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Tax History: Broaden the Base and Lower the Rates: What if It’s a Bad Idea?

Posted on Mar. 15, 2021

Everyone knows the formula for income tax reform: Broaden the base and lower the rates. Pursued with honesty and coherence, that sort of program will advance the goals of sound taxation: fairness, efficiency, and simplification.

At least that’s what everyone says. But what if everyone is wrong?

In the policy community, the Tax Reform Act of 1986 enjoys almost mythic status, thanks to its fidelity to that ideal of modern tax reform. That law represents a moment of improbable success, when good ideas and disinterested expertise gained a foothold in the messy world of politics. While not unsullied by compromise, the law still represents the apotheosis of modern tax reform.

But TRA 1986 embodied just one flavor of tax reform — the one defined by the base-rate trade-off. Other versions of reform, however, not only are possible but have actually been on the menu at various points in American history. (Prior analysis: Tax Notes, Feb. 18, 2013, p. 777.) The version of reform that triumphed in 1986 was a product of its particular time and circumstance; conceived in the 1950s, it gathered momentum over the next two decades and came to fruition in the 1980s.

But postwar tax reform (for want of a better shorthand reference) was never without its critics, especially during the early years of its formulation. These skeptical voices were all but silenced by the rising intellectual hegemony of the postwar reform movement — but not before they had raised important questions about its wisdom and political viability.

Questions that still resonate today.

A Cogent Critic

Consider the arguments of J. Reid Hambrick, then a law professor at George Washington University. In a 1963 article, “The Illusion of Tax Reform,” Hambrick targeted the Kennedy administration’s high-profile plans for “urgent and obvious tax adjustments,” as well as its longer-term vision for a “comprehensive tax reform program.”

Hambrick’s article did a fine job describing these various reforms, but Time magazine covered the same ground more expeditiously. In a 1961 profile of President Kennedy’s chief economic adviser, Walter Heller, it offered a snapshot of his views on tax reform:

He wants to lower the federal income tax rates from the present range of 20 percent-91 percent to 14 percent-60 percent and abolish virtually all loopholes and preferential deductions. Heller considers the present income tax structure not only inequitable, but uneconomic too: it impedes economic efficiency by distorting economic decisions. Thorough tax reform, he believes, would improve the U.S. economy’s overall efficiency.

Hambrick took issue with the very heart of this reform program: trading preferences for rate cuts. It might seem to be a reasonable and astute political compromise, but it would actually make the tax system less fair and more dysfunctional. Or it would if it had any chance of enactment — which it did not. Presented by its champions as a masterstroke of fiscal realpolitik, it was actually naïve and out of touch. Postwar tax reform was doomed to fail.

Cynic or Skeptic?

Hambrick was a hard sell when it came to idealistic talk; his was a skeptical mind, verging on the cynical. And he was especially dubious about efforts to improve the tax system. “Tax revision is like the weather,” he observed. “Actually, it is worse, because the more you try to do something about it, the greater becomes the need for reform.”

Over the previous two decades, Congress had enacted roughly 30 revenue acts, he noted. Yet over the same period, “the statutes have been filled with ‘loopholes,’ ‘truck holes,’ ‘gimmicks,’ ‘preferences,’ ‘differentials,’ and ‘special dispensations.’” Legislative effort was clearly no guarantee of improvement; salutary neglect might well have produced better results.

With that cheery thought, Hambrick tried to explain why Congress had failed to produce good tax legislation — and why it would almost certainly fail again. He said the key could be found in the “forces and group pressures” that drive the policy process, and especially in what he saw as the critical issue behind every important tax debate: “the simple uncouth question of who is to pay how much.”

Debate over this question was typically framed in terms of “the ideology of ability to pay,” Hambrick wrote. And in policy terms, that ideology usually translated into a progressive rate structure for the personal income tax.

At least that had been the case for the first half of the 20th century. Since World War II, however, popular commitment to that ideology had begun to fade. “The old ardor that defended progression in the name of reducing economic differences is gone,” he said, a victim of declining interest in wealth inequality.

Hambrick was deeply concerned about inequality, but less for moral reasons than for economic ones. It was less about redistributing between rich and poor, per se, and more about redistributing between “those who consume and those who save and invest.” His version of redistribution was more about increasing jobs and prosperity and less about leveling and equality.

Hambrick was a demand-side liberal of the old school, and he believed the health of a mature economy depended fundamentally on redistributing income from those inclined to save it (the rich) to those inclined to spend it (the non-rich). Only a progressive income tax could manage that task. “Progression in tax policy tends to increase consumption spending, both private and public, and to diminish savings,” he wrote. “The result is a better balance between the two. In an economy that is already highly developed, consumption spending has a relatively greater importance than savings.”

