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CPR for Tax Reform

Monday, September 1, 1997

The Tax Revolt That Failed
William A. Niskanen

The tax revolt that began 20 years ago has so far been a failure. For all the sound and fury over tax cuts, the average rates of federal, state, and local taxation are slightly higher than 20 years ago. True, top marginal rates have fallen steeply, even after accounting for the significant increases of the Bush and Clinton years. But otherwise the modern tax-limitation movement has achieved few of its objectives. This failure continues with the modest and incoherent tax reductions included in the 1997 federal budget agreement.

The modern tax-limitation movement was born in late 1972 when Governor Ronald Reagan convened a small group, of which I was a member, at his Century Plaza office in Los Angeles. Reagan observed that, notwithstanding the recent landslide re-election of a Republican president, conventional political processes would be insufficient to restrain the growth of government spending. Indeed, even real spending in Reagan's own state was growing at a record rate during his tenure as governor of California. He asked us to consider an unconventional measure--a constitutional amendment to limit the spending and taxing authority of the state government.

A committee of his advisers drafted a ballot initiative for a state constitutional amendment, called Proposition 1, to limit the spending and taxing authority of the state of California. The first political tests of these proposals were discouraging. Proposition 1 lost narrowly in 1973, and a similar amendment was defeated in Michigan in 1976. The first "supply-side" tax-cut proposal, offered as a substitute for President Carter's fiscal stimulus proposal, was defeated in Congress in 1977.

The breakthrough for tax limitation came in 1978, when Tennessee passed a general spending and tax-limitation amendment. California voters then approved Proposition 13, an amendment that substantially reduced local property tax rates while also, unfortunately, centralizing school authority and financing. Soon thereafter, Michigan voters approved a general spending and tax-limitation amendment. In later years, similar amendments were approved in six other states.

Breakthroughs in federal fiscal policy also occurred in 1978. Congress approved a reduction in the capital-gains tax rate over the opposition of the Carter administration. The Senate also approved a measure that combined a 30 percent cut in income-tax rates with a general limit on federal spending; it withered under Carter's veto threat. The annual report of Congress's bipartisan Joint Economic Committee endorsed this new supply-side fiscal policy in both 1979 and 1980. In 1980, the Senate Finance Committee approved a tax measure very similar to that proposed by Reagan, then a presidential candidate. A bipartisan consensus for the tax cuts later proposed by President Reagan formed before he was even inaugurated.

The growing tax revolt led to the Economic Recovery Tax Act (ERTA) of 1981, the first major reduction in federal tax rates since the Kennedy years. This legislation reduced federal income tax rates from a range of 14 to 70 percent to a range of 11 to 50 percent, indexed the personal exemption and tax brackets for inflation, and included a complex package of investment incentives.

Since 1981, however, Congress has enacted six major changes in federal tax policy, and here the record is mixed. Most of the investment incentives in ERTA were reversed in 1982, 1984, or 1986. The social-security legislation of 1983 accelerated a scheduled increase in payroll tax rates. The major tax-reform legislation in 1986 broadened the tax base, increased the personal exemption, and set two income-tax rates of 15 and 28 percent. After that, however, the pattern of rate reductions reversed. President George "no new taxes" Bush signed a 1990 tax bill that increased the top rate to 31 percent. And the Clinton tax legislation of 1993 increased the top income-tax rate to 39.6 percent and, by broadening the Medicare tax base to all earnings, increased the top rate on earnings to 42.5 percent.

All this legislative turmoil has made little difference to taxpayers. As Figure 1 illustrates, average tax rates as a percentage of net national output of goods and services have been remarkably stable since 1978. A much finer scale (Figure 2) is necessary to identify any significant trend or variation. Average federal tax rates have risen and fallen with little apparent trend; most of the variation has been due to changes in the employment rate and (before 1985) to the inflation rate. Contrary to the charge that the Reagan tax cuts eroded the federal revenue base, the average federal tax rate was slightly higher in 1989 than at a comparable stage of the business cycle in 1979.

The average state and local tax rates, in contrast, have been less variable but have increased slightly over this period. Overall, the average total tax rate has stayed essentially the same over this period, in part because the average federal tax revenues tend to move in inverse, cyclical relation to average state and local tax revenues.

