Showdown at Gucci Gulch

by Alan Murray

  Pearlman, still ensconced in the theoretical tower of Treasury I, started the meeting by asking the triple amputee in Socratic fashion, “Why should veterans disability payments be treated differently than any other income?” The meeting went downhill from there. It was a natural question for Pearlman, who knew that some disabled veterans with jobs that paid over $100,000 a year were still getting tax-free benefits from Uncle Sam, but to the veterans in his office, Pearlman’s comment was heresy. They were accustomed to being catered to in the nation’s capital, and they had never heard anything like this. Recognizing his error, a red-faced Pearlman desperately tried to dig his way out of the hole, but to no avail. The veterans left his office and went on the warpath, calling all their allies in the White House and on Capitol Hill. They even convinced Senator Alan Cranston of California to introduce a resolution urging that the Treasury not tax their disability benefits.

  The disabled veterans demanded a second meeting at the Treasury, this time with Baker. They showed the secretary a full-page advertisement that they were planning to run in The New York Times, The Washington Post, and U.S.A. Today. It had a huge picture of Commander Colley in a wheelchair, his missing appendages painfully evident. At the top of the page, in large bold letters, the copy read: WHAT’S SO SPECIAL ABOUT DISABLED VETERANS? In smaller type below, it continued: “That’s what a top Treasury official said to Chad Colley …”

  As soon as the veterans departed, Baker called Pearlman down to his office. He showed him the advertisement and said bluntly, “I think we’ll have to drop this one.”

  Many other provisions of Treasury I were similarly cast off during the first few months of 1985, as Baker listened to various complainants. The new secretary’s job during this period was to decide which tax breaks he could afford to preserve without seriously undermining tax reform and which breaks he could repeal without bringing on the opposition of overwhelmingly powerful interest groups. He kept an arduous schedule. The leaders of corporate America streamed through his door. In February alone, he met with the chairman of Texaco, who was concerned about oil-and-gas tax breaks; the chairman of the Ford Motor Company, who worried about the end of investment incentives; the president of the National Federation of Independent Business, who was disturbed by the elimination of lower tax rates for small businesses; an official from the Securities Industry Association, opposed to the elimination of the preferential treatment of capital gains, and the president of the Chamber of Commerce, who complained about plans to eliminate a host of tax benefits. In March, the pleaders included representatives of nonprofit organizations worried about losing deductions for charitable contributions, and the chairmen of E. I. du Pont de Nemours, the National Association of Manufacturers, the American Iron and Steel Institute, the Mid-Continent Oil and Gas Association, and the National Association of Home Builders. There seemed to be no end to the rich and powerful people who wanted to see the secretary, and virtually all of them demanded that their favored tax breaks be retained.

  But not everyone complained. On March 28, Baker, Darman, Tutwiler, and Pearlman met with a group of seven corporate executives who supported tax reform. They included John Richman of Dart & Kraft, James Ferguson of General Foods, Roger Smith of General Motors, Allen Jacobson of 3M, William Howell of J. C. Penney, John Smale of Procter & Gamble, and Alton Whitehouse of Standard Oil of Ohio. The meeting made clear that there was a split in the business community on tax reform. Many companies, particularly those that paid high tax rates and made only modest use of investment incentives, favored eliminating tax preferences in return for lower rates. A small group of others—like Roger Smith of GM—thought tax reform would be good for their customers and encourage sales.

  The fabled unity of the business community that had triumphed during the 1981 tax bill was now gone. If Baker and Darman could fashion a tax-reform plan that pried that crack in the business community a bit wider, they might at least weaken the business opposition to their bill. A strategy of divide-and-conquer could allow tax reform to succeed.

  One group that the Treasury team worked hard to woo was high-tech firms, especially the small entrepreneurial start-up companies that had become the symbols of hope and promise for a changing American economy. Computer companies, software firms, biotechnology firms—these were the cutting edge of the nation’s industry, developing new technologies that many hoped would reinvigorate the economy. Secretary Regan’s tax team had thought these high-tech types would be natural supporters of their proposal. Unlike smokestack industries, they did not invest heavily in equipment and gained little benefit from investment tax breaks; their efforts instead relied on knowledge and research. For such companies, the trade off of lower tax rates for fewer tax preferences was an attractive one.

