The modern world has tens of thousands of international organizations, ranging from the Fédération Aéronautique Internationale (based in Lausanne, Switzerland) to the World Association of Zoos and Aquariums (based in Gland, Switzerland). Some are more than a hundred years old. The first wave of internationalization occurred in the late nineteenth century, when amazing innovations like electricity, telegraphy, steamships, and railroads created a need for global agreements on time zones, power grids, weights and measures, and so on. The drive for standardization came from Europe, which is why we still measure time and longitude based on a meridian running through Greenwich, England, and why the global standards for the meter and the kilogram are stored in a vault in Sèvres, France. In the twentieth century the United Nations, the World Health Organization, Interpol, the International Olympic Committee, the International Committee of the Red Cross, NATO, and the like were created.
In recent decades, the Internet and the smartphone, Facebook and Snapchat, have sparked a new rush of international organization creation. There’s an international Video Electronics Standards Association and an International Programmers Guild. There are global fan groups for dozens of video games you’ve probably never heard of. There are hundreds of global associations for specific industries, ranging from the International Federation of Beekeepers’ Associations to the International Society of Sugar Cane Technologists to the International Association of Wood Anatomists.
Inevitably, there’s also an international organization of international organizations: the Union des Associations Internationales, based in Brussels. In 2015, its annual directory (published in English, Spanish, German, and Esperanto) listed 68,029 global groups.1 Several of the international associations listed in that huge directory focus on issues of national finance and taxation. There are world federations of accountants and investment advisers, of tax law professors and import duty collectors. There’s the World Trade Organization, which struggles to get countries to agree on rules of cross-border commerce.
But the heavyweight players in this field, the three organizations that have the most clout in the realm of budgets and tax policy, are the World Bank, the International Monetary Fund, and the Organization for Economic Cooperation and Development.
These three institutions often work together on the same international problems (although they don’t always agree on the solutions). So it’s easy to confuse them. Even John Maynard Keynes, the British economist who was a central player in creating all three, said he always thought of the World Bank as a “fund” and the International Monetary Fund as a “bank.” In fact, though, their basic functions are somewhat different:
These international financial watchdogs all compile comparative data on national and international financial matters; when you see a listing, say, of the world’s richest countries, the source is probably one of these three. Such studies are invaluable to the harmless drudges (like me) who write comparative policy books on health care, taxation, and similar topics. The book you’re reading now probably couldn’t exist without the mountain of charts, tables, and rankings churned out every year by the World Bank and the OECD.
In addition, all three institutions provide advice to nations—big and small, “developed” and “developing,” democracies and dictatorships—on everything related to government finance. Which means they pour out a steady stream of reports and recommendations on tax policy. Their economists and accountants know what makes for an efficient and successful tax system and what makes for a bad one. While these organizations sometimes differ from each other on their economic nostrums—there was considerable argument in 2008–9 as to whether “austerity” or “stimulus” was the best medicine for recovery—all of them agree on the core framework that should underlie any national tax regime. When it comes to designing a country’s tax system, the World Bank, the IMF, and the OECD all preach the same sermon, relying on the same fundamental principle. This rule is not particularly complicated; it is easy to understand, although not always easy to implement. In fact, it’s so simple that the economists generally reduce the essential formula for good taxation to a four-letter word: “BBLR.”
That stands for “broad base, low rates.”
BBLR means that if the tax base—that is, the total amount of income, or sales, or property that can be taxed—is kept as large as possible, then the tax rate—that is, the percentage that people have to give to the government—can be kept low. Virtually all economists and tax experts agree that this is the best way to run a tax regime.
A broad-based income tax is one in which just about every penny a citizen earns during the year is taxable, without a bundle of exemptions, deductions, credits, allowances, and so on that reduce the taxable income. A broad-based sales tax is one in which sales tax has to be paid on every purchase, without exemptions for food, medical supplies, and so forth. A broad-based property tax is one that taxes the full assessed value of a home or building or piece of land.
To demonstrate, let’s imagine two citizens; we’ll call them Bill and Helen. Their economic circumstances are nearly identical, but they live in different states with different income tax rules.
