by Alan Murray
As they listen to the applause, many of the lobbyists are still confused by the remarkable turn of events. But one thing is clear to all of them: In the early hours of the morning of May 7, tax reform completed its transformation from the impossible to the inevitable.
The income tax was enacted three quarters of a century ago in an attempt to bring fairness to the tax system. At the close of the nineteenth century, the government raised all of its revenue from tariffs and excise taxes, which placed a heavy burden on low-income Americans. “If taxation is a badge of freedom,” stormed income tax advocate William Jennings Bryan in a fiery 1894 House debate, “let me assure my friend that the poor people of this country are covered all over with the insignia of freedom.”
Bryan fought for an income tax, but was thwarted in 1895, when the Supreme Court ruled that the levy was unconstitutional. The debate raged for nearly two decades, but in 1913 the Sixteenth Amendment to the Constitution was ratified and the income tax became law.
The idea was to tax people according to their ability to pay, and income was considered the best measure of that ability. From the start, however, Congress made exceptions to that basic principle, allowing special treatment for income that was used for certain purposes or that came from certain sources.
Payments for mortgage interest and state and local taxes, for instance, were made deductible by the 1913 law. Farmers were allowed immediate write-offs for their equipment investments in 1916. Charitable contributions were made deductible in 1917. Military benefits were excluded in 1918. The special tax treatment of capital-gains income earned from the sale of assets, such as securities or real estate, was enacted by Congress in 1921. Employers’ contributions to pension funds were excluded from taxable income in 1926. The list of special deductions, exclusions, and credits grew and grew, as Congress, acting at the behest of various interest groups, found more and more reasons to make exceptions to the original principle of the income tax.
Tax rates were boosted to help finance World War I and again to finance World War II. After the wars, Congress was slow to lower the rates, choosing instead to give back money through ever more tax breaks. The steady erosion of the income tax base became a landslide in the late 1970s and early 1980s. High rates of inflation increased the tax burden on individuals and businesses in various subtle ways, and as a result, the clamor for special tax breaks reached a furious pitch. In 1981, the Reagan administration and Congress bowed to these pressures and enacted a tax bill that not only cut tax rates, but also included the biggest package of tax breaks for business in history. By 1984, even Trappist monks were petitioning Congress for special treatment, asking that they be allowed to use the lucrative investment credit. “We’d like to have it,” said Father John Baptist, bookkeeper of the Trappist Abbey in Lafayette, Oregon, “because everyone else has it.”
Many of these tax preferences were enacted with the best of intentions. They were supposed to provide “incentives,” promoting laudable social or economic goals, but the sheer volume of the breaks became a menace. As the list expanded, the code became like a giant Swiss cheese with too many holes. It was on the verge of collapse.
The astonishing dimensions of the problem were illustrated in a pamphlet published each year by the Joint Committee on Taxation. It listed federal “tax expenditures”—a term devised to show that tax breaks were really no different than direct government spending. In page after page of small type, the pamphlet showed the many ways in which the code deviated from the principle of taxing all income equally, the many ways in which the government “spent” its revenue through tax breaks.
The list included tax credits for people who paid for child care or made contributions to political candidates. There were deductions that allowed people to escape taxes on the portions of their income that went to pay medical bills, adoption expenses, or losses from theft. And there were various types of income that were simply excluded from taxation altogether, such as employer-paid fringe benefits, interest earned on life insurance, military disability payments, interest on municipal bonds, and ministers’ housing allowances.
For businesses, the tax breaks were more complex. Tax experts agreed that a firm’s legitimate business expenses should be subtracted from its revenues before arriving at the income subject to tax. But the definition of legitimate business expenses could be bent and twisted, and with the assistance of armies of tax lobbyists, Congress had found countless ways over the years to do just that. Oil and gas companies, for example, were able to write off certain costs of drilling successful wells in one year, even though the wells would produce oil or gas for many years—a ploy that saved the industry more than $14 billion a year in taxes. As an additional incentive, the law also allowed oil and gas firms to deduct a percentage of their gross income. Manufacturers, similarly, were able to save taxes by writing off investments in heavy equipment over five years, even though the equipment might last fifteen years or longer. Banks were allowed to deduct the money they put into “bad-debt reserves,” even though those reserves were far larger than the amounts of money the banks actually lost to bad debts.