  The Treasury I team had forgotten, however, that the lifeblood for many small companies is venture capital and that the low tax rate for capital gains encouraged venture investment. By eliminating the low gains rate, venture-capital experts complained, the Treasury tax plan would “dry up” the money available for start-up operations.

  Baker and Darman were sympathetic to these high-tech arguments. Darman, in particular, felt American businessmen were too cautious and would avoid risk unless given an incentive. For weeks, he struggled with ways to develop a special capital-gains “carve-out” that would only benefit investors in risky entrepreneurial enterprises, but in the end, he failed. He found it impossible to draw a meaningful line between entrepreneurial investments and other investments. Convinced that political pressures for a low capital-gains rate would be too great to withstand, he and Baker agreed to retain the gains preference—another big loss for Treasury’s tax reformers.

  The new Treasury team also realized that Regan’s proposal to tax most fringe benefits would have to be severely modified. Packwood made it clear from the start that his top goal was to save the tax-free status of employee fringes, especially health insurance. He told Baker point-blank that he would “kill the bill if I have to,” unless employee benefits were protected. He threatened to extend Senate hearings indefinitely or form coalitions with oil-state lawmakers to block the proposal. He even threatened to take his position public and go “toe-to-toe” with President Reagan to preserve the tax-free status of benefits.

  Tax-free fringes were dear to one of the Democratic party’s chief backers, organized labor, which liked to bargain for hefty benefits for its members. Ironically the unions found their fiercest defender in Republican Packwood, not Democrat Rostenkowski. Rostenkowski urged the Treasury to “hang tough” with the Treasury I fringe-benefit proposal. The Ways and Means chairman knew that if the House passed a bill that taxed fringes, he would have a powerful bargaining chip when he faced Packwood in the House-Senate conference committee, where the measures passed by each chamber would be reconciled into a final bill. Packwood would accept almost anything Rostenkowski served up in order to preserve the benefits, Rostenkowski thought. The Ways and Means chairman even told AFL-CIO president Lane Kirkland, during a testy meeting, that he would not protect labor’s fringe benefits and that the AFL-CIO would have to send its lobbyists to the Hill to defend them.

  Baker, Darman, and Pearlman met with Packwood on several occasions in his office to discuss the fringe-benefit problem. The Treasury officials argued that they could not afford to give up the taxation of all fringes. Treasury I raised almost $50 billion over five years by taxing the benefits, and the Treasury needed some of that money to help pay the cost of lower tax rates. After several discussions, Packwood offered a compromise: Health insurance was the biggest fringe, and Packwood suggested taxing just the first few dollars’ worth of employer-provided health insurance, instead of taxing the amount of insurance that exceeded a set cap, as Treasury I proposed. Treasury reformers preferred the cap approach because it would end the incentive for excessively large health plans, which some economists claimed contributed to the skyrocketing cost of health care. Packwood, however, opposed the cap because its burden fell hardest o
n union members with hefty benefits. His proposal, which would tax the first twenty-five dollars a month in health benefits received by every worker, would do nothing to reduce the incentive for excessive health benefits, but it would raise money and be relatively less painful to labor groups. Packwood tried to distance himself from the idea by saying that it was given to him informally by Lane Kirkland.

  Treasury officials immediately recognized the Packwood plan as bad tax policy, because it hit those workers with only modest health benefits just as hard as those with excessively large ones. “The proposal was absolutely crazy,” says Pearlman. “It was 180 degrees from where we should be.” But Baker and Darman believed they had no choice; they could not afford to alienate the Finance chairman.

