Showdown at Gucci Gulch

by Alan Murray

  The bookish Steuerle organized the issues to be addressed: It was important, he thought, to be comprehensive; the Carter reforms had failed because they were piecemeal. It was important also to have details, prepared by Treasury lawyers, on how to implement the changes. The Blueprints for Basic Tax Reform proposal of the Ford administration had gone nowhere in part because no one knew how to put its changes into place.

  “It was a strange experience,” says Steuerle. “As I was working on it, I began to realize it was a serious effort. I don’t know what Secretary Regan expected initially. But what is clear is that as the secretary got more and more into the process, he got more and more committed to it.”

  A cornerstone of the Treasury’s ambitious plan was to adjust, or “index,” various portions of the tax code to take account of inflation. The rapid inflation of the 1970s had distorted the tax system tremendously. The average taxpayer had felt the consequences through “bracket creep,” which pushed taxpayers into higher tax brackets even though their incomes, adjusted for inflation, were unchanged. Inflation wrought other, more subtle, damage to the tax system as well. If a man paid $30,000 for a house in 1970 and then sold it for $50,000 a decade later, he had to pay taxes on a “gain” of $20,000, even though $50,000 in 1980 was actually worth less than the $30,000 in 1970 after adjustment for inflation. Similarly, if a woman placed her money in a savings account earning 5 percent a year, she had to pay taxes on the annual interest even though in the late 1970s, when inflation raged at over 10 percent a year, the value of her money was actually deteriorating; she was losing money, not making it.

  The 1981 tax bill had required that tax brackets be “indexed” to take account of inflation, starting in 1985. But Treasury tax experts wanted to go far beyond that. They wanted to adjust everything for inflation: capital gains, depreciation, even interest payments and interest deductions. Under their plan, a lender would be taxed on interest income only to the extent that the interest rate exceeded the inflation rate. Likewise, a borrower would be able to deduct interest payments only to the extent the interest rate exceeded the inflation rate. Such comprehensive indexing was a bold and ambitious effort, and also a complex and confusing one. It was an essential element in the ideal tax system, but one unlikely to win support among practical politicians.

  Nevertheless, Regan went along with it. He was particularly intrigued by the idea of “indexing” capital gains. In fact, it was because of inflation indexing that the Treasury chief was willing to adopt one of the most controversial proposals that his tax aides suggested: the complete elimination of the special tax break for capital-gains income.

  As the former head of a brokerage house, Regan had always been a fan of the special low tax rate on capital-gains income earned from the sale of assets. The capital-gains tax break had been a feature of the tax code since 1921; since 1978, efforts to push the gains tax even lower had found tremendous support in Congress and in the country at large. The top tax rate on capital gains dropped from 35 percent or more to 28 percent in 1978, and again to 20 percent in 1981, far below the top 50-percent rate on ordinary income.

  But the capital-gains tax break added significantly to the complexity of the tax code, and it encouraged game-playing by taxpayers eager to convert ordinary income into capital gains income. Cattle-breeding tax shelters, for instance, allowed taxpayers to invest in cows one year, then get back income two years later that would be taxed at the low capital-gains rate.

  McLure and Pearlman argued that the capital-gains break should be eliminated. Income from the sale of assets, they said, should be treated just like any other income. Egger provided powerful support for that view, saying that a third of the tax code was devoted to problems caused by allowing the preferential rate for capital gains.

  Regan at first resisted, but he became a convert after discovering the powerful effects of indexing capital gains for inflation. The Treasury secretary worked out examples showing that the tax owed on a blue-chip stock purchased in the 1970s and sold in 1984 would actually be lower under his staff’s proposal than under existing law. That was because most of the gain in that period was due to inflation, and under the proposed plan, that part of the gain would not be taxed at all. Armed with such examples, he decided to reverse his oft-repeated endorsement of cutting capital-gains taxes, instead supporting his tax aides’ radical proposal to eliminate the special gains rate altogether.

  The inflation of the 1970s had created extra problems for the poor, and the Treasury policymakers were well aware of the fact. Throughout the 1960s and 1970s, Congress tried to assure that no family with an income below the federally designated poverty level would pay income taxes. But rampant inflation in the late 1970s pushed the poor back onto the income-tax rolls, and the Reagan tax bill in 1981 only exacerbated that situation. The huge Reagan tax cuts for the middle class and the wealthy masked enormous tax increases for those at the bottom of the scale. By 1982, almost half of the individuals and families living in poverty were burdened with federal taxes. In 1984, a family of four had to begin paying income taxes at $8,700 in income, even though the poverty level was more than $10,600.

  The condition became an embarrassment for the Reagan administration. Conservatives could argue with straight faces that welfare programs for the poor needed to be cut back to eliminate waste, but they could scarcely defend imposing big tax increases on the poor. Ways and Means Democrat Charles Rangel from New York held hearings that took the Reagan administration to task for its insensitivity, and the lambasting had an impact. By the summer of 1984, even the president realized something had to be done. “Because of the tax laws we inherited,” he said at the Republican convention, trying to blame the Carter administration for the failings of his own policies, “the number of households at or below the poverty level paying federal income tax more than doubled between 1980 and 1982.”

