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Are the Stars Aligning for Tax Reform?

Posted on February 2, 2017 by Mindy Herzfeld

Newly inaugurated President Trump has promised that fighting for tax reform legislation will be a priority during his first 100 days in office. That has led to increased optimism about tax reform becoming a reality, with some companies touting plans to increase investments in the United States in anticipation of lower tax rates.

Optimists also take hope from a Republican-controlled Congress that is focused on the need for tax reform, including reducing tax rates for both individuals and businesses. Nevertheless, it worthwhile to remember why comprehensive tax reform is so rare -- it is, quite simply, hard to do. Since the last comprehensive U.S. tax reform in 1986, many well-intentioned plans have fallen by the wayside.

Tax reform is difficult for several reasons: Trade-offs must be made; losers always speak louder than winners; and many people are invested in the status quo. Promises about economic growth speak to the future. But increased tax burdens and deficits can be the immediate consequences.

What makes the stars align for tax reform? What roadblocks stand in its way, and how can reform efforts overcome them? Jeffrey Birnbaum and Alan Murray's comprehensive account of the enactment of the Tax Reform Act of 1986, Showdown at Gucci Gulch, may help answer those questions. Reading the work of these two Wall Street Journal reporters who covered TRA 1986 from genesis to signing may help identify similarities and differences between 1986 and today, as well as the conditions necessary to achieve, and the obstacles in the way of, tax reform.

Tax Reform Takes Time

In his preelection "Contract With the American Voter," Trump promised to introduce tax reform legislation and fight for passage during his first 100 days in office (https://goo.gl/NyGCsh). The promise on timing is the first part of this pledge that will be hard to meet. A review of the events that led to TRA 1986 -- see box -- shows how it took more than four years between the introduction of a comprehensive reform bill and the act's enactment.

One could perhaps argue that a 2017 tax reform package represents the culmination of much thought given to comprehensive reform over the past several years. After all, the 2005 report of the President's Advisory Panel on Federal Tax Reform recommended a destination-based cash flow tax similar to the current Ways and Means proposal. And in February 2014, former Ways and Means Committee Chair Dave Camp introduced a comprehensive reform proposal that prompted further thinking on the topic.

But the flaw in that argument is that the reform proposal now under consideration by House Republicans -- the "Better Way" proposal -- has but a tenuous relationship to the Camp plan, while the 2005 report was a high-level proposal that got little traction. While the "Better Way" proposal has thus far been sketched out in broad terms for the public, it includes several new concepts that would require much of the tax code to be rewritten. It also lacks the kind of detail that would appear in draft legislation (and that highlights the potential losers). It leaves unanswered questions about how it might affect major sectors of the economy, such as financial services. Proposals to impose a single tax rate on business income earned by passthroughs also venture into uncharted territory.

The major outlines of Sen. Bill Bradley's 1982 tax reform proposal and President Reagan's tax reform goals coincided in important ways, and focused on lowering individual rates and broadening the base to create a fairer tax system. In contrast, while current House Republicans' and Trump's ideas for tax reform as laid out in his campaign platform share similarities -- such as lower corporate and individual rates -- they also differ on important points. Shortly before his inauguration, Trump spoke out against a central tenet of the House Republican plan, the border adjustment tax, saying it was too complicated. (Prior coverage: Tax Notes, Jan. 23, 2017, p. 395.)

Tax reform takes time because the country's founders designed the system that way. Under the republican form of government laid out by the U.S. Constitution, several different branches of government must be involved, and many people need to agree. Each step of the process creates new pressures that could make the whole thing fall apart.

                    Timeline for 1986 Tax Reform Act

 ______________________________________________________________________

 1981                  President Reagan inaugurated; Economic Recovery Tax Act passed

 1982                  Tax Equity and Fiscal Responsibility Act passed

 Aug. 1982          Sen. Bill Bradley and Rep. Richard Gephardt offer Fair Tax Act reform bill

 Jan. 1984          Reagan calls for tax reform based on broader base and lower rates

 Apr. 1984           Sen. Robert Kasten and Rep. Jack Kemp introduce Republican tax reform bill

 Nov. 1984          Treasury releases reform proposal (Treasury I)

 May 1985           Reagan and Democratic chair of Ways and Means Committee both endorse tax reform on TV

 May 1985           Treasury presents second tax reform proposal (Treasury II)

 Summer 1985     Ways and Means holds hearings on tax reform

 Oct. 1985           Ways and Means begins drafting tax reform bill

 Nov. 1985           Ways and Means approves tax reform bill

 Dec. 1985           House passes tax reform bill

 Mar. 1986           Senate Finance Committee Chair Bob Packwood begins drafting tax reform bill

