Showdown at Gucci Gulch

by Alan Murray

  For Pearlman and McLure, it was a rare and heady experience. Pearlman had just moved into the top tax-policy-making position that summer, after serving as deputy to Buck Chapoton. McLure, a conservative economist affiliated with the Hoover Institution at Stanford University, came to the department a year earlier thinking his principal task was to head the department’s effort to stop states from using an arcane taxing device known as the “unitary tax.” Now, with little direction from above, the two men were being allowed to design what they thought was a perfect tax system. Indeed, Regan specifically instructed them to ignore political concerns. Occasionally, Bruce Thompson or some other member of the group would mention that a particular proposal suggested by Pearlman and McLure was going to cause howls among some powerful interest groups, but Regan was always quick to cut off such discussions. “We’ll deal with the politics of it later,” he said. Pearlman called the effort “the most stimulating experience I’ve ever had. It’s the way government at some level should always work.”

  The theory behind the tax plan prepared by Pearlman and McLure was this: All income should be treated equally by the tax system, regardless of where it comes from, what form it takes, or what it is used for. It was a simple idea; but its ramifications were enormous. The existing tax code reflected seventy-one years of history. It represented an intricate web of social, economic, and political goals and aspirations, as complex and contradictory as America itself. The plan at Treasury would clear away that web and replace it with an academician’s tax system, elegant and clean.

  Pearlman and McLure guided Regan and the other members of the group through the tax code, explaining the radical changes they wished to make. They felt strongly and sincerely that their vision of tax reform was the only way to go, and they argued their case with conviction. They called for a “neutral” tax system, a system that does not influence private decisions. They chose their words carefully to appeal to Regan’s conservatism. McLure railed against “tax-code socialism,” arguing that the tax system should not be used as an “industrial policy.” With the help of the bespectacled Egger, the two tax aides regaled Regan with stories of proliferating tax shelters and companies that paid no taxes. The time had come for a break with the past, they said. The tax code should be returned to its original purpose, which was to raise revenue for the government, not to engineer the economy or promote social change.

  In the secluded conference room, those stories hit home with the Treasury chief. He listened carefully to the arguments and read the papers for each meeting from start to finish, even though they often descended into almost unintelligible technical jargon. He surprised his advisers by discovering inconsistencies in the dense arguments made to defend the proposals. But in the end, he swallowed those arguments, hook, line, and sinker. He adopted nearly every proposal his tax experts cast up, no matter how sharp a break with the past it was, no matter how certain to create a public or political furor.

  “We knew we were stepping on a lot of toes,” Regan recalled later. “We knew we were slaying a lot of dragons.”

  The dragon carcasses piled up at a frightening pace. Employee fringe benefits? Tax them, Regan said; never mind that they were the bread and butter of every labor union in America. Unemployment insurance and disability payments? Tax them too; they’re no different from other income. Deductions for state and local taxes? Eliminate them; they are merely a subsidy for services provided by state and local governments. Deductions for charitable contributions? Cut them back. Extra personal exemptions for the blind and the elderly? Change them; they provide the greatest benefits to those in the least financial need. Tax-free allowances for ministers’ housing? “We’ve already stuck it to the blind, elderly, and cripples,” joked one member of the group. “We might as well get the preachers too.”

  The harshest test of Regan’s resolve as a loophole-slaying Saint George emerged on the business side of the tax code. There, he encountered the huge business-investment incentives that President Reagan himself signed into law in 1981—the crown jewels of Charls Walker and the Carlton group, the result of a legislative effort that Regan himself spearheaded. Pearlman and McLure were determined that their plan repeal both the generous investment tax credit and the accelerated depreciation write-offs. They believed that those business giveaways were a major cause of the proliferation of tax shelters, and that they enabled many large companies to “zero out”—pay nothing or even get refunds—on their federal income tax forms.

  But the two tax experts also knew that these provisions lay very near the heart of the 1981 Reagan revolution and could not easily be eliminated. They knew that Regan, even before joining the administration, was a fierce advocate of such investment incentives. How could anyone expect him, or President Reagan, to embrace a tax plan that did an abrupt about-face on these once-cherished policies? “How could we,” thought Pearlman, “go in and say, ‘Let’s abrogate 1981?’ ”

  The investment credit, a brainchild of the Kennedy administration, was one of the biggest loopholes in the code. It provided a tax credit to businesses equal to 6 percent to 10 percent of the purchase price of new equipment. Ironically, many businesses had opposed the investment credit when it was enacted in 1962, but over the years they had learned to love this Democratic creation. It was repealed twice, but put back soon after each repeal. Now the Treasury was proposing to get rid of it for good, arguing that it distorted investment decisions. It gave huge tax advantages to businesses that invested heavily in equipment, Pearlman and McLure said, but did nothing for service and high-tech firms that did not.