  In April, Pearlman and Darman paid a visit to Packwood’s office to seal the deal. Packwood indicated to the Treasury officials that he had talked with union representatives and that they supported his compromise proposal. Darman said the Treasury was willing to accept it. Then Pearlman spoke up. Knowing that the Oregon senator cared deeply about timber tax benefits as well as fringes, Pearlman said, “Mr. Chairman, are you okay on timber capital gains?” Darman put his hand on Pearlman’s arm hoping to quiet him, but Packwood broke in, “That’s okay, I can answer that.” As long as there is “equal treatment” for all industries, he said, he would be willing to see the special capital-gains benefit for timber producers eliminated.

  Darman and Pearlman left the meeting with a sense of relief. The fringe-benefit proposal made little sense, to be sure, but at least, they thought, Packwood and the unions were on board.

  That relief, however, was premature. In the end, the unions were not satisfied with the Packwood compromise. They were determined to preserve the tax-free status of all fringe benefits, and they turned their backs on the Treasury plan. Kirkland’s AFL-CIO, in particular, never backed the proposal. Rostenkowski later heaped criticism on the Treasury team for the deal: They had given away half the store to Packwood, but they had gotten nothing in return. The Treasury officials did get one thing they needed, however: the promise of Packwood not to torpedo reform.

  As political deals were struck at Treasury, Rostenkowski urged Baker and Darman not to give away too much. He told the two administration officials that any tax breaks they gave away probably would not be taken back, that their plan would be the “high-water mark” of reform. Privately, Rostenkowski also feared the Treasury would make so many concessions that his committee would be unable to make concessions of its own to favorite interests.

  The chairman also warned the Treasury secretary that there was one issue that would be his “litmus test” of real reform. If Baker failed to handle it correctly, he argued, it would be clear that the administration was not sincerely interested in reforming the tax code. That issue was oil and gas.

  Oil and gas drillers had received favored tax treatment for almost as long as the income tax had existed. The generous percentage depletion allowance—a huge tax break allowing companies to deduct a percentage of their income as an incentive for pulling oil out of the ground—was enacted in 1926. The immediate write-off for certain “intangible” drilling costs came into the tax code through a series of administrative rulings by the Treasury and won full congressional approval in the Revenue Act of 1954. Treasury Secretary Henry Morgenthau railed against percentage depletion in 1937, calling it the tax code’s “most glaring loophole.” In 1950 and 1951 President Harry Truman took on the oil-and-gas tax breaks, arguing that a “forward-looking resources program does not require that we give hundreds of millions of dollars annually in tax exemptions to a favored few at the expense of the many.” But proposals to repeal the oil and gas tax breaks were repeatedly trounced in Congress.

  The oil industry owed its tax successes to a long string of oil-state legislators who managed to accumulate remarkable power in Congress. In the 1950s and early 1960s, Senator Robert Kerr of Oklahoma, the “uncrowned king of the Senate,” was a powerful protector of the industry and managed to easily rebuff any attempts to eliminate or reduce the depletion tax break. Representative Sam Rayburn of Texas, speaker of the House in the 1940s and 1950s, wouldn’t even consider allowing a member of the House to have a cherished seat on the Ways and Means committee unless he was committed to the depletion tax break. Senator Russell Long of Louisiana, chairman of the Finance Committee throughout the 1970s, was equally committed to preserving the oil industry’s favorite tax advantages. With such powerful friends, oil couldn’t lose.

  Ignoring this long history, Treasury Secretary Regan had proposed taking on the oil industry once again. But this time congressional protectors of the oil and gas industry had little reason to worry. New Treasury Secretary Baker was not about to forget his Texas friends. Pearlman argued strongly that tax reform would seem an empty shell if it did not tackle oil and gas. Darman argued that Baker would weaken his position in future negotiations if he caved on oil-and-gas issues and pointed out that any oil-and-gas preferences slated for repeal by the Treasury plan would probably be restored anyway by the Finance Committee, which was packed with oil-state senators. But there was no use trying to pry Baker away from his favorite tax preferences. Protecting the oil industry clearly meant more to him than promoting reform. He agreed to a slight trimming of oil tax breaks, but no more. Instead of allowing drillers to deduct all their drilling costs in a single year, he proposed allowing them to deduct 60 percent of those costs in the first year and the rest the second year. It was a very mild swipe, designed only to enable Baker to say publicly that no special interest was spared the tax-reform knife.