  To correct this, the tax experts proposed large increases in the so-called standard deduction used by those taxpayers who do not itemize their deductions. They also proposed to expand the earned-income credit, which gave some working poor a tax refund, and to increase the personal exemption for each family member. The personal-exemption increase was being pushed by several “pro-family” organizations, and White House aide Bruce Chapman even visited Treasury to promote the cause. The failure of the personal exemption to keep up with inflation, Chapman contended, led to homicides, suicides, and virtually every other imaginable social ill. “We subsidize family failure and punish people trying to hold their families together,” he argued. Increasing the personal exemption, he said, would “take some of the sting out of having families.” Although such pro-family arguments later assumed a big role in the tax-reform campaign, they were never discussed in meetings of the Treasury’s tax group. The personal exemption was increased to $2,000 from $1,080 largely to help ensure that poor families came off the tax rolls.

  Another key element of the Treasury’s ideal plan was an effort to reduce the “double taxation” of corporate income. Tax experts had long acknowledged that some corporate income was subject to tax twice: once when earned by the corporation and again when distributed to shareholders. That problem could not be solved (as President Reagan had suggested less than two years earlier) by simply eliminating the corporate tax—corporations would then become giant tax shelters in which the wealthy could hide their income—but double taxation might be alleviated by allowing companies that pay dividends to take a deduction for the payouts. The Treasury tax experts decided to propose a tax deduction to corporations for 50 percent of the dividends they paid out.

  Like interest indexing, the dividend deduction had tremendous attractiveness to academics and little appeal elsewhere. Ironically, the managers of corporations that stood to benefit from such a proposal had the least interest in it; they feared it would force them to pay out more of their profits each year in dividends. Nevertheless, Regan, still swinging for the fences, put his stamp of approval on the controversial notion.


  Tax-free employee fringe benefits—health care, life insurance, child care, and education aid—were also important targets of Regan’s plan. Over the years, the list of benefits that employees could receive from their employers without paying tax had grown steadily. The cost to the Treasury in lost revenue from such tax-free fringes totaled $80 billion a year or more. Reformers viewed the alarming growth as unfair. Some employees received as much as a third of their income in tax-free benefits, while others received no such benefits and had to pay tax on the money they used to buy health insurance or life insurance.

  The tax-free treatment of fringe benefits began as far back as 1921, when the income from pension trusts was exempted from taxes. Health-care costs were first excluded from taxation in 1939. But the real explosion in fringe benefits occurred after World War II, with such benefits jumping from 15 percent of average personnel costs in 1951 to 32.5 percent in 1981. The 1970s brought the addition of such new fringes as employee stock-ownership programs, employer-paid legal assistance, van pooling, educational assistance, and child care.

  The Treasury plan proposed wiping out all of those. Companies could still provide such benefits to their employees, but under the proposal, the benefits would be taxed as income. A partial exception would be allowed for health insurance, which the Treasury Department said would be taxed to the extent the cost of a health plan exceeded $175 per month for a family.

  Business-expense deductions, long a target of reformers, also were hit hard by the Treasury Department. Presidents Kennedy and Carter had both failed in attempts to curb these deductions. In Kennedy’s day, the proposal to cut back expense write-offs caused such an uproar among hotel and restaurant workers that a waiter at Duke Zeibert’s restaurant in Washington dumped a plate filled with a hamburger, french fries, and green peas onto the lap of IRS Commissioner Mortimer Caplin. By 1984, the deductions had become the stuff of satire. Humorist Art Buchwald, a frequent patron at Washington’s posh expense-account restaurants, told the story of one man who leaned over to another in a restaurant and asked, “Do you want to buy this restaurant?” When the startled diner said “No,” the man asked: “Well then, may I have your name so I can say we discussed business?”

  The Treasury plan proposed to wipe out entertainment-expense deductions entirely for such things as basketball and theater tickets. For meals, it limited the deduction to $10 per person for breakfast, $15 for lunch and $25 for dinner. (When congressional staffers were later briefed on the proposal, several shouted out, “What about brunch?”)

  As for the numerous provisions in the tax code benefiting specific industries, the Treasury plan slated most for termination, including the rehabilitation credits used by real estate developers, energy credits, bad-debt-reserve deductions, oil-and-gas benefits, timber benefits, and others. In a move that would later spark one of the most vicious lobbying efforts of the entire tax-reform debate, the Treasury even proposed taxing the interest or “inside buildup” earned on life insurance policies. After all, Treasury officials reasoned, the insurance income is really no different than that earned on savings accounts.

  There seemed to be no limits to the Treasury’s desire to eliminate tax breaks. McLure even gave serious thought to going after the most popular tax break in the code—the deduction for home-mortgage-interest payments.

  Home ownership was the American dream, and the interest deduction was the government’s way of encouraging that dream. Millions of Americans owned their own homes, and the rest worked for the day when they could do the same. Any attempt to trim back the home-mortgage deduction would surely bring a cry of outrage from across the country. But in McLure’s view, the home-mortgage deduction channeled into housing billions of dollars that might be better used elsewhere. It was, in effect, a massive tax shelter for middle-class America, and he wanted to eliminate it.