By extension, any diminution of the existing tax system’s level of progressivity would be a step in the wrong direction, Hambrick pointed out. If progressivity were immediately and completely eliminated from the income tax rate schedule, disaster would ensue: “The net result would be a large contraction of consumer spending, widespread industrial shut-downs and unemployment, which would further decrease disposable income, and a collapse of the stock market, though not necessarily in that order,” he predicted.

More modest reductions in progressivity would have more modest but still deleterious effects. The piecemeal erosion of progressivity that had occurred during the 1950s fell into that category; the proliferation of tax preferences reduced the effective level of progression, thereby cutting redistribution and reducing overall, demand-driven economic growth.

Clearly, something had to be done.

But Not That!

Enter the new generation of tax reformers, who had a plan for all those base-eroding tax breaks. But it wasn’t a plan that Hambrick could embrace. “Their preoccupation with ‘erosion of the tax base’ is about to lead them into a debacle,” he warned. “It is as if they had fallen under the spell of a sort of ideological death-wish. They propose to trade rate reductions for a more comprehensive tax base.”

The reformers had arrived at that agenda out of desperation, Hambrick contended. Americans of the early 1960s still believed in progressive taxation, but as noted earlier, they were simply less interested in tax policy. “In our contemporary society the principle of ability to pay has lost most of its evangelistic fervor,” Hambrick said.

That waning public interest left tax experts — or at least those wed to the ideology of ability to pay — without a clear raison d’être. Soon enough, however, they settled on a new one: “the problem of appearance and reality in taxation.” Hambrick explained their new, urgent mission:

The income tax is not really as progressive as it appears to be. The graduated rate schedule of existing law presents the appearance of a steeply progressive tax. But the rate table does not tell the whole story. Indeed, it tells an essentially false story. A rate schedule without an adequate income base is an empty thing. The gap between appearance and reality of progression in the income tax is accounted for by a long list of income exclusions, deductions, credits, and preferences, sometimes collectively referred to as “tax differentials.”

The champions of postwar tax reform set out to shrink the gap between statutory and effective rates, working on both ends of the problem. “They appear to be prepared to go along with a drastic reduction in the top rates from the present maximum of 91 percent to as low as 65 percent, if the tax base can be shored up by the elimination of loopholes and preferential provisions,” Hambrick wrote. They had convinced themselves that the only way to resist pressure for new preferences was to remove the high rates that created that pressure in the first place.

Nowadays, that sort of logic seems more than reasonable, having been the received wisdom for decades. And to be honest, it was the received wisdom in 1963, too. Since at least the late 1930s, tax experts had been complaining that marginal rates were too high, distorting economic incentives and creating political pressures for relief. These complaints, moreover, came not only from conservatives, but from tax experts in Franklin D. Roosevelt’s own Treasury Department.

And the pressure for relief got results. In 1943, as wartime tax rates reached stratospheric levels, lawmakers packed a pending revenue bill with numerous special relief provisions — so many that Roosevelt felt compelled to veto the law. The act “is not a tax bill but a tax relief bill providing relief not for the needy but for the greedy,” he objected. It was the first veto of a revenue act in American history — and a reminder of the pressure that high rates can put on a tax system.

In other words, Hambrick may have disapproved, but the sort of tax reform ascendant in 1963 had a relatively long, bipartisan pedigree. Still, the link between rates and base erosion was hardly conclusive. In particular, Hambrick challenged the idea that rate reductions would do anything to slake the thirst for tax preferences.

“If the top rate were 65 percent, pressure would be exerted for a maximum tax rate on capital gains of 15 percent or less,” Hambrick wrote. “If the top rate were 25 percent, a capital gains tax of 5 percent would stifle incentive and ambition to save, invest, and produce, especially to produce.” Ultimately, tax preferences had a life of their own. “Pressures for special tax benefits will always be with us, no matter what the rate picture may be,” he wrote. “These pressures cannot be bought off through rate reductions.”

No Constituency

More broadly, Hambrick was unconvinced that tax reform would ever find a constituency among the voting, taxpaying public. Wealthy taxpayers, who were most likely to be the ones exploiting current preferences, would be disinclined to relinquish any of them for the sake of lower statutory rates. After all, many of those taxpayers were already paying even lower effective rates, so why take the chance?