  The two Treasury officials also wanted to make drastic changes in depredation write-offs. Tax experts agreed that businesses should be allowed to take deductions each year to account for the wear and tear of their buildings and equipment, but over the years, those deductions had become inordinately generous. Prior to 1954, the tax law required that depreciation write-offs be spread evenly over the “service life” of an asset. If a company bought a machine for $1,000 that was expected to last ten years, for instance, it could deduct $100 each year. Starting in 1954, however, Congress began to accelerate the deductions, shortening the write-off period and allowing larger amounts to be deducted in the first years after an asset is purchased. The 1981 bill included a sharp acceleration, providing a huge tax subsidy that far exceeded any reasonable calculation of wear and tear. Pearlman and McLure wanted to end this subsidy and return to depreciation write-offs based roughly on the expected life of an investment.

  Pearlman and McClure found a tough opponent in Manuel Johnson, the assistant secretary for economic affairs. Brought to the Treasury by supply-sider Paul Craig Roberts, Johnson was committed to using the tax code to spur business investment. “This isn’t an academic exercise,” Johnson complained. “The question is, how can we best achieve long-term economic growth?” In his view, that was no question at all. Tax incentives had helped boost the economy, he believed. To repeal them at a time when American industry was struggling to keep up with overseas competition seemed pure folly.

  Johnson proposed instead a powerful new system of investment incentives called “expensing,” which would allow the entire cost of an equipment purchase by a business to be written off in a single year. The scheme was even more generous to business than the existing accelerated-depreciation allowances were, and it was, Johnson argued, a logical extension of the policies launched in 1981.

  Both McLure and Johnson were soft-spoken Southerners; McLure so much so that the others sitting around the conference table had to strain to hear his words. Although a modest and even shy man, McLure, forty-four years old, had strong views about how the tax code should be shaped, and he shared every theorist’s desire to impose those views on the world. Johnson, a thirty-five-year-old former economics professor at George Mason University in Fairfax, Virginia, was well-liked at Treasury for his friendly demeanor. The Alabaman was also a former Army Ranger and a Green Beret, who had learned the importance of determination
as well as equanimity while training in the north Georgia mountains and the Florida cypress swamps. The purpose of that training, which was legendary for its rigor, was “to force people to their physical and mental limits,” Johnson said in 1984. “It made me very disciplined.” He was a formidable adversary.

  For months, McLure and Johnson carried on a quiet but fierce debate in the confines of the conference room. Both men were determined in their views. McLure thought his plan was the only one that made sense. Johnson’s expensing plan would tilt the tax code unfairly in favor of heavy industry and away from service and high-tech firms, he said. It would also aggravate the nation’s tax-shelter problems. Johnson was equally convinced that McLure’s plan could cause serious damage to the economy by discouraging equipment investment. He presented figures showing that the McLure proposal would tax investment even more heavily than the Democrats’ Bradley-Gephardt proposal. He insisted the result would be slower economic growth and fewer jobs.

  The two went back and forth, repeating the same arguments in seemingly endless repetition. The debate dragged on intermittently for five months. “It became like the old story of the procession of jokes in a prison,” recalls McLure, “where someone says, ‘Joke 91,’ and everyone laughs because they know the joke and the punchline.” At times the discussions slipped into technical economic language, causing others at the table to lose interest. At one point, Regan interrupted the duo in exasperation, and shouted: “Can’t you guys work something out? I’m going under for the third time!”

  The more the decision was delayed, the more it became clear that McLure would ultimately prevail, if only by default. Johnson’s expensing proposal was expensive; it would cost the government hundreds of billions of dollars in forgone tax revenues. If Regan adopted the Johnson plan, he would have to find a way to raise other revenue in order to pay for lower rates and ensure the tax plan met the president’s requirement of “revenue neutrality.”

  As the deadline for completing the plan approached, Regan realized he had to make a decision. The tax group was called together in the conference room to hear the debate one last time. The choice that faced them was an unpleasant one: If they accepted McLure’s proposal, they would be adopting a complete reversal of the administration’s position in 1981. It would be a retreat of tremendous proportions, and one that would outrage Charls Walker and his business-lobbyist friends. If they adopted Johnson’s proposal, on the other hand, they would be continuing the policies of 1981, but they would be abandoning a key component of tax reform.

  Still troubled by the split among his advisers, Regan called for a vote. As he went around the table, one after another tipped his support to McLure. Egger, who worried about the proliferation of tax shelters, felt McLure’s proposal would help slow the growth of such schemes. Thompson, who was a former aide to Senator William Roth of Delaware, one of the fathers of the Kemp-Roth tax cut of 1981, voted with McLure, because he favored getting tax rates as low as possible, and he knew that McLure’s depreciation scheme would raise far more revenue to pay for lower rates. Only Alfred Kingon, the last person to vote, gave his vote to Johnson. He worried that McLure’s depreciation scheme might harm the economy.

  With the druthers of his advisers clear, Regan made his own decision. He agreed to lead the Treasury in an abrupt about-face, a 180-degree reversal from four years earlier. He agreed to propose to the White House that they repudiate their own policies and throw out the investment tax breaks. It was a remarkable flip-flop. Outside the Treasury Department, none of the Washington lobbyists who worked on the 1981 bill would ever have guessed that Regan would be such a traitor to their cause. But inside the conference room, he and the others who had spent months listening to the arguments of Pearlman and McLure were convinced that the investment incentives had to go. Tax reform had found a fervent advocate in the unlikeliest of places.