  “I was pondering what we might do, knowing the political problems and the sanctity of this provision,” recalls McLure. “Left to my own devices, I might have proposed that we try to phase the deduction out.”

  While McLure was mulling over this idea, however, President Reagan pulled the rug out from under him. On May 10 Reagan made a speech before more than four thousand members of the National Association of Realtors in Washington. He had been hounded for several days by real estate lobbyists who feared that his tax-reform effort might attack the mortgage-interest deduction. With the election approaching, the president and his advisers decided to ease the realtors’ minds. “In case there’s still any doubt,” he said, “I want you to know we will preserve the part of the American dream which the home-mortgage-interest deduction symbolizes.” The statement attracted little interest outside the Treasury, since few people had even imagined that the administration would tamper with such a popular deduction. Inside the Treasury, where the home-mortgage deduction was on the chopping block, the president’s speech caused a storm. Political reality had suddenly intruded into the dreamworld of Treasury experts. The policymakers not only had to put the home-mortgage deduction off limits, they also had to fear the possibility that other interest groups might use the pressure of the election campaign to get the president to declare their tax breaks off limits.

  The pressure built up at Treasury again during the summer, due to continuing misapprehension that Walter Mondale was on the verge of releasing details of a tax-reform plan of his own. White House aides asked Regan if he could have a plan ready quickly under such circumstances, and Regan replied yes, without asking his own people first. In fact, Treasury officials did not know how they could possibly complete even the rough outlines of a plan prior to November. More important, they feared that if their proposal became part of the election campaign, it would be doomed.

  “It was scaring us to death,” says Pearlman. “I believe that would have been the end of tax reform. That would have put all the issues out in the political arena and they would have just gotten knocked down, one after the other.”

  In midsummer, Senator Bradley called Treasury to ask if the department had run revenue estimates on his plan. The call was immediately interpreted as a sign that Mondale was going to embrace the Bradley plan. The tax experts waited in suspense, fearing each day they would read about the candidate’s announcement in the morning newspaper. In fact, Bradley was calling for other reasons. He was worried that his own campaign opponent might use Treasury estimates of either his bill or Kemp-Kasten as an issue. Fears that Mondale would endorse any sort of tax overhaul effort were entirely misplaced.

  The coarse light of politics did shine on the tax group’s discussions on a few other occasions. When Pearlman sheepishly brought in a proposal to require people who inherit property to pay a capital-gains tax on their inheritance, for example, the idea was quickly thrown back in his face. Congress had fought long and hard over that issue in the 1970s and the reformers had lost; Regan did not want to fight that battle again. Existing law enabled people to pass on stock and property to their heirs without paying any tax, thus allowing huge accumulations of untaxed wealth. Efforts to change that law invariably brought a raft of complaints from family farmers, small businessmen, and a host of others who hoped to pass on their estates to their families. “I was on the Hill when they tried that before, and I remember the uproar,” said Thompson, who vigorously opposed Pearlman’s proposal. “There’s a difference between being a tax-cutting populist and being a Jimmy Carter liberal. This is what real liberal tax reformers want to do.” Sobered by the strong reaction, Pearlman quickly withdrew the proposal.

  Individual Retirement Accounts (IRAs) were another break that escaped the Treasury’s scorched-earth plan, in part because officials feared the popular tax-free savings accounts were politically untouchable. Indeed, the Treasury’s proposal actually expanded the annual contribution to IRAs to $2,500 per worker, up from $2,000 under current law; and to $2,500 for a nonworking spouse, up from $250. The Treasury group would never have guessed that while most of their sweeping proposals would be ignored, IRAs would
end up being sacrificed in the bill that finally became law two years later.

  It was October 31—Halloween—when the tax-reform group met in the conference room to get its first look at possible tax rates for the plan. The group had worked throughout the year, making tough decisions to eliminate loopholes, but they had not calculated how far their plan would allow tax rates to fall. This was to be the day of the payoff. The men arrived in good spirits, expecting the plan would allow the top rate to fall as low as 25 percent—half the 50-percent rate under existing law.

  But Pearlman brought bad news. The department’s number-crunchers had fed all the details of the plan into a computer and had asked the computer to design a three-rate structure that met two main requirements: the plan must be revenue neutral—raising neither more nor less money than the existing tax system—and distributionally neutral—causing no major changes in the distribution of the tax burden among income classes. The computer’s response: for corporations, a rate of 28 percent; for individuals, three rates of 16 percent, 28 percent, and 37 percent.

  The numbers shocked the group. They had courageously attacked even the most politically sensitive tax breaks and still the top rate was no lower than 37 percent. It hardly seemed worth the effort. “We’ve gone through all this, and this is the best we can get?” said Kingon. Johnson said that with those kinds of rates, the plan should be called “ZAP.”

  Pearlman and McLure were bothered by the rates as well, although for another reason. A top individual rate of 37 percent combined with a top corporate rate of 28 percent would create problems, they believed. Individuals would form corporations to shelter their income and escape the higher personal tax rate. The opportunities would be immense for the very kind of game-playing that they were trying to end. The top personal rate and the top corporate rate needed to be closer together.