 Apr. 1986           Senate Finance starts again with new tax reform  bill

 May 1986          Senate Finance unanimously approves tax reform bill

 June 1986         Senate passes tax reform bill

 July 1986          House-Senate conference on tax bills

 Aug. 1986         Conference report approved by conference committee

 Sept. 1986        House and Senate pass conference bill

 Oct. 1986          Reagan signs Tax Reform Act of 1986

Another challenge to achieving tax reform is that it will swamp everything else on the legislative agenda. Staffers who worked on TRA 1986 describe an all-consuming process involving many sleepless nights for both themselves and lawmakers. Unlike in 1986, when no other major legislation was on the table, this year Congress and the president have given high priority to other issues, including repeal of the Affordable Care Act. But the same people would have to work on both tax reform and healthcare legislation.

Presidential Leadership

Showdown at Gucci Gulch highlights the importance of strong presidential leadership in ensuring passage of a tax bill. Birnbaum and Murray write that without Reagan's support, tax reform could never have happened, but that with his support, it became "a powerful political juggernaut." They argue that although Reagan didn't take an active role in the negotiations, "the conservative president's support for an effort once considered the bastion of liberals carried tremendous symbolic significance."

Reagan, a passionate believer in low individual tax rates, made tax reform an essential part of his 1984 reelection campaign. He won the 1984 election by a landslide, winning the popular vote by about 15 million. Showdown at Gucci Gulch describes how Reagan's leadership and lawmakers' awareness of his popularity were important factors at critical points in the legislative timeline. When the bill nearly died in the House, Reagan made a personal appearance on Capitol Hill to emphasize his support for tax reform. According to Birnbaum and Murray, the vote that followed his appearance -- which enabled the measure to pass the House -- was because "Reagan's presence made an impact."

While Trump has shown a desire to lead on the issue, he enters office without Reagan's popularity or experience in governing. But other considerations may be involved. The broad support that tax reform now has in the Republican caucus was lacking in the lead-up to TRA 1986. Unlike in 1986, the GOP has much to lose if it fails to enact tax reform. Also, the House is led by a speaker -- Republican Paul D. Ryan of Wisconsin -- who is as passionate about tax reform as Reagan ever was.

Bipartisan or Nonpartisan

Showdown at Gucci Gulch shows how tax reform can be a bipartisan issue, but might be better characterized as nonpartisan. Because support for specific reform proposals often cuts across party lines, it's harder to maintain strict party discipline on tax reform. The exception may be when the reform under consideration involves only a rate cut.

During negotiations over TRA 1986, Republicans from states with high state and local taxes were unwilling to support a proposal to eliminate the state and local tax deduction, and banded together with Democrats on the issue. Birnbaum and Murray argue that it was only Ways and Means Chair Dan Rostenkowski's agreement to retain the state and local tax deduction that allowed the bill to clear the committee. And while measures protecting tax breaks for the oil and gas industry received strong Republican support, they were also defended by House Majority Leader Jim Wright, a Texas Democrat.

In 1986 the two parties were able to come together on reform because they could consolidate their different objectives into a single reform package. Reformers on the left were most focused on closing loopholes that were seen as unfairly benefiting wealthier individuals and large companies. Reformers on the right wanted to achieve faster capital cost recovery. Reform gained bipartisan support because it addressed both those goals.

Also in 1986, Republicans controlled the Senate and Democrats the House, so reform required bipartisan support. Many today argue that reform would be easier now because Republicans control both houses. But that ignores potential underlying differences between the House and the Senate. For example, while the House leadership has campaigned heavily in favor of their "Better Way" proposal, Senate Republicans have been silent on the specifics of that proposal.

Republicans control the Senate by a four-seat majority. Even though the Senate could pass tax reform using the budget reconciliation process -- avoiding the need to get a filibuster-proof 60 votes -- that slender majority leaves little room for defections (as well as presenting other procedural challenges). For example, any reform proposal perceived as hurting large retailers (like a destination-based cash flow tax) is unlikely to win the support of senators from Arkansas. Advancing such a proposal would then require Democratic support. Republican deficit hawks may be less inclined to support a proposal that could lead to large increases in the deficit.

The challenges specific tax reform proposals could face even among Republicans were evident at the confirmation hearings for Steven Mnuchin, Trump's nominee for Treasury secretary. Sen. Pat Roberts, R-Kan., made clear that his support for tax reform would depend on how passthrough entities fared under it. Tax reform that is seen as treating passthroughs unfairly -- and a rate cut could still be viewed as unfair if it places passthroughs at a competitive disadvantage to corporations -- appears unlikely to gain the support of the Republican senators from Kansas.