—Bill Broad lives in a state that has adopted a broad-based definition of income. He works for Galactic Airlines, earning $75,000 per year, plus assorted benefits: the company pays $1,000 per month for his health insurance; the company contributes $200 per month to his 401(k) retirement plan; the company pays for his parking fees at the airport where he works, which is valuable because parking would cost $20 per day if he had to pay for it. Bill owns a house in town, with mortgage interest payments of $2,000 per month. He sends his kids to private school, at a cost of $9,000 per year. He donates $50 per month to his church, and $500 each year to the United Fund campaign. The property tax on his house comes to $4,500.
Under the broad-based tax regime in his state, everything Bill receives from his employer is counted as income; that’s $75,000 in wages, plus $12,000 in health insurance premiums, plus $2,400 in retirement contributions, plus the value of the company-paid parking, which comes to $5,000 per year. Add it all up, and Bill’s gross income is $94,400. That’s also his taxable income, because his state doesn’t give any deductions for mortgage payments, property tax, charitable contributions, or education expenses. The state income tax rate is 10%, so Bill pays $9,440 in taxes.
—Helen High lives in a state that offers a generous assortment of income tax exemptions, credits, and deductions and makes up for them by imposing high tax rates. She, too, works for Galactic Airlines. She earns the same annual salary as Bill ($75,000); she gets the same $1,000-per-month insurance policy, paid for by the company. She gets the same $200 retirement contribution each month, and the company provides her free parking at the airport. Helen, too, has a mortgage on her house, with $2,000 of interest payments monthly. She, too, has kids in private school, at a cost of $9,000 per year. Just like Bill Broad, she donates a total of $1,100 each year to church and charities. And she, too, pays property tax of $4,500 per year.
Under the narrow-based tax rules where Helen lives, her salary counts as income, but her employer’s contributions to her health insurance and 401(k) plan do not. She is not taxed on the value of the free parking her company provides. She gets a deduction for the interest on her mortgage payment and additional deductions for her tax payments and charitable contributions. She gets a credit for her children’s educational expenses. So when Helen reaches the “taxable income” line on her tax return, the total, after all those exemptions and deductions, is $52,500. In order to get the same amount of revenue that Bill Broad paid—$9,440—the state will have to tax Helen High’s income at a rate of 17.98%. In other words, the tax rate has to be set nearly 80% higher to offset all the tax preferences that slashed Helen’s “taxable income.”
Because both taxpayers end up providing the same amount of revenue, what’s the difference? Why does it matter whether somebody is taxed at 10% or 17.98%, as long as government gets the revenue it needs?
First, nearly all economists believe that tax should be a “neutral” factor when people and corporations are making business decisions. An economy works best if financial decisions are based on sound business principles; if tax considerations influence the decision, they distort the economics. If International Widgets decides to buy a $20 million industrial robot, it should do so because that acquisition makes business sense—that is, this new tool will increase our profit—and not because there’s a big tax break for investing in robots. If some millionaire is looking for a bank to hold her life savings, she should look for the most trustworthy bank, rather than depositing her money in the Cayman Islands in order to hide it from the IRS. If a big U.S. tractor company decides to move the headquarters of its spare-parts business to Switzerland, that should happen only if Switzerland is an important hub of the parts business, not because Switzerland has rock-bottom corporate tax rates.
This is where low rates come in. If the rate is low, it’s less likely to influence personal and financial decisions; that is, the tax will be “neutral.” If the tax you owe is only 10% of your income, it’s probably not worth your while to pay a lawyer to design some complex tax haven scheme, or to move a whole branch of your company to a low-tax country. But if the tax man is going to take 17.9% or 35% or (in France) 75% of your income, then the lawyer’s complex scheme can save you serious money. The economist John Maynard Keynes was a famous advocate of progressive taxes, but he warned that higher rates run the risk of “making skillful evasions too much worthwhile.”2 High tax rates prompt people to spend money on the tax lawyers and finance wizards who design those skillful evasions. For the lawyers and the finance guys, this is a boon. But for the overall economy, it’s a significant loss. The money these taxpayers spent on legal fees and complicated financial constructions could have been invested in ways that would grow the national economy or solve social problems.
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BEYOND THAT, A TAX SYSTEM studded with preferences—exclusions, exemptions, accelerated depreciation, intangible drilling credits, and so on—is a complicated tax system. Getting rid of all those loopholes so that all income is treated the same way makes the whole business of taxation easier for both the taxpayer and the tax collector. If dividends you received from a “Subchapter S” partnership (whatever that means) were taxed the same as all other income, you wouldn’t have to dig through the verbal jungle of IRS Form 1065 to figure out how much of the dividend is an “unrecaptured section 1250 gain” (whatever that means). If there’s no deduction for contributions, charities don’t have to produce a certified receipt for each donation, and the contributor doesn’t have to track down the nine-digit Tax ID Number of each charity she wants to support.
