The 1986 tax reform that lowered rates by closing loopholes

Check your wallet. A politician walks up and says: I will lower your tax rate, and all I ask is that you give up your favorite deduction. Every sensible taxpayer's hand goes there on instinct. Yet in 1986 a Republican President and a Democratic House Ways and Means chairman, who agreed on very little else, sold exactly that deal to the country and to Congress, and it passed. The law that resulted, the Tax Reform Act of 1986, cut the top individual rate to 28 percent, cut the corporate rate from 46 to 34 percent, and killed off a whole industry of tax shelters, and it was signed by Reagan on October 22, 1986.

I want to tell you how that happened, because it is the only time in modern American history that both parties agreed to make the tax code both simpler and lower at the same time. Then I want to be straight about what the law did not do: it did not stay put. If you want to know what a modern tax reform must copy, you have to look at the bargain, the actors, and the reason it frayed.

The code Reagan inherited

Start with the ugly truth about the tax code of the early 1980s. Rates had come down with the 1981 law (see reagan's 1981 tax cut and the quiet end of bracket creep), but the code was still dense with provisions that rewarded how you earned your money rather than how much of it you earned. The individual schedule had 14 brackets from 11 to 50 percent. On top of the rates sat a thicket of deductions, credits and special treatments, and the most notorious were the tax shelters.

Here is a hypothetical to show the mechanism, simplified. A dentist in the 50 percent bracket puts $20,000 into a real estate or equipment partnership. Through depreciation and borrowed money, the partnership hands him $40,000 of paper loss in year one, and he deducts it against his dental income. At a 50 percent rate, a $40,000 deduction cuts his tax bill by $20,000 (0.50 times $40,000). In year one he is a dollar ahead on his investment, on a project that never had to turn a profit. The cash flow was a gift from the Treasury, and the project was picked because of the gift, not because it was needed.

That is how an economist sees a shelter: money flowing to what saves tax rather than what makes sense. A fair-minded person sees a second problem. The man with a tax lawyer in 1984 could shelter income, while his neighbor with a W-2 could not. Everyone knew that some high earners paid little or nothing. The code's rates said 50; its practice said something else. That was an offense against a basic conservative principle, which holds that law should apply to people equally and be understandable by the people it governs.

Where the idea came from

The reform did not start with Reagan. Two Democrats, Senator Bill Bradley of New Jersey and Representative Dick Gephardt of Missouri, introduced the Bradley-Gephardt plan in the early 1980s: far fewer brackets, lower rates, and most of the deductions and preferences repealed. A pair of Republicans, Representative Jack Kemp and Senator Bob Kasten of Wisconsin, introduced a rival flat-leaning plan. For the conservative side of this, see Jack Kemp, the quarterback who sold the party on growth. Here was a strange sight: Democrats and Republicans offering competing versions of the same idea.

In his 1984 State of the Union address, Reagan asked the Treasury to study simplification. Treasury produced a report in November 1984 under Secretary Donald Regan, a plan that radically rewrote the code and that the business lobbies hated on sight. After the White House shuffle in early 1985, when James Baker moved to Treasury and Regan became chief of staff, the administration produced a revised version in May 1985. Reagan took it on the road. His pitch was a populist one, and populism was what the moment needed: a code where the plumber and the lobbyist paid by the same rules.

The Washington cast

Every bill that works has a few people who made it work. Here are the ones to know.

1. Dan Rostenkowski of Illinois, the Democratic chairman of the House Ways and Means Committee, a Chicago machine product who was no one's idea of a reformer. He decided that this was his chance to leave a monument and drove a bill through his committee by the end of 1985.
2. Bob Packwood of Oregon, the Republican chairman of the Senate Finance Committee, who came to the idea late. His committee spent the spring of 1986 stuck on one question: how do you pay for lower rates when every deduction has a defender? Eventually Packwood went back to basics, wiped out many preferences, and got a bill out of the committee with an unanimous bipartisan vote.
3. Reagan, who did what presidents do best: he made it politically expensive to oppose the idea in public. In December 1985 the first House vote went wrong; most Republicans voted against the procedural rule that would have taken the bill to the floor, and the whole thing nearly died. Reagan went to Capitol Hill himself and pleaded with his own party, and the bill moved.
4. Bradley and Gephardt, who supplied the intellectual spine and cover on the Democratic side.

Notice what is unusual. This law was made with a Democratic House and a Republican Senate. Neither party could pass it alone. The pressure that worked was that nobody could be left looking like the defender of loopholes.

The bargain, in numbers

The final law was hammered out in a conference committee in the summer of 1986. Its major pieces:

1. Individual rates: the fourteen brackets from 11 to 50 percent became basically two, 15 and 28 percent. There was a "bubble" in the middle, a band of income where the benefit of the 15 percent rate and the personal exemption was phased out, so that a taxpayer in that band faced a marginal rate of 33 percent before dropping back to 28. Nothing in life is simple.
2. Corporate rate: from 46 percent to 34 percent.
3. Personal exemption and standard deduction: both were raised, taking a good number of low-income families off the income tax rolls.
4. Capital gains: the 1981 preference was eliminated; gains were taxed at the same rates as other income, with a top rate of 28 percent. That is a point Republicans who tell the story as a pure tax cut often skip, and it matters.
5. Passive loss rules: this is the section that killed the shelter. The new rule said that a loss from a "passive activity," like a limited partnership in which you did no real work, could be deducted only against passive income, not against your wages or practice. There was a limited allowance for rental real estate in which an owner took an active part. Under the old code, my hypothetical dentist deducted his paper loss against dental income. Under the new one, he could not.
6. Investment tax credit: repealed.
7. Depreciation: schedules for business property were lengthened.