Dozens of other methods, all perfectly legal, were used to keep from paying taxes on business income. There was no end to the diversity of tax-avoidance schemes that Congress, with the help of clever lobbyists and tax lawyers, could devise.
The accumulated effect of all these tax breaks was breathtaking. The Joint Committee on Taxation concluded that by 1987, tax expenditures would cost the government $450 billion a year in lost revenue—more than the total amount the government would collect that year in individual income taxes!
The tax system became dangerously unbalanced. Some activities were taxed at extremely high rates; others faced no tax at all. Economic decisions by people and businesses were distorted by these variations in tax, and the result was to create enormous inefficiencies in the economy. Money poured into those businesses and investments that were favored by the tax system, and avoided those that were not. The tax system became an impediment in the workings of the market.
At the same time, the uneven tax system created significant disparities among taxpayers. Those who were fortunate or clever enough to benefit from the many loopholes reaped large benefits; those who were not paid a stiff penalty. Roscoe Egger, the commissioner of the Internal Revenue Service during the first five years of the Reagan administration, summed it up this way:
People were rapidly becoming disenchanted with the whole system. We began to see the emergence of tax protesters. Groups refused to file, backyard churches began to claim income as charitable contributions, tax shelters reached entirely different proportions. One couldn’t fail to recognize that this was a reflection of deep-seated unhappiness with the entire tax system. By 1983 we even began to see people in the lower income levels, with incomes of only $18,000 or $20,000 a year, buying into phony tax shelters, private churches, master recordings, that sort of thing. They listened to this siren song and said, “Gee, everybody else is doing it. Why not me?”
Opinion polls showed that public dissatisfaction with the tax system was rising sharply and steadily. Horror stories about millionaires and large corporations that managed to pay no income taxes at all were commonplace. Many Americans began to perceive that the U.S. income tax was not very “progressive.” It seemed that the average man on the street paid a higher portion of his income in taxes than the typical millionaire paid, rather than the other way around.
Public perceptions of the income tax changed drastically. A 1972 poll by the Advisory Commission on Intergovernmental Relations showed that Americans generally viewed the federal income tax as fairer than state income taxes, state sales taxes, or local property taxes. But by 1985, the federal tax was judged in the same poll to be the least fair, by a long shot.
In part, this dissatisfaction with the tax system had its roots in the inflation of the 1970s: As wages and salaries rose to keep pace with prices, middle-income Americans found themselves pushed into higher an
d higher tax brackets, even though their new, inflated incomes bought no more at the grocery store than their old ones did. But mostly, the dissatisfaction reflected a recognition of the proliferation of tax breaks.
Gary Hecht, an assistant school principal in New York City, expressed the sentiments of millions of taxpayers in a December 1984 discussion group conducted by The Wall Street Journal. “My feeling with the federal tax goes back to the same old story: The rich get richer, the poor stay poor, and the middle class gets poor too,” he complained. “Because of the loopholes, this is going to constantly occur.”
On tax day, April 15, 1985, Deputy Treasury Secretary Richard Darman gave a speech that highlighted the extent of the problem. Darman was the administration’s top reform strategist, and he had a sharp mind that grasped both the politics and the substance of the issue.
The overwhelming majority of taxpayers eat lunch without being able to deduct their meals as business expenses. They buy baseball or hockey tickets without being able to enjoy the luxury of business-related skyboxes. They talk on fishing boats, but don’t take the tax deduction for ocean-cruise seminars. They strain to pay interest on their home mortgages and may take the tax deduction for their payments, but they can’t quite figure out how others can invest in real estate shelters and get more back in tax benefits than is put at risk. They read that of those with gross income of over $250,000 before “losses,” more than a fifth pay less than 10 percent in taxes; and of those with gross incomes over $1 million before “losses,” a quarter pay 10 percent or less in taxes.