Getting rid of the complications also makes it easier for the tax agency to check a tax return or to perform an audit. And a broader tax base makes the system feel fairer. If deductions, credits, and such are strictly limited, the average wage earner won’t have that sneaking suspicion that rich people have their own special escape clauses to cut their tax burden.
The principle of BBLR applies to other types of taxes as well. Consider a state sales tax. Let’s say the total of retail sales in a certain state is $1 billion per year. If the state’s sales tax applies to every purchase, without any exemptions, the sales tax base will be the entire $1 billion. With a sales tax of 9%, the state will take in $90 million in sales tax revenue. But if the sales tax exempts food, medicine, children’s clothing, and newspapers—these are the common exceptions—the sales tax base is only $500 million. To bring in the same $90 million of revenue, the state would have to double its sales tax rate to 18%. And all those exemptions make the process difficult for retailers, who have to figure out on every sale which items are tax exempt and which are not.
For all these reasons, there is broad consensus among economists and tax experts that a broad tax base, making it possible to lower the rates, is the gold standard for the design of any revenue system. When President George W. Bush appointed a blue-ribbon commission in 2005 to write a new, improved tax code—the President’s Advisory Panel on Federal Tax Reform—the advisers’ main suggestion was a BBLR approach. In response, each of the predictable interest groups complained loudly about the proposed elimination of its favorite credits and deductions; the plan went nowhere. When President Barack Obama appointed a blue-ribbon commission to find ways to cut the deficit—it was officially the National Commission on Fiscal Responsibility and Reform, but everybody called it “Simpson-Bowles”—that group, too, recommended a BBLR tax reform. In response, each of the predictable interest groups complained loudly about the proposed elimination of its favorite credits and deductions; the plan prompted extensive debate but never got to a vote in Congress.
Because economists are usually not unanimous about anything, it’s downright strange to see the virtually universal endorsement of the BBLR principle by academics, tax-reform advocates, think tanks around the world, and the three big international financial organizations. Yet there are a few dissenters. One is Professor James R. Hines, an economist at the University of Michigan. He acknowledges the benefits of a simplified tax system with low rates. But he says it’s fairer if the law gives special breaks to taxpayers in special circumstances, like parents or the chronically ill or corporations that have to make large capital investments. Yes, this makes taxes more complicated, the professor concedes, but “good policy is messy.” Professor Hines also argues, tongue in cheek, that it’s probably better if Congress fritters away a lot of time writing tax loopholes. If all exemptions and preferences were eliminated, he says, “the only tax policy role of Congress would be to choose tax rates. Should we worry about what Congress might do with all the extra time?”3
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THE OECD PUBLISHES A broad variety of reports and proposals on financial topics, but one of its perennial bestsellers is a 160-page guidebook called Choosing a Broad Base–Low Rate Approach to Taxation.
“In general,” the guide says, “tax reforms that broaden tax bases and lower rates should reduce the extent to which tax systems distort work, consumption, and investment decisions, increasing output and enabling improvements in social welfare.” Governments may think they have good reason to create provisions giving tax breaks to particular groups, but the OECD economists beg to differ. “Whatever the reason, tax provisions entail a loss of government revenues, which necessarily means that other taxes have to be higher than otherwise. . . . These higher rates may create additional efficiency losses, adverse effects on income distribution, and administrative and compliance costs.”4
Many countries, rich and poor, have moved in the direction of BBLR. Among them are Canada, Great Britain, and Germany, which have eliminated exemptions and credits at various times to broaden the tax base and lower rates. As we’ll see shortly, the United States took a big leap toward BBLR some thirty years ago. But then the lobbyists pushed (successfully) to get their preferred exemptions back into the U.S. tax code; this narrowed the tax base, so rates had to go up to bring in the same amount of revenue.
