December 1, 2023

High & Low Finance: A Starting Point for Tax Reform: What Reagan Did

Tax Reform report of the Treasury Department to President Ronald Reagan, November 1984

As Washington grapples with the budget, it might be worth asking a simple question: What would Ronald Reagan do?

He was the last president to preside over a significant tax reform, one that did exactly what both candidates in this year’s presidential election said they want to do: lower tax rates and close loopholes.

And a critical part of that reform was to end the historical system of taxing capital gains at lower rates than ordinary income.

In the name of fairness, the Tax Reform Act of 1986 raised the maximum tax rate on long-term capital gains to 28 percent from 20 percent at the same time it reduced the maximum rate on ordinary income to 28 percent from 50 percent.

Doing that again in a tax reform act of 2013 would do more than raise revenue and increase fairness. It would bring an abrupt end to the “carried interest” tax dodge, in which managers in the private equity business are able to define their compensation as capital gains and thus pay far lower income tax rates than do ordinary people with far less income.

Ideally, there will be two tax reform efforts in the next 18 months.

The first, going on now, is a simple patch-up, aimed at dealing with the pending increases in taxes brought on largely by the expiration of the Bush “temporary” tax cuts. If the lame duck Congress and President Obama can avert disaster, raising some revenue while not devastating the economy, they will have succeeded.

But the next move should be aimed at comprehensive tax reform. The Obama administration should look to President Reagan’s second term for inspiration. The Reagan method included a comprehensive, well-thought-out proposal that dealt with the myriad details that can rise up to frustrate any efforts at change, put together painstakingly by the Treasury Department.

Then there was a bipartisan effort to get it through Congress, with inevitable compromises but with clear goals in mind.

The proper way to approach that proposal is to accept that the government needs to raise a certain amount of money. There can be differences over spending, obviously, but there should be consensus that whatever decisions are reached, the tax system adopted should be expected to finance those expenditures over an economic cycle, with deficits in difficult economic times and surpluses in good years.

With an agreement that taxes should raise a certain amount of revenue — presumably expressed as a percentage of G.D.P. — then the debate on actual tax policies can take place in an atmosphere very different from the ones we have had in the past. Every tax deduction and every tax exemption should be viewed not just as giving a break to whatever deserving group has hired a good lobbyist but as forcing the rest of us to pay more.

One way to do that would be to calculate a system, based on a simple progression of tax rates, without any deductions or exclusions, that would produce the needed revenue. Then the debate over each tax break would include a discussion of just how much the rates would have to rise if that break were granted for those who can take advantage of it.

Do you want to preserve the deduction for interest on home mortgages, in the name of encouraging homeownership? Fine. Just understand that it would raise the marginal tax rate for every one of us by a certain number of percentage points. The same goes for charitable deductions, or not taxing certain fringe benefits like the cost of health insurance premiums.

With that in mind, we come to the capital gains tax break. It is defended as critical to economic growth and prosperity, on the theory that without it money will not be invested. But the empirical data to back that up is lacking, to say the least. Over the last 30 years, the economy and the stock market has tended to do better when the capital gains rate was high.

That does not prove causation, of course. But if the data went the other way you can be sure supporters of low capital gains rates would be citing it.

It also needs to be understood that the current system ends up discriminating against many who own stocks and mutual funds and thus receive capital gains and dividends. If your investments are in retirement plans, like 401(k) accounts, the profits are not taxed until the money is taken out. And then the money is taxed at ordinary income tax rates, regardless of whether it originated as capital gains.

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