The composition of taxes has also not changed very much. Figure 3 illustrates the average tax rates (also as a percentage of net national output) by major type of tax. Average individual income-tax rates are about the same as at the beginning of this period, although lower than the inflation-affected rates of the early 1980s. Average payroll-tax rates increased by more than 1 percentage point of national output by 1988 and have been roughly stable since then. The sum of all other types of taxes (on corporate income, sales, property, excises, and so on) has been a roughly stable share of national output over this period; some decline in the average corporate and property tax rates have been offset by an increase in the average sales tax rate.

The most important change in taxes during this period has been the structure of federal tax rates on labor income (Figure 4). The top marginal tax rate was sharply reduced by both the 1981 and 1986 tax laws, though it has increased by 14.5 percentage points since 1990. For lower-income workers subject to both the payroll tax and the individual income tax (but ineligible for the earned income tax credit), however, the effective marginal tax rate has risen by about 4 percentage points. For the five years from 1988 through 1992, the marginal federal tax rate on labor income was roughly flat for all brackets (except for a fairly small group of middle-income taxpayers subject to both the payroll tax and the 28 percent income tax rate). The tax revolt, in other words, did reduce substantially the progressivity of federal tax rates, but even this gain has been mostly offset in recent years.

Some of my friends suggest that the tax limitation movement has at least succeeded in stopping the growth of taxation, even if it hasn't led to actual reductions. Maybe so, but that is a difficult hypothesis to test. Maybe the reduction in marginal tax rates makes the whole effort worthwhile, but again that is difficult to test because economic growth is also affected by a number of other conditions. In fact, productivity growth during this period, at least as conventionally measured, has been much lower than during the 1960s, so the economic advantage of lower marginal tax rates has been insufficient to offset other conditions that hurt productivity growth. But this analysis is complicated, because our conventional measure of output understates productivity growth.


The failure to reduce government spending relative to
national output is the primary reason for the
stability of average tax rates.


 

Four major lessons can be learned from the failure of the tax revolt over the past 20 years:

  • Tax cuts are unlikely to last unless they are matched by a reduction in government spending. The failure to reduce government spending relative to national output is the primary reason for the remarkable stability of average tax rates over the past 20 years. Any substantial tax cut should be made contingent on a roughly equal reduction in government spending.
  • Tax cuts do not necessarily lead to reduction in government spending. The issue of whether government spending rises or falls in response to a reduction in tax revenues has been debated and tested for this whole period without resolution. Nobel laureates Milton Friedman and James Buchanan are on opposite sides of this issue, and the empirical studies are also mixed. My own recent statistical estimates conclude that changes in real total federal spending between 1949 and 1996 were independent of prior changes in real total federal revenues. If tax cuts do not reduce government spending, of course, and end up increasing the budget deficit, they shift part of the burden of current spending to the next generation.
  • Tax cuts do not necessarily increase economic growth. The net economic effect of a tax cut depends on the type and rate of the tax, the type and level of spending that is reduced, and whether government subsequently alters its borrowing; the net effect may help or hinder growth. To increase economic growth, we should reduce those marginal tax rates that have the largest negative effect per dollar of tax revenue-combined with a reduction of spending for those programs with the lowest marginal value.
  • A narrow focus on tax cuts is not a sufficient economic program for the Republican party. Sooner or later, there is no way to avoid taking a position on what types of taxes to cut, what spending programs should be reduced, under what conditions a deficit may be appropriate, and the variety of other policies that affect the economy. A general bias in favor of tax cuts is commendable, but Republican politicians are often perceived as "Johnny One Note"s, proposing some type of tax cut to address almost any problem. The incoherent mishmash of the tax cuts in this year's budget deal is only the latest example of this problem.

The trivial tax cuts in the 1997 bipartisan budget agreement make it clear that the tax revolt has run out of steam at the federal level. But the tax revolt is reviving in the states. Almost all of the state constitutions require that the operating budget be balanced, and a large number of states now have a constitutional or statutory tax limitation. Increasing concern about interstate competition, and prodding by the Cato Institute's annual "fiscal report card," has recently led some of the highest tax states such as New York to reduce their tax rates. Twenty-five governors have proposed net tax cuts for the coming fiscal year. If this momentum is to be sustained in the states, and returned to the federal government, it will have to be accompanied by serious efforts to reduce government spending.