When I asked the economists at the World Bank, the IMF, and the OECD which countries have the best tax system, they agreed on a prime candidate. New Zealand, they all told me, is Exhibit A for demonstrating the merits of the broad-based, low-rate approach. The academic literature supports this conclusion. “The New Zealand tax system stands out in comparative perspective,” concluded a 2012 study in the Journal of Public Policy. “Over the last three decades, New Zealand arguably moved further than any other advanced economy in neo-liberal tax reform, i.e. in the direction of low rates, broad bases, and neutral taxation. . . . The top rates on labor income in New Zealand are extraordinarily low by international standards. . . . The [sales tax] rate also remained relatively low by international standards.”5
It’s not really surprising that New Zealand followed the economists’ advice. This island nation has been a policy leader for decades among the world’s rich democracies. The Economist magazine noted that “New Zealanders have a right to be smug” at international meetings, because so many of their governmental innovations have been copied around the world.
New Zealand was the first nation on the planet to let women vote (in 1893). It has given new meaning to the term “paying with plastic”; the nation’s currency is printed on waterproof, tear-resistant plastic, with transparent windows in the middle of the bill. The money doesn’t wear out, it’s almost impossible to counterfeit, and it floats if you drop it in a river. As a result, the Kiwis have sold this monetary innovation to dozens of countries. (Kate Sheppard, the proto-feminist who led the world’s first successful campaign for women’s suffrage, is on New Zealand’s plastic $10 bill.) While other nations ponder the idea of privatizing the post office, New Zealand already has competing public and private postal services, with mailboxes of different colors side by side on the street. (I tried both systems and found the government delivery a little cheaper and just as fast.)
The nation has also been a leader in dealing with the indigenous population. As early as 1840, when white colonial settlers around the world—including the U.S. Cavalry—were waging war on the aboriginal residents of their new lands, the British pioneers who came to New Zealand signed a treaty recognizing members of the Maori tribe as equal citizens. (American Indians didn’t become U.S. citizens until 1924.) The Maori language has been an official language since the birth of the nation. All government agencies print their documents in English and Maori. The Inland Revenue Department—also known by its Maori name, Te Tari Taake—provides both English and Maori versions of Form IR3, the local equivalent of Form 1040.
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A GREEN MOUNTAINOUS ISLAND NATION with almost no manufacturing, New Zealand might seem to be an unlikely candidate for membership in the OECD, an organization limited to the world’s richest industrialized democracies. But the Kiwis have built an advanced, prosperous, industrialized democracy—without heavy industry. They’ve done it by promoting a vigorous business of “adventure tourism” that lures rock climbers, windsurfers, snowboarders, bungee jumpers, and the like from all over the world, and by exporting the fruits of their farms and forests—primarily dairy products, timber, wool, and wine. To compete with much larger agricultural nations, New Zealand promotes its products as “100% pure,” containing nothing artificial or genetically modified. The point is made emphatically on the label of a beer called Steinlager Pure, a delicious brew and a successful export found all over Asia. “You are holding in your hand one of the purest beers anyone can make,” the label declares. “No additives. No preservatives. Sourced from the purest place on earth, New Zealand.”
The focus on purity has been so successful that New Zealand ranks among the richest countries in the world. It was one of the earliest members of the OECD. When it joined that international group in 1973, New Zealand had a tax code that looked like the tax structure in other rich countries. It relied primarily for revenue on a personal income tax, and the tax was riddled with exemptions, credits, and giveaways for particular groups and companies. In short, it was the opposite of BBLR. All those preferences made for a fairly narrow tax base, which meant that tax rates had to be high to raise the required revenue. By the early 1980s, the country’s top marginal income tax rate was 66%. “We had an income tax that was like a swiss cheese, it had so many exemptions,” a veteran Kiwi bureaucrat, Graham Scott, told me. “And with all those holes in it, the rates had to be kept high to bring in the money we needed.”
Graham Scott told me that “in the ’70s a wine expert—an enologist, he’s called—came to visit from the University of California. Well, this bloke noticed that our Marlborough region [basically, the northeast corner of the South Island] had a geography and a climate that looked like Napa Valley. Well, a few entrepreneurs drove out the sheep and started planting the grapes that you grow in California. And this has turned into a huge export industry. The sauvignon blanc from Marlborough is world famous now; we export more sauvignon blanc to the United States than France does! But at first, nobody had ever heard of a Marlborough wine. So we gave the winemakers all sorts of tax benefits in the beginning. Hell, that’s what we always did; in those days, we were giving every industry tax breaks, left and right. That’s one of the reasons we had all those holes in the income tax.”
