rostenkowski told the sleepy survivors of what had been a horde of waiting reporters that a final package was now just "inches away." But the inches seemed to turn into yards later in the morning as the two huddled separately with the other conferees from their chambers. Rebellions broke out over this and that provision, and for a while it seemed doubtful whether the chairmen could even hold the conferees together for a meeting of the full committee before the members scattered on their vacations. Finally, however, the desire for agreement overcame fatigue and shortened tempers.
Once the bill becomes law, there will be ample reason to celebrate. The story of tax reform concludes, politically at least, with few if any losers. For once, political calculation and personal ambition pulled in the same direction as idealism to produce a victory for common sense. There was a larger triumph too. For several years, skepticism has been growing about Government's ability to repair rusting systems. Lately, stubborn reformers have challenged that view, and this time they won a big battle. Says Darman: "Tax reform re- creates the sense of the possible in the American system. It is possible to be bold."
But how lasting will the victory be? There is an uncomfortable chance that future Presidents and Congresses will begin riddling a fairly rational tax system with deductions and special breaks all over again. Sometimes the goals that social and economic tinkerers try to achieve through the tax code seem worthy, and many groups of taxpayers can make a plausible case for special treatment. Charls Walker, a powerful business lobbyist, shrugs off his clients' defeat on the tax-reform bill with a cheery "Wait till next year." To resist those pressures will require not just a one-time public embrace of reform. It will demand a lasting commitment to a system designed simply to raise revenue while treating everyone alike so far as possible. For now, the political system has proved (belatedly and in a byzantine fashion, to be sure) that it can fix a problem that has been festering for decades. The next challenge is to keep the infection of tax loopholes and complexities from spreading anew.
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With reporting by Laurence I. Barrett, Jay Branegan and Michael Duffy/Washington