Coalitions Are Fragile

The history of TRA 1986 illustrates just how close to death the various proposals came. But just as important as building coalitions supporting reform is whether its opponents can organize to defeat it. Birnbaum and Murray posit that success was ultimately due to the fact that "the many powerful interest groups lined up in opposition to reform never joined forces to defeat it." They suggest that the lobbyists were "afraid to be pinned as opponents of reform," and that special interest groups faced challenges in fighting what was deemed populist legislation.

The current debate may provide a case study for how special interest groups may have learned a lesson from the past. Groups already aligned against the "Better Way" proposal couch their opposition in terms of the need to maintain competitiveness, and the potential for the proposal to spawn new and higher taxes (such as a VAT), raising prices on imported goods (Brian Garst, "Political and Economic Risks of a Destination-Based Cash Flow Tax," available at https://goo.gl/Hzx6sY).

Staff Matters

David Brockway, chief of staff of the Joint Committee on Taxation during consideration of TRA 1986, testified in 2012 at a House Ways and Means and Senate Finance hearing on tax reform and the tax treatment of capital gains. Brockway is widely credited with coming up with the innovation -- restricting the deductibility of passive activity losses -- that allowed the Finance Committee to move beyond a failing attempt at tax reform to a bill that passed the committee unanimously.

"It will be very difficult for you to move a bill to completion if you don't trust the staffs, including in particular the revenue-estimating staffs, to be honest and to do their absolute best to represent you and the interests of the general public," Brockway told the committees. Beyond the economists who perform revenue estimates, the advice also speaks to a broader point on the importance of staff expertise in general and commitment to the reform process.

What Are We Solving For?

Showdown at Gucci Gulch points out that while tax reform appeals to the public imagination, rarely does the public throw its wholehearted support behind it. This was true even in the 1980s, when there was widespread satisfaction with the system. Roscoe Egger, IRS commissioner under Reagan, said that in the early 1980s, "people were rapidly becoming disenchanted with the whole system. . . . Groups refused to file . . . tax shelters reached entirely different proportions."

Randall Weiss, deputy chief of staff at the JCT in 1986, told the Senate Finance Committee in 2010 that it is difficult to overemphasize the extent to which the "public's perception that the income tax was unfair -- driven by countless stories of high-income individuals and large corporations that paid little or no tax -- was pervasive during the early 1980s," and how much that aided the progress of TRA 1986.

In the early 1980s, concerns about high individual rates -- along with the rise in tax shelters, which Birnbaum and Murray called "the central part of the problem" -- fed the public's perception that reform was needed. Also at issue was a loss in confidence because "U.S. corporations were paying an ever-smaller share of the nation's tax burden." But even with high rates and widespread perceptions of unfairness, and even with a president who had campaigned on tax reform, the public was still ambivalent over the need for reform. Birnbaum and Murray noted that while lawmakers in Washington may have been obsessed with lowering individual rates, elsewhere, "the great populist awakening that was supposed to sweep tax reform to victory remained only a yawn. Taxpayers disliked the existing system, to be sure, but they still weren't convinced Congress was going to make it any better."

Today's reform efforts -- heavily focused on lowering the tax rates on corporate profits -- are likely to receive even less public support. While economic growth is the mantra of the day, it remains unclear whether the public will buy into the concept of lowering tax rates for large corporations in order to achieve that growth. Meanwhile, a tax law that allows large corporations that have held cash overseas to repatriate it at lower rates is something that could whip up populist ire.

Trade-Offs and the Deficit

Tax reform is hard because it generally requires trade-offs in order to avoid increasing the federal deficit. Showdown at Gucci Gulch demonstrates the extent to which everyone who worked on TRA 1986 -- in the White House, Treasury, and Congress -- felt bound to preserve revenue neutrality. But if you don't care about deficits, tax reform can become much easier.

While TRA 1986 shut down many individual tax shelters, the essential trade-off it made was to lower individual rates in exchange for higher corporate taxes -- $100 billion in individual tax cuts in exchange for $100 billion in corporate tax increases. It was the shift in the tax burden from individuals to corporations that allowed reformers to preserve revenue and distributional neutrality.

Today, the most significant revenue raiser in the House plan -- the border adjustment -- faces pressure from all sides, including those who see their own businesses as adversely affected and, potentially, Trump. But having less concern about paying for the cost of tax cuts opens up far more opportunities to pass legislation. In the interest of achieving the paramount goal of tax reform, concerns about deficits may fall by the wayside.