In the 1980s, Graham Scott became the policy chief in New Zealand’s Finance Ministry, which meant that fixing that swiss-cheese tax code was his job. (He did the job so well that the queen knighted him for his work; he is now Sir Graham Scott, although he seemed embarrassed when I called him that.) When Scott took over the policy shop, the Labour Party—roughly like the U.S. Democratic Party—had just won a national election. The Labour finance minister, Roger Douglas, Scott recalls, wanted to “clean up” the tax code.
“We said, ‘Roger, what do you mean, “Clean up”?’ And he said, ‘Let’s cut out all the special business allowances. Let’s cut out all the agriculture subsidies.’ Frankly, the politics of it were favorable, because Labour didn’t have farm support anyway, didn’t have business support. So we could get rid of all the special allowances and rebates and deductions. In those days, we had tax incentives for timber companies; for tourist companies; for insurance companies; hell, you could deduct the premiums for your life insurance policy. If a company built a factory for $10 million, we would let them depreciate the whole $10 million in the first five years, even though the building would last for fifty. Well, we killed all of those write-offs. We didn’t allow individuals to take the two big deductions that your U.S. has, for mortgage interest and contributions to a church.”
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THIS WAS BASE BROADENING on steroids, but even so, the bureaucrats did not satisfy Douglas, the finance minister. He wanted to cut the top income tax rate in half. But even with virtually all preferences eliminated from the tax code, the government couldn’t get enough revenue with such low rates. To solve that problem, Scott and his fellow bureaucrats proposed a national sales tax—they called it the goods and services tax—and used the same broad-based approach for that levy. Unlike other countries’, New Zealand’s GST applied to virtually any product or service you could buy (including the prostitutes in the legal brothels). With that addition, the income tax rates could be cut in half for every taxpayer in the nation—with no loss of revenue to the government.
In essence, New Zealand’s government said to its citizens, “If you want to make a contribution to charity, that’s fine. But you don’t get a tax break for it. If you want to take out a mortgage to buy a house, that’s good. But you don’t get a tax deduction for the interest you pay. You want to put a solar array on your roof? Great idea, but don’t expect a tax write-off. If you buy a life insurance policy to protect your family, more power to you. But we’re not going to let you deduct the annual premium.”
Inevitably, taxpayers and businesses that lost a cherished deduction complained angrily. “But we said to them, if you want to keep that deduction, we’ll have to raise the rates for everybody,” Scott recalls. “And people understood the trade-off; you lose a deduction, but you get a simpler tax code and much lower rates.” From the left, there were complaints that the big cut in income tax rates was a gift to the richest Kiwis. “But we said to them, the tax is still progressive,” Scott says. “The more income you have, the higher your tax rate. But a progressive tax doesn’t necessarily have to soak the rich.” Tax lawyers and accounting firms also complained, Scott told me, “because after all we were putting a lot of them out of business when we took away all the loopholes they used to manipulate.”
In the end, the sweeping reform was widely accepted—by individuals, businesses, and both major political parties. “It was a success. Even the conservatives eventually had to accept that this was extremely popular,” said Maurice McTigue, who was a member of Parliament at the time from the National Party, the conservative opposition. “A key reason was that we did it big. They changed almost everything at once. And that’s an important lesson: if you’re going to do tax reform, you’d better make it a large reform. That way, for every change a taxpayer doesn’t like, there’s something else in the package that he wants.”
Despite the predictable efforts of various industry and interest groups to wedge their favorite tax preferences back into the tax code, New Zealand clung fairly tightly to the BBLR principle over the next two decades. Over time, though, some deductions and credits were permitted—including that accelerated depreciation write-off that Graham Scott thought he had killed. All this narrowed the tax base and forced the government to raise income tax rates; the top income tax rate had risen from 30% in 1986 to 39% by 2010. Taxpayers were not happy. And so New Zealand did tax reform again; in 2010, deductions and credits were cut, and that accelerated depreciation scheme was killed (for the second time). Income tax rates could be cut yet again, with no loss of revenue.
The result is a tax code that imposes the lowest rates on average workers of any developed nation. The comparison with the United States is instructive. An American couple bringing in the median family income—about $55,000 per year—and taking the standard deduction will pay about 15% of their annual earnings in personal income tax, another 6.5% in Social Security tax, another 2.9% for the Medicaid tax, and roughly 5% in state income tax. In addition, an average American family will pay 5% to 10% of income for health insurance. Add it all up, and the median earner in the United States is paying about 35% of earnings for taxes and health care. (A self-employed American would pay even more, because Social Security taxes and health-care premiums are higher for the self-employed.)