William A. Niskanen is the chairman of the Cato Institute and a founder of the National Tax Limitation Committee. He was a member of President Reagan's Council of Economic Advisers.


Tax Reform at the Grass Roots
Grover Norquist

In the 1970s Representative Jack Kemp and Senator Bill Roth, flanked by the Wall Street Journal editorial page and leading neo-conservative intellectuals, marched supply-side tax cuts through the institutions of the Republican party. In 1980, Ronald Reagan, who had run for president in 1976 as a budget cutter, based his winning campaign on a "tax cut of 33 percent."

It has now been 16 years since Republicans have delivered any tax cuts at the national level. Between now and then there have been many reversals and betrayals: the 1982, 1983, and 1984 tax hikes, Bush's broken pledge in 1990, and the failure to stop the Clinton tax increase in 1993.

Now the tax revolt is gathering national momentum again. A Republican Congress is about to pass a modest tax cut that a Democratic president has promised to sign into law. And four decisions by the Republican leadership this year have put the tax issue front and center as a winning issue for the future.

The first was the announcement by Speaker Newt Gingrich and Senate Majority Leader Trent Lott that the Republican party is committed to abolishing the estate tax and the capital gains tax on savings and investment. In the past, Republicans had timidly called for small reductions in both levies, sounding like special pleaders asking for a loophole. Gingrich and Lott elevated the call for abolition to the level of principle: It is wrong to double-tax and triple-tax savings and investment; it is wrong to ask any American to visit the undertaker and the IRS on the same day. Republicans and taxpayer activists are now establishing coordinating committees in each congressional district dedicated to abolishing the estate and capital gains tax.

The second breakthrough was the announcement by Gingrich and Bill Archer, the chairman of the Ways and Means Committee, that the Republican leadership is committed to introducing tax-cut bills every year. President Clinton may veto tax cuts that are passed. But taxes, Archer has announced, are going in only one direction: down.

The third revolutionary change was Congress's decision to hold an annual vote on a constitutional amendment to require a two-thirds vote of both chambers to raise any taxes or to impose any new ones. This amendment, already in place in 10 states, will protect tax cuts from repeal and stop the imposition of new taxes.


The tax is gathering national momentum again;
four decisions by Republican leaders have put
the tax issue front and center.


Fourth, the flat-tax idea promoted by House Majority Leader Dick Armey and Senator Richard Shelby and introduced in the 1996 presidential primaries by Steve Forbes has now become a consensus issue within Republican ranks. Republicans are now preparing to hold a three-year debate about the advantages of moving to a flat-rate income tax or to a national retail sales tax. Republicans now agree on moving to a single-rate tax that taxes income only once. No matter what the outcome of the internal Republican debate on how best to scrap the present system and cut the tax burden, taxpayers cannot lose.

These four initiatives are also moving forward at the state level, where Republican governors are eliminating estate taxes, passing annual tax cuts and, in places such as Arizona and Connecticut, proposing radical reforms such as abolishing the state income tax altogether. State legislators and governors are lashing themselves to the tax-cut mast by signing the Taxpayer Protection Pledge against any and all tax hikes. The Taxpayer Protection Pledge now has 203 signers in the House of Representatives and 40 in the Senate. State taxpayer groups in all 50 states have challenged state legislators and governors to sign pledges against all state tax hikes; 767 state legislators have signed it to date--10 percent of all state legislators.

If Republican leaders keep their commitments, the modest tax cut of 1997 will be only the first step. Tax reduction will once again be at the center of American political debate.

Grover Norquist is the president of Americans for Tax Reform, in Washington, D.C.


Guiding Principles of Tax Reform
Grace-Marie Arnett

The National Commission on Economic Growth and Tax Reform, chaired by Jack Kemp, issued a report on January 17, 1996, after months of hearings and analysis of the tax system. The Tax Reform Commission recommended that the current 7-million-word Internal Revenue Code be repealed in its entirety and replaced with a simpler, fairer system.

