Tax Reform: Then and Now

The daily barrage of headlines on tax reform can be dizzying. Rather than attempting to anticipate every twist and turn—a mug’s game if ever there was one—investors may do better taking a broader perspective. This note is an attempt to do just that. We first take a view on the chances of tax reform passing, then with regard to what may eventually pass. The second question—what will pass—is harder. We base our perspective on lessons from the Tax Reform Act of 1986, which remains relevant today.

Expectations for legislative changes were clearly overdone at the end of last year. At Western Asset we were consistently skeptical of the optimistic assessments. Deputy CIO Michael Buchanan made the point forcefully in his December 2016 webcast, in which he characterized the post-election market moves as “too far, too fast.” Pessimism then reasserted itself, so that by the end of the summer conventional wisdom held that nothing would get done in Washington. Congress’s recent progress on a budget renewed some optimism, although the general mood remains cautious.

Just as expectations were too optimistic at the end of last year, they may be too pessimistic today. The reasons to expect some kind of tax reform are, in our view, straightforward and compelling. First, unlike the previous six years, the Republicans control both houses of Congress and the White House. This is an important ingredient to any major legislative change and should not be overlooked. Second, tax reform has traditionally been an issue that has unified the Republican Party. Of course there are some important differences, especially with regard to budget deficits, but these are likely surmountable. Finally, a successful tax reform would give Republicans an important legislative victory—a not-insignificant consideration in a Congressional election year.

Lessons from the Tax Reform Act of 1986

We turn next to the more difficult question: what will tax reform look like? The 1986 tax reform provides a useful template for how these processes tend to unfold, and there are a number of lessons that can be applied to today. Much of what follows is based on Showdown at Gucci Gulch, which is an excellent, contemporaneous account of the 1986 tax reform process¹. The book itself is recommended reading for enthusiastic historians; we believe the observations below should suffice for interested investors.

1. Tax Reform Was Bipartisan I: Democrats Championed “Base-Broadening”

The 1986 tax reform was bipartisan by necessity if not by choice. The Democrats controlled the House of Representatives, so that progress would have been impossible without sponsorship from House Speaker Tip O’Neil and House Ways and Means Committee Chairman Dan Rostenkowski. These two men needed a reason to advance tax reform. President Reagan’s popularity and a general desire to get something done played a role, but those alone were unlikely to be sufficient for such a big legislative effort.

A larger part of O’Neil and Rostenkowski’s motivation was the prospect of populist reform that explicitly redistributed tax benefits. In particular, they worked to craft a bill that took away loopholes enjoyed by corporations and wealthy taxpayers, and delivered the benefits to middle-class taxpayers through lower marginal rates. One of the largest tax increases in the final bill came from disallowing the deduction of passive business losses from individual income. Prior to 1986, passive losses provided a popular tax shelter used primarily by high-income taxpayers, so that by disallowing them legislators redistributed tax benefits while at the same time raising revenue. By pushing the “base-broadening” aspect of reform, the Democrats attempted to capitalize on the widespread frustration regarding a rigged system, with the aim of emerging as champions of fairness.

Read across to today: The Republicans do not need Democratic support for the current effort. (Budget reconciliation will allow tax reform to pass with simple majority votes in both houses). However, Republicans are likely to be attracted to the same goal that motivated Democrats in 1986—fairness. Republicans are actively looking for ways to make the reform more populist, potentially by adding an additional tax bracket for high-income taxpayers. While the final form of such provisions is unclear, we suspect some aspects of these populist policies will be featured in the final bill.

2. Tax Reform Was Bipartisan II: Republicans Championed Lower Rates

The 1986 reform lowered the top marginal tax rate from 50% to 28% for individuals. This was lower than most observers thought possible, and actually lower than the initial proposals from Treasury. In this sense the 1986 reform did not follow the normal legislative progression, in which ambitions are gradually eroded and far-reaching proposals end up as watered down tweaks to existing policy. Part of the reason for the surprising result was the Republican commitment to lowering tax rates. Republicans believed then (as many believe today) that lower rates would lead to faster economic growth due to improved incentives. The commitment to lowering rates was so strong that Republicans were willing to tolerate other changes that would otherwise have been unpopular on their own merits.

There are two interesting details regarding the top marginal tax rate in 1986. First, although the bill was signed in October 1986, the lower marginal rate was not immediately applied. Instead, lower rates were phased in: dropping from 50% in 1986 to 38.5% in 1987 and then finally to 28% in 1988. Throughout the process legislators used phase-ins either to reduce the cost of the bill or to distribute favors in order to secure votes. Second, while the published top rate was 28%, some taxpayers actually faced a 33% marginal rate (known as a “phantom” marginal rate), due to the way lower tax brackets where phased out for high-income taxpayers. The phantom rate remained in place until 1990, at which time it was replaced with a new 31% top marginal tax rate. The phantom rate serves as a useful reminder that in taxes as with other things, reality may differ from what is advertised.

Read across to today: President Donald Trump has been particularly focused on lowering the corporate tax rate. The most recent plan featured a 20% top marginal corporate tax rate. Many analysts think such a low rate is unachievable and have speculated that the eventual rate will have to move higher, perhaps as high as 30%. We are not so sure. As in 1986, the prospect of a very low marginal corporate tax rate is what makes reform appear ambitious and worth doing. If the corporate rate is lowered only a few percentage points then the rationale for the whole package weakens. We suspect President Trump will continue to advocate for a very low corporate rate, even if achieving that requires a sleight of hand in other parts of the bill.