In New Zealand, in contrast, the median wage earner pays about 17.5% in income tax. But that one payment also covers his old-age pension (there’s no separate tax for Social Security), plus free health care for life (there’s no separate tax for health care), plus free education through college graduation (there’s no separate tax for schools). So the average New Zealander’s wages are taxed at less than half the rate of the average American’s. And yet New Zealand provides more government services than the United States—with half the tax rate. That’s the beauty of BBLR.
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NEW ZEALAND’S EXPERIENCE IS INSTRUCTIVE, but what does it have to do with the United States? It’s an island country, closer to Antarctica than to the equator, with four million people and about as many sheep. It has a unicameral legislature and a government tradition in which elected politicians defer to professional bureaucrats—like Sir Graham Scott—on all the important policy questions. In a country like that, a major change of the national tax code must be easier to achieve than in a sprawling, contentious place like the United States, where nearly all public policy issues are heavily politicized and corporate money flows freely through the halls of Congress. With our fractious politics and our sharply polarized electorate, surely the United States could never bring about a tax reform as sweeping and as successful as New Zealand’s swing to BBLR.
But, in fact, we did.
In the mid-1980s, the American political landscape was as fractious as it is today. The Republican president had won a substantial electoral college victory, but the country was polarized. The government then was divided, with a conservative president from California battling a liberal House of Representatives led by a Democrat from Massachusetts. With leaders of both parties constantly maneuvering for political gain, Washington was gridlocked on the major issues. There wasn’t much hope for significant progress in any policy area and certainly not on tax reform.
The election in 1980 of President Ronald Reagan, an unabashed tax hater, launched a flurry of tax laws that pushed rates down, up, down again, and up again with no clear pattern. In Reagan’s first months in office, he successfully pressured Congress to pass the Economic Recovery Tax Act of 1981—known inside the Beltway as ERTA—giving big tax cuts to every individual and corporate taxpayer. (ERTA was so laden with breaks and credits for various industries that it was called, accurately, “a frenzied craze of tax giveaways.”6) The economic rationale for this huge tax reduction was the so-called “supply-side” argument that lower taxes would stimulate business activity and bring in more revenue. Sadly, as we’ve seen, this something-for-nothing theory has never worked in practice. ERTA led to such a big jump in the government’s deficit that Reagan and Congress quickly reversed course, increasing taxes the next year in the Tax Equity and Fiscal Responsibility Act—known as TEFRA. That was followed by tax cuts in 1983, and yet another tax increase in the Tax Reform Act of 1984 a year later.
By the time Reagan won reelection in 1984, the U.S. tax code was, as the economist Henry Aaron put it, “a swamp of unfairness, complexity, and inefficiency . . . that represents no consistent policy.” Each new exemption or credit spawned many more. Oil drillers had traditionally enjoyed a tax break called a depletion allowance, based on the theory that the amount of oil in the well must be depleting over time. Seeing that, other industries clamored for their own depletion allowances, and Congress responded. By the mid-1980s, the tax code allowed depletion or depreciation allowances that cut taxes for cement companies, Christmas tree farms, apple orchards, gravel pits, railroad cars, rubber importers, cattle growers, and many, many more. There was even a depreciation allowance for human beings; professional sports teams were allowed to write off their players as “depreciable assets” as they slowed down with age.
Nobody defended this mess, but hardly anybody expected things to get better. When the Treasury Department began testing various reform plans in 1984–85, the respected political scientist John Witte wrote that “there is nothing, absolutely nothing . . . that indicates that any of these schemes have the slightest hope of being enacted in the forms proposed.”7
And yet there were two men in official Washington who still believed that liberals in Congress and the conservative in the White House could agree on significant tax reform. These two were strange bedfellows indeed. One of them, a conservative Republican, was a Wall Street tycoon; the other, a liberal Democrat, was a basketball star.
