Federal tax policies lie at the core of ongoing arguments between the two major political parties. Unfortunately, this debate focuses on only one issue, marginal tax rates for individual income taxes. It ignores the equally important issues of what should go into the “tax base” and what loopholes should be allowed. It is too bad we have forgotten the experience of the Reagan era, when all of these issues were on the table. But no elected officials seem to have the leadership ability or political courage to broaden the debate.
The Reagan administration brought about the most fundamental changes in U.S. federal tax policy in the past 70 years. The changes generally followed the dual prescriptions of supply-side economists, to lower tax rates and broaden the tax base. “Broadening the base” meant closing myriad loopholes and thus making more income subject to taxation, both for corporations and for individuals.
Tax rates were higher back then. The top marginal rate for individuals was 70 percent when Reagan took office, down somewhat from the 90 percent rates in effect from World War II until after John F. Kennedy’s death. Reagan’s first tax bill lowered that to 50 percent and then to 28 percent in the last year of his administration.
That lowering of tax rates is what has remained in the public mind. Nearly forgotten is the fact that other legislation advanced by the Reagan administration closed numerous loopholes, most of which favored high-income taxpayers.
Over the years, loopholes involving various tax avoidance ploys had grown exponentially, and much income was exempted from the nominal top rate.
The resources wasted by tax avoidance were precisely what caught the eye of the economists who came to be known as “supply-siders.” Their prescription always contained the dual elements of lower marginal rates but a much broader base. For most of the early and sincere supply-siders, it was this broadening of the base rather than some voodoo response of higher economic growth that would keep deficits from exploding. Moreover, closing the loopholes would promote economic efficiency because tax avoidance gambits usually resulted in wasteful applications of capital.
Tax rates were lowered successively for 1982, 1987 and 1988. The base was broadened, and enormous loopholes were plugged. Reagan’s legislation also increased FICA taxes on self-employment income and broke with tradition by subjecting some Social Security benefits to the income tax.
The lower tax rates did contribute to the near tripling of the national debt in eight years. But these years included a harsh recession engendered by the Federal Reserve to reduce inflation and large increases in defense spending. High interest rates helped push up interest costs on Treasury borrowing. So there is plenty to argue about when examining this unprecedented peacetime increase in the national debt.
Contrary to popular myth, however, there was virtually no increase in social spending outside of Social Security. Nor was there some dramatic burst in GDP growth, national savings or investment.
But there is no question that plugging loopholes and broadening the base of taxable income kept revenues from falling as far as they might have if only rates had been cut while leaving the tax base unchanged.
The sag in corporate income tax revenues was large and lasting. It was not until 1994 that these revenues, adjusted for inflation, got back up to where they had been in 1978 and 1979.
But despite the cut in the top marginal rate from 70 percent to 50 percent, revenues from individual income taxes got back up to pre-tax-rate-change levels by 1985 and might have even sooner if not for the recession. And this was due largely to the base-broadening component of the Reagan reforms. The dramatic increases in savings and investment predicted by the “tax cuts will pay for themselves” subset of supply-siders never materialized, and GDP grew at about the post-war average.
But closing loopholes is a never-ending task. The underlying factors of campaign financing, well-funded lobbying and interest group politics combined to generate a steady trickle of special exemptions and credits almost immediately.
A quarter-century has passed since the Reagan base-broadening, and the U.S. tax code is more complicated than ever. This is not because of some perverse practices by the Internal Revenue Service but rather because one interest group or industry after another has succeeded in getting its own pet treatment written into the tax code.
Unfortunately, once the Reaganites were out of office, any interest in promoting economic efficiency and maintaining federal revenues with a simplified, loophole-free tax code fell by the wayside. The fact that neither party is talking about re-broadening the base and re-closing loopholes says something about how intellectually impoverished our politics have become.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.