  Kingon says the Treasury chief was sensitive to the arguments made by Egger: “Regan felt very strongly about tax-shelter abuses. He felt strongly about corporations that didn’t pay any taxes and a law that allows them to have huge cash flow, great revenues, and still escape taxation. You should have heard him. He was a solid citizen when it came to that. He despised, and I don’t think I’m overstating the case, he despised those who avoided paying their own fair share of taxes.”

  Regan himself makes a similar argument: “Some companies were paying no taxes at all as a result” of the incentives, he said. “We’d swung too far one way rather than the other and we had to bring the pendulum back.”

  In part, the decision to abandon investment incentives reflected the fact that Regan, sealed in the conference room away from the outside world, had become a captive of his bureaucracy. Pearlman and McLure kept tight control of the tax-writing process, and kept Johnson constantly on the defensive. Had the circumstances been different, had other administration officials and outside interests been given the opportunity to whisper in Regan’s ear, the outcome might have been very different.

  But the radical proposal also reflected Regan’s taste for the dramatic. He didn’t want his plan to elicit a yawn from Washington politicians and pundits; he wanted it to shock them as something bold.

  “He knew we were swinging for the fences,” recalls McLure, “and if we got there, he knew that he’d be the one to go into the baseball hall of fame.”

  In his State of the Union address at the beginning of the year, the president had asked for a tax plan that was simple, fair, and good for the economy. He had insisted that it not be a tax increase in disguise, that it raise the same amount of tax revenue as current law. Beyond that, however, the Treasury Department was free to design a tax system as it saw fit.

  Early on, Regan and his aides toyed with the idea of scrapping the income-tax system and switching to a tax plan based on consumption. It was an option suggested in a pamphlet issued by outgoing Treasury Secretary William Simon in 1977, called Blueprints for Basic Tax Reform, and it appealed to many academic economists who argued that an income tax by its very nature is biased against savings and investment.

  Under an income tax, if you use your earnings to buy a pleasure boat, proponents of the consumption-based tax said, you are taxed only once, and then you may enjoy the benefits of that boat tax-free as long as it lasts. If instead you use the same income to invest in a savings bond, however, you are taxed twice: once on the income used to purchase the bond and again on the income earned by the bond. The result is a tax system that encourages people to spend more and save less, resulting in less investment and slower economic growth. The so-called consumed-income tax, on the other hand, would only tax income that is used for consumption, not income that is saved or invested.

  The consumed-income tax was also popular among Charls Walker and his fellow lobbyists, who saw it as a way to free business investment from all taxation. But the mechanics of taxing consumption were hopelessly complex, and Treasury officials knew such a tax would probably be perceived as unfair by the American people. All savings would be tax-free, allowing the wealthy to bring in vast amounts of income without paying any tax. Borrowings, on the other hand, would be taxed if they were used to pay for consumption, causing heavy borrowers to face tax bills completely out of proportion to their incomes. During one meeting at which the consumption approach was discussed, Regan turned to Pearlman and said: “I’ll tell you what. The next time you go to a cocktail party, you ask people what they think of a tax system in which borrowings are treated like income. They’re going to tell you you’re crazy.” Talk of a consumed-income tax soon died out.

  The group also discussed the virtues of using a value-added tax (VAT), which is a sort of sales tax imposed at the national level, to supplement the income tax. The VAT had been turned to by many European countries and had the same sort of appeal to business as a consumed-income tax. McLure was an expert on the economics and structure of VATs, but Egger made it clear to the group that a VAT would be hugely expensive to administer. Such an extensive new tax
system would only be worth doing if it were big—raising $100 billion a year or more. Because the tax bill was not supposed to raise revenue, a large VAT seemed out of the question, and the idea was dropped. The secretary allowed his tax experts to prepare a book on the pros and cons of a VAT, which they thought might be useful in future budget debates, but he rejected the idea of making a VAT part of tax overhaul.

  With the consumed-income tax and the VAT ruled out, a total revamping of the income tax seemed the only possible route for the Treasury’s tax plan to take. “It wasn’t by design,” Pearlman says. “It just sort of happened.”

  The initial spadework on the tax plan got a big boost in early April, when Eugene Steuerte, a tax economist, returned from a year’s leave at the prestigious Brookings Institution, a Washington think tank. The Treasury veteran had been schooled in Harvard Professor Stanley Surrey’s theories of how to construct an ideal income tax. “When I came back to Treasury, there was nothing given to me in the way of directions,” Steuerle recalls. “There were no instructions coming down from the top, and that paralyzed people.”

  Without direction from above, the Treasury discussions became a sort of bottom-up process. Steuerle and his colleagues would prepare proposals for McLure and Pearlman, which in turn were taken to Regan and the tax group. The Treasury tax bureaucracy felt ignored during the first years of the Reagan administration. It was forced to support a 1981 tax bill that was a vestige of the election campaign, and it had watched Senator Dole, the Finance Committee chairman, usurp all control of the tax-writing process in 1982. Now, suddenly, in 1984, the tax experts in the bowels of Treasury found themselves in a position of power.