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THE WALL STREETER WAS Donald Regan, who left his post as chairman of the nation’s largest stockbrokerage, Merrill Lynch, to become secretary of the Treasury in Reagan’s cabinet. Despite his position at the top of the financial community, Regan had a populist, anti-establishment streak. Like everybody else, Regan considered the U.S. tax code an unruly beast that badly needed taming. But unlike most of his predecessors, the new cabinet secretary began talking regularly to tax policy experts deep in the Treasury bureaucracy. He encouraged the bureaucrats to think boldly; among much else, he dispatched a pair of economists to New Zealand to study the bold changes the Kiwis were making under the guidance of Sir Graham Scott. By the end of 1984, Regan and his policy team had put together a sweeping tax-reform plan—it became known as Treasury I—that incorporated the basic principle of “broadening the base to lower the rates.” When James Baker replaced Regan as Treasury secretary, he, too, became an advocate for the BBLR approach to tax reform.
This was a concept that the other key reformer, Bill Bradley, had championed even before Treasury I was issued. An all-American at Princeton and a Rhodes scholar, Bradley came home from Oxford to join the New York Knickerbockers of the National Basketball Association. He became the team’s biggest star, and the best paid as well; he was given the nickname Dollar Bill. Fellow players steered Bradley to the usual army of tax lawyers and accountants, who showed him all the legal tax-avoidance mechanisms available to the richest of taxpayers. Bradley said he found it appalling. He was even more disturbed when the Knicks’ finance chief mentioned that the team could label its star forward a “depreciable asset,” and thus cut its taxes. Bradley later recalled that he really got interested in the U.S. tax code when he learned that “I had been a loophole for the New York Knicks.”
Bradley was elected to the U.S. Senate in 1978, and he brought to this new position the same determination and diligence that had made him a standout in school and in sports. I was a reporter covering the U.S. Senate on January 15, 1979, when the new Congress convened and the newly elected senators were sworn in, with great hoopla. Right after that formal ceremony, all the members left the Senate floor to attend celebratory parties—all of them, that is, except Senator Bradley. On his first day in the Senate, he spent some three hours at his desk going over the Senate rules with the parliamentarian.
With a seat on the tax-writing Finance Committee, Bradley immersed himself in the policy and politics of tax reform. He made an important discovery: in taxation, the policy issues and the political considerations neatly overlapped. Lowering the rates was something Republicans wanted. Broadening the base—cutting out special interest preferences—was something Democrats wanted. So combining a broad base with low rates should win support from both parties and thus get a real reform bill through Congress. Bradley used this combination approach in a tax bill he introduced, the Fair Tax Act, which proposed to cut the top marginal rate by half, to 30%.
“The trade-off between loophole elimination and a lower top rate became obvious,” Bradley wrote later; “the lower the rate, the more loopholes had to be closed to pay for it.”8 Bradley stuck to the mantra of “broad base, low rates” for years, telling anybody who would listen that a significant cut in tax rates would win the votes needed to broaden the base. “The key to reform was to focus on the attractiveness of low rates, not on the pain of limiting deductions.”
The enticement of low rates also helped land a crucially important supporter for tax reform: Ronald Reagan himself. As a major Hollywood star, Reagan had been a member of the financial 1% in the 1950s, when the top marginal income tax rate was 90%. The sting of the annual tax return, Reagan used to say, was one of the factors that converted him from a liberal labor union leader to a conservative champion of business. He saw himself as a defender of the hard-pressed average taxpayer. On the stump, he loved to tell an old joke: “The taxpayer—that’s the only person who works for the federal government without passing the Civil Service exam.”
When Regan, Baker, and Bradley approached the president with a promise to cut the top rate to 30% or lower, accordingly, Reagan signed on. In 1984, the popular president announced that far-reaching tax reform was his top domestic issue—a declaration that made it harder for his fellow Republicans in Congress to oppose the reform when the plan came to a final vote in 1986.
And yet the path to passage, as set forth in the definitive history of the 1986 act, Showdown at Gucci Gulch, was hardly smooth. Every time a reform plan seemed to be getting somewhere in either the House or the Senate, corporate lobbyists would swarm in to protect their favored tax break—and each tax break that was approved meant the rates had to go higher. For most of 1984 and 1985, the efforts to overhaul the income tax looked like all the other so-called reform plans of recent years; they made the tax code more complicated and more littered with preferences for the powerful.
At the end of 1985, the House of Representatives, controlled by liberal Democrats, passed a bill that moved in the direction of reform, although it left the top marginal rate at 38%. But when the Senate Finance Committee, controlled by Republicans, took up the issue, the members seemed far more interested in creating new benefits for various corporate groups than in broadening the base or cutting rates. The vaunted effort to reform our tax code turned into the kind of bill that senators called a “Christmas tree”—there were goodies for everybody.