Middle- and lower-income taxpayers also had little to gain in the tax reform bargain. Some of the preferences that Stanley Surrey and friends had added to the chopping block — the exclusion for Social Security income, for instance, or the extra exemption and increased medical expense deduction for filers over 65 — were broadly popular. So were deductions for mortgage interest and property taxes, as well as the liberal treatment of fringe benefits.

The problem, as Hambrick explained it, was essentially one of democracy. Tax preferences were created because they served the interest of both taxpayers and the lawmakers they elected. Neither group had an interest in seeing those preferences disappear, merely for the sake of “tax reform” or “sound taxation” or some other high-minded ideal.

“The proliferation of special tax benefits which entail no change in the overall rate structure has become standard operating procedure in Congress,” Hambrick argued. “These limited ‘breaks’ have been put forward and justified on grounds of removing inequities and stimulating incentives without arousing undue skepticism on the part of the great mass of taxpayers.” Lawmakers would never surrender such a useful tool. And taxpayers wouldn’t let them, anyway.

The new breed of tax reformers was too politically naïve to understand that dynamic, Hambrick contended. They couched their arguments in the abstract rhetoric of merit, fairness, and equity, but they never seemed to grasp that taxation was fundamentally a political phenomenon. “Their approach to the taxing process is essentially introspective,” he wrote. Reformers spoke reverently in defense of the “general public” and “the integrity of the tax structure,” while decrying the corrupting influence of “special interests.” But those were all bloodless abstractions, not actual humans.

“Implicit in their position is the absence of a constituency,” Hambrick concluded of the reformers. “They speak for the ‘people’ because they have no group to represent. The low-income groups have lost interest in the issue of economic differences, and the liberal spokesmen have lost interest in low-income groups.”

More Progression, Not Less

Ultimately, Hambrick’s biggest complaint with postwar tax reform was its willingness to sacrifice high marginal tax rates for the sake of dubious improvements to the tax base. The reformers “would condone the present compromised position of progression,” he complained. “What we need to do is to restore progression to the higher income brackets. We need more progression, not less.”

As noted earlier, Hambrick believed that progression was important for economic reasons, since it redistributed income to those most inclined to spend it — no small thing in a demand-driven economy. And he agreed with the new tax reformers that a postwar decline in the tax system’s effective progressivity (thanks to erosion of the tax base) was a real problem.

But Hambrick also believed that trying to solve that problem using the new model of tax reform was a fool’s errand, doomed by its own political insularity and naivete. Even if successful, the effort would “solve” the problem by giving away the only thing that mattered — progressivity in the upper reaches of the income tax. The very place, he insisted, where it mattered most.

Hambrick’s indictment of postwar tax reform is entertaining, shot through with snark and cynicism. I suspect it won him no friends. It also reads as a period piece; if the tax reformers of 1963 were a product of their particular time and place, so too was Hambrick. But his ideas were rooted in a late New Deal, Keynesian-inflected liberalism. That view of tax policy was already passing from the scene by the early 1960s — if indeed it ever really dominated it in the first place.

Hambrick’s insistence on the overweening importance of consumer demand is defensible. But his repeated, uncompromising dismissal of the importance of capital formation — which recurs throughout the essay — seems hard to defend. It was certainly an unpopular argument to be making during the Kennedy years, when tax experts spent a lot of time pondering investment incentives.

The best parts of Hambrick’s essay are his political insights. Over the short run, he was right about the lack of a political constituency for tax reform. It would take another 20 years for Americans to lose their faith in the structures of federal taxation. And even then, it’s far from clear that popular opinion played a decisive role in getting the 1986 legislation over the finish line; poll data on that is ambiguous. But he has a point about the limited appeal of base broadening as a tool for boosting progressivity, especially when compared with the political salience of rate increases.

More important, Hambrick was clearly right about the political dynamics that make tax reform a Sisyphean task. The process of preference creation is simply too rewarding — both for taxpayers and for lawmakers — to think that tax reform in the postwar model will ever produce durable results. People can and do argue about the long-term durability of TRA 1986. To be sure, some of its revisions stuck around, but many others — including marquee reforms to the rate schedule and the capital gains preference — did not.

Ultimately, Hambrick’s essay remains relevant today because it resonates with contemporary complaints about technocratic tax reform. He rejected the fundamental bargain of postwar tax reform: Broadening the base was nice, but it was simply not worth the cost of lowering the rates. Many on today’s left would agree with that conclusion, as well as Hambrick’s bottom line: “What we need to do is to restore progression to the higher income brackets. We need more progression, not less.”

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