Although the Tax Reform Commission recommended a single low rate, taxing income only once, it did not recommend a specific rate of taxation. But the Commission did offer a set of principles to guide major tax reform. The following are excerpts from the commission's report on principles for a new tax system.

The present tax system is beyond repair: It is impossibly complex, outrageously expensive, overly intrusive, economically destructive, and manifestly unfair. It is riddled with special-interest tax breaks, and it over-taxes both labor and capital.

A new tax system should be created that is based upon a vision of America that places the individual--not the government--at the center of society. It should recognize that government doesn't create opportunity; citizens do, if only government will get out of their way.

We begin by asking what a tax system should accomplish. A fair and simple tax code must generate sufficient revenue for the federal government to carry out its legitimate tasks. It must not place a tax burden on those members of society least able to bear one. And, perhaps most important of all, it must not restrict the innovative and entrepreneurial capacities of Americans upon which rising living standards and our general prosperity so greatly depend.

Before devising a new tax system, the American people must engage in a dialogue about the basic principles upon which the new system will be based. The Tax Reform Commission developed six working principles for a 21st-century tax system. It developed these principles after hearing thousands of comments and concerns from the American people and after systematically reviewing the current tax code. These are not isolated ideas, but rather principles that link together to form a sequence--a chain of economic DNA--that can renew the health of our economy and release the entrepreneurial spirit of the American people.

Economic Growth. The engine of opportunity and prosperity can only be unleashed by a tax code that encourages initiative, hard work, and saving. Expanding opportunity, prosperity, and social mobility form the foundation of a free and healthy society. None of the myriad challenges confronting our nation--poverty, crime, racial tension, welfare dependency, or the budget deficit--can be solved without strong economic growth. Therefore, any new tax system must be predicated, first and foremost, on a commitment to revitalizing the American economy and lifting barriers to opportunity.

Fairness. A system must be based upon treating all citizens equally. The current code--with its proliferation of rates, deductions, exemptions, and transfers of wealth from one constituency to another--contributes to the overwhelming conviction of many Americans that the present system is unfair. By restoring basic fairness, we can restore faith in the system and keep the tax rate low.

Simplicity. The system should be simple enough that anyone can figure it out. Filing tax returns has become one of life's most nerve-wracking, gut-wrenching, and mind-numbing chores. The authors of The Federalist Papers warned, "It will be of little avail to the people that the laws are made by men of their own choice if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood." A simplified, fairer tax system will let Americans get a handle on their taxes, a grip on their government, and a hold on their future.

Neutrality. A fair tax system should not pick winners or losers, or tax saving more heavily than consumption. The tax system should free people to make decisions based upon their own needs and dreams. The tax code should be used to raise revenue to operate the government while doing the least possible damage to the economy. As Senator Robert Bennett of Utah pointed out, "Neutrality means that the tax code should not be used to punish the bad guys and reward the good guys. We have other laws for that." Unfortunately, the current code strives to act as an economic traffic cop-giving green lights to certain economic activities and flashing red lights at others.

Visibility. Everyone deserves an honest accounting of government's cost. Those who pay the price of government have a right to see the bill. The current system hides the cost of government behind a chronic deficit and a maddening multiplicity of taxes--many of which are virtually invisible to the taxpayers who pays them. The invisibility of many taxes perpetuates the fantasy that government is free--even as its real costs shrink our paychecks, sap our savings, drain our economy, and inflate the federal budget deficit. Goods and services don't pay taxes. People do. A visible system gives taxpayers an honest accounting of the expenses of government that they are paying for and will make it far more difficult for politicians to tinker with the tax code without democratic consent.

Stability. People ought to be able to plan for their futures without the rules being changed in the middle of the game. Uncertainty has a debilitating effect on the economy, making it very difficult for families and businesses, particularly small businesses, to plan for their future with confidence. A stable tax code must allow individuals to start a business, buy a house, take out a loan, put money into savings, or plan for their children's education without fear of what might lurk behind the next election cycle.


Any new tax system must be predicated on
a commitment to revitalizing the American economy
and lifting barriers to opportunity.


In his last public address, Abraham Lincoln said, "Important principles may and must be inflexible." By laying out these important principles, this commission hopes to help build a future of growing prosperity for many generations to come.

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