Do the arithmetic on the shelter. At a 50 percent rate, a $40,000 deduction saved $20,000. At a 28 percent rate it would have saved $11,200 (0.28 times $40,000). The value of each dollar of deduction fell from 50 cents to 28, a drop of 44 percent (22 divided by 50). Lower rates did half of the work of killing the shelter; the passive-loss rule did the rest. Rate cuts and base broadening reinforced one another, which is the entire theory behind the bargain.

The theory: a broad base lets low rates raise the same money

Why would anyone give up deductions for a lower rate? Because the arithmetic of revenue is the rate times the base. If the base is full of holes, you need a high rate to raise a given amount. Fill the holes and you can lower the rate and still raise the same money. The policy was meant to be roughly revenue-neutral, with individuals getting a net cut and corporations picking up more of the bill, thanks to the loss of the investment credit and the slower depreciation.

The best argument against the bargain deserves an honest hearing, and its source is conservative. Some on the right argued that this was the wrong trade: the code's special treatment of savings and investment is not a loophole but a correction, because an income tax double-taxes saving, and a consumption-style system would be better. Others said losing the capital gains preference would hurt investment. These are real arguments, and the debate over a flat tax or a consumption tax continues. My answer: a politician has to pick the best deal that can pass. A deal that lowered the top rate from 50 to 28 percent, cut off the shelters, and treated the lawyer and the plumber the same was a deal that moved the target in the right direction.

Why rates crept back

The honest part of the story is the ending. The rates did not stay at 15 and 28 percent. Four years later, the 1990 budget agreement under George H. W. Bush raised the top individual rate to 31 percent; the story of that deal and its political price is told in Read My Lips and How the 1990 Budget Deal Led to the 1992 Defeat. In 1993, under President Clinton, new brackets of 36 and 39.6 percent were added. The loopholes crept back as well, one lobbyist at a time, because each carve-out has a constituency and each new Congress has a donor list.

What does that teach? Three things.

1. A reform is a bargain, and bargains need enforcement. The 1986 coalition held together for one bill and dissolved afterward. Nothing in the law kept a later Congress from raising rates or reopening the base.
2. The base is harder to defend than the rate. A rate is on a bumper sticker. A deduction has a trade association. Loopholes return because their friends are organized and their victims are diffuse.
3. Revenue-neutral reform needs someone who loses. In 1986 the losers were real-estate syndicators, certain industries and shelter promoters. A reform without losers is not a reform; it is a tax cut with a nicer name.

What a modern reform would have to copy

If you want to be serious about this, there are lessons in the 1986 playbook.

• Start with a public blueprint. The Treasury's 1984 report started the conversation. Everyone could argue about a document.
• Make both parties own it. The law only passed because Rostenkowski and Bradley could say it was theirs.
• Pick a number and hold to it. The lawmakers set the top rate first, then paid for it by repealing preferences. The reverse approach never works, because each preference has a friend.
• Make the losers public. A reform in which every group keeps its favorite exemption is a reform of nothing.
• Decide what to do about saving. The 1986 law taxed capital gains as ordinary income, which many conservatives would not accept today. Any modern copy has to settle this one in the open.

The 2017 law shared some of these features and not others, which you can judge for yourself in five changes in the 2017 tax law that reached the kitchen table. And if you want to be armed against the popular misinformation about all of this, seven tax myths that scare working families and cost them money is a useful start. For a rate-by-rate comparison with the 1981 law, see The Reagan Tax Cuts Rate by Rate and the Tax Reform of 1986.

The rebuttal to the cynic

Somebody at your table will say: "Reform never works. They always bring the loopholes back." The argument has a true premise and a false conclusion. The loopholes did come back. But the shelters of the early 1980s did not, at least in anything like their old form, because the passive-loss rule remained in the code for decades. A reform that lasts in part is still better than no reform. Lower rates for working families lasted for years. And the principle that a tax code should treat people alike remains a standard you can hold Congress to. You can use that standard today.

There is a second cynic, on our own side, who says Reagan gave away too much by signing a bill that raised the tax on capital gains and shifted a larger share of the load onto corporations. I take that argument seriously. A President who signs a bill gets the whole bill, the parts he likes and the parts he swallows. But weigh it against the alternative that was actually on the table in 1985: not a perfect conservative code, but the old one, with the shelters, the 50 percent top rate, and a Democratic House content to leave it alone. Politics is the art of the available, and the available deal in 1986 left working families with a lower rate, a bigger exemption and a code with fewer places to hide. When someone on the right says a deal was impure, ask what number it replaced and who was in the room. Purity is a fine thing to have at a rally. It has never yet passed a Ways and Means Committee.

The bottom line

• The Tax Reform Act of 1986, signed October 22, 1986, cut the top individual rate to 28 percent and the corporate rate from 46 to 34 percent, and paid for it by ending shelters and preferences. Its logic was simple: a broad base lets a low rate raise the same money.
• It passed because both parties owned it. Reagan, Rostenkowski, Packwood, Bradley and Gephardt are the names to remember, and the lesson is that a big reform needs the other party's fingerprints on it.
• Rates did not hold. Later Congresses raised them and reopened the base. When a politician promises a simpler code, ask what stops the next Congress from undoing it.
• Judge any modern tax plan by the 1986 test: does it lower rates, does it close something, and who loses? You can read the bill text yourself on our bills page or at Congress.gov.
• Take a hard look at your own deductions. If you would trade one for a lower rate, you are already a tax reformer.