3. Middle-Class Tax Breaks Survived Intact

For all of the discussion about loopholes and special interests, the largest tax expenditures by dollar value benefit mainly middle-class taxpayers. Today those include tax preferences for employer-sponsored health insurance, mortgage interest, charitable giving and retirement savings. They also include the deductibility of state and local taxes as well as preferential rates for capital gains and dividends. The list was slightly different in the 1980s, but similar to today, the largest tax expenditures by dollar value were primarily middle-class tax deductions. Most of these middle-class tax expenditures survived the 1986 reform with limited or no changes.

When the 1986 reform process started, the Treasury Department identified a number of these deductions as not worth keeping. Treasury’s initial proposal eliminated the deductions for mortgage interest, charitable giving, and state and local taxes. President Ronald Reagan personally insisted that the mortgage interest deduction and charitable giving deduction be fully reinstated. In one of its first actions, the House Ways and Means Committee reinstated the state and local tax deduction². After that there was no serious discussion of eliminating any of these popular tax advantages. (The lone exception was the deduction for IRA contributions, which was eliminated for workers with employer-sponsored pensions.)

Read across to today: This is a case where history is repeating itself. From the beginning, President Trump has insisted that the deductions for mortgage interest and charitable giving remain unchanged. While the initial proposal from the White House eliminated the state and local tax deduction, Congress is reportedly working to reinstate it, at least in some form. The lesson is clear: significant changes in tax advantages that benefit the middle class would be unpopular and will therefore be approached reluctantly, if at all.

4. Individual Tax Cuts Were Paid for By Corporate Tax Increases

There were two goals at the beginning of the 1986 reform process: revenue neutrality (total revenues would remain unchanged) and distributional neutrality (distribution across groups would remain unchanged). Of the two, only the first goal was achieved, while the second was quietly abandoned. As mentioned above, the final bill included some provisions aimed specifically at higher-income taxpayers, although these taxpayers also benefited from lower marginal rates. A more significant departure from distributional neutrality was that the 1986 reform raised taxes on corporations by $150 billion over a five-year period. The additional revenue from corporations was used to pay for lower taxes on individuals and make the whole package revenue neutral.

The redistribution from corporations to individuals surprised observers at the time. Such a policy was in obvious tension with the deregulatory atmosphere that emphasized a reduced role for government in corporate decisions. Moreover, Reagan had previously cut corporate taxes, notably by allowing for much more generous accelerated depreciation in 1981. As part of his 1980 campaign Reagan had even said that he was in favor of removing all corporate taxes! Nonetheless, the increase in corporate taxes was necessary to meet the first goal of revenue neutrality, and it ended up being included in the final reform bill without too much of a fight.

Read across to today: Perhaps the most significant tension in the current effort is how to pay for the various tax cuts. The initial proposal included net tax cuts for both corporations and individuals, and relied on faster growth to balance the budget. The growth assumptions will be debated, but most agree that they can only be pushed so far. At some point Congress may have to identify losers in order to pay the winners. This problem, although not insurmountable, remains the single biggest threat to successful reform.

5. Progress Mostly Depended on Congress, Not on President Reagan

Tax reform is primarily a Congressional process. The bill starts in the House, where it needs to clear the Ways and Means Committee before being voted on by the full House. Similarly, it will need to clear the Senate Finance Committee before a full Senate vote. Finally, a conference between both committees is needed to reconcile the differences before the bill faces two more up-or-down votes for final passage. Only after all that is completed will the president have a formal role in signing the bill. Each step along the way requires deals to be cut, technical and political solutions to be found, and wavering members to be convinced. In 1986 it was congressmen and senators, not President Reagan, who succeeded in finding solutions and clearing each of the necessary hurdles.

This is not to assert that President Reagan was uninvolved. To be sure, Reagan played a role by setting the agenda in his 1985 State of the Union Address and by keeping the focus on reform with multiple speeches throughout the process. Reagan also pressured some Republican Congressmen to vote for the bill in the House, helping to rescue it after a failed procedural vote.

Perhaps more revealing is what Reagan did not do in 1986. Reagan did not broker any meaningful compromises. To the contrary, Reagan’s Treasury was yet another constituency that needed to be accommodated (especially Treasury Secretary James Baker’s interest in the oil and gas sector). Reagan’s relationships with senators and congressmen did not prove instrumental. The personal relationships between legislators were much more important. Neither Reagan nor other administration officials provided the intellectual framework for reform. The final bill had more in common with a 1982 reform proposal from Senator Bill Bradley and Congressman Richard Gephardt than it did with the various Treasury proposals. Throughout the process it was congressmen and senators, rather than Reagan or administration officials, who propelled reform forward and deserve credit for its ultimate success.

Read across to today: The media has put President Trump at the center of the tax reform process. Every day the prospects for tax reform are analyzed through a lens of the president’s popularity, his personal relationship with specific congressmen or senators, or what his Treasury secretary says. This focus may be misplaced. Certainly Trump has a role, but it is arguably not all that central. A misstep or two from the White House is unlikely to jeopardize the prospects for success. Instead, the focus should be on Congress, which is where the real work happens and where the make-or-break decisions will be made.

Conclusion

We admit to being unable to anticipate every new development in the ongoing tax reform process. However, that doesn’t prevent us from having a view on the broader issues. As discussed earlier, we think there is a compelling case that Congress will be successful in passing some kind of tax reform bill. Based on the lessons from tax reform in 1986, we suspect the unfolding process will have the following characteristics. First, legislators will include some provisions explicitly aimed at promoting a sense of fairness. Second, the focus will remain on low corporate tax rates—as that is what makes the bill ambitious and worth doing. Third, middle class tax advantages will remain relatively untouched. Fourth, at some point legislators will have to identify losers to offset the winners, and that poses the biggest risk to the bill’s ultimate success. Finally, the most important parts of the action will remain in Congress, and while not quite irrelevant, President Trump is not all that central.