The Tax Foundation

October 10, 2006

Tax Reform: What Has Changed Since 1986?

by Gerald Prante

There is an old saying that those who forget history are doomed to repeat it. The issue of tax reform is no exception.

The Tax Reform Act of 1986, which was signed into law twenty years ago this month, was considered at the time one of the most significant pieces of legislation ever passed. The fact that Congress went against the wishes of powerful lobbyists in overwhelmingly passing such legislation was seen as a triumph of the American people.

But despite the temporary success of tax reform in 1986 and the apparent conquest of the public interest over the special interests, two failures were evident. First, while the legislation did close special tax shelters for select individuals—events that often became nightly news stories—the reform did little to close the many significant exemptions that inhibit overall economic growth. Also, much of what passed in 1986 to limit special tax loopholes has already crept back into the system courtesy of politicians quick to give in to whatever lobby fills their pockets.

How long did it take before talks of rolling back the reforms began to emerge? Consider the Wall Street Journal on the day following Mr. Reagan’s signature:

Yesterday, shortly after 11 a.m., Ronald Reagan signed HR 3838, the landmark tax-reform bill of 1986. The battle to get tax reform is over; the battle to keep it is just beginning.

Mr. Reagan recognized this in his statement at the signing ceremony, pledging to stop rate increase, and laying out a remarkably thoughtful explanation of the principles behind the movement to cut tax rates. Enjoy it while you can. Congress will be back on Jan. 6, and the movement to take away tax reform will start. (WSJ: Oct. 23, 1986)

So have we just now begun to realize these failures of the Congress that took place both during and after the tax reform of 1986? Hardly. Twenty years ago, economists such as Martin Feldstein and Milton Friedman warned that that the then-pending legislation was not reform and that the only way to get lasting reform in such a political system may be a complete overhaul of the current system.

Feldstein wrote:

It is not tax reform. The original goal of a fundamental reform to broaden the personal tax base and reduce tax rates has been abandoned. All of the major tax-code provisions targeted by tax reformers for so long -- the deduction for interest on home mortgages and consumer loans, the exclusion of employer-paid health insurance premiums and other fringe benefits, and the deduction of state and local tax payments -- have now been judged to be either socially desirable or politically untouchable. (Martin Feldstein, WSJ: Feb. 14, 1986)

With the exception of the deduction for consumer loans, each of these tax deductions that distort economic decision-making remains in the tax code. And it remains an uphill battle today on these very same issues, as evidenced by the uproar from both lawmakers and lobbyists last year over the recommendations of the President’s tax reform panel, which called for scaling back the use of these deductions.

Why have politicians taken the stance that they would rather have tax deductions whose benefits are narrow rather than a broad-base, low-rate tax system that would benefit everyone and promote economic efficiency?

The simple answer is that special interests benefit heavily from narrow tax deductions and exemptions, even though the average taxpayer only benefits marginally. Therefore, while the overall benefits to society from overhauling the tax code would be significantly greater than the benefits of maintaining the status quo—the special deductions and complexity that permeate our tax system—special interests have a much greater incentive than the average American to lobby Congress on this issue

As Milton Friedman explained in a 1986 column and predicted so accurately:

From the citizens' point of view, the function of tax legislation is to decide who shall pay how much to finance government spending. But from Congress's point of view, tax legislation has an additional and very important function: It is a way to raise campaign funds.

Why is it that hardly a year passes without a new tax bill? The reason is that so long as a tax bill is under consideration, with many billions of dollars at stake, lobbyists are actively pressing for the introduction or retention of special provisions to benefit their clients. And so long as lobbyists are active, thousand-dollar-a-plate dinners and similar devices will tap them for campaign funds.

That is why members of Congress put such a high value on being assigned to the Ways and Means or Finance committees. And that is also why Congress has denied the citizenry the benefit of a stable tax system, changed only at long intervals, to which individuals and enterprises could adjust, rather than having to cope with continual and complex changes year after year.

The end result is a tax system so complex that literally no one can master it in full detail. (Milton Friedman, WSJ: July 7, 1986)

Thanks to a few members of Congress, like Oregon Senator Ron Wyden (D-OR) and John Linder (R-GA), present-day tax reform still has some signs of life. But when the time comes again for tax reform, will Congress and the President put the public interest ahead of special interests, as they only partially succeeded in doing in 1986? Or will they merely make quick “fixes” that will be repealed within five years at the behest of their biggest contributors?

Gerald Prante is an economist at the Tax Foundation in Washington, D.C.