By the spring of 1986, the senators were being denounced, in both national and home-state media, for selling out to special interests. Among those taking the heat was the Finance Committee chairman, Robert Packwood of Oregon, a moderate Republican who was up for reelection that year. The Oregon press was bashing him as a corporate stooge, as the man who killed tax reform. They gave him a brutal nickname: Senator Hackwood.
Having tried everything else, the senators finally turned back to Bill Bradley and his simple formula: broaden the base to lower the rates. At a Finance Committee meeting in mid-April, Chairman Packwood put aside the Christmas tree bill and handed out copies of the Fair Tax Act that Bradley had introduced years earlier. Just as Bradley had predicted, the lure of sharply lower rates proved stronger than the senators’ attachment to their special interest tax breaks. With Ronald Reagan and the liberal Democrats pushing together, the drive for genuine tax reform gathered so much momentum that the BBLR bill—the Tax Reform Act of 1986—swept through both the Senate and the House and was signed into law by a beaming president in October.
That 1986 law, generally recognized as “the most significant reform in the history of the income tax,”9 reduced the top marginal rate for individual taxpayers from 50% to 28%—the biggest reduction of any tax bill before or since. It did that by eliminating a broad range of “tax shelter” breaks available only to the rich. It cut back the deduction for mortgage interest and completely eliminated the deduction for interest on consumer loans, like auto loans and credit cards. It eliminated the deduction for state and local sales taxes. It limited deductions for charitable contributions, IRA deposits, medical bills, and other personal expenses. It set the tax rate on capital gains—that is, profit on stocks, real estate deals, and so on—at the same level as the top income tax rate, so that financiers could no longer cut their tax bill by defining all their pay as capital gains. In fact, the reform changed so many aspects of the tax code that the official name of the basic law of U.S. income tax was updated for the first time in thirty-two years. What had been the Internal Revenue Code of 1954 became the Internal Revenue Code of 1986, which it still is today.
The new law produced significant tax cuts for low-income and median-income Americans and provided tax savings for the rich as well. But somebody had to pay for all that lost revenue, and the burden was shifted largely to corporations. Although the bill cut the basic corporate tax rate, from 48% to 34%, it took away so many of industry’s cherished credits, deductions, and depletion allowances that corporate taxes increased by some $120 billion over five years.
In short, Congress and the president achieved a fundamental change in the income tax by heeding two lessons from the New Zealand reform: they broadened the tax base to make low rates possible, and they made a large, sweeping reform all at once so that every change the taxpayers didn’t like was offset by changes that they wanted badly.
This stunning and unexpected tax reform, particularly coming out of a politically polarized Washington, D.C., drew attention, and prompted action, around the world. When little New Zealand transformed its tax code, the other wealthy nations found it interesting; when the mighty United States did the same thing, the rest of the world found it imperative, on political and fiscal grounds, to do the same. In short order, Britain, Ireland, Canada, the Netherlands, and other democracies dramatically lowered their tax rates by broadening the tax base. The OECD called this wave of tax reduction a “global revolution,” and the United States lit the spark.
But soon the lobbyists and political contributors started leaning on Congress to restore many of the credits, exemptions, allowances, and shelters. Many industries got their depreciation or depletion allowances fully restored. Families got new tax credits for child-care expenses and student loan interest. Under pressure from Wall Street, the tax rate on capital gains was sharply cut; this was a windfall for the wealthiest taxpayers, and one that gave the finance community new incentives for complicated schemes to make salaries look like dividends. All these giveaways narrowed the tax base, which meant tax rates had to be increased to bring in the same amount of revenue. After three increases in the 1990s, the top marginal rate of income tax was back up to 39.6%, where it sat in early 2017. After proudly patting itself on the back because of the 1986 reform, Congress in the next three decades made more than thirty thousand changes to the 1986 code. Most of them ran counter to the ethos of BBLR. Virtually all of them made the tax code more complicated—including that bizarre “anti-complexity clause,” Section 7803(c)(2)(B)(ii)(IX).
Three decades after the passage of the 1986 reforms, the U.S. tax code is a mockery of the BBLR principle. It is stuffed to the roof with loopholes that narrow the tax base and thus force tax rates higher. If we are to fix our complicated and inequitable tax code again, Americans will have to agree—as we did three decades ago—to purge many of those deductions, including some of the write-offs that are most popular.
But which ones?