  To be sure, not every special interest got such generous treatment at the Baker Treasury. For example, Baker and Darman kept a modified version of Secretary Regan’s plan to tax annual increases in the cash value of life insurance policies, known as inside buildup. Regan had proposed taxing all policies; the new plan only applied to new policies. Still, it created an uproar among the more than a million employees and agents of the nation’s enormous life insurance industry.

  Treasury tax experts argued that the cash buildup on insurance policies was no different than interest paid on savings accounts and should therefore be taxed as interest. Treasury I proposed the change, prompting the insurance industry to launch a massive lobbying campaign against the plan soon after it was unveiled. The industry hired a consulting firm to engineer a postcard assault on Congress. Full-page advertisements in Time, Newsweek, People, U.S. News & World Report, and Sports Illustrated carried sets of three postcards intended for mailing to each reader’s senators and representatives. Insurance agents were given similar postcard sets, which they passed out to their clients. A videotape, entitled David and Goliath, Round Two, was used to whip up opposition to the tax plan among the life insurance industry’s many minions, and offered step-by-step instructions on how to personally lobby members of Congress. Even in faraway places like Fairmont, Minnesota (population 13,000), the insurance industry managed to run advertisements in the local papers, the Fairmont Sentinel and the Blue Earth (Minn.) Town Crier. As a result, Congress was deluged by postcards from voters, with members receiving more than a million pieces of mail on the arcane subject during the first half of 1985.

  The insurance industry’s political action committees (PACs) also arranged massive campaign contributions to House and Senate tax writers. Early in the year, Ways and Means member Henson Moore, Republican of Louisiana, was able to attract thirty insurance lobbyists to a $1,000 a plate fundraising dinner. Alignpac, the insurance agents’ fundraising group, exceeded PAC spending limits by bundling up contributions from individual members and sending them to key tax writers.

  Recognizing the mounting strength of the opposition to the proposal, Baker and Darman decided that they should negotiate with the insurance executives. They planned to give in, and in return, they hoped to win the insurance industry’s support for reform. But while Baker and Darman were still negotiating with industry officials, the American Council of L
ife Insurance, headed by former Republican Senator and Health and Human Services Secretary Richard Schweiker, launched a series of television ads criticizing the tax plan. The fierce ads included staged man-on-the-street interviews, in which the interviewees complained bitterly not only about the inside-buildup proposal, but about reform itself. The ads ran on prime-time television in sixty-two major cities across the nation.

  It was a big and expensive mistake by the insurance industry. Rather than drop the insurance tax proposal, as they had planned, Baker and Darman did an about-face. Angered by the TV ads, they decided to propose to tax the inside-buildup of new policies, which threatened to cripple the industry’s sales of cash-value life insurance. The insurers’ TV advertisements backfired, and as a result, the insurance industry had to carry on its costly battle for many more months, until finally the Ways and Means Committee, battered by postcards and complaints from constituents, agreed to drop the provision.

  As the list of givebacks to special interests lengthened, the Treasury Department ran up against its most persistent problem: revenue shortages. The president demanded that his tax plan have a top rate of 35 percent or lower, but that was an awfully expensive demand—costing more than $250 billion over five years, by one estimate. Enough tax preferences had to be curbed to raise that money. As Treasury officials tossed out the loophole-closing provisions from Treasury I, they soon found themselves deeply in the red. The new tax system had to raise as much money as the existing system, and it became increasingly difficult to make the numbers balance.

  Estimating the revenue effects of tax changes is a tricky business. Sometimes, the estimates are a matter of simple arithmetic. Other times they require intricate mathematical calculations, based on large amounts of detailed tax data spun through long and elaborate econometric computer models. More often than not, the estimates also require some very sophisticated assumptions about the complex set of interrelationships that make up the U.S. economy. Who can know, for instance, how a change in the treatment of horse-breeding tax shelters will alter reproduction on stud farms? Who can guess the extent to which limits on consumer-interest deductions will cause people to refinance their homes to circumvent the limits?