The phenomenal rise in tax shelters was a central part of the problem. These investments were structured to bunch several different tax incentives—interest deductions, rapid depreciation write-offs, low capital-gains rates, credits for rehabilitating buildings, credits for research and development—in ways that enabled investors to get several dollars in tax savings for every dollar they invested. Although precise figures are difficult to come by, tax-shelter sales are believed to have jumped from less than $2 billion in 1976 to over $20 billion in 1983.
Real estate partnerships were the most popular shelters. Under these schemes, investors made relatively modest contributions to a building project, and the tax-shelter partnership borrowed the rest of the money it needed. By deducting the interest and taking rapid depreciation write-offs, the partnership was able to show huge paper losses, which the investors divided among themselves and wrote off on their income tax returns. Thus, for an investment of only $10,000, a person in the 50-percent bracket might buy “losses” of $20,000 or more, saving $10,000 or more in taxes; and when the building was finally sold, the income would be taxed at the low capital-gains rate. It was an unbeatable deal—and perfectly legal.
These new tax schemes drastically altered the economics of the real estate business, making it possible for developers to build new office buildings even if the demand for office space was not strong. So-called see-through office buildings—structures with few tenants—became commonplace in cities like Houston, where the real estate market was driven by the desire for tax-sheltered investments rather than by the need for office space.
Oil and gas partnerships also attracted investors seeking to hide from the tax collector, and there were other, more exotic, tax shelters as well: cattle-feeding shelters, equipment-leasing shelters, boxcar shelters, billboard shelters, videotape shelters, even llama-breeding shelters. In Girdletree, Maryland, Bill Lilliston set up the Chincoteague Bay penny-oyster shelter, a scheme that he promised would reduce taxes, prevent prostate problems, and improve potency all at the same time. In California, a group of dentists invested thousands of dollars in jojoba beans, hoping to take large deductions during the three years it takes to determine whether a plant is female and could therefore bear more beans. The jojoba scam prompted an angry complaint from California Representative Fortney “Pete” Stark: “We shouldn’t be giving tax breaks to anything that takes three years to figure out its sex.”
The ultimate effects of this tax-shelter mania were dramatically illustrated in a 1985 study prepared by the Treasury Department for House Ways and Means Democrat J. J. “Jake” Pickle of Texas. The study showed that in 1983 alone, about thirty thousand taxpayers with earnings exceeding $250,000—including three thousand millionaires—paid less than 5 percent of their income in taxes. Little wonder that people felt the progressive tax was a fraud.
Expense-account living also irked the average taxpayer. People saw that their neighbors with well-paid accountants could find dozens of creative ways to beat the system. These clever taxpayers would deduct their Mercedes, their expensive meals, their country club dues, even their vacations. Ski resorts in places such as Vail, Colorado, offered “investment seminars.” After a long day on the slopes, skiers could drop by the seminars, fix a cocktail, and watch a videotape telling them how to make tax-shelter investments; they could then deduct the trip as an investment expense. The average taxpayer was, in effect, subsidizing ski trips for investors who wanted to learn more about escaping taxes!
Confidence in the tax system was further undermined by the fact that U.S. corporations were paying an ever-smaller share of the nation’s tax burden. Over three decades, the corporate contribution to government revenues had plummeted from 25 percent in the 1950s to just over 6 percent in 1983; the 1981 tax bill brought the corporate tax near extinction. “It’s like Alice’s Cheshire Cat,” joked Van Doom Ooms, chief economist for the House Budget Committee. “Everything’s gone but the grin.”
The decline in corporate taxes was highlighted in 1982 when a controversy broke out over the so-called lease-a-tax-break law, a provision in the 1981 tax bill. The scheme had been hatched by the Treasury Department, working in conjunction with a group of business lobbyists, and was designed to ensure that the generous new business breaks in the 1981 bill would help those companies that most needed them—companies suffering losses and therefore not paying any taxes. The provision allowed profitless companies to sell their tax breaks to profitable companies in a transaction known as a “safe-harbor lease.”
Although it may have been sound in theory, the safe-harbor-leasing arrangement proved to be a political disaster in practice. The new law led to a frenzy of strange tax deals that outraged the public and their representatives in Congress: Global Marine reportedly sold tax benefits on oil rigs worth $135 million to Hilton Hotels. Ford Motor sold IBM the tax breaks on its entire $1 billion 1981 investment program, reportedly for a price of between $100 million and $200 million. Occidental Petroleum sold benefits on $94.8 million in investments, LTV sold breaks on $100 million in equipment, and Chicago & North Western sold tax benefits on $53 million worth of locomotives, freight cars, and other property. In each case, both the buyer and the seller benefited, and all at the taxpayers’ expense.
The furor in Congress over the tax-break sales was swift and sharp. The safe-harbor-leasing provision was repealed, but not until after the affair had burned itself well into the public psyche.
An even bigger flap over corporate taxes was sparked in early October 1984, when a little-known public-interest lawyer named Robert McIntyre dropped a bombshell. Sitting at his computer in a cluttered little office in Washington, the scruffy McIntyre spent endless hours combing through the annual reports of the largest corporations of America. He calculated each company’s domestic profit and how much federal income tax each actually paid. His result: 128 out of 250 large and profitable companies paid no federal income taxes in at least one year between 1981 and 1983. Seventeen of the companies paid no taxes in all three years.
The McIntyre list included the best-known names in corporate America: General Electric, Boeing, Dow Chemical, Lockheed, and others. In a particularly embarrassing revelation, the study showed that among the corporate freeloaders was W. R. Grace & Company, whose chairman, J. Peter Grace, had headed a commission for President Reagan that concluded that wasteful government spending was “sending the country down the tubes for future generations of Ameri
cans.”
“Americans are wondering why the federal government is incurring the largest deficits in history even while they are paying the highest taxes ever,” said McIntyre when his report was released. “This study documents one important answer: the demise of the corporate income tax.”
The study made instant news. In Los Angeles, the Herald Examiner overlooked the American League play-offs to make this its banner headline: 128 BIG FIRMS PAID NO FEDERAL INCOME TAXES. A story in Rolling Stone magazine shouted in big bold letters: EARN A BILLION! PAY NO TAXES! Conservative columnist James J. Kilpatrick complained of “corporate welfare” and “AFDC: aid for dependent corporations.” A labor leader at a rally in New Jersey held up a package of General Electric lightbulbs and said they had cost him more money than GE’s entire contribution to the cost of government. And on national television, Democratic Senator Robert Byrd of West Virginia told of a woman in Milwaukee, “the mother of three children, who in 1983 earned $12,000. On that income she paid more in taxes than Boeing, GE, DuPont, and Texaco, all put together.”
Other analysts had documented the decline in corporate taxes before, but never before had anyone named names. In the public mind, it became a powerful indictment of the income tax. “It’s a scandal when members of the Fortune 500 pay less in taxes than the people who wax their floors or type their letters,” McIntyre said.
Needless to say, McIntyre generated considerable irritation in corporate America. “His whole study is a pile of bunk,” groused John R. Mendenhall, vice president for taxes at Union Pacific, which showed a slim 3.5-percent effective tax rate in the study. And even Whirlpool, which had the highest effective tax rate on McIntyre’s list at 45.6 percent, was not particularly happy about the publicity. “It’s a double-edged sword,” explained Robert Kenney, the company’s tax counsel. “We owe it to our shareholders to take legitimate and